Crude oil prices remain a key determinant of global economic scenario. Higher prices distress the global economy via an array of channels.

● There is a reallocation of earnings from oil consumers to oil producers. As oil producers have a lower propensity to consume than oil consumers on average, global demand falls.

● The cost of production of goods and services rises, possibly reducing profit margins. In the case of advanced countries, this supply-side effect, which was sizable during the 1970s, has fallen in the past three decades in line with their reduced dependency on oil.

In contrast, for developing countries, which have not reduced their dependency on oil as much as industrial nations, the supply-side impact are likely to be relatively higher.

● Inflation rises by an amount that depends on the degree of monetary tightening associated with the oil price rise and the extent to which consumers and producers can offset the declines in incomes and profits, respectively.

● Associated movements in actual and anticipated economic activity, corporate earnings, inflation, and monetary policy affect equity and bond valuations, causing financial markets to react adversely to higher oil prices.

The follow-on effects in terms of investor confidence and willingness to commit to longer-term capital projects may lower growth prospects further.

● Depending on the duration and extent of the price increases, the change in relative prices creates incentives for suppliers of energy to increase production and investment, and for oil consumers to move toward other sources of energy.

Estimates of the impact of oil price shocks on the global economy suggest that a US $ 5 increase in oil prices would reduce global growth by about 0.3 percentage point after one year.

Higher dependence on oil

The overall response of a specific region or country differs depending on the relative importance of the short-run links between activity and oil prices indicated above, as well as the underlying flexibility of individual economies to absorb shocks.

The estimated impact is higher in the United States and euro area, about 0.4 percentage point, largely because of their higher dependence on oil and, in the case of the euro area, rigidities in labor markets that limit the pace and extent of real wage adjustments.

The impact on the group ?other industrial countries? is smaller because the largest two members, the United Kingdom and Canada, are net oil exporters. The negative impact on Japan at 0.2-percentage point is smaller than other industrial countries because of high efficiency in energy consumption and heavy reliance on nuclear power.

For emerging market economies, the negative impact on Asia is the largest at 0.4-percentage point because of a larger presence of net-oil-importing nations in its aggregate economic activity. Africa and emerging Europe are less affected by the shock owing to the larger influence of net oil exporters.

Labour market rigidities

While oil exporters clearly stand to benefit from the direct impact of higher oil prices, lower domestic demand and substantial second-round effects cause overall activity to decline for some oil exporting countries.

Turning to the price level effects of higher oil prices, core inflation rises in all countries, with the magnitude depending in part on the extent of labor market rigidities. Last year, futures prices implied an average 2004 oil price of around US $ 37 a barrel, or about US $ 8 (or 30 percent) a barrel higher than average 2003 levels.

The estimated impact of the US$8 increase on the net trade balance for advanced countries in 2004 is at about 0.3 % of GDP, which is less than one-tenth of the average effect attributable to the two oil price shocks in the 1970s.

The smaller impact reflects both the reduced dependency of industrial countries on crude oil compared with the 1970s and the significantly smaller percentage increase in nominal crude oil prices relative to the oil price shocks of the 1970s.

Nitish Benimadhu Your comments are most welcomed: [email protected]