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Effect Of Fuel Prices On Gross Domestic Product Economics Essay

5214 words (21 pages) Essay in Economics

5/12/16 Economics Reference this

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Gross Domestic product is defined as the total market value of all final goods & services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, subtract the value of imports, and it can be effected by the fuel prices.

Prices of Petroleum start rising from 2003 and it was almost doubled in April 2006, too many reasons were involved like Demand and supply problems and economic condition in US.

Oil prices shocks have a stagflation effect on the macro economy of a country who imports oil, they just slow down the growth rate may even reduce the output level and they lead to an increase in the level of price and capable of an increase in the inflation rate. An oil price hike have an effect like a tax on consumption and for a country like United States who import oil the tax benefits go to oil producers rather than the U.S. government (Brad Setser, 2004).

Price of oil is an important issue for the world economies today and its attendant consequences on economic output. The relation between oil prices and levels of economic activity has been a subject of attention. In the past in United States the increase in oil prices led to economic recession (O. Felix Ayadi, 2005).

Global demand for oil grew due to economic conditions in the US, as well as strong economic performance in developing Asia from last couple of years. 1.3% of grew rate noted From 1990 to 2003 world demand while 7% for the People Republic of China and India (combined) at and accounted for almost 40 percent of the demand growth(Afia Malik, 2008).

Oil prices have increased dramatically in the recent years. This analysis is upon the increase of this oil prices on Chinese government because it is the second largest consumer of Oil after the USA therefore the increase in the price of the oil can have macro economic effect upon the Chinese economy.

China occupies an important and a major role in the international market and a change in its economic activity can influence world growth. So change in the consumption of oil by china can misbalance these markets (Sana Zaouali, 2007).

Whenever fuel prices increased automatically we see a change in the prices of everything just because of whenever fuel prices increase automatically fare increase, when fare is increased its effect everything.

In US, there have been many studies upon oil prices shocks on aggregate economic activity. One such study was by Hamilton (1983) who said that post war recessions in US were due to these shocks.

1.1 Research Problem

Countries economy can be influenced by the fuel prices, in Asia whenever country government change first step they take to balance the expenses is change and raise the fuel prices in response price of everything change.

According to Hunt et al (2001), an increase in oil prices can influence the economy through many channels, including the following. The first mechanism reflects the transfer of income from importing to oil exporting countries, which leads to a decrease in global demand in the oil-importing nations. The demand decrease in the oil-importing countries outweighs the increase in the oil-exporting countries because of an assumed low propensity to consume in the latter. Secondly, given the level of capital stocks and assuming that wages in the short run are relatively inflexible. An increase in input costs of production resulted in non-oil output being effected. Note that crude oil is a basic input in production and an increase in oil prices leads to increase in cost of production. The third channel is when workers and producers resist a decrease in their real wages and profit margins. This results in upward pressure on labor costs and prices (O. Felix Ayadi, 2005).

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The exchange rates & balance of trade between countries also change due to increase in fuel prices, Net fuel importing countries put downward pressure on exchange rates and experience gradually worse in their balance of payments, Result imports become expensive and exports value decrease leading to drop in real national income.

The economic & energy policy response to combination of lower real output, high inflation, low exchange rates, higher unemployment and also affects the overall impact on the economy in the long term (International Energy Agency, 2004).

1.2 Justification of Research

The most important single issue confronting a growing number of world economies today is the oil price and its attendant effects on economic output (O. Felix Ayadi, 2005).

Overall for global economic performance fuel price stays an important determinant, Fuel price increase results to income transferred through a shift in the trade terms from importing to exporting countries.

Higher oil prices lead to inflation, increased input costs, reduced non-oil demand, lower investment in net oil importing countries.(International Energy Agency, 2004).

China occupies a preponderant place on the international scene, and a large drop in its economic activity could significantly effect world growth. It, therefore, is important for us to ask what the impact of the current increase in oil prices on the Chinese economy might be (Sana Zaouali, 2007).

1.3 Scope

This work examines the linkage between fuel prices, Economic development of country and GDP gives us the idea what effect can be done on GDP if the fuel prices increase or decrease or which effect the GDP more.

This study attempts the following:

Find out how much fuel prices are effecting the GDP.

Find out which fuel is effecting more the GDP and Economy of country.

1.4 Limitation of Research:

There were number of limitations in this research:

Lack of information and data bases on history of the Pakistan.

The data collection was restricted no one have the complete data.

Only 3 year’s Limited data available.

It is up to upcoming researcher to find out the other possible causes of such findings that this research explored.

1.5 Research Methodology

The research is aimed to find out how much fuel prices are effecting the GDP or are they effecting or not. Fuel prices and GDP values are taken from April 2006 till August 2008 to find out more accurately, in that period of time fuel prices were changing so frequently.

The multivariate regression function is used and it is applied to asses the relationship between dependant variable and independent variable (Super) through the stepwise method which is applied to test the hypothesis.


This study is organized into six chapters in order to examine the above mentioned research.

Chapter One, the Current chapter, provides a general overview of the study.

Chapter Two presents Literature review of effect of fuel price on GDP.

Chapter Three develop Theoretical Frame work of Hypotheses.

Chapter Four describes fuel price effect in Pakistan.

Chapter Five discusses Research Methodology.

Chapter Six describes Results and Hypotheses Testing.


2.1 The History of Oil Prices

The birth of the modern oil and natural gas industry in the 19th century forever changed the world’s economic landscape, powering massive industrial growth, revolutionizing travel, and changing the way that families live. Today, changes in energy prices reverberate throughout the entire economy, often with dramatic impacts. In 1880-99 the Standard Oil monopoly controlled prices for years, but prices rose as reserves in the Northeast declined. 1980-91 OPEC’s power declined and so did prices, until the 1990-91 Gulf War shot them upward again(swift energy,2006)

In 1998-1999 a flooded market knocked oil prices down to 50-year lows. With OPEC countries lowering their production, prices began to rise in 1999. As history has shown, though, oil prices have rarely stayed stable for long and cyclical prices can be expected for years to come.

Today, the economy is recovering (even if the recovery is in many ways fragile), labor markets, while still very slack are improving, the dollar has weakened over the last year, imported inflation is up (both commodity prices and import prices) and the inflation rate is increasing together with inflation expectations. Thus, the Fed cannot afford to ease further. If anything, some argue that the Fed is already behind the curve in terms having caused a dangerous bubble in asset markets and having moved too slow to stem higher inflation expectations and actual inflation rates.

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Oil prices increase reflects strong demand growth, particularly in Asia, more than any outright falls in supply though the Saudis could have done more to increase their output at the margins, as they are now signaling they do this summer. However for the United States, higher oil prices stemming from an Asian boom act much like higher oil prices from a reduced supply. (Nouriel Roubini, 2004)

2.2 Peak Fuel Theories

Peak Fuel is the point at which the highest possible price of global petroleum extraction reached. If supply cannot increase to meet the rising demand then the Peak fuel point may reach earlier. The effects of the peak fuel point raising fuel prices, first was M. King Hubbert who use peak fuel concepts in 1956 to predict that U.S fuel production would peak between 1965 & 1970.

Optimists argue that technology should advance quickly to create new fields & extract oil at inaccessible prices also that often they underestimate the amount of reserves and the fuel prices rise only to increase return from investing in technology. It’s also argued that raise in prices has not yet reflected in decision of investments there is a significant time slot between fuel prices & investment. The current high fuel prices lead to boom in fuel investment in future, Mr. Simmons (Peak theorist) argues that many predictions of supply of fuel increases are wishful thinking. Evidence by EIA suggested the fuel industry is close to 99 percent capacity and supply is inelastic in relation to price raising this only show that supply constraints are a problem.

2.3 How higher fuel Prices Affect the Global Economy.

For global economic performance fuel prices remain an important determinant. The magnitude of direct effect of a fuel price increase depends on share of the cost of fuel in NI, the degree of dependence on fuel (Imported) and ability of end consumer to reduce their consumption and switch away from fuel. Naturally, bigger the macroeconomic impact if prices increase and longer higher prices are sustained. For fuel exporting countries real national income increases if price increase through higher export earnings, though side of this profit would be offset later by losses from low demand for exports generally due to recession suffered by trading partners.

Fuel price increase also affects exchange rates & balance of trade between trading countries. Net fuel importing countries experience become worse in their payment balances put pressure on exchange rates results, more expensive imports, exports less valuable & leading to drop in real NI without change in central bank & monetary policies. The dollar may likely to rise as fuel producing countries demand for dollar denominated international reserve.

The economic growth boost in fuel exporting countries provided by high fuel prices in time before has always lower than loss of economic development in importing countries and always have negative effect. The world economy growth has always fallen sharply in each big run up in fuel prices including that of 1999 & 2000, Reason is because the tendency to consume of importing countries that lose from high prices is generally higher than that of exporting countries. (International Energy Agency, 2004)

2.4 Quantifying the Impact on OECD countries

OECD countries remain vulnerable to oil-price increases, despite a drop in the region’s net oil imports and an even more marked decline in oil intensity since the first oil shock. Net imports fell by 14% while the amount of oil the OECD uses to produce one dollar of real GDP halved between 1973 and 2002. Nonetheless, the region remains heavily dependent on imports to meet its oil needs, amounting to 56% in 2002. Only Canada, Denmark, Mexico, Norway and the United Kingdom are currently net exporting countries. Oil imports are estimated to have cost the region as a whole over $260 billion in 2003 – equivalent to around 1% of GDP. The annual import bill has increased by about 20 % since 2001.

2.5 Quantifying the Impact on Developing countries and Transition Economies

Developing countries who import oil have adverse economic impact even more pronounced than for OECD countries because of higher fuel prices and the economic impact on poorest countries is very serious. The economies of oil-importing developing countries in Asia and Africa would suffer most from higher oil prices reason is economies are more dependent on imported oil. In addition, energy-intensive manufacturing generally accounts for larger share of their Gross Domestic Product and energy less efficiently used. Idea is oil importing developing countries use twice as much oil to produce one unit of economic output as do developed countries.

Cost of oil imports relative to Gross Domestic Product is particularly high in Africa. 14% spent in 2000 of their GDP on oil imports by Sub Saharan African countries. As a result sharp up and downs in fuel prices can lead high shifts in their present balance account, often amounting to be more than 1 percent of Gross Domestic Product. This leads to a sharp economic adjustment involving sharp contraction in consumption, reason is these countries have limited access to international market to finance a not lasting increase in the present deficit account. (International Energy Agency, 2004)

There exists a large literature on the macroeconomic effects of oil price fluctuations. Given that crude oil is a basic input to production, the theory normally predicts that supply-side consequences of oil price hikes include a contraction in overall economic activity and inflationary pressures. In addition, aggregate demand is expected to fall in oil importing countries, and go up in oil exporting countries. (Jiménez-Rodríguez and Sánchez, 2005)

2.6 The effects of oil price shock on the United States and global economy

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Oil prices shocks raise unemployment and lack of growth on the macro economy and lead to an increase in the level of price and inflation rate of an oil importing country. (Nouriel Roubini, Brad Setser.2004)

It depends on many factors:

– The real price and the percentage increase in oil prices.

– The shock’s persistence

– The dependency of the economy on energy and oil

– The policy response of fiscal & monetary authorities

Oil shocks have caused the United States and global recessions of the last thirty years

Today, there are two concerns:

1- The current high oil prices exert a significant drag on the world, and the U.S. economy.

2- Violence in Iraq/ attacks on Iraq’s petroleum infrastructure, concerns about terrorism in Saudi Arabia, the Israeli-Palestinian conflict.

2.7 Average IEA Crude Oil Import Price:

The mechanisms of high oil prices that effect the global economy and a quantitative assessment of the impact on the OECD’s Interlink model.

Oil intensity defined as oil consumed per unit of Gross Domestic Product, in developing countries relative to the OECD. India, for example uses more than 2 and half as much fuel as developed countries per unit of GDP, while the economies of Thailand, China, and African countries are very oil intensive, Estimated that $15 billion or 3% of GDP cost India on oil imports in 2003. The bill of oil import has increased by 16% between 2001 and 2003. Rising fuel intensity is reflected in the share of imports of fuels in total imports, which is increasing in developing countries notably in India and China. It’s easily noticed that in OECD countries the share of fuel in total commodity imports by value fell from only 4% in the late 90s and 13% in the late 70s, but since rebounded with higher fuel prices. (International energy agency May, 2004)

Primary oil consumption per unit of GDP

2.8 Oil price, Gross Domestic Product in Germany:

Germany has not hit negatively due to oil price increase and a structural divergence is observed. High oil price is world wide phenomena and therefore firms have raised goods prices and the consumers become the losers who pay the bill. Germany as a supplier of investment goods is positively effected by rising demand of oil exporting countries. Both effects over compensate reductions of imports of investment goods of oil importing countries.

2.9 Oil price fluctuations in Nigerian economy:

Price of oil is an important issue for the world economies today and its attendant consequences on economic output. There are some studies who have taken the Hamilton (1983) approach in investigating the oil prices on domestic product. The relation between oil prices and levels of economic activity has been a subject of attention. In the past in United States the increase in oil prices led to economic recession. An oil price shocks leads to decline in the GDP, and this is more seen in the oil importing countries. Increase in oil increases the output of oil exporting countries. It is also important that Nigeria focuses on the gas resources in order to diversify. Current practice of flaring gas should be discontinued which is done during oil exploration. The country has huge gas reserves which can use in several ways.


3.1 Hypotheses


H1: Fuel Prices and GDP (Gross Domestic Product) are positively correlated to each other.

H2: Fuel Prices explains the GDP.

These hypotheses are discussed in general in the literature review chapter. Our further look is focused on changes in international demand that are induced by the expanding oil exporting economies. A second international trade effect is induced by changes of the competitiveness of the economies. If an oil importing economy has higher costs and as a consequence higher impacts on its goods prices than its competitors on international markets, it lose trade shares in export and may suffer from higher import ratios on the goods markets as an indirect consequence of the oil price shock.


The inflated oil prices are affecting group of low income people and collectively every Pakistani. It’s an alarming situation effecting Micro and Macro Elements of Country Development and Economic Growth.

The fuel prices behave much like any other commodity with price swings in times of shortage or over supply. Crude oil price cycle over several years responded to different in demand as OPEC and non OPEC supply.

4.1 Pakistan Energy Sector Scenario

Pakistan estimated population around 160 million has been on the way of rising Gross Domestic Product growth for the last 3 or 4 years, where growth reaching 8.4% in 2004-05, GDP Growth 6.6% in 05-06, and some recovery in 2006-07 with growth reaching 7%. Energy sector has a direct connection with the development of a country with rising rate of Gross Domestic Product demand for energy has grown strongly. Figure demonstrates the energy mix in 2005-06, where oil accounts for 32 percent of the total energy used.

Figure shows the last 6 years, the trend in the use of different sources of energy. Consumption of oil has declined in the last few years but still 32% of the total energy consumed therefore Pakistan has to import crude oil from Middle East and due to limited refining capacity have to import petroleum products. 16 million tons is the demand of petroleum products according to the Ministry of Natural Resources and Petroleum of which only 18 % are met through local resources while the balance 82 % is met through imports. This is the reason why the international oil price fluctuations have a direct impact on the oil prices in the local market.

4.2 Oil Reserves and Refining Capacity

Around 300 million barrels approximately of oil reserves Pakistan has till June 2006 and major part of oil comes from southern half of country, where 3 largest fuel producing fields are located.

Few producing fields are located in middle and upper Indus basins. Pakistan has not experienced any new oil fields since the late 1980s.

4.3 Oil Consumption, Future Demand and Imports

Pakistan economy is growing and so is the energy demand.

Consumption of oil and its products grew sharply during the 1980s and 1990s at about 6% per annum, but has become negative in the last five years. Consumption of petroleum products grew negatively.

In 2005-06 Pakistan consumes 16 million TON of petroleum Products. Out of which almost 15 million TONS are energy products during 2005 and 06. Diesel despite negative growth in the last five years accounts for 52 % of total oil products consumed, motor spirit accounts for 8.4%, aviation fuel 5 %, kerosene 2%, and HOBC accounts for a very minor share of 0.06%.

Oil refining capacity highly increased because of demand for refined petroleum products due to this half of imports are refined products (Table 5). As demand is growing faster then production Pakistan’s net fuel imports are projected to rise substantially in coming years. Table 5 exactly shows the forecasted demand and production of oil products.

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4.4 Deregulation

Until 1999, the government had tight control over the petroleum sector in Pakistan. All the decisions were made solely by the government and were often based on political as opposed to economic considerations

Petroleum products prices were under tight government regulation. Since 2000, the government has initiated an ambitious pro market reforms programmed in the sector. The objective behind these market base policies was to limit the government role to any policy related issues, and pricing and regulatory. As government moving towards market liberalization, competition level on the supply side of the oil industry is almost insignificant lack of proper incentives not giving space to competition and not proper operation of companies due to this no benefits of market reforms have so far given to consumers. Level playing field is needed to enable competition (World Bank 2003)

4.5 Capping of sale price

Despite deregulation in the oil sector, some elements of regulation have still remained its part.

The international prices of crude oil are increasing sharply since 2003; creating disturbing situation for the economy, which is dependent largely on imports for its petroleum products demand.

This prompted the government to strengths its control of the sector. The government claimed that if the international prices had passed on entirely to the government, the prices of kerosene and diesel would have increased by Rs. 17 and Rs. 15 per litre, respectively. However, the government has never mentioned the fact that the prices of Motor Spirit and HOBC could also be reduced by Rs. 14 and Rs. 24, respectively. Moreover, naphtha, which is a surplus produce is exported at the rate of Rs. 40 per liter and sold in the domestic market at Rs. 54 per liter (Kiani 2007).

4.6 Impact of high oil prices

Oil prices are constantly on the rising side since 2003, End of 2007 has seen the maximum of $100/barrel.

This rising trend in oil price in international market has hurt the economies of many countries in the world including that of Pakistan.

Oil dependency or how much vulnerable a country is to price shock can be observed from the following indicators.

4.6.1 Oil self sufficiency index:

It is the percentage change in oil production minus consumption to oil consumption.

This ratio negatives for oil importers if the value is -1; country has no oil imports; positive number means country is net exporter. Despite the slight decline country is highly susceptible to high oil prices.

4.6.2 Oil intensity in energy consumption:

Vulnerability to rising oil prices also depends on the intensity, which fuel is used.

The intensity of fuel use in energy consumption index measures the quantity of oil in economy’s primary energy consumption. Oil intensity in Pakistan has declined over the years because of switching to alternatives, more specifically gas and to some extent coal.

4.6.3 Energy intensity:

This variable measure the energy intensity for entire economy, Decrease in energy intensity is considered as the most promising route for reducing vulnerability to oil shocks. There are number of factors effecting energy intensity including country’s climate, size, level of development, as well as whether its refines oil or produces. Countries consume more energy which have colder climate, while countries with a large fuel contribution to Gross Domestic Product are more energy intensive. It also varies with income levels. Its decline can be achieved moving away from energy intensive industries; changing household consumption patterns away from activities which require large amounts of energy (e.g., using less transportation); and involvement in those production activities that are more energy efficient, in response to the rising input. For Pakistan energy intensity is almost constant since 1990-91 to 2005- 06. It indicates the efficiency with which the energy is used. And the trend for Pakistan indicates no improvement in efficiency.

All the indicators discussed above are closely correlated with a country’s susceptibility to fuel price shocks it’s a way to bring this information together and to measure the potential impact of higher fuel price on fuel import costs.

4.6.4 Net oil imports in GDP:

The direct effect of a price increase depends on the share of net oil imports in GDP.

In other words, it is an index of the relative importance of the oil price rise to the economy in terms of the potential adjustment needed to offset and for net importers ratio get negative. Higher value of this ratio create more concerns for the government, may be to reduce oil imports and more willingness to pass through the price to consumer so as to stimulate a reduction in demand12. For Pakistan over the last few years, this ratio has risen to -5.24 in 2005-06.

4.7 Macroeconomic Effects:

As discussed above, direct effect of price increase depends on quantity of the cost of oil in NI. Unless country is running in surplus, or has extremely large foreign exchange reserves, high oil price is dealt by a reduction in total demand for all imported goods, so as to restore balance of payment equilibrium. High fuel prices lead to increased inflation, input cost, reduced none and lower oil demand. The fall in final expenditure indicates that the shocks to households and firms in terms of welfare may be large since the price they pay for imports is much higher and has to be balanced by lower quantities (Bacon and Kojima 2006, IEA 2004).

4.8 Oil prices and inflation:

Another channel via which high prices may effect macro economic performance is through the high cost of production thus reducing output. Pakistan foreign debt has also swelled by almost US $10 billion in the last four years or so and it is now US$ 42 billion. High oil prices has also become an important factor (along with rising house rents and shortage of food items) contributing to high inflation in Pakistan in the past few years. General Price level (for virtually all goods and assets) has been increasing (9.3 percent in 2004-05 considerably very high compared to the previous years). Even in the last two years average inflation was near 8 percent (Table 10). Despite efforts from SBP through tight monetary policy19 (high interest rates) average inflation was 7.1 percent in the first quarter of 2007/0820 (IMF 2008).

4.9 GDP growth and oil prices:

At the time oil prices have been raising, Pakistan’s economy has shown a high growth trend resulting in a large increase in the demand for energy and increase fuel prices squeeze demand and income. At a given exchange rate, for the same volume of oil imports more domestic output is needed to pay. If the currency depreciates in response to persuade payment deficits, this further cuts the purchasing power of domestic income over. One reason might be consumers have been shielded by limiting the direct pass through to final oil prices. The extensive use of fuel subsidies in the form of PDC was helped by strong foreign reserves position; it may have contained output losses in the past few years.

The government has consumed its budgetary target of bank borrowing (Rs. 130 billion) by January 2008, further borrowing from banking or non-banking sources may destabilize the financial health (Khan 2008).

4.10 Balance of payment effect:

Our petroleum imports account for 24 percent of total imports in 2006-07. Improving terms of trade would mean that a smaller volume of exports would be needed to pay for a given quantity of imports. Pakistan this ratio however is decreasing, that is more exports are needed to offset the burden of rising import bill. The government has failed to improve the export performance. However, significant increase in imports has laid a negative impact on trade deficit. Pakistan’s trade deficit has swelled to $7.2 billion, an increase of 32.38 percent in the period July-November (2007-08) as compared to $5.44 billion in the corresponding period last year. It is the third consecutive year that the country is missing its export target. Trade deficit is expected to reach $9-10 billion by the end of this fiscal year (Khan 2008).

4.11 Fiscal impact:

Fuel taxes have important revenue implication for Pakistan. Oil and gas sector together accounts for a significant share of government revenues. Taxes on petroleum products are the largest source of indirect revenues in Pakistan. Petroleum product prices are higher than the parity price because of these taxes. Petroleum products contributed Rs 120 billion to government revenues in the form of indirect taxes in 2006-2007. It is 23.2 percent of total indirect taxes 24 collected in 2006-07, while this share was only 12 percent in 2000-01. Petroleum development levy (PDL) is not included in this total petroleum development levies collected in 2005-06 were Rs. 24500 million 25. The taxing of fuel is one of the easiest and relatively straight forward way to raise revenue, as consumption of petroleum products is relatively price inelastic and income elastic, ensuring buoyant revenue as income rises and tax rates are increased (Bacon 2006).

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4.12 Policy response or implications:

As discussed earlier, the direct effect of high oil prices on an economy is felt through the worsening of the balance of payment and the resultant contraction of the economy.

The use of foreign exchange reserves and increased borrowing or grants may give short relief for net oil importers.

4.13 Demand Management and supply side strategies:

GDP growth is regarded as the driver of oil demand besides its price. It has the tendency to reduce vulnerability as the share of oil imports decline as income rises. In Pakistan oil intensity has declined along with rising GDP growth over the last years but its vulnerability measured in terms of oil imports share in GDP has increased becaus

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