An oil "shock" of one form or another is surely on the way.

(for economics students- otherwise you mightn't understand)

Every major world recession in the last 60 has come just after a sharp spike in the oil price. That doesn't mean to say that there is a direct causation, but clearly oil is a vital commodity, so any fluctuations in its price are bound to have a large influence on global supply chains.

The oil price is essentially a "business cost", meaning that it influences the level of aggregate supply in the short term. The strength of short run growth in the economy depends on cheap oil. In the very long run, investment in substitutes can be made, meaning that growth is more resilient to oil price spikes.

Within the last 9 months, oil has soared from $70 to $120 dollars a barrel, and growth has stagnated. Big firms such as airlines "hedge" their oil costs by purchasing annual contracts at fixed price with their fuel supplier, to the full force of the rise takes several months to feed through. The IMF regards any oil price over about $90 as dangerous, and it has been higher than that for around 6 months.

When the global economy went into free-fall in the autumn of 2008, few noticed that oil had reached an all time higher of $147 in the summer.

Oil is an example of land, a factor input including all natural resources. The operation of capital also requires energy input, a significant amount of which is oil. For instance, nearly every product or service is in some way reliant on oil for transportation, packaging, etc.

Since oil is such a significant component of the economy- the total oil "bill" of the economy is typically around 5% of GDP - it is a significant determinant of the overall price level in the economy (the rate of inflation). Upwards movements in inflation cause a contraction down the demand curve, so the combination of a shift to the left in aggregate supply and a downwards movement along aggregate demand will in the short run move equilibrium growth output far within the trend average shown by the LRAS.

In the long run higher oil prices may stimulate investment in alternative energies or further oil extraction infrastructure, which may correct the problem.

In terms of "preventing" the oil crunch problem in a pro-active manner, the government would have to ensure substitutes were made available by the market in preparation to continue upward supply of total energy when the supply declines, as it appears to be doing. Industry is almost certainly unable to predict supply issues because firms will not have perfect information about any supply issues other firms are facing.

LRAS is determined by factor inputs, and oil is not thought to be a factor input, however, the output (production of oil) is to a great extent determined by for instance the number of oil wells, which count as capital, so the argument can be made that any oil supply crisis, if prolonged would influence LRAS as well as SRAS.

Expansionary fiscal policy would only boost demand in the economy so it would not address what is essentially a supply side problem with oil. Expansionary monetary policy would have the immediate effect of boosting demand and the long or medium term effect of proving investment money to develop new capital to shift the LRAS rightwards and boost the productive potential of the economy, but the opportunity cost of this strategy of short term demand push inflation caused by the purchase of and investment in alternative energy sources would have to be considered. Another supply side policy would be cutting taxes on oil companies, but this would not certainly boost production in the long term because there are geological issues with oil production- it is finite, so tax cuts may just boost profit.

To conclude, a supply side shock resulting from an oil price spike would cause a fall in output, both because of a shift to the left in SRAS, and a higher prices causing a movement along the demand curve to lower levels of output, resulting in lower equilibrium growth than the LRAS. The negative output gap would not be good in terms of the macroeconomic objectives. Inflation would already be an issue, and the underutilized productive potential resulting from the supply side shock would cause unemployment. The only benefit may be an improvement of the balance of trade account because the higher inflation would likely cause a depreciation in the value of sterling, making our exports more competitive, although export lead demand would shift the demand curve back rightwards in the medium to long run, resulting in a worsening of inflationary pressures ceteris paribus, so the impact is undesirable with respect to macro objectives on almost all fronts.