Will High Energy Prices Limit Economic Recovery? Or High Interest Rates?

As the global economy expands, folks are worried about higher energy prices. There's also some concern about higher long-term interest rates. One could also find worry about freight rates, industrial commodity prices, and any number of other prices. Should business leaders be worried?

To understand why I am not worried about higher prices limiting economic growth, let's recall the basic supply and demand from your first economics class. You remember that, right?

SupplyDemand energy

(Let's review the basics. The demand curve (red) slopes downward, showing that at lower prices, a higher quantity will be demanded by buyers. The supply curve (blue) slopes upward, showing that higher quantities of production require higher prices. The intersection is where supply equals demand. The price is P1, and the quantity produced and sold is Q1.)

When the demand for a product or service increases, we depict that by moving the demand curve to the right. The new intersection is at a higher price. One might be tempted to wonder about whether the higher price chokes off demand. Well, go to that first equilibrium. Now move directly to the right until you reach the new demand line. That's the pure increase in quantity demanded. But at this price, demand exceeds supply. So the price rises. Now move along the new demand curve toward the new equilibrium. This is where the demand is being limited by higher prices. But there are two fundamentally important points here:

  1. The price rises only because demand increased
  2. Even with some limitation of demand by the price increase, the total quantity produced and sold is higher than in the initial situation.

How does this apply to today's world (as of February 2011)? Energy prices are up due to the growth of the global economy. That's good. More energy is being used by the larger economy. The higher price rations the limited amount of energy available. The world economy would certainly be even larger if energy were more abundantly available, but that's not a very relevant point. Even though energy prices have risen, the economy is still growing.

The same analysis applies to interest rates. Long-term rates have risen because of an increase in global demand for credit. Even though interest rates are up, the global economy continues to expand.

Note that this analysis would be wrong if the trigger for the price increase was a reduction in supply. That could occur from an oil supply disruption. However, that's not what happened.

So of all the things you could possibly worry about, move this one to the bottom of your list.