Oil and Price Inflation

January 16, 2008

I recently received the following question from a student in Malaysia.  I thought it was a good question so I am including it here.

Dear Sir,

Greetings, I am a student of  International Islamic School Malaysia, Kuala Lumpur.

I hope you are well. I am in grade 10 and I take business studies as one of my subjects.

Recently I  had a class on inflation in my school. The teacher said when fuel prices alone rises we cannot term that as inflation.

I disagree with that because I think that rising fuel price is the only exception where we can say that it is inflation.

When fuel prices increase the price of all other commodities increase ... please tell me if  it is right or wrong to say that 'high fuel prices is inflation'. I would really appreciate your help.                                                                                                                  thank you..  Samin

Dear Samin,

That is a very thoughtful question.  Often professors, analysts and the news media remove Energy and Food prices from the “inflation equation” because they are so volatile (these prices change a lot in the short term) without them it is called “core inflation”. 

Of course they are also a major component of our daily expenses, so in real life we cannot just ignore them.  The core inflation rate is really only useful as an academic theory so we can see trends in the underlying inflation rate more clearly.

 When your teacher told you about inflation he was probably referring to “Monetary Inflation” unfortunately most people do not understand the difference between “monetary inflation” and “price inflation” and so they use the term “inflation” to refer to both.  See our article What is the Real Definition of Inflation?   

The real meaning of monetary inflation is that prices increase (price inflation) because the money supply has increased.  So if the price of fuel increases because of a supply disruption like a natural disaster that is not a result of monetary inflation although it is still price inflation (however it is usually temporary).

However, if the price increases along with most other commodities due to an increase in the money supply then you have price inflation caused by monetary inflation. Which is probably what your teacher was referring to.  

 The fact that fuel is a component in most other commodities (either in producing them or transporting them to the consumer) is not relevant to the question of whether it is a result of “monetary inflation” or not.

Oil is a major component of both consumer prices and producer prices although a very volatile one.   And rising fuel costs can trigger a compounding effect. (If fuel costs rise everything else will have to rise to cover the additional costs incurred by the producers of the products).  However, this increase in prices would normally be the result of an increase in the money supply although it can also be a result of a decrease in the supply of oil , either through natural disasters, or things like oil cartels voluntarily reducing the supply to try to increase prices.

Hope this helps,

Tim McMahon, Editor

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