Question

Explain why during the short run, an increase in the price of oil will cause an increase in the interest rate.

Answer 1

When oil price increases, importing companies and countries have to pay more money or USD for same volume. In the short run, BOT of oil importing countries deteriorates as their exports remains unchanged. As a result, demand for USD grows and the domestic currency depreciates in the process.

In order to increases profit margins, the oil importing companies will increase the prices of retail petroleum products they offer. Increased prices may be regulated by the government. After all, expense on petrol and diesel will increase and consequently savings volume will be decreased assuming incomes of residents constant. Further, due to increased petrol/ diesel price, transport cost will be increased and ultimately expenditure level will be increased across the business sector. They will increase the price of their products and pass on the burden to their customers. All these phenomena lead to rise in general price level in the home economy. In other words, inflation occurs in the economy. In order to fix the economy, the Central Bank will adopt contractionary monetary policy through increasing interest rates. Suddenly, commercial and other banks will increase deposit and lending rates.

In this way, due to increase in crude oil prices, interest rate rises in the home economy in the short run.