AQA Specification focus:
‘How changes in world commodity prices affect domestic inflation.’
Commodity price movements directly shape UK inflation by influencing production costs, import prices, and consumer purchasing power, making global markets highly significant for domestic price stability.
Understanding Commodity Prices and Inflation
World commodity prices refer to the global market prices of raw materials such as oil, gas, metals, and agricultural products. Since the UK is a net importer of many of these commodities, fluctuations in their global prices directly affect domestic inflation. Changes in these prices filter into the UK economy primarily through their effects on costs of production, consumer prices, and overall aggregate demand and supply conditions.
Inflation: A sustained rise in the general price level of goods and services in an economy, measured using indices such as the Consumer Prices Index (CPI).
Transmission Mechanisms of Commodity Prices
1. Direct Impact on Consumer Prices
Energy prices (oil, natural gas) strongly influence household fuel bills and transport costs.
Food commodities (wheat, rice, coffee) affect supermarket prices, which make up a significant part of the CPI basket.
Metals (copper, aluminium) influence durable goods prices, as they are vital inputs in production.
2. Cost-Push Inflation
A rise in commodity prices increases production costs for firms. Firms often pass these higher costs on to consumers, leading to cost-push inflation.
For example, an increase in global oil prices raises transportation and manufacturing costs, shifting the short-run aggregate supply (SRAS) curve leftward, pushing up prices.
Cost-Push Inflation: Inflation caused by rising production costs leading firms to increase prices to maintain profit margins.
3. Exchange Rate Effects
Commodity prices are usually denominated in US dollars. If the pound sterling depreciates against the dollar, imported commodities become more expensive, amplifying inflationary pressures. Conversely, a stronger pound can offset rising commodity prices by making imports cheaper.
4. Demand-Pull Channels
In cases where commodity prices fall, households experience lower energy and food bills, increasing their real disposable income. This may stimulate aggregate demand (AD) and contribute indirectly to inflationary pressures if the economy is close to full capacity.
Examples of Major Commodities Affecting UK Inflation
Oil
A key driver of UK inflation because of its importance in transport, heating, and industrial energy.
Oil price shocks in the 1970s caused surges in UK inflation, highlighting the vulnerability of oil-importing nations.
Food
Agricultural commodity prices affect UK inflation as the country imports significant amounts of food.
Climate events such as droughts or floods in major producing countries can raise prices and increase UK inflation.
Metals and Industrial Inputs
Prices of industrial metals such as copper and steel influence construction and manufacturing costs, indirectly feeding into consumer prices.
Short-Run vs Long-Run Impacts
Short run: A sudden increase in commodity prices raises inflation through cost-push effects.
Long run: Sustained high commodity prices may encourage efficiency improvements, substitution towards cheaper inputs, or investment in alternative energy sources, moderating the inflationary impact over time.
Interaction with UK Monetary Policy
The Bank of England monitors commodity price fluctuations closely because they can trigger deviations from the 2% inflation target.
If inflation rises due to a temporary commodity price shock, policymakers may choose not to respond immediately, since tightening monetary policy could worsen unemployment.
However, if rising commodity prices feed into inflation expectations, the Bank may raise interest rates to anchor expectations and maintain credibility.
Inflation Expectations: The rate at which households and firms expect prices to rise in the future, influencing wage demands and pricing behaviour.
Global Influences on UK Inflation
Commodity price changes are often driven by global factors outside the UK’s control:
Rising global demand from emerging markets such as China and India increases competition for limited supplies.
Geopolitical events (e.g., conflict in oil-producing regions) can disrupt supply and cause sharp price spikes.
Speculation in commodity markets may amplify price movements, creating volatility.
Exchange rate fluctuations further mediate how global prices affect UK imports and inflation.
Benefits of Falling Commodity Prices
While the syllabus focuses on inflationary pressures, falling commodity prices also have important consequences:
Reduced production costs lower inflation (or even cause disinflation).
Higher consumer purchasing power boosts economic growth.
However, persistently low commodity prices can harm UK exporters of raw materials and reduce investment in energy sectors.
Disinflation: A fall in the rate of inflation, where prices are still rising but at a slower pace.
Summary Points for Students
Global commodity price changes have a direct and significant effect on UK inflation.
Main channels: direct consumer prices, cost-push inflation, exchange rate effects, and demand-pull mechanisms.
Key commodities include oil, food, and industrial metals.
Impacts vary in the short run versus long run.
The Bank of England’s policy response depends on whether price shocks are temporary or persistent.
External global events such as geopolitical tensions, demand shifts, and speculation make UK inflation sensitive to international markets.
FAQ
In developed countries like the UK, commodity price changes often pass through indirectly via production costs and consumer goods. The effect is moderated by diversified economies and monetary policy responses.
In developing countries, commodities may make up a larger share of household spending, especially on food and energy. As a result, inflationary effects can be more immediate and severe, with fewer policy tools available to offset shocks.
Oil is used across multiple sectors: transport, manufacturing, energy generation, and agriculture. This widespread role means changes in oil prices influence both business costs and consumer spending.
Unlike some other commodities, oil has fewer close substitutes in the short term, making its impact on the cost of living more direct and unavoidable.
Speculators in commodity markets can drive prices up or down beyond what supply and demand fundamentals justify.
For the UK:
Rising speculative demand may inflate prices of oil, metals, or food, increasing import costs.
Sudden sell-offs may cause rapid price drops, reducing inflationary pressures.
This creates volatility in UK inflation, making it harder for policymakers to predict and manage price stability.
UK manufacturers rely on imported raw materials and intermediate goods. When global commodity prices rise, supply chain costs increase, feeding into UK production costs.
Global supply chains amplify effects:
A rise in shipping fuel prices raises international transport costs.
Commodity shocks in one country quickly spread through trade networks, impacting UK prices even if direct imports are limited.
Commodities are priced in US dollars. If the pound weakens, UK importers pay more in sterling for the same goods, intensifying inflation.
A stronger pound, however, can shield UK consumers and firms from global price rises. This makes exchange rate stability an important factor in determining the true inflationary effect of commodity price changes.
Practice Questions
Explain one way in which rising world oil prices can lead to higher inflation in the UK. (3 marks)
1 mark: Identifies that oil is a key input/commodity for the UK economy.
1 mark: Explains that higher oil prices increase production/transport costs (cost-push pressure).
1 mark: Explains that firms pass these costs to consumers, raising the general price level (inflation).
Discuss how changes in world commodity prices can affect inflation in the UK economy. (6 marks)
Up to 2 marks: Explains that rising commodity prices (e.g., oil, food, metals) raise input costs, causing cost-push inflation.
Up to 2 marks: Explains that falling commodity prices can reduce inflationary pressure, lowering CPI or even causing disinflation.
Up to 1 mark: Develops point on exchange rates (sterling depreciation making imports more expensive, amplifying inflation).
Up to 1 mark: Explains short-run vs long-run effects (short-run cost pressures vs long-run adjustments like substitution or efficiency gains).
Level of response guidance:
1–2 marks: Limited knowledge with little development.
3–4 marks: Reasonable knowledge and some development of effects on inflation.
5–6 marks: Clear, well-developed discussion showing understanding of multiple channels and their impact on UK inflation.
