Notes

1. Macroeconomics project

Since 2021, the increase in energy prices has raised “the question of the extent to which households will reduce their consumption in response. With the global economy in the process of recovering from the coronavirus (COVID-19) pandemic, the prices of many commodities – including oil and gas – have soared [...]. Since demand for energy is inelastic in the short run,
those large price increases imply signi…cant declines in households’ purchasing power, which will
need to be absorbed through (i) reduced consumption of non-energy goods and services, (ii) a
reduction in savings or (iii) an increase in income.” (ECB Economic Bulletin, Issue 3/2022)
Explain to a public audience, i.e., which does not necessarily have any background in economics:
How does the increase in energy prices raise the chances of a recession? How can we expect
the increase in energy prices to di¤erentially a¤ect the consumption of the poorest and richest
households?

The rise in energy prices should be seen in the context of an exceptional economic recovery, but other factors are also playing a role. While the impact that energy prices have on consumption has been studied before, the recovery following the COVID-19 crisis is atypical from a historical perspective. Thus far, it has been characterised by a surge in global demand for durable and non-durable consumer goods, leading to unprecedented bottlenecks in production and trade, with households having accumulated record levels of savings in the course of the pandemic

[1] Moreover, the supply of energy has been hampered by a lag in the production of oil, as well as geopolitical tensions – especially Russia’s recent invasion of Ukraine – and technical disruptions affecting the provision of natural gas to European countries.

[2] It is important to account for these confounding factors in order to understand the aggregate impact that higher energy prices will have on private consumption and formulate an appropriate policy response.

2nd question.

While a change in energy prices can have several origins, an individual household will tend to perceive it as an exogenous shock to its real disposable income. When making decisions on consumption and savings, households take energy prices as a given, not considering the implications that their decisions have for energy prices. When energy prices rise, it leads to a reduction in households’ real disposable income, even if that price rise is caused by increased demand for energy. Depending on the aggregate economic conditions, a rise in energy prices will either exacerbate any decline in disposable income or partly offset any increase (e.g. in the context of an economic upturn). For those reasons, this section focuses on the direct distributional effects of changes in energy prices, while controlling for the underlying macroeconomic drivers of energy shocks, which were explored above in the section on the aggregate perspective.

Energy is a necessary consumer good, so household exposure to fluctuating energy prices declines as income rises. Since energy consumption responds to basic needs, which households cannot give up entirely, demand for energy tends to be price inelastic in the short run. Households typically accommodate any rise in energy prices by revising their saving plans and reallocating spending. However, the extent to which households need to resort to either of those strategies depends on their exposure to energy repricing. The share of households’ monthly income that goes on utilities and transport services (i.e. energy-intensive consumption) is an approximate indicator of their exposure to an energy price change. That exposure differs widely across income groups, standing at almost 35% for the lowest quintile of the income distribution but less than 10% for the top quintile.
[16] Thus, the distributional effects of a rise in energy prices are sizeable, with low-income households facing almost four times the impact that is experienced by households in the top quintile of the income distribution
(Chart 6).[17]
When spending on energy rises, households reduce their purchases of essential goods and services to a small extent. The average elasticity of substitution between spending on energy and other essentials (e.g. groceries, housing and health services) is fairly low, albeit the response varies across income quintiles (Chart 7; see Box 2 for details of the estimation methodology). Where basic needs are met primarily through low-cost items (which is the case for the households with the lowest incomes), there is very limited scope to compress spending on other essentials in response to rising energy prices (with that scope estimated at 0.2 percentage points of total spending for each percentage point rise in energy spending).
[18]