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War is a Drag
Subject Fiscal policy
Topic Productivity and Growth
Key Words Recovery, Economic Growth, Budget Deficit, Consumer Confidence
News Story

According to many analysts, war with Iraq is a 90 percent probability and there is an 80 percent chance it will happen in the next 90 days. There is a considerable difference between the best- and worst-case scenarios if the U.S. goes to war with Iraq. The war could end in a matter of days with little damage to Iraq's oil fields and few casualties. Alternatively, the U.S. could be involved in a protracted battle with terrorist retaliations in the U.S. Given the uncertainty over the severity and budgetary impact of the war, it is not surprising that business firms are reluctant at this time to commit to major investment projects.

The reluctance of businesses to invest is understandable in light of the economy's relatively mediocre performance and the war's uncertainties. Another, related drag, has been the high price of oil. The possibility of a decrease in Iraqi oil supplies as a consequence of a war has caused oil prices to slowly increase. Political unrest in Venezuela has recently pushed oil to over $30 a barrel. Higher oil prices put pressure on certain industries to raise prices or decrease supplies. Even if the situation in Venezuela changes, oil prices are likely to stay high until the situation with Iraq is resolved.

Another question related to a possible war with Iraq is the effect of a conflict on consumer confidence. A quick victory would likely embolden consumers and cause a surge in spending. On the other hand, a protracted action with successful terrorist actions in the U.S. could cause consumers to retrench. About 41 percent of corporate executive are also worried about major terrorist attacks in the U.S., according to a survey by TEC International, a chief executives' trade group. More than two-thirds of those surveyed feel that a war with Iraq would have a negative effect on their business.

(Updated April 3, 2003)

Questions
1.

Suppose that Iraqi oil shipments are interrupted. How would this impact the price of oil? Draw an aggregate supply/aggregate demand diagram and illustrate the impact of higher oil prices on the economy.

2. One important unknown in assessing the impact of a war on the economy is the effect on consumer confidence. Why is consumer confidence important to understanding the economy? Show using your aggregate supply/aggregate demand diagram, the impact of a loss in consumer confidence on the economy.
3. Another factor is the cost of a war with Iraq. In the Gulf War, U.S. allies footed the bill for the war. Assuming little aid from other countries. How could the U.S. finance a war? What would be the impact on the economy?
Source Daniel Altman, "War Uncertainty Weighs on Economy," The New York Times, January 18, 2003.

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