Microeconomic and Macroeconomic Effects of Falling World Oil Prices

Question from my student: Could you write something about oil prices?

Oil prices have plunged over the last couple of months and economists predict that they could even go much lower than this. What are the possible reasons for this? What are the microeconomic and macroeconomic effects, both good and bad? Is there a lesson to be learnt from here?

First, let us look at the most fundamental reasons for dwindling oil prices- market demand and market supply. If the overall demand is greater than the supply, then there will be a shortage which is responsible for driving the price up. By contrast, if the overall supply is greater than demand, then there will be a production glut and prices will be adjusted downward. The latter explains what is actually happening behind the global oil market. Demand side is softening but the world supply remains stubbornly high. There is more than enough for everyone

In better details:

a. Bleak economic outlook in the Europe and China. The euro-zone economies as a whole is not performing. There is no sign that the economic malaise will subdue soon. In fact, the latest statistics by Eurostat are putting more pressures onto policymakers. Germany which is traditionally known as the euro-zone growth driver recorded the biggest ever fall in retail sales of 3.2%, a sign that the worse events are yet to come in 2015. The same can be said about the Chinese economy. Slowdown can be seen in both the manufacturing sector as well as consumption. Faltering growth is the prime reason why demand for oil falls. Fewer people buy car, those who did may opt to travel less, uncertainty means less likely to travel abroad for holidays and most importantly fewer plastic/ rubber goods were made which in fact covers almost everything-your gadget, car tyres, basic furniture, all the toys you see in Toys ‘R’ Us, consumer goods and others

b. Oversupply. Perhaps, countries like South Sudan, Nigeria, Angola, Libya and Iraq are slow to react to market responses. According to the law of supply, the higher is the price, the greater will be the incentive to produce more output. The same goes here. Earlier on, when prices were at record high level, these countries must have made too much investment thus resulting in oversupply concurrently when the demand is not even there

c. Sanction against Russia. There is also a possibility that the largest oil producer, Saudi Arabia is working closely together with the Washington to put more pressure onto the sanctioned Russia. It is an established fact that Russian economy is highly oil-dependent. About 70% of its revenue is fully derived from oil production. With every $1 fall in world oil price, it loses $2.1 billion and with the current trend, it may lose as much as $30 to $40 billion. If this continues, there is a possibility that its economy will go into recession-unless it has a deep pocket. This justifies why in the recent OPEC oil cartel meeting, Saudi Arabia being the most influential producer refused to cut its supply further to push up prices when it can easily do so in its position

d. Pressuring USA. Once the usage of shale gas is to be more commercialised, the demand for oil from the OPEC will continue to dwindle. Saudi Arabia and other influential members are not going to benefit from this, not into the long term. This is why they brilliantly allow the market supply to remain high so that its price continue to stay low. The intention is to rival the production and sale of shale gas. They are well aware that shale gas is very expensive to extract. By putting pressure on both prices, the margin for shale extractors will remain low and hopefully there won’t be much incentive to continue investing

e. Emergence of substitute. In the study of economics, we always say that one of the determinants of PED is time period. In the short run, PED may be inelastic but in the long run, the development of substitutes may cause PED to appear elastic. True enough in this case. Shale gas is a potential substitute. Thanks to innovative drilling, the USA has successfully discover unlocked oil and natural gas trapped in shale rock. Interestingly, for the first time in 30 years, the States has stopped importing oil from Nigeria. If the recent development continues, there is a possibility that the demand for oil from OPEC will also continue to fall

f. Strong dollar. It is also worth noting that oil is traded in dollar around the globe. When the dollar appreciates, it makes oil artificially more expensive to countries outside the US. Basically, this lowers the demand from those nations that are affected. Perhaps, this is also the reason why cheaper oil prices are not reflected at the petrol pump stations in Malaysia (my country). While global prices have dwindled from about $110 to $62 per barrel, our MYR (Malaysian Ringgit) continues to slide further against the greenback. Therefore, we are unable to enjoy the full benefits of falling oil prices

Possible positive economic effects

a. Lower cost-push inflation. Oil is used in almost everything. In fact, it is the ‘mother’ of all commodities. You can name it- every single thing that you have ever touched is related to oil like tyres, erasers, toys for kids, plastic kettle, car, basic furniture, clothes hanger and many more consumer items. Besides, it also affects the operating costs of airline and shipping firms. Theoretically, when the costs of production fall, prices fall too. This may be passed on in the form of lower price and hence lesser cost-push inflation

b. Possible improvement in the standard of living. Global economic slowdown is far from over. With stagnating wages growth rate, a fall in inflation is something to cheer about as this translates into higher real wages. It may not be very large, but, every dollar saved is a dollar earned. There is lesser opportunity cost for everyone. More money can be allocated elsewhere say, food, healthcare, child’s education, holiday, Christmas gifts and others

c. Jobs creation. Falling oil prices may boost the competitiveness of manufacturing industry especially for some uncompetitive euro zone economies as well as the UK. Lower costs should be reflected in the final price of output. An improvement in price competitiveness should be able to increase exports. Factory orders will gradually improve and more jobs should be created over the time. The same can be said domestically. As people are more able to spend, jobs should be created everywhere, from factories to banks

d. Higher potential growth. Theoretically, falling oil prices shall reduce the operational costs of a firm and hence more funds are available for investment. They may consider this as the right time to invest e.g. replacing old machines with newer and better ones, build new factories and others. Investment is one of the components of AD and hence AD may shift rightward. In the long run, it also improves the supply-side of an economy by raising its potential capacity. A boost of (X-M) as mentioned earlier can also contribute to the rightward shift of AD and hence an increase in the real GDP

e. Reducing the current account deficit. Inflation back at home may be lower than elsewhere and after making price comparisons, people decide to shop domestically. This may contribute to lower overall imports. At the same time, price competitiveness may help to boost exports and considering both simultaneously, inflows of money may be greater than outflows. This should be able to reduce the size of current account deficit

Possible negative economic effects

a. Prices are sticky upwards. Most of us don’t actually realise one thing. When oil prices increase, the retailers almost instantly increase the prices of all their goods and services. However, the same cannot be said when oil prices fall. In fact, prices remain stubbornly high. Business owners are reluctant to do so on many excuses such as suppliers are not willing to reduce their price, having need to ‘wait-and-see’ and others. Cost-push inflation may not necessarily eased in this case

b. Jobs cut. While jobs are created somewhere, the oil and gas industry is most likely to shed workers. Oil producing and oil dependent nations are the worst affected. A plunge in oil prices makes investment relatively uninteresting and there is no point to keep so many workers as before. Someone just have to leave their job. Unemployment in the economy will probably increase

c. Economic crisis. Venezuela, Iran, Nigeria and Russia will be in huge economic mess in near future if oil price is not restored to at least $100 per barrel. As mentioned earlier, bulk of the state revenue comes from oil extraction and with a continuous free fall, budget/ fiscal deficit will worsen and this may lead to more problems e.g. rising unemployment from the public sector, negative multiplier effect and hence an economic recession, more expensive to borrow/ issue bonds and others

d. Deflationary threat. Countries in the euro zone are already struggling with falling AD and most of them are experiencing price disinflation- a case where prices are increasing but at a much slower rate. If this is not curb, then it may turn into a full blown deflation, which is the worse evil between the two. As people expect prices to fall, they will cut spending/ consumption into the economy with the hope that they can purchase it at a lower price in the future. However, if everyone thinks a like, then AD will fall further (Consumption is one of the components of AD) thus triggering another round of price deflation. Again, consumption will fall and the vicious cycle repeats itself. It is the least that ECB would expect because there is already not much room to cut interest rate to boost spending and investment

e. More emissions. When oil prices are really cheap, people tend to care less about travelling and conserving. In fact, driving will increase, people will buy large gas-guzzler vehicles, incentives to use or conduct research on renewable energy will slow down and many more

Macroeconomic Logic-What Textbook Doesn't Tell You (Important for CIE/ CAL AS Economics) (Part 3)

This is a continuation from the previous post on Macroeconomic Logic. Another problem with our CIE AS curriculum is that students are not told that expenditure-dampening policies to correct/ reduce current account deficit are actually contractionary fiscal and monetary policy themselves. In short, they are macroeconomic policies designed to reduce the level of national income so that the people have lesser income to spend on imports, which is where the name of EXPENDITURE-DAMPENING comes from-dampening the ability to consume imports. Knowing this underlying concept or fact is so important to avoid the confusion with EXPENDITURE-SWITCHING

Let me explain further:

Expenditure dampening policies: They are macroeconomic policies to reduce the level of national income so that people generally have lesser money to spend onto foreign goods and services and hence the reduction in the size of current account deficit

Fiscal policy: It is the manipulation of government spending and level of taxation in order to influence the movement of AD and overall level of economic activities

Contractionary fiscal policies as expenditure-dampening measures

1. Cut in government spending to fix current account deficit. When the public sector reduces spending into the economy, this will cause the AD curve to shift leftward. This is because government expenditure (G) is one of the components of AD. As a result, the level of output/ real GDP (as explained in earlier posting) will equally decline. Fall in output is almost always followed by a decline in national income. This implies lesser income to spend on imports. Assuming exports constant, current account deficit should decline

In case if you still don’t see how a cut in public sector spending can reduce average income, this is another version of explanation. When the government reduces public sector spending, it may imply that lesser jobs are created. It can also be the case where private firms are awarded with fewer projects than before and hence dampen the ability to spend into the domestic economy (yes, G can influence C and I)

2. A rise in direct taxation. When individuals pay more income tax, this means that their disposable income will fall. With lesser money than before, obviously they can afford fewer imports. Lesser outflows of money help to reduce the size of current account deficit. Another one is raising the level of corporate tax rate. As firms pay more tax, their retained profits will fall. This implies fewer capital goods can be imported from abroad. Less money flows out of the country and again, current account deficit may shrink

Monetary policy: It is the manipulation of interest rate or money supply in order to influence the movement of AD and overall level of economic activities

Contractionary monetary policy as expenditure dampening policies

1. Higher interest rate. The Bank of England may raise the base rate/ repo rate/ overnight rate to dampen the level of economic activities. Higher rate will encourage savings. Also more expensive borrowing will discourage household consumption on credit. These two will lead to an overall fall in consumption (C) into the economy. As AD shifts leftward, real output/ real GDP will fall. A decline in income per capita/ per person will reduce ability to consume imports

Another way to look into this is, higher rate of interest may be extended onto the usage of credit cards. As the cost of borrowing increases, people will tend to spend less using their credit cards. Less imports will be purchased and hence the improvement in current account deficit

2. Reducing the money supply. When money supply is cut, financial institutions will generally be less able to extend credit. Fall in the ability to generate new loans will lead to a decline in overall level of economic activities. Fewer people will go shopping, travelling domestically, buy houses and others. This explains why national income will fall hence reducing the ability to consume imports

Another way to look into this is, the credit card limit can be reduced. This means a fall in the maximum amount of money a credit card holder can spend. As a result, fewer imports can be afforded and hence a fall in current account deficit

What you should know in addition?

Contractionary fiscal policy. Since national income falls, that also implies that more people will be unemployed. Government finances may worsen eventually as more money will need to be spend to address rising unemployment e.g. Job Seeker’s Allowance. On top of that it also allows the economy to reduce demand-pull inflation

Contractionary monetary policy. National income will fall and current account deficit will shrink. But it is also worth noting that unemployment will rise, demand-pull inflation may reduce and government finances will probably worsen due to more benefits paid but lesser tax revenue collected

Macroeconomic Logic-What Textbook Doesn't Tell You (Important for CIE/ CAL AS Economics) (Part 2)

In my previous posting on Macroeconomic Logic, I had explained how all the main four main macroeconomic variables such as economic growth, unemployment, inflation and current account deficit interact with one another in the most logical way. What I didn’t mention was, there are in fact more macroeconomic variables, or to be more precise macroeconomic objectives than you think. Three other crucial ones are government finances, income inequality and environmental goals which I had purposely omitted. I will add them into our discussions one at a time, so as to minimise confusions

In this second posting, I will introduce another two. One is government finances and another is appreciation/ depreciation of exchange rate. To make things simple, I will consider pound sterling all the time

 

1. Currency depreciation vs. growth. When the value of pound decreases, British goods will become artificially cheap. This will most likely lead to an increase in the amount of exports. At the same time, weak currency implies that foreign goods will now become artificially more expensive. Imports will likely fall. The combination of these two, holding other factors constant, will lead to a rise in (X-M). Since this is one of the components of AD, that means AD will now shift to the right. Economic growth is achieved as more goods/ services are produced to cater for foreigners

2. Currency depreciation vs. unemployment. When the value of pound decreases, home-made goods will become artificially cheap. As such, value of exports will increase. At the same time, foreign goods will appear artificially more expensive to Britons. That leads to lower imports. Rise in factory orders both from the international and home market will help to rejuvenate the beleaguered manufacturing industry in the UK. Firms will now require more manpower to produce the output. Unemployment is expected to fall

3. Currency depreciation vs. current account deficit. In theory, the weakening of home currency will promote international price competitiveness. Foreigners will now perceive British goods as artificially cheap and so, this may lead to greater exports. In contrast, Britons will consider any imported goods and services to be artificially expensive with the fall in pound. This discourages the consumption of imports. Assuming other factors to be constant, a rise in inflows coupled with a decline in outflows will overall reduce the size of the UK’s current account deficit

4. Currency depreciation vs. inflation. The fall in the value of pound can generally lead to three types of inflation within the UK. First, as exports become artificially cheap while imports artificially expensive, value of (X-M) will increase. This will shift AD to the right thus contributing to demand-pull inflation. Second, a weak pound will indicate that imported final goods, raw materials, spare parts and semi-finished goods are now artificially more expensive. Businesses, facing higher production costs will normally pass this on in the form of higher price to ensure a healthy margin of profits. Cost-push inflation is resulted. Interestingly, if the imported goods become expensive due to relatively higher inflation in other countries or due to weaknesses of home currency, that will contribute to imported inflation, which is also a type of cost-push inflation

5. Currency depreciation vs. government finances. The weakening of pound will promote the international competitiveness of British goods. A rise in factory orders is expected to increase the margin for factories. At the same time, unemployment is likely to fall in this key area due to more manpower needed. If one was to consider carefully, this will probably contribute to greater tax revenue due to higher corporate tax and higher income tax collected. At the same time, the government is expected to pay less in terms of Job Seekers’ Allowance as well as subsidies to prevent bankruptcy

More to come in my next posting. I will introduce fiscal policy and monetary policy and how it works to reduce current account deficit. On top of that, I will also show you how they can actually create effects onto other macroeconomic variables. This is one of the most crucial areas that is not properly introduced in CIE