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Oil Prices and the Global Economy

OIL PRICES AND THE GLOBAL ECONOMY 12

Table of Contents

1 Introduction 4

2 Oil Prices and the Global Economy 4

2.1 Gross Domestic Product (GDP) Impact 5

2.1.1 Oil Importers 6

2.1.2 Oil Exporters 7

2.2 Impacts on Inflation 7

2.3 Impact on Global Confidence 9

3 Conclusion 11

4 References 12

Abstract

The following research paper discusses how oil prices affect theglobal economy. Oil prices have dropped by 50% since June 2014. Thedecline is associated with rising oil production by oil manufacturingcompanies. When supply increases, it causes a decrease in demand,which in turn pushes prices down. Reduced oil prices result in thegrowth of the world economy and reduce global inflation. However, asoil prices continue to plummet, they cause a decline in globaleconomic confidence. In addition, while the economies of countriesthat export oil and importers gain from reduced prices in oil, theeffect is more positive in oil importing countries.

1Introduction

Oil prices have recorded a significant decline from mid 2014. Whencalculated in American dollars, the price has dropped by close to 50%from June 2014 (Monetary Policy Report, 2015). In reference tothe Brent benchmark, oil prices were ranging at 115 US dollars forevery barrel before the decline. However, the prices have declinedand oil is currently trading at below 60 US dollars. The price dropis largely associated with a surplus of oil supply. Oil productionhas amplified over the years due to improved production by oilproducing nations, which in turn enhances supply. Such changes in oilprices result in positive as well as negative impacts on the worldeconomy.

In the following discussion, the paper discusses the impacts of thedrop in oil prices on the global economy.

2

The current plummet observed in oil prices is the second largest,since the 2008-2009 financial crises, which was a result of a declinein the demand for oil globally. Nevertheless, the drop in oil pricesfrom June 2014 to date, are influenced by increasing worldwide oilavailability. Specifically, North America has improved its productionof shale oil in recent years, resulting in a heavy rise in total oilmanufacture in America and Canada (Griffin&amp Teece, 2016). Also, oil producing countries like Iraq,Russia and Libya have increased the amount of oil they produce.Unlike before, when declines in oil prices resulted in reducedproduction by oil making countries, “Organization of the PetroleumExporting Countries (OPEC)” maintained their oil producing levels(Griffin &amp Teece, 2016).The impacts of these oil prices on the world economy are eitherpositive or negative.

Generally, regardless of whether countries are oil producing orimporters, a drop in oil prices arising from increased oil supply areanticipated to cause an increase in the growth of the global economy(Cashin, Mohaddes, Raissi &ampRaissi, 2014). Current approximations from the “InternationalMonetary Fund” support a growing world economy. These growths willbe experienced differently by the different economies owing todisparities in the trade patterns in products that are related tooil, as well as the intensity of oil production. For economies thatimport oil, dropping oil prices are anticipated to cause a rise interms of trade, enhanced purchasing power for households, in additionto reduced input expenses for businesses (Cashin,Mohaddes, Raissi &amp Raissi, 2014). Economies that exportoil will experience a decline in terms of trade, which will be offsetby their household purchasing power as well as reduced input expensesfor businesses.

Significant to note is, despite fact that a plummet in oil pricesleads to the growth of the global economy, if the low prices remainconstant for a long time, the impact on the world economy will bestronger. This is because countries will react strongly towards thereduced oil prices. The aftermath of dropping oil prices on theeconomy’s development relies on approaches used by nations toadjust their monetary as well as fiscal policies to these pricefalls. Provided that oil prices remain low, the negative effects aremore likely to be experienced by countries that produce oil in largescale. On the other hand, the economies of oil-importing nations arelikely to benefit. Below the impacts of oil prices on the globaleconomy are subdivided into different significant aspects.

2.1Gross Domestic Product (GDP) Impact

Owing to the fact that oil prices have declined due to improvedproduction, which resonates to increased oil supply, it is presumedthat the low prices may have positive impacts on the growth of theworld economy. However, it is worth noting that the impacts aredissimilar from one economy to another, which is reliant on if acountry is a net oil exporter or importer. Historical relationshipsbetween oil prices and the economy signifies that the reducing oilprices from mid 2014 will cause a rise in the world level of grossdomestic product by close to 1% in the coming years (MonetaryPolicy Report, 2015). But, such a GDP is reliant on oil pricesremaining constant. In addition, research also indicates that oilprice changes on the growth of the world economy have declined overtime. This implies that approximations of the impacts of oil pricechanges on the world economy must be interpreted cautiously, withconsideration as to whether countries are exporters or importers. Itis not possible to assume that low oil prices will benefit theeconomies of all countries.

2.1.1Oil Importers

The economies of countries that are oil importers will benefitpositively from the drop in oil prices. In nations that import oil,the current plummet in oil prices has an overwhelmingly constructiveimpact on their GDP growth. When the price of oil drops, it causes anincrease in the consumption of household products (Byrne, Fazio &ampFiess, 2013). This is because companies are able to produce goods atreduced prices owing to their reduced transportation in addition toproduction expenses. At the same time, consumers are able to affordand buy goods that they could not previously purchase. Theconsumption of household goods may be impeded by their high prices,but once the prices are reduced, more consumers are willing topurchase the goods (Byrne, Fazio &amp Fiess, 2013).

When consumers are able to purchase more products, it in turn causesa rise in profits, recruitments and investments for the countries.Such impacts are more apparent in countries that have highenergy-intensive. This refers to countries that heavily rely onimporting oil. The economies benefit from price drops because theyare able to save money on the production of goods. These economiesinclude India, China and Indonesia, which are countries that havebeen able to ensure goods are available to consumers at affordableprices. Every percentage drop in oil prices resonates to savingbillions of dollars on the countries’ trade balance.

2.1.2Oil Exporters

While the economies of oil importers seem to benefit from thecurrent price decline, the opposite effect is experienced by oilexporters. The increased supply of oil implies that the demand foroil has declined. As a result, oil producers are compelled to selloil at reduced prices. Many countries that export oil rely on therevenue generated from such exports. But as prices decline, itimplies that the benefits from oil export are also falling, leadingto dampening of gross domestic product growth for such economies(Griffin &amp Teece, 2016).

In order to recover from the reduced oil prices, some oilmanufacturing nations tend to produce as well as export more oil(Griffin &amp Teece, 2016).Such a move is aimed at ensuring they do not lose a lot of exportrevenue. What such countries fail to realize is that such actionsonly result in more supply and enhanced plummeting oil prices. Sincethe economies of oil exporters are heavily reliant on oil prices, itis impossible for the countries to experience growth in GDP in thesame way as oil importing economies (Griffin&amp Teece, 2016). The prices of crude oil in oilmanufacturing countries have fallen below the prices needed tomaintain a balance in government budgets.

2.2Impacts on Inflation

Reduced oil prices, affect not just the GDP development of the worldeconomy, but also inflation. Research demonstrates that when oilprices drop, they cause a decline in world inflation. According tothe World Bank, there was a reduced global inflation of between 0.4to 0.9 percent points in 2015, which is closely linked to the turndown in the prices of oil in the same year (Monetary PolicyReport, 2015). Reduced oil prices acts as a form of tax cut,which makes it possible for companies to produce goods at affordableprices. Hence, the prices of products reduce, which ensures thatinflation remains low. Nevertheless, the relationship between oilprices and inflation differs from one nation to another. This is dueto factors like “the weight oil products have in the CPI basket,the effects of the oil price on wages and other prices, exchange ratedevelopments, how much freedom of action monetary policy has and thestructure of oil-related taxes and subsidies” (Monetary PolicyReport, 2015).

In countries where oil-linked goods acts as a huge section of theirCPI basket, declines in oil prices are anticipated to directlyinfluence inflation (Baumeister &ampPeersman, 2013). The amount of indirect impacts, meaning thelevel to which prices as well as wages become influenced by a declinein oil prices, differs among countries. At the same time, the amountof taxes derived from oil products has a direct effect on the pricesof consumers. For instance, petrol prices in America are higher forconsumers as compared to countries like Sweden. This is because,America has a “lower volume-based specific taxes on petrol, whichare independent of the price” (Monetary Policy Report,2015). Hence, the section of petrol price that is affected bychanging oil prices is higher in America. While in Sweden, reducedoil prices, when calculated in dollars, has resulted in a downgradingof the country’s money as compared with the dollar.

Generally, reduced oil prices seem to benefit all nations. However,as oil prices continue to drop, it is likely that some countries willexperience deflation (Cashin,Mohaddes, Raissi &amp Raissi, 2014). This includes countriesthat already have low inflation levels such as the United States,United Kingdom and Euro zone. Specifically, America has a close tozero inflation rates, which implies that as oil prices continue toreduce, they will not have a significant impact on reducing thecountry’s inflation. Instead, oil prices with result in deflation,which is bad for the economy. Deflation results in a rise in theinterest rates, a rise in wages and debt inflation. Owing to the factthat the global economy is weak, declining oil prices are acting as athreat to causing deflation, which will eventually outweigh theadvantages derived from the oil tax cut effect. While it is necessaryfor countries to cut taxes in line with reduced oil prices, to ensurethat the prices of products are balanced, more tax cuts could causeprices to decrease beyond normal. This in turn causes a situationwhere the global economy becomes too weakened by over reduced pricesof commodities within economies.

2.3Impact on Global Confidence

In the same way that reducing oil prices have a positive as well asnegative impact on the inflation of the world economy, the sameimpact is experienced in regard to global confidence. Globalconfidence is linked to the economic wellbeing of nations.

Economies that do not produce oil have an enhanced global confidencebecause they are able to enjoy the benefits of reduced oil prices.The countries do not seem to experience any economic hardshipsbecause their GDP’s are affected positively. For instance,companies are able to reduce the costs of products and servicesoffered, as they benefit from reduced tax, production as well astransportation costs. Such a situation could result in the assumptionthat oil exporting countries are less likely to experience anyeconomic hardships associated with declining oil prices. However, theeconomic hardships for these nations are indirect. There is thepossible danger that the world economy may be derailed by nationsthat go bankrupt owing to falling oil prices. This in turn leads tobank losses in addition to reducing global confidence (Pettinger,2016).

While the economic hardships experienced by oil importing nations areindirect, these hardships are directly experienced by oil exporters.In the past, reducing prices in oil have been countered through areduction in the production of oil, by oil producing nations, toensure that prices are balanced. But, since mid June 2014, countriesthat produce oil in large scale have reacted to changing oil pricesby increasing production. The objective has been to counter lowprices with benefits that can be gained from more oil production. Thedownside is that as more oil is supplied into the global economy,prices have continued to plummet (Pettinger, 2016). It is impossibleto predict whether oil prices will stabilize, but oil exporters havealready began to experience these direct economic hardships.

The hardships are evident owing to the fact that many oilmanufacturing countries are falling out of the oil business. Regions,like the North Sea Oil have seized to become economic (Pettinger,2016). As a result, oil producing companies have been compelled toreduce manufacturing and lay off employees. Many oil companies arealso going bankrupt. This will lead to a negative effect on the worldfinance system. Banks that had given out money to be used in oilinvestment have a high risk of losing their money, which could resultin a tightened global credit. Also, major oil producing countries arebeing compelled to push for austerity, which has the impact ofreducing the flow of international capital (Pettinger, 2016).

The measures taken by oil producing countries are linked to the factthat most oil producing economies face recession. Recession has anegative impact on global economy because it slows development. Asmall decline in oil prices does not have a high negative impact onglobal confidence. However, the price fall from mid June is alarmingbecause the oil prices have not managed to stabilize, which couldhave more adverse effects than earlier oil price drops.

3Conclusion

The decline in oil prices from 2014 has resulted in positive andnegative impacts on the global economy. The impacts are broken downinto GDP impacts, the impact that oil prices have on inflation aswell as global confidence. A drop in oil prices has a general goodeffect on how the world economy develops. Nevertheless, oil exportingcountries have not benefited from the plummet in oil prices. Also, asoil prices drop, they cause reduced inflation in the world economy.But, countries that already enjoy reduced inflation risk deflation.The global confidence has reduced owing to the negative impacts ofdropping oil prices on oil manufacturing economies.

4References

Baumeister, C., &amp Peersman, G.(2013). Time-varying effects of oil supply shocks on the USeconomy.&nbspAmericanEconomic Journal: Macroeconomics,&nbsp5(4),1-28.

Byrne, J., Fazio, G &amp Fiess, N. (2013). Primary commodity prices:Co-movements, common factors and fundamentals.&nbspJournalof Development Economics&nbsp101,16-26.

Cashin, P., Mohaddes, K., Raissi,M., &amp Raissi, M. (2014). The differential effects of oil demandand supply shocks on the global economy.&nbspEnergyEconomics,&nbsp44,113-134.

Griffin, J. M., &amp Teece, D. J.(2016).&nbspOPECbehaviour and world oil prices.Routledge.

Kumhof, M., &amp Muir, D. (2014).Oil and the world economy: some possible futures.&nbspPhilosophicalTransactions of the Royal Society of London A: Mathematical, Physicaland Engineering Sciences,&nbsp372(2006),20120327.

Monetary Policy Report. (2015). Effects of the falling oilprice on the global economy, 45-50. Retrieved from:http://www.riksbank.se/Documents/Rapporter/PPR/2015/150212/rap_ppr_ruta2_150212_eng.pdf

Pettinger, T. (2016). Are falling oil prices good for the economy?Economics. Retrieved from:http://www.economicshelp.org/blog/15601/oil/are-falling-oil-prices-good-for-the-economy/