Impact Of Oil Prices On The AD And AS Of An Economy

Drivers of sharp decline in Global Oil Price

How oil prices affect the AD or AS of an economy?

The oil industry had always been a subject of booms and busts but recently it has witnessed a new downturn. There are several companies that had previously earned record profits but they are eventually forced to decommission rigs and sharply decrease their investment in the exploration and production. In this regard, there was a loss of jobs by more than 100,000 of the oil workers and there was a reduction in the manufactures of drilling and production equipment. The international benchmark for the Brent crude was around $55 per barrel and that of the American benchmark is at $49 per barrel. Since 2010, the Brent crude price was as high as $155 per barrel and it remained high till the mid June 2014, thereafter there was a sharp decline in the oil price which was more than half of the previous oil price of about $49 per barrel. The drivers of oil price increase include the oversupply of oil by the US and strong US dollar (BBC News, 2015). There was significant impact by the US negotiation for the possible nuclear deal with Tehran which would again increase the oil exports by the Iran into the global oil market. This caused oversupply of oil in the market and lowered the oil price. This paper helps to understand the causes and impact of the sharp decline in the global oil price. In this context, the impact of oil price drop on the Chinese economy is also evaluated with the help of the Aggregate Demand and Aggregate Supply curve (The Economist, 2015).

The reasons for the sharp fall in the oil price are primarily two fold. To understand the economics of the oil market, it is important on to derive the demand and supply and the market structure of the global oil industry. Initially, the global oil market depicted and followed the characteristics of oligopoly but with the increase in the oil producing countries the competition increased and the oil market started depicting the characteristics of the competitive market. Some of the features include that there are many number of buyers and sellers of oil, the sellers of the oil market are price takers, there is complete freedom of entry and exit in and out of the market and the sellers maximizing their profit. The demand and the supply curves of the oil are inelastic in nature (Hartley, 2015). This is because large changes in the price of oil will have little impact on the quantity of oil demanded and quantity of oil supplied. The diagram is attached in appendix 1 (Smith, Round and Perloff, 2014).

Impact of fall in global oil price on the oil importers

The two primary reasons behind the oil price fall is the weak demand by the emerging markets like China which lowered the demand for oil and automatically driving the situation to excess supply of oil and this caused the sharp fall in the price of oil. This phenomenon is explained with the help of diagram attached in the appendix 2. The next reason behind the fall in the global oil price is the OPEC’s refusal to decrease the oil production. OPEC contributes around 60% of the world’s total supply of oil which means that OPEC has substantial power to fluctuate the price of oil by increasing and decreasing the oil supply (Imf.org, 2015). OPEC is the oil cartel consisting of 12 oil producing countries which held a meeting where countries like Venezuela and Iran proposed on lowering the oil production so that the oil price remains stable in the global market but Saudi Arabia which is the second largest oil producer refused to cut down the production so that the price of oil is lowered. This is shown by the diagram which is attached in the appendix 3.

The sharp decline in the global oil piece has significant impact on the oil exporters and oil importers which means that there are winners and losers in this circumstance (Liu et al., 2014). The fall in the oil price positively impacted the oil importers as they have to pay less for the same amount of oil purchase and thus, their disposable income has increased. They can now purchase more of other goods and increase their consumption. In this case, India had been implementing disinflationary pressure and derived positive effects from the oil price fall. It is evident from the survey by IMF that if there is 30% fall in the oil price then there is 0.8% hike in the economic growth in these countries (Forbes, 2015). Thus, it can be said that the oil importing countries are winners (Salisu, 2014). In the case of the oil exporting countries, the low oil price implies that there is a reduction in their oil revenue which will pose as a constraint in the economic growth and development of these countries. For example, Venezuela had to decrease 20% of its government expenditure to combat the budget deficit which can be attributed to the fall in the oil price. Thus, the oil exporting counties are losers in such circumstances.

Impact of global oil price on China and the aggregate demand

The fall in the global oil price will positively impact the oil importing counties as they can now have to pay less for the same level of purchase of oil. This enables the consumers of the oil importing countries to increase their personal disposable income. This helps the consumers to demand and consume more commodities than before. This will increase the aggregate demand of the importing countries. The second impact that affects the oil importing countries is the decrease in the cost of production of the final goods which will increase the profit and thereby the investment (Silverstein, 2015). The third significant impact is on the inflation rate. The price of oil has the ability to affect the price of other commodities and thus, create a situation of low inflation which lowers the real interest rate. The oil importing countries have the ability to reduce the energy subsidies with the advent of low oil prices. Since the oil importing countries increases the consumption within the economy, this will increase the aggregate demand of the countries and shift the curve to the right. This is shown by the diagram attached in the appendix 4.

The dramatic changes in the global oil market had impacted the Chinese Economy substantially. The low oil price has positive impacted the Chinese economy which can be explained by the decrease in the imports of the oil in dollar amounts have increase the current account surpluses. In 2014 China had imported 6.2 million barrels per day whereas in 2015 China imported 6.5 million barrels per day of crude oil (Fang and You, 2014). The next impact is on the economic growth of China. The low oil prices have the potentiality to augment economic growth in the economy by increasing the GDP of the country which is shown by the chart attached in the appendix 5. The oil price decline will support the government of China to reform the tax and fiscal systems of China (Financial Times, 2015). There is also a significant negative impact which is the continued trend of falling price of oil will influence the price of other commodities and can cause deflation whereas there will be significant negative impact on the investment in domestic energy and oil and gas production which will lower the contribution of these sectors to the GDP of the country (Basnet, Vatsa and Sharma, 2014).

The concept that the low oil price will increase the real income of the consumers of China is directed towards the aggregate demand. As the real income of the consumers has increased, it implies that the consumers can purchase more of other goods and increase the consumption expenditure of the economy. Since the aggregate demand consists of consumption expenditure which when increased will increase the aggregate demand and shift the curve to the right which will increase the real GDP of the Chinese economy (Wang and Zhang, 2014). This phenomenon is shown by the diagram attached in the appendix 6.

Conclusion

Conclusion:

The global oil price is always experiencing booms and busts in the past and recently there was a sharp decline in the global oil price which impacted both the oil importers and exporters. There are mainly two reasons behind the fall in oil supply which are the weak demand for oil from the emerging economies like India and China and the next is the refusal of OPEC to reduce the oil production. Both the situation caused an excess supply within the oil market which lowered the oil price to equilibrate the market. In this paper, the focus is on the oil importing countries and the evaluation of the impact of the fall in the global oil price. In this context the third largest importer of Oil which is China is considered (Zhang and Chen, 2014). There was significant positive impact of the fall in the global oil price on Chinese economy like economic growth, inflation rate and the reform in the tax and the fiscal structure but there is also a significant negative impact on the economy through the threat of deflation (Zhao et al., 2014).

References

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