Falling World Oil Prices (Chain of Analysis)

Here is an example of a chain of reasoning on the macroeconomic impact of a fall in world crude oil prices

Chain of reasoning (1)

For oil exporting countries such as Norway, a fall in world prices causes a deterioration in their terms of trade. 

This means that the weighted index of their export prices divided by import prices has declined 

One consequence of this is that export revenues per barrel for Norway will fall leading to a possible decline in their current account surplus 

As a result the oil sector will contribute less to the growth of Norwegian real GDP whilst oil prices remain low 

A fall in the terms of trade causes a drop in real living standards because Norway will have to sell more oil for each unit of imports 

A slowdown in growth and a decline in real wages especially in the oil sector might then lead to a cyclical slowdown & disinflationary pressures

Chain of reasoning (2)

For oil-importing countries such as the UK, a drop in the global price will cause a fall in costs in many industries. 

For example, the cost of aviation fuel and diesel used in the logistics industry will probably drop leading to a fall in operating costs. 

This is likely to cause an outward shift of short-run aggregate supply and therefore a period of disinflationary pressure. 

Disinflation is when the rate of inflation falls, i.e. from 5% to 2%. As a result, the cost of living will rise at a slower annual rate. 

One macro effect of such a drop in inflation is that – if nominal wages grow faster than inflation – real wages might start to pick up. 

And a rise in real wages in the labour market may then help to stimulate an increase in consumer demand and therefore higher AD