As oil prices crawl around lows of $30 per barrel (making the recent oil price plunge possibly the most important global commodity price collapse in the last century), the economic implications remain unclear. One thing is obvious though, a small economy model like that from the previous post is not terribly helpful, … except for residents of small island economies; and even then it fails to consider the interaction between the exporters and importers.
This post considers global implications of the recent unexpected increase in the supply of oil. To cut a long story short, for a global oil supply shock to increase global GDP, your author’s model suggests that certain things must be true: Oil demand must be somewhat unresponsive to the oil price, and people in oil importing countries must tend to spend more of their income than oil exporters do. Moreover, the impact on the global economy will be bigger if people in both types of country tend to save less. But, as discussed at the end of the post, there are many caveats; we will consider a few that could reduce the size of the overall effect. As a result, it is perhaps not so surprising that the global oil glut is not boosting income as much as many people had expected.
As in the last post, the analysis is technical and is here only to help the author think through the logic (it was written on numerous bus rides, he hopes it makes sense and is putting it up here so that anyone else that is interested can use it). The model is linear, and there is no investment, but (as Jim Haley over at The New Age of Uncertainty noted) that would need to be the next step towards a more complete understanding of the matter. Still, this abstract model is still useful to understand the impact on global demand and GDP.
The setup of the model is Keynesian, and mathematical, building on the small island case from the previous post. Now, however, there is an oil exporter. The oil exporting economy is just like the oil importer from the previous post except, in addition to producing a consumption good similar to the one that the oil importer produces, it owns an oil well (a very big oil well, capable of supplying the world). There are no resources used in pumping oil (except the run down of reserves) and it is assumed that the pump can be regulated to open wider when the price is high, or closed off when prices fall. The exporting country decides how much to export based on its national income and the oil price. It exports oil to the oil importer and imports the consumption good to supplement its domestic production. The oil exporters’ import demand for consumer goods must equal the exports of the oil importing country, and its exports of oil must equal the oil importer’s demand; the oil price (and changes in global income) adjust to ensure that the global markets for goods and oil clear.
In mathematical terms, using the same notation as we did in the last post, we have the following:
We also have the following conditions that must hold since one country’s exports are the other’s imports.
If we use the d notation to represent changes, we can write (1) and (2) as
dY= dC+ dX– dM – M.dp (1a)
dY*= dC* + p.dX* +X*.dp – dM* (2a)
dX*=dS – x*dY* (9)
Equation 9 is the only equation that is much different from the model in the earlier post. It simply says that the oil exporters exports go up by the increase in the oil supply, dS, offset by the increase in its own oil demand coming from an increase in its own income (x* is the propensity to consume oil out of income).
We can use this model to work through a number of questions. Let’s start with considering how opening the oil tap up affects world GDP. This is analogous to think about how removing sanctions on Iran affects world GDP. To keep things short, the math is left out, but your author plans to scan in his scribblings at the end of the post.
The impact on world income
With some manipulation of equations (1)-(9) the change in world income works out to be as follows:
d(Y+Y*)/dS =(1+E).(c-c*).(1/A) (10)
Mathematically, there are three parts to equation 10 that combine to determine the overall impact on global GDP. The first (1+E) depends on E, the price elasticity of demand for oil (= p/M . dM/dp or the percentage change in the oil importer’s demand for oil due to a 1 percent increase in its price). If oil demand is unresponsive to price changes, then E takes a value between -1 and 0. That makes sense, so that is what we assume, so 1+E is positive. If E is less than -1, then things get a whole lot more complicated. Nevertheless, it could be worth thinking about, because you could use this model to imagine the effects of an increase in supply of other goods that may not be so inelastically demanded (let’s just not do that now).
The third term in (10) is also interesting. 1/A is the “global multiplier”. It is a fairly complicated expression. It turns out that a sufficient (but not necessary) condition for it to be positive is if oil demand is relatively more sensitive to income in the importer than the exporter, and if the propensity to consume out of income, c, is higher in the oil importing country than the oil exporting country, i.e. c>c*. That is important because if that is true and if the (1/A) term is positive, then the term (c-c*) is positive and our model predicts that global income will rise in response to an oil price shock. It is generally true that the share of spending out of income is higher in oil importers (like Europe) than exporters (like Saudi Arabia) (though it is worth remembering that some advanced countries like the US are major oil producers, and have high propensities the consume). One last observation; generally speaking, given our assumptions, the overall size of the multiplier (1/A) will be larger the higher are the propensities to consume in both countries.
So there we have it. The global oil shock should boost global demand. But there are some clear caveats that could imply that the overall impact is not so big.
One reason that the boost to global demand might not be so big is that the fall in the oil price might be thought of as temporary. If so, importers will be tempted save the windfall, and spread the spending of the gains out over their lifetimes, while exporters could do the opposite. The propensity to consume in the importing country, c, would then be smaller than normal and the propensity to consume in the exporter, c*, would be bigger. In other words, there might not be too much difference between the oil importer’s marginal propensity to consume out of the oil price shock (which is what matters) and the oil exporter’s. if c=c*, then the impact on global GDP is zero!
The global impact could also be reduced if the uncertainty created by the shock encouraged everyone to save more. That would leave the differential between the spending shares roughly the same, but reduce the size of the global multiplier.
Yet another reason is because with globally integrated capital markets, the fall in oil income could be transferred to the oil importing country if it’s households happen to own shares in oil companies.
The last reason is that investment could fall. Nowadays, oil production is an extremely capital intensive venture. Exploiting the more marginal oil reserves often involves building an offshore oil platform, or a facility to convert oil sands into oil. As such cuts in oil prices resulting from the reentry of oil producer like Iran, will lead to a disproportionately large cut in global investment, compared with a shock to other sectors of the economy.
Once you take all this into account, its not clear that in the short term, in a world where there is high implement and insufficient demand, that the oil fall in oil prices should result in a significant boost to growth.