International business homework
Economists have for a long time appreciated that, the oil industry, is the only industry in the globe that, concentrates more capital than any other industry[i]. Less appreciated is the fact that, the global economy is immensely sensitive to the oil trade than any other industry (Hamilton 23). It has been proven that, the significance of trade imbalances, and the huge transfer of wealth, has its origin in the oil market. This has left the trade imbalance unabated and not understood by the major economies in the world. This is not to the best interest of these countries. This paper will analyze the effects of changing oil prices in the developed countries[ii], why the effects vary among countries, and how this affects trading and other patterns of imports and exports (Mankiw 16)
Effect of changing oil prices in developed countries
Oil prices spikes creates challenges to central bankers in most developed countries. An increase in the price of oil for instance, raises the cost of a particular firm and the prices that they charge for products (Hamilton 23). When none energy prices are constant, this raises inflation, and for a particular level of aggregate demand, drives the economy towards a recession[iii]. When faced with such a scenario, the central bank has a choice between implementing a money policy to fight the inflation and the recession. Oil shock; affect the macro economy by depressing the demand for key consumption and investment of goods[iv]. In the past, oil crisis was characterized by a widespread concern on the price and availability of energy
Economic growth effects
Oil price shocks have a significant effect in the macroeconomic variables. The impact of changing oil prices in most developed countries reflects a reduction in output, in most of the economic activities. The manufacturing and transportation sectors are immensely affected by increase in cost[v]. Many studies have confirmed the link between the oil prices changes, and the economic growth in many countries (Strahan 45). The origin of the oil price change is relevant to the significant or magnitude of the effect of changing oil prices in the developed countries. The supply shocks, have led to negative impacts on output, however the demand shock lead to positive impact[vi].
Reduction in the domestic output of the developed countries reflects the effects of lower purchasing power on the domestic demand (Singleton 16). Energy shocks have a significant impact on the employment levels. This is part of the fact that, a weak economic growth decreases the demand for labor significantly[vii]. Changes in the oil prices affect the stock markets of the developed countries. Changes in oil prices have a significant impact on the real stock returns of large economies.
Balance of payments effects
Oil price change affect the terms of trade. They do this by changing the ratio between the value of imports and exports (Mankiw 12). This has repercussion on the countries balance of payment. The deterioration of the balance payments adversely affect, the economic growth of many developed counties, however it is worth noting that, countries for example America are very good when it comes to absorbing shocks[viii]. The effects of oil shock on the balance of payments in most developed countries are not necessarily negative. Oil trade balance may fall after the shocks that raise the price of oil; the non trade balance may improve or even deteriorate depending on the shock. In most developed countries, the long term effects of changing oil prices may follow a distinctive pattern[ix].
Since changes in oil prices have effects on employment, food and transport prices, they also have significant distributional effects in the developed countries. People, who work in the informal sectors, are more vulnerable to this effect[x]. The urban poor, who work in the informal sectors, are specifically exposed to the price shocks. The challenge posed by distributional effects, have made many developed countries come up with policies which shield the consumers from the price increase (Hamilton 17). Countries like the U.S have made plans to diversify from oil intensified activities whenever oil price rise. Many developed countries have emergency oil tanks used for storing oil[xi].
Increased oil prices, imply a higher production cost for many firms in the developed counties. The firms pass this onto the consumers, by raising the price of products. In contrasts to the direct effects of changing oil prices, this effect has an influence on the inflation (Ono 43). In developed countries that import oil, the cost effect significantly affect the GDP deviator and the import deflator[xii]. The latter is termed as the price of domestic value, excluding the foreign inputs (Strahan 32). The direct and cost effects are reflected in a shift of the foreign deflator. In the GDP deflator, the remaining indirect effects are captured. In the United States, there is no reaction of the GDP deflator to the changes in oil prices despite the country being an oil producing country. Increase in the United States core inflation, can therefore be attributed to the cost effect (Mankiw 17). This case is similar to that of Japan. The situation in Europe and especially Switzerland is different. Major economies in these zones always experience a rise in the GDP inflator after an unfavorable oil price change[xiii].
Second round effects
Unfavorable Oil price change has the capability of increasing the GDP deflator in the developed countries through positive second round effects (Strahan 28). Second round effects, are triggered whenever the employees raise nominal wages to maintain the purchasing power, whenever there is an increase in energy prices[xiv]. This results in costs to firm increase. When the firms in developed countries pass on higher wage costs to output the prices, there is an upward pressure on the prices of goods and services. Contrary to second round effects, direct and cost effects leads to permanent shifts in the price levels (Singleton 34). The second round effects can lead to a self sustaining spiral, of increasing wages and prices. This results to a more persistent consequence on the inflation[xv].
The second round effects existence, can depend on the responses of inflation expectations, and supply and demand. In the United States, second round effects are not present, this is because the nominal wages do not rise and the price wage ratio is constant. The rise in overall consumer price in the United States implies that, the loss of the purchasing power is borne by the employees (Ono 36). In Japan this situation is different. The GDP deflator remains constant as a result of a rise in the nominal wages. This happens after an unfavorable oil supply shock (Mankiw 43). The situation contrast that, of the United States in that, major producers suffer through a significant fall in price wage ratio. This results to wage increase and signals the presence of a detrimental demand effect in the country. In Europe the real consumer wages remain constant in the long run. There is a significant fall in the price wage ratio. This openly indicates that, demands effects are present in the Euro area.
Increase in cost and price, lower demand and the economic activity. For the developing countries which import oil, an increase in oil takes away the disposable income. Given a relatively small elasticity of oil and the energy demand, the income effect depresses the demand for other goods that are domestically produced (Mankiw 56). If there is an increase in uncertainty of oil prices, it may be essential for these countries to postpone the irreversible purchase of investment, and the consumption of goods which are connected to energy
Reason this impacts vary among countries
The economic structure of a country to a large extent determine the macroeconomic effects of oil shock, a country like Germany; which is a producer of high quality goods, for which the transport costs are a minor determiner of the international competitiveness has a good position in case there is an increase in oil prices (Mankiw 48). In addition to this, many oil producing countries have an immensely high share, when it comes to German exports. This results to the indirect effects of Germany being positive.
In addition to the economic factors, the geographic factors have an influence on the magnitude caused by the oil shock[xvi]. For instance, countries that have a large population, and have a high domestic demand, and are located near the export markets, are better protected when it comes to increase in the oil price (Mankiw 76). This factor can be used to explain the reason why Japan is negatively affected than the European countries, for example France.
Inflammatory pressures may differ across the developed countries. The effects of high energy prices depend in part on how important energy is in a particular economy. Countries for example the U.S.A and Japan use more oil per dollar as compared to countries like France and Germany. Americans consume approximately twenty four million barrels of oil per day (Hamilton 56). Europe which has roughly the same size as the United States consumes fifteen million barrels.
In the United States, energy intensity has gone substantially low in the last decade. This has been influenced by the energy conservation acts. The changing structure of the United States industry has also influenced this (Strahan 76). There has been a declining share of manufacturing, and a growing share in the less energy intensive services. Nonetheless, the United States leads in energy intensity as compared to other developed countries. Based on the purchase-price parity concept, the United States produces three times as much as Britain and other developed countries across Europe. The country consumes between six to nine times, as much energy. The disparity for this is that, retail energy prices are greater in Europe
Developed countries in Europe, have strong Unions and Institutional arrangements. This makes them prone to the wage-price spirals (Hamilton 68). The unions in most developed countries across Europe are more likely to extract high wage concessions in their response to the rising consumer prices. As compared to the United States, the product market is less intense in developed countries across Europe (Hamilton 70). Therefore producers in Europe, are more likely to trigger a wage price spiral .In the United States, workers are likely to absorb the high oil prices through energy intensive goods and the high oil price itself.
The disequilibrium between the global oil supply and demand in various developed countries can result to changes in oil prices in those countries. Sharp price increase can result due to an increased demand and a stagnant supply. There is a relative sensitivity of oil demand to changes in income and price (Hamilton 78). Many researchers have suggested that, the main determinant of oil demand is income. Therefore a rapid growth in income levels in the developed countries, influence the oil global market significantly (Hamilton 83).
Developed countries have different macroeconomic environments. Variables that are related to different economies across the developed countries results to different effects. The reduction in domestic output in developed oil importing nations reflects the effects of lower purchasing power, on the domestic demand.
3. Effect of oil shock on trading patterns of other imports and exports
Many economics have argued that, uncertainty that arises from oil price volatility; to a great level reduce trade flows. This is because; it raises the risks faced by the importers and the exporters. The impact of oil price fluctuation on trade flows is well understood through the uncertainty channel. The fluctuation in oil prices may result to uncertainty about the future path of oil prices. This causes the consumers to postpone the irreversible purchases of the consumer durable goods (Hamilton 88). Many firms postpone irreversible investments. The reduction in domestic consumption and the investment expenditures, implies a reduction in aggregate demand, and therefore reduces international trade.
The effects of an oil demand shock, which is driven by high economic activity in the world, results in the economy having a transitory increase in the GDP. Many developed oil importing countries, experience growth in output, since the country is able to effectively trade with other countries around the world (Hamilton 112). The global growth, increase the demand for products in a particular country, since the country can be able to effectively export its goods
Oil has a systemic relationship with fuel. The food price and oil price have risen and fallen in Tandem in the past decade (Mankiw 76). Many developed countries use machinery to farm. The machinery is fueled using oil. Oil is also used as an input in many agricultural products. With an increase in oil prices, more pressure is put on the commercial food systems. The high prices in food stuff are passed to the consumer through, increased prices of products. Many countries like the United States; which export foodstuff increases the price of that foodstuff significantly. Export led agriculture, has also contributed significantly to the oil shock (Mankiw 99). Many developed countries have urged the developing countries, to produce cash crops at the expense of food crops. These countries are forced to import, or depend on foreign food aid programs. The rising transport costs, directly contribute to the rising price of food imports, this makes them less affordable
Potential increase in oil prices has a direct effect on the transportation cost (Strahan 101). Many developed countries, depend on transport to export their goods, and to import them. Increase in oil prices, result to increased freight transportation. Countries like Japan depends on freight to export their automobiles, the increased transportation cost, is directed to customers who buy the automobiles more expensively. This decreases the market capacity and affects the import and export capabilities of Japan.
[i] The oil industry controls the major economies in the world. It has a major significance to the growth of a countries economy (Mankiw 44)
[ii] Developed countries are largely concentrated in Europe and America. These countries are characterised by a high economy (Ono 12)
[iii] Inflation in this case means the increase of price in goods in a particular country (Hamilton 43).
[iv] Uncertainty in the macroeconomics has the ability to change the impact of oil prices change in a given economy (Strahan 32).
[v][v] Increased manufacturing cost in most cases results from production. (Singleton 16)
[vi] Growth effect can be significantly y good for the purpose of biodiversity (Strahan 34)
[vii] For a contrasting view see (Strahan 43)
[viii] For more research on this issues go to chapter four of (Strahan 46)
[ix] This information is similar to the one given by (Singleton 20)
[x] Simon Ono expounds on this by giving a detailed analysis of a specific case (Ono 17)
[xi][xi] Several other studies have pointed to the same conclusion, see (Hamilton 44) and (Singleton 46)
[xii] More information about the GDP can be found in (Singleton 45)
[xiii] On deep analysis regarding the GDP see (Ono 76)
[xiv] This is similar to what (Mankiw 56)says in his book
[xv] More information in regards to inflation can be found in (Singleton 54)
Hamilton, James. Analysis of the Transmission of Oil Price Shocks Through the macroecomy. California: University of California, 1996.
Mankiw, James. Priciples of economics. South Western: Thomson Publishers, 2004.
Ono, Simon. “Oil Price shocks and Price Markets.” European Journal Of comparative economics 1.29 (2011): 29-45.
Singleton, Kennedy. The 2008 Boom/Bust in oil prices.working paper. Standford: Stanford University Press, 2010.
Strahan, David. The Last oil shock. New York: John Murray, 2011.