Every country needs some oil to run its errands, but the oil producing nations (OPEC nations) are few in number. From an economic point of view, whenever the suppliers are few, they tend to manipulate the prices of their products. Essentially, OPEC nations agree on the amount of oil to produce and the prices of selling the oil. OPEC nations discuss the target markets, and they dictate the distributing channels for their own good.
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In a span of one month, oil prices can raise considerably, but since oil has no substitute, the demand for oil remains inelastic. Indeed, oil prices affect nations’ GDPs in one way or another. This paper will give a clear outlay of the effect of oil prices on the various variables in the GDP equation using clear illustrations and graphs.
The gross domestic product (GDP) presents the market value of the economic activities within a nation. The GPD sums all the amounts of monies spent in a nation.
The four factors that measure the GPD include the consumption levels of the consumers, investment levels of businesses (amount businesses spend on purchasing goods and services), the government spending, and the net exports. In this case, the net exports amount is the difference between the exports and imports. Oil prices have an indirect effect on each factor of the GDP equation, which in turn affects the nation’s GDP levels (Maeda 112).
GDP = C +I +G+X
Where C is the total consumption of the consumers,
I is the investment levels of the businesses,
G is the federal, state and government spending, and
X is the net exports (exports minus imports).
Oil prices and their effects on the total consumption of consumers
Consumption is directly proportional to the income levels of a household because people can only spend the amount of money that they earn. However, not all the money is spent; earners have to pay income taxes to the government, and some households save some of their income.
Whenever the oil prices are high, businesses tend to increase the prices of their products to cater for the rise in the production costs (Pinno and Serletis 202). This factor decreases the consumers’ spending powers, and consumers tend to buy few items. Essentially, some consumers would decide to save their money rather than spend it with the hope that the prices of products would decrease in the near future.
The price elasticity of demand will play a critical role in such a case, where, consumers will only purchase necessities and shy away from buying luxuries. Consumer spending forms the largest part of the GPD in most nations. Therefore, whenever the oil prices rise, they reduce the consumer spending indirectly, and consequently, the GPD reduces. In the United States, two third of the GDP comprises of consumer spending. Therefore, a decrease in consumer spending would have a significant effect on the GPD of the US (Kilian and Vigfusson 79).
Oil prices and their effects on the total investments
As stated before, business investment is the amount of money that businesses spend on purchasing products and services. Moreover, businesses make long-term investments through the purchase of land, fixtures, and equipments. A rise in oil prices is a shock on the supply side of the economy and it has adverse consequences on the economies of countries (Kim 140).
Obviously, businesses will experience an increase in the variable costs, especially for manufacturing businesses that heavily depend on oil. The businesses will resolve on increasing the prices of their products to remain at the same profit margins. From an economic point of view, an increase in prices causes the demand of products to contract, and the businesses are likely to have reduced sales than before.
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If the oil prices continue to rise, there is a possibility of an economy to experience an inflationary effect. Essentially, the decreased sales means decreased profits; therefore, businesses will have insufficient money to invest. The amount that businesses invest contributes to about 15% of the nation’s GDP. Although the 15% contribution to the nation’s GDP is considerably small, a decrease in the total investments will decrease the nation’s GDP.
Oil prices and their effects on the total government spending
The government is an overseer that responds to tough economic conditions of the nation. As described, an increase in oil prices is a supply side shock that would inflate the price levels of products and deflate the real output of the economy. The government can respond by relaxing the monetary policy through decreasing the interest rates and taxes. Therefore, businesses will have their production costs somewhat reduced because of the reduced taxes.
Another alternative would be increasing government spending by subsidizing the costs prices. However, the options may have adverse consequences on the general economy. Increasing the oil subsidy bill would mean that the government would have to increase its budget and this would affect the other sectors of the economy.
Although upstream companies like the Oil And Natural Gas Corporation and Oil India would share a third of the subsidy burdens, the government may have to make short-term borrowings to cater for the unanticipated shock. On the other hand, decreasing interest rates and taxes would decrease the government revenues. Essentially, rise is oil prices would decrease the government spending on goods and services and increase its spending on transfer payments, which is a threat to the GDP.
Oil prices and their effects on the total net exports
If there is an increase in fuel prices, a country that exports manufactured goods may experience an increase in the production costs of the products that it exports. Therefore, the country may lower its productivity and export less of the products than before. Moreover, the country is forced to spend more money on importing the essential petroleum product than before. The two incidences would bring an imbalance on the total net exports and the country may have negative net exports.
Clearly, a rise in oil prices is an external shock that affects economies in one way or another. Economies that entirely depend on oil-energy for their production processes would suffer greatly if oil prices increased drastically. Sometimes the oil prices drop, but they have negligible effects on the GDP.
Therefore, to reduce the effect of the increase in oil prices, companies should find ways of containing other costs and increasing the labor productivity (Ravazzolo and Rothman 461). It is clear that oil is an essential product with an inelastic demand. Therefore, governments that do not reserve enough oil when the oil prices drop will continue suffering from the supply shocks. It would be advisable for governments to build oil reserves that would greatly help the nation during shortages and during shocks.
Kilian, Lutz and Robert Vigfusson. “Do Oil Prices Help Forecast U.S. Real GDP? The Role of Nonlinearities and Asymmetries.” Journal of Business & Economic Statistics 31.1 (2013): 78-93. Print.
Kim, Dong. “What Is An Oil Shock? Panel Data Evidence.” Empirical Economics 43.1 (2012): 121-143. Print.
Maeda, Akira. “On the Oil Price-GDP Relationship.” Japanese Economy 35.1 (2008): 99-127. Print.
Pinno, Karl and Apostolos Serletis. “Oil Price Uncertainty and Industrial Production.” Energy Journal 34.3 (2013): 191-216. Print.
Ravazzolo, Francesco and Philip Rothman. “Oil and U.S. GDP: A Real-Time Out-Of-Sample Examination.” Journal of Money, Credit & Banking 45.3 (2013): 449-463. Print.