Oil prices in the international market have been on a consistent decline since June 2014 and the impact of this decline on the economy of the country has been evident. The economy of the United States, just like many other nations around the world, largely relies on oil. The industrial sector relies on oil to run normally, and any changes in the cost of oil often have a direct impact on its productivity.
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When oil prices decline, other sectors of the economy may benefit from reduced cost of production. On the other hand, the economy will be affected negatively by reduced income from the oil and gas sector and a possible loss of job. For a country that has oil and gas as one of the major exports then the negative impacts may outweigh the benefits which are derived from the reduced international oil prices. However, a country that relies less on export of oil to support its economy will benefit from the reduction of oil prices.
The United States is one of the leading producers and consumer of oil. It means that there will be a mixed outcome of the consistent reduction of the international oil price. In this paper, the researcher will look at how this shock can affect the country’s economic growth if it continues for the next five years.
The fiscal sector will be one of the areas that will be significantly affected by the falling prices of oil in the international market. The United States heavily relied on foreign borrowing to finance its budget deficit. The ongoing reduction of international oil prices may have varying impacts, depending on the net effect the scenario may have on the economy. The first possible scenario is that there may be net benefits.
This is possible if the reduced cost of production in the industrial is more beneficial. If that is the case, then the government will be able to collect more income in form of taxes, and there may be a budget surplus. On the other hand, if the net effect of this scenario has a negative impact on the amount of tax the government collects, a budget deficit may not be avoidable. The figure below shows a possible shift from a budget surplus to a budget deficit caused by a scenario where the revenues remain constant or reduce while the expenses increase.
It is in the interest of the government to fully fund its expenditures without having to rely on borrowing. However, this can only be achieved if the economic forces make it possible to have a steady flow of income in terms of tax. However, if the declining oil prices may have a net negative impact on the taxes the government collects, then a budget deficit may not be avoidable in the coming years.
Inflation (Domestic Prices) and Unemployment
The domestic prices are directly affected by the forces in the oil and gas sector. Most of the manufactured goods in the country rely on oil. The cost of transport is also defined by the pump prices. As such, domestic prices are directly affected by the changing price of oil in the international market. It is expected that the reduction in the cost of oil will have a positive impact on the domestic prices. As Negishi notes, there are two primary causes of inflation within a given economy (28).
The first one is a demand pull inflation that occurs when the demand for products in the market outweigh their supply. The price goes up to the level where it is only the rich that can afford such products. Given the scenario we are dealing with in this case, it is possible that the country may experience increased demand for some products as their costs go down. For instance, more people may be interested in buying cars because of the reduced cost of using it. As shown in the figure below, if the demand for such products continues to increase, then the prices of the products may go up.
Cost push inflation is the second type, and it occurs when the cost of production goes up. Based on the current trend where the cost of fuel is reducing, it is very unlikely that the country may experience cost-push inflation unless it is driven by other economic forces. The overall impact of the trend is expected to reduce unemployment in the country. Firms outside the oil and gas sector will experience increased profitability which may help them expand hence more people will get employment.
Monetary and Financial Sector
The expected reduction of oil prices may to have a major impact on the financial sector within the country’s economy. According to Gnos and Rossi, one of the leading industries in the United States is that of oil and gas (12). Companies such as ExxonMobil are pumping a lot of cash into the financial sector. Banks, insurance companies, investment funds, and the real estates all benefit a lot from the flow of cash from the oil and gas companies. The industry has remained very lucrative, but as it is it seems things have changed and the financial sector should expect a consistent decline in the rate of flow of money from these sectors. The figure below shows the expected reduction of cash flow from this sector.
According to Gillespie, when the financial sector suffers a reduced rate of flow of cash, then the impact may be felt in the entire economy (76). The ability of these financial institutions to give out loans to firms may be reduced and this may have a negative impact on the economic growth. Assuming that the income from other sectors remains the same while that from the oil and gas sector is reduced, then the money markets may be affected negatively.
External Sector (Balance of Payments)
The balance of payment may be directly affected by the continued reduction of the oil prices in the international market. The United States is one of the leading producers of oil and gas in the world (Marino 118). However, it does not rely primarily on any single sector of the economy, hence it is expected that the weak oil prices may have devastating impacts on the economy. It is important to note that the balance of payment may be affected in one way or the other.
For instance, ExxonMobil is one of the leading American companies that earn this country foreign exchange. The prevailing oil prices may reduce its profitability, which means that the income it gets from its overseas operations may be reduced. It may not be easy to precisely determine the effect the current forces may have on the balance of payment. However, analyzing the past trends may help in predicting the future. The table below shows the balance of payment from 1997 to 2009 when the price of oil was on a consistent rise.
Assuming that all other forces in the economy remain unchanged, it is possible to have a deficit in the country’s balance of payment.
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According to Devarajan and Mottaghi, the strength of the dollar against other major world currencies directly affects the country’s economy (90). A weak dollar means that the imports will be expensive and exports to other countries will be cheap. It will motivate local firms to exports their products. A strong dollar may have a complete opposite impact. Based on the history of the exchange rates in the United States, it is less likely that the decline in the oil prices may have an adverse effect on the country’s currency. However, one cannot possibly rule out a possible impact on the exchange rate even if the impact is negligible.
Given the fact that the economy of the United States is driven by numerous industries, it is likely that other than the oil and gas industry, other industries shall benefit from the decline in oil prices. The cost of production will be lowered, which means that exports from the country will be priced competitively compared to the products from other countries. The country’s currency will remain stable, a reflection of the stability of the economy.
Social Reaction in General after All the Negative or Positive Impacts
It is expected that after all the negative and positive impacts, there will be a social reaction. The negative reaction is expected to come from the players in the oil and gas industry. The reduced profitability in this industry may force them to consider investing in other sectors of the economy to reduce their loss of income. The majority of the American population is expected to have a positive reaction to the falling oil prices.
The players in the transport and manufacturing sectors will be pleased with the reduced cost of fuel because their cost of production will be lowered. They will be in a position to price their products competitively in the local and international markets. The general public will also react positively to the reduction of oil prices. The cost of operating personal cars will be reduced. Cost of life will also reduce because of the reduction in the cost of basic items. Those who rely on gas for domestic use will also enjoy reduced cost of purchasing this item. There will be an overall improvement in the living standards of Americans.
Oil is one of the most important products whose price and availability has significant impacts on a country’s economy. Since June 2014, the international oil price has been on the decline. As a result, the profitability of the industry has been affected. However, other industries within the economy may benefit. Their cost of production may be significantly reduced and this may spur the economic growth within the country.
Devarajan, Shantayanan, and Lili Mottaghi. Plunging Oil Prices. Washington, D.C.: International Bank for Reconstruction and Development, 2015. Print.
Gillespie, Andrew. Foundations of Economics. Oxford: Oxford University Press, 2016. Print.
Gnos, Claude, and Sergio Rossi. Modern Monetary Macroeconomics: A New Paradigm for Economic Policy. Cheltenham: Edward Elgar, 2012. Print.
Marino, Rich. Submerging Markets: The Impact of Increased Financial Regulations on the Future Growth Rates of Brics Countries. Hampshire: Palgrave Macmillan, 2013. Print.
Negishi, Takashi. Elements of Neo-Walrasian Economics: A Survey. New York: Springer, 2014. Print.
Rudebusch, Glenn. The Estimation of Macroeconomic Disequilibrium Models with Regime Classification Information. Berlin: Springer Berlin Heidelberg, 2010. Print.