The Effect of Falling Oil Prices until 2021

Several consequences are anticipated if oil prices fall in the next five years. The reduction would have an effect on various aspects of the economy, including transportation and industry costs. Even though the drop in oil prices is good news for some, especially importers, it is bad news for exporters due to the decrease in income.

Lowering oil prices is primarily determined by a country’s fiscal sensitivity. Lower energy prices would result in a reduction in government income. Lower economy-wide prices subsequently results in lower household incomes and decline in different corporate profits (Cologni and Manera 865). Also, reduction in oil prices will reduce the personal and corporate income tax revenues and EI premiums as well as revenues from sales of goods and services. Also with lower prices the expenses of the government will reduce and this certainly results in a partial offset to the losses from revenue. Some of the spending that are done on statutory programs like benefits to the elderly will decrease. Also, the spending that are linked to the growth in nominal GDP like those of territorial governments will automatically reduce.

Balance of Payments

If oil prices reduce in the next 5 years, there will be effect on net exports and imports. Decline in oil price will be beneficial to the importers given that the value of oil imports will decline. The reduction in value will reduce the existing account deficit of oil importers. On the other hand, for the oil exporters, the decline in oil prices for the 5-year period will reduce the value of the exports hence lower trade surplus. The effect carries on to the current account of a country especially when they are big importers or exporters of oil.

Often, most of the oil exporting countries rely on tax revenue that accrue from oil to fund the spending in governments hence a bad news. This means that government spending will be largely affected during the time. During the five years, the governments that rely on oil are likely to experience a budget deficit. This means the government will have to increase the taxes or cut on their expenditures.

Inflation and Unemployment

When the oil prices fall, the Short Run Aggregate Supply (SRAS) will shift to the right. The shifting to right results into lower inflation and subsequent rise in the real GDP. If the oil price decline by a unit, the real GDP is likely to increase by a unit. Reduction in oil prices will result in increased unemployment levels in the oil exporting countries (Cologni and Manera 861).

Social Reaction in General after all the Negative or Positive Impacts

When the oil prices decline the cost of living is likely to reduce. Also, the oil related transport costs will also fall hence leading to lower cost of living and lower rate of inflation. When the real wages are stagnant, the fall in oil prices is significant as it is likely to give the consumers more discretionary income. Reduction in oil prices over this period is like a free tax cut. The fall in oil prices is likely to lead to increased spending on the goods and services and add to real GDP. For the oil exporting countries that highly rely on oil revenues to fund their social spending, a fall in oil prices lead to significant budget deficit and subsequent social problems.

Exchange Rate

Usually, the negative terms of trade shock like a fall in oil prices for an exporter results in reduction of the price of non-traded goods in a domestic economy hence the real exchange rate. Real exchange rate is defined as the relative price of a basket of traded and non-traded goods that is between the domestic and foreign economy. Given that the prices of non-traded goods are likely to be sticky, the adjustment of the real exchange rate will need nominal exchange rate to depreciate as well (Rautava 317).

When there is negative oil price shock, wealth is transferred from to importers from the oil exporters. In the long run, noticeably, the 5-years, there will be large shifts in current account balances and portfolio relocation as well. To get the external net financial sustainability of oil importers, the real exchange rate need to depreciate owing to the negative shock that happens to the oil price. This is the only way that non-oil trade balance can be improved.

Monetary and Financial Sector

Oil price decline has several effects in an economy. First, reduction in oil prices results into amplification of credit risk. When the oil prices fall the risk premiums on countries and companies that rely on oil revenue widen (Rautava 320). The widening will be reflected in the manner bond spreads, on equity prices and the movement of currencies. Having the fall in the oil prices for a period of years is likely to put at risk the debt servicing capacity of exploration and production firms especially those that have high cost base.

Works Cited

Cologni, Alessandro, and Matteo Manera. “Oil prices, inflation and interest rates in a structural cointegrated VAR model for the G-7 countries.” Energy economics 30.3 (2008): 856-888.

Rautava, Jouko. ”The role of oil prices and the real exchange rate in Russia’s economy—a cointegration approach.” Journal of comparative economics 32.2 (2004): 315-327.