Economics Essay Paper on FALL IN OIL PRICES

FALL IN OIL PRICES

Introduction

The story in the Globe and Mail titled “Should Canada fear a “catastrophic” collapse in energy prices? Russia does” presents an emerging issue about the drop in oil prices observed recently (Babad 2014). Both Canada and Russia has had crude oil reserves on which the income of the two countries rely heavily. While Russia already fears for further reduction in oil prices as it might lead to a reduced GDP, Canada is kind of shielded from the impacts of reduced oil prices due to a variety of factors. The drop in crude oil price in the global market has been more than 30 percent in the recent times.

According to the article, some analysts claim that Canada might be shielded from the catastrophic fall in oil prices due to its trade in heavy oil coupled with a drop in currency (Babad 2014). It is still debatable how much these two factors could shield the country’s economy. However, this assertion could turn out to be true due to the higher demand that generally exists for light crude oil in comparison to the heavy crude in which Canada trades.

Although the reduced Canadian currency value and the discount rates on heavy crude may shield Canada from the impacts of the heavy decline in oil prices, there is a possibility that any further reduction in the oil prices might result in a loss of at least 0.2 percent GDP from the Canadian economy as a whole. The impacts of reduced oil prices will be more strongly felt in oil producing counties such as Alberta and Saskatchewan. Alberta derives at least 25 percent of its revenue from Royalties associated with oil. Since the revenue earned by counties always trickles to the national government, it is clear that any loss to the oil producing counties will lead to a loss to the national government. Consequently, although the short term impacts of reduced oil prices may be limited on the national government, the country is not shielded in the Long term.

Application to IS-LM Model

Since oil is a source of revenue to the Canadian government, a reduction in oil price ordinarily means a reduction in the disposable income to the government. To off-set the resultant deficit, there is an increased probability that the interest rates in the lending sectors will have to be raised in the long term. Consequently, the levels of fixed capital investments will have to reduce due to the increased lending rates. This will result in a shift of the IS curve outwards and to the right indicating a rise in both interest rates and the income levels.

In the money market, the demand for money is a positive function of the real income in an open economy. Any rise in the real income results in a subsequent increase in liquidity. Consequently, the reduction in nominal income that may result due to the reduction in oil prices is more likely to cause a reduction in the money demand as well as in the real income since the real income or money supply is a positive function of the nominal amount of money available. This tends to shift the money market equilibrium downwards.

 At the same time, the reduced value of the Canadian dollar is an indication of excessive circulation of funds. This normally results in an increase in the disposable income available to consumers. Therefore, this may also result in reduced fiscal deficit spending by the government hence reduction in the interest rates. A reduction in the interest rates is more likely to lead to an increase in investment hence shifting the IS curve inwards i.e. to the left. Also, since the demand for money is a negative function of the price, a reduction of the price of the goods or money will definitely result in the increase in demand. In addition, due to the high volume of funds in circulation, the amount of nominal income is high hence the money supply is subsequently high. This results in an upward shift of the money market.

In conclusion, a combination of the opposing effects of the fall in both oil prices and the value of the Canadian dollar is most likely to result in a constant equilibrium position between the money market and the goods market. It can therefore be said that in the short term, the impacts of the fall in oil prices will not be felt by the Canadian economy.

REFERENCES

Babad, Michael. 2014. “Should Canada fear a “catastrophic” collapse in energy prices? Russia does.” The Globe and Mail (November 14), http://www.theglobeandmail.com/report-on-business/top-business-stories/should-canada-fear-a-catastrophic-fall-in-oil-prices-russia-does/article21587808/