Question

1. Adverse Oil Price Shock

At the beginning of the semester we identified falling oil prices as a potential risk factor for the global economy. The last few months the price of oil has dropped significantly for various reasons, and more recently shutdowns globally have exacerbated the problem by decreasing demand. Discuss the impact of a negative oil price shock on current account deficits, fiscal deficits and exchange rates.

Answer 1

For major countries, the economy for which is run by money which comes in through oil exports, a sudden decline in the exports would cause big time problems in the country.

Across the globe, the Corona Virus pandemic has led to a situation of Lock Down, meaning that people are not allowed to exit their homes and accordingly, the demand for oil products is declining as consumer demand falls rapidly.

This causes a situation wherein, negative demand would cause decline in funds for oil exporting countries. The result would be that deficits would rise. This is because expenses remain the same whereas income declines for countries. When this happens, lesser of foreign exchange is collected in the treasury. The end result being that the value of the exchange rate declines in comparison.

This would have a negative impact on almost all works of life. Imports would become expensive for companies and the government alike. Lesser amounts of money will be generated through the exports which the country does and the economic demand for products and services may fall even further.

An example explaining the same is as follows:-

If the current price of oil suddenly drops, then the asset side of the government begins to decline. This is because revenue fall in value and quantity. Once this happens, the government is no longer able to manage paying for its exports as well as it did earlier. With lesser foreign exchange available, the government may chose to print more currency to be able to pay of debt if any. This further devalues the local currency available.

Lack of demand means people lose their jobs relatively quickly. As a result of which, the currency further falls and demand further falls leading to cyclical issues in the country.

Please feel free to ask your doubts in the comments section if any.