Question

Oil prices have gone down significantly since the start of this year. Most of the developing markets that rely on imported oil can benefit from low oil import bill due to unprecedented decrease in oil prices.

Question: How it would affect the currency exchange rates, inflation and interest rates in developing economies? Provide the reasons for your answer as well.

Answer 1

The oil prices going down benefits all those devloping countries as their export bill will get at all time low with high supply of oil. Devloping economies such as China and India are stock piling oil at lower rate but they do not wish to grant all the benefit of lower oil rate to its customer as increasing taxes make them more revenue to stabilise the old price and benefiting from taxes.

Affect On currency exchange rates - An oil price decrease may be resulted  to the exchange rate through two main channels:

1) The terms of trade: A negative terms of trade shock (say, a decrease in oil prices for an oil exporter comapnies) brings down the price of non-traded goods in the domestic economy and thereby the real exchange rate, which is explained  as the relative price of a basket of traded and non-traded goods between the domestic and the foreign economy. As prices of non-traded goods may be sticky, the adjustment of the real exchange rate could require nominal exchange rate depreciation too;

2) Wealth effects: A negative oil price shock transfers Money from oil exporters to oil importers, leading to large shifts in current account balances. In order to restore the external net financial sustainability of oil importers (exporters), the real exchange rate has to depreciate (appreciate) following a negative shock to the oil price, in order to improve the non-oil trade balance.

Affect on Inflation - Oil prices and inflation are often termed as being connected as a cause and effect relationship. as oil prices goes up, inflation also increases and if the oil prices falls, inflation starts to decreases.

The actual reason why oil and inflation are attached because oil plays most important part of these developing economies- it is used in main activities such transportation, electricity generation and if the oil prices rises so then the end products.

Affect on interest rates -The fall in crude oil prices offers relief to global investors in the same sense that it could lower the energy demanded inflation in the global economy and may force major central banks to go slow, either in limiting bond purchases or in the planned interest rates hikes.

Higher oil prices generally impacts the increase in input costs across economies and inflation rises across the globe due to the increase in energy prices. The current decline in oil prices offers relief to investors, as it is likely to pause further rise in inflation and any prospect for higher interest rates in major economies.