ARTICLE:
The Economic Effects of Lower Oil Prices

Article Synopsis: This article looks at the short- and long-term effects of the drop in the price of oil in 1993

Relevant Chapters: 27, 28

Topics Covered: demand and supply; aggregate demand and price adjustment; short-run effects of price changes; long-run effects of price changes

Focus Questions:

1. Using an ADI-PA diagram, show how lower oil prices benefit the United States economy as a whole in the short run.
2. What are the long-run effects of lower oil prices?
3. Why don't lower oil prices benefit all sectors in the United States in the short run?

The Economic Effects of Lower Oil Prices

(source: "The Economic Effects of Lower Oil Prices" by The United States Government Printing Office. Economic Report of the President, Washington: 1994, p. 71.)

Oil prices tumbled during 1993. Over the first half of the year, West Texas Intermediate crude oil averaged about $20 per barrel. By the middle of October the price was down to about $18.25 per barrel, and by late December the price had fallen to about $14.25--more than 25 percent lower than earlier in the year. Weak global economic conditions, including the recessions in Europe and Japan, the seeming inability of the Organization of Petroleum Exporting Countries (OPEC) to restrict its members' production levels, and the possibility that Iraq would soon be exporting substantial quantities of oil again were likely contributors to the price declines.

A drop in the price of oil, like any relative price change, has microeconomic consequences: Some sectors benefit and others are hurt. Lower oil prices will likely bring painful dislocations in the U.S. oil industry and the regions where it is concentrated. If oil prices remain low, domestic oil output is likely to decline faster than it already has been. U.S. dependence on foreign oil would also be likely to increase. Lower oil prices would also cause more energy to be used and might lead to higher levels of pollution.

Because oil is such an important input into the U.S. economy, however, lower oil prices will also have favorable effects on the U.S. macroeconomy in 1994--if prices stay in the $15-per-barrel range. There are several transmission channels. The main beneficial effect is that lower oil prices translate into lower inflation, which boosts real disposable income for consumers, giving them the wherewithal to make more nonoil purchases. Lower oil prices also mean that businesses have lower costs, which translate into higher cash flow and profit margins, leading in turn to more investment spending. Foreign industrial economies also get an upward boost from lower oil prices and in turn demand more U.S. exports.

Some economic models suggest that if the 25-percent drop in oil prices in 1993 were sustained over 1994, real GDP growth would be between 0.3 and 0.4 percentage points higher in 1994. The same models predict that CPI inflation would be noticeably lower.