ChainWhat it assumes · how to break it
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World oil prices rise sharply for an economy that is a net importer of oil and gas, such as the UK in 2022.
1
As a result, the price of each barrel of imported oil and fuel rises.
import prices
import prices
Assumes: The country is a net importer of oil.
But: A net exporter such as Norway earns more from each barrel it sells, so its trade balance improves.
2
Since demand for oil is price inelastic in the short run, the quantity imported falls by a smaller proportion than the price rises.
price elasticity of demand (PED)
price elasticity of demand (PED)
Best link to attack
Assumes: Firms and households cannot quickly reduce oil use.
Assumes: Firms and households cannot quickly reduce oil use.
But: Over several years they switch to more efficient vehicles, renewables and insulation, so the volume imported falls more.
3
Therefore, total spending on oil imports rises, so the value of imports rises.
value of imports
value of imports
Assumes: Other imports do not fall to offset it.
But: The squeeze on real incomes may reduce spending on other imported goods such as cars and electronics.
4
Consequently, the trade balance and current account deficit worsen, and the terms of trade deteriorate because import prices rise relative to export prices.
current account deficit · terms of trade
current account deficit · terms of trade
Assumes: Export earnings do not rise.
But: Oil-exporting countries earn more and may spend some of it on the importer's goods and services, raising its exports.
End
The trade balance worsens and the current account deficit widens for an oil-importing economy.
Evaluation chain
- E1However, the rise in the import bill depends on demand for oil being price inelastic.
- E2Because switching away from oil requires new vehicles, boilers and power stations, demand is inelastic in the short run but becomes more elastic over several years.
- E3As a result, the volume of oil imported falls further the longer the high price lasts.
- E4So the trade balance worsens sharply at first, and the deterioration shrinks over time as the economy adjusts, especially if the high price speeds up investment in renewables.
Another way to attack it: The higher oil price also slows growth in the importing economy, which reduces demand for all imports and partly offsets the worse oil balance. Any depreciation of the currency would raise the domestic price of oil further, though it would help exports.
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Questions this answers
- Assess the likely impact of a rise in world oil prices on the UK's current account.
- Explain why the effect of an oil price rise on a country's trade balance depends on the price elasticity of demand for oil.
- Discuss how an oil price shock affects the terms of trade of oil-importing and oil-exporting countries.
Diagram
No standard diagram. A PED diagram for oil (steep demand curve, supply shifts left) shows spending rising; data on the energy trade balance makes strong evidence.
Reverse and related
Fall in world oil prices → the import bill falls for an oil importer, so its trade balance and terms of trade improve.