Tuesday, January 27, 2015

The Fall in Oil Price and Economic Growth

The fall in the price of oil will slow down growth in Canada through a decrease in business investment.

While consumers are enjoying the fall in the price of oil, federal and provincial governments are worrying about its negative impacts on their finance. Finance Minister Joe Oliver struggling to balance as promised the federal budget had no choice than postponing its announcement until April at the earliest [here]. In Alberta, the largest oil producer in Canada, the fall in oil price turned the budget surplus the province projected this year into a $500 million deficit [here].

The fall in the price of oil decreases the price of gasoline. This raises consumer surplus, increases the use of cars and consequently the consumption of gasoline. The induced increase in households’ mobility raises their propensity to consume: eating out, shopping...

The first panel of the figure below shows the evolution of the average propensity to consume along with that of the consumer price index (CPI) of gasoline.   The average propensity to consume is the ratio of households’ final consumption expenditure to their income. I have used gross domestic product (GDP) as a proxy for households’ income. 

Average Propensity to Consume, Investment Intensity, and CPI of Gasoline, Canada, 1981:Q1-2014:Q3, Data Source: Statistics Canada
Average Propensity to Consume, Investment Intensity, and CPI of Gasoline, Canada, 1981:Q1-2014:Q3

Growth in the average propensity to consume is negatively correlated with growth in the CPI of gasoline. The correlation coefficient between the two growth rates is -.011.

Only consumers benefit from a fall in the price of oil. Businesses and governments incur losses.  
Growth in investment intensity is positively correlated with growth in the CPI of gasoline (.16). Investment intensity is the share of business investment in GDP. A fall in the price of oil reduces the profit margin, increases uncertainty, and discourages new investment in the oil industry. To understand the importance of the oil industry in Canada, note that in provinces such as Alberta and Saskatchewan oil and gas extraction represented an average of 28 % and 18% of their respective annual GDP between 1997 and 2013. To these two shares, one can add the support activities for oil and gas extraction, which represent about 2% of the GDP of these provinces. Across Canada, oil and gas extraction represents on average 6% of GDP.
As far as federal and provincial governments are concerned, the correlation coefficient between their general revenue as a share of GDP and the CPI of gasoline is .23. 

So what could stimulate the economy given this expected slowdown? Bank of Canada’s decision on January 21st to cut its key rate from one percent to .75% could stimulate investment and further increase households’ consumption.