Plunging Oil Prices as a Positive Supply Shock ?

A year ago, oil prices had plunged from $110/barrel to around $70/barrel. There was much concern then, as there is today with oil prices under $40/barrel, about the effects on the Canadian economy. The Globe & Mail ran a story “Oil’s Plunge to Buoy Global Economy: A $1.3 Trillion Boost to Consumers.”

While media stories usually don’t use the language of aggregate demand and aggregate supply shocks (Macroeconomics for Life, Ch. 8), this is a good example of how real world events can be “translated” into the terms of that model.

“Let’s not forget that there are many winners from what is effectively a positive supply shock,” said senior economist Robert Kavcic of BMO Nesbitt Burns, adding that consumers are “the clear and immediate beneficiaries” of the plunge in crude.

If you demonstrate the positive supply shock to students, the bigger challenge is to explain why some of the model’s predictions (lower prices) have come to pass, but others (increased GDP) have not.

Because plunging oil prices affect aggregate demand, especially in Alberta, there are interdependencies in the model that the simply positive supply shock does not capture.

This is also an example of the fallacy of composition. While falling oil price are good for an individual consumer or business, for the economy as a whole (including Alberta), the effects are not so positive.

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