Question

An article in the Wall Street Journal discussed the views of then Canadian Minister of Finance Joe Oliver on the effect of falling oil prices on the Canadian economy. According to the article, Oliver argued that "lower oil prices would have a broadly neutral impact on real ... gross domestic product, but have a negative effect on nominal GDP." Given this view, can we tell what effect Oliver must have expected lower oil prices to have on the inflation rate? Briefly explain.

Short answer

According to Minister Joe Oliver's view, lower oil prices would likely lead to a decrease in inflation or possibly even cause deflation.

Step-by-step solution

Understand Gross Domestic Product

GDP comes in two versions: Real and Nominal. Real GDP is the economic output after adjusting for the effects of inflation. Nominal GDP is the economic output without adjusting for inflation.

Interpret the Statement

According to Joe Oliver, lower oil prices will broadly have a neutral impact on real gross domestic product, but have a negative effect on nominal GDP. This means that the quantity of goods and services produced will not change significantly, but the overall value of those goods and services will decrease.

Infer the Potential Effect on Inflation

If real GDP is unaffected (quantity of goods and services remains constant) and nominal GDP decreases (overall value of goods and services decreases), this would imply there's a decrease in the price level, which is also known as deflation. Hence, it implies that lower oil prices may cause a decrease in the inflation rate, or may even cause deflation if the price level drops enough.

Key concepts

Real Gross Domestic Product (GDP)

Real Gross Domestic Product, or Real GDP, is a vital economic indicator that measures the value of all finished goods and services produced within a country's borders over a specific period, typically a year or quarter, adjusted for inflation. By using base-year prices, it provides a more accurate representation of an economy's true growth, as it strips out the effects of price changes.

In other words, Real GDP reflects the volume of production and economic activity, taking into account changes in the purchasing power of money. If Real GDP is stable, it indicates that the economy is producing at a constant rate, irrespective of fluctuations in prices or the inflation rate. This is a crucial concept in economics as it helps separate actual growth from apparent growth that might just arise from changes in price levels.

Nominal Gross Domestic Product (GDP)

Nominal Gross Domestic Product, or Nominal GDP, is the total market value of all final goods and services produced in a country within a given period without an adjustment for inflation. As prices change due to inflation or deflation, Nominal GDP is affected, which can give a misleading picture of an economy's health. For instance, if a country experiences inflation, Nominal GDP may rise simply because prices are higher, even if the actual volume of goods and services hasn't changed.

Understanding the difference between Real GDP and Nominal GDP is critical as it allows us to isolate the impact of inflation and understand the real economic growth. When comparing economic output over time, it is essential to look at Real GDP for a more accurate assessment.

Deflation

Deflation is the general decline in the price level of goods and services within an economy over a period of time. Unlike inflation, which is the rise in prices and erosion of purchasing power, deflation increases the purchasing power of money as prices go down.

Although falling prices might initially seem beneficial, deflation can lead to a decrease in consumer spending, known as a deflationary spiral. As consumers anticipate lower prices in the future, they may delay purchases, which in turn leads to reduced production, job losses, and further economic decline. Recognizing signs of deflation, such as a decrease in nominal GDP with constant Real GDP, is essential to prevent such potential detrimental impacts on an economy.

Oil Prices Effect on Economy

The price of oil plays a significant role in the global economy. As a major input for various industries and a critical component in transportation and heating, changes in oil prices can have widespread effects. When oil prices fall, it can lead to lower transportation costs and production expenses for businesses, potentially reducing the price of goods and services.

For oil-exporting countries, however, falling oil prices might reduce the nominal value of their exports, negatively impacting Nominal GDP. Conversely, for oil-importing countries, cheaper oil can lead to reduced costs and potentially spur economic growth. The overall impact on Real GDP may be neutral if the production volume does not change, but the effect on Nominal GDP can be negative due to lower revenues from oil sales. It's crucial for policy-makers and economists to understand these dynamics when assessing the health and growth prospects of an economy.