Intro: Terms of trade refer to the price of a countries exports relative to its imports. Oil price increases benefit oil exporting countries by allowing a greater amount of imports for any given level of exports. This allows more inputs to the domestic production process to be purchased from overseas, thus benefiting the profitability of investment and economic growth.
It is intuitive that rising oil prices will benefit growth in an oil exporting country, but the dynamics at play are more complex than often understood. Take for example the impact of a surge in global oil prices not related to rising production costs on the US economy. It is generally considered that this acts as an effective tax on consumers which of course have to pay of their disposable income on fuel. However, what about the consumers which work in the oil industry that have find their disposable income increase substantially by the fact that they receive huge pay increases, or the consumers who benefit from rising equity prices thanks to a rise in energy stocks. To think in terms of ‘consumers’ is not particularly useful when trying to understand the impact of oil prices changes on the economy overall. What ultimately matters is whether the country is a net oil importer or exporter.
If the economy’s oil imports and exports are balanced, then an increase in the price of oil will simply result in gains for the oil sector at the expense of most other sectors. On the other hand, if an economy is a net exporter of oil and oil prices surge, the benefit to the oil sector will likely outweigh the loss to the non-oil sector. Essentially, the oil producers will benefit at the expense of domestic consumers as well as overseas importers.
However, how does this increase in oil prices lead to an overall increase in economic output in the oil exporting country? The answer is that higher oil price result in a net inflow of dollars into the oil sector, which allows domestic businesses to gain access to foreign capital to expand domestic production. While it could be the case than an oil exporting country uses the dollar inflows from an oil price spike to solely increase consumer goods imports that don’t actually benefit domestic growth, generally speaking at least some portion of the increased imports are likely to be growth enhancing.
Thinking about it the other way around, falling oil prices are positive for growth in oil importing countries because less dollars flow out of the country to purchase oil, allowing for greater imports of other goods, which helps to boost domestic profitability. It is tempting to argue that lower oil prices mean greater consumer purchasing power and therefore stronger growth, but in reality growth comes from the ability of businesses to profit and invest.