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My intuition is that as the price level falls, cost of inputs is falling for suppliers and their output increases. More people are then employed to increase production - correct?

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    $\begingroup$ It depends on which country you are. Since USA and Saudi Arabia inundated the markets with cheap oil (second half of 2014), they were able to break three enemies of the USA - Russia, Iran and Venezuela - all in a single stroke. $\endgroup$ – Rodrigo Jan 28 '18 at 21:33
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We need to distinguish between theory and the real world.

In theory, anything can happen. You would need a model that incorporates something that resembles an oil price (many standard models just have a single aggregated good). What then happens depends upon what other assumptions you stick into the model. Whether any of these models have any relationship to the real world is unclear. In any event, you would need to fix a particular model, and as a new question about its behaviour. (E.g., “What is the effect of an oil price rise in {Model X}?”)

In the real world, we need to distinguish the measured unemployment rate, and the “natural rate.” There are a number of ways of estimating the natural rate of unemployment, and what happens to them depends on all of the inputs into the estimation procedure.

What really matters in the real world is what happens to the measured unemployment rate (which may flow into the estimates of the “natural unemployment rate”, as many of the estimation procedures resemble low pass filters). I think the answer is a definite “it depends.”

Firstly, it depends on what country you are talking about. For an oil producer, falling oil prices can easily be a disaster for employment. Many oil producing countries have government revenues that are highly sensitive to oil prices, and so they may be forced to cut back spending. However, they generally have financial reserves, and so can handle limited price falls with limited disruption. Therefore, you need to look at each involved country separately.

For an oil consumer, a rapid rise in oil prices is disruptive; the 1970s experience could be used as an example. Consumers have to spend more on energy, making some products and services unviable. Meanwhile, the increased income is flowing to overseas producers. There is a “terms of trade” shock. The economy will eventually adjust to the new pattern of activity that incorporates higher oil prices, but in practice, the adjustment implies higher unemployment in the near run.

If the fall in oil prices is reversing a previous spike, this will presumably undo the previous disruption. However, if prices were previously stable, effects may be less dramatic. The effects on the economy will depend on how consumers react to the fall in energy prices. If they use the energy savings to buy domestically-produced goods and services, the total volume of domestic production rises, and so firms would presumably need to hire extra workers to produce the greater volume of output. However, the energy savings could just lead to higher savings, leading to no change in domestic production, and presumably employment (in the near run, at least).

The key is that falling input prices are generally not enough to cause increased production by itself; the firm needs to sell a greater quantity of goods, or else the extra production would just represent an undesired increase in inventories. (Since firms have to project demand, they could ramp up production (and hence, employment) to meet projected demand, but if that demand is not realised, they would have to reverse that decision.

For a country that is both a consumer and importer of oil (such as the United States) there is a trade-off between the benefit to consumers versus the potential loss of fixed investment in energy production. Therefore, it could go either way; you would need to do a fairly detailed model to get an estimate.

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Falling oil prices may or may not lead to a lower price level depending on how you're measuring the price level and what measure of inflation the monetary authority is trying to target. Is the relevant inflation figure the GDP deflator? The PCE deflator? The CPI? The "core" CPI?

Ignoring any nominal effects of falling oil prices if they exist at all, the mantra here is "never reason from a price change". Why is the price of oil falling? Is it because we've invented a new technology which allows us to synthesize oil at low cost, or is it because there was a recession in China which is leading to lower global demand? In the latter case, clearly the experience of the US and of China would be different.

There's also the fact that higher productivity of the kind that would be caused by a new technology allowing easier production of oil may not necessarily translate into higher employment. In general, there are competing income and substitution effects in these situations - as you become wealthier you want to work less, but as wages are higher you want to work more. It's not clear a priori which effect would dominate.

Finally, "unemployment" as used in "natural rate of unemployment" is meant to be a proxy for output gaps - if unemployment is higher than the "natural rate", then there's a negative output gap, and vice versa. In down-to-earth terms, we define "unemployment" as the state of not working but actively looking for a job, and the unemployment rate is the ratio of the number of such people to the size of the labor force. A change in the employment rate (the employment-to-population or employment-to-working age persons ratio) need not have any effect on the unemployment rate. Unemployment in a time of negligible output gaps is mostly the result of search frictions in the labor market. If a technological development made it easier to match potential employees with employers we would expect the "natural rate of unemployment" to fall, but it's not clear if or how an oil price change would lead to such an outcome.

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  • $\begingroup$ Interesting. You only forgot to mention oversupply as a cause, since the oil prices fell much more than other commodities. Now, WHY would oil producers increase supply when the demand is falling, if not for geopolitical reasons, as I stated in the other comment? $\endgroup$ – Rodrigo Jan 29 '18 at 12:14
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    $\begingroup$ @Rodrigo I'm not interested in engaging in "geopolitical" speculation. However, you shouldn't confuse movement along the supply curve with the movement of the supply curve itself - it's entirely possible that "lower demand" (the demand curve shifting, i.e movement along the supply curve) can be offset by "higher supply" (the supply curve shifting). "Oil prices fell much more than other commodities" may just mean that the supply curve for oil has a higher slope than the one for other commodities - it need not imply anything about "oversupply". $\endgroup$ – Starfall Jan 29 '18 at 12:22

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