The Regional Effects of the Oil Boom

Consider a simple quantity-theory-of-money model with modest growth in the money supply and no change in the income velocity of money. In this economy, with moderate economic growth, there will be little-to-no inflation.



Now shock this economy with a massive increase in demand in one sector and one geographic region (say, a big increase in the demand for oil in Alberta). In that part of the economy, wages will go up because labour mobility is costly and the adjustments are not instantaneous. Also, in that part of the economy, prices of fixed inputs will sky-rocket (e.g. housing and land).



If those prices go up by considerably more than the rate of growth in the money supply minus the rate of growth in real output (still assuming velocity is constant), then prices somewhere else have to fall. Where?



The primary candidate is housing and land elsewhere in the economy, but that's a difficult political move and could trigger bankruptcies in those areas, especially if consumers have used home equity to support their consumption; it also helps explain why premiers in the Maritimes are trying to stem the emigration of their residents (e.g. see this in the Globe and Mail).



There might also be lower wages in construction (and other occupations) in those areas for workers who don't move so easily to the areas where there is a growth in the derived demand for labour. But longer-term contracts and other rigidities make it next-to-impossible for these wages to fall. So instead, unemployment might rise. Or more likely people will be inclined to say "I can't get work here, so I'm moving out west" in response to the market signals. And this has clearly been happening. From the same G&M piece:

“Probably 20 per cent of the parents on my son's hockey team, the fathers travel back and forth to Alberta and work in place like Fort McMurray,” he [Nova Scotia Premier, Rodney MacDonald] said.



... A report released last month said nearly 13,000 people migrated to Alberta from the Atlantic provinces over a one year period ending July 1.

What should monetary policy makers do in this case? If they maintain a low, steady rate of overall, measured inflation, the average of the high rate of inflation in one sector will have to be offset by deflation elsewhere. But the downward rigidities in the slow or shrinking sectors mean that prices cannot fall there, leaving them to suffer from increased unemployment among those who are less mobile and/or lower growth rates. At the same time, though, implementing policies trying to avoid slumps in the declining sectors and regions of the economy will add fuel to the inflationary pressures in Alberta and the oil patch.



To the extent that this simplified analysis has some validity, it is easy to see why policy makers might favour allowing a bit more inflation when there are large sectoral upheavals in the economy. So far, the Bank of Canada has been doing a decent job of balancing these concerns:

Prices in Alberta rose 4.7 per cent in December from a year earlier: A much higher inflation rate than the national average of 1.6 per cent, and well above any other province. (British Columbia takes second place at 2.1 per cent.) And Alberta's inflation rate has been consistently higher than the rest of the country for about three years.

My guess is that The Bank will let the Alberta rate go wherever it goes, but will try to avoid deflation in any geographic region of the economy. If so, there might be good reason to expect Canadian inflation to move into and remain in the upper regions of the targeted band national inflation rate of 1 - 3%. But if oil prices continue to decline, it'll be another story for another posting.