The macroeconomics of oil price shocks has been one of the most discussed issue in the extensive literature of energy economics since the mid-seventies, when the 1973-74 oil shock increased the debate concerning the oil economy as never before. In this regard, several areas of investigation about oil and economic performances have emerged as important subjects of research. If immediately after a price shock, researchers were investigating whether the higher price of oil might be a permanent feature of a changed natural resource regime, on the other side researchers were also exploring how the economy should adjust to the new international oil context generated by sudden oil supply shocks. As underscored above, increasing attention to these dynamics emerged during the mid-seventies when, in particular, the oil price shock of 1973 and subsequently of 1979 were pointed out as the principal reasons of lower U.S macroeconomic performances after the shocks. The oil shock impact on economic growth depends on several factors partially linked:
(i) the shock size (measured by the price change in percentage terms);
(ii) the shock’s persistence (for how long the shock lasts on the financial markets);
(iii) the economic dependency on oil and energy (if the economy is more or less energy intensive);
(iv) the policy-makers’ strategic decisions (if the monetary and fiscal policies implemented to reduce the oil shock impact will have the effect of reducing the negative consequences of the shock itself).
In this context, this brief essay will provide some key-contributes with the aim to shed light on this diverse and somewhat fragmented framework on the oil price effect on the economy.
The literature on the relationship between oil shocks and macroeconomics can be divided into two broad strands: the first examines the relationship between energy prices, economic activity and the direct effects of oil price increases on the aggregate output (Hamilton 1983, 1985, 1988, 1996, 2003, 2005; Kilian 2005; Rogoff 2006; Rotemberg and Woodford 1996); the second analyses the direct and indirect effects arising from central bank policy responses to the inflation caused by oil price increases (Bohi 1989, Bernanke et al 1997, Hamilton and Herrera (2004)). However, despite the considerable amount of literature on the topic, the origins and causes of oil shocks remain an area of continuous discussion both by the supply side (the shocks of 1973, 1979, 1980 and 1990 have commonly been included in the supply side shocks category) and the demand side (the shock of 2007-2008, principally driven by the increasing energy demand from emerging economies such as India and China, see table 1.).
Table 1: World Supply-Demand Balance for Oil in 1990 (a) and 2010 (b)
Source: Dicembrino, C., Scandizzo, P.L., “The Deterministic and Speculative Component of the Oil Spot Price: A Real Option Value Approach, 2011. Paper presented at the Energy and Finance Conference, School of Economics, Erasmus Rotterdam University, 5-6 October 2011.
Analysing the U.S. output growth between 1948 and 1980, Hooker (1996) has illustrated that a 0.6% decrease of GDP growth has been due to a 10% increase in oil prices, conﬁrming Hamilton’s results over the period between 1948 and 1972. Furthermore, Hamilton (1983) calculated with a similar data set (from 1949 to 1980) that a 10% increase in oil prices will result later in a reduced level of U.S. GDP growth (approximately he estimated a 1.4% of GDP) as compared to GDP levels without oil price increases. Rotemberg and Woodford (1996) estimated for the same lapse of time, a U.S. GDP decrease of 2.5% caused by the spike of 10% in oil prices. Lee et al. (1997) argued that this abrupt and unexpected oil price growth has had a highly significant and asymmetric impact on output. Mory (1993) showed that increases and decreases in real oil prices have asymmetric effects on output and other macroeconomic variables between 1951 and 1990, and important effects on personal income and earnings in many industries from 1959 to 1989.
Ferderer (1996) found evidence that conservative monetary policy in response to oil price increases might affect domestic output; moreover, he found that central bank decisions cannot explain alone the oil price shock effects on real GDP. Barsky and Kilian (2002, 2004) investigated the idea of considering oil price shocks as a direct contributor to macroeconomic fluctuations since 1970. They reviewed the most important oil price shocks, in particular the 1990-91 Gulf War and the 2001 boom in oil prices, by arguing that, despite the fact that these episodes might seem similar, in reality they are very different (Figure 1).
Figure 1: Oil price behaviour (1965-2011) and the most important oil-shock since the World War II
Source: Author elaborations on BP database. $US per barrel, 2010 prices.
In this context, Hooker (1996) analysed the dramatic crude oil increases during the 1980s, finding evidence that increases in oil prices have significantly impacted the economy, while the price decline effects during the same lapse of time have had a smaller impact and have been more difficult to model. As it has already been mentioned above, Hamilton (1983), by examining a data set from 1948 to 1980, found that oil price variation has a strong casual and negative correlation with the real U.S. GNP growth. Following the Hamilton paper (1983), Mork (1989) showed that, by extending the sample to 1988, the correlation becomes only marginally significant and that there are asymmetric effects between oil price fluctuations and GDP growth. Furthermore, he found a negative correlation with oil price increases and a statistically scarce significant correlation with oil price decreases. Burdidge and Harrison (1984), by analyzing the lapse of time between 1962 and 1982, examined the effects of oil shocks in several OECD countries. Rotemberg et al. (1996) and Finn (2000) analysed oil price shocks with an imperfect and perfect competitive model, respectively. Rotemberg et al. (1996) discussed the oil price turmoil effects on the U.S. economy, by hypothesizing that monopolistic competition is responsible for amplifying the oil price shock impact. By using imperfect competitive models, they explained the effect of oil price increases on output and real wages. The results indicate that a large monetary contraction might produce effects on output and real wages, but it is unclear why “such large monetary contractions should follow oil price increases” (Rotemberg et al. (1996), p.572). Against the Rotemberg et al. (1996) theory, Finn (2000) argued that, through a theory of perfect competition, it is possible to explain the Rotemberg et al. (1996) evidence, concluding that an increase in energy prices might be considered as a technology shock able to induce contractions in the economic activity. The power of these shocks depends principally on the relationship between energy usage and capital services.
The aim of Hooker’s paper (2002) was to analyse the structural break in the core of U.S inflation before 1981. His query concerns whether the abrupt decrease in energy prices can be attributed to an energy intensity decline of the U.S economy, the deregulation of energy industries and the monetary policy change in favour of less accommodative regimes. However, he did not find empirical support in any of the three hypotheses investigated. He claimed that the real cause of the energy prices decline can be linked to the movement to a low inflation environment resulting from a change in the monetary regime, thus rejecting the hypothesis that the pass-through was dampened by other factors.
Following the strand of the aforementioned literature, Hamilton (2003), by analysing the effect of oil shock on GDP growth rate, described the following relation between the GDP rate of growth (yt) in quarter t and oil shocks (o#t) measured with 100 times the logarithmic amount by which oil prices exceed their peak over the previous 12 quarters, (while if the oil price are below the peak o#t = 0, there is no oil shock):
yt =β1yt-1+β2yt-2 +β3yt-3 +β4yt-4 +β5o#t-1 - β6o#t-2 + β7o#t-3-β8o#t-4 +c
He stated that oil price increases have a stronger effect on the economy, whereas such decreases do not seem to have the same impact. Moreover, Hamilton (2005) argued that oil price changes could not be predicted from earlier movements in other macro variables, and that one of the origins of oil spikes can be linked to exogenous factors such as military conflicts.
Among the most recent contributions in this field, the studies of Blanchard and Gali (2007) and Hamilton (2008) analysed the causes and consequences of the 2007-2008 oil shock. Blanchard and Gali (2007) studied the reduction over time of the oil shock extent; they found that the recent oil shocks had a smaller effect on prices and wages, as well as on output and employment. Key causes for these changes are: (i) real wages rigidities (that generated a trade-off between the stabilszation effect of inflation and the output gap); (ii) the way monetary policy is conducted “[...] the stronger commitment by central banks to maintaining a low and stable rate of inflation targeting strategies, may have led to an improvement in the policy trade-off that make it possible to have a smaller impact of a given oil price increase on both inflation and output simultaneously” (Blanchard-Gali, 2007, pp 6); (iii) the lower presence of oil-intensive industry in the economy may have decreased the macroeconomic effects of price changes.
Strictly focusing only on the determinants that engendered the unexpected oil price turmoil during the past few years, Hamilton (2008) said that among the many reasons that boosted the oil price during the summer of 2008, there was a low price elasticity of demand, strong growth from emerging economies (table 1), and the failure of global production to increase and thus respond to higher level of oil consumption (figure 2).
Figure 2: Main world oil producers
Source: Author elaboration on BP 2011 data set. Thousand barrels daily
Furthermore, Hamilton (2008) said that the oil turmoil had a great effect on the U.S. economy in 2007 and 2008, concluding that it was one of the most important causes of the 2008 recession: ‘‘[...] the evidence to me is persuasive that, if there had there been no oil shock, we would have described the U.S economy in 2007:Q4-2008:Q3 as growing slowly, but not in a recession”. Jimenez-Rodriguez and Sanchez (2005) worked on the symmetric and asymmetric effects of oil price shocks on the real economic activity of the main industrialised economies (G7 countries, Norway and the Euro area) distinguishing between net oil importing and exporting countries. Through a Vector Autoregressive approach (VAR), he found that the real GDP growth of oil importing economies is negatively affected by increases in oil prices in both linear and non-linear models. In this type of uncertain oil price scenario, Rogoff (2006) stressed the unpredictable role of oil shock effects on the output, by highlighting the current lower impact of oil price fluctuations on the economic global growth rate as compared to two or three decades ago.
Overall, I can conclude that, despite the vast literature related to economic growth and oil price behaviour, there is no shared consensus on the impact of oil price oscillations on economic growth. Nevertheless, the attempt to provide a general and unambiguous view on this issue has highlighted some principal features on the relationship between oil price fluctuations and economic growth:
I) The exponential oil demand growth from China, the Middle East and other newly industrialised economies has contributed to the unstable oil prices level during last decade;
II) The reduced amount of oil supplies in industrialised countries and the strong demand determine a tight situation on the oil market. This situation makes the whole market particularly vulnerable, leaving Saudi Arabia as the only producer with huge spare capacity;
III) There is a stronger effect of rising, as opposed to decreasing, levels in oil prices on economic growth;
IV) The importance of the shock-size, both in terms of the new real price of oil and the percentage increase in oil prices;
V) All the recessions after 1973 have been associated with oil shocks, but not all oil shocks have led to a recession (Blanchard and Gali 2008, Hamilton, 2009 p. 255).
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