Dept. of Economics & International Business
Sam Houston State University
A higher oil price has preceded most economic recessions since World War II, leading Hamilton (2011) to consider the price of oil to be a forward-looking indicator of economic activity. Although the real oil price appears to be correlated with business cycles, the significance of an oil price shock on macroeconomic aggregates has declined (Kilian & Lewis, 2011). Thus, instead of examining the macroeconomic impacts of an oil price shock, the underlying causes (i.e. oil supply, global aggregate demand, precautionary demand) of this shock and their effects are what should concern policymakers (Kilian, 2009; Baumeister & Peersman, 2009). Furthermore, since the 1980s, the underlying cause of fluctuations in the oil price appears to be primarily from global demand for oil. Therefore, the question I ask in this paper is whether an oil price shock or a global demand for oil shock has greater impacts on the unemployment rate, output, and inflation.
To disaggregate the macroeconomic effects from a natural rate of unemployment, aggregate supply, and aggregate demand shocks and from either an oil price or global demand for oil shock, I construct a structural vector autoregressive (VAR) representation by estimating a four-variable VAR model with quarterly data from 1974-2011 and imposing long-run restrictions to identify each of the structural shocks. I attempt to answer my question by examining the estimated impulse responses and variance decompositions. Different cases are discussed, depending on which oil-related shock and which inflation rate are in the estimated model.
To identify different shocks within a system of variables and evaluate the economic effects from these shocks, I build a VAR model with the following variable ordering: the unemployment rate, either Kilian's (2009) measure of global real economic activity or the real oil price, economic output, and either the headline or core (excludes food and energy) rate of inflation for the consumer price index (CPI). After estimating this VAR model, I impose fully recursive long-run restrictions based on an oil-related model to construct a structural VAR representation that identifies a natural rate of unemployment, global demand for oil or oil price, aggregate supply, and aggregate demand shocks, respectively.
The impulse responses and variance decompositions of each of the cases I evaluate indicate that the effects of macroeconomic aggregates are different between the two oil-related shocks. In particular, a global demand for oil shock has larger and longer impacts on the U.S. unemployment rate and economic output than an oil price shock. Although an oil price shock has a larger effect on the headline rate of inflation, the durations of the effects to the headline and core rates of inflation are longer for a global demand for oil shock.
Since a higher oil price has preceded 10 out of the last 11 U.S. recessions, the macroeconomic effects from an oil price shock concern policymakers. Although there is evidence that these effects may be declining, additional evidence indicates that it is not the oil price shock that matters but its underlying cause. Since the 1980s, the primary underlying cause has been from a global demand for oil shock; therefore, this research examines whether the macroeconomic effects of a global demand for oil shock are greater than those from an oil price shock.
After estimating a four-variable VAR with quarterly data from 1974:1-2011:3 and constructing a structural VAR with long-run restrictions, I compare the effects from natural rate of unemployment, global demand for oil or oil price, aggregate supply, and aggregate demand shocks on the unemployment rate, economic output, and the headline and core inflation rates in the U.S. My results indicate that the macroeconomic effects of a global demand for oil shock are greater in magnitude and duration than those from an oil price shock. Therefore, policymakers should not necessarily be concerned with the price of oil, but how their policies influence or react to global economic activity.
Considering that the U.S. is the world's largest economy and consumer of oil and that monetary policies from other countries tend to follow the Fed's actions, it is likely that the impact on global demand from those policies chosen by the Fed would indirectly drive up the price of oil and magnify the effects of a global demand for oil shock. These indirect effects on oil price shocks from global economic growth by a monetary authority have been noted by Barsky and Kilian (2004) and Anzuini, Pagano, and Pisani (2012). Therefore, further research should examine the impacts that monetary policy has on the index of global real economic activity because a global demand for oil shock has larger macroeconomic effects than an oil price shock.
Anzuini, A., Pagano, P., & Pisani, M. (2012). Oil supply news in a VAR: Information from financial markets, Temi di discussione, no. 851, Banca d'Italia.
Barsky, R., & Kilian, L. (2004). Oil and the macroeconomy since the 1970s. Journal of Economic Perspectives, 18(4), 115-134.
Baumeister, C., & Peersman, G. (2009). Time-varying effects of oil supply shocks on the US economy. Working Paper, Ghent University.
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Hamilton, J. (2011). Historical oil shocks. NBER Working Paper No. 16970.
Kilian, L. (2009). Not all oil price shocks are alike: disentangling demand and supply shocks in the crude oil market. American Economic Review, 99(3), 1053-1069.
Kilian, L., & Lewis, L. (2011). Does the Fed respond to oil price shocks? The Economic Journal, 121(555), 1047-1072.
King, T., & Morley, J. (2007). In search of the natural rate of unemployment. Journal of Monetary Economics, 54(2), 550-564.