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Time-Varying Effects of Oil Supply Shocks on the US Economy. Christiane Baumeister Ghent University Gert Peersman Ghent University. Motivation. The dynamic effects of oil supply shocks on the economy have probably changed over time

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Time varying effects of oil supply shocks on the us economy l.jpg

Time-Varying Effects of Oil Supply Shocks on the US Economy

Christiane Baumeister

Ghent University

Gert Peersman

Ghent University


Motivation l.jpg
Motivation

  • The dynamic effects of oil supply shocks on the economy have probably changed over time

    • Negative oil supply shocks are frequently considered as the underlying source of the 1970s stagflation

    • The second part of the eighties is recognized by significant declines of oil prices without corresponding effects on economic growth

    • Recent oil prices have never been as high whilst inflation remains stable and output growth reasonable

  • This paper investigates the importance of oil supply shocks when time variation is accounted for

    • Influence on oil production, the real price of crude oil, US real GDP growth and consumer price inflation


Why time variation l.jpg
Why time variation?

  • The oil market has undergone substantial changes over time

    • Global capacity utilization rates in crude oil production have not been constant over time

      • Constantly above sustainable capacity since late 1980s as well as in 1973/74 and 1979/80 (Kilian 2006)

    • Dramatic rise in oil price volatility since 1986

      • Transition from a regime of administered oil prices to a market-based system of direct trading in the spot market and collapse of the OPEC cartel

      • Lee, Ni and Ratti (1995) and Ferderer (1996): increased volatility has led to a breakdown of oil price-macroeconomy relationship

    • Relative importance of driving forces behind oil price movements has changed

      • Shifts in composition of oil supply and demand shocks (Barsky and Kilian 2002, Hamilton 2003, Rotemberg 2007)

      • Kilian (2007): these shifts help explain unstable estimates over time


Why time variation4 l.jpg
Why time variation?

  • Macroeconomic structure has changed over time

    • Improved monetary policy

      • Bernanke, Gertler and Watson (1997), Blanchard and Gali (2007)

    • Time-varying mark-ups of firms (Rotemberg and Woodford 1996)

    • Changes in firm capacity utilization (Finn 2000)

    • More flexible labor markets (Blanchard and Gali 2007)

    • Share and role of oil in the economy has varied over time

      • Declining share in consumption and production (Bernanke 2006)

      • Changes in the composition of automobile production and declining overall importance of the automobile sector (Edelstein and Kilian 2007)


Contribution l.jpg
Contribution

  • Multivariate time-varying parameters bayesian vector autoregression (TVP-BVAR) with stochastic volatility to model time variation

    • Used in “Great Moderation” literature: Cogley and Sargent (2002, 2005), Canova and Gambetti (2004), Benati and Mumtaz (2007)

    • Existing evidence

      • Splitting the sample in two subperiods assuming a break in mid 1980s (Edelstein and Kilian 2007, Herrera and Pesavento 2007)

      • Bivariate VARs over different time windows (Blanchard and Gali 2007)

      • Find a more muted impact on the real economy in more recent times

    • TVP-BVAR should capture smooth transitions in the propagation mechanism of oil shocks without imposing a specific breakpoint

    • Stochastic volatility models changes in the magnitude of structural shocks and its immediate impact

    • Multivariate approach to learn more about sources of variation


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Contribution

  • New method to identify exogenous oil supply shocks

    • Most studies: all variations in oil prices are assumed to be exogenous oil supply shocks

      • Barsky and Kilian (2002), Kilian (2006): only a small fraction can be attributed to exogenous oil production disruptions

      • Kilian (2007): exact underlying source is crucial for economic consequences

    • Hamilton (2003), Kilian (2006): measure oil production shortfalls in the wake of political crises and military conflicts

      • Selection of episodes is crucial and no generic supply shocks are identified

    • Kilian (2007): oil supply shocks only source of innovations in oil production (demand shocks only affect oil prices immediately)

      • Less appropriate for a quarterly VAR

    • We use sign restrictions from a simple supply and demand model of the global oil market

      • Oil supply shocks the only disturbances that displace the oil supply curve

      • Supply and demand shocks can affect oil production and prices


Empirical model l.jpg
Empirical model

  • TVP-BVAR with global oil production, real crude oil price, US real GDP and US CPI

    • “Great Moderation” literature: Cogley and Sargent (2002, 2005), Canova and Gambetti (2004), Benati and Mumtaz (2007)

    • First differences, 4 lags

    • 1947Q1-2006Q2 (first 20 years as a training sample)

    • Drifting coefficients to capture time variation (smooth transition) in the propagation mechanism


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Empirical model

  • Stochastic volatility: time-varying covariance matrix

    • Allows for heteroskedasticity of the shocks and time variation in the simultaneous relationships between the variables

      • Approach is particularly useful given instabilities in oil-macro relationship

      • Up to the data to determine source of time-variation: shocks and contemporaneous impact and/or propagation mechanism

      • Error terms of transition equations are independent of each other and of the innovations of the observation equation

      • Estimated with Bayesian methods (MCMC algorithm): Primiceri (2005)


Identification l.jpg

Poil

S1

D

S2

P1

P2

Q1

Q2

Qoil

Identification

  • Sign restrictions from a simple supply and demand model of the global oil market

    • Faust (1998), Uhlig (2005), Peersman (2005)

    • Oil supply shocks: disturbances that displace the oil supply curve

      • Shock which moves oil prices and oil production in opposite direction

      • Other oil (demand) shocks moves prices and production in same direction

    • Supply and demand shocks can affect oil production and prices immediately and this impact can change over time



Results11 l.jpg
Results

  • Considerable time variation which is statistically significant

    • Typical oil supply shock is characterized by a much smaller impact on world oil production and a greater effect on the real price of crude oil over time


Results12 l.jpg
Results

  • Considerable time variation which is statistically significant

    • Typical oil supply shock is characterized by a much smaller impact on world oil production and a greater effect on the real price of crude oil over time

    • Complicates the analysis of time-varying dynamic effects

      • The way the normalization is done becomes very important


Results13 l.jpg

10% oil price rise

1% oil production shortfall

Results


Results14 l.jpg
Results

  • Considerable time variation which is statistically significant

    • Typical oil supply shock is characterized by a much smaller impact on world oil production and a greater effect on the real price of crude oil over time

    • Complicates the analysis of time-varying dynamic effects

      • The way the normalization is done becomes very important

      • Comparing the impact of a 10 percent rise of real oil prices (Blanchard and Gali 2007): smaller impact on real economic activity over time

        • Assumes a constant oil demand curve over time

        • Corresponds to a fall in oil production of currently 1-2 percent whilst 15 percent in 1970s

      • Comparing the impact of a 1 percent production shortfall: currently substantial stronger impact on oil prices and consequently also on real economic activity and inflation

      • What does really matter? Oil production or oil prices?


Interpretation l.jpg

Panel A

Panel B

D’

Poil

Poil

S1

D

D

S1

S2’

S2

S2

P1

P1

P2’

P2

P2

P2’

Q1

Q1

Q2’

Q2

Q2’

Q2

Qoil

Qoil

Interpretation

  • Why such a change in the oil market over time?

    • Identification problem: magnitude of shocks versus contemporaneous impact (economic structure)

    • Oil demand curve must have become steeper (less elastic) over time!


Interpretation16 l.jpg
Interpretation

  • Why less elastic oil demand w.r.t. oil price fluctuations?

    • Transition from a regime of administered prices to a (flexible) market-based system of direct trading in the spot market (mid 1980s) cannot explain this

      • Could only affect the speed of adjustment, not the long-run effect (correct fundamental price)

      • Even smaller volatility of oil production detected

      • Steeper oil demand curve could be a source of increased volatility and transition to flexible system

    • “Great Moderation” (mid 1980s) cannot explain this

      • No obvious reason for a steeper oil demand curve

      • If it is the quantity of oil production what really matters, production disruptions became smaller over time (1/4th) and could be considered as a source of reduced macro volatility


Interpretation17 l.jpg
Interpretation

  • Why less elastic oil demand w.r.t. oil price fluctuations?

    • Structural changes in industrialized economies since id-1980s

      • High oil prices of 1970s caused industries to switch away from oil to other sources of energy

        • Smaller cost share of oil in total production (oil intensity) can make firms less reactive to oil price movements

          • Especially in environment of increased oil price volatility where cost increases are likely to be reversed quickly

        • Remaining amount of oil is absolute necessity, so less elastic because there are no substitutes anymore (e.g. transportation)

          • Declining share of industries with high price elasticity of oil demand

      • Developing economies that are in the process of industrialization (e.g. China, India) heavily rely on oil and are therefore particularly dependent on oil as an input factor

        • Their increasing (less elastic) share in world oil demand could have contributed to the steepening of the oil demand curve


Interpretation18 l.jpg
Interpretation

  • Why less elastic oil demand w.r.t. oil price fluctuations?

    • Capacity utilization rates of crude oil production: close to full capacity can lead to relative higher share of (less elastic) precautionary oil demand

      • A production shortfall cannot be replaced somewhere else

      • Can also explain the increased price elasticity in 1973/74 and 1979/80


Other findings l.jpg
Other findings

  • Variance decompositions


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Other findings

  • Variance decompositions

    • Oil supply shocks account for approx. 30% of oil production variance, which is rather constant over time

    • Contribution to real GDP and consumer price inflation: 10%-20%

      • Share in output volatility relatively constant over time

      • Slight increase in explaining inflation (decreased inflation variability combined with higher leverage effect on oil prices)

    • Contribution to variability of oil price declines over time from 30% to 15%

      • Current oil price fluctuations are more demand driven

      • Also the oil supply curve must have become steeper over time

        • Confirmed in further research (Baumeister and Peersman, 2008b)

        • Steeper oil supply curve can also be considered as a source of increased oil price volatility


Other findings21 l.jpg
Other findings

  • Baumeister and Peersman (2008b)


Other findings22 l.jpg
Other findings

  • Historical contributions


Other findings23 l.jpg
Other findings

  • Historical contributions

    • Major oil shocks are not only supply driven

      • Baumeister and Peersman (2008b): also oil-specific demand shocks and demand shocks resulting from economic activity (e.g. monetary policy) played an important role

      • Confirmation of Barsky and Kilian (2002, 2004)

    • Significant (but non-exclusive!) role in 1974/75 and 1990s recessions

    • Minor importance in 1980/81 and millennium slowdowns

    • Explain little of the “Great Inflation”


Robustness l.jpg
Robustness

  • Very robust for several alternative variables, specifications and implementation sign restrictions

    • E.g. adding interest rate, using GDP deflator or unemployment

    • Always a steeper oil demand curve over time

  • Model properties: time-varying parameter methodology

    • Splitting sample in two and use sign restrictions


Robustness25 l.jpg
Robustness

  • Model properties: identification stra tegy

    • TVP-BVAR but using Choleski decomposition (Kilian 2007)


Conclusions l.jpg
Conclusions

  • Remarkable structural change in the oil market over time

    • “Typical” oil supply shock is characterized by a much smaller impact on world oil production and a greater effect on the real price of crude oil over time

      • Steepening of the oil demand curve (less elastic oil demand) is the only possible explanation for this stylized fact

      • Complicates the comparison over time of specific experiments (because a constant slope is implicitly assumed)

    • The contribution of oil supply shock to real oil price fluctuations has decreased considerably over time

      • Current oil prices are more demand driven

      • Also oil supply curve became steeper over time

  • The role of supply shocks in explaining the macro-economy

    • Significant but non-exclusive role in 1974/75 and early 1990s recessions

    • Minor importance in the 1980/81 and millennium slowdowns

    • Explains little of the “Great Inflation”

    • Increased relative importance to explain inflation variability


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