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

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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
- 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?

- 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 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

- 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

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

- 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

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)

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

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

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

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?

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!

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

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

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

- Variance decompositions

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 findings

- Baumeister and Peersman (2008b)

Other findings

- Historical contributions

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

- 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

Robustness

- Model properties: identification stra tegy
- TVP-BVAR but using Choleski decomposition (Kilian 2007)

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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