OIL PRICE SHOCKS: THE ROLE OF MONETARY POLICY (ENCYCLOPEDIA)
If the recessionary consequences of oil price shocks are due to oil price shocks themselves, or instead to monetary policy decisions implemented as a policy tool to lower the repercussions of these shocks, is still a matter of discussion in the current debate about oil price turmoil in financial markets. However, two principal strands of literature have analysed this phenomenon, deconstructing its effects into two different phases. In the first phase, an increase in oil prices produces a rise in domestic inflation: it implies a depression effect in the demand and, also, an important impact on the output level. This implies higher interest rates, lower demand, and as a result, lower output (Segal 2007). Subsequently, in the second phase, other consequences arise once domestic consumers are conscious of the decline in real income caused by the effects of the first phase. In particular, the empirical literature investigating the link between oil shock and monetary policies has been deeply interested to analyse the propagation mechanism through which the oil shock favours or gives its contribution to the macroeconomic recessions. The most important mechanisms examined are:
(i) the labour market: Davis and Haltiwanger (2001) say that the oil shock are one of the principal sources of employment distruction in any industrial sector. This is particularly due to the effect of the oil shock on the output and productivity;
(ii) the use of instrumental good. Finn (2000) developed at the aggregate level a system where oil price increases depress the capital marginal output reducing, at the same time, the investment levels and the future capital stock;
(iii) the interest rates behaviour. Balke et al. (2002) found the evidence that there is a consistent difference between the commercial papers' interest rates at 6 months, and the interest rates of the T-Bills at 6 months. It means that when the oil prices increases there is a bigger incentive for investors to buy less risky asset (T-Bills);
(iv) the uncertainty and the investments level reduction. Bernanke (1983) estimated that there is a widespread tendency, in the industrial sector, to postpone any kind of investment until the uncertainty characterising the oil price behaviour decreases;
(v) the sectoral shock. The idea of the sectoral shock sustained by Lilien (1982) and Hamilton (1988) says that a shock with differential effects over different sectors might have a bigger impact on the aggregate employment. This happens because the effect on the employment of the oil shock on one sector might indirectly affect the employment level on another sector, if there are strict connections and mechanisms between the two sectors.
Source: Author elaboration
Nevertheless, there are a valuable number of contributions that do not convey the idea that an oil shock could have such a strict effect on the output as aforementioned. Since the end of the Eighties, Bohi (1989) has analysed the economic impact of the 1973-74 and 1979-80 oil shock on Japan and the USA economy. He did not find any evidence of the link between oil price variations and employment level in the productive sector, thus supporting the idea that the output reduction has to be attributed to a tight monetary policy (implemented to reduce the oil shock impact) rather than to the oil shock. The same view is shared by Mork (1989) who, introducing for the first time the concept of the asymmetric effects of oil price increases and decreases on output, found evidence that although oil price increases reduced the economic development, there is no evidence that oil price decreases stimulated the GDP growth. Through the idea of asymmetric effects of oil shock on GDP growth, Gilbert and Mork (1986) offered an explanation of the flat GDP growth elasticities to the oil shock decreases.
By analysing the past U.S. business cycles and the oil price shock between 1965 and 1995 (table 2), Bernanke, Gertler and Watson (1997) discussed the decisions implemented by policy-makers to respond to macroeconomic shocks. In particular, they assessed the role and effects of the Federal Reserve’s policy response to the inflation caused by an oil price shock. Considering that oil shocks were exogenous, the Federal Reserve raised its interest rates in order to control inflation, obtaining the result of a monetary contraction, which is among the principal causes of economic downturns.
Although on one side a contractionary monetary policy has the effect to reduce the inflation level (figure. 1), on the other side, it might have a negative impact on the economic performance.
Figure 1: Effects of an oil price increase
Bernanke et al. (1997) claimed that an alternative monetary policy during the Seventies, i.e. fixing the nominal interest rates, might have a better effect on aggregate output, thus erasing the negative consequences of oil-price shocks on the U.S economy. Hamilton and Herrera (2004) rebuted this work. They reshaped the Bernanke et al. (1997) study, by using a different approach and finding that oil price increases are the principal cause of lower levels of real output: contractionary monetary policy does not play the bigger role in generating this downturn. Bernanke et al. (1997) underlined the positive and influential role of monetary policy in eliminating any recessionary consequence of an oil price shock. Their work sustains the idea that a proper monetary policy has to beset in order to eliminate, or at least reduce, any recessionary consequences of oil price shocks. Conversely, Hamilton and Herrera (2004) argued that even with aggressive monetary policies, the Federal Reserve System did not succeed in averting a downturn. Focusing on this view, Leduc and Sill (2004) examined a variety of monetary policy options in different general equilibrium models, concluding that the central banks behavior cannot be considered wholly efficient in protecting their economies from the consequences of oil-price shocks. In the light of the discussion above, it emerges that the relationship between oil price movements, macroeconomics and inflation is neither clearly predictable nor straightforward to understand. We can nonetheless draw the following conclusions:
1) the relationship between oil price and inflation has been weakened so much that the correlation between these changes is in fact weaker now than in the Seventies (Rogoff 2006; Blanchard and Gali, 2008). Furthermore, the new market composition has helped to reduce the impact of oil price turmoil on real and expected inflation;
2) as argued in Segal (2007), monetary policy is the most important channel through which fluctuations in oil prices affect aggregate output. This is because when oil prices affect inflation, monetary authorities raise interest rates, thus slowing down the growth rate (Roubini, 2004).
Overall, I can state that the choice of which policy is better suited to face the oil price turmoil has to be examined by considering the peculiarities and the conditions of each shock. All the macroeconomic effects that an oil price increase might generate have to be taken into consideration, including a deep analysis on the potential output. Furthermore, it might result very important to observe any other factor affecting the inflation level, as the oil price shock effects are much weaker now than during the Seventies. This analysis will not set aside from the study of the origin of these shocks (led by supply and demand components), where more appropriate monetary policies might be implemented at the national and international level, to limit the strong impact and consequences of a shock on the real economy.
1 Historically, the most important oil shocks have been caused by a supply shock.
2 A key factor to understand that the real economy consequences of the last increases in the oil prices are much weaker as compared to the ones during the Seventies is provided by the productive structure and the factors endowment that look at the industrialised European economies that are less oil-intensive.
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