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Inationary Eects of Oil-Price Shocks

Alexandre Jasinski & Bilal Gorduk, 2011 Professor : Christophe Boucher

This paper analyzes the inuence of oil-price shocks on the price level. We develop which variables can be inuenced by oil shocks. For this, we estimate this eect using the Phillips curve. We show that there are other variables which are modied in time because of oil-price shocks.


Oil-price, ination, shock, crises, Phillips curve.

I Introduction 3


Historical reasons of oil Shocks

1 2 3 4

The cartel of OPEC and the Yom Kippur War The Iranian revolution The economic crises of 2008-2009 The other shocks

3 4 4 4


Empirical Strategy

5 6

The Phillips Curve The Data and model

6.1 6.2 Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Vector Autoregressive Models . . . . . . . . . . . . . . . . . . . .

4 5
5 6

Estimation Results
7.1 7.2 7.3 7.4 7.5 Stationarity Test, the Augmented Dickey Fuller Test . . . . . . . Causality Test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cointegration Test VECM estimation

7 8 9 9 16

Asymmetric Information . . . . . . . . . . . . . . . . . . . . . . .




Part I

Since 1973, there were dierent oil shock periods; the most important were between 1973-1974, 1979-1980 and 2007-2008. Macroeconomists have seen changes in the price of oil as an important source of economic uctuations because these shocks were the trigger of ination and recession. What was the reason of these shocks and how these were became to normality ? All of these periods have particular origins and the countries used dierent policies to answer these shocks. Which economic variables are touched by these shocks ? What are the eects of these oil-prices shocks ? We will explain with more precision the reasons of these shocks and give also some example of policies followed by dierent countries. Then we will introduce which data we use for this subject and which model. We will see the impact of the ination on the unemployment. And then we will introduce our model and explain the impact of shocks on the ination.

Part II

Historical reasons of oil Shocks

There are three big oil-price shocks; two of them were begun from the MiddleEast and one from the western countries. But there were other small shocks as well.

The cartel of OPEC and the Yom Kippur War

The rst oil crises began in October 1973. During the Yom Kippur War i.e. the war between Israel and a coalition of Arab states led by Egypt and Syria When the U.S. took decision to re-supply the Israel military, the Arab members of the Organization of Petroleum Exporting Countries (OPEC) decided to build an embargo on the oil. The production of oil was cut by ve percent until their political objectives were respected. The price of crude oil was increased from $3 to $12 per barrel. stopped. The central banks of the Western nations decided to cut the interest rates to encourage growth. But this was caught up by the stagation. The unemployment rose from 3% to 5% in the Organization for Economic Co-operation and Development`s (OECD) countries in 1978. The world's economy was in recession and this caused the end of the Bretton Woods. This energy crisis pushed people to invest in research of renewable energies especially of the solar panels and wind turbines. The end of the embargo came when R. Nixon wanted to create peace in the Middle East with an Israeli pullback after the ghting

The Iranian revolution

Around 40,000

The Iranian Revolution in 1979 caused the second oil shock. Mohammad Reza Pahlavi in October 1977.

workers from Iran's nationalized oil reneries went on strike against the Shah This strike had reduced the oil production by four. The Shah left Iran for exile. Ayatollah Khomeini took the head of the government and replaced a modernizing monarchy by a policy based on Providence of the Jurist. The OPEC increased the price to make more prot. The price of crude oil rose from $15.85 to $39.50.

The economic crises of 2008-2009

From 2003 to 2006 the price of crude oil had increased from $25 to $70. This price had increased until 2008 where the price of crude oil was equal to $137. This augmentation can be explained by dierent events like the Iranian nuclear plans in 2006, Hurricane Katrina, the global recession or simply by the war against the terrorism. So the demand of oil is more than the supply which is stagnated for the OPEP and for the speculation. price of crude oil begin to rise again. With the Arab Spring the

The other shocks

We can see three other shocks: In September 1980, without the crises of the Iran revolution stopped, the war between Iran and Iraq started which stopped the Iranians exportation. This war increased the crude oil price from $26 to $32. The shock of 1990-1991: it can be explain by the Gulf War where Iraq of Saddam Hussein wanted to invade the Kuwait. The shock of 2001: it is explain by the September 11 attacks. Suicide attacks were sent by the terrorist group Al-Qaeda on the world trade center in New York. These shocks create ination in the prices which can have an eect on the unemployment.

Part III

Empirical Strategy
5 The Phillips Curve
Phillips curve William Phillips, a New Zealand economist, has shown in 1958 the relationship between the ination and the unemployment rate. He studied this for the United Kingdom form 1861 to 1957. He said that when the unemployment rate was high, wages increased slowly, while when the unemployment rate was low, wages increased rapidly. He describe that saying when the unemployment rate is low the rms must increase wages to attract scarce labor.

Phillips give us this relation:

e t = + t + ut + z




respectively the margin rate and unemployment benets.


positive real number.

is the ination rate and

e t

the anticipated ination


is the unemployment rate.

The short run Phillips Curve

Source : http://en.wikipedia.org/wiki/Phillips_curve The short-term Phillips curve look like a normal Phillips curve, but shifted in the long run as expectations changed. The stagation is explained by the NAIRU (non-accelerating ination rate of unemployment). When we have an unemployment rate and an ination (A) in short run the expansionary policy moves the economy up so we can move o from (A) to (B). But in the long run expected ination rises, and the short-run Phillips curve shifts to the right (to C) . And we get a new short-run Phillips curve.


The Data and model


The analysis will focus on the American economy. To carry out our study, we will build on the relationship of Philips to understand how ination reacts with certain variables. According to Philips, ination will depend on reversing the unemployment rate. Assumptions based on the inationary eects of oil prices lead us to introduce the oil prices in the model Philips. The variable used for the model is the price index of United States excluding energy and food prices

(core ination).The data of oil price is from the West Texas intermediate. The value of this variable is in dollar per barrel. Thus, we create a new Phillips curve "augmented" by the price of oil. We also add the following variables : A weighted average of the foreign exchange value (daily gures) of the U.S. dollar against the currencies of a broad group of major U.S. trading partners (China, Japan, United Kingdom...) ; the Dow Jones index. Foreign exchange values for U.S. are important to examine in detail, because during an inationary period the value of the U.S. dollar can change. Dow Jones is an important economical indicator, we are going to analyze if this variable can explain the ination during the oil shocks.


Vector Autoregressive Models

A VAR is in a systems regression model i.e. there is more than one dependent variable. Simplest case is a bivariate VAR

y1t = 10 + 11 y1,t1 + ... + 1k y1,tk + 11 y2,t1 + ... + 1k y2,tk + 1t

y2t = 20 + 21 y2,t1 + ... + 2k y2,tk + 21 y1,t1 + ... + 2k y1,tk + 2t

We want to know how we can stationarise this model. We can do this with a Johansen's method where we are going to seek how much is there a relationship of cointegration. The number of cointegration selected will be the stationary linear combinations. For that we need to turn the VAR of the form

yt = 1 yt1 + 2 yt2 + ... + k ytk + ut (g1) (gg)(g1) (gg)(g1) (gg)(g1) (g1)

under each matrix of parameters or variables we have the number of column and row of this matrix Into a VECM, this model can be write as follow:

yt =

yt1 + 1 yt1 + 2 yt2 + ... + k1 yt(k1) + ut

k j=1 j )Ig and


i = (

i j=1 j )Ig

is a long run coecient matrix since all the

yti = 0

The test for cointegration between the y's is calculated by looking at the rank of the For matrix via its eigenvalues.

is dened as the product of two matrices:

contains the cointegrating vectors while gives the loadings

tegrating vector in each equation.

of each coin-

We will use this model to understand which is the impact of the variables on each of them. We will also test whether there is a cointegrating relation between variables. In which case we will use a VECM model.


Estimation Results
Stationarity Test, the Augmented Dickey Fuller Test

The Dickey Fuller Test is a stationarity test which have the following hypothesis :

H0 : yt = yt1 + ut , vs. H1 : yt = yt1 + ut , < 1

It is corresponding to : H0: series contains a unit root, vs. H1: series is stationary, is I(0) The Augmented Dickey Fuller Test above is only valid if the residual is white noise. In particular, the residual will be autocorrelated if there was autocorrelation in the dependent variable of the regression (yt ) which we have not modeled. The solution is to  augment the test using p lags of the dependent variable. The model alternative model is :

yt = yt1 +

yti + ut


is a white noise

We use the same critical values from the DF tables. A problem now arises in determining the optimal number of lags of the dependent variable. If we consider the simple regression :

yt = yt1 + ut
So, we test :

H0 : = 0 , vs. H1 : < 0
It is corresponding to :

H0 : y t I(2) , vs. H1 : y t I(1)

The procedure is to test the stationarity of all our variables. If they are all I(0) we can estimate our model with the OLS method. But, if they are not, we dierentiate all the variable and we do the ADF Test on all our variables. We

can also perform the Phillips-Peron to assure the stationarity of all our variables after one dierentiation. The Phillips-Peron Test is similar to ADF tests, but it incorporate an automatic correction to the DF procedure to allow for autocorrelated residuals.

Augmented Dickey-Fuller Unit Root Test variables ination rate d(ination rate) Unemployment rate d(Unemployment rate) oil price d(oil price) Exchange rate d(Exchange rate) Dow Jones d(Dow Jones) number of lags 12 11 4 3 5 12 1 2 10 11 DW 1.99 2.00 2.02 2.001 2.032 2.00 2.06 2.00 1.95 1.98 ADF Test Statistic -2.08 Critical Value (1%) -3.45 -3.45 -3.45 -3.45 -3.45 -3.45 -3.45 -3.45 -3.98 -3.45






We can see that all the variables are I(1).


Causality Test

It is likely that, when a VAR includes many lags of variables, it will be dicult to see which sets of variables have signicant eects on each dependent variable and which do not. We test this by the Granger causality test, i.e. by the Fisher test. This test seek to show if a variable changes cause it changes in another variable.

Does the variable Granger Cause ? Variables

no no no no

no no

no no

no no no no

no no no no -

Ut Ot Pt Et Dt


The causality test indicates that the variable exchange rate is caused by the oil price and the variable unemployment rate is caused by the price index.


Cointegration Test

To test the estimating cointegration systems on the VAR we have to use the Johansen's test. The statistics for cointegration are formulated as follows:

trace (r) = T

ln(1 i )

is the estimated value for the i-th ordered eigenvalue from the trace tests the null that the number of cointegrating vectors is
equal to r against an unspecied alternative. The hypotheses for the H0 : r=0 vs H1 :0<r H0 : r=1 vs H1 : ... H0 :r=g-1 vs H1 : r=g

matrix less than



g 1<r g

We consider a constant in the cointegrating relationship and a constant in the relationship of short-term. We can take a model with a constant and a trend. At short term, we will instead use a constant and not a trend. In the short term the trend added to the growth rate will explode the model. If we consider that there is a trend in the short-term equation, we will consider that there is a equation with a quadratic tendency in the long term. The Johansen Test show the following results :

Johansen Tests for Cointegration between the variables r (number of cointegrating vectors under the null hypothesis) 0 Test statistic 91.92 Critical Values 5% 68.52 1% 76.07

2 3

19.02 7.38

29.68 15.41

35.65 20.04

We reject the null hypothesis for 0 cointegration. But we don't reject the null hypothesis for 1 cointegration. The Test indicates one cointegrating vector between the variables. Here r = 1.


VECM estimation

We can estimate now a VECM model.

yt =

yt1 + 1 yt1 + 2 yt2 + ... + k1 yt(71) + ut


Ut Dt Et yt = Pt Ot

and the rank of

is 1.

Residuals shall be white noise. The number of lags of the model is determined on this criterion. We have also to minimize the Akaike criterion. For 7 lags, we have minimized the Akaike criterion and we have the following correlogram of the residuals : Correlogram of the residuals

The probabilities associated to the Q-Stat are greater than 5%. It proves that the residuals are not correlated together. The results of the VECM estimation are the following :

Long-term equation (A) Cointegrating Equation: Coe. 1.00 (B) Coe. (C) Coe. -3.11 (-0.16) -4.24 (-0.16) -0.24 (-0.17) -1.54 (-1.32) 6.42 (0.16) 0.01 (0.17) -0.97 0.002 (1.26) -0.15 -67.13 1.00 (D) Coe. -0.48 (-1.26) -0.66 (-1.32) 0.16 (0.16) 1.00 (E) Coe. -214.7 (-1.87) -292.4 (-1.87) 68.9 (0.16) 442.9 (1.26) 1.00

Et1 Ot1 Ut1 Pt1 Dt1


(2.60) 1.00

(2.60) -0.32 (-0.17) -2.06 (-1.27) -0.005 (-1.87) 0.31

(-2.72) 0.23


The cointegrating variable is the parameter with a coecient equal to 1. The rst cointegrating equation have one parameter signicant the long-term equation. The constant for the Oil price variable is the set of other variables that will impact the Oil Price course. We consider the model (B) and obtain the following results for the short-term equation : Short-term equation Error correction Cointegrating parameter



-0.95 (-8.77)

0.09 (3.42)

19.73 (-1.86)

0.006 (1.22)

0.007 (1.00)

We see that the error correction term for the coecient of the price index, unemployment and Dow Jones is not signicant, but for Exchange rate and oil price is signicant. This means that the price index, unemployment and Dow Jones are exogenous. Exchange rate and oil price will return to the exogenous variables. These two variables will cause the model equilibrium.

Impulse response function :

We examine the response of the endogenous variables has an initial shock to the system. The idea is to look at the transmission of shock through time.


The shock on the variable Oil Price will impact all other variables. stabilize.


variables will be unbalanced for 20 periods. After these periods the variables


The shock on the variable Exchange rate will impact all other variables. All variables will be shocked for 17 periods. After these periods the variables stabilize. Unlike a standard VAR model, the variables will not stabilize at 0, as they were before the shock. They will stabilize at a new level. This is due to the presence of an error correction in the model. Error correction is via variable Oil Price and Exchange rate.

Variance decomposition:

The goal here is to determine the impact of a shock to the variance of the variable. We will thus determine what are the consequences for other variables.


We note that a shock on the variable Oil Price is the impact itself very strongly. It will impact the other variables. It seems that the variables do not quickly return to equilibrium.


We note that a shock on the variable Oil Price is the impact itself very strongly. Price. To view on a longer period where the variables converge after the shock on the Oil Price we have the following graph. It will impact the other variables but not as strong as for the Oil


Here we see that the Dow Jones variables (CBF) and Exchange Rate (DTWE) will be very strong impact and reach an equilibrium level much higher than before the shock on the variable Oil Price. The variable price level will be slightly impacted and will take a long time before returning to an equilibrium level. Equilibrium levels have all changed after the shock of Oil Price. This is due to the cointegration relationship that exists between the variable Oil Price and the rest of the variables.


Asymmetric Information

To test the asymmetry of information on the Oil Price variable we will proceed to the ANOVA test on the average of this variable over dierent periods. The null hypothesis is : periods i and j where

H0 mi = mj .

m1 = m2 = . . . = mk

, vs

H 1:

there is 2

The test follows a Fisher's law. We perform the ANOVA test on six periods of the sample. The test concludes that there are means which are dierent during these periods. It means that during the period 1970 to 2011, the Oil Price have changed.


The eect of this change is less important than the rise in prices during this period in the U.S.

Part IV

To conclude we have shown that a shock on the Oil Prices have long-run eect on the ination. The VECM model showed that there is a cointegration relationship between variables in the short-term and long-term model. We have seen that the variable exchange rate could impact the variables Dow Jones, Unemployment, Price Level and Oil Price. The variable that is most signicant for the error correction term is Oil Price. A shock on the variable Oil Price has an impact for all other variables in the model. An increase of Oil Price will increase the other variables in the model. Therefore Ination will also increase. The VECM model shows that an impact on Oil Price will change the price level to a higher level. This is explained by the information that the long-term model gives us because of the cointegrating relation on the variable Oil Price. The Philips equation is useful to explain the ination by the unemployment and particularly Oil Price. Historical facts about the oil crisis and inationary eects on the economy are veried by our model. However, there is still a change in regime of the Oil Price. The inationary eects of oil price shocks will tend to be mitigated in the 2000s. It veries the assumptions of Mark A. Hooker, the Oil Price shocks will less impact the ination. This can be explained by the dierent accommodative monetary policies of the Fed during the oil shocks of the late 20th century.


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