OIL PRICES AND THE WORLD ECONOMY

Ray Barrell and Olga Pomerantz NIESR November 2004

Introduction
Oil price increases and inflation were associated in the 1970s and 1980s
What factors affect oil prices What makes oil prices cause inflation How do higher oil prices affect the level of output

Why is the world different

What affects output and inflation

The oil intensity of production Nominal inertia in wages and prices The monetary policy response The speed of recycling oil revenues into demand Patterns of trade have an important influence

What should modellers and forecasters look at

Temporary and permanent shocks differ
Expectations influence the impact of shocks The effects on long term interest rates differ

The use of oil revenues influences outcomes

Oil shocks redistribute income flows The effects on trade in goods and services determine the pattern of effects So include oil producers and trade in services

The Role of OPEC

OPEC is a lead producer, but it only sets a floor to prices
A positive output gap in the OECD puts upward pressure on prices

Real oil prices display dollar inertia because OPEC sets dollar prices
The real oil price is influenced by movements in the dollar real exchange rate Recent price increases have been much less marked in euros

Oil Intensity
The amount of oil per unit of GDP has been falling since 1975
In Europe oil intensity has fallen by one third since 1982 In the US oil intensity has fallen by as much

Oil intensity is now 60 per cent higher in the US than in the major Euro Area countries The first round effect on output and prices must be higher in the US

Oil Intensity of Output

(barrels of oil per unit of real output at 1994 PPPs)
1.300 1.200 1.100 1.000 0.900 0.800 0.700 0.600 0.500 0.400 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 France Germany UK US

Oil as per cent of total energy supply

60 55 50 45 40 35 30 25 20 15 10 1982 1984 1986 1988 1990 1992 1994 Europe Other Asia 1996 1998 2000

OECD non-OECD

North America China

Pacific Latin America

Oil Prices and Trade

Oil prices affect the terms of trade
Higher dependence on oil imports raises the impact on GDP
The impact on saving and investment is greater Tax revenues and solvency are affected

Patterns of OPEC (Russian, Norwegian) imports affect the pattern of trade impacts
The US has 22% of world GDP but only 11 percent of major oil exporters imports

All other Transition countries Norway

import share less export share

Russia DE OPEC LA Other Asia JP Other N. America US Other EU countries Euro Area
0.3 0.2 0.1 0 -0.1 -0.2 -0.3 -0.4

World Tade in Oil

Share of Oil Producers Imports, 2000

Share of World GDP (at PPPs), 2000

US 11% Other 32%

Japan 7%

Other 27%

US 22%

Japan 7%
Euro Area 26% Asia excl. Japan 18% UK 6%

Asia excl. Japan 24%

UK 3%

Euro Area 17%

The role of the labour market

An increase in the oil price reduces equilibrium income for each level of output Real wages need to fall
Bargaining institutions may resist and induce a recession The central bank may allow inflation to reduce output costs There may be asymmetries between upward and downward shocks

Labour market institutions are now more flexible than in the 1970s because of reforms Bargainers realise that real wages must change Hunt and Laxton NIER 2002 discuss these issues

Oil Prices and NiGEM

The model is an estimated new Keynesian description of the world economy
Almost all OECD countries are covered OPEC, and other regions are included Trade and financial markets cover the world Each country has a demand and supply structure with a government sector Financial, exchange rate and labour markets have forward looking expectations

Monetary Policy Rules

All countries must have monetary policy We have an ECB strategy with a nominal aggregate and inflation as targets
rt = 1 (log( Pt Y t ) log( Pt Y t )*) + 2 ( log Pt + j log Pt + j *)

We also have a Taylor Rule (TR) whose coefficients can change

rt = 1 (logYt logYt *) + 2 ( log Pt + j log Pt+ j *) + 0

They have different implications for prices as TR treats inflation misses as a bygone

A permanent 25% rise in oil prices

Output effects are similar in the long run for the US and the Euro Area Short run effects depend on oil intensity, trade links and labour markets
2005 0.2 0 -0.2 -0.4 -0.6 -0.8 -1 -1.2 2006 2007 2008 2015-19

Output Effects (% difference from baseline)_ Euro Area Output Effects (% difference from baseline)_ UK Output Effects (% difference from baseline)_ US

Impacts on Output of a 25% permanent rise in oil prices

0 -0.1 -0.2 -0.3 -0.4 -0.5 -0.6 -0.7 -0.8 -0.9 -1

France

Germany

Japan

UK

US

% difference from baseline

2005

2006

2007

2008

Impacts on Inflation of a 25% permanent rise in oil prices

Inflation -% points difference from base 0.6 0.5

2005
0.4 0.3 0.2 0.1 0

2006

2007

2008

Euro Area

Japan

UK

US

Long term effects of a 25% permanent rise in real oil prices

Higher oil prices change the terms of trade for the OECD as a whole The saving investment balance has to change Real interest rates have to rise, and output will be lower in the long run The rise in long term real interest rates will affect output now

The impact of a 25% permanent real oil price increase on long rates
Percentage points difference from base 0.3 0.25 0.2 0.15 0.1 0.05 0

Euro Area long rate

Euro Area long real rate 2005

US Long Rate 2006 2007

US long real rate

Spending oil revenues

Increased oil receipts are spent on goods and services imports, but only with a lag In the first two years aggregate demand is likely to be lower as OPEC adjusts Impacts of a 25% permanent increase in real oil prices
30 25 20 15 10 5 0 2005 2006 2007 2008 2009

% difference from base

Opec Import volumes Opec Service Imports

Opec Import Values Opec Export values

Slower spending of oil receipts

0 Until 1985 OPEC recycled money into -0.2 goods at half the -0.4 speed they now spend at so we cut -0.6 the speed of reaction to half its level -0.8 Output effects of an -1 oil price shock increase, especially in-1.2 inertial Europe 2005 2006 2007 2008 2009

Output %difference from base

Euro Area Base

Euro Area Slow

US Base

US Slow

Impact of slower spending of oil revenues of trade

25
0 2005 2007 2009 2011 2013 2015 2017 2019

20 % d i f f e r e n c e f r o m b a s e lin e
% diffeence from baseline

-0.5

15

-1

10 Opec imports - fast 5 Opec imports - slow

-1.5

-2 World trade - fast world trade - slow

0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

-2.5

The role of monetary policy

Short run effects on output also depend on policy a looser monetary stance can half the impact on output Inflation effects depend on wage price flexibility and the policy rule
A looser monetary stance must mean a greater price impact More real wage inflexibility raises the costs of keeping price effects small

Changing Policy in the US

We compare our default with a looser response and output effects are smaller in the short run Inflation effects are larger after the first year and the price level is noticeably higher in the long run than in the default Looser Monetary Policy in the US
Ratio of loose to tight
2.50 2.00 1.50 1.00 0.50 0.00 2004 Effects of Loosening policy (loose/tight) Inflation 2005 2006

Effects of Loosening policy (loose/tight) Output

% difference from baseline

0.5 1 2 3 4 5

1.5

2.5

3.5

4.5

Long Run Impacts on US prices

Tight response Loose response

20 05 Q 20 1 05 Q 20 4 06 Q 20 3 07 Q 20 2 08 Q 20 1 08 Q 20 4 09 Q 20 3 10 Q 20 2 11 Q 20 1 11 Q 20 4 12 Q 20 3 13 Q 20 2 14 Q 20 1 14 Q 20 4 15 Q 3

Are temporary shocks different

We compare a permanent shock to a 2 year shock under the same rules Temporary shocks have less output effects because real interest rates do not rise Inflation effects can be larger as a result
Euro Area Inflation Output Inflation UK Output Inflation US Output

0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 -1.2

% difference temporary and permanent shocks

2004

2005

Conclusions
Higher oil prices lead to higher prices
Output should fall in the short and long run Real interest rates should rise

Wage price spirals worsen problems Oil intensity is important for output effects Inflation depends on the central bank
Output effects can be reduced in the short run

The speed of re-spending revenues on goods and services affects the impacts on output

Sources
Much of the argument is contained in
Barrell and Pomerantz Oil Prices and the World Economy NIESR Discussion Paper July 2004. available at www.niesr.ac.uk Al Eyd et al The world economy in National Institute Economic Review July and October
Information available at www.niesr.ac.uk

Contact Ray Barrell (rbarrell), Ian Hurst (aihurst) or Olga Pomerantz (opomerantz) @niesr.ac.uk for details