The economic effects of energy price shocks

Lutz Kilian, Tue, 11/13/2007

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In Discussion Paper 6559 Research Fellow Lutz Killian dispels a number of myths concerning oil price shocks and their impact on the US economy. What is the origin of oil price shocks? Only a few years ago, the prevailing view in the literature was that crude oil price increases were “exogenous” with respect to the U.S. economy, and were associated with political disturbances in the Middle East. This view has not held up to scrutiny: measures of exogenous shocks to the production of crude oil do not help us forecast crude oil prices. This suggests that attempts to link oil price increases to disruptions of crude oil production alone will not be successful. Instead, most oil price shocks since the 1970s have been driven by a combination of strong global demand for industrial commodities (including crude oil) and expectations shifts that increase precautionary demand for crude oil specifically. These expectations shifts reflect the market’s perception of the likelihood of a future shortfall in the supply of oil, which is driven by expectations about future demand as well as future supplies of crude oil. These precautionary demand shocks are important: unlike other oil demand and oil supply shocks, they tend to have immediate and large effects on the U.S. economy.

Analyzing the source of oil price shocks also matters for monetary policy. Dynamic stochastic general equilibrium (DSGE) models now incorporate global and domestic energy markets in order to analyze the effects of energy price shocks, but these DSGE models with few exceptions have remained extremely simplistic in treating crude oil prices as exogenous driving processes. The empirical evidence, Lutz argues, suggests that this is a very bad assumption. More refined models are needed in order to properly assess how monetary policy should respond to changes in oil prices.

DP6559 The Economic Effects of Energy Price Shocks

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URL:  http://www.cepr.org/pubs/new-dps/dplist.asp?dpno=6559.asp

Topics:  Energy

Tags:  Asymmetry, Causality, Channels of transmission, Crude oil, Elasticity, Gasoline, Price shocks, Propagation

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