The price of oil and the state of the world economy: using terrorism as the instrumental variable

Natalie Chen, Liam Graham, Andrew Oswald, Sun, 08/17/2008



There is both casual and formal evidence from the post-war period that abrupt movements in the price of oil have significant effects on the macroeconomy, as neoclassical economic theory would predict. Higher energy prices are likely to reduce profitability of industry and thus could bring about an economic downturn.

However, the price of oil and the state of the world economy are endogenously determined and the links and interactions between the two are far from simple. The authors of DP 6937 experiment with terrorist acts as the instrumental variable, in order to examine the relationship between the price of oil, terrorist incidents and the resultant effects on profitability and margins.

Using disaggregated 1981-2003 data from seventeen manufacturing and services industries from twelve countries, they focus on the long-run results and find that terrorist acts, when combined with other exogenous variables, explain roughly one quarter of the fluctuations in the price of oil.

By means of this model, Chen, Graham and Oswald are able to show that, not only does the price of oil matter to profitability, but it could play an important role in economic slowdowns.

Summarised by CEPR staff

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Topics:  Energy Global economy

Tags:  energy prices, terrorism, economic recession, profitability


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