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OIL PRICE SHOCKS AND MACROECONOMY: PRECAUTIONARY DEMAND IN
CRUDE OIL MARKET
Islam Rizvanoghlu, Rice University, +1 832 278 7247, [email protected]
Overview
The energy crisis of 1973-1974 coincided with one of the longest post-World War recessions, gave rise to many studies on the
effects of oil price increases on the economy. A large number of studies tried to establish theoretical links and document empirical
evidence in support of the idea that oil prices were responsible for the recessions, periods of inflation, reduced productivity and
economic growth. Traditional literature on energy economics gives central role to exogenous political events in modeling the oil
market. However, more recent studies (Barsky&Kilian (2004), Kilian (2009), Blanchard&Gali (2007), Campolni (2007)) takes a
different stand and provides arguments in favor of reverse causality from macroeconomic variables to oil prices. Besides, all other
papers draw attention to differences between oil prices shocks and their macroeconomic implications in 70s and 2000s. The main
conclusion of those papers was that oil price shocks were caused by supply disruptions in 70s and aggregate demand shock in
2000s. Only Kilian (2009) constructs a structural VAR model of the global crude oil market and concludes that oil price shocks
have been driven mainly by a combination of global aggregate demand shock and precautionary demand shock, rather than simple
oil disruptions caused by exogenous events in Middle East. He claims that while exogenous political events do affect oil prices,
especially in 90s, it is less the physical supply disruptions than the increased precautionary demand for oil triggered by increased
uncertainty about future oil supply shortfall is driving price of oil.
Methods
Based on these findings, we propose to build a theoretical model to explore macroeconomic consequences of precautionary demand
motives in crude oil market. The intuition is that since firms, using oil as an input in their production process, are concerned about
the future of oil prices, it is reasonable to think that in the case of uncertainty about future oil supply, such as a highly expected war
in the Middle East, they will buy futures and forward contracts to guarantee future price and quantity. Moreover, higher demand in
futures market and thus higher future prices induce spot price to increase, as well.
First step is to simulate the effects of demand shocks in oil market on macroeconomic variables, such as GDP and inflation. Second
step is to analyse the role of alternative monetary policies in amplifying or dampening the economy’s response to oil price shocks.
Under new specification for the source of these shocks, we may expect to have different policy proposals compared with the
existing literature.
We build on the analysis of oil prices, macroeconomy and monetary policy implications undertaken by Leduc and Sill (2004) and
Carlstorm and Fuerst (2006). These papers construct and calibrate dynamic stochastic general equilibrium model where
monopolistically competitive firms are using oil in their production process. Besides, oil price is given and exogenous. Our novelty
is to endogenize oil price by add oil market to these models, where firms can buy oil futures to offset future energy supply and
price uncertainty. As a result of this modification, high uncertainty about oil supply in the future can lead to oil price shock today.
Conclusions
Our model with endogenous oil price reveals the effect of precautionary demand motives in crude oil markets. Spot prices can spike
even though we do not observe oil supply disruption in the market, as a result of increasing demand in futures market.
Yet, we have examine alternative monetary policy rules to find the best response in the case of oil price shock resulted from
precautionary demand in crude oil market.
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