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PRECAUTIONARY DEMAND SHOCKS IN CRUDE OIL MARKET AND MONETARY
POLICY
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. On the other hand, many researchers (Leduc and Sill (2004), Carlstorm and Fuerst (2006)) explored the
contribution of monetary policy to those recessions, as high oil prices historically coincided with high interest rate.
Methods
Traditional literature treats oil price shocks either as a consequence of supply disruption (supply shock) or aggregate demand
growth (demand shock). Both of these shocks have persistent macroeconomic effects. However, we propose to build a theoretical
model to explore macroeconomic consequences of precautionary demand motives in crude oil market, motivated by Kilian (2009).
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.
References
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