The Economic Consequences of Oil Shocks: Differences across Countries and Time | Conference – 2009 (2024)

1. Introduction

The interaction between oil and macroeconomic performance has long attracted attentionin the economicl*terature.^[2]This interest dates back to the 1970s. As shown in Figure 1, the 1970s and early1980s were characterised by large oil price spikes. Unfavourable oil supplyshocks are frequently considered to have been the underlying source of worldwidemacroeconomic volatility and stagflation during that period (see, for example,Blinder and Rudd 2008). The longstanding debate surrounding the relationshipbetween oil and the macroeconomy has recently intensified in light of dramaticoil price fluctuations. Specifically, while the price of crude oil hoveredaround US$12 per barrel at the beginning of 1999, the price shot up to US$133by the middle of 2008and collapsed to US$39 in early 2009. In this paper, we examine the macroeconomiceffects of oil shocks across a set of industrialised economies that are structurallydiverse in terms of size, labour market characteristics, monetary policy regimes,and the role of oil and other forms of energy in the economy: Australia, Canada,the euro area, Japan, Norway, Switzerland, the United Kingdom and the UnitedStates. We analyse the interaction between oil and the macroeconomy from threedifferent perspectives which can provide valuable insights for monetary policy.

First, we assess the economic repercussions of several types of oil shocks. Understandingthe consequences of different oil shocks is important for formulating an appropriatepolicy response. It is likely that these consequences depend on the sourceof the oil price shift and differ across countries. Indeed, recent studiesby Kilian (2009) and Peersman and Van Robays (2009b) have shown that the effectson the United States and the euro area economy vary considerably dependingon the source of oil price movements. For example, exogenous disruptions inthe supply of crude oil that lead to higher oil prices are expected to resultin depressed economic activity and rising inflation in oil-importing economies.Alternatively, oil prices can rise because of increased demand for oil whichcould reflect worldwide economic expansion or precautionary motives, with potentiallydifferent effects on output.

The repercussions of oil shocks for oil-exporting economies are less clear, sincerising oil prices imply higher oil export revenues in an inelastic market.Further, countries that export non-oil forms of energy could be affected byoil disturbances in a different way. Since the prices of alternative sourcesof energy typically rise with the price of crude oil due to substitution, oil-importingcountries that produce and export other forms of energy could potentially benefitfrom soaring oil prices through an increased demand for their oil substitutes(Peersman and Van Robays 2009a).

In Section 2 of the paper, we investigate the extentto which the cause of the oil price increase matters for the dynamic effectsacross countries. Within a structural vector autoregression (SVAR) framework,a distinction is made between exogenous disruptions to oil supply, oil demandshocks driven by a thriving global economy, and oil-specific demand shocks,which could be the result of speculative activities or precautionary buying.We demonstrate different consequences depending on the underlying source ofoil price shifts. After an unfavourable oil supply shock, oil- and energy-importingeconomies face a permanent fall in economic activity, while the impact is insignificantor even positive in net energy-exporting economies. Inflationary effects arealso smaller in the latter group, which can be explained by an appreciationof their exchange rates. On the other hand, the dynamic effects of oil demandshocks driven by global economic activity and oil-specific demand shocks turnout to be much more similar across countries. In particular, for all countries,we find a transitory increase in real GDP after a global activity shock, whereasoutput temporarily declines following an oil-specific demand shock.

Second, we examine the transmission mechanism through which oil shocks affect inflationand economic activity. Direct effects on the general price level through risingenergy prices are expected at short horizons because energy prices are a componentof the consumer price index. However, additional inflationary effects may ariseas higher energy input costs or higher wage demands feed through to consumerprices. These indirect effects are more delayed than the direct effects andcan thus be influenced by the monetary policy reaction. For this reason, itis crucial for a forward-looking central bank to understand the transmissionof oil shocks to inflation so that it can implement appropriate policy.

Following Peersman and Van Robays (2009b), we assess the quantitative importanceof individual channels for all the oil-importing economies in Section 3. Consistent with the results of Peersmanand Van Robays, we find that the direct effects of rising energy prices onconsumer prices are significant for all economies, whereas additional indirecteffects vary substantially, particularly the second-round effects. The latterare sizeable in the euro area and Switzerland, mild in Japan and absent inthe United States. As a consequence, the speed and magnitude of the pass-throughto consumer prices are also very different for these economies.

Finally, we investigate whether the dynamic effects of oil shocks have changed overtime. On the one hand, the evolution of the monetary policy framework couldexplain the weaker effect of recent oil price changes. Other leading explanationsfor this resilience include a declining share of oil in the economy, more flexiblelabour markets, changes in the composition of automobile production and theoverall importance of the automobile sector (see,for example, Bernanke 2006; Blanchard and Galí 2007; and Edelstein and Kilian2009). On the other hand, the oil market itself has gone through a series ofstructural changes that could affect macroeconomic interactions. Lee, Ni andRatti (1995) and Ferderer (1996) attribute the instability of the empiricalrelationship between oil prices and economic activity to the increased oilprice volatility since the mid 1980s. Baumeister and Peersman (2008) provideevidence of a considerably less elastic global oil demand curve over time.Accordingly, more recent oil supply shocks are characterised by a much smallerimpact on world oil production and a greater effect on oil prices comparedto the 1970s and early 1980s, which can also bring about time-varying effects.

The steepening of the oil demand curve, as argued by Baumeister and Peersman (2008),distorts empirical comparisons of macroeconomic effects over time. By estimatingthe effect of exogenous oil supply shocks before and after the mid 1980s, wedemonstrate that the choice of normalisation is crucial in concluding whetherthe economic consequences of oil shocks have changed in Section 4. In particular, when an oil supply shockis measured as a similar shift in oil prices (for example, a 10 per cent rise),the impact on real GDP and inflation becomes smaller over time, which is inline with the existing evidence comparing the impact of oil price shocks overtime (for example, Blanchard and Galí 2007; Edelstein and Kilian 2009;and Herrera and Pesavento 2009). However, normalising on a similar oil priceincrease implicitly assumes a constant elasticity of oil demand over time,which is rejected by the data. In particular, the shift of the oil supply curveneeded to generate for example a 10 per centoil price increase is much smaller in more recent periods compared to the 1970s andearly 1980s. When a typical one standard deviation oil supply shock is considered,the impact in many countries has not changed significantly over time. Whetherthe underlying magnitude of such an average oil shock has changed can unfortunatelynot be identified.

The cross-country dimension of our analysis, however, should allow us to explorethe sources of time variation. Specifically, while all economies experienceda fall in oil intensity, the magnitudes have varied; some countries switchedfrom being net oil-importers to net oil-exporters over time (for example, Canadaand the United Kingdom). Accordingly, we can evaluatethe relevance of the dependence on oil and other forms of energy by comparingthe relative changes between countries across time. This exercise does notsuffer from a normalisation problem, since the structural changes in the globaloil market are the same for all countries. We show that modifications in therole of oil and other forms of energy across sub-periods are important in explainingtime variation in the dynamic effects of oil shocks. In particular, countriesthat had the greatest improvement in their net oil and energy positions overtime also became less vulnerable to oil supply shocks.

2. The Dynamic Effects of Different Types of Oil Shocks

2.1 Country characteristics

The first panel of Appendix Table B1contains some country-specific structural indicators of the role of oil andother forms of energy. All entries are calculated as averages per unit of GDP.The role of oil is very different across the economies considered. Australia,the euro area, Japan, Switzerland and the United States are net oil-importingeconomies, whereas Canada, Norway and the United Kingdom are net oil-exporters.Imports of oil are considerably higher in the euro area, Japan and the UnitedStates compared to Australia and Switzerland. Australia and the United Statesalso have a domestic oil-producing sector that cannot be ignored. On the other hand,average oil exports in Norway are about 35 times higher than in Canada andthe United Kingdom.

The role of other forms of energy could also lead to cross-country differences inthe dynamic effects of crude oil shocks. The prices of non-oil sources of energy,such as natural gas, typically move closely with oil prices. This is clearlythe case when the oil price shift is driven by an expansion of worldwide economicactivity which triggers a general surge in demand for commodities. For exogenousoil supply and oil-specific demand shocks, the magnitude of this effect willdepend on the substitutability of oil with other sources of energy. Hence,an oil-importing economy that produces and exports other forms of energy couldtherefore still benefit from an adverse oil shock via increased demand foralternative sources of energy. Australia is a good example of this (see Table B1).Conversely, while being an oil-exporting economy, the United Kingdom is a netimporter of non-oil energy. On the other hand, Canada and Norway are net exportersof both, and all other oil-importing economies (the euro area, Japan, Switzerlandand the United States) also import other forms of energy. As shown in Peersmanand Van Robays (2009a),the role of oil and energy can explain differences in the economic effects of oilshocks across countries. After discussing the model specification and identificationin the following two sections, we reconsider their findings in light of thechallenges they pose for monetary policy-makers in Section 2.5.

2.2 A benchmark SVAR model

Not every oil price increase is alike because the underlying source can differ. Theoil price shocks of the 1970s, for instance, are typically attributed to exogenousshortfalls in oil production, whereas the prolonged build-up in oil pricesthat started in 1999 is commonly said to be mainly driven by shifts in thedemand for crude oil (for example, Hamilton 2003,2009b).^[3]Knowing what drives an oil price increase is important for understanding the impacton the economy and for designing the appropriate monetary policy response.Indeed, Kilian (2009) and Peersman and Van Robays (2009b) show that the economiceffects of oil shocks in the United States and the euro area differ significantlydepending on the cause of the oil price shift. In our analysis, we make anexplicit distinction between oil supply shocks, oil-specific demand shocks,and oil demand shocks caused by global economic activity. Following Peersmanand Van Robays (2009a), we rely on a SVAR framework that has the followinggeneral representation:

The vector of endogenous variables can be divided into two groups. The first group,X_t, captures the supply and demand conditionsin the crude oil market and includes world oil production (Q_oil),the nominal refiner acquisition cost of imported crude oil expressed in USdollars (P_oil) and a measure of world economic activity(Y_w). The other block of variables, Y_j,t,is country-specific and contains real GDP (Y_j), consumerprices (P_j), the nominal short-term interest rate (i_j)and the nominal effective exchange rate (S_j) of countryj. c is a matrix of constants and lineartrends, A(L) is a matrix polynomial in the lag operator L,and B is the contemporaneous impact matrix of thevector of orthogonalised error terms and ; captures the structural shocks in the oil marketand are shocks specific to country j. In thispaper, we focus on shocks emanating from the crude oil market. This model isreferred to as the benchmark SVAR model. A separate SVAR is estimated for eachcountry j.

2.3 Identification of different types of oil shocks

Identification of the underlying structural shocks in an SVAR model requires a numberof restrictions on the relationships between the endogenous variables. Kilian(2009) disentangles oil supply shocks from demand shocks by assuming a short-runvertical oil supply curve in a monthly SVAR, so shifts in the demand for oildo not have contemporaneous effects on the level of oil production. In addition,he postulates that economic activity is not immediately affected by oil-specificdemand shocks. His recursive identification scheme is, however, less appropriatefor estimations with quarterly data such as real GDP. He therefore averagesthe monthly structural disturbances over each quarter to estimate the impacton real GDP using a single-equation approach in a second step. Instead, wefollow Peersman and Van Robays (2009b) and Baumeister and Peersman (2010) torecover the structural innovations by imposing the following more general signrestrictions:

The identification restrictions are derived from a simple supply and demand modelof the oil market. First, an oil supply shock moves oil prices and oil productionin opposite directions. Such shocks could, for instance, be the result of productiondisruptions caused by military conflicts or changes in the production quotasset by the Organization of the Petroleum Exporting Countries (OPEC). Followingan unfavourable oil supply shock, world economic activity will either fallor not change.

Second, demand shocks result in a shift of oil production and oil prices in the samedirection, as demand-driven rises in oil prices are typically accommodatedby increasing oil production in oil-exporting countries. Demand for oil canincrease because of changes in macroeconomic activity, which induces risingdemand for commodities in general. Increasing demand from emerging economieslike China is a good example. We define such a shock as an oil demand shockdriven by economic activity. Accordingly, this shock is characterised by apositive co-movement between world economic activity, oil prices and oil production.

Finally, shifts in demand for oil that are not driven by economic activity are labelledoil-specific demand shocks. Fears concerning the availability of future supplyof crude oil or an oil price increase based on speculative motives are obviousexamples. In contrast to the demand shock driven by economic activity, oil-specificdemand shocks do not have a positive effect on global economic activity sincethey emerge in a climate of uncertainty. Thus, the final impact on world activitycould even be negative because of the associated oil price increase.

The sign conditions are imposed to hold for the first four quarters after the shocksto allow for sluggish responses. These conditions are sufficient to uniquelydisentangle the three types of shocks, and no zero restrictions on the contemporaneousrelationships among the oil market variables are needed. Since all individualcountry variables are left unconstrained in the estimations, the directionand magnitude of these responses are determined by the data. Except for theinterest rate, all variables are transformed to quarterly growth rates by takingthe first difference of the natural logarithm. A more detailed explanationof the data used and the estimation procedure is provided in Appendix A.

2.4 Relevance of different types of oil shocks

Variance decompositions of the benchmark SVARs indicate that disruptions in the supplyof oil are the single most important driving force behind oil price fluctuationsover the period 1986–2008. The two types of oil demand shocks in combinationexplain about the same extent of oil price volatility as the oil supplyshocks.^[4]The importance of exogenous oil supply disruptions is also reflected in the historicaldecomposition of the oil price. As shown in Figure B1, oil supply shocks drovesizeable fluctuations in the oil price, including: the considerable fall inthe oil price in 1986 when Saudi Arabia decided to raise oil production; theincrease in oil prices after Iraq's invasion of Kuwait in 1990; and thesignificant rise in the oil price in 1999 driven by the joint decision of OPECand non-OPEC members to cut oil production. Although shocks to oil demand seemincreasingly important in explaining the more recent run-up in oil prices sincethe early 2000s, oil production disruptions clearly remain a key factor forunderstanding fluctuations in the price of crude oil.

2.5 Economic consequences of oil shocks across countries

The results reported in this section are based on estimations of the benchmark SVARmodel over the sample period 1986:Q1–2008:Q1 with three lags. The choiceof starting date is motivated by Baumeister and Peersman (2008)who find a considerable break in the oil market dynamics in the first quarter of1986 in a time-varying SVAR framework; the model remains relatively stablethereafter (see also Section 4). This date,which coincides with the collapse of the OPEC cartel and the start of the ‘GreatModeration’, is also often selected for sample splits in the oil literature.

Figures 2 to 4 summarise the estimated median impulse response functions of macroeconomicvariables for each economy to the different types of oil shocks which are discussedin Sections 2.5.1–2.5.3.^[5],[6]Apart from the interest rate, the responses have been cumulated and are shown inlevels to aidinterpretation.^[7]For reasons of comparability, each oil shock has been normalised in such a way thatit leads to a 10 per cent long-run increase in the nominal price of oil, whichis close to the observed quarterly volatility of oil prices over the estimationperiod. The responses for output and consumer prices are shown inTable B1 for horizons which vary depending on the type ofshock.^[8]

2.5.1 Oil supply shocks

Figure 2 illustrates that the economic consequences of an oil supply shock are verydifferent for oil-importing and oil-exporting economies. Consider real GDPin the top two panels. All net oil and non-oil energy-importing economies (theeuro area, Japan, Switzerland and the United States) experience a permanentfall in real economic activity. The long-run magnitude is somewhat greaterin Japan compared to the other three economies (see also Table B1).Moreover, output falls very slowly in the euro area and Switzerland, whereaswe observe an immediate decline in Japan and the UnitedStates.^[9]This difference in timing will be further discussed in Section 3when we examine the oil transmission mechanism. On the other hand, output permanentlyincreases in countries that export both oil and other forms of energy, thatis, Canada and Norway. Despite being a net oil-importing country, real GDPonly falls in Australia temporarily. However, Australia is a significant non-oilenergy-exporting country, which probably compensates for the negative oil priceeffect. The United Kingdom, which is an oil-exporting but non-oil energy-importingcountry, also undergoes only a transitory decline in activity. Overall, notonly the role of oil but also that of other forms of energy is likely to beimportant for the dynamic effects of oil supply shocks on the economy.

The dependence on oil and non-oil energy products also seems to matter for the inflationaryconsequences. The exact pass-through for net energy-importing countries willbe analysed in Section 3, but the impulse responses reported in Figure2 reveal a relatively strong impact on consumer prices for all of the net energy-importingeconomies (except for Japan) whereas inflationary pressures are negligibleor even negative in energy-exporting countries. This different impact on consumerprices is probably driven by the response of exchange rates, which tend toappreciate in energy-exporting countries, exerting a downward effect on inflation.

As shown in Figure 2, all net energy-importing economies raise their interest ratesubstantially in order to fight the inflationary pressures the oil supply shockgives rise to. The tightening is much stronger in the euro area and Switzerland,compared to the slight increase in Japan and the United States. On the otherhand, the monetary policy reaction is rather weaker in the net energy-exportingcountries since the long-run effects on consumer prices are insignificant.In general, the reaction of monetary policy to an oil supply shock is thusconsistent with the response of inflation.

2.5.2 Oil demand shock driven by global economic activity shocks

The effects of an oil demand shock driven by rising global economic activity aresubstantially different from oil supply shocks. Figure 3 shows that all economiesface significant long-run inflationary effects and a transitory increase inreal GDP due to this shock. Somewhat surprising is the result that output inCanada, Japan and the United Kingdom declines in the long run. Whenwe compare the magnitudes of the maximum impact across economies using Table B1,the temporary increase in output is rather similar, irrespective of the relevanceof energy products. This is not a surprise since we are considering an oilprice increase that is driven by an expansion of worldwide economic activity.Output can even rise in oil-importing economies because the country itselfis in a boom, or because it indirectly gains from trade with the rest of theworld. Accordingly, other structural features probably determine the size ofthe effects. In particular, shocks that affect global economic activity could,for instance, be technology or aggregate demand shocks. Also, the inflationdifferences are small between most economies. We only observe a stronger impactin Australia and Norway. Given the strong inflationary effects and the temporaryincrease in economic activity in all economies, no trade-off exists for monetarypolicy in the short run. Consequently, the interest rate is raised significantlyin all countries with the exception of Norway.

2.5.3 Oil-specific demand shocks

The dynamic effects of oil-specific demand shocks are very different from the twoother shocks, as shown in Figure 4. In all economies except Japan, this shockis followed by a temporary fall in real GDP with the peak mostly within thefirst year after the shock. The effects on consumer prices are, on average,much smaller compared to other types of oil shocks and only significantly positivein Australia and the United States. In the oil- and energy-exportingcountries, the exchange rate does not respond significantly, in contrast to the appreciationafter an oil supply shock. Comparing cross-country differences in the magnitudesof the effects of this shock on GDP indicates that oil-importing and oil-exportingeconomies react in a similar way (Table B1). That is, the role of oil and energy in the economy againseems not to matter much for this shock. Figure 4 also shows that no cleardistinction can be made between the inflationary effects in the net energy-importingand exporting economies.

The temporary fall in economic activity in combination with the rise of consumerprices in most economies creates a trade-off for monetary policy-makers. Thenegligible reaction of consumer prices, however, should give more room to stabilisedeclines in output. Indeed, the interest rate tends to decrease in the aftermathof an oil-specific demand shock, although this response is mostly insignificant.In line with the other oil shocks, the monetary authorities generally changetheir interest rate in accordance with the effect on inflation. Only the UnitedStates accommodates the fall in economic activity despite the significant increasein consumer prices.

In summary, the economic effects of an oil price change critically depend on thecause of the price change. As a result, monetary policy implications differdepending on the nature of the oil shock. In addition, the role of oil andother forms of energy in the economy (that is, being an energy-importing orenergy-exporting country) is only important for understanding cross-countrydifferences in the case of conventional oil supply shocks.

3. The Pass-through to Inflation and Economic Activity

Knowledge of how oil market developments are transmitted to the macroeconomy is keyto determining the appropriate policy reaction in response to oil shocks. First,the magnitude of the final effects on inflation and output depends on whichchannels are operative as well as on their relative strengths. Second, thetiming of the impact is also important for policy decisions. Given that monetarypolicy actions affect headline inflation only with a lag, direct effects ofrising energy prices are unavoidable. However, if the initial shock to relativeenergy prices also creates indirect effects by feeding into the price of non-energygoods and services over longer horizons, there is a stabilisation role forcentral banks. In what follows, we focus on the pass-through after oil supplyshocks in oil-importing economies for two reasons.

First, as shown in the historical decompositions inSection 2.4, oil supply shocks are the single mostimportant driving force behind oil price fluctuations. Furthermore, it is notstraightforward to determine the precise transmission channels of oil priceshifts driven by global economic activity since they could be correlated withdomestic shocks, such as shocks to productivity or trade, which makes the interpretationdifficult. This carries over to oil-specific demand shocks, after which theinflationary consequences are only significantly positive in Australia andthe United States.

Second, as already documented in the previous section, there exist significant differencesin the inflationary consequences between oil-importing and oil-exporting economiesafter an exogenous oil supply shock. The latter group is actually not confrontedwith rising consumer prices, which can be explained by an appreciation of thenominal and real effective exchange rates. Therefore, we investigate the relativeimportance of different transmission channels in oil-importing economies byapplying a procedure proposed in Peersman and Van Robays (2009b).The idea is to examine the transmission of oil shocks by disentangling the effectson consumer prices and economic activity into several separate effects thatare captured by the responses of different price measures and GDP components.This should help in understanding the cross-country differences of the monetarypolicy responses.

More specifically, we consider the direct effect of oil shocks on the energy componentof consumer prices, the indirect effect via rising production costs of non-energygoods and services, second-round effects of rising wages, and an impact dueto a fall in aggregate demand. The first three channels have a positive effecton inflation, whereas the latter channel should reduce inflationary pressures.Adverse aggregate demand effects are also reflected in the response of economicactivity and its components. In order to evaluate the relevance of the individualtransmission channels, we extend the analysis of Section 2.2 by re-estimating the benchmark SVARsfor all economies by adding one additional variable at a time that capturesa specific channel (see Appendix A for details).The results of the median estimates are summarised in Figures 5 and 6; the16th and 84th percentile confidence bands are available from the authors onrequest.

The upper-right panel of Figure 5 shows that the ultimate effect on consumer pricesand the speed of pass-through is very different across oil-importing economies.The upper-left panel displays the estimated median oil price responses, whichare normalised to be 10 per cent increases over the longrun.^[10]The impact of this oil price increase on consumer prices is strong in the euro area(0.58 per cent), insignificant in Japan (0.10 per cent), very strong in Switzerland(0.88 per cent) and subdued in the United States (0.35 per cent); see alsoTable B1.Even more striking is the difference in the speed of adjustment. While pass-throughis still less than half after one year in the euro area and Switzerland, itis almost complete in Japan and the United States over the same horizon. Asalready mentioned, the shapes of the output responses after an oil supply shockare different across countries (see Section 2.5.1).The response of economic activity is very sluggish in the euro area and Switzerland,compared to a much quicker decline in Japan and the United States. These remarkabledifferences are explained in the next sections.

3.1 Direct effects

To measure the direct effect of an oil price shock on inflation, we consider theimpact of an oil supply disturbance on the energy component of the CPI. Theimpulse response functions for a rise of 10 per cent oil price over the longrun are displayed in Figure 5. Not surprisingly, there is a significant reactionof the energy component of the CPI in all economies. The magnitude is 3.0,1.4, 4.1 and 2.7 per cent for the euro area, Japan, Switzerland and the UnitedStates, respectively. The stronger response in Switzerland is partly drivenby a significant exchange rate depreciation. For Japan and the United States,the impact on the energy component of the CPI is already complete after 1–2quarters, while it takes about 1 year in the euro area and Switzerland.

If only direct effects are relevant, then prices of non-energy goods and servicesshould not be influenced by the oil shock and the final effect on inflationis determined by the increase in relative prices. This can be examined by lookingat the impact on core CPI, which explicitly excludes energy prices. These estimatedresponses (the second row of Figure5) reveal that significant indirectinflationary effects are present in the euro area, Switzerland and the UnitedStates. The long-run magnitudes of these indirect effects are respectively,0.36, 0.53 and 0.14 per cent.In addition, the speed of transmission to core inflation is very different. Coreinflation starts to rise relatively quickly in the United States, while thepass-through is very sluggish in the euro area and Switzerland. These differencesin speed and magnitude carry over to headline inflation. For Japan, we do notfind additional indirect effects – the response of core CPI is insignificant.In turn, the magnitude and timing of the indirect inflationary effects dependon the presence and relative strength of its components: the cost effects,second-round effects and demand effects.

3.2 Cost effects

Increased oil prices imply higher production costs for firms, which will attemptto pass these onto consumers by raising their prices. In contrast to the directeffects, this cost effect has an influence on core inflation. To evaluate therole of cost pressures on core inflation, we estimate the effect on both theGDP deflator and the import deflator. Since only net oil-importing economiesare considered, the cost effect should only affect the import deflator andnot the GDP deflator, since the latter is the price of domestic value addedthat explicitly excludes foreign inputs. Both the direct and cost effects arethus only reflected in a shift of the import deflator, and the response ofthe GDP deflator captures the remaining indirecteffects.^[11]The import deflator not only incorporates the price of imports of crude oil, butalso the price of imported final goods and other foreign commodities that couldbe directly or indirectly influenced by oil price shifts. For Switzerland,this effect is aggravated by an estimated significant depreciation of the exchangerate.

Impulse responses for the GDP and import deflators are presented in Figure 5. Whereasimport prices increase significantly, there is no reaction of the US GDP deflatorto an oil supply shock, despite being an oil-producing country. Consequently,the rise of US core inflation can be fully attributed to the cost effect. Similarlyin Japan, an oil supply shock does not affect the GDP deflator in the longrun. We even find a fall in the short run. Given the insignificant reactionof core inflation, the latter implies only a limited transitory cost effectin Japan.

The situation in the euro area and Switzerland is completely different. These economiesexperience a significant rise in the GDP deflator after an unfavourable oilsupply shock. Given the reaction of the import deflator, which combines directand cost effects, the existence of a cost effect in both economies cannot beexcluded.^[12]However, the speed and magnitude of the responses reveal that the bulk of the reactionof core inflation can be explained by the reaction of the GDP deflator. Thisstriking contrast with Japan and the United States will be further examinedin the next section.

3.3 Second-round effects

An unfavourable oil supply shock could increase the GDP deflator via positive second-roundeffects and decrease it via negative demand effects. The demand channel isanalysed in the next section. Second-round effects are triggered if employeessuccessfully raise nominal wages to maintain their purchasing power after arise in energy prices. As a result, the costs to firms increase. If firms passon higher wage costs to output prices, there is upward pressure on the pricesof goods and services contained in the non-energy component of CPI. In contrastto direct and cost effects, rising wages also affect the GDP deflator. Moreover,while direct and cost effects only result in a permanent shift of the pricelevel, second-round effects could lead to a self-sustaining spiral of increasingwages and prices which results in a more persistent impact on inflation. Theexistence of second-round effects could depend on the response of inflationexpectations and the supply and demand conditions in the labour market. Notethat second-round effects could also be triggered if price-setters increasetheir mark-ups because of higher inflation expectations.

The relevance of second-round effects in oil-importing economies can be evaluatedby examining the reaction of (nominal)total labour costs per employee, real consumer wages and the producer price-wageratio. The latter variable can be considered as the inverse of real producerwages or, alternatively, as the sum of profits and net indirect taxes. Themedian impulse responses of these variables can be found in the bottom rowsof Figure 5. Strikingly, the existence of second-round effects is very differentacross countries and seems to be the key explanation of cross-country differencesin the ultimate impact of an oil supply shock on inflation. For theUnited States,since nominal wages do not rise and the price-wage ratio remains constant, second-roundeffects are not present. Given the rise in overall consumer prices, this impliesthat the loss of purchasing power is entirely borne by employees, with a significantfall in the real consumer wage.

The situation is different in Japan. While the GDP deflator remains constant in thelong run, nominal wages do rise slightly after an unfavourable oil supply shockand workers succeed more or less in maintaining their purchasing power. Incontrast to the United States, producers suffer via a significant fall in theprice-wage ratio, which offsets the wage increase and signals the presenceof significant adverse demandeffects.^[13]

In the euro area, real consumer wages remain constant in the long run and there isa significant fall in the price-wage ratio. The latter indicates that demandeffects are also present in the euro area, thereby limiting the transmissionto headline inflation. However, in contrast to Japan, the fall in the price-wageratio only partially offsets rising labour costs. Accordingly, rising labourcosts and second-round effects also result in higher producer and consumerprices. The second-round effects are reflected in the significant rise of theGDP deflator. As is the case in the euro area, a significant increase in nominalwages in Switzerland triggers second-round effects that explain the rise inthe GDP deflator. Although in the short run the loss in purchasing power isborne by the employees in Switzerland, they manage to keep their real wagesconstant in the longrun.^[14]

These cross-country differences in the pass-through to inflation have different implicationsfor monetary policy. More specifically, the main channel through which an oilsupply shock passes through to inflation in the euro area and Switzerland isvia second-round effects. In order to stabilise inflation, a strong monetarypolicy response is needed since such a wage-price spiral could otherwise triggerpersistent inflationary effects. Conversely, the final impact on consumer pricesin the United States is mainly determined by direct and cost effects, and inJapan by direct effects, since nominal wage increases are not passed on toconsumer prices. Accordingly, oil supply shocks in these latter two countriesdo not have a persistent effect on inflation, and a strong monetary policyresponse is not needed. This is exactly the monetary policy behaviour thatwe observe after an oil supply shock (Figure2).

3.4 Demand effects

A reduction in aggregate demand is the final transmission channel of an adverse oilsupply shock to inflation we need to consider, and is one that also influencesthe GDP deflator. On the one hand, an increase in costs and prices will lowerdemand and economic activity, with the aggregate supply curve shifting alonga downward-sloping aggregate demand curve. To limit the fall in production,firms could react by decreasing profit margins or negotiating lower wages fortheir employees. The pass-through to inflation will depend, among other things,on the elasticity of aggregate demand. An oil shock could also trigger an independentreduction of aggregate demand – a shift of the aggregate demand curve.These additional demand-side effects further reduce economic activity but havea tempering impact oninflation.^[15]

For oil-importing economies, an increase in oil and energy prices erodes disposableincome. Given a relatively small elasticity of oil and energy demand, thisincome effect depresses the demand for other domestically produced goods. Inaddition, consumers may decide to increase their overall precautionary savingsbecause of a greater perceived likelihood of future income loss, which alsoresults in a reduction of private spending. Furthermore, if uncertainty increasesabout future availability of oil and its price, it may be optimal to postponeirreversible purchases of investment and consumption goods that are complementaryto energy. Bernanke (1983) shows that increased uncertainty about the futureprice of irreversible investments raises the option value associated with waitingto invest, which will lead to less investment and durable consumption expenditure.Finally, aggregate demand could also fall if the central bank tightens policyin response to the inflation induced by the oil shock. These independent demand-sideeffects should reduce the ultimate pass-through of an oil supply shock to consumerprices.

To learn more about the existence of demand effects, Figure 6 shows the median impulseresponses of real GDP, private consumption, investment and the nominal interestrate. (The impulse response functions with confidence bands and the estimatedreaction of exports and government consumption are available from the authorson request.) The results are again very different across economies. In theUnited States, there is an immediate fall in private consumption in line withthe response of real GDP. This pattern is consistent with the existence ofan income and precautionary savings effect. It is not very likely that a monetarypolicy effect is present in the United States: we hardly find an increase in thenominal interest rate and certainly not in the real interest rate, and theinvestment reaction, which should capture the main channel of monetary transmission,is only marginally significant. The rather insignificant response of investmentalso indicates that the uncertainty effect, and the associated postponementof irreversible investment, is negligible.

The nature of the demand-side effects in the euro area and Switzerland is completelydifferent to that in Japan and the United States. Private consumption declinesvery sluggishly, which is not in line with an income or precautionary savingseffect for which a relatively quick response is expected. For the euro area,this is not surprising given the insignificant reaction of real consumer wages.In Switzerland, purchasing power remains constant in the long run. In addition,there is a considerable decline of investment in the euro area and Switzerlandthat also only starts accelerating with a delay. This pattern of consumptionand investment responses indicates that another effect is at play. The inflationaryeffects caused by the oil shock, and the existence of harmful second-roundeffects in these two economies, result in a monetary tightening as capturedby the significant estimated interest rate increase in both economies. Thismonetary policy effect is likely to be responsible for the fall in economicactivity and can also explain the different speed of pass-through to real GDP.Given lags in the monetary transmission mechanism, consumption, investmentand real GDP only start to fall with a delay. The much stronger decline ininvestment is a feature that confirms the presence of monetary policy effects.The lack of an interest rate reaction in Japan, combined with the absence ofa loss in purchasing power for consumers, results in an insignificant reactionof private consumption and investment. Hence, demand effects in Japan are onlyreflected in a significant fall of the price-wage ratio reported in Section 3.3.

4. Time-varying Effects of Oil Supply Shocks

There is reason to believe that the economic effects of oil shocks have changed fundamentallyover time. The two large oil price shocks of the 1970s were associated withhigher inflation and lower economic growth. In contrast, the latest, sustainedrun-up in oil prices appears to have had a relatively modest impact on realeconomic activity and consumer prices. Instabilities over time in the relationshipbetween oil and the macroeconomy are widely documented in theliterature.^[16]On the one hand, the macroeconomic structure has evolved considerably over time.Prominent features of this change are improved monetary policy (Bernanke, Gertlerand Watson 1997 and Blanchard and Galí 2007), more flexible labour markets(Blanchard and Galí 2007), changes in the composition of automobileproduction and the overall importance of the US automobile sector (Edelsteinand Kilian 2009), and modifications in the role and share of oil in the economy(Bernanke 2006 and Blanchard and Galí2007).^[17]On the other hand, the oil market itself has undergone substantial changes. For instance,institutional transformations such as the transition from a regime of administeredoil prices to direct trading in the spot market, and the collapse of the OPECcartel in late 1985 were accompanied by a dramatic rise in oil price volatility.Lee et al (1995) and Ferderer (1996) make the casethat this increased oil market volatility led to the breakdown of the relationshipbetween oil prices and economic activity.

For the US economy, Blanchard and Galí (2007), Edelstein and Kilian (2009),and Herrera and Pesavento (2009) find a reduced impact of oil price shockson real GDP and inflation over time. Baumeister and Peersman (2008), however,have shown that such intertemporal comparisons are seriously distorted sincethe global oil market has been characterised by further structural change sincethe mid 1980s. In what follows, we further document this structural changeand the consequences for our analysis.

4.1 Structural change in the oil market

In order to explore how the interaction between oil shocks and the macroeconomy hasevolved over time, Baumeister and Peersman (2008) estimate a multivariate BayesianVAR that features time-varying coefficients and stochastic volatilities inthe innovation processes for the period 1970:Q1–2008:Q1. The time-varyingcoefficients are meant to capture gradual transition in the propagation mechanismof oil shocks, while the stochastic volatility component models changes inthe magnitude of structural shocks and their immediateimpact.^[18]Using this time-varying SVAR model, they document that the crude oil market is characterisedby a considerably less elastic, hence steeper, oil demand curve since the mid1980s. Figure 7 shows the estimated slope of the oil demand curve at each pointin time with 16th and 84th percentiles of the posteriordistribution.^[19]While the price elasticity fluctuates between −5 per cent and −15 percent during the 1970s and early 1980s, the contraction in oil demand aftera 10 per cent increase in oil prices is as small as 1 to 2 per cent sincethe mid 1980s.

This steepening of the oil demand curve seriously complicates comparisons of thedynamic effects of oil supply disturbances over time. For instance, a comparisonthat is based on a similar change in crude oil prices (for example,a 10 per cent rise) implicitly assumes a constant price elasticity of oil demandover time, which is obviously rejected by the data. Consequently, this experimentcompares the impact of a totally different underlying oil supply shock. FigureB2 illustrates that the shift of the oil supply curve needed to generate asimilar oil price increase clearly differs for a steep, as opposed to a flat,oil demand curve. For exactly the same reason, measuring an exogenous oil supplyshock as a similar shift in world oil production over time (for example, adrop in production of 1 per cent) is a biased experiment since the resultingoil price increase will be very different. However, the impact of a ‘typical’(for example, one standard deviation) oil supply shock can be compared. Evenso, the magnitude of a representative oil supply disturbance could have changedover time, which could also influence the outcome. Whether the size of a typicaloil supply shock has changed unfortunately cannot bedetermined.^[20]This problem of comparability also carries over to shocks originating on the demandside of the oil market. Baumeister and Peersman (2010) show that the short-runoil supply curve became highly inelastic over time. Accordingly, comparisonsof normalised demand shocks are biased since a constant slope of the oil supplycurve is assumed. In the next section, we demonstrate the consequences ofthis structural change for drawing conclusions about time variation.

4.2 Has the economic impact of oil shocks changed over time?

The results of Baumeister and Peersman (2008) presented in Figure 7 clearly showa break in the slope of the oil demand curve in the first quarter of 1986.To compare the dynamic effects of oil supply shocks, we use our benchmark SVARmodel of Section 2.2 for the United States, estimated fortwo different sample periods: 1970:Q1–1985:Q4 (the ‘1970s’)and 1986:Q1–2008:Q1 (the ‘1990s’). The latter period correspondsto the model reported in the previous sections. The top row of Figure B3 containsthe impulse responses of world oil production and the oil price following atypical one standard deviation oil supply shock. An unfavourable oil supplyshock in the 1990s is characterised by a much smaller fall in oil productionin combination with a larger increase in the price of crude oil relative tothe 1970s. The corresponding estimated slope of the oil demand curve, whichis depicted in the top-right panel, confirms the considerable steepening overtime.

The consequences of this structural change in the crude oil market for US real GDPand consumer prices is shown in the second and third rows of FigureB3.^[21]Clearly, the choice of normalisation becomes very important. Consider, for instance,the effect of an oil supply shock which raises the price of crude oil by 10per cent. Such a shock has a more muted impact on economic activity and inflationin more recent times compared to the 1970s. This finding complies with thegeneral perception and the empirical evidence on time-varying effects of oilprice shocks discussed above. This experiment, however, is biased since itimplicitly assumes a constant slope of the oil demand curve across both sampleperiods, which is clearly not the case. More specifically, a 10 per cent risein oil prices corresponds to an oil production shortfall of less than 1 percent in the more recent sample period. To elicit the same oil price movementin the 1970s, a decline in oil supply of around 3 per cent was required. Despitethe assertion by Blanchard and Galí (2007) that ‘what matters… to any given country is not the level of global oil production, butthe price at which firms and households can purchase oil’ (p 17), itis the volume of oil which matters for the production process. For instance,the impact on revenues for oil-exporting countries and corresponding income-recyclingeffects via trade depend on both the amount of oil production and itsprice.^[22]

Alternatively, we could consider a 1 per cent reduction in oil production. Oil supplyshocks have often been associated with physical disruptions in the productionof crude oil due to deliberate decisions by OPEC aimed at imposing a certainprice level, or as a result of the destruction of oil facilities in the wakeof military conflicts. Figure B3shows that the accumulated loss in US real GDP growth is about twice as large inthe 1990s compared to earlier times and the response of consumer prices ismuch more pronounced in the more recent period. This finding is not surprising,since a similar reduction in oil quantities triggers a substantially largeroil price increase in the recent period due to the much lower elasticity ofthe oil demand curve. More specifically, oil prices are estimated to have increasedby 23.9 per cent in response to a 1 per cent shortfall in world oil productionin the 1990s, while they only rose by 3.2per cent in the 1970s. Normalising on the quantity variable to make intertemporalcomparisons is therefore also problematic, because a typical (one standarddeviation) shift of oil supply in the 1990s is characterised by a change inworld oil production that is only one-fifth of an average shift in the 1970s.Given the inability to distinguish volatility and the immediate impact of astructural shock in an SVAR, it is not possible to identify whether these smallervariations in oil production are just the result of a steeper oil demand curve,or also the consequence of smaller shifts in the underlying supply curve overtime.^[23]

When we consider the dynamic effects of a typical one standard deviation oil supplyshock, the middle and lower right-hand-side panels of Figure B3 show that theimpact on US macroeconomic aggregates is rather similar across the two sampleperiods. This is consistent with the evidence provided in Baumeister and Peersman(2008).^[24]If the effects of average oil supply disturbances on the US economy have not dramaticallychanged over time, it is surprising that the perceived consequences of currentoil shocks are so different now from those in the 1970s. To explain this, Baumeisterand Peersman demonstrate that oil supply shocks made only a limited contributionto the ‘Great Inflation’. Alternative factors, such as loose monetarypolicy, were much more important explanators of excessive inflation experiencedduring this period, in line with the propositions made by Barsky and Kilian(2004). Oil supply shocks contributed in varying degrees to the recessionsof 1974–1975, the early 1980s and 1990s, but other shocks were also atplay. Unfavourable oil supply disturbances substantially dampened real activityaround 1999,which made the ongoing boom more subdued. As a consequence, the timing of oil shockscould have shaped the general perception that adverse oil supply shocks weremore detrimental to the economy in the 1970scompared to more recenttimes.^[25]Baumeister and Peersman (2008) show that the most recent oil price surges were moredemand-driven, consistent with our findings concerning the historical decompositionof the oil price (see Section 2.4). Sinceeconomic consequences are very different for demand-side induced oil shocks,the fact that they currently dominate oil price movements could have alteredthe way that their effects are perceived.

4.3 Cross-country differences over time

The previous section documented that comparisons of the dynamic effects of oil supplyshocks over time are problematic because of the problem of how to normalisethe shocks. However, Peersman and Van Robays (2009a) show that the cross-countrydimension of the analysis can be exploited to learn more about time variationwhile circumventing this normalisationproblem.^[26]Specifically, they argue that if reduced reliance on crude oil and other forms ofenergy is at the origin of a more subdued response to oil shocks, the changeover time should be greater for countries that improved their net energy positionor reduced the oil intensity of economic activity the most. Table B2reports several indicators of the average shares of oil and energy for theeconomies in our sample for 1970–1985 and 1986–2008. While alleconomies experience a noticeable fall in total energy intensity and an improvementin net oil and energy dependence, the cross-country differences are substantial.Canada and the United Kingdomeven switched from being oil importers in the 1970s to net exporters more recently.Even within the group of oil and energy-importing economies, the changes overtime vary across economies. Unlike the euro areaand Japan which significantly lowered their reliance on oil imports, Switzerlandand the United States hardly improved their oil dependence.

To evaluate whether a change in the importance of oil and other forms of energy inthe economy is important in explaining time variation, we examine the impactof an oil supply shock, normalised to a 10 per cent long-run oil price rise,for all economies for the periods 1970–1985 and 1986–2008 (FigureB4).^[27]The differences between both periods based on the maximum value of the median responsesover the impulse response horizon are also reported in Table B2.Normalising on oil prices, the ultimate output consequences have indeed reducedover time for all economies, in line with the evidence for the United Statesreported above. However, the degree of improvement is very different acrosseconomies. Figure 8 provides a better sense of the link between oil and energydependence and macroeconomic performance. It shows the rank correlations betweenchanges in the net oil and energy imports per unit of GDP and changes in outputeffects measured by the difference in the maximum median impact of an oil supplyshock on real GDP across sub-samples.

The resulting scatter plots reveal a strongly positive relationship between improvementsin the net oil and net energy positions and the moderation of consequencesfor economic activity. The relationship is more significant based on net oilimports. More specifically, economies that made the greatest advancements ineither reducing their oil dependence, the euro area and Japan, or extendingtheir net oil positions, Norway and the United Kingdom,experienced the greatest mitigation of output effects. Switzerland and the UnitedStates, which made only little progress in lowering net oil imports, face smallerreductions in economic activity over time. With regard to changes in net energyimports, all countries that are currently net exporters of energy, Australia,Canada, Norway and the United Kingdom, made the largest improvement in theirnet energy position over time. While their output effects were more or lessequally severe as in the other countries in the 1970s, the impact in thesefour countries became insignificant or even positive in more recent times.Both developments are reflected in the scatter plot, with these countries beingconcentrated in the upper-right corner of the right-hand panel of Figure 8.Even among the energy-importing economies, we notice a reduction in the outputeffects in combination with lower net imports of energy; again this is moremodest in Switzerland and the United States since these economies hardly improvedtheir net energy dependence overtime.^[28]Overall, these results support the hypothesis that the importance of oil and otherforms of energy help to explain different output effects of oil supply shocksover time. For inflation, we also find a stronger reduction in the effectsfor economies that improved their net energy position the most over time (seeFigure B4).

5. Conclusions

This paper investigates the dynamic effects of oil shocks on a set of industrialisedeconomies that are very diverse with respect to the role of oil and energyin the economy. By approaching this cross-country analysis from three differentperspectives, we can provide useful guidance regarding how monetary policycan best deal with oil price movements. Several results stand out.

First, the consequences of an oil price increase depend crucially on the underlyingsource of the oil price shift in all countries, in line with the results ofKilian (2009) and Peersman and Van Robays (2009b). More specifically, afteran oil demand shock driven by a global economic upswing, output temporarilyincreases and consumer prices rise strongly. This is in contrast to an oil-specificdemand shock, after which economic activity temporarily declines and inflationaryeffects are mostly insignificant. For both types of oil demand shocks, thedegree of dependence on oil and energy is not important for explaining cross-countrydifferences in the economic effects. Conversely, being a net oil- or energy-exportingcountry does matter for exogenous oil supply shocks. We find that all the netoil- and energy-importing economies (the euro area, Japan, Switzerland andthe United States) experience a permanent contraction in economic activityand a significant boost in inflation, whereas the long-run output responsein the oil- and energy-exporting countries (Australia, Canada, Norway and theUnited Kingdom) is insignificant or even positive. The inflationary consequencesfor these oil exporters are limited, probably because of the appreciation ofthe effective exchange rates in the aftermath of an oil supply shock.

Second, the pass-through of an oil supply shock to consumer prices differs considerablyamong oil-importing economies. While the direct effects of oil supply disturbancesto inflation are strong and significant in all of these economies, cross-countrydifferences in inflationary pressures are due to indirect effects, which aremainly determined by the existence of second-round effects. In the euro areaand Switzerland, the GDP deflator as well as nominal wages increase notably,which explains the relatively pronounced and sluggish responses of consumerprices. In contrast, in Japan and the United States the GDP deflator does notreact in the long run. Second-round effects are not present in the United Statessince nominal wages and mark-ups do not adjust, whereas the slight increasein the wage rate in Japan is completely offset by a decrease in producers'profit margins. Also, demand and output effects are different across countries.In the United States, the income and precautionary savings effects help toaccount for the immediate fall in real GDP, while a delayed decrease in economicactivity in the euro area and Switzerland can be attributed to monetary policythat tightens to halt second-round effects.

Finally, we find that countries that have improved their net energy position themost over time became relatively less susceptible to oil supply shocks. Byexploring the cross-country dimension, we have avoided the normalisation problemthat is inherent in comparing macroeconomic effects of oil supply shocks acrosstime periods. This problem arises because the oil demand curve has become muchless elastic since the mid 1980s. Accordingly, a similar oil price increaseover time, or a similar oil production disruption, imply totally differentunderlying shifts of the oil supply curve.

It is likely that in addition to the dependence on oil and other energy products,changes in monetary policy credibility and labour market characteristics couldplay an important role in explaining time variation in the effect of oil supplyshocks. Analysing the relative importance of these structural changes is leftfor future research. Another interesting question is whether the inflationaryeffects of oil shocks are symmetric.

Appendix B