Systematic Monetary Policy and the Effects of Oil Price Shocks - Case Study Example

In this research paper, we will look at the major effects that increases in oil prices have on the global economy. In our paper, we will first look at the theory provided by the IMF, with regards to this topic and then we will look at a critical theory which is in contrast to what the IMF have to say, hence, provided us with a holistic picture on this matter. In the recent months, oil prices are certainly below their August 2006 peaks. However, there are still concerns that unless we carry out measures for cutting short demand for oil and create extra ability, oil price variability may continue to pose significant risks for the global economy. A customary perception based on what happened in the 1970s is that oil price shocks trigger recessions. However, the recent past does not fit this view—oil prices are about 2 1/2 times their 2002 levels—but this increase has seemingly not had much impact on the global economy. This seeming puzzle has brought attention to the need to identify the sources of the oil price increase, in particular, to distinguish the role of supply and demand reasons. [1] This box examines these issues using an extended version of the Global Economy Model (GEM) to analyze the causes and outcomes of changes in oil prices. It also looks at the global macro-economic impact of higher taxes on petroleum products. It is important to this clear this from the beginning the analysis does not take on to assess the relative importance of demand and supply causes in the recent run-up in oil prices. In contrast, the main focus is on patterning the channels through which oil prices and growth interact. Global Macro-economic Implications of a Supply Impelled Oil Price Hike First: take the case where oil-exporting economies restrict the supply of oil (as in the 1970s). Oil prices rise sharply (100 per cent at the peak of the simulation) and this results in a global slowdown as redistribution of income to the oil-exporting economies, which have a lower inclination to spend than the oil-importing economies. In addition, higher oil prices raise the cost of production and put upward pressure on the collect price level leading to an increase in interest rates, which— in sync with the direct influence on manufacturing outlays—would further decrease in the short run. As a result, world GDP falls 1.4 per cent below the baseline at the trough and global inflation rises about 1.5 percentage points (first figure). The regional macro-economic outcomes of higher oil prices depend on whether a country is a net oil exporter or importer, and on its oil intensity. Oil exporters run a large trade surplus, peaking around 6 per cent of GDP above the baseline, and enjoy a vigorous expansion. In contrast, the oil-importing economies suffer weakening in their external balances and a slowdown in. The impact is more significant in immerging Asian economies chiefly because of their higher oil intensities about advanced economies. On balance, the effects on inflation and GDP in this scenario are significantly smaller than viewed in many industrial countries in the 1970s. [1] First, this partially reflects the lower oil intensities of consumption and production, which lessen both the direct affects on inflation and the medium- and long-term affects on GDP. Second, these simulations assume that forward-looking inflation targeting central banks raise interest rates at once to prevent a ratcheting up of inflation expectations and a spillover into wages and other prices, unlike what happened in the 1970s. Third, many countries have fulfilled reforms that have increased flexibility in both labor and product markets, simplifying more rapid adjustment in relative prices in response to oil price shocks. Combined with creditable monetary policies that have anchored longer-term inflation expectations, these improvements have allowed containing inflationary pressures caused by the higher oil prices without excessively dampening. However, the simulations do not account for possible business and consumer confidence affects or capital market disruptions, including difficulties in financing individual countries’ current account shortfalls. Persistent Productivity Shocks with Low Oil Ability Macro-economic responses are different in an in which demand shock has boosted oil prices. Consider an of low spare oil production ability in which sees limited responsiveness of supply to oil price changes over the short to medium term. In this case, a significant increase in productivity growth in oil-importing countries that permanently raises global growth by ½ of a percentage point forms a significant short-run surge in oil prices sustainable over the medium term (see first figure). This response of oil prices reflects the low short-term elasticity of supply as new ability must be on-stream to satisfy higher levels of current and future demand. However, the short-run path for world GDP is opposite to that resulting from a supply impelled increase in the price of oil because stronger growth leads to higher prices. [1] Impact of Higher Oil Prices: Low spare ability and higher oil prices have heightened the awareness of the outcomes of growing oil use both now and in the future. However, consuming hydrocarbons, petroleum products, is a key source of climate-changing carbon emissions—a cost the market does not internalize. [1] Given these concerns, several observers have suggested raising taxes on oil consumption, and it is useful to look at the macro-economic outcomes of such a policy shift. Consider the implications of a worldwide increase of gasoline taxes by 10 percentage points with a suiting decrease in labor taxes that keeps the fiscal stance unchanged (second figure). The gasoline tax encourages a gradual substitution away from energy consumption that builds steadily overtime owing to the low short-run oil demand elasticities. In contrast, oil prices decline about 7 per cent on impact, creating a wealth transfer away from oil-exporting countries. The macro-economic implications are the mirror image of the supply impelled rise in oil prices, now benefiting the oil-importing economies instead of the oil-exporting economies. The United States and immerging Asia experience improvements in growth, external positions, and consumption, further heightened by an appreciation in their real exchange rates and a decrease in distortion labor taxes made possible by higher fuel taxes. In contrast, oil exporting countries experience weakening in their external balances and slower growth. On balance, however, world GDP is modestly higher—as taxation has shifted from a reason of production (labor) to a less price-elastic good (gasoline) -suggesting that it may be possible to design a that could share the income gains from such a policy in an equitable way across regions. [1] Now, we will look at a critique to the theory provided by the IMF. In the view of Paul Segal, the analysis is misleading, and likely to confuse rather than clarify the question of the between demand, supply, oil prices, and the world economy. The graphs compares the impact on the world economy of a supply driven oil price shock with the impact of a demand-driven oil price shock using the IMF’s Global Economic Model (GEM).In the model, the supply driven oil price shock is a control in supply that leads to a rise in the oil price of 100 per cent at its peak. This standard exercise results in a drop in world GDP of 1.4 per cent at its trough, a little over one year after the shock, while world inflation rises by 1.5 per cent at its peak, after two quarters. The authors cite three mechanisms through which the oil price rise affects the macro economy, all of which are possible: the redistribution to oil exporters, the ‘direct impact on production costs’, and a rise in interest rates impelled by a rise in inflation. In the model, the description of monetary policy is that of a creditable commitment to an interest rate rule that targets inflation, so the pass-through of oil prices to core inflation impels a rise in interest rates. But, monetary policy’s importance in the association between oil prices and the macro economy – as highlighted by the literature on oil price shocks – a consideration of the impacts of different monetary policy reaction roles would have been clarifying. [2] Then, they move on to what they call “demand shock”. This “demand shock” is a significant increase in productivity growth in oil-importing countries that permanently raises global growth by ½ of a percentage point [which] forms a significant short-run surge in oil prices; continued over the medium term… [reflecting] the low short-term elasticity of supply. Now, we need to understand the impact of this oil price shock on world GDP? They report the short-run path for world GDP is opposite to that resulting from a supply impelled increase in the price of oil because stronger growth causes increased prices. This evaluation is problematic. We place scare-quotes around “demand shock” because the shock that they model is a demand shock only from the belief of the oil market: from the belief of every other market, a rise in productivity growth is a supply shock. But worse than this, setting up the shock tells us nothing about the impact of oil prices. Why? Because composing the rise in productivity growth is to raise global growth by ½ a percentage point per year within the model. Their Figure 1 shows that under the “demand shock”, world GDP rises above baseline at a rate of ½ a percentage point a year. To then view the “demand shock”-impelled oil price shock did not prevent world GDP growth from rising by ½ a percentage point a year is simply to view the calibrators successfully performed the proposed calibration. [3] The calibrations presented in the main text therefore tell us nothing about the difference impacts of different kinds of oil price shocks. The Box reports a more useful exercise, however, where it is states that “If we consider the same increase in productivity in a version of the model that does not include oil, world GDP expands by slightly more in the short and medium term than in the model with oil.” This is an apt comparison as it tells us whether the rise in oil prices effects GDP growth for a given rate of productivity growth. World GDP expands by only “slightly more” without oil leads the footnote to close that this suggests that while high oil prices have resulted in a drag on world growth, these effects are minor. [4] While this comparison is, it is not comparative to the exercise with an oil supply impelled oil price shock, because the two different shocks involve different sizes of increase in the price of oil. While regulating oil supply shock is to impel a peak rise of 100 per cent in the price of oil, the “demand shock” impels a rise in the price of oil which spikes at only 35 per cent in the first year. Since the impelled oil price shocks are of such different extents, the exercises reported in the Box tell us nothing about the difference made by the source of the oil price shock. [5] The theory, therefore, is unable to evaluate the response of policy changes, and thus rather incorrectly labels it as “demand shock”. Yet beyond these specifics, our stand is the take on to distinguish between sources of oil price shocks is the wrong way to think about policy. Policy makers face a world full of economic happenings and make a policy in the light of all available information. Today, demand worldwide is increasing. In such an environment the rise in the oil price may have helped to rein in excess demand by reducing outlays on non-oil. With low-priced exports from China that further lessened inflationary pressures, high oil prices may have by it made easy low global interest rates. During the 1970s stagflation, on the other hand, an expansionary monetary policy intended to offset the rise in the oil price would have led to unacceptable levels of inflation. Rates of growth and inflation are important in controlling policy. But whether high growth or a check in supply leads to a given rise in the price of oil a given rise in the price of oil is still up for debate. [2] Graphical Representations: Bibliography: 1. IMF (2007): World Economic Outlook, April 2007, Washington, D.C.: IMF. 2. Paul Segal (2007) “A note on oil prices and the world economy in the IMF’s World Economic Outlook” Research Fellow, Oxford Institute for Energy Studies and New College, Oxford. 3. Bernanke, Ben S., Mark Gertler, and Mark Watson (1997): “Systematic Monetary Policy and the Effects of Oil Price Shocks,” Brookings Papers on Economic Activity 1, 91– 142. 4. Elekdag, Selim, René Lalonde, Douglas Laxton, Dirk Muir, and Paolo Pesenti (2007): “Oil Price Movements and the Global Economy: A Model-Based Assessment”, Bank of Canada, Working Paper 2007-34. 5. Roubini, Nouriel (2004) “The effects of the recent oil price shock on the U.S. and global economy” Stern School of Business, NYU and Brad Setser Research Associate, Global Economic Governance Programme, University College, Oxford Read More