Analyzing the Oil Price-GDP Relationship and its Historical Changes

1. Analyzing the Oil Price-GDP Relationship and its Historical Changes International Energy Workshop 2005 in Kyoto 5-6 July, 2005 Akira Maeda Tetsuo Tezuka Kyoto University

2. Background • Recent high world oil prices may affect the macroeconomy in each country. • The IEA study • IEA(2004). “Analysis of the Impact of High Oil Prices on the Global Economy.” May. • The IEA employed energy-economic model simulation to calculate how much the increase in oil prices reduces GDPs in several countries. • The details of the model, however, are not available. • IEA says that the model includes IEA’s World Energy Model (WEM) within the frame, but still, it is a black box.

3. The increase in world oil prices • imposes higher production costs on industries • affects firms’ profits. • adds up to the decline in GDP in the economy. (direct/primary effect) • permeates into the economy through the increases in factor prices and wages, the decline of employment, etc. • may cause recession in a business cycle. (indirect/ secondary effect)

4. The issues • To what degree does real GDP decline? • To what degree does price level in the economy rise? • Are their relationships b/w oil price and real GDP, and b/w oil price and domestic price levels stable ? The information is summarized by • the values of the oil price elasticity of real GDP and that of domestic price level, and • their historical changes.

5. The IEA estimates • The IEA study • considers hypothetical increase of world crude oil prices from 25 dollars to 35 dollars per barrel. • and estimates • The US GDP decreases by 0.3% • Japan by 0.4% • The Euro zone by 0.5%. • Among similar studies, the IEA result is most influential. • In the economic literature, there found many studies that examine the relationship between oil price and the macroeconomy. • There seems no consensus about how, why and to what degree the macroeconomy is affected by world oil price changes.

6. Past studies in econ. literature • Time series analysis • examines the causal relations between economic downturns and the increases in oil prices. • Vector autoregressive (VAR) models are popular. • Many studies inc. Hamilton(1983: J. Political Econ.) • Computational models • simulate economic impacts of higher oil prices inc. the impact on GDP. • Keynesian-type models • EMF7 (1987): “Macroeconomic Impacts of Energy Shocks” • Neo-classical type models • Real business cycle (RBC) • Computational general equilibrium (CGE) • Combinations of the above (inc. the IEA study.)

7. Computational models • Computer simulation • works on detailed sectors and periods, • incorporates production and utility functions, • Cobb-Douglas / CES • needs to have parameters set by • calibration • other studies’ suggestion • modeler’s discretion • Problems of computational models: • Calculation results are directly affected by the parameters used. • The model structure inc. parameters used may change in time and / or due to national energy policies, but such change is hardly captured by the simulation.  • More transparent and clearer insights is needed: A simple model, rather than complex ones, would be beneficial.

8. The aim of the study • To examine the oil price-macroeconomy relationship and its historical changes. • To show that straightforward algebra and simple formulae effectively represent the elasticity of the oil price-real GDP relationship, as well as that of the oil price-consumer price relationship. • The model affords policy makers a clearer view of how oil-importing countries are affected by world oil prices.

9. The analytical frame • Consider a simple economy that comprises of • final consumption, • energy transformation (oil refinery), and • crude oil production sectors. • Crude oil is assumed to be the only good that is internationally traded. • The final consumption sector uses capital, labor and energy product as inputs and produces single consumer product. • The energy transformation sector produces energy product from crude oil by refining process, using capital and labor as well. • The domestically produced crude oil and imported one are treated as different goods. (The Armington assumption) • The domestic crude oil production requires capital and labor as well. • Crude oil produced for domestic use and that for export are also treated as different goods. (The Armington assumption)

10. exogenous variables The model • Final consumption good sector: • Energy transformation sector: • Crude oil production sector: • National income:

11. The changes in oil prices • Direct effect  our interest! • Small changes in endogenous variables around the equilibrium point w.r.t. the small changes in the exogenous variables. • They are represented by the price elasticities. • Indirect effect • Transition from a disequilibrium state to a new equilibrium point. • It would be represented by the process to a new stationary state in a dynamic model.

12. Elasticity of real GDP • Assumption 1: The world crude oil market is competitive, and thus export and import prices coincide. • Assumption 2: In each sector, input-output relations are optimized under the current prices. • The real oil price elasticity of real GDP : • The real oil price elasticity of real GDP in an economy is equalized to the ratio of a country’s net export of crude oil to its nominal GDP.

13. Elasticity of the price level • Assumption 3: The sectors of the final consumption good and energy transformation are competitive. • The oil price elasticity of consumer prices :  • When domestic good prices are completely flexible, the nominal-oil price elasticity of consumer price in an economy is equalized to the ratio of a country’s gross import of crude oil to the sum of its nominal GDP and its net import of crude oil.

14. Findings (1) Changes in real GDPs w.r.t. World Oil Prices （under the same conditions as those of IEA estimates） Note) IEA estimates US: - 0.3% Japan: - 0.4% Euro: - 0.5%.

15. Findings (2) Historical Changes in Oil Price-Real GDP Elasticities (multiplied by 40)

16. Findings (3) Historical Changes in Oil Price-Domestic Price Level Elasticities (multiplied by 40)

17. Findings (4) Oil Prices That Would Have The Same Economic Impact as Those of Past Oil Shocks

18. Conclusion (1) • This paper provides rough estimates of the world oil price elasticities of real GDPs and consumer prices, as well as historical changes in these elasticities in several economies. • We showed that straightforward algebra and simple formulae effectively represented these elasticities. • Compared to large-scale modeling, our approach may be too simple to account for indirect effects on business conditions. • However, such simplicity has the benefit of affording policy-makers a more transparent, clearer view of the effect of oil price increases.

19. Conclusion (2) • The vulnerability (= price elasticity) of these economies to oil price shocks, in light of both real GDP and the domestic consumer prices, has changed since the 1970s. • In OECD countries, the vulnerability had sharply declined in the late 1980s and stayed low through 1990s. • The Euro-zone countries in these days are becoming vulnerable more than before while Japan is not. • The Chinese economy is slightly different in that it is becoming much more vulnerable than others as it grows and gets more dependent on imported oil.