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OIL PRICE VOLATILITY AND ECONOMIC ACTIVITY: A SURVEY AND LITERATURE REVIEW

Raphael Sauter and Shimon Awerbuch, Ph.D. 1 IEA Research Paper IEA, Paris
August 2003

Summary...................................................................................................................................3 1. Oil price changes and economic output...............................................................................5

Basic studies establishing the oil price economic growth relationship..........................................................5 Asymmetry in effects......................................................................................................................................6 Exogenous oil price shocks and imperfect competition.................................................................................7

2. The influence of oil price volatility.......................................................................................8

Oil price shocks..............................................................................................................................................8 Uncertainty in investments.............................................................................................................................9 Unemployment growth through sectoral shifts.............................................................................................10 Oil price volatility and the difficulty of forecasting GDP growth................................................................10

3. Stock markets......................................................................................................................11 4. The Financial Risk of Oil and Natural Gas Price Volatility ............................................12 5. Conclusion...........................................................................................................................12 6. References:..........................................................................................................................13 Table: Overview of the studies cited and their principal results..........................................15
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Sauter, a research assistant at the IEA, is on loan from the Department of Political Science, Free University of Berlin; he holds a Master's degree of Political Sciences. Awerbuch is Senior Advisor Energy Economics, Finance and Technology, IEA.
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ADD: David L. Greene and Nataliya I. Tishchishyna, Costs of Oil Dependence: A 2000 Update Oak Ridge National Laboratory May 2000 , ORNL/TM-2000/152
Youngho Chang and Chan Jiang -- Oil Price Fluctuations and Chinese Economy 2003 - draft.

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Summary
This paper surveys recent research in the area of oil price movements and their effect on economic and financial performance in IEA countries. To the extent they correlate negatively with economic indicators, future oil (and natural gas) price streams represent a highly risky obligation for energy consumers. Every time oil (and natural gas) prices rise, economic activity e.g. people's income and the value of their assets declines by some measure. Based on capital market theory (and common sense), any future cost stream that rises at a time when economic activity and asset values are in decline is highly risky. This adds an important dimension to fossil price risk and the idea of energy security and diversity. The existence of a negative relationship between oil prices and macroeconomic activity has become widely accepted since Hamiltons 1983 work indicating that oil prices increases reduced US output growth between 1948-1980. Hamilton's results have been confirmed and extended by a number of other researchers. More recently, the research emphasis has broadened to include not only the effects of changes in oil price level (mean price in a given period), but also the effects of price volatility (standard deviation in a given period) as well. The evidence confirms that volatility has a considerable influence on economic output. For example, recent US EIA estimates blamed oil price volatility between 1999 and 2001 for a loss of 0.7 percentage points of GDP growth in the U.S. economy.2 This translates to losses that potentially range in the tens and even hundreds of billions. The idea that rising oil prices and price volatility serve to stifle economic activity and reduce asset values has by now become widely accepted in the literature and seems virtually axiomatic. For example, Yang, Hwang and Huang (2002) flatly state that "Higher [oil] prices [yield] subsequent recessions in oil consuming nations, as oil prices are negatively correlated to economic activities."3 The negative relationship between oil prices and asset values suggests that the financial risk of oil price fluctuations should be observable. Beta, a standard finance risk indicator, measures the covariance between fluctuations in an asset's value and fluctuations in the value of a widely diversified asset portfolio. A number of researchers, using different data and different estimation procedures, find that the estimated Beta for oil (and natural gas) is negative,4 which implies a strong negative covariance risk with a widely diversified asset portfolio. This has several implications. First, it implies that traditional electricity generating cost estimates significantly understate the cost of fossil-based generation. Further, a negative beta for fossil fuels clearly suggests that fossil fuel price spikes have a double whammy effect for consumers. They not only drive up the cost of everything from driving to switching on the lights, but they also produce measurable declines in consumers' wealth higher energy prices eventually lower their incomes and the value of their homes and other assets. It is therefore essential that policy makers fully understand the impact of fossil fuel price movements on their national economies. Moreover, it is essential that policy makers understand that one of the principal implications of the negative relationship between fossil
2 3

Energy Information Administration, http://www.eia.doe.gov/oiaf/economy/energy_price.html, 07/18/2002 Yang, Hwang and Huang, 2002, 107 4 Stoft and Kahn, 1993; Awerbuch 1993, 1995, 1995a; Bolinger, Wiser, and Golove 2002

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price movements and the economy is that traditional fossil-based electricity cost estimates are significantly understated relative to renewables and other non-fossil technologies.

Principal Findings From the Literature

1. The economic effect of oil price increases has been quantitatively measured. The table below shows the economic impact of a 10% increase in oil prices as reported in three papers. The average historic oil price (1989 to 2000) is $17.63 USD, so that a 10% increase ($1.76) implies a GDP growth decrease in the different studies as follows: Approximate Historic GDP Decreases After a 10% Oil Price Increase a/
Authors Hooker Hamilton (2000) Rotemberg and Woodford
a

Period Studied 1948-1972 1948-1980 1948-1980

% GDP Growth Decrease 0.6 1.4 2.5

Quarters after initial price shock 3-4 4 5-7

Average historic oil price (Refiner acquisition cost) is $17.63 US; 10% price increase = $1.76 USD

The table suggests that relatively small oil price increases yield sizeable economic losses. The range of loss in response to a $2.50 (e.g. approximately 10%) price increase is 0.6 to 2.5 GDP growth percentage points. Translated to the total economic activity of IEA countries such GDP growth reductions could total in the tens and even hundreds of billions USD. For example: the year-2000 GDP for the US and the EU-15 is $9,896 billion and $7,836 billion respectively. A 3% economic growth would translate to a GDP increase of about $300 billion for the US and about $240 billion for the EU. Averaging the three results in the table above yields an annual GDP reduction of 1.5%. Therefore, a 10% oil price increase, would cut an expected 3% GDP growth by half, or 150 billion USD in the US and 120 billion USD in the EU. If this GDP reduction were to last between three and six months, the combined effect for the US and the EU would be a loss in the range of $67.5 $135 billion USD. Using Rotemberg-Woodford's upper range estimate would yield a three-six month GDP reduction in the range of $112.5 $225 billion USD. Of course, this is only an illustration, based on the estimates in the table above, which were estimated using data for the years 1948 -1980. As previously noted, more recent data suggest that GDP losses are driven by oil price volatility as well as price level, a result that is more difficult to illustrate with a simple example. 2. Oil price and volatility patterns seem to change after 1986: Most oil price movements in the 1948-1985 period consisted in price increases. Starting in 1986 the pattern changes. There are large price increases and decreases that reflect a substantial rise in the volatility of real oil price. 3. Oil price increases matter substantially more than oil price decreases. But the degree of this asymmetry depends on the previous volatility of oil prices. Volatility weakens the economic response to oil price changes. When it comes to oil price movements, it is the degree of surprise that matters.

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4. Price volatility creates uncertainty in investments and reinforces sectoral shifts in labor markets. Thus, monetary and fiscal policy measures, e.g. increasing interest rates, and therefore increasing prices only explain a part of the oil price macroeconomy relationship. 5. In the postwar period, especially after 1986, oil price hikes had a significant and detrimental effect on stock markets. The stock returns are negatively affected by both current and lagged oil price variables. The effects of oil shocks on the US and Canadian stock markets can be completely explained by their effects on contemporaneous and future real cash flows. Higher costs of production due to higher oil prices will cause earnings to decline.

1. Oil price changes and economic output

Basic studies establishing the oil price economic growth relationship Hamilton (1983) stated that the correlation between oil price evolution and economic output was not of a historical coincidence for the 1948-72 period. An increasing oil price was followed 3-4 quarters later by slower output growth with a recovery beginning after 6-7 quarters. These results also apply to the period 1973-1980. The negative effect is more distinct in inflationary times. It wouldnt have been possible to anticipate these reductions in real GNP growth on the basis of the previous situation of output, prices, or money supply. In general, Hamiltons results have been confirmed by several subsequent studies. In 1986, Gisser and Goodwin indicated for the analyzed period from 1961 to 1982 that the oil price hadnt lost its potential to predict GNP growth. Moreover, they presented two interesting results concerning the relationship between oil price changes and macroeconomic variables. First, they showed that monetary and fiscal policy measures alone cannot explain the effects of oil price shocks on macroeconomy after oil market disruptions. Thus, oil shocks also have an impact on economic output by other means than inflationary cost-push effects. Second, oil price effects on the U.S. economy did not change after 1973 when the OPEC period began. Hooker (1996) confirmed Hamiltons results and demonstrated for the period 1948-72 that the oil price level and its changes do exert influence on GDP growth. This is shown by an increase of 10% in oil prices that led to a GDP growth roughly 0.6 % lower in the third and fourth quarters after the shock.5 According to Hamilton's (2000) calculations with data from 1949:2 to 1980:4, a 10% increase in oil prices will result four quarters later in a level of GDP growth that is 1.4% lower than it actually would be. Regarding Hamiltons analysis, more data was added by further investigations until 1988 including the oil price collapse in 1986. The real price of oil was considered in the analysis (Mork 1989), as well. Instead of using the producer price index (PPI) for crude oil, which
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Hooker, 1996, 199

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merely reflects controlled prices of domestically produced oil6, Mork operated with the refiner acquisition cost (RAC) for (domestic and imported) crude oil since 1974. The study verified Hamiltons result as to a negative correlation between output growth and oil price increases. The correlation is even stronger than expected. A supposed linear relationship between oil price changes and economic growth would imply a stimulation of economic growth by an oil price decline. However, in the 1980s, economic output growth was slowed down by oil price changes although oil price declines occurred as well. Thus, Mork examined possible asymmetric effects of oil market disruptions. Asymmetry in effects Asymmetry in effects means that oil price increases have a clear negative impact on economic growth while oil price declines dont affect economic activity significantly. Mork (1989) examined the asymmetric response to oil changes by decomposing oil price changes in real price increases and decreases. The analysis showed for the U.S. economy that the correlation with price decreases is significantly different and perhaps zero.7 Mork, Olsen and Mysen (1994) confirmed the asymmetry in effects for other OECD countries. In comparison with the other countries, oil price increases seem to slow down economic growth in the U.S. to a great extent, even if this country is less dependent on imported oil than countries like Germany, France, and Japan. Lee et al. (1995) also revealed the stability of asymmetric effects in the period before and after 1985 and whether or not it depended on other variables. In order to explain the so-called asymmetry puzzle, the asymmetric mechanism between the influence of oil price changes and economic activity, Ferderer (1996) focused on three possible ways: counterinflationary monetary policy, sectoral shocks, and uncertainty. Originally, three other models were also supposed to have the potential to explain the oil price macroeconomy relationship, but could be excluded due to the fact that they presume a symmetric relationship between oil price changes and output growth. These are: the model of real balances (supposes that oil price increases lead to inflation which lowers the quantity of real balances in the systems), the income transfer model (describing income transfer between oil exporting and oil importing countries) and finally the potential output model (suggesting that oil and capital are complements, so that an increasing oil price decreases the economys productive capacity). Ferderer finds a significant relationship between oil price increases and counterinflationary policy responses. Nevertheless, the analysis shows that oil price increases help predict output growth irrespective of monetary policy variables. In addition, Ferderer showed that monetary policy measures in response to decreases in real oil prices closely resemble those for oil price increases. Therefore, asymmetric monetary policy responses can only explain a part of the asymmetric oil price-output relationship. Ferderer suggests that sectoral shocks and uncertainty channels could account for part of the asymmetry effects but this would need additional research.
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The Texas Railroad Commission (TRC) controlled the U.S. domestic oil price in the pre OPEC-period by influencing the quantity of U.S. oil production. 7 Mork, 1989, 744

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Balke et al. (2002) give a similar explanation of the asymmetric effects oil price shocks have on macroeconomic activity. Monetary policy cannot alone explain real effects of oil price shocks on real GDP. They also conclude that interest rates seem to be an important mechanism through which oil prices affect economic output. Possible explanations are anticipation of asymmetric real effects and Ferderers suggestion of investment uncertainty. Oil price volatility emphasizes the role of these two channels (see 2.). Exogenous oil price shocks and imperfect competition Rotemberg and Woodford (1996) asked in a considerably different approach how come that oil prices have such an impact on the economy when the factor of production in question, oil, represents only a small part of the total marginal cost of production. In their analysis, Rotemberg and Woodford focus on private added value subtracting government added value because their theories of pricing and production decisions do not apply to governmental demand. In order to explain the apparent contradiction, they included the effects on real wages and the imperfectly competitive product market model in their analysis. Using data from 1948:2 to 1980:3, they observed that
private output does indeed decline following a positive innovation in oil prices. A 1 percent increase in oil prices results in a reduction in output of about -.25 percent after five-seven quarters. 8

Interestingly, this decline in output is higher in the second year following the oil price change than in the first. Finally, Rotemberg and Woodford estimated that after an oil price increase of 10%, real wages would fall by 1% after five or six quarters9. Moreover, Chaudhuri (2000) showed another important relationship between oil prices and real prices of primary commodities. The analysis showed that the non-stationary behavior of real commodity prices is due to the non-stationary behavior of real oil prices. Of course, this impact varies depending on the commodities. This is also the case even if oil is not being used directly in the production of commodities. A change in the oil price may affect the prices of primary commodities through the impact of the oil price changes on real exchange rates.

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Rotemberg and Woodford, 1996, 555 The period (1948-1980) chosen by Rotemberg and Woodford seems to weaken their results because volatility gets much greater after 1980. Awerbuch and Sauter 2002 7

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2. The influence of oil price volatility

Most oil price movements from 1948 - 1985 consisted in price increases. From 1986 onwards, the pattern is changing. There are large price increases and decreases reflecting a substantial rise in the volatility of the real oil price. Volatility is defined as the standard deviation in a given period. Recent experience has shown the magnitude of oil price volatility: in the first quarter of 1997, the world oil price expressed in nominal dollars per barrel was at $21.02 and fell to a low of $10.86 in the first quarter of 1999. Then, in the second quarter of 1999, the world oil price began to rise dramatically to a high of $29.11 in the third quarter of 2000.10 Thus, Hooker (1996) argued that the relationship oil price-U.S. economy growth had changed and could not be described neither by a linear relation between oil prices and output nor by the asymmetric relation presented by Mork (1989) after 1986 and increasing oil price volatility. Hookers analysis could not confirm that only oil price increases have a negative effect on economic growth, while oil price decreases dont affect macroeconomy. These results are completed by subsequent studies. Hamilton (1996) agreed with Hooker and found out that the majority of increases in oil prices since 1986 have been followed immediately by even larger decreases. Therefore, he proposed to compare the current price of oil with the price level of the previous year rather than only compare it with the price level of the previous quarter; he introduced the net oil price increase (NOPI)11. Applied on the data after 1986, it showed that individual price increases were simple corrections to earlier declines except for the time during the Gulf War, which was followed by the first recession in the US. In contrast to Hooker, Hamilton demonstrated that the relation between GDP growth and NOPI remains statistically significant when the full sample from 1948:1 to 1994:2 is used. Thus, Hamilton concluded that even if oil price increases seemed to have had a smaller macroeconomic effect after 1973, oil supply disruptions have a major effect on macroeconomy as the Gulf War showed. Oil price shocks Lee et al. (1995) showed that its not sufficient any more to explore the issue of causality of real oil price to the macroeconomy through 1992 with the classical instrument - the oil price level variable - but that volatility has to be taken into account. Using the same instruments as Mork (1989), they showed that in the period after 1988 which has not been considered by Mork the sole consideration of changes in the real oil price had lost its power to predict real GNP.12

10 11

Energy Information Administration, http://www.eia.doe.gov/oiaf/economy/energy_price.html, 07/18/2002 It compares the price of oil each quarter with the maximum value observed during the preceding four quarters. If the price of oil in quarter t is lower than it had been at some point during the previous four quarters, the series is defined to be zero for date t. Hamilton 1996, 217 12 Lee, Shwan and Ratti, 1995, 41

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Including the oil price shock variable in their analysis, which measures how a given oil price change differs from the historic pattern, they can also predict GNP growth after 1988. So, its the surprise of an oil shock that implies a greater impact on real GNP growth (and unemployment). Low volatility on the oil markets before a strong oil price increase lead to a higher impact of the oil price shock on macroeconomy than a highly volatile oil price environment. What matters is the surprise of an oil shock. Using a 24-quarter horizon, they predict the largest negative economic growth impulse 4 quarters after the oil price shock; recovery begins about 6 quarters later. The effect of an oil shock diminishes considerably after ten quarters.13 Ferderer (1996) showed that both oil price changes and oil price volatility have a negative impact on output growth, but in different ways: volatility has a negative and significant impact on output growth, immediately and again eleven months later, whereas oil price changes have a significant impact on output growth after about one year. In addition, Ferderer observed that oil price volatility strongly correlates with real oil price increases. So, oil price increases are considerably more important for oil price volatility variance than negative real oil price changes. In order to explain the phenomenon of fluctuations in industrial production, oil price volatility largely dominates the oil price level. Oil price volatility explains 22% of the forecast error variance for industrial production at the 24-month horizon, while the oil price level explains only 9%.14 So its rather the volatility of oil prices than the level of oil prices that has an important influence on economic growth according to Federer. Hooker (1996) also emphasized the importance of volatility for the period after 1973. He discovered that in the period from 1973:4 to 1994:2, changes in oil price levels could not predict neither unemployment nor GDP growth any more. On the contrary, oil price volatility can predict the GDP in the 1973-1994 period. 15 This suggests again that it is not the oil price level but its volatility to have a significant negative impact on economic activity in the period from 1973 to 1994. Ferderers (1996) analysis of the asymmetric mechanisms between oil price changes and macroeconomy demonstrated the effect of volatility on economy in two primary ways: uncertainty in investments and sectoral shifts. Uncertainty in investments Uncertainty in investments means that volatility in oil prices is more important than the level of oil prices, as regular changes in oil prices increase uncertainty whether to invest or not. Ferderer refers to Bernanke who has shown it was ideal for companies to postpone

13 14

Lee, Shwan and Ratti, 1995, 51 Ferderer, 1996, 23 15 Hooker, 1996, 205

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irreversible investment expenditures when they experienced increased uncertainty concerning the future oil price.16 Unemployment growth through sectoral shifts After an oil price shock in a multi-sector economy, where the shift of specialized labor and capital from one sector to another is very costly, workers dont change immediately to another sector but wait for conditions to improve. This can reduce aggregate employment. Loungani (1986) examined the effect of world oil market disruptions on the reallocation process in U.S. labor market. Lounganis analysis from 1947 to 1982 for 28 industries showed that oil price increases in the 1950s and 1970s seem to account for disturbing the labor reallocation process. Furthermore, Ferderer (1996) indicated that aggregate unemployment rises when relative price shocks become more variable.17 This implies that volatility in oil prices would reinforce disturbance of sectoral adjustment on the labor market and therefore lead to greater unemployment. Lee et al.s analysis confirmed this hypothesis. Real oil price surprise has a greater impact on unemployment (as to GNP growth) than changes of the level. A stable environment before the surprise reinforces this effect. Unemployment begins to rise 4 quarters after the oil shock through 8 quarters after the shock that is not offset at later dates. Papapetrou (2001) confirmed negative effects of oil price shocks on employment. Papapetrous (2001) analysis showed that an oil price shock has a negative effect on employment. Increasing costs of production result in lower output and lower levels of employment, so she concluded:
Oil price shocks explain a significant proportion of the fluctuations in output growth and employment growth. Oil price shocks have an immediate negative effect on industrial production and employment.18

Oil price volatility and the difficulty of forecasting GDP growth In recent works it is widely accepted that increasing oil price volatility has a great impact on the macroeconomy and largely dominates the oil price level. Investments are postponed and the labor market's reallocative process is disturbed. Hamilton (2000) concluded that
the nature of the nonlinearity is an asymmetry in which oil price increases matter substantially more than oil price decreases and in which the sensitivity of the

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Ferderer, 1996, 3 Ferderer, 1996, 3 18 Papapetrou, 2001, 530-531

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economy to oil price changes seems to be dampened by previous volatility of oil prices.19

Hamilton pointed out that there is not enough information in the historical experience to choose one particular functional form unambiguously over another20 in order to predict GDP growth. However, nonlinear representations as Lee et al. (1995) and Hamilton (1996) suggested are superior to linear forecasting models. Moreover, its obvious that oil price increases are considerably more important than oil price decreases. Oil price changes in a volatile market environment are less useful to forecast GDP growth. Nevertheless, this does not question the abundant evidence that exogenous disruptions in petroleum supplies [] are an important factor in causing the economic downturns.21

3. Stock markets
Jones and Kaul (1996) belong to the first authors to analyze the reaction of international stock markets to oil shocks by current and future changes in real cash flows and/or changes in expected returns. Their study considered stock markets in the US, Canada, UK and Japan, taking different institutional and regulatory environments into account. Except for the UK, oil prices allow to predict stock returns and output through 1991 in the other three countries. It shows that in the postwar period oil price hikes had a significant, and (on average) detrimental effect on the stock market of each country22. It is dramatic in the case of Japan and less important for Canada. The stock returns of each country except UK are negatively affected by both current and lagged oil price variables. The latter are negatively more significant. This rises the question whether oil shocks induce any variation in expected stock returns or whether the stock markets are inefficient. Due to measurement errors for all macroeconomic variables, the authors emphasize that the true effects of oil shocks on stock returns are likely to be even stronger.23 The results showed that the effects of oil shocks on the US and Canadian stock markets can be explained completely by their effects on current and future real cash flows. However, real cash flows and expected return proxies cannot explain the fluctuations on the stock markets in Japan and the UK. For the stock markets of these two countries, the authors assume that postwar oil shocks seem to have generated volatility. Sadorsky (1999) and Papapetrou (2001) contributed further studies of stock markets. Sadorskys analysis is based on monthly data from 1947 to 1996 - in contrast to quarterly data used in the study of Jones and Kaul. The analysis showed that an oil price shock has a negative and statistically significant initial impact on stock returns. Higher production costs due to higher oil prices will cause earnings to decline. An efficient stock market will react

19 20

Hamilton, 2000, 25 Hamilton, 2000, 34 21 Hamilton, 2000, 35 22 Jones and Kaul, 1996, 471 23 Jones and Kaul, 1996, 472 (explained in Appendix B)

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with an immediate decline in stock prices.24 Thus, individual oil price shocks depress real stock returns. Sadorsky divided the period of his analysis, 1947 to 1996, into two sub-periods. The analysis showed that oil price shocks had a larger impact after 1986. Thus, theres rather a change in dynamics than a change in the response of the system to these shocks.25 Finally, Sadorsky concludes oil price shocks had a significant impact on real stock returns although this impact was strongest after 1986 [].26 Papapetrou (2001) estimated that real stock returns are affected negatively. This impact lasts for approximately 4 months. Ciner (2001) extended existing studies on the relationship between oil prices and the stock market by testing for nonlinear linkages considering recent works on this subject (Hamilton 2000). Prior studies as the one by Hung, Masulis, and Stoll (1996 hereafter HMS) gave evidence for a significant causality from oil futures to stocks of individual companies, but showed no impact on a broad-based index like the S&P 500. Thus, they concluded that influence of oil price shocks on the aggregate economy is rather myth than reality 27. Ciner refuted this conclusion criticizing this study for not detecting sufficient nonlinear linkages. Using HMS data, Ciner demonstrates a significant nonlinear causal correlation between crude oil futures returns to S&P 500 index returns and evidence that stock index returns also affect crude oil futures. This indicates a feedback relation between S&P 500 stock returns and crude oil futures. The analysis for the 1990s (from March 1990 until March 2000) - when volatility had increased - provided an even stronger nonlinear relationship than for earlier samples and backed up Sadorsky (1999).

4. The Financial Risk of Oil and Natural Gas Price Volatility

Section to be written Significant negative betas reported for natural gas by: LBNL, (Steve Stoft and Ed Kahn 1993), around -0.7 LBNL ( Mark Bollinger and Ryan Wiser 2002) -- about -0.7 or smaller Awerbuch, 94, 96, -1.00, -0.5, eventually -0.1 Imply that natural gas and oil present high cost-risk to consumers in IEA countries.

5. Conclusion
Since the 1980s, oil price volatility is more significant in its effect on economic activity than the oil price level. A volatile environment weakens the effect of price level changes since it
24 25

Sadorsky, 1999, 458 Sadorsky, 1999, 465 26 Sadorsky, 1999, 450 27 Ciner, 2001, 204

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reduces the "surprise." Increasing volatility creates market uncertainties that induce companies to postpone their investments. Furthermore, volatility affects labor markets by disturbing the reallocative process among sectors. Again, it is the surprise of an oil price increase that matters. Hooker, Hamilton and Rotemberg/Woodford demonstrate similar results. They predict a decline of output growth after about four quarters. The magnitude of the slow down, however, diverges among these authors: for a 10 % increase in oil prices, Hooker predicts a decline of 0.6 %, Hamilton a 1.4% decline and Rotemberg/Woodford predict as much as 2.5%. Rotemberg/Woodfords inclusion of the effect on real wages and the fact that they supposed an imperfectly competitive product and market model led to this result. Hamilton (2000) concluded in his study on different models predicting GNP growth evolution with the variable of oil price changes and oil price volatility that theres not enough historical experience to express this relationship in one clear model in order to make clear predictions. However, theres no doubt about the negative impact of oil price increases and oil price volatility on economic growth during the last decades. He emphasises that its less the level of oil prices suggested by production-function-based models (Rotemberg, Woodford 1996) to influence economic growth than disruption in supplies or surprise in pricing as it is proposed by dislocation-based interpretation (Loungani 1986). This is also evident for the stock markets since the relationship has become even stronger after 1986 when the high price volatility on oil markets began. An oil price shock leads to an immediate decline of real stock returns.

6. References:
Awerbuch, S. [1993], The Surprising Role of Risk and Discount Rates in Utility Integrated-Resource Planning, The Electricity Journal, Vol. 6, No. 3, (April), 20-33 Awerbuch, S. [1995], Do Consumers Discount the Future Correctly? A Market-based Valuation of Fuel Switching, (with William Deehan), Energy Policy, Vol. 23, No. 1 (January), 57-69 Awerbuch, S. [1995a], Market-Based IRP: Its Easy!!!, The Electricity Journal, Vol. 8, No. 3 (April), 50-67 Balke, N.S., Brown, S.P.A., Ycel, M.K., [2002], Oil Price Shocks and the U.S. Economy: Where Does the Asymmetry Originate?, The Energy Journal, 23, 3, 27-52 Bolinger, M., Wiser, R., Golove W. [2002], Quantifying the Value that Wind Power Provides as a Hedge against Volatile Natural Gas Prices, Lawrence Berkeley National Laboratory. Chaudhuri, K. [2000], Long Run Prices of Primary Commodities and Oil Prices, Working Papers, The University of Sydney. Ciner, C. [2001], Energy shocks and Financial Markets: Nonlinear Linkages, Studies in Nonlinear Dynamics and Econometrics, October, 5 (3), 203-212 Ferderer, J. P. [1996], Oil Price Volatility and the Macroeconomy, Journal of Macroeconomics 18 1, Winter, 1-26

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Gisser, M.; Goodwin, T.H. [1986], Crude oil and the macroeconomy: Tests of some popular notions. J. Money Credit Banking 18 1, pp. 95-103 Hamilton, J.D. [1996], This is what happened to the oil price-macroeconomy relationship, Journal of Monetary Economics 38, 215-220 Hamilton, J.D. [2000], What is an oil shock?, NBER Working Paper 7755 Hooker, M.A. [1996], What happened to the oil price-macroeconomy relationship?, Journal of Monetary Economics 38, 195-213 Hung, R.D.; Masulis, R.W.; Stoll, H.R. [1996], Energy shocks and financial markets, Journal of Futures Markets, 16, 1-27 Jones, C.M.; Kaul, G. [1996], Oil and the Stock Markets, The Journal of Finance, Vol LI, No. 2 Kahn, E., Stoft, S. [1993] (unpublished draft), Analyzing Fuel Price Risks Under Competitive Bidding. Berkeley, Calif.: Lawrence Berkeley National Laboratory. Lee, K.; Ni, Shwan; Ratti, R.A. [1995], Oil Shocks and the Macroeconomy: The Role of Price Variability, Energy Journal, Vol. 16, 39-56 Loungani, P. [1986], Oil price shocks and the dispersion hypothesis. Rev. Econ. Stat. 68 3, 536-539. Mork, K.A., Olsen, O. and Mysen, H.T. [1994], Macroeconomic responses to oil price increases and decreases in seven OECD countries. Energy Journal 15 4, 19-35. Mork, K. [1989], Oil and the Macroeconomy, When Prices Go Up and Down: An Extension of Hamiltons Results, Journal of Political Economy, vol. 97, No. 51 Papapetrou, E. [2001], Oil price shocks, stock market, economic activity and employment in Greece, Energy Economics Vol. 23 (5) September, 511-532. Rotemberg, J.J.; Woodford, M. [1996], Imperfect Competition and the Effects of Energy Price Increases on Economic Activity, Journal of Money, Credit, and Banking, Volume 28, Issue 4, Part 1 Nov., 550-577 Sadorsky, P. [1999], Oil price shocks and stock market activity, Energy Economics 2, 449-469 Yang, C.W.; Hwang, M.J.; Huang, B.N. [2002], An analysis of factors affecting price volatility of the US oil market, Energy Economics 24, 107-119

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Table: Overview of the studies cited and their principal results

Authors and period studied Hamilton (1983) 1948-1980 Objective / General idea Demonstrates that historic correlation between oil price increases and economic recessions is not a statistical coincidence. Results Oil price increase was followed 3-4 quarters later by slower output growth with a recovery beginning after 6-7 quarters. Nominal oil price increase could be expected to lead to a minor output effect during inflationary times than in noninflationary times Comparison to other studies Comments

Gisser, Goodwin (1986) 1961-1982 Loungani (1986) 1947-1982 Quarterly employment data for 28 industries Mork (1989) 1948-1988 Assumes that disruptions in the world oil market generate significant unemployment through sectoral shifts.

Show that oil price effects on economic output cannot be explained only by monetary and fiscal policy. The relationship between oil price shocks and U.S. economy didnt change after 1973. Oil price increases in the 1950s and 1970s appear to account for disturbing the labor reallocation process.

Confirm Hamiltons observation (1983) regarding a similar relationship before and after 1973

Analyses if Hamiltons results remain correct when the oil market collapse of the 1980s and the real oil price are considered as well. Shows an even stronger negative correlation between oil price increase and output growth than Hamilton. Despite of oil price declines in the 1980s, economic output growth is slowed down by oil price changes asymmetry in effects.

Confirms Hamiltons (1983) observation of a negative correlation between output growth and oil price increases and extends data until 1988.

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Authors and period studied Lee et al. (1995) 1950-1992

Objective / General idea Objective: Examinating causality of real oil price to the macroeconomy through 1992

Results In a long period of stability, oil price shocks (= surprise) have a greater impact than in a volatile environment. - For output growth in a 24-quarter horizon the largest negative impulse appears 4 quarters after the oil price shock, recovery begins about 6 quarters after the shock. - Unemployment begins to rise 4 quarters after the oil shock through 8 quarters after the shock that is not offset at later dates.

Ferderer (1996) 1970-1990 daily spot market oil prices

To explain the asymmetry in effects

Rotemberg and Woodford (1996) 1948-1980

Volatility and oil price changes have a stronger and more significant impact on economic activity than monetary policy variables - Oil price increases are accompanied by greater volatility - Oil price volatility and the Federal funds rate dominate the oil price level in terms of explaining fluctuations in industrial production - Volatility has a negative and significant impact on output growth immediately and again eleven months later. - Oil price changes have a significant impact on output growth after about one year. Imperfectly competitive market models can explain the great effect of oil price changes on output growth and real wages. - A 1% increase in oil prices results in a reduction in output of about -.25 percent after 5 - 7 quarters - After an oil price increase of 10%, real wages fall by 1% after 5 or 6 quarters after this increase The decline in output and real wages gains importance in the second year after the oil price shock. -

Comparison to other studies The important point of this study is the inclusion of the variable oil price shock, that means the measure of how a change in the given oil price differs from the historical pattern. U.S. economy is affected by oil market disruptions from the 1970s til the 90s through sectoral shocks and uncertainty as shown by Lee et al.

Comments

Ferderer finds evidence that volatility has a greater impact than the oil price level!

The period chosen seems to weaken the qualitative results because oil price declines and volatility occur in the 1980s.

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Authors and period studied Hooker (1996) 1948-1994

Objective / General idea

Results 1948-1972: 10% increase in oil prices led to GDP growth roughly 0.6 % lower in the third and fourth quarters after the shock 1973-1994: Neither unemployment nor GDP growth can be predicted by oil prices levels. However, GDP growth could be predicted sometimes by volatility .

Hamilton (1996) 1973-1994

Due to the oil price volatility since 1986, the period of the previous year has to be considered rather than only the previous quarter when analyzing oil price development (net oil price increase (NOPI))

Relation between GDP growth and NOPI remains statistically significant for the full period from 1948:1 to 1994:2.

Comparison to other studies Refutes the linear relation between oil prices and output (Hamilton 1983) and the assymmetric relation based on oil price increases (Mork 1989). Hamilton agrees completely with Hooker refuting linearity and asymmetry in the oil price macroeconomy relationship.

Comments

Hamilton (2000) 1949:1999

Chaudhuri (2000) 1973-1996

Oil price increases matter substantially more than oil price decreases. Increases that occur after a long period of stable prices have a bigger impact than those that simply correct previous decreases. From 1949 to 1980 a 10% increase in oil prices resulted four quarters later in a level of GDP growth that was 1.4% lower. But today, there is not enough historical experience to choose one particular functional form unambiguously over another. Real oil prices have an influence on real commodity prices, even if oil is not being used directly in the production of commodities. An oil price change may affect the prices of primary commodities.

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Stock markets
Authors and period studied Jones, Kaul (1996) U.S.: 1947-1991 Canad.: 1960-1991 Japan: 1970-1991 UK: 1962-1991 Objective / General idea Objective: examinating if stock prices rationally reflect the impact of news on current and future real cash flows in the U.S., Canada, Japan and UK. Results Oil price hikes had a significant, and (on average) detrimental effect on the stock market of each country28. It is dramatic in the case of Japan and much weaker for Canada. - For each country except UK both current and lagged oil price variables affect stock returns negatively. The fact that the latter has a greater negative influence suggests that oil shocks induce some variation in expected stock returns or the stock markets inefficiency. The average value of a negative shock is 20% larger in absolute value than the average value of a positive shock. - Oil price shocks have an immediate significant impact on real stock returns, this impact was strongest after 1986. Increasing oil prices depress real stock returns. - After 1986 theres rather a change in dynamics than a change in the response of the system. Thus, oil price volatility shocks play an important asymmetric role. In a mid- and long-term relationship, oil price shocks account for 20% (up to 22%) of change in industrial production. 1) Effects of an oil price shock including industrial production: - Immediate increase of interest rates - Immediate decrease of industrial production (peak after 4 months) - Immediate decrease of real stock returns 2) Effects of an oil price shock including employment: - Immediate increase of interest rates - Decrease of employment (after 4 months) - Decrease of real stock returns Significant nonlinear causality from crude oil futures returns to S&P 500 index returns and evidence that stock index returns also affect crude oil futures, suggesting a feedback relation. The relation is even stronger in the 1990s. Comparison to other studies Comments

Sadorsky (1999) 1947-1996

The study back up the results of Jones and Kaul by using monthly data instead of quarterly data.

Papapetrou (2001) 1989-1999 for Greece

Ciner (2001) 1983-2000

Confirms Sadorskys (1999) results of stronger effects of oil price shocks after 1986.

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