Summary:
Francesco Lippi argues that the current rise in price of oil is due to a demand shock, not a supply shock. Effects of a demand shock on the US economy are very different from a supply shock. A demand shocks tend to lead to an increase in industrial production, due to the booming of emerging economies. America’s specialisation in the production of goods not supplied by emerging economies is key to this result. It is the ability – or lack thereof – to innovate and produce goods that are not easily substitutable that determines whether the new challengers represent a risk or an opportunity for industrialised countries. (Published: 11/06/08)
Notes:
- Most analysts attribute the increase in the price of crude oil to growing demand from Asian economies.
- Economic theory suggests that the real effect of an oil price increase depends on its underlying fundamentals. If it stems from
- a change in supply conditions: the resulting price increase depresses economic activity, as energy inputs are more expensive
- case with the Iranian revolution, the first Gulf war, or policy tightening by OPEC
- an increase in demand by emerging economies
- production in other economies like the US is subject to both a negative effect
- due to the higher price of energy and
- a greater demand for US goods and services by the growing emerging economies
- i.e. effect on the US is positive
- weak relationship between oil prices and the US business cycle in recent years reflects oil demand shocks
- while the episodes in the ‘70s and ‘80s can be ascribed to oil supply shocks
- study identifying the oil demand and supply shocks underlying fluctuations in oil prices (deflated by the US CPI)
- allows estimation of the effects of these shocks on the US business cycle
- identification strategy assumes that oil production and price move in opposite directions following a supply shock, while they move in the same direction following a demand shock
- analysis focuses on the real effects of the shocks, disregarding the inflation effect, which depends to a large extent on monetary policy
- A historical decomposition of the oil price time series shows that demand shocks emerge as a main cause underlying the current increase.
- oil supply shocks account for less than half of oil price fluctuations over the last 30 years.
- More than half are due to oil demand shocks.
- effects of oil demand and supply shocks on the US economy are markedly different
- after a negative oil supply shock (that reduces production and increases the oil price), US industrial production falls with an estimated probability of about 80% one year after the shock
- after an oil demand shock (causing a comparable increase in the price of oil), industrial production increases with an estimated probability of about 70% one year after the shock
- Despite the “negative” production effect stemming from the higher oil price, the booming emerging economies ultimately lead to an increase in US industrial production the majority of the time.
- emergence of new players in the global economy makes some resources scarcer, increasing their cost, but it also offers new trade opportunities
- positive correlation between the price of oil and US industrial production shows that the US economy enjoys a net output gain from these developments
- America’s specialisation in the production of goods not supplied by emerging economies is key to this result
- It is the ability – or lack thereof – to innovate and produce goods that are not easily substitutable that determines whether the new challengers represent a risk or an opportunity for industrialised countries.
