Asian Development Bank Institute. ADBI Working Paper Series

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1 ADBI Working Paper Series Macroeconomic Effecs of Oil Price Flucuaions on Emerging and Developed Economies in a Model Incorporaing Moneary Variables Farhad Taghizadeh-Hesary and Naoyuki Yoshino No. 546 Ocober 2015 Asian Developmen Bank Insiue

2 Farhad Taghizadeh-Hesary is Assisan Professor of Economics a Keio Universiy, Tokyo and a research assisan o he Dean of he Asian Developmen Bank Insiue. Naoyuki Yoshino is Dean and CEO of he Asian Developmen Bank Insiue. The views expressed in his paper are he views of he auhor and do no necessarily reflec he views or policies of ADBI, ADB, is Board of Direcors, or he governmens hey represen. ADBI does no guaranee he accuracy of he daa included in his paper and acceps no responsibiliy for any consequences of heir use. Terminology used may no necessarily be consisen wih ADB official erms. Working papers are subjec o formal revision and correcion before hey are finalized and considered published. The Working Paper series is a coninuaion of he formerly named Discussion Paper series; he numbering of he papers coninued wihou inerrupion or change. ADBI s working papers reflec iniial ideas on a opic and are posed online for discussion. ADBI encourages readers o pos heir commens on he main page for each working paper (given in he ciaion below). Some working papers may develop ino oher forms of publicaion. Suggesed ciaion: Taghizadeh-Hesary, F., and N. Yoshino Macroeconomic Effecs of Oil Price Flucuaions on Emerging and Developed Economies in a Model Incorporaing Moneary Variables. ADBI Working Paper 546. Tokyo: Asian Developmen Bank Insiue. Available: hp:// Please conac he auhors for informaion abou his paper. farhadh@gmail.com, nyoshino@adbi.org Asian Developmen Bank Insiue Kasumigaseki Building 8F Kasumigaseki, Chiyoda-ku Tokyo , Japan Tel: Fax: URL: info@adbi.org 2015 Asian Developmen Bank Insiue

3 Absrac The goal of his paper is o examine he impac of crude oil price movemens on wo macro variables, he gross domesic produc (GDP) growh rae and he consumer price index (CPI) inflaion rae, in hree counries, he People s Republic of China (an emerging economy), Japan, and he Unied Saes (developed economies), in a model incorporaing moneary variables (money supply and exchange rae). The main objecive of his research is o invesigae wheher hese economies are sill reacive o oil price movemens and compare heir reacions. Moneary variables are included in his survey because our earlier research showed ha hey have a significan role in oil price deerminaion. To assess he relaionship beween crude oil prices and macro variables we adop an N-variable srucural vecor auoregression (SVAR) model. The resuls sugges ha he impac of oil price flucuaions on developed oil imporers GDP growh is much milder han on he GDP growh of an emerging economy. On he oher hand, however, he impac of oil price flucuaions on he People s Republic of China s inflaion rae was found o be milder han in he wo developed counries ha were examined. JEL Classificaion: Q43, E31, O57

4 Conens 1. Inroducion and Lieraure Review Overview of Oil and Energy in he PRC, Japan, and he US People s Republic of China Japan Unied Saes Theoreical Framework Relaionship beween Energy Prices and Economic Growh Relaionship beween Energy Prices and he General Price Level Impac of Higher Energy Prices on he Supply and Demand Side of he Economy Model Empirical Analysis Daa Analysis Empirical Resul Conclusions References... 22

5 1. INTRODUCTION AND LITERATURE REVIEW More han 40 years have passed since he firs oil price shock of During his period, global demand for oil has risen drasically, while a he same ime, new energy-relaed echnologies and new energy resources have made global consumers more resisan o oil shocks. Since he oil shocks of he 1970s, emerging economies have come o play a much larger role in global energy consumpion. The People s Republic of China s (PRC) share, for example, is 5 imes larger han i was in he 1970s. On he oher hand, he shares of he wo larges developed oil consumers, he US and Japan, decreased from abou 32% and 10% o 21% and 5%, respecively. Following he oil crises of he 1970s and he economic recessions ha followed, several sudies have found ha oil price shocks played a significan role in economic downurns. In recen years, boh he sharp increase in oil prices ha began in 2001 and he sharp decline ha followed in 2008 following he subprime morgage crisis have renewed ineres in he effecs of oil prices on he Macroeconomy. Following he financial crisis of , crude oil prices dropped from $ in July 2008 o below $42.01 in December 2008, due o decreased global demand. Shorly afer his drop, however, hey sared o rise sharply again. In his research we will assess and compare he impac of oil price flucuaions on he following macroeconomic facors: he gross domesic produc (GDP) growh rae and consumer price index (CPI) inflaion. We look a hese facors in he hree larges crude oil consumers: he Unied Saes (US) and Japan (developed economies), and he PRC (an emerging economy). We will answer he quesion of wheher hese economies are sill elasic o oil price movemens, or wheher new, energy-relaed echnologies and resources, like renewables and shale gas, have compleely shelered hem from shocks. If hey are sill elasic, are emerging and developed economies influenced o he same degree? Reviewing he lieraure of oil prices since 1970s unil now, several sudies have assessed he impacs of oil prices on various economic variables. Blanchard and Gali (2007) characerized he macroeconomic performance of a se of indusrialized economies in he afermah of he oil price shocks of he 1970s and of he las decade, using a six-variable vecor auoregression (VAR) model. They found a significan role of oil prices in he economic downurns. The variables used in heir survey were he nominal price of oil (in US dollars), hree inflaion measures (CPI, GDP deflaor, and wages) and wo quaniies (GDP and employmen). Kilian (2008a) addressed a numbers of issues, including how energy price shocks affec US real oupu, inflaion, and sock prices. The variables used were he nominal oil price, real oil price, and GDP. The sudy found ha i is criical o accoun for he endogeneiy of energy prices and o differeniae beween he effecs of demand and supply shocks in energy markes. Leven and Acar (2011) analyzed he economic effecs of oil price shocks for Turkey as a small, open oil- and gas-imporing counry. They analyzed he poenial long-erm effecs of oil price shocks on macroeconomic variables of ineres including GDP, consumer price inflaion, indirec ax revenue, he rade balance, and carbon emissions using a dynamic, muli-secoral general equilibrium model for he Turkish economy. Their simulaion resuls showed ha oil prices have significan effecs on macro indicaors. In a more recen sudy, Taghizadeh-Hesary e al. (2013) evaluaed he impac of oil price shocks on oil producing and consuming economies; he sudy used a simulaneous equaion framework for differen counries wih business relaions. As expeced, he resuls showed ha oil producers (Iran and he Russian Federaion) benefi from oil price shocks. For oil-consuming economies, he effecs are more diverse. In some counries, oupu falls in response o an oil price shock, 3

6 while ohers seem o be relaively immune. Variables used in he survey were GDP, rade share, and oil prices. However, he advanage of our survey compared wih he aforemenioned papers and oher research ha has been done in he field of oil prices is ha we include moneary variables (money supply and exchange rae). Moneary policy has a significan impac on inflaing he price of oil and oher commodiies (see, iner alia, [2014, 2015] and Yoshino and Taghizadeh-Hesary [2014a]). On he oher hand, moneary policy has a crucial role in general price deerminaion and on economic growh movemen (e.g., Sims [1980, 1992]; Romer and Romer [1989]; Yoshino e al. [2014]; and Yoshino and Taghizadeh-Hesary [2015]). Bernanke, Gerler, and Wason (1997) argue ha much of he decline in oupu and employmen in he US was due o he rise in ineres raes. Hence, due o he above reasons i is essenial o include moneary variables (money supply and he exchange rae) in our survey. Our analysis shows ha he impac of oil price movemens on developed oil imporers GDP growh is much milder han on he GDP growh of an emerging economy. On he oher hand, he impac of oil price flucuaions on he PRC s inflaion rae was found o be milder han in he wo developed counries. This paper is srucured as follows. In he nex secion, we presen an overview of oil and energy in he PRC, Japan, and he US. In he hird secion we provide heoreical framework including: he relaionship beween energy prices and economic growh, he relaionship beween energy prices and general price levels, and he impac of higher energy prices on supply and demand in he economy. Our model is explained in he fourh secion, and in he fifh secion we describe our empirical analysis. The sixh secion concludes he paper. 2. OVERVIEW OF OIL AND ENERGY IN THE PRC, JAPAN, AND THE US 2.1 People s Republic of China The PRC has quickly risen o he op ranks in global energy demand over he pas few years. I is he world s second larges oil consumer behind he US and became he larges global energy consumer in The economy was a ne oil exporer unil he early 1990s and became he world s second-larges ne imporer of crude oil and peroleum producs in The PRC s oil consumpion growh accouned for one-hird of he world s oil consumpion growh in 2013 (EIA 2014a). Naural gas use in he PRC has also increased rapidly in recen years, and he counry has sough o raise naural gas impors via pipelines and he use of liquefied naural gas (LNG). The PRC is he world s op coal producer, consumer, and imporer, and accouns for abou half of global coal consumpion an imporan facor in world energy-relaed carbon dioxide emissions. The PRC s rising coal producion is he key driver behind he economy becoming he world s larges energy producer in Coal supplied he vas majoriy (69%) of he PRC s oal energy consumpion in Oil was he second-larges source, accouning for 18% of oal energy consumpion. While he PRC has made effors o diversify is energy supplies, hydropower sources (6%), naural gas (4%), nuclear power (nearly 1%), and oher renewables (1%) accoun for small shares of energy consumpion (Figure 1). 4

7 Figure 1: Toal Energy Consumpion in he PRC by Type, 2011 Noe: Percenages may no oal 100% because of rounding. Source: Energy Informaion Adminisraion. Inernaional Energy Saisics. Washingon, DC: Unied Saes Energy Informaion Adminisraion. According o a projec carried ou by he Insiue of Energy Economics of Japan (IEEJ 2013), he PRC s oil consumpion will almos double over he nex 30 years, reaching 866 million ons of oil equivalen 1 (Moe) by During his period, he PRC will replace he US as he world s larges oil consumer. Driving he increase will be he ransporaion secor, including road ransporaion. Wih he poenial o expand he vehicle marke from is curren 7% vehicle ownership rae, he number of vehicles in he PRC is expeced o increase o 360 million in 2040, meaning ha he ransporaion secor will double is oil consumpion. The counry s share of global gasoline consumpion is also expeced o expand from is curren 8% o 18%, exceeding is share of he global populaion. This projecion coninues by saying ha by 2040 he PRC will have he world s larges nuclear power generaion capaciy, and will accoun for half of he increase in global nuclear generaion capaciy beween 2011 and Renewable energy will accoun for 9.7% of he counry s primary energy consumpion in 2040 (Taghizadeh- Hesary, Yoshino, and Assari-Arani 2015) Oil Consumpion in he PRC As of January 2014, he PRC held 24.4 billion barrels of proven oil reserves, up by over 0.7 billion barrels from he 2013 level and he highes in he Asia and he Pacific region. The PRC s oal oil and liquids producion, he fourh larges in he world, has risen by abou 54% over he pas 2 decades and serves only is domesic marke (EIA 2014a). However, producion growh has no kep pace wih demand growh during his period. In 2013, he counry produced an esimaed 4.5 million barrels per day (bbl/d) of oal oil liquids, of which 93% was crude oil. The EIA forecass oil producion o rise o abou 4.6 million bbl/d by he end of Over he longer erm, he EIA projecs a seady growh for he PRC s oil and liquids producion, o 4.6 million 1 Equal o abou 6,186 million barrels of oil equivalen. 5

8 bbl/d in 2020 and 5.6 million bbl/d by Mos of he growh over he long erm is from nonperoleum liquids such as gas-o-liquids, coal-o-liquids, kerogen, and biofuels, as crude oil producion remains relaively fla. Oil consumpion growh has eased afer a high of 14% in 2009, reflecing he effecs of he recen global financial and economic downurn. Despie he slower growh, he counry sill made up nearly a hird of global oil demand growh in 2013, according o EIA esimaes, wih an esimaed consumpion of 10.7 million bbl/d of oil in 2013, up 380 housand bbl/d, or almos 4%, from In 2009, he PRC became he second larges ne oil imporer in he world behind he US, and average ne oal oil impors reached 6.2 million bbl/d in Noably, for Q4 2013, he PRC acually became he larges global ne imporer of oil. The counry s oil demand growh hinges on several facors, such as domesic economic growh and rade, power generaion, ransporaion secor shifs, and refining capabiliies. The EIA forecass ha oil consumpion will coninue growing hrough 2014 a a moderae pace o approximaely 11.1 million bbl/d, and ne oil impors will reach 6.6 million bbl/d compared o 5.5 million bbl/d for he US (EIA 2014a). 2.2 Japan Japan is he world s larges liquefied naural gas (LNG) imporer, he second larges coal imporer, and hird larges ne oil imporer behind he US and he PRC. Japan has limied domesic energy resources, which mee less han 15% of he counry s own oal primary energy use Toal Primary Energy Consumpion in Japan In March 2011, a 9.0 magniude earhquake sruck off he coas of Sendai, Japan, riggering a large sunami. The damage o Japan resuled in an immediae shudown of abou 10 gigawas (GW) of nuclear power generaing capaciy. Beween he 2011 Fukushima nuclear power plan disaser and May 2012, Japan los all is nuclear capaciy as a resul of scheduled mainenance and lack of governmen approvals o reurn o operaion. Japan replaced he significan loss of nuclear power wih generaion from impored naural gas, low-sulfur crude oil, fuel oil, and coal (Yoshino and Taghizadeh-Hesary 2014a). Oil remains he larges source of primary energy in Japan. Coal coninues o accoun for a significan share of oal energy consumpion, alhough naural gas is increasingly imporan as a fuel source and is currenly he preferred fuel of choice o replace he nuclear shorfall. The oal primary consumpion of naural gas rose from 19% in 2010 o 24% in Before he 2011 earhquake, Japan was he hird larges consumer of nuclear power in he world, afer he US and France, and nuclear power accouned for abou 13% of he counry s oal energy in In 2012, he nuclear energy share fell o 1% of oal energy consumpion (and conribued a similar level o primary energy consumpion in 2013 as only wo reacors were operaing for a lile more han half of he year), and in 2014 Japan did no produce any nuclear power. Hydropower and oher renewable energy comprise a small percenage of oal energy consumpion in Japan (EIA 2014b). Figure 2 shows primary energy consumpion in Japan by ype based on hermal values from 1990 o

9 Figure 2: Primary Energy Consumpion in Japan by Type Based on Thermal Values, Noes: Annual daa were obained by summing up he monhly daa in each year. Thermal values are based on General Energy Saisics (Agency of Resources and Energy). Hydropower daa before 1999 include geohermal power. The daa include esimaed values. Sources: Minisry of Economy, Trade and Indusry of Japan. Monhly Saisics of Elecric Power, Coal Saisics Repor, Oil Saisics Repor. Monhly Saisics of Demand and Supply of Energy, Trade Saisics Oil Consumpion in Japan Figure 3 shows he shares of he world s hree major oil consumers: he US, Japan, and he PRC. As he figure shows, he US and Japan s shares are decreasing while he shares of he PRC and he res of he world are on he rise. 7

10 Figure 3: Share of he Three Major Oil Consumers in Global Oil Consumpion, Res of he World Unied Saes Japan PRC PRC = People s Republic of China. Source: Organizaion of he Peroleum Exporing Counries (2013). Annual Saisical Bullein. Vienna: Organizaion of he Peroleum Exporing Counries. Japan consumed nearly 4.6 million bbl/d in 2013, down from 4.7 million bbl/d in 2012, making i he hird larges peroleum consumer in he world, behind he US and he PRC. However, oil demand in Japan has declined overall since 2000 by nearly 15%. This decline sems from srucural facors, such as fuel subsiuion, a declining populaion, and governmen-mandaed energy efficiency arges. In addiion o he shif o naural gas in he indusrial secor, fuel subsiuion is occurring in he residenial secor as high prices have decreased demand for kerosene in home heaing. Japan consumes mos of is oil in he ransporaion and indusrial secors, and is also highly dependen on naphha and low-sulfur fuel oil impors. Demand for naphha has fallen as ehylene producion is gradually being displaced by perochemical producion in oher Asian economies. Demand for low-sulfur fuel oil and direc use of crude oil rose subsanially in 2012 as hese fuels replaced some nuclear power generaion and suppored he pos-disaser reconsrucion works. Japan s oil consumpion rose by 255,000 bbl/d in 2012 from he 2011 level. Oil consumpion began declining in 2013 as Japan relied more on naural gas and coal o subsiue for he los nuclear generaion. The EIA assumes ha ne oal oil consumpion will coninue declining in 2015 as nuclear capaciy comes back online (EIA 2014b). In he wake of he Fukushima nuclear inciden he price of elecriciy was raised for he governmen, uiliies, and consumers. Increases in he cos of fuel impors have resuled in Japan s op 10 uiliies losing over $30 billion in he pas 2 years. Japan spen $250 billion on oal fuel impors in 2012, a hird of is oal impor charge. Despie srengh in expor markes, he yen s depreciaion and soaring naural gas and oil impor coss from a greaer reliance on fossil fuels coninued o deepen Japan s recen rade defici hroughou Oil remains he larges source of primary energy in Japan, alhough is share of oal energy consumpion declined from abou 80 % in he 1970s o 43 % in Japan consumed over 4.7 million barrels of oil per day in

11 2.3 Unied Saes Toal Primary Energy Consumpion in he US In 2012, he US consumed over 94 quadrillion Briish hermal unis (BTU) of primary energy, making i he world s second larges energy consumer afer he PRC (Taghizadeh-Hesary e al. 2015). Figure 4 shows US primary energy consumpion by source. The share of crude oil decreased from 46% in 1973 o 36% in 2012, while he shares of naural gas (driven especially by he shale gas revoluion), nuclear power, and renewable energy have risen drasically. Figure 4: Unied Saes Primary Energy Consumpion by Source, BTU = Briish hermal uni. Noe: Naural gas consumpion excludes supplemenal gaseous fuels. Source: EIA (2014c). As for oil consumpion, he US sill ranks highly among global oil consumers, wih consumpion a abou million bbl/d (EIA 2014c). Alhough oil consumpion decreased from is peak in 2005, i is sill he main energy source in he US. Today, oil mees 36% of US energy demand, wih 70% direced o fuels used in ransporaion gasoline, diesel, and je fuel. Anoher 24 % is used in indusry and manufacuring, 5% is used in he commercial and residenial secors, and less han 1% is used o generae elecriciy. Oil is he main mover of US naional commerce and is use in ransporaion has allowed people o become more easily conneced. Almos all US ransporaion is dependen upon fuel in concenraed liquid form. The major sources of US impored oil are Canada, Mexico, and Organizaion of he Peroleum Exporing Counries (OPEC), paricularly Saudi Arabia, including 20% coming from he Persian Gulf. In 2014, he US proved is reserves of crude oil and lease condensae and exceeded 36 billion barrels. 9

12 3. THEORETICAL FRAMEWORK 3.1 Relaionship beween Energy Prices and Economic Growh On he supply side of he economy, in addiion o elemens of labor and capial, energy is also considered o be a subsanial elemen of producion. Therefore, producion can be shown as a funcion of labor, capial, and energy. Hence: W PE Q = ( L (, Q ), K ( i, Q ), E (, Q )) (1) PQ where Q sands for gross oupu, L is labor inpu, K is capial inpu, E is energy (oil, gas, and coal) inpu, W denoes he nominal wage rae, i is he nominal ineres rae, and P E and P Q are he energy price, 2 and consumer price index (CPI), respecively. Eq. (1) shows ha he hree elemens of labor, capial, and energy lead o he aleraion of levels of producion. Furhermore, here are direc relaionships beween he use of such elemens and he level of producion. In oher words, a rise of each of he elemens leads o an increase in producion: PQ Q Q Q > 0, > 0, > 0 (2) L K E In addiion, he consumpion of each of he energy resources, oil, gas, and coal, is a reverse funcion of heir price levels: E < 0 and EO EG EC < 0, < 0, < P P P P 0 (3) E O where, E O, EG, E sands for oil, gas, and coal consumpion, respecively. P denoes he oil C O price, P G he gas price, and P C he coal price. Therefore, if he general index of energy prices is increased, is consumpion decreases. However, if only he price of one source (given oil) increases among oher he sources of energy, or if is price increase is higher han oher sources, hen he increase in price of ha source will parly be offse by a subsiuion of oher sources. The raes of such subsiuion will depend on he echnical abiliy of oher sources o replace i and on he period of ime available for such an adjusmen. Therefore, an increase in oil price shall lead o he subsiuion of oil by oher sources of energy. Furhermore, as i is a producion facor, i will have shor-erm effecs on he increase of producion coss and will lead o he reducion of real producion of oil imporer counries. In he long run oo, i leads o a rise in coss; he rae of which will depend on he abiliy of oher sources o replace oil. If he abiliy o subsiue exiss, such price increases will have no imporan effec on coss. Usually, mos researchers consider he relaionship beween energy and labor and capial o be a subsiuion under normal condiions. However, hey consider he cross elasiciy beween hem o be negaive in he shor run. In oher words, energy and labor and capial will be supplemens of each oher in he shor run because he srucure of indusries is such ha hey may no reac agains a rise in coss (Bohi 1991). Hence, we may conclude ha he shor-erm effec of an energy price shock will be bigger han is long-erm one. This is reasonable because when here is a rise in energy prices, in he long run indusries change he srucure of heir producion as much as possible o use fewer cosly resources. In indusries where energy is G C 2 Weighed average of crude oil, naural gas and coal prices. 10

13 used as an inermediary resource of producion, a rise in energy prices drasically affecs he poenial producion oupu, hereby affecing GDP. If we consider ha energy and labor and capial are subsiuable, he rise in energy prices leads o an increase in he use of he wo parameers of capial and labor, which makes he allocaion coss of parameers and relaive shares for he wo parameers of labor and capial rise (Taghizadeh-Hesary e al. 2013). This secion showed ha higher energy prices as one of he producion inpus, reduces he oupu level. On he oher hand, following higher energy prices, household consumpion and he demand side of he economy also suffer and resul in a lower GDP level (see Secion 3.3 of his paper). 3.2 Relaionship beween Energy Prices and he General Price Level In order o show he relaionship beween energy prices and he general price level, we adop a hree-inpu Cobb-Douglas producion funcion: and assuming: α W β (, ) ( ( M ) Q K i, Q ) P Q γ PE (, Q ) P Q Q = ΤL E (4) PQQ (5) L = L1 W Q K i ( M ) K = (6) = E E1 1 PQQ P E where α, β, γ are he oupu elasiciies of labor, capial, and energy, respecively, and assuming heir summaion is equal o one, meaning consan reurns o scale. These values are consans deermined by he available echnology and Τ is he oal facor produciviy, which is assumed o be consan. M is he money supply, which deermines he ineres rae level. By subsiuing Eqs. (5) (7) in Eq. (4) and log linearizing he resul, hen obaining he firs derivaive wih respec o ime and wriing he resul for CPI, we obain he below equaion for he growh raes: (7) or, LnPQ LnW Lni ( M ) LnP α β γ E = δ + χ + η ; δ =, χ =, η = (8) α + γ α + γ α + γ P Q = δ W + χi ( ) + ηp (9) M E Eq. 9 depics he relaionship beween producion inpu prices which are: wage rae, ineres rae and energy price growh rae and he CPI inflaion rae in he supply side of he economy. Higher energy prices, higher wages, and higher money amoun which ease he ineres rae will push up general price level. Higher energy prices affec no only he supply side of he economy bu also household consumpion on he demand side of he economy suffers as well. A more deailed descripion of he reacions of boh he supply and demand sides of he economy o higher energy prices are graphically demonsraed in he following secion. 11

14 3.3 Impac of Higher Energy Prices on he Supply and Demand Side of he Economy A simple aggregae supply and demand model will clarify he analysis in his secion. Figure 5: Impac of Higher Energy Prices on Oupu and Price Level Source: Auhors compilaion. In Figure 5, he economy is iniially in equilibrium a poin A wih price level P Q0 and real oupu level Q. AD is he aggregae demand curve and AS sands for he aggregae supply curve. 0 Aggregae supply curve has an upward sloping curve, which shows ha a some real oupu level i becomes difficul o increase real oupu despie increases in he general level of prices. A his oupu level, he economy achieves full employmen. Suppose ha he iniial equilibrium, poin A is below he full employmen level. When he relaive price of energy resources (crude oil, naural gas, coal, ec.) increases, he aggregae supply curve shifs o A S. The employmen of exising labor and capial wih a given nominal wage rae requires a higher general price for oupu, if sufficien amouns of he higher-cos energy resources are o be used. The produciviy of exising capial and labor resources is reduced so ha poenial real oupu declines oq 1. In addiion, he same rae of labor employmen occurs only if real wages decline sufficienly o mach he decline in produciviy. This, in urn, happens only if he general level of prices, P, rises sufficienly given he nominal wage rae. This moves he economy o he level Q1 of oupu Q 1 and price level P Q1. This poin is indicaed in Figure 5 a poin B, which is a disequilibrium poin. Given he same supply of labor services and exising plans and equipmen, he oupu associaed wih full employmen declines as producers reduce heir use of relaively more expensive energy resources and as plans and equipmen become economically obsolee. On he oher hand, on he demand side of he economy, when he prices of energy resources rise, heir consumpion declines. Because of his drop in consumpion, he aggregae demand curve shifs o A D, which in urn decreases prices from heir previous disequilibrium level a P Q1 and ses hem a P as he final equilibrium price. This lowers he oupu levels due o reduced Q2 12

15 consumpion in he economy, from he previous poin of Q o 1 Q 2. This poin is indicaed in Figure 5 a poin C, which is he final equilibrium poin. The economy may no adjus insananeously o poin C, even if poin C is he new equilibrium. For example, price rigidiies due o slow-moving informaion or oher ransacions coss can keep nominal prices from adjusing quickly (Taom 1981). Consequenly, oupu and prices move along an adjusmen pah such as ha indicaed by he arrow in Figure 5. In his case, aggregae supply is he main chain of ransmission of energy price shocks compared o aggregae demand. This means ha he supply side of he economy is more affeced by oil price shocks han he demand side of he economy, resuling in higher prices and lower oupu levels a he final equilibrium poin, C, when compared o he iniial equilibrium poin A. If he demand side of he economy were he main ransmission channel, he resul would be a decrease in oupu and lower price levels compared o he iniial equilibrium poin. 4. MODEL The main objecive of his research is o assess and compare he impac of he price movemens of crude oil, he main energy resource, on GDP growh raes and CPI inflaion raes of an emerging and wo developed economies in a model incorporaing moneary variables. In developing his model we used (2013a) as a reference. In heir model, hey assumed ha oil price movemens ransfer o macro variables hrough eiher supply (he aggregae supply curve) or demand channels (he aggregae demand curve). In order o examine he effecs of his ransfer, hey used an IS curve o look a he demand side and a Phillips curve o analyze inflaionary effecs from he supply side. Using his aforemenioned research as inspiraion, we chose o use he following variables in our survey: crude oil prices, naural gas prices, GDP, consumer price index (CPI), money supply, and he exchange rae. We included he naural gas price because i is he main subsiue energy source for crude oil. GDP and CPI are included in our variables mainly because heir movemens have an impac on he crude oil marke (Taghizadeh-Hesary and Yoshino 2013b, 2014), and also because our objecive is o assess he impac of oil price flucuaions on hese wo macro variables. The money supply and he exchange rae are moneary policy variables ha have an impac on he crude oil marke and on he whole economy. Hence, i is necessary o include each counry s money supply and he exchange rae in our analysis (Barsky and Kilian 2002; Leduc and Sill 2004; Hamilon and Herrera 2004; 2014, 2015; Yoshino and Taghizadeh 2014a). (2014) explain ha oil prices acceleraed from abou $35/barrel in 1981 o beyond $111/barrel in A he same ime, ineres raes (he federal funds rae) subsided from 16.7% per annum o abou 0.1%. By running a simulaneous equaions model, hey found ha during he period , global oil demand was significanly influenced by moneary policy and supply acually remained consan. Aggressive moneary policy simulaes oil demand, while supply is inelasic. The resul is skyrockeing crude oil prices, which inhibi economic growh. 3 3 Taghizadeh and Yoshino (2014), in order o define he deerminans of crude oil prices, used wo subsiuion sources for crude oil prices (naural gas prices and coal prices), wo moneary policy facors (he exchange rae and ineres rae) and GDP growh rae, which shows economic aciviy growh. In his presen paper since we use an SVAR model, in order o avoid idenificaion problems, we mus use he minimum possible number of variables. 13

16 Yoshino and Taghizadeh-Hesary (2014) examined how moneary policy affeced crude oil prices afer he subprime morgage crisis. They found ha afer he subprime morgage crisis, he weaker exchange rae of he US dollar caused by he counry s quaniaive easing pushed oil prices in US dollars upward over he period by causing invesors o inves in he oil marke and oher commodiy markes while he world economy was in recession in his period. This rend had he effec of imposing a longer recovery ime on he global economy, as oil has been shown o be one of he mos imporan producion inpus. Figure 6 depics wo moneary policy facors: base money and real effecive exchange rae movemens along wih crude oil price movemens. I illusraes he base money growh rae rend and he crude oil price movemens during he period February 2007 Sepember As is clear, in mos cases hey end o follow he same pah. Figure 6: Base Money and Crude Oil Price, February 2007 Sepember 2013 Crude oil prices (lef-hand scale) Base money growh rae (righ-hand scale) Noes: Crude oil prices are in consan dollars obained using a simple average of: Dubai crude oil prices in he Tokyo marke, Bren crude oil prices in he London marke, and WTI crude oil prices in he New York marke, deflaed by he US consumer price index (CPI). The base money growh rae is for he US, seasonally adjused. The lef-hand scale is for crude oil real prices and he righ-hand scale is for he base money growh rae. Source: Yoshino and Taghizadeh-Hesary (2014a). Figure 7 shows he real effecive exchange rae (REER) and real crude oil price movemens during he period January 2000 December The inverse relaionship beween hese wo variables is apparen in his figure. In mos cases, crude oil prices began o rise following a depreciaion of he US dollar, and dropped following an appreciaion. As such, for subsiuion sources of crude oil, we limied our selecion o naural gas, which is he main subsiue fuel, and eliminaed coal hroughou our sudy. As for moneary variables we used he money supply and he exchange raes. Moreover we added CPI, since his is one of he variables on which we expec o measure oil price movemen impacs. 14

17 Figure 7: Exchange Rae and Crude Oil Prices, January 2000 December 2013 REER = real effecive exchange rae. Noes: crude oil prices are in consan dollars obained using he simple average of: Dubai crude oil prices in he Tokyo marke, Bren crude oil prices in he London marke, and WTI crude oil prices in he New York marke, deflaed by he US consumer price index (CPI). The real effecive exchange rae (REER) is for US dollars. The righ-hand scale is for REER and he lef-hand scale is for real crude oil prices. Sources: Inernaional Energy Agency (IEA) (2013); Inernaional Financial Saisics (IFS) (2013); and he Energy Daa and Modelling Cener (EDMC) daabase of he Insiue of Energy Economics, Japan (IEEJ). To assess he relaionship beween crude oil prices, naural gas prices, GDP, he consumer price index (CPI), money supply, and he exchange rae variables, we adop he N-variable Srucural Vecor Auoregression (SVAR) model and sar wih following VAR model: 4 Y 1 + u (10) = A Y ApY p where Y is a (N 1) vecor of variables. Ai ( i = 1,, p) are (N N) fixed coefficien marices, p is he order of he VAR model, and u is a (N 1) vecor of VAR observed residuals wih zero mean and covariance marix E ( u u ) =. The innovaions of he reduced form model, u u, can be expressed as a linear combinaion of he srucural shock, ε, as in Breiung, Bruggemann, and Lukepohl (2004): u 1 = A Bε (11) where, B is a srucural form parameer marix. Subsiuing Eq. (10) ino Eq. (11) and following minor operaions, we ge he following equaion, which is he srucural represenaion of our model: 4 The SVAR approach has been developed over he las decade o inerpre business cycle flucuaions and o help idenify he effecs of differen economic policies. I is an exension on he radiional heoreical VAR approach in ha i combines economic heory wih ime-series analysis o deermine he dynamic response of economic variables o various disurbances. The main advanage of SVAR analysis is ha he necessary resricions on he esimaed reduced form model, required for idenificaion of he underlying srucural model, can be provided by economic heory. These resricions can be eiher conemporaneous or long-run in naure depending on wheher he underlying disurbances are considered o be emporary or permanen in naure. Once he idenificaion is achieved i is possible o recover he srucural shocks (Goschalk 2001). 15

18 AY * * = A1 Y ApY p + Bε (12) * 1 * where Aj ( j = 1,, p) is a (N N) marix of coefficiens; Aj = A A j ( j = 1,, p) and ε are a (N 1) vecor of unobserved srucural shocks, wih ε ~ (0,I k ). The srucural innovaion is orhonormal; he srucural covariance marix, = E ( ε ε ), I is he idenifying marix. This model is known as he ε N AB model, and is esimaed in he form below: Au = Bε (13) The orhonormal innovaions, ε, ensure he idenifying resricion on A and B: A A = BB (14) Boh sides of he expression are symmeric, which means ha N(N + 1)/ 2 resricions need o be 2 imposed on 2N unknown elemens in A and B. A leas 2N 2 N( N + 1) / 2 addiional idenifying resricions are needed o idenify A and B. Considering he six endogenous variables ha we have in our model: M, X, P, P, P, Q, which are he money supply, exchange rae, naural gas G O Q price, crude oil price, CPI, and GDP, he errors of he reduced form VAR are: M X P P P Q M X P P G O Q G PO Q Q u = u + u + u + u + u + u. The srucural disurbances, ε, ε, ε, ε, ε, ε, are he money supply, exchange rae, naural gas price, crude oil price, CPI, and GDP shocks, respecively. This model has a oal of 72 unknown elemens, and a maximum number of 21 parameers can be idenified in his sysem. Therefore, a leas 51 addiional idenifiable resricions are required o idenify marices A and B. The elemens of he marices ha are esimaed are assigned a rc. All of he oher values in he A and B marices are held fixed a specific values. Since his model is over-idenified, a formal likelihood raio (LR) es is carried ou in his case o es wheher he idenificaion is valid. The LR es is formulaed wih he null hypohesis ha he idenificaion is valid. Our sysem will be in he following form: (15) 16

19 The firs equaion in his sysem represens he money supply as an exogenous shock in he sysem. 5 The second row in he sysem specifies exchange rae responses o money supply shocks. 6 The hird row represens naural gas real price responses o exchange rae shocks. The forh equaion allows crude oil prices o respond conemporaneously o exchange rae and naural gas price shocks. The fifh equaion exhibis CPI responses o money supply, exchange rae, and crude oil price shocks. The las equaion depics GDP as he mos endogenous variable in his sysem. The money supply, exchange rae, naural gas price, crude oil price, and CPI are variables ha have an impac on GDP (see, iner alia, [2013a]; Taghizadeh-Hesary e al. [2013]). The main purpose of his paper is o measure and compare a54 & a which are he impacs of crude oil prices on CPI and GDP for he PRC, Japan, 64 and he US. In order o accomplish his, we need o run his sysem for each of hese hree counries separaely. 5. EMPIRICAL ANALYSIS As menioned earlier, he increase in oil prices ha began in 2001, he sharp decline ha followed he 2008 subprime morgage crisis, and he immediae recovery ha was experienced shorly afer have renewed ineres in he effecs of oil prices on he macroeconomy. Following he financial crisis of , crude oil prices dropped from $ in July 2008 o below $42.01 in December 2008, due o decreased global demand. Shorly afer his drop, however, prices sared o rise sharply again. In his paper, for his reason, we seleced a period ha covers he significan flucuaions menioned above. Because of he presence of a srucural break 7 in oil prices in July 2008, we divided our analysis ino wo subperiods, January 2000 July 2008 and Augus 2008 December 2013, and ran regressions for our SVAR for each of hese hree counries during he wo subperiods before and afer he sub-prime morgage crisis, he even ha caused he recen flucuaions in crude oil prices, hen compared he findings. 5.1 Daa Analysis In order o reach a more realisic analysis, we express all variables in real erms. As for he oil prices, because each of hese hree oil imporers are imporing crude oil from various sources, hence for he crude oil prices, we used he simple average of hree major oil price sources as in Korhonen and Ledyaeva (2010) and Taghizadeh-Hesary e al. (2013): Dubai crude oil prices in he Tokyo marke, Bren crude oil prices in he London marke, and WTI crude oil prices in he New York marke, all in consan dollars and seasonally adjused. Naural gas prices are in consan dollars obained using a simple average of hree major naural gas prices: US Henry hub, UK Naional Balancing Poin (NBP) and Japanese impored LNG average prices, seasonally adjused. The GDP of all hree counries is in consan US dollars, fixed PPPs, seasonally adjused. All of he hree daa series above were deflaed by he US consumer price index (CPI), as mos crude oil, and naural gas markes are denominaed in US dollars and he 5 For more informaion on exogeneiy ess in srucural sysems wih moneary applicaions, see Revankar and Yoshino (1990). 6 For he impac of he money supply on he exchange raes, see Yoshino, Kaji, and Asonuma (2012). 7 In order o find he presence of srucural changes hroughou he period of our survey, we used he Chow es a various poins where oil prices flucuaed significanly. The resuls confirm a srucural break in July 2008, when global oil prices dropped sharply because of lower oil demand due o he recession following he financial crisis. As a resul we can deermine wo subperiods for our analysis: January 2000 July 2008 and Augus 2008 December

20 amoun of GDP for each counry was also in US dollars. For he exchange rae in he PRC s SVAR, we used he yuan REER, for Japan we used he yen REER and for he US, we used he US dollar REER (2005=100). As for he money supply, we used M2 for he PRC, Japan, and he US for each counry s SVAR. From now on, whenever we refer o he price of crude oil, naural gas, and GDP, unless oherwise saed, we refer o heir real values. Sources of daa are Inernaional Energy Agency (IEA) (2013), Inernaional Financial Saisics (IFS) 2013, he Energy Daa and Modeling Cener (EDMC) daabase of he Insiue of Energy Economics, Japan (IEEJ), Monhly Energy Review of he US Deparmen of Energy (DOE), and he Bank of Japan (BOJ) daabase. In order o evaluae he saionariy of all series, we used an Augmened Dickey Fuller (ADF) es for all series wih inercep and rend. The resuls imply ha wih he excepion of M2 for he US and GDP for he PRC, which were saionary a he log level, all oher variables are nonsaionary a log level. However, when we applied he uni roo es o he firs difference of loglevel variables wih inercep and rend, we were able o rejec he null hypohesis of uni roos for each of he variables. These resuls sugges ha he M2 for he PRC and Japan, he exchange raes of all hree counries, Japanese and US GDP, crude oil prices, and naural gas price variables all conain a uni roo. Once he uni roo es was performed and i was discovered ha he variables are non-saionary in level and saionary in firs differences, hey were inegraed of order one. Hence hey will appear in he SVAR model in he firs differenced form. This means ha insead of CPI, we will have CPI growh rae or he inflaion rae, and insead of GDP we will have he GDP growh rae. For oher variables, we will have heir growh raes in our regressions. In order o es wheher he idenificaion is valid, he LR es was run for each counry s SVAR. The LR es does no rejec he under-idenifying resricions a he 5& level, implying ha he idenificaion is valid. 5.2 Empirical Resul Regressions resuls of our SVAR model for each counry are presened in Table 1. Table 1: Empirical Resuls Counry January 2000 July 2008 Augus 2008 December 2013 People s Republic of CN a 64 = S.E.= 0.07** CN a 64 = S.E.= 0.39 China CN a 54 = 0.02 S.E.= 0.02 CN a 54 = 0.02 S.E.= 0.02 Japan JP a 64 = 0.03 S.E.= 0.005** JP a 64 = -0.1 S.E.= 0.02** JP a 54 = 0.03 S.E.= 0.007** JP a 54 = S.E.= US US a 64 = a S.E.= 0.002** 64 = - Unied Saes 0.01 S.E.= 0.01 = 0.07 S.E.= 0.002** US = 0.03 S.E.= 0.01* S.E. = sandard error. US a 54 i i a (,, ) Noe: 64 i = CN JP US a (,, ) shows he impac of oil price flucuaions on GDP growh, 54 i = CN JP US shows he impac of i i a (,, ) /.. oil price flucuaions on CPI inflaion. The z-saisic is obained by 64 i = CN JP US S E a ( i CN, JP, US) / S. E and 54 =. To ge an inerpreaion of he conemporaneous coefficiens, he sign of he A marix is reversed; his follows from Eq. 12. * indicaes significance a he 5% level, ** indicaes significance a he 1% level. The signs, sizes, and significances of he conemporaneous impacs of crude oil price movemens on GDP growh raes and on CPI inflaion raes deserve discussion because hey have imporan policy and heoreical implicaions. a 54 18

21 Our empirical resuls show ha oil price flucuaions had an impac on he macroeconomic variables of hese hree economies, which is in accordance wih he heoreical par of his paper ha shows oil prices have an impac on GDP (Eq. 8) and also on general price deerminaions (Eq. 9). However he size and magniude of his impac varies for each counry and for differen ime periods. Below we inerpre he sign, size, and magniude of he conemporaneous impacs of crude oil price movemens on GDP growh raes and on CPI inflaion raes of hese hree counries. The PRC s elasiciy of GDP growh rae and inflaion rae o oil price movemens did no change afer he 2008 financial crisis. Before he crisis, he elasiciies of he counry s GDP growh rae and inflaion rae o crude oil price changes were (significan) and 0.02 (nonsignifican), respecively, and afer he crisis hey were -0.27(non-significan) and 0.02 (nonsignifican). The main cause for his is he appreciaion of he yuan. Slighly afer he sub-prime morgage crisis, oil prices sared o increase sharply. This happened because of a mild recovery in he global economy and huge quaniaive easing (QE) policies by he US and oher counries moneary auhoriies (Yoshino and Taghizadeh-Hesary, 2014a). A he same ime, he yuan appreciaed compared o oher currencies, which means ha he price of crude oil in he PRC s domesic marke did no flucuae much. The resul was ha boh before and afer he crisis, he impac of crude oil prices on he PRC s economy (GDP and inflaion) was almos consan. There are several earlier sudies on he impac of oil shocks on he PRC s economy ha mach our resuls (Zaouali 2007; Tang, Wu, and Zhang 2010; Du, Yanan, and Wei 2010). The PRC s oil consumpion doubled over he pas decade because of he counry s high economic growh, which required large amouns of energy. In addiion, he PRC is he second larges consumer of oil in he world behind he US. I has high energy inensiy, and he energy consumpion per $1,000 GDP in 2007 was 0.57 ons of oil equivalen, higher han ha of Germany (0.09), Japan (0.12), and he US (0.17). Japan s elasiciy of GDP growh rae o oil price flucuaions became negaive afer he 2008 financial crisis, a 0.1 (significan). The reason for his is ha in he wake of he Fukushima nuclear inciden in March 2011, oil remains he larges source of primary energy in Japan. The disaser made he counry fully dependen on impors of fossil producs, especially crude oil. Japan spen $250 billion on oal fuel impors in 2012, a hird of he counry s oal impor charge. Before he crisis, in he firs subperiod, he elasiciy of he Japanese GDP growh rae o crude oil price movemens was posiive, a 0.03 (significan). Worldwide increases in oil prices have had a posiive effec on Japan s GDP. These findings are also in accordance wih hose of Jiménez-Rodríguez and Sánchez (2004), Blanchard and Galí (2007), Kilian (2008b), and Taghizadeh-Hesary e al. (2013), who all conclude ha Japan has fared relaively well in he face of recen exogenous oil price shocks. However he findings by Korhonen and Ledyaeva (2010) for Japan are he reverse, as hey observed negaive impacs of oil shocks on GDP. This posiive elasiciy exiss due o several reasons, such as increased energy efficiency, accumulaing huge sraegic reserves of crude oil, declining crude oil demand semming from srucural facors like fuel subsiuion (he use of nuclear elecric power and naural gas), and populaion decline. Anoher reason is ha in firs subperiod, alhough crude oil prices saw huge increases, because of appreciaion of he yen, resuling from accumulaed foreign reserves in he counry, energy prices in he domesic marke did no increase much. As for he elasiciy of CPI inflaion o crude oil price growh raes, in he firs subperiod he value was 0.03 (significan), bu became negaive afer he crisis ( 0.01, non-significan). The reason for his negaive impac on prices is ha in Japan, aggregae supply (AS) is almos consan. Higher energy prices mainly affec he demand side of he economy. This is clearly eviden in he second subperiod, shorly following he uncerain siuaion ha occurred in he counry afer 19

22 he Fukushima nuclear disaser. This uncerainy caused domesic consumpion o shrink, resuling in price deflaion. Our empirical resuls show ha he US economy in boh periods was affeced by oil prices, which is in line wih several papers (Hamilon 1983, 2005; Blanchard and Gali 2007; Kilian 2008b). The absolue value of he US elasiciy of GDP growh rae o oil price growh rae was reduced following he 2008 financial crisis because of lower aggregae demand in he counry, caused by recession. Moreover, he impac of higher oil prices on inflaion decreased in he second period because of lower aggregae demand. The impac of oil price flucuaions on US and Japanese GDP is much milder han for he PRC. However, he PRC s CPI sees smooher raes of inflaion in oil shocks compared o he US and Japan because of he higher growh rae in he PRC s economy, which shifs he AS curve forward and avoids higher prices in oil shocks. In Japan s case, he AS curve has been almos consan recenly, and in he US is seeing only a small forward shif. Figure 8 compares energy inensiies in he PRC, Japan, and he US and is evidence for our finding ha he PRC s GDP is more responsive o oil price flucuaions GDP for he US and Japan. Energy inensiy measures he amoun of energy (oal primary energy consumpion) a counry needs o generae a uni of GDP. Figure 8: Energy Inensiy, Bu = Briish hermal unis. Noe: Toal primary energy consumpion per US dollar of GDP (Bu per year, 2005 US dollars [marke exchange raes]). Source: US Energy Informaion Adminisraion (EIA), Independen Saisics & Analysis, Inernaional Energy Saisics hp:// (rerieved Sep 21, 2015). As is clear, alhough for he case of he PRC energy inensiy has decreased over he las 3 decades, several reasons explain his decline: faser growh of GDP han energy demand, he services secor having a growing share of he economy, and energy efficiency programs. However, while he PRC s energy inensiy decreased significanly, i is sill much higher han he US and Japan s. There are several reasons behind his large gap ha can be summarized in energy conservaion. 8 8 Energy conservaion means decreasing he quaniy of energy used wihou any change in oupu. 20