The University of New Haven Department of Economics

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1 The University of New Haven Department of Economics Special studies series no Crude oil price and inflation in the United States: Alan A. D Auria May, 2015 Department Special Studies Series are preliminary materials circulated to stimulate discussion and critical comment. The analyses and conclusions set forth are those of the authors and do not necessarily reflect the views of other members of the Department, the College of Business, the University of New Haven or its Board of Governors. Upon request, single copies of the paper will be provided. References in publications to Department Special Studies Series should be cleared with the Individual author to protect the tentative character of these papers.

2 Crude Oil Price and Inflation in the United States: Alan A. D Auria 1 Department of Economics University of New Haven Abstract The purpose of this research is to study the impact of crude oil prices on domestic inflation in the United States. The model used measures the impact of oil price change (percent) on inflation using the variables of real GDP growth, M2 money stock growth and the growth of crude oil prices, while holding oil price shocks constant. The data used to estimate the model was an annual time series from The model showed the change in crude oil price did indeed impact the inflation rate. More specifically, the greater the increase in crude oil price resulted in a direct increase in the domestic inflation rate. 1 This paper is based on my senior thesis written under the direction of Professor A.E. Rodriguez. adaur1@unh.newhaven.edu 1

3 1. Introduction DRAFT: April 29, 2015 In the last century, oil has become the most important natural resource in the world today for industrialized nations. It produces heat, fuels planes and automobiles, operates machinery for factories, and is used for many chemical products. To say oil greatly affects our lives every day would be an understatement as the world collectively consumes roughly 14 billion liters of oil each day. With oil being an essential component in most goods and services worldwide, it inevitably has substantial economic power. Any change in supply, demand, and price in the marketplace is bound to have significant impact on a macro level. For most of the 20 th century, the international price of oil remained fairly constant. However, in 1979, the Iranian crisis was the chief catalyst for the first major increase in the price of oil. With supply restricted, the price of oil began to rise to about a $100 dollars per barrel in The economy responded in the eighties by developing more energy efficient and sustainable businesses and importing smaller, more fuel-efficient vehicles. Paired with the discovery of new oil in Europe, the drop in demand and increase in new supply resulted in the world oil price to drop significantly down to $17.10 per barrel in However, as developing countries became more industrialized and transportation became more prevalent worldwide, going into the 21 st century there was a much greater demand for oil which sent the world price back up again, peaking at nearly $100 per barrel in

4 A change in oil prices has several different macroeconomic effects in the economy. Nations who suffer the worst from these increased prices would be those who are not as energy-efficient and those who are a net importer of oil and very reliant on oil from foreign countries. A trucking company or airline, for example, experiences significant margin degradation whenever the price of oil rises. However, every country is impacted in some way from both a supply and demand perspective. From a supply side, as previously mentioned, corporations who use oil in their products face higher production costs when the price of oil rises. This is because oil is such a key component in the production process, especially in goods made with petroleum such as fertilizers and paint. Consequently, gasoline prices rise when oil prices do. Not only is oil used in the production process but also as mentioned before, oil is utilized to operate large machinery and for heating, making production costs even more substantial. When producers are faced with higher production cost, the effect is higher prices in the market and a drop in the aggregate supply in the economy. This also results in reduced profits and financial restraints on other business expenses, indirectly having a negative impact on the global economy. The demand side is affected by consumer patterns and investment. Since oil is an essential natural resource, the price elasticity of demand is low. When price elasticity of demand is low, higher oil prices can result in a decrease in consumption on other goods and services in the economy and can also be dilutive to household savings. Therefore, if more money is spent on crude oil based products, this will reduce the amount spent on other goods in the market (Still 2007). Oil price fluctuations not only affect the supply and demand, it also has a direct correlation to the overarching price level and inflation rate in the economy. The increased production costs aforementioned, 3

5 result in companies having to charge more for goods and services, therefore causing inflation to increase. This also affects the currency exchange rate of both exporting and importing countries. For those importing, as oil prices rise, the currency is depreciated due to the increased supply of that currency in the foreign market. At the same time, the currency of the exporting country will appreciate, as the demand is increased. An oil price shock is a quick, dramatic change in the price of oil. For an oil importing country, this price shock would likely lead to an increase in the price level, an increase in the inflation rate, stagnant economic growth and possibly recession. The effects of the shock, however, will depend on the size of the shock, its duration, the countries dependency on oil and their response. The most recent shock started in 2003 and ended in Known as the 2000 s oil crisis, the price of oil peaked in July of 2008 at per barrel, this global recession forced the demand for energy to fall and the price of oil finally stabilized in late The purpose of this study is to estimate and analyze the effect of crude oil prices and U.S. inflation in past few decades ( ). There have been studies that look at the impact of inflation and the problems that occur as a result. In a study, (Cebula 2000) describes the impact of crude oil price changes on domestic inflation in the United States from He concluded that the higher the percentage rate of increase in oil prices, the resulting increase in inflation was less significant. Therefore any economic policy implemented on the matter would be unnecessary. In another study, (Cebula, McGrath, Saadatmand, & Toma, 2001) where they studied the effects of oil price change on inflation in the UK, they concurred that the rise in the price of imported crude oil did indeed lead to greater inflation. Also, in a related study, Basnet and Upadhyaya (2014) 4

6 that looked at the impact of an oil price shock on inflation in five Asian countries, they found the price shocks didn t explain a significant variation in the price level. This Paper is organized into four sections. Section 1 is the introduction and review of the literature, following is section 2 the methodology and data. Section 3 will be the results of the data, and finally, section 4 will be a summary and conclusion. Cebula Cebula, McGrath, Saadatmand, & Toma, Upadhayaya 2. Methodology and Data We use the model in Cebula, et al (2001) that is based on the standard IS/LM/AD/AS theoretical model. Within this formulation the inflation rate (P) is assumed to depend on several demand-side and supply-side type factors. The following demand-side variables are considered: The growth rate of real GDP; The growth rate of the M2 money stock; The growth rate in the price of oil; The various periods of crude oil price shocks Ex ante, we reason that the greater the growth rate of real GDP, the greater the growth rate of aggregate demand for goods and services which will result in greater domestic inflation rate, all else equal. In addition, we also hypothesize that an increased rate of growth of the supply of money will also stimulate aggregate demand. Formally, the 5

7 greater the growth rate of the money supply, the greater the growth in the aggregate demand for goods and services. As a result, this money supply driven increase in AD will also result in an increased rate of the inflation rate; similarly, holding all else equal. 2.1 The Empirical Model We estimate the following reduced-form model: P t = α + β 1 Y (t-1) + β 2 M2 (t-1) + β 3 POIL (t-1) + β 4 POILSHOCK t + β 5 Time + µ t Where: α = constant term P t = inflation rate of the consumer price index in the U.S. in year t. Y (t-1) = growth rate of real GDP in the U.S. in year t-1 M2 (t-1) = growth rate of the M2 money supply in the U.S. in year t-1 POIL (t-1) = growth rate in the price of USD per barrel of crude oil in the U.S. in year t-1 POILSHOCK(t) = a dummy (binary) variable to indicate the years in which the price per barrel of crude oil in the US changed by 30% Time = a trend variable µ t = stochastic error term The ADF Test 6

8 The Augmented Dickey-Fuller (ADF) test reveals that for the study period, two of the variables in the system (M2 and POIL) are stationary in levels but with a trend. The remaining variables are all stationary in levels. Accordingly, in the model below a trend variable is also included. dfuller cpi, lags(0) Dickey-Fuller test for unit root Number of obs = Interpolated Dickey-Fuller Test 1% Critical 5% Critical 10% Critical Statistic Value Value Value Z(t) MacKinnon approximate p-value for Z(t) = dfuller gdp, lags(0) Dickey-Fuller test for unit root Number of obs = Interpolated Dickey-Fuller Test 1% Critical 5% Critical 10% Critical Statistic Value Value Value Z(t) MacKinnon approximate p-value for Z(t) =

9 . dfuller m2, lags(0) Dickey-Fuller test for unit root Number of obs = Interpolated Dickey-Fuller Test 1% Critical 5% Critical 10% Critical Statistic Value Value Value Z(t) MacKinnon approximate p-value for Z(t) = Data Source FRED. Inflation Rate Real GDP Federal Reserve Economic Data CPALTT01USA657N Real Gross Domestic Product, Percent Change from Preceding Period, Annual, Not Seasonally Adjusted A191RL1A225NBEA Money Stock M2. dfuller wti, lags(0) Dickey-Fuller test for unit root Number of obs = Interpolated Dickey-Fuller Test 1% Critical 5% Critical 10% Critical Statistic Value Value Value Z(t) MacKinnon approximate p-value for Z(t) = M2 Money Stock, Percent Change, Annual, Not Seasonally Adjusted M2NS_PCH Crude Oil Prices 8

10 Crude Oil Prices: West Texas Intermediate (WTI) - Cushing, Oklahoma, Percent Change, Annual, Not Seasonally Adjusted MCOILWTICO_PCH 3. Data Visualization oil price changes and the rate of inclation cpi wti 9

11 Figure 1 growth of money supply and the rate of inclation cpi m2 It is well known increases in the supply money cause inflation. 10

12 4. Results SUMMARY OUTPUT Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 27 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Intercept E gdp(-1) m2(-1) wti(-1) shock trend

13 4. Summary & Concluding Comments With oil playing such a huge role in society today, there was never any doubt on the impact it has on the economy. As far as the price of oil and its direct impact on the inflation rate in the United States, this study proves that oil prices indeed do directly affect the inflation rate. In our model, where real GDP and the m2 money supply growth were both used, the data shows the increase in WTI price of oil leads to and increase in the inflation rate. This would lead to the assumption that a decrease in the price of oil would cause a drop in the inflation rate. As far as oil price shocks which we constituted as a 30% or more increase in the inflation rate in a given year, our data found that shocks alone do not impact inflation rate. 5. References References Cebula, RJ. (2000) "A Breif EMpirical Note on the impact of Crude Oil Prices on Domestic Inflation: The Case of the United States, " Economia Internazionale, Cebula, McGrath, Saadatmand, & Toma (2001) "An Empirical Note on the Impact of the Price of Imported Crude Oil on Inflation in the United Kingdom" Updahyaya, K., & Basnet, H. (2014) "Impact of oil price shocks on output, inflation, and the real exchange rate: evidence from selected ASEAN countries" 12

14 University of New Haven Department of Economics Special Studies Series No. Title Author Date 1505 An analysis of regression and classification Models in predicting of probability of bankruptcy Elizabeth Jaikes May Impact of climate change on wheat production in Kansas Joshua Howard May Crude oil price and inflation in the United States: Alan A.D Auria May Microfinance and its effectiveness on developing nations Josh Apfel May Government size and economic growth: Evidence from selected OECD countries Alice Aleksandrovich May 2014 Department of Economics Special Studies Series are materials circulated to stimulate discussion and critical comment. The analyses and conclusions set forth are those of the authors and do not necessarily reflect the views of other members of the Department, College of Business, the University of New Haven or its board of Governors. Upon request, single copies of the paper will be provided. References in publications to Department Special Student Series should be cleared with the individual author to protect the tentative character of these papers. The series editor is Professor Esin Cakan. You may contact her via at or write to her at: Department of Economics College of Business University of New Haven West Haven, CT The Department Senior Thesis Series is administered by the Editor, Esin Cakan and benefits from the commentary and direction of its board members: Professors A.E. Rodriguez and Kamal Upadhyaya.