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The Macroeconomic Effects of an Oil Price Shock on the World Economy : A Simulation with the NIME Model [Working Paper 06-05]

In this Working Paper, we use the nime model to assess the macroeconomic effects of an oil price shock on the world economy. We start with an overview of the nime model, and a presentation of our modelling of oil price shocks. Next, we examine the effect of a permanent 25 per cent increase in the price of oil, under the assumption that the shock is caused by an increase in the mark-up of the oil price.

The reader should be aware that the short-term forecasts and medium-term projections for the Belgian economy carried out within the Federal Planning Bureau (fpb) do not necessarily retain nime oil price scenarios in their underlying international economic assumptions.

The simulation results for a permanent 25 per cent oil price shock show that, in the long run, such a shock reduces aggregate private sector output by 0.27 per cent in the euro area, 0.30 per cent in the Western non-euro eu Member States, 0.33 per cent in the United States, and 0.23 per cent in Japan. In the long run, the effects on total employment are negligible, though real producer wage rates and the return on capital drop proportionally to the decline in output. The effects on the general price level depend on the conduct of monetary policy. In this paper, we assume that the monetary authorities set the short-term interest rates according to a Taylor rule. Under a Taylor rule, the rise in prices is directly proportional to the decline in volumes, thereby leaving unaffected the current price value of aggregate output, nominal gdp, and the money supply.

In the medium-term, various adjustment costs prevent demand from immediately adjusting to its new long-run equilibrium. These adjustment costs include the cost of implementing the revised expenditure plans of households and enterprises, as well as the menu and information costs associated with price adjustments. As a result, certain components of aggregate demand can deviate significantly from their new long-run solution in the medium-term.

Looking at the results for the euro area, we note that imports are the most severely affected component of demand, as they drop immediately by 0.43 per cent. Moreover, as the impact of the oil price shock becomes stronger, imports pursue their fall and bottom out at 2.21 per cent below baseline in the third year, compared to 1.91 per cent below baseline in the new steady state. Private consumption in the euro area falls by 0.24 per cent in the first year, mainly due to a strong decrease in (expected) disposable income and household wealth, a 0.40 percentage point increase in the short-term interest rate, and a 0.30 per cent increase in the consumer price. Private consumption bottoms out at 0.45 per cent below baseline in the third year. As of the fifth year, as disposable income and household wealth stabilise and monetary policy is relaxed, private consumption recovers somewhat, and then gradually converges to its new equilibrium level at 0.32 per cent below baseline. Total gross fixed capital formation falls only moderately, down by 0.14 per cent after four years, and by 0.06 per cent in the long run, mainly due to the fact that enterprise investment is almost unaffected. The decline in enterprise investment is small, as the relative price of capital falls in order to reflect the drop in the return on capital. Furthermore, we note also that real producer wages do not adjust immediately to their new equilibrium, leading to a decline in private sector employment in the medium-term.

Apart from the long-run supply effects and the medium-term demand effects in the oil-importing countries, a change in the price of oil also generates a temporary income transfer from oil-importing countries to oil-exporting countries. Indeed, as the price of oil increases, the traded oil volume adjusts only gradually to its new steady state level. This initially raises oil-exporting countries’ export revenue above its equilibrium level, allowing oil-exporters to temporarily increase their expenditures. However, as adjustment progresses, oil export volumes will fall proportionally to the rise in oil prices, and drive total oil revenues back to their baseline level.

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