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Oil Price Uncertainty in a Small Open Economy

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  • Yusuf Soner Baskaya
  • Timur Hulagu
  • Hande Kucuk

Abstract

We analyze business cycle implications of oil price uncertainty in an oil-importing small open economy, where oil is used for both consumption and production. In our framework, higher volatility in oil prices works through two main channels. On the one hand, it makes the marginal product of capital riskier, creating an incentive to substitute away from capital. On the other hand, it increases the demand for precautionary savings, which might imply higher capital accumulation in response to a rise in oil price uncertainty depending on whether agents have access to an alternative asset, international bond in our model. We show that the fall in investment following a rise in the volatility of real oil prices in the case of financial integration is more than twice the fall in investment observed under financial autarky. Moreover, the interaction between shocks to the level and volatility of oil prices is quantitatively important: initial responses of investment, output and consumption to a rise in oil prices are almost doubled, when there is a simultaneous rise in the volatility of oil prices.

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Bibliographic Info

Paper provided by Research and Monetary Policy Department, Central Bank of the Republic of Turkey in its series Working Papers with number 1309.

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Date of creation: 2013
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Handle: RePEc:tcb:wpaper:1309

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Keywords: Oil price; stochastic volatility; financial market integration;

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Cited by:
  1. Barbara Rossi, 2012. "The changing relationship between commodity prices and equity prices in commodity exporting," Economics Working Papers 1405, Department of Economics and Business, Universitat Pompeu Fabra.
  2. Benjamin Born & Johannes Pfeifer, 2014. "Risk Matters: A Comment," CESifo Working Paper Series 4793, CESifo Group Munich.

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