Arbitrage and the Price of Oil
The model simulated in this paper shows that falling interest rates contribute to rising oil prices. This occurs because oil producers treat oil in the ground as an asset and attempt to arbitrage differences between its rate of return and the interest rate. When calibrated to match observed data over the last two decades, model results indicate that this arbitrage behaviour may have made the largest contribution to the pre-crisis boom in oil prices. Productivity driven growth shocks raise the oil price by about 70 percent, but this rises to 150 percent when falling interest rates are included.
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