Oil and the Macroeconomy: A Quantitative Structural Analysis

We model an economy where the cost of the oil input, industrial production, and other macroeconomic variables fluctuate in response to fundamental oil supply shocks, as well as aggregate demand and supply shocks generated domestically and in the world economy. We estimate the effects of these structural shocks on US monthly data over 1973.1-2007.12, using robust sign restrictions suggested by the model. It is shown that the interplay between the oil market and the US economy goes in both ways. First, US output falls below the baseline for a prolonged period of time after a negative oil supply shock. However, oil-supply shocks explain a relatively modest part of overall output fluctuations (about 10%). Second, most variations of (real) oil prices occur in response to shocks originated in the global economy and in the US. In particular, supply shocks in the rest of the world and in the US explain more than half of the variance of oil price fluctuations. Finally, the correlation between oil prices and the US business cycle depends on the nature of the fundamental shock: a negative correlation emerges in periods when oil-supply shocks or global demand shocks occur, while a positive correlation emerges in periods of supply shocks in the global economy or the US. The unconditional correlation between oil prices and US production over a long sample period is tenuous because it blends conditional correlations with different signs.