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Expectations, Learning, and the Changing Relationship between Oil Prices and the Macroeconomy

  • Fabio Milani

    ()

    (Department of Economics, University of California-Irvine)

This paper estimates a structural general equilibrium model to investigate the changing relationship between the oil price and macroeconomic variables. The oil price, through the role of oil in production and consumption, affects aggregate demand and supply in the model. The assumption of rational expectations is relaxed in favor of learning. Oil prices, therefore, affect the economy through an additional channel, i.e. through their effect on the formation of agents' beliefs. The estimated learning dynamics indicates that economic agents' perceptions about the effects of oil prices on the economy have changed over time: oil prices were perceived to have large effects on output and inflation in the 1970s, but only milder effects after the mid-1980s. Since expectations play a large role in the determination of output and inflation, the effects of oil price increases on expectations can magnify the response of macroeconomic variables to oil price shocks. In the estimated model, in fact, the implied responses of output and inflation to oil price shocks were much more pronounced in the 1970s than in 2008. Therefore, through the time variation in the impact of oil prices on beliefs, the paper can successfully explain the observed weakening of the effects of oil price shocks on real activity and inflation.

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File URL: http://www.economics.uci.edu/files/docs/workingpapers/2008-09/milani-23.pdf
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Paper provided by University of California-Irvine, Department of Economics in its series Working Papers with number 080923.

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Length: 31 pages
Date of creation: Jun 2009
Date of revision:
Handle: RePEc:irv:wpaper:080923
Contact details of provider: Postal: Irvine, CA 92697-3125
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Web page: http://www.economics.uci.edu/

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