May 22, 2023

Unexpected increases in oil prices and declines in U.S. economic activity have gone hand-in-hand since World War II. Research on the sources of oil price fluctuations and their effects on the U.S. economy has undergone important transformations in the last decade. These include identifying whether oil price fluctuations are driven by demand or supply shocks, instead of assuming that oil price changes are exogenous to the evolution of the world economic activity, developing new methodologies to evaluate possible asymmetries in the response of economic activity to oil price decreases and increases, advances in understanding the relationship between economic uncertainty (regarding oil prices, the news, and economic policy) and aggregate economic activity, and making explicit the role of the researcher’s beliefs (or priors) in estimating whether demand and supply disturbances in the oil market lead to recessions.

In a newly published paper in the Journal of Applied Econometrics, Ana María Herrera and Sandeep Kumar Rangaraju of Weber State University, return to these issues in a comprehensive empirical investigation of how oil prices affect economic activity. They evaluate how alternative modelling strategies (e.g., identification assumptions, period spanned by the data, lag length) map into different conclusions regarding the effect of oil supply shocks on real oil prices and U.S. real GDP.

Three important insights are derived from their investigation. First, models that incorporate additional variables without imposing additional restriction --for instance, differentiating between domestic and foreign demand without constraining the magnitude of the elasticities—result in rather imprecise estimates of the dynamic effects of oil price shock. Second, accounting for the role of crude oil inventories is key for identifying the response to oil demand and supply shocks. Finally, their study highlights how alternative beliefs regarding the price elasticity of supply result in different conclusions regarding the role played by oil supply shocks in driving fluctuations in oil prices and U.S. economic activity.