Term Paper: Persian Gulf War Effects

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[. . .] S. economy greater extent than a stochastic growth model (which assumes a perfectly competitive product market).

Finn (2000) shows that perfectly competitive model can also explain the effect of oil price shocks. He uses the concept of utilization rates for productive capital. The main idea of his model comes from the relationship between energy usage and capital services. Specifically, energy is essential to obtain the service flow from capital. Capital utilization rates are determined by energy use. Due to the oil price shocks, the decline of energy use reduces output and labour's marginal product, leading to a decline in wages and labour supplied. According to him, an oil price shock is like an adverse technology shock in inducing a contraction in economic activity.

Kling (1985) investigates the relationship between crude oil price changes and stock market activity for the period of 1973-1982 in the U.S. And finds that crude oil price changes affect the future stock prices in the industries which use oil as input factors.

Jones and Kaul (1996) test on the rationality of stock prices as to whether they reflect the impact of news on current and future real cash flows, thereby finding that oil price increases in the post war period have a significant detrimental effect for the U.S., Canadian, Japanese and UK stock market.

Sadorsky (1999) investigates the dynamic interaction between oil price and other economic variables including stock returns using an unrestricted VAR with U.S. data. He presents variance decompositions and impulse response functions to analyze the dynamic effect of oil price shocks. Variables include industrial production, interest rate of a 3-month T-bill, oil price (measured using the producer price index for fuels), and real stock returns (calculated using the difference between the continuously compounded returns on the S&P 500, and the inflation measured using the consumer price index). Data are monthly from 1947.1 to 1996.4. After unit root and co integration tests, he runs an unrestricted VAR with ordering of interest rates, real oil price, industrial production and real stock returns. For oil price changes he uses the growth rate of real oil price and oil price volatility (SOP) which is calculated by a GARCH (1-1). He finds that oil price changes and oil price volatility have a significantly negative impact on real stock returns. He also finds that industrial production and interest rates responded positively to real stock returns shocks. In particular, he split the full sample period into two sub-periods, pre-1986 and post-1986, because in 1986 the oil price declined significantly and the oil price has been more volatile since 1986. In post-1986 period oil price changes and oil price volatility have a larger impact on the economy than in the pre-1986 period. According to him, the response of the stock market to oil price shocks is asymmetric. When he uses asymmetric oil price shocks (positive oil price changes and negative oil price changes), positive shocks explain more forecast error of variance in real stock returns, industrial production and interest rates than negative shocks during the full sample period. For the post-1986 period, positive and negative oil price shocks explain almost the same fraction of forecast error variance of real stock returns, while in the pre-1986 period positive oil price shocks contribute more to the forecast error variance in real stock returns than negative oil price shocks. In the case of oil price volatility over the full period and two sub-periods, positive oil price volatility shocks (SOPI) had a greater influence on stock returns and industrial production than negative oil price volatility shocks (SOPD). In the post-1986 period, oil price movements explain more forecast error variance in stock returns than interest rates.

References

Baxter, Marianne. "Real exchange rates and real interest differentials: Have we missed the business-cycle relationship." Journal of Monetary Economics vol. 33, 1994 pp: 5-37.

Finn, M.G..(2000), "Perfect Competition and the Effects of Energy Price Increase on Economic Activity," Journal of Money, Credit and Banking 32:400-416

Golub, Stephen S. "Oil Prices and Exchange Rates." Economic Journal, Royal Economic Society, vol. 93 (371), 1983, pp 576-93.

Hamilton, J.D. (1988), "A Neoclassical Model of Unemployment and the Business Cycle," Journal of Political Economy 96: 593-617

Kling, John L (1985), "Oil price shocks and stock market behavior" Journal of Portfolio Management 12(1)

Krugman, Paul. "Oil shocks and exchange rate dynamics." In Frenkel, J.A. (Ed.), Exchange Rates and International Macroeconomics, 1983, University of Chicago Press, Chicago.

Maeso-Fernandez, Francisco and Chiara Osbat and Bernd Schnatz. "Determinants of the euro real effective exchange rate: A BEER/PEER approach." European Central Bank, Working Paper No. 85, 2001.

Okruhlik, Gwenn. "Rent Wealth, Unruly Law, and Rise of the Opposition: Political Economy of Oil States." Comparative Politics. Vol. 3 No. 3(April… [END OF PREVIEW]

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