Analyse the effects of oil price, Macroeconomics

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As previously stated, the aim of the paper is to observe and analyse the effects of oil price shocks on key macroeconomic indicators in the UK economy. From this the aim is to conclude whether there is sufficient evidence of a relationship between oil price shocks and economic performance in the UK. Previous studies provided a sound basis and contributed to the initial understanding of this problem. Since the mid-2000s the UK has become a net importer of oil which further emphasised the need to carry out this study, as economic theory suggests that future oil price shocks would have a far greater negative impact on the macroeconomy than when the UK was a net exporter of oil. The most effective method of analysing this problem was to use an unconstrained VAR. From this we found the impulse response functions of the key macroeconomic indicators to a one standard deviation shock in the price of oil.The most interesting findings are described below.

The Granger Causality tests showed that at the 95% significance level, oil price granger caused GDP, inflation and interest rates. The importance of these findings is that theysuggest that any change in the oil price variable will induce further changes in these three variables.

Following on from the causality testing, the Cholesky impulse response functions were estimated. This part of the results is without doubt the most telling about the relationships between oil prices and the remaining variables. The three variables that are Granger caused by oil prices provided very interesting impulse responses. Firstly, as oil prices are a large component in calculating inflation, it was no surprise to observe that following a shock in the oil price, inflation rose sharply and it took five years for the level to revert back to its original level. A similar pattern emerged from the GDP impulse response to oil, although it's maximum and minimum were both within the first five quarters, a lot quicker than for inflation. GDP reverted back to its normal level after approximately 15 quarters, almost four years.


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