Price - macroeconomy relationship, Macroeconomics

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There are many other macroeconomic indicators which one might expect to be affected following an oil price hike. Perhaps more obviously affected than GNP is inflation. DePratto et al (2009) based their study on many different economic variables, and they analysed the effects in many different countries. Their main conclusion was that in the UK, after an oil price shock, the level of inflation increased significantly. This would be in the form of cost push inflation, and assuming that real wages did not increase in accordance with the level of inflation during this sample period, the majority of UK households would have seen a severe decline in their disposable income. Thus it can be suggested that their standard of living decreased as a result of an oil price shock. The results are perhaps not surprising because inflation is calculated by analysing the price changes of goods, period to period. Oil has a heavy weighting in comparison to other goods considered due to the importance of oil to the UK consumer. Therefore should oil prices increase by a small amount, one might expect to observe that this would result in inflation. Also when there is an oil price shock, one might expect to see rather large changes to the level of inflation in the economy.

Finally, Olson (1988) seemed to buck the trend of most economists insofar as in the vast majority of cases, the effect of oil price shocks on GNP would be negligible. His reasoning for suggesting this was that oil is only a minor component of GNP. However I believe that this will vary from country to country. Many countries have a huge reliance on exporting oil; therefore I would expect that in these countries, an oil price shock would impact positively on GNP. Furthermore, whilst oil is directly only a small component of GNP for most economies, it will affect other components of GNP which will then indirectly impact upon GNP. In conclusion, it is worth noting that Cooper (2003) has proven that in the short run, the price elasticity for oil is extremely inelastic. This infers that consumers are unable to change their consumption level of oil immediately and that only in the long term are they able to find alternative methods of decreasing their consumption.

The literature has provided a very sound level of initial understanding of the oil price-macroeconomy relationship. However there are certain findings which I believe are subject to query. From intuition, I would have expected oil price shocks to have great demand side effects in the economy. This paper, which is differentiated from the aforementioned studies as it only focuses on the UK, will explore the effects of oil price shocks not only onGDP, but also on other macroeconomic variables. This will hopefully provide greater insight into the true relationship between oil prices and economic performance in the UK. The vast majority of literature has assessed quarterly data and this paper will follow suit.

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