Macroeconomic Dynamics of Oil Price Shocks in an Open Economy: Case Study of Pakistan

Abstract

The study aims to measure the vulnerability of the small open oil importing developing economy in terms of output loss, soaring inflation and depreciating of the domestic currency to an exogenous oil price shock. Critical review of the existing literature confirms the lack of appropriate theoretical foundations, and therefore contradictory empirical evidence has surfaced. As basis for analysis there is hardly any study especially for a developing oil importing economy, where prevailing rigidities are modelled in a theoretical framework. It is surprising because the New Keynesian models have been found to have advantage to capture the stochastic components theoretically and not on ad hoc basis like the RBC models. Developing economies are more oil dependent due to their imperfect market structure and inefficient use of energy hence deserve serious attention. The current study is an attempt to fill this gap; incorporating the limited access to international financial markets and mounting fiscal deficit further strengthen the scope of this study. The theoretical model developed in the present study has been empirically analysed by adopting the two step procedure devised by Keating (1990). Keeping in view the core objective of the study, macroeconomic dynamics in response to oil price shocks is focused along with assessing the impact of other internal and external shocks. Innovations, other than oil price shock have been considered to capture the indirect impact of oil price fluctuations in the international market. The estimation proceeds in three steps, estimation of structural parameters, the impulse response analysis and the variance decomposition. It has been observed that oil prices significantly important in explaining the magnitude and direction of macroeconomic aggregates and the variations in these important variables. It has been observed that due to heavily subsidization of the energy sector during the deregulation period further aggravated the economic performance of the economy. The State Bank of Pakistan, on the other hand, has been unable to anchor expectations about inflation. The results of present study confirm the crowding-in effect. There is complementarity between government spending and private investment. Additive fiscal shock seems to be an important source of growth in the country which persists for about three quarters keeping aggregate demand above its long run trend. Cost push shock, monetary policy shock and risk premium shock are also important sources hindering economic development in terms of low demand and high inflation which further elaborate the importance of less or no reliance of producing energy through using oil. Monetary authority, due to lack of transparency in the policy, is unable to avoid deteriorating influence of oil prices shocks.