The effects of oil price shocks on the UK economy

This thesis examines the impact of oil price movements on the UK economy. To this end, it is composed of three chapters which use different approaches in order to assess the causes and the consequences of oil price shocks on the main UK macroeconomic fundamentals. In Chapter 1, we analyse the impact of oil price fluctuations on the UK economy using a two-stage method. This empirical strategy allows us to decompose oil price changes depending on the underlying source of the shock. In line with previous studies, our results show that, since the mid-1970s, oil price movements have been mainly associated with shocks to oil demand rather than oil supply. We contribute to previous literature by finding that the consequences of oil price changes on UK macroeconomic aggregates depend on the different types of oil shocks. Thus, for instance, increases of global real economic activity do not depress the domestic economy in the short run. Conversely, shortfalls in crude oil supply cause an immediate fall of UK GDP growth. As a consequence, the Bank of England sets the nominal interest rate depending on the nature of the shock hitting the oil market. Our results also show that domestic inflation increases following a rise in the real oil price. Finally, we find that in response to oil price increases, although UK macroeconomic fundamentals worsen, the government deficit reduces. In Chapter 2, we develop and estimate, using Bayesian methods, an open economy two-bloc DSGE model in order to analyse the responses of the UK economy and the rest of the world to different sources of oil price shocks. We consider the period in which the UK was a net oil exporter that also corresponds to the Non-Inflationary, Consistently Expansionary (NICE) decade (1990-2005). In line with previous literature, our findings confirm that global oil shocks are mainly responsible for UK oil price changes. Our impulse response analysis shows that a drop in the oil price stimulates UK GDP and reduces domestic inflation inducing the BoE to lower the nominal interest rate. In contrast to previous studies, we find that the UK exchange rate responds differently according to the source of oil price shocks. In particular, a positive shock to foreign oil intensity induces an appreciation of the Pound. Conversely, a positive shock to foreign oil supply causes a depreciation of the British Sterling. Generally, a fall in the oil price worsens the UK trade balance, since UK is a net oil exporter. Finally, our historical decomposition analysis contributes to previous literature by showing that episodes of sharp increases in the oil price are associated with falls in the UK output and rises in the domestic inflation. In Chapter 3, we study the main transmission channels of oil price fluctuations for the UK economy and the consequences of oil price changes on its public finances. Our model is estimated with Bayesian techniques over the same sample period as in Chapter 2. In line with previous literature, our results show that foreign oil demand and supply shocks are the main factors explaining the UK oil price volatility. In contrast to existing studies we find that the variation of UK government debt is broadly explained by oil price fluctuations related to changes in the foreign oil intensity. We extend the previous literature by estimating the parameters of several fiscal policy rules. In particular, we find that the response of petroleum revenue tax to oil price changes is stronger than the response of fuel duty tax to domestic oil demand. In line with Chapter 2, our impulse response analysis indicates that a decrease in the oil price positively affects the UK economy inducing an increase in its GDP and a fall in the domestic inflation. However, the drop in the oil price generates a negative effect on the UK trade balance. In contrast to Chapter 2, we find that a positive foreign oil intensity shock causes depreciation in the Pound. The latter effect occurs as the decrease in the UK VAT causes a reduction in the price of domestic consumption goods. Finally, we are able to quantify the size of the responses of UK public finances to oil price shocks. Our results indicate that a fall in the oil price induces a reduction in UK total tax receipts and, in turn, causes the rise in the government debt. Thus, for example, we find that a positive shock to foreign oil intensity increases UK government debt by £ 700 millions during the first year and £ 1100 millions in four years