Which Side of the Economy Is Affected More by Oil Prices: Supply or Demand?

Abstract

This chapter develops a New Keynesian model to examine a theoretical global economy with two basic macroeconomic components: an energy producer and an energy consumer. (From now on in this chapter whenever we refer to the “energy” or “energy prices”, we refer to “crude oil” and “crude oil price”, which is the main source of energy.) This simple economy uses these two components to evaluate how oil prices affect the consumer economy’s gross domestic product and inflation from 1960 to 2011. This model assumes that changes in the oil price transfer to macro variables through either supply (aggregate supply curve) or demand channels (aggregate demand curve). In order to examine the effects of this transfer, an IS curve is used to look at the demand side and a Phillips curve is used to analyze inflationary effects from the supply side. The empirical analysis concludes that movements in the oil price mainly affect the economy through the demand side (shifting the aggregate demand curve) by affecting household expenditures and energy consumption. This analysis provides several additional findings, among which is that easy monetary policies amplify energy demand more than supply, resulting in skyrocketing crude oil prices, which inhibit economic growth.