Time-Varying Effects of Oil Supply Shocks on the U.S. Economy

Bank of Canada working papers are theoretical or empirical works-in-progress on subjects in economics and finance. The views expressed in this paper are those of the authors. No responsibility for them should be attributed to the Bank of Canada. ii Acknowledgements We thank the editor, three anonymous referees, Dijk and Timo Wollmershäuser as well as numerous conference and seminar participants for useful comments and suggestions. Special thanks to Lutz Kilian for many insightful discussions and feedback on earlier versions of the paper. We acknowledge financial support from the IUAP Programme – Belgian Science Policy [Contract No. P6/07] and the Belgian National Science Foundation. All remaining errors are ours. Abstract We use vector autoregressions with drifting coefficients and stochastic volatility to investigate how the dynamic effects of oil supply shocks on the U.S. economy have changed over time. We find a substantial decline in the short-run price elasticity of oil demand since the mid-eighties. This finding helps explain why an oil production shortfall of the same magnitude is associated with a stronger response of oil prices and more severe macroeconomic consequences over time, while an oil price increase of the same magnitude is associated with a smaller decline in oil production and smaller losses in U.S. output in more recent years. We also show that oil supply shocks more recently account for a smaller fraction of the variability of the real price of oil, implying a greater role for oil demand shocks. Notwithstanding this time variation, the overall cumulative effect of oil supply disruptions on the U.S. economy has been modest. Oil supply shocks contributed to some extent to the 1991 recession and slowed the economic boom of 1999-2000, but they do not explain other U.S. recessions nor do they help explain the " Great Inflation " of the 1970s and early 1980s. Résumé Les auteurs se servent de modèles vectoriels autorégressifs dotés de coefficients variables et d'une volatilité stochastique pour étudier comment ont évolué au fil du temps les effets dynamiques des chocs d'offre pétroliers sur l'économie américaine. Les auteurs notent une baisse prononcée de l'élasticité-prix de la demande de pétrole à court terme depuis le milieu des années 1980. Cette observation aide à expliquer pourquoi, à ampleur égale, un déficit de production s'accompagne d'une réaction du prix de l'or noir et de dégâts à l'économie de plus en plus importants au fil de la période étudiée, alors que des …