Oil prices and their effect on potential output

Abstract

This article describes some of the mechanisms by which oil price fluctuations produce changes in the long-run growth of the economy. The analysis suggests that a (permanent) increase in oil prices can significantly reduce potential output. From an economic policy point of view, this effect may be more marked when competition in the product markets is low or when wage indexation is high; thus, reforms aiming to increase competition and improve wage-setting mechanisms help to reduce the negative effects of higher oil prices on long-run economic growth.

Keywords:

• oil price
• potential output

JEL Classification:

• O13
• O47
• J64

Notes

¹It proxies the technical efficiency with which the productive factors are used and its behaviour is related to technological progress.

²Higher oil prices are thus equivalent to a decrease in the productivity of the two primary inputs. Therefore, a similarity exists between an oil price shock and a TFP shock.

³And assuming for simplicity that the only intermediate consumption is imported oil.

⁴That is, if the elasticity of substitution between oil and the other intermediate inputs is higher than 1.

⁵This loss of profitability may arise because another less oil-intensive technology becomes available and/or because the products manufactured by them are oil intensive and demand thus declines.

⁶The intuition for this is that if energy is an essential complement of equipment goods needed to generate production services, the user cost of capital should include the price of oil and, therefore, be positively correlated with it. As a result, the optimal degree of utilization of the capital stock will diminish, and, if the depreciation rate depends on the degree of utilization, it will also decline. Therefore, for a given level of production, the investment and the capital stock should be lower.

⁷The intuition is that if the share of labour income demanded by workers is much higher than that which firms are able to pay, there will be a disequilibrium which will be adjusted through an increase in the unemployment rate.

⁸Again assuming that the gross production function of a representative firm (with market power) is of the Cobb–Douglas type with constant returns to scale in the two primary inputs (capital and employment) and in intermediate consumption.

⁹Implying a lower markup of value-added prices on value-added marginal costs.

¹⁰This approximation is perhaps an excessive simplification of the problem, since theoretically, when factor cost shares in gross production are allowed to change, the marginal cost determining the selling price is not simply the unit labour cost. In fact, in this case, marginal cost should also include the real price of oil. In any event, this new element will have an incremental effect explained in the main text.

¹¹On the other hand, a high NAIRU reduces the potential employment of the economy and, thus, potential output, and, moreover, the labour market participation of the working-age population is lower in countries with higher unemployment rates. This is a consequence of the unemployment rate being an (inverse) indicator of job-finding probability.

¹²Both the TFP used here and the NAIRU (analysed below) were obtained from the AMECO database constructed by the European Commission. It includes 11 euro area countries (the absences are Luxembourg and Slovenia, due to data limitations), the United Kingdom, Sweden and Denmark for the period 1965 to 2007. All the variables are presented in deviations from time averages for each country. Therefore, the estimated slopes can be understood as the between-estimator for a panel. In any case, other determinants of the variables on the vertical axis are not taken into account. This means that the simple correlations estimated here could be biased if the omitted variables are related to real oil prices.

¹³Thus, the middle panel plots the inverse of the real unit labour cost, which can be considered a good approximation to the behaviour of firms' markups.

¹⁴After productivity and unemployment effects are taken into account.