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Oil Price Uncertainty in a Small Open Economy

Yusuf Baskaya (), Timur Hulagu and Hande Kucuk ()

Working Papers from Research and Monetary Policy Department, Central Bank of the Republic of Turkey

Abstract: We analyze business cycle implications of oil price uncertainty in an oil-importing small open economy, where oil is used for both consumption and production. In our framework, higher volatility in oil prices works through two main channels. On the one hand, it makes the marginal product of capital riskier, creating an incentive to substitute away from capital. On the other hand, it increases the demand for precautionary savings, which might imply higher capital accumulation in response to a rise in oil price uncertainty depending on whether agents have access to an alternative asset, international bond in our model. We show that the fall in investment following a rise in the volatility of real oil prices in the case of financial integration is more than twice the fall in investment observed under financial autarky. Moreover, the interaction between shocks to the level and volatility of oil prices is quantitatively important: initial responses of investment, output and consumption to a rise in oil prices are almost doubled, when there is a simultaneous rise in the volatility of oil prices.

Keywords: Oil price; stochastic volatility; financial market integration (search for similar items in EconPapers)
JEL-codes: E20 E32 F32 F41 Q43 (search for similar items in EconPapers)
Date: 2013
New Economics Papers: this item is included in nep-dge, nep-ene, nep-mac and nep-opm
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