ECON240C Oil Price and Inflation Zhengying Cao, Hongtao Xu, Yiling Liu, Jinying Shao, Meng Yu University of California, Santa Barbara, CA

ECON 240C Introduction and Motivations Oil supply is a main energy input for US economy. How does oil price impact on the inflation rate? War for Oil?

ECON 240C Data Collection Original data since 1970: Monthly CPI (Consumer Price Indexes) Monthly Crude Oil Price Annual % Oil Expenditures in GDP

ECON 240C Model Setup CPI Oil Price Inflation rate % change of oil price Time series oil price model Inflation vs % change of oil price

ECON 240C INFRATE What’s the inflation rate?

ECON 240C Correlogram and root test

ECON 240C AOILPRICEOILPRICE is the inflation rate at time t. Why? We need normalized oil prices respected to buying power. Inflation adjusted oil price

ECON 240C % change of adjusted oil price ADJOILPRATE

ECON 240C Correlogram and root test

ECON 240C PERCENTAGE = C(1) + [AR(1)=C(2),AR(15)=C(3),AR(4)=C(4),MA(1)=C(5),MA(13)=C(6),BACKCAST=1976:04] Estimate Equation

ECON 240C Results

ECON 240C Forecast of adjusted oil price AOILPRICEAOILPRICE_F PERCENTAGEPOILPRICE % change of adjusted oil priceadjusted oil price

ECON 240C Inflation vs Oil Price Impacts Lags

ECON 240C Inflation rate model INFRATE=C(1)*ADJOILPRATE+C(2)*ADJOILPRATE(-1)+C(3) +[AR(1)=C(4),AR(9)=C(5),AR(11)=C(6),AR(12)=C(7),MA(1)=C(8),MA(9)=C(9),M A(15)=C(10),MA(11)=C(11),MA(12)=C(12),MA(2)=C(13),MA(22)=C(14),MA(8)=C (15),BACKCAST=1976:02]

ECON 240C

Forecast of the inflation rate INFRATEINFRATE_F

ECON 240C Conclusions and Explanations 10% change in oil price will cause 0.06 increase of inflation in current period and 0.08 increase of inflation rate in next period. There is an almost immediate impact on inflation that is roughly proportional to the weight of energy price. Also with more of a lag, the impact of oil price fluctuations on the CPI is indirectly augmented through the use of oil as an input in the production of other goods and services, such as transportation. Finally, the second round effects of oil price shocks cause the concern that higher prices at the gas pumps and factory gates can rekindle inflation expectations and filter though to rising wage pressures with a lag of quarters and even years.

ECON 240C Discussion In times of political tension or war in the Middle East, the price of oil tends to inflate. Oil dependency has fallen substantially after 1981.

ECON 240C Further Discussions Expenditures for petroleum are currently three to four times smaller than in Efficiency improvements, switching to other fuels, and much lower inflation- adjusted petroleum prices all contribute to less utilization of petroleum in the U.S. Several countries, most notably Norway and Russia, have emerged as key competitors to OPEC.