The impact of oil price on inflation the case of vietnam

Focusing on the reduced-form of causal relationships between world oil price expressed in Vietnamese price and macroeconomic variables, I have used both linear and non linear form of oil

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY THE HAGUE

VIETNAM THE NETHERLANDS

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE IMPACT OF OIL PRICE ON INFLATION

THE CASE OF VIET NAM

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

TRUONG NGO TRONG NGHIA

Academic Supervisor:

DR NGUYEN VAN NGAI

HO CHI MINH CITY, NOVEMBER 2012

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Acknowledgement

Over two years not so long but it is one of the most interesting periods of my life with many impressive memories I would like to take this opportunity to express my deep gratitude to the Vietnam-Netherlands Master Program for Economics of Development for organizing many helpful and exciting curriculums

For the completion of this thesis, I have indebted to many people who have given

me their continued support, advice and guidance

First of all, I would like to express my sincere gratitude to my supervisor Dr Nguyen Van Ngai who gave me valuable guidelines, comments, suggestions, and inspiration for the successful completion of this study Besides, his friendly and thoughtful instructions have given me a great deal of encouragements to overcome difficulties in the whole research process

I am also thankful to Dr Nguyen Trong Hoai, Dr Nguyen Hoang Nam, Dr Tu Van Binh, MBA Ly Thi Minh Chau, Tutor-Mr Phung Thanh Binh and all lecturers and program administrators in the Vietnam – The Netherlands Program for M.A in Development Economics They gave me advanced knowledge and help me kindly during the course

I would like to express my heartfelt thank to all my classmates in MDE15, MDE16, especially Tran Tuyet Hanh, Tran Van Long, Le Trong Binh, Vo Thi Ngoc Trinh,

Le Anh Khang, Nguyen Van Dung, Nguyen Xuan Phap, Nguyen Le Thao Nguyen and other classmates for their continuous support and encouragement

Last but not least, I would like to express my deepest thanks to my parents, my brother, my close friends who have always given the most favorable environment and kept encouraging me that made me feel more confident during my study

Signature

Truong Ngo Trong Nghia Date: / / 2012

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Abstract

A steep upward trend in the price of crude oil in recent years, reaching a spike record in middle of 2008, has led to increasing concern about its impacts on macroeconomic, both abroad and in Vietnam In this study, using the vector auto regression approach (VAR) with monthly dataset from 2001M1 to 2010M10, I attempt to empirically investigate the dynamic effects of oil price and Vietnam macroeconomics Focusing on the reduced-form of causal relationships between world oil price (expressed in Vietnamese price) and macroeconomic variables, I have used both linear and non linear form of oil prices to get the results of their impact on price level and output In empirical analysis, I find consistent evidence that oil price shocks have a significant effect on output and price level in short term

In detail, my research finds a weak and positive statistically significant association between oil price shocks and price level The output is more highly sensitive and I find an empirical evidence about the negative impact of oil price shocks on economic growth although it’s not straight forward I also assert the existence of asymmetric impact of oil price proxies’ changes on economic growth rate

Key words: inflation, GDP, oil price shock, VAR models, Cointegration, Granger

causality, Phillips curve

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TABLE OF CONTENTS

Acknowledgement ii

List of Tables 4

List of Figures 5

List of Acronyms 6

Chapter 1: Introduction 7

1.1 Problem statement 7

1.2 Research Objectives 8

1.3 Research Questions 8

1.4 Scope and methodology of the Study 9

1.5 Thesis structure 10

Chapter 2: Literature Review 11

2.1 Review oil shocks in history 11

2.1.1 Suez Crisis in period 1956-1957 14

2.1.2 OPEC Embargo in 1973-1974: 14

2.1.3 Iranian revolution and oil price fluctuation in 1979 15

2.1.4 Iran-Iraq War in 1980-1981 15

2.1.5 The great price collapse in 1981-1986 15

2.1.6 First Persian Gulf War in 1990-1991 16

2.1.7 The downtrend of oil price in 2001 16

2.1.8 Growing demand and stagnant supply 17

2.2 How higher oil prices affect the economy 18

2.2.1 Why oil shock seems to be the big economic headache 18

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2.2.2 The scenario of oil price and inflation in Vietnam 21

2.3 Review price level and inflation theories 22

2.4 The transmission mechanism of oil price shocks 25

2.5 Approaches to estimate oil impact on macro economy variables 30

2.6 Empirical studies about the oil price-macroeconomic relationship 32

2.7 Conceptual Framework 44

Chapter 3: Model Specification and Data 45

3.1 Analytical Framework 45

3.2 Model Specifications 46

3.3 Steps of Estimation 50

3.3.1 Descriptive statistics 50

3.3.2 Unit root testing 50

3.3.3 Granger Causality Test 51

3.3.4 Impulse response functions 53

3.3.5 Variance decomposition 53

3.4 Data Sources 53

Chapter 4: The impact of oil price on inflation-the case of Vietnam 56

4.1 Descriptive Statistics 56

4.2 Unit Root Test 57

4.3 Var Granger Causality Test 58

4.4 Impulse Responses and Variance Decompositions 61

4.5 Asymmetric Impacts 65

4.6 Result comparisons 70

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Chapter 5: Conclusion and Policy Implication 73

5.1 Conclusions 73

5.2 Policy Implication 75

5.3 Limitation and Further Studies 78

5.3.1 Limitation 78

5.3.2 Further Studies 79

References 81

Appendix 88

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List of Tables

Table 2.1: Summary results of empirical studies 40

Table 3.1 The definition of variables in the model 55

Table 4.1: Description statistic of key variables 56

Table 4.2: Augment Dickey-Fuller test 57

Table 4.3: Philips-Perron test 58

Table 4.4: Optimal lag length 59

Table 4.5: VAR Granger- CausalityTest 60

Table 4.6: Variance Decompositions for Var Model 62

Table 4.7: Granger causality test of proxies of oil price shocks 65

Table 4.8: Accumulated Response of PC_IP_SA to non-linear oil price shocks 68

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List of Figures

Figure 2.1: Price of oil in 2009 dollars, 1973:M1-2010:M10 Price of West Texas

Intermediate deflated by CPI (Hamilton, 2011) 12

Figure 2.2: The natural logarithm of the real price of oil, 1861-2009, in 2009 U.S dollars 12

Figure 2.3: When oil prices head up, the US turns grey: the oil market and US recessions 18

Figure 2.4: Illustration of oil price and macroeconomic variables in level 21

Figure 2.5: Factor contributions of price level 23

Figure 2.6: Cost-push inflation in the AS-AD model 24

Figure 2.7: Demand-pull inflation in the AS-AD model 25

Figure 2.8: Two round effects of oil price increases 26

Figure 2.9: Mix transmission channels of oil price shocks 27

Figure 2.10: Conceptual framework 44

Figure 4.1: The relationships of variables 60

Figure 4.2: The impulse response functions for basic model 62

Figure 4.3: The variance decompositions of variables 64

Figure 4.4: The impulse response functions of output to negative oil price changes 66 Figure 4.5: The impulse response functions of price level to net oil price increase 69

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List of Acronyms

AIC: Akaike Information Criterion

AR: Autoregressive

ARCH: Autoregressive Conditional Heteroskedasticity

CPI: Consumer Price Index

GARCH: Generalized Autoregressive Conditional Heteroskedasticity INF: Inflation

OLS: Ordinary least squares

OPEC: Organization of Petroleum Exporting Countries

PPI: Producer Price Index

SBV: State Bank of Vietnam

SC: Schwartz criterion

UK: the United Kingdom

US: the United States of America

VAR: Vector Auto Regressive

WTI: West Texas Intermediate

In recent years, although Vietnam is to start a crude oil exporter but we still import a large amount of petrol The volatile oil prices and oil shocks potentially cause vulnerability of the economy Vietnam The story of inflation is going on and will certainly create bad impacts Inflation was rather low from 1996 to 2006 But after 2006, high inflation returned to Vietnam’s economy with two-digit rate At the early beginning of the year 2011, Viet Nam has to face with the very high pressure of inflation On 24 February, 2011, the Viet Nam’s Government has to issue the 11 The Resolution of "package solution" to control inflation, stabilize macro-economy, ensuring social security

Because of the inflation in Viet Nam is so hot up to now This study tries to make the researches on two aspects as follows:

First, most of the empirical studies focused primarily on the relationship between oil price and macroeconomics in the economy of the developed countries such as US or OECD countries (e.g Brown et at, 1995, 1999, 2004; Cunado and Gracia, 2003; Darrat and Otis, 1996; Hamilton, 1983, 1996, 1999, 2000, 2009, 2011; Hooker, 1996, 1999; Jimenez and Sanchez, 2004, 2005; Katsuya, 2008; Lee et al, 2002; Mork, 1989, 1994; Mory, 1993; Nagy, 2000; Webber, 2006…) Although some researches of developing countries in Africa (e.g Aliyu, 2009; Chhiber & Shafik, 1990; Farrell, 2001; Kiptui, 2009; Nkomo, 2006) could be identified, just few studies

of Asian developing countries with relatively high inflation rates could be found In

1.2 Research Objectives

With the respect to the period of 2001-2010, this study aims mainly the impact

of oil price on inflation in Vietnam Following the main objectives for the case of Vietnam, the study is attempted:

- To analyze the effect of oil prices on macro economies, especially the

price level and output

- To find out the evidence of asymmetries when oil price is in trend of

increasing and in trend of decreasing throughout examining the relationship between proxies of oil price changes and inflation rates and proxies of oil price changes and economic growth rate

- To suggest policies to stabilize macroeconomic

1.3 Research Questions

In order to meet these objectives, the thesis will attempt to answer the following questions:

Main question:

- What are the impacts of oil price and its proxies on the macro economy

in the context of Vietnam over the period of 2001-2010?

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Sub-questions:

- Which are the directions of the causality relationships among oil price,

price level and output?

- How are the impacts of oil price on the macroeconomics?

- Are there any different impacts of proxies of oil price on inflation rate

and economic growth rate of Vietnam when oil price is in trend of increasing and in trend of decreasing?

- What policies should be implied to mitigate the bad impacts of oil price

and to develop Vietnam macro economy more sustainably?

1.4 Scope and methodology of the sstudy

This study applies both qualitative and quantitative method The first one will

be concerned later on a little bit in section 2.2.2 The second one will be concerned mainly in section 2.6 and others next

The quantitative method will apply the econometric techniques related to Vector Auto-regression (VAR) model with monthly time series dataset from 2001M1

to 2010M10, with the following macro indicators: world oil price, consumer price index, industrial production, money supply and exchange rate, taken from IMF’s International Finance Statistic (IFS), IMF’s Direction of Trade (DOT) and Vietnam General Statistic Office (GSO)

To carry out above objectives, I will apply the descriptive statistic and the econometric techniques In this study, the overview of all variables will be shown out

by the descriptive statistic as the first step It is the full collection of max-min-mean values, variation of all original and transformed data Thus, we have an overview and

an evaluation about the used data quality

With regarding to the analyzing time series data, the econometric techniques related to vector auto regression (VAR) model will be employed to answer key questions Firstly, unit root test is used to examine for stationary of all variables by the validation of t-test and F-test Secondly, optimal lag lengths for VAR model are chosen by different criteria to have the best model VAR Granger causality test will help us answer the first sub question whether the effect of oil price to inflation and

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output of economy Then, impulse responses and variance decompositions are two popular techniques of VAR model to answer next sub questions Next, asymmetric testing procedures with some proxies of oil price are used to explore the last sub question Collecting from those empirical results, we can conclude the role of oil price

in the context of Vietnam and propose the appropriate policies for Vietnam’s economy

1.5 Thesis structure

The thesis is organized in four chapters Chapter 1 is introduction Chapter 2 covers literature review and empirical studies Chapter 3 presents the research methodology Chapter 4 reports the findings and discussion Chapter 5 presents the conclusion, suggests some practical policy implications, and discusses the limitation and direction for further studies

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Chapter 2: Literature Review

This chapter concerns about the overview of oil shocks in history, the serious impacts

of high oil prices on world economics, the scenario of oil price and inflation in Vietnam It also includes the review inflation theories, the transmission mechanism of oil price shocks, the approaches to estimate oil price impacts and summary results of empirical studies about the oil price-macroeconomic relationship

2.1 Review oil shocks in history

Definition of oil shock

One of the clearest definitions of an “oil shock”, Wakeford (2006, p2) stated that: “Oil shocks are usually defined in terms of price fluctuations, but these may in turn emanate from changes in either the supply of or the demand for oil In practice it

is unlikely for demand to grow rapidly enough to cause a price shock unless it is motivated by fears of supply shortages Historically, as is indicated in the following section, the supply side has been primarily responsible for observed oil price shocks,

at least as an initial trigger”

At least, there are two important attributes of a price shock The first one is the amplitude of the price increase which can be measured in absolute values or in percentage changes The second is one of timing including the speed and durable spell

of oil price increases In which, three cases can happen: (1) A sharp and sustaining price increase that can be called a “break” (e.g occurring within a few quarters); (2) A rapid and temporary price increase that is called a “spike”; and (3) a slowly sustaining rise can be called a “trend” The speed of an oil shock can harm directly economies because it affects the ability of economies to adjust by them while able adjustments are typically restricted in the short run The durability of oil price increasing impacts obviously the overall performance of many economies and extent of the consequences

According to Nkomo (2006: 10), vulnerable level of a particular oil-importing country to oil shocks depends on some dimensions of the economy: the dependence

on oil importing activity or the oil consumption imported in percentage of the whole

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world; the dependence on oil resource or the proportion of oil use over the total

energy use; and the intensity of energy or the spending energy cost in percentage of

the real gross domestic product’s value Furthermore, the developed countries could

be less vulnerable than the developing countries during the period times of oil price

shock affects; especially industrial mine and production industrialization are

considered as the important sectors being get serious impacts

Figure 2.1: Price of oil in 2009 dollars, 1973:M1-2010:M10

Price of West Texas Intermediate deflated by CPI (Hamilton, 2011)

Measure price of oil

As the figure 2.1 showed out, many oil shocks had at least a doubling of the oil

price within a year or two And in history, there were three eras in the determination

of international crude oil prices (Nkomo, 2006) Global oil companies determined

mainly oil prices until the 1970s Since then the Organization of Petroleum Exporting

Countries (OPEC) set the price via its output decisions based on its influence power

and its oil export capacity Since the late 1980s, world oil prices were set by a

market-13

related pricing system which linked oil prices to the ‘market price’ of a particular reference crude (Farrell et al., 2001: 69) Now, two important reference prices, Brent and West Texas Intermediate (WTI) are determined on the London and New York futures exchanges, respectively

Figure 2.2: The natural logarithm of the real price of oil, 1861-2009, in 2009 U.S dollars.

Data source: Statistical Review of World Energy 2010, BP; Jenkins (1985, Table 18); and Historical Statistics of the United States

Key oil shocks

According to Hamilton (2011), key post-World-War-II oil shocks reviews include the Suez Crisis of 1956-57, the OPEC oil embargo of 1973-1974, the Iranian revolution of 1978-1979, the Iran-Iraq War initiated in 1980, the first Persian Gulf War in 1990-91, and the oil price spike of 2007-2008 Each of the major postwar oil shocks since 1973 which is closely connected with political conflict and economic downturns that followed

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2.1.1 Suez Crisis in period 1956-1957

The crisis begun from Egyptian President Nasser nationalized the Suez Canal

in July of 1956 Hoping to regain the power of canal controlling, France and Britain encouraged Israel to invade Egypt’s Sinai territories on October 29, and in short time later they succeeded by their own military forces During the war, 40 ships were sunk and blocked around the canal In order to get through, 1-1/2 million barrels of oil were transported per day They established the pumping stations for the Iraq Petroleum Company’s pipeline Through these stations, an additional half-million barrels moved per day to Syria arriving to ports in the eastern Mediterranean They were also sabotaged That occupied 10.1% of total world output by that time It is a bigger fraction of world production that would be seed of the subsequent oil shocks That case would be experienced study in the following decades

And overall U.S exportations of goods and services started to fall after the first quarter of 1957 That is proven to be an 18% decline over the next year (Hamilton, 2011)

2.1.2 OPEC Embargo in 1973-1974:

An attack on Israel was led by Egypt and Syria beginning on October 6, 1973

On October 17, some members of the OPEC, the Arab members announced an embargo on oil exportation They punished all countries viewed as supporting Israel that were followed the significant cutbacks in OPEC’s total oil production In November the capacity of production from Arab members of OPEC was down 4.4 mb/d compared with what it was in September, a shortfall corresponding to 7.5% of global supply side The consequences later, on January 1974 the Persian Gulf countries doubled the price of oil

Frech and Lee (1987) estimated that the time was spent for waiting in queues to buy gasoline added more 12% to the cost of gasoline in December 1973 and 50% in March 1974 in USA urban The problem was evaluated to be more severe in rural areas, with respectively estimated costs of 24% and 84%

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2.1.3 Iranian revolution and oil price fluctuation in 1979

The beginning of a turbulent decade in the Middle East was remarked by the Arab-Israeli War in 1973 In defiance of the Arab states, Iran increased the oil production bypass the 1973-74 embargoes At the beginning of 1978, Iran exported 5.4 millions of crude oil barrels per day which were up more than 17 percent of OPEC But that met a public resistance in 1978, strikes spread out on the oil sector through the fall of 1978 It caused the oil production of Iran downed by 4.8 mb/d (or 7% of world production at the time) from October 1978 to January 1979

Frech and Lee (1987) estimated that the opportunity cost of waste time queuing added about a third to the cost when Americans bought gasoline on May of 1979 During 12 months, gasoline queues were again a hot phenomenon and price of oil barrel increased from $15.85 to $39.5 That was the premise of crisis lasting 30 month

in U.S.A In 1980, the increasing of oil price hiked the inflation rate to get peak 13.5 percent

2.1.5 The great price collapse in 1981-1986

The consequences of oil crises in 1973 and in 1979 were the reasons that the economic growth of the industrial countries, oil demands all over the world slowed down from 1981 to 1986

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This really caused oil price strongly felt from $35 in 1981 to lower than $10 in

1986 While this event was a motivation for development on the demand side of oil consumers, vice versa this delegated an “oil shock” for the producers

2.1.6 First Persian Gulf War in 1990-1991

By 1990, Iraqi production recovered its levels of the late 1970s Due to this country invaded Kuwait on August 1990, its production collapsed again and it parallel induced Kuwait’s substantial production down At that time, both countries accounted for nearly 9% of world production Then, the oil exporting embargo with Iraq and Kuwait was enforced by United Nations Organization It rejected 5 million barrels per day out of the market and pushed the oil price increase Despite oil price did not exceed the peak of 1979 and 1979-1980 crises, as fever it lasted within nine months External expression during 2 months, the price of each barrel doubled from $17 to $36 per barrel

This crisis may be the reason that led the USA recession to the collapse of financial market Other powerful countries also were rolled in recession because they had to suffer indirect influence such as Japan, Australia, England and Canada

2.1.7 The downtrend of oil price in 2001

In the summer of 1997, Asian crisis started with Thailand, South Korea, and other countries Like a domino effect, it spread out their currency with serious stresses

to the financial system At the end of 1998, the dollar oil price followed the crisis falling below $12 a barrel In 1999, the world petroleum consumption restored to strong growth But after 2000, the world economy declined Especially after the event

of September 11th terrorism, the oil price trended to decrease more A broader global economic downturn happened and the tenth postwar U.S recession began in March of

2001 In 2001, due to the decreasing of consumption rate contributed to oil price fall, the price was only $20 per barrel

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2.1.8 Growing demand and stagnant supply

Global economic growth in 2004 and 2005 was quite impressive, with the IMF estimating that real gross world product grew at an average annual rate of 4.7% (Hamilton, 2009b) Over this period, world oil consumption grew up 5 mb/d and 3% per year on average Even though there was initially enough excess capacity on supply side to keep production growing along with demands, these strong demand pressures were the key to make the oil price increase steadily In recent years, one of the most important suppliers has been Saudi Arabia This nation contributed 13% of global field production in 2005 and kept an active role as the world’s residual supplier during the 1980s and 1990s They could decide to increase their production whenever needed But in the event, Saudi production was 850,000 barrels a day lower in 2007 than it had been in 2005 However, oil demands continued to grow, along with world real GDP increasing an additional 5% per year in 2006 and 2007 That was a faster rate of economic growth in which oil consumption accompanied the 5 mb/d increasing during 2003 - 2005 Especially, China increased its own consumption by 840,000 barrels a day from 2005 to 2007

In the short-run, according to Hamilton (2009a), price elasticity of oil demand has been quite low and may have been even smaller over the last decade (Hughes, Knittel, and Sperling, 2008) It means a little bit demand increase needs a compensation of large price increase With no more oil being produced, a large shift

of the demand curve in case of the increasing limit on supply side led a raise of oil price from $55 a barrel in 2005 to $142 a barrel in 2008

On December of 2007, the USA recession began again that was likewise the worst in postwar experience, but of course the financial crisis rather than any oil-related disruptions were the leading contributing factor of that downturn

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2.2 How higher oil prices affect the economy

2.2.1 Why oil shock seems to be the big economic headache

Why we should worry

In 2008, oil prices reached USD150 per barrel Shortly afterwards, the global economy collapsed Based on HSBC (2011, February), at that time many problems occurred such as the imploding US housing market, the beginnings of a securitization crisis, the collapse of Lehman Brothers Nevertheless events in three years ago, much evidence were shown that substantial changing oil prices are so hot news for the global economy

Figure 2.3 shows the level of oil prices in real terms (adjusted using the US consumer price index) tracked against US recessions Seemingly like a cycle, increases in oil prices of more than 100% lead to declining GDP

Figure 2.3: When oil prices head up, the US turns grey: the oil market and

US recessions

Source: Thomson Reuters Datastream

As oil prices approach historical record levels, there are some debates to discuss how is important the impact of oil price changes on the global economy have been clarified Quite recently, according to Rasmussen and Roitman (2012, February)-two IMF economists found that generally there has been a relationship between oil price rises and good times in the global economy They concluded that causing of the oil price shocks there were lagged negative effects on the output of OECD economies

of world economic growth rate by between 0.4 and 1% in the following year

So as oil prices approach historical hikes, that the global economy is seriously vulnerable Wherever oil prices eventually end up, it is possible to tease out some of the more important economic effects There are immediate winners (net oil producers and exporters) and losers (consumers and importers) despite any given shift in oil prices It is not only a straight-forward redistribution of income but also a big problem occurs

HSBC Bank emphasized that for global demand, one of the most important matters is the marginal propensity to spend of oil producing nations relative to oil consuming nations In general, that is higher for oil consuming nations than producers (for example, comparring the balance of payments position of the US with Saudi Arabia) Therefore, a big increase in oil prices intends to dampen global demand

Oil prices as a tax

It’s obvious that for net oil consuming nations, higher oil prices have an effect similar to an extra in indirect taxes The target to smooth over the effects of higher oil prices is either to offset by an tax cut on importing price or to subsidize the downstream of oil products (subsidizes are simply negative taxes) By these ways, inflationary pressures can be suppressed and real incomes can be conserved for a while at least

The second round effects: demand, supply and inflation

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The confidence of business and consumer can easily be vanished by higher oil prices because of both the immediate harming real incomes and the uncertainty generating of future real income (how long do oil prices stay at the higher level or, worse, will oil prices go up even further?) In this situation, economic activities are weak for a while or even slow down further; these are called second round effects

Besides, in theory, a lower level of demand should be sufficient to prevent any initial raising inflation But there are two additional worries as the follows:

 If a country’s capital stock was installed on the foundation that the oil prices would average, for instance, USD80 per barrel in given year but oil prices got double that year, at least some of the capital stock would be loss and even be scrapped By another way, when demand in an economy was down because of higher oil price, this affected directly supply potential economy and led to the uncertainties over the amount of spare capacity

 What happens if nominal wages are increased when rising price level simply has been pressing down real wages? HSBC Bank gives an argument that at the moment, this seems that the emerging countries are suffering from risky more than the developed world But in reality, there are a plenty

of Western policymakers who are now increasing nervous Obviously, interest rate is considered to rise by three members of the Bank of England’s Monetary Policy Committee (MPC) That is reflecting the worries about wage growth and rising inflationary expectations

In history, there were lots of areas of great uncertainty Following the big event

in 1991 (Iraq invasion of Kuwait), the Bank of Japan prioritized to protect macro economy from the near-term inflation threat associated with the higher oil prices and ignore the affect of deflationary forces that made against an appearance of the whole Japanese economy In fact, with high interesting rate, the inflation came down Although the policy worked but the consequence as we actually known, the longer-term costs were enormous including stagnation, economic underperformance and deflation

Experienced from history, in 2005, the interest rate was cut by the Bank of England’s decision in the light of a low inflation and a beginning steady increase of

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oil prices Over the medium term, the interest rates in the Western world are published nearly at zero with the confidence of controlling inflation ability But later on, this confidence was less after the oil price reached a spike in middle of 2008 Finally, the reason that fears of inflation are back, the interest rate has been considered to be up

2.2.2 The scenario of oil price and inflation in Vietnam

As we have concerned before, by qualitative method, the overall picture of the macro economy will be drawn with some variables including consumer price index, industrial production, oil price, money supply as the following figure 2.4

Figure 2.4: Illustration of oil price and macroeconomic variables in level

Source: by author

It is clear that crude oil price (VOP) was in uptrend year by year with high variation from 2001 to 2010 VOP was increasing gradually during the period 2001M1-2007M6 It reached 1.1 million VND/barrel in 2007M7 Then it temporarily

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downed a little bit before started to be rising up incredibly It’s up to peak at 2.2 million VND/barrel in the middle of 2008 (up over 100% after 1 year) After that it had fallen off freely, turned back under 1 mil VND/barrel at the end of 2008

Moving along with oil price VOP, seasonal adjustment in regard to consumer price index (CPI_SA) was also increasing gradually year by year (the based year 2005 with index value of 100) After approached the value of 125 at the end of 2007, it’s raising very sharply, reached peak 150 at the end of 2008 (up over 20% after 1 year)

Parallel, the moving of money supply (M2) was a little bit similar to CPI_SA graph But it was different during the period 2007-2008 (none sharply increasing) While the moving of the industrial output (IP_SA) is nearly linearity with the slope very small It seemly there is exists that the constraint or gripper holds back the uptrend of the output (quite flat) From 2007M12 to 2008M12, the growth rate of IP_SA just got 13% with high deviation

Are there special relationships among VOP, IP_SA, CPI_SA?! Whether can the increase of VOP be factor to explain the increase of CPI_SA after a few months?! Or could the increase of VOP impact on the moving of IP_SA badly way? We will explore the Granger causal relationships among them by the quantitative method in

section 2.6 and chapter 3

2.3 Review price level and inflation theories

Definition

In economics, “inflation is a rise in the general level of prices of goods and services in an economy over a period of time A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time”1 So the proxy of measuring price level is calculation CPI from the basket of goods and services

And many factors can contribution of changing in price level due to changing CPI that we can focus as following figure:

1 It’s available at : http://en.wikipedia.org/wiki/Inflation

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Figure 2.5: Factor contributions of price level

Role of inflation in whole economy

Inflation affects multiply both positive and negative side on the economy In

this research, the negative effect of inflation is only referred to One of the negative

impacts of inflation is that the real value of money and other related items reduce over

time Unpredicted future inflation could harm savings and investment situation In

details, it triggers a decrease of productive capital investment as well as an increase of

savings in non-producing assets (e.g selling stocks and buying gold) Overall

economic productivity rates thus can be reduced

Category type of inflations

According to Keynesian view, there are three major types of inflation, as part

of what Robert J Gordon (1990) called “triangle model”:

Exchange rate Aggregate Demand Aggregate Supply

Money and credit Interesting rate Income Wealth Government spending and taxes

Import and domestic input cost Supply side mark-up Exchange rate

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The most important one which is often mentioned in this research is cost-push

inflation It is also call “supply shock inflation”, is caused by a drop in aggregate

supply (potential output) Cost-push inflation is an inflation that results from an initial increase in costs In general, natural disasters or the increase of input prices lead to rising costs The increased costs come from an increase of wage rate and raw materials price (e.g oil)

Figure 2.6: Cost-push inflation in the AS-AD model

Source:

http://www.bized.co.uk/virtual/bank/economics/mpol/inflation/causes/theories2.htm

Demand-pull inflation happens when the level of aggregate demand grows

faster than the underlying level of supply It is caused usually by increasing private and government spending, etc Demand-pull inflation helps the economic growth fast because the great demand and favorable conditions of market would encourage expending production and investment

Aggregate demand is made up of all spending in the economy as the following formula:

AD = C + I + G + (X-M)

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Where:

C stands for consumer expenditure

I stand for investment

G stands for the government expenditure

X and M respectively stand for exports and imports

Figure 2.7: Demand-pull inflation in the AS-AD model

Source:

http://www.bized.co.uk/virtual/bank/economics/mpol/inflation/causes/theories1.htm

Thirdly, the last type is called the inflation expectation It is resulted from adaptive expectations and has a close relationship in term of “price/wage spiral” It reflects a phenomenon that workers try to request a raise in an effort to keep their annual income higher the rate of inflation, which makes businesses tend to pass the increase in labor cost on their consumer with higher ware prices Thus, it turns around

as a “vicious circle’

2.4 The transmission mechanism of oil price shocks

According to Schneider (2004), oil price shocks affect the economy through different channels: the supply side (higher production costs, reallocation of resources), the demand side (income effects, uncertainties) and the terms of trade

On the demand side, the general prices level is increased by oil price shock, which directly absorbed into the real disposable incomes As a result, the demand

On the term of trade, economy is affected by the changes of the international environment through oil price shocks Jumped import prices lead to worsen the terms

of trade and welfare losses falling as well Thus, the monetary policy is important to economy stability

Furthermore, oil imported countries are particular examples Oil exported

nations get profits due to higher export revenues but diminishes from global demand

reducing

By the simple way to explain the transition mechanism, rise in oil prices pass

through 2 round effects on the domestic economy (Kiptui, 2009) As shown in figure 2.8 below, the first round in short term effects of an oil price shock is transferred

directly to wages and producer prices through the pricing structure of the economy

The second round in the longer term effects results in slowing down of economic

activity with a possible downward impact on the inflationary pressures

Figure 2.8: Two round effects of oil price increases

Oil prices 

Inflation 

Wage-price spiral 

Policy response: tightening monetary policy?!

Uncertainty: timing, magnitude and exchange rate effects

Policy response: loosening monetary policy?!

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Source: Adopted from the Royal Bank of Scotland Group Economics (2004)

Other more complex mechanisms, according to Brown and Yücel (2002), price changes affect the performances of macroeconomic variables through the following six transmission channels as following:

oil- Supply-side shock effect: a change of marginal product cost rooted from oil price shock leading to affect output directly;

 Wealth transfer effect: referring to the dissimilar marginal consumption rate of average trade surplus and petrodollar;

 Inflation effect: focusing the relationship between oil price and domestic inflation;

 Real balance effect: analyzing the alternation of monetary policy and money demand;

 Sector adjustment effect: measuring the adjustment in industrial structure cost

In fact, it could help to clarify the asymmetric influence of oil price shocks; and

 Unexpected effect: investigating the fluctuation of oil price and its results in the uncertainty

Most of the industrialized nations have proved the above transmission channels

Figure 2.9: Mix transmission channels of oil price shocks

Note: Arrow indicates incomplete transfer (insignificant relationship)

Source: Adapted from Tang et al., (2010)

It cannot deny that crude oil plays an important role to industrial production as

main raw materials Its price fluctuation effects directly output Arrow (1) in Figure

2.9 shows the reduction of production caused by the oil price shocks, which make an

increase in the marginal cost of almost industries It means the effect of supply side

shock It can recover in term of capacity when outputs reduce due to cutting down the

capacity utilization

Micro Foundation 

For Price/Monetary Transmission Mechanism

4

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Nevertheless, the oil price shocks affect to the output in the long run through Monetary Transmission Mechanism/Price (referring arrow (3)) because cost shocks of upper stream industries would be transferred from sectors and producers to end-users For regarding developed industrial sectors, shock of inflation could move from upper-stream to down-stream2 Consequently, the profit of producer would be affected and contemporarily fall the real balance of consumers because both of them bear a part of overall cost increase

As the real output and consumption reduce, this transmission finishes Almost developed nations reflex this status However, there is a little different in some countries For example China, limited domestic demand and hard price competition of export field forced to control price and producer surplus (Arrow (4))

The down-stream producers decrease their profit to compensate the price rising

as their capital limitation This tends to reduce their investment The production expansion depends on the investment For example, the potential output capacity cannot retrieve in a short run even as cost shock passes, the investment decrease would drag on long term output decrease (Arrow (5))

The net influence of oil price shock on interest rate is not clear because a reduction in investment could diminish money demand in the market while a decrease

in real balance could expand it This is proved in the Arrow (8) and Arrow (9) So, the monetary policy is no need to apply in this situation Yet, in the fact that monetary authorities still set up the policy targets aiming at control inflation if cost shocks included oil price increase doubt to cause inflation It is really terrible for long term output to apply a tightening monetary policy because the interest rate will be increased and the investment will be decreased (Arrow (7))

2 “The downstream oil sector is a term commonly used to refer to the refining of crude oil , and the selling and distribution of natural gas and products derived from crude oil Such products include liquified petroleum gas (LPG) , gasoline or petrol , jet fuel , diesel oil , other fuel oils , asphalt and petroleum coke

The upstream oil sector is a term commonly used to refer to the searching for and the recovery and production

of crude oil and natural gas The upstream oil sector is also known as the exploration and production (E&P)

sector” (Wikipedia, 2011; Available from:

http://en.wikipedia.org/wiki/Downstream_%28petroleum_industry%29)

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2.5 Approaches to estimate oil impact on macro economy variables

There are lots of models, among them we concern on three type popular models that economists have been used to estimate as following:

1 Oil price standard in Phillips curve- Mark A Hooker (1999):

Hooker (1999) used Phillips curve framework to estimate the effects of oil price increasing on U.S inflation Before 1980, oil shocks played considerably to core inflation On the contrary, the research revealed that the change of oil price effected inflation via the price index rate but no through core measurement since 1980 Michael Leblanc (2004) estimates the effect of oil price changes on inflation for the U.S.A, the U.K, France, Germany, and Japan using an augmented Phillips curve framework The statistical estimates suggest current oil price increases are likely to have a modest effect on inflation in the U.S, Japan, and Europe Applying the same methodology, Moses Kiptui (2009) proved that the sharp increase in world oil price in

2002-2008 was associated with high inflation in Kenya

Moses Kiptui (2009) estimates a generalized Phillips curve as follows:

m i i

m i i

t t

t i t t

2 Vector auto regressive model (VAR model):

By another methodology, Burbidge and Harrison (1984), Brown and Yucel

(1999), Abeysinghe (2001) conducted vector auto regressions (VAR) and computed

impulse responses to oil prices with VAR model; or Structural Vector Autoregressive (SVAR) models (Jimenez Rodriguez and Sanchez, 2004; Cologni and Manera, 2008)

In additional, Camen (2006) used a VAR system with monthly data for the periods from February 1996 to April 2005 and found that: rice price and oil price are

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important which play the important role for commodity prices and exchange rate All their results induced the same conclusion that there is an increasing of price level after oil price spike

When the variables are stationary in levels, a VAR model is employed The VAR model proposed by Sims (1980) can be written as follows:

Y(t)= k + A1Y(t-1)+ A2Y(t-2)+….+ ApY(t-p)+ u(t); u(t) ~ i.i.d.(0,Σ) (2)

Where Y(t) is an (n x 1) vector of variables, k is an (n x 1) vector of intercept terms, A is an ( n x n) matrix of coefficient, p is the number of lags, u(t) is an (n x 1) vector of error term for t= 1,2,….T In addition, u (t) is an independently and identically distributed (i.i.d) with zero mean; E (u (t)) =0 and an (n x n) symmetric variance- covariance matrix Σ

3 Vector error correction model (VECM):

If the variables are non-stationary, a vector error correction (VEC) model is usually used because of the VAR in differences containing only information on short-run relationships between the variables In recent researches, Katsuya (2008), Jin (2008) and Aliyu (2009) used VEC model (VECM) to examine the impact of oil prices on the macroeconomic variables such as inflation, real effective exchange rate and real GDP for Russia, Russia-Japan-China, Nigeria respectively

The VECM developed by Johansen (1988) can be written as follows:

ΔZ (t) =k + Γ (1) ΔZ (t-1) + … + Γ (p-1) ΔZ (t - p +1) + Z (t-1) + u (t) (3)

Z (t) = [Y (t), X (t), W (t)…]

Where Z (t) is the vector of many variables, Δ is the different operator; Γ

denotes an (n x n) matrix of coefficient and contains information regarding the run relationships among variables  is a (n x n) coefficient matrix contained

short-information regarding the long run relationships We decomposed as =αβ’, where α and β’ are (n x r) adjustment and coin-integration matrices or long run matrix of

coefficients respectively

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2.6 Empirical studies about the oil price-macroeconomic relationship

The early empirical studies about the link between inflation and macroeconomic were investigated by Hamilton (2003), one of the most famous economists in energy field He argued that except one time in 1960, most of the events

of post-World War II (WWII) U.S recessions had at least partial impacts of oil-price increases

Following Hamilton’s paper series, there are lots of the researches on many economic aspects In which, the relationship between the oil-price shocks and the whole performance of economic aggregate has been explored during the four decades

in many nations by Burbidge and Harrison(1984); Gisser and Goodwin (1986); Mork (1989, 1994); Mork et al (1994); Lee et al (1995); Cologni and Manera (2008)

In recent years, Tang et al (2010) suggested to broadly classify most of those studies into three categories The first category is the large group of gathering researches on the theoretical mechanisms and channels in which the oil-price increase

is investigated as a major factor that can retard the economic activities (Hamilton,

1983, 1996, 2000; Mork ,1989; Mory ,1993,1994; Lee, Ni and Ratti, 1995; Hooker, 1996; Lee et al., 2002; Brown and Yücel, 2002; Cunado and Perez de Gracia, 2003, 2005; Jimenez and Sanchez, 2005; Grounder and Bartleet, 2007; Katsuya, 2008; Jin, 2008; Aliyu, 2009; Du et al., 2010…) The second category focuses mainly on the empirical investigation on the relationship between oil-price change and national aggregate economic activity Either symmetric or asymmetric, either linear or non-linear, the mathematical relationship were verified most of the developed countries during the 1970s up to now (Burbidge and Harrison, 1994; Gisser and Goodwin, 1986; Chaudhuri, 2000; Cunado and Perez de Gracia, 2003, 2005; Gounder and Bartleet, 2007; Mohammad and Gunther, 2007; Cologni and Manera, 2008; Kiptui, 2009; Weiqi et al., 2009; Limin et al., 2010…) The remaining studies focus on analyzing the role of macroeconomic policies to be able to cope with the impact of oil price shocks All the elements can weaken the negative impact of oil price fluctuations

in aggregate economic activities have also been studied and carefully analyzed over time And other factors can impact economy beside oil price effects have been considered (Ferder, 1996; Bernanke et al., 1997; Hamilton and Herrera, 2001; Hooker,

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2002; Leduc and Sill, 2004; Huang et al., 2005; Blanchard and Gali, 2007…) Indeed, the majority of studies are concentrating to propose appropriate monetary policies for coping with the oil supply shock Meanwhile, the slowdown of total output and inflation are widely considered as the two inevitable impacts of oil-price fluctuations

in the world wide context

First category

On the empirical side, Hamilton (1983, 1996) had lots of contributions in which most of U.S recessions were preceded by increases in the price of oil That suggested oil price increases had an essential role as one of the main cause of recessions

Mork (1989), Lee et al (1995) and Hamilton (1996) introduced non-linear transformations of oil prices to examine the negative relationship between increasing oil prices and economic downturns as well as to re-confirm the existence of Granger causality between both variables

Mork (1989) examined whether Hamilton’s outcomes were still accurate in the case of the 1980s’ oil market collapse, also considered real oil price Furthermore, that allowed an asymmetric response of the US economic activity to oil price changes in which the real prices of oil were separately specified increases and decreases by different variables In details, the impacts of oil price increases on economic activities were different from those of decreases, and even the latter’s were not statistically significant in most cases Furthermore, an asymmetric relationship for the US also found by Mory (1993) A little bit different from the confirmations of Loungani (1986) and Hamilton (1988) about the oil-induced dislocations, Mory argued that the macroeconomics would be recessionary whether initial triggered by price increases or decreases

Mork et al (1994) observed Japan, Germany, USA, Norway and Canada They found that the USA was negatively impacted by both oil price increases and decreases, while Canadan and German were less affected; the outcomes of all the rest were impacted unclearly

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After a long time researching, Lee, Ni and Ratti (1995) focused on volatility, maintaining that “an oil shock is likely to have greater impact in an environment where oil prices have been stable than in an environment where oil price movement has been frequent and erratic” because price changes in a volatile environment are likely to be soon reversed Economists used the Garch model to study the conditional variance through real price changes In all sample periods, they got the evidence of an asymmetry between the positive effects and negative normalized shocks Positive non-normalized shocks in real oil price were strongly related to positive unemployment and negative real growth Meanwhile, negative oil price shock impacts were insignificant

Jimenez-Rodriguez and Sanchez (2005) assessed empirically the effects of oil price shocks on the real economic activity of the main industrialized countries using multivariate VAR analysis, combined with both linear and non-linear models They had the evidence of a non-linear impact of oil prices on real GDP In details, their results analyzed that oil price increases intervened with more impact on GDP growth than that of oil price declines Specially, among oil importing countries, oil price increases had a negative impact on economic activity in all cases excluding Norway and Japan A negative impact of oil price shock of 1.1% on European Union countries after eight quarters following the shock and a positive impact to the tune of 0.89 % and 1.1 % in the case of Norway and Japan respectively were recorded Surprisingly, one phenomenon was exhibited: while it was expected an oil price shock which had positive effects on the GDP growth in a net oil exporting country as England; but in reality, the oil price increase 100% actually led to loss of British GDP growth rate more than 1% after the first year in all specifications The explanation was because of

an extensive literature highlighted that the unexpected result of oil price hikes has done many facts In which, that led to a large real exchange rate appreciation of the pound, which was being described as the Dutch disease in the literature3

3 “The Dutch Disease is the standard example of the Paradox of Plenty In the 1970s large revenues to the Dutch state from the extraction of natural gas led to the temptation to build a welfare state that was unsustainable in the long run The competitive ability of the private sector was reduced and the industrial sector experienced a setback from which it took many years to recover In the case of oil exporting countries, this is even more likely

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Katsuya (2008), he researched the relation between oil prices and Russian economy from 1997Q1 to 2007Q4 used the VAR model But in his data, the variables were non-stationary, so a vector error correction (VEC) model was suitable for the research The analysis led to the finding that a 1% increase in oil prices contributed to real GDP growth by 0.25% over the next 12 quarters, whereas that to inflation by 0.36% over the corresponding periods

Jin (2008), in a recent research into the impact of oil price shocks and exchange rate volatility on economic growth, he showed that the oil price increases caused negative effect on economic growth in Japan and China On the other hand, an appreciation of the real exchange rate led to a positive GDP growth in Russia

Aliyu (2009) showed that there was a unidirectional relationship in which the oil price shock Granger cause real GDP of the Nigerian economy In additions, the oil price shock and the appreciation of real exchange rate had both positive impacts on real economic growth through a long-run vector error correction model applied Moreover, based on the Hamilton’s (1983) linear specification, Jin (2008) and Aliyu (2009) were also confirmed the existence of a symmetric oil-real GDP relationship

By applying VAR and Structure VAR, Du et al (2010) found out the break point of relationship between the world oil price and China’s macro-economy Before the break date (2002:M1), China had policy for the oil price regulation, so that the correlation between the world oil price and domestic oil price of China was not strong enough It caused the impact of the world oil price on China’s macro-economy was not significant After the break date, due to the oil price reforms, the relationship between the world oil price and China’s macro-economy became much more significant Furthermore, Granger causality tests showed that China’s macro-economy could not affect the world oil price while China’s GDP and CPI were both positively correlated with the world oil price And the impulse-response functions of the linear impact model showed the largest impact reached in the second month and disappeared completely after about 12 months Unlike most of the developed countries investigated in the existing literature, a 100% increase of the world oil price

because abundant petroleum revenues change the calculations of even the prudent rulers, thus making learning more difficult, not only between countries but also within them”

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cumulatively increased GDP and CPI of China by about 9% and 2%, respectively The results of non-linear models also informed there was an asymmetric impact of the world oil price on China’s GDP

Second category

By VAR model, Burbidge and Harrison (1984) found that consumer price index (CPI) and oil price have positive relationship in Germany and Japan, and larger effect in the UK

Chaudhuri (2000) concluded that although oil does not exist in products but in does influence goods price Oil price fluctuation can affect the necessary goods price

Cunado and Perez de Gracia (2003) researched the effect of oil prices on production and inflation of European countries VAR model was used with quarterly data for the duration from 1960 to 1999, and the result was that oil price had a constant impact on inflation and had inverse effects on production growth rate in the short term

With regarding to Cunado and Perez de Gracia (2005), both economic activity and price indexes were significantly affected by oil prices in the short run, especially these impacts were more significant when oil price shocks were defined in local currencies in all analyzed countries Moreover, they found evidence of asymmetries in the oil prices–macro economy relationship

Gounder and Bartleet (2007) had the proof in which the higher inflation and the higher unemployment resulting from energy price shock or energy crisis on the demand-side In fact, at the same time, the ‘oil crises’ of the 1970s and early 1980s led

to rise both inflation and unemployment as the ‘stagflation’ phenomenon The linear transformations of oil prices were also applied to re-establish the negative relationship between increases in oil prices and economic downturns, as well as to expose Granger causality between both variables

non-Using VAR model in the case of Iran, Mohammad and Gunther (2007) conducted the result that if the oil prices changed either negatively or positively, the inflation would be seriously increased Moreover, there was a close relationship between industrial growth and positive oil price changes