Crude oil is a vital commodity for bothimporting and exporting nations, as it is either an important input factor orsource of income. A rise or fall in price is therefore of interest to theseeconomies and can affect various macroeconomic variables, such as economicgrowth. A special attention has been given to oil prices in the literatureafter World War II, because after World War II Oil price changes are one of themost significant supply shocks which hit the world economy.
It is difficult tofind a factor which had a greater impact on an economy than oil prices since1970. Due to oil embargo of OPEC in 1974oil price increased and most economies experienced an economic recession.Therefore, lay people as well as economists has keen interest in therelationship between oil prices and the economy.According to the history of oil productionand extraction, Edwin Drake has done the first successfully realized oilextraction process in Pennsylvania in 1859.
(Ali Baghirov, 2014). Ever since oil was found andextracted, world has become very dependent of oil. It is used in production, tofuel our cars, planes, and factories. Over the last decades there has beenlarge fluctuations on oil prices, many studies have been conducted exploringthe impacts of oil prices on different macroeconomic factors in the interest tounderstand the oil’s effect on countries.According to Ghalayini (2011), “From themiddle of twentieth century onwards, crude oil has become one of the mainindicators of economic activity worldwide, due to its outstanding importance inthe supply of the world’s energy demands” (p.127).
(Ghalayini, L. 2011).Hence the oil price is very important factor,which plays an essential role in affecting economic activity and it impactseconomies through various ways.In developing countries economic growthdepends on the country’s ability to import capital goods and technology neededfor building technological capacity and expanding the productive structure. Theprocess of structural changes that focus on the supply side of the economy tostrengthen the productive capacity, induce technologic change, expandproduction, increase services and improve worker skills is the process of development.
The growth potential of aneconomy depends on the creation of productive capacity capable of stimulatingaggregate demand and increasing investment spending. Increase in oil prices could have a negativeimpact on aggregate demand causing expenditures on both public and privateinvestment, productivity growth and employment to decline. Similarly, higheroil prices increase the cost per unit of output produced pushing up the cost ofliving. Under globalization, macroeconomic policies become less effective dueto external forces which in turn make government policies unable to manage theeconomy and correct financial imbalances. (Amer Al-Roubaie, 2010) As described by Mork and Hall (1980)an oil price shock will affect the economy in two ways.
The first is loweringthe growth path of the economy due to the increased price which will increasethe scarcity of energy and the other, creating a temporary loss due to slowadjustments of other prices. These two will affect the macroeconomic factors offinancial interactions, investments, and consumption differently which areconnected to the GDP growth of a country. The way it affects investments ismaking it more expensive and it will be affected mainly through the slowadjustment of prices. The increased energy price will reduce the labor demandwhich will lower wage rate. But due to the slow adjustments of prices the wagewill be too high for the new equilibrium and employment will fall which willdecrease production even more under the new growth path. Consumption will beaffected primarily through the first way; the overall lower productivity of theeconomy will decrease output which will increase the prices of products.
Combined with lower employment and after the wages have adjusted the overallconsumption will decrease. In the financial aspect, since the price level hasincreased and the money supply is unchanged it could be viewed as a decrease ofthe real money supply. This increased interest rates will again lower theinvestments (Mork & Hall, 1980). A shock ofincreased prices will therefore theoretically lower the GDP or slow down thegrowth at least and a drastic fall in the oil price will speed up the growth. It is claimed in economicsurvey of Pakistan (2011-12) that Pakistan’s economy showed better growth thenother developing economies and GDP remained at its high growth of 3.7% (higherin last three years).
But in 2011-12 due to increase of oil prices, Pakistan’scurrent account balance is affected. Oil prices have also great impact on CPIof Pakistan, that causes the increase in prices of electricity and gas. Oil prices have positive impact on real GDPin short but in long run it has negative impact on real GDP. (Nazir and Hameed, 2015) Moreover, effects of oil price increases on economic output growth in anoil-exporting country is explained by one of the most popular theories that isthe Dutch disease theory. Thistheory was discussed by W. Max Corden and J.
Peter Neary (1982) in his paperand the theory states that, generally, the change in industrial structure ofthe oil-exporting country is due to higher oil prices, that makes country moreconcentrated on oil industry and non-traded sectors. Moreover, it is mentionedthat the higher oil revenues lead to the appreciation of local currency, whichconsequently causes the increase of imports of consumer goods. So, because ofthe high concentration on imports the competitiveness of the local producerswill decrease automatically. Hence, according to the Dutch disease theory, an increase in oil prices is not abeneficial situation for the economy of an oil-exporting country. As Yudong Wanga(2013) also discussed in his paper that in oil-importing countries oil-specificshocks have negative impact on stock market. This can be lead to the negativeeffect of oil price increases on the national economy in oil-importingcountries. (Yudong Wanga, 2013).According to Ahmed F(2013) there are different transmission mechanisms for possible impact ofoil price shocks on economic growth.
First is the classic supply size effect,according to which, increase in oil prices leads to decline in the outputlevel, because oil is considered as the basic input of the production. Therefore,higher oil prices would result in the higher output costs, results in loweredproduction rate and declined growth rate. Second, the demand side effect, this transmissioneffect discusses the adverse effect of oil price shocks on investment and consumption.As Capital is the major input for the industries that comes from theinvestments of local and foreign investors. When economic activities are atdecline, investors withdraw their investments from markets and take money outof the country and invest in higher profitable and growing economies, resultingin further lowering of production and economic activities in the country. Achraf Ghorbel, and Younes Boujelbene,(2013) mentioned in their paper that Hamilton (1983), Cunado and Perez deGarcia (2005) and Kilian (2008) reported that “oil price shocks exert aninfluence on recessions, inflation, economic growth, and other economicvariables in most developed andemerging countries.
Guo and Kliesen (2005) proved the positive effect of theincrease in oil price for oil-exporting countries, and negative foroil-importing countries.” Furthermore, they also discussed the work ofHammoudeh and Aleisa (2004), who have done research on GCC stock markets duringthe period 1986-2003. Their studies showed that oil price shocks have negativeeffects on US stock returns. (Achraf Ghorbel, 2013). According to this empirical analysis, theimpact of oil price shocks on the three large NIEs’ stock prices is mixed. Firstly,the oil prices always have a negative impact on India’s economy as long as theoil price is not driven by the increasing oil consumption of India, Additionally,it is concluded from this research that only when the oil price movement isdriven by Russian oil-specific supply shocks are there significant positiveimpacts on Russia’s stock returns. Finally, it is observed that since theenergy efficiency of China is relatively low and China’s financial market isnot complete, the oil price driven by global oil demand shocks has aninsignificant effect, and China’s oil-specific demand-driven oil price has asignificant negative effect during the 3rd to 6th months.
(Chung-Rou Fang ?, 2014).It is concluded from literature review thatoil prices shocks effect economic growth of country. Increase in oil pricesnegatively influence the economy but it is different in context of oil exportingand oil-importing countries.
Increase in oil prices positively effectoil-exporting countries and negatively effect oil importing tries.