Impact of oil price fluctuations on Indian economy

• Author: Anurag Goyal,Priyanshi Gupta
• DOI: http://doi.org/10.1111/opec.12046
• Date: 01 June 2015
• Published date: 01 June 2015

Impact of oil price fluctuations on

Indian economy

Priyanshi Gupta* and Anurag Goyal**

*PhD Candidate, Department of Financial Studies, University of Delhi, South Campus, New Delhi 110021,

India. Email: priyanshiguptadu@gmail.com

**Postgraduate, Faculty of Management Studies, University of Delhi, New Delhi 110007, India.

Email: anuraggoyal10@gmail.com

Abstract

Indian economy has been facing the twin issues of mounting trade imbalance and persisting infla-

tion. Oil constitutes one-third of the country’s total imports and is considered to have wide-

ranging impact on its economy.This paper empirically examines how oil price fluctuations impact

Indian economy through various channels, viz. real sector, monetary policy, external trade,

exchange rate and investment. The results of cyclical correlation analysis suggest that oil is pro-

cyclical to output, price level, stock market, gold, interest rate and foreign exchange reserves,

while it is counter-cyclical to money supply, net exports and exchange rate. Also, it is found that

oil Granger causes output, general price level and net exports. The study employs vector auto-

regression (VAR) analysis and examines variance decomposition to capture the linear inter-

dependencies among the variables. The structural stability tests demonstrate that there is no

evidence of structural break in the VAR model, confirming the reliability of estimated relation-

ships under the VAR model.

1. Introduction

An OECD research paper (Fournier et al., 2013) released in the first quarter of 2013 pre-

dicted that oil prices could rise to between $150 and $270/b by 2020, driven byprojected

demand growth in markets like India and China (Gross, 2013). Oil has always been one

of the most dynamic and influential commodities. Hamilton (1983) demonstrated that

all but one of the US recessions in the post-war period have been Granger-preceded by a

dramatic oil price increase.

Recently, it has become increasingly important to study the oil macroeconomic

dynamics in the context of developing nations, especially India, due to three-fold

reasons: (i) India is one of the countries that are being projected for fastest growth in

fuel consumption corresponding to their growth in GDP (EIA, 2013). (ii) Given the

drastic policy change in India with the deregulation of oil pricing, it is critical to

141

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understand the impact of oil price shocks on economic and investment activities in the

country. (iii) Oil constitutes more than one-third of the total imports value (ESI, 2013)

in India, which is struggling with high current account deficit (CAD). A value-at-risk

analysis was reported to suggest that with every $10 increase in oil prices, CAD would

rise by 0.4 percentage points.1

This paper empirically examines how oil price fluctuations impact India’s economy

through various channels: (i) impact on the real sector variables of growth and inflation;

(ii) monetary policy responses in the form of interest rates and money supply to gauge the

role of monetary policy in the overall oil dynamics; (iii) impact on the external sector vari-

ables, i.e. net exports, exchange rates and foreign exchange reserves; and (iv) impact on

the investment front, both financial (i.e. stock exchange) and the popular alternative

investment instrument in India (i.e. gold).

The theoretical framework of the study is captured in Fig. 1. The flow chart depicts

how an oil price shock affects the overall economy through the various macroeconomic

channels, monetary policy and investment variables.

The remainder of this paper is organised as follows.Section 2 briefly reviews the exist-

ing literature; Section 3 lays down the data description and methodology; Section 4 pre-

sents the empirical results of the study, and Section 5 puts forward the conclusion and

documents policy implications.

External Factors: gl obal production, global consumpti on,

production caps by produ cers, speculation, et c.

Oil price increases

Input cost increases

across sectors Import cost increases Exchange rate

deteriorates

Government

subsidies increase Output falls Adverse trade balance Increase in external

payments due

Price level rises Stock markets fall Foreign exchange

reserves affected

Money supply

affected

Interest rate

rises

Demand for

gold increases

Figure 1 Impact of oil price shock on Indian economy.

Priyanshi Gupta and Anurag Goyal142

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