Oil prices and European household consumption expenditures

• DOI: http://doi.org/10.1111/opec.12170
• Date: 01 March 2020
• Author: Maruška Vizek,James E. Payne,Junsoo Lee
• Published date: 01 March 2020

Oil prices and European household

consumption expenditures

Maru

ska Vizek*, Junsoo Lee** and James E. Payne***

*Director, Institute of Economics Zagreb, Trg J. F. Kennedya 7, Zagreb, Croatia . Email: mvizek@eizg.hr

**Professor, Department of Economics, Finance and Legal Studies, The University of Alabama,

Tuscaloosa, AL 35487, USA . Email: jlee@cba.ua.edu

***Dean, College of Business Administration, Paul L. Foster and Alejandra de la Foster, Distinguished Chair

in International Business, University of Texas at El Paso, El Paso, TX 79968, USA . Email: jpayne2@utep.edu

Abstract

This study examines the influence of changes in oil prices on total household consumption along

with its sub-components from 1996 to 2018, a period characterised in the literature by the

declining impact of oil price shocks on macroeconomic activity. Using several dynamic panel

VAR econometric approaches, we examine the role of oil prices alongside income, wealth and debt

on household consumption expenditures of 30 European countries. Results from the Granger

causality tests and impulse response analysis suggest an unanticipated increase in oil prices lowers

household consumption. These results are robust to changes in proxies for income, wealth and oil

prices, variable ordering, estimation method and the addition of household debt service. Moreover,

the inclusion of a Fourier function to the baseline panel specifications to control for unobserved

non-linear structural breaks does not change our main findings. A threshold panel VAR model with

median oil price changes used as a threshold indicator suggests the reaction of household

consumption to oil price shocks is regime-dependent; i.e., consumption only reacts to oil price

shocks during periods when oil prices grow faster than the median rate of change. All consumption

sub-components decrease in response to increasing oil prices, but as expected, the consumption of

durable goods exhibits the largest decline after an oil price shock.

1. Introduction

The relationship between oil prices and the macroeconomy has been intensively debated

in the literature over the last four decades. Studies by Rasche and Tatom (1977, 1981),

Hamilton (1983), Burbidge and Harrison (1984), Santini (1985a,b), Mork (1989, 1994)

and Hooker (1996) and more recent research from Hamilton (2005), Cunado and Perez

de Gracia (2005), Kilian (2006; 2008a,b; 2010), Lescaroux and Mignon (2008), Lippi

and Nobili (2012) and Baumeister and Kilian (2016) conclude oil prices have a

significant effect on economic output.

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Studies also tend to agree that the economic

effects of oil price shocks have decreased over time (Edelstein and Kilian, 2007;

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Blanchard and Gali, 2007; Lescaroux and Mignon, 2008; Herrera and Pesavento, 2009;

Blanchard and Riggi, 2013; Ramey, 2016). This has been attributed to several factors: (i)

improvements in energy efficiency and alternative energy sources, (ii) the reduction in

wage indexation, (iii) shift in industrial structure towards less-energy-intensive industries

and (iv) enhanced credibility of monetary policy to combat inflation as more central

banks have moved towards inflation targets (Lescaroux and Mignon, 2008; Kilian,

2008a; Blanchard and Riggi, 2013).

2

Although there is a great deal of empirical evidence suggesting oil prices influence

overall economic activity, the research on the impact of oil prices on household

consumption behaviour has been rather limited. This study extends the literature on the

impact of oil prices on the macroeconomy by focusing our attention on household

consumption, the largest component of GDP. In our study, we examine the impact of oil

prices on household consumption for countries within the European Union (EU) along

with Iceland and Norway. Since the global financial crisis in 2008, there has been an

overall slowdown in household consumption spending in Europe in part due to the

deleveraging associated with the build-up of household debt leading up to the crisis. The

recent slowdown in European overall consumption spending can also be attributed to

demographic changes and disparities in income trends across countries, especially for

those transition countries within the EU (Bouyon, 2015; Coletta et al., 2019). As for the

influence of energy consumption in the EU, according to the World Bank Development

Indicators in the 28 EU member countries, fossil fuels continue to dominate primary

energy consumption, although their share declined from 85.2 per cent in 1960 to 71.1 per

cent in 2015. Even though the share of primary energy consumption of oil has declined

from 35 per cent in 1990 to 31 per cent in 2016, due in large measure to the proliferation

of renewable energy sources, oil still remains the most important source of primary

energy consumption in the EU.

To the best of our knowledge, this study is the first to explore in a systematic fashion

the oil price–household consumption relationship for European countries. Specifically,

we first explore the effects of oil price shocks on household consumption expenditures

by drawing upon two well-cited consumption theories: the permanent income of

Friedman (1957) and the life-cycle hypotheses of Ando and Modigliani (1963). We

incorporate proxies of income and wealth alongside oil prices in explaining household

consumption in the aggregate and by consumption sub-components (durable, semi-

durable, non-durables and services). Secondly, given the literature on the economic

effects of oil prices has yielded divergent results regarding the potential non-linear

effects of oil price changes on economic activity, we also test for the possibility of non-

linearity. Thirdly, we use both the national and market prices of oil in assessing the effect

of oil price changes on household consumption expenditures. Fourthly, we conduct

several robustness checks with the inclusion of aggregate household debt service in order

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60 Maru

ska Vizek et al.

to account for possible balance sheet effects that oil price increases may exert on private

consumption. Fifthly, our analysis employs a battery of dynamic panel econometric

approaches in the use of GMM estimators in the context of panel vector autoregressive

(P-VAR), panel error correction (P-EC) and threshold panel VAR to understand the oil

price–household consumption relationship.

Section 2 reviews both the direct and indirect channels by which changes in oil

prices impact household consumption expenditures and the studies specific to the oil

price–household consumption relationship. Section 3 presents the methodology and

data, while Section 4 discusses the results. Section 5 provides concluding remarks.

2. Literature review

According to Mork (1994), Brown and Yucel (2002) and Kilian (2008a,b), there are four

direct channels by which consumption spending is affected by energy price shocks.

Firstly, the discretionary income channel assumes that higher energy prices lead to

higher energy expenditures by households, which, in turn, decreases the discretionary

income of households. As noted by Hamilton (2011), the elasticity of any macroeco-

nomic aggregate, with respect to the relative price of energy, is the energy expenditure

share times the price elasticity of energy demand. As the share of energy consumption of

total consumption is relatively small, even with the perfectly inelastic demand for

energy, the discretionary income effect has an upper bound. Secondly, changing energy

prices may create uncertainty about the future path of energy prices, causing consumers

to postpone irreversible purchases of consumer durables (Bernanke, 1983 and Pindyck,

1991). Thirdly, even when purchase decisions are reversible, household consumption

may decrease in response to energy price shocks as consumers increase their

precautionary savings. This precautionary savings effect may arise if consumers smooth

their consumption spending because they perceive a greater likelihood of future

unemployment and income losses. ’Fourthly, higher energy prices affect the consump-

tion of durables (such as cars and other machinery requiring fossile fuels) throught

operating cost effect, i.e. as the operating cost of such goods increase due to higher

energy prices, the consumption of such goods is postponed.

In addition to the four direct channels outlined, Mehra and Petersen (2005) also

define a fifth direct channel called the real balance effect. The real balance effect

suggests that oil price increases spawn inflation, thereby lowering real money balances

held by households and firms, thus decreasing aggregate demand and real output. In

response to the inflationary effects of an oil price increase, the indirect effect of the

monetary authorities’response to inflationary pressures through a restrictive monetary

stance may further reduce real output. Another indirect effect is the income transfer

effect, which depends on the extent to which oil price increases create income transfers

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