Revisiting the macroeconomic effects of oil and food price shocks to Pakistan economy: a structural vector autoregressive (SVAR) analysis

• DOI: http://doi.org/10.1111/opec.12020
• Published date: 01 June 2014
• Date: 01 June 2014

Revisiting the macroeconomic effects of oil

and food price shocks to Pakistan economy:

a structural vector autoregressive

(SVAR) analysis1

Muhammad Arshad Khan* and Ayaz Ahmed**

*Associate Professor, COMSATSInstitute of Information Technology, Park Road, Chak Shahzad,

Islamabad Post Code No. 44000, Pakistan. Email: arshad.khan@comsats.edu.pk

**Senior Research Economist, Pakistan Institute of Development Economics, Quaid-i-Azam University

Campus, Islamabad Post Code No. 44000, Pakistan. Email: ayaz@pide.org.pk

Abstract

This study examines the impact of global food and oil price shocks and their transmission channels

to the selected macroeconomic variables including the inflation rate, output, money balances, inter-

est rate and real effective exchange rate for Pakistan using monthly data over the period 1990M1–

2011M7. An empirical analysis is carried out by employing a structural vector autoregressive

frameworkto identify different structural shocks and explore the relative contribution of oil and food

price shocks. Generalised impulse response functions and generalised forecast variance decomposi-

tions are employed to track the impact of oil and food price shocks on Pakistan’s economy. The

results suggest that oil price shocks negativelyaffect industrial production, appreciates real effective

exchange rate and positively affectinflation, either the shocks are positive or negative. Only the oil

and food price shocks have asymmetric impact on the short-term interest rate. In contrast, following

the positive (or negative)food price shock, industrial output, interest rate and inflation rate respond

positively. However, the variation in interest rate due to food price shock is relativelylarger than that

of oil price shocks. Generalised impulse response functions revealthat real effective exchange rate is

the most important source of disturbances following either oil price or food price shocks. General-

ised forecast variance decompositions analysis also supports the findings based on generalised

impulse response functions. The results clearly reveal that oil and food price shocks significantly

affect output, short-term interest rate, inflation rate and the real effective exchange rate. However,

among all, real effective exchange rate has been a dominant source of variation in Pakistan. This

implies that supply-side and demand-side disturbances originated by external shocks are the major

sources of variation in output and inflation in Pakistan.

1An earlier version of this paper was presented in the 27thAnnual General Meeting and Conference

of Pakistan Society of Development Economists (13th-15th) December, 2011, Islamabad

(Pakistan).

JEL Classification: Q43, C32, E3

184

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1. Introduction

Recent rises in oil and food prices have been a major cause of concern for policymakers

around the globe, and Pakistan’s economy is no exception. Changes in global oil and food

prices have been viewed as major source of macroeconomic fluctuations.An upsurge in

global commodity prices, particularly food and oil prices during 2007–2008, leads to

increase cost of production, which hinders industrial productivity and fall in output

growth. An unprecedented rise in food and oil prices during 2007–2008, coupled with

global recession, financial crises and slowdownin the US economy has posed a number of

serious challenges to the world economy. Movements in international commodity prices

have been largelyconsidered as a main source of business cycles, and there is a plethora of

literature that shows a negative correlation between the international commodity prices

and macroeconomic performance of oil-importing countries through the supply-side and

demand-side channels.

It is well documented in the literature that crude oil was trading between $18 and $23

in the 1990s. It crossed the $40 mark in 2004 and rose to around $60 in 2005. During the

summer of 2007, the oil price jumped above $70 per barrel and even crossed to $147 per

barrel mark in July 2008 before a sharp downturn. This upsurge of oil prices produces

adverse impacts on oil-importing countries. The rise in the crude oil prices exerts adverse

effect on consumers and producers via pass-through effect on petroleum products. From

the consumer standpoint, a rise in oil prices causes energy bills to grow, whereas from the

producer standpoint, firms are subject to a rise in unit costs (Lescaroux and Mignon,

2008). Similarly,food costs have increased sharply since 2007. Prices of rice, palm oil and

wheat rose by 62 per cent, 94 per cent and 107 per cent respectivelyin the first quar ter of

2008, compared with 39 per cent for overall food prices (Jongwanich and Park, 2009). It

can be argued that higher oil prices have indirect effect on consumer prices, whereas

higher food prices have a more direct effecton inflation. This is because oil is a productive

input but food is consumed directly (Jongwanich and Park, 2011).A rise in oil prices may

cause a drop in productivity, which in turn produces adverse affects on real wages and

employment, selling price and core inflation, profits and investment as well as stock

market capitalisation (Lescaroux and Mignon, 2008). On the other hand, an increase in

food prices has a sizable impact on overallconsumer price level because food accounts for

a sizable part in the consumption basket in developing countries (Jongwanich and Park,

2011).

Theoretical and empirical studies have shown that increases in oil prices negatively

affect macroeconomic activities of oil-importing countries through the supply-side and

demand-side channels. Hamilton (1983) argued that sevenof the eight post-war recessions

in the United States were proceeded by a spike in crude oil prices. Similarly, Brown and

Yucel(2002) concluded that rising oil prices proceeded eight of the nine post–World War

Asymmetric food and oil price shocks to Pakistan macroeconomy: a structural VARanalysis 185

OPEC Energy Review June 2014© 2014 Organization of the Petroleum Exporting Countries

II economic recessions and the key role that energy plays is still subject to debate among

academia and researchers. A large body of empirical literature on oil prices is concerned

with the identification of various transmission channels through which oil prices mayhave

an impact on economic activity.One strand of literature suggests that a rise in the oil price

deteriorates terms of trade for oil-importing countries (Dohner, 1981; Husain et al., 2008).

Oil prices affect real money balances as it increases money demand, interest rates and

retard economic growth (Pierce and Enzler, 1974; Mork, 1994). Galesi and Lombadi

(2009) argues that the effects of food and oil price shocks could be disentangled in two

components: a first round effect hitting headline inflation, as oil and food prices are

included in the consumer price index (CPI); and a second-round effect passing from head-

line through core inflation. Hooker (2002) suggests that the reaction function of monetary

authorities is the main driver of second-round effects of oil price shocks; fiscal and mon-

etary policy response may not be neutral to positive oil shock and negative food price

shocks. However, oil and food price shocks havea different impact on core inflation imply-

ing that monetary authorities react differently depending on the nature of the shocks

(Galesi and Lombadi, 2009). This reveals that increases in oil and food prices generate

inflation. However, a rise in oil price has only a moderate impact on inflation, and this

could be due to a different response of monetary policy (Hamilton, 1983, 1996; Burbidge

and Harrison, 1984; LeBlanc and Chinn, 2004).

Subsequent to Hamilton’s seminal work, a large body of empirical work is devoted

to explore the relationship between oil price shock and aggregate economic perfor-

mance of various economies (for example, Burbidge and Harrison, 1984; Gisser and

Goodwin, 1986; Mork, 1989; Mork et al., 1994; Lee et al., 2001; Cologni and Manera,

2008, among others). These studies can be divided into three main categories (Tang

et al., 2010). The first category includes a number of studies that have investigated the

theoretical transmission channels through which the oil price increase may reduce

potential output and increase inflation (Rasche and Tatom, 1981; Bruno and Sachs,

1982, Darby, 1982; Barro, 1984, Burbidge and Harrison, 1984; Gisser and Goodwin,

1986; Mork, 1989; Lee et al., 1995; Hamilton, 1996; Hooker, 1996; Abel and Bernanke,

2001, Papapetrou, 2001, among others). The second category of studies carried out by

Mory (1993), Cunado and Perez de Gracia (2003), Lee et al. (2001), Lee and Ni (2002)

and Lardic and Mignon (2008) have examined the relationship between oil price and

macroeconomic activities using asymmetric or non-linear formulation for developed

countries over the period 1970s to the 1990s and concluded that economic activity

responds asymmetrically to oil price shocks. The third group of studies, inter alia, by

Huang et al. (2005), Cologni and Manera (2008) and Leduc and Sill (2004) have tar-

geted on the role of macroeconomic policies in dealing with the oil price shock. These

studies have examined the possibility of weakening relationship between oil price fluc-

tuations and macroeconomic activity.

Muhammad Arshad Khan and Ayaz Ahmed186

OPEC Energy Review June 2014 © 2014 Organization of the Petroleum Exporting Countries