Oil price shocks, systematic monetary policy and economic activity

Abstract

This study quantifies the impact of oil price shocks and the subsequent monetary policy response on output for Pakistan. It employs a quarterly Structural Vector Auto-regression framework for the period 1993-2015. It first discovers that Hamilton's (1996) Net Oil Price Increase indicator appropriately reveals most of the oil price shocks hitting Pakistan's economy. We find that a contractionary monetary policy, resulting from the oil price shocks, contributes to significant output loss in Pakistan. After encountering the Lucas critique, the present study finds that around 42 percent of the output loss is due to the ensuing tight monetary policy. This suggests that the central bank of Pakistan can reduce the impact of oil price shocks by reducing its intervention in the market.