The Effect of Oil Price Shocks on the Dynamic Relationship between Current Account and Exchange Rate: Evidence from D-8 Countries

Abstract

The effect of oil price shocks on global economy has been a great concern since 1970s and has instigated a great deal of research investigating macroeconomic consequences of oil price fluctuations. Later on, the instability in the Middle East and recent oil price hike confirmed the enduring significance of the issue. Though a voluminous body of literature has evolved examining the bearings of oil prices for internal sectors of economies [to name a few, e.g., Barsky and Kilian (2004); Kilian (2008a,b); Hamilton (2008)], the studies analysing the external sector response to oil price shocks are very few [see, e.g. Kilian, et al. (2007)]. The determination of current account and exchange rate—the two major indicators of external sector—has been studied widely in theoretical and empirical literature but mostly the discussion of the two variables largely remained separate [Lee and Chinn (1998)]. Similarly, investigation of simultaneous response of these two variables to an oil price shock remained relatively less ventured avenue of research. Initial work done on the relationship between current account and oil price could not ascertain conclusive link between these two variables.1 Recent work on the issue revealed the diversity of responses of current account of different countries to an oil price shock. For instance, oil price increase deteriorates current account balance of developing countries [OECD (2004); Rebucci and Spatafora (2006); Killian, et al. (2007)] but may improve it if the country happens to be a net oil-exporter. This implies that the relationship depends on the number of factors among which oil dependency of country, oil-intensity of production process2 and responses of non-oil trade balance3 and sources of oil price fluctuations4are of particular significance.