19

substantial statistical and theoretical evidence pointing to a relationship
between relative price changes (a change in oil prices) and the overall
inflation rate (Fischer 1982, Cukierman 1982, and Marquez and Vining 1983).
For cur purposes, what matters is that an increase in the price of oi] will
increase the inflation rate, to which government economic policies

respond?

diay — pad

dE°/dP,= (4E°/dP,)(dP,/4P,)s or
diay — ard

dE“/dP = (dE°/dP)ngs

where we capture the influence of oil prices on inflation by their effect on
the price of manufactures. If we assume a linear response of government
expenditures to changes in Pa equal to y<0, then the response of ed to

changes in Po can be represented as:

d
aY"/4P = ((y22u11- Yi2wa1) + Y22¥"Q)/det (I). (25)

The oil price multiplier allowing for changes in government
experditures can be decomposed into two terms. The first term captures the
impact of oi] prices on real income taking into account only the inter-
national transmission channels, direct and indirect. The second term
captures the direct effect of fiscal policy changes as well as the feedback
effects that fiscal policy changes have on DC's income via their impact on
OPEC and other LDC's.

With this decomposition we see that even if oil prices have a positive
impact on real income (given that the first term of equation could be

positive) a large enough restrictive fiscal policy response to an oil price


13

To determine the direction of the impact of an increase in the
price of oi] on the real income of both developed and non-OPEC developing
economies, i.e., the sign of the derivatives, we apply the "Correspondence
Principle" developed by Samuelson (1947), which allows us to use the
stability conditions of the model in determining the sign of the comparative
static results. Following Metzler (1950), the model is stable if and only
if, all the principle minors of the r matrix are positive. This implies

that the following conditions must hold:
d
Yue l- ef 4 (1-8 )¢in6 >0,
+ + + -
det (Ty) = Y11¥22- Yi2¥21>0, (20)
det (Tr) = det(T,,) >0.

Examining these stability conditions we conclude that a sufficient

condition for the model to be stable is that 1- cf

> 0, i.e., the marginal
propensity to consume should be less than one.
Limiting our attention to oil importing economies, we derive the

impact of an increase in the price of oi] on developed economies as:

+ + +
ay4/aP =( (Yooiin1-Yiziien)* Y22 (dE /dP, )) /det (7) § 0. (21)

For non-OPEC developing countries, the impact of an increase in the price of

oil on their real income is:


23

variable depending on (1) the effect that oil price changes have on income

of oi’ importing economies and (2) their counterinflationary policies.

VI. CONCLUSIONS

In this paper we have developed a three-region world model to
study the international transmission of oil price effects. We find that, in
general, the effect of oil price changes on real income of oi] importers
depends on:

-- the import price elasticities of DC's and LDC's, “ and ef,
-- the absorption capacity of OPEC, g;
-- the markup coefficient of manufactures prices on the price of
oil, TM)3
-- the response of fiscal policy to the increase in the price of
oil; and
-- the volume of international trade.

Secondly, we find that the existence of international
repercussions makes ambiguous the impact of oil price increases on the real
income of developed countries, even though these price increases reduce
unambiguously real income of non-OPEC developing countries. Finally, there
are feedback effects of oil price changes to the demand for oi] which should
be taken into account in setting the optimal price of oil. Not recognizing
these feedback effects raises the price elasticity relevant for OPEC pricing

decisions and the oil price path, neither of which is in OPEC's best

interest.


Table 1

A Theoretical Model of a Three Region World Economy

Developed Countries

vis cl cyty + Efe pt , q)
B= X8- £(Po/P_ )MG* (P/P, MO] (2)
uo= Mi (Pa/P, Yo (3)
= 18) (P, Pp o¥9) (4)
Pam *oPot *pPp (5)

Non-OPEC Developing Countries

vee e(K, Ty ; (6)
Khe ke (7)
The ig + amt (8)

= (Rt PMS - PME )/P, (9)


20

increase could offset the initial positive impact. In particular, if

% < -(y220117 Yi2¥21)/ (4 oY22) »

then the combined effect of an increase in the price of oi] and of a

restrictive fiscal policy will reduce real income of developed economies.

V. THE INTERNATIONAL TRANSMISSION OF OIL PRICE EFFECTS AND OPEC'S PRICING
POLICY

So far we have assumed that the only supplier of oi] is OPEC.
Given that a monopolist (with zero marginal cost) increases prices to the
point where the direct price elasticity equals one, it seems natural to ask
what prevents OPEC from increasing the price of oil even more. This is an
important question since empirical estimates of the (absolute value) of the
demand price elasticities are well below one and it is well known that, from
a theoretical viewpoint, it is not optimal for the monopolist of non-
renewable resources to operate on the inelastic portion of the demand
curve.

We address this question by considering the demand for oi! that

OPEC faces:

The total effect of an increase in the price of oil on D° can be decomposed
in a direct effect and an indirect, or feedback effect since oil price
changes affect real income of oil importers, and this in turn affects oil

imports:


22

Figure 1

Effects of Oil Price Changes on Oil Revenues

P,
Do
D
tooo‘
P “ B
(0) N :
N
\
‘N
aN
N\
“N
A-
a “IN
Q, Q


17

Table 3
Effects of Oil Prices on GDP of LDC's:

Summary of av* yar,

o<B<l - -



OPEC

OPEC income determination is analogous to the case. of non-OPEC
developing countries. Since OPEC: does not import oi], we focus on the
recycling of OPEC's exports earnings via the purchase of manufactures from
developed economies. We assume at this stage that OPEC recycles a constant
fraction 8 of their export revenues, as indicated by equation (11). This
type of relation was first introduced by Adams (1979) in an analysis showing
that higher oil prices are not necessarily associated with declining growth
rates in developed economies. A constant value of g implies that OPEC's
absorption capacity does not change over time. We assume here that it is
constant because (1) it simplifies the analytical derivations, and (2) we
study in section III the effects of changes in this parameter on the

analytical solutions by simply using alternative values of g.

ITI, THE INTERNATIONAL TRANSMISSION OF OIL PRICE EFFECTS

We use the model representred by equations (1 - 17) to identify
the channels through which an increase in oi] prices is internationally
transmitted to both OPEC and the oil consuming economies, as well as to
establish the direction of the effects.

We have divided the channels of oi] price effects into two types,
direct and indirect. One direct channel is the transfer of real income from
oil importing countries to OPEC. In the case of the LDC's this transfer
takes the form of reduced foreign-exchange availabilities with subsequent
indirect dynamic effects on output growth through the influence on imports
of manufactured goods and the growth of capital stock. In the case of the
DC's the direct effect is on the real balance of payments which deteriorates
with the increased cost of oi] imports in terms of manufactured goods. As

anticipated, the direct effects of oil price increases on real income are


2)

3)

Y: GDP

P: prices

I: investment

B: trade account

E: exogenous variable
X: exports

R: Resource transfers

Superscripts

gz: Non-OPEC LDC's

o: OPEC
d:. DC's
Subscripts
o: oil

p: raw materials

m: manufactures


QB _ Q
Mi= M5 (PQ/P p> y*)
OPEC

yo= F(K°)

0

k= Ko, + 1°

+1
1°= bo+ b Me
m

OL to)
Mae BPQXO/P,,

EQUILIBRIUM CONDITIONS

Notation

1) Variables

TM: = imports
K: capital
L: labor

C: consumption plus investment

(10)

(11)

(12)

(13)

(14)

(15)

(16)

(17)


18

prices but also as a result of higher prices of manufactured goods despite
the positive effect of a higher markup coefficient on income of the DC's.
For a given value of the markup coefficient, increases in the price of oil
reduce LDC's real income by less the higher is the recycling coefficient.
This is because as g increases, OPEC imports more and this represents a
stimulus to real income of DC's which is then transmitted to developing
countries in the form of more imports of raw materials.

In summary, our analysis indicates that the effects of an increase
in oil prices on an oil importing economy depend, in addition to the
economy's internal characteristics, on the volume of international trade and
the values of structural parameters such as price and income elasticities.
And as .a corollary of recognizing the international repercusions of oil
price effects, we find that an increase in the price of oil may have a
negative or positive impact on the GDP of the DCs. Marquez (1983) reaches
similar conclusions. It is important, however, to remember that no
offsetting counterinflationary policy or capacity constraints have been
assumed in the DC's so that the demand-side impacts can work out fully; we

deal with the counterinflationary policies below.

IV. COUNTERINFLATIONARY POLICIES AND THE EFFECT OF OIL PRICES ON THE
WORLD ECONOMY

The impact of an increase in the price of oi] on real income, as
represented by equations (23) and (24), is derived under the assump*:ion: that
government expenditures (E4) do not respond to changes in oil prices. In
principle, if prices are perfectly flexible, then it might not be necessary
to alter economic policies in response to a change in the price of 9i]
because an increase in oil prices will be followed by a decrease in other

prices leaving the overall inflation rate unchanged. However, there is


Non-OPEC Developing Countries

Real income of non-OPEC developing economies, y* in equation (6),
is determined from the supply side within a production function framework
with capital, red and fixed labor, Das factors. The assumption of fixed
labor may be justified since what is relevant for production decisions is
not just the number of man-hours, but the number of effective man-hours
which captures education and experience of the labor force. However,
education is a process that takes place only gradually and for our purposes
it can be left out.

The capital stock is obtained by accumulation of net investment,
which in turns depends on the amount of imports of capital goods. This
relation between net investment and imports of capital goods can be
derived by treating the aggregate capital stock as an aggregate of a
domestic component and foreign component as suggested by McKinnon (1964) and
Taylor (1979). Following their approach, we obtain equation (8).

It has been widely recognized that foreign exchange constraints
play a role in determining the growth of output of developing economies
(Chenery-Strout 1966, McKinnon 1964, Taylor 1979). In our model, foreign
exchange constraints apply to imports of manufactures, " equation (9). In
this way, if foreign exchange constraints are binding, then imports of
manufactures will be limited thus dampening capital accumulation and income
growth. We deduct oil payments from the computation of foreign exchange
resources, and assume that these countries use whatever is left over to
finance imports of manufactures- This implies that their trade account
is in balance except for external credits. Finally, oi] imports, we in

equation (10), are determined as a function of terms of trade and real

income.


24

Endnotes
This paper represents the views of the author and should not. be
interpreted as reflecting the views of the Board of Governors of The Federal

Reserve System or other members of its staff.

Equation (5) postulates a strictly proportional relation between
commodity prices and the price of manufactures. Adams (1979) has shown that
the inclusion of a constant intercept is relevant for taking capacity
constraints into consideration. However, the inclusion of a constant term
does not affect our results here because in the process of differentiation

the constant term drops out.

We also studied the case where only a fraction y of foreign
exchange resources is used to finance manufacture imports. The analyzical
solutions, equations (23) and (24), represent the limiting cases of the
general solutions as y > 1. We choose to use y=1 so as to give the LDC's

all the leverage possible to finance their growth.
A more general formulation would be:
d d d avd d
dE°/dP |= a(dE°/dP,) (dP, /dP,) + (1-a)(dE°/d¥" )(4Y°/dP,),

i.e., government policies respond to inflation and to recession (see

Marquez 1983).


International Finance Discussion Papers
Number 229

September 1983

THE INTERNATIONAL TRANSMISSION OF OIL PRICE EFFECTS

by

Jaime Marquez

NOTE: International Finance Discussion Papers are preliminary materials
circulated to stimulate discussion and critical comment. References in
publications to International Finance Niscussion Papers (other than an
acknowledgment by a writer that he has had access to unpublished material)
should be cleared with the author or authors.


nN

Analytical Solution of the Model

From the discussion of the international transmission of oi] price
effects we notice that the direction of the impact of an increase in the
price of oi] is not unambiguous. The direct and negative impacts of oil
price increases on oil importing economies may be offset by the indirect
impacts arising out the effects of oi] price changes on the world economy.
~In addition, changes in real income due to changes in oil prices affect
import activities which in turn affect real income given the simultaneous
nature of the model. To solve the model simultaneously we begin by totally
differentiating the system of equations (1) - (17). Using the equilibrium
condition that world export supply of one commodity equals the world import
demand for that commodity, we can reduce the system from a seventeen
equation system to a three differential equation system. In addition, we
adopt the (very) common practice in international trade theory, of setting

initial prices equal to 1. The resulting system of equations is:

T(y;) dy = a(w.y) dx, i,j=1,338=1,35k=1,2;
where
‘ diy 40
dy = (dY¥° ay’ dy),

d

dx = (dP, dE°).

The elements of I are:
d
ye l- te (1-844 ng > 0,
&
Y12= (1-6 gene >0,
Yi3= 0,
', did
= -f <0,
Y21 1 $y "p
Ya2= 1+ dant i >0,


10

negative.

The indirect channels of influence are through OPEC's real
recycling and increases in the export price of manufactures of DC's. An
increase in oil prices raises oil revenues of OPEC who in turn recycles a
fraction g in the form of imports of manufactures from DC's. This increased
recycling represents a stimulus to activity in the DC's--one which may or
may not be offset by the direct negative effect. In turn, this stimulus to
real activity in the DC's causes an increase in the volume of imports of
primary commodities from Non-OPEC LDC's, enlarging LDC's foreign-exchange
resources which in turn are used to purchase imports of manufactured goods
from the DC's.

The second channel of indirect effects is through changes in the
price of manufactured goods which is a markup on oil and primary-commodity
prices. An increase in the price of oil, when translated into an increase
in the price of manufactured goods, reduces the terms of trade deterioration
of the DC's. This means a reduction in the value of their imports (assuming
price inelasticity) in terms of manufactures. But it also decreases imports
of manufactured goods of both OPEC and LDC's and thus adversely affects the
GDP of the DC's. This adverse indirect effect of oil prices on DC's real
income is then fed back to OPEC in the form of lower oil imports and to non-
OPEC LDC's in the form of lower imports of raw materials; the decline in
exports of LDC's reduces foreign exchange resources beyond the reduction due
to the higher price of manufactures, and thus induces a decline i1 imports
of capital goods and capital accumulation with a dampening effect on output

growth.


on consumption and investment, c4cy4), both in terms of manufactures, depend
on the level of real GDP, yi The term ed represents exogenous variables
such as government expenditures. The balance of payments, Bt equation (2),
equals the trade account since the only type of capital movements we
recognize are those that compensate for the flow of goods. Notice also that
the trade balance is expressed in terms of manufactures (hy deflation by the
price of manufactures). This is an important consideration because it means
that: the model recognizes the terms-of-trade effect of changes in oi] prices
since oil imports are valued in terms of the exports of manufactured goods
that: would be required to pay for them.

On the export side, we have exports of manufactures to both OPEC
and non-OPEC LDC's depending on the terms of trade and export revenues for
these two blocks of countries. On the import side we assume that both oi
imports, Wi in equation (3), and raw materials imports, os in equation (4),
depend on terms of trade and real income.

The price of manufactures, equation (5), is assumed to be a linear
function of the prices of raw materials and oil: This is a simplification
of a more realistic formulation in which the price of manufactures depends,
in addition to the variables just mentioned, on the price of labor and
excass capacity utilization. Our formulation can be derived from a
production function with constant returns to scale while assuming zero

profits.


21

to) dd & 2
aD" /dPy= [ My eg (1-5) + Mp eG] +

°
1
dd & Ty] 0
+(45N6 #69) u ~ a1} '
-1 21 22 d
Tali 1 31 3) dE“ /dP

where the first term represents the direct effect of oil price changes, and
the second term represents the indirect, or income feedback effect. In
figure 1 we show the feedback effect of an increase in the price of oi] on
o° assuming that ef = om = 0, and that the initial price-quantity
comb‘ nation is given by point A. An increase in the price of oi] from PO to
Po increases oi] revenues of OPEC by the area ABP APS as long as the demand
funct:ion D° remains stable. But as we have seen, the increase in the price
of o°1 may reduce real income of oi] importers (especially if followed by
counterinflationary policies) shifting the demand for oil leftward to D'.
As a result, we find that the decision to increase oi] prices might lead to
a loss of oil revenues, which clearly is suboptimal. This is because what
matters for optimal price determination is the total effect of oil price
changes on the demand for oil. And thus, even if there is no direct effect
of oil prices on oi] demand, there is an income feedback effect, which
increases the price elasticity relevant for OPEC pricing decisions and
therefore explains why it is that oil prices do not increase in the face of
estimated demand price inelasticities.

Finally, we notice that as a consequence of the existence of
income feedback effects, the price elasticity relevant for OPEC's pricing

strategies is no longer a constant parameter but rather is an endogenous


-- the developed economies, whose GDP is determined from the demand
side while the influence of supply enters through price
determination;

-- the OPEC countries, who recycle their oi] revenue by purchasing
manufactured goods from the developed economies, with no imports
from the non-OPEC developing economies; and

-- the non-OPEC developing economies, whose output is determined from
the supply side using a production function approach.

The internationally traded goods we consider are:

-- oi], exported by OPEC to both developed and non-OPEC developing
economies ;

-- raw materials, exported by non-OPEC developing economies to
developed economies; and

-- manufactures, exported by developed to both OPEC and non-OPEC
developing economies.

We consider three prices for the internationally traded goods:

-- the export price of manufactures of developed economies, which we
determine endogenously,

-- the export price of raw materials, exogenously given: and

-- the price of oil.

Table 1 contains the specification of our theoretical model where
we see the differences in structure for each block of countries as well as
the main trade relations. We now proceed with a more detailed explanation

of this model.

Developed Economies
As mentioned earlier, real income (in terms of manufactures) is

determined from the demand side as in equation (1). We assume that spending


14
2 + + - + - C <
dy" /aP (=((Ya1iiai- Y21811) - Y2i (de /dP,))/det(T) 50. (22)

Assuming no fiscal policy response to the change in oi] prices and price

inelasticity, we find that
d _ tos + + / <
ay°/dP o> (yaawii- Yigwei)/det(r) 50» (23)

te oe
dy" /aP = (yy 10217 Yai) /det(r) < 0. (24)

The signs for av9/dP, may be ambiguous even in this simple model
because the direct effect of an increase in the price of oil, the transfer
of real income to OPEC, could be offset by the indirect effects of increases
in the price of manufactures and the recycling activities of OPEC. This
clearly suggests that the direction of the impact of an increase in the
price of oi] on the real income of DC's depends on the volume of trade, i.e.
the openness of the various economies and on the parameters My? Bs nye and
el.

J

In Table 2 we present the signs for av4/4P, for alternative values
of TN and g assuming price inelasticity. The results in Table 2 are
consistent with the results of previous models and with what one might
expect intuitively, i.e., if there is no markup in oil prices and the value
of the recycling coefficient is less than one, then an increase in oi]
prices results in a net transfer of real income to OPEC and therfore has
negative impact on DC's real income. Moreover, the effect of oil price
increases on real income is zero if the initial transfer to OPEC is recycled
back to DC's, i.e. if B=1. However, as soon as the markup takes positive

values, the impact of an oil price increase on the GDP of the DC's may be

positive


16

or negative given that an increase in TT reduces both exports of
manufactures and the value of imports in terms of manufactures. In other
words, the sign (a(av"/aP ,)/an,) = 0(8) is not unambigous, although we find
that 0(1)<0. That is, if OPEC recycles all their export revenues, then an
increase in the markup of oil prices reduces real income of developed
economies, i.e., oil price increases have a stagflationary effect.

For any 1 >0, we conjecture that the larger the recycling
coefficient, 6, the less negative (or more positive) is the impact of an oil
price increase on the income of the DC's. The positive impacts may appear
on the surface to be counterintuitive. However, recall that the
ambiguity of the sign of the oil price multiplier of the GDP of the DC's is
due to mutually offsetting effects arising from the multiple channels of
transmission. In particular, the increase in Po initially worsens the trade
account of the DC's and thus their GDP. However, OPEC imports more
manufactured goods at a higher price and thus it may offset the original
income deterioration.

In contrast to the case of developed economies, the impact of oil
price increases on the GDP of non-OPEC developing countries is unequivocally
negative. As Table 3 suggest, this result holds for all values of # and
T, between zero and one. Furthermore, as the value of the indexing
parameter un increases, the effect of an oil-price increase on the GDP of

the LDC's decreases, i.e., becomes more negative:
sign (a(ay*/aP, )/an, ) <0 for 8 e [0,1].

This result is reasonable since the available foreign exchange

resources of the LNC's have been reduced not only through the higher oi]


is important in determining oil price strategies since oil price changes
affect real income of the world economy, and thus OPEC's oil exports.
Furthermore, as we will see below, these income feedback effects may offer
an explanation to the question of why oil prices have not increased even
more despite the overwhelming empirical evidence pointing to oi] demand
price inelasticity.

Our purpose in this paper is to formulate a theoretical model of
the world economy to highlight the channels by which the effects of an
increase in the price of oi] are internationally transmitted to the GDP of
the developed countries (DC's), OPEC, and the non oi] exporting less
developed countries (LDC's). The orientation of the paper is primarily
short run. There are not so far, any allowances for the long run adjustment
of oi] consumption and supply from alternative energy sources in response to
price increases.

We start our analysis in section II, where we present a
theoretical model aimed at capturing these feedback effects of oil price
changes. This model is solved analytically and the comparative statics of
an increase in the price of oil are derived in section III. We examine, in
section IV, the influence of policy responses to oil price changes on income
and oil trade. In section V we analyze the effects that oil price changes
have on the demand for oil faced by OPEC, taking into account the income
effects arising out of a relative price change. Finally, section VI

contains our conclusions.

II. A THEORETICAL MODEL OF OIL PRICE EFFECTS
The model we use here differs from those developed in the
literature in that we consider three blocks of countries whose analytical

structures are different from each other:


25
REFERENCES

Adams, F. G. (1979). "Must High Commodity 2rices Depress The World Economy?

An Application of a World Model System." Journal of Policy
Modeling. Vol. 1, No.2: 201-215.

Bruno, M., and J. Sachs (1979). “Macroeconomic Adjustments with Import
Price Shocks: Real and Monetary Aspects." The Maurice Falk
Institute for Research in Economics. Discussion Paper 793,
Jerusalem, Israel.

Chenery, H. and A. Strout (1966). "Foreign Assistance and Economic Develop-
ment." American Economic Review. Vol. 56, No.4: 679-733.

Cukierman, A. (1982). "Relative Price Variadility and Inflation. A Survey
and Further Results." Paper prepared for the November 1982
Carnegie-Rochester Conference on Public Policy.

Findlay, R., and C. A. Rodriguez (1977). "Intermediate Imports and Macro-
economic Policy under Flexible Exchange Rates." Canadiaa Journal
of Economics. Vol. 10, No.2: 208-217.

Fischer, S. (1981). "Relative Shocks, Relative Price Variability, and
Inflation." Brookings Papers on Economic Activity. No. 2: 381-
441.

Marquez, J. (1983). “The International Transmission of Oi] Price Effects
and the Derivation of Optimal Oil Prices." Ph.D. dissertation,
University of Pennsylvania, °hiladelphia.

Marquez, J. and D. Vining (1983). “Inflation and Relative Price Behavior:
A Survey of the Literature" in M. Ballabon Economic Perspectives
Vol. 3: 1-56. Hardwood Academic Publishers, New York Forth
coming).

McKinnon, Re (1964). "Foreign Exchange Constraints in Economic Development

and Effictent Aid Allocation." Economic Journal. Vol. 74,
No.294: 387-409.

Metzler, L. (1950). "A Multiple-Region Theory of Income and Trade."
Econometrica. Vol. 18, No.4: 329-354,

Samuelson, P. (1947). Foundations of Economic Analysis. Cambridge:
Harvard University Press.

Schmid, M. (1976). "A Model of Trade in Money, Goods, and Factors."
Journal of International Economics. Vol. 6, No.4: 347-362.

Solow, R. (1980). “What to Do (Macroeconomically) When OPEC Comes?" In
S. Fischer (ed.) Rational Expectations and Economic Policy.
Chicago: National Bureau of Economic Reserach.

Taylor, L. (1979). Macro Models for Developing Countries. New York:
McGraw-HilT.



The International Transmission of Oil Price Effects
Jaime Marquez*
International Finance Division
Board of Governors of The Federal Reserve System
September 1983

I. INTRODUCTION

That increases in oil prices (and/or in the prices of other
primary commodities) can upset the world economy has been amply demonstrated
in the last ten years. What is not so clearly apparent, however, are the
dimensions of the effects and the complex channels of interaction by which
they operate.

Interest in modeling the channels through which disturbances are
internationally distributed is by no means new. Indeed, starting with
Metzler (1950), a vast literature has emerged in an attempt to model these
channels of transmission. More recently, large oil price changes have led
to modeling approaches with more emphasis on the role of relative price
changes (Schmid 1976, Findlay and Rodriguez 1977, Bruno and Sachs 1979,
Solow 1980). Greatly simplified, the purpose of these models is to
determine how oi] price changes affect real income, prices, and employment
in a small open oi] importing economy, and how these oil price effects may
change as a result of monetary policy responses and wage indexation.
However, one important limitation of these models is their partial
equilibrium nature, i.e., there is no recognition for the fact that the
effects of oil price changes on the domestic economy depend on how these
price changes affect in turn the rest of the world economy.

Recognition of the international repercussions of relative price
changes is important given that economic activity in different regions are
linxed through international trade. From the standpoint of oi] importing
economies, an increased recycling of OPEC's revenues through greater
imports reduces the income transfer that arises out of higher oil prices.

Fron OPEC's viewpoint, the international transmission of oi] price effects


12

237 0,

,
¥a1= F bs end «<0,

- 2
Y327.-F DB dng <0,
¥33° 1.
The elements of 9 are:
2 d d <

wyr= Ray (1-B)(ME(1te8= 4, )4M6 (1te5)(1-4,)) 5 05
wi2= 1,

- d d 2 2 <
w= -F i(Rmy + Ma (1+ ep Jay + MG(Iteg - t)) 5 9
w22= 9,

d d 2 L <

w3)= F'bp(M, (Ite, y+ My (te Q- 1) > %

w32= 0,
where the following notation has been used:
i

9;

_ wi j iL i i i iL i i
SMG VT, mhz (1/65) (2M5/ aY" Js ©5= (P5/M5)(IN5/9P 5)»

Fiz aF/ak, f'= af/aK® > for i = d,o,2 and j = p,o,m.

Partitioning © as:

iy Y) O'= (00), Mae (145) i=1,2;j=1,2,
re eee ceceeeee > with
1

u
Tar: Tair (¥31 Y32)>

we obtain the impact of an increase in the price of oil on real income for

each of the regions as:

1o

Ti. O11 1 dP

dy = a 21 922 . (19)
Tal, 1 3, 32 dE


6

Table 2
Effects of Oil Prices on GDP of DC's:

Summary of ay4yaP,

8B T
(0) O<m<il 1
0 - - or + - or +

9<BpB <1 - - or + - or +