19

Table 3
Main Behavioral Relations in
Global Econometric Model

Developed Economies

d

_ gpd yd
ch = FRY YY Peon) (27)
19 = #(y4, rd) (28)
d_ dd
wo f(PL/ Po, YS) (29)
de
AnH, =FCORP, ABP). ARPS a ata) (30)
ey4= F(LJEK,E(0,C)I) (31)
do d
Of = F(P,. Pos Pye Pes GY") (32)
ad = of 08 (33)
ad _ a 2g d
6 = A - x(Py/ Pes YS) (34)
yf ad , of
Mo =C PPS CME + REY (35)
OPEC
O_ Diy, yh
Mi= #(PQ/ PO(MO+ Me) ) (36)
Non-OPEC Developing Countries
ay*= #(k* 0*) (37)
L_ grok 2 2, od
IY = F(PE/ Py, Ys Res PS) (38)
QL & 2 d
me = (1%, REY pA) (39)
2 erpdy pe yd
xh = (PCy Pt, y%) (40)
of = F( Pep, ay") (41)

m= of 084 + v (42)


40

iywenweweus re

uee
ate

ura RL th OL

A Wewwereueurenwnceree. 7

UVAA UaAd SLAVE AO “LUT

d4d0 AO SLUOdXA ‘HO

Zt eunby

rs

Ons UXO


36

re
@

mit
8h o wu 4 be

eseg

Savriod "S01 40 “THE

$,90 JO AWOONI ‘Wal

g aunBbLy

veaneppeee! vee Paweyeenes Cerees J. n 1

E e0Se

- 9892

fF e0L2e

eese

F 0e62

ewes roomy


45

eo rai)

SPvewe renee |

Wt

on Gh uA Ah 4 St ne el

eee ee eee LLL Le REL eetn eee eT eT ey ROW Tee CeOS TO eTOUCSS FOUN OOTINTT

SuvTiOg ‘Sn 40 “TH

S Od 40 GYWOONI ‘Iva

F eene

- 8S2

f e092

- 0022

- 0862

f e062

- O88E

ewes —tocorw


13

results in a net transfer of real income to OPEC and therefore has a
negative impact on DC's real income. However, oil price increases do not
affect DC's real income if the initial transfer to OPEC is recycled hack to
DC's, i.e., if B=l. If the markup is greater than zero, then the impact of
an oil price increase on the GDP of the NC's may he positive or negative
given that an increase in 1% reduces both exports of manufactures and the
value of imports in terms of manufactures. Even though the
sign(a(dY*/dP..)/an,) = 0(8) is ambiguous in general, we find that o(1)<n.
That is, if OPEC recycles all their export revenues, then an increase in the
markup of oi] prices reduces real income of developed economies implying
that oil price increases are stagflationary.

Positive impacts of oil price increases may appear on the surface
to be counterintuitive. This possibility arises, nevertheless, because the
direct effects of oi] price increases may be offset by the indirect effects
arising from the multiple channels of transmission. In particular, the
increase in Po initially worsens the NC's trade account 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 negative for
all values of g and 1 between zero and one. Furthermore, there is an
inverse relationship between the indexing parameter 1% and the effect of an

oil-price increase on y*:
sign (a(dv*/aP,)/an, ) <0 for 6 © [0,11.

This result is reasonable since the available foreign exchange
resources of the LNC's are reduced not only by the higher oi] prices, but

also by the corresponding increase in the price of manufactured goods. For


73

Total Imoorts

a a £ & 4a a
= + ‘i
M No Xo + Rn + ne + Mexo

Inflation Rate of Manufactured Gooas

4% P = 0.9741 + 0.0904 4% P
mt (0,3) (1.5) Otel
+ 0.327 48. Po + 0.349 AS P., - 6.162 U
(0.85) ae (3.02) rt (20,2) +

R2 = 0.47 D.w. = 1.095 S.S.E. = 4.66

Period of estimation: 1960-1979

Value Added

Growth Rate of Domestic Product

As yd = (in (x?) - in (v9) oy) 100

Gross Domestic Product



55

mit
€A en in en Gh 7 tA u

PTET eeS Peer ieee Preerenrnen Prervreend PYUrrreeed (ttt ier trerererrs srrr ier eret oo rocoto,

UVAA NAG STAMNVE AO “Tut

§ 9d 40 NOLLdUWASNOD ‘ILO

22 aanBL4

SL

hh

eh

- ence!

- 00021

- O@0ES

f e0est

Ons COZMstar—oz


53

€8 en i) oo BL el ub ot

POGUUNNEEEN PONTURTTET teverenent SrCooroc tak SppeeyeN PrUNTepres fyyeereere Kewwerrrcs foe ory

a

suvriod ‘s'A 40 “rd

Sod 0 AWOONIT Tall

Oz eunbiy

pene nan ee

- e@he

f eese

f e092

f eece

f e082

fF e062

f @0e€

E ote

auc —zoorw


59

Figure 21). This is because, the increase in capital transfers enlarges
foreign exchange reserves enabling a 16 percent average increase in the
amourts of capital goods imports, which increases capital formation and,
therefore, output growth.

Increases in real income of LNC's, together with their positive
impact on DC's real income, stimulate oil demand and OPEC's oi] exports.
This increase in OPEC's oi] exports represents a rightward shift of their
export demand schedule which reduces (in absolute value) the total oil price
elasticity from 2.7 for Case II to 1.3 for this case. Nevertheless, OPEC's
exports are below the baseline solution by an annual average of 10 percent
with a total price elasticity greater than one which implies that increases

in oil prices will result in losses of oi] export revenues.

VI. CONCLUSIONS

In this paper we have developed a three-region world model to
study the channels through which oil price changes are internationally
transmitted. The direct channel of transmission is the transfer of real
income from oil importers to OPEC. This direct, and adverse, effect of oi]
price increases may be offset hy the indirect effects, which arise only in a
multicountry setting. These indirect effects operate through both OPFC's
recycling and markups in oi] prices. The relative importance of these
international transmission channels depends on the values of certain key
parameters such as:

-- the (ceteris paribus) import price elasticities of NC's and LDC's,
i and et,

-- the absorption capacity of OPEC, 8;

-- the markup coefficient of manufactures prices on the price of


63

dé4/dP 4= a(dE4/dP,,) (dP_/4Po) + (1-a) (dE4/av4) (dv4/aP,),

i.e., government policies respond to inflation and to recession (see
Marquez 1983).
9 These conclusions also extend to the dynamic case where oi] is
considered as a non-renewable resource (see Marquez 1983).
1
° This suggests that the price elasticity relevant for OPEC's
pricing strategies is no longer a constant parameter but rather is an
endogenous variable as pointed out by Stiglitz (1976); see also Marquez
(1983).
ll

The model is stable if a sustained change in one of the exogenous
variables induces a change in the endogenous variables such that this change
does not explode as time passes (Klein 1983).
12

For the period 1973-1979 we use actual values of the exogenous
variables, but for the period 1980-1983 we employ the assumptions used in
the LINK meetings of September 1982 and March 1983.
13

Sachs (1982), Blinder (1979), Lehment (1982), Shigera (1982),
Vangrevelinger (1982).
14

We notice that the reduction in exports of raw materials is of
smaller magnitude than the reduction in exports of manufactures. This
result can be explained in terms of the differences in income elasticities
for these two types of exports. As we recall, exports of manufactures are
income elastic whereas exports of raw materials are income elastic, which
then implies that exports of manufactures will fall more than raw materials
exports after a decline in DC's real income.
8 This can be readily seen by the increase in the real income
multipliers from -7 percent in 1983, for Case II, to -0.8 percent for Case
Ill.


51

fiscal policy on real income of LNC's, since the path for ye is still below
the baseline case by 0.05 percent in 1973, 1 percent in 1978 and 1.45
percent in 1983 with an annual average reduction of 1.9 percent (Figure 15).
The increase in OPEC's recycling also has a feedback effect on
NC's of] consumption and thus on OPEC's oi] exports. In particular, oi]
exports of OPEC are now below the baseline case by an annual average of 7.9
percent, in contrast to an average reduction of 15 percent in Case II
(Figure 18). Obviously, the smaller reduction in oi] exports of OPEC helps

to finance part of the increase in imports of manufactures.

Case IV: Increased Lending to Non-OPEC Developing Economies

Another way of offsetting the burden that higher oi] prices have
on Non-OPEC developing countries is through an increase in the level of
capital transfers by OPEC to these countries. We assume that OPEC transfers
to these countries an amount equal to 50 percent of the net capital
transfers of that year, in each year, from 1974-1983. This implies a
nominal transfer of US$ 18 billions in 1974, and an annual average nominal
transfer of US$ 24 billions. Table 7 contains the results for Case IV which
are also shown in Figures 20 to 25.

Figure 20 shows that the increased lending to Non-OPEC LNC's by
OPEC cloes not offset the impacts of higher oil prices and
counterinflationary policies on NC's real income, although it does
represents an improvement over Case II.

The main beneficiary of this financial transfer is the group of
Non-OPEC developing countries. Even though income of LNC's is below the
baseline case for 1973 and 1974, we find that the positive effect on real

income increases from 0.004 percent in 1975 to 19 percent in 1983 (see


23

[mports of manufactures, wt in equation (39), are derived using the
fact that the capital stock is an aggregate between the domestic capital
stock and the foreign capital stock with a non-zero elasticity of
substitution. Following Marquez (1982), we obtain imports of
manufactures as a function of net investment, , and foreign exchange
reserves. Our results point to an elasticity of imports of manufactures
with respect to investment of 0.8 and an elasticity with respect to
(real! foreign exchange reserves in excess of one.

Exports of manufactures to DC's, xt in equation (40), depend on (i)
the export price of manufactures of DC's relative to the export price of
manufactures of LDC's, pa / pt and (ii) the real GDP of DC's. Oi1
consumption, o* in equation (41), is modeled as a conditional demand
function derived from the production function (equation 37) and thus
depends on relative factor prices and gross output ey*. Using the
identity between world consumption (in barrels) and world oi] production
(in barrels), we derive imports of oi] from OPEC, a s(in barrels) as the
difference between LDC's oi1 demand and (exogenously given) oi] supply,
oo * plus exports of oi] of LDC's to DC's. Finally we link oi] imports
in barrels to oi] imports in real value following the same steps as in

equation (35) for DC's.

III.2 Dynamic Simulations of Oil Price Shocks

Our purpose here is to study the quantitative dimensions of oi]
price effects with model simulations using the estimated econometric model.
The period for simulation is from 1973 to 1983, a total of eleven years

ll
which allows us to determine whether the model is dynamically stable. We


41

mit

a. a

eeaene RUSEENayen Ceewes

Suvriod "8'N 40 “Tit

OAd0 JO SANNLOVAANVW JO SLUOdWI Tau

ECZDUCoRsaw —racaH


72

Consumption Price beflator

a = 5
in P 1.596 + 6.1008(0.75 InPo.t 0.25 InP, ees)

con,t (41.4) (4-98)

+ 0.557 1nPe,
(11.72)

Re= 0.99 O.W. = 2-27

S.S.E. = 0.0242 Rho = 0.217

Period of estimation: 1960-1977

Poon, °*P (1nP oon, t?

Value Added Price Deflator

a a a
= -0. +1. . - 0.
In Pye 03°32 19005 InP att v.2853 inP 0.05 InPy,

"R22 0.99 DW. = 2.028 S.S.E. = 0.000043

Period of estimation: 1960-1977

d

Py = exp(1nP..)

Total Exports

abo ee

m exo.


4
Table 1

A Theoretical Model of a Three Region World Economy

Developed Countries

vs chy’) + gts 34
aL yd

Be x [(e/P oma + (P pom oe ]
did

Mos Mi(Po/P a> x4 )

ws we, IP iY ay
P

PeaP+ mt ?P
m o0 pp

Non-OPEC Developing Countries

y= e(r®, £*)
we y+ ot
ts ig + in*
m
Q_ d_ g
(R+ PM, POM /P
g &

w= CP /P,, Yy")

OPEC

y= F(R°)
exp +P
1°= bot b M°
nm

OL °o
Mi BPX /P,

EQUILIBRIUM CONDITIONS

xt = M+ ft
ran

Wt 0 ro
la oe =}

(1)
(2)
(3)
(4)
(5)

(6)
7)
(8)
(9)

(10)

(11)
(12)
(13)

(14)

(15)
(16)

(17)

Notation
1) Variables
M: imports
K: capital
L: labor
C: consumption plus investment
Y: GDP
P: prices
I: investment
B: trade account
E: exogenous variable
X: exports
R: Resource transfers
2) Superscripts
2: Non-OPEC LDC's
0: OPEC
d: DC's
3) Subscripts
o: oil
p: raw materials
m: manufactures.


75

Ili. LESS DEVELOPED ECOWOMIES

Gross Output

in cy* = -0.829817 + 1.00092 1n 2%

(-1.626) (8.9637)
R? = 0.8545 D.w. = 0.8343

S.S.E. = 0.0129048 Rho = 6.882091

ae = [(1-4)(K*) + (ote) Py -P

6 = 0.01 p = 0.360434
cy* = exp(in cy*)

Demand for Oil, Barrels

in of'* = (-0.140789 + 0.10951 {1n (Gy*)
(-0 1869) (115472)

7. 4 (dcby

p
(1 + ( $

+ 1og(o* (Py/Pey ety) Py)

+ 0.954486 log(o*"*) 1)
(17.48)

R“ = 0.956 D.W. = 2.389 S.S.E. = 0.0658495

ep = 0.3604 ¢ = 0.01 o = 0.7351

ot d,&

= exp(ln G )


74

Il. OPEC

Imports of Manufactures

Po a 2
in (=) (Ng, +h . = 2.986

in MO =
m oft-i (29.7)

i

v

0 1

Wow

m

Vo = 0.3058 ( 5.91) y.

0.2732 (10.42)

Zz
V1 = 0.3613 (11.63) ¥, = 0.0416 ( 1.07)
R2 = 0.998 O.W. = 2.467 S.S.B. = 0.00108

Perioa of estimation: 1965-1977
ne = exp(ln ne)

Total Imports of OFEC, Real Terms

no = +
y Mn Mexo .

Total. Exports of Oil, Barrels



77

Net. Investment

Imports of Manufactures

n 2 tod é 2
Mi = 72.25458 + 0.536848 I w, (RPO) ey t I e; SY
(-1.96) (3.67) i=l i=0

R2

0.987 OW.

2.444 S.S.E. = 1.0163

0.02052 oy = 0.02737 on 0.02052;
(7.192) (7.192) (7.192)

$9 + oy + oo 0.068414

#) = 6.3 85 = 0.7

Nalue Added


34

decline in of] revenues. This decline in revenues results in a reduction of
OPEC's imports of manufactures of 0.25 percent in 1979, after an average
increase of 2.1 percent above the baseline solution for the previous six
years (Figure 7). Although OPEC's real income is not determined in our
empirical model, a reduction in imports of manufactures slows the
development process in OPEC. This suggests that a sustained 10 percent
increase of of] prices over the base solution may not be in OPEC's best long
run interest.

Case II: Higher Oil Prices and Restrictive Fiscal Policy Response

One of the consequences of an increase in the price of oi] is an
increase in the inflation rate in of] importing countries. The response of
economic policies in developed economies to the inflation generated by the
two oi] price shocks has been, in general, restrictive’ "Gee, ys0). For
this reason we investigate the impacts of a reduction in real government
spending on real income, prices, and international trade. In particular, we
reduce real government expenditure by US$ 8 billions (approximately two
percent of real government expenditures) from 1974 to 1983 as a response to
the 10 percent increase in the price of oil. The delayed response of fiscal
policy may be justified on the basis that the budget appropriation process
operates with a lag of a year. Table 5 contains the dynamic multipliers for
Case II; Figures 8 to 13 contrast the results of the base solution to the
present case.

The reduction in government expenditures adversely affects real
income of developed economies in the first year beyond the recessionary
effects of oil price increases without much success in reducing the price
level. The combined effects of higher oi] prices and restrictive fiscal
policies result in a real income path for NC's below the baseline case by

1.4 percent in 1974, 3 percent in 1977, and 7 percent in 1983, with an


20

Developed Economies

Consumption, cf in equation (27), depends on a distributed
lag of nominal value added " yt deflated by the consumption price index
ron 3 the short run mpc is 0.47 and the long run income elasticity is
one. Investment, 14 in equation (28), is a function of a distributed lag of
real income as well as the long term nominal interest rate rt, the short run
mpi is 0.13 and the long run elasticity with respect to income is 1.18; the
long run elasticity with respect to the interest rate is -0.20.

Imports of raw materials from Non-OPEC developing countries, wi in
equation (29), are a function of (i) present and past values of the price of

raw materials, Pie relative to the export price of manufactures of NC's, pa,

and (ii) real income of DC's yt; the long run relative price elasticity is -
0.69 and the long run income elasticity is 0.63.
The inflation rate of the export price of manufactures, axe in

equation (30), depends on (i) the rate of change of wages, A%P., with a

v
coefficient of 9.3266; (ii) the inflation rate of oi] prices, a4 > lagged
one period with a coefficient of 0.09; (iii) the inflation rate of the price
of raw materials with a coefficient of 0.34; and (iv) a measure of capacity
of utilization, U, obtained as the difference between potential output and
actual output.

Potential output, Y*, is estimated as a trend of actual output but
we split the period of estimation in two subperiods: 1960-1972 and 1973-
1979. The estimated growth rate for potential output for the period

prior to 1973 is 4.7% and for the period after 1972 is 2.9%.

The demand for oil, of in equation (32), (in barrels) is derived as a


26

Table 4

Dynamic Multipliers: Case I

a L d-d dyt ad <8

x x Oo ° aS nt
ITS =. 50 05 CTE C2 OB DDI
1974 =.59 se) 4.33 16410-6623 6.71
1975. -.76 020-423-5462 - 2.04 8.29 -8. 91
1976 -.93 -.44 -6.37 -2.67 -8.99 -9.65
1977 -1.16 9«--.71 6.62 --3.30 --9.24 = -9.95
1978 -1.37. -.99 --6.88 «=0-3.95 -9.55 -10.30
1979 -1.58 -1.26 -7.14 -4.60 -9.91 -10.70
1980 -1.81 -1.49 -7.41 -5.26 -10.88 -11.79
1981 -2.12 -1.69«--7.74 «5.92 --12.88 -14.18
1982 -2.52 -1.80 -8.16 -6.59 -15.08 -17.09
1983 -2.91 -1.83 -8.63 -7.25 -16.18 -18.80

cy a t L ° L

x nS Me xt no we
1973 -2.08=2.01 1-30 -.76 236-02
1974 --5.86 «=-6.08 + -2.39 -1.75 3.84 -.24
1975 -8.01 -8.04 -3.86 -2.51 3.77 -1.13
1976 8.93 -8.80 -4.96 2.58 1.88 -2.30
1977. -9.63 -9.09 -6.85 ~-2.83 669 -- 2.33
1978 -10.05 -9.43 -7.74 -3.03 .ll -1.83
1979 -10.57 -9.80 -8.75 -3.29 -.25 -1.40
1980 -11.87 -10.61 -10.70 -4.20  -.71 -1.28
1981 -14.48 -12.17 -13.39 -5.65 -1.65 -1.03
1982 -17.32 -13.99 -15.48 -6.51 -3.08 -.39
1983 -18.71 -15.26 -16.19 -6.59 -4.53 .18

xt ud re rt pd pa pd

m p m m Y
TS73-1.34 2 EEO Ta
1974 -1.58 -.27 -5.44 -6.18 1.24 94
1975. -1.49--.23. 7.38 0-801 1.23 1.02
1976 -2.02 -.21 -4.88 -5.41 1.08 1.05
1977 --2.70 0 --.31) 2.55 =2.94 87 1.08
1978 -3.36 0-655-113-1134 47 1.08
1979 -4.03 --.80 +19 1210-205 1.09
1980 -4.78 1.09 3.94 4.24 -.77 1.09
1981 -5.76 -1.45 9.12 9.74 -1.69 1.05
1982 -6.99 -1.89 14.12 15.17 2.90 195
1983 -8.18  -2.36 8.95 10.37 4.34 .78



22
imports in real terms as in equation (35).

OPEC

OPEC's real income is not determined in our empirical formulation.
Instead, we analyze their the absorption capacity. For this we explain
their imports of manufactures, wt in equation (36), as a function of a
distributed lag of oi]1 revenues deflated by the export price of manufactures
of NC's. The absorption elasticity in the first year is 0.31, 0.36 in the
second year, and 0.04 after four years. The long run absorption elasticity

is 0.98.

Non-OPEC Developing Countries

To determine gross output (value added plus oi] imports in real
terms), ay* in equation (37), we use a two level nested CES production
function with capital, K, and oi] consumption, 0, as arguments. The
parameters of this function are estimated in two steps by using the first
order conditions for cost minimization and the production function
itself. The short run elasticity of substitution between oi] and capital is
0.05 and the long run elasticity is 0.73.

Following Coen (1971), we determine capital formation, 1° in
equation (38), as a function of the rental price of capital, Pe relative
to the price of oi], and on gross output. In addition, we allow the
speed of adjustment of capital formation to depend on the availability of
foreign exchange resources in real terms, R*y ot « We find an inelastic
response of investment with respect to changes in both income and
relative prices. However, we find investment to be quite responsive to

changes in foreign exchange reserves (an elasticity in excess of one).


35

Table 5
Dynamic Multipliers: Case II

d 2. d,d d,k od ot

XY Y 10) fe) Mo Mo

1973 -.51 -.05 -1.42 -.74 2.08 -2.21
1974 -1.36 -.ll -4.83 -1.41 6.94 -7.40
1975 71.95 -.23 -6.67 -2.04 9.83 -10.42
1976 -2.44 -.48 -7.91 -2.69 -11.14 -11.80
1977 -3.01 -.83 -8.62 -3.37  -12.04 -12.74
1978 -3.54 71.26 -9.30 4.10 -12.91 -13.66
1979 -4.07 -1.72 -9.97 -4.87 -13.84 -14.65
1980 -4.66 -2.21 -10.67 -5.69 -15.65 -16.59
19810-5439 --2.70 -11.47 -6.57 -19.U9 -20.49
1982 -6.35 9 -3.15 -12.48 -7.51 -23.05 -25.39
1983 --7.24  «--3.54 -13.56 -8.50 -25.42 -28.62
go d L £ ° L

xX Mo Mo X Lae Mn

1973 -2.08 -2.01 -1.30 -.76 2.36 -.02
1974 6.49 -6.70 3-2.76. 3-2.49 3.65 -.24
1975 -9.39 -9.40 -4.63 -3.90 3.15 ~1.28
1976 -10.94 -10.77 -6.14 -4.48 274 "2.95
1977) -12.30 -11.64 -8.63 -5.17 294 -3.43
1978 -13.26 -12.51 -9.88 -5.79 -1.91 -3.38
1979 -14.34 -13.41 -11.34 -6.47 2.58 -3.48
1980 -16.48 -14.92 -14.04 -7.99 -3.34 -3.87
1981 -20.48 -17.58 -17.78 -10.31 -4.75 -3.79
1982 -25.06 -20.80 -21.02 -12.04 -6.93 -3.22
1983) -27.74 -23.23 =-22.60 -12.68 -9.21 -2.84
£ d £ Ld d d

x Mo R R’/PD PL Py

T973" -1.34 -.320° -1.54  =1.54 200 732
1974 --3.62 -.76 -6.97 -7.69 1.24 94
1975 -4.61 -.99 -10.96 -11.46 1.01 98
1976 -6.05 -1.24 “9.94 -10.17 249 095
1977 -7.69 71.65 -10.72 -10.60 -.30 88
1978 -9.30 -2.23 -13.56 -13.01 -1.41 76
1979 -10.93 72.87 3-12.43 -11.36 2.96 59
1980 -12.73 -3.60 -7.62 -5.87 -5.08 235
1981 -14.92 4.48 -3.53 -.96 -7.64 -.01
1982 -17.64 -5.56 -.87 2.63 -10.91 -.47
1983 -20.19 -6.65 -5.54 -1.26 -14.63 -1.06



Pp
fa)

17

Figure

1

Effects of Oil Price Chanues on Oil Revenues

Dd,

Do

D
N\

\ B
~

‘“

\
\
N
\

A
\
Q, Q.


76

Rental Price of Capital

4
2 _ oa Pa
Pet Pmyena (3 + 33 (—))
m,t-l

Imports of Oil from OPEC, Barrels

~% a2 , xt _ oset
" "o

Imports of Oil from OPEC, Keal Terms

wm = 1.6979

(53.6)

R2 = 0.99 Period of Estimation: 1960-1977

Gross Investment Demand

. 3
r= 6.19586 + 0.0673201 Jw, acyt,
(-1.8897) (0.3040) i=0 »
+ 1.01661 i o, (RY 72%)
(3.16) i=l + mtr
R= 0.99 D.wW. = 2.11 S.S.E. = 2.639
wy = 0.5 8, = 0.3 w, = 0.2 6) = 0.3 65
& = 0.033

0.7


61

channels, we find that the long run total price elasticity for OPEC's oi]
demand may be -in absolute terms- as low as 0.2 or as

high as 2.8 depending on whether one allows for counterinflationary
policies. The fact that the price elasticity may increase as a result of
policy responses to changes in oi] rices is crucially important for OPEC
pricing strategies. An oil price path that does not allow for such policy
responses may lead to a significant loss in revenues, contrary to what may

be expected by OPEC.


1

Mh 9 m1 we dP,
dy = a a 22 al: (19)
-Ta Thy 1 03) 32 dE

We apply the "Correspondence Principle" (Samuelson 1947) in
determining the direction of the impact of an oil price increase on the real
income of oi] importers. Following Metzler (1950), the model is stable if,
and only if. all the principle minors of the Tr matrix are positive. This

implies that the following conditions must hold:

mizl-ct+ (1-2) 66ng >0,
a
det(Thi) = niyvae- n2va>9, (20)

det(T) = det(T,,) >0.

Examining these stability conditions we conclude that a sufficient
condition for stability is that 1- c4> 0, i.e., the marginal
Propensity to consume should be less than one.

Limiting our attention to oi] importing economies, we derive the

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

+ + +
d¥9/dP = ((Y22d1~"h atin + Yoo(dE"/aP, ) )/det(r) §

9. (21)
For non-OPEC developing countries, the impact of an increase in the price of
oil on their real income is:

+ -
d¥"/dP= (Ci tia - Yar hr) = Yo (AE*/dP,))/det(r)S0. (22)


32

wie

€8 e0 19 ly 6h 94 Sh ne

POW OCC COU e NU NWe TONES rent

MIVTIOT “SA AO “TNE

Judd0O dO SAM NLOVANNVIN 10 SLUOdWE Twa

Z aanbly

€L

pa Deauyewees reuunuuwee peewwewaws fy

Pst

[ee

Se

I @E

SE

Oh

Sh

EzDucoesaw —racaeen


68

Imports of Raw Materials
in nm? = ( ;? $. ln (P_/e%) + 0.6306 In (¥7) - 0.078)
r iso + roem'tel (9,41) (-0.24)
R2 = 0.923 D.w. = 2.35 S.S.E. = 00168
$9 = 70-1384 (-3.08) $4 = -0.2076 (-2.24)
1 = -0-2076 (-3.62) $3 = 0.1384 (-0.24)
a a
he = exp(in Hy)
Demand for Gil
- 3 3
a,d_.v d v a
in Of7% = of n) Ye in (Fe)e-g te A yg dn (PQ).2g +
i=0 i=0
3 , 3
v [ol v
oe do ¥, In (PO gg to a ¥, In (8g) gy
3
uy f 6, in cy? + a”
Y i=o
R2 = 0.99 DW. 2.93 S.8.E. 0.000137
Yo = 0.2 YF 0.5 Y= 0.2 37 0.1
$9 = U5 o) = 062 6) = 0.175 ¢, = 05125
ab = -0.871 wt = -0.272 w= 0.292
(-0.358) (-1.6) (1.60)
wh = -0,3069 wf = 0.2872 yt = 1.704
(-0.53) ; (0.732) (3.23)


70

Imports of Oil from OPEC, Real Terms

Imports of Oil from Non-OPEC, Barrels

l
in HE = -18.076 +. 0.5084 J wyin (Po/P,)
(2.7) (1.036) iz0

1 . 1
« a
+ 1.8649 J} w.in(po/p_). + 2.2232 J w,in(poy BP).
(1.983) izo FS OEE (19h) Geg HOR Or tnd

1.542 1ncy? + 0.7712 incyd_,
(2.64) (2.65)

Wo = 0.6 we 0.4
2

R°= 0.824 D.wW.= 3.03 S.S.E. = 0.199

~h wh
Xo exo(ln Xo)

Imports of Oil from Non-OPEC, keal Terms



71

Export Price of manufactures

gd _ ,a > pd
Pat = Paytel (1 + 48 Poy)

Potential Output

in Gy"? = (4.34508 + 0.047173 T) D+

(54.79) (39.327)

(5.576778 + .0294922 T)(1 - D)
(23.986) (9.784)

b ={5 if v < 1972
0 if T > 1972

R2 = 0.99, D.W. = 1.357, S.S.£. = 0,0002618

Period of estimation: 1960-1979

ey"? = exp(lin ey*4)

Excess Capacity

*
GY d bad cya
x
cy 4


29

ELIT

Ls] ta] to ee 6 a db 96 se he

SyeUeeeeNed SVETTTTTeS Prpnyeeuwe Peuerenvun Peverruees lrectrrereneneccerrd Soon rete lotro)

UVAA WA SEMIVIE AO TTT

5,00 dO NOLLUWASNOD ‘HO

py aunbly

yeeenweres ©

es

| coon

f eeect

- OOGEL

- 900ST

Ons vormsraR--oz


cy"4

81

barrels/year.

Potential output of DC's; billions of $uS, 1970
Prices and exchange rates.

Total exports of DC's; billions of suS, 1970
prices. :

Imports of manufactures of LDC's from DC's;
billions of $US, 1970 prices (SITC # 5-9).

Total imports of DC's; billions of suS, 1970
prices.

Exports of manufactures of LDC's to DC's; billions
of $US, 1970 prices (SITC ¢ 5-9).

Imports of oil by LDC's from OPEC; billions of
$US, 1970 prices (SITC # 3).

Total imports of OPEC; billions of $US, 1970
prices.

OPEC's total exports; billions of sus, 1970
Prices.

Demana for oil of LDC's; billions of barrels/year.
LDC's gross domestic output, billions of $uS, 1970
prices and exchange rates = value added plus oil
imports.

Rental orice of capital, LoCc's, 1970 = 100.

value addea of LDC's; billions of $US, 1970 prices

and exchange rates.


6

The price of manufactures, P| in equation (5), is assumed to he a

m
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 excess capacity utilization. Our formulation can be

derived from a production function with constant returns to scale while

assuming zero profits.

Non-OPEC Developing Countries

Real income of Non-OPEC developing economies, y* in equation (6),
is determined using a production function with capital, Ke and fixed labor,
i*as factors. 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 output growth of developing economies. In our
model, foreign exchange constraints apply to imports of manufactures, ut in
equation (9). In this way, if foreign exchange constraints are binding,
then imports of manufactures will be limited, dampening capital accumulation
and income growth. We deduct oi] 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 and aid. Finally, oi

imports, My in equation (19), are determined as a function of terms of trade


-- 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.

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
on consumption and investment, c4y4y, depends on the level of real GNP, y4,
The term ed represents exogenous variables such as government expenditures.
The balance of payments, Bt in 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. In this way we recognize the terms-of-trade effect
of changes in oi] prices since oi] imports are valued in terms of the
exports of manufactured goods used to pay for them.

Exports of manufactures to both MPEC and non-OPEC LDC's depend on
the terms of trade and export revenues of these last two blocks of
countries. Oi] imports, we in equation (3), and raw materials imports, wp

in equation (4), depend on terms of trade and real income.


18

10
elasticity.

III. OIL PRICE EFFECTS IN PRACTICE

The theoretical results of section II have been derived under a
number of assumptions that are not generally valid in practice. First, OPEC
is not the only supplier of oi1, and we should recognize that Non-OPEC
LDC's supply oi] to DC's, as well as manufactures. Second, the production
side of oil importers determines -to a large extent- the behavior of tne
demand for oil, and this should be explicitly recognized. Third, dynamic
effects are absent from the theoretical analysis and they need to be
incorporated because of their crucial role in evaluating oil price effects.
While it is true that these considerations can be incorporated in a
theoretical model, the resulting analysis becomes quite cumbersome. In
fact, even with the simpler model of section II, we find that the direction
of oil price effects is not always unambigously determined. Thus we use
model simulations to estimate the effects oi] price changes while relaxing

the assumptions implied in our theoretical analysis.

III.1 A Global Econometric Model of Oil Price Effects

In a compact form, the model has 52 equations, 16 of which are
behavioral (see Marquez 1983 for a detailed description of the model).
The parameters of the model are estimated using data for 1960-1979,
although some of the relationships are estimated using data only up to
1977. The estimation method we use is OLS; the advantage of alternative
parameter estimators such as 2SLS, 3SLS, and FIML need not hold for small
samples such as ours (Mariano 1978). We now describe the main behavioral
equations which are shown, in general form, in Table 3. Appendix A contains

the estimated equations and the countries included in each country block.


YN 3 9,

var of 1 48 mpe0,
Yo9= 1+ went 4 >0,
Y23= 0,

Yas -F'b @ an4 <0,
32> “Fb B any <0,
Y337 1.

The elements of & are:
2 LR d d <
wy = -Ray- (1-8) (Mj (1+e5- T))#M (1+€5) (1-1) ) > 9

wy a= 1,

‘. d d g <
wg> -f i(Ra, + MO(1t €) )ny + Wi(1te8 - 1,))

> %

w22= 0,
' d d & L <
w3)= F ba(My (Ite, y+ My (te g- 1) ) >

wg" 0,
where the following notation has been used:

i

i_ yi, yi iy ayipayiy iL tye yi
ojE My YO. ony (1/45) (2M 5/2Y ), e595 (P5/M;)( a45/9P 5),

Fiz aF/aK°, fi = af/aK* . for i = d,o,g2 and j = p,oym.

Partitioning © as:
Qi g'= (00), Tie (43) i=1,2;j=1,2,
T=]...

Ta

Ta= (ya Y32)>

we derive the impact of an increase in the price of oi] on real income for

each of the regions as:


83

Excgenous Variables

Poe Index ot rental price of capital of OC's; 1970 =
100

rf; Nominal long term interest rate percent per year
of DC's.

Pr: Import price index of intermediate Proaucts; 1970
= 100.

Pe, Price index of labor of DC's; 1970 = 100.

Pot Price index of oil; 1970 = 100.

Pg: Price index of new capital goods of DC's; 1970 =
100.

08 9, Domestic supply of oil, DC's; millions of
barrels/year.

xd

exo? Remaining exports of DC's not explained in the

model; billions of $us, 1970 Prices.

Nexo! Imports of DC's not explainea by tne model.
G4; . Government expenditure of DC's; billions of $us,

1970 prices and exchange rates.
Mexo? OPEC's imports not explained in the model;

billions of sus, 1970 Prices.

Rexo?t OPEC's exports not explained by the moael,.

of'*, Domestic oil supply of LOC's; billions of
barrels/year.

ety LDC's export price index of manufactures; 1970 =

100.


24

are also interested in contrasting theoretical and empirical results. To
estimate the quantitative effects of an oil price increase on the variables

of interest, we use dynamic multipliers, which we define as:

a) j b
M5 7 (Vie > Yin) Vit >
where
y = base solution value for the ith endogenous variable at time

t,
vi = solution value for the ith endogenous variable at time t
under the jth alternative scenario.
The alternative cases we consider are:

-Case I: An exogenous increase in the price of oil].

-Case II: An increase in the price of oi] combined with

counterinflationary policies in NC's.

-Case III: The same as Case II but with a higher respending by

OPEC.

-Case IV: The same as Case II but allowing for increased lending

to Non-oil LDC's.

In examining the response of the model to changes in exogenous
variables, we need a base solution that can be used as a benchmark for
comparisons. For this we extrapolate the exogenous variables outside the
period of estimation ?

-- Domestic oi] production in developed economies is assumed to

grow at 1% per year;

-- Domestic oi] production in Non-OPEC developing countries is

assumed to grow at 2% per year (Daly-Griffin-Steele 1983,

MacAvoy 1982).


International Finance Discussion Papers
Number 237
January 1984

OIL PRICE EFFECTS IN THEORY AND PRACTICE
by

Jaime Marquez

NOTE: International Finance Discussion Papers are preliminary materials
circulated to stimulate discussion and critical comment. References in
publications to International Finance Discussion Papers (other than an

acknowledgement by a writer that he has had access to unpublished material)
should be cleared with the author or authors.


47

TIT ose) \

UVAA UA SHIVA AO “THT

§ Od 10 NOLdWASNOD

QT aanbl4

ILO

ennel

fF eoelt

[ eeezt

 O@0Et

- eoeht

- 980ST

ens Cores tar-cz


ll

turn are used to purchase imports of manufactures from the DC's.

An increase in the price of oil, when translated into an increase
in the price of manufactured goods, dampens 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, which has a positive impact
on their real income. However, the increase in Pay dampens imports of
manufactures of both OPEC and LDC's and thus adversely affects the GDP of
the NC's. This adverse indirect effect of oil prices on DC's real income
feeds back to both OPEC -in the form of lower oi] imports- and to non-OPEC
LNC's -in the form of lower imports of raw materials: the decline in
exports of LDC's reduces their foreign exchange resources beyond the
reduction due to the higher price of manufactures, and thus induces a
decline in imports of capital goods and capital accumulation with a
dampening effect on output growth.

Although the sign for ay*/aP, is negative, the sign for av"/aP., is
ambiguous even in this simple model. This is because the direct effect of
an increase in the price of oil -the transfer of real income to MPEC- could
be offset by the indirect effects -increases in the price of manufactures
and OPEC's recycling. In other words, whether an increase in oi] prices is
stagflationary or not is an empirical question which depends -to a large
extent- on how these price increases affect the rest of the world economy,
which in turn depends on the relative magnitudes of key parameters such as
Ty» Bs ny and a

Table 2 summarizes the comparative static results for alternative
values of 1% and g assuming price inelasticity. For the case of developed
economies, if there is no markup in oi] prices and the value of the

recycling coefficient is less than one, then an increase in oi] prices


10
Equations (21) and (22) indicate that, in general, an increase in the price
of oi] need not he associated with a reduction in oi] importers' real
income. If we assume (1) no fiscal policy response to the change in oi]
prices and (2) price inelasticity, then we get

<

So , (23)

d + = + +
dy /4P O= (Y22m11- ¥1 20m )/det( Tr)
$e ae
av*/dP = (Vira 7 Yawn )/det(r) < 0. (24)

The direction of the income effect of oil price changes remains
ambiguous for developed economies, although it is unambiguously negative for
Non-OPEC developing countries. In order to explain these results, we
decompose the total effect of an oil price increase into direct and indirect
effects. The direct effect is the transfer of real income from oil
importing countries to OPEC. In the case of the NC's, this direct -and
negative- effect takes the form of a deterioration of the real balance of
payments, given the increased cost of oil imports in terms of manufactured
goods. In the case of the LDC's, the 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
investment.

The indirect effects of influence are through OPEC' recycling and
increases in the export price of manufactures of DC's. An increase in oil
prices raises oi] revenues of OPEC who in turn recycles a fraction gp in the
form of imports of manufactures from DC's. This increase in OPEC's
imports represents a stimulus to activity in the NC's--one which may not be
offset by the direct negative effect. In turn, this stimulus to real
activity in the NC's causes an increase in the imports of primary

commodities from Non-QPEC LNC's, enlarging LDC's foreign resources which in


60

oil, Ty?

-- the response of fiscal policy to the increase in the price of
oil; and
-- the volume of international trade.

We estimate the theoretical model using data for 1960-1979. We
find that a 10 percent increase in the price of oi] reduces real income of
developed economies by 0.5 percent in the first year, by 1 percent for the
second year, and by 2.9 percent after eleven years. Real income of
developing economies is also adversely affected by an increase in oi]
prices.

Counterinflationary policies are effective in reducing the price
level after being imposed for as long as seven years. These policies,
however, reduce real income of both developed and less developed economies
below the already reduced income levels arising from higher oil prices.

Although a 33 percent increase in OPEC's absorption capacity does
not completely offset the recessionary effects of higher oi] prices and of
counterinflationary policies, there is an improvement in real income of
developed and developing countries over the results of Case II.

Higher capital transfers from OPEC to Non-OPEC developing
countries raises real income for the latter group of countries above the
values for the base solution; real income of developed economies is above
the values taken in Case II, but still helow the values for the base
solution.

Our empirical analysis provides valuable insights into the
quantitative dimensions of the feedback effects that oi] prices have on the
oil demand that OPEC faces. llsing the notion of total price elasticity,
which accounts for the direct effects of oil price increases on oi] demand,

and the feedback effects that occur through the international transmission


43

Case JII: Higher Absorption by OPEC

A remedial tool that frequently has been suggested is for OPEC to
spend a larger fraction of their oil revenues on imports of manufactures.
Hooper and Tryon (1982) have found that increasing OPEC's recycling by 50
percert in nominal terms eliminates the output losses due to higher oil
prices in 1982 for Japan and Germany; similarly, Adams and Marquez (1983)
have found that a higher absorption capacity for OPEC offsets the negative
effects of oi] price increases. Here we assume an increase of 33 percent in
OPEC's absorption capacity in real terms, in addition to the assumptions of
Case II. This scenario amounts to an increase in the recycling coefficient
8 of section II, and as we saw then, increases in g reduce the negative
impact of oi] prices. We increase OPEC's imports of manufactures in real
terms hy US$ 3 billions in 1973, US$ 10 billions in 1976 and US$ 16 billions
in 1982 with an annual average increase of !IS$ 10.7 billions. The results
for this case are shown in Table 6 and are depicted in Figures 14 to 19.

We find that an increase of 33 percent in OPEC's imports of
manufactures, a demand stimulus to developed economies, does not completely
offset the negative effects of higher oi] prices and counterinflationary
policies on real income of developed economies (Figure 14), although the
higher recycling on the part of OPEC does offset the adverse effects of
counterinflationary policies.

Real income of Non-OPEC developing countries is above the levels
for Case II. This is hecause MPEC's increased recycling stimulates real
income of DC's, which in turn induces an increase in LNC's exports of both
manufactures and raw materials to DC's by annual averages of 8 percent (9.8
for Case II minus 1.8 for Case III) and 2.5 percent respectively. This
increase in exports increases foreign exchange reserves, which stimulate
imports of manufactures, capital formation and real income of Non-OPEC
developing countries. Nevertheless, the higher recycling of OPEC does not

completely offset the negative impacts of higher oi] prices and restrictive


e

CF

xo*

84

Exports of LDC's not explained by the model;
billions of $US, 1970 prices.

Net capital flows to LOC's; billions of $US,
current value.

LDC's exports not explained by the model; billions
of $US, current value.

LDC's imports not explained by the model; billions
of $US, current value.

Price index of coal of DC's; 1970 = 100.


31

€6 eo

BLES

10 60 GL LA Mk 94

See eee eee eee TOT eT CEION FOOT TOIO inn t peeee

I esvd

dO AO SIMOUXH "HO

g aunbiy

Ons wxcoane


48

cA

a eeweee

n

POP TPRUS PUSTECTTEN PUCURTpeNY reeeureees cveserpare sermrrrcreroscorl ccs Dey meee

2

Wik
on 6. OL ut gL se he el

UVAA WA SHONVE AO “TTT

$90 40 SLMOdWI "HO

ZT aanbly

Ons =racKRa


30

WVHA Mad 814

40 “Pt

$,00 10 SLaOdWI WO

g aunby

wracerKe

oma


APPENDIX A

GLOBAL ECONOMETRIC MODEL

I. Developed Economies.

Corsumption Function.

a \d4 4
10.185 + 0.4681(P° y4yp ) + 0.2376c9_
(0.222) (6.19) YE to consto 9 Ci Tasy tnd

c

ro

R* = 0.98 Dw. = 1.6
s.

S.E. = 10.3 Rho

0.69 h=0.97

Period of estimation: 1960-1977

Private Gross Investment

. 2 . ;
1° = 4.31703 + 0.25636 J #; Ye 7 13.1547 an
(0.094) (2.768) i=0 (-3.697)

_R2= 0.875 D.W. = 0.952

S.S.E. = 17.529 Rho = 0.399847
5 = 0.5 oF 0.3 = 0.2
Period of estimation: 1960-1979

67


and real income.

OPEC

OPEC's income determination is analogous to the case of non-NPEC
developing countries. However, we assume that OPEC recycles a constant
fraction g of their exports. earnings via the purchase of manufactures from
developed economies, as indicated by equation (14). Although the assumption
of a constant value of gp implies that OPEC's ahsorption capacity does not
change over time, we use it because (1) it simplifies the comparative
statics derivations, (2) we can study the effects of changes in g on the

analytical solutions, and (3) it is relaxed in the empirical analysis.

II.1 The International Transmission of Oil Price Effects

To solve the model 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 reduce the system from a seventeen equation system to a three
differential equation system. In addition, we assume that initial prices

are equal to 1. The resulting system of equations is:

dx, 1,j=1,335=1,35k=1,2;

where

(dy4 ay® ay°),

a
Ke
"

_ d
dx = (dP, dE).
The elements of I are:

nit 1 - cle (1-8) 96 nf > 0,

N2= (1-8) 9305 >0,


21

conditional demand function from a three level CES production function,
equation (31), whose arguments are labor, L, capital, K, oi], 0, and coal,
C. In this way we account for both capital-energy substitution
possibilitites and interfuel substitution possibilities. In addition, an
aggregate measure of energy consistent with the structure of production can
be derived. The conditional demand for oi] depends on the prices of oil,
coal, labor, and the rental price of capital as well as on gross
output: (value added plus oil imports) ey, We estimate a linearized
version of this demand function with a distributed lag (4 periods) for
prices and income, allowing for homogeneity of degree zero in prices. In
estimating this relationship, we use switching regression with a split of
the sample in 1972. The long run oi] price elasticity declines from -0.27
to -.57. The long run coal price elasticity increases from 0,29 to 0.91.
The estimated income elasticity declines from 1.70 to 1.34. The hypothesis
of homogeneity of zero degree in prices cannot be rejected.

Total imports of oil, ie in equation (33), (in barrels) are equal to
the difference between the demand for oi] (in barrels) and the exogenously

given supply of oil, 0°, (also in barrels). Imports of oi] from OPEC, ad in

0
equation (34), are equal to total imports of oi] minus imports of oi] from
Non-OPEC LDC's, bee , which in turn depend on the price of oi] relative to
the price of coal as well as on real income of NC's. To link oil imports
in barrels to oil imports in real value we use the identity between the
value of oi] imports given by the product of total oil imports in real
terms, “, and the oil price index, Po and the value of oi] imports given hy

the product of the price of oil, Pa, (in dollars per barrel) and total

imports of oi] in barrels, ae . We then solve from this identity for oi]


58

po)

Wit
i) an 64 on ab o Sh he

€2

RIVTIOT “SN 40 “THE

dO JO SUMALOVIANVA lO SLMOdWI Wau

gz eunBr4

EEZDuUCoRsaw race


82

Oil imports of LDC's from OPEC; billions cf
barrels/year,

Gross investment of LDC's; billions of $US, 1970
prices and exchange rates,

Net investment of LDC's; billions of $us, 1970
prices and exchange rates.

Capital stock of LDC's; billions of $US, 1970
prices and exchange rates.

Total value of exports of LOC's; billions of $US,
current value.

Foreign exchange reserves of LDC's; billions of
$US, current value,

Total exports of LDC's; billions of Sus, 1970
Prices.

Total imports of LDC's; billions of sus, 1970
Prices,

Total imports of LDC's; billions of $US, carrent
value.

Total exports of oil by OPEC; billions of
barrels/year.

Imports of oil of DC's from OPEC; in 1970 prices;
billions of sus (siTc 4 3).

Imports of manufactures of OPEC from OC's; 1970

prices; billions of $US (SITC#5-9).


65

Lehment, H. (1982). "Economic Policy Response to the Oil Price Shocks of
1974 and 1979." European Economic Review Vol. 18, Nos. 1/2:
235-242.

MacAvoy, P. (1982). Crude Oil Prices as Determined by OPEC and Market
Fundamentals. Cambridge: Ballinger Publishing Co.

Mariano, R. (1978). "Commodity Market Modeling: Methodological Issues and
Control Theory Applications." In F. G. Adams and J. Behrman
(eds.) Econometric Modeling of World Commodity Policy.
Lexington: Lexington Books.

Marquez, J. (1982). "Foreign Exchange Constraints, Investment Demand, and
Imports of Manufactures in LDCs." Center for Analysis of
Developing Economies, Discussion Paper 82-47, Philadelphia:
University of Pennsylvania.

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

Marquez, J. and D. Vining (1984). "Inflation and Relative Price Behavior:
A Survey of the Literature" in M. Ballabon Economic Perspectives
Vol. 3: 1-56. Hardwood Academic Publishers, New York Cforth-

coming).
McKinnoa, R. (1964). “Foreign Exchange Constraints in Economic Development
and Efficient 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.

Sachs, J. (1982). "The Oil Shocks and Macroeconomic Adjustment in the United
States." European Economic Review Vol. 18, Nos. 1/2: 243-248.

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.

Shigehara, K. (1982). "Absorption of the Two Oil Shocks. The Japanese Case."
European Economic Review Vol. 18, Nos. 1/2: 249-261.

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.

Solow, R. (1974). "The Economics of Resources or the Resources of
Economics." American Economic Review. Vol. 54, No. 2: 1-14.

Stiglitz, J. (1976). "Monopoly and the Rate of Extraction of Exhaustible
Resources." American Economic Review. Vol. 66, No. 4: 655-661.



38

0 an

Il 960)

MIL
in oo OL ne Lb

weet e reas benee eer eed esses ebnenee

UVAA WA Suv AO “Ture

$,00 10 NOLLUWASNOO
t

OT eunbl4

OL

HO

st

hh

ee

ae Verpareres peeeverres feeereerer cr ircriocng

f e008

F eoaot

- ene2t

f @eeet

- @@ht

eoest

On4 vozusraR-oz


78

Growth kate of Value Added

ag y* = (in YE - In vi _ 1) #100

Exports of Manufactures to Developed Economies

in xt = -18.2776 + 2.6796 In Y2 + 0.6966 In (P0/Pr)
m= (=20.82) (23.47) (2.45)
R2 = 0.984 D.W. = 1.28 S.S.E. = 0.005

Period of Estimation: 1960-1977
2 _ 2
x = exp(ln x)

Total Exports of Developing Economies

2 od 2 2 £
xv = My, + Xn t Kayo, * Xo

Total Imports of Developing Economies

Foreign Exchange Reserves, Nominal Terms

; «yt _ of
Rv = Rey + $x Su + CEL


39

Mit
mW on OL LA aa LIA SL ne

Een Cre OTeees POT PEOerEn Peerrenter feererrnre rrieverres Mitecerern fore rots aa

UVAA Seanive a0 “THT

$,00 40 S&MOdWT THO

i

IT eunbi4

€é

Pewevey 5

-ricaee

Onn


54

clint
on 6. a hb o st he €L

ae

- sh
f 86S
fF ess
- 009
fF esd
eos
- OSL
- 008

ese

SUVTION “S'N AO “TIT

$,O0T HO AWOONT ‘TVau

12 eanBi 4

-zoorw

ewe


27

IML
6L LTA db 94

penwe nyuveweere! n foes pew)

waad,

givriod (s'0 Ao “TH

$90 AO GWOONT ‘1WVAIa

Z aun s

ne et

Gopewees neeweerces!

- 6@he

ft @ese

F e092

 @0l2

- e082

fF e862

f- @veE

- OO1E

-z0crw

ewoo


57

aH
£0 en m on ura nh AL , Sh he et

POPE TeTNUOn DTTNNNNSEN PEenentNen feemntetel Perrttrecrst itive Tor sooo pevuvewwenwweererce:

sete eh

UVAA Wad SHNIVA AO “THA

d4d0 AO SLUOdXA TIO

ve aunbt4

ORs WXAoane


66

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

Taylor, L. (1981). "South-North Trade and Southern Growth: Bleak Prospects
from the Stucturalist Point of View." Journal of International
Economics Vol. 11: 589-602.

Vangrevlinghe, G. (1982). "Absorption of the Two Oil Shocks. The French
Case." European Economic Review Vol. 18, Nos. 1/2: 263-266.



price of oil are internationally transmitted.

We obtain the comparative static results of an increase in the
price of oil, as well as their sensitivity to fiscal policy responses.

Also, we decompose the effect of an oil price increase on OPEC's exports
into substitution and income effects, and show how the income effects
raise -in absoulte terms- the price elasticity of OPEC's exports.

An empirical version of the theoretical model is econometrically
estimated and used in section III to contrast the theoretical results with
dynamic model simulations. In particular, we study the effects of oi] price
changes on the real income of oi] importers (NC's and Non-OPFC LNC's) and
the consequent feedback effect on their demand for oi] and OPEC's exports.
We then examine how sensitive are the effects of oi] price changes to fiscal
policy responses, greater recycling on the part of OPEC, and larger

financial transfers to LDC's.

II. A THEORETICAL MONEL OF OIL PRICE EFFECTS

Qur theoretical model, shown in Table 1, differs from those
developed in the literature in that we consider three blocks of countries
whose analytical structures are different from each other:

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

-- the MPEC 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.

The internationally traded goods we consider are:


46

€0 ti]

(PEeaee Nene PEN ar aT

11 esea

ELITS
an BL LTA th 94 st

PPR TET TPES Rerreneeas Reeth Parers Server neererrroars:

SUVTIOd “S'A AO “THE

$,0d1 10 AWOONI Wael

ST eunbLy

ds eon

Fes
F 00S
ess
- 809
fF eso

t 0OL

F OSL

-z0ctw

ewe


44

Table 6

Dynamic Multipliers: Case III

d L did dy od ok
Y x 3) oO Mg Me
1973 -.20 =.05  -1.22 —.74 -1.79~—CO 1
1974 -.74 -.11 -4.31 71.41 -6.20 -6.67
1975 -.76 -.21 -5.62 -2.03  -8.28 -8.90)
1976 -.76 -.42 6.26 -2.66 -8.82 -9.51
1977 -.89 -.69 -6.39 -3.28 -8.92 -9.64
1978 -1.00 -.97  -6.51 -3.92 -9.03  -9.7%
1979 -.95 -1.21 6.54 4.56 -9.08 9.88
1980 -.83  -1.41 -6.48 -5.20 -9.50 -10.42
1981 -.69 -1.54 -6.33 -5.83 -10.54 -11.83
1982 -.66 -1.57 -6.22 -6.43 -11.50 -13.39
1983 -.81 1.45 -6.27 -7.01 -11.76 3-14.10
fie) d L & ° L
xX MO Mo XS Mo MO
1973 -1.82 -.18 -T.14 247 32.24 =.02
1974 «--5.83 --6.04 «9-24.41 --1.81 935.65 -.17
1975 -7.99 -8.03 -3.85 -2.51 37.74 -.93
1976 -8.80 -8.67 -4.85 -2.43 34.74 -2.31
1977 --9.32  --8.80 -6.61 <-2.51 32.98  -2.356
1978 -9.56 -8.96 -7.40 <-2.58 32.34 <-1.71
1979 -9.77.  -9.05 .-8.19 -2.56 36.05 -1.09
1980 -10.56 9.38 -9.77 -3.02 34.79 -.77
1981 -12.27 -10.15 -11.86 -3.77 35.16 -.27
1982 -13.98 -10.97 -13.34 -3.94 36.85 272
1983 -14.60 -11.45 -13.67 -3.66 39.35 1.76
2 d L Lod d d
xn My R R'/P,, a Py
1973 =.55 =.13 =.99 =.99 700 vol
1974 -1.96 -.35 -5.39 6.17 1.32 295
1975 1.45 -.21 -7.65 -8.30 1.28 1.03
1976 -1.55 -.08 4.69 -5.24 1.13 1.06
1977 -1.96 -.12 -1.47 -1.92 299 1.10
1978 -2.35 -.28 1.12 82 +69 1.12
1979 --2.31 -.34 3.48 3.34 034 1.15
1980 -2.13 -.37 8.55 8.57 -.06 1.21
1981 9 -1.85 -.39 16.77 16.96 -.48 1.26
1982 -1.87 -.47 26.33 26.67 -.87 1.30
1983 -2.35 -.66 21.27 21.73  -1.27 1.32



69

a* = 0.8779 w2 = 0.57 w2= 0,908
(0.30) (-3.5) (4.11)

w2 = -0,2362 wf = -0,0995 w2 = 1.335
(-0.694) (-0.64) Y (2.165)

veil if t < 1972, v = 2 if t > 1972.
Period of estimation: 1960-1979.

<9 = exp(1n of"),

Total Imports of Oil, Barrels

“BE = (o9"4 ~ 08") 1000

ingorts of Oil from OPEC, Barrels

~a _ =a _ yt
hy = ho > %


14
a given value of the markup coefficient, the impact of an oil price increase
on LOC's real income is directly related to 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 effect of an increase
in oil prices on an oi] importing economy depends critically on how the oi]
price increase affects the rest of the world economy. As a result, we find
that an increase in the price of of] may have a negative or positive impact
on the GDP of the DC's. 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.

II.2 Counterinflationary Policies and the Effect of Oil Prices on the
World Economy

The previous comparative statics were derived under the assumption
that government expenditures (Ft) do not respond to changes in oi] prices.”
For our purposes, we assume that an increase in the price of oi] will
increase the inflation rate, to which government economic policies are
assumed to respond as:

dE" /aP = WG
where we capture the influence of oi] price increases on inflation by their
effect on the price of manufactures. We assume that the response of
government expenditures to changes in Pa is equal to y. y<O. The response

of yd to changes in Py is then equal to:

av9/aP = ((y22m1- N20) + Y220",)/det(T),


56

Il e8e5D

mut
84 La Ma LA

UVAA Nad SIDE 40 WTI

§,90 10 SLMOdH1 THO

€z aanbi4

Gh

LTA

i74

OPTTTE PONEUEOTINT POPWCnPOCs RUTROPE SSS Creer Ciro say

«J

Onn —rAceRea


62

Endnotes
*

This paper is based on my dissertation at the University of
Pennsylvania. I am grateful to F. Gerard Adams, Lawrence Klein, Peter
Pauly, Wilfred Ethier, Lance Taylor, Albert Ando, Kenneth Rogoff, and
Thomas Glaessner for their comments and criticisms. Any remaining errors
are my own. 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.

, Schmid (1976), Findlay and Rodriguez (1977), Bruno and Sachs
(1979), and Solow (1980). An important exception is Taylor (1981). I am
became aware of Taylor's paper after completing this research: I am grateful
to Lance Taylor for pointing this paper to me.

2 One important assumption here is the exogeneity of oi] prices

since it implies that oi] importers are small economies. Marquez (1.983)
relaxes the small country assumption and applies (closed loop) optimal
control to the model developed in this paper to determine optimal oi]
prices.

3

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.

* 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.

° For earlier analyses, see Chenery and Strout (1966), McKinnon
(1964): for a more recent analysis, see Taylor (1979).

® We also studied the case where only a fraction y of foreign
exchange resources is used to finance manufacture imports. The analytical
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.

’ In principle, if prices were perfectly flexible, then it might not
be necessary to alter economic policies in response to a change in the price
of oil. Other prices would decrease leaving the overall inflation rate
unchanged. However, there is substantial statistical and theoretical
evidence pointing to a positive relationship between relative price changes
(a change in oil prices) and the overall inflation rate (Fischer 1931,
Cukierman 1982, and Marquez and Vining 1984).

8
A more general formulation would be:


16

The total effect of an increase in the price of oi] on D° is:

&

C) _ dod L.
(26) dn /dP o> C My €,(1-",) + My e! +

1
did th hr 9 41 oe {ft
H($qng $575)
rat otf | 82? Nae sap
Ta Th w
313) 9

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
p°, assuming that “ = “ = 0, and that the initial price-quantity
combination is given by point A. The increase in the price of oil from Po
to Po raises OPEC's oi] revenues (the area ABP PO ) only if the demand
function N° remains fixed. But as we have seen, the increase in the price
of oi? may reduce real income of oi] importers (especially if followed by
counterinflationary policies) shifting the demand for oi] leftward to N'.
As a result, OPEC's decision to increase oil prices might lead to a loss of
oil revenues, even if the direct price elasticities (as seen by consumers)
are equal to zero. This is because what matters for optimal price
determination is the total price elasticity as seen hy OPEC, which takes
into account not only the substitution effects of an oil price increase but
also the associated income effects. Furthemore, notice that the total price
elasticity depends on the fiscal policy response in the DC's. In

particular, a restrictive policy response reduces real income and therefore

has the effect of increasing the (absolute value of) the total price


-To what extent is income in developed and less developed
economies affected by oil price changes? And how these income effects
feedback to OPEC's oi] exports?

-Can a greater recycling of oi] revenues by OPEC offset the
adverse impacts of oi] price increases?

-What is the influence of oi] price increases on the price of
manufactures, and how increases in this price affect OPEC and other
developing countries?

-How successful is a restrictive fiscal policy in combating the
inflationary impacts of an increase in the price of oi], and what are the
repercussions for the rest of the world?

-What are the financial transfers to developing countries required
to offset the adverse impacts of oil price increases on economic growth?

Recognition of the international repercussions of oi] price
changes is important given that economic activity in different regions are
linked 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 oi] prices.
From OPEC's viewpoint, the international transmission of oi] price effects
is important in determining oil price strategies since oi] price changes
affect real income of the world economy, and thus OPEC's oil exports.

Although the question of international repercussion has been
analyzed using large econometric models (e.g.,Project LINK, Federal
Reserve's MCM, Fair's (1982) model), their complexity and heterogeneity
often obscure the channels of interaction. There is some advantage to
simplicity and transparency. In section II of this paper we formulate a
three regions-three goods theoretical model of the world economy to

highlight the channels by which the effects of an exogenous increase in the


37

EDITS

a 28 in 08 BL e. tL 94
a ivavegenees reewes dae soatan [eyeenenene rf

St

he

€L

II esed

$01

Suvriod ‘SN 40 “Tit

lO GNOONI Wad

6 aunbLy

- 80h

F 08S

fF ess

- @09

F 6s3

fF oeL

> OSL

ewes =zcormw


79

Total Exports of Developing Economies, Nominal Terms

2 ok ok a L
Sxo = PL x,t Poo, + SXoxo, + PQ XS

Total Imports of Developing Economies, Nominal Terns

2 2
m + Po Mg + SMexo,


25

-- Net capital flows to Non-OPEC developing countries are
assumed to grow at 3% per year, in nominal terms.

-- Oil prices take their historical values.

-- Long term nominal interest rates are assumed to be 14% in
1982 and 10% in 1983.

-- Prices of raw materials are assumed to grow at 9%.

-- Nominal wages are assumed to grow at 10% per year.

-- Export prices of manufactures of developing economies are
assumed to grow at 9% per year.

-- The exogenous components of total exports and imports are
assumed to grow at rates such that the difference between
exogenous exports and exogenous imports remains constant at
their 1977 values.

-- Government real expenditures are assumed to grow at 0.9% per

year.

Case I: An Increase in the Price of Oil

In this simulation we assume an increase of 10 percent in the
price of oil in 1973, which then grows at the historical growth rate until
1983; we present our results in Table 4. A 10 percent increase in the price
of oi] reduces real income of developed economies by 0.5 percent in
1973, 1.2 percent in 1977 and 2.9 percent by 1983 (see Figure 2). This
reduction in real income is due to an increase in the consumption price
deflator which reduces real income available for consumption and therefore
reduces, consumption expenditures. The increase in the consumption deflator
is not offset by the smaller increases in the GNP deflator. In addition, an
increase in the price of oil raises exports of manufactures to OPEC and

reduces: oil imports representing an improvement in the real trade account


Oil Price Effects in Theory and Practice
Jaime Marquez

January 1984

T. INTRODUCTION

That increases in oi] 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 oi] price changes have led
to modeling approaches with more emphasis on the role of relative price
changes. The purpose of these models is to determine how oil price changes
affect real income, prices, and employment in a small open oil importing
economy, and how sensitive are these price effects to alternative policy
responses and wage indexation schemes. However, one important limitation of
these models is their partial equilibrium nature, i.e., the effects that oil
price changes have on the domestic economy are assumed to be independent
from the impacts that these price changes have on the rest of the world
economy,

Our purpose in this paper is to study -theoretically and
empirically- the effects of oil price changes allowing for its feedback

effects. We address the following questions:


49

th % Sh he eh

Peeve Peepwavens Reneearre Treseerrestreccroccs,

UVAA WA SIOAVE AO WPI

O41d0 AO SPUOdXA TWO

Cnn wa came


33

and therefore a stimulus to real income. However, our results imply that
the improvement in the trade account is not strong enough to offset the
reduction in consumption leading to a net deterioration of NC's real
income.

Real income in Non-OPEC developing countries also deteriorates as
a result of an increase in the price of oi1, which reduces not only nominal
holdings of foreign exchange resources, but also their real purchasing power
due to the increase in the export price of manufactures of DC's. This
decline in real foreign exchange reserves adversely affects imports of
manufactures, capital formation and the capital stock, which in turn dampens
output growth. In addition, the increase in oi] prices reduces oil
consumption in LDC's by 0.7 percent in 1973, by 3.3 percent in 1977 and by
7.25 percent in 1983. The decline in the capital stock and in oil
consumption adversely affects production in Non-OPEC LNC's with respect to
the baseline case by 0.05 percent in 1973, 0.7 percent in 1977, and 1.8
percent in 1983 (see Figure 3).

The sustained increase in oi] prices reduces oi] consumption of
developed economies (Figure 4) by an annual average of 6.4 percent with
respect to the base solution. This in turn reduces oi] imports of DC's
(Figure 5) and oi] exports of OPEC (Figure 6). The initial reduction in
OPEC's 911 exports (in bbY) is 2.1 percent, which gives a total price
elasticity of -0.21. However, as the dynamic effects of higher oil prices
work themselves out, we find that the total price elasticity (in ahsolute
value) increases to 9.56 in 1974, and to 1.0 in 1978. In other words, it
takes sx years to move from the inelastic portion of the oil demand curve
faced by OPEC to the elastic zone.

Price increases beyond the point where the demand is elastic

result in more than proportionate reductions in oi] consumption leading to a


42

average reduction of 3.7 percent per year (see Figure 8).

Oil demand in the NC's is below the baseline case by five percent
in 1974, 10 percent in 1980 and 13 percent by 1983, with an annual average
reduction of 8.8 percent over the 11 year period (Figure 10). This decline
in oil demand in the NC's results in a reduction in their total oi] imports
and oil exports of OPEC (Figures 11 and 12). For this last variable we find
a reduction of 6.5 percent in 1974, 9.4 percent in 1975 and 28 percent by
1983, with an annual average reduction of 15 percent with respect to the
baseline. Naturally, these reductions in oi] exports of OPEC imply a
substantial increase in (the absolute value) of the total price elasticity
which increases from 0.7 in 1974 to 2.8 by 1983. This adversely affects
OPEC's oi] revenues and therefore their imports of manufactures from [IC's by
1 percent in 1979, 5 percent in 1981 and 9 percent in 1983 (see Figure 13).

The reduction in real income of developed economies also adversely
affects real income in Non-OPEC developing economies. In particular,
exports of manufactures of LDC's to NC's fall by 4 percent in 1974, by 10
percent in 1978 and by 20 percent in 1983, with an annual average reduction
of 9.8 percent with respect to the baseline case. Similarly, exports of raw
materials of LDC's to DC's fall with respect to the baseline case by an
annual average of 2.8 percent.” The overall decline in exports of LNC's,
coupled with reduced real foreign exchange resources dampens imports of
manufactures, capital accumulation and real income of Non-OPEC LDC's by 0.11
percent in 1974, 1.7 percent in 1979 and by 3.5 percent in 1983 with an
average annual reduction of 1.5 percent with respect to the baseline case

(Figure 9).


28

4)

a

ca

a

in

Suvriod (S70 Ao “8

S$ O01 dO GWOONE TVA

€ aunb

te

F @Sh

88S

F ess

f 009

f 0OL

- OSL

-zecrw

ecu


12

Table 2

Comparative Static Results of an Oil Price Increase

Summary of dy? for DC's

dp,
0 o< Tye 1
0 - ? ?
o<B<l - ? ?
1 0 - -

Summary of ay! for LDC's
dp



REFERENCES

Adams, F. G. (1979). "Must High Commodity Prices Depress The World Economy?
An Application of a World Model System." Journal of Policy
Modeling. Vol. 1, No.2: 201-215.

Adams, F.G., and J.R. Marquez (1983). "A Global Model of Oil Price Impacts."
In F.G. Adams and B. Hickman (eds.) Global Econometrics: Essays in
Honor of Lawrence R. Klein. Cambridge: MIT Press.

Blinder, A. (1979). Economic Policy and the Great Stagflation. New York:
Academic Press.

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.

Coen, R. (1971). "The Effect of Cash Flow in the Speed of Adjustment." In
G. Eromm (ed.) Tax Incentives and Capital Spending. Washington,
D.C.: Brookings Insitution

Cukierman, A. (1982). "Relative price Variability and Inflation. A Survey
and Further Results." Paper prepared for the November 19&2
Carnegie-Rochester Conference on Public Policy.

Daly, G., J. Griffin, and H. Stele (1983). "The Future of OPEC: Price Level
and Cartel Stability." The Energy Journal Vol. 4, No. 1: 65-78.

Fair, Ray (1982). "Estimated Output, Price, Interest Rate, and Exchange Rate
Linkage Among Countries." Journal of Political Economy Vel. 90,
No. 3: 507-535.

Findlay, R., and C. A. Rodriguez (1977). "Intermediate Imports and Macro~
economic Policy under Flexible Exchange Rates." Canadian 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.

Hooper, P. and R. Tryon (1982). "Macroeconomic and Exchange Rate Effects of
an Oil Price Shock Under Alternative OPEC Investment Scenarios."
In K. Clinton (ed.) Proceedings of the Fifth Pacific Basin Central
Bank Economist's Conference: Supply Side Shocks, the Balarice of
Payments, and Monetary Policy (Bank of Ottawa).

Klein, L. (1983). Lectures in Econometrics, Amsterdam: North Holland.

64


80

NOTATION

Endogenous Variables

c4; Consumption expenditure of DC's; billions of $US;

1970 prices ana exchange rates.

14, Gross domestic private investment of DC's;
billions of $US; 1970 prices and exchange rates.

yd; Value added of DC's; billions of $US; 1970 prices
and exchange rates.

ey?; Gross output, defined of value added (x4) plus
total oil imports.

Poet ; Value Added Price Deflator.

Po ont! Consumption Price Deflator. /

no: Imports of intermediate products other than oil
(SITC # O-1 + SITC # 2 + SITC # 4).

Pa, Export price index of manufactures of DC's; 1970
100.

of'4, Demand for oil of DC's; millions of barrels/year

xi Exports of oil of LDC's to OC's in 1970 prices;
billions of $US (SITC # 3).

ne: Imports of oil of DC's from OPEC; billions of
barrels/year.

U: excess capacity in OC's, percentage

Re: Imports of oil of DC's; billions of barrels/year.

x: Exports of oil of LDC's to DC's; billions of


50

WIL
on 6. ns, Lb aL Sh he ee

ORE POR ROSR EES CORPSE CUES REVO ae eee renee Peer errere Perel recon errcusooes!
Fe

m4

Qivrlod “SN AO “THT

OMd0 AO SHUNLOVAANVW AO SLUOdWI Tad

61 eunbiy

EEPDUcoesaw —racann


52

Table 7

Dynamic Multipliers: Case IV

Y fo) QO Mo Mo
1973 =.50 -.05 -1.42 -.74 -2.08 -2.21
1974 -1.36 -.1ll 4.83 -1.41 6.94 -7.40
1975 -1.76 01 -6.55 -2.02 -9.66 -10.26
1976 -1.65 -84 -7.35 2.53 -10.35 -11.03
1977 -1.50 2.60 -7.34 -2.85 -10.25 -10.99
1978 -1.42 5.11 -7.24 -2.92 -10.05 -10.83
1979 -1.47 8.00 -7.21 -2.71 -10.00 -10.82
1980 -1.58 11.02 -7.26 -2.23) -10.65 -11.58
1981 -1.79 13.94 -7.44 71.51 -12.37 -13.68
1982 -2.12 16.62 -7.74 -.-59 -14.31 -16.29
1983 2.49 18.96 -8.14 049 3-15.27 -17.83
go d 2 & te) £
x Mo Mo Xe Ln My
1973 -2.08 -2.01 -1.30 -.76 2.36 -.02
1974 6.49 -6.70 -2.76 -2.49 3.65 7.24

1975 -9.23 -9.26 -4.50 -3.72 3.20 3.06
1976 -10.17 -10.06 -5.43 -3.66 1.03 15.17

1977 -10.47 -10.04 -6.65 -3.48 -.ll 24,14
1978 -10.25 -9.91 -6.44 -3.26 -.29 25.84
1979 -10.14 -9.91 -6.07 -3.25 -.07 24.75
1980 -10.70 -10.42 -6.10 -3.95 +1300 (23.51
1981 -12.07 -11.73 -6.17  -5.23 -.02 21.19
1982 -13.32 -13.34 -5.33 -5.96 -.44 19.43
1983 -13.46 -14.47 -3.60 -5.99 -.74 18.34
£ d £ L404 d d

x ce R R'/eo Po Py

1973. -1.34 =.32 -1.54 1.54 700 Ay]
1974 -3.62 -.76 36.49 35.43 1.24 +94
1975 --4.14 -.88 85.13 84.10 1.01 +98
1976 9-399 -.73 90.37 89.83 255 96
1977 --3.78 -.67 96.17 96.15 03 394
1978 9 --3.75 -.79 97.84 98.31 -.53 +91
1979 --4.07 -1.00 68.58 69.38 -1.16 +90
1980 -4.48 -1.24 43.59 44.63 -1.96 88
1981 -5.21 -1.55 27.60 28.85 -2.86 -84
1982 --6.24 9 =--1.93 7.02 8.37 -4.01 +75

1983 -7.36 «-2.35 -16.76 -15.43 -5.31 .61



15

= (dV"/dP|dE%20) + Yoovn,/det(T). (25)

The oi] price multiplier allowing for fiscal policy responses can
be decomposed into two terms. The first term captures the impact of oi]
price changes on real income assuming that fiscal policy does not respond to
oil price changes. The second term captures the direct and indirect effects
that fiscal policy changes have on domestic output. The direct effect is
equal to the contractionary impact of a reduction in government expenditures
in a closed economy. The indirect effects stem from the impact that fiscal
policy changes have on DC's imports with the subsequent feedback to NC's
exports and income.

From equation (25) we see that, even if oi] prices have a
positive impact on real income (given that the first term of equation (25)
could be positive), a restrictive fiscal policy response to an oi] price

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

¥< -(¥22m17 N2Ha)/ (Cm y22) »

then the effect of an increase in the price of oil coupled with a

restrictive fiscal policy will reduce real income of developed economies.

II.3 Income Feedback Effects and the Price Elasticity of 0i1 Demand

Given that oi] price changes affect real income of oi] importers
and that these income effects are transmitted to OPEC's exports, it seems
natural to ask how is OPEC's pricing policy affected hy the instability of
the denand schedule due to the income feedback effects of oi] price changes.
We address this question by considering the demand for oi] that OPEC

faces: