Impact of oil price uncertainty shocks on China’s macro-economy

Abstract

This study investigates the impacts of crude oil price uncertainty shocks on China’s macro-economy using empirical and theoretical approaches. The vector auto-regression with stochastic volatility in mean (VAR-SVM) model reveals that increasing oil price uncertainty significantly depresses output and raises inflation. To fully understand the transmission channels of oil price uncertainty shocks, we develop a new Keynesian dynamic stochastic general equilibrium (DSGE) model that incorporates oil demand of household, intermediate sector, and transportation sector. Increasing income uncertainty induced by high oil price volatility leads to enhanced precautionary saving and thus a decrease in consumption, particularly durable consumption, of individual households. The precautionary working mechanism is plausible in the changes of households’ labor supply and firms’ production behaviors when oil price uncertainty increases. Furthermore, with decreasing forward-looking market demand, intermediate firms choose higher prices to avert risk, which results in higher inflation in China. To explore how to mitigate the negative effects of oil price uncertainty, we consider a number of possible factors. The results illustrate that increasing competitiveness among transportation firms, reducing oil intensity of intermediate sector, targeting headline inflation by the central bank, and decreasing the Frisch elasticity of labor supply are effective measures. Our findings also suggest that deregulation of refined oil price in China would not amplify negative effects of oil price uncertainty.