Oil prices and macroeconomic dynamics of the Oman economy

Abstract

Recent oil price changes have significantly influenced the macroeconomic activities of both oil importing and exporting economies. It has shifted the external balances of many economies. This study investigates the short and long run effects of oil price changes on macroeconomic activities of small open economy of Oman. The short-run changes in oil prices affect the economy via exchange rate and terms of trade channels, which in turn, affect the aggregate demand and supply aspects. While in long run, if the shocks remain persistent, the economy experiences the significant revenue windfalls and positive external balances. However, the degree of external shocks to domestic economy depends on the domestic response to external shocks. Vector Auto Regression (VAR) model is used to trace out those dynamics. VAR model is considered suitable methodological option in identifying the structural shocks through generalized innovations of impulse response functions and variance decompositions. The vector of six key macroeconomic variables is expressed in VAR framework. The framework establishes the joint behaviour of key variables through time and determines the structural dynamics of Oman economy. The variance decompositions are generated from a moving average representation of the VAR system and show the forecast error variance for each variable in the system attributable to both of its own innovations and those comes from other variables. Results suggest that changes in oil prices significantly affect the real exchange rate, output and external balances. Impulse response functions and variance decompositions results confirm positive effect of oil price changes on real effective exchange rates, real - output and consumer prices. To contain the inflationary expectations both in short and long run, the governments are usually resorting towards expansionary policies. The long run changes in oil prices is the key determining factor of output growth and subsequent changes in fiscal and monetary policy adaptations. The results further indicate that innovations in real output largely influenced by changes in prices. Innovations in money supply induce by changes in real output. Real output innovations positively affect by crude oil prices. Money supply is positively influenced by real output. In short run, the expansionary policies are consistent and have served well in containing the inflationary expectations and by maintaining the positive external balances. However, in long run, over reliance on stabilization policies in pegged exchange rate economies like of Oman economy may provide fewer options to contain the external shocks.