Oil Shocks and the U.S. Economy: Evidence from a FAVAR Model

Abstract

We investigate the economic effects of three separate types of oil price shocks on the U.S. economy using a factor augmented vector autoregression framework and 185 monthly macroeconomic indicators from 1978 to 2017. We find that while increases in the price of crude oil triggered by oil supply shocks and oil demand shocks lead to a significant and permanent increase in the U.S. price level, the main drivers of fluctuations in the price of crude oil and the U.S. price level are oil-specific precautionary demand shocks. Further, while increases in the price of oil triggered by oil supply shocks are recessionary and lower U.S. economic activity, those triggered by oil demand shocks driven by global economic activity are associated with increased U.S. economic activity. We also find evidence that monetary policy-makers tighten monetary policy in response to oil demand shocks to mitigate inflationary effects, however we find no such evidence for oil supply shocks. Finally, we find the U.S. dollar real exchange rate depreciates in response to increases in the price of oil caused by both oil demand and supply shocks, however the effects from oil supply shocks are more permanent.