Abstract
We illustrate the theoretical relation among output, consumption, investment, and oil price volatility in a real business cycle model. The model incorporates demand for oil by a firm, as an intermediate input, and by a household, used in conjunction with a durable good. We estimate a stochastic volatility process for the real price of oil over the period 1986-2011 and utilize the estimated process in a non-linear approximation of the model. For realistic calibrations, an increase in oil price volatility produces a temporary decrease in durable spending, while precautionary savings motives lead investment and real GDP to rise. Irreversible capital and durable investment decisions do not overturn this result.
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