Jungho Baek Professor of Economics School of Management University of Alaska Fairbanks … · 2017-11-14 · Miljkovic and Baek (2017) is perhaps one of the few studies that has analyzed

Jungho Baek

Professor of Economics

School of Management

University of Alaska Fairbanks

Dragan Miljkovic

Professor

Agribusiness and Applied Economics

North Dakota State University

Outline of Today’s Presentation

Introduction Previous Studies

Objective

Empirical Model

Empirical Results

Summary and Conclusions

2/23

An historical view of economics states that relative prices of goods are determined by real supply and demand factors with little regard to nominal monetary factors.

However, a review of the existing literature shows the importance of monetary policy in the determination of the real commodity prices using the overshooting hypothesis.

Bordo (1980); Barnett et al. (1983); Frankel (1984); Lai et al. (1996); Saghaian et al. (2002)

Previous Studies

3/23

The overshooting hypothesis, originally developed by Dornbusch (1976), claims that whenever some markets (e.g., fix-price manufactures and services sector) adjust slowly in response to a monetary change, those sectors of the economy that are free to move (e.g., a flex-price commodity sector) must bear the burden of that sluggishness.

When a monetary shock occurs, the prices in the flexible commodity sectors overshoot their long-run equilibrium values.

Previous Studies (Contd.)

4/23

In this sense, monetary changes can have real short-run impacts on commodity prices.

It implies that money supply is not neutral and monetary impacts can change relative prices in the short-run.

Previous Studies (Contd.)

5/23

However, the emphasis of the existing literature has typically been on agricultural commodity prices with few studies considering the effect of monetary policy on energy commodity prices (i.e., oil prices).

Miljkovic and Baek (2017) is perhaps one of the few studies that has analyzed the monetary policy impacts on energy commodity prices (i.e., coal prices) in a close economy setting.

They find that U.S. monetary policy has a non-neutral impact on coal prices.

Previous Studies (Contd.)

6/23

To empirically examine the effects of U.S. monetary policy on oil prices, controlling for industrial (manufacturing) prices and exchange rates, in a dynamic framework of cointegrated vector autoregression (CVAR).

The case of oil is of interest in particular because oil is a heavily traded commodity and the U.S., while historically one of the world’s largest producers, has been one of the very net-importers of crude oil too.

Objective

7/23

Empirical Model

An empirical model is a variation of Saghaian et al. (2002).

Saghaian et al. (2002) expand the overshooting hypothesis of Dornbusch (1976) to include a third sector (i.e., agricultural prices) and relax the close economy assumption of Frankel (1986)’s model to allow international trade (i.e., exchange rate).

8/23

Empirical Model (Contd.)

In this research, we analyze energy commodities (i.e., oil prices) rather than agricultural commodities in an open economy setting.

Oil prices and exchange rates have their own separate and different adjustment paths and are assumed to be flexible and adjust quickly to monetary shocks.

However, the price of industrial goods are assumed to be sticky.

9/23

Empirical Model (Contd.)

The first requirement for CVAR is that the variables must be non-stationary.

The presence of a unit root in the variables is tested using the Dickey-Fuller generalized least square (DF-GLS) and Perron-Vogelsang (PV) test.

The PV test is used to validate the results of the DF-GLS and to identify a potential structural break in the series that can be incorporated into further analysis.

10/23

Empirical Model (Contd.)

In a nonstationary VAR, the variables move together in the long-run only if they are cointegrated.

Cointegration test is conducted to identify the number of cointegration vectors and long-run structural relations among the variables using the latest Johansen multivariate cointegration method that allows for known structural breaks (Johansen et al., 2000).

11/23

Empirical Model (Contd.)

VEC model uses the cointegrating relationship as a restriction to provide flexible short-run dynamics (i.e., short-run overshooting).

The parsimonious vector error-correction (PVEC) proposed by Hendry (1995) is estimated using full-information maximum likelihood (FIML).

12/23

Data

Quarterly data for 1980-2014 (1980:Q1-2014:Q4)

U.S. Money supply (M2)

International Financial Statistics (IFS)

Crude oil and industrial prices

Measured in PPI commodity index (2010=100)

International Financial Statistics (IFS)

Real effective exchange rates (2010=100)

Bank of International Settlement

13/23

Empirical Results

The DF-GLS and PV tests show that the four variables are non-stationary and integrated of order 1, I(1).

Since the PV test identifies a single structural break around 1995:Q1 for such our key variables as oil prices and money supply, we allow for this breakpoint when conducting cointegration analysis.

14/23

Empirical Results (Contd.)

The latest Johansen test indicates that there are three cointegrating vectors.

With multiple cointegrating vectors, restrictions on the cointegrating spaces (β) are imposed to identify whether they are unique and whether they tell us any information about the structural economic relationship underlying the system.

Null hypothesis Eigenvalue Trace statistics 5% (10%) cv

r=0 0.365 122.23** 84.35 (80.08)

r≤1 0.165 60.09** 59.04 (55.41)

r≤2 0.148 35.43* 37.38 (34.42)

r≤3 0.094 13.55 18.92 (16.78)

15/23

Empirical Results (Contd.)

EC1: (Oil prices)t = 0.525*(Money supply)t

EC2: (Industrial prices)t = 3.037*(Money supply)t

EC3: (Exchange rates)t = -7.910*(Money supply)t

EC1 and EC2 show that, since each of the coefficients on oil and industrial prices is not equal to unity, the price of the industrial good relative to crude oil is not unit proportion to the rate of growth of the money supply in the long-run.

Apparently, there is evidence of the non-neutrality of money supply in the long-run.

16/23

Empirical Results (Contd.)

EC1: (Oil prices)t = 0.525*(Money supply)t

EC2: (Industrial prices)t = 3.037*(Money supply)t

EC3: (Exchange rates)t = -7.910*(Money supply)t

EC3 shows that the estimated effect of the money supply on the exchange rates is negative, implying that money supply causes a depreciation of the exchange rate via interest rate reduction.

17/23

Empirical Results (Contd.)

EC11 = -0.070 and EC22 = -0.044 indicate a short-run positive departure of oil and industrial prices from the long-run money supply relationship (i.e., overshooting), requiring both prices must fall in order to restore the equilibrium.

∆(Oil prices)t

∆(Industrial prices)t

∆(Exchange rates)t

∆(Moneysupply)t

EC1 -0.070** 0.003 0.006 0.002

EC2 -0.230 -0.044** 0.040 0.027**

EC3 -0.137 -0.022** 0.022 0.015**

18/23

Empirical Results (Contd.)

|EC11|> |EC22| implies that relatively more flexible oil prices adjust more quickly than industrial prices to restore the long-run equilibrium, thereby affecting relative prices in the short-run.

∆(Oil prices)t

∆(Industrial prices)t

∆(Exchange rates)t

∆(Moneysupply)t

EC1 -0.070** 0.003 0.006 0.002

EC2 -0.230 -0.044** 0.040 0.027**

EC3 -0.137 -0.022** 0.022 0.015**

19/23

Empirical Results (Contd.)

EC12 = -0.230 in the oil prices equation implies that oil prices must decrease when industrial prices overshoot their long-run equilibrium.

∆(Oil prices)t

∆(Industrial prices)t

∆(Exchange rates)t

∆(Moneysupply)t

EC1 -0.070** 0.003 0.006 0.002

EC2 -0.230 -0.044** 0.040 0.027**

EC3 -0.137 -0.022** 0.022 0.015**

20/23

Summary and conclusions

After identifying a unit root in oil prices, industrial prices, exchange rates and money supply, we find that all of the four variables are fully cointegrated over the sample period using the latest Johansen method.

We find that monetary shocks cause adjustments of oil prices and industrial prices to be vastly different in the long-run, thereby indicating non-neutrality of money in the long-run.

21/23

Summary and conclusions

It is also found that oil prices tend to adjust more quickly than industrial (sticky) prices to monetary shocks in order to achieve the long-run equilibrium, thereby affecting relative prices in the short-run.

Hence, U.S. monetary policy is likely to escalate the variability and fluctuations in oil prices and hence energy market instability.

22/23

Thank you!

23/23