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MBA ECO Salvatore’s Introduction to International Economics

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MBA ECO Salvatore’s Introduction to International Economics

  1. 14, Salvatore’s Introduction to International Economics, 3rd Ed.

 

  1. Evaluating the Effect of a Petroleum Price Shock

The staff of the Board of Governors of the Federal Reserve System constructed a large-scale macroeconomic model, which was used to evaluate the effect of various economic shocks, such as a petroleum price shock, and the monetary policy responses to them, in the United States and in other countries. One simulation experiment conducted was to use the model to analyze the effect of a $5 permanent increase in the price of imported petroleum into the United States, first without and then with an appropriate monetary policy response. At the time of the simulation in 1987, a $5 dollar increase in the price of petroleum represented a 25 increase in the price of petroleum. During 1999, the price of imported petroleum increased by about $15, and so the effect of this price shock would be three times larger than for the simulation experiment reported below.

The model shows that a $5 permanent increase in the price of imported oil would lead to an increase in the U.S. inflation rate of about 0.5 percent by the end of the first year and an increase in the U.S. trade deficit of $13.1 billion (see the following table), but it would have little or no effect on real GDP in the absence of any U.S. monetary policy response. With a 20 basis point (i.e., with a two-tenths of 1 percent) increase in the U.S. interest rate to eliminate the inflationary effect of the petroleum price shock, U.S. real GDP would fall by 0.3 percent by the end of the year, but as the inflationary impact of the increase in the price of petroleum subsides, the interest rate increase can be eliminated and the real GDP of the United States goes back to its original level by the end of the third year.

The following table shows the effect of a $5 increase in the price of imported petroleum on the G-7 countries, on the smaller OECD countries, on the Newly Industrializing Economies of Asia (NIEs), on OPEC countries, and on the rest of the world in the absence of any policy response on the part of the United States and other countries. The table shows that the trade balance of the United States deteriorates by $13.1 billion in the first year of the increase in the price of petroleum, $4.0 billion in the second year, and

$1.8 billion in the third year. In other words, the $5 increase in the price of petroleum is gradually absorbed by the U.S. economy with (as indicated above) only a small dip in the real GDP of the United States. The effect on the trade balance of other countries is shown in the table. Note that, as exporters of petroleum, the increase in the price of petroleum improves the trade balance of Canada the United Kingdom a little and the trade balance of OPEC a lot in the first year, but then the effect peters out.

Table: Effect of a Petroleum Price Shock on Trade Balances (in Billions of Dollars)

Year 1                    Year 2                    Year 3

United States                                                        -13.1                       -4.0                        -1.8

Canada                                                                    1.3                       0.3                        0.2

Japan                                                                     -12.3                       -7.9                        -5.7

Germany                                                               -4.7                       -3.3                        -3.0

France                                                                    -2.7                       -2.1                        -1.9

United Kingdom                                                     0.5                       -0.2                        -0.2

Italy                                                                       -3.0                       -2.6                        -2.3

Smaller OECD Countries                                   -1.2                       0.2                        -1,7

NIEs                                                                       -3.2                       -4.4                        -4.8

OPEC                                                                     34.5                       26.8                        21.8

Rest of the World                                                   2.7                       -4.1                        -5.5

Source: Board of Governors of the Federal Reserve System, “Evaluating International Economic Policy with the Federal Reserve’s Global Model,” Federal Reserve Bulletin, October 1997, pp. 797-817.

Read the above and write a 250- to 450-word paragraph that responds to the following questions:

  • What is the initial effect of the increase in world petroleum prices on trade balances?
  • What happens to the effect after three years?
  • What is causing the effect on the trade balances?
  • What prediction could we make about the effects of a decrease in world petroleum prices on trade balances?