Does Oil Price Shocks Affect Business Cycles?

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It is often said that oil price shocks affect business cycles, triggering a detrimental effect on the economic activity of some countries when they rise and a favourable effect when they fall. One instance could be the U.S., where the data suggests that most recessions after 1973 have been headed by oil price increases, which is often taken as evidence of recessions being caused by oil price shocks. This brings up to question through which channels oil price shocks might be transmitted to economic activity, to what extend specific countries and the global economy can be affected by oil price shocks and whether there is a coincidental relationship between oil prices and recessions as a result of a correlation of the former with other…show more content…
Unless savings are reduced or borrowing increases, the deterioration in the terms of trade may trigger lower domestic consumption in net oil-importing economies .
Besides the effect in the terms of trade, an oil price increase may have immediate effects on aggregate demand by means of higher consumer energy prices since inflationary pressures reduce consumers’ real disposable income, and, therefore, consumption. This is known in the literature as direct first-round effect. The size of the direct effect of an oil-price increase depends on the share of the cost of oil in national income, the degree of dependence on imported oil and the ability of end-users to reduce their consumption and switch away from oil .
On the other hand, producers in oil-importing countries will face higher production costs with negative implications in profits since their short term ability to react to oil price increases by substituting to another source of energy is limited . Firms may respond to this by either reducing supply or pricing, thus creating inflationary pressures. In addition, firms may postpone or even cancel new investments fearing further oil-price increases in the future. Changes in consumer prices that occur as a result of the impact of oil prices on production costs are known as indirect first-round effects and they depend on the

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