The Impact of Oil Prices on Income and Energy

By Glasure, Yong U.; Lee, Aie-Rie | International Advances in Economic Research, May 2002 | Go to article overview

The Impact of Oil Prices on Income and Energy


Glasure, Yong U., Lee, Aie-Rie, International Advances in Economic Research


The major determinant of real income growth in Korea is real oil prices, followed by money supply, exchange rates, energy consumption, and government spending. Over the longer horizon, the effects of exchange rates, oil prices, government spending, and money supply become more pronounced. For energy consumption, the most important factor is oil prices, followed by exchange rates, government spending, money supply, and income. For the association between energy consumption and real income, energy consumption influences real income growth only through energy consumption, while real income affects energy consumption only through the error correction term. The findings of the study thus suggest that the level of economic activity and energy consumption mutually influence each other. (JEL Q43, O52)

Introduction

Crude oil prices have risen by more than $30 a barrel since February 1999, from a low of $10 a barrel in 1998. That is comparable to the three episodes of crude oil price hikes in 1973-74, 1979-80, and 1990. Recent oil price levels also are similar to record high levels during the second oil shock and the Gulf War. Hence, rapidly rising oil prices have become a major concern of oil-importing economies such as Korea, whose reliance on foreign sources for its energy requirements was above 98 percent based upon its total indigenous energy production to foreign imports in 1998. Korea's oil dependency in 1998 was 3.5 percent (net oil imports in U.S. dollars to GDP), compared to about 0.5 percent for both the United States and Japan.

The Korean economy, therefore, is highly susceptible to sudden and sustained increases in World oil prices. However, the empirical literature on the relationship between energy consumption and real income not only ignores the effects of oil prices on economic growth and energy consumption, but also neglects the effects of exchange rates, money supply, and government. (1) In a related study, Glasure and Lee [1999] show that the exchange rate provides the most information concerning future fluctuations in real economic growth, followed by money supply, and government expenditure. Their findings thus suggest that the omitted variables may overstate or mask the effects of energy on real income or real income on energy. (2) Moreover, Glasure and Lee [1996] also note that the combined effects of money supply and government spending in the relationships between U.S. energy consumption and employment components account for more than 35 percent of the variance of energy consumption. Hence, an empirical examination of the association between energy and real income must include oil prices, exchange rates, money supply, and government spending. Yet, no work has been undertaken to provide evidence to empirically support this proposition in the Korean case, thus meriting further investigation.

This study investigates the degree of importance of oil prices, exchange rates, money supply, government spending, and energy consumption (real income) in explaining economic growth (energy consumption) for the Korean case. (3) In addition, the empirical association between energy and real income is evaluated while controlling the effects of these variables. The annual data from 1961-90 are used.

The plan of the paper is as follows. The next two sections discuss the specification of the model and data sources, while the following section presents the results. The last section gives a summary and conclusions.

The Model

The standard augmented Dickey-Fuller (ADF) tests are inappropriate for the variables with apparent structural changes, possibly due to the oil price shock [Perron, 1989, 1997; Zivot and Andrews, 1992]. Thus, this paper uses Perron's [1997] method, and the results are reported in Table 1. The estimated statistics of the variables in first differences are greater than the critical value, and thus nonstationarity is rejected for all the variables at the 10 percent level. …

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