Sunday, December 18, 2016

Gasoline Prices, Transport Costs, and the U.S. Business Cycles

 

Gasoline Prices, Transport Costs, and the U.S. Business Cycles


One sentence summary: Technology and monetary policy shocks have significant effects on the U.S. business cycles in the long run, while gasoline supply and demand shocks play an important role in the short run.

The corresponding paper by Hakan Yilmazkuday has been published at Journal of Economic Dynamics and Control.

The working paper version is available here.

Abstract
The effects of gasoline prices on the U.S. business cycles are investigated. In order to distinguish between gasoline supply and gasoline demand shocks, the price of gasoline is endogenously determined through a transportation sector that uses gasoline as an input of production. The model is estimated for the U.S. economy using five macroeconomic time series, including data on transport costs and gasoline prices. The results show that although standard shocks in the literature (e.g., technology shocks, monetary policy shocks) have significant effects on the U.S. business cycles in the long run, gasoline supply and demand shocks play an important role in the short run.


Non-technical Summary
There is a close relationship between gasoline prices and the business cycles. One reason is that transportation of goods between producers and consumers is achieved by using gasoline as the main input. A second reason is that gasoline is by far the most important form of energy consumed in the United States; e.g., it accounts for 48.7% of all energy used by consumers. A third reason is that gasoline prices reflect the developments in the global energy markets. A fourth (and maybe the most important) reason is that gasoline is the form of energy with the most volatile price, which is important for any business cycle analysis.

This paper investigates this relationship for the U.S. economy. The main innovation is to include a transportation sector (that uses gasoline as an input of production) between producers and consumers in an otherwise standard DSGE model. In the model, we distinguish between demand and supply shocks by assuming a given (exogenous) endowment of gasoline, while letting the gasoline price to be determined in equilibrium. The optimization of households and firms results in an expression for the nominal price of gasoline depending on future nominal gasoline prices, future gasoline supply shocks, and nominal interest rates. The equilibrium real price of gasoline further depends on the global real economic activity together with the global endowment of gasoline.

In equilibrium, the effects of transport costs and gasoline prices are further summarized in an IS equation, a Phillips curve, a terms of trade expression, a monetary policy rule, and real prices of transportation and gasoline. Hence, in this paper, possible effects of gasoline supply and demand shocks on output, inflation, and transport costs can be investigated together with the effects of other shocks accepted as standard in the literature. We pursue such an approach to investigate the volatilities in gasoline prices and their effects on the U.S. business cycles.

The introduction of large number of shocks allows us to estimate the full model using a large data set (with five series). We match the model with the seasonally-adjusted U.S. data on output growth, home CPI inflation, home nominal interest rates, real transport costs, and real gasoline prices. The results show that although standard shocks in the literature (e.g., technology shocks or monetary policy shocks) have significant effects on the U.S. business cycles in the long run, gasoline supply and demand shocks play an important role in the short run. Therefore, the optimal policy depends on the horizon considered in the U.S. economy. The results are mostly driven by discretionary income effects of transportation costs (and thus gasoline prices) which are important for a country like the U.S., which is a net oil importer.



Regarding the details of empirical results, the U.S. output volatility is governed mostly by technology and gasoline endowment shocks, followed by monetary policy shocks. Although transportation technology shocks and gasoline endowment shocks are effective in the short run, production technology shocks and monetary policy shocks are more effective in the long run; therefore, gasoline supply and demand shocks have played an important role in historical U.S. business cycles, especially in the short run.

The volatility in U.S. CPI inflation is governed mostly by monetary policy shocks, followed by transportation technology shocks and gasoline endowment shocks; the effects are stable across different horizons. The volatility in real transport costs are affected mostly by monetary policy shocks and gasoline endowment shocks, followed by technology shocks and markup shocks. As expected, the volatility in real gasoline prices are mostly governed by gasoline endowment shocks and transportation technology shocks (i.e., gasoline supply and demand shocks). Finally, the volatility in interest rates are mostly governed by transportation technology shocks, followed by monetary policy shocks and gasoline endowment shocks.

Regarding the details of the economic intuition behind the empirical results, a positive transportation technology shock has positive effects on the economic activity measured by the output. The model works through the partial removal of a friction in the U.S. economy, leading to relatively higher demand for goods (i.e., discretionary income effect, just like the removal of a consumption tax) that increases both prices and output in equilibrium. Such increases in output also lead to higher demand for transportation services, increasing both nominal transportation costs and nominal gasoline prices (due to the increase in gasoline demand). Since the positive response of CPI is higher (lower) than the positive response of nominal transportation costs (nominal gasoline prices), real transportation costs (real gasoline prices) go down (up), where the difference between the responses of transportation costs and gasoline prices are mostly governed by transportation technology shocks. In sum, positive transportation technology shocks reduce real transportation costs, and they increase real gasoline prices, working as only gasoline demand shocks (i.e., there is no change in gasoline supply in this process).

Positive gasoline endowment shocks have almost similar effects, except for the response of real gasoline prices. It is straightforward to follow the chain of logic to understand the nuance: An increase in gasoline endowment (i.e., a gasoline supply shock, by definition) leads to a reduction in gasoline prices, which, in turn, reduces transportation costs. Accordingly, the discretionary income effects come into picture to increase output and prices, which, in turn, increase the demand for transportation services and thus gasoline. Therefore, both supply and demand for gasoline are affected in this process, where the effects of gasoline demand dominate, and nominal gasoline prices increase. Nevertheless, the positive response of nominal gasoline prices is lower than the positive response of CPI, implying that real gasoline prices decline. In sum, positive gasoline endowment shocks reduce both real transportation costs and real gasoline prices. This result, together with the last sentence of the previous paragraph, is the key in understanding the contribution of this paper, where we distinguish between the effects of gasoline demand and gasoline supply shocks. 






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