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Runninh Head: IMPACT OF FALLING OIL PRICES ON INFLATION RATE IN UK

1

Impact of Falling Oil Prices on Inflation Rate in UK

Name

Affiliation

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IMPACT OF FALLING OIL PRICES ON INFLATION RATE IN UK

2

Introduction

This study provides a comprehensive approach to evaluate the long run and short

relationship et!een the oil prices and the "PI inflation rate of the United Kingdom# The oil

prices decline has affected the gloal economy in a noticeale e$tent and the policy ma%ers

around the !orld are considering this oil price decline as persistent# &everal measures has een

proposed y the policy ma%ers around the !orld to handle the effects of this oil price decline#

The effects on the economic and financial mar%ets are severe in some cases !here the economic

fundamentals are also sho!ing deteriorating signs in the real terms#

'ate advancements in !orld!ide oil mar%ets have happened against a long pattern of

more note!orthy than(foreseen supply and less than anticipated supply# )$pectations of

!orld!ide oil demand have een reconsidered do!n!ards due to the incorporation of different

ne! sources of energy production# In the middle of *uly and +ecemer 2,-. the anticipated

demand for petroleum products have een found do!n!ard trending /I)A0 2,-.a and 2,-.1#

orld!ide development in 2,-3 is relied upon to remain much !ea%er than it !as during the

2,,4(,5 period at the point !hen oil price in the international mar%et climed significantly0

/Finn0 2,,,1# Further0 the oil intensity of !orld!ide 6+P has practically divided follo!ing the

-78,s as a conse9uence of e$panding energy productivity and declining oil intensity of energy

use0 /Peersman and :an Roays0 2,-21#

This study focuses on the insights of the trend in gloal oil prices since -755 and finds

the relationship et!een the oil prices and inflation rate of the UK economy y utili;ing a

statistical approach# The study utili;es time series data to measure the impact of oil prices

movement on the inflation rate in the economy considering the historical data for the t!o time

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series considering other support variales !hich are e$pected to have significant relationship

!ith the inflation rate# The statistical techni9ue used in the analysis is vector auto(regressive

model !hile a long run co(integrating relationship has een chec%ed efore the ma%ing the

analysis report#

Objectives of the Study

The study is focused to find the insights of the relationship et!een the time series of

inflation and the oil prices< international mar%et data# The o=ective of study is to integrate the

phenomenon of economic and international mar%et comple$ities to assess the right coefficient

for the long(run and short(run impact on the inflation rate of the UK economy#

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.

2. Literature Review

&ince the oil prices are falling e$pansionary0 the effect has een e$pected to e recorded

more on the gro!th rate of developed countries as they have less scope of gro!th and are highly

volatile to the changes in gloal scenarios# The )uropean Union0 UK and the United &tates are

e$pecting high recession in the coming years also the general price level has een falling in these

countries0 /Peersman and :an Roays0 2,-21# &ome countries in the )uropean union has

recorded a negative inflation or dis(inflation in the past fe! years that is supposed to e an

outcome of falling oil prices# The most common reasons that analysts e$plain for the falling oil

prices is the unalanced supply and demand mechanics in the gloal oil mar%et#

2.1 Theories that explain fall in Oil Prices

A numer of theories have een presented y different analysts for the reason of falling

oil prices# The most common reason !hy the e$pansionary decline in oil prices is persistent is

due to the decisions of OP)" and &audi Araia# The :arious hypotheses have risen# OP)" itself

places that the decays are ecause of hypothesis in the usiness and that re9uest isn>t as lo! the

same numer of may thin%# Others attle that e$panded rivalry0 as e$panded U#&# shale oil

creation0 gives motivators to OP)" to hold costs do!n# In any case0 a fe! studies propose that

oil costs need to tumle to ?@, or even lo!er to stop oil production development0 /OP)"0 2,-.1#

The reasons also point the decisions ta%en y &audi Araia# The !orld>s iggest ma%er is

protecting its piece of the overall industry y cutting costs instead of creation# Others !ould go

so far as to say that &audi Araia is pushing costs do!n to hit its territorial adversary0 Iran0 !here

it harms most the economy0 /Finn0 2,,, OP)"0 2,-. Peersman and :an Roays0 2,-21#

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This paper inspects the effect of oil value stuns on the UK economy0 investigating ho!

the effect of these stuns may have changed after some time# After the sensational oil price hi%e of

the -78,s and the !orld!ide susidence that %ept running close y0 policyma%ers have given

careful consideration to variances in internationally e$changed oil costs and agoni;ed over the

potential effect on financial development and household value s!elling# 'ate years have y and

y seen sustantial change in oil costs0 !ith costs rising from ?-3 a arrel in -775 to almost ?-.,

a arrel in 2,,5# This ascent and the unpredictaility in oth the oil cost and monetary e$ecution

since have revived the veral confrontation aout ho! and y ho! much0 oil stuns influence

economies and ho! financial strategy should react0 /Rasmussen and Roitman0 2,--1#

2.2 Relationship between nflation and Oil prices

The asolute relationship et!een the falling prices of oil has een noticed in the -78,s0

!hen the e$pense of oil rose from an ostensile cost of ?4 efore the -784 oil shoc%s to around

?., the -787 oil emergency# This helped reason the customer value record /"PI10 a %ey measure

of e$pansion0 to dramatically multiply from .-#2, in mid(-782 to 5@#4, efore the end of -75,#

The policy ma%ers and analysts oth ta%e this oil shoc% effect as very dramatic and provide many

insights !hy the economic fundamentals have reacted to the oil price shoc%s in that time# The

research has sho!n y analysing historical data0 the consumer price inde$ ta%es aout t!enty

four years to ta%e a t!ofold figure !hile in the -78,s0 it too% only eight years to e douled

around it figure0 /Peersman and :an Roays0 2,-21#

The relationship et!een oil prices and the inflation rate has een !itnessed to ehave

differently after the -75,s# Bost of the analysts argue that during the time0 inflation rate has

acted li%e independent of the gloal oil prices in the -75,s !hen the oil price has douled from

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@

?2, to ?., !hile the rate of inflation has een found almost stale around the !orld# This

departure in the relationship !as much more ovious amid the oil prices %eep running up from

-777 to 2,,30 in !hich the yearly normal ostensile cost of oil rose from ?-@#3@ to ?3,#,.#

Along the same period0 the "PI has found a rapid increasing trend from -77@ to 2,,3# According

to this information0 it creates the impression that the solid connection et!een oil costs and

s!elling that !as found in the -78,s has deilitated essentially# The !hole scenario creates a it

difficult %ind of scenario as mostly0 the consumer price inde$ is found less responsive to the oil

prices in the last decade of -75,s !hile the relationship et!een oil prices and inflation has een

controversial since the -75,s as many researchers allocated different reasons for the inflation

trend in -78,s#

Past literature provided several insights to the e$perimental relationship et!een usiness

cycle and the gloal oil prices ups and do!n follo!ing -7840 the year of the first oil shoc%# The

initial t!o analysts !ho evaluated the effects of oil cost increments on the real economic

variales specially the inflation and e$change rate# hile it has also een said the capacity of the

variales considered clarifying the fluctuation of oil prices and the eventual change in inflation

rate and other economic indicators are related to each other# Research discovered measuraly

critical connections et!een oil price changes and real 6+P gro!th !hile the inflation rate

fluctuations has also een seen in a meaningful trend for the UK economy data in the period

efore -75,s and after the decade of -75,# The negative relationship et!een oil price increase

and financial development mirrored a causal connection from oil costs to aggregate financial

movements in the economy#

The rate of inflation in the United Kingdom has dropped from ,#4 per cent in *anuary to a

record lo! that is further e$pected to decline to desires of a tumle to ,#- per cent# 'o! inflation

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rate ecause of falling oil price is causing the general level of consumption# In any case0 the

figures !ill !eigh on the policy of the Can% of )ngland that is highly concentrated to force the

people to save more rather to spend all their money# For the purpose0 the Can% of )ngland is

specifically designing the Bonetary Policy !hich sets the premium rates at a record lo! of ,#3

per cent# &o far the Can% of )ngland has ta%en the perspective that falls in inflation rate is

interim and there is no compelling reason to slice rates to ta%e it ac% to its o=ective of 2 per

cent0 /Peersman and :an Roays0 2,-21#

Numerous researchers0 analysing the recent figures of "PI0 no! thin% the Can% !on>t

ma%e its mar%et rate move until the midst of 2,-@# This !ould help control the e$ceedingly

indeted firms and families# 'o! rate of inflation is significantly connected !ith falling dets

and reasonale financial administration# Not so for this situation# )$pansion fell in +ecemer

completely ecause of the late oil price decline0 !ith Crent rough tumling from more than ?--,

/D841 a arrel in *une to around ?3, today#

2.! The supply chain fra"ewor#

A consistent decline in oil price affects specifically the "PI through decrease in the costs

of profoundly oil intensive factors of production# These immediate impacts have a tendency to

deliver a typically direct0 decline in the rate of inflation t!elve months suse9uent to entering the

"PI# The most critical direct impact is on petrol costs0 !hich have a !eight of 4#3E in the "PI

items as%et# In any case since petrol oligations are settled in pence and record for a vast

segment of retail petrol costs0 the e$tent of this direct impact depends to some degree on the

eginning level of oil costs the ring do!n the oil value0 the littler the effect of moves in oil

costs on e$pansion# To the degree that ad=ustments in oil costs are =oined y changes in other

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!holesale vitality costs for e$ample0 common gas0 falls in oil costs could0 thusly0 moreover

impact family unit vitality ills0 !hich represent another .#3E of the "PI items as%et#

One reaction is that UK petrol costs are falling0 for the present0 and sheltered utilities

might soon e constrained at long last to reflect lo!er !orld!ide vitality costs in our family unit

ills to in light the fact that they are sufficiently speedy to reflect !orld!ide costs !hen they

rise# &uper !orld!ide reporting oliges speculation# Kindly impart this article to others

utili;ing the connection underneath# Indeed0 the analysts stay persuaded that falling inflation rate

!ill help purchaser spending# GInstead of eing a !orry0 the drop in s!elling is a shelter to the

economy0 furnishing families !ith more note!orthy investing force at energy !hen pay

development remains frustratingly feele#

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!. $ethodolo%y

The theoretical frame!or% of the relationship et!een inflation and oil prices is comple$#

The researchers e$plain the relationship in different perspectives that directly or indirectly relate

the t!o# Oil prices have a direct effect that comes through the reduction in petroleum products#

The most significant effect is on the petrol price that is included in the "PI as%et and covers a

4#3 per cent !eight in it# The change in petrol price thus effect the inflation rate directly that

falls# Also the falling oil price affects the "PI indirectly that has een noticed y researchers# The

indirect effect is actually complicated and difficult to e measured# Researchers e$pect the effect

goes to diverse sectors of the economy and the effect appears on the final products in every

sector# The proale net positive effect of the residential interest and supply conse9uences for the

inflation rate !ill li%ely hence conflict !ith the effect of the roundaout impacts0 !hich !ill

!eigh on e$pansion# In the medium term0 the general effect of these contradicting inflationary

!eights !ill0 to a limited e$tent0 rely on the reaction of financial arrangement to falling oil price#

It is argued that any response through the monetary policy ma%ers may e restricted0 especially if

the immediate conse9uences for "PI are liale to e generally fleeting#

This study specifically follo!s the indirect channel of effect of falling oil prices on the

"PI inflation rate that is amiguous in any %ind of arguments that are !idely discussed in the

discussions# The main effect that is direct is indeed not of very interest as it is ovious# The focus

of this study is thus to analyse the impact of oil prices on the inflation rate of the United

Kingdom# This study thus utili;es a statistical model to analyse the impact of oil price on the

inflation rate#

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-,

!.1 The $odel

The effect of falling oil prices can e of t!o types that are indirect and direct# This study

focuses the indirect channel of effect that impacts the trend of inflation in the economy# The

study utili;es a :AR /vector auto(regressive1 model to analyse the impact# The model captures

the short run and long run impact through finding the co(integrating relationship et!een the

variales# The model has specificity that it separately e$plains the coefficients to represent the

impact of falling oil prices on inflation rate in the short and long period of time# The simple

model that defines the statistical relationship et!een the variales is given elo!

CPI t H , J - OILt J 2 GDP t J 4 INT t J . EXCH t J ui ############## /4#-1

!here0

CPI t H "PI rate of inflation at time period t<

OILt H Oil price at time t<

GDP t H 6ross +omestic Product at time t<

INT t H rate of interest at time t<

EXCH t H e$change rate at time t<

ut H the !hite noise error term

The variale LOP” represents the historical data of oil prices in the model /-1 !hile the

other variales are included as control variales !hich support the analysis and provide a good

fit of the model# The variales included in the model have economical ac%ground that =ustifies

their inclusion in the model that !ill e e$plained in the chapter no# .#

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--

!.2 &xpected si%ns of the variables

The study includes the variales in the model that have comple$ implications in the

economic literature that helps to e$plain the possile signs that the variale !ill appear !ith# It is

e$pected that the oil prices have a direct relationship !ith the inflation rate as !hat the historical

data and the theories of falling oil prices e$plain the scenario# The direct effect although does not

e$plained y this model ut have significant effect on the inflation trend# The e$pected sign !ith

the oil price is positive as in the long run0 oil prices e$hiit a positive relationship !ith the

inflation rate# The relationship et!een inflation and 6+P of a country is also e$pected to e

positive# &ome researchers suggest that the relationship is amiguous as it is not very clear

!hether inflation causes the 6+P to gro! or 6+P gro!th causes inflation to increase# In the

study !e e$pect a positive relationship et!een the 6+P gro!th rate and inflation as the

increasing 6+P ma%es the consumer availale !ith higher disposale incomes to spend that

causes eventually the inflation rate to rise#

The other t!o variales are interest rate and e$change rate# Mere0 !e e$pect a negative

relationship et!een inflation and interest rate# The relationship is ased on an indirect

frame!or% that e$plains the effect of interest rate fluctuation in the economy# The negative

relationship et!een the t!o variales can e e$plained through the e$ample of decreasing

interest rate that ma%es the people availale !ith more money to spend as the cash in hand is

increased# The increase in consumer spending affects the aggregate demand and thus eventually

the inflation rate rises# The relationship is reverse for an increasing interest rate# The relationship

et!een inflation rate and e$change rate is amiguous as many analysts point out the comple$ity

of the relationship et!een the t!o# The relationship has found significant !hen the e$change

rate is high ut the same is insignificant !hen the e$change rate is fluctuating at a lo!er rate#

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-2

The amiguity in e$change rate is thus not guaranteeing any asolute sign for the coefficient and

!e cannot e$pect a particular sign !ith the coefficient of e$change rate#

!.! Short'run (ersus Lon%'run &ffects

This study is a comprehensive approach to find the effects of historical oil prices on

Pa%istan economy# The data has een modelled in the :AR model to e$hiit the long run and

short run relationship et!een the variales# The research in economics field has found that real

variales have diverse properties in different time periods# The short run and long run effects of

real variales are significantly different to each other# The difference can e oserved in terms of

the e$tent of their response to an event or they can even change their pattern of ehaviour !hen

analysed in different spans of time# The response a variale sho!s in the short run may e

entirely different than !hat it sho!s in the long run# Thus0 the policy ma%ers are more concerned

aout ho! a variale respond in the long run rather than aout its short run attitude#

!.) The (ector *uto'Re%ressive $odel +(*R,

The model used in this study to analyse the short run and long run impact of oil prices on

the inflation rate of the UK economy is modelled through :AR techni9ue# :AR model actually

used to chec% the linear independence et!een the variales utili;ed in the analysis# :AR model

sums up the univariate autoregressive model y ta%ing into consideration more than one

developing variale# All variales in a :AR are dealt !ith symmetrically in an au$iliary sense in

spite of the fact that the assessed 9uantitative reaction coefficients !on>t !hen all is said in done

e the same every variale has a comparison clarifying its development ta%ing into account its

o!n slac%s and the slac%s of the other model variales# :AR displaying does not re9uire as much

information aout the po!ers affecting a variale right no! models !ith concurrent

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-4

mathematical statements The main earlier learning needed is a rundo!n of variales !hich can

e guessed to influence one another inter(temporally#

A general :AR model contains an arrangement of m< variales all of them are presented

separately as a linear function of p< lags of itself and all other variales including the !hite noise

error term# It is an important feature that the :AR model includes the e$ogenous variales0 for

e$ample0 regular shams or time drifts in a :AR ho!ever !e might concentrate on the asic case#

ith t!o variales0 $ and y0 a re9uest p :AR !ould e the t!o e9uations as follo!s

t H y, J yy-yt(- JJ yypyt(p J y$-$t(- J J y$p$t(p J vty

Qt H $, J $y-yt(- J J $yp yt(p J $$-$$(- J #J $$p $t(p J vt$

The model presented aove is a general :AR model that represents a t!o variale :AR

frame!or% !here $yp represents the coefficients of variale y in the second e9uation for $ !here

p represents the lag length#

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-.

). (ariables0 -ata Source and &sti"ation Procedure

This chapter covers the data sources of different variales0 the complete description of

variales and the estimation procedure in detail# The detail of the models run and the step!ise

e$planation of the steps follo!ed are presented in this chapter#

).1 -ata Sources

In this study0 the time series data of UK economy and the gloal oil prices have een

utili;ed for a period of 28 years# The data is all used !ith annual fre9uency and collected from

authentic sources# The data utili;ed in this study cover the time series from -755 to 2,-. !ith

annual fre9uency# The variales descried in the model of chapter 4 are used in the analysis

!hile a rief description of these variales is given in follo!ing headings# The data of "PI

inflation rate0 6ross +omestic Product0 interest rate and the e$change rate of the United

Kingdom has een gathered from the !e source of IF& /International Financial &tatistics10 the

dataase of the International Bonetary Fund /IBF1#

).2 (ariables onstruction

:arious variales are used in the analysis that are constructed a follo!s

).2.1 nflation Rate

Rate of inflation is the dependent variale in our analysis# The "PI inflation rate data has

een gathered from the !di !hile the series is included !ith a ase year of 2,-,# The data of "PI

has een ad=usted seasonally !hile the trend in the data has also een chec%ed# The data series

used in the analysis is thus stationary and suits the re9uirements of :AR model#

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-3

).2.2 /-P /rowth Rate of 0

The data of gro!th rate of 6ross +omestic Product has also een gathered from the same

source of IBF# The series is presented in percentage form !hile the series ranges from -755 to

2,-.0 in totality0 comprises a series of 28 oservations that are recorded in annual fre9uency#

).2.! nterest Rate

The rate of interest is also considered as an important variale in the analysis that has

critical implication found in the literature# The series of interest rate has ta%en from IF& and it is

recorded in a fre9uency of percentage per annum# The series of interest rate ranges from -755 to

2,-. that in totality counts 28 oservations in numer#

).2.) &xchan%e rate

The currency e$change rate is included in the analysis as an important variale that is

e$pected to have significant impact on the decreasing inflation rate# The analysis includes the

series of e$change rate as an inde$ !hile the series has een ta%en from IF&# The e$change rate

ta%en for the analysis is nominal effective e$change rate !hile that series ranges from -755 to

2,-.#

).2. Oil Prices

LOil prices is the variale that is the centre of interest in the analysis# The hypothesis of

this study is ased on the relationship et!een oil prices and the inflation rate in the United

Kingdom# The series of oil prices has een gathered from !hile the series is recorded in nominal

million dollars that represents the price of Crent crude oil per arrel in the international mar%et#

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-@

The series has een ta%en in annual fre9uency and the data represents nominal price of Crent oil

in the international mar%et#

).! &sti"ation Procedure

The study is particularly focused to find the impact of oil prices on the inflation rate

!hile the data has een modelled in :AR frame!or%# The !hole estimation procedure of the

:AR model is ta%en in a step!ise manner !hich is descries riefly as follo!s

• Unit root test for stationarity

• Initial model estimation !ith various lags and differences

• &election of e$planatory variales and lag length for endogenous variales• ald(test

• t(test

• &ch!art;(Cayesian criterion

• &election and estimation of final :AR model

• )stimation of :)"B models

• *ohanson test of "o(integrating relationship

).!.1 *-3 0nit Root Test

The time series econometrics gives great importance to the stationarity of a series# If a

series under study has a Ltime variant mean0 variance or covariance0 the series !ould e

said to contain a unit root# Presence of one or more unit roots in a series means that the usually

otained regression parameters can e spurious as the t(ratios !ill no more follo! the t(

distriution unless the re9uirement of co(integration is satisfied# Non(stationarity can persist in a

series in t!o forms0 either a stochastic trend or a deterministic trend# Although0 oth of the types

are actually trend in the series ut0 !hat econometricians suggest is0 not to ta%e a difference in

the case of a deterministic trend ecause0 although0 it !ill remove the unit root from the

series ut !ill generate a moving average process in the error of the series# The most commonly

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-8

used test for the presence of unit root in a series is Augmented +ic%y Fuller /A+F1 test0 an

improved form of +ic%y Fuller test0 first presented y +ic%y and Fuller /-7870 -75-1# A+F test

ad=usts the +F test for the possiility of serial correlation in the error terms y adding the lagged

difference terms of the independent variales in the test e9uation#

For the test of stationarity of the series0 !e have used the A+F test# The test e9uation may

e one of the follo!ing three forms

No intercept or trend

Intercept ut no trend

Intercept and trend

here0 ut is the !hite noise error term and St H / t t(-1# In using the A+F test0 !e test the

null hypothesis that H , /presence of a unit root1 against the one tailed alternative hypothesis

that V - /asence of a unit root1#

).!.2 (*R and (&$ $odels

Time series sometimes include the co(integrated variales that may e proved to co(

integrate in a relatively longer period of time# For that purpose0 the researcher !idely utili;es the

option of :AR models !hich provide the integrated components that represent the estimators of

the covariate and stationary variales# The study utili;es the :AR model to assess the short run

and long run effects of the oil prices on inflation rate of the UK economy# The specified :AR

model provides the coefficients estimate of the long run effect of oil prices and other variales on

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-5

the "PI inflation rate !hile the :)"B models represent the short run relationship et!een the

variales# &ince the study is comprised to assess the relationship et!een oil prices and inflation

rate0 !e !ill !orry only aout the coefficients of the :)"B /vector error correction model1

made for the oil prices and inflation rate# The :AR model specified for the study is presented as

follo!s

CPI t H , J - OILt J 2 GDP t J 4 INT t J . EXCH t J ui ############## /.#-1

!here0






ut H the !hite noise error term

,0 is the intercept term !hile - 0 2 0 4 and . are the long run estimates of the coefficients#

The :)"B models made for the analysis are presented elo!

CPI t H -, J -- CPI t(- J -2 GDP t J -4 EXCH t J -. INT t J -3OILt J - EC t-1 J u-t ########################

/.#21

OILt H 2, J 2- OILt(- J 22 GDP t J 24 EXCH t J 2. INT t J 23CPI t J 2 EC t-1 J u2t ########################

/.#41

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GDP t H 4, J 4- GDP t(- J 42 OILt J 44 EXCH t J 4. INT t J 43CPI t J 4 EC t-1 J

u4t ######################### /.#.1

INT t H ., J .- INT t(- J .2 OILt J .4 EXCH t J ..GDP t J .3CPI t J . EC t-1 J u.t #########################

/.#31

EXCH t H 3, J 3- EXCH t(- J 32 OILt J 34 INT t J 3.GDP t J 33CPI t J 3 EC t-1 J

u3t ########################## /.#@1

!here0






EC t-1 = is the error correction term

p, is the intercept term for the four :)"B models !here p ranges from - to 3# Also the

estimates p- p2 p4 p. are the short run parameters of the short run coefficients in the :)"B

model !here p ranges from - to 3# The results of these models are presented in section 3#

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2,

. Results and -ata *nalysis

The literature sho!s that there is significant and positive relation et!een international

crude oil prices and inflation rate in United Kingdom# To chec% this long run relation !e applied

the *ohansson co(integration test# For this purpose !e first have to chec% the data for stationarity

and then apply :AR lag selection criteria# After completing the preliminary re9uirements !e

follo! !ith the *ohansan approach to loo% for a long run relationship among the variales# All

the steps are given in detail in the follo!ing section#

.1 *-3 Results

It is necessary for the data to e integrated of order one in order to apply *ohansan co(

integration techni9ue# For this purpose !e applied A+F test to find the unit root in the data# The

results are reported in the tale no# - elo!

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2-

Table no. 1

ase +none,ase +intercept

only,ase +trend 4 intercept,

(ariables t'value p'value t'value p'value t'valuep'

valueResult

P -#.,@.@7 ,#73@, (,#427-2. ,#7,8, (-#73.-2. ,#37.4 Non(

&tationary

/-P (2#.5-37- ,#,-34 (4#372554 ,#,-4- (4#473558 ,#,845 Non(

&tationary

OL PR&S -#-335.8 ,#74-@ (,#,87,.8 ,#7.-7 (-#785523 ,#3532 Non(

&tationary5T&R&ST

R*T& (-#35.338 ,#-,.5 (-#,,3535 ,#8435 (2#..48.7 ,#43,@

Non(

&tationary&67*5/

& R*T&(,#[email protected] ,#48.5 (-#35252, ,#.8@5 (-#@284@5 ,#8345

Non(

&tationaryPt'1 (3#,88,.3 ,#,,,, (3#,,7.38 ,#,,,3 (.#75--@2 ,#,,25 &tationary

/-Pt'1 (.#7@8-3- ,#,,,, (.#52@588 ,#,,,5 (.#8,,-2. ,#,,32 &tationaryOL

PR&St'1

(3#4,[email protected] ,#,,,, (.#5.@553 ,#,,,5 (3#@553,- ,#,,,@ &tationary

5T&R&ST

R*T&t'1

(.#4,3327 ,#,,,- (.#8,..,. ,#,,-, (.#@82574 ,#,,32 &tationary

&67*5/

& R*T&t'1

(4#5,.,,. ,#,,,3 (4#84287@ ,#,,75 (4#@..-4. ,#,.@- &tationary

The aove delineation sho!s that all the variales are non(stationary in their level form#

All the p(values for the variales in level form are greater than ,#,3 !hich re=ect the null

hypothesis of unit root# Mo!ever !hen data is chec%ed after ta%ing the first difference the p(

value as !ell t(states ecomes significant# It also indicates that the data ecomes stationary in the

first difference form# &o the data is appropriate to apply *ohansan co(integration test#

.2 (*R La% selection riteria

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22

It is also necessary to chec% for the numer of lags to e included in the estimation# For

this purpose !e simply use the :AR lag selection criteria# The results of the different lag

selection criterion are given in tale no# 2 as elo!

Table no. 2

La% Lo%L LR 3P& * S 78

9 (48.#,7.4 NA -,2,.532 4,#42833 4,#38-42 4,#473-@1 (2.4#3538 -75#484-W 24-,#.52W 2-#55@5@W 24#4.73-W 22#272342 (2,3#733. .2#-.37@ --,@#745 2,#[email protected] 24#3387@ 2-#@2,-8

In the aove tale four out of si$ lag selection criterions suggest the optimal lag length at

one lag# According to 'i%elihood ratio0 FP)0 Ac%ai%e information "riterion and &ch!ar;

criterion numer of optimum lags is one# e !ill include all the variales up to one lag length in

our empirical analysis#

.! o'inte%ration Results

It is necessary to chec% the co(integration relationship among the variales# The process

is follo!ed to see the long run relationship among the variales# In *ohansan co(integration there

are t!o methods to chec% the long run relationship# These methods include Trace statistics and

Ba$imum )igen values# The results for oth of these criteria are reported in tale no# 4 as under

Table no. !

Unrestricted "ointegration Ran% Test /Trace1

Mypothesi;ed Trace ,#,3 No# of ")/s1 )igenvalue &tatistic "ritical :alue Pro#WW

None W ,#8.7,5- @8#8@838 @,#,@-.- ,#,,78

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24

At most - ,#3-,.,, 44#2,-7- .,#-8.74 ,#2-,3At most 2 ,#4-2-27 -3#4.88. 2.#2837@ ,#.25.At most 4 ,#-354-4 3#774572 -2#42,7, ,#.4@8At most . ,#,@3-58 -#@532-. .#-277,@ ,#2252

Trace test indicates - cointegrating e9n/s1 at the ,#,3 level W denotes re=ection of the hypothesis at the ,#,3 level WWBacKinnon(Maug(Bichelis /-7771 p(values

The results for trace statistics re=ect the null hypothesis of no co(integration among the

variales at conventional level of significance0 !hich is 3E# It means that there is at least one co(

integrating e9uation among these variales in the long run# The re=ection of the hypothesis is

depicted y the p(values and critical values in the aove tale# It means that the t!o variales

converge to the e9uilirium point at some point in the long run# It is not necessary that there

should e only one co(integrating e9uation in the variales0 rather there could e more than one

co(integrating e9uations in the long run in the tale no# . as elo!

Table no. )

Unrestricted "ointegration Ran% Test /Ba$imum )igenvalue1

Mypothesi;ed Ba$()igen ,#,3 No# of ")/s1 )igenvalue &tatistic "ritical :alue Pro#WW

None W ,#8.7,5- 4.#3@3@@ 4,#.47@- ,#,-..At most - ,#3-,.,, -8#53.-5 2.#-372- ,#2525At most 2 ,#4-2-27 7#4345.4 -8#8784, ,#333-At most 4 ,#-354-4 .#4,5@85 --#22.5, ,#3875At most . ,#,@3-58 -#@532-. .#-277,@ ,#2252

Ba$(eigenvalue test indicates - cointegrating e9n/s1 at the ,#,3 level W denotes re=ection of the hypothesis at the ,#,3 level

WWBacKinnon(Maug(Bichelis /-7771 p(values

The second part for detecting the long run co(integration relationship among the variales

is that of the Ba$imum )igen :alues# The results of the Ba$ )igen values are similar to that of

the Trace statistics# The aove tale sho!s that the null hypothesis of no co(integration

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2.

relationship is re=ected at 3E level of significance# The proaility is less than ,#,3 and hence

there is a long run co(integration relation among these variales# It is clearly depicted y the

Ba$ )igen :alues that there e$ists at least one long run "o(integrating e9uation among these

variale# "omining the results of Trace statistics and Ba$ )igen :alues0 !e can say that there

e$ists significant long run co(integration relation among these variales#

.) Lon% Run Results

After confirming long run co(integration relationship among the variales0 it is necessary

to see and chec% the impact of these variales on each other in the long run# For this purpose !e

!ill see the long run coefficients and their impact on the dependent variale for the economy of

)ngland#

The tale elo! sho!s that there is a positive and significant relation et!een the

international oil prices and inflation rate in UK# The t(value is much greater than 2 in asolute

form hence the variale is impacting the inflation significantly# The results sho! that one unit

change in the international oil prices !ill change the rate of inflation y 24 percentage points in

the same direction#

Table no.

(ariable o'efficient St. &rror t'value

Oil Prices ,#248355 ,#,-752 --#77,4/-P /rowth Rate (-#,@@3,. ,#28437 4#575-5

nterest Rate (2#,45@45 ,#2,2,7 -,#,587&xchan%e Rate ,#,55,5, ,#,43.8 2#.5443

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23

The results also sho! that the 6+P gro!th rate0 interest rate and )$change rate are also

significant# The t(statistics values are greater than 2 in asolute terms# Along !ith this the value

of standard error for all the variales is less than -0 !hich is acceptale# The coefficient value of

interest rate and 6+P are negatively affecting the rate of inflation in UK<s economy# If there is -

unit increase in the nominal interest rate0 it !ill decrease the rate of inflation y aout 2,,

percentage points# In case of 6+P gro!th rate a unit increase in the gro!th rate !ill decrease the

inflation rate y aout -,, percentage points# &imilarly the e$change rate is positively affecting

the rate of inflation over the period of -755(2,-.# The results sho! that one unit change in the

nominal mar%et e$change rate !ill increase the rate of inflation y aout 5 percentage points#

&imply !e can conclude that all the variales included in the model ae significant and are

affecting the inflation rate in accordance !ith the theory e$cept 6+P gro!th rate# The overall

significance of the model is depicted from the value of the R(s9uared and Ad=# R(s9uared#

. (&$ Short Run Results

After reporting and analysing the long term relation0 it is necessary to oserve and

evaluate the short run relation among the variales# For short run !e have used :)"B analysis#

The results of the various short run e9uations are given in tale no# @ as under

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2@

Table no. :

&rror orrection; -+P, -+&67, -+/-P, -+5T, -+OL,

&rror orrection Ter" ,#[email protected] (,#3747-4 ,#-5.4.4 ,#4,35-, -#-33@48

/,#,@5881 /,#8.83@1 /,#-4-@21 /,#-255.1 /-#283-.1X(2#3@@.,Y X ,#87..8Y X(-#.,,34Y X(2#484.7Y X(,#7,@25Y

-+P+'1,, (,#@,33-5 (,#453585 ,#,.7,-@ ,#8.@52- -#2.2@-7/,#-34241 /-#@@3841 /,#274271 /,#258,71 /2#5.-4,1X 4#73-87Y X ,#24-@@Y X(,#-@8-4Y X(2#@,-42Y X(,#.484.Y

-+&67+'1,, ,#,,,87. (,#,7-873 (,#-,224- (,#,74,34 (,#4.-,.7/,#,2@7@1 /,#274,81 /,#,3-@,1 /,#,3,3-1 /,#.777,1X(,#,27.@Y X ,#4-422Y X -#75--5Y X -#5.222Y X ,#@5224Y

-+/-P+'1,, (,#-43-33 (,#-8-5-3 (,#,35524 (,#-5.373 (2#7,7,-8/,#,8@4,1 /,#527.31 /,#-.@,.1 /,#-.27@1 /-#.-.541

X -#88-45Y X ,#2,8-.Y X ,#.,285Y X -#27-23Y X 2#,3@,7Y

-+5T+'1,, (,#.4.847 ,#224372 ,#.5@@.3 (,#4,2487 (2#424@87/,#--2241 /-#22,,@1 /,#2-.521 /,#2-,251 /2#,5--,1X 4#584@3Y X(,#-542@Y X(2#2@3.,Y X -#.4875Y X -#--@3@Y

-+OL+'1,, ,#,4@72@ ,#,32528 ,#,7@,23 ,#,243-3 ,#.45@-./,#,-.,41 /,#-32381 /,#,2@5@1 /,#,2@4,1 /,#2@,2.1X(2#@4-,5Y X(,#4.@23Y X(4#38.@2Y X(,#57.2@Y X(-#@53.-Y

The tale sho! that the deviation from the e9uilirium is corrected in every short run

time period y only interest rate and inflation itself# The inflation itself corrects the deviation due

to adaptive e$pectations of the rational individuals and agents in the economy0 !hile interest is

!idely used tool to control the money supply y means of strict monetary policy# The results

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28

sho! that in the short run -8E deviation from the e9uilirium path is corrected y the inflation

and 4,E is corrected y the interest rate# The error correction terms of all other variales are

insignificant in the short run#

The short run results sho! that the inflation is rate is positively and significantly affected

y the change in the international oil prices# &imilarly interest rates have significant ut negative

impact on the inflation rate in the short run# Cesides these t!o variales the other variales are

insignificant in the short run# On the contrary inflation rate of UK has no impact on the

international oil prices in the short run# Mo!ever interest rate and 6+P gro!th rate are also

positively and significantly affecting each other in the short run#

.: -iscussion

The history reveals that the inflation rate and oil prices had a long lasting and positive

relation# The supply shoc%s of the oil prices affected the international oil prices !hich in turn

changed the monetary policy patterns of the developed !orld due to pre(supposed inflation#

Cefore -75,s the international oil prices and rate of inflation moved in the same direction due to

supply and demand shoc%s# The positive relation in these variales is =ustified y many

researchers on the grounds that the oil serves as the ac% one of the economy y providing

energy# The oil crisis of -787 is self(e$plaining for this relationship# According to literature the

oil price increased from ?4 per arrel to ?., per arrel and resulted to increase the consumer

price inde$ from .-#2, to 5@#4, in -75,# It !as the highest of the international oil shoc%s

/Alessandro "ologni0 2,,51#

The relation positive relation can also e =ustified on the grounds that oil is used for the

production of energy in ul%s in the developed countries# hen oil prices increase it also

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25

increase the cost of production for almost all the consumer goods# In this !ay the overall

inflation rises# Mo!ever the effects of the increased oil prices are oserved more in the

developed countries in comparison#

Bichael /2,,.1 estimated the effects of the oil prices on the consumer price inde$ for the

6(3 countries# Me follo!ed the Philips curve approach and oserved that the effect of oil prices

increment is decreased in the U&A and )urope# Although )urope is thought to e more sensitive

to the international oil prices ut the due changing patterns of the energy production its impacts

are decreased significantly# The study sho!ed that -, percentage point increase in the

international oil prices !ill increase the inflation only up to ,#-(,#5 percentage points in the

)urope and U&A /"hinn0 2,,. 1#

Another study y Alessandro /Alessandro "ologni0 2,,51sho!ed that as oil is the ma=or

ingredient of the usiness cycle due to its importance in the production department# The oil

supply shoc%s in the international mar%et have decreased the overall economic activity in the

)uropean region# Mo!ever the effect !as considered to e indirect on the economy due to

inflationary prices# The author argued that the governments in the developed countries li%e UK

and U&A change their monetary policy to respond the increasing price level this on turn

decreases the economic activity y decreasing the level of investment# The :AR model applied

on all the 6(8 countries sho!ed same results#

&ame thing is indicated y the results of our study# In UK the oil prices directly affect the

consumer price inde$ due to its capacity of energy production# +ue to changes in the patterns of

production of energy the effect of the oil price changes in the international mar%et has decreased

significantly on the domestic prices# The long run results sho! that there is only 24 per cent

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27

effect on the consumer price inde$ due to international oil prices# The effect has decreased

consideraly as compared to the last t!o decades#

The correlation of the oil prices and consumer price inde$ !ee%end over the time

consideraly and affectively due to development and innovation of the ne! techni9ues# The fact

can also e oserved from the oil supply shoc%s of the late -77,s and early 2,,3s# The oil prices

increased in the international mar%et due to 6ulf ars in the -77,s from ?2, to ?., per arrel

ut the consumer price inde$ increased only !ith three percentage points from -4.#@ to -48#7# In

comparison the effect is negligile# A similar trend !as oserved in the early 2,,3#

:.1 onclusion

This paper has evaluated the long run and short run relationship et!een the inflation and

the oil prices in the international mar%et# It has een found that the hypothesis of positive

relationship et!een the oil prices and inflation rate is accepted ased on the statistical analysis

results# It can e said that the relationship et!een inflation and oil prices in the United Kingdom

are parallel as !hen oil prices are falling0 !e found that the "PI inflation rate decreases# The

study reveals the statistical relationship et!een the t!o variales on the asis of analysis result

as !ell as the historical trend in the t!o variales that have sho!n clear signs of parallel

movement of the t!o series#

It has een found !orld!ide that the oil is used as a ma=or source of energy production0

mainly electricity0 and it significantly affect the production process and the overall costs of

production# e can conclude on the asis of this study that UK has to ma%e its economic

fundamentals a it less vulnerale to the oil prices and other !orld!ide shoc%s# The more the

economy is vulnerale to e$ternal shoc%s0 the more there are chances of recession#

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4,

:.2 Reco""endations

The study has analysed the impact on the inflation and found that decreasing trend in

inflation may cause many serious prolems to the other economic fundamentals li%e overall

saving rate0 and consumption as !ell as the energy sector !ill e affected sharply due to this# To

handle the scenario0 the policy ma%ers should design a policy that may target the saving rate of

the general population# For the purpose0 the Can% of )ngland may choose to tac%le the prolem

through the interest rate policy# The policy ma%ers may choose to fi$ a higher interest rate on the

savings people ma%e so that the people have more incentive to save rather to spend their money

at the first hand#

Another thing that the policy ma%ers may choose to handle this decreasing inflation is

through the e$change rate policy# The e$change rate policy may e a it comple$ and affect

some other things too ut it !ill ma%e sure the economy !ill not lose its capital that may happen

in the other case through the capital flight phenomenon# The policy ma%ers thus choose to

deteriorate the e$change rate so that the products in the international mar%et ecome e$pensive

for the pound earners# This !ill ma%e the pound earners to spend less on the things outside the

United Kingdom#

Also the government of UK should ta%e steps to support the rene!ale energy production

that may get affected through this oil price decline# The decline in oil prices may affect the

rene!ale energy industry in the sense that the producers and researchers !ill have a less

response of the people and other supporters due to the lo!ering cost of other energy sources li%e

electricity produced through oil concentrated generators# A higher level of susidy to the people

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4-

in energy rene!ale energy sector !ill ma%e them continue their research and efforts to find ne!

and less costly !ay of producing energy resources#

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42

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4@

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*ppendices

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