IV Encuentro de Economa AplicadaDo oil price shocks matter?Evidence for some European countries*A preliminary version of this paper is publised in Documento de Economa y Finanzas Internacionales 01-02, AEEFI-FEDEA.Cuado, JuncalPrez de Gracia, FernandoUniversity of NavarraAbstractThis paper analyzes the oil price-macroeconomy relationship by means of analyzing the impact of oil prices on inflation and industrial production indexes for many European countries using quarterly data for the period 1960-1999. First, we test for cointegration allowing for structural breaks among the variables. Second, and in order to account for the possible non-linear relationships, we use different transformation of oil price data. The main results suggest that oil prices have permanent effects on inflation and short run but asymmetric effects on production growth rates. Furthermore, significant differences are found among the responses of the countries to these shocks.JEL Classification: E32 Key words: oil price shocks, inflation, economic activityCuado Eizaguirre, JuncalPrez de Gracia Hidalgo, FernandoUniversidad de NavarraUniversidad de NavarraFac. EconmicasFac. EconmicasCampus UniversitarioCampus Universitario31080 Pamplona31080 PamplonaTfno.: 948-425625Tfno.: 948-425625Fax: 948-425626Fax: 948-425626E-mail: jcunadounav.esE-mail: fgraciaunav.es1. IntroductionAmong the most severe supply shocks hitting the world economies since World War II were sharp increases in the price of oil and other energy products. During the period 1960 to 1999, we have witnessed four important oil shocks: in 1973-1974, when the Organization of Petroleum Exporting Countries (OPEC) first imposed an oil embargo and then greatly increased crude oil prices, the price of the barrel increased from $3.4 to $13.4; in 1978-1979, after the Iranian revolution disrupted oil supplies, the price rose from $20 to $30; a third one followed Iraqs invation of Kuwait in 1990, when prices went from $16 to $26; finally, and due to the most recent oil shock, prices have grown up from $12 to $24 in 1999.The negative impact of these oil price changes was evident in most cases, as the magnitude of growth rates of industrial production indexes and inflation rates of some countries the immediate periods after these shocks suggest. Table 1 shows the lowest growth rate of the industrial production index of each of the countries within the first periods after each of the first three shocks already mentioned, and the greatest increase in the inflation rate within the same period. For example, we could mention the great decrease in the Industrial Production Index in Luxembourg after the shocks in 1974 and 1979 or the negative impact on the Greek inflation rates. As far as the most recent shock is concerned, the European Central Bank states that the recent increase in the euro area inflation rates was almost entirely caused by developments in energy prices. See Annual Report 1999 from the European Central Bank. Insert Table 1These four episodes may explain why oil price shocks receive important consideration for their presumed role on macroeconomic variables. They are included in several models such as those of Rasche and Tatom (1981), Bruno and Sachs (1982) and Hamilton (1988). Furthermore, they have been credited with affecting the natural rate of unemployment (Phelps, 1994; Caruth, Hooker and Oswald, 1998), reducing the role of technology shocks in real business cycle models (Davis, 1986) and depressing irreversible investment through their effects on uncertainty (Ferdered, 1996). Thus, from a theoretical point of view, there are different reasons why an oil shock should affect macroeconomic variables, some of them calling for a non-linear specification of the oil price-macroeconomy relationship. For example, the oil shock can lead to lower aggregate demand since the price rise redistributes income between the net oil countries which are net oil importers and exporters. Second, the oil price increase reduces aggregate supply since higher energy prices mean that firms purchase less energy; consequently, the productivity of any given amount of capital and labor declines and potential output falls. The decline in factor productivity implies that real wages will be lower. If some labor supply is withdrawn voluntarily as a result, potential output will be lower than it would otherwise be, thus compounding the direct impact of lower productivity. Furthermore, it may have a non-linear effect on economic activity if it affects through sectoral reallocations of resources or depressing irreversible investment through their effects on uncertainty (Ferdered, 1996). See Mork (1994) for a further discussion of various mechanisms. From an empirical point of view, considerable research finds that oil price shocks have affected output and inflation (Hamilto