The impact of oil price shocks on

household consumption.
The case of Norway

Author: Viktor Boman

Supervisor: Carl Lönnbark

Viktor Boman
Spring 2018
Master Thesis 1, 15 ECTS
Master program Economics
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 Acknowledgments!
I would like to pay deep gratitude to my supervisor, Carl Lönnbark, for his guidance during
the writing of this thesis. Also, I would like to thank my fellow students for their providence of
motivation and laugh during the research process. It has been of immense help.

Sincerely

________________________
Viktor Boman
Date 2018-06-10

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III
 Abstract
Since the end of World War II, oil price shocks and its impact on the economy have been a
hot topic among economic researchers and agents. The price of oil has experienced several
fluctuations during the late 20th century and the initial empirical findings suggest that these
unexpected changes have several negative effects within countries’ economies. However,
most of the research apply only on oil-importing countries and the same results from oil
shocks aren´t expected for oil-exporting countries. Furthermore, the robustness of the
relationship has recently come to be revaluated since many countries move towards
alternative energy resources, thus moving away from its oil dependence.
The purpose of this study is to examine the relationship between oil shocks and consumption
for the small democratic economy of Norway. The choice of selecting an oil-exporting
country for this analysis is somewhat unique since many of the world economies are oil-
importers and the research made up until now are focusing on these economies. To do this,
the study ends up with analyzing the short-run effects of oil shocks on household
consumption by using a Vector autoregression model, Granger-causality test and an Impulse
response function. The result suggests that there is a granger causality between oil shocks and
consumption. Also, for Norway, we find that a shock due to increased crude oil prices has a
positive short effect on household consumption.

Keyword: Household consumption, Oil shocks, Life-cycle hypothesis, Vector autoregressive

model.

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V
 Table of contents

1.Introduction ............................................................................................................................. 1

1.1 Background ...................................................................................................................... 2

1.2 Research question ............................................................................................................. 3

1.3 Contribution and objective of this study .......................................................................... 3

1.4 Delimitations .................................................................................................................... 4

2. THEORETICAL FRAMEWORK AND EARLIER RESEARCH ........................................ 5

2.1 Oil and the Norwegian economy ...................................................................................... 5

2.2 Transmission Mechanism Channels ................................................................................. 6

2.3 Literature review .............................................................................................................. 8

2.4 Theoretical model ........................................................................................................... 10

2.5 Hypothesis ...................................................................................................................... 13

3. EMPIRICAL APPROACH .................................................................................................. 14

3.1 Methodical approach ...................................................................................................... 14

3.2 Data ................................................................................................................................ 14

3.3 Statistical approach ........................................................................................................ 16

3.3.1 The Engle-Granger test ........................................................................................... 16

3.3.2 Vector Autoregression model (VAR) ..................................................................... 16

3.3.3 Lag order selection model ....................................................................................... 17

3.3.4 Augmented Dickey-Fuller test ................................................................................ 18

3.3.5 Granger causality test .............................................................................................. 19

3.3.6 Impulse response function ....................................................................................... 20

3.3.7 Possible drawbacks ................................................................................................. 21

4. Results .............................................................................................................................. 21

4.1 Augmented Dickey-fuller test ........................................................................................ 22

4.2 Engle-granger test .......................................................................................................... 22

4.3 Vector autoregressive model .......................................................................................... 23

VI
 4.4 granger causality test ...................................................................................................... 25

4.5 Impulse response function .............................................................................................. 26

5. Discussion ............................................................................................................................ 27

6. Conclusion ............................................................................................................................ 29

6.1 Further research .............................................................................................................. 30

7.Reference list ......................................................................................................................... 31

8. Appendix .............................................................................................................................. 36

Appendix 1 ........................................................................................................................... 36

Appendix 2 ........................................................................................................................... 38

VII
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VIII
 1.Introduction
In this chapter, the reader will be given a good understanding and insight about the objective
and purpose of this study. This section will give a good overview of how oil price shocks may
affect macroeconomic variables within economies and how different the shocks affect the
individual economies.

Since the end of world war II, a large body of research has suggested that oil price fluctuations
have severe consequences for macroeconomic activities. For example, Hamilton (1983) links
all US recession during this period to spikes in the crude oil price. High oil prices typically
hamper world demand for goods and services since oil-intensive production becomes more
expensive due to higher production costs. In the aftermath of the work by Hamilton(1983),
studies based on data on oil-importing countries suggest that oil shocks have negative
consequences on economic activities. Whether one uses different modeling or data procedures,
these effects hold fast independently. (see Mork 1989; Jiménez-Rodrıguez & Sanchez 2005;
Hamilton 2003). Their research also finds that this significant oil-price relationship has become
much weaker in the 2000´s century compared to the 1980s.
While most research focuses on general macroeconomic activities, Mehra and Peterson (2005)
took a different path and analyzed the oil shocks and the impact on household consumption in
the US, which at the time where a large importer of oil. Although oil dependency among
countries have decreased since the late '80s, oil is still a key component for many economies
(BP 2017, p11) and consumption contributes for a large share the total demand of an economy

However, the results above mainly concern oil-importing country and that oil shocks are bad
news for the economy. For oil-exporting countries, an oil price increase should be good news
for the economy. Following an oil price increase, the income generated by the price increase
gives oil producers additional income and wealth effects. If these effects are transferred to the
domestic economy, it will boost investment among agents and firms. In turn, unemployment
should decrease and thereby let households consume more.
However, there is a shortfall of research analyzing this relationship in oil-exporting countries.
For this reason, this study will focus on the changes in consumption that follows an oil price
shock in an oil-exporting country.

1
 1.1 Background

The country that this paper focuses on is Sweden's neighbour in the west, namely Norway.
Norway´s economy, with the discovery of the oil and gas fields in the Northern Atlantic, have
been able to build a well functional welfare state. Today, the country´s oil industry stands for a
large proportion of both total export and GDP in its economy (Graph 4, Appendix 1).
From a global perspective, Norway is one of the top 15 of oil producers, contributes
approximately 2% of the total global oil demand and 13% of the oil import for the EU. (Statistic
Norway).
Given the importance that the oil industry plays for the Norwegian economy together with the
large household consumption level of total GDP (Appendix 1), it will be of interest to study
how household consumption in the economy is affected by unexpected oil price increase.
To analyze this relationship, this paper will rely on the theory presented in the paper done by
Mehra and Peterson (2005). The period this paper chooses to cover reaches between 2002-2017,
a period that has come to experience quite large price volatility of the Brent oil, experiencing a
large upswing at the beginning of 2008 and later followed by a large drop in the 3rd quarter of
the same year (Graph 1). Today, Norway is one of the more advanced and technological
economies, still heavily dependent on the revenues from the oil industry and therefore it will be
interesting to see how the household consumption changes within the country. (Moses & Letnes
2017)

Oil Brent
160,00
140,00
120,00
100,00
80,00
60,00
40,00
20,00
0,00
2001-10-01

2017-02-01
2002-06-01
2003-02-01
2003-10-01
2004-06-01
2005-02-01
2005-10-01
2006-06-01
2007-02-01
2007-10-01
2008-06-01
2009-02-01
2009-10-01
2010-06-01
2011-02-01
2011-10-01
2012-06-01
2013-02-01
2013-10-01
2014-06-01
2015-02-01
2015-10-01
2016-06-01

2017-10-01

Graph 1, crude oil price Brent in dollar/barrel, quarterly frequency year 2002-2017

2
This paper will be divided into five sections. Following this part, section 2 presents the
theoretical framework and give the reader the underlying work behind the Life-cycle model of
consumption. The methodology is presented in section 3 where the empirical approach and the
selection of variables is presented. Section 4 presents the results from the tests followed by a
concluding discussion in sector 5.

1.2 Research question

This study is of importance since it will shed light on how the household consumption changes
in an oil-exporting country following an unexpected increase in oil prices.

The research question for this study is the following:

• Is there a relationship between oil shocks and consumption?
• If there is a relation, which sign will the relationship between an oil price increase and
consumption take.

1.3 Contribution and objective of this study

The objective of this study is to:

• Analyze how and if changes in the price of crude oil have an effect on household
consumption expenditure in Norway.
• Analyze the relationship between a negative oil price change and consumption
expenditure in Norway.

Since 2002, crude oil has experienced a lot of volatility in prices with a peak in 2008. Therefore,
this paper aims to draw a relationship between an oil price increase and consumption within the
Norwegian economy. Since most of the present research of the relationship is based on oil-
importing economies, this paper will try to shed light on the relationship of an export country.

3
 1.4 Delimitations

This study objective is to draw a relationship between oil shocks and consumption within
Norway economy. However, our study will only be able to analyze how a shock from increased
oil prices will affect household consumption in the short run. Hence, this study will not be able
to draw a conclusion of a decreasing oil prices and a possible asymmetric relationship, which
is suggested by earlier research presented above.1

1
Hamilton (2003) uses ”net oil price increases” to study the response from oil shocks on GDP growth.

4
 2. THEORETICAL FRAMEWORK AND
EARLIER RESEARCH
This chapter presents earlier studies conducted within the research area to give the reader a
deeper understanding of how consumption pattern within the economy may be affected due to
oil shocks. The chapter will also present the underlying theoretical model and the necessary
assumption that lays the foundation of this study.

2.1 Oil and the Norwegian economy

Since the discovery of the oil fields in the second half of the 20th century, Norway has become
one of the top oil exporters in the world. As for other oil exporting countries, Norway economy
isn’t unaffected by large oil price swings and while countries relying on oil imports are expected
to disfavor from oil price increases, it's not necessarily the case that it is bad news for oil-
exporting economies.
However, unlike many other oil-exporting countries, Norway has managed to avoid the
“Paradox of plenty”2, which faced many of the Petro-states during the end of the 20th century.
According to Moses and Letnes (2017), Norway has managed to avoid this scenario by
developing good institutions. The wage-bargain framework and the floating exchange rate
together with the wealth found GPFG developed by the Norwegian authorities, gives Norway
the advantage to reduce the initial market uncertainty and inflationary pressure that usually
follows from unexpected oil price changes. (Moses & Letnes 2017).
Norway, like many other western economies, has since the '70s developed to a less oil-intensive
economy and thus are less exposed towards large fluctuations in crude-oil prices. However, the
evidence still shows that the Brent oil price correlates strongly with both Norway’s
unemployment level and floating exchange rate. (graph 2 & 3, Appendix 1)
Also, the transmission mechanisms through which oil price shocks effect the economy today
may be significant different from the ones that occurred in the 70´s, a time with larger oil-
dependence among economies. (Jiménez-Rodrıguez & Sanchez 2005). The research so far
discuss several possible transmission mechanisms and the most eminent will be discussed in
the next section.

2
See Karl, T. L. (1999). The perils of the petro-state: reflections on the paradox of plenty. Journal of
International Affairs, 31-48.

5
 2.2 Transmission Mechanism Channels

Since the '70s, the literature focusing on oil price fluctuations doesn’t present any unitary
conclusion about the main transmission channel how oil price shocks affect macroeconomy
actives. Furthermore, the magnitude of the impact oil prices has on the economy and how these
fluctuations influence the economy aren't necessarily the same as today. The beginning of
2000s´is a period affected by larger oil price hikes that and compared to the increases in the
70s´, seem to have a more moderate impact on the economy.

One of the mechanisms focuses on the direct effects of inflationary pressure, that an oil price
increase leads to an increase in the CPI. The magnitude of the oil price increase would thus
depend on the share of oil-product in the total consumption basket. Furthermore, because of the
decline of household purchasing power due to the inflationary pressure, there is a second -round
effect where household asks for higher wages leading firms to increase prices on the seller side.
This, in turn, will lead to an upward revision of expectations about inflation. However, these
indirect effects have seemed to be cushioned during the 2000s. Since central banks started to
become more independent and direct their attention towards inflation targets rather than output
stabilization, these effects seem to fade out more quickly. Another explanation is that in a global
environment, firms in open economies competing in the international market aren’t able to pass
oil price increases onwards to selling prices since they are exposed to a wider competitive
market. (Bachmeier 2007)

Another possible channel through an oil price increase may affect households is its effect on
domestic fuel prices. Increasing fuel prices decrease household's disposable income leading to
that less income is spent on consumption expenditure. This is true for both oil-importing and
exporting countries. This effect could be moderate if the consumer expects the increase to be
short-lived. This is the case since rational consumers would smooth out their consumption by
borrowing more and save less and thus pressing interest rates upwards.
However, if the effects of the increase are long-lasting, the effect would affect unemployment
and lead to changes in industries production structures. For heavily oil-dependent industries,
this would lead to lower return and firms would adopt new production methods. In turn, this
leads to labor and capital reallocations and changes the unemployment level due to layoff or
hiring. However, the effects are expected to be different between net oil-exporting and

6
importing countries. Net-exporting countries are expected to benefit from these changes since
increased prices would cause a “spillover effect” Bjørnland (2009). If the oil producers (i.e
Government) reinvest the positive income and wealth effects to purchase goods and services,
this would generate higher levels of investments and activity in the domestic economy.
However, negative trade effects occurring from lowered global demand could net out the first
effect and have a negative effect on the domestic economy. (Bjørnland 2009; Hamilton
1983,2003; Loungani 1986).

Lastly, tightly linked to the effects described earlier, Hickman et al (1987) describe another
channel through the “terms of trade” mechanism. An oil price increase would lead to an income
transfer between import countries and export countries. For importing countries, the first effects
would lead to reduced spending and lower aggregated demand in the domestic economy. The
inflationary pressure from increased oil-prices would thus affect the production industry leading
the central bank to tighten monetary and thus reduce households demand for goods and services.
This is bad news for the export country, since their trading partner now demands less goods and
services from the export sector. However, for the export country, if the additional revenues
from an increase in oil-prices would be invested into the domestic industry, this could overturn
the negative effect from lower global demand and thus stimulate the activity within the domestic
economy.
Overall, from the discussion above, it´s understood that several transmission channels may
influence the way through which oil prices influence the Norwegian economy. The literature
after the work Hamilton (1983), where he found a granger-causal relationship between oil
shocks and GNP, doesn´t present any unitary result about the significance of each effect.
Since more data becomes available, the significant relationship between oil shocks and the
macroeconomic variables seems to become weaker in the 2000´s. However, the result are still
mainly based on oil-import countries and there is an absence of literature identifying the
relationship on exporting countries. Specifically, the literature covering the relationship
between oil shocks and consumption in oil-exporting countries is non-existent.

7
 2.3 Literature review

As mentioned earlier, the bulk of the literature that focuses on oil shocks have come to focus
on general macroeconomic activities. Since Hamilton (1983) found a Granger-causality
relationship between oil price changes and several macroeconomic variables, numerous papers
have focused on the links between oil shocks and variables such as stock market, international
trade, GDP growth, and net export. (see Bjørnland (2009) Jiménez-Rodrıguez & Sanchez
(2005); Mehrara 2008; Kilian et al 2010)

The study by Blanchard (2007) for example, finds that the oil shocks differ in their impact on
general macroeconomic performance and compares the shocks during the '70s against the ones
observed at the beginning of the 21st century. Blanchard argues that factors such as smaller
share of oil production and stronger independent central banks in advanced countries are the
main why the relationship has weakened.

However, since most of the literature focuses on the impact of oil shocks on general economic
activity, another branch of research has come to direct their attention towards household
consumption. The work by Mehra and Peterson (2005) and Kilian (2008) studies the effects on
household consumption from unexpected oil price changes.

In the study by Mehra and Peterson (2005), they develop a model based on the life-cycle model
of Consumption (Modigliani and Brumberg 1954). Their study is based on data from
households in the US, an oil-importing country, and identifies the direct effects of oil price
shocks in the model. By including income, wealth and interest rate with a Vector Error
Correction model, they find that oil shocks don´t have any effect on household consumption in
the long-run but that the effect is significant in the short-run. Furthermore, by using “net oil
price increases” and “positive oil price increases” as proxy´s for oil shocks, they find that the
relationship is negative which is line with earlier results. Extending their work, Zhang and
Broadstock (2014) exclude interest rates in their model and find a similar negative relationship
for the countries in the ASEAN region.

Since Mehra and Peterson (2005) are one of the pioneers to put consumption under an empirical
macroeconomic context, this paper will closely follow the same approach proposed in their

8
study. However, since the findings considering this relationship mainly covers oil-importing
countries, some economic intuition based on the work by Jiménez-Rodrıguez & Sanchez (2005)
and Bjørnland (2009) will be addressed to highlight how household consumption behave when
an oil-exporting economy is exposed to an oil price increase.

Moving away from the literature looking at the effects of oil shocks in importing countries.
Jiménez-Rodrıguez & Sanchez (2005), by using a VAR-model, investigate the relationship
between real GDP and Oil shocks in 7 OECD countries, where UK and Norway act as exporting
countries. In their study, they find that all countries, except Norway, experience negative
growth in GDP level following an oil price increase. Norway however, experiences a positive
GDP growth following an oil price increase. Jiménez-Rodrıguez & Sanchez (2005) finds that
the UK appreciation rate and inflations adjustment are much larger than in Norway, while at
the same time the real wage in Norway increases whereby in the UK it decreases. This provides
us with a useful guideline for household behavior, since higher real wage according to economic
theory increases disposable income,thus leading to increased consumption.

Furthermore, in a study by Bjørnland (2009), she identifies a similar result looking at the Stock
market returns in Norway by using OSEBX and OSEAX as variables. She finds that an
unexpected increase in the Brent oil price of 10% the stock market returns increases around
2,5%. This suggests a similarly positive reaction in the Norwegian economy to oil price shocks
as in Jiménez-Rodrıguez & Sanchez (2005). She further concludes that aggregated wealth and
demand increases in the Norwegian economy and consequently, unemployment falls. Based on
her results and macroeconomic theory, higher returns from the stock market together with lower
unemployment levels would generate higher disposable income for a household in the domestic
economy and as a response, consumption increases.

9
 2.4 Theoretical model

According to macroeconomic theory, household optimize consumption based on theories from

two very similar hypothesizes, the Permanent Income Hypothesis (PIH) and the Life-Cycle
Hypothesis (LCH). (Carlin et al 2006)
Milton Friedman layed the foundation for the Permanent Income Hypothesis which over time
have become the real “workhorse” in the macroeconomic world explaining the household
consumption model. Both the Permanent Income Hypothesis and Life-cycle model presents an
alternative view compared to the other classic consumption function, namely the Keynesian
consumption function. (Carlin et al 2006 p 207; Hall 1978).

To analyze household consumption expenditure, the theoretical model that will be used for this
study is the one presented by Mehra & Peterson (2005). Furthermore, the hypothesis for the
model will be based on the work done by Modigliani and Brumberg (1954).

The aggregate consumption life-cycle model suggested identifies wealth and income as the
determinants of consumer expenditure. The function is given by:

𝐶𝑡𝑝 = 𝜔0 + 𝜔1 𝑌𝑡 + 𝜔2 𝑊𝑡 + 𝜔3 𝑌𝑡+𝑘
𝑒
(1)

𝑒
Where 𝐶𝑡 represents current planned consumption, 𝑊𝑡 actual current wealth while 𝑌𝑡 , 𝑌𝑡+𝑘
respectively corresponds to actual current income and average anticipated future income.
Hence, equation 1 is based on the life-cycle theory stating that the planned aggregate
consumption is based on the expected value of individual resources during the lifetime, which
is the sum of current financial wealth and tomorrows expected income. From the LCH, the
assumption is that the consumer maximizes his/her consumption utility subjected to his/her
current and future lifetime earnings. Furthermore, we also assume that the consumer faces a
budget constraint during his/her lifetime, this budget constraint is derived from the theoretical
household budget constraint:

𝑊𝑡+1 = (1 + 𝑟𝑡 )(𝑌𝑡 + 𝑊𝑡 − 𝐶𝑡 ) (2)

10
Where the wealth of the next period is the discounted value of today’s income and wealth minus
𝑡+1𝑊
today’s consumption. Furthermore, we impose a condition that lim ((1+𝑟) 𝑡
) = 0 and assume
𝑖𝑡→∞

that (𝑟𝑡 = 𝑟𝑡+1 = 𝑟) so we can write current wealth as:

𝐶 𝑌
𝑊𝑡 = ∑∞ 𝑡+𝑖 ∞ 𝑡+𝑖
𝑖=0 (1+𝑟)𝑖 − ∑𝑖=0 (1+𝑟)𝑖 (3)

Also, with the assumptions that consumption follows a martingale process (Hall 1978) and
income(Y) have a constant growth rate of g (Mehra & Peterson 2005) we have that:

𝑟 𝑟 𝜏
𝐶𝑡 = 𝑟−𝑔 𝑌𝑖 + 1+𝑟 𝑊𝑡 + ∑∞ 𝑡+1
𝑖=1 (1+𝑟)𝑖 (4)

Where 𝜏𝑡+1 is a white noise process. The assumption that income grows at a constant rate over
𝑒
the lifetime for households makes 𝑌𝑡+𝑘 = 𝑌𝑡 equation (4) can be rewritten in a simpler version
as:

𝐶𝑡𝑝 = 𝜔0 + 𝜔1 𝑌𝑡 + 𝜔2 𝑊𝑡 (5)

𝑟 𝑟
Where 𝜔1 = 𝑟−𝑔 and 𝜔2 = 1+𝑟 and the expected value of the error term in (5) is 0.

Equation 5 establish the estimated long-run relationship and the” error correction” term the
model makes use of. However, the actual consumption in period t could differ from the planned
consumption level, leading Mehra and Peterson (2005) to suggest the following equation:

𝑝 𝑝
∆𝐶𝑡 = 𝛼0 + 𝛼1 (𝐶𝑡−1 − 𝐶𝑡−1 ) + 𝛼2 ∆𝐶𝑡 + ∑𝑘𝑠=1 𝛼3 ∆𝐶𝑡−𝑠 + 𝜇𝑡 (6)

Equation (6) considers the possibility that planned and actual consumption differs in period t
due to habit persistence in consumption behavior or adjustment cost. (Mehra 2001)

Substituting in equation (4) in the model suggested by Mehra (2001), we add the assumption
that consumer has rational expectations and that future income will grow at a constant rate in
relation to today’s income. The final theoretical dynamic consumption model becomes:

𝑝
∆𝐶𝑡 = 𝛽0 + 𝛽1 (𝐶𝑡−1 − 𝐶𝑡−1 ) + 𝛽2 ∆𝑌𝑡−1 + 𝛽3 ∆𝑊𝑡−1 + ∑𝑘𝑠=1 𝛽4𝑠 ∆𝐶𝑡−𝑠 + 𝜇𝑡 (7)

11
where
𝐶𝑡𝑝 = 𝜔0 + 𝜔1 𝑌𝑡 + 𝜔2 𝑊𝑡 (4)

Equation (7) captures the effect of consumption changes in the long and short run. Here the
error correction term establishes the long run relationship (𝜔0 + 𝜔1 𝑌𝑡 + 𝜔2 𝑊𝑡 − 𝐶𝑡−1 ), which
we presented earlier in this section. (Mehra & Peterson 2005)
For the purpose of this study, we include oil and the short-term interest rate as exogenous
variables in equation (7) and the final model becomes:

𝑝
∆𝐶𝑡 = 𝛽0 + 𝛽1 (𝐶𝑡−1 − 𝐶𝑡−1 ) + 𝛽2 ∆𝑌𝑡−1 + 𝛽3 ∆𝑊𝑡−1 + ∑𝑘𝑠=1 𝛽4𝑠 ∆𝐶𝑡−𝑠 + ∑𝑘𝑠=1 𝛽5𝑠 ∆𝑂𝐼𝐿𝑡−𝑠 +
∑𝑘𝑠=1 𝛽6𝑠 ∆𝐼𝑅𝑡−𝑠 + 𝜇𝑡 (8)

and equation (4) is rewritten as:

𝐶𝑡𝑝 = 𝜔0 + 𝜔1 𝑌𝑡 + 𝜔2 𝑊𝑡 + 𝜔3 𝑂𝐼𝐿𝑡−1 + 𝜔4 𝐼𝑅𝑡−1

Given the consumption equation in (8), we also assume that the values of current wealth and
income aren’t observable which makes planned consumption to depends on yesterday’s value.
Hence, current consumption expenditure depends on the lagged values of net wealth, income,
oil prices, and interest rate.

Equation (8) corresponds to a VECM model and given that it holds true, we can establish the
long and short-run causality following an oil prices shock. However, the work done by Zehra
& Broadstock (2014) finds little evidence of long-run equilibrium considering oil price changes.
If we fail to find a long-run relationship, the error correction term in equation (8) will be
excluded from the model and a VAR-model will instead be used to analyze only the short-run
causality. The process to identify potential long-run relationship will be discussed later in the
chapter.

12
 2.5 Hypothesis

To answer the research question of this study the hypothesis we will be tested are:

H0,1: There is no relation between oil shocks and consumption expenditure

Ha,1: There is a relation between oil shocks and consumption expenditure

H0,2: There is no Granger causality from oil to consumption expenditure

Ha,2: There is Granger causality from oil to consumption expenditure

Where the oil shocks are measured by using the Brent blend oil(dollar/barrel), this will be
further explained in the data section. The Granger causality test gives the direction of the
relationship and not the causal relationship between the two variables.

13
 3. EMPIRICAL APPROACH
This next section of the study presents to the reader the methodical approach used for the
objective of the paper. The chapter starts by explaining the chosen dataset and afterward
discusses the statistical process used in this study. At the end of this section, we highlight
possible drawbacks and error that could be present.

3.1 Methodical approach

The purpose of this study is to analyze the short-term association between the Brent oil price
and household consumption expenditure in Norway. The control variables included in the
model are net financial wealth, disposable income and the short-term interest rate and will be
discussed in depth in the next section. To see if oil price shocks increase or decrease the
consumer spending in the Norwegian economy, we will use a time-series dataset. Since the
study includes more than two variables the model the time series will be a multivariate model.

3.2 Data

The variables chosen for our model are Private final consumption of Households, Net financial
assets of Household, Disposable income of the household sector, Short term interest rates and
Brent oil spot prices.
The data for Private final consumption, disposable income, and the net financial asset has been
collected from SSB (2018). The two other variables, the 3 months interest rate (NIBOR) and
the Brent crude oil has been collected from the OECD database and the Federal Reserve Bank
of St Louis respectively. The choice of using the spot price on Brent oil is reasonable since it’s
linked to the price of oil extracted from the North Sea and BFOE oil fields, the fields within
The Norwegian borders. (EIA 2017; Moses & Letnes 2017).

The data is gathered on a quarterly level between the first quarter of 2002 quarter 1 and last
quarter of 2017. Consumption, Net financial wealth and disposable income have all been
adjusted for inflation with the Norwegian CPI index (SSB) to represent inflation changes and
have later been converted to US dollar with the exchange rate level from Federal Reserve Bank
(2018). The same variables have been converted to constant US dollars of 2010 price level

14
Furthermore, consumption, net financial wealth and disposable income are also divided with
the total population level, since we want to capture the effects on the consumer level. Also for
the estimation, all variables except short-term interest are transformed into its natural logarithm.
This transformation of the variables is done since we want to capture the relative changes in the
model and in line with the transformation done in earlier research (see Mehra and Peterson
2005; Jiménez-Rodrıguez & Sanchez 2005)

Variable Abbreviation Explanation

Private final consumption Total final consumption expenditure
expenditure of household DCONS_log in 2010 constant US$/capita.
Logarithm values

Net financial Wealth Household The Net financial wealth of

(NPISH) DINC_log household sector- asset minus
liabilities-2010 constant US$/capita.
Logarithm values
Disposable income of the Net disposable income for the
household sector DWEALTH_log household sector- 2010 constant
US$/capita. Logarithm values
Short term interest rate NIBOR 3 months short term money market
DIR interest rate NIBOR

Brent oil spot price DOIL_log Brent crude oil spot prices US$
Logarithm values

Table 1, data description

Sources: OECD database, statistic Norway, US Energy information administration

15
 3.3 Statistical approach

The choice of model for the analyze will be a Vector Autoregression model (VAR) and to
estimate the relationship between oil and consumption, a Granger causality test together with
an impulse response function will be used.

It should be noticed that the choice of the VAR-model and not a VECM model is based on a
test called ENGLE-GRANGER test. The test is performed to identify the possible presence of
cointegration in our theoretical model, which suggest that we have a long-term relationship
between the variables in our model. Hence, if cointegration is present we use the VECM model
explained in chapter 2 (equation 8). The result from this test shows no evidence of a long-term
relationship within the model. This result makes the “error term” from the model to drop out
and the appropriate model to use becomes a VAR-model (Brooks 2014; Stock & Watson 2015).
The test will be discussed more thoroughly in the next section.

3.3.1 The Engle-Granger test

The method suggested by Engle and Granger( 1987) is a residual based approach to identify
cointegration in the model. The test performs an OLS regression on the variables included in
the “error term”, where the residuals from the OLS regression are used in a Dickey-fuller test
and checks for stationary (Brooks 2014). The hypothesis for the residuals are:

𝐻0 : 𝑢̂~𝐼(1)
𝐻𝑎 : 𝑢̂~𝐼(0)

Under the null hypothesis, the residuals are non-stationary which indicate that we have no
cointegration. Under the alternative, the residuals are stationary, and we have evidence of
cointegration in our model. Hence, if we fail to reject the null hypothesis we have no
cointegration and no evidence of a long run relationship. The critical values used to test this
hypothesis is based on the paper by Phillips and Ouliaris (1990) and presented in Appendix 2.

3.3.2 Vector Autoregression model (VAR)

16
To analyze several time-series, a vector autoregression model will be used to perform the task.
The VAR model is an extension from the univariate AR model which only regress one variable
time series while the VAR model lists several vectors of time series. The Var model let us
forecast our chosen variables in our model and their respective impact they have on each other
based on their common history (Stock & Watson 2015)
When the equations each possess the same number of p lags, the system is called VAR(p).

Assuming we have a model with two variables 𝑌𝑡 and 𝑋𝑡 , the VAR model with two equations
will be (Stock & Watson 2015):

(3.1) 𝑌𝑡 = 𝛼10 + 𝛼11 𝑌𝑡−1 + ⋯ + 𝛼1𝑝 𝑌𝑡−𝑝 + 𝛿11 𝑋𝑡−1 + ⋯ . 𝛿1𝑝 𝑋𝑡−𝑝 + 𝜇1𝑡
(3.2) 𝑋𝑡 = 𝛼20 + 𝛼21 𝑌𝑡−1 + ⋯ + 𝛼2𝑝 𝑌𝑡−𝑝 + 𝛿21 𝑋𝑡−1 + ⋯ 𝛿2𝑝 𝑋𝑡−𝑝 + 𝜇2𝑡

Here α and δ are unknown coefficients of the two equations while the variable μ are white noise
independent of Y and X past. The VAR approach is an extension of OLS since the coefficients
are estimated from each equation by using the OLS assumption on the VAR time series. The
equations above can be structured in a matrix form assuming p=1:

𝑌 𝛼10 𝛼 𝛿11 𝑌𝑡−1 𝜇1𝑡

(3.3) ( 𝑡 ) = (𝛼 ) + ( 11 )( ) + (𝜇 )
𝑋𝑡 20 𝛼21 𝛿21 𝑋𝑡−1 2𝑡

To forecast the selected variables, the VAR-method uses historical data on the variables in the
model and estimations of the coefficients are assumed to be jointly normal. For example, if
𝛿11 ≠0 the past values of X explain Y. When we have samples large enough, the coefficients are
assumed to be jointly normal under the VAR time series assumption and we can compute an F-
statistic from our sample. However, the interpretation of the coefficients isn’t straightforward
and hard to interpret. Hence, to understand the results in a better fashion granger causality will
be used together with an Impulse response function.

3.3.3 Lag order selection model

17
To perform a time-series regression model with multiple predictors, it´s important to determine
the correct number of lags. A common approach to decide the number of lags in a VAR-model
is to make use of the Lag-order selection model (Stock & Watson 2015).

The lag order selection model gives two important indicators, namely the Bayesian Information
Criterion(BIC) and the Akaike Information Criterion(AIC). For this study we will rely on the
AIC when determining our optimal number of lags, assuming we have 𝑑 coefficients in the
model, we can write the AIC as:

𝑆𝑆𝑅(𝑑) 2
𝐴𝐼𝐶(𝑑) = 𝑙𝑛 [ ] + (𝑑 + 1) 𝑇
𝑇

According to Stock and Watson (2015), there are a few principal factors to consider choosing
the "right" number of lags for the model at hand. Choosing too few lags will give less
information about the statistic outcome of the model while including too many lags there is a
risk that the coefficient in the model is overestimated. (Stock & Watson 2015)
The benefits and cost of these two risks must be considered when choosing the lag length for
our model at hand. Also, it´s important to consider the type of data the model is based on, this
since the argument could differ about the appropriate correct model lag length dependent on if
its annual, quarterly or monthly data the model is based on.

3.3.4 Augmented Dickey-Fuller test

When time-series data are used in the regression model one key assumption is that the data are
stationary. Since we use historical data to forecast the future, it´s important that there are no
fundamental differences in the relationship between the future and the past relationship (Stock
& Watson 2015).
Hence, the data needs to be stationary in the time series 𝑌𝑡 , where stationarity implies that the
probability distribution isn't hanging over time. If the probability distribution changes it´s said
to be non-stationary. (Stock & Watson 2015). In the case of a two-variable time series,
including 𝑌𝑡 and 𝑋𝑡 , they are said to be jointly stationary implying that
(𝑋𝑠+1 , 𝑌𝑠+1 , 𝑋𝑠+2 , 𝑌𝑠+2 , … , 𝑋𝑠+𝑇 𝑌𝑠+𝑇 ) regardless of T, aren’t dependent on s. Non-stationarity
in time series implies that the history can´t predict the future which in that case creates a serious
problem for our VAR-model.

18
Furthermore, the general assumption for our time series regression with k predictors are
following(Stock & Watson 2015):

1. 𝐸(𝑢𝑡 |𝑌𝑡−1 , 𝑌𝑡−2 , … , 𝑋1𝑡−1 , 𝑋1𝑡−2 , … , 𝑋𝑘𝑡−1 , 𝑋𝑘𝑡−2 , … ) = 0

2. (a) The random variables (𝑌𝑡 , 𝑋1𝑡 , … , 𝑋𝑘𝑡 ) have stationary distribution, and
(b) (𝑌𝑡 , 𝑋1𝑡 , … , 𝑋𝑘𝑡 ) and (𝑌𝑡−𝑗 , 𝑋1𝑡−𝑗 , … , 𝑋𝑘𝑡−𝑗 ) becomes independent as j approaches
infinity.
3. Large outliers are unlikely: 𝑋1𝑡 , … , 𝑋𝑘𝑡 and 𝑌𝑡 have non-zero, finite fourth moments,
and
4. There is no perfect multicollinearity.

To test if the data are subjected to stationarity a Dickey-Fuller test can be used. The Dickey-
fuller test the null hypothesis that 𝑌𝑡 has a stochastic trend against the alternative that 𝑌𝑡 is
stationary.

(3.4) ∆𝑌𝑡 = 𝛼0 + 𝛿𝑌𝑡−1 + 𝛽1 ∆𝑌𝑡−1 + 𝛽2 ∆𝑌𝑡−2 + ⋯ + 𝛽𝑝 ∆𝑌𝑡−𝑝 + 𝑢𝑡

(3.5) ∆𝑌𝑡 = 𝛼0 + 𝛾𝑡 + 𝛿𝑌𝑡−1 + 𝛽1 ∆𝑌𝑡−1 + 𝛽2 ∆𝑌𝑡−2 + ⋯ + 𝛽𝑝 ∆𝑌𝑡−𝑝 + 𝑢𝑡

In equation 3.4 the dickey-fuller test the H0:𝛿 = 0 and is computed from the OLS one-sided t-
test. Equation 3.5 accounts for the deterministic linear time trend with the unknown coefficient
𝛾. The null hypothesis tests whether the series has a unit root against the alternative that the
series doesn’t have a unit root and thus is stationary.

Since the dickey-fuller test doesn’t have a normal distribution under large samples, the critical
values that are used to reject the null hypothesis are unique for the Dickey-fuller test and
accounting for the appropriate distribution from the sample. The critical values will depend on
whether we base our test on equation 3.4 or 3.5.

3.3.5 Granger causality test

19
To identify if our variables in the VAR-model have any predictive power of one another a
Granger causality test will be performed. The test reports the direction of the causality in our
model, that variable X causes Y or not, and vice versa. Furthermore, we test whether the joint
lag coefficients of X in our model have any predictive power on variable Y. The null hypothesis
becomes that the joint lag coefficient is zero versus the alternative hypothesis which is that the
lag coefficient is different from zero (Brooks 2014). The test is based on a basic F-statistic test.

It should, however, be mentioned that the Granger causality test hasn't much to do with causality
as one might think (Stock & Watson 2015). The test shows how good X predicts Y given the
variables in the model, ceteris paribus. Hence the term Granger predictability is according to
Stock and Watson(2015) a more suitable name for the test. If X granger cause Y we claim that
past values of X contain information useful to forecast changes in Y. (Stock Watson 2015)

For our paper, we will test whether the lagged coefficient of oil jointly contains significant
information to predict future changes our dependent variable consumption.

3.3.6 Impulse response function

The result from the Granger causality test will help us to analyze which of the variables in the
model having a significant impact in predicting future values in the VAR-model. Even though
we have significant results which direction the causality between our variables goes, we aren’t
able to analyze the potential negative or positive relationship between them.

To overcome this problem, the test called the Impulse Response Function (IRF) will be used.
The IRF allows us to analyze how fluctuations around the mean of one variable behave when
we shock another variable in the model with one standard deviation (Brooks 2014). Hence, the
variables in the VAR model is subject to a unit chock on the error term and we can trace out
the responsiveness over time of the response variable. In the presence of a stable VAR system,
the chock that our response variable is affected by will eventually die out as time passes.
(Brooks 2014)
The IRF will provide with a good compliment of the Granger causality test. If we the Granger
causality test show significant results, the IRF will provide us with a visual insight of the effects

20
the chock causes. In the presence of insignificant results from the granger test, the response
from the IRF will be zero and no useful results can be used from the IRF.

3.3.7 Possible drawbacks

Applying the presented methodical approach in this section, it is important to be aware of

possible risks that can be present. Possible errors may arise and it´s good being able to identify
these specific errors in the model.
Firstly, for our model at hand, the appropriate lag lengths will be based on the lag selection
criteria and economic theory. As stated in the lag lengths section, using too many lags will
reduce the information that more lags could contribute to while using too many will
overestimate the coefficients. However, Hendry & Huselius (2001) argue that the appropriate
lag length should be such that the residuals are free of autocorrelation in our VAR-model and
will thus be considered for our paper.
Furthermore, there is some criticism considering the Dickey-Fuller test concerning the power
of the test. Under the classical hypothesis framework, we fail to accept the null hypothesis,
meaning that it's stated that the null hypothesis is either rejected or not rejected. To go around
this problem we will run a KPSS test suggested by Kwiatkowski et al (1992) to tackle this
possible problem.
Secondly, the same problem is faced to the Engle-Granger test used to decide whether we
should use a VECM or VAR model. Since we use a dickey-fuller test to check if the residuals
are stationary or non-stationary, the problem arising from type 1 and type 2 errors would make
us choose the wrong model. The correct distribution concerning the DF-test I debated in the
research world of economics. For this paper, the Critical values presented by Phillips & Ouliaris
(1990) will be used.

4. Results

21
In this section, the result from the statistical tests discussed in the earlier section will be
presented. The results will be briefly analyzed and discussed. The section presents the result
from the Augmented Dickey-fuller, Engle-Granger test, Var-model, Granger causality, and IRF
test respectively.

4.1 Augmented Dickey-fuller test

To see if consumer expenditure is affected by an unexpected oil price increase, we need to

check if our selected variables are stationary or not. An ADF test is performed on the variables
at levels to check whether the variables are stationarity or not. If our variables are non-
stationary, we will need to make them stationary using differentiation (Brooks 2014).
In our test, all variables in the model were non-stationary at a 1 and 5 percent significant level
and all variables were stationary at 5% significance level after differentiation. (see Appendix 1.
However, the ADF-test has become under criticism since it fails to estimate the slope and
intercept of the trend under the presence of unit root (Brooks 2014). To make our tests more
robust, a KPSS (Kwiatkowski, Denis, et al 2015) test is performed and the results are shown in
Appendix 1. From the KPSS test, the results indicate that our differenced variables are
stationary.

4.2 Engle-granger test

With the presence of cointegration between the variables in our model, the correct approach to
estimate the effects of oil shocks on consumption would be by using a VECM (Brooks 2014).
However, with no cointegration between the variables, the error term in the model would drop
out and we wouldn’t be able to find a long-run equilibrium level. If there is no cointegration
the right model to use is the VAR model. (Mehra and Peterson 2005)
The test finds no evidence of cointegration and we will accept the null hypothesis of no
cointegration. Hence, we will only be able to look at the short-run effects. The result is presented
in appendix 2.

22
 4.3 Vector autoregressive model

Since we have no presence of cointegration between our variables, the error correction term in
the theoretical model suggested by Mehra & Peterson (2005), drops out and our final model
becomes:

∆𝐶𝑡 = 𝛽0 + 𝛽1 ∆𝑌𝑡−1 + 𝛽2 ∆𝑊𝑡−1 + ∑𝑘𝑠=1 𝛽3𝑠 ∆𝐶𝑡−𝑠 + ∑𝑘𝑠=1 𝛽4𝑠 ∆𝑂𝐼𝐿𝑡−𝑠 + ∑𝑘𝑠=1 𝛽5𝑠 ∆𝐼𝑅𝑡−𝑠 +
𝜇𝑡 (9)

To analyze the relationship between consumption and oil shocks we run a VAR model, we set
consumption as the dependent variable and set the lag length in the model to be four. Hereafter
the model will be reflected as VAR(p), where p is the number of lags included in the model.
The choice of setting the lag length equal to four is based on earlier research and economic
intuition derived from the paper by Hendry & Huselius(2001)3

Oil price brent Consumption Test-statistic p-value

coefficients
DOIL_log (-1) 0.144 2.79(**) 0.005
DOIL_log (-2) 0.002 0.03 0.977
DOIL_log (-3) 0.028 0.53 0.598
DOIL_log (-4) -0.051 -0.99 0.320

R-squared 0,3116
AIC -19.90546

Table 2, Vector autoregressive model, stars indicate the coefficients significant level at: (***)=1%, (**)=5% and
(*)=10%.

3
Mehra and Peterson (2005) and Kilian et al (2009) uses a lag length of 4 and 6 respectively which support the
lag length used in this paper,

23
In table 2, we present the coefficients from the lagged oil variables in our VAR (4) model. The
result shows that all coefficient of DOIL_log, except the lagged 1 coefficient, is found
insignificant. It can be seen from the table above that the first leg of the coefficient is positive
which is in line with the economic reasoning from earlier research.

Furthermore, from the autocorrelation test given in appendix 2, we can see that our VAR (4)
model have no presence of autocorrelation.
However, we cannot draw any useful interpretation from this result, since the variables take a
turn being dependent and independent it becomes hard to interpret the dynamics of how the
variables affect each other over time.
The result from the Granger causality test and Impulse Response Function in the following
section.

24
 4.4 granger causality test

The Granger causality test performed is used to map how the variables together and individually
affect the dependent variable. The test also allows us to identify in which direction the causality
between consumption and our oil variable.
From table 3, we can conclude on the 10% significance level that there is a "Granger causality"
from oil to consumption and we accept the alternative hypothesis. Also, we can see that wealth
also granger cause consumption while the short-term interest rate and income don’t.

Y X P-värde

Cons Inc 0.103

Cons Wealth 0.031(**)
Cons IR 0.282
Cons Oil 0.062(*)
Cons All 0,000(***)
Inc Cons 0.062(*)
Inc Wealth 0.765
Inc IR 0.305
Inc Oil 0.074(*)
Inc All 0.000(***)
Wealth Cons 0.022(**)
Wealth Inc 0.252
Wealth IR 0.127
Wealth Oil 0.715
Wealth All 0,151
IR Cons 0.880
IR Inc 0.241
IR Wealth 0.001(***)
IR Oil 0.013(**)
IR All 0,000(***)
Oil Cons 0.122
Oil Inc 0.607
Oil Wealth 0.704
Oil IR 0.480
Oil All 0,301
Table 3, shows the output of the Granger causality test. stars indicate the coefficients
significant level at: (***)=1%, (**)=5% and (*)=10%.

25
 4.5 Impulse response function

From our VAR (4) model we find evidence that there is a granger causality between oil and
consumption. To draw a conclusion if an unexpected oil price increase affects household
consumption expenditure, we expose the oil variable with one standard deviation increase to
simulate a shock of the price of Brent oil.
From table 4, we can see that a positive oil shock increases the consumption expenditure in on
period before recovering to earlier levels. We can also see that the short-term interest rate shows
equivalent results. However, the result is graphically interpreted, and the possible underlying
channels will be discussed in the next section.

Table 4, Impulse response function. Vertical axis measuring the percentage change of Brent oil price and
horizontal axes measures time. One period corresponds to one quarter.
The graphs indicate how an exogenous shock in the oil price of one standard deviation affects the endogenous
variables over 20 periods forward in time. Order 1 and order 1b are the correlated and uncorrelated shocks.

26
 5. Discussion
This chapter provides a discussion of the results together with an analyze of possible strengths
and drawbacks of the results. Also, we connect the result with the theoretical framework
presented in chapter 2 to provide the reader with a deeper understanding of how this study
answers the research question.

With no cointegration between our variables, this paper ends up studying the short-term effects
from unexpected oil price changes on consumer expenditure. This makes us rule out the
suggested theoretical VECM model presented in chapter 2 and a VAR model is used.
The results from the dicky-fuller test and lag-order selection test suggest a VAR (4) model to
be used and the presence of no autocorrelation shows that our chosen number of lags gives a
robust model.

From our VAR (4) model, we can conclude that oil shocks do influence household consumption
expenditure in the short run within the Norwegian domestic economy. The Granger causality
test shows a significant result at 10% level that there is an association between oil and
consumption. Also, the test shows that the direction of the “causality goes from oil on
consumption and not the other way around. As we see in the results, the coefficient of the lagged
(-1) oil variable is positive which is in line with the findings of Jiménez-Rodrıguez & Sanchez
(2005) and Bjørnland (2009), that oil-exporting countries benefit from increased oil prices
through increasing demand within the economy. The Granger test also shows that the variables
together affects consumption. Also, oil does granger cause all variables except financial wealth
and we find no evidence that the other variables granger cause oil.

From the IRF results, which gives a visual demonstration of how an unexpected increase in oil
prices affect household consumption, we can see that the consumption level increase in 1 period
and before recovering to the equilibrium level. Since we use quarterly data this period translates
to 3 months. The shock is due to a one standard deviation increase in the Brent oil price and the
possible channels the transmission mechanism this effect work through on consumer
expenditure are many. A possible explanation can be drawn from the theory suggesting that
wealth is transferred from importing to oil-producing countries due to higher oil prices. An oil
price increase would, therefore, generate higher activity in the domestic economy and for our
result, this could provide us with a possible explanation why consumption levels increases due

27
to an oil shock within the Norwegian economy. This reasoning is supported by the work of
Jiménez-Rodrıguez & Sanchez (2005) and Bjørnland (2009). Even though they analyze shocks
on GDP growth, consumption contributes for 45,5% of the total GDP share within Norway's
economy hence it´s not surprising we find equivalent results.

The quick transitions back to equilibrium following an oil shock aren´t surprising and could be
further explained by the work by Letens & Moses (2017). They argue that Norway avoided the
paradox of plenty by developing institutions which made Norway become less affected by
volatile oil shocks compared to other oil producing countries (Karl TK 1997)

Furthermore, since an oil price increase leads to increased activity within economies, it´s
expected from economic reasoning that an oil-producing economy would experience
inflationary pressure. As can been seen from our IRF result, the Norwegian short- term interest
rate, NIBOR, also increases over the same period when exposed to an oil shock. This could be
explained by the actions taken in 2001 when the Norwegian central bank let the exchange rate
float and started following a monetary policy with the purpose of maintaining a low a stable
inflation.
Thus, inflationary pressure thereby forces the decision makers within the central bank of
Norway to react when an oil shock is realized, which we find evidence for in our results. Also,
the Norwegian wealth found GPFG gives the authorities in Norway to absorb initial inflationary
pressure (Letnes & Moses 2017) and thereby becomes a tool for the legislators to boost the
Norwegian economy in periods of recession. The GPFG, therefore, can redirect the revenues
from the oil extraction entering the domestic economy and hence affect the magnitude of the
initial shock on consumption. Hence, the Norwegian GPFG is one of the factors contributing
to Norway quick respond when exposed to unexpected oil price changes.

Even though we find evidence that shocks in the price of Brent-oil do have a positive short-
term effect on household consumption level, we cannot draw any major conclusion. The model
presented in this paper describes a simplified version of a complex world and as mentioned
earlier, the possible channels through which oil prices may affect household consumption are
many and still heavily debated among researchers. The results presented should be interpreted
with caution and since data were collected through several sources the validity and reliability
could be questioned. Also, the result presented from earlier research between the relationship
between oil price shocks and consumption is mainly from data on oil-importing countries. This

28
makes our intuition of the results to heavily rely on theoretical reasoning and assumption from
economic textbooks.

6. Conclusion
In this section a summarize of all components in this study will be summarized. The idea is to
provide a conclusion and a last thought on the findings and background of the study. Also, a
suggestion for further research is presented.

The purpose of this study where to investigate whether oil price shocks affected household
consumption within the Norwegian economy and provides new evidence of how the
relationship between oil shocks and household consumption appears in an exporting country in
the 21th century.
Understanding how fluctuations in Brent- oil prices affect the consumption behavior remains a
key tool for policymakers in Norway in order to implement an effective economic decision to
avoid recessionary periods.
Our findings from our VAR-model combined with the Granger-causality test and IRF-graph
shows that unexpected oil price increases do have a positive impact on household consumption
in the short-term. The result from the granger test shows that oil price changes do affect
Household consumption, Disposable income, and the short-term interest rate NIBOR. Since
little research can verify our result directly, we rely on the research made by Letnes and Moses
(2017), Bjørnland (2009), Jiménez-Rodrıguez & Sanchez(2005).4

The fact that household consumption responds positively to an oil price increase compared to
other net-exporting countries is in line with earlier research. The development of good effective
institutions and practises since the discovery of its oil resources seems to explain why Norway
as an export country benefit from oil price increases while others don’t.
However, the suggestions through which transmission mechanism oil increases should affect
Norway´s household consumption remains debatable, and we aren´t able to address them all.
Our study however provides a deeper understanding about how household consumption is
affected from oil shocks in an export country. This during the beginning of the 21th century, a
time when fossil fuels are starting to be replaced by alternative energy sources.

4
We can´t make any useful interpretation from the results based on Mehra & Peterson (2005) and Zhang &
Broadstock (2014) since they look at oil-importing countries.

29
 6.1 Further research

Within the existing literature that analyzes the relationship between oil shocks and consumption
expenditure, the selection of the variable measuring oil has come to be questioned. Our choice
of using the Brent oil price is sound. However, our study doesn't consider the net oil price
increase of Brent-oil as an alternative to a variable. It could be of interest to analyze how
consumption expenditure respond to this alternative variable since earlier research suggests that
the response of oil price changes is non-linear and comparing both variables over the same
period of time gives a more extended analyze. Due to limited time, this study cannot investigate
this further and we let future researcher analyze this.
Furthermore, our study is only able to investigate how increased oil prices affect consumption,
it could be of interest to analyze how households consumption responds on a shock due to
decreasing oil prices to see if the relationship is linear or not within the Norwegian economy.
As more countries become more independent of oil and moves towards alternative energy
sources, it will be of interest to evaluate the relationship drawn by existing research to see how
robust the relationship is over time.

30
 7.Reference list

Bachmeier, L., 2008. Monetary policy and the transmission of oil shocks. Journal of
Macroeconomics, 30(4), pp.1738–1755.

Bernanke, B.S., 1983. Irreversibility, Uncertainty, and Cyclical Investment. The Quarterly
Journal of Economics, 98(1), pp.85–106.

Bjrønland, HC 2009, `Oil Price Shocks and Stock Market Booms in Oil Exporting
Country`Scottish Journal of Political Economy, vol. 56, no. 2, pp. 232-254

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 8. Appendix

Appendix 1

Graph 2, NOK exchange rate, A negative slope indicates a weaker NOK exchange rate (left axis) and Brent crude
oil dollar/barrel(right axis)
Sources: Thomson Reuter and Norges Bank.

36
 Unemployment rate and
crude oil brent
$160,00 6,00%
$140,00 5,00%
$120,00
$100,00 4,00%
$80,00 3,00%
$60,00 2,00%
$40,00
$20,00 1,00%
$- 0,00%
2005-05-01

2011-03-01
2002-01-01
2002-11-01
2003-09-01
2004-07-01

2006-03-01
2007-01-01
2007-11-01
2008-09-01
2009-07-01
2010-05-01

2012-01-01
2012-11-01
2013-09-01
2014-07-01
2015-05-01
2016-03-01
2017-01-01
brent oil Unemp rate

Graph 3, unemployment in %(right axis) and crude oil Brent blent in dollar/barrel(left axis)
Source: OECD database and US energy administration.

Graph 4, Source: Export of Norwegian oil and gas- Norwegian petroleum.no

Left axis in percentage

37
Graph 5, Consumption share of total GDP, world bank

Appendix 2

Dickey-fuller test (at level)

Variables Test statistic p-value

Consumption -2.808 0,0571

Wealth -2,851 0,0514
Income -2,768 0,0630
Interest rate -3.305 0,0147
Brent Oil -2,502 0,1149
Stars indicate the coefficients significant level at: (***)=1%, (**)=5% and (*)=10%.

Dickey-fuller test (first difference)

Variables Test statistic p-value

Consumption -7,506(***) 0,000

Wealth -5,681(***) 0,000
Income -4,132(***) 0,0009
Interest rate -3,567(***) 0,0064
Brent Oil -7,325(***) 0,000
Stars indicate the coefficients significant level at: (***)=1%, (**)=5% and (*)=10%.

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KPSS (at level)
Variables Test statistic Test
(level) statistic(differenced)

Consumption 0,646(***) 0,0414

Wealth 0,392(***) 0,0421
Income 0,602(***) 0,0528
Interest rate 0,144(**) 0,0851
Brent Oil 0,574(***) 0,0349
Stars indicate the coefficients significant level at: (***)=1%, (**)=5% and (*)=10%.

Engle-granger 2-step cointegration test

Variable Test statistic 1% critical value 5% critical value 10% critical
value

𝜇𝑡 -3,799 -5,3576 -4,7423 -4,44625

We accept the null hypothesis and find no evidence of cointegration

Lag order selection

Lag FPE AIC SBIC

0 1.3e-14 -17.7538 -17.5761

1 4e-15 -18.9635 -17.8977
2 3.9e-15 -19.0087 -17.0548
3 2.7e-15 -19.4466 -16.6046
4 1.9e-15* -19.8585* -16.1284
5 2.7e-15 -19.7172 -15.099*

Autocorrelation test of VAR (4) model

Lag Chi2 df Prob>chi2

1 22.1753 25 0.626
2 43.3577 25 0.013(**)
3 22.6699 25 0.596
4 27.8689 25 0.314

39
40