Persian Gulf War Effects of war in the Persian Gulf on the U.S. Economy

Okruhlik notes that "state strategies chosen to manage crises- like price booms and busts, worldwide recession, and war- have very real, though unintended, social and political consequences" (p. 297). This essay analyzes the relationship between Persian Gulf War and its impact on U.S. economy. The writer tries to explore impacts of conflict in Middle East and how it results as an increase in oil prices as well fluctuation in stock markets.

The previous research show that, oil price shocks have an asymmetric effect on economic activity and the stock market such that increases in oil prices have a larger impact than oil price decreases.

As the Gulf Coast was hit and many of the oil production and distribution facilities were damaged, world oil prices experienced a dramatic increase in the aftermath of the hurricanes. A few months after the hurricanes, major oil giants posted record high profits; thereby coming under fire. The price of oil is one of the major topics debated today and millions of people wonder whether the prices will go down or keep on climbing to the real levels of the late 1970s and early 1980s.

Persian Gulf War and Oil Prices

Since oil price changes are one of the most significant supply shocks which hit the world economy after World War II, a special consideration has been given to oil prices in the literature. There have been numerous studies related to the interaction among oil prices, the stock market and the overall economy.

As oil prices are denominated in the U.S. dollars, it is of interest to see how the effective exchange rate is affected by the real price of oil. As the real world is never a two variable model, this paper will take into account not only the real price of oil, but other variables in its attempt to examine the role played by economic fundamentals in explaining the behaviour of the U.S. real effective exchange rate.

Theoretical studies on the impact of oil prices

According to economic theory, oil price changes influence economic activity through both supply and demand channels. Supply side effects could be explained based on the fact that oil is an important input in production. Therefore, oil price increases reduce the demand for oil, decreasing productivity of other input factors which induce firms to lower output. Furthermore, oil price changes have demand side effects through consumption and investment. Consumption is affected indirectly by its positive relation with disposal income. When the oil price increases, an income transfer occurs from oil importing countries to oil exporting countries. Therefore, consumption in oil importing countries decrease and the magnitude of this effect is greater the more the shocks are perceived to be long-lasting. Oil price increases also have an adverse effect on investment by increasing firm's cost. In addition to these supply and demand effects oil price changes could influence the economy through foreign exchange markets and inflation.

Impact of Oil Prices on Economy

It is not easy to find a factor which had a greater impact on an economy than oil prices since 1970. After the oil price increase caused by the oil embargo of OPEC in 1974 most economies experienced an economic recession, and similar situations continue to occur. Therefore, the relationship between oil prices and the economy has been and continues to be a keen interest to lay people as well as economists.

Therefore, I want to analyze the relationship between oil prices and the stock market for U.S. with the recent data. In particular, I am interested in the asymmetric effect of oil price changes on the stock market because the pattern of oil price fluctuations has changed since the mid-1990's and oil price increases occur more frequently than oil price decreases, while the average magnitude of increases is smaller for decreases. (Table 1.1)

Figure 1-World real oil price

< Date of substantial spot oil price change > [footnoteRef:2] [2: "Measuring oil-price shocks using market-based information" by Michele Cavallo and Tao Wu (2006)]

1986. 2 May -- Soviet nuclear reactors were closed some in wake of Chernobyl disaster

30 October...

18 July -- Iran accepts UN calls for cease fire.
1989. 12 December -- Frigid temperatures in the U.S.

20 December -- U.S. invasion of Panama.

1990. 2 August -- Iraq invasion of Kuwait; U.S. led oil boycott.

September to December -- Middle East tensions.

1991. January -- First Gulf war.

19 August -- Soviet coup.

1996. 13 February -- Freezing temperatures in the U.S. northeast and in northern Europe.

23 February -- Iraq accepted UN resolution 986: exchange of oil for food.

17 June -- UN-Iraq weapons inspection standoff; Many believe that the oil-sale deal may be in jeopardy.

3 September -- U.S. bombing on southern Iraq.

16 December -- Frigid weather across the U.S.

1998. 26 January -- U.S. comments that patience with Iraq is running out.

3 September -- Disruption to Russian and Nigerian crude oil supplies; U.S.-Iraq tension on weapon inspection.

16 December -- UN weapons inspections withdraw from Iraq, a military strike in Iraq may be possible; however, despite the air strike, Iraqi oil continues to flow.

2002. 2 January -- Cold weather in the U.S.

16 December -- Strikes in Venezuela continue.

23 December -- Ongoing general strike in Venezuela; Potential war against Iraq

2003. March -- Second Gulf war; U.S. invades Iraq; Traders expected a relatively short war in Iraq with minimal damage to oil installations, but the war looks tougher; British and U.S. military officials say that it will take months before oil from Iraq's southern fields is again ready to be exported; ongoing civil unrest in Nigeria, where approximately 800,000 barrels per day of oil is shut.

2003. 22 July -- Saddam's two sons die at the hands of U.S. troops.

1 August -- Pipeline fire in Iraq, suspected to be caused by sabotage; Heightened concerns about the situation in Iraq.

23-24 August -- Concerns over Tropical Storm Jose and another suspension of Basrah oil loadings in Iraq supported oil prices; New forecasts for a storm (Katrina) hitting the U.S. Gulf Coast and another hefty withdrawal in gasoline stocks pushed crude futures on the New York Mecantile Exchange (Nymex) to a new record.

Some work has been done on the effects of fluctuations of real oil prices to explain the movements in the U.S. real exchange rates. Papers by Krugman (1983) and Golub (1983) have noted on the importance of the real oil prices in determining movements in exchange rates. Amano and van Norden (1998) took it a bit further and used some new econometric techniques in trying to explain the relationship. Their results suggest that oil prices may have been the dominant source of persistent real exchange rate shocks. However they only consider a two variable model.

When it comes to the relationship between the real interest rate differentials and real exchange rate fluctuations, several researchers including Baxter (1994) and Clarida and Gali (1994) have pointed out to the lack of co integrating relationship between the variables and therefore to the failure of real interest rate parity..

Maeso-Fernandez, Osbat, Schnatz (2001) provided an empirical analysis of the medium-term determinants of the Euro effective exchange rate and found that differentials in real interest rates and productivity, and (in some specifications) the relative fiscal stance and the real price of oil, have a significant influence on the Euro effective exchange rate. Our models look at some of the variables they employ in order to explain fluctuations in the U.S. real effective exchange rates.

The impact of Oil Prices fluctuation on Stock Market

In the sub-sample period (1996.5-2005.12) when oil price increases more recurrently than oil price decreases and the average enormity of oil price increases is lesser than that of oil price decreases, stock markets in most part of the world are more affected by oil price decreases than oil price increases in the discrepancy breakdown analysis. In particular, statistically significant evidence at the 5% level is found that oil price decreases have a greater impact on real stock returns than oil price increases after the mid-1990's in the U.S.

Hamilton (1988) analyzed a common symmetry model of unemployment and business cycle model where it is expensive to move labour and capital inputs flanked by sectors. In such a model he shows that energy price shocks can reduce aggregate employment by inducing workers in adversely affected sectors to remain unemployed while they wait for labor conditions to improve in their sector, rather than move to a sector not adversely affected.

Rotemberg and Woodford (1996) study the impact of oil price shocks on output and real wages with a simple aggregative model by assuming imperfect competition in the product market. Allowing for a modest degree of imperfect competition (such as an implicit collusion between oligopolists) can account for declines in output and real wages after oil price shocks. According to them, an imperfect competition model can explain the effects of oil price shocks on the U.S. economy greater extent than a stochastic growth model (which assumes a perfectly competitive product market).

Finn (2000) shows that perfectly competitive model can also explain the effect of oil price…