A study of the relationship between oil prices and inflation

Abstract

This dissertation aims to find the extent to which oil prices affect inflation. It intends to do so by testing five European countries; France, Germany, Italy, Spain and the United Kingdom. It uses quarterly data for the testing of the period between 1999 and 2016. The Vector Autoregression model, followed by Granger-Causality and Impulse Response Functions are used in order to test for causal links between oil prices and inflation; as well as the exchange rate and the GDP, whilst also observing the effects of the shocks that the variables have on each other. This study shows that there is a reasonable amount of evidence which proves the possibility of a relationship between oil prices and inflation in some of the countries analysed. The price of oil is found to cause changes in inflation, however, this change is only relevant for an extremely short term. The effects of the variables on each other are short-lived since after two quarters such effects are insignificant. This analysis suggests that the pass-through effects of oil prices may be captured in different variables, other than inflation, the exchange rates and GDP, and hence, the effect is spread out. However, not all countries in this study register the same results. While for France, Germany and Italy, there was evidence of causality between oil prices and inflation; for Spain and the United Kingdom, there was no relationship whatsoever. The results of the latter countries provide that oil prices and inflation do not cause any change to each other. These findings indicate that the relationship is not a strong one and is not apparent in all countries. This result corroborates the existing empirical evidence which shows that such a relationship was found to be of little significance in the last two decades.