Decomposing the links between oil price shocks and macroeconomic indicators: Evidence from SAARC region

This study examines the impact of oil price shocks on key macroeconomic variables (i.e., real GDP, interest rate, inflation and exchange rate) for five SAARC countries (i.e., India, Pakistan, Bangladesh, Sri Lanka and Bhutan). For this purpose, we adopt contemporary macroeconomic policy modeling tool called impulse response function (IRF) and forecast error variance decomposition method (FEVDM) in the structural vector autorepression (SVAR) setting using time series data over the extended period from 1982 to 2014. In addition, Johansen (1991) cointegration method is applied for long-run relationship. The results of cointegration test confirms the long-run equilibrium relationship between all the underlying variables. However, the empirical findings of IRF explained significant variation among all underlying macroeconomic variables in response to exogenous oil price shocks at different time horizons. It means the macroeconomic factors are sensitive to even small oil price shocks and possess various socio-economic implications in the region. The results of FEVDM evidence that each country in a study group responds differently to oil price shocks, it corresponds their independent policies, macroeconomic fundamentals, sector constructions and heterogeneity across the countries. The findings help governments to reform public policies in the region by controlling macroeconomic fluctuations due to oil price shocks. 1. Introduction The oil crisis was the major cause of 1970's recession which mainly affected the western economies. Since then, there is a plethora of literature studying the effect of oil price shocks on macroeconomic variables. Yet, the debate on this front is ongoing due to contrasting empirical findings and overall macroeconomic implications of oil price shocks both in developed and developing countries (Morana, 2017). For example; many researchers have examined the causal links between oil price shocks and key macroeconomic indicators, and found that effect significantly varies across the countries (Iwayemi and Fowowe, 2011). Nonetheless, majority of the studies conclude that the oil price shocks are detrimental to economic growth (see: Van-de-ven and Fouquet, 2017; Rafiq and Bloch, 2016). For instance; Hamilton (1983) and Mork (1989) conclude that the oil price shocks originate economic downturn. Furthermore, their results explain that the oil price shocks affect real economic output from both the supply side and as well as the demand side. The supply side effect comes from the production side when market supply diminishes due to rising resource (oil) prices and shifts the market equilibrium downward. Whereas, the demand side impact is associated with the spending and consumption pattern of the families