The Effect of Oil Price Shocks on the Dynamic Relationship between Current Account and Exchange Rate: Evidence from D-8 Countries

The effect of oil price shocks on global economy has been agreat concern since 1970s and has instigated a great deal of researchinvestigating macroeconomic consequences of oil price fluctuations.Later on, the instability in the Middle East and recent oil price hikeconfirmed the enduring significance of the issue. Though a voluminousbody of literature has evolved examining the bearings of oil prices forinternal sectors of economies [to name a few, e.g., Barsky and Kilian(2004); Kilian (2008a,b); Hamilton (2008)], the studies analysing theexternal sector response to oil price shocks are very few [see, e.g.Kilian, et al. (2007)]. The determination of current account andexchange rate—the two major indicators of external sector—has beenstudied widely in theoretical and empirical literature but mostly thediscussion of the two variables largely remained separate [Lee and Chinn(1998)]. Similarly, investigation of simultaneous response of these twovariables to an oil price shock remained relatively less ventured avenueof research. Initial work done on the relationship between currentaccount and oil price could not ascertain conclusive link between thesetwo variables.1 Recent work on the issue revealed the diversity ofresponses of current account of different countries to an oil priceshock. For instance, oil price increase deteriorates current accountbalance of developing countries [OECD (2004); Rebucci and Spatafora(2006); Killian, et al. (2007)] but may improve it if the countryhappens to be a net oil-exporter. This implies that the relationshipdepends on the number of factors among which oil dependency of country,oil-intensity of production process2 and responses of non-oil tradebalance3 and sources of oil price fluctuations4are of particularsignificance.