Revisiting the Role of Economic Uncertainty in Oil Price Fluctuations: Evidence from a New Time-Varying Oil Market Model

Abstract

In existing literature, economic uncertainty may have positive, negative, or insignificant effect on crude oil prices. Based on our newly proposed two-stage tests and empirical analysis, we show that such disagreement is often caused by the conventional assumption on time-invariant market structure. To capture the time-varying market structure, using monthly oil market data in 2000-2020, we construct a new time-varying parameter oil market model. We confirm that economic uncertainty shocks have negative effects on crude oil price returns, and further find that the magnitudes of the time-varying effects are generally countercyclical to oil prices, which may be caused by the malfunctioning conventional stimulation policies during recessions. Furthermore, we show that economic uncertainty shocks dominate fundamental shocks in generating variations in oil price returns during the Global Financial Crisis, which sheds some light on the puzzling price slump that cannot be explained by the fundamentals during that period.

Keywords: Economic uncertainty; Time-varying forecast error variance decomposition; Nonlinear causality; Crude oil market

JEL Classification: F3