Causes and consequences of oil price shocks on the UK economy

In this paper, we assess the impact and repercussions of oil price fluctuations on the UK economy. We use an empirical strategy which allows us to decompose oil price changes from the underlying source of the shock. Our results show that the consequences of oil price changes on UK macroeconomic aggregates depend on different types of oil shocks. While increases in aggregate and oil market-specific demand do not depress the UK economy in the short run, shortfalls in crude oil supply cause an immediate fall in GDP growth. We also find that domestic inflation increases following a rise in the real oil price. Our variance decomposition shows that oil shocks play a non-negligible role in terms of variation in the main UK macroeconomic aggregates. In particular, aggregate and specific oil demand substantially contribute to changes in GDP growth, inflation, nominal interest rate and unemployment rate. Our study provides evidence that the Bank of England responds to the underlying sources of oil price shocks rather than oil price changes themselves. In particular, unanticipated booms in aggregate and specific oil demand cause an increase in the nominal interest rate whereas the opposite occurs in the case of unexpected oil supply disruptions.