Macroeconomic Transmission Mechanism of International Oil Price Rise (the Indian Situation)

Topics: Macroeconomics, Inflation, Economics Pages: 3 (814 words) Published: January 17, 2013
Macroeconomic Transmission Mechanism of International Oil Price Rise: The Indian Situation In this Article, an effort has been made to trace the impact of an increase in international oil prices on Indian economy outlining the various transmission mechanisms. These transmission mechanisms take into account some of the important macroeconomic relationships, as relevant to the Indian context, and the administered nature of domestic oil price in India. The three broad channels through which the international oil prices impact the macroeconomy are identified as the (a) Import channel,

(b) Price channel and
(c) The fiscal channel.
(a) A rise in international price of oil will translate to higher import bill for oil for the net oil importing countries like India (see, Table 1 and 2). Under the reasonable assumption of low price elasticity of demand for oil, ceteris paribus, the trade balance will worsen due to an increase in international oil price. Rise in inflation due to increase in oil prices means that the growth in real GDP is even lower. The compression in aggregate domestic demand dampens growth. In figure 1, the import channel is indicated by the link from international oil prices to current account balance to nominal GDP. Although managed float, the nominal exchange rate in India is observed to be determined solely by the capital account and not by the current account in the present Indian context. The second order adjustment to higher import bill and worsened trade balance occurs only through contraction in aggregate demand and decline in imports and it does not occur through movements in exchange rate (depreciation). Finally, it is expected that the slowdown in economic growth would subsequently reduce the demand for imports which, in turn, would partially mitigate the adverse impact of high international oil prices on trade balance. (b) The price channel links the international prices to domestic inflation. For a typical developing country like India...
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