Oil prices and the economy: A global perspective

In this paper we introduce a global factor-augmented error correction model to quantify the interaction of oil price with the global economy. Global factors are constructed for global oil price and global interest rate, money, real output and inflation over 1999-2012. The global factors are constructed to capture developments in the largest developing and developed economies. At global level the quantity theory of money operates in the sense that global money, output and prices are cointegrated. Positive innovation in global oil price is connected with global interest rate tightening. Positive innovation in global money, CPI and outputs is connected with increase in oil prices while positive innovations in global interest rate are associated with decline in oil prices. The US, Euro area and China variables are the main drivers of global factors. Granger causality test shows that US and China variables Granger cause global interest rate, money, output and prices.