Transitional Dynamics of Oil Prices

There has been a well-known relationship between macro financial fundamentals and oil prices, yet there is also ample evidence that this relationship weakens during some periods. In this paper, we investigated whether the relationship between oil and macro financial fundamentals vary depending on gold price of oil. To achieve this, a Markov model is implemented to the monthly data for the period 1974 - 2010. In the Markov model utilized in this paper, transition probabilities are endogenous and governed by the volatilities of oil, gold, stock market and exchange rate. This allowed us to endogenously model the switching process. Our results provide evidence that the link between oil price and macro financial fundamentals disappears in the periods of inexpensive gold price of oil. Our findings also provide evidence that the volatilities of the variables matter only when gold price of oil is inexpensive.