Contents

Chapter I - Introduction:......................................................................................................4
1. Research Aim, Research Questions and Research objectives:..................................4
2. Brief history on role of crude oil and impacts towards economy:............................4
3. Economic Theories:..................................................................................................5
Demand and supply of fuel:.............................................................................................6
Oil derivatives market and its impact on prices:..............................................................7
4. Organization of Study:..............................................................................................8
Chapter 2: Literature Review...............................................................................................9
2. 1. Chapter Overview....................................................................................................9
2.2. Factors that cause inflation.....................................................................................14
2.2.1. Practical cases of inflation and the causes...........................................................16
2.3. Inflation and the economy......................................................................................18
2.4. Crude oil and the economy.........................................................................................21
2.5. Correlation between crude oil and inflation ………………………………………...23
2.6. Economic trends of UK and frequency of inflation....................................................25
2.7. Political and economic views on crude oil and the economy of UK.........................29

2.8. Effect of oil prices fluctuation on economic activities of the households…………30

2.9. Effect of crude oil prices on the business……………………………………………
34

2.10. Theoretical Foundation.............................................................................................34

2.11. Gaps in literature………………………………………………………………… ..35

2.12. Synopsis of the chapter……………………………………………………………35

Chapter 3 - Research Methodology………………………………………………..…….36

3.1 Research Objective:.....................................................................................................36

3.2 Data Collection............................................................................................................36
3.3Hypothesis:...................................................................................................................37
3.4Econometric Specification:...........................................................................................37

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 3.4.1Model Specification...............................................................................................37
3.4.2Ordinary least square method:...............................................................................38
3.4.3 The Stationary Test (Unit Root Test)....................................................................39
3.4.4 Co-integration Test- Johansen approach...............................................................41
3.4.5 The Granger Causality test....................................................................................41
3.4.6 Error Correcting Models.......................................................................................41
3.5 Study Limitations.........................................................................................................42
3.6 Summary......................................................................................................................42
Chapter4.............................................................................................................................44
4.1 Data Description:....................................................................................................44
C h a p t e r 5......................................................................................................................47
5.1 Augumented Dickey-Fuller Test:............................................................................47
5.2 Phillips–Perron (PP) tests.......................................................................................48
5.3 Equilibrium correction or error correction models:................................................49
5.4 The Johansen’s Approach:......................................................................................50
5.5 Long-run Causality Tests:.......................................................................................52
5.6 Short-run Causality Test:........................................................................................53
5.6.1 Wald Statistics.................................................................................................53
5.6.2 Breush- Godfrey Serial Correlation LM test:.......................................................57
5.6.3 Heteroskedasticity Test: Breush- Pagan Godfrey Test:...................................58
5.6.4 Normality Test: Jarque-Bera............................................................................60
5.7 Granger Causality Test: VAR Model:..................................................................61
5.8 Correlation Test:..................................................................................................65
Chapter 6............................................................................................................................67
6.1 - Findings of the research:...................................................................................67
6.2 Summary of VECM model and Wald statistic:...................................................68
6.3 Conclusion:.........................................................................................................69
6.4 Recommendations....................................................................................................70
6.5 Limitations:..............................................................................................................70
6.6 Suggestions for further studies:...............................................................................70

2
Abstract:

Oil prices play a very vital role in economic decisions of a country. The fluctuation in the
prices of oil is always a cause of concern for the policy makers. The volatility in the
prices of oil has an impact on the overall prices of all the commodities and if such
volatility is not checked and acted upon within a stipulated time it may have series impact
on the growth of the economy.This is primarily because of the reason that the world still
depends on nonrenewable sources of energy to a maximum extent for its energy needs.
The oil prices are considered to have impact on various economic variables such as
inflation, exchange rate, balance of trade, balance of payments, savings, forex reserves,
exports, imports and Gross Domestic Product (GDP) of the economy. The oil prices
fluctuate due to the demand and supply of the commodity. Various factors such as
political unrest, war,etc. in the oil supplying nations leads to areduction in thesupply of
oil and hence the increase in price of demand being constant. Other factors such as
reduction in production capacity, investment blocks, no new oil exploration sites also
pose a risk or fear of reduction in supply thereby artificially increasing the price. Experts
have observed that theinsufficient availability of data in a timely manner from the
producers also affect the oil prices. In order to tackle this price fluctuation, oil derivatives
were looked upon as a solution where the risk of increase or decrease in prices can be
hedged. But this derivatives have off late been used as tool to make aprofit by users other
than the oil suppliers and buyers.

Our study is thus aimed to understand whether the impact of crude oil prices changes in
UK economy. This study would thus cover the changes in the oil prices and its influence
in UK with light into effect on crude oil on economic variables such as exports, exchange
rate, and inflation. The study uses time series data for the period 2005 to 2015. The data
for the purpose of the research has been obtained from various sources such as World
Bank, Trading Economics and Statistics of UK. The data includes variables that are
quarterly series of seasonally adjusted exchange rate, GDP, Balance of trade, Exports,
US-UK Exchange rate of the currency, inflation and crude oil prices from Jan 2005 to Jan

3
2015. The period 2005 to 2015 is included to study specifically the impact of pre and post
crisis period. The study uses various statistical tools in order to test the impact of oil
prices on other economic variables. The statistical tools include Ordinary Least Square
method, Unit Root Test, Johansen Co-integration test, Granger Causality test, Vector error
correction model, Correlation test, R-Square values and Wald statistic test. The results
from the above test have indicated that there is a long-run causality between inflation and
crude oil prices.

Chapter I - Introduction:

1. Research Aim, Research Questions and Research objectives:

a) Research Aim:

The aim of the research is to investigate the impact of crude oil price changes on UK
economy.

b) Research Questions:
1. To study about the changes of crude oil prices and its influence on UK
2. To ascertain the factors (determinants) that influence on crude oil
3. To evaluate the effect of crude oil on the Economy with particular reference to the
composition of exports, exchange rate, and CRUDE OIL.
4. To evaluate the impact of crude oil over the short term and long term on inflation.
c) Research Objectives:

The test for causality and cointegration between crude oil and its impact on inflation in
UK economy and establish the influence of inflation on macroeconomic variables like
Exports, Exchange rate, Balance of Trade and Crude oil.
4
 2. Brief history of role of crude oil and impacts towards economy:

Oil prices play a vital role in economic decisions of the policy makers. The fluctuation in
prices of the oil has been a cause of concern over the last three decades. The dependency
on oil in various segments has impacted in global vulnerability on various
macroeconomic factors. The observes that price fluctuation is apparent in all
commodities, however in the case of crude oil the volatility is very high and frequent that
it affects the global economy. If the price changes are not controlled or not checked in a
timely manner, it may have a huge destabilizing effect on the economy. It will pose as a
barrier to the future growth of the economy. Though countries have tried to concentrate
on renewable sources of energy more, the dependency factor of the crude oil has not
reduced. Ebrahim (2014) states that the world is still dependent on fossil fuels, and the
same constitutes 90% of the world’s energy consumption.

3. Economic Theories:
Oil prices affect various economic activities such as inflation, growth, the balance of
payments, trade balances and others directly or indirectly. As oil price increase or
decrease, the inflation also follows the same direction since oil is an important input in
the economy.When the cost of this primary input increases, secondary and tertiary
product prices too get impacted (Cologni and Manera 2005). Many experts have observed
that the large or sudden oil price changes have larger effects on the economy (Lee, Ni,
and Ratti, 1995). The oil price increase also has adverse effects on the growth and the
Gross Domestic Product (GDP) of an economy. Hamilton (2003) observes that the
increase in oil price affect the inflation but decrease in the price does not matter. He also
observes that if there is a fluctuation in the price after a period of stable price affects the
economy more than the general fluctuations occurring in the price.

5
Source: Ebrahim 2014

The increase in oil prices also has aneffect on spending of both the economy and the
ordinary household. In case of countries importing oil, increasing prices affect the
spending pattern of the economy. Such increase in prices would result in overall price
increase across all segments leading to an imbalance in the reserves. In the case of
household, an increase in oil prices affects consumers spending (Mehra and Petersen
2005). It also puts consumer spending on big items likes automobiles on hold due to
increase in fuel prices.

In developing countries the prices of oil, the increase in the price internationally increases
the domestic inflation leading to a reduction in foreign exchange reserves. This in turn
has an effect on the supply of such reserves leading to depreciation in the current value of
the local or domestic currency leading to increasing in import prices.

Oil prices also affect the trade balance. When the oil price increases, the public
expenditure increases leading to increasing in the consumer price index. All these force
the developing countries to borrow from other countries or World Bank to meet its
additional expenditure (Subhani et.al 2012).

6
Source: Ebrahim (2014)

The three main sources that affect the oil prices as defined by Ebrahim (2014) are:

Demand and supply of fuel:

The demand and the supply of the fossil fuels are the fundamental concepts that drive the
price of the product. High demand and stable or less supply increase the price and
conversely low demand and stable or high supply results in a reduction of the price.
Marginal changes in demand and supply over a short run does not vary the price heavily.
In other words, there is a marginal change in price when there is a marginal change in the
demand and supply over a short period. However in a long run transition in demand and
supply has resulted in huge volatility in prices affecting the economy. During 2003 to
2008, the production of crude oil stagnated while the demand remained increment. The
inelasticity of supply was due to adecrease in production capacity, investment block and
reduction in thediscovery of new sources of production, political risk and instability of
investment in Iraq - one of the important oil-producing nations. The seasonality
associated with demand also affects the price. The largest fluctuation of prices have been
7
observed in oil producing nation’s political instability and conflicts or domestic
issues(Namboodiri,1983, Kilian, 2010). Experts also talk about the 2011 Libyan Civil
War, and the tension prevailing in the nation and the situations in the Iranian nuclear
program have resulted in an increase in oil prices substantially (Triki 2011). The suppliers
of oil have recently undertaken steps to ensure stable production by spreading the
geography of supply and reducing dependency on some of the regions only. Saudi Arabia
has increased its production level in the year 2012 to a 30 year high in an attempt to
maintain stability in supply and turn in prices(Blas 2012).

Oil derivatives market and its impact on prices:

Derivative front in oil initiated to handle the risk of increasing prices in an effective
manner. Various financial instruments were adopted to manage effectively the funds and
diversify risk. With technological advancement and a wide range of financial tools,
investors effectively manage their portfolio in the derivatives market. The market has
now grown from being primarily to hedge against price shocks to commercial users using
the market to accept risk for a reward arising out of the financial transaction. This
speculative action in the commodity results in price instability (Kilan, 2010)

1. Inadequacy of oil market data:

Lack of proper and accurate data from the oil market such as production, inventory,
estimation of production and future supplies also result in volatility and uncertainty. Joint
Organizations Data Initiative (JODI) was created to provide adequate and accurate data
on the oil production and supply with the objective of moderating the excess fluctuation
in the prices. Though there has been better transparency in reporting of the data, there is

8
variation in reporting standards, delay in submission of timely data, inconsistency, etc.
still affect the prices of the oil. Also, this does not cover data on the reserves of oil (Ahn
2011)

4. Organization of Study:
The structure of this study is divided into following section, to provide for chapter1
introduction about the crude oil in world markets. The literature on oil and inflation
relationships theory and evidence on economic theory. Chapter3 is followed by Research
Methodology. Chapter 4, Description of data, followed by five variables, Chapter 5
empirical results on the interrelationship between inflation and crude oil. Chapter 6
conclusion, followed by Appendix.

9
Chapter 2: Literature Review

2. 1. Chapter Overview

Baglione ( 2012) suggests that the purpose of the literature review is to take into account
already established secondary sources for developing the framework for a particular
research. The researcher does not introduce any new information or report any original
work in a literature review (Baglione, 2012) which makes it clear that this chapter will
help the readers in developing a clear picture of the impact of crude oil prices throughout
UK and its relation to the country’s growing rate of inflation. The chief sources that will
be for a literature review include case studies, peer reviewed journals and news reports,
academic books, and other sources that are academically acknowledged. It has been
realized that a systematic literature review chapter will develop properly and provide
logical data on further empirical studies if it follows the track of remembering,
understanding, applying, analyzing and evaluating the sources (Bloom & Krathwoh,
1956; Granello, 2001; Shields and Rangarjan, 2013). Therefore, the entire chapter will be
divided into several subheads so that the research can analyze factors such as the actual
consequences of change in oil process in UK, the key factors that foster inflation in an
economy and how inflation and crude oil influences the economy. This in-depth study
will assist in developing a rational standpoint on the correlation between oil price
decrement in UK and inflation.

2.2. Factors that cause inflation

2.2.1. Practical cases of inflation and the causes

Inflation is a situation when the price of goods and services suddenly and develops a
10
situation where each unit of currency can purchase fewer things as compared to what it
could buy previously. The obvious consequence of inflation is decrement in the
purchasing power of the mass population and loss of real value of the country’s currency
(Flemming, 1976; Walgenbach, Dittrich and Hanson, 1973; Wilson, 1961).

i. Case of inflation in Turkey

A case study conducted on the causes of inflation in Turkey over a long tenure of more
than twenty years revealed that among the chief factors that led to the situation include
monetary growth and budget deficit as demand side determinants, and nominal exchange
rates and change in oil prices as the supply side factors. To be more specific, the research
found out that inflation is a “net result of sophisticated and continuous interactions of
demand-side (or monetary) shocks, supply-side (or real) shocks, price-adjustment (or
inertial) factors and political processes” or other institutional determinants (Kibritcioglu,
2001.). Inflation is one of the menaces of the African economies. Thus, research was
conducted on a sampled population of ten sub-Saharan African countries to identify the
key factors behind inflation. The findings suggested that the “relative importance of
monetary growth and exchange rate depreciation” happens to be the major factors that
lead to inflation in Africa. However, the research also revealed some other factors that
contribute equally to inflation. Among these factors include structural bottlenecks of the
financial and administrative infrastructure of a country and lack of adoption of an all-
encompassing macroeconomic strategy that would include adequate protective measures
for both the monetary and exchange rates policies (Canetti and Greene, 1991).

ii. Case of inflation in Mainland China region

A research was conducted in Mainland China region in order to identify the factors that
blow up or deflate a country’s economy. It was found that world prices, the value of
renminbi and level of productivity act as chief determinants that either cause inflation or
11
deflation of the economy. After the initiation of economic reforms in the country about
two decades back, Mainland China had to pass through several phases of price
adjustments. Especially during the 80s, there was considerable price increase throughout
the country due to the adoption of price liberation policies and rush of investments that
were financed by monetary expansions. In addition to this, there was devaluation of
renminbi, the official currency of People’s Republic of China, from 3.2 yuan/USD to 3.7
yuan/USD in July 1986 and to 4.7 yuan/USD in December 1989. This served as a factor
that caused inflation in China, thereby creating a situation where the “year-on-year CPI
inflation rate reached a high of close to 30% in 1989 (Ha, Fan, and Shu , 2003).”

Fig. 1. : Inflation, growth and nominal exchange rate in Mainland China from 1982
to 2002

12
Source: Ha, J., Fan, K. and Shu, C. (2003). The Causes Of Inflation And Deflation In
Mainland China. Hong Kong Monetary Authority Quarterly Bulletin, pp.23-31.

However, long term and short term fuel supply shocks have also been recognized as
major factors that caused inflation in China. Here, it needs attention that while short-term
supply shocks indicate towards commodity prices and WTO-related tariff cuts and
eventually lead to inflation, long-term shocks are associated with productivity gains that
arise from aspects of reforms in state-owned enterprises, adoption of new technologies
and greater competition from more open markets. However, continuous expansion of a
country’s capacity and excess supply of labour force depress prices (Ha, Fan and Shu,
2003) in the international prices and increase commodity prices in the domestic market as
it happened in case of China.

Fig.2: World prices, unit labor cost, and inflation

13
Source: Ha, J., Fan, K. and Shu, C. (2003). The Causes Of Inflation And Deflation In
Mainland China. Hong Kong Monetary Authority Quarterly Bulletin, pp.23-31.

iii. Case of inflation in UK

Inflation is a commonplace occurrence in developed economies like UK, USA, Australia

and Canada too. Therefore, research was conducted by Wehinger (2000) to identify the
factors that cause inflation in economies like Australia, Germany, Italy, UK, USA, and
Japan. The most immediate factors that were identified include “energy price shocks,
supply shocks, wage setting influences, demand and exchange rate disturbances and
money supply surprises(Wehinger, 2000).” If we consider the economy of UK in more
precise manner, it might be found that the economy passed through several stages of
inflation and deflation from 1875 to 1991. The major factors that acted as catalysts were
changes in economic policies of the country and shifts in the exchange rate regimes.
Among the other obvious factors that led to inflation in UK economy include the two
14
world war and the two subsequent oil crises, and legislative and technological alterations
within the country (Hendry, 2001). There had been marked changes in the economic
growth of UK along with shifting interest rates as a consequence of inflation(Berument,
1999; Wright, 2002.).

2.2.2. Scholarly theories on factors that encourage inflation

i. Keynesian economic theory:

According to the Keynesian economic theory, there is no direct connection between

money supply and the process of consumer commodities. Rather, pressure on a country’s
economy gets reflected in the form of price rise as symbolic of visible inflation (Hjelm,
2007; Portelli, 2013). In this context, mention needs to be made of the triangle model
developed by new Keynesian economics that is derived from Philips Curve and named by
Robert J. Gordon. According to this model, three root causes lead to inflation. They are
built-in inflation, demand-pull inflation and cost-push inflation (Macroeconomics:
Theory and Policy, 1983; Gordon, 2004). The detailed descriptions are as follows:

 Built-in inflation:

In the built-in inflation, the labor force pressurizes the employees to increase their wages
so that this increment rises above the rate of inflation and helps them to counter the
situation. The employers in their turn pass on the burden of high labor cost to their
consumers in the form of increased prices of products supplied by them. This creates a
vicious cycle in the entire economy. However, the cause that initiates this vicious cycle
exists in some specific fiscal events that took place in the past, and creates hangover
inflation (Gordon, 2004; Strebel, 1976).

 Demand-pull inflation:

Demand-pull inflation is a condition when the market experiences an aggregate increase

in demand for consumer goods and services as a result of factors like increment in
15
government and private expenditures. An inflation like this has positive effects on a
country’s economy because it facilitates economic growth by showing excess demand for
consumer goods and subsequent creation of favorable market condition for new
investments and business expansions (Barth and Bennett, 1975; Selden, 1959).

 Cost-push inflation:

Cost-push inflation occurs when there is a sudden decrease in the supply of a particular
consumer commodity. A situation like this arises due to several factors like reduction in
the export of that product, natural disaster, increase in the price of inputs and
infrastructure, etc. A sudden decrease in the supply of that product in a condition when
the demand remains constant results in increment of its price. Thus, when the suppliers
increase the price of that commodity, the consumers are forced to pay the increased price
for purchasing it. The situation manifests in the form of cost-push inflation (Trevithick
and Lundberg, 1978; Vroman, 1990).

ii. Monetarist theory:

According to the monetarist theory, inflation is a monetary phenomenon that are

consistent with nature. Changes in the monetary policy and delayed growth of the
economy of a country are the key factors that lead to inflation. The monetarists believe
that inflation and deflation are determined by the monetary authority of a country as it
controls the supply of money. This theory further asserts that the aim of these monetary
authorities is to encourage economic growth and economic stability of the country along
with lowering of unemployment rates and preventing unpredictable fluctuations in the
exchange rates. Thus, according to this theory the major responsibility of these authorities
is to predetermine the exact inflation or interest rate that an individual should pay so that
it results in price stability (Barro and Gordon, 1983; Scott, 2005).

16
 iii. Rational expectations theory:

According to the rationalist expectations theory, the stakeholders of a country’s economy

are the factors that determine whether the economy will witness inflation of deflation.
The theorists who support this notion assert that the agents make a prediction of the
future of a country’s economy. These expectations are balanced with the statistical values
of a country’s fiscal structure. These agents tend to follow the decisions of the financial
institutions of the country like that of the central bank and act ways that accomplish the
future predictions of elevated economic inflation. Thus, the second factor here is the
central bank. If the policies of the central are perceived as tough on inflation by the
stakeholders then they will have faith in them and their eventual inflation expectations
will automatically come down. This will in turn make inflation come down and cause
negligible economic disturbance to a country. The scenario will be just the opposite if the
policies of the central bank are considered as weak against inflation by these agents.
Hence, it is clear from this argument that this theory stresses upon the activities of the
agents and the specific monetary policies are the chief factors that lead to inflation
(Diamond and Verrecchia, 1981; Grossman, 1981; Muth, 1961).

2.3.Inflation and the economy

17
In general, inflation means decrease in the overall purchasing power of a country.
However, if the deeper analysis is made, then it can be found that inflation creates
mixed reactions to an economy because it is not evenly distributed. Those who own
assets like property, stock, etc. gain due to the phenomenon because the price of
their holdings increase, and those who wish to buy them end up paying more money
than what they would have paid in normal situation (Hendershott, & Hu, 1979)
(Lerman & McKernan, 2008; Rudel, 1987). On the other hand, the consumer class
remains at the receiving end because their purchasing power get negatively affected
due to inflation. It creates a discrepancy between the household purchasing plans of
the consumers and the actual purchase. Eventually, the negative impact of inflation
on the consumers gets reflected in the form of decreased economic activity of the
consumers (Juster et al., 1972). In case of cost-push inflation, this situation can
result in a situation that features demand for rapid wage and salary increase so that
the consumers can afford the price rise. However, it increasing wages in such
situations fuel the inflation further thereby making the workers demand further
increase in wages. Eventually, the economy experiences wage spiral Blanchard,
1985; Sideris, 1996). Relocation of the purchasing power of the international
trading partners takes place, thereby indicating noteworthy declination “in the
degree to which firms ‘pass through’ changes in costs to prices (Taylor, 2000).” It is
noteworthy here that there are a correlation trade balance and inflation. Thus, when
the exchanged are fixed and applied globally, the highly inflated economies suffer
because its exports become costlier (Bahmani-Oskooee, 1985: Sundararajan, 1986).
However, even though inflation erodes the real value of money and stocks, this is a
short-term effect on the economy of a country (Rapach, 2002). But the real long-
term effect of inflation on a country’s economy manifests in the form of ineffective
market that loses the interest of the investors. The companies decide to hold back
their investment plans in that market for a long term. In peak situations, some
companies even take the decision to shift away the resources from the market and
exclusively focus towards calculating their profits and losses from the inflation
(Taylor, 2008).

18
2.4. Crude oil and the economy

There is a direct relationship between the economy of a country and the price of
crude oil. It is considered as positive for the world importers when the prices of
crude oil fall. Basically, when the global crude oil prices get reduced the importing
countries have to spend much less fiscal resources for the same quantity of crude oil
that they have been importing at a higher rate so far (Barsky & Kilian, 2004). Since
most of the highly developed countries are oil importers, it can be said that the
economy experiences positive effects when the prices of crude oil fall. On the other
hand, the economies of the oil producing, and exporting countries pass through a
negative phase when crude oil prices fall (Barsky & Kilian, 2004; Ramcharran,
2002).

2.5.Correlation between crude oil and inflation

While there are several factors, that affect the economy of a country and encourage
inflation. However, oil prices should be considered as one of the crucial factors among
them that either inflate or deflates an economy. Conventionally, increase in oil prices is
directly proportional to inflation of an economy. Actually, oil happens to be one of the
key consumer products that is further used to manufacture a number of secondary
products. Hence, the demand for oil remains same even on occasions when oil prices
increase, and consumers end up paying a higher price for the same quantity of oil or oil-
based products that they used to buy previously. This leads to inflation (Bhar and Mallik,
2012; Chen, 2009; Thoresen, 1982). If the case of inflation in the European economy
during the span from 1960 to 1999, it will be seen that the “oil prices have permanent
effects on inflation and short-run but asymmetric effects on production growth
rates(Cuñado and Pérez de Gracia, 2003).”

19
Parallel researches like the one conducted by LeBlanc and Chinn(2004) suggest that the
traditional conception that increase in oil prices will invariably lead to inflation no longer
applies to the present economic condition of the entire world. The research on the
economies of G5 countries like U.S.A, Japan, and Europe revealed that oil prices have an
asymmetric and nonlinear effect on the economic output of a country. In addition, the
traditional viewpoint that even ten percent increase in oil prices will directly lead to an
inflationary increase of 0.1-0.8 percentage in an economy has become non-existent now.
Rather, there is hardly any significance of the increase in oil prices in the economy of a
country (LeBlanc and Chinn, 2004.).

It has even been seen that the increase in oil prices has caused a boomerang effect on its
demand in the consumer market. Among the most important factors that prevent the
inflationary effect of increased oil prices on an economy is the decreased demand or it.
When inflation forces the consumers to pay higher prices, it affects their real income.
This, in turn, puts descending pressure on the demands of the consumers for oil and oil
based products. In a situation like this, the middlemen are under tremendous pressure
because on one hand they have to bear the burden of elevated input costs and on the other
hand they have to encounter decreased consumer demand. Such situations force
businesses to cut down their profit margin and future investment expenditures(Hamilton,
1996; Manera and Grasso, 2005; Radchenko, 2005). Thus, situations like this suggest
that increased oil prices fail to encourage the consumers to pay more for the same
quantity and eventually take the economy to an inflationary status.

Another dimension of oil prices and inflation is that drop in oil prices can be shocking for
the economy of a country. Chris Giles of Financial Times (2014) reports that the
significant consequence of about 40% reduction in the oil price is that there was
decreased consumer demand for it. As a result, the suppliers have entered into steep
competition with each other in order to find potential customers who would buy oil from
them. As a result, the rich oil stocks of the prominent global oil supplying countries are at
stake. This is, in turn, affecting the economic health and employment status of such
countries. Thus, it is clear “when oil prices fall, there is no iron law that enhances global
economic growth (Giles, 2014).”
20
 Fig. 11: Ratio of import and export of global economies after oil price fall

Source: Giles, C. (2014). Winners and losers of oil price plunge Chris Giles. The
Financial Times. [online] Available at: http://www.ft.com/intl/cms/s/2/3f5e4914-8490-
11e4-ba4f-00144feabdc0.html#axzz3UGKHgdPx [Accessed 13 Mar. 2015].

2.6. Economic trends of UK and frequency of inflation

The economy is UK is an amalgamation of the economies of leading countries like

England, Scotland, Northern Ireland and Scotland. Thus, the economy of UK is counted
as the fifth largest national economy in respect of its nominal GDP and eighth largest in
respect of its Purchasing Power Parity. The economy ranks fourth in the world as far as
the exports and imports are concerned (Central Intelligence Agency, 2015). The economy
has passed through several ups and downs from the middle half of the 20 th century till the

21
present date. It passed through frequent periods of recession from 1945 to 1973
immediately after the Second World War (Dow, 1998). By the turn of the 50s, the status
of UK economy improved even though unemployment remained a serious problem. The
oil crisis of 1973 forced the country to enter into another spell of recession. This is the
dark phase of UK economy because it was characterized by unemployment and double
digit recession (Bell and Blanchflower, 2010; Henry and Ormerod, 1978; Nelson and
Nikolov, 2003). The country expected a revolution in its economic scenario with the
election of Margaret Thatcher in 1979. Nevertheless, the steps taken to beat inflation did
not prove fruitful. Rather, it resulted in increasing the rate of unemployment throughout
the country. The government policy to close traditional factories and coal pits were the
major factors that resulted in ahigh rate of unemployment dung this phase. However, the
scenario of unemployment improved when Thatcher was elected for the third time
(Campbell, 1988)(Matthews et al., 1987). Nevertheless, this phase was short-lived as the
country went into another phase of recession in the late 90s, thereby resulting in an
increase in the rate of unemployment and economic crisis (Nickell, 1990).

When Blair came to the government, the economic status of UK showed relative much
greater improvement that commenced from May 1997 to 2008. The growth rate of UK
economy was so strong during this tenure that the country was counted among the major
developed economies of the world and the strongest economy of Europe (Blair, 1998)
(Walker and Wiseman, 2003). Nevertheless, after 2008 UK economy entered into another
phase of recession that war marked by growing rate of unemployment, nationwide steep
inflation and increased interest rates (Brewer, 2008; Campbell, Shiller and Viceira, 2009).
However, this dark phase of UK economy was short-lived and ended in 2009 (Duca,
Muellbauer and Murphy, 2010; Kolasinski, 2011). During 2012 UK economy stagnated
and could not reverse the effect of the recession. It was by 2014 when the economy
slowly revived and encouraged increase in the volume of GDP to 3.4% (Office of
National Statistics, 2014). Thus, within a period from 2005 to 2014 the UK economy fell
from its 5th global position in terms of household income to 12 th rank. Devaluation of the
UK currency due to inflation is considered as the major factor behind it. However, the
22
reports published by Office of National Statistics, UK suggest that this time inflation was
less unpredictable and comparatively more resilient in nature. In addition, in spite of
decrement of average UK household income during this phase, the household expenditure
and wealth of UK economy were more stable and stronger than other OECD countries
(Office of National Statistics, 2013).

Fig. 5: Household Actual Disposable Income in OECD countries in 2011

Source: Office of National Statistics, (2013). The Economy - International Comparisons,

2011.UK.

Fig 6: Household Actual Consumption Per Head in OECD Countries in 2011

23
The X-axis represents the annual consumption of oil, and the Y-axis presents the OECD
countries.

Source: Office of National Statistics, (2013). The Economy - International Comparisons,

2011.UK.

Fig.7: Financial per head net wealth of households in OECD countries in 2011

24
The X-axis represents net wealth per household, and the Y-axis presents the OECD
countries.

Source: Office for National Statistics, (2013). The Economy - International Comparisons,
2011.UK.

Fig. 8: Yearly change in Harmonized Index of Consumer Prices (HICP) in OECD

countries

25
Source: Office for National Statistics, (2013). The Economy - International Comparisons,
2011.UK.

The X-axis represents the differential consumption prices of domestic commodities, and
the Y-axis presents the years. The pink line (----) represents United States, blue( ____)
stands for Germany; Black (-----) represents France and violet (_____) is for United
Kingdom.

Fig. 9: Real per head GDP growth in OECD countries

26
The X-axis represents per head annual GDP growth and Y-axis presents the OECD
countries.

Source: Office of National Statistics, (2013). The Economy - International Comparisons,

2011.UK.

Fig. 10: Inflation Rate in UK from 2004 to 2014

27
Source: Office for National Statistics, (2014).

The X-axis represents the rate of inflation the Y-axis presents the corresponding years.

Year 2015 has made UK economy experience the worst phases of inflation because the
inflation rate fell to alowest ever rate of 0.5%. Researchers suggest that drop in oil prices
and subsequent drop in the retail business due to decreasing consumer market demands
Monaghan, 2015). Thus, the Office for National Statistics (2015) declared that “the
Consumer Prices Index (CPI) grew by 0.5% in the year to December 2014, down from
1.0% in November” 2015. The root factors behind this were the increase in the prices of
gas and electricity in 2013 and continuous drop in motor fuel prices. The resultant of
these factors was approximately 0.1% increase in consumer inflation rates as compared
to 0.6% that was prevalent in December 2014 (Office for National Statistics, 2015).

2.6. Political and economic views on crude oil and the economy of UK

The drop in oil prices has been analyzed from different angles by different scholars and

28
authorities. While some suggest that there is a direct connection between thedrop in oil
prices and anti-inflation status of an economy, others perceive that price fall might invite
secondary consequences that ultimately lead to inflation. Thus, political institutions of the
world are among these authorities that have a distinctive view of reduction in oil prices.
The recent drop in oil prices has also resulted in mixed reactions among different
economies of the world. While countries like America and UK will be able to take
advantage of the situation, Russia, and Saudi Arabia will be among the countries that will
be at the receiving end (Bowler, 2015; The Economist, 2015) as they are oil producers
and exporters. The political ambiance of UK is especially taken into account in this
context. Assumptions are that fall in oil prices is supposed to changed the pattern of
consumption of oil. The consumers will use more oil than usual, thereby resulting in
affecting the energy policy of the country. Hence, the situation might compel the UK
government to rethink about the energy policy of the country and cut down the rate of
emissions. One of the possible political stances that the country might take in order to
curtail the excessive domestic use of oil is to increase its import of natural gas prices are
both of these are interlinked. The political authorities of the country are making
endeavors pass on the positive effects of this situation on the general masses. Political
personalities like George Osborne, who is an eminent British Political Party politician,
has reported in The Guardian the recent drop in oil prices is the lowest in the five years.
Nevertheless, the benefit of the phenomenon is remaining restricted to the big companies
only. Therefore, an investigation will be done to know the reason behind this so that the
benefits can be passed on to the “…..families at petrol pumps, through utility bills and
airfares.” This political stance suggests that political attempts are being made to “fend off
a political onslaught” that has been created in UK due to historic drop in oil prices (Allen,
Mason and Monaghan, 2015).

Fig. 12: Drop in oil prices in UK over the period from 2010 to 2012

29
The X-axis represents the price of oil in UK, and the Y-axis represents the years from
2010 to 2014.
Source: Allen, K., Mason, R. and Monaghan, A. (2015). George Osborne fires warning
shot over tumbling oil prices. The Guardian. [online] Available at:
http://www.theguardian.com/politics/2015/jan/06/george-osborne-warning-shot-falling-
oil-prices-consumers [Accessed 13 Mar. 2015].

While the drop in oil prices in UK apparently looks favorable and supportive of the
economic growth of the country, it signals towards underlying dangers. If the scenario
continues like this for long, it can make the investors lose interest in the country in the
context of crude oil production. While throughout the period starting from 2010 Brent
Crude traded in a narrow range, “averaging close to $110 per barrel,” the period from
2011 to 2013 led to an average triple dollar price of crude oil. Nevertheless, the drop in
oil prices in UK has forced other trading nations to undertake different economic
approaches. For instance, Saudi Arabia has decided to cut down its production quota so
that the production cost remains within control. It is being perceived that a political and
30
economic war is going on keeping oil prices at the background. Assumptions are that
countries like America and Saudi Arabia are trying to damage the economies of their
contending nations, Russia and Iran by capitalizing on an oil price drop in UK (Halligan,
2014).

2.7. Effect of oil prices fluctuation on economic activities of the households

An assessment of the effect of fuel price fluctuation on the economy of UK was

conducted by the Office For Budget Responsibility (2010) to understand its effect on
public finance and household income. It was estimated that a temporary hike in the oil
prices would have a marginally positive effect on public finance in the first year.
However, if the rise in fuel price becomes a consistent characteristic of the economy, then
it will have the permanently detrimental effect of it. “The detrimental effect on receipts
from lower output more than offsets the boost to UK oil and gas revenues.” This
assessment was done by taking into consideration the three-factor production function
approach that indicates towards labor, oil, and capital. Thus, the model suggested that
only a 20% increment in the real oil prices for a temporary period manifests in the form
of slightly over 0.3% reduction in the potential output in the first year. Nevertheless, the
oil prices get reverted to the pre-shock level beyond the first year with no notable impact
on potential output. Thus, in a situation characterized by real oil price shock where the
rise in real oil prices becomes a constant issue, the potential output become
approximately 0.5% lower in the medium term. Here, the report found out that the effect
of the permanent drop in oil prices is positive in nature as far as the potential output of a
country is concerned. A situation like this would encourage improved public finance in
the medium term. However, there remains a persistent dilemma whether the significant
changes in oil prices of public finance would last for a year or not and if this increase is
permanent in nature or not. The report suggests that the distinction between ‘temporary’
and ‘permanent’ oil shock is highly subjective because it is “extremely difficult to
identify in real time whether movements in the oil price are temporary or are likely to
persist beyond the near term (Assessment of the Effect of Oil Price Fluctuations on the
Public Finances, 2010).”
31
Oil can be considered as one of the essential products that are used by firms to their
production process, as well as the household consumers for personal consumption. Thus,
a mathematical representation of production can be given as follows:

qt = at + ®n nt + ®m mt

In this equation, qt is (gross) domestic output; at is an exogenous technology para-

meter; ntis labor; mt is the quantity of imported oil used in production and ®n + ®m · 1.8

Now consumption can be represented in the following manner:

ct ´ (1 ¡ Â) cq;t + Â cm;t

In this equation, ctis consumption; cq;t is the consumption of domestically produced

goods (gross output); and cm;t is the consumption of imported oil.

Again, the price of domestic output is represented as pq;t, and the price of consumption
as pc;t. Let pm;t be the price of oil, and st ´ pm;t ¡ pq;t be the real price of oil. Now the
relation between consumption price and domestic output price is given by:

pc;t = pq;t + Â st

32
Thus, the equation suggests that when the real price of oil increases there is proportional
increase there is a proportional increase in the consumption price relative to the rise in
domestic output (Blanchard and Galí, 2007.). Thus, it suggests that the decrease in oil
prices will lead to decreased consumption rate in the UK households.

Contrary to the above two estimations of oil price rise and its subsequent effect on
households is the perception of the economists who believe that 2015 is going to be a
year when there will be an overall increase in the standard of living in UK households.
The condition that is characterized by failing oil process and rising wages would boost
households and UK will come out of the dismal phase that has been created due to fall in
real incomes. However, some apprehensions suggest that in spite of falling oil prices
throughout UK, the situation has not come to a stable position. It is expected that oil
process will decrease even further. Now, if situations of UK economy and income of UK
households are considered according to the volatile market situation then it can be said
that low productivity of the labour market and low pay jobs will remain as consistent
features. These would eventually result in inflation and cause a detrimental effect on the
household income across UK. As a result, the rise in the standard of living throughout UK
will be temporary in nature because the process is “without foundation.” The increment
ion the standard of living will not be able to meet the parameters of the pre-crisis level
(Cadman and Giles, 2015).

Economists report to the Financial Times (2015) that decrease in oil prices will result in
enhancing the incomes of the consumers, especially those who have disposable income.
The continuous decrease in oil prices since the past six months has been a welcome
feature for the household consumers because they have so much money at hand now that
they spend their money on goods other than petrol. This has eventually reflected in the
retail sales throughout UK, the volume of rose in December to “0.4 per cent against a
forecast 0.7 per cent contraction.” Wage growth has outpaced inflation, and inflation has
become remarkably lower than the annual growth in earnings since November
33
(Giugliano, 2015).

An interesting aspect of fluctuations in crude oil prices is that it has a direct relation to the
consumption pattern of customers. When oil prices sharply increased during the 1970s,
technological processes were employed so that the intensity of household consumption
could be reduced, and surplus oil can be extracted from various offshore fields
simultaneously. But a change in the oil policy and market share of Saudi Arabia resulted
in declination of oil process in December 1985 with proportionate increment in the
consumption pattern of the household consumers. A further decline in oil prices in the
recent years signals that “long-term developments in supply and demand” is one of the
catalysts for the process.” Implementation of technological methods has resulted in the
overall development of the global oil fields. Now more oil is being produced that what it
used to be a few years back. For instance, there has been a sharp increase in the shell oil
production in UK since 2011, which estimates at some 0.9 million barrels per day. UK
alone contributed towards 1% global supply of shell oil in 2014. But disappointing
economic growth around the world has resulted in a downward trend in global demand
for oil. During the same year 2014, the projected household demand for oil dropped by
0.8 mb/d . This has eventually affected the global growth of oil industry. In addition to
this, the decrease in oil prices and oversupply of oil has also resulted in decreasing the oil
intensity of global GDP which are further aided by processes like increase in energy
efficiency and declination in oil intensity of energy consumption. In a situation like this,
which is characterized by a reduction in energy bills and reduction in oil prices, the real
income of consumers is bound to increase with eventual increase in their consumption
rate. However, core inflation and inflation expectations do not have much relation to
falling oil prices. Hence, if the decreasing oil prices fail to elevate inflation then the
central banks might refrain from responding to a monetary policy “such that the impact
on real activity could be small (World Bank, 2015).”

34
2.7. Effect of crude oil prices on a country’s business

A sharp decline in oil price acts as a warning bell for the oil exports. As the decrease in
oil demand is one of the major causes of theglobal reduction in oil prices, firms which
exclusively rely on oil exports has to think of opportunities “to reinvigorate their efforts
to diversify.” Low oil prices for a temporary span might encourage firms to move
towards a more intensive nature of production that is centered on fossil fuels or energy.
Since fall in oil prices is directly related to substantial volatility in the foreign exchange
and the equity markets of a number of emerging economies, the investors are forced to
reassess their future prospects in the oil-exporting countries. Eventual shift of interest of
the investors in the firms of oil producing factories contributes towards “capital
outflows, reserve losses, sharp depreciations, or rising sovereign CDS spreads in many
oil-exporting countries (World Bank, 2015).”

The most immediate effect of the drop in oil prices on a country’s economy is the
simultaneous reduction in future investment plans by multinationals and international
firms. However, sources suggest that the actual picture is not as intensive as it is being
thought. For instance, for a sharp 30% drop in oil prices there was only 3% reduction in
business investment in oil and gas extraction during 2015. Nevertheless, the picture was
drastically different 2009 when there was 40% drop in investment probabilities in
coordination to 38% drop in the U.S, the dollar value of oil in the same year. A
comparative study of these two findings hints that drop in oil price is not the only factor
that determines investment decision of the firms. Rather, there are other integral factors
such as financial crisis and credit crunch which force businesses to cut back on
investments and preserve cash instead. Investment decisions are also based on factors
such as the presence of any disruption that can impede businesses from gaining access to
capital and if the latest fall in oil prices is perceived as structural shift by businesses
rather than a temporary phenomena. A research on the impact of the drop in the price of
oil on the Canadian economy is suggestive of this. During 2013, oil and natural gas

35
extraction worked in collaboration with other closely related industries of Canada in
accounting for more than one-third business investment in the country. Nevertheless, this
still amounted to only 5% share of GDP since business investment itself accounts for
around 13% of the entire GDP. Moreover, import of Canadian equipment investment is
also very high and suggests that the decline of any portion of the business investment will
result in “weaker import growth rather than weaker domestic production.” Thus,
considering the import content of Canada, there will be approximately 0.1ppts subtraction
from Canadian GDP growth in an occasion of 3% fall in investment of oil and gas
extraction. This suggests that a considerable decline in investment prospects in oil and
gas extraction can have a very modest effect on the GDP growth of a country (Royal
Bank of Canada, 2015).

Fig 13: Canada’s investment in oil and gas extraction in Canada and GDP growth

Source: Royal Bank of Canada, (2015). Accounting for the Impact of Lower Oil Prices on
the Canadian Economy. RBC Economics.

36
A survey on the economy of USA suggests that investment in oil and gas industry
surmounts to approximately 7.3% of the total US private non-residential investment in
2013. Oil and gas extraction along with other closely related industries resulted in about
10% total private non-residential business investment during the same year. In terms of
value addition to the country’s economy, oil and gas extraction contributed about 1.7% to
the total GDP of USA. It needs mentioning here that energy products are one of the
cardinal constituents in the production process for many industries in USA, as well as the
rest countries of the world. “Close to $600 billion of energy was used up as an
intermediate production input across all private industries in the U.S. in 2013.” This
suggests that drop in oil prices is detrimental to the oil and gas extraction industry while
the phenomena serve positively for most other industries “which collectively account for
the other 96.7% of U.S. GDP.” Thus, it is clear that the drop in oil prices will benefit
countries like USA and Canada due to several reasons (Royal Bank of Canada, 2015).

Fig. 14 : US investment in oil and gas related industries in 2013

37
Source: Royal Bank of Canada, (2015). Accounting for the Impact of Lower Oil Prices on
the Canadian Economy. RBC Economics.

Fig. 15: Current production in oil and gas extraction industry in USA during 2013

Source: Royal Bank of Canada, (2015). Accounting for the Impact of Lower Oil Prices on
the Canadian Economy. RBC Economics.

The drop in oil prices makes investors the greatest losers in the game. A survey on
Americas’ oil and gas extraction industry conducted by New York Times revealed a
38
detrimental impact of the phenomena in the industry. It has predicted that the energy
firms would be the major sufferers as a result of price drop of oil. The stock market has
already shown a negative reaction to the process. There has also been a subsequent drop
in the broad market average to approximately 2% of the original value. An analysis of
eighty oil and gas exploration companies revealed that their market value has been down
by “11.14 percent in 2015 and 35.4 percent over the last 52 weeks.” Similar is the
condition of the top oil services companies that show a sharp 5.2% fall in their market
value particularly in 2015, and a total of 12.4% fall over the last year. These metrics
suggest that oil and gas producers, investors, service providers, suppliers, industry
workers as well as lenders would face the negative impact of fall in oil prices. The
investors apprehend that the US economy will show them the negative impact of the drop
in fuel prices in the form of “layoff announcements, disclosures of capital spending cuts
and falling rig counts.” Although it was assumed that low oil prices will bring negative
effects on business and industry, positive impact on small businesses, on the SMEs of
USA cannot be ruled out. This scenario will offer these businesses the opportunity to
increase their capital expenditure. Capital spending among small businesses will thus
help in offsetting the drop in the price of oil and natural gas. It is further being said that
drop in oil prices will add at least 1% growth in the real GDP growth of USA this year
(The New York Times, 2015).

Econometric models:

(Allen, 2005), in his study confirmed that unit root are required in thepreliminary step of
any model development, and the question of co integration testing were based on theory
and restrictions are less effective. The forecasting model enumerates on various model
selections and its simulation provide an empirical test of the required model to be used in
VAR model to be fit.(Hamilton, 1994)Has recommended on this special property of series
in testing for unit root and their desirable present would impose. The studies by (Stock &
Watson, 2003), concludes that more reliable way of testing a trend data is by transforming
the series to log. Even the null hypothesis of unit root do have unit root series; the data
become approximate in testing autoregressive and with theuse of difference rather than
leveling difference.(Granger, 1969) has analyzed on time series variables named as X and
39
Y variable with time t. The variable X andY are verified for Granger cause if the Yt were
able to predict the timeline of X. The econometric models were selected using Granger
Causality test.

Thus, the relationship between crude oil and economy is such that the short-term
impact of fall in global oil prices will foster increased consumption of petroleum
products by the consumers. The real value of money in correlation will crude oil will
also increase because consumers will be able to buy more oil paying much less
money as compared a situation of fuel price increment where value of money gets
decreased. On the other hand, the long-term effect of declination of crude oil prices
will make the oil producing, and exporting countries suffer most. There will be
aworldwidereduction in the demand for oil among the trading nations. The stock
values of oil producing firms will also decline . As a result, thereby creating a volatile
market situation. The fluctuation in oil prices will make the foreign investors
skeptical, and they will not take aninterest in the sector for quite some time. While
unemployment and layoffs will increase, the phenomenon will set blow on the profit
of the entire global energy sector.

40
2.9. Theoretical Foundation

Nelson (1990) states that findings from the theoretical framework of a research help
the researcher in developing a well-framed methodology section. This in turn, assists in
generating relevant data for empirical in investigations. In addition, the theoretical
foundation of the research also helps in the process of future experimentations and
research on similar topics (Nelson, 1990). Hence, the purpose of this part of the chapter
will be to generate answers to the research questions that can be used for future studies on
the impact of falling fuel prices on the economy of UK. Realism will be considered as the
main theoretical framework for this research as it realistic perspective helps in
understanding the impact of an occurrence or the effect of an incident in real life
situations (Johnson, Burke and Christensen, 2010). Therefore, it is presumed that crude
oil, inflation and macroeconomic condition of a country are correlated. IT can be further
understood by analyzing the dominant theories about the nature of different economies
and the primary and secondary factors that negatively and positively determine their
growth are taken into account. As understood from the literature review section, drop in
oil prices is not the only factor that results in inflation or deflation of an economy. Rather,
an amalgamation of factors determines it. Thus, the main point of argument that would
the foundation of the theoretical foundation of this research is inflation. An attempt will
be made to interpret the exact correlation between crude oil and inflation.

2.10. Gaps in literature

The literary sources that have been used here in order to understand how crude oil
determine inflation in an economy. The very phenomenon of reduction in fuel prices is
seen as a positive factor in some of the sources, while others suggest that phenomenon
has a long term effect on a country’s economy and ultimately leads to inflation. This gap
in various perspectives on falling crude oil prices in UK has encouraged in establishing
the actual relationship between inflation and crude oil. However, the weakness of the
research that is its second major gap is that time and resources bind the research. The
41
researchers will not be able to gain access to a wider pool of secondary sources for
making a more in-depth analysis of this fiscal correlation.

2.11. Synopsis of the chapter

This chapter has presented that crude oil is one of the major determinants of an economy.
While falling oil prices may prove beneficial for a country’s economy, it can wreck havoc
to the investment opportunities and prospects of domestic and international business of
another country. Change in the prices of oil in the world market has a subsequent effect
on the economic activity of the entire globe. A survey conducted by the National Bureau
of Economic Research (1996) found out that even ten percent innovation in the oil prices
is expected to contrast the output of the output of the private sector output by at least one
and a half percent. This is again related to an output decline of 2.5% at the most within a
span of five to six quarters after the innovation. However, scholars like Hamilton (1985)
remark that there is little correlation between change in oil prices and subsequent
response of a country towards it and that of the overall economic condition of a country.
Low demand of oil and gas extracts in the import is perceived as the effect of an
unpredictable and unstable falling of oil prices. It also indicates towards decrement in
labor wages and output volume that can a market uncompetitive in nature. Therefore,
incidents like recession following oil fluctuation often act as a measure to tighten the
monetary policy of a country and fight aggressive inflation rather than presenting a
picture of the country’s economy. Realism has been considered as theoretical framework
of this research which will help in addressing the research objectives and answering the
research questions in relation to inflation, its causes and primary determiners (Rotemberg
and Woodford, 1996).

42
Chapter 3 - Research Methodology

3.1 Research Objective:

 The study aims to study the changes in crude oil prices and its influence on its
inflation of UK
 To ascertain the factors (determinants) that influence on crude oil
 To evaluate whether the effect of crude oil has affected the Economy with particular
reference to the exports, exchange rate and CRUDE OIL.
 To evaluate the impact of crude oil over these short term and long term on inflation.

3.2 Data Collection

The study is based on macroeconomic factors that impact the economic growth of UK.
The study employs secondary data as the variables taken are from already available
resources from government. The study focus is towards analyze how the crude oil prices
impact the inflation, so time-series data is used as the study covers the period of 1995 to
2015. Hence, there was no need for primary data source in this study. There are two types
of research one is qualitative, and other is quantitative research. As the data involved are
of discrete series and quantitative research is employed to study on the linkages and no
primary data was used. The formulas used in this study are right from descriptive
statistics like analysis on mean, standard deviation, skewness, and kurtosis. The time
series data are employed by calculating the averages so that they produce a greater degree
of accuracy as the data are covering different time periods to check on the reliability of
the data and accuracy, averages were calculated. The time-series data were tested based
on confidence interval of 95%. The research used is inductive. The secondary data
required has been collected from various sources like World Bank, Trading economics,
yahoo finance, economic and social sites of UK. The data collection has been made from
Jan 2005 to Jan 2015 for a period of ten years. The objective of this selection period is to
analyze how the relation between oil prices and inflation varied by employing quarterly
data basis. The total observation of data is 42. The primary variables used in this study
are identified that impacts on its inflation of UK. In order to decrease the errors and
troubles the heteroscedasticity test to agreat extent, all the variables are taken in natural

43
logarithms.

The aim of studying these variables is to identify the long term relationship between
crude oil prices and its impact towards inflation of UK. The estimation of this
relationship is carried out through various tests like unit root test, cointegration and
Vector error correction model. The study is further done in understanding their
association with the inflation, so analytical tools like trend analysis, correlation and
regression have been employed at its relevant places.

3.2 Hypothesis Testing:

The hypothesis test has been made for testing on causality and cointegration between oil
prices and inflation based on this following hypothesis are formulated:

 To check on the causality on both variables oil prices and inflation whether
there is a relationship between these variables?
 To ascertain in the directional relation between inflation and crude oil in
theshort term?
 Whether there a long run relationship between CRUDE OIL prices and
INFLATION of UK.?
 Whether there exists a short-run relationship between INFLATION and other
variables like exports, thebalance of trade and exchange rate of UK?

3.4 Econometric Specification:

3.4.1 Model Specification

The econometric model is chosen in such a manner it would permit and generate all the
parameters taken and does not leave any missing data that is vital.

The econometric model under this study is shown below:

44
Inflation = f (crude oil)

Where,

Crude oil prices and inflation of UK represent the total economic growth of UK.

The above equation is treated with Cobb-Douglas function where crude oil prices in UK
and inflation is taken as the explanatory variable in this study.

The above equation connects to the economic growth by measures of its crude oil prices
and inflation in UK, and the expression is produced in its linear form as shown below:

Where values of “α” and “β” are greater than 0.

The error term denotes to be normally, identically and independently distributed in the
linear form. The ‘α’ and ‘β’ values in this equation, illustrates on the slope and coefficient
of regression. The coefficient of regression value beta reveal how a unit amend in the
independent variable i.e. crude oil affects the dependent variable inflation and the
below-mentioned equation represents with regression equation with other variables that
have an impact on the INFLATION.

Where,

1. INFLATION stands for its Economy Growth

45
2. CRUDE OIL stands for Dollar price per Barrel

3. CRUDE OILG is the level of Economic Growth

4. INFLATION stands Inflation Percentage of Changes

3.4.2 Ordinary least square (OLS) method:

The ordinary least square model is employed for testing the hypothesis:

 There is no significant relationship between Inflation and oil prices

 There is no significant relationship between inflation and Balance of Trade, oil
prices, Exchange, Exports, and GDP.

To test the above-said hypothesis regression test has been undertaken based on inflation
and oil prices, thebalance of trade, exports, and theexchange rate.

To test for the long-term causality between inflation and oil prices in UK. The
cointegration and Vector error correction model were employed to identify the
relationship between the variables as from the study of (Asari, 2011) in these sectors. To
establish any short-term causality on the above said variables Wald statistics test were
employed. Foremost in undertaking this short-term causality test is to observe on the
stationary of the variables over the time series, through unit root test and cointegration
test the number of cointegration equation is obtained. Further on checking on lag
difference in time series before regression unit root tests are undertaken, these test were
adopted from Dickey and Fuller (1979) and Phillips-Perron test are also applied in
checking out on stationary of the data.

3.4.3 The Unit Root Test:

With regards to time series statistics, there were numerous econometric subjects that were
able to influence the regression test like r-square would help us in identifying how much
the values have asignificant association. Before regression process undertaken in time
series, it becomes necessary to check on thenon-stationary process. So, before the co-
integration and granger causality test is done the study check out on these macro-
economic variables for non-stationary. The no stationary data presents a stochastic and
46
deterministic trend inregression equation. This is hence suggested to carry out on unit
root test to examine on the integration level between the variables.

A time series data is said to be in stationary if the time and variable are same and move
unto same direction. The non-stationary time series tend to produce a mean and is of time
dependent. The variables need to be stationary if the variables are not found to be then the
granger causality test becomes invalid. Hence, in understanding on stationary, it becomes
necessary that mean should be representing by [E (yt)]. The variance of the variables are
denoted by Var (Yt) where the ‘y’ denotes the time constant represented by variable ‘t’.
The covariance variables (covar(Yt, Ys) as stated in studies of (Diebold and kililan,
2000). Since, the data requirement for regression analysis to be stationary, the existence
of this requirement is ascertained to check on selected series before regression process.
For testing this unit test, the ADF named as Augmented Dickey Fuller test is done and the
equation is provided for same:

Where Ɛt is white noise error term in this model of the unit root test. The null hypothesis
is tested based stating that the variable has a unit root. The ADF value is observed in the
unit root to test Yt has the unit root present in the variables. To observe this all variables
has unit root test or not, the natural log is taken of these variables and are represented at
time period ‘t’. The variables that contain ‘y’ unit root is rejected and when the co-
efficient observed are greater than zero. Hence, rejection of null hypothesis informs that
data series is stationary. If the test provides t-statistic lower value than the critical values
of ADF test, then the null hypothesis is not rejected. The test is performed at various
levels, first the test is performed at level difference i.e., constant and the values are
checked in t-statistics whether those values are greater than critical value and p-value is
also examined to confirm on the rejection of null hypothesis. Then the test is undertaken
by examining on intercept level and tends level. The stationary is confirmed at all these

47
levels first is at constant, second is on theintercept and third is on trend level after
examining at these levels the conclusion is derived from unit root test.

The Phillips-Perron tests are used in time-series analysis to test the null hypothesis again
on theunit root. The PP test are checked for integration whether the variables are
integrated of order 1, 2, 3 difference, the Model is based on D-F test in testing the null
hypothesis as provided in below equation:

Where,

Δ is the first difference operator.

The PP test is built on non-parametric test with reference to a test statistic of the t-test.
The next step in this is to confirm on the number of lags that need to be used in the
estimation of co integration equation as per the study of (Perron, 1995). Further, the
granger residual test is also undertaken in confirming the co integration between inflation
and oil prices where other variables are observed at constant. By establishing co
integration relationship if it ceases, then Vector error model test are applied tofirst
difference. The variables are observed integrity; further the model is framed.

48
3.4.4 Johansen Co-integration Test:

The Johansen co integration test is done to check for time series data whether there is
observed long run or equilibrium relation between variables considers inflation as
dependent variables and other variables like Exports, Balance of Trade, Exchange rate
and Crude oil prices as independent variables the test are performed using first order. To
check on this first order difference and long –term relationship the Johansen approach is
used. The ADF test confirms on the first order integrity, and the next step followed by
time series with Johansen test. The Johansen test provides us to find out about long-term
relationship and has been employed in previous study of (Charles S. Wassell, Jr. and Peter
J. Saunders,2003)

3.4.5 Granger Causality Test:

This model is widely used by many authors for building on forecasting. The model
provides a statistical feedback on the data about the causality (Granger, 1969). The model
was developed by Granger and Sims used this model in the application of econometrics
model. The test are used for determining whether the series are significant enough in
forecasting series of data. The study helps us to determine from the past values and are
used in forecasting in predict with another variable. Here, in this study we employ how
much influence the oil prices have on inflation whether the drop in oil prices has been
significantly observed in this study. ( Francis, 2001) , employed in his study to determine
the influence of variables. The Granger test means that in conditional observation of
lagged value whether the dependent variables was able to add information on the
movements of independent variables beyond the lagged values of independent itself.

The causality test also helps in measuring the information of independent variables with
the lag values of another variable. If the variable independent is observed in predicting
the dependent variable “Y” that it is informed that the Variable “X” helps on prediction of

49
“Y”. In another way, the null hypothesis also states that “X” variables do not granger or
produce causality on “Y”. The causality is run from inflation to oil prices, exchange rate,
exports and balance of trade. The series used F-statistics in observing on significance.

3.4.6 Vector Error Correction Model:

The VECM model was initially used by researcher (Charles & Peter, 2003) in his paper.
The same become popularized with from the study of Engle and Granger. This model was
meant to reconcile on the short run and on the long run behavior of the macroeconomic
variables. The short term and long term causalities are checked (Robert and Granger
1987). The majority of research studies have presented that time series variables are non-
stationary and can further accomplish for testing on regression and causality.

Where

‘t’ represents period

d represents first difference calculation

ecm represents the errors of long-term balance taken from the long-run co-integration
relationship between the crude oil and inflation. The λ = 0 is rejected; it implies that the
ECM model appears and has to be tested for establishing long-term causality on variables
on reliability. On the other part, if the beta value are rejected there assumed on short-term
causality and if not the results shows no co-existence on short-term.

50
3.5 Limitations of Study:
The limitations of this study like other econometric studies faced are mentioned below:

1. The primary objective of this study to understand at various levels. As the

time period is taken for around ten years from 2005 to 2015 to observe the
data on daily basis it becomes cumbersome and as few variables are
homogeneous denoted by quarterly basis and from different distinctive
sources calculation of averages provides a comfortable level of analysis of
data and further the study has employed on quarterly basis of data but as
the crude oil prices provide variation on daily basis the study has limited
on quarterly. The study used compounding averages to analysis on their
trend, growth rate and about its deviation from the true value of data.
2. The value of Inflation was taken from the sources of UK and private
websites of trading economics. The assumption behind this inflation is still
under debate as no proper methods were available to cross check on
obtaining the inflation, so the data provided from the source were taken to
support our assumption.
3. Due to time constraint and non-availability of GDP data as certain parts
provides negative log value it was not undertaken as GDP reflects to be
main variables in analysis on inflation, due to limitation of negative
values, natural log was unable to obtain.
4. Since the study is focused on macroeconomic perspective rather than
micro economic , the analysis can be further classified into regional wise
and sector wise to understand how the oil prices high or fall has been
associated with growth of sector.

3.6 Summary of Methodology:

It is evident from the previous studies and data observed throughout the analysis that
inflation plays a vital role for thedevelopment of UK economy. The government has to
take serious steps in understanding the value of oil prices and their impact towards
inflation that effects the economy. The oil prices hike gets distributed not only to
51
particular sectors but also on agriculture, automobiles, banking, etc. The sector wise
analysis would also help further to understand the provision and become worth in
justification of numbers for the economy growth. Thus, the overall impact can help us in
understanding about how the government reforms and implementation should be linked
based on oil prices. The analysis of the causality explains the relationship between
macroeconomic factors and their influence towards inflation.

Chapter4

4.1 Description of Data:

The variables used for testing are obtained from obtained from World Bank and Trading
Economics and Statistics of UK. The data include quarterly series of seasonally adjusted
exchange rate, GDP, Balance of Trade, Exports, US-UK Exchange rate of the currency,
inflation data and crude oil prices from Jan 2005 to Jan 2015. The period of data includes
in the pre-crisis period and post-crisis period. The summary statistics of correlation
matrix is presented below:

52
Table #1. Summary statistics

CRUDEOIL EXCHANGE EXPORTS GDP INFLATION

Mean 82.85049 0.595095 36610.20 0.315000 2.690244

Median 82.15000 0.615865 36917.00 0.550000 2.400000

Maximum 132.5500 0.694637 43375.00 1.300000 5.000000

Minimum 42.89000 0.489318 26207.00 -2.200000 0.300000

Std. Dev. 23.27132 0.058101 5260.674 0.742328 1.018039

Skewness -0.031047 -0.353558 -0.243861 -1.987928 0.368550

Kurtosis 1.950429 1.992062 1.724077 6.847510 2.822829

Jarque-Bera 1.888485 2.652917 3.187500 51.01794 0.981789

Probability 0.388974 0.265416 0.203162 0.000000 0.612079

Sum 3396.870 24.99400 1501018. 12.60000 110.3000

Sum Sq. Dev. 21662.17 0.138405 1.11E+09 21.49100 41.45610

Observations 41 42 41 40 41

Table #2. Contemporaneous correlation matrix

CRUDEOIL EXCHANGE EXPORTS GDP INFLATION

CRUDEOIL 1
53
 EXCHANG
E 0.16 1.00

EXPORTS 0.82 0.59 1.00

GDP -0.13 -0.08 -0.05 1.00 -

INFLATION 0.37 0.18 0.27 -0.44 1

Figure #1. Summary statistics

54
 balance of trade(GBP m illion) Crude Oil Price (Dollars per Barrel)
-1,000 140

120
-2,000

100
-3,000
80

-4,000
60

-5,000 40
05 06 07 08 09 10 11 12 13 14 15 05 06 07 08 09 10 11 12 13 14 15

exchange(US/GBP) exports(GBP m illion)

.70 44,000

.65 40,000

.60 36,000

.55 32,000

.50 28,000

.45 24,000
05 06 07 08 09 10 11 12 13 14 15 05 06 07 08 09 10 11 12 13 14 15

GDP INFLATION
2 6

5
1

4
0
3
-1
2

-2
1

-3 0
05 06 07 08 09 10 11 12 13 14 15 05 06 07 08 09 10 11 12 13 14 15

The above figure 1 provides on quarterly data from Jan 2005 to Jan 2015. The graph
provides there is no seasonality breaks in the graph. Hence, the data would be considered
for further analysis for time-series.

55
Chapter5
Estimation of Results

The methodology outlined in below section is provided for checking stationary properties
of data using the Augmented Dickey-Fuller unit roots. The results of the test are provided
based on the Level and Intercept and to check on stationary of data the level of series are
considered with first lag difference and second lag difference to check on Correlation and
Shocks due to the Crude oil on inflation.

The financial time series data like Crude Oil, inflation, Balance of Trade, Exchange rate,
Exports appeared to be non-stationary. In order to analyze the presence and form of such
data, the unit root tests has been used.

The Unit roots tests have been profound by Hamilton 1994, Fuller 1996 and Verbeek
2008, etc. The two methods are applied to detecting the stationary of the data

 Correlogram visual time series graph inspection

 By using Unit root tests.

Stationary process undertakes the transformations of data into either first order by first
difference. The order of integration is the minimum number of times the series difference
first to yield on stationary. The integration of first order in time series is denoted by I (1).
The time series data integrated at level is indicated by I (0).

5.1 Augmented Dickey-Fuller Test:

Unit root tests:

Time series of this test is denoted by Yt in the form of

yt = α + βt + ut

where ut is a white noise disturbance

56
This test is used for testing the hypothesis

H0: = 1, H0: series contains a unit root versus.

H1:< 1 H1: series is stationary.

The existence of unit root is proved by the null (i.e.,) polynomial function has a unit root
equal to the unit. The null hypothesis also informs that Yt is a trend is stationary.

Variable T-statistics PP ADF Order of Significance

Integration

BOT -12.11 -9.6 I(1) 0.000*

Crude Oil -8.08* -4.79 I(1) 0.0004*

Exchange -4.89 -5.22 I(1) 0.0001*

Exports -6.30 -6.27 I(1) 0.000*

Inflation -3.77 -3.86 I(1) 0.0052*

*denotes on first difference

Δyt = ψyt−1 + ut

so that a test of φ = 1 is equivalent to a test of ψ = 0 (since φ − 1 = ψ). The DF test is also

popularly called as τ -tests. It can be performed allowing for an intercept, or for an
intercept and its deterministic trend or using test regression. The model in each case is:

yt = φyt−1 + μ + λt + ut

The ADF tests decide on how many lags of Δy to include in regression equation. With
results of ADF, it provides us to include lags difference of 1. The F-test to test the null
(β,р)= (0,1) against the alternative hypothesis of (β, р)≠ (0,1). The decision from the
output provides that ‘y’ variable does not have a unit root and is stationary. The results of

57
Balance of Trade in ADF with the test statistics of -9.6 which is way higher than critical
value of -4.88 and the probability of 0.00 which is less than 0.05. Hence the null
hypothesis is rejected. The alternate hypothesis which states that Balance of Trade (BOT)
variable does not have unit root and is stationary, moreover the co-efficient is also
negative of –(0.80). Similarly, the results are obtained of first difference with crude oil of
-4.79, exchange rate of -5.22, exports of -6.27 and inflation(-3.86), all these variables
rejects on the null hypothesis and provide that trend is stationary.

5.2 Phillips–Perron (PP) tests

Phillips and Perron's tests are applied to testing unit root non-stationary. The tests are
similar to ADF tests. The regression for PP test is

Δyt = φ yt-1 + α+ βt+µt

Where, µt denotes on stationary. For checking on normality of data, the Phillips & Perron
tests is approached. The null hypothesis under the test is φ = 0.

The absolute value of t-statistics above the critical value at 1% significance level is
observed. The lag difference at first level provides the trend to be stationary and rejects
null hypothesis, the t-statistics value of PP test in five variable -12.11 Balance of Trade,
Crude oil of (-8.08) was not significant at first lag and difference is observed in second
difference d-2(crude oil) and Exchange of -4.89, Exports (-6.30), and inflation of (-3.77).

5.3 Equilibrium correction or error correction models:

In order to prove a relationship between 5 variables, the approach should be statistically
valid, to overcome the problem and to check for long run relation between the five
variables the model is tested using zero lag difference and then the model is tested using
first difference and co integration between variables is tested with below equation.

_yt = β1_xt + β2(yt−1 − γ xt−1) + ut

This model is called the error or equilibrium correction model. The term yt−1 − γ xt−1 is

58
the error correction term.

In order to check for co integrity between the variables, the study checks for potential
number of lags, Akaike information criteria & Schwarz Info criteria were employed and
results are provided in the below mentioned table.

Lag Probability(p-value) AIC HQIC SIC

0 0.15 -1.03 -1.15 -1.15

1 0.00* -6.93 -6.93 -11.80

*significant at 1% level.
The summary of five variables provides that p-value of five variables provide that p-
value of 0.15, AIC of -1.03, HQIC-1.15 & SBIC of -1 at level ‘0’. With the first
difference and lag of 1, the p-value of -0.00 < 0.05, AIC of -6.93, HQIC of -6.93 & SIC
of -11.80. With the above Unrestricted Error correction model and summary of unit root,
test provides that the lag difference is of first difference and further can be tested for co
integration test and Causality tests.

5.4 The Johansen’s Approach:

Johansen Cointegration model can be undertaken on the basis of lag difference to be same
in all five variables in Balance of Trade, Exports, Inflation, Crude oil and Exchange rate.
The VAR model used in Johansen method with K *1 matrix is provided below:

Yt = _1Yt−1 + ... + _pYt−p + ut, t = 1, ..., T,

Where, ut ~ IN(0, ∑).

As the below mentioned provided the conversion of data into time-series using VECM
model
59
ΔYt = ΠYt−1 + Г1_Yt−1 + ... + Гp−1ΔYt−p+1 + ut,

The maximum likelihood of the rank are determined with the matrix of eigen vectors
corresponds to largest eigen values in the k * K matrix (Hamilton, 1994), (Lutkepohl,
1991), (Harris, 1995). The likelihood determines the number of cointegration equation
can be used in VECM model.

The null hypothesis tested in Johansen's is

H0 : r = r0 vs. H1 : r > r0

The likelihood ratio statistic, also known as the trace statistic is given as follows:

LR trace(r0) = −T

The trace statistics check for the lowest Eigen value whether statistically different from
zero.

The co-integration number is determined when the null hypothesis (H 0: r = r0) is tested
against the alternate hypothesis (H 1 : r > r0).We can confirm that there exist atleast one co
integration when the null hypothesis is rejected. If the sample sizes tend to be small the
asymptotic critical values are considered without biasing.

The Eigen values are provided in second column and in Trace statistics are provided in
third column. When the trace statistic are higher than the corresponding critical value for
testing the null hypothesis at 5% significance. If the trace statistics are higher than the
critical we provide that there is no co integration. The null hypothesis is rejecting at most
0 with trace statistics of 74.99 greater than critical value of 69.81. The rank with Eigen
values of 0.32, trace statistics of 28.75 greater than critical value of 47.85 denotes with p-
value of 0.70 and null hypothesis is rejected. When the equation at most one has been

60
provided in co integration equation the null hypothesis is rejected. With the at most rank
of 1, the null hypothesis cannot be rejected and the number of co integration equation is
less than or equal to two against the four alternatives and found at 5% level of
significance. The number of co integrating vector is equal to two against four alternatives.

The Johansen tests for co integration are provided below:

Max Rank Eigen value λ trace α = 5% λ max α = 5%

0 0.69 74.99 69.81 46.23 0.001*

1 0.32 28.75 47.85 15.48 0.70

2 0.20 13.27 29.79 8.99 0.83

3 0.09 4.27 15.49 4.07 0.85

4 0.005 0.202 3.84 0.202 0.65

The at most two variables denotes they are integrated and they have long-run
relationship. According to Trace Statistics, Critical values and Max & Eigen values of
two tests provides the variables are co integrated.

Normalized cointegrating coefficients:

inflation Balance of Crude oil Exchange Exports

Trade

1.00 1.422 (0.38) -9.56(1.24) -7.96(2.13) 20.17(2.95)

 Figure in parenthesis provides on standard error

61
The above table provides crude oil has negative influence on inflation. The balance of
Trade provides influence of 1.422 with Standard Error of 0.38. The exchange rate has
negative influence of -7.96 with inflation & S.E of 2.13, Exports has positive influence of
20.17 with inflation & Standard Error of 2.95.

As from the estimation of Johansen test and Max Eigen value, we obtain a series of tests
to support equation model.

D(LOGINFLATION) = C(1)*( LOGINFLATION(-1) - 9.5663100026*LOGCRUDE(-1)

- 7.96327840669*LOGEXCHANGE(-1) + 20.1797968407*LOGEXPORTS(-1) +
1.42244178387*LOGBOT(-1) - 186.238753486 ) + C(2)*D(LOGINFLATION(-1)) +
C(3)*D(LOGCRUDE(-1)) + C(4)*D(LOGEXCHANGE(-1)) +
C(5)*D(LOGEXPORTS(-1)) + C(6)*D(LOGBOT(-1)) + C(7)

5.5 Long-run Causality Tests:

Constant Δln_inflation Δln_crudeoil Δln_Exports Δln_Exchange Δln_BOT

ECT(-1) -0.135(0.06) 0.09, (0.03) -0.01(0.01) -0.029(0.009) -0.164(0.08)

R2 -2.04 (0.298) 2.51 -0.117 -3.057 (-1.85)

Adjusted 0.167 0.149 -0.03 0.281 0.133

R2

SE Of 3018 1.07 0.07 0.06 5.67

Regression

F-statistics 2.27 2.11 0.77 3.48 1.97

The long-run causality test results are provided in above table has been normalized for
crude oil. All variables Inflation, Crude oil, Exports, Exchange, Balance of Trade are
62
established with VECM in one co integration equation and one lag in every equation is
established. The VECM permits long-run equilibrium relationship will allows for a wide
range of short-run causality. The co-efficient of error-correction term of inflation variable
carrier the non-significant at 1% level and has a coverage of 29.8%. The exports of
inflation provides significant with 12.6% coverage. Exchange rate provides 28.1%
coverage & significant and Balance of Trade is not significant with 13.3% coverage on
the VECM model.

The Model provided is shown below:

(LOGINFLATION) = C(1)*( LOGINFLATION(-1) - 9.5663100026*LOGCRUDEOIL(-

1) + 20.1797968407*LOGEXPORTS(-1) - 7.96327840669*LOGEXCHANGE(-1) +
1.42244178387*LOGBOT(-1) - 186.238753486 ).

The co-efficient C(1) of inflation is negative and the probability value 0.04 is less than
0.05 provides the term to be significant and there is a long-run causality running from
Inflation to crude oil, exports, exchange and balance of trade.

5.6 Short-run Causality Test:

C(3) = C(4) = C(5) = C(6) =0

Where C3 denotes on crude oil, C5 denotes on Exports, C4 denotes on Exchange and C6

Denotes on Balance of trade.

5.6.1 Wald Statistics

Wald statistic test is conducted to determine the presence of short term relationship
between inflation, one of the variables and the rest of the four variables. Wald Statistics
helps to test the combined significance of the subset of co-efficients of crudeoil, exports,
exchange and balance of trade. These four variables are individually insignificant based
on t-test results.

63
Wald Test:

Equation: Untitled

Test Statistic Value df Probability

F-statistic 1.303619 (5, 32) 0.2871

Chi-square 6.518096 5 0.2590

Null Hypothesis: C(2)=C(3)=C(4)=C(5)=C(6)=0

Null Hypothesis Summary:

Normalized Restriction (= 0) Value Std. Err.

C(2) -0.028067 0.211942

C(3) -0.264667 0.578643

C(4) -0.552131 1.375921

C(5) 2.051653 1.537787

C(6) 0.330105 0.130652

Restrictions are linear in coefficients.

64
For F-test the significance of all variables in model and the null hypothesis is set equal to
zero.

Null hypothesis: H0 : Beta Crude oil = Beta of Exchange = Beta of Exports= Beta of
Balance of Trade = zero

Alternate Hypothesis H1: Not equal to zero.

Wald Test:

Equation: Untitled

Test Statistic Value df Probability

F-statistic 0.113046 (2, 32) 0.8935

Chi-square 0.226091 2 0.8931

Null Hypothesis: C(2)=C(3) =0

Null Hypothesis Summary:

Normalized Restriction (= 0) Value Std. Err.

C(2) -0.028067 0.211942

C(3) -0.264667 0.578643

Restrictions are linear in coefficients.

65
The table above indicates the Wald statistic test result on the casuality relationship
between the GDP and FDI. The chi-square statistic probability value is higher than 5%,
hence the null hypothesis is not rejected. The C(2) = C(3) =0 means that there is no
short-run causality from Inflation to crude oil.

Equation: Untitled

Test Statistic Value df Probability

F-statistic 0.089619 (2, 32) 0.9145

Chi-square 0.179237 2 0.9143

Null Hypothesis: C(2)=C(4)= 0

Null Hypothesis Summary:

Normalized Restriction (= 0) Value Std. Err.

C(2) -0.028067 0.211942

C(4) -0.552131 1.375921

Restrictions are linear in coefficients.

66
This table displays the Wald statistic test result of causality relationship between
inflation and exchange rate. The probability value of the chi-square statistic is higher
than 5%. Thus there is no short-run causality from Inflation to Exchange rate.

Wald Test:

Equation: Untitled

Test Statistic Value df Probability

F-statistic 0.891248 (2, 32) 0.4201

Chi-square 1.782497 2 0.4101

Null Hypothesis: C(2)=C(5)=0

Null Hypothesis Summary:

Normalized Restriction (= 0) Value Std. Err.

C(2) -0.028067 0.211942

C(5) 2.051653 1.537787

Restrictions are linear in coefficients.

The above table provides about the Wald statistic test on the short-run causality from

67
inflation to Exchange rate. The probability value of the chi-square statistic is very larger
as than 5%. So, the null hypothesis is not rejected that C(2) = C(5) =0 means that there is
no short-run causality from Inflation to Exports rate.

Wald Test:

Equation: Untitled

Test Statistic Value df Probability

F-statistic 3.203217 (2, 32) 0.0539

Chi-square 6.406434 2 0.0406

Null Hypothesis: C(2)=C(6)=0

Null Hypothesis Summary:

Normalized Restriction (= 0) Value Std. Err.

C(2) -0.028067 0.211942

C(6) 0.330105 0.130652

Restrictions are linear in coefficients.

The above table provides about the Wald statistic test on the short-run causality from
inflation to Exchange rate. The probability value of the chi-square statistic is very larger
as than 5%. So, the null hypothesis is not rejected that C(2) = C(6) =0 means that there is
no short-run causality from Inflation to Balance of Trade rate.
68
5.6.2 Breush- Godfrey Serial Correlation LM test:

Breusch-Godfrey Serial Correlation LM Test:

F-statistic 0.011745 Prob. F(1,31) 0.9144

Obs*R-squared 0.014770 Prob. Chi-Square(1) 0.9033

Test Equation:

Dependent Variable: RESID

Method: Least Squares

Date: 04/23/15 Time: 15:42

Sample: 2005Q3 2015Q1

Included observations: 39

Presample missing value lagged residuals set to zero.

Variable Coefficient Std. Error t-Statistic Prob.

C(1) -0.004516 0.079271 -0.056974 0.9549

C(2) -0.031785 0.363824 -0.087363 0.9309

C(3) -0.050395 0.749490 -0.067239 0.9468

C(4) -0.041939 1.450258 -0.028919 0.9771

69
C(5) 0.109619 1.860984 0.058904 0.9534

C(6) 0.004048 0.137874 0.029360 0.9768

C(7) -0.001767 0.056200 -0.031438 0.9751

RESID(-1) 0.047824 0.441286 0.108374 0.9144

R-squared 0.000379 Mean dependent var -9.11E-16

Adjusted R-squared -0.225342 S.D. dependent var 0.289453

S.E. of regression 0.320411 Akaike info criterion 0.742257

Sum squared resid 3.182558 Schwarz criterion 1.083501

Log likelihood -6.474016 Hannan-Quinn criter. 0.864692

F-statistic 0.001678 Durbin-Watson stat 1.612501

Prob(F-statistic) 1.000000

The R-square value is 0.014 and the p-value of chi-square is 0.9023. This implies that the
null hypothesis is accepted. The serial correlation results indicate that the output of the
model is desirable.

5.6.3 Heteroskedasticity Test: Breush- Pagan Godfrey Test:

The Breush-Pagan –Godfrey test regresses the squared residuals on the original
regressors. This test by default takes the difference of order as a first step and secondly
the heteroskedasticity test is performed in order to test the null hypothesis that the
residuals does not have heteroskedasticity.

70
Heteroskedasticity Test: Breusch-Pagan-Godfrey

F-statistic 1.490453 Prob. F(10,28) 0.1949

Obs*R-squared 13.54814 Prob. Chi-Square(10) 0.1946

Scaled explained SS 27.26231 Prob. Chi-Square(10) 0.0024

Test Equation:

Dependent Variable: RESID^2

Method: Least Squares

Date: 04/23/15 Time: 15:49

Sample: 2005Q3 2015Q1

Included observations: 39

Variable Coefficient Std. Error t-Statistic Prob.

C -18.60671 9.726903 -1.912912 0.0660

LOGINFLATION(-
1) -0.043248 0.150230 -0.287877 0.7756

LOGCRUDE(-1) -0.613596 0.362724 -1.691633 0.1018

LOGEXCHANGE(-
1) -0.182835 0.933210 -0.195921 0.8461

LOGEXPORTS(-1) 1.708693 1.136432 1.503559 0.1439

71
LOGBOT(-1) -0.046157 0.107699 -0.428576 0.6715

LOGINFLATION(-
2) -0.170893 0.150560 -1.135046 0.2660

LOGCRUDE(-2) -0.147512 0.380240 -0.387944 0.7010

LOGEXCHANGE(-
2) -0.983611 0.935493 -1.051436 0.3020

LOGEXPORTS(-2) 0.327194 0.993014 0.329495 0.7442

LOGBOT(-2) 0.077738 0.100044 0.777031 0.4437

R-squared 0.347388 Mean dependent var 0.081635

Adjusted R-squared 0.114313 S.D. dependent var 0.202203

S.E. of regression 0.190295 Akaike info criterion -0.247734

Sum squared resid 1.013944 Schwarz criterion 0.221476

Log likelihood 15.83081 Hannan-Quinn criter. -0.079386

F-statistic 1.490453 Durbin-Watson stat 1.320457

Prob(F-statistic) 0.194897

The R-square value as shown by the table is high at 13.54% and the p-value is 0.19 also
higher than the significant level of 0.05%. This proves that the null hypothesis is accepted
that the model does not have heteroskedasticity and the model is fit.

5.6.4 Normality Test: Jarque-Bera

The residuals of the model is tested using Normality test- Jarque-Bera test, the null
hypothesis is tested that there is normal distribution. The normality test results indicate
that jarque-bera value of 31.86 and also the value of proabability is 0.00. This indicates
72
that the residuals are not normally distributed.

10
Series: Residuals
Sample 2005Q3 2015Q1
8 Observations 39

Mean -9.11e-16
6 Median -0.008221
Maximum 0.580396
Minimum -1.095951
Std. Dev. 0.289453
4
Skewness -0.973031
Kurtosis 6.977810
2
Jarque-Bera 31.86646
Probability 0.000000
0
-1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6

This also proves that the model suffers from the drawbacks and there is no short-run
causality between Inflation to Crude oil, Exchange rate, Exports and Balance of Trade.

5.7 Granger Causality Test: VAR Model:

The Granger Causality test output is given in the table below. The objective of this is the
find out the influence of inflation on the 4 other variables. The output of the study shows
the presence of a bi-directional causality that run from the inflation investment to Crude
oil, Exports, Exchange rate and balance of trade. The null hypothesis is that inflation does
not cause causality with the crude oil. Inflation is compressed with lag(1) and as
independent variable. The other variables like Crude oil, Exchange, Exports and Balance
of Trade both lag(1) are taken as independent variable and Inflation is taken as a
dependent variable.

73
VEC Granger Causality/Block Exogeneity Wald Tests

Date: 04/23/15 Time: 16:02

Sample: 2005Q1 2015Q2

Included observations: 39

Dependent variable: D(LOGINFLATION)

Excluded Chi-sq df Prob.

D(LOGCRU
DE) 0.209208 1 0.6474

D(LOGEXC
HANGE) 0.161026 1 0.6882

D(LOGEXP
ORTS) 1.779980 1 0.1822

D(LOGBOT
) 6.383706 1 0.0115

All 6.500468 4 0.1648

Dependent variable: D(LOGCRUDE)

Excluded Chi-sq df Prob.

D(LOGINFL 0.096387 1 0.7562

74
ATION)

D(LOGEXC
HANGE) 0.756124 1 0.3845

D(LOGEXP
ORTS) 0.009631 1 0.9218

D(LOGBOT
) 0.078557 1 0.7793

All 1.041536 4 0.9034

Dependent variable:
D(LOGEXCHANGE)

Excluded Chi-sq df Prob.

D(LOGINFL
ATION) 2.756527 1 0.0969

D(LOGCRU
DE) 11.24903 1 0.0008

D(LOGEXP
ORTS) 0.356445 1 0.5505

D(LOGBOT
) 0.060792 1 0.8052

All 16.47685 4 0.0024

75
Dependent variable: D(LOGEXPORTS)

Excluded Chi-sq df Prob.

D(LOGINFL
ATION) 0.054601 1 0.8152

D(LOGCRU
DE) 1.411642 1 0.2348

D(LOGEXC
HANGE) 0.573221 1 0.4490

D(LOGBOT
) 0.844244 1 0.3582

All 3.029980 4 0.5528

Dependent variable: D(LOGBOT)

Excluded Chi-sq df Prob.

D(LOGINFL
ATION) 0.217254 1 0.6411

D(LOGCRU
DE) 1.064909 1 0.3021

76
D(LOGEXC
HANGE) 0.113536 1 0.7362

D(LOGEXP
ORTS) 0.608475 1 0.4354

All 1.518630 4 0.8233

D(LOGINFLATION) = C(1)*( LOGINFLATION(-1) - 9.5663100026*LOGCRUDE(-1)

- 7.96327840669*LOGEXCHANGE(-1) + 20.1797968407*LOGEXPORTS(-1) +
1.42244178387*LOGBOT(-1) - 186.238753486 ) + C(2)*D(LOGINFLATION(-1)) +
C(3)*D(LOGCRUDE(-1)) + C(4)*D(LOGEXCHANGE(-1)) +
C(5)*D(LOGEXPORTS(-1)) + C(6)*D(LOGBOT(-1)) + C(7)

Dependent Variable: D(LOGINFLATION)

Method: Least Squares

Date: 04/23/15 Time: 16:07

Sample (adjusted): 2005Q3 2015Q1

Included observations: 39 after adjustments

D(LOGINFLATION) = C(1)*( LOGINFLATION(-1) -

9.5663100026

*LOGCRUDE(-1) - 7.96327840669*LOGEXCHANGE(-1) +

20.1797968407*LOGEXPORTS(-1) +
1.42244178387*LOGBOT(-1) -

77
 186.238753486 ) + C(2)*D(LOGINFLATION(-1)) +
C(3)*D(LOGCRUDE(

-1)) + C(4)*D(LOGEXCHANGE(-1)) +
C(5)*D(LOGEXPORTS(-1)) + C(6)

*D(LOGBOT(-1)) + C(7)

Coefficient Std. Error t-Statistic Prob.

C(1) -0.135511 0.066383 -2.041351 0.0495

C(2) -0.028067 0.211942 -0.132427 0.8955

C(3) -0.264667 0.578643 -0.457393 0.6505

C(4) -0.552131 1.375921 -0.401281 0.6909

C(5) 2.051653 1.537787 1.334159 0.1916

C(6) 0.330105 0.130652 2.526600 0.0167

C(7) -0.062782 0.052946 -1.185766 0.2444

R-squared 0.298846 Mean dependent var -0.047329

Adjusted R-squared 0.167380 S.D. dependent var 0.345678

S.E. of regression 0.315425 Akaike info criterion 0.691354

Sum squared resid 3.183764 Schwarz criterion 0.989942

Log likelihood -6.481402 Hannan-Quinn criter. 0.798485

F-statistic 2.273179 Durbin-Watson stat 1.601723

Prob(F-statistic) 0.061169

78
The results prove that inflation depends on crude oil, exchange rate, exports and Balance
of trade. The results also prove that inflation does not have any influence on crude oil.
The results of other variables are verified with dependent variable. The above table also
indicates the causality to be uni directional (causality runs from Crude oil, exchange rate,
exports, Balance of Trade) to Inflation.

5.8 Correlation Test:

LOGCR LOGEXCHA LOGEXPORT LOGINFLATI

LOGBOT UDE NGE S ON

LOGBOT 1

-
0.03739180643311
LOGCRUDE 515 1

- 0.126979
LOGEXCHA 0.35087456598380 0872673
NGE 98 499 1

- 0.750770
LOGEXPOR 0.30330466528488 8932980 0.6031511754
TS 22 322 88559 1

0.415654
LOGINFLATI 0.11741177330181 4705550 0.0285258041 0.0579944631
ON 06 67 2110824 746153 1

79
The correlation test reveals about the movement of the variables, Inflation and Crude oil,
Exchange, Exports and Balance of trade moves in the same direction, and influence of the
inflation variable on these four macro-economic variables are less significant and
moderately related to inflation.

80
Chapter 6

6.1 - Findings of the research:

The aim of this study obtain the relationship between important variables as inflation and
oil prices of UK in the period 2005 to 2015. A unit root test of data was examined with
the help of augmented Dickey-Fuller test (ADF) test, P-P test, Johansen Cointegration
test, granger causality test were applied for examining the short-run and long-run
causality relationship among them.

Thus the major conclusion built-in representation is:

The unit root test is simplified with the testing of inflation and other variables in
macroeconomic data, they are examined at the first level of difference through the ADF
test. The time series of data of the other variables are also observed through the ADF test
on the first level of difference in namely exports, exchange rate, GDP and Balance of
trade, as the GDP data provided on the quarterly basis on negative figure the variables log
return provided to be missing and eliminated for study. The inflation and oil prices
indicate from the study that there exists a long-run relationship. The Johansen test
confirms that inflation between other macroeconomic variables that one almost equation
is established by test results of Cointegration.

The Granger test from the study confirms that there present a unidirectional causality
along the variables, especially on inflation and oil prices, between exports, exchange and
balance of trade. The equation is further run in estimation across four variables to
examine on short-run between them by thetest of wald statistics.

The model is first run on VECM model to find out whether the model is statistically
81
significant and the negative sign of the co-efficient of model confirms on its long-run
equilibrium relationship between independent and dependent variables as mentioned as
“X” and “Y” in equation. The relation between them is confirmed through sequent tests
like serial correction, Heteroskedasticity test, and the normality do not confirm that the
residuals are generally distributed and provides that the model is fitted.

The summary of the Residual diagnostics test:

 The SM knows as Serial Correlation LM test informs that the model suffers on
serial correlation.
 The heteroskedasticity test informs that themodel does not have, and residuals of
the model are fitted.
 The residuals whether they are normally are verified through Jarque-Bera and
through the test of p-value, and the rejection of hypothesis provide that models are
fit.

The results shows that inflation has contributed towards the crude oil prices in UK for the
time period January 2005 to January 2015 therefore it is imperative for the government of
UK to make policy on crude oil prices towards its economic growth as the correlation
results provide that influence of inflation variable on crude oil in UK.

6.2 Summary of VECM model and Wald Statistic:

 There is long-run causality between inflation and oil price, exchange rate,
thebalance of trade and exports.
 There is no short run causality found from inflation in oil prices, exchange,
exports and balance of trade.

The outcomes of the study are similarly linked with empirical studies were
undertaken by (Bosworth, Collins 1999), (Bengo, Sanchez-Robles 2003), (Hansen
and Rand 2004). The study estimated on the VAR model to integrate on the
correlation between oil prices and inflations. Over the long-run period, though the
influence of oil prices is found in inflation yet on short-run causality the variables
were not significant in establishing their relationship. The exchange rate and balance
82
 of trade variable no short-run causality found between them with inflation. So the
government needs to take favorable steps in looking forward to long term on their
impact. The study also determined that the impact of exports on its inflation, though
there was apositive correlation between the variables. The inflation influence the
exports sectors, so government need to take care whenever inflation is on higher side,
the exports gets affected, so the resources can be founded by improving on their
exchange rate which in turns improve the economy.

6.3 Conclusion:

The purpose of this research study is to analyze or establishing the relationship

between how the oil prices lower or higher affect the inflation in the period 2005 to 2015.
It is observed that there was long run causality between inflation and crude oil and the
results from the observation are similar with (Sandalcilar and Altiner, 2012). The majority
of study provided that there established a strong positive relation to crude oil prices
towards inflation. The Mehmet study to observe and are linked with the results obtained
from the present study on exports towards inflation, oil prices towards inflation and
exchange rate vs. exports are Co integrated on a long-term basis. Inflation is seen to be
essential factors that contribute towards economic growth. The macroeconomic variables
like exports play a major role, and it leads to more trade and to increase in theexchange
rate.

In the study concerning Cambodia Lim GuechHeang and Pahlaj Coolio monitor that
the impact of crude oil is both direct and circumlocutory to the economic growth of the
country. Moses, Joseph Shaw& Yao Shen 2013, based their study on the phase of 1980 to
2012 in Tanzania.

They experienced the data based on the ADF and pragmatic inflation, and crude oil
were not still, and the variables observed stationary on the first order difference. The
study also observed on the Eigen value and trace statistics in order to determine the
number of Co integration equations. The granger causality reveals about the increasing
causalities observed the variables and the unidirectional relationship between crude oil
prices and its exports. The variables observed no causality over short terms and were in
83
line with the study of (Borensztein et al., 1998). They discussed on concluding that its
impact ongrowth of theeconomy is highly dependent based on theconsumer price index
and human capital employed in thehost country and study further established or linked
with consumption of goods towards inflation.

(Kotrajaras, 2011), a study was also based on understanding the impact of crude oil on 15
east Asian countries and concludes that lower prices of oil benefits the economy. The
study classified across countries like middle-income group and upper-income group and
used the Co integrated test on his research, he established there was positive relationship
between the countries and they posted a positive relationship as the oil prices are
important factors that decide on economy in turns affect all sectors of education, a skilled
workforce, trade system and infrastructure development. The results of our study are in
line with (Kose, 2006) in observing the presence of economic conditions that favor
towards investments and determining the inflation.

6.4 Recommendations
The middle- income countries have good government investment and openness to trade
while the education level is not as appealing as the high-income group countries. He
concludes that investment in own oil source would reduce the inflation and is important
for developed countries.

6.5 Limitations:
The study has been limited toperiod of ten years. Analyzing the impact of crude oil price
changes on inflation, the daily pricechanges were not considered in the study due to time
limitations and as the study covers on inflation and other macroeconomic variables, the
study focused more on quarterly data.

6.6 Suggestions for further studies:

The study revealed that, increasesin oil price have a negative impact on inflation and on
economic growth over the long-run and government would reinforce in the form of fuel
subsidies. The UK government, though the crude oil prices does not affect much on its
84
economy, but on long-run period the results reveal on is the impact and look into
alternative sources of energy which are quite less compared to crude oil.

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