The Effects of Oil Shock on Trade Balance and Macroeconomic Variables in Iran Using a Dynamic Stochastic General Equilibrium Model

Document Type : Research Article

Authors

Abstract

International trade is an important channel for transmitting the effect of an oil shock to the trade balance and macroeconomic variables. In an international framework, the trade channel transmits oil shocks across economies through changes in the non-oil traded goods. Most researches that have investigated the effect of an oil shock on macroeconomic variables in Iran have ignored the role of trade channel.  The main goal of this paper is to fill this gap in the literature for Iran as an oil producing and exporting country. More specifically, we develop and solve a New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model for an open economy to study the effect of an oil shock on trade balance and macroeconomic variables in Iran.
The model consists of households, firms, government, central bank and foreign sector. Following Kia and Darrat (2007), Walsh (2010) and Sanchez (2011) household derives utility from consuming a final good, holdings of domestic and foreign real balances and leisure. This study is different from other researches on Iranian economy by introducing foreign real money balance in the utility function of our representative household. Production sector consists of domestic goods producing firms and intermediate goods producing firms. Production of these goods requires capital, labor, and oil. The investment bundle is a composite of the domestically produced good and inputs imported from abroad. The consumption bundle is a composite of the domestically produced good, oil consumption and imports of foreign goods. Thus, oil is considered in both the production function and the consumption basket. Another distinct feature of this study from other Iranian studies is the presence of oil in both production function and consumption bundle. This allows us to examine the dynamics of trade balance in response to an oil shock.
In order to evaluate the model, we compared the moments of actual and simulated data. Our finding confirms the validity of model. The impulse response functions show that an oil shock to Iranian economy reduces the ratio of non-oil trade balanced to GDP. This might be due to the fact that a positive oil shock has an adverse effect on the growth rate of foreign oil importing countries. Hence, lower economic growth of oil importing  countries will result in lower imports from oil producing countries. This in turn will deteriorate the non-oil trade balances in oil exporting countries. Given the role of non-oil trade balance in boosting  employment and generating jobs and foreign reserves, this finding suggests that policymakers in Iran should take appropriate measures to reduce the economic dependence on oil sector as a major source of income. In addition, a positive oil shock has direct effect on the ratio of total trade balance to GDP. In other words, in an oil-exporting country such as Iran in which oil is an important source of foreign income, an increase in oil price results in an improvement in trade balance. However, the indirect effect of oil shock on the trade balance is negative. However, our result shows that the net effect of oil shock on the trade balance of Iran as an oil-exporting country is positive.
Moreover, we find out that oil shock will transfer income from oil-importing country to the oil-exporting country. Therefore, positive oil shock induce wealth effect and cause the GDP to increase. Moreover, a positive oil shock results in higher investment. In addition, oil shock changes the cost of producing goods and services and cause inflation.The impulse responses show that adjustment of trade balance is slower than that of other macroeconomic variables. 

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References

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Journal of Applied Economics Studies in Iran
Volume 6, Issue 23
November 2017
Pages 35-60

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