Observed that there are six transmission channels

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observed that there are six transmission channels through which oil price shocks can affect the economy: uncertainty effects; supply side shock effects; sector adjustment effects; wealth transfer effects; real balance effects; and inflation effects. Regarding uncertainty, most investors prefer gambling with their fortunes in a relatively stable economic environment. When there is uncertainty about future oil prices, firms postpone investment expenditure and there are decreased investment incentives from different sectors of the economy (Bernanke, 1983). Uncertainty also arises on consumption demand due to product pricing associated with supply side shocks (higher production costs). Oil price shocks also can lead to a decrease in aggregate employment as there are rigidities on movement of workers from negatively affected sectors to positively affected sectors (Hamilton, 1988). This results in different adjustment in different sectors and wealth transfer effects. Higher oil prices also deteriorate the terms of trade in oil importing countries resulting real balance effects (Dohner, 1981). Oil price increases can cause cost-pushed inflation and oil and related products are inputs to many outputs in an economy. Generally, From a theoretical perspective, the impact of oil price shocks can be transmitted to economic activities through six channels (Brown and Yücel 2002): (i) supply-side shock effect, (ii) wealth transfer effect, (iii) real balance effect, (iv) inflation effect, (v) sector adjustment effect and (vi) unexpected effect. Supply-side shock effect causes a negative impact on output due to the increase of marginal production costs as oil price increases. This can also have a negative impact on employment. Wealth transfer effect can deteriorate terms of trade for oil-importing countries due to the transfer of wealth from oil importing countries to oil-exporting countries. When the monetary authorities fail to increase money supply to meet growing money demand due to the increase in oil price, there would be a rise in interest rate and a retard in economic growth. Brown and Yücel (2002) define this as real balance effect on the economy.
11 Inflation effect is defined as the rise in oil price generating inflation in an economy. When the observed inflation is caused by oil price-increased cost shocks, a contractionary monetary policy can deteriorate the long-term output by increasing interest rate and decreasing investment. The sector adjustment effect works via effects of oil price shocks on the labour market by changing relative production costs in some industries. Finally, unexpected effects focus on the uncertainty over oil price and its impact. Even as these studies indicate gross effect of oil prices on macroeconomy, there has not been a consensus on the relationship between oil price shocks and macro-economic indicators.

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