We show that dependence on foreign energy can increase economic instability by raising the likelihood of equilibrium indeterminacy, hence making fluctuations driven by self-fulfilling expectations easier to occur. This is demonstrated in a standard neoclassical growth model. Calibration exercises, based on the estimated share of imported energy in production for several countries, show that the degree of reliance on foreign energy for many countries can easily make an otherwise determinate and stable economy indeterminate and unstable.Petroleum industry and trade ; Economic stabilization

Luís Aguiar-Conraria

Yi Wen

English

Research Papers in Economics

      Research Division 
          Federal Reserve Bank of St. Louis 
                   Working Paper Series 
 
 
 
 
A Note on Oil Dependence and Economic Instability 
 
 
 
 
Luís Aguiar-Conraria 
and 
Yi Wen 
 
 
 
 
 
Working Paper 2006-060B 
http://research.stlouisfed.org/wp/2006/2006-060.pdf 
 
 
 
November 2006 
Revised September 2007 
 
 
 
FEDERAL RESERVE BANK OF ST. LOUIS 
Research Division 
P.O. Box 442  
St. Louis, MO 63166 
 
______________________________________________________________________________________ 
The views expressed are those of the individual authors and do not necessarily reflect official positions of 
the Federal Reserve Bank of St. Louis, the Federal Reserve System, or the Board of Governors. 
Federal Reserve Bank of St. Louis Working Papers are preliminary materials circulated to stimulate 
discussion and critical comment. References in publications to Federal Reserve Bank of St. Louis Working 
Papers (other than an acknowledgment that the writer has had access to unpublished material) should be 
cleared with the author or authors. A Note on Oil Dependence and Economic Instability￿
Lu￿s Aguiar-Conraria
NIPE, Economic Policies Research Unit ￿Universidade do Minho
aguiarconraria@gmail.com
Yi Wen
Federal Reserve Bank of St. Louis
yi.wen@stls.frb.org
July 30, 2007
Abstract
We show that dependence on foreign energy can increase economic instability by rais-
ing the likelihood of equilibrium indeterminacy, hence making ￿ uctuations driven by self-
ful￿lling expectations easier to occur. This is demonstrated in a standard neoclassical
growth model. Calibration exercises, based on the estimated share of imported energy in
production for several countries, show that the degree of reliance on foreign energy for many
countries can easily make an otherwise determinate and stable economy indeterminate and
unstable.
Keywords: Indeterminacy, Energy Imports, Externality, Returns to Scale, Sunspots,
Self-Ful￿lling Expectations.
JEL Classi￿cation: E13, E20, E30.
￿This is a substantially shortened version of our working paper, "Oil Dependence and Economic Instability"
(Federal Reserve Bank of St. Louis, 2006). We thank Karl Shell, Nicholas Kiefer, and an anonymous referee for
comments. The usual disclaimer applies. Correspondence: Yi Wen, Research Division, Federal Reserve Bank
of St. Louis, P.O. Box 442, St. Louis, MO 63166-0442, USA. Email: yi.wen@stls.frb.org
11 Introduction
Sharp increases in the prices of oil have triggered two signi￿cant world-wide recessions since
World War II: one in 1974-75 and another in 1979-81. The underling reason is that many in-
dustrial economies depend heavily on imported energy in production, making them vulnerable
to changes in the prices of oil in the world market. Although it is well known that increases
in the prices of foreign energy can act like adverse productivity shocks to domestic economy,
many economists also argue energy price shocks by themselves are not su¢ cient for causing a
massive recession as large as we experienced in the 1970s and the early 1980s. For example,
Bernanke et al. (1997), Barsky and Killian (2001) and Leduc and Sill (2004) argue that mon-
etary policies signi￿cantly aggravated the negative impact of oil shocks; and Hamilton (2003)
argues that a sharp decrease of aggregate demand due to pessimistic expectations of the future
at the time of oil shocks exacerbated the negative impact of higher energy prices.
This paper claims that reliance on foreign energy has another potentially important e⁄ect
on economic activity ￿it destabilizes the economy by increasing its likelihood of indeterminacy,
hence making the economy more susceptible to ￿ uctuations driven by self-ful￿lling expecta-
tions. Economic data show that energy imports account for a signi￿cant fraction of total costs
in domestic production for industrial countries. For example, Table 1 shows that the cost
shares of imported energy can be as high as 16% of a country￿ s GDP.1 We argue that cost
share of foreign energy as high as indicated in Table 1 can easily make an otherwise stable
economy susceptible to sunspots-derive ￿ uctuations.
The framework we adopt to make our point is Aguiar-Conraria and Wen (2007), which
introduced oil into an indeterminate RBC model similar to Benhabib and Farmer (1994) and
Wen (1998). In that paper, we showed that the large negative impact of oil price shocks on GDP
and investment in the 1970s can be better understood by a multiplier-accelerator mechanism
based on indeterminacy. However, we did not formally and systematically investigate the
relationship between the magnitude of foreign energy shares in GDP and the conditions of
indeterminacy.
In this note we formally prove that the dependence of production on imported energy
(such as oil and natural gas) can make indeterminacy easier to arise. For example, the required
returns to scale for indeterminacy in the model of Wen (1998) can be reduced by 50% when the
share of imported energy reaches 15% of GDP. Based on realistic and conservative estimates of
the aggregate returns to scale, a cost share even as low as 5% of GDP can subject an otherwise
stable economy to sunspots-driven ￿ uctuations.
1The data for all EU-25 countries are taken from Eurostat (2006). The energy share for the EU-15 countries
is easy to estimate based on the database. But to estimate the energy share of the remaining 10 countries: Czech
Republic, Est￿nia, Cyprus, Latvia, Lithuania, Hungary, Malta, Poland, Slovenia, and Slovakia, we assume the
unit import cost of oil or oil equivalent is the same as for the other EU-15 countries. The ￿gure for Ukraine
is from Davis et al. (2005). For the United States, we use data from the Energy Information Administration.
Finally, information for South Korea was found in Rabobank (2006). All data refers to the year of 2004, except
for South Korea, which refers to 2005.
2Table 1. Cost Share of Imported Energy in GDP
Lithuania 16:0% Luxembourg 3:6%
Ukraine 15:7% Austria 3:4%
Slovakia 12:1% Portugal 3:5%
Latvia 8:3% Greece 3:2%
Belgium 7:7% Finland 2:9%
South Korea 7:6% Sweden 2:8%
Netherlands 5:8% Spain 2:8%
Estonia 5:5% Germany 2:4%
Hungary 5:4% France 2:3%
Czech Republic 5:2% Italy 2:0%
Malta 4:9% United States 1:8%
Cyprus 4:5% Ireland 1:8%
Slovenia 4:0% United Kingdom 1:4%
Poland 3:9% Denmark 1:3%
2 The Model
A representative agent chooses a trajectory for consumption (c), hours (n), capacity utilization
(u), energy demand (e), and capital accumulation (_ k) to solve
max
Z 1
0
exp(￿￿t)
h
log(ct) ￿ n
1+￿
t =(1 + ￿)
i
dt (1)
subject to
_ k = ￿￿k + y(uk;n;e) ￿ c ￿ pe; (2)
where p denotes international energy price, which is exogenous to the economy. The agent
pays the amount pe in terms of output to foreigners to receive energy imports. Note that trade
is balanced in every period since the cost of energy imports is fully paid for with exports of
output. Hence, national income is given by y ￿ pe, which equals domestic consumption and
capital investment (_ k + ￿k).
The production technology is given by
y(uk;n;e) = ￿(uk)
￿k n￿ne￿e; (3)
where ￿k + ￿n + ￿e = 1 and ￿ is a measure of production externalities and is de￿ned as a
function of average aggregate output which individual ￿rms take as parametric:
￿ = [(uk)￿kn￿n (e)
￿e]
￿ ; ￿ ￿ 0: (4)
3The rate of capital depreciation, ￿; is time varying and is endogenously determined in the
model by the relationship
￿ =
1
￿
u￿; (5)
which states that capital depreciates faster if used more intensively. We require ￿ > 1; which
imposes a convex cost structure on capital utilization.
To see the e⁄ects of foreign energy on the economy, we can substitute out ￿ and the optimal
demand for e in the production function to obtain the following reduced-form production
function in equilibrium,
y = A(uk)
(1+￿)￿k
1￿(1+￿)￿e n
(1+￿)￿n
1￿(1+￿)￿e ; (6)
where A =
￿
￿e
p
￿ (1+￿)￿e
1￿(1+￿)￿e is a Solow residual, which is inversely related to the energy price.2
In this reduced-form production function, the e⁄ective returns to scale are measured by
(1 + ￿)￿k
1 ￿ (1 + ￿)￿e
+
(1 + ￿)￿n
1 ￿ (1 + ￿)￿e
; (7)
which increases with ￿e under the constraint (￿k + ￿n + ￿e) = 1, provided that ￿ > 0. Hence,
the reliance on imported energy ampli￿es the true returns to scale when there are externali-
ties. The following proposition shows formally that indeterminacy is easier to arise when ￿e
increases.
Proposition 1 The necessary and su¢ cient conditions for indeterminacy are given by
￿n
(1 ￿ ￿n)
> ￿ >
￿[(1 + ￿)(1 ￿ ￿e) ￿ ￿n] ￿ (1 + ￿)￿k
￿￿n + (1 + ￿)(￿k + ￿e￿)
: (8)
Proof. See the Appendix.
It is clear from condition (8) that an increase in ￿e; either holding ￿n constant or holding
(￿e+￿n) constant, will decrease the term on the right-hand side, making indeterminacy easier
to arise. Note that for realistic parameter values the inequality on the left-hand side does not
bind.
Calibration. We calibrate the model￿ s structural parameters following Aguiar-Conraria
and Wen (2007). Namely, we correspond one unit of time to a quarter, we set the inverse
labor supply elasticity ￿ = 0 (Hansen￿ s indivisible labor), the rate of time preference ￿ = 0:01
(analogous to the discount factor of 0:99 in a discrete-time model), ￿ = 1:4 (implying a steady-
state rate of ￿ = 0:025; see the Appendix), and the labor elasticity of output ￿n = 0:7.
Given these parameter values, the following table shows the relationship between the share
of foreign energy in GDP and the threshold value of the production externality (￿￿) for inducing
indeterminacy.
2This negative relationship substantiates the claim that oil price shocks act like adverse productivity shocks.
4Table 2. The E⁄ect of Factor Shares on Indeterminacy
Energy Imports Required Reduction
Share (￿o) Externality of ￿￿
0.00 0.094 0
0.04 0.083 14%
0.08 0.067 28%
0.12 0.054 42%
0.16 0.042 56%
We observe in Table 2 that as the share of foreign factor in domestic production increases,
the threshold value of the production externality for inducing indeterminacy (￿￿) decreases
signi￿cantly. For example, when we increase the share parameter of imported energy ￿e from
zero percent to 8 percent, the reduction in the externality is 28%. And if we increase the share
parameter to 16 percent, then the reduction in the externality is 56%.3
If we compare the values of Table 1 with Table 2, we see that the required returns to
scale for indeterminacy may vary between 1:04 and 1:10 in the presence of foreign energy
imports. These values imply that many industrial countries are in the dangerous zone of
indeterminacy. For example, Laitner and Stolyarov (2004) found the estimated returns to
scale around 1:09 ￿ 1:11 for the U.S. economy. Inklaar (2006) found the estimated returns to
scale around 1:16 for Germany and 1:12 for France. Hansen and Knowles (1998) found the
average estimated returns to scale around 1:105 for high income OECD countries (including
Australia, Belgium, Canada, Finland, France, West Germany, Japan, Norway, Sweden, the
United Kingdom and the United States). Miyagawa et al. (2006) found estimated returns
to scale in Japan about 1:075, and Kwack and Sun (2005) found it to be around 1:1 for
South Korea. With these numbers in mind, it is clear that dependence on imported energy
can signi￿cantly increase a country￿ s risk of indeterminacy, thereby making the country more
susceptible to sunspots-driven ￿ uctuations.
3 Conclusion
The impact of oil price shocks on economic ￿ uctuations have been widely recognized. But the
relationship between economic stability and the reliance on foreign energy has not been fully
investigated in the literature. This paper shows that dependence of domestic production on
imported energy, such as oil or natural gas, can signi￿cantly increase the economy￿ s instability
in the presence of externalities or increasing returns to scale, because it reduces the required
3Table 2 is computed under the assumption that the foreign imported factor is mainly a substitute for capital,
hence when ￿e increases, ￿n remains constant but ￿k decreases such that ￿k + ￿e remains constant (assuming
constant returns to scale at the ￿rm level). If we assume imported energy is mainly a substitute for labor instead
(i.e., ￿n + ￿e is ￿xed), then a larger ￿e has the same qualitative consequences, although less dramatic.
5degree of returns to scale for indeterminacy. As a result, the economy is more susceptible to
endogenous ￿ uctuations driven by self-ful￿lling expectations.
Appendix
Let ￿exp(￿￿t) be the Lagrangian multiplier for the household￿ s budget constraint, the ￿rst
order conditions with respect to fc;n;e;u;kg are given respectively by ￿ = 1
c; n￿ = ￿￿n
y
n;
p = ￿e
y
e; u￿￿1k = ￿k
y
u; and
_ ￿
￿ = ￿￿k
y
k + 1
￿u￿ +￿: To simplify analysis, we utilize the reduced-
form production function (which is obtained by substituting out the optimal demand for energy
and the capacity utilization rate in the production function in equilibrium),
y = ~ Ak
￿k(1+￿)(￿￿1)
￿￿(1+￿)(￿k+￿￿e)n
￿n(1+￿)￿
￿￿(1+￿)(￿k+￿￿e); (9)
where ~ A ￿ (￿k)
(1+￿)￿k
￿￿(1+￿)(￿k+￿￿e)
￿
￿e
p
￿ ￿(1+￿)￿e
￿￿(1+￿)(￿k+￿￿e) :
The ￿rst order conditions and the budget constraint can be simpli￿ed to the following
system of equations, _ c
c = ￿￿1
￿ ￿k
y
k ￿ ￿; _ k =
￿
￿k
￿￿￿1
￿
￿
+ ￿n
￿
y ￿ c; and c = ￿n
y
n1+￿; where
output is given by (9). In the steady state, we have
￿ y
￿ k =
￿
￿k
￿
￿￿1; ￿ c
￿ y = ￿k
￿￿￿1
￿
￿
+ ￿n; ￿ c
￿ k =
￿((￿￿1)￿k+￿￿n)
(￿￿1)￿k ; and ￿ n =
￿
￿￿n
(￿￿1)￿k+￿￿n
￿ 1
1+￿. From the budget constraint and the Euler equation
for consumption one can derive the steady state depreciation rate ￿ ￿ =
￿
￿￿1; which implies
￿ =
￿
￿ ￿ + 1:
Linearizing the economy around its steady state, the dynamics of the model can be repre-
sented by a system of two linear di⁄erential equations:
 
_ c
_ k
!
= M
 
c
k
!
; (10)
where
M =
2
4
￿￿n(1+￿)￿n
(￿n+￿e(1+￿))(1+￿)￿n￿(1+￿) ￿
￿((￿￿1)￿k+￿￿n)
(￿￿1)
￿
(1+￿)(1+￿)￿k￿
(￿n+￿e(1+￿))(1+￿)￿n￿(1+￿) +
￿
￿k
￿
￿n(1+￿)￿n
(￿n+￿e(1+￿))(1+￿)￿n￿(1+￿) ￿ 1 ￿
(1+￿)(1+￿)￿k￿
((￿n+￿e(1+￿))(1+￿)￿n￿(1+￿))
(￿k(￿￿1)+￿￿n)
(￿￿1)
3
5:
The model exhibits local indeterminacy if and only if the eigenvalues of M are both negative.
This is true if and only if the determinant of M is positive and the trace of M is negative. The
determinant and trace of M are give, respectively, by
det(M) =
￿
￿￿n(1 + ￿)￿n￿k +
￿
￿k +
(￿n+￿e(1+￿))(1+￿)￿n￿(1+￿)
(1+￿)(1+￿)￿k
￿
(1 + ￿)(1 ￿ ￿e (1 + ￿)￿n)
￿
￿;
Tr (M) =
(1+￿)￿(￿n￿￿(1+￿)(￿k(￿￿1)+￿￿n))
((￿n+￿e(1+￿))(1+￿)￿n￿(1+￿))(￿￿￿k(1+￿));
where ￿ =
(￿k(￿￿1)+￿￿n)(1+￿)(1+￿)
(￿￿1)
￿
￿
((￿n+￿e(1+￿))(1+￿)￿n￿(1+￿))
￿2
> 0:
6The condition det(M) > 0 implies
(1 ￿ ￿e ￿ ￿k)
￿e + ￿k
> ￿ >
￿((1 + ￿)(1 ￿ ￿e) ￿ ￿n) ￿ (1 + ￿)￿k
￿￿n + (1 + ￿)(￿k + ￿e￿)
: (11)
Note that the numerator of Tr(M) trace is always negative, so the trace will be negative when
the denominator is positive, which is equivalent to the condition
￿ >
￿((1 + ￿)(1 ￿ ￿e) ￿ ￿n) ￿ (1 + ￿)￿k
￿￿n + (1 + ￿)(￿k + ￿e￿)
; (12)
which is the same as the right-hand side of condition (11).￿
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8

A note on oil dependence and economic instability

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