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Do Oil Shocks Drive Business Cycles? Some U.S. and International Evidence

Oil prices rose sharply prior to the onset of the 2007-2009 recession. Hamilton (2005) noted that nine of the last ten recessions in the United States were preceded by a substantial increase in the price of oil. In this paper, we consider whether oil price shocks significantly increase the probability of recessions in a number of countries. Because business cycle turning points generally are not available for other countries, we estimate the turning points together with oil’s effect in a Markov-switching model with time-varying transition probabilities. We find that, for most countries, oil shocks do affect the likelihood of entering a recession. In particular, for a constant, zero term spread, an average-sized shock to WTI oil prices increases the probability of recession in the U.S. by nearly 50 percentage points after one year and nearly 90 percentage points after two years.

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