Oil Price Effects on Exchange Rate, Output and Consumer Price: A Case Study of Small Open Economy of Oman

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(ProQuest: ... denotes formulae omitted.)1. IntroductionOil price shocks have significantly shifted the wealth of nations; induce huge windfalls and external imbalances for both oil importing and exporting countries (see, for example, Coudert et. al., 2008). The impact of shocks and their associated effects on output, consumer prices and on external balances have been recognized by a number of scholars (Schneider, 2004; Setser, 2007; Roubini and Setser, 2004; Allsopp, 2006, among others).Theoretically, in fixed exchange rate economies, oil price shocks are transmitted to exchange rates through terms of trade channel. A typical positive oil price shock induces the consumer prices of imported and non-traded goods in domestic economy and appreciates the real exchange rates. Governments in these situations usually anticipate wage-price spiral cycles. The inflationary expectations are being countered by resorting towards expansionary fiscal policy measures, such as, price subsidies and wage adjustments. Increasing inflationary pressure and appreciation in real exchange rate are usually the compelling conditions for turning the real interest rates into negative zone. This complicates the conduct of fiscal and monetary policies. The use of expansionary fiscal or monetary policies in these situations turns to be a riskier option (expansionary fiscal policy at the times when it requires containing the inflationary expectations, expansionary monetary policy may aggravate the prices). A fall in oil prices may have a reverse effect such as loss in government revenues, lower government spending or a situation of disinflation and a rise in real interest rates. A restrictive monetary policy could put the growth objective in danger.The small oil-based open economy of Oman is an interesting case study in this context. Oman is known as one of the impressive success stories in the Gulf and in the Arab world, despite possessing relatively smaller resources as compared to its neighbours. With a consistent high growth, lower level of inflation and stable external account surpluses, Oman has achieved a significant progress on the economic front. The economic growth primarily is driven by its hydrocarbon sector. Nominal GDP is roughly 80.5 billion of US dollars in 2014. The current account balance (percentage of GDP) is 10.6 percent with a global rank of 15. Table 1 refers to the average trends in the major macroeconomic variables from 2011-2014. Most economic indicators show impressive trends in last few years. Real GDP growth is 4.4 percent on average for last four years. Consumer price index is around 2.25 percent on average. Fiscal balance is 6.2 percent of GDP and current account balance is around 12.7 percent of GDP on average.Figure 1 indicates that trend in real GDP growth is steep during the last three decades. The GDP per capita (PPP) of Oman is US$29,800 with a global rank of 43.Figure 2 indicates the growth in GDP per capita since 1980. The trend shows that GDP per capita is increasing on average at around 9-10 percent. Oman's exchange rate is pegged with the US dollar and has long been maintained at 0.35 Omani riyal to 1 US $ from 1975 till 1985 and thereafter, at 0.38 riyals to 1 US $ from 1986, and it remains stable since long. The officially declared purpose of the peg is to maintain the price stability in the country, apparently fixed exchange rate regime which is linked to US interest rates3.However, the global economic trends are changing. In particular, the changes are frequently occurring in the real value of US dollar and real oil prices, which have continuously been affecting the business cycles of both the oil exporting and importing countries as well. In these circumstances, continuation of fixed or pegged exchange rate policy or dollar pegging of Omani riyal has widely been questioned. The continuation of pegging of Omani riyal with dollar may be a suitable policy option to anchor the exchange rate fluctuations in short run, but at least it may be a less feasible option in long run. …