The Relationship between Oil Prices and Inflation – the Role of Oil Dependency

Abstract: In the last decades, due to geopolitical tensions, climate change, and technological advancements, countries worldwide are becoming less dependent on oil. This thesis aims to establish if decreased oil dependence weakens the impact of oil price shocks on inflation, thus contributing to the existing literature on the oil-inflation relationship. To this end, a Structural Vector Autoregressive (SVAR) model is estimated for each of the G-7 countries. The model includes an exogenous dummy variable which captures the oil dependency of these economies. Based on this dummy variable, the sample is split into periods of oil dependence and independence, respectively. Impulse Response functions (IRFs) and Forecast Error Variance Decompositions (FEVDs) are estimated in both subsamples for each country. The results suggest that in periods of oil independency, oil price shocks induce a lower response in inflation compared to periods in which the G-7 economies are considered oil dependent. The results are policy relevant as they highlight one benefit of moving towards less oil dependency: the country's economy will remain more stable as oil prices fluctuate when becoming less dependent on oil.