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Research Proposal

Do High Oil Prices Cause High Inflation in Viet Nam? Policy Implications for Macroeconomic and Oil Resource Management Nguyen Hoai Bao

Keywords: oil price, inflation, macroeconomic policies, oil resource management, Viet Nam.

1. Background of the study Vietnam’s annual inflation rate shot up to 28 percent (y/y) in August 2008, the highest rate in the past 10 years and it was among the highest in East Asia. This took place in an economy that had been growing at over 8 percent annually in the last five years and amid soaring international oil prices. Vietnam is a crude oil exporter and an importer of almost all of its petroleum product needs. In this context, international oil price increases tend to affect prices and output through both aggregate demand and aggregate supply and the directions of those domestic price and output impacts depend on whether the short or the medium term is considered. As an oil exporter, higher international oil prices would bring more earnings. These earnings could be used for investment to expand domestic production capacity, thus raising aggregate demand in the short term while increasing the aggregate supply in the medium term. As an importer of oil products, higher international oil prices would increase the costs of production, thus reducing aggregate supply in the short term. But, in the medium term, due to adjustments in the production process, either through substitution of labor for oil or through increase in production efficiency, aggregate supply would increase. Thus, international oil price increases tend to lead to domestic price increases and output contraction in the short term, while in the medium term, domestic prices would decline and output increase. The short-term impacts of higher international oil prices have been observed; domestic prices of oil products have closely tracked the international prices and even so, following the recent removal of subsidies on imported oil products; and real GDP growth have been revised downward from some 8% to 7% for 2008. Recently, some authors showed that the international higher oil prices tended to influence higher domestic prices. Giang (2008), based on the Vietnam’s Social Accounting Matrix, estimated that a 36 percent oil price increase would add 1.4 percentage points to inflation. Thành, Bùi and Đào (2008), using Vietnam’s Input – Ouput table, estimated that a 30 percent

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oil price increase would add 3.67 percentage points to inflation. However, both models above made limiting assumptions, such as the zero elasticity of substitution between oil and labor, and did not distinguish between short term and long term effects. 2. Aim of the study This study seeks to investigate the effects of oil prices on Vietnam’s inflation and to derive appropriate policy responses. 3. Research objectives The objective of this study is to response to three question: First, what were the root causes of inflation in Vietnam in the past ten years? Vietnam has been a net oil exporter, we will test the hypothesis that recent increases in international oil prices would not be as important a factor of leading to inflation as capital inflows, and domestic credit expansion. Second, what is the effect of increasing of international oil prices on Vietnam’s inflation during the past ten years? Third, what should be the mix of economic policies and how could domestic oil resources be managed to minimize the price and output impacts of higher oil prices on the economy in the short and over the medium term 4. Research methodology My research will attempt to provide quantitative responses to the above questions. While the specific model to be employed cannot not be finalized at this stage, I have reviewed some of models that have been used to test the effect of oil price shocks. Hamilton (1983, 1996) uses linear VAR models. Mork (1989) extends the work of Hamilton, allowing oil price shocks to have asymmetric effects. Hallman (1989, 1990) uses the P-star model to investigate the sources of inflation dynamic where oil prices are represented by a dumy variable. Benjamin, (2001) resorts to the MULTIMOD framework. Blance and Menzie (2004) incorporate the oil prices increases in the traditional Phillips curve approach. More recently, Blanchard (2007) estimated the effects of oil price shocks by structural VARs. Almost all models above were tested on an economy where data were available. For VietNam, data constraints may dictate the choice of the quantitative framework to be used in the study. 5. Data sources Quarterly nominal and real GDP will be from the Vietnam General Statistic Officer. Prices, interest rates, exchange rates, monetary variables will be gathered from the International Financial Statistic. Data related to oil, notably prices, production, consumption will be collected from domestic and international sources, such as Vietnam Energy Information Administration, or International Energy Agency. 6. Potential policy implications Based on the results of the investigation, the study will propose the mix of macroeconomic policy options, including the appropriate mix of monetary, fiscal, exchange rate policies and

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the management of oil resources, including the uses of oil earnings for productive investments to minimize the effects of oil prices increases on domestic prices and output in the short and the medium term. 7. References Benjamin Hunt, Peter Isard and Douglas Laxton (2001): “The Marcoeconomic Effects of Higher Oil prices”, IMF Working Paper No. WP/01/14. Blanchard, Oliver and Jordi Galí (2007): “The Macroeconomic Effect of Oil Price Shocks: Why Are the 2000s so Different From the 1970s?”, NBER Working Paper No. 13369. Giang, Lê Hồng (2008): “Ảnh hưởng Tăng Giá Xăng dầu lên CPI” [Impact of rising gasoline price on CPI], Minh Biện website Hamilton, James D. (1983): “Oil and the Macroeconomy since World War II,” Journal of Political Economy, Vol. 91, pp. 228-48. Hamilton, James D. (1996): “This Is what Happened to the Oil Price- Macroeconomic Relationship,” Journal of Monetary Economics, Vol. 38, pp. 215-20. Hallmann, Jeffrey S., Richard D. Porter and David H. Small, “M2 per Unit of Potential GNP as Anchor of the Price Level”, Staff Study # 157, Board of Governors of the Federal Reserve System, April 1989. Hallmann, Jeffrey S., Richard D. Porter and David H. Small, “Is the Price Level Tied to the M2 Monetary Aggregate in the Long Run?”, American Economic Review, 81 (Sept. 1991) pp. 841-58. Thành, Nguyễn Đức, Bùi Trinh và Đào Nguyên Thắng (2008): “Ảnh hưởng của tăng giá xăng dầu: một số phân tích định lượng ban đầu”, College of Economics, Hanoi. Mork, Knut Anton (1989): “Oil and Macroeconomy when Prices Go Up and Down: An extension of Hamilton’s results,” Journal of Political Economy, Vol. 97, pp. 740-4. Shabsigh, Ghiath; Ilahi, Nadeem (2007), “Looking Beyond the Fiscal: Do Oil Funds Bring Macreconomic Stability?”, IMF Working Paper, WP/07/96. World Bank (2008): Taking Stock: An Updated on Vietnam’s Recent Economic Development, World Bank report 2008.