Oil Price Uncertainty in a Small Open Economy

In this paper, the business cycle implications of oil price uncertainty are analyzed for an oil-importing small open economy. Higher volatility in oil prices works through two main channels. On one hand, it makes the marginal product of capital riskier, creating an incentive to substitute away from capital. On the other hand, it increases the demand for precautionary savings. The latter may imply higher capital accumulation in response to a rise in oil price uncertainty depending on whether agents have access to an international bond as an alternative asset. The investment decline because of higher oil price volatility under financial integration is almost twice as much as the decline under financial autarky. Moreover, the interaction between shocks to the level and volatility of oil prices is quantitatively important.