Some Implications of North Sea Oil for the U.K. Economy

Over the past few years, the U.K. economy has been going through a major adjustment process. The sharp rise in the price of oil and the rapid buildup of oil production from the North Sea have set in motion a transformation of the structure of the U.K. economy. This structural transformation has been taking place at a time of an important shift of emphasis in economic policy toward giving pre-eminent weight to controlling inflation through monetary restraint and framing policy in a medium-term context rather than in the context of short-term stabilization.

Abstract

Over the past few years, the U.K. economy has been going through a major adjustment process. The sharp rise in the price of oil and the rapid buildup of oil production from the North Sea have set in motion a transformation of the structure of the U.K. economy. This structural transformation has been taking place at a time of an important shift of emphasis in economic policy toward giving pre-eminent weight to controlling inflation through monetary restraint and framing policy in a medium-term context rather than in the context of short-term stabilization.

Over the past few years, the U.K. economy has been going through a major adjustment process. The sharp rise in the price of oil and the rapid buildup of oil production from the North Sea have set in motion a transformation of the structure of the U.K. economy. This structural transformation has been taking place at a time of an important shift of emphasis in economic policy toward giving pre-eminent weight to controlling inflation through monetary restraint and framing policy in a medium-term context rather than in the context of short-term stabilization.

The degree and severity of the adjustment pressures are perhaps best indicated by the development of the real exchange rate for the pound sterling. The real exchange rate (relative unit-labor costs in manufacturing, adjusted for exchange rate changes) appreciated by almost 70 per cent between 1977 and the beginning of 1981, with the largest part of the appreciation occurring during 1979 and 1980. Although the real exchange rate fell back during 1981, at the end of the year it was still 45 per cent above the level in 1977. Such a large and rapid shift in the competitive position of a major industrial country is without precedent, at least in recent history. The emergence of the United Kingdom as a major oil producer and the tight financial policy stance have probably been the primary influences bearing on the behavior of the real exchange rate, thus initiating the structural transformation of the U.K. economy now taking place. This paper attempts to analyze these factors and, in particular, to assess the implications of North Sea oil for the U.K. economy.

Oil production from the North Sea increased from 13 million tons in 1976 to some 80 million tons (1.7 million barrels a day) in 1980, and during 1980 the United Kingdom became self-sufficient in oil. Production is expected to rise to a peak of about 90-120 million tons per annum in the mid-1980s and to decline slowly thereafter. The exportable surplus is expected to average one fourth of annual production for the decade of the 1980s. On the basis of the real price of oil in 1980, the North Sea’s direct contribution to gross national product (GNP) would rise from 1¼ per cent in 1978 to 3 per cent in 1980 and to 4¼ per cent by 1983. However, these gains in income arise in a highly unbalanced form. While the contribution of North Sea oil to GNP is moderate, the gain accruing to the current account of the balance of payments is sizable. As a result, a relative shift of output away from other tradables (mostly manufactured goods) and an increase in the domestic absorption of imported goods can be expected to occur, a rise in the real exchange rate being the main mechanism for bringing this about. This would occur as long as income from the oil sector is not fully spent or invested abroad. Thus, some of the direct contribution of North Sea oil to total output may be offset by lower output from the rest of the traded goods sector—predominantly the manufacturing sector—which, in turn, may be partly offset by a relative expansion in the nontradable sector. The movement of oil prices and North Sea oil production and developments in the effective exchange rate, the trade balance, and production and investment in manufacturing between 1970 and 1981 are shown in Chart 1.

Chart 1.
Chart 1.

United Kingdom: North Sea Oil and the Manufacturing Sector, 1970-81

Citation: IMF Staff Papers 1982, 003; 10.5089/9781451972702.024.A001

Sources: Various issues, U.K. Central Statistical Office, Economic Trends and Monthly Digest of Statistics; Phillips & Drew Economic Forecasts; British Business; and International Monetary Fund (IMF), International Financial Statistics. Also, IMF Data Fund.

The evolution and final outcome of the adjustment process will, of course, depend crucially on the policies followed by the authorities. The incipient improvement in the current account of the balance of payments on account of increased production of North Sea oil will lead to upward pressure on the real exchange rate for sterling, although this upward pressure could be mitigated to the extent that proceeds from North Sea oil were invested abroad, by either the Government or the private sector. At the same time, however, the emergence of North Sea oil, with the resulting status of sterling as a petrocurrency, may attract foreign capital into the United Kingdom, which would tend to increase upward pressure on the real exchange rate. The appreciation of that rate can occur as a result of either holding the nominal exchange rate fixed and allowing the money stock and thus the domestic price level to rise or holding the money stock fixed and allowing the nominal exchange rate to rise. The real appreciation could be moderated to the extent that effective sterilization of the monetary consequences of any official foreign exchange market intervention proved possible.1

A large portion of the income gain to the domestic economy from expanding oil production will accrue to the Government in the form of tax revenues. These revenues can be channeled into the economy directly as cuts in personal taxation to generate increased domestic consumption, as investment incentives to private industries to increase future productive potential, or as increased public spending. They can also be channeled into the economy indirectly through lower interest rates as a result of a lower requirement for borrowing by the public sector, or part of the revenues can be invested abroad. Clearly, the method of channeling these revenues will influence the structural adjustment in the domestic economy.2 The Government’s objective, as stated in its medium-term financial strategy, is to reduce the public sector borrowing requirement as well as to reduce taxation; no explicit reference is made to any specific use of oil revenues. Any reallocation of resources will be left primarily to market forces.

To facilitate a quantitative assessment of some of the effects of the development of the oil sector on the U.K. economy, a small macroeconomic model of the U.K. economy has been estimated. As opposed to short-run demand or long-run supply models, the model here is a medium-term one, analyzing the interaction between demand and supply. A dynamic system is imposed on the model, where the dynamic forces are the evolution of price expectations and the movement of relative prices. The model is used to simulate the effect of the oil sector on the structure of the economy. The most important effect that is examined is the impact of North Sea oil on the real exchange rate, and thereby on the U.K. manufacturing sector. The appreciation of the real exchange rate owing to North Sea oil produces a deterioration in the competitive position of the traditional tradable sector and negatively affects its productive potential. The exchange rate change also affects other variables, such as domestic prices, profits, wages, and the terms of trade. While the effects of the relative contraction of manufacturing on employment may be offset over time by a relative expansion of the nontradables sector (mainly services), this shift is not modeled here.

Policy reaction functions have not been included in the model, since policy objectives have frequently changed over the observation period of this study 1960-80). This formulation implies that overall monetary and fiscal policies are set independently and are not explicitly influenced by developments in the oil sector, an assumption that comes close to reality in the United Kingdom. Nevertheless, the model permits some assessment of the likely impact of the authorities’ medium-term strategy of squeezing inflation out of the economic system through a policy of financial restraint. The model is used to perform alternative policy simulations in order to provide information on the magnitudes of policy effects on important variables. Monetary and fiscal policies, and an oil price shock, are considered following fairly simple procedures.

The plan of the paper is as follows. The framework for analyzing the effects of North Sea oil and of government policies on the economy is provided first, and the basic structural specification of the model is described in Section I. The estimation results are presented in Section II, while Section III contains the alternative policy scenarios. The conclusions are summarized in Section IV.

I. Theoretical Framework

The macroeconomic model, formulated with the aim of assessing the effects of oil production on the economy under a number of alternative scenarios, is outlined in the Appendix in Tables 1 and 2, and the definition of the variables is given in Table 3. The model has been estimated with annual data. Many nonlinear functions are included, and autocorrelation of various orders exists among the structural disturbances. Whenever necessary, the two-stage least-squares approach has been used. In other parts, the structural equations have been estimated using ordinary least squares. Where collinearity among the variables proved to be particularly problematic for estimation, some coefficients were set at theoretically plausible values.

The model comprises markets for domestically produced goods and imports (split into oil, manufactures, and other non-oil), financial assets, foreign exchange, and labor. The links between the financial and real sectors are provided by the interest rate, the exchange rate, and the rate of inflation. Three groups of goods are produced at home—manufactures, oil, and other non-oil—and these goods are both consumed domestically and exported. Consumers have distinct preferences for either domestically produced or foreign-produced manufactures, whereas the consumer may show no marked preference for either type of oil. The other non-oil sector is treated as being exogenous. The price of manufactures is determined in the domestic market (with due consideration given to competitors’ prices), and the price of oil is determined in world markets. Tax policy plays a role in the determination of consumption and investment. On the supply side, the model captures the effect of the price of oil on productive potential of the manufacturing sector.

A floating exchange rate regime is incorporated, where the exchange rate influences both the balance of payments and the rate of inflation. Both oil production and oil prices, as well as financial policies, affect the exchange rate. Oil production and prices influence the exchange rate directly through their effect on the current account and indirectly through the market’s perception of sterling as a petrocurrency. Financial policies have a direct influence on the exchange rate through domestic interest rates and an indirect influence through the current account of the balance of payments. Accordingly, it is possible, in principle, to separate those components of real exchange rate changes that have been affected by North Sea oil, and that may prove to be long lasting, from those affected by the stance of financial policies that may be more temporary in nature.

The wage/price block utilizes the expectation-augmented Phillips curve approach; it includes the impact of inflationary expectations on domestic inflation and captures the effects of exchange rate changes on prices. The formulation implies that while there may be a short-term trade-off between inflation and economic activity, there would be none in the long run.

Domestic Product Market

The real side of the model consists of the product-market equilibrium equation, consumption, investment, and aggregate production functions. The consumption sector is relatively straightforward with real consumption disaggregated into manufactures, oil, and other non-oil—equations (3)-(5). Real consumption of oil is the sum of private and industrial demand; the consumption of domestically produced oil is the residual between domestic production and exports. Clearly, real consumption of oil changes as the price of energy substitutes, such as coal, gas, and electricity, changes. However, no attempt has been made to assess how prices of these alternate energy supplies will affect consumption of oil in the United Kingdom.

The investment function for manufactures—equation (8)—is based on the neoclassical theory of investment. The desired level of the capital stock in the manufacturing sector is affected by expected profitability. As an appreciation of the exchange rate raises domestic unit-labor costs (adjusted for exchange rate changes) relative to those abroad, profitability of both export-competing and import-competing manufactures falls, and the growth of output in manufacturing is reduced. This is one mechanism whereby structural change in the domestic economy arising from North Sea oil takes place. The reduced profitability of the manufacturing sector leads to a reduction in the desired capital stock in that sector. Investment in manufacturing is the rate at which the capital stock is adjusted toward its desired level after allowance for the rate of depreciation of the capital stock, and is related to the real rate of interest, relative unit-labor costs (adjusted for exchange rate changes), the output gap in manufacturing, output in manufacturing, and the level of the capital stock at the beginning of the period.

On the supply side, potential output for the manufacturing sector depends upon the capital stock, the rate of technical change, and the real price of oil. Actual output in the manufacturing sector is demand determined and is equal to real consumption plus the proportion of manufactures in total real investment plus real exports of manufactures minus the portion of imported manufactures that goes to final demand—equation (10).

Domestic Asset Market

The equation for the implicit demand for money—equation (14)—is of a standard form where the demand for narrow money (M1) varies inversely with the rate of interest and positively with real domestic income. Although the monetary targets as originally outlined in the authorities’ medium-term financial strategy were set in terms of broad money (sterling M3), the demand for M1 has proved to be more stable; recently, the narrower aggregates have also mirrored the recession and the slowdown in inflation much more closely than has broad money. The restatement of the financial strategy in the budget for 1982/83 relates the monetary target to M1, sterling M3, as well as to private sector liquidity (an even wider concept than broad money). Wider aggregates—the demand for other financial assets (such as time and savings deposits with banks, deposits with building societies, and bonds)—are not explained in the model, mainly because the demand for such assets was found to have been highly unstable in the United Kingdom throughout the 1970s. For example, the institutional changes in connection with the introduction of competition and credit control in 1971, the periodic imposition of the “corset,”3 and the abolition of exchange controls have led to various kinds of leaks that are difficult to quantify, and shifts into and out of sterling M3 related to changes in relative interest rates have created enough instability to make it an unreliable indicator of the stance of monetary policy. The narrower aggregates have, however, been largely free from such unpredictable shifts. The nominal supply of money—equation (16)—is determined by the monetary base (central bank money), which is assumed to be under the control of the central bank, and the money multiplier, which is interest sensitive. The interest rate is assumed to clear the money market.

Recently, the U.K. authorities examined their existing monetary techniques with a view to improving short-term monetary control, and a number of changes in monetary control techniques were introduced in 1981. The changes, which are consistent with an eventual adoption of control of the monetary base, involve changes in the Bank of England’s methods of intervention in the money market so as to allow market forces a greater role in determining short-term interest rates. Thus, although the monetary authorities in the United Kingdom do not aim at steering the monetary base along a predetermined path, the afore-mentioned modeling of the money supply does appear to reflect reality fairly well.

In the government budget constraint—equation (19)—it is asserted that nominal government expenditure minus taxes minus the central bank’s net domestic assets (government paper held by the central bank) will be equal to government paper held by the private sector. The decision to finance the budget deficit either through the creation of central bank money or through the private sector will influence the money supply. Taxes are made endogenous in the model—equation (20)—as are the changes in net wealth—equation (18). Changes in net wealth have been estimated because of the unavailability of some of its determining variables.

Balance of Payments

The growth of the oil sector in the United Kingdom over recent years has led to considerable change in the structure of the balance of payments, and this structural change is expected to continue throughout the 1980s. The growth in oil production has resulted in a strong improvement in the oil balance. Balance of payments equilibrium is restored through an appreciation of the real exchange rate, which reduces the competitiveness of traditional exports and increases the attractiveness of non-oil imports, although the effects on the non-oil balance so far have been masked by the recession. The appreciation of the real exchange rate also brings about internal structural change by reducing profits in the manufacturing (traded) sector, compared with those in the oil and the nontradables sectors. The loss in competitiveness may also lead to a deterioration of the contribution of invisibles to the current account. Moreover, since a significant portion of oil investment is foreign financed, outflows of income from investments in oil have increased considerably. The balance of payments equations—equations (21)–(41)—are designed to explain the current account. The treatment of trade in manufacturing is similar to that reported in Deppler and Ripley (1978), except that relative unit-labor costs in manufacturing, adjusted for exchange rate changes, replace relative prices. The import equation for manufactures is not a function of the same variables as the consumption equation for manufactures. The main reason is that the decision to consume imports is made by both consumers (final demand) and industry (intermediate demand), and the variables in the equation are intended to capture both effects. A simple equation relating exports of oil to domestic supply, domestic consumption, and imports of oil is utilized. The invisibles account is modeled in a form similar to that in Bond (1979), except that a more aggregate form of the model is utilized. Real imports and exports of invisibles excluding oil investments are estimated. These flows of invisibles are determined by relative prices, trend effects, real disposable income (imports), and the foreign market variable for invisibles (exports).

Foreign Exchange Market

Through most of the 1970s, the exchange rate for sterling was floating, although at times it was heavily managed. For example, in 1977 the authorities attempted to preserve the competitive gains flowing from the depreciation in 1976 by holding the nominal exchange rate against market tendencies through massive intervention in the foreign exchange market. While this policy allowed rebuilding of foreign reserves, it also resulted in eventual loss of domestic monetary control, and the policy was abandoned in late 1977. Since 1979 the policy of the U.K. authorities has been to allow the exchange rate to be determined mainly by market forces while intervening to smooth day-to-day fluctuations.

One way to assess the effects of North Sea oil and domestic financial policies on the exchange rate is to utilize a modified asset-market approach to exchange rate determination, where portfolio substitution takes place over time in response to changes in actual or expected yield differentials. The exchange rate adjusts, following a change in the interest differential or the current account, to bring about changes in the relative yields. The exchange rate change must be sufficient to ensure that capital flows will continuously match the current account balance; thus, slow adjustment in portfolio composition provides the link between the current account and the exchange rate. Following this approach, the main determinants of the exchange rate are the expected future value of the sterling rate, the interest differential, and the current account of the United Kingdom relative to that of other industrial countries. This is shown in equation (42). With a completely flexible exchange rate, the exchange rate will adjust to maintain the balance of payments in equilibrium. If, however, the authorities attempt to influence the exchange rate through intervention, foreign reserves will change and, through their impact on the money supply, will affect the exchange rate.

The expected future value of the spot sterling rate—equation (43)—is assumed to depend upon relative inflation rates, the discounted present value of the future earnings from North Sea oil (dependent on oil production, oil prices, and the government bond yield), and actual exchange rate movements. By substituting equation (43) in equation (42) and constraining the coefficient on relative normalized unit-labor costs to equal one, the real exchange rate equation is derived. In this equation, the impact of North Sea oil on the exchange rate, which includes the petrocurrency effect, is captured by two variables—the discounted value of future North Sea oil production and the change in the current account. The effects of financial policies on the real exchange rate can also be assessed.

Domestic Wage/Price Sector

The domestic wage/price block of the model consists basically of an expectation-augmented Phillips curve to explain wage earnings and cost-plus pricing to explain domestic inflation.

The rate of consumer price inflation—equation (47)—is assumed to be determined by the weighted average of the rate of inflation of domestically produced goods and services (the gross domestic product deflator), and foreign inflation expressed in local currency (the import-price deflator), with the weights derived from previous studies (Brown and others (1980)). This relationship captures not only the inflationary impact of factors exogenous to the U.K. economy, such as movements in oil prices, but also the impact on domestic inflation of such factors as exchange rate movements. The rate of inflation of domestically produced goods and services—equation (48)—is based on the assumption of cost-plus pricing, with the constant term allowing for the trend increase in productivity. The domestic rate of inflation is also assumed to be cyclically responsive.

The crucial relationships are those for wage inflation and inflationary expectations. The increase in average earnings is assumed to be determined by inflationary expectations and to be cyclically responsive, with demand pressure measured by the output gap. Inflationary expectations are assumed to be formed on an extrapolative basis, reflecting current and past rates of consumer price inflation—equation (50).

II. Parameter Estimates

Estimates of the parameters obtained from annual data are presented in the Appendix, Table 2. The numbers in parentheses are t-statistics. The estimation period spans 1960 to 1980, but for individual equations the observation period was determined by the availability of data. The domestic asset market and wage/ price sector were estimated using two-stage least squares, and the rest of the model was estimated using ordinary least-squares procedures.

The results obtained for the consumption equations—equations (3’)–(5’)—are relatively straightforward. Although both real net wealth and disposable income are important determinants of consumption, an increase in disposable income will have almost twice the effect on consumption as an increase in real net wealth. The dummy variables for the change in value-added taxes (VAT), which took place in 1979, imply a change in the consumption mix, reducing consumption of manufactures and oil and increasing the consumption of other non-oil products, for which the effective VAT is lower.

In the investment equation—equation (8’)—a rise in domestic normalized unit-labor costs relative to those of other countries depresses investment in the manufacturing sector, with most of the fall taking place after two to three years. The interest rate variable was dropped from the equation because it was collinear with relative normalized unit-labor costs. The estimated coefficients on output and the output gap are large; a rise of 1 per cent in the output gap will lead to a fall of 2.9 per cent in investment in manufacturing after one year.

The results for potential output in the manufacturing sector are presented in equation (11’). The estimate of the coefficient on the capital stock shows that a rise of 1 per cent in the capital stock will produce a rise of 1 per cent in potential output in manufacturing. On the other hand, an increase of 10 per cent in the real price of oil would result in a drop of 0.2 per cent in potential manufacturing output. This estimate may be quite imprecise because of the small price changes that took place prior to 1974. There was also a slight decrease in the growth of potential output in manufacturing over the period 1963-79 that could possibly be accounted for by an increase in the average age of the capital stock.

The estimated coefficients for the equations for the domestic asset market are shown in equations (14’)–(20’). The equations for the money market—equations (14’) and (16’)—were estimated using two-stage least squares. The nominal quantity of money is determined on the supply side, while the real quantity of money is determined by conditions of demand. It is assumed that the price elasticity of the demand for money is unity and, consequently, that there is no money illusion. The evidence from other econometric studies (Artis and Lewis (1976); Coghlan (1978)) suggests that the adjustment between the changes in people’s desire to hold money balances and actual changes in money balances is completed after six to nine months, so that no lagged responses are included here. Solving equation (14’) for the real money stock yields the explicit money demand equation and gives a long-run real income elasticity of 1.0. The interest elasticity is -0.5; both elasticities are very much within the range provided by other studies. On the supply side, an increase of 10 per cent in central bank money (as a result of an increase in either net domestic assets or foreign reserves) will bring about an increase of 11 per cent in the money supply as measured by M1. On the other hand, a rise of 10 per cent in the treasury bill rate (say, from 10 per cent to 11 per cent per annum) will reduce the money supply by about 1 per cent.

The parameter estimates for the balance of payments equations are reported in equations (24’)–(39’) in Table 2. Changes in relative normalized unit-labor costs4 (adjusted for exchange rate changes) affect the volume of manufacturing exports over a period of four years, with a higher proportion of the change taking place over the last two years. The response of the volume of manufacturing imports is much faster than that of exports, and most of the effect of changes in relative costs on imports will be felt after two years. These results are similar to those obtained by the U.K. Treasury model (Brown and others (1980)) and suggest that some of the adverse effects of the 1979/80 appreciation and changes in costs that took place in the United Kingdom have yet to show up in trade flows. The estimated coefficients on relative normalized unit-labor costs in the import and export equations, including the period 1978-80, have fallen in comparison with estimates for the period up to 1977, indicating that these elasticities may change when large changes in costs take place.

The effect of the domestic recession on manufactured imports is captured by their responsiveness to economic activity. The coefficient on this variable was constrained to one because it was highly collinear with the cyclical variable and the trend term. The behavior of the United Kingdom’s exports in manufacturing is also affected by domestic potential output relative to foreign potential output, which reflects the opportunity to export; relative capacity utilization, which measures the short-term constraint on the supply side; and the foreign market variable. Because of the high collinearity between the foreign market variable, relative potential output, and the time trend, the coefficients on the first two variables were constrained to one.

The results from the exchange rate equation—equation (42’)—show that the United Kingdom’s position as an oil producer against a background of rising world oil prices and fears about security of supplies, high interest rates in the United Kingdom, and the relatively strong position of the U.K. current account compared with that of other industrial countries all explain the strength of the real exchange rate through 1980. The sensitivity of the real exchange rate to the discounted present value of North Sea oil is quite strong. An increase of 10 per cent in the discounted present value of North Sea oil (caused by further oil discoveries in the North Sea or an increase in the price of oil) will lead directly to an increase of about 1.5 per cent in the value of the pound in real terms. The effect of the U.K. relative current account is also strong; a change of 1 per cent in the current account position of the United Kingdom compared with that of the remaining industrial countries will lead to a change of 1.1 per cent in the real exchange rate.

The estimated coefficient on the interest rate differential is rather low, which may be related to a relatively fast adjustment of the exchange rate to changes in interest rates, which would be expected to occur within the period of annual observations. Two dummy variables were included in the equation: to capture the intervention policies that took place in the mid-1970s and to represent the beginning of the floating rate. The results from this equation can be utilized to assess how much of the recent appreciation of the real exchange rate is due to North Sea oil and how much to tight domestic financial policies.

Results from the wage/price sector, which were estimated using two-stage least squares, are shown in equations (47’)–(49’), and these results may give an indication of how the present Government’s policy of progressively reducing the rate of monetary expansion will affect output and inflation over time. The results show the importance of inflationary expectations in both price and wage inflation. Inflationary expectations were found to be formed on actual consumer price inflation lagged one year. In the model, the coefficient in the expectations equation was set equal to one, so that expected consumer inflation is equal to actual consumer inflation in the previous year. Furthermore, wage inflation was found to be responsive to the output gap in manufacturing with a one-year lag, but there was no evidence that the monetary targets of the authorities had any direct effect on wages. Tight monetary policies affect the inflation rate mainly through the reduction in import prices that arises as the exchange rate appreciates and from the resulting fall in output and employment.

III. Simulation Results

Alternative simulations have been performed to assess the effects of various developments on the U.K. economy. A change in the real price of oil is considered along with alternative fiscal and monetary policies, and the results obtained from these scenarios are compared with a control solution. The control solution of the model was derived by running the model outside the historical period (from 1980 to 1989), given the following assumptions about the exogenous variables. Real government expenditure was assumed to be constant, central bank money was assumed to grow by 8 per cent per annum as were world prices, the nominal price of oil in U.S. dollars, and normalized unit-labor costs for the rest of the world. The year 1989 was chosen as the final year of the simulation period because a period of ten years was sufficient to assess the effects of the shock considered. For each of the scenarios the exogenous variables were changed for the year 1980. Thereafter, the growth in the exogenous variable was set equal to the control solution, implying a once-and-for-all change in the level of the exogenous variable. The results are assessed in terms of how the growth path of the economy following a shock would differ from the growth path under the control solution.

The responses of real income, manufacturing output, rates of inflation, and real exchange rates to an exogenous shock are presented in the form of multiplier paths, and these paths are analyzed in the light of the adjustment mechanisms discussed in the model. The exogenous shock is generated by increasing the exogenous variable (z) by x per cent above its growth in 1980 and letting its growth return to the path for the control solution (zc) thereafter. The dynamic multiplier for the endogenous variable is calculated as follows:

m=y˙y˙cz˙z˙c

for each period to 1989, where c denotes the control solution.

oil price rise

The first simulation entails an increase in the real price of oil by 10 per cent above its level in 1980 and a return to the growth rates in the control solution thereafter. Dynamic multipliers have been calculated for the growth in real income and in manufacturing output; the rate of inflation, measured by the consumer price index (CPI); and the real exchange rate (Chart 2 (A-D)).

Chart 2.
Chart 2.

United Kingdom: Dynamic Multipliers—Rise in Price of Oil, 1980-891

(In per cent)

Citation: IMF Staff Papers 1982, 003; 10.5089/9781451972702.024.A001

1 The dynamic multiplier measures the difference between the growth in the endogenous variable following a sustained rise of 10 per cent in the real price of oil and its growth in the control solution.

The simulation suggests that, in the first two years, a sustained rise of 10 per cent in the real price of oil would reduce real income growth by 0.2 per cent and 0.25 per cent and growth in manufacturing output by 0.3 per cent and 0.2 per cent, respectively (Chart 2 (A and B)). The impact on the rate of growth would remain negative for a number of years. By the end of the simulation period, the level of real income and manufacturing output would be 0.8 per cent and 1.8 per cent, respectively, lower than in the control solution. The main factor accounting for this development would be an appreciation in the real exchange rate for sterling. According to the simulation, a sustained increase of 10 per cent in the real price of oil would result in an appreciation in the real exchange rate of 2 per cent and 1 per cent during the first two years (Chart 2 D). The appreciation would reflect not only the effect of a higher oil price on the present value of North Sea oil production5 but also an improvement in the current account of the United Kingdom relative to that of other industrial countries. At the end of the simulation period, the real exchange rate would have appreciated by about 3½ per cent. With monetary policy fixed, the real appreciation would be brought about through a nominal appreciation of sterling. In fact, the simulation suggests that the nominal appreciation would be sufficient to more than outweigh the direct impact of higher oil prices on the cost of living, such that a rise of 10 per cent in the price of oil, in combination with an unchanged growth in the money stock, would reduce the rate of inflation in the United Kingdom slightly (by ½ of 1 per cent) over the first few years (Chart 2 C).

In interpreting these results, it should be borne in mind that, first, the impact on overall output is clearly overstated, since no allowance is made in the model for a shift from non-oil tradables into nontradables, which is likely to occur as a result of changes in relative prices and which should, over time, offset the negative impact on traditional tradables. Second, the estimated effect of a rise in oil prices or oil production on the real exchange rate does incorporate the so-called petrocurrency effect on sterling, which is related to the status of the United Kingdom as an oil producer. As noted earlier, the exchange rate equation assumes that exchange market participants are forward looking, and the exchange rate is related to the discounted value of North Sea oil. Exchange rate expectations are thus assumed to be influenced by the fact that the United Kingdom will be a significant net exporter of oil throughout the 1980s and beyond, while the fact that oil production will cease during the twenty-first century may yet have little impact on current exchange rate expectations.6 However, the estimated equation reflects the behavior of exchange market participants only through the 1970s, and their behavior may well differ in the 1980s.

The latter factor may explain much of the difference between the estimates of the effect of North Sea oil on the real exchange rate for sterling presented here and in some other studies. For example, a study issued by the U.K. Treasury7 estimates that a rise of 10 per cent in oil prices would raise the real exchange rate for sterling by 2½ per cent.8 This estimate does not allow for the petrocurrency effect on sterling and is based on a higher relative- cost elasticity of manufactured exports than is estimated in this study.9 In a recent paper issued by the Bank of England (1982), the authors, while accepting the view that the real exchange rate for sterling would have to rise as a result of the buildup of North Sea oil production and the rise in the price of oil, argue that the strength of sterling in recent years must be seen to be due largely to other factors, such as the asset preferences of oil exporters or high U.K. interest rates. However, to the extent that the asset preferences of oil exporters (or any other investors) would be influenced by the United Kingdom’s position as an oil producer, this would reflect the petrocurrency status of sterling and clearly would be related to the possession of North Sea oil.

It is also sometimes argued that short-run movements in the real exchange rate on account of the petrocurrency effect may differ from those needed in the longer run to re-establish balance of payments equilibrium, which of course would complicate the economic adjustment difficulties. A similar argument has been made that, in the very long run, a restructuring of the U.K. economy involving a relative shrinking of the manufacturing sector will not be needed because North Sea oil is a depletable resource. Thus, any such restructuring would have to be reversed later, when the oil reserves run out. However, the United Kingdom currently is more than self-sufficient in oil and is expected to be a significant net exporter of oil at least over the next decade; it appears that these facts, whether properly or improperly discounted, have dominated behavior of exchange market participants in recent years.

Despite a fall during 1981, at the end of that year the real exchange rate for sterling was still about 45 per cent higher than in 1977. The simulation results suggest that the rise in the real price of oil since 197710 may have accounted for some 25 percentage points of that appreciation. This would indicate that while the effect of North Sea oil on the real exchange rate, and thus on the structural adjustment of the U.K. economy, may have been substantial, the contribution of other factors, such as the relative tightness of monetary policy, also had a pervasive and sizable influence.

The simulation results also suggest that some negative short-run effects of an oil price increase on the growth of output could have been avoided without sacrificing the anti-inflationary objectives. As noted earlier, the simulation suggests that in the short run (over a few years) an oil price rise with unchanged monetary policy would slightly reduce the rate of inflation in the United Kingdom because of the resulting appreciation of sterling. If these results were valid, some of the increased demand for sterling could have been satisfied through an increase in the money stock, with unchanged anti-inflationary objectives11 but with a smaller drop in U.K. output.

monetary policy

The second experiment entails a straightforward once-and-for- all monetary shock. The monetary shock is generated by lowering central bank money by 1 per cent below its growth rate in 1980 and letting it return to the growth path in the control solution thereafter. Dynamic multipliers have been calculated for growth in real income and manufactures, the inflation rate, and the real exchange rate.

Chart 3 A shows the response of the growth of income to the monetary shock. The reduction in monetary growth reduces net wealth and raises the domestic interest rate. The change in the interest differential induces an appreciation of nominal and real exchange rates. The real exchange rate rises mainly because of the relatively sluggish response of wages to the monetary tightening. Real investment worsens as a result of the rise in the real exchange rate. A fall in consumption takes place as a result of the decline in real net wealth, and the level of stocks falls as output declines. All these factors contribute to an initial decrease of 0.4 per cent in real income (below the control solution). Although the effect of a monetary contraction on the growth of output is negative only in the first year, it takes about five years to recoup the initial loss in the level of output.

Chart 3.
Chart 3.

United Kingdom: Dynamic Multipliers—Reduction in Monetary Growth, 1980-891

(In per cent)

Citation: IMF Staff Papers 1982, 003; 10.5089/9781451972702.024.A001

1 The dynamic multiplier measures the difference between the growth in the endogenous variable following a reduction of 1 per cent in the monetary base and its growth in the control solution.

The fall in import prices resulting from exchange appreciation is fed through into the CPI. Thus, wage inflation decreases as a result of lower inflationary expectations. Chart 3 C shows the time path for the CPI inflation multipliers. Each reduction of 1 per cent in the money supply leads to a drop of 0.2 to 0.3 per cent in inflation during the first few years. The real exchange rate (Chart 3 D) appreciates above the control solution following the monetary shock but thereafter depreciates below it for a number of years. For these years, the decrease in domestic inflation is not fully offset by the appreciation of the nominal exchange rate because of the lagged effects of real exchange appreciation on the current account and the narrowing of the interest differential following the monetary contraction.

In recent years a prime objective of policy in the United Kingdom has been to squeeze inflation out of the economic system through monetary restraint. To this end, monetary targets have been set on a decelerating growth path. Although the initial targets expressed in terms of growth in broad money (sterling M3) have been exceeded by wide margins, the narrower monetary aggregates, as well as the achievement of a lower rate of inflation, leave little doubt that monetary policy has in fact been tight over recent years. In particular, the average rate of growth of the monetary base was reduced from 13½ per cent in 1979 to 8 per cent in 1980 and to 5½ per cent in 1981. Use of the simulation results suggests that this deceleration in monetary growth, ceteris paribus, may have lowered the rate of inflation by 1 percentage point in 1980 and by an additional 2 percentage points in 1981, and that it would lower inflation in 1982 by perhaps an additional 2½ percentage points. Moreover, a significant portion of the effect would still be felt in later years. However, the costs of reducing inflation in terms of lost output may have been substantial. The deceleration in monetary growth may have reduced the growth of output by 2 percentage points in 1980 and 1981. In the absence of a further deceleration, or with a reacceleration in monetary growth, the growth of output would still be negatively affected (by 1½ per cent) in 1982 but would be boosted after 1983.

In fact, consumer price inflation in the United Kingdom rose sharply, going from 13½ per cent in 1979 to 18 per cent in 1980 before falling back to 12 per cent in 1981; it is likely to decline into single digits in 1982. On the other hand, overall output decreased by 7½ per cent over the two years to mid-1981,12 or by more than 10 per cent relative to potential output. Both these developments cannot be explained by the adjustment pressures owing to North Sea oil or the policy of nominal monetary restraint; they may be the result of the sudden emergence of the pressures of domestic costs. These increased pressures followed the breakdown in incomes policy in early 1979 and were strongly reinforced by the near doubling of VAT rates in mid-1979 and the large increase in public service pay in 1979-80. It was the simultaneous combination of the adjustment pressures owing to North Sea oil, the pursuit of monetary stringency, and the sudden cost push that produced the initial sharp rise in inflation followed by an even sharper fall and the most severe recession since the 1930s.

fiscal policy

The third experiment entails a once-and-for-all fiscal shock with monetary policy unchanged. The fiscal shock is generated by reducing government expenditure by 1 per cent below its growth rate in 1980 and letting it return to the growth path in the control solution thereafter. The real income growth multiplier (Chart 4 A) shows that for a reduction of 1 per cent in the growth of government expenditure, real income will decline by 0.4 per cent in the first year. However, for subsequent years the growth multiplier for real income would be slightly positive, and by the end of the simulation period almost half of the initial drop in output would be reversed, indicating substantial but partial crowding out.

Chart 4.
Chart 4.

United Kingdom: Dynamic Multipliers—Fiscal Contraction, 1980–891

(In per cent)

Citation: IMF Staff Papers 1982, 003; 10.5089/9781451972702.024.A001

1 The dynamic multiplier measures the difference between the growth in the endogenous variable following a reduction of 1 per cent in government spending and its growth in the control solution.

Since the fiscal contraction is not matched by a decrease in the money supply, the treasury bill rate falls to equilibrate the money market. The change in the interest differential induces a depreciation in the exchange rate, which in turn causes import price inflation and, therefore, consumer price inflation to rise for the first year (Chart 4 C). Thereafter, the rate of inflation improves, as demand pressures are reduced. The change in the real exchange rate brought about by exchange depreciation also causes an initial improvement in the current account. The time path for the exchange rate is shown in Chart 4 D. As the current account improves, the real exchange rate appreciates; this process continues until exchange rate equilibrium is achieved.

IV. Conclusions

Economic developments in the United Kingdom over the past few years have been dominated by an unprecedented appreciation of sterling in real terms, which has resulted in a sharp squeeze of the traditional tradable goods sectors of the economy. The emergence of the United Kingdom as a major oil producer and the simultaneous pursuit of a tight anti-inflationary financial policy have often been cited as the main factors behind the appreciation of the real exchange rate. This paper analyzes these factors and assesses some of the implications of North Sea oil for the U.K. economy.

The paper argues that the buildup of oil production from the North Sea, and the sharp rise in the real price of oil, necessitated a structural change in the U.K. economy, involving a relative shift of output away from other tradables (mostly manufactured goods), with an appreciation in the real exchange rate being the main mechanism to bring this about. The simultaneous pursuit of strong anti-inflationary policies has added to the pressures on the real exchange rate in the short term, although this effect should fall away as domestic inflation adjusts.

To facilitate a quantitative assessment of these interactions, a small dynamic macroeconomic model has been estimated, where the dynamic forces are the evolution of price expectations and the movement of relative prices. The model has been used to simulate some of the effects of the oil sector on the structure of the economy as well as the main effects of the anti-inflationary policy strategy.

Despite a decline during the year, at the end of 1981 the real exchange rate for sterling was about 45 per cent higher than in 1977. This paper suggests that more than half of this increase may have been due to the existence of North Sea oil and the rise in the real price of oil. However, the results also suggest that other factors—in particular, the relative tightness of monetary policy—had a sizable influence on the real exchange rate in the short run, but that its influence should prove to be temporary. The results also indicate that a rise in the price of oil with an unchanged monetary policy would slightly reduce the rate of inflation in the United Kingdom, because the resulting appreciation of sterling would more than offset the direct price impact of higher oil prices. Thus, with unchanged anti-inflationary objectives, some of the increased demand for sterling could have been met through an increase in the money stock.

This paper also indicates that the anti-inflationary policy of financial restraint should be and has been successful in winding down inflation, although at a high short-term cost in terms of lost growth of output. The main reason for this has been the relatively inflexible labor market, with a sluggish response in inflationary expectations to changes in monetary policy. Thus, the monetary deceleration that occurred between 1979 and 1981 may have reduced the rate of inflation by 1982 by 5½ percentage points, although the growth of output in that year may still be reduced by 1½ per cent. The paper suggests, however, that the growth of output should be boosted after 1983. The results also indicate that a fiscal contraction through lower public spending would reduce growth in the first year, although this effect would be offset over time through increased economic activity in the private sector.

No discussion of economic developments in the United Kingdom in recent years would be complete without highlighting the sudden emergence of major pressures of domestic costs that were unrelated to monetary policy. Wage expectations had already been buoyed by the breakdown of incomes policy in early 1979 and were powerfully reinforced by a near doubling of VAT rates in mid-1979 and by a sharp increase in public service pay in 1979-80. These pressures of domestic costs clearly worsened the short-term trade-off between inflation and output and employment, therefore deepened the recession, and postponed the time when the fruits of the anti-inflationary policy can be reaped.

APPENDIX

Table 1.

United Kingdom: Model of Effects of North Sea Oil on the Economy

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These equations have been estimated or utilized for the simulation exercise outside the historical period; for the historical period, the variable on the left-hand side is exogenous.

Table 2.

United Kingdom: Empirical Results of the Model

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Coefficient constrained.

Table 3.

United Kingdom: Definition of Variables in the Model

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*

Ms. Bond, economist in the Developing Country Studies Division of the Research Department, was in the External Adjustment Division when this paper was prepared. She is a graduate of the University of Essex and received her doctorate from the London School of Economics and Political Science. She was formerly a member of the faculty of the University of Reading, England.

Mr. Knöbl, Chief of the Northern European Division of the European Department, is a graduate of the Hochschule fur Welthandel, Vienna, and was a scholar at the Institute for Advanced Studies and Scientific Research, Vienna.

1

Such a policy is equivalent to overseas investment of the proceeds from North Sea oil by the Government.

2

For a detailed theoretical analysis of the adjustment issues involved, see Corden (1981 b).

3

The “corset” imposed quantitative restrictions on banks’ liabilities; it was abolished in 1980.

4

That is, unit-labor costs adjusted for cyclical fluctuations in productivity.

5

In the model, an increase of 10 per cent in the annual North Sea oil output would have the same effect as a rise of 10 per cent in the real price of oil.

6

Estimates suggest that the United Kingdom is likely to have enough oil reserves to last, at current rates of consumption, for at least 15 and perhaps for as much as 50 years.

8

This estimate relates to the impact of an increase of 10 per cent in the price of oil on the real exchange rate compared with a situation without oil production. Byatt and others (1982) argue that in the absence of North Sea oil the real exchange rate would have to depreciate by about 1 per cent in response to a rise of 10 per cent in the price of oil to pay for the increased cost of oil. They argue therefore that, given the existence of North Sea oil, a real exchange rate appreciation of only 1½ per cent may be observed. However, since the real effective exchange rate is measured here against the currencies of the other industrial (oil importing or non-oil producing) countries, it appears that the comparison with a situation without oil production would be the relevant one for comparing the estimates.

9

The relative-cost elasticity of the volume of manufactured exports estimated here is below 0.6, compared with 0.8 in the U.K. Treasury study. A lower cost elasticity would, ceteris paribus, raise the estimated effect of North Sea oil on the real exchange rate. Recent U.K. experience does support the view of relatively low elasticities.

10

Amounting to about 75 per cent. The rise in the real price of oil dominated the movement in the discounted value of North Sea oil production over that period.

11

A similar point has been argued, for example, by McKinnon (1981). The preceding argument is also consistent with the view that, at times, the exchange rate may be a more accurate indicator of the monetary stance (at least as far as its impact on inflation is concerned) than is the money stock.

12

Manufacturing output fell by more than 17 per cent during the same period.

IMF Staff papers: Volume 29 No. 3
Author: International Monetary Fund. Research Dept.
  • View in gallery

    United Kingdom: North Sea Oil and the Manufacturing Sector, 1970-81

  • View in gallery

    United Kingdom: Dynamic Multipliers—Rise in Price of Oil, 1980-891

    (In per cent)

  • View in gallery

    United Kingdom: Dynamic Multipliers—Reduction in Monetary Growth, 1980-891

    (In per cent)

  • View in gallery

    United Kingdom: Dynamic Multipliers—Fiscal Contraction, 1980–891

    (In per cent)