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Subsidy Elimination With and Without a Global Price Shock: The Macroeconomics of Oil Price Policy Reform

Publication date

Jan, 2012

Details

Report submitted to the Planning Commission

Authors

Sudipto Mundle, N. R. Bhanumurthy, Sukanya Bose

Abstract

Oil is a strategic commodity. The disruption of oil supplies, a quantity shock, can drive an economy to a grinding halt. The price of oil is an equally sensitive subject, both internationally and at home. Whenever global oil prices increase, it triggers a spike in inflation. In India, where the domestic price of most oil products are still largely administered, whenever global oil prices rise, the government is faced with a dilemma whether or not to pass on the price increase to domestic consumers. The oil price policy debate is often animated but rarely takes into account the complex mechanisms through which changes in the global price of oil effect macroeconomic outcomes such as inflation, growth, and the fiscal deficit. A study was undertaken to inform the policy debate by doing precisely this. It traced the linkages through which a change in the global price of oil impacts macroeconomic outcomes and quantified these impacts. The main channels through which the impact plays out were integrated into an empirically estimated macroeconomic model. The estimated model was then used to simulate different policy and oil price shock scenarios: a one shot full pass through without a global oil price increase, a gradual pass through without a global price increase, a one shot full pass through with a global price increase., and a gradual pass through with a global price increase. The main policy conclusions that emerged from a comparison of these simulation exercises suggest that a full pass through is desirable for fiscal consolidation and macroeconomic stability, as also to eliminate distortions in resource allocation. However, it would be prudent to eliminate the subsidies in a phased manner, rather than in a single shot, to avoid excessive macroeconomic instability.

 

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