Transmissions of Structural Oil Shocks to Korea’s Terms of Trade

Purpose - This study empirically examines whether oil price shocks affect Korea’s terms of trade (TOT) differently, depending on the fundamental sources of oil price hikes, and assesses the quantitative significance of its fluctuation. Design/Methodology - Following Baumeister and Hamilton (2019), I first distinguish the underlying causes of oil price changes into oil supply shocks, economic activity shocks, oil consumption demand shocks, and inventory demand shocks. Based on the local projection framework where the extracted structural oil shocks are taken as explanatory variables, I estimate the impulse response of TOT and quantify the importance for its variation using the variance decomposition method. Findings - The main findings are summarized as follows. First, there exists a substantial heterogeneity in the oil price pass-through to Korea’s TOT depending on the sources of oil price increases: oil supply and consumption demand shocks lead to a sharp fall in the net barter TOT, whereas economic activity shocks have almost negligible effects for the first few months. Especially, economic activity shocks even increase the income TOT significantly for several months with the expansion in export volumes. Second, structural oil shocks can explain more than 85% and 35% of the net barter TOT and the income TOT at 12-month forecast horizon, respectively. Third, the effects of structural oil shocks on the TOT are asymmetric, with most positive shocks having larger effects than negative ones. Lastly, the negative effects of oil supply and consumption demand shocks on the net barter TOT have strengthened in recent years. Originality/value - Despite the close relationship between oil prices and TOT, there is little research comprehensively analyzing the heterogeneous effects of structural oil shocks on TOT. This study fills this gap by examining how Korea’s TOT reacts differently to each of the structural oil shocks and quantifying the significance for its fluctuation. Moreover, this study attempts to analyze the potential asymmetric and time-varying effects of structural oil shocks on Korea’s TOT. These results have important implications for policymakers in implementing effective monetary and exchange rate policies.