...that of number of prominent non-linear specifications. The key findings are: (1) the new oil price specification is appropriate in both empirical and theoretical terms and allows for a well-founded distinction between "large" and "normal" oil price increases. (2) The observed impact of oil price shocks on real GDP growth is largely attributable to no fewer than three large oil price increases, namely those of 1973-74, 1979 and 1991, while variables such as consumer and import prices are also affected by normal oil price increases.

1. INTRODUCTION

A vast quantity of literature considering the relationship between oil price movements and manifold macroeconomic variables has been produced in the past decades, pursuing both theoretical and empirical strategies. On the empirical front, a concerted effort to determine the relationship between the oil price and fundamental macro variables has developed in the 1990s, with a specialization in the particular role of large oil price increases in this relationship emerging in recent times. It is these two related issues, the oil price-macro discussion and its more recent "large increase" offshoot, that form the core of this paper.

First, establishing this oil price-macro relationship has proven to be surprisingly difficult. The issues of linearity vs. non-linearity, symmetry vs. asymmetry, and stability vs. instability have been investigated in a large body of work. This sparked the introduction of a variety of non-linear oil price transformations [Mork, 1989; Lee et al., 1995; Hamilton, 1996] which have been included in traditional VAR models. This central theme, well-known to those familiar with the oil price literature, can be regarded as this study's reference point.

[FIGURE 1 OMITTED]

Second, in recent publications the impact of large oil price increases has received growing attention--Figure 1's plots of the real oil price vividly illustrate the dominance of such oil price hikes. (1) In particular, Huang et al. (2005) demonstrate by employing a multivariate threshold model that the oil price must exceed a certain threshold value in order to have a considerable effect on industrial production; Kapetanios and Tzevalis' (2004) application of a state space approach shows that large oil price increases reveal themselves to be responsible for the structural instability of the oil price-macroeconomy relationship. Although these "large increase" papers can be seen as an offshoot of the central theme mentioned above, they differ from the latter in that these papers do not employ standard VAR models.

This paper brings together these approaches and investigates the impact of large oil price increases within a traditional VAR framework. It considers the following issues for the US economy: firstly, a univariate Markov-switching (MS) analysis of the oil price is performed in order to get a better description of its thoroughly peculiar behavior. Secondly, based on this MS analysis, two new non-linear oil price specifications are introduced, which distinguish large oil price increases from normal ones. Including these specifications in VAR models of different dimensions enables one to evaluate whether or not these different-sized oil price increases also differently affect variables such as real GDP growth, short term interest rates and price level measures. Moreover, it is possible to compare these new specifications' explanatory power to that of a number of prominent nonlinear oil price specifications.

The following findings can be drawn from this study: (1) the new oil price specifications are appropriate in both empirical and theoretical terms and allow for a well-founded distinction between "large" and "normal" oil price increases, and (2) the observed impact of oil price shocks on US real GDP growth is largely attributable to no fewer than three large oil price increases--namely those of 1973-74, 1979 and 1991. Moreover, variables such as the consumer and the import prices are significantly affected by normal oil price increases.

The oil price-macro discussion owes its origin to work emanating from the early 1980s. Shortly after Sims' (1980) praise of VAR models, this method was embraced by the oil price-GDP literature [Hamilton, 1983; Burbidge and Harrison, 1984]. Subsequently, in the late 1980s and early 1990s, researchers were confronted with the finding that the oil price-GDP relationship collapsed, in that the oil price ceased Granger causing GDP measures. In response to that, various non-linear oil price transformations have been proposed. (2) Recent papers such as Hooker (1999) and Jiminez-Rodriguez and Sanchez (2005) employ these non-linear transformations in their empirical investigations. A more comprehensive motivation for the use of non-linear transformations has been developed over time; Jones et al. (2004) and Rogoff (2006) provide excellent surveys of this literature.

The rest of the paper is organized as follows. Section 2 briefly summarizes the discussion on non-linear oil price specifications and introduces the new MS based non-linear specifications; Section 3 outlines the modelling strategy. In Section 4 the results obtained from including both this paper's newly introduced and a number of prominent oil price specifications in different VAR models are presented and discussed. Section 5 offers some concluding remarks.

2. NON-LINEAR OIL PRICE SPECIFICATIONS

This section outlines the three prominent non-linear oil price specifications stemming from Mork (1989), Lee et al. (1995) and Hamilton (1996), proposed in response to the collapse of the oil price-GDP relationship asserted above and, furthermore, introduces the new MS based oil price specifications.

Mork (1989) finds that oil price increases and decreases do not have the same impact on real GDP and, therefore, simply divides oil price movements in increases and decreases. As this specification is rather simple, it is in stark contrast to the specification proposed by Lee et al. (1995). It takes into account that oil price movements after a long period of stability may have different effects than those in...

NOTE: All illustrations and photos have been removed from this article.



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