DOI: 10.11648/j.ijeee.20261103.13 ISSN: 2575-5021

The UK Economy and Oil Price Shocks: An Empirical Assessment Under the New Keynesian Framework

Vivek Chauhan
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This study investigates the macroeconomic effects of the global oil price shocks on the United Kingdom from 2004 to 2024 within the framework of the New Keynesian (NK) model for small open economies. Employing reduced-form VAR and SVAR approaches, we analyse the dynamic responses of real GDP, inflation, the interest rate, and the real exchange rate to exogenous oil price movements. Beyond interpreting these effects, the study critically assesses how closely real-world outcomes align with NK model predictions. From VAR analysis, our findings (by interpretating impulse-response functions) largely validate the NK framework. For a positive oil price shock, it results in cost-push inflation by raising firms' marginal production costs. Inflation increases persistently in the short to medium term, while output contracts due to declining real income and tighter financial conditions. Monetary policy responds endogenously through interest rate hikes aimed at stabilizing inflation expectations, amplifying short-run output losses. The real exchange rate depreciates following adverse oil shocks, reflecting both deteriorating trade conditions and monetary tightening dynamics. While findings largely validate the NK model's qualitative implications, the study has its own diagnostic limitations such as non-normal residuals and model simplification. Overall, the study provides contribution to empirical evidence validating the relevance of the NK model framework, particularly for understanding oil price shocks to an open small economy.

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