Focus
How does news about future output affect current inflation in open economies? A large oil or gas discovery signals higher future national income, although extraction may take years to begin. We construct a new data set covering 1,309 large oil and gas discoveries across 79 economies from 1980 to 2019, focusing on those with realised production lags of at least five years. This provides a direct and observable measure of news about future output and allows us to separate anticipation effects from changes in physical supply. We then trace the dynamics of prices, real activity, external balances and exchange rates over the decade following the discovery.
Contribution
Our research uses large oil and gas discoveries as real-world news shocks with clearly defined dates. This approach avoids the model-dependent statistical assumptions typically used to infer unobserved news shocks, as estimates of their effects can be sensitive to assumptions that are difficult to test. Previous research has focused mainly on closed economies or on real economic activity. We instead examine how news about future output affects inflation in open economies, showing that the exchange rate regime plays a central role in this process. We explain these findings with a three-sector New Keynesian model of a small open economy.
Findings
We find that news of a large discovery leads to a persistent increase in core consumer prices over the decade that follows. About half of the total increase occurs before extraction begins. The effect is concentrated in non-tradable goods and services, whereas producer and tradable prices change little. Economic activity also expands before oil production starts, consistent with forward-looking behaviour. The real exchange rate appreciates persistently. The current account initially worsens as domestic demand increases, then turns to surplus when new oil production begins. Inflation rises mainly under inflexible exchange rate regimes but is largely absent under flexible regimes. Our three-sector New Keynesian model explains this difference. Flexible exchange rates absorb demand pressures through currency appreciation, while inflexible regimes experience higher domestic inflation.
Abstract
We study how news shocks affect inflation in open economies, using large oil and gas discoveries with realized production lags of at least five years as observable news about future output. Panel local projections show that discoveries raise core consumer prices over the subsequent decade, with about half the increase occurring prior to extraction. The response is driven by nontradables, while tradable and producer prices barely respond. The real exchange rate appreciates persistently and real activity expands ahead of extraction, while the current account first deteriorates and then improves as new oil comes online. The inflationary response is concentrated under inflexible exchange-rate regimes but muted under flexible ones. A three-sector New Keynesian small open economy model rationalizes these findings through competing demand and exchange rate channels, with exchange-rate policy determining which force dominates.
