Two Illustrations of the Importance of Dynamics for Modeling Energy-Capital Substitutability

摘要

Effects of high and uncertain oil prices upon the growth and stability of the economy are addressed. A key component is the effects of energy price increases on the level of capital investment. Energy price shock propagation through the economy also depends on how capital utilization is affected, and on whether changes in capital utilization dampen or amplify a shock arising in world oil markets. The straightforward way of ascertaining those effects is by estimating the elasticity of substitution between capital and energy, defined as the percentage change in the ratio of capital to energy inputs caused by a 1% increase in the price of energy relative to that of capital. Researchers have come to dramatically opposed conclusions in regard to the sign of the elasticity of substitution leading to uncertainty about prospects for the economy in the presence of changing energy prices and to confusion as to what policy measures might be appropriate. This report shows how errors in the specification of econometric models might be responsible for the contradictory results obtained by researchers. The authors then question whether correctly estimated elasticities of substitution can in principle provide unambiguous answers to questions about how energy price shocks affect the economy. Theoretical and numerical examples show that conventional substitution elasticities convey little useful information because knowing the sign of the elasticity of substitution is not sufficient to determine whether an oil price shock will alter demand for capital at any particular point in time. Even the accepted premise that energy and capital are complements in the short run and substitutes in the long run is shown to be of little help in predicting the dynamic response to an energy price shock. These results lead the authors to propose an alternative, explicitly dynamic approach to analyzing energy-capital substitutability. (ERA citation 10:043732)