There is a large body of literature that claims that oil prices have a causal relationship with the macroeconomy. In light of recent developments in the oil market and the strength of the U.S. and Australian macroeconomies, the proposed relationship no longer appears valid. This thesis will examine the causal hypothesis for Australia, a country which has not been previously studied in the literature. As the first step in the estimations, the real trade weighted index is constructed for the period 1959 to 2006 in order to allow the study to extend from 1959 to 2006. Retracing the major developments in the international literature, it is found that oil prices have not had a causal relationship with either the level or growth rate of real GDP in Australia. The incorporation of asymmetric channels or alternate oil price specifications, as proposed in the literature, do not change these results. Yet, there is some evidence that the unemployment rate has been significantly affected by past oil price shocks.
Employing a new improved econometric technique proposed by Toda and Yamamoto (1995), the causal hypothesis is further examined in a more robust manner. Similar to before, the results suggest that oil price changes have only had a significant effect on the Australian unemployment rate. Pursuing these findings further in a vector error correction model, it is found that a long run relationship exists between global oil prices and the long run unemployment rate in Australia. This may reflect cost-push factors which have reduced the demand for labour. We propose that due to the use of limited data in past studies, exceptional events surrounding the occurrence of past oil price shocks, rigidities in the labour market, policy responses and institutional arrangements, the importance of oil price shocks on the macroeconomy has been unjustifiably magnified in the international literature