Traditional literature on energy economics gives a central role to exogenous political events (supply shocks) or to global economic growth (aggregate demand shock) in modeling the oil market. However, more recent literature claims that the increased precautionary demand for oil triggered by increased uncertainty about a future oil supply shortfall is also driving the price of oil. The intuition behind the precautionary demand is that since firms, using oil as an input in their production process, are concerned about the future oil prices, it is reasonable to think that in the case of uncertainty about future oil supply (such as a highly expected war in the Middle East), they will buy futures and/or forward contracts to guarantee a future price and quantity. We find that under baseline Taylor-type interest rate rule, real oil price, inflation and output loss overshoot and go down below steady state at the next period if uncertainties are not realized. However, if the shock is realized, i.e. followed by an actual supply shock, the effect on inflation and output loss is high and persistent.
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