Examining substitution and income effects of oil prices through the Environmental Kuznets Curve framework

This paper focuses on the decomposition of the substitution effect (SE) and income effect (IE) of oil prices within the framework of the EKC hypothesis. The objective is to analyze the contemporaneous impact of oil price shocks on other panel variables. Using panel data for G20 countries covering the period 1985-2022, the paper employs the PSVAR method for empirical analysis. Our results show that the EKC hypothesis is confirmed in G20 countries. Moreover, the SE is estimated to be negative and significant in the model where income is held constant, and oil price changes are allowed. In the model where oil prices are held constant and income changes are allowed, oil behaves as an inferior good at the beginning of economic growth. However, as economic growth progresses and income reaches a critical threshold, oil becomes a normal good. Substitution and income effects can foster sustainable growth by mitigating the environmental consequences of oil price fluctuations.