## _wp09285 - References

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### Introduction and contribution
- Purpose: analyze impacts of oil price movements caused by different sources (increase in aggregate demand, unexpected oil supply disruption, precautionary oil demand) on an oil-importing small open economy (SOE) and on the rest of the world (ROW).
- Key modeling choices:
  - Sticky-price DSGE model with oil included in the production function.
  - World economy composed of a domestic SOE (negligible effect on world) and a continuum of other small open economies; ROW treated as a closed economy where oil price is determined.
  - Oil supply follows an exogenous stationary AR(1) process; precautionary demand introduced via temporary oil stock build-up.
- Main claim: distinguishing between causes of oil price shocks is crucial for identifying impacts on macro variables and for designing appropriate policy responses.

### Model structure (SOE and ROW)
- Agents and sectors:
  - Representative household maximizing lifetime utility with consumption composite Ct of domestic and imported goods (CES) and labor Nt.
  - Firms produce differentiated goods using labor and imported oil input; Calvo pricing with probability θ that a firm cannot change price in a period.
  - Government with home-biased spending; balanced budget each period via lump-sum taxation.
  - Monetary authority follows a Taylor rule.
- Key equations and mechanisms:
  - Phillips curve: marginal-cost-based New Keynesian Phillips Curve (equation (9)).
  - IS curve and uncovered interest parity stemming from complete international financial markets.
  - Oil real price in ROW (log-linearized): equation (16)
    - pstilde_o = Γ1 * y* - Γ2 * g* - Γ3 * y*_G? + Γ4 * b* + Γ5 * s_t_o   (text notation: s_t d_t o = o*; see (16) for full form).
  - Oil market with precautionary demand (expected future shortage): equation (18), which adds the expected future supply shortfall term Δm to the real oil price.

### Calibration and baseline parameter values (selected)
- Time unit: quarters.
- β = 0.99 (implying a riskless annual return of approximately 4 percent in steady state).
- σ = 1 (log utility).
- φ (inverse of labor supply elasticity) = 3.
- α (degree of openness) = 0.4.
- η (share of labor in production) = 0.983 (implying share of oil in production (1-η) = 1.7 percent).
- θ (Calvo parameter) = 0.75.
- ε (elasticity of substitution among differentiated goods) = 6 (flexible-price mark-up μ = 1.2).
- Monetary policy coefficients: ϕπ = 1.5 and ϕy = 0.5 (original Taylor estimates).
- Persistence parameters for shocks (foreign labor productivity ρ_a*, oil efficiency ρ_b*, government spending ρ_g, oil supply ρ_o) set to 0.9.
- Share of government purchases in GDP = 20 percent.

### Impulse response scenarios and key dynamic findings
- Aggregate demand shocks (ROW) — two cases:
  - Foreign labor productivity increase (1 percent shock in figures):
    - Higher labor productivity raises world oil demand (positive output effect dominates substitution away from oil).
    - World real oil price rises while CPI inflation in ROW falls because marginal costs decline.
    - In SOE: with spillover (0.3 percent domestic productivity response per 1 percent foreign), SOE output rise is higher and more persistent; real oil price rise is higher in SOE with spillover due to lesser currency appreciation; CPI behavior similar with/without spillover.
    - Conclusion: higher oil prices do not necessarily imply higher inflation and lower output when driven by productivity shocks.
  - Government spending increase (1 percent shock in figures):
    - Raises world aggregate demand and real oil price; CPI inflation and nominal interest rates rise in ROW.
    - In SOE: output declines below steady state (two channels: decreased ROW private consumption reduces ROW import demand; real exchange rate depreciation of SOE has offsetting effect but is weaker), CPI inflation in SOE increases.
    - Conclusion: different aggregate demand shocks (productivity vs government spending) that both raise oil price can have opposite effects on CPI and output.

- Unanticipated oil supply shock (10 percent negative oil supply shock; Figure 3):
  - A 10 percent decline in world oil supply leads to an immediate, almost one-for-one, jump in the world real oil price.
  - ROW: output declines and CPI inflation rises for two reasons:
    1. Direct reduction in world output through production function (less oil input).
    2. Higher oil price increases marginal costs → higher CPI; monetary policy raises nominal interest rate → higher real interest rate that further depresses output.
  - Under baseline calibration (symmetry and equal distribution of oil revenue), responses of SOE and ROW are symmetric and real exchange rate effect is negligible.

- Precautionary demand (expected negative oil supply shock of 10 percent; Figure 4):
  - Timing: at time t, agents learn of a possible oil supply disruption in period t+1; firms in ROW build oil reserves in period t equal to expected shortage, producing an immediate precautionary demand.
  - Immediate (period t) effects:
    - Real oil price jumps above steady state (expectations-driven).
    - Output declines in both SOE and ROW because oil is reserved for future use.
    - CPI inflation rises in both SOE and ROW in period t.
    - Real exchange rate appreciates slightly (small effect).
  - Two alternative period t+1 outcomes:
    - Expectation not realized:
      - Producers deplete stocks in t+1 → oil demand and real oil price fall sharply in t+1; in t+2 variables return to steady state.
      - The price fall in t+1 stimulates output growth above steady state in both ROW and SOE.
    - Expectation realized (supply actually declines in t+1):
      - Real oil price returns to steady state in t+1 because the supply decline is offset by the earlier stock build-up (firms use reserves).
      - CPI inflation in ROW and SOE decreases in t+1.

### Policy implications and recommendations
- Distinguish the origin of oil price shocks when designing macroeconomic policy responses; shocks with identical oil price outcomes can require opposite policy responses because of differing effects on marginal costs, inflation, and output gap.
- A direct monetary policy response to oil prices (e.g., adjusting interest rate based on oil price inflation) is likely suboptimal:
  - Oil prices exhibit high short-run volatility driven by expectations (precautionary demand), so excluding oil prices can improve measurement of underlying inflation trends.
  - Uncertainty about shock origins implies that raising interest rates in response to an oil-price rise that is driven by foreign productivity increases could unnecessarily contract output and move economy away from steady state.
- Operational conduct of monetary policy should focus on inflation and output-gap dynamics as the monetary authority's objectives and account for the different transmission channels of oil shocks.

### Additional model insights and extensions
- Modelling SOE and ROW together allows identification of real exchange rate and trade channels transmitting global shocks to the SOE; treating oil price as exogenous for SOE can be misleading.
- Precautionary oil demand mechanism explains sharp expectation-linked oil price volatility not attributable to contemporaneous macro fundamentals.
- Suggested extensions: welfare evaluation, incorporation of wage rigidity, habit persistence, wage indexation, and financial frictions to study optimal policy and normative conclusions (not covered in this unit).

*Source: IMF Working Paper — Section 4, "Impulse Responses to 10 Percent Expected Negative Oil Supply Shock."*

### References .............................................................................................................

### _wp09285 - References

### Tables
- 1.   Model in Log-Linearized Form: Behavioral Equations for SOE ...................................5
- 2.   Model in Log-Linearized Form: Behavioral Equations for the ROW 
                 and the Oil Market ..................................................................................................10
- 3.   Model in Log-Linearized Form: Parameters ................................................................10
- 4.   Model in Log-Linearized Form: Exogenous Processes ...............................................11
- 5.   Parameters Values Used in Calibration .......................................................................13

### Appendix: Equilibrium Conditions
- A. Households and Goods Market Equilibrium in SOE ....................................................19
- B. Marginal Cost and Inflation Dynamics .........................................................................20
- C. Rest of the World and Oil Market Equilibrium .............................................................21

### Appendix Figures
- 1.   Impulse Responses to 1 Percent Labor Productivity Shock ........................................22
- 2.   Impulse Responses to 1 Percent Government Spending Shock ...................................23
- 3.   Impulse Responses to 10 Percent Negative Oil Supply Shock ....................................24

*Source: _wp09285 - References (page listings and appendices).*

### 4.   Impulse Responses to 10 Percent Expected Negative Oil Supply Shock ....................25

### 4.   Impulse Responses to 10 Percent Expected Negative Oil Supply Shock

### Introduction and contribution
- Purpose: analyze impacts of oil price movements caused by different sources (increase in aggregate demand, unexpected oil supply disruption, precautionary oil demand) on an oil-importing small open economy (SOE) and on the rest of the world (ROW).
- Key modeling choices:
  - Sticky-price DSGE model with oil included in the production function.
  - World economy composed of a domestic SOE (negligible effect on world) and a continuum of other small open economies; ROW treated as a closed economy where oil price is determined.
  - Oil supply follows an exogenous stationary AR(1) process; precautionary demand introduced via temporary oil stock build-up.
- Main claim: distinguishing between causes of oil price shocks is crucial for identifying impacts on macro variables and for designing appropriate policy responses.

### Model structure (SOE and ROW)
- Agents and sectors:
  - Representative household maximizing lifetime utility with consumption composite Ct of domestic and imported goods (CES) and labor Nt.
  - Firms produce differentiated goods using labor and imported oil input; Calvo pricing with probability θ that a firm cannot change price in a period.
  - Government with home-biased spending; balanced budget each period via lump-sum taxation.
  - Monetary authority follows a Taylor rule.
- Key equations (log-linearized behavioral blocks summarized in text and Appendix):
  - Phillips curve: marginal-cost-based New Keynesian Phillips Curve (equation (9)).
  - IS curve and uncovered interest parity stemming from complete international financial markets.
  - Oil real price in ROW (log-linearized): equation (16)
    - pstilde_o = Γ1 * y* - Γ2 * g* - Γ3 * y*_G? + Γ4 * b* + Γ5 * s_t_o   (text notation: s_t d_t o = o*; see (16) for full form).
  - Oil market with precautionary demand (expected future shortage): equation (18), which adds the expected future supply shortfall term Δm to the real oil price.

### Calibration and baseline parameter values (selected)
- Time unit: quarters.
- β = 0.99 (implying a riskless annual return of approximately 4 percent in steady state).
- σ = 1 (log utility).
- φ (inverse of labor supply elasticity) = 3.
- α (degree of openness) = 0.4.
- η (share of labor in production) = 0.983 (implying share of oil in production (1-η) = 1.7 percent).
- θ (Calvo parameter) = 0.75.
- ε (elasticity of substitution among differentiated goods) = 6 (flexible-price mark-up μ = 1.2).
- Monetary policy coefficients: ϕπ = 1.5 and ϕy = 0.5 (original Taylor estimates).
- Persistence parameters for shocks (foreign labor productivity ρ_a*, oil efficiency ρ_b*, government spending ρ_g, oil supply ρ_o) set to 0.9.
- Share of government purchases in GDP = 20 percent.

### Impulse response scenarios and key dynamic findings
- Aggregate demand shocks (ROW) — two cases considered:
  - Foreign labor productivity increase (1 percent shock in figures):
    - Higher labor productivity raises world oil demand (positive output effect dominates substitution away from oil).
    - World real oil price rises while CPI inflation in ROW falls because marginal costs decline.
    - In SOE: with spillover (0.3 percent domestic productivity response per 1 percent foreign), SOE output rise is higher and more persistent; real oil price rise is higher in SOE with spillover due to lesser currency appreciation; CPI behavior similar with/without spillover.
    - Conclusion: higher oil prices do not necessarily imply higher inflation and lower output when driven by productivity shocks.
  - Government spending increase (1 percent shock in figures):
    - Raises world aggregate demand and real oil price; CPI inflation and nominal interest rates rise in ROW.
    - In SOE: output declines below steady state (two channels: decreased ROW private consumption reduces ROW import demand; real exchange rate depreciation of SOE has offsetting effect but is weaker), CPI inflation in SOE increases.
    - Conclusion: different aggregate demand shocks (productivity vs government spending) that both raise oil price can have opposite effects on CPI and output.

- Unanticipated oil supply shock (10 percent negative oil supply shock; Figure 3):
  - A 10 percent decline in world oil supply leads to an immediate, almost one-for-one, jump in the world real oil price.
  - ROW: output declines and CPI inflation rises for two reasons:
    1. Direct reduction in world output through production function (less oil input).
    2. Higher oil price increases marginal costs → higher CPI; monetary policy raises nominal interest rate → higher real interest rate that further depresses output.
  - Under baseline calibration (symmetry and equal distribution of oil revenue), responses of SOE and ROW are symmetric and real exchange rate effect is negligible.

- Precautionary demand (expected negative oil supply shock of 10 percent; Figure 4):
  - At time t, agents learn of a possible oil supply disruption in period t+1; firms in ROW build oil reserves in period t equal to expected shortage, producing an immediate precautionary demand.
  - Immediate (period t) effects:
    - Real oil price jumps above steady state (expectations-driven).
    - Output declines in both SOE and ROW because oil is reserved for future use.
    - CPI inflation rises in both SOE and ROW in period t.
    - Real exchange rate appreciates slightly (small effect).
  - Two alternative period t+1 outcomes:
    - Expectation not realized:
      - Producers deplete stocks in t+1 → oil demand and real oil price fall sharply in t+1; in t+2 variables return to steady state.
      - The price fall in t+1 stimulates output growth above steady state in both ROW and SOE.
    - Expectation realized (supply actually declines in t+1):
      - Real oil price returns to steady state in t+1 because the supply decline is offset by the earlier stock build-up (firms use reserves).
      - CPI inflation in ROW and SOE decreases in t+1.

### Policy implications and recommendations
- Distinguish the origin of oil price shocks when designing macroeconomic policy responses; shocks with identical oil price outcomes can require opposite policy responses because of differing effects on marginal costs, inflation, and output gap.
- A direct monetary policy response to oil prices (e.g., adjusting interest rate based on oil price inflation) is likely suboptimal:
  - Oil prices exhibit high short-run volatility driven by expectations (precautionary demand), so excluding oil prices can improve measurement of underlying inflation trends.
  - Uncertainty about shock origins implies that raising interest rates in response to an oil-price rise that is driven by foreign productivity increases could unnecessarily contract output and move economy away from steady state.
- Operational conduct of monetary policy should focus on inflation and output-gap dynamics as the monetary authority's objectives and account for the different transmission channels of oil shocks.

### Additional model insights and extensions
- Modelling SOE and ROW together allows identification of real exchange rate and trade channels transmitting global shocks to the SOE; treating oil price as exogenous for SOE can be misleading.
- Precautionary oil demand mechanism explains sharp expectation-linked oil price volatility not attributable to contemporaneous macro fundamentals.
- Suggested extensions: welfare evaluation, incorporation of wage rigidity, habit persistence, wage indexation, and financial frictions to study optimal policy and normative conclusions (not covered in this unit).

*Source: IMF Working Paper — Section 4, "Impulse Responses to 10 Percent Expected Negative Oil Supply Shock."*

### REFERENCES

### REFERENCES

### Literature on oil prices and the macroeconomy
- Backus, D. K., P. J. Kehoe, and F. E. Kydland, 1992, “International Real Business Cycles,” The Journal Political Economy, Vol. 100, No. 4, pp. 745–775.
- –––––––– and M. J. Crucini, 2000, “Oil Prices and the Terms of Trade,” Journal of International Economics, Vol. 50, pp. 185–213.
- Barsky, R. B. and L. Kilian, 2004, “Oil and the Macroeconomy Since the 1970s,” Journal of Economic Perspectives, Vol. 18, No. 4, pp. 115–134.
- Hamilton, J. D., 1983, “Oil and the Macroeconomy Since World War II,” The Journal of Political Economy, Vol. 91, No. 2, pp. 228–248.
- –––––––––,1996, “This is What Happened to the Oil Price-Macroeconomy Relationship,” Journal of Monetary Economics, Vol. 38, pp. 215–220.
- Hamilton, J. D., 2008, “Oil and the Macroeconomy,” in The New Palgrave Dictionary of Economics, ed. by S. Durlauf and L. Blume, (forthcoming).
- Kilian, L., 2008a, “Exogenous Oil Supply Shocks: How Big Are They and How Much Do They Matter for the U.S. Economy?” Review of Economics and Statistics, Vol. 90, No. 2, pp. 216–240.
- ––––––––, 2008b, “The Economic Effects of Energy Price Shocks,” Journal of Economic Literature, (December), Vol. 46, No.4, pp. 871–909.
- ––––––––, 2009, “Not All Price Shocks are Alike: Disentangling Demand and Supply Shocks in the Crude Oil Market,” American Economic Review, Vol. 99, No. 3, pp. 1053–69.
- Kilian, L., A. Rebucci, and N. Spatafora, 2007, “Oil Shocks and External Balances,” IMF Working Paper 07/110 (Washington: International Monetary Fund).
- Segal, P., 2007, “Why Do Oil Price Shocks No Longer Shock?” OIES Working Paper, WPM 35 (Oxford, United Kingdom: Oxford Institute for Energy Studies).

### Monetary policy, inflation, and macroeconomic modeling
- Bernanke, B. S., M. Gertler, and M. Watson, 1997, „Systematic Monetary Policy and the Effects of Oil Price Shocks,” Brookings Papers on Economic Activity, Vol. 1, pp. 91–142.
- Blanchard, O. J. and J. Gali, 2008, “The Macroeconomic Effects of Oil Price Shocks: Why Are the 2000s So Different From the 1970s?” in International Dimensions of Monetary Policy, ed. by J. Gal and M. Gertler (Chicago: University of Chicago Press).
- Bodenstein, M., C. J. Erceg and L. Guerrieri, 2008, “Optimal Monetary Policy with Distinct Core and Headline Inflation Rates,” Journal of Monetary Economics, Vol. 55, pp. S18–S33.
- Calvo, G., 1983, “Staggered Prices in a Utility-Maximizing Framework,” Journal of Monetary Economics, Vol. 12, pp. 383–98.
- Clarida, R., J. Gali, and M. Gertler, 2001, “Optimal Monetary Policy in Open vs Closed Economies:An Integrated Approach,” American Economic Review, Vol 91, No. 2, pp. 248–252.
- Leduc, S. and K. Sill, 2004, “A Quantitative Analysis of Oil-Price Shocks, Systematic Monetary Policy, and Economic Downturns,” Journal of Monetary Economics, Vol. 51, 781–808.
- Monacelli, T. , 2005, “Monetary Policy in a Low Pass Through Environment,” Journal of Money, Credit and Banking, Vol. 37, No. 6, pp. 1047–1066.
- Rotemberg, J. and M. Woodford, 1996, “Imperfect Competition and the Effects of Energy Price Increases on Economic Activity,” Journal of Money, Credit, and Banking, Vol. 28, No. 1, pp. 550–577.
- Woodford, M., 2003, Interest and Prices: Foundations of a Theory of Monetary Policy, (New Jersey: Princeton University Press).
- ––––––––, 2007, “Globalization and Monetary Control”, NBER Working Paper No.13329 (Cambridge, Massachusetts: National Bureau of Economic Research).

### Open economy, small-economy, and welfare analyses
- Campolmi, A., 2008, “Oil Price Shocks, Demand vs. Supply in a Two-Country Model,” MNB Working Papers, No. 2008/5 (Budapest: Magyar Nemzeti Bank).
- Elekdag, S. A. and D. Laxton, 2007, “Understanding the Link Between Oil Prices and the Economy,” Box 1.1 in World Economic Outlook, April 2007: Spillovers and Cycles in the Global Economy, World Economic and Financial Surveys (Washington: International Monetary Fund)
- ––––––––, R., Lalonde, D., Laxton, D., Muir, and P. A. Pesenti, 2008, “Oil Price Movements and the Global Economy: A Model-Based Assessment,” NBER Working Paper No. W13792 (Cambridge, Massachusetts: National Bureau of Economic Research).
- Gali, J., J. D. Lopez-Salido, and L. J. Valles, 2007, “Understanding the Effects of Government Spending on Consumption,” Journal of the European Economic Association, Vol. 5, No. 1, pp. 227–270.
- –––––––– and T. Monacelli, 2005, “Monetary Policy and Exchange Rate Volatility in a Small Open Economy,” Review of Economic Studies, Vol. 72, pp. 707–734.
- Nordhaus, W. D, 2007, “Who's Afraid of a Big Bad Oil Shock?” Brookings Papers on Economic Activity, 2007:2 (Washington: Brookings Institution).
- Unalmis, D., I. Unalmis, and D. F. Unsal, 2008, “Oil Price Shocks, Macroeconomic Stability and Welfare in a Small Open Economy,” Central Bank of the Republic of Turkey Working Paper No. 08/02 (Ankara: Central Bank of the Republic of Turkey).

### Reviews and methodological critiques
- Hooker, M. A., 1996, “What Happened to the Oil Price-Macroeconomy Relationship?” Journal of Monetary Economics, Vol. 38, pp. 195–213.
- Kilian, L., 2008b, “The Economic Effects of Energy Price Shocks,” Journal of Economic Literature, (December), Vol. 46, No.4, pp. 871–909.
- Segal, P., 2007, “Why Do Oil Price Shocks No Longer Shock?” OIES Working Paper, WPM 35 (Oxford, United Kingdom: Oxford Institute for Energy Studies).

*Source: _wp09285 - REFERENCES*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp09285.pdf_