Energy and Monetary Policy in the Euro Area

We develop and estimate an open economy DSGE model for the euro area in which imported energy, priced in foreign currency, enters both consumption and production. Global energy prices and the exchange rate therefore jointly determine domestic inflation. We find that energy and exchange-rate disturbances account for the bulk of short-run volatility in headline euro area inflation, with energy price shocks driving most of the post-pandemic surge. Because energy and non-energy goods are poor substitutes, an adverse energy price shock raises import values, deteriorating the trade balance and depreciating the real exchange rate through the net-foreign-asset and UIP channels. The exchange-rate channel strengthens monetary transmission and improves the short-run inflation-output trade-off relative to a non-energy economy. Optimal policy can exploit this channel rather than looking through energy price shocks. However, the case for looking through such shocks becomes stronger when the central bank assigns a greater weight to output gap stabilization and prices become stickier.