Impact of oil prices in an estimated EU12 open economy model

This paper adds oil prices to an estimated DSGE model for the euro area. The price of oil is an important macroeconomic driving factor for most industrialised countries. The euro area is importing most of its oil from abroad; therefore changes in oil prices have effects on domestic income via the trade balance and on domestic output, since oil is an intermediate input in production. We extend the production function by explicitly modelling final domestic output as a function of capital, labour and intermediate oil imports and we empirically identify the production effects. In a second step we use the model to analyse the short and long run price, income and output effects of temporary and permanent changes in oil prices and compare the effects we obtain to existing studies. In the estimation we devote special attention to the set of parameter coefficients ensuring saddle path stability of our forward looking model. The paper presents a simple mapping procedure, based on the filtering of Monte Carlo samples of model coefficients within prior bounds. A detailed sensitivity analysis of the RMSE’s of each single observed series versus model coefficients is shown, to further clarify the effect of including oil prices. Impulse response analysis will also be accompanied by a sensitivity analysis. The sensitivity analysis routines are an extension of the ones presented in Ratto et al (2005) at the time on a development phase presently part of DYNARE version 4.