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Oil Price Shocks, Macroeconomic Stability and Welfare in a Small Open Economy

  • Deren Unalmis
  • Ibrahim Unalmis
  • Derya Filiz Unsal

Since the beginning of 2000s the world economy has witnessed a substantial increase in oil prices, which is seen to be an important source of economic fluctuations, causing high inflation, unemployment and low or negative growth rates. Recent experience, however, has not validated this view. Despite rising oil prices, world output growth has been strong, and although inflation has recently been increasing, it is relatively much lower compared with the 1970s. This paper focuses on the causes of oil price increases and their macroeconomic effects. Different from most of the recent literature on the subject, which understands the price of oil to be an exogenous process, we model the price of oil endogenously within a dynamic stochastic general equilibrium (DSGE) framework. Specifically, using a new Keynesian small open economy model, we analyse the e¤ects of an increase in the price of oil caused by an oil supply shock and an oil demand shock. Our results indicate that the effects of an oil demand shock and an oil supply shock on the small open economy are quite different. In addition, we investigate the sensitivity of the general equilibrium outcomes to the degrees of oil dependence and openness, as well as the strength of the response of monetary policy authority to the inflation. Finally, we evaluate the welfare implications of alternative monetary policy regimes.

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Paper provided by Research and Monetary Policy Department, Central Bank of the Republic of Turkey in its series Working Papers with number 0802.

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Date of creation: 2008
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Handle: RePEc:tcb:wpaper:0802
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  1. Helmut Reisen, 1998. "Sustainable and Excessive Current Account Deficits," OECD Development Centre Working Papers 132, OECD Publishing.
  2. Andrew Levin & Volker Wieland & John C. Williams, 2003. "The Performance of Forecast-Based Monetary Policy Rules Under Model Uncertainty," American Economic Review, American Economic Association, vol. 93(3), pages 622-645, June.
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  17. Kilian, Lutz, 2005. "Exogenous Oil Supply Shocks: How Big Are They and How Much do they Matter for the US Economy?," CEPR Discussion Papers 5131, C.E.P.R. Discussion Papers.
  18. Hamilton, James D, 1983. "Oil and the Macroeconomy since World War II," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 228-48, April.
  19. Milesi-Ferretti, G.M. & Razin, A., 1997. "Origins of Sharp Reductions in Current Account deficits: An Empirical Analysis," Papers 25-97, Tel Aviv.
  20. G. Russell Kincaid & Martin Fetherston & Peter Isard & Hamid Faruqee, 2001. "Methodology for Current Account and Exchange Rate Assessments," IMF Occasional Papers 209, International Monetary Fund.
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