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

Since the beginning of 2000s the world economy has witnessed a sub-stantial 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 effects 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.