Abstract
In this paper, we have built a New Keynesian DSGE model to quantitatively investigate two main issues concerning a small open economy: (1) whether incorporating oil as an intermediate input in the production process would help the New Keynesian DSGE model explain the cyclical properties of key macroeconomic variables; (2) whether the policy interventions on domestic oil prices would affect the economy’s responses to exogenous shocks. The numerical results suggest that in the model with nominal rigidities, the money supply shock plays a dominant role in explaining the volatility of the variables of interest. The role that oil-price shock plays in explaining the volatility of macroeconomic variables is limited, and this result is not substantially affected by the presence of nominal rigidities. Even if oil-price shock is included, the theoretical model still falls short of capturing the volatility of exchange rates. This paper also aims to explore the implications of alternative policy interventions on oil prices for the model dynamics. First, in response to domestic money supply shock, the zero pass-through regime may induce sharper rises in output, investment, utilization of capital for all periods than other policy interventions. Second, the responses to domestic productivity shock seem not to be substantially affected by policy interventions. Third, in response to an increase in foreign price level, the real domestic oil price rises. The complete pass-through regime would induce sharper declines in investment, consumption, and output in the short run than the zero pass-through regime. Fourth, in contrast with the foreign price level shock, an increase in foreign real interest rate induces an appreciation of real exchange rate. This further implies a decline in real domestic oil price under the complete pass-through regime. Thus, the complete pass-through regime would induce greater increases in the capital utilization, investment, and output than the zero pass-through regime. Lastly, in response to the real world price of oil shock, the zero pass-through regime markedly dampens the short-run effects of oil-price shocks on nominal and real variables.