Oil Price Shocks and Current Account Imbalances within a Currency Union.

• Author: Baas, Timo

1. INTRODUCTION

Global current-account imbalances have been a vital issue in the international policy debate for over two decades. The IMF and the G7 countries repeatedly pointed out the risks of large imbalances to the world economy's stability. These seem to have materialized in the government debt crisis that hit the European Union, especially the Eurozone, after 2010 and may reemerge with the Covid health crisis after 2020 and the energy crisis in 2022. Imbalances between member states in the Eurozone seem even more worrying, as an adjustment of exchange rates that drives balances back to equilibrium is not available. Instead, real prices and wages have to adjust. The adjustment of wages, however, depends on labor market institutions. As these institutions differ among member states, even symmetric shocks, such as, for instance, oil price shocks, can have asymmetric consequences. This paper focuses on oil price shocks, which seem to be among the leading sources of macroeconomic fluctuations. (1) Between 1999 and 2008, 2009 and 2014, and in 2022, the world economy experienced a period of increasing oil prices. In 2008, 2014, and 2020, however, oil prices sharply decreased. In June 2008, WTI crude oil was at 157.87 USD per barrel and dropped to 29.67 USD per barrel in January 2016. In October 2017, the WTI crude oil price was at 52.10 USD per barrel and collapsed during the Covid crisis to 16.94 USD. (2) Finally, during the energy crisis in March 2022, it increased to 124.85 USD. As a result of this development, we should see an increase in internal imbalances if oil-prices fall and decreasing balances if oil-prices rise. This effect, however, depends on the speed of adjustment of wages and prices. Therefore, it is crucial to examine the impact of an oil price shock on currency union members considering asymmetric labor market institutions. Furthermore, discussing possibilities for the common monetary authority to reduce these shocks' negative consequences in such a setting is essential.

To address these issues, we build a two-country DSGE model of a currency union and show the transmission of oil price shocks on the current account depending on two institutions, the central bank and labor markets. More specifically, our contribution to the literature is threefold: First, to all of our knowledge, we are the first to discuss oil price shocks in a currency union setting with imperfect labor markets. These imperfect labor markets decrease the speed of adjustment, so it takes ten quarters for half of the shock's impact on tradable production and five to eight quarters for half of the shock's impact on employment to be absorbed. Second, we discuss a central bank's possibilities to reduce the impact of an oil-price shock using different monetary targets. Targeting core inflation in the wake of oil price shocks is an inferior strategy decreasing the production of tradables twofold and shrinking employment by an additional one-third. However, the foreign country's foreign debt fluctuates one-fifth less, reducing current account imbalances within the currency union, which might benefit an asymmetric monetary union. Third, we discuss different kinds of labor market institutions that could reduce the burden of real adjustments. The more flexible labor markets are, the fewer costs a core inflation monetary policy target imposes. For example, reducing firing and vacancy posting costs, which was subject of the labor market reforms in a variety of European countries at the end of the 1990s and the beginning of the 2000s, reduces the impact of a positive oil price shock on tradable production by one-sixth, on employment by two-thirds, and on foreign debt of the foreign country, indicating the sum of current account imbalances, by one fourth.

Despite that research on oil price shocks in currency unions is scarce, there is a vivid debate about the impact of oil prices on global imbalances either directly or through a contractionary monetary policy. The direct effects of oil price shocks on the current account were first discussed in the late 1970s. Agmon and Laffer (1978) analyzed wealth and income effects following the oil crisis in 1973. They found that the balance of trade and the balance of payments of industrialized countries deteriorated markedly after the oil price shock. Kilian et al. (2009) confirm an increase in global imbalances driven by oil price shocks for the period before the economic and financial market crisis. Schubert (2014), using time-nonseparable preferences, theoretically explains the deterioration and the following gradual improvement over time. Like Agmon and Laffer (1978), Gao et al. (2014) see the adjustment burden on less energy-intensive products that react more elastic to income changes than oil or energy-intensive products. Using a general-equilibrium model, Backus and Crucini (2000) show that oil accounts for much of the variation in terms of trade over the last twenty-five years. Its quantitative role varies significantly over time. Kilian et al. (2009) pay attention to the non-oil tradable goods that are crucial in determining the size of the impact of oil price shocks on the current account. Le and Chang (2013) confirm these findings for Asian countries. In a recent empirical study, Bayraktar et al. (2016) find that in fragile countries, namely Indonesia, Brazil, India, South Africa, and Turkey, oil price fluctuations explain 13 percent of the current account deficit. In building a two-country DSGE model, Bodenstein et al. (2011) underpin these empirical findings theoretically and add that the simultaneous occurrence of multiple shocks can also cause the missing link, as are various sources of oil price movements and different propagation channels..

A second branch of the literature discusses the interdependence of oil price shocks and monetary policy. As prices of less oil-intensive products drop, Bernanke et al. (1997) see a tightening monetary policy as one reason for a strong real effect and a fast adjustment of the current account. Leduc and Sill (2004), using a DSGE model, find that 40 percent of the adjustment to oil prices results from monetary policy. Wang et al. (2020) also find a strong but significantly smaller impact of monetary policy on oil price shock absorption using a similar model. However, using alternate assumptions, Carlstrom and Fuerst (2006) deny such a strong impact. Similarly, Kilian and Lewis (2011) also found no evidence that monetary policy responses to oil price shocks had significant macroeconomic effects. In this context, Bodenstein et al. (2012) stress that the oil price shock source is crucial in determining the optimum monetary policy response. Bodenstein and Guerrieri (2011), using an estimated DSGE model, see links in non-oil trade as essential for transmitting shocks that affect oil prices. Bodenstein et al. (2013) argue that when policy rates reach their zero lower bound, shocks' propagation is changed. In sum, the empirical literature suggests a significant impact of oil price shocks on oil-importing and oil-exporting countries depending, among other things, on country-specific institutions, monetary policy, and the exchange rate regime. Gnimassoun et al. (2017) provide a recent and comprehensive literature review of studies that directly or indirectly treat the nexus between current accounts and oil prices. He concludes that despite the rising interest in the oil price-current account nexus, surprisingly few theoretical papers directly treat this issue.

Notwithstanding that we have learned from the literature that institutions are essential for the transmission of oil prices, very few papers address oil price shocks in an environment with imperfect labor markets. One of those papers is Herrera et al. (2017), who use a factor augmented vector autoregressive (FAVAR) model to analyze job-market behavior after an oil price shock. They show that the pace of gross job reallocation is slowing. This channel is essential in a monetary union, where the exchange rate as an adjustment mechanism is absent. More flexible labor markets help to reduce imbalances as prices and wages can adjust faster. Unfortunately for EMU, the quality of labor market institutions varies across member countries (de Pace, 2013), making the implementation of an optimum monetary policy more difficult. While labor markets are more flexible among northern members, they tend to be more rigid in the South (Bertola, 2017). For this reason, asymmetric labor markets may reduce the impact of oil price shocks in some countries, while the effect remains strong in others.

This paper explains how oil price shocks increase or decrease imbalances in a currency union like the Eurozone and how monetary policy might affect these. We take from the literature that any such model should include labor markets, as they are more rigid in the European Union than in the United States (Edmans et al., 2014; Zanetti, 2011; Krause et al., 2014; Krause and Uhlig, 2012a) and less integrated than financial markets. Therefore, labor markets may be one force that prevents real adjustment to oil price shocks. In this sense, flexible labor markets help reduce the costs of a common monetary policy in a heterogeneous currency union that aims to reduce current account imbalances. The remainder of this paper is organized as follows. The following section introduces the model; the third section presents the model's reaction to oil price shocks under different monetary policy...