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Board of Governors of the Federal Reserve System (US)
Finance and Economics Discussion Series
Macroeconomic Implications of Oil Price Fluctuations : A Regime-Switching Framework for the Euro Area
Fédéric Holm-Hadulla
Kirstin Hubrich
Abstract

We investigate whether the response of the macro-economy to oil price shocks undergoes episodic changes. Employing a regime-switching vector autoregressive model we identify two regimes that are characterized by qualitatively different patterns in economic activity and inflation following oil price shocks in the euro area. In the 'normal regime', oil price shocks trigger only limited and short-lived adjustments in these variables. In the 'adverse regime', by contrast, oil price shocks are followed by sizeable and sustained macroeconomic fluctuations, with inflation and economic activity moving in the same direction as the oil price. The responses of inflation expectations and wage growth point to second-round effects as a potential driver of the dynamics characterizing the adverse regime. The systematic response of monetary policy works against such second-round effects in the 'adverse regime' but is insufficient to fully offset them. The model also delivers (conditional) probabilities for being (staying) in either regime, which may help interpret oil price fluctuations -- and inform deliberations on the adequate policy response -- in real-time.


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Fédéric Holm-Hadulla & Kirstin Hubrich, Macroeconomic Implications of Oil Price Fluctuations : A Regime-Switching Framework for the Euro Area, Board of Governors of the Federal Reserve System (US), Finance and Economics Discussion Series 2017-063, Jun 2017.
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Keywords: Regime Switching models ; Inflation ; Inflation expectations ; Oil prices ; Time-varying transition probabilities
DOI: 10.17016/FEDS.2017.063
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