External Shocks and Optimal Monetary Policy in Oil Exporting Small Open Economies

  • Sunday Oladunni

Student thesis: Doctoral ThesisPhD


Using empirical and theoretical macroeconomic models, we explore external shocks, business cycle dynamics and optimal monetary policy in oil exporting small open economies. Paper one employs a sign restricted Bayesian structural vectorautoregression (BSVAR) to analyse how three external shocks, namely: global demand, oil price and the US monetary policy shocks impact on the Nigerian business cycle variables. Our main objective is to uncover the dominant drivers of the business cycle. The results show that the global demand shock and oil price shock are the principal foreign drivers of the Nigerian business cycle. The global demand shock contributes the most to the evolution of the domestic output growth and inflation while oil price shock exerts considerable pressure on the domestic interest rate and the terms of trade. Robustness exercise show that macroeconomic risk arising from the global demand shock is systematic, owing to its considerable impact on output and interest rate before and during the global financial crisis (GFC) of 2008/2009. However, the GFC increased inflation volatility. A policy package designed to maximise gains from positive global demand shocks, shield the domestic economy from effects of oil price oscillation and improve domestic economic resilience is advised.
Paper two builds a small open economy (SOE) New Keynesian dynamic stochastic
general equilibrium (NKDSGE) model that feature domestic and foreign production sectors. There is a representative monopolistically competitive domestic firm which sets price according to Calvo (1983a) scheme and a representative perfectly competitive oil firm which produces crude oil exclusive for export and takes oil price as given. Oil imported from the SOE is combined with a foreign intermediate good in the rest of the world (ROW) to produce foreign final good which is in turn, imported by the SOE for consumption. The model is closed with Taylor (1993)-type monetary policy rule. Model calibration matches standard SOE and oil exporting emerging economy characteristics. Macroeconomic response to a simulated positive oil price shock indicates evidence of Dutch disease. The exchange rate appreciates while interest rate falls in response to the non-oil output decline, induced by the Dutch disease. Domestic inflation targeting policy rule is the most welfare-friendly in the class of optimized simple rules while the commitment policy dominates both discretion and optimized simple rules.
In paper three, we construct a small open economy New Keynesian DSGE model
to capture important structural features of net oil exporting emerging economies.
We establish a direct connection between crude and refined oil prices and highlight the seeming structural chasm between domestic oil and non-oil sectors in some net oil exporting countries. Results of a negative oil price shock simulated on the model show that, in a zero oil price pass-through environment, the choice of the particular inflation measure to target in the Taylor rule does not matter. This is because macroeconomic responses to the shock under all monetary policy specifications are similar. Such similarity tends to indicate that full oil subsidy which guarantees a zero oil price pass-through interferes with monetary policy transmission mechanism in the model economy. In addition, the negative oil price shock precipitates stagflation which manifests via the income and exchange rate channels. Under the assumption of perfect labour mobility, the shock triggers movement of workers from the oil sector to the non-oil sector, thereby boosting non-oil productivity and output. The central bank responds to inflationary and exchange rate pressures by raising the interest rate. Tight external borrowing condition adds an extra layer of external vulnerability
to the negative oil price shock. Macroeconomic volatility is least palpable under the zero oil price pass-through scenario. The optimized simple rules policy exercise show that either core or oil inflation targeting maximizes welfare given zero oil price pass-through, while oil inflation targeting is welfare superior under partial or full oil price pass-through. Targeting core inflation seems the feasible optimal option for practical monetary policy purposes in net oil exporting small open economies.
Date of Award19 Feb 2020
Original languageEnglish
Awarding Institution
  • University of Bath
SponsorsCentral Bank of Nigeria
SupervisorChristopher Martin (Supervisor)


  • External Shocks, Sign Restrictions, Structural VAR, Oil Exporting Countries, NK DSGE Models, Optimal Monetary Policy

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