The Impact of Oil Shocks in a Small Open Economy New-Keynesian Dynamic Stochastic General Equilibrium Model for South Africa

This paper studies the effects of foreign (real) oil price shocks on key macroeconomic variables for South Africa: a net-importer of oil. We develop and estimate a small open economy new-Keynesian dynamic stochastic general equilibrium model with a role for oil in consumption and production. The substitutability of oil for capital and consumption goods is low, import price pass-through is incomplete, domestic and foreign prices and wages are sticky, and the uncovered interest rate parity condition holds imperfectly. Foreign real oil price shocks have a strong and persistent effect on domestic production and consumption activities and, hence, are a fundamental driver of output, inflation and interest rates in both the short- and long-run. Oil price shocks also generate a trade-off between output and inflation stabilisation. As a result, episodes of endogenous tightening of monetary policy slow the recovery of South Africa's real economy. Our findings go further to suggest an important role for oil prices in predicting the South African output during and after the recession that followed the 2008 global financial crisis.