What is a Fossil Fuel Embargo Shock?

Abstract

In this paper, we focus on the impact of a occasionally binding quantity constraint on fossil fuel imports and compare the effects with those of an exogenous fossil fuel markup price shock. We show that while both shocks have similar responses to GDP and CPI inflation, they differ with respect to other macroeconomic components, such as consumption, exports, the trade balance and the functional income distribution.Our findings are relevant for policymakers when determining the most effective fiscal stabilization policy. We compare different temporary fiscal stabilization policies, such as energy tax reduction, transfer to liquidity-constrained households, and a valued-added tax cut. We find that fiscal policies are less effective in the case of an embargo shock. In particular a reduction of the energy tax is completely ineffective when there is an embargo. In contrast, in the event of a price markup shock, an energy tax reduction is effective because it counteracts the price increase and allows companies to respond according to their energy demands.In the case of an embargo, we show that transfer policies which redirect income to households receiving mostly labor income have good stabilization properties. However, this policy measure leads to a higher increase in all inflation rates which could widen the monetary policy trade-off between stabilizing output and inflation.

Keywords: Energy prices, embargo, general equilibrium model, Fiscal Policy