Oil and Small Open Macroeconomy: A case of Korea

Abstract

The world oil price has risen significantly since the late 1990s and reached a record high in 2008. The recent oil price hike raises concerns regarding the possible negative effects of the rising oil price on the economy as in the 1970s. We investigate the effects of the oil price hike on the Korean economy using a Bayesian dynamic stochastic general equilibrium (DGSE) model. We explicitly model the small open economy nature of the Korean economy and its oil usage and estimate the constructed model within a unified Bayesian framework. We also examine possible changes in the effects of world oil shocks on the Korean economy using counterfactual simulations. We find the adverse effects of world oil shocks as well as their importance in Korean business cycles have diminished due to reductions in the relative usage of crude oil in the economy, while world oil shocks themselves have changed relatively little over time.

Keywords:

• Oil shocks
• small open economy
• DSGE model
• Bayesian estimation
• business cycles

JEL CLASSIFICATION:

• E32
• E37
• E47

Acknowledgement

We thank the participants in the 20^th NBER EASE conference for their valuable comments and suggestions. The second author would also like to thank Hankuk University of Foreign Studies for their research grant of 2011.

Notes

1. Data concerning key macro variables in the DSGE model, such as nominal interest rate, are available from 1991 in Korea. We choose this sample period accordingly.

2. We calibrate 0.376 and 0.084 for the sample period before 1990. The values are same as the calibrated values of α _n and α _cr based on the 1980 Korean input–output table in Section 4.1. The world subjective discount factor and the prior distributions of estimated parameters are set the same as before, as in Section 3.