Prepared by Benjamin Hunt.
Because adjustment is costly, prices and volumes respond gradually to disturbances, allowing a fundamental stabilization role for policy in GEM. The theoretical structure and the derivation of the model can be found in Pesenti (2003), and an extension of the model fully incorporating the oil market is explained in Hunt (2003).
The model structure implies that distribution costs are fixed in terms per unit. Consequently, the distribution sector has an effect similar to most types of energy taxes. Per unit taxes on energy goods lead to a smaller percentage increase in the retail price of energy than the percentage increase in the producer price of energy.
A half life of one year implies that the price of energy has moved half way back to its initial level after one year (from 50 percent to 25 percent above baseline).
From a modeling standpoint it is easier to achieve a desired path for energy prices by changing the producer markup than by changing the quantity of land available for energy production. Preliminary work suggests, however, that the source of the shock does not significantly affect its impact.
Simulations assuming that real energy prices are expected to return to baseline more gradually do not show an appreciably larger first-quarter impact on real GDP or headline CPI inflation. Even if the shock is expected to be permanent, the first quarter impact on real GDP is only 1 percent.
The two-country setup used for this analysis implies that the rest of the world (which includes energy exporters) experiences a positive terms of trade shock. Initially, output in the rest of the world declines by slightly more than in the United States, since production is assumed to be more energy-intensive. Especially under the more persistent shocks, however, the positive income effects eventually lead to a much smaller decline in absorption than in the United States. While the effect on other oil-importing countries would be similar to that in the United States, positive effects would essentially be confined to oil exporters.