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Appendices to: Oil Efficiency, Demand, and Prices: a Tale of

Ups and Downs

Martin Bodenstein and Luca Guerrieri


Federal Reserve Board

August 2011

Contents
A Appendix: Model Solution 2
A.1 Equilibrium Conditions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
A.1.1 Country-Specific Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
A.1.2 Bilateral Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
A.1.3 Important Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
A.1.4 Relationships Between Model Variables and Observed Data . . . . . . . . . . . . . 15
A.1.5 Decomposition of Marginal Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
A.2 Balanced Growth Path . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
A.2.1 Calibrated Expressions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
A.2.2 Composite Parameters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

B Appendix: Data 24

C Appendix: Plots of Data and In-Sample Forecast Errors 26

D Appendix: Plots of Smoothed Estimates of Shock Processes and Their Innovations 42

E Appendix: Interpreting Oil Efficiency Shocks 58

1
A Appendix: Model Solution
A.1 Equilibrium Conditions

This appendix summarizes the equilibrium conditions of the model both in nonlinear and linearized form.
The stochastic processes for the exogenous variables are presented in Table 1, in the main body of the
paper.
Xi,t

refers to the value of variable Xi at time t along the balanced growth path. Xi,0

is the initial
value of the variable at time 0. x̂i,t denotes the log-deviation of variable Xi at time t from its value along
the balanced growth path. xi,t denotes the absolute deviation of variable Xi at time t from its value along
the balanced growth path.

A.1.1 Country-Specific Relationships

1. First order condition for C1,t :

−1 C
P1,t
c
Z1,t C1,t − κ1 C1,t−1 = λq1,t d
, (1)
P1,t

where λq1,t = λc1,t P1,t


d
and λc1,t is the Lagrange multiplier on the households budget constraint. The
linearized equation is given by:
  d 
−1 c κ1 q Pc
  ĉ1,t + ẑ1,t − ĉ1,t−1 = λ̂1,t + . (2)
1 − µκ1 µz P d 1,t
z

2. First order condition for L1,t :

−χ0,1 (1 − L1,t )χ1 = λq1,t w1,t


f
. (3)

The linearized equation is given by:

L∗1,0 q
f
ŵ1,t = χ1 ˆl1,t − λ̂1,t . (4)
1 − L1,0

f d
Note, that w1,t is the desired real wage expressed in terms of P1,t .

3. Relationship between desired and actual wage:

2
(a) If wages are flexible:

f θw∗
1,0 w
w1,t = w1,t + w∗ θ̂ 1,t (5)
1 + θ1,0

(b) If wages are sticky:


 !−1 
X f

1+ τw W1,t+j d
P1,t+j W1,t ω l1,t,j 1 + θw1,t+j 
Et Ξw
1,t+j
 1 r
W1,t − d =0
j=0
θw
1,t+j P1,t+j W1,t+j W1,t+j w
θ1,t+j
w j
Ξw l
1,t+j = (ξ 1 ) ψ 1,t,t+j L1,t+j (h)ω 1,t,j . (6)

r W1,t (h)
The relative wage is defined as W1,t = W1,t
. The linearized equation is given by:
1 β1
(ω 1,t − ιw w
1 ω 1,t−1 ) − ∗ (ω 1,t+1 − ι1 ω 1,t )
π1

π1
w  
(1 − ξ w1 β 1 ) (1 − ξ 1 ) f θw
1 w
= ŵ1,t+j − ŵ1,t+j + θ̂1,t (7)
ξw1 1 + θw
1
1
As customary, in the numerical implementation we using the approximation π ∗1
(ω 1,t − ιw
1 ω 1,t−1 ) =

ω 1,t − ιw
1 ω 1,t−1 . See for example Smets and Wouters (2007).

4. Wage inflation ω 1,t :


 
W1,t
ω 1,t = log . (8)
W1,t−1
The linearized equation is given by:

ω 1,t = ŵ1,t − ŵ1,t−1 + π d1,t . (9)

5. First order condition for I1,t :


 2 !  
ψ i1 I1,t I1,t 1
0 = 1− i
q1,t Z1,t 1− − µz + i
q1,t Z1,t I1,t ψ i1 − µz
2 I1,t−1 I1,t−1 I1,t−1
 
i
P1,t+1 λc1,t+1 I1,t+1 I1,t+1
−β 1 i
q1,t+1 Z1,t+1 I1,t+1 ψ i1 − µz , (10)
i
P1,t λc1,t I1,t 2
I1,t
Q1,t
where q1,t = i λc
P1,t
and Q1,t is the Lagrange multiplier on the capital accumulation equation. The
1,t

linearized equation is given by:

i
q̂1,t + ẑ1,t = ψ i1 µ2z (ı̂1,t − ı̂1,t−1 ) − β 1 ψ i1 µ2z (ı̂1,t+1 − ı̂1,t ) . (11)

3
6. First order condition for K1,t :

d
P1,t λq1,t+1 R1,t+1
k i
P1,t+1 d
P1,t λq1,t+1
q1,t = β 1 + (1 − δ 1 )β q
1 1,t+1 d . (12)
i
P1,t λq1,t P1,t+1
d i
P1,t+1 P1,t λq1,t

The linearized equation is given by:


  \ i
! \ i
 \ i
!
q q β1 P β P P
q̂1,t = λ̂1,t+1 − λ̂1,t + 1− (1 − δ 1 ) k
r̂1,t+1 − 1
d
+ 1 (1−δ 1 ) q̂1,t+1 + 1
d
− 1
.
µz P1 t µ z P1 t+1 P1d t
(13)

7. Capital accumulation:
 2 !
ψi I1,t
i
K1,t = (1 − δ 1 ) K1,t−1 + Z1,t I1,t 1− 1 − µz . (14)
2 I1,t−1

The linearized equation is given by:


 
1 1 i

k̂1,t = (1 − δ 1 ) k̂1,t−1 + 1 − (1 − δ 1 ) ẑ1,t + ı̂1,t . (15)
µz µz

8. Consumption basket:
 ρo ρo
1+ρo1
1  1+ρ
1 1  1+ρ
1
(ω cc 1+ρo ne
(ω oc µtzo Z1,t
o c
o 1+ρo o
C1,t = 1 )
1 C1,t 1 + 1 )
1 O1,t 1 . (16)

The linearized equation is given by:


ĉ1,t = ω cc ĉ
1 1,t
ne
+ ω oc
1 o c
1,t + ẑ o
1,t . (17)

9. Nonoil consumption aggregate:


  c
ne
ρc
1
c 1+ρc1
 1
d 1+ρc1
ρc
1
mc 1+ρc1 m
 1 1+ρ1
c 1+ρc1
C1,t = (ω 1 ) C1,t + (ω 1 ) Z1,t M1,t . (18)

The linearized equation is given by:

 c 
ĉne c d mc
1,t = ω 1 ĉ1,t + ω 1
m
m̂1,t + ẑ1,t . (19)

4
d
10. First order condition for C1,t in consumption basket:

c  1 
 1+ρ
ρo
ne  1+ρ
1 ρc
P1,t ω cc
1 C1,t
o
1 ω c1 C1,t c
1

d ne d
= 1. (20)
P1,t C1,t C1,t

The linearized equation is given by:


\ 
P1c ρo1 ne
 ρc1 
− d − o
ĉ 1,t − ĉ 1,t − c
ĉne d
1,t − ĉ1,t = 0. (21)
P1 t 1 + ρ1 1 + ρ1

c
11. First order condition for M1,t in consumption basket:

m c   1+ρ
1 
ρo  1+ρ
ρc
1
P1,t P1,t C1,t o
1 ω mc ne
1 C1,t
c
1

d
= d
ω cc
1 ne m c
m
Z1,t . (22)
P1,t P1,t C1,t Z1,t M1,t

The linearized equation is given by:


\  \ 
P1m P1c ρo1 ne
 ρc1 ne c m
 m
d
= d
+ o
ĉ 1,t − ĉ 1,t + c
ĉ 1,t − m̂ 1,t − ẑ 1,t + ẑ1,t . (23)
P1 t P1 t 1 + ρ1 1 + ρ1

c
12. First order condition for O1,t in consumption basket:

o c   1+ρ
ρo
1
P1,t P1,t ω oc
1 C1,t
o
1

d
= d c c
µtzo Z1,t
c
. (24)
P1,t P1,t µtzo Z1,t O1,t

The linearized equation is given by:


\  \ 
P1o P1c ρo1 c o
 o
d
= d
+ o
ĉ 1,t − ô 1,t − ẑ 1,t + ẑ1,t . (25)
P1 t P1 t 1 + ρ1

13. Investment basket:


 ρc ρc
1+ρci
 1+ρ
i  1+ρ
1  1+ρ
i  1+ρ
1
ω i1
c d c
ω mi
c i i c
I1,t = i I1,t i + 1
i Z1,t M1,t i . (26)

The linearized equation is given by:

 i 
ı̂1,t = ω i1 ı̂d1,t + ω mi
1
m
m1,t + ẑ1,t . (27)

5
14. First order condition for Itd in investment basket:

 ρc
 1+ρ
1
i
P1,t ω i1 I1,t c
1

d d
= 1. (28)
P1,t I1,t

The linearized equation is given by:


\ 
P1i ρc1 
d
+ c
ı̂1,t − ı̂d1,t = 0. (29)
P1 t 1 + ρ1

i
15. First order condition for M12,t in investment basket:

 ρc
 1+ρ
1
m i
P1,t P1,t ω mi
1 I1,t
c
1
m
d
= d m i
Z1,t . (30)
P1,t P1,t Z1,t M1,t

The linearized equation is given by:


\  \ 
P1m P1i ρc1 
d
= d
+ c
ı̂1,t − mi12,t − ẑ1,t
m m
+ ẑ1,t . (31)
P1 t P1 t 1 + ρ1

16. Value added aggregator:


 ρv ρv
1+ρv1
 1+ρ
1 1  1+ρ
1  1+ρ
1
ω k1 ω l1 µtz Z1,t L1,t
v 1+ρv v v
V1,t = 1 (K1,t−1 ) 1 + 1 1 . (32)

The linearized equation is given by:


 
v̂1,t = φk1 k̂1,t−1 + φl1 ẑ1,t + ˆl1,t , (33)

with
  1+ρ
1
K1,0
∗ v
1
φk1 = ω k1 , (34)
ω k1 µz V1,0

  1+ρ
1
L∗1,0 v
1
φl1 = ω l1 , (35)
ω l1 V1,0

and φk1 + φl1 = 1.

6
17. Output aggregator:
 ρo ρo
1+ρo1
1
vy 1+ρo
1
o
1
oy 1+ρo t o y
 1+ρ
1
o
Y1,t = (ω 1 ) 1 (V1,t ) 1 + (ω 1 ) 1 µzo Z1,t O1,t
1+ρ 1 . (36)

The linearized equation is given by:



ŷ1,t = ω vy oy
1 v̂1,t + ω 1 ôy1,t + ẑ1,t
o
. (37)

18. First order condition for K1,t−1 in output aggregator:

  1+ρ ρv
1 
ρo  1+ρ
1
k
R1,t M C1,t Y1,t 1
o
ω k1 V1,t v
1

d
= d
ω vy
1 . (38)
P1,t P1,t V1,t K1,t−1

The linearized equation is given by:

k ρo1 ρv1  
r̂1,t c 1,t +
= mc (ŷ 1,t − v̂ 1,t ) + v̂ 1,t − k̂1,t−1 . (39)
1 + ρo1 1 + ρv1

19. First order condition for L1,t in output aggregator:

  1+ρ ρv
1 
ρo  1+ρ
1
1 W1,t M C1,t ω vy
1 Y1,t
o
1 ω l1 V1,t v
1

d
= d
. (40)
µtz Z1,t P1,t P1,t V1,t µtz Z1,t L1,t

The linearized equation is given by:

ρo1 ρv1  ˆ

ŵ1,t c 1,t +
= mc (ŷ1,t − v̂1,t ) + v̂1,t − ẑ1,t − l1,t + ẑ1,t . (41)
1 + ρo1 1 + ρv1

y
20. First order condition for O1,t in output aggregator:

  1+ρ
ρo
1
o
P1,t M C1,t ω oy
1 Y1,t
o
1

d
= d t o y µtzo Z1,t
o
. (42)
P1,t P1,t µzo Z1,t O1,t

The linearized equation is given by:


\ 
P1o ρo1 o
 o
d
= c
mc 1,t + o
ŷ1,t − ô1,t − ẑ1,t + ẑ1,t . (43)
P1 t 1 + ρ1

21. Evolution of marginal costs:

7
(a) If prices are flexible:
M C1,t 1 + τ p1
= . (44)
d
P1,t 1 + θp1,t
The linearized equation is given by:
1
c 1,t = −
mc θˆp 1,t . (45)
1 + θp∗
1,0

(b) If prices are sticky and export prices are set in the currency of the producer:
X ∞  
r p j 1 + τ p1 l d
P1,t (i) (ξ 1 ) ψ 1,t,t+j p π 1,t,j Y1,t+j (i)
j=0
θ 1,t+j
"∞ p
#
X p P d
M C1,t+j 1,t+j d 1 + θ 1,t+j
= (ξ 1 ) ψ 1,t,t+j d d
Y1,t+j (i) p , (46)
j=0
P1,t+j P1,t θ1,t+j

where
d
r
P1,t (i)
P1,t = d
(47)
P1,t
d
P1,t λc1,t+j
ψ 1,t,t+j = β j1 (48)
d
P1,t+j λc1,t
j
Y  ι
π l1,t,j = π d1,t−1+i (π ∗1 )1−ι (49)
i=1
p
!− 1+θp 1,t+j
d d l
d d
P1,t (i) P1,t π 1,t,j θ
1,t+j
Y1,t+j (i) = Y1,t+j d d
(50)
P1,t P1,t+j
or after simplifying
 !−1 
X

1+ τ p1 M C1,t+j d l
P1,t π 1,t,j 1+ θp1,t+j
Ξ1,t+j  p
r
P1,t −  =0
j=0
θ1,t+j d
P1,t+1 d
P1,t+j θp1,t+j
!− p
1
1+θ
p
c d l
p j λ1,t+j P1,t π 1,t,j θ
1,t+j
r
− θ
p
1,t+j
d
Ξ1,t+j = (ξ 1 β 1 ) P1,t 1,t+j Y1,t+j . (51)
λc1,t d
P1,t+j
The linearized equation is given by
 
1 d p d
 β1 d p d
 (1 − ξ p1 β 1 ) (1 − ξ p1 ) θp∗
1,0 p
π − ι1 π t−1 = ∗ π t+1 − ι1 π t + c 1,t +
mc p∗ θ̂ 1,t (52)
π ∗1 1,t π1 ξ p1 1 + θ1,0
In the numerical implementation we use the approximation typically used in the literature
p d

π
1
∗ π d
1,t − ι1 π t−1 = π d1,t − ιp1 π dt−1 . See, for example, Smets and Wouters (2007).
1

8
22. Government spending Gd1,t :

g
Gd1,t = g1 Z1,t d
Y1,t . (53)

The linearized equation is given by:

d d g
ĝ1,t = ŷ1,t + ẑ1,t . (54)

d
23. Market clearing condition for Y1,t :

d d d
Y1,t = I1,t + C1,t + Gd1,t + X1,t . (55)

The linearized equation is given by:


d∗ d∗
d
I1,0 d
C1,0 d
Gd∗
1,0 d
d∗
X1,0
ŷ1,t = ı̂
d∗ 1,t
+ ĉ
d∗ 1,t
+ ĝ
d∗ 1,t
+ x̂ .
d∗ 1,t
(56)
Y1,0 Y1,0 Y1,0 Y1,0

24. Oil demand O1,t :

c y
O1,t = O1,t + O1,t . (57)

The linearized equation is given by:


c∗ y∗
O1,0 O1,0
ô1,t = ∗ ô1,t + ∗ ôy1,t .
c
(58)
O1,0 O1,0

s rs
25. Nominal interest rate R1,t and real interest rate R1,t :

1 λq1,t+1 P1,t
d
= β . (59)
s
1 + R1,t λq1,t P1,t+1
d

The linearized equation is given by:


 q q

rs s
r1,t = r1,t − π d1,t+1 =− λ̂1,t+1 − λ̂1,t , (60)

s rs
assuming that β 1 /µz is close to 1. r1,t and r1,t are measured in absolute deviation from their values
along the balanced growth path.

9
s
26. Monetary policy reaction function i1,t = R1,t − 1:

y gap
i1,t = ī1 + γ i1 (i1,t−1 − ī1 ) + (1 − γ i1 )(π core π core core
1,t + γ 1 (π 1,t − π̄ 1,t ) + γ 1 y1,t ). (61)

The linearized equation is given by:

s y gap
r1,t = γ i1 r1,t−1
s
+ (1 − γ i1 )(π core π core core
1,t + γ 1 (π 1,t − π̄ 1,t ) + γ 1 y1,t ). (62)

ne
27. Core price level P1,t :

  1+ρ
ρo
1
ne c ω cc
1 C1,t
o
1
P1,t = P1,t ne
. (63)
C1,t

The linearized equation is given by:


\  \ 
P1ne P1c ρo1 ne

= + ĉ 1,t − ĉ 1,t
P1d t P1d t 1 + ρo1
 c \  !
1 \ P1 ω oc P1
o
= − 1cc o
− ẑ1,t . (64)
ω cc
1 P d
1 t ω 1 P d
1 t

In constructing the core price index the shock to oil efficiency enters, as this shock changes the
c
share of oil in the headline price index P1,t .

28. Inflation of domestic prices π d1,t :


!
d
P1,t
π d1,t = log d
. (65)
P1,t−1

29. Inflation of core prices:


 ne 
core
P1,t
π 1,t = log ne
. (66)
P1,t−1

The linearized equation is given by:


\  \ 
P1ne P1ne
π core
1,t = − + π d1,t . (67)
P1d t P1d t−1

10
30. Inflation of headline prices:
 c 
head
P1,t
π 1,t = log c
. (68)
P1,t−1

The linearized equation is given by:


\  \ 
P1c P1c
π head
1,t = − + π d1,t . (69)
P1d t P1d t−1

31. Aggregate imports M1,t :


m m
P1,t c
P1,t i
M1,t = d M1,t + d M1,t . (70)
P1,t P1,t

The linearized equation is given by:


\  ! \  !
c∗ i∗
M1,0 P1m c
M1,0 P1m
m̂1,t = ∗ + m̂1,t + ∗ + m̂i1,t , (71)
M1,0 P1d t M1,0 d
P1 t

as relative prices are calibrated to be 1 along the balanced growth path.

32. Aggregate exports X1,t :

1 c i

X1,t = M2,t + M2,t , (72)
ζ1
c i
as country 1’s real per capita exports X1,t and country 2’s real per capita imports M2,t + M2,t are
related through ζ 1 . The linearized equation is given by:
c∗ i∗
M2,0 c
M2,0
x̂1,t = c∗ i∗
m̂2,t + c∗ i∗
m̂i2,t . (73)
M2,0 + M2,0 M2,0 + M2,0

33. Trade balanced to gross output ratio:


o
P1,t o

N T1,tbal X1,t − M1,t + d
P1,t
Y1,t − O1,t
d d
= d
. (74)
P1,t Y1,t Y1,t

The linearized equation is given by:



o∗  
X1,0

M1,0
∗ o∗ o∗
P1,0 Y1,0 o o∗ ∗
P1,0 O1,0 o∗
P1,0 O1,0

− Y1,0 \
P1o
tbal
1,t = d∗ x̂2,t − d∗ m̂1,t + d∗ d∗ ŷ1,t − d∗ d∗ ô1,t − d∗ d∗
. (75)
Y1,0 Y1,0 P1,0 Y1,0 P1,0 Y1,0 P1,0 Y1,0 P1d t

11
34. Nonoil trade balance to gross output ratio:

N Gbal1,t X1,t − M1,t


d d
= d
. (76)
P1,t Y1,t Y1,t

The linearized equation is given by:


 ∗ ∗ 
bal
X1,0

M1,0

X1,0 M1,0 d
g1,t = d∗ x̂1,t − d∗ m̂1,t − d∗
− d∗ ŷ1,t . (77)
Y1,0 Y1,0 Y1,0 Y1,0

The conditions for country 2 are analogous.

A.1.2 Bilateral Relationships

35. Relative import prices under producer currency pricing:

(a) for country 1


m c d c
P1,t e1,t P2,t P2,t P1,t
d
= c c d
, (78)
P1,t P1,t P2,t P1,t
c
e1,t P2,t
where e1,t is the nominal exchange rate and rer1,t = c
P1,t
the consumption real exchange
rate. The linearized equation is given by:
\m \  \ 
P1,t P2c P1c
d
c 1,t −
= rer + . (79)
P1,t P2d t P1d t

(b) for country 2


\m \  \ 
P2,t P2c P1c
d
c 1,t +
= −rer − . (80)
P2,t P2d t P1d t

36. Uncovered interest rate parity condition:

λq2,t+1 P2,t
d c
P2,t+1 λq Pd Pc
b rer1,t+1 1,t+1 1,t 1,t+1
= φ1,t . (81)
λq2,t P2,t
c d
P2,t+1 rer1,t λq1,t P1,t
c d
P1,t+1

The linearized equation is given by:


 q q
  q q

λ̂2,t+1 − λ̂2,t = λ̂1,t+1 − λ̂1,t + φb1 b1,t + rer
c 1,t+1 − rer
c 1,t (82)
\  \  \  \ 
P1c P1c P2c P2c
− d + + − . (83)
P1 t P1d t+1 P2d t P2d t+1

12
37. Net foreign asset condition:
b
e1,t P2,t B1,t bal
= e1,t B1,t−1 + N T1,t . (84)
φb1,t

The linearized equation is given by:

βb1,t = b1,t−1 + tbal


1,t . (85)

e1,t B1,t−1
where b1,t−1 is the absolute deviation of d Yd
P1,t
from 0. tbal
1,t is the deviation of the trade balance
1,t

to gross output ratio from its value along the balanced growth path.

38. Oil market clearing condition:

o o
ζ 1 Y1,t + Y2,t = ζ 1 O1,t + O2,t . (86)

The linearized equation is given by:


o∗ o∗
ζ 1 Y1,0 o
Y2,0 o
ζ 1 O1,0

O2,0

o∗

o∗ 1,t
+ o∗

o∗ 2,t
= ô 1,t + ô2,t . (87)
ζ 1 Y1,0 + Y2,0 ζ 1 Y1,0 + Y2,0 ζ 1 O1,0

+ O2,0

ζ 1 O1,0

+ O2,0

39. Law of one price for oil:


o c d o
P1,t P1,t P2,t P2,t
d
= rer 1,t d c d
. (88)
P1,t P1,t P2,t P2,t

The linearized equation is given by:


\  \  \  \ 
P1o P1c P2c P2o
c 1,t +
= rer − + . (89)
P1d t P1d t P2d t P2d t

A.1.3 Important Definitions

40. Definition of GDP1,t using the Laspeyres index:

d o y o o
P1,t−1 Y1,t − P1,t−1 O1,t + P1,t−1 Y1,t
GDP1,t = GDP1,t−1 d o y o o
. (90)
P1,t−1 Y1,t−1 − P1,t−1 O1,t−1 + P1,t−1 Y1,t−1

13
The linearized equation is given by:
 o∗ y∗ o∗ o∗     µ 
P1,0 O1,0 P1,0 Y1,0
1 − d∗ d∗ + d∗ d∗ d d
gdp1,t − gdp1,t−1 − z
ŷ1,t − ŷ1,t−1
P1,0 Y1,0 P1,0 Y1,0 µgdp,1
o∗ y∗   o∗ o∗  
P1,0 O1,0 µo y y P1,0 Y1,0 µo o o
= − d∗ d∗ ô − ôt−1 + d∗ d∗ ŷ − ŷ1,t−1
P1,0 Y1,0 µgdp,1 t P1,0 Y1,0 µgdp,1 1,t
 o∗ y∗ o∗ o∗    \ 
P1,0 O1,0 P1,0 Y1,0 µo P1o
− d∗ d∗
− d∗ d∗ −1 . (91)
P1,0 Y1,0 P1,0 Y1,0 µgdp,1 P1d t−1

Absent trend growth the linear approximation of the Laspeyres index for GDP is a constant price
aggregate.

41. Ratio between nominal GDP and nominal gross output:


o y o o
N GDP1,t P1,t O1,t P1,t Y1,t
d
= 1 − d
+ d
. (92)
P1,t Y1,t P1,t Y1,t P1,t Y1,t

The linearized equation is given by:

∗  \   o∗ y∗ o∗ o∗  \ !
N GDP1,0 N GDP1 P1,0 O1,0 P1,0 Y1,0 P1o
d∗ d∗
= − d∗ d∗ ŷ1,t − (93)
P1,0 Y1,0 P1d Y1 t d∗ d∗
P1,0 Y1,0 P1,0 Y1,0 P1d t
o∗ y∗ o∗ o∗
P1,0 O1,0 y P1,0 Y1,0 o
− ô
d∗ d∗ 1,t
+ d∗ d∗ 1,t
ŷ . (94)
P1,0 Y1,0 P1,0 Y1,0

42. Oil price deflated by GDP deflator:


N GDP1,t−1
o GDP o d
P1,t P1,t−1 P1,t P1,t−1 d
P1,t−1 Y1,t−1 GDP1,t Y1,t−1
GDP o
= d Po N GDP1,t
. (95)
P1,t P1,t−1 P1,t 1,t−1 d Y
GDP1,t−1 Y1,t
P1,t 1,t

The linearized equation is given by:


 obs !  obs ! "   \  #
o
P1,t o
P1,t−1 N\ GDP1 N GDP1
log GDP
− log GDP
= − d
− − [ŷ1,t − ŷ1,t−1 ]
P1,t P1,t−1 P1 Y1 t P1d Y1 t−1
\  \ 
P1o P1o d 1,t − gdp
d 1,t−1
+ d − + gdp
P1 t P1d t−1
 
µzo µgdp,1
+ −1 . (96)
µz

14
43. Trade balance to GDP ratio:
bal bal d
N T1,t N T1,t P1,t Y1,t
= d . (97)
N GDP1,t P1t Y1,t N GDP1,t

The linearized equation is given by:


 \  d∗ d∗
N T1bal P1,0 Y1,0 bal
= t .
∗ 1,t
(98)
N GDP1 t N GDP1,0

44. Nonoil trade balance to GDP ratio:


!
N Gbal
1,t 1 d
X1,t P1,t M1,t
= N GDP1,t
− d . (99)
N GDP1,t d Y
Y1,t P1,t Y1,t
P1,t 1,t

The linearized equation is given by:


 \  ! 
N Gbal
1 1 X1,0
∗ d∗
P1,0 M1,0

N\
GDP1 1 bal
= − N GDP ∗ d∗
− d∗ d∗
+ g1,t (100)
P1d Y1 t N GDP1,0

N GDP1 t 1,0
d∗ d∗
Y1,0 P1,0 Y1,0 d∗ Y d∗
P1,0 Y1,0 P1,0 1,0

A.1.4 Relationships Between Model Variables and Observed Data

The observed data carries the superscript “obs”.

45. Observation equation for GDP:

  
obs
log GDP1,t obs
− log GDP1,t−1 d 1,t − gdp
= gdp d 1,t−1 + µgdp,1 − 1 . (101)

46. Observation equation for oil production:


   
o,obs o,obs o o
log Y1,t − log Y1,t−1 = ŷ1,t − ŷ1,t−1 + (µo − 1) . (102)

47. Observation equation for oil imports as share of GDP:


o o
 o  o 
P1,t O1,t − Y1,t P1td Y1,t P1,t O1,t Y1,t
= d
− . (103)
N GDP1,t N GDP1,t P1,t Y1,t Y1,t

15
The linearized equation is given by:
  "  #
\ d∗ d∗  ∗ o∗   \ 
P1o (O o
1 − Y1 ) P1,0 Y1,0 O1,0 Y1,0 N\
GDP1 P1o
= d∗
− ∗ − + − ŷ1,t
N GDP1 t N GDP1,0 ∗
Y1,0 Y1,0 P1d Y1 t P1d t
d∗ ∗  ∗ o∗ 
P1,0 Y1,0 O1,0 Y1,0 o
+ ô − ∗ ŷ1,t .
d∗ 1t
(104)
N GDP1,0 ∗
Y1,0 Y1,0

48. Observation equation for the price of oil:


 o obs !  o obs ! \  \ 
P1,t P1,t−1 P1o P1o µzo µgdp,1 − µz
log GDP
− log GDP
= − + . (105)
P1,t P1,t−1 P1GDP t P1GDP t−1 µz

d M
P1,t 1,t
49. Observation of nonoil import share N GDP1,t
:

d d d
P1,t M1,t P1,t M1,t P1,t Y1,t
= d . (106)
N GDP1,t P1,t Y1,t N GDP1,t

The linearized equation is given by:


 \  d∗  \ !
P1d M1 P1,0 M1,0

N GDP1,0∗
N GDP1
= d∗ d∗ d∗ d∗
m̂1,t − ŷ1,t − . (107)
N GDP1 t P1,0 Y1,0 P1,0 Y1,0 P1d Y1 t

d X
P1,t 1,t
50. Observation of nonoil export share N GDP1,t
:

d d d
P1,t X1,t P1,t X1,t P1,t Y1,t
= d . (108)
N GDP1,t P1,t Y1,t N GDP1,t

The linearized equation is given by:


 \  d∗ d∗  \ !
P1d X1 P1,0 X1,0 N GDP1,0∗
N GDP1
= d∗ d∗ d∗ d∗
x̂1,t − ŷ1,t − . (109)
N GDP1 t P1,0 Y1,0 P1,0 Y1,0 P1d Y1 t

51. Observation of the real exchange rate:

c obs
rer c 1,t .
1,t = rer (110)

16
c C
P1,t 1,t
52. Observation of consumption share N GDP1,t
:
c c d
P1,t C1,t P1,t C1,t P1,t Y1,t
= d . (111)
N GDP1,t P1,t Y1,t N GDP1,t

The linearized equation is given by:


 \  c∗ ∗ \   \ !
P1c C1 P1,0 C1,0 N GDP1,0∗
P1c N GDP1
= d∗ d∗ d∗ ∗
ĉ1,t + d
− ŷ1,t − . (112)
N GDP1 t P1,0 Y1,0 P1,0 Y1,0 P1 t P1d Y1 t

i I
P1,t 1,t
53. Observation of (fixed) investment share in GDP N GDP1,t
:
i c d
P1,t I1,t P1,t I1,t P1,t Y1,t
= d . (113)
N GDP1,t P1,t Y1,t N GDP1,t

The linearized equation is given by:


 \  c∗ ∗ \   \ !
P1i I1 P1,0 I1,0 N GDP1,0

P1i N GDP1
= d∗ d∗ d∗ d∗ ı̂1,t + d
− ŷ1,t − . (114)
N GDP1 t P1,0 Y1,0 P1,0 Y1,0 P1 t P1d Y1 t

54. Observation of core price inflation:

π core,obs
1,t = π core
1,t + (π 1 − 1).

(115)

55. Observation of wage inflation:

ω obs
1,t = ω 1,t . (116)

56. Observation of the nominal interest rate:

s,obs s
r1,t = r1,t . (117)

57. Cost minimization of firms implies for φk1 and φl1 :


  1+ρ
1
v
k k shareky1 1
φ1 = ω 1 k
, (118)
ω 1 µz sharevy1
and
  1+ρ
1
v
sharely1 1
φl1 = ω l1 , (119)
ω l1 sharevy1
where φk1 + φl1 = 1.

17
A.1.5 Decomposition of Marginal Costs

Define the marginal factor products as:


ρo1 o
 o
d 1,t =
mpo o
ŷ1,t − ô1,t − ẑ1,t + ẑ1,t (120)
1 + ρ1
d 1,t ρo1 ρv1  
mpk = (ŷ1,t − v̂1,t ) + v̂1,t − k̂1,t−1 (121)
1 + ρo1 1 + ρv1
d 1,t ρo1 ρv1  ˆ

mpl = (ŷ 1,t − v̂ 1,t ) + v̂ 1,t − ẑ 1,t − l 1,t + ẑ1,t , (122)
1 + ρo1 1 + ρv1
and notice that the first order conditions for firms can thus be rewritten as
\ 
P1o
= mcc 1,t + mpo
d 1,t (123)
P1d t
r̂k = mc d 1,t
c 1,t + mpk (124)
1,t

ŵ1,t = mc d 1,t .
c 1,t + mpl (125)

Multiplying equation (123) by ω oy vy vy


1 , equation (124) by ω 1 φ1 , and equation (125) by ω 1 (1 − φ1 ), and

adding over these three equations, we obtain the desired expression:


\  !
P o    
c 1,t = ω oy
mc 1
− d
mpo 1,t + ω vy
φ 1 r̂ k
− d
mpk 1,t + ω vy
(1 − φ 1 ) ŵ 1,t − d
mpl 1,t (126)
1 1 1,t 1
P1d t

since ω oy vy vy
1 + ω 1 φ1 + ω 1 (1 − φ1 ) = 1.

A.2 Balanced Growth Path

Along the balanced growth path real quantities grow at the common rate µz , except for oil demand
and supply, and hours worked. Prices (relative to the domestic good), including real marginal costs, are
constant except for real wages and the real price of oil. With labor augmenting technological progress,
hours worked are stationary and real wages need to grow with the common growth rate µz . Oil supply
µz
and oil demand grow at the rate µo < µz , while the price of oil grows at the rate µzo < µo
. Nominal
prices grow at the inflation rate π ∗1 . Below, we define relationships that need to hold along the balanced
growth path. Unless noted otherwise, an expression presented for the home country s identical to the
one for the foreign country. The size of country 1 relative to that of country 2 is denoted by ζ 1 .
Xi,t

refers to the value of variable Xi at time t along the balanced growth path. Xi,0

is the initial
value of the variable at time 0.

18
A.2.1 Calibrated Expressions

Some parameters in our model are not estimated, but are implicitly pinned down by assigning data means
to the following expressions.

1. Nominal oil use as share of nominal gross output shareoy1 :


o∗ ∗ o∗ ∗t ∗
P1,t O1,t P1,0 π 1 O1,0 µto t o∗ ∗
P1,0 O1,0 O1,0

shareoy1 = d∗ d∗
= d∗ ∗t d∗ t zo
µ = d∗ d∗
= d∗
, (127)
P1,t Y1,t P1,0 π 1 Y1,0 µz P1,0 Y1,0 Y1,0
as the real price of oil is assumed to be 1 in period 0.

2. Ratio of oil use in production and oil use in consumption ratiooyoc1 :


o∗ y∗ y∗
P1,t O1,t O1,0
ratiooyoc1 = o∗ c∗ = c∗ . (128)
P1,t O1,t O1,0
3. Overall investment as share of gross output shareiy1 :
I1,t

I1,0

shareiy1 = d∗ = d∗ . (129)
Y1,t Y1,0
4. Overall government consumption as share of gross output sharegy1 :
G∗1,t G∗1,0
sharegy1 = d∗
= d∗
. (130)
Y1,t Y1,0
5. Ratio of oil production to oil consumption ratioyoo1 :
o∗ o∗
Y1,t Y1,0
ratioyoo1 = ∗ = ∗ . (131)
O1,t O1,0
6. Overall imports as share of gross output sharemy1 :
M1,t

M1,0

sharemy1 = d∗
= d∗
. (132)
Y1,t Y1,0
7. Ratio of imports in investment relative to imports in consumption ratiomimc1 :
i∗ i∗
M1,t M1,0
ratiomimc1 = c∗
= c∗
. (133)
M1,t M1,0
8. Share of hours worked labshare1 :
L∗1,t L∗1,0
labshare1 = = . (134)
1 − L∗1,t 1 − L∗1,0

9. Normalization of ω l1 :

ω l1 = 1. (135)

19
A.2.2 Composite Parameters

Given the parameter choices and the expressions described above, the remaining parameters of the model
can be computed as shown below.

1. From condition 20 define shareoyy1 and compute ω oy


1 :

y∗ y∗
µtzo O1,t O1,0
ω oy
1= d∗
= d∗ = shareoyy1 (136)
Y1,t Y1,0
 
1
shareoyy1 = shareoy1 1 − . (137)
1 + ratiooyoc1

2. From condition 17 define sharevy1 and compute ω vy


1 :

V1,t

V1,0

ω vy oy
1 = 1 − ω1 = = = sharevy1 . (138)
Y1,t
∗d
Y1,0
∗d

k∗
3. From condition 6 compute r1,0 :

k∗ µz
r1,0 = − 1 + δ1. (139)
β1

4. From condition 7 define shareky1 :


K1,t

K1,0

1
= = shareiy1 = shareky1 . (140)
d∗
Y1,t d∗
Y1,0 1 − 1−δ
µ
1
z

5. From conditions 7 and 18 define omegak1 :


  1+ρ
ρv
v
1
1 µz 1 1 shareiy1
ω k1 = 1−δ 1
− 1 + δ1 . (141)
1− µz
β1 µz sharevy1

6. From condition 16 define sharely1 :


µtz L∗1,t L∗1,0   −1 1+ρv1
k k∗ ρv1
d∗
= d∗ = sharevy1 1 − ω 1 r1,0 = sharely1 . (142)
Y1,t Y1,0

7. From consolidated budget constraint define sharecy1 :


c∗ ∗ d∗ ∗ d∗ ∗ o∗ o∗ o∗ y∗
P1,t C1,t P1,t I1,t P1,t G1,t P1,t Y1,t P1,t O1,t
d∗ d∗
= 1 − d∗ d∗
− d∗ d∗
+ d∗ d∗
− d∗ d∗
= sharecy1 (143)
P1,t Y1,t P1,t Y1,t P1,t Y1,t P1,t Y1,t P1,t Y1,t
sharecy1 = 1 − shareiy1 − sharegy1 + shareyoy1 − shareoyy1 . (144)

20
8. From condition 12 define shareocc1 and compute ω oc
1 :

µtzo O1,t
c∗ c∗
O1,0
ω oc
1 = = = shareocc1 , (145)
C1,t

C1,0

where

shareoy1 − shareoyy1
shareocc1 = . (146)
sharecy1

9. From condition 8 compute ω cc


1 :

ne∗ ne∗
C1,t C1,0
ω cc
1 =1− ω oc
1 = ∗ = ∗ . (147)
C1,t C1,0

10. From condition 10 compute ω c1 :


d∗ d∗
C1,t C1,0
ω c1 =1−ω mc
= ne∗ = ne∗ = sharecdcn1 . (148)
C1,t C1,0

11. From condition 11 define sharemccn1 :


c∗ c∗
M1,t M1,0
ω mc
1 = ne∗ = ne∗ = sharemccn1 , (149)
C 1,t C1,0

where sharemccn1 is computed from

sharemy1 1
sharemccn1 = . (150)
sharecy1 sharecnc1 1 + ratiomimc1

12. From condition 14 compute ω i1 :


d∗ d∗
I1,t I1,0
ω i1 =1− ω mi
1 = ∗ = ∗ . (151)
I1,t I1,0

13. From condition 15 define sharemii1 and compute ω mi :


i∗ i∗
M1,t M1,0
ω mi
1 = = = sharemii1 , (152)
I1,t

I1,0

where

sharemy1 ratiomimc1
sharemii1 = . (153)
shareiy1 1 + ratiomimc1

21
14. Define exports relative of gross output country 1 sharexy1 :
d∗ ∗ d∗ o∗ ∗ o∗ o∗
P1,t X1,t P1,t M1,t

P1,t O1,t P1,t Y1,t
d∗ d
= d∗ d∗
+ d∗ d∗
− d∗ d∗
= sharexy1 , (154)
P1,t Y1,t P1,t Y1,t P1,t Y1,t P1,t Y1,t

or

sharexy1 = sharemy1 + shareoy1 − shareyoy1 . (155)

15. Define exports relative of gross output country 2 sharexy2 :


 y∗ o∗  d∗
X2,t

M2.t
∗ O1,t Y1,t Y1,t
d
= d∗
− d∗
+ d∗
ζ , = sharexy2 ,
d∗ 1
(156)
Y2,t Y2,t Y1,t Y1,t Y2,t

or
d∗
Y1,0
sharexy2 = sharemy2 − (shareoy1 − shareyoy1 ) d∗ ζ 1 . (157)
Y2,0

16. If trade is balanced along the balanced growth path, we define sharemy2 :
d∗ o∗ o∗
 d∗ d∗ d∗
P1,t M1,t

P1,t O1,t

− Y1,t e∗1,t P2,t M2,t

P2,t Y2,t 1
d∗ d∗
+ d∗ d∗
= d∗ d∗ d∗ d∗ ζ
= sharemy2 , (158)
P1,t Y1,t P1,t Y1,t P2,t Y2,t P1,t Y1,t 1

or
d∗
Y1,0
sharemy2 = (sharemy1 + (shareoy1 − shareyoy1 )) d∗ ζ 1 (159)
Y2,0

17. From condition 42 define sharengdpny1 :


o∗ y∗ o∗ o∗ o∗ y∗ o∗ o∗
N GDP1,t ∗
P1,t O1,t P1,t Y1,t P1,0 O1,0 P1,0 Y1,0
d∗ d∗
= 1 − d∗ d∗
+ d∗ d∗
= 1 − d∗ d∗
+ d∗ d∗
, (160)
P1,t Y1,t P1,t Y1,t P1,t Y1,t P1,0 Y1,0 P1,0 Y1,0

or

sharengdpny1 = 1 − shareoyy1 + shareyoy1 . (161)

18. From condition 34 define mugdpss1 :

µz − (shareoyy1 − shareyoy1 ) µo
µgdp,1 = . (162)
1 − (shareoyy1 − shareyoy1 )

22
d∗
Y1,t
19. Gross output ratio d∗
Y2,t
:

d∗ d∗
Y1,t Y1,0 sharely2 L∗1,0
d∗
= d∗
= . (163)
Y2,t Y2,0 sharely1 L∗2,0

20. From condition 39 define the share in world oil production for country 2 shareoprod2 :
o∗
Y2,0
o∗
Y2,t Y d∗
o∗ o∗
= Y o∗ Y 2,0d∗ o∗ = shareoprod2 , (164)
ζ 1 Y1,t + Y2,t ζ 1 Y1,0
Y2,0
d∗ Y d∗ +
1,0
d∗
Y2,0
1,0 2,0

or

shareyoy2
shareoprod2 = Y d∗
. (165)
shareyoy2 + shareyoy1 ζ 1 Y1,0
d∗
2,0

21. From condition 39 define the share in world oil consumption for country 2 shareocon2 :
O2,0

O2,t∗ d∗
Y2,0
o∗
= d∗ = shareocon2 , (166)
ζ 1 O1,t

+ Y2,t O ∗
ζ 1 Y 1,0
Y1,0 O2,0

d∗ Y d∗ + d∗
Y2,0
1,0 2,0

or

shareoy2
shareocon2 = Y d∗
. (167)
shareoy2 + shareoy1 ζ 1 Y1,0
d∗
2,0

22. Overall oil production as share of gross output shareyoy1 :


o∗ o∗
Y1,t Y1,t O1,t

d∗
= d∗
= shareyoy1 , (168)
Y1,t O1,t

Y1,t

or

shareyoy1 = ratioyoo1 shareoy1 . (169)

23
B Appendix: Data
The model is estimated by the method of maximum likelihood. The data are quarterly and run between
1984 and the third quarter of 2008. A presample of 10 years from 1974 to 1984 is used to train the
Kalman filter used to form the likelihood. The observed series are the following:

1. the log of U.S. real GDP, from NIPA Table 1.1.3 (line 1);

2. the log of trade-weighted foreign GDP. The series reflects GDP data from national sources for the
26 most important trading partners of the United States. A description of the export weights is
in Loretan (2005). The countries included account for well over 90% of U.S. exports, as well as
imports.

3. the log of the U.S. real dollar price of oil defined as the refiners’ acquisition cost for imported crude
from the U.S. Energy Information Administration
(http : //www.eia.doe.gov/dnav/pet/pet pri rac2 dcu nus m.htm) normalized by the GDP defla-
tor from NIPA Table 1.1.4 (line 1);

4. the log of U.S. crude oil production from Table 11.1b of the Monthly Energy Review of the U.S.
Energy Information Administration
(http : //www.eia.doe.gov/totalenergy/data/monthly/#petroleum);

5. the log of foreign oil production (calculated as world production net of U.S. production) from
Table 11.b of the Monthly Energy Review of the U.S. Energy Information Administration (http :
//www.eia.doe.gov/totalenergy/data/monthly/#petroleum);

6. the log of U.S. hours worked in the nonfarm business sector from the Labor Productivity and Cost
Database of the U.S. Bureau of Labor Statistics, normalized by the U.S. civilian non-institutional
population from the U.S. Bureau of Labor Statistics
(http : //data.bls.gov/pdq/querytool.jsp?survey = pr);

7. the log of the broad real dollar exchange rate from the U.S. Federal Reserve Board
(http : //www.f ederalreserve.gov/releases/H10/summary/, the weights are the same as the ones

24
described for the measure of foreign GDP above);

8. U.S. personal consumption expenditures from NIPA Table 1.1.5 (line 2), expressed as a share of
U.S GDP from NIPA Table 1.1.5 (line 1);

9. U.S. crude oil imports from the Energy Information Administration


(http : //www.eia.doe.gov/dnav/pet/pet move impcus d N U S Z00 mbbl m.htm), expressed as a
share of U.S. GDP using the refiners’ acquisition cost for imported crude and GDP from NIPA
Table 1.1.5 (line 1);

10. U.S. imports of non-petroleum goods from NIPA Table 4.2.5 (line 54), expressed as a share of GDP;

11. U.S. goods exports from NIPA Table 4.2.5 (line 2), expressed as a share of GDP;

12. U.S. fixed investment from NIPA Table 4.2.5 (line 8), expressed as a share of GDP;

13. U.S. core inflation measured as the log change in the deflator for personal consumption expenditures
excluding food and energy prices from the Federal Reserve Bank of St. Louis Fred Database,

14. U.S. wage inflation (demeaned) measured using the log change in nominal compensation from the
Labor Productivity and Cost Database of the U.S. Bureau of Labor Statistics
(http : //data.bls.gov/pdq/querytool.jsp?survey = pr);

15. and the U.S. effective federal funds rate (demeaned) from the Federal Reserve Board (http :
//www.f ederalreserve.gov/releases/h15/data.htm).

25
C Appendix: Plots of Data and In-Sample Forecast Errors
This appendix contains plots of all the observed data, the in-sample 1 step ahead forecasts, and the
forecast errors.

26
Figure 1: Data and Forecast Errors
U.S. GDP
0.8
Data
0.7 Fitted Values (in sample, 1 step ahead forecast)

0.6

0.5
Log Scale

0.4

0.3

0.2

0.1

0
1985 1990 1995 2000 2005

Forecast Error
0.015

0.01

0.005
Log Scale

−0.005

−0.01

−0.015

−0.02
1985 1990 1995 2000 2005

27
Figure 2: Data and Forecast Errors
Foreign GDP
0.9
Data
0.8 Fitted Values (in sample, 1 step ahead forecast)

0.7

0.6

0.5
Log Scale

0.4

0.3

0.2

0.1

−0.1
1985 1990 1995 2000 2005

Forecast Error
0.02

0.015

0.01
Log Scale

0.005

−0.005

−0.01
1985 1990 1995 2000 2005

28
Figure 3: Data and Forecast Errors
U.S. Oil Production
0.1
Data
0 Fitted Values (in sample, 1 step ahead forecast)

−0.1

−0.2
Log Scale

−0.3

−0.4

−0.5

−0.6

−0.7
1985 1990 1995 2000 2005

Forecast Error
0.06

0.04

0.02

−0.02
Log Scale

−0.04

−0.06

−0.08

−0.1

−0.12

−0.14
1985 1990 1995 2000 2005

29
Figure 4: Data and Forecast Errors
Foreign Oil Production
0.45
Data
0.4 Fitted Values (in sample, 1 step ahead forecast)

0.35

0.3

0.25
Log Scale

0.2

0.15

0.1

0.05

−0.05
1985 1990 1995 2000 2005

Forecast Error
0.08

0.06

0.04
Log Scale

0.02

−0.02

−0.04

−0.06
1985 1990 1995 2000 2005

30
Figure 5: Data and Forecast Errors
U.S. Oil Imports (GDP share)
3
Data
Fitted Values (in sample, 1 step ahead forecast)
2.5

2
Percent

1.5

0.5

0
1985 1990 1995 2000 2005

Forecast Error
0.8

0.6

0.4

0.2
Percent

−0.2

−0.4

−0.6
1985 1990 1995 2000 2005

31
Figure 6: Data and Forecast Errors
Real Oil Price
1
Data
Fitted Values (in sample, 1 step ahead forecast)

0.5

0
Log Scale

−0.5

−1

−1.5
1985 1990 1995 2000 2005

Forecast Error
0.4

0.3

0.2

0.1
Log Scale

−0.1

−0.2

−0.3

−0.4

−0.5
1985 1990 1995 2000 2005

32
Figure 7: Data and Forecast Errors
U.S. Nonoil Goods Imports (GDP share)
13
Data
Fitted Values (in sample, 1 step ahead forecast)
12

11

10
Percent

6
1985 1990 1995 2000 2005

Forecast Error
0.6

0.4

0.2

0
Percent

−0.2

−0.4

−0.6

−0.8
1985 1990 1995 2000 2005

33
Figure 8: Data and Forecast Errors
U.S. Goods Exports (GDP share)
10
Data
Fitted Values (in sample, 1 step ahead forecast)
9

8
Percent

4
1985 1990 1995 2000 2005

Forecast Error
0.6

0.4

0.2

0
Percent

−0.2

−0.4

−0.6

−0.8
1985 1990 1995 2000 2005

34
Figure 9: Data and Forecast Errors
U.S. Real Exchange Rate
0.3
Data
0.25 Fitted Values (in sample, 1 step ahead forecast)

0.2

0.15
Log Scale

0.1

0.05

−0.05

−0.1

−0.15
1985 1990 1995 2000 2005

Forecast Error
0.05

0.04

0.03

0.02

0.01
Log Scale

−0.01

−0.02

−0.03

−0.04

−0.05
1985 1990 1995 2000 2005

35
Figure 10: Data and Forecast Errors
U.S. Private Consumption Expenditures (GDP share)
72
Data
71 Fitted Values (in sample, 1 step ahead forecast)

70

69
Percent

68

67

66

65

64

63
1985 1990 1995 2000 2005

Forecast Error
1

0.5

0
Percent

−0.5

−1

−1.5
1985 1990 1995 2000 2005

36
Figure 11: Data and Forecast Errors
U.S. Fixed Investment (GDP share)
18
Data
Fitted Values (in sample, 1 step ahead forecast)
17

16
Percent

15

14

13

12
1985 1990 1995 2000 2005

Forecast Error
0.6

0.5

0.4

0.3

0.2
Percent

0.1

−0.1

−0.2

−0.3

−0.4
1985 1990 1995 2000 2005

37
Figure 12: Data and Forecast Errors
U.S. Core Inflation (qr)
2
Data
Fitted Values (in sample, 1 step ahead forecast)

1.5

1
Percent

0.5

−0.5
1985 1990 1995 2000 2005

Forecast Error
0.8

0.6

0.4

0.2
Percent

−0.2

−0.4

−0.6

−0.8

−1
1985 1990 1995 2000 2005

38
Figure 13: Data and Forecast Errors
U.S. Federal Funds Rate (qr)
3
Data
Fitted Values (in sample, 1 step ahead forecast)
2.5

2
Percent

1.5

0.5

0
1985 1990 1995 2000 2005

Forecast Error
0.3

0.2

0.1

0
Percent

−0.1

−0.2

−0.3

−0.4

−0.5
1985 1990 1995 2000 2005

39
Figure 14: Data and Forecast Errors
U.S. Wage Inflation (qr)
4
Data
3.5 Fitted Values (in sample, 1 step ahead forecast)

2.5
Percent

1.5

0.5

−0.5
1985 1990 1995 2000 2005

Forecast Error
2

1.5

0.5

0
Percent

−0.5

−1

−1.5

−2

−2.5

−3
1985 1990 1995 2000 2005

40
Figure 15: Data and Forecast Errors
U.S. Hours Worked (PC)
0.14
Data
0.12 Fitted Values (in sample, 1 step ahead forecast)

0.1

0.08
Log Scale

0.06

0.04

0.02

−0.02
1985 1990 1995 2000 2005

Forecast Error
0.01

0.005

0
Log Scale

−0.005

−0.01

−0.015
1985 1990 1995 2000 2005

41
D Appendix: Plots of Smoothed Estimates of Shock Processes
and Their Innovations
This appendix contains plots of all the shock processes and their innovations. A key to the symbols
denoting each shock process is given in Table 1 in the main body of the paper.

42
Figure 16: Data and Forecast Errors
Shock Process Z1,t
0.22

0.2

0.18

0.16

0.14
Log Scale

0.12

0.1

0.08

0.06

0.04

0.02
1985 1990 1995 2000 2005

Innovations to Shock Process Z1,t


2.5

1.5

1
Log Scale

0.5

−0.5

−1

−1.5

−2
1985 1990 1995 2000 2005

43
Figure 17: Data and Forecast Errors
Shock Process Z2,t
0.45

0.4

0.35

0.3
Log Scale

0.25

0.2

0.15

0.1

0.05
1985 1990 1995 2000 2005

Innovations to Shock Process Z2,t


3

1
Log Scale

−1

−2

−3
1985 1990 1995 2000 2005

44
Figure 18: Data and Forecast Errors
o
Shock Process Y1,t
0

−0.2

−0.4
Log Scale

−0.6

−0.8

−1

−1.2

−1.4
1985 1990 1995 2000 2005

o
Innovations to Shock Process Y1,t
3

0
Log Scale

−1

−2

−3

−4

−5
1985 1990 1995 2000 2005

45
Figure 19: Data and Forecast Errors
o
Shock Process Y2,t
0.1

0.05

0
Log Scale

−0.05

−0.1

−0.15

−0.2

−0.25
1985 1990 1995 2000 2005

o
Innovations to Shock Process Y2,t
4

2
Log Scale

−1

−2

−3
1985 1990 1995 2000 2005

46
Figure 20: Data and Forecast Errors
o
Shock Process Z1,t
1.05

0.95

0.9

0.85
Log Scale

0.8

0.75

0.7

0.65

0.6

0.55
1985 1990 1995 2000 2005

o
Innovations to Shock Process Z1,t
3

1
Log Scale

−1

−2

−3

−4
1985 1990 1995 2000 2005

47
Figure 21: Data and Forecast Errors
o
Shock Process Z2,t
2

1.8

1.6

1.4

1.2
Log Scale

0.8

0.6

0.4

0.2

0
1985 1990 1995 2000 2005

o
Innovations to Shock Process Z2,t
4

2
Log Scale

−1

−2
1985 1990 1995 2000 2005

48
Figure 22: Data and Forecast Errors
c
Shock Process Z1,t
0.05

0.045

0.04

0.035

0.03
Log Scale

0.025

0.02

0.015

0.01

0.005

0
1985 1990 1995 2000 2005

c
Innovations to Shock Process Z1,t
4

2
Log Scale

−1

−2
1985 1990 1995 2000 2005

49
Figure 23: Data and Forecast Errors
c
Shock Process Z2,t
0.03

0.02

0.01

0
Log Scale

−0.01

−0.02

−0.03

−0.04

−0.05

−0.06
1985 1990 1995 2000 2005

c
Innovations to Shock Process Z2,t
5

2
Log Scale

−1

−2

−3
1985 1990 1995 2000 2005

50
Figure 24: Data and Forecast Errors
m
Shock Process Z1,t
0

−0.1

−0.2
Log Scale

−0.3

−0.4

−0.5

−0.6

−0.7
1985 1990 1995 2000 2005

m
Innovations to Shock Process Z1,t
3

1
Log Scale

−1

−2

−3
1985 1990 1995 2000 2005

51
Figure 25: Data and Forecast Errors
m
Shock Process Z2,t
0.3

0.2

0.1

0
Log Scale

−0.1

−0.2

−0.3

−0.4

−0.5
1985 1990 1995 2000 2005

m
Innovations to Shock Process Z2,t
2

1.5

0.5
Log Scale

−0.5

−1

−1.5

−2

−2.5
1985 1990 1995 2000 2005

52
Figure 26: Data and Forecast Errors
w
Shock Process θ1,t
20

10

0
Log Scale

−10

−20

−30

−40
1985 1990 1995 2000 2005

w
Innovations to Shock Process θ1,t
3

1
Log Scale

−1

−2

−3
1985 1990 1995 2000 2005

53
Figure 27: Data and Forecast Errors
p
Shock Process θ1,t
1.5

0.5
Log Scale

−0.5

−1

−1.5
1985 1990 1995 2000 2005

p
Innovations to Shock Process θ1,t
3

2.5

1.5

1
Log Scale

0.5

−0.5

−1

−1.5

−2
1985 1990 1995 2000 2005

54
Figure 28: Data and Forecast Errors
Shock Process π̄1,t
0.06

0.04

0.02

0
Log Scale

−0.02

−0.04

−0.06

−0.08

−0.1
1985 1990 1995 2000 2005

Innovations to Shock Process π̄1,t


3

1
Log Scale

−1

−2

−3

−4
1985 1990 1995 2000 2005

55
Figure 29: Data and Forecast Errors
i
Shock Process Z1,t
0.3

0.25

0.2
Log Scale

0.15

0.1

0.05

−0.05
1985 1990 1995 2000 2005

i
Innovations to Shock Process Z1,t
4

2
Log Scale

−1

−2
1985 1990 1995 2000 2005

56
Figure 30: Data and Forecast Errors
g
Shock Process Z1,t
0.2

0.15

0.1

0.05
Log Scale

−0.05

−0.1

−0.15

−0.2
1985 1990 1995 2000 2005

g
Innovations to Shock Process Z1,t
3

1
Log Scale

−1

−2

−3
1985 1990 1995 2000 2005

57
E Appendix: Interpreting Oil Efficiency Shocks
While oil efficiency shocks are meant to capture fundamental changes in the demand for oil – such as
a shift towards motorization in emerging Asia, continuing industrialization of China, or energy-efficient
cars becoming more popular in the United States – we would like to exclude the possibility that the
efficiency shocks are nothing but a catchall for all unmodeled disturbances that can affect oil demand.
Accordingly, we conduct a simple exogeneity test for our estimated oil efficiency innovations εzo
1,t

and εzo
2,t following the exercise in Evans (1992) for technology shocks. Let

εzo zo
i,t = Ai (L)εi,t−1 + Bi (L)xt−1 + ν i,t , (170)

where ν i,t is a mean zero, i.i.d random variable, Ai (L) and Bi (L) are polynomials in the lag operator L,
x is a vector that includes potential explanatory variables for oil demand. Ideally, none of the variables
included in xt−1 should Granger cause the innovations εzo zo
1,t and ε2,t .

Unmodeled determinants of oil demand that we would like to see assessed as unimportant for our
measure of oil efficiency are: (i) log-changes in oil inventories (OECD and U.S. inventory data), (ii) log-
changes of the price of oil substitutes in energy generation (price of coal), (iii) financial market activities
(log-changes in oil futures, real stock market returns), (iv) changes and the level of activity-driven demand
for all commodities (index proposed in Kilian (2009)) as these should already be captured by our GDP
measures.1
When including each of the variables separately with up to three lags, the null hypothesis of
exogeneity, B2 (L) = 0, was never rejected for the foreign oil efficiency shocks at the 5% significance
level.2 For the U.S. oil efficiency shock, the null hypothesis was rejected at the 5% level of significance for
1
The variables in xt−1 in equation (170) enter either as a return or in growth rates. The data sources are as follows.
Oil inventory: U.S. Energy Information Administration; given the lack of data on crude oil inventories for countries other
than the United States, we construct OECD crude oil inventories by scaling OECD petroleum stocks over U.S. petroleum
stocks for each period as suggested in Hamilton (2009), and Kilian and Murphy (2010). Price of coal: Australian Coal,
World Bank Commodity Price Data (Pink Sheet). Oil futures: three months NYMAX contract, U.S. Energy Information
Administration. Stock market index: S&P 500, FRED database St. Louis Fed. World commodity demand: index of global
real economic activity in industrial commodity markets, available at http://www-personal.umich.edu/ lkilian/reaupdate.txt.
2
A detailed description of Granger causality tests in a multivariate context is given in Hamilton (1994), chapter 11.
Let σ̂ ν i (0) be the estimate of the variance of the innovations, σ ν i under the null hypothesis and σ̂ ν i be the unrestricted
estimate. The test statistic T {ln|σ̂ ν i (0)| − ln|σ̂ ν i |} follows a χ2 distribution with the degrees of freedom, df, given by the
product of the number of lags and the number of variables included in x. If the test statistic exceeds the α% critical value
for χ2 (df ), the block exogeneity assumption is rejected at the α% level of significance.

58
log-changes in OECD oil inventories and changes in Kilian’s shipping index. Yet, the adjusted R2 never
exceeds 11%. With up to three lags in the VAR, no combination of variables ever implied a rejection
of the null hypothesis at conventional significance levels for the foreign oil efficiency shock (up to 10%).
Moreover, the adjusted R2 never exceeds 12%. For the U.S. oil efficiency shock, the most challenging
combination of variables is given by the set of changes in Kilian’s activity measure, and log-changes
in OECD and U.S. oil inventories. In this case, the null hypothesis of block exogeneity is rejected at
the 1% significance level for each lag-length up to three lags. However, with adjusted R2 values not
exceeding 15%, the combined explanatory power of these variables is low. We conclude that none of the
combinations we tested poses an important challenge to our interpretation of the oil efficiency shocks.3

3
Further increases in the lag-length not only did not overturn our overall assessment, but reinforced it, instead.

59
References
Evans, C. L. (1992). Productivity Shocks and Real Business Cycles. Journal of Monetary Economics 29,
191–208.

Hamilton, J. (1994). Time Series Analysis. Princeton, NJ: Princeton University Press.

Hamilton, J. (2009). Causes and Consequences of the Oil Shock of 2007-08. Brookings Papers on
Economic Activity (1), 215–84.

Kilian, L. (2009). Not All Price Shocks Are Alike: Disentangling Demand and Supply Shocks in the
Crude Oil Market. American Economic Review 99 (3), 1053–69.

Kilian, L. and D. Murphy (2010). The Role of Inventories and Speculative Trading in the Global Market
for Crude Oil. Mimeo, University of Michigan.

Loretan, M. (2005). Indexes of the Foreign Echange Value of the Dollar. Federal Reserve Bulletin, 1–8.

Smets, F. and R. Wouters (2007). Shocks and Frictions in US Business Cycles: A Bayesian DSGE
Approach. American Economic Review 97 (3), 586–606.

60