What is the Difference between Fossil Fuel Embargo and Price Shocks?

Abstract

In this paper, we model a fossil fuel embargo as a temporary quantity constraint on fossil fuel imports and wecompare the impact with the effect of a fossil fuel price shock. We show that while both shocks have similar responses of output and inflation, they differ with respect to the reaction of other macroeconomic components,such as consumption, exports and the trade balance. In particular, an embargo has more adverse effects onthe functional income distribution.Our findings are relevant for policymakers when determining the most effective stabilization policy. We compare different monetary and fiscal stabilization policies, such as different interest rate policies, energy taxreduction, transfer to liquidity-constrained households, and a value-added tax cut. We find that fiscal policy cancomplement monetary policy, by targeting distributional objectives. There is no conflict with monetary policyin the case of energy taxes and VAT, while in the case of transfers output and consumption stabilization of low-income households is accompanied by slightly higher inflation. We find that fiscal policies are less effective in stabilizing GDP 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 fossil fuel price shock, an energy tax reduction is effective because it counteracts the price increase and allows companies to respond according totheir energy demands.