OPTIMAL ECONOMIC POLICY AND OIL PRICES SHOCKS IN RUSSIA

ISSN 1561-2422 OPTIMAL ECONOMIC POLICY AND OIL PRICES SHOCKS IN RUSSIA Roman Semko Working paper No 13/03E This projec (No 11-5741) was suppored by he Economics Educaion and Research Consorium and funded by GDN All opinions expressed here are hose of he auhors and no hose of he EERC, GDN and Governmen of Sweden Research disseminaion by he EERC may include views on policy, bu he EERC iself akes no insiuional policy posiions

Research area: Moneary Policy, Commodiy Markes and Open Economy Macroeconomics JEL codes: E12, E52, E58, F41. Semko R. Opimal economic policy and oil prices shocks in Russia. Kyiv: EERC, 2013. The goal of he paper is o explain and analyze wheher Cenral Bank of Russia should include commodiy prices ino he liss of variables hey ry o respond. We augmened New Keynesian DSGE small open economy model of Dib (2008) wih he oil sabilizaion fund and new Taylorype moneary policy rule and esimaed he model using Bayesian economerics. The resuls show ha Cenral Bank s mild response o he oil price changes may be desired in erms of minimizing flucuaions of inflaion and oupu only in he case when sabilizaion fund would be absen, while his response is redundan when excess oil revenues can be saved in he fund. Keywords: opimal moneary policy, oil prices, sabilizaion fund. Acknowledgemens: I would like o say special hank Oleksiy Kryvsov (Bank of Canada) and oher paricipans of EERC seminars for heir useful ideas and valuable commens from which I benefied a lo. Roman Semko Kyiv School of Economics* 04119 Kyiv, Yakira sr. 13 Ukraine el. (+38)044 492-80-12 e-mail: rsemko@kse.org.ua * All opinions expressed here are hose of he auhor and no hose of he Kyiv School of Economics 2

Conen Non-Technical Summary... 4 1 Inroducion... 5 2 Overview of he lieraure... 8 3 New Keynesian DSGE Model... 11 3.1 Households... 12 3.2 Oil Secor... 17 3.3 Manufacuring Secor... 18 3.4 Non-Tradable Secor... 21 3.5 Impor Secor... 23 3.6 Final Good... 24 3.7 Governmen... 25 3.8 Cenral Bank... 25 3.9 Equilibrium... 26 4 Model parameerizaion... 26 5 Priors and daa... 28 6 Resuls discussion... 30 6.1 Opimal Moneary Policy... 30 6.2 Exension: Sabilizaion Fund... 34 7 Conclusions... 36 Appendices... 38 Appendix A1. Producion funcion parameers evaluaion based on Inpu-Oupu ables.... 38 Appendix A2. Daa descripion... 40 Appendix A3. Priors and poseriors... 43 Appendix A4. Impulse response funcions... 47 References... 50 3

Non-Technical Summary Significan oil prices flucuaions is an imporan facor influencing real economic variables, especially in he counries wih large dependency on expor of naural resources. In such condiions i is naural o consider he possibiliy of economic policy o fine une he real economy, achieve inflaion sabiliy and o weaken he negaive influence of oil prices shocks. In erms of moneary policy, auhoriies realize he exisence of many channels hough which oil marke is relaed o he real secors and inflaion. Cenral Bank of Russia should analyze he necessiy o reac o oil prices and o change he effec of hem on he real economic variables. In erms of economic policy he mos ypical ways of reacion o oil prices in Russia Federaion is accumulaion of reserves a Reserve Fund. The idea of he fund is o direc he revenues from oil expor o he budge only when he price of oil does no exceed prespecified level and he residual income should be accumulaed in he fund. In addiion, Cenral Bank of Russia may respond wih is refinancing rae o he changes of he oil price via augmened wih oil price Taylor rule or indirecly wihou inclusion of commodiy quoes ino he moneary policy rule. This research considers wheher Cenral Bank of Russia should formally esablish he policy of responding o he changes of oil prices. The key evaluaion crierion for selecing he opimal response is he minimizaion of inflaion and GDP flucuaions. Taking ino accoun he resuls of applied model (mild response of Cenral Bank o oil prices), i may mean ha opimally Cenral Bank should include oil price ino is ineres rae Taylor moneary rule, ha is, i should reac o oil price quoes bu only in he case of sabilizaion fund absence. Suggesed opimal moneary policy implies posiive direc response o he oil price shocks: 1% of oil price increase (decrease) should rigger CBR o raise (decrease) refinancing rae by 0.1%. In he case of sabilizaion fund presence here are no necessiy o responds o oil prices since he former one sabilize he siuaion when oil prices flucuae oo much. 4

1 Inroducion Russian economy is locaed on a naural resources-rich area. This realiy significanly influences economic developmen and policy of he counry. Firs of all, in such a siuaion he economy is vulnerable o he large exen o commodiies demand flucuaions on exernal marke, especially o he price (quoes) behavior. In Figure 1 i is shown ha here is a leas posiive associaion beween oil prices and Russian GDP growh. Figure 1: Oil prices (righ scale) and GDP growh (lef scale) in Russia Commodiy prices in he counries, which are significanly dependen on he raw maerialsinensive secors, have implicaion no only o he GDP and expor/impor growh bu also o he budge defici and oher relaed issues like social policy and inequaliy. For example, negaive commodiy prices shocks during recen financial crises can be considered as he key facors ha led o significan welfare losses and povery increase in Russia, while posiive shocks have couner effecs during before he crises period (World Bank, 2008; Cerami, 2009). Naural resources exporing counries ofen faces he problem of Duch disease, which refers o a permanen effec of naural resource prices on radable goods secor. Since he paper is focused on shor-erm sabilizaion and oil price shock does no have a permanen componen, his problem will be no addressed here. 5

The goal of he paper is o explain and analyze he relaions beween oil prices, which may play a cenral role in such emerging economy as Russia and moneary policy using modern developmens in macroeconomics and economerics. Commodiy pricing modeling is an acive area of modern economic research. Significan commodiy prices flucuaions is an imporan facor influencing real economic variables, especially in he counries wih large dependency on expor/impor of naural resources. Russia definiely belongs o his group: crude oil revenues accoun for 32% of oal expor. Addiional significan source of expor incomes in Russia is generaed by naural gas (no condensaed): is average 5 years share in expor is 13%. In erm of impor, Russia does no have significan shares of commodiies in is impor bundle. In such condiions i is naural o consider he possibiliy of economic policy o fine une he real economy, achieve inflaion sabiliy and o weaken he negaive influence of commodiy prices shocks. In erms of moneary policy, auhoriies realize he exisence of many channels hough which asse (commodiy) marke is relaed o he real secors and inflaion. Cenral Banks should analyze he necessiy o reac o commodiy prices and o change he effec of hem on he real economic variables. The idenificaion of economy drivers from he posiion of commodiy marke can be very useful for he economy sabilizaion during he periods of significan up- and downurns. On he way from fixed o floaing exchange rae regimes in Russia sill play fiscal policy an imporan role in comparison o he moneary one and carry i significan burden of macroeconomic adjusmen. In erms of fiscal policy, regulaors can manage such fiscal variables as revenues and expendiure o miigae he influence of commodiy prices shocks. The relaions beween governmen policy and naural resources prices pass hrough differen channels, including fiscal spending, savings and oher. An imporan elemen in his mechanism is he oil reserve fund. A he beginning of 2004 Sabilizaion fund was esablished in he Russian Federaion. The goal of i was o balance federal budge when he oil prices fall below some cup-off poin. In 2008 he fund was 6

spli ino wo pars: a Reserve Fund (invess in low-yield securiies and is used when oil prices fall) and Naional Welfare Fund (invess in riskier asses). In he booming period he Funds absorb he excess liquidiy and, as a resul, reduce inflaionary pressure and overheaing of he economy. Regardless of he exisence of many channels hrough which economic policy can sofen negaive effecs of commodiy prices flucuaions, policy managemen ofen (in conradicion o he recommendaions of he sandard heory o be counercyclical) leads o he increasing business cycle expansions and conracions caused by changing prices of naural resources or a leas is no effecive in miigaing real variables deviaions from heir long-erm values, ha is, i is acyclical. As shown in differen sudies (e.g., Frankel, 2011; Sinno, 2009; Sinno, Nash & Torre, 2010; Cespedes & Velasco, 2011), he procyclicaliy of economic policy is especially acue in commodiy-rich counries like Russia. The siuaion can be furher worsened by he presence of Duch Decease and all ypical negaive consequences of his effec. In addiion o he negaive empirical experience of macroeconomic adjusmens, from he heoreical poin of view very ofen economiss pay oo much aenion o he quaniies (consumpion, invesmens, ec.) han o he prices (Fernandez-Villaverde, 2010). As a resul, any macroeconomic model which is based on quaniies ignores o he large exen prices which is inconsisen since prices are he inegral par of he economic sysem. In he ligh of he imporance of commodiy markes modeling wihin coheren macroeconomic models, we invesigae he quesion wheher Cenral Bank of Russian should reac o he flucuaions of he oil prices. We use producion-inensive DSGE small open economy model wih oil producing secor of Dib (2008) and inroduce sabilizaion fund assuming ha oil revenues axed by he expor duy may be used as governmen expendiures or savings in he fund. Cenral Bank is represened by moneary policy rule, which may include oil price. The model is calibraed and esimaed on he Russian daa using Bayesian echniques. For he purpose of economic policy opimizaion we es sandard and augmened wih oil prices policy rules for heir abiliy o macroeconomic adjusmens. The rule which is he mos efficien in erms of flucuaions 7

minimizaion would be reaed as he mos opimal. The resuls shows ha Cenral Bank may consider mild response o he oil price, however, he economic gain in erms of flucuaions minimizaion is very small when here is sabilizaion fund in he counry. The effec is more significan if he fund would be absen implying ha eiher Cenral Bank or sabilizaion fund should sabilize he economy when oil prices deviae from he seady-sae level and here is no significan necessiy in using boh of hem. To summarize, he analysis has implicaions for boh policy making and macroeconomic modeling. Good macroeconomic model of any heavily dependen on naural resources counry canno ignore commodiy markes which are inexricably linked o he real economy. Consruced model will allow assessing moneary rules which has direc policy implicaion. The res of he paper is organized as follow. In he nex secion a discussion on key seleced works on economic policy and commodiy pricing is provided. Then New Keynesian macroeconomic model augmened wih oil prices elemens is discussed. Secion four describes he mehod of model esimaion. Finally, shor daa analysis is followed by he resuls discussion. A he end we conclude. 2 Overview of he lieraure The discussion of exising works and recommendaions on economic policy is presened wihin wo-dimensional framework. Firs, we sar his lieraure review from he foundaions of simple models relaing economic policy wih commodiy pricing using Vecor Auoregressive family models and hen swich o he modern approach, buil on DSGE models. Second, considered invesigaions are divided by regions of ineres: res of he world and works specifically dedicaed o he Russian economy. Differen frameworks have been proposed o sudy he links beween macroeconomic/moneary/fiscal variables and commodiy prices. Awokuse and Yang (2003) sae ha early sudies (e.g., Bessler, 1984) have focused on analyzing cause and effec relaions beween 8

variables of ineres. Laer on VAR mehodology was improved by aking ino accoun possible long-run relaions, ha is, using VECMs (e.g., Garner, 1989; Sephon, 1991; Marquis & Cunningham, 1990; Cody & Mills, 1991). These works, sudying as a rule US economy, ofen sugges moneary auhoriies o use prices on impored commodiies in heir decision-making process since hey may form a good signal of fuure developmen of he economics sysem. On he oher hand, an alernaive poin of view is represened by very influenial papers of Bernanke, Gerler and Wason (1997) and (2004). Auhors argue ha endogenous reacion of moneary policy o he negaive oil price shock amplifies he negaive influence of he shock per se and accouns for more han 50% of he corresponding drop in GDP. Even hough in his siuaion moneary policy plays a role of a negaive oil acceleraor effec, i does no mean ha alernaive opimal reacion canno have desired counercyclical properies. I should be noiced ha previous works analyzed, as a rule, large open economies which impor naural resources. While hey are relevan o modelling commodiies impor, exporing issues o he large exen are omied. Tha is why i is necessary o overview invesigaions direcly relaed o Russia. Anoher prominen feaure of he works dedicaed o oil exporing counries is horough analysis of no only of moneary bu as well as fiscal or quasi-moneary policies. To be specific, Io (2008) buil a small-scale VAR model of Russia economy o research he influence of oil prices on macroeconomic variables. The resuls show ha 1% oil price shock leads o he oscillaion of he ineres rae during he nex 4 quarers in he (-0.1;0.1) range. Then i suddenly drops and finally converges o he long-erm value. Similarly, indirec reacion of moneary policy o he oil shock is demonsraed in Merlevede, Schoors and Aarle (2007): oil shock causes exchange rae o deviae from sable value which hen riggers moneary policy reacion. Fiscal policy boh governmen revenues and expendiures are direcly relaed wih he oil expor. Rauava (2002) found ha 1% oil price increase should lead o 0.3% increase in federal governmen real revenues. These models are based on aheoreical ground and hey canno explain inrinsic reasons of commodiy marke role in he economic policy. I is also hard o disinguish beween direc 9

(exogenous) and indirec (endogenous) reacion of economic policy and o form more opimal rules. Moreover, he aemps o explain and es he relaions ofen occur in he parial equilibrium framework. Finally, empirical VAR family models are vulnerable o he Lucas criique, when esimaed coefficiens are policy-dependen. In such a siuaion policy analysis and experimening, especially if policy significanly differs from he observed one, may be misleading. This gap in he lieraure has been rying o fill in by means of micro founded Dynamic Sochasic General Equilibrium (DSGE) models, significan progress in developmen of which was observed during he las hree decades. Using DSGE model and having inroduced oil price growh ino he Cenral Bank policy rule, Kormilisina (2011) confirms he resuls of Bernanke, Gerler, and Wason (1997) and (2004) on recession amplificaion. However, i was shown ha opimal moneary policy (Ramsey opimal) in conras o he esimaed one has much smaller desabilizing effec on oupu and relaed variables. From he poin of view of he exporing counry, Dagher, Goschalk and Porillo (2012) assumes ha Ghanaian governmen policy is deermined by policy rule ha manages deposis accumulaion formed parly by oil revenues, which also conribues o he reserves of he Cenral Bank (is arge is a long run value of reserves). Such policy can sofen he influence of he negaive oil shocks on oil producing counry in comparison o he benchmark siuaion, when governmen full spending is assumed and Cenral Bank sell all foreign inflows received from he oil expor. Pieschacon (2009) has found on he examples of wo oil exporing economies Mexico and Norway ha fiscal policy is a key ransmission channel and wihou i he model poorly mimic observed daa. Fiscal policy was allowed o respond o he oil price shock by he change of he oil revenues ax rae. Such reacion has no wealh effec on labor, while generaes subsiuion effec as wages rises emporally leading o he ransiory increase in labor. In conras o he res of he world, especially o he US and oher developed economies, much less aenion is dedicaed o Russia. I would like o menion he DSGE model developed for he Russia by Sosunov and Zamulin (2007). The auhors found i o be useful for he model qualiy o 10

incorporae he asse holding block ino he consumpion problem of he represenaive household. Governmen posiion includes bonds as asses. However, no direc ess of oil/oher commodiies pricing modeling qualiy were conduced. Charnavoki (2010) analyzed opimal moneary policy in a small commodiy exporing counry For he case of Russia i was shown flexible exchange rae regime dominaes fixed one. Also core CPI and non-commodiy domesic inflaion argeing are no opimal in general; however, hey significanly dominae fixed regime. Differen resuls received Konorev (2011). The mos opimal moneary rule is CPI inflaion argeing and exchange rae peg under some alernaive specificaions of he welfare funcion. The former case is similar o he Sosunov and Zamulin (2007) resuls. The criic which we would like o address o he se of papers on commodiy pricing modeling and economic policy wihin DSGE framework concerns wo hings. Firsly, very few works are dedicaed o Russia where he srucure of he economic sysem significanly differs from hose one in he developed markes. Secondly, in majoriy he model and analysis is buil around oil or oher commodiies impor, neglecing such big oil exporing counries as he Russian Federaion. In sum, nobody has ried o answers he quesion of he necessiy o model commodiy prices and o incorporae hem ino economic policy rules in Russia using DSGE framework. The novely of his work incorporaes he applicaion of DSGE model o oil exporing counry, augmening he model wih reserve fund and furher assessmen of differen moneary policies for he necessiy o reac o he naural resources prices. 3 New Keynesian DSGE Model There are differen ways of incorporaing commodiies ino he model. We seleced sandard NK DSGE small open economy model of Dib (2008), which is similar also o Ambler e al. (2004), Orega and Rebei (2006) and Bergin e al. (2007). This model is a good candidae o describe he Russian economy, which is small and open and heavily depends on oil expor. 11

In general, he DSGE model describes he behavior of households, which consume, save and work, inermediae firms in oil, radable (also called manufacuring) and non-radable secors, which ren capial, labor and use oil o produce inermediae goods and services; final producer, which aggregaes inermediae producion and impor; governmen; Cenral Bank; mechanisms of marke imperfecions, ha is, elemens of monopolisic compeiion, wage and price sickiness; shocks and equilibrium relaions. We assume ha households in he economy are indexed on a coninuum range h 0,1 and each of hem maximizes he following ineremporal uiliy funcion: M 1 h, P vi 1 1 Ch, H h, E0 b, (1) 0 1 1 vi 1 where E 0 is expecaion operaor given he available informaion on period zero, C h, is consumpion level, 1 1 1 1 h, M, h, N, h, X, h, H H H H denoes oal hours worked based on CES funcion in manufacuring secor, H M, h,, non-radable secor, H N, h,, and in oil indusry, H X, h, is he household s discoun facor, and, vi,, and are sricly posiive parameers describing he elasiciy of corresponding variables., 3.1 Households Households monopolisically supply labor o compeiive firms which aggregae i based on he Dixi-Sigliz (1977) echnology (here and furher M denoes manufacuring secor, N denoes non-radable secor, and X denoe oil producion): 1 1 1 i, i, h, 0 H H dh, i M, N, X (2) where H i, is aggregae labor supply in corresponding secor of producion and 1 is elasiciy of subsiuion. Each household faces he following demand funcion by ypes of labor: 12

H W H i, h, i, h, i, W i,, (3) and akes aggregae demand/supply H i, and nominal wage index Households can buy or sell domesic and foreign bonds, B h, and 1 1 1 1 i, i, h, 0 W W dh as given. B, wih reurns R and * h, * * e B R, respecively. exp * P Y is counry risk premium, which depends on he raio of oal real counry deb B / P (ranslaed ino domesic currency wih nominal exchange rae e ) o real * * GDP, Y, and 0 is he parameer reflecing counry risk premium. This mechanism allows solving he problem of non-saionary foreign deb explosion. Foreign nominal price inflaion P / P is modeled as exogenous AR (1) process * * * 1 log * * log e (4) * 1 *, where 0,1 is he AR parameer wih idenically and independenly disribued innovaion * e N (0, ). * *, Households also consume and spend he income on invesmens, I I M, I N, I X,. They generae revenues from rening capial, K i, h,, a marke renal rae Q i,, receiving wage W i, h, on labor supplied and from facor paymens of naural recourses, L, which has a price of P L, and w h is he naural resource share of he household h, 1 0 whdh 1. Toal amoun of dividends is D DM, DN, DX, and lump-sum ax paymens are h,. Summarizing, he budge consrain is given by * B e B P C I Q K W H... h, h,,, *,,,,,,, h h i i h i h i h R R im, N, X... B e B whp L D (5) * h, 1 h, 1 L, h, h, 13

Foreign ineres rae evolves according o where R * 0,1 log * * log R R e, (6) * 1 * R R, is he auoregressive parameer wih uncorrelaed innovaions e * N(0, * ). R, R Each period he volume of capial consiss from previous period capial depreciaing a he rae of and new invesmen I i, h, insalled subjec o capial-adjusmen coss K i 2 K i, h, 1 i, h, 2 1 K i, h, : 1, K K I K K (7) i, h, 1 i, h, i, h, i, h, 1 i, h, Household deermines C h,, Ki, h, 1, B and * B solving is opimizaion problem represened by he objecive funcion (1) and subjec o he consrains (5) and (7). The resuling FOCs are: C h, h, ; (8) vi M h, h, 1 b h, E ; (9) P 1 2 h, 1 K i, h, 2 Ki, h, 2 K i, h, 2 K i i, h, 1 E qi, 1 1 i 1 1 i 1 1; (10) h, K i, h, 1 Ki, h, 1 2 K i, h, 1 K i, h, E ; (11) h, h, 1 1 R S S E, (12) h, 1 h, 1 * * R 1 where h, is he Lagrangian muliplier, qi, Qi, / P, P / P 1, S e P P, * / M h, P is real capial ren, CPI inflaion and real exchange rae, and real money balances, respecively. Dividing (12) by (11) we receive uncovered ineres rae pariy: 14

R e 1 (13) * R e In addiion o choosing opimal consumpion, real money balances, capial levels and bonds porfolio, household as monopolisic supplier of labor deermines desired wage level. Assuming Calvo-ype sicky adjusmen, a he beginning of period wih he probabiliy 1 i each household is allowed o change he desired level of wage o W i, h,. If here is no such possibiliy o choose new wage level, he laer will be indexed by domesic inflaion. As a resul, for each secor i M, N, X households solve he following maximizaion problem: l M h, l l max E,, 0 U Ch, l,, Hi, h, l h, l W i h Hi, h, l / P l W i, h, l 0 P, (14) subjec o H l W i, h, i, h, l H i, l W i, l. The FOC is: E l 1 l W W P 0 W i, l P P l l i, h, i, h, i Hi l i, l 0, (15) 0, l where i, U H U C i, h, is he marginal rae of subsiuion beween consumpion and labor in some i, h, secor i. Dividing (15) by P and rearranging, we can receive he following expression: w i, h, E w H l0 1 E w H l0 l l l i h, l i, l i, l i, l k k 1 l l l1 1 i h, l i, l i, l k k1, (16) 15

where W i, h, Wi, h, wi, h, is opimal real wage and w P i, h, is real wage index which evolves P according o he following recursive equaion: 1, 1 1 W i i Wi i W,, 1 1 i, (17) or in real erms w 1 1 i, 1 w i, i 1i w i, 1 (18) Assuming symmeric equilibrium, when each household selecs he same opimal wage and supplies he same amoun of labor, and based on (16) i is possible o receive non-linear recursive equaion w i, f 1 f, (19) 1 i, 2 i, where 1 l 1 i, i h, l i, l i, l i, l k h, i, i, i, i, 1 l0 k1 l l 1 i (20) f E w H w H E f and l 1 2 1 2 i, i h, l i, l i, l k h, i, i, i i, 1 l0 k1 l l1 1 (21) f E w H w H E f Using (16) and (18) we can also derive New Keynesian Phillips curve 1 i, i, i wi wi 1 i 1i w, (22) 16

where W is he wage inflaion (variables wih ha are log-deviaions from he seady sae). w i i, Wi, 1 3.2 Oil Secor Oil secor, indexed by X, is represened by perfecly compeiive company which uses aggregaed capial, 1 KX, KX, h, dh, labor, 0 1 H X, H X, h, dh, and naural recourse, L, (oil 0 deposis) o produce he oupu based on consan reurn o scale Cobb-Douglas funcion X X X X, X, X, Y K H L, (23) where X, X, and X are corresponding shares of capial, labor and naural recourse in oil producion summing o one. Amoun of available naural recourse evolve as AR(1) process log log L L e, (24) L 1 L, where 0,1 is he auoregressive parameer and e N L independenly disribued innovaions., 0, L are idenically and L Produced oil is expored or used in domesic producion as an inpu for manufacuring or non-radable secors such ha Y ex M N X, YX, YX, YX,. Oil producing company akes as given world oil prices, P, renal capial rae, Q X,, wage * X, level, W X,, and price of naural recourse, L, o deermine K X,, H X,, and L ha maximize is profi max e P Y Q K W H P L / P (25) * K,,,,,,,,,,, X H X L X X X X X X L subjec o he producion echnology consrain (23). Resuling FOCs are presened below: 17

q S p Y / K ; (26) * X, X X, X, X, w S p Y / H ; (27) * X, X X, X, X, p S p Y L, (28) * L, X X, X, / X where p P is real oil price, which can be modeled assuming Russia is a small open P * * X, X, economy as exogenously given AR(1) process where 0,1 p X innovaions. log * log * p p e, (29) X, px X, 1 px, is he auoregressive parameer and ep, N 0, p X are uncorrelaed X 3.3 Manufacuring Secor Manufacuring secor, indexed by M, is represened by he coninuum of firms j 0,1, each using capial, 1 KM, j, KM, j, h, dh, labor, 0 1 M H M, j, H M, j, h, dh, and oil, Y X, j,, o produce 0 is oupu based on Cobb-Douglas echnology where M, M M M Y A K H Y M M, j, M, M, j, M, j, X, j, (30) A is echnology shock following AR(1) process log log uncorrelaed innovaions ea, N 0, A M. M A A e wih M, AM M, 1 AM, Produced oupu by he manufacuring company j is consumed domesically and expored d ex abroad so ha YM, j, YM, j, YM, j,. Assuming producer currency pricing behavior, each company 18

ses he same price boh for foreign and domesic consumers. Under his assumpion he law of one price holds and demand from abroad is e P Y w Y ex M, j, * M, j, ex * P (31) where wex 0 is he fracion of spendings on domesically produced manufacuring goods in oal consumpion of foreigners. I is small since Russia is reaed as a small open economy and has no influence on he world prices. World GDP, where e N * * log * Y, evolves as a AR(1) exogenous process * * log Y Y e (32) * 1 * Y Y, 0, are independenly and idenically disribued residuals., Y Y Received profi is disribued o he shareholders in he form of dividends l * M M, j, l M, j, l M, j, l M, l M, j, l M, l M, j, l l X, l X, j, l D P Y Q K W H e P Y (33) where M, j, l P is he opimal price which he company can se wih probabiliy 1 M oherwise, he price is indexed by inflaion level, ha is, prices are Calvo-sicky. Then, maximizaion problem has he following form, or, max M K M, j,, HM, j,, YX, j,, PM, j, E0 l M j, ldm, j, l / P l (34) l0 subjec o (30), (33) and demand funcion Y P M, j, M, j, l Y M, l P M, l. The FOCs are q Y / K ; (35) M, M M, j, M, M, j, w Y / H ; (36) M, M M, j, M, M, j, 19

S p Y / Y, (37) * M X, M M, j, M, X, j, where (35) is capial demand funcion, (36) describes demand for labor and (37) model demand for oil. The opimal real price will have he following form p M, j, l l l E M j, lm, j, l pm, lym, j, l k l0 k1 l 1 l l1 1 E M j, l pm, lym, j, l k l0 k1 (38) and will evolve according o he following equaion p 1 1 M, 1 p 1 p M, M M M, 1 (39) By analogy o he oil producing secor case we can derive non-linear recursive relaion p x, (40) 1 M, M, 2 1 xm, where 1 1 1 M, j, M, M, j, M, M M, 1 x Y p E x (41) 1 2 1 2 M, j, M, M, M M, 1 x Y p E x (42) and New Keynesian Phillips curve is given by 1 M 1M M, M, 1 M, (43) M 20

where M, P M, is price inflaion in manufacuring secor (has denoes log-deviaions from he P M, 1 seady sae). 3.4 Non-Tradable Secor Non-radable secor has index N and is modeled analogously o he manufacuring secor. The only key difference is ha non-radable company j 0,1 canno expor is goods or services. For producion process companies ren capial 1 KN, j, K N, j, h, dh and hire labor 0 1 H N, j, H N, j, h, dh and consan elasiciy of subsiuion producion funcion 0 N N N Y A K H Y wih echnological facor log log N N, j, N, N, j, N, j, X, j, (44) A A e. N, AN N, 1 AN, Profi of he company (laer disribued as dividends) is given by l * N N, j, l N, j, l N, j, l N, l N, j, l N, l N, j, l l N, l X, j, l D P Y Q K W H e P Y (45) and company maximizes is objecive funcion max N K N, j,, H N, j,, YX, j,, PN, j, E0 l N j, ldn, j, l / P l (46) l0 subjec o (44), (45) and demand curve Y l P N, j, N, j, l Y N, l P N, l receiving as FOCs facor demand funcion q Y / K ; (47) N, N N, j, N, j, N, j, w Y / H ; (48) N, N N, j, N, j, N, j, 21

S p Y / Y. (49) * N X, N N, j, N, j, X, j, Prices are Calvo-sicky wih opimal price given by p N, j, l l l E N j, ln, j, l pn, lyn, l k l 0 k 1 l 1 l l1 1 E N j, l pn, lyn, l k l0 k1 (50) which evolve as a weighed average of pas and opimal price p 1 1 N, 1 p 1 p N, N N N, 1 (51) Non-linear recursive form is given by p x (52) 1 N, N, 2 1 xn, where 1 1 1 N, j, N, N, N, N N, 1 x Y p E x ; (53) 1 2 1 2 N, j, N, N, N N, 1 x Y p E x. (54) Corresponding secor sandard New Keynesian Phillips curve relaes curren and lead nonradable secor inflaion, N, P P N, N, 1, and secor s marginal coss (all variables wih ha are logdeviaions from he seady sae). 1 N 1N N, N, 1 N,. N 22

3.5 Impor Secor Imporers, indexed by F, impor o he Russia foreign goods and services and differeniae hem cosless o sell on monopolisically compeiive marke o receive profi l * D PF, j, l e P Y (55) F, j, l l F, l F, j, l Each company j 0,1 maximizes is ineremporal objecive funcion l max E 0 F j, ldf, j, l / P l PF, j, (56) l0 subjec o (55) and demand curve Y l P F, j, F, j, l Y F, l P F, l. So he only ask of he imporer is o selec selling price. By analogy o previously described secors, opimal Calvo-sicky price is given by p F, j, E p Y l 0 1 E p Y l 0 l l l F j, l F, l F, l F, l k k 1 l l l1 1 F j, l F, l F, l k k 1, (57) which evolve as p 1 1 F, 1 p 1 p F, F F F, 1. (58) The nonlinear recursive form is p x, (59) 1 F, F, 2 1 xf, where 1 1 1 F, j, F, F, F, F F, 1 x Y p E x, (60) 1 2 1 2 F, j, F, F, F F, 1 x Y p E x. (61) 23

Secor s New Keynesian Phillips curve has he form 1 F 1F F, F, 1 F,, (62) F where F, is impored good price inflaion (has denoe log-deviaions from he seadysae). F, P P F, 1 3.6 Final Good Represenaive final good producing company working on perfecly compeiive marke aggregaes manufacuring goods lef for domesic consumpion, non-radable and impored goods based on he following echnology 1 1 1 1 1 1 1 M M N N F F d,,, Z Y Y Y (63) where M, N, and F are shares of manufacuring, non-radable and impored goods in final good summing o one, is he elasiciy of subsiuion beween goods-inpus, which are aggregaed as,, j, 1 1 1 Y Y dj for M, N, F. 0 Final good producer opimizaion problem is given by he objecive funcion max d YF,, YM,, YN, d PZ PF, YF, PM, YM, PN, YN, (64) subjec o (63). The resuling FOCs represen demand funcions for inpus: Y P Z, F, F, F P P d M, YM, M Z P, and Y P Z N, N, N P wih he price index (assuming zero-profi condiion) 1 1 1 1 P P P P 1. Final good consiss from F F, M M, N N, 24

consumpion, invesmens in hree secors and governmen demand: Z C I G, where I I I I. M, N, X, In erms of economic policy he mos ypical ways of reacion o oil prices are Cenral Bank ineres rae changes and formaion of reserve funds, and he laer mechanism, as i is arguing by Sosunov and Zamulin (2007), is more a quasi-moneary ool. 3.7 Governmen Governmen collecs axes, paricipae on he bond marke and buy goods and services PG B B R, (65) 1 / where governmen expendiures evolve as AR(1) process log log G G e (66) G 1 G, 3.8 Cenral Bank Cenral bank moneary policy rule has he following form R R R R 1 log or log 1 or *... P...* o log o log o log o log e * Z e X, Z e P X * R, Z e P X. (67) We have added o he classical Taylor rule he erm oil price. Basically he goal of his sudy is o find opimal value o such ha i minimizes economic flucuaions. In addiion, we assumed * P X (as in Sosunov and Zamulin, 2007) ha some share, addiional amoun of Cenral Bank s reserves: rs w, of foreign revenues from oil expor forms Rs w S p Y (68) rs * ex X, X, and his purchase is financed by issuing necessary amoun of money such ha oal money growh rae is: 25

u 1 1 i i1 M P Rsi i1 1. (69) M P Rs 3.9 Equilibrium Assuming symmeric equilibrium, all decisions of households and companies are he same, implying ha Ch, C, Bh, B, B B, Ii, h, Ii,, w i, h, wi,, Hi, h, Hi, j, Hi,, * * h, X X X X Ki, h, Ki, j, Ki,, YM, j, YM,, YN, j, YN,, Y, j, Y,, p p for all h 0,1, 0,1, j,, j, i M, N, X, F, M, N wih marke-clearing condiion PG, B 0, for all 0. Defining added value Y Y S p Y / p for i M, N, aggregae GDP can be va * i i, i, X, X, i, expressed as Y va va va pm, YM, pn, YN, px, YX,. Finally, reserves are inroduced o inernaional posiion of he counry and is curren accoun balance is given by b b p (70) * * 1 * M N M, ex p * * X, YX, YX, YX, YM, YF, Rs R S where b B / P. * * * We define opimal policy as he moneary rule ha minimizes flucuaions of inflaion and GDP providing he wo imes larger weigh o he former in he quadraic loss funcions. 4 Model parameerizaion Discoun facor which measure impaience of he households is se a 0.9961. I is calculaed as a reciprocal of real ineres rae and corresponds o he average (seady-sae) quarerly inflaion level of 2.4% and nominal credi rae of 2.8%. Choosing sandard in he RBC lieraure value for ineremporal elasiciy of subsiuion 0.5, we can define parameer he inverse of he former a 2. Similarly he inverse raio of Frisch labor elasiciy,, is calibraed a sandard value 26

of one and following Horvah (2000), labor elasiciy of subsiuion across secors,, can be defined also as a uniy. Capial depreciaion rae is ypically se in he lieraure a 0.025 level. Producion funcions parameers are calculaed based on he inpu-oupu ables of Russian economy. To model he producion process in oil secor we need o assume ha share of naural recourse income, X, is 0.2 as in Suber (1998) and Macklem e. al (2000) since his facor of producion is no explicily shown in he daa. Then, based on 0.8 reurn o scale for capial and labor, heir shares, X and X, are 0.37 and 0.43, respecively. Shares of capial, labor and oil inpus in manufacuring and non-radable secors are se a 0.45, 0.49 and 0.07 ( and 0.55, 0.44 and 0.01 ( N, N and N ), respecively (see Appendix A1 for more deails). M, M and M ) We assume ha average seady-sae markup consiues 25%, which is in line wih he findings for Russian economy (e.g., Zaboloskiy, 2005). As a resul, parameer measuring degree of monopolisic compeiion,, is equal o 5. Elasiciy of subsiuion for differen ypes of labor is se a 6 implying wage markup of 20%. Elasiciy of subsiuion beween manufacuring, nonradable and impored goods,, is 0.67 as esimaed by Belomesnova (2002) and New Economic School (2005) and used in Zamulin and Sosunov (2007). I means ha hese goods are complemens. On he oher hand, Knobel (2011) on he 2000-2010 daa esimaed impor price elasiciy a 0.95 in comparison o 0.67 closer o he subsiuion region. In addiion, Zamulin and Sosunov (2007) esed heir DSGE model of Russian economy using wo values: esimaed 0.67 and hypoheical 1.5, where he leer capures he case of goods subsiuion. Parameer w ex is calibraed a 0.24 based on he average share of non-oil expor in GDP for 2000-2011 period. Shares of non-radable, w N, impored, manufacured good, w F, and domesically produced and used w M, are calculaed on he 2002-2011 daa as 0.69, 0.27 and 0.04, respecively. Risk premium parameer is he average for 2000-2010 period raio of ne inernaional invesmen posiion of counry o GDP and is evaluaed a 5.2%. The following variables consiues 27

he nex shares of GDP: 50% has consumpion, 22% invesmen, 18% governmen expendiures, 34% expor, 23% manufacuring expor, 10% oil expor, 22% impor, 60% non-radable goods, 25% manufacuring and 14% oil exracion. On average 65.6% of people are employed in non-radable secor, 33.8% in manufacuring and 0.6% in oil secor and households allocae one hird of heir ime for employmen (he laer one is a sandard assumpion). I is assumed ha each quarer 15% of oil expor revenues forms addiional volume of reserves. Values of naural recourse, echnology levels in manufacuring and non-radable secors are se o uniy a seady-sae. 5 Priors and daa During he las hree decades many compeiive economeric procedures have been proposed o parameerize and evaluae DSGE models, ranging from calibraion, over generalized mehod of momens (GMM) and minimum disance esimaion based on he discrepancy among VAR and DSGE model impulse response funcions o full-informaion likelihood-based esimaion. I was only recenly DSGE model prove heir pracical usefulness in policymaking: Chrisiano, Eichenbaum and Evans (2005) show ha hey can be applied effecively o moneary policy shocks analysis and Smes and Wouers (2003) reveal he dominance of DSGE models esimaed wih Bayesian economerics in he forecasing abiliy over he classical wide-spread VAR models (which also can be esimaed wih Bayesian economerics, ha is, BVAR models). Bayesian economerics is based on a simple probabiliy rule. Le assume ha here exis some daa generaing process which produces observables seleced for DSGE model. The marix of daa may be denoed Y daa. The vecor of parameers is param. In erms of Bayes formula we ge: p Ydaa param * p( param) p param Ydaa, (71) p( Y ) or is probabiliy kernel densiy will have he following form daa p Y p Y * p( ), (72) param daa daa param param 28

where p( param Ydaa ) is he poserior densiy of param given Y daa, p( Ydaa param ) is he likelihood funcion evaluaed based on he Kalman filer and p( param ) is he prior densiy of param should be specified by researcher. Bayesian esimaion of poserior densiy procedure consiss of he following seps: 1. Prior is se based on he exogenous o he daa informaion., which 2. The poserior disribuion is generaed by one of several Markov Chain Mone Carlo (MCMC) algorihms (we will use popular Random Walk Meropolis-Hasings). Priors are specified in Appendix A3. The model for Russian economy is esimaed in Dynare package for Malab/Ocave on quarerly daa covering he period from 2003Q1 o 2012Q2. Key variables which describes he evoluion of he proposed economic sysem are real per capia governmen expendiures, oil, radable and non-radable producion, quarerly ineres rae, inflaion, real exchange rae, foreign inflaion and GDP. The daa is seasonally adjused by X12- ARIMA filer and rend componen is exraced wih Hodrick-Presco filer. Governmen expendiures are measured in 2008 Russian rubles and are calculaed as he final expendiures of public secor. Percenage changes in oil producion are approximaed by he percenage changes in mineral resources exracion. Tradable secor is represened by agriculure, fishing, foresry, and differen manufacuring secors. Non-radable producion is measured by he sum of oupus in producion and ransporaion of elecriciy, gas and waer (uiliies), consrucion, wholesale and reail rade, hoels and resaurans, ransporaion and communicaion, finance, insurance and real esae, public governance, educaion, healh and social services and oher services. Each ypes of economic aciviy is expressed in 2008 rubles per capia. Ineres rae is an average quarerly nominal credi rae. Russian inflaions is measured as he change in CPI. Price of oil is he 2008 price index of oil expor average prices measured in euros per barrel. World economy is represened by EU-27 counries. This approximaion is reasonable since rade urnover beween Russia and EU- 27 counries consiues around 40% of oal Russian urnover. Correspondingly, real exchange rae 29

is he nominal exchange rae of ruble per euro muliplied by EU-27 CPI and divided by Russian CPI. Foreign inflaion is measured as he change in EU-27 nominal deflaor and foreign oupu is he nominal EU-27 GDP divided by he deflaor (addiional informaion on he daa is presened in Appendix A2). 6 Resuls discussion 6.1 Opimal Moneary Policy The resuls of esimaion show ha pricing srucure in manufacuring secor is more flexible wih Calvo pricing parameer equal o 0.51, while in non-radable one i is 0.73 implying more rigid adjusmen (for impored goods i is 0.65). Wage adjusmen parameers are close in oil, manufacuring and non-radable secors around 0.5 implying average period for salary change half a year. Esimaed capial adjusmen parameers signals ha mos quickly capial is changing wih new invesmens in manufacuring secor while he adjusmen is more rigid in oil and nonradable secors. Auoregressive parameers for echnology evoluion in manufacuring and non-radable secors are 0.07 and 0.26, respecively, and for naural resource i is 0.81 implying ha he shock is relaively persisen. Governmen expendiures are also relaively sable wih he AR parameer 0.94, oil price coefficien is 0.74. Foreign GDP evolves as AR process wih coefficien equal o 0.68, coefficien for foreign inflaion is 0.36 and for foreign ineres rae i is 0.06. Sandard deviaions of shocks lie in he [0.03, 0.10] range (see Appendix A3 for more deails). Impulse response funcions are shown in Appendix A4. Negaive moneary policy shock leads immediaely o he rise of domesic inflaion. While oupu also rises, he magniude of is increase is significanly lower. Similarly, consumpion rises a lile bi and converges o he seady-sae. By secors, producion in manufacuring indusry sars rising and afer achieving he pick of growh in 4-6 quarers sars gradually declining. Producion in non-radable and oil secors also rises bu are 30

very close o he seady-sae level. Similarly o he producion behaves invesmens in hese secors. Real exchange rae depreciaes which correspondingly lead o he increase of reserves. Posiive oil price shock mildly influence he economic sysem. Firs of all, producion significanly rises in he oil secor iself, while in manufacuring and non-radable secor i decreases emporally. The cumulaive effec on GDP is relaively small. The shock leads o he currency appreciaion which finally neglecs he effec of rising euros revenues from oil producion implying small reducion in reserves formaion (oil expor decreases, his srange resul may be caused by absence of oil price domesic and foreign differenial combined wih exchange rae appreciaion). Employmen, compensaion level, capial sock (also invesmens) and price of capial (Tobin s q) in oil producion secor rise and gradually converge o heir long-erm values. Finally, we consider reserve formaion posiive shock. This shock has a very small influence on almos all economic variables. As a resul, posiive increase of reserves immediaely disappears in he nex quarer. Neverheless, i should be noed ha real exchange rae appreciaes and foreign deb slighly rises. Reserve increase is financed by new money issuing, while he demand for real money balances from he households side decreases. In Table 1 we presen he resuls moneary policy rule esimaion and opimizaion. I suggess ha Cenral Bank of Russian Federaion ses up refinancing rae unsmoohly reacing more o he curren and expeced fuure even and poorly relying on he pas ineres rae rajecory ( is relaively small). Response o inflaion is accommodaive, no oo aggressive. The reacion o he changes in oupu is even smaller since oupu sabilizaion is no he primary goal. The mos srongly CBR responds o he changes in nominal exchange rae since ruble sabiliy is one of he mos imporan goals of he moneary regulaor. I appears ha CBR also mildly reac o he oil prices: he rise of oil price by 1% will rigger refinancing rae o rise on average by 0.12%. I means ha CBR conducs counercyclical moneary policy and ake ino accoun oil price quoes. or 31

Then we run hree key opimizaion exercises: (i) keeping all parameers excep o px as esimaed and opimizing wih respec o he reacion o oil price, (ii) opimizing all parameers excep parameers. or keeping i a he esimaed value and (iii) opimizing agains all moneary policy rule Suggesed reacion in he firs case is significanly lower ha esimaed and consiues only 0.03% of 1% oil price increase. On he oher hand, he las wo cases sugges ha response o oil price shock should be slighly lower ha he esimaed level a he 0.1 level. The model suggess also CBR o ignore compleely pas values of refinancing rae. The esimaed response o inflaion is close o he opimal. I is suggesed o increase he response o he nominal exchange rae from 1.66 o he aggressive level 2.26. If we compare opimal rule wihou response o oil price (case 0) wih such a response (case 3), suggesed parameers of reacion are almos he same for all variables ha can be compared. Table 1: Opimal reacion under differen policy rules Moneary policy rule or o o o z e o px Esimaed 0.07 1.06 0.47 1.66 0.12 Opimizaion 0 0.00 1.12-0.06 2.27 - Opimizaion 1 - - - - 0.03 Opimizaion 2-1.14-0.04 2.25 0.10 Opimizaion 3 0.00 1.12-0.06 2.26 0.10 Received resuls are inuiive, excep suggesed reacion o he oupu. To research his issue we es he same rule augmened wih he response o he oupu change. Esimaed resuls are close o he previous one. Opimal rules are also close o hose wihou oupu change (Table 2). Opimal reacion o he oupu level is suggesed o be almos zero while CBR should respond o he change in oupu: each 1% change in he oupu change should be followed by corresponding 0.3% change in he refinancing rae. 32

Table 2: Opimal reacion under policy rules wih oupu change variable o px dz Moneary policy rule or o o o z e o Esimaed 0.07 1.07 0.46 1.64 0.12 0.42 Opimizaion 1 - - - - 0.02 - Opimizaion 2-1.14-0.04 2.25 0.10 0.3 Opimizaion 3 0.01 1.13-0.05 2.25 0.10 0.3 Robusness ess were ran for hree alernaive ypes of models: model wih flexible wages bu sicky prices, model wih sicky wages bu flexible prices and model wih flexible wages and prices. Resuls sugges ha opimal response o he oil price shock is close o zero as in he firs opimizaion cases. In addiion, we consider he influence of differen moneary policy regimes on he opimizaion resuls. Since 1999 Cenral Bank of Russia has inroduced managed floaing regime coninuously decreasing inervenions on he exchange marke. This regime wih some modificaions exiss ill he curren momen. The mos significan reform was conduced in 2005, when moneary regulaor made a sep o floaing exchange rae, having officially inroduced he band for he ruble. Cenral Bank sell or buy foreign currency only when he exchange rae is a he inerval border. I should imply ha he coefficien a exchange rae in he moneary policy rule should decrease wih he passage of ime (fixed regime would imply infinie coefficien and floaing zero value). For his reason, he model is reesimaed on he 2005-2012 daa se. However, Cenral Bank reacion o he exchange rae did no change significanly (coefficien changed by less han 3%). The recommendaion for he opimal rule also changed no oo much: suggesed response o he oil price is negligible and o he exchange rae i decreased a lile bi. There is a necessiy o consider he poenial influence of Duch Disease on received resuls. As can be seen from he figure 1, since 2007 oil price sared rising very rapidly. We also reesimaed and analyzed opimal moneary policy for he 2003-2006 period o eliminae he case of poenial Duch Disease. Esimaed reacion o he exchange rae is higher now and consiues 1.92. 33

Oher parameers do no changed significanly. In conras o he previous cases, response o he exchange rae appears o be close o he opimal wihou necessiy o raise i above 2.25 level. Taking ino accoun he presence of rigidiies in he economic sysem, we may sugges o respond mildly ( o px 0.1) o he oil price movemens. Such posiive response may mean ha increasing oil prices leads o general economy increase overheaing he economy and correspondingly lower refinancing rae will sabilize i a accepable inflaion level, keep under he conrol exchange rae movemens and oher variables on lesser imporance. However, he improvemen in he value of he loss funcion when he Cenral Bank sars reacing o he oil prices (from 0.0 o 0.1) is no significan (less han 1%) implying ha moneary policy should no reac o oil prices and his reacion canno generae economically significan resuls. 6.2 Exension: Sabilizaion Fund So far oil prices have impac mainly on in he oil producing secor and o some exen on he Cenral Bank reserves. However, oil revenues are also significanly using in fiscal policy making. In paricular, in Russia here is a special expor ax (duy) on oil and peroleum producs. Proceeds from his duy ill 2004 were included ino he cenral budge as governmen expendiures. In fac, i brough a lo of insabiliy ino governmen secor and his effec so far was no capured in he model since governmen expendiures (66) are assumed o be a simple AR(1) process. To sofen poenial vulnerabiliy of he Russian economy o he oil price movemens, sabilizaion fund was formed so ha excess oil revenues from oil expor were no spen in oal bu some par may be saved in he fund. In case of oil revenues decrease, o keep governmen expendiures sable, accumulaed resources in he fund may be used. 34

We assume ha governmen expendiures in he curren period are relaed o he previous expendiures. In addiion, oil revenues (received share from he expor duy 1 ), ineres rae revenues on funds asses, and change in he fund asses may be used by he governmen: * ex g g s p y r swf swf swf e, (73) G 1 0.1* X, X, + 1 * 1 1 G, where small leers denoe log-deviaions from he seady-sae of corresponding variables denoed by capial leers, swf is sabilizaion fund. If he oil revenues are used by he governmen and canno be accumulaed in he fund (he case before 2004), hen as in Dagher, Goschalk and Porillo (2012) we assume ha SWF SWF 1 0, (74) oherwise, we assume ha governmen expendiures are consan share of GDP (forward looking governmen rule): G Z G Z 1 (75) 1 so ha excess oil revenues will be accumulaed in he sabilizaion fund. Wih inroducion of oil revenues ino governmen expendiures in boh cases of sabilizaion fund presence and absence economic flucuaions significanly rises. Recommended response o oil quoes wihou sabilizaion fund (equaion (74) is acive) is slighly higher han recommended response when he fund is acive (equaion (75) is used insead of (74)). I means ha he necessiy in moneary policy rule reacion o he oil prices is higher when here are no sabilizaion fund, however, i is sill of he 0.1 magniude. I should be noed ha in boh cases Cenral Bank may form par of is reserves from he oil revenues as well. Miigaing effec of he fund on he Russian economy was also found by Merlevede, Schoors and Aarle (2007). They simply inroduced fund presence dummies, which capures he drop of oil 1 I should be noed ha he revenue in he equaion (25) and corresponding FOCs now are reduced by expor duy. 35

price elasiciy of governmen expendiures. Moneary policy was modeled in a sandard way and is influence on he oil revenue managemen is secondary. Konorav (2011) model also showed ha inroducion of sabilizaion fund ino he model did no change significanly ranking of alernaive moneary policy rules/ regimes wih respec o inflaion and exchange rae (oil prices were no considered). Welfare improvemen was proporional across all rules. The recommendaion o he moneary auhoriy no o reac o he oil prices (a leas when he fund is presen) is also in line wih he dominaing general recommendaion o oil-imporing counries (see, for example, Bernanke, Gerler & Wason, 1997 and 2004). 7 Conclusions To conclude, despie of he wide lieraure on consrucing and esimaing DSGE models, here are no models for Russian economy which ook ino accoun he influence of exporing oil prices on he macroeconomic variables and answer he quesion on opimal moneary policy reacion on prices flucuaions. This paper should fill his gap, which ulimaely can posiively influence he effeciveness of policy managemen in Russia and oher counries wih similar economic srucures. I should be also noed ha hese resuls are obained wihin he model where reserve forming mechanism is inroduced. I means ha flucuaions of macroeconomic variables may be smoohed boh wih he help of sabilizaion fund and Cenral Bank policy in he form of Taylor-rule. Suggesed opimal moneary policy implies posiive mild direc response o he oil price shocks: 1% of oil price increase should rigger CBR o raise refinancing rae by 0.1% bu only in he case of sabilizaion fund absence; oherwise, he gain of response is no significan. I highlighs he imporance of policy coordinaion wih respec o he commodiy shocks sofening. Similar suggesion was made by Dagher, Goschalk and Porillo (2012). Fiscal smoohing (sabilizaion fund) can help o sabilize he economy and improve welfare; however, pure Cenral Bank reserves 36

accumulaion wihou fiscal backing canno guaranee macroeconomic sabiliy. Our paper also shows ha his sabiliy can be improved if moneary policy reacs o oil prices (when fiscal fund is absen). Collier e al. (2009) argue ha here are more effecive han sabilizaion fund insrumens absorbing excess oil revenue. They propose o inves money o deepen capializaion of he economy hrough public spending. To miigae poenial crowding ou and Duch Disease, public spending should be designed in such a way ha hey will increase he compeiiveness of privae invesmens. On he oher hand, moneary policy is no considered for consumpion smoohing. This and oher alernaive views on he reacion o he oil windfalls may form a good ground for fuure research. 37

Appendices Appendix A1. Producion funcion parameers evaluaion based on Inpu-Oupu ables. Calculaion of share of inpu-facors is based on Herrendorf and Valeninyi (2007). There are 24 branches, n, producing 24 commodiies, m. Le W be a n m marix where enry ij, shows wha share of commodiy j is produced by indusry i. Le B denoe m n marix wih enry ij showing he ruble amoun of commodiy i (inpu) necessary o produce one dollar of oupu in indusry j. Le q be a m 1 vecor of oal commodiy oupu and g be a n 1 vecor of final producion of indusries. Final goods and services are consumed by end users in he amoun e, a m 1 vecor. Toal producion of commodiies q is used for inermediary inpus, Bg, or is consumed by end users, e such ha In addiion q Bg e (A1.1) Using (A1.1) and (A1.2) we can solve for g : g Wq (A1.2) 1 g W I BW e, (A1.3) where enry ij of marix g shows he amoun of oupu of indusry i necessary o deliver one ruble of commodiy j o he final user. Final consumpion is divided beween oil expor, y X, commodiy domesic and expor consumpion, y M, and non-radable consumpion, y N e yx ym yn (A1.4) 38

and ' YY * PP 1 e is oal GDP. Le K, H, and X be vecors of capial, labor and oil incomes generaed by recourse owners per uni of oupu g. Then i can be shown ha Cobb-Douglas producion funcion parameers can be calculaed as param j ' 1 jw I BW y j 1 K H X W I BW y j ' ' ', (A1.5) where j X, M, N. The daa used for parameers calculaion he Sysem of Inpu-Oupu ables of Russia for 2003. Marix W is Table 5.1. Srucure of producion in differen branches of economy, marix B is Table 8.1. Coefficiens of direc and indirec inpus, Table of using commodiies in he Russian economy. y j and j are calculaed based on Table 3.1. 39

Appendix A2. Daa descripion Time series used o prepare final daa se for model esimaion: governmen expendiures: consan 2008 rubles; seasonally adjused; Russian Federaion Federal Sae Saisics Service, The Special Daa Disseminaion Sandard (SDDS) of he Inernaional Moneary Fund. oil producion: approximaed by percenage changes in mineral resources exracion consan 2008 rubles; seasonally adjused; Russian Federaion Federal Sae Saisics Service, The Special Daa Disseminaion Sandard (SDDS) of he Inernaional Moneary Fund. manufacuring secor: agriculure, fishing, foresry, and differen manufacuring secors; consan 2008 rubles; seasonally adjused; Russian Federaion Federal Sae Saisics Service, The Special Daa Disseminaion Sandard (SDDS) of he Inernaional Moneary Fund. non-radable secor: producion and ransporaion of elecriciy, gas and waer (uiliies), consrucion, wholesale and reail rade, hoels and resaurans, ransporaion and communicaion, finance, insurance and real esae, public governance, educaion, healh and social services and oher services; consan 2008 rubles; seasonally adjused; Russian Federaion Federal Sae Saisics Service, The Special Daa Disseminaion Sandard (SDDS) of he Inernaional Moneary Fund. ineres rae: average quarerly nominal credi rae; The Cenral Bank of The Russian Federaion; 40

Russian inflaions: change in CPI of goods and services; 2008 index = 1.0; Russian Federaion Federal Sae Saisics Service, The Special Daa Disseminaion Sandard (SDDS) of he Inernaional Moneary Fund. price of oil: oil expor price of Russian Federaion; ransformed ino index wih 2008 value equal o 1.0; The Cenral Bank of The Russian Federaion. nominal exchange raes are aken from oanda.com as inerbank average quarerly raes. real exchange rae is measured as he nominal exchange rae of ruble per euro muliplied by EU-27 CPI and divided by Russian CPI. foreign inflaion: EU-27 harmonized index of consumer prices HICP (2005 = 100) recalibraed o 2008 base year (prc_hicp_midx); Eurosa daabase; foreign deflaor: EU-27 index (2005 = 100) recalibraed o 2008 base year (namq_gdp_p); Eurosa daabase; foreign oupu: nominal EU-27 GDP divided by he deflaor (namq_gdp_p); seasonally adjused; Eurosa daabase; populaion: oal populaion of Russian Federaion or EU-27. Yearly daa for Rissia were ransformed linearly ino quarerly; Russian Federaion Federal Sae Saisics Service and Eurosa daabase. 41

Figure A2.1. HP-filered daa Noe: quarers on horizonal axis, changes in percens divided by 100 on verical axis 42

Appendix A3. Priors and poseriors Table A3.1: Specified prior disribuions and esimaed poserior modes Parameer Descripion Domain Prior Poserior Densiy Mean S.d. mode Calvo pricing parameer in M manufacuring secor [0,1] Bea 0.5 0.05 0.51 Calvo pricing parameer in nonrading secor N [0,1] Bea 0.5 0.05 0.73 Calvo pricing parameer for F imporing goods [0,1] Bea 0.5 0.05 0.65 Calvo wage parameer in M manufacuring secor [0,1] Bea 0.5 0.05 0.50 Calvo wage parameer in nonrading secor N [0,1] Bea 0.5 0.05 0.53 X Calvo wage parameer for oil [0,1] Bea 0.5 0.05 0.45 Capial adjusmen parameers in X oil secor R Normal 11.0 4.0 9.44 Capial adjusmen parameers in M manufacuring secor R Normal 2.0 0.5 2.11 Capial adjusmen parameers in N non-rading secor R Normal 7.0 1.0 7.69 o Ineres rae smoohing parameer R of moneary policy R Normal 0.1 0.05 0.07 o Moneary policy reacion parameer on inflaion R Normal 1.5 0.5 1.06 o Moneary policy reacion Z parameer on final good R Normal 0.5 0.2 0.47 o Moneary policy reacion u parameer on money growh R Normal 0.5 0.2 1.01 Moneary policy reacion o e parameer on exchange rae R Normal 2.0 0.2 1.66 o Moneary policy reacion PX parameer on oil price R Normal 0.1 0.05 0.12 Inverse R S.d. of moneary policy shock R Gamma 0.2 0.09 AR parameer for echnology AM evoluion in manufacuring secor R Normal 0.5 0.25 0.07 S.d. of echnology shock in Inverse AM manufacuring secor R Gamma 0.2 0.07 AR parameer for echnology AN evoluion in non-rading secor R Normal 0.5 0.25 0.26 S.d. of echnology shock in nonrading secor Inverse AN R Gamma 0.2 0.04 AR parameer for price of oil P X evoluion R Normal 0.5 0.25 0.74 Inverse X P S.d. of price of oil shock R Gamma 0.2 0.04 L AR parameer for naural recourse evoluion R Normal 0.5 0.25 0.81 43

Inverse L S.d. of naural recourse shock R 0.2 0.10 Gamma AR parameer for governmen G R Normal 0.5 0.25 0.94 expendiures evoluion S.d. of governmen expendiures Inverse G shock R 0.2 0.10 Gamma AR parameer for foreign ineres * R R Normal 0.5 0.25 0.06 rae evoluion Inverse * R S.d. of foreign ineres rae shock R 0.2 0.04 Gamma * AR parameer for foreign inflaion evoluion Inverse * S.d. of foreign inflaion shock R Gamma * Y AR parameer for foreign GDP evoluion R Normal 0.5 0.25 0.36 0.2 0.03 R Normal 0.5 0.25 0.68 Inverse * Y S.d. of foreign GDP shock R Gamma 0.2 0.03 Inverse Rs S.d. of reserves shock R Gamma 0.2 0.09 Noe: for Inverse Gamma disribuion mode and degrees of freedom are presened Figure A3.1. Calvo-pricing and Calvo-wage parameers Noe: gray line denoes prior disribuion, black line denoes poserior disribuion, green line denoes poserior mode 44

Figure A3.2. Moneary policy parameers Noe: gray line denoes prior disribuion, black line denoes poserior disribuion, green line denoes poserior mode Figure A3.3. Auoregressive parameers Noe: gray line denoes prior disribuion, black line denoes poserior disribuion, green line denoes poserior mode 45

Figure A3.4. Sandard deviaions of he shocks Noe: gray line denoes prior disribuion, black line denoes poserior disribuion, green line denoes poserior mode 46

Appendix A4. Impulse response funcions Figure A4.1: he effec of 1% negaive moneary policy shock Noe: quarers on horizonal axis, changes in percens divided by 100 on verical axis 47

Figure A4.2: he effec of 1% posiive oil price shock Noe: quarers on horizonal axis, changes in percens divided by 100 on verical axis 48

Figure A4.3: he effec of 1% posiive reserve shock Noe: quarers on horizonal axis, changes in percens divided by 100 on verical axis 49

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