What if Oil is Less Substitutable? A New-Keynesian Model with Oil, Price and Wage Stickiness including Capital Accumulation.

The recent literature on fossil energy has already stated that oil is not perfectly substitutable to other inputs, considering fossil fuel as a critical production factor in different combinations. However, the estimations of substitution elasticity are in a wide range between 0.004 and 0.64. This paper addresses this phenomenon by enlarging the dsge model developed in Acurio-Vasconez et al. (2015) by changing the Cobb Douglas production and consumption functions assumed there, for composite Constant Elasticity of Substitution (ces) functions. Additionally, the paper introduces nominal wage and price rigidities through a Calvo setting. Finally, using Bayesian methods, the model is estimated on quarterly U.S. data over the period 1984:Q1-2007:Q3 and then analysed.
The estimation of oil’s elasticity of substitution is 0.14 in production and 0.51 in consumption. Moreover, thanks to the low substitutability of oil, the model recovers and explains four well-known stylized facts after the oil price shock in the 2000s’: the absent of recession, coupled with a low but persistent increase in inflation rate, a decrease in real wages and a low price elasticity of oil demand in the short run. Furthermore, ceteris paribus, the reduction of nominal wage rigidity amplifies the increase in inflation and the decrease in consumption. Thus in this model more wage flexibility does not seem to attenuate the impact of an oil shock.