Mitigating the impact of fuel subsidy removal in an oil-producing emerging economy

Abstract

This paper examines the implications of fuel subsidy removal in an oil-producing economy, focusing on the central bank’s response to volatile oil prices. Using a Markov-switching dynamic stochastic general equilibrium model, we analyze the welfare effects of this policy change under different regimes of oil price volatility and monetary policy. Our empirical findings, based on data from Nigeria (2000:2 - 2021:4), reveal time-varying switches in oil price fluctuations and monetary policy adjustments that synchronize with states of high oil price volatility. We also find that subsidy removal has welfare-reducing and heterogenous effects on households, especially when implemented in an environment of heightened volatility. The efficacy of monetary policy in mitigating the impacts of subsidy removal depends on the ability of the central bank to design a flexible framework capable of adapting to economic shifts, while balancing its stabilization objectives. Furthermore, the observed monetary policy switching endogenous to different states of oil price shocks suggests a need for the central banks of oil-producing emerging economies to consider the prospects of a dual-mandate regime.