Oil price shocks and their transmission mechanism in an oil-exporting economy: A VAR analysis informed by a DSGE model

•Analyzes oil price shocks and transmission mechanism in oil-exporting country, Canada.•Uses structural VAR with two-country dynamic stochastic general equilibrium model.•Controls across countries for reverse causality and for contemporaneous interaction.•Quantifies contribution of endogenous U.S. monetary policy responses to oil price shocks.•Oil shocks stimulate Canadian demand, appreciate Canadian dollar, and reduce real wage. This paper examines the macroeconomic effects of oil price shocks and the oil shock transmission mechanism in an oil-exporting country, Canada. We use a structural VAR with sign restrictions that comes from a two-country dynamic stochastic general equilibrium (DSGE) model to jointly identify oil price, domestic supply and U.S. and domestic monetary policy shocks. This identification strategy not only controls for reverse causality from the Canadian and U.S. macroeconomic conditions to the real oil prices, but more importantly, it also allows for contemporaneous interactions between the Canadian and U.S. variables. We find that oil shocks have a stimulative effect on Canadian aggregate demand, appreciate the Canadian dollar, improve the terms of trade and reduce real wages. Foreign disturbances, including innovations in oil prices and the U.S. interest rate, have a significant influence on Canadian economic activities. Our counterfactual analysis indicates that the reaction of the U.S. interest rate as an indirect transmission channel for oil price shocks plays a moderate role in explaining the real exchange rate and inflation, but has negligible impacts on the Canadian output and interest rate.