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Energy and Monetary Policy in the Euro Area

Working paper 863
Working Papers
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Published: 29 June 2026

By: Alice Albonico Guido Ascari Qazi Haque Kostas Mavromatis Andra Smadu

We develop and estimate an open economy DSGE model for the euro area in which imported energy, priced in foreign currency, enters both consumption and production. Global energy prices and the exchange rate therefore jointly determine domestic inflation. We find that energy and exchange-rate disturbances account for the bulk of short-run volatility in headline euro area inflation, with energy price shocks driving most of the post-pandemic surge. Because energy and non-energy goods are poor substitutes, an adverse energy price shock raises import values, deteriorating the trade balance and depreciating the real exchange rate through the net-foreign-asset and UIP channels. The exchange-rate channel strengthens monetary transmission and improves the short-run inflation-output trade-off relative to a non-energy economy. Optimal policy can exploit this channel rather than looking through energy price shocks. However, the case for looking through such shocks becomes stronger when the central bank assigns a greater weight to output gap stabilization and prices become stickier.

Keywords: Monetary policy; Inflation; Energy;Bayesian estimation.


Working paper no. 863

863 - Energy and Monetary Policy in the Euro Area

863 - Energy and Monetary Policy in the Euro Area

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Highlights

  • We construct and estimate a medium-scale open economy model for the euro area. We find that imported energy prices—interacting with exchange rate movements—explain most of the short‑run volatility in euro area inflation and were key drivers of the post‑pandemic inflation surge.

  • Because energy is imported and priced in foreign currency, monetary policy affects inflation not only through demand but also by affecting the exchange rate, which directly and indirectly influences energy costs and firms’ marginal costs.

  • The exchange-rate channel strengthens monetary policy effectiveness and improves the inflation–output trade‑off compared to standard models without energy, allowing inflation stabilization at lower output costs in the short run.

  • A “look‑through” approach to energy shocks is optimal when price stickiness is high and output stabilization matters, while a more aggressive tightening becomes optimal as prices become more flexible or as the central bank prioritizes inflation control.

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