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Inflation-output gap trade-off with a dominant oil supplier

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  • Anton Nakov

    ()
    (Banco de España
    Universitat Pompeu Fabra)

  • Andrea Pescatori

    ()
    (Universitat Pompeu Fabra)

Abstract

An exogenous oil price shock raises inflation and contracts output, similar to a negative productivity shock. In the standard New Keynesian model, however, this does not generate a tradeoff between inflation and output gap volatility: under a strict inflation targeting policy, the output decline is exactly equal to the efficient output contraction in response to the shock. We propose an extension of the standard model in wich the presence of a dominant oil supplier (OPEC) leads to inefficient fluctuations in the oil price markup, reflecting a dynamic distortion of the economy´s production process. As a result, in the face of oil sector shocks, stabilizing inflation does not automatically stabilize the distance of output from first-best, and monetary policymarkers face a tradeoff between the two goals.

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Bibliographic Info

Paper provided by Banco de Espa�a in its series Banco de Espa�a Working Papers with number 0723.

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Length: 57 pages
Date of creation: Jul 2007
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Handle: RePEc:bde:wpaper:0723

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Keywords: oil shocks; inflation-output gap tradeoff; dominant firm;

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Cited by:
  1. Lutz Kilian, 2010. "Oil Price Shocks, Monetary Policy and Stagflation," RBA Annual Conference Volume, in: Renée Fry & Callum Jones & Christopher Kent (ed.), Inflation in an Era of Relative Price Shocks Reserve Bank of Australia.
  2. Vipin Arora, 2011. "Asset Value, Interest Rates and Oil Price Volatility," The Economic Record, The Economic Society of Australia, vol. 87(s1), pages 45-55, 09.
  3. Anton Nakov & Andrea Pescatori, 2007. "Oil and the Great Moderation," Working Paper 0717, Federal Reserve Bank of Cleveland.
  4. Lutz Kilian & Logan T. Lewis, 2011. "Does the Fed Respond to Oil Price Shocks?," Economic Journal, Royal Economic Society, vol. 121(555), pages 1047-1072, 09.
  5. Jean-Marc Natal, 2009. "Monetary policy response to oil price shocks," Working Paper Series 2009-16, Federal Reserve Bank of San Francisco.
  6. Hassan, Syeda Anam & Zaman, Khalid, 2012. "Effect of oil prices on trade balance: New insights into the cointegration relationship from Pakistan," Economic Modelling, Elsevier, vol. 29(6), pages 2125-2143.

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