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Inflation Premium and Oil Price Volatility

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Author Info
Paul Castillo
Carlos Montoro
Vicente Tuesta

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Abstract

This paper provides a fully micro-founded New Keynesian framework to study the interactionbetween oil price volatility, pricing behavior of firms and monetary policy. We show that when oilhas low substitutability, firms find it optimal to charge higher relative prices as a premium incompensation for the risk that oil price volatility generates on their marginal costs. Overall, in generalequilibrium, the interaction of the aforementioned mechanisms produces a positive relationshipbetween oil price volatility and average inflation, which we denominate inflation premium. Wecharacterize analytically this relationship by using the perturbation method to solve the rationalexpectations equilibrium of the model up to second order of accuracy. The solution implies that theinflation premium is higher when: a) oil has low substitutability, b) the Phillips Curve is convex, andc) the central bank puts higher weight on output fluctuations. We also provide some quantitativeevidence showing that a calibrated model for the US with an estimated active Taylor rule produces asizable inflation premium, similar to the levels observed in the US during the 70s.

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Paper provided by Centre for Economic Performance, LSE in its series CEP Discussion Papers with number dp0782.

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Date of creation: Mar 2007
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Handle: RePEc:cep:cepdps:dp0782

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Related research
Keywords: Second Order Solution; Oil Price Shocks; Endogenous Trade-off;

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Find related papers by JEL classification:
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian
C63 - Mathematical and Quantitative Methods - - Mathematical Methods and Programming - - - Computational Techniques

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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Jean-Marc Natal, 2009. "Monetary policy response to oil price shocks," Working Paper Series 2009-16, Federal Reserve Bank of San Francisco. [Downloadable!]
  2. Montoro Carlos, 2007. "Oil Shocks and Optimal Monetary Policy," Working Papers 2007-010, Banco Central de Reserva del Perú. [Downloadable!]
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