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Inflation Premium and Oil Price Volatility

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  • Paul Castillo
  • Carlos Montoro
  • Vicente Tuesta

Abstract

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

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Bibliographic Info

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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Web page: http://cep.lse.ac.uk/_new/publications/series.asp?prog=CEP

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

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Citations

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Cited by:
  1. Montoro Carlos, 2007. "Oil Shocks and Optimal Monetary Policy," Working Papers 2007-010, Banco Central de Reserva del Perú.
  2. Zhang, Zibin & Wetzstein, Michael E., 2008. "New relationships: ethanol, corn, and gasoline volatility," Transition to a Bio Economy Conferences, Risk, Infrastructure and Industry Evolution Conference, June 24-25, 2008, Berkeley, California 48718, Farm Foundation.
  3. Jean‐Marc Natal, 2012. "Monetary Policy Response to Oil Price Shocks," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44(1), pages 53-101, 02.
  4. Wetzstein, M. & Wetzstein, H., 2011. "Four myths surrounding U.S. biofuels," Energy Policy, Elsevier, vol. 39(7), pages 4308-4312, July.

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