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

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  • Anton Nakov
  • Andrea Pescatori

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 any trade-off 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. Modeling the oil sector from optimizing first principles rather than assuming an exogenous oil price, we show that the presence of a dominant oil supplier (OPEC) leads to inefficient fluctuations in the oil price markup. The latter reflects a dynamic distortion of the production process, and as a result, stabilizing inflation does not automatically stabilize the distance of output from first-best. Our model is a step away from discussing the effects of exogenous oil price changes and toward analyzing the implications of the underlying shocks that cause the oil price to change in the first place.

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Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 0710.

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Date of creation: 2007
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Handle: RePEc:fip:fedcwp:0710

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Keywords: Monetary policy ; Petroleum products - Prices ; Business cycles;

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References

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  1. Robert B. Barsky & Lutz Kilian, 2002. "Do We Really Know that Oil Caused the Great Stagflation? A Monetary Alternative," NBER Chapters, in: NBER Macroeconomics Annual 2001, Volume 16, pages 137-198 National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Lutz Kilian, 2010. "Oil Price Shocks, Monetary Policy and Stagflation," RBA Annual Conference Volume, Reserve Bank of Australia, in: Renée Fry & Callum Jones & Christopher Kent (ed.), Inflation in an Era of Relative Price Shocks Reserve Bank of Australia.
  2. Lutz Kilian & Logan T. Lewis, 2011. "Does the Fed Respond to Oil Price Shocks?," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 121(555), pages 1047-1072, 09.
  3. Jean-Marc Natal, 2009. "Monetary policy response to oil price shocks," Working Paper Series, Federal Reserve Bank of San Francisco 2009-16, Federal Reserve Bank of San Francisco.
  4. Hassan, Syeda Anam & Zaman, Khalid, 2012. "Effect of oil prices on trade balance: New insights into the cointegration relationship from Pakistan," Economic Modelling, Elsevier, Elsevier, vol. 29(6), pages 2125-2143.
  5. Vipin Arora, 2011. "Asset Value, Interest Rates and Oil Price Volatility," ANU Working Papers in Economics and Econometrics, Australian National University, College of Business and Economics, School of Economics 2011-536, Australian National University, College of Business and Economics, School of Economics.
  6. Anton Nakov & Andrea Pescatori, 2007. "Oil and the Great Moderation," Working Paper 0717, Federal Reserve Bank of Cleveland.

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