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How Should Monetary Policy Respond to Changes in the Relative Price of Oil? Considering Supply and Demand Shocks

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  • MICHAEL PLANTE

    ()
    (Federal Reserve Bank of Dallas)

Abstract

This paper examines optimal monetary policy in a New Keynesian model where the relative price of oil is affected by exogenous supply shocks and a productivity-driven demand shock. When wages are flexible, stabilizing core infation is optimal and the nominal rate rises (falls) in response to a demand (supply) shock. When both prices and wages are sticky, core inflation falls (rises) in response to the demand (supply) shock. Stabilizing CPI inflation generates small welfare losses only if the demand shock is the main driver of oil prices. Based on a VAR estimated using post-1986 data for the U.S., both shocks have had minimal impacts on core inflation. The federal funds rate rises in response to the demand shock but falls in response to the supply shock, consistent with the predictions of the theoretical model for a policy that stabilizes core inflation.

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File URL: http://www.iub.edu/~caepr/RePEc/PDF/2009/CAEPR2009-013.pdf
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Bibliographic Info

Paper provided by Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington in its series Caepr Working Papers with number 2009-013.

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Length: 35 pages
Date of creation: Aug 2009
Date of revision:
Handle: RePEc:inu:caeprp:2009-013

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References

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  1. Martin Bodenstein & Christopher J. Erceg & Luca Guerrieri, 2008. "Optimal monetary policy with distinct core and headline inflation rates," International Finance Discussion Papers 941, Board of Governors of the Federal Reserve System (U.S.).
  2. Michael Plante, 2009. "How Should Monetary Policy Respond to Changes in the Relative Price of Oil? Considering Supply and Demand Shocks," Caepr Working Papers 2009-013, Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington.
  3. Leduc, Sylvain & Sill, Keith, 2004. "A quantitative analysis of oil-price shocks, systematic monetary policy, and economic downturns," Journal of Monetary Economics, Elsevier, vol. 51(4), pages 781-808, May.
  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. Rajeev Dhawan & Karsten Jeske, 2007. "Taylor rules with headline inflation: a bad idea," Working Paper 2007-14, Federal Reserve Bank of Atlanta.
  6. Anton Nakov & Andrea Pescatori, 2010. "Monetary Policy Trade-Offs with a Dominant Oil Producer," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(1), pages 1-32, 02.
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Cited by:
  1. Michael Plante & Nora Traum, 2012. "Time-Varying Oil Price Volatility and Macroeconomic Aggregates," Caepr Working Papers 2012-002, Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington.
  2. Jean-Marc Natal, 2009. "Monetary policy response to oil price shocks," Working Paper Series 2009-16, Federal Reserve Bank of San Francisco.
  3. Michael Plante, 2012. "How should monetary policy respond to changes in the relative price of oil? considering supply and demand shocks," Working Papers 1202, Federal Reserve Bank of Dallas.

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