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Exchange Rates, Oil Price Shocks, and Monetary Policy in an Economy with Traded and Non-Traded Goods

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  • Michael Plante

    ()
    (Indiana University, Ball State University)

Abstract

This paper examines monetary policy responses to oil price shocks in a small open economy that produces traded and non-traded goods. When only labor and oil are used in production and prices are sticky in the non-traded sector the behavior of ination, the nominal exchange rate, and the relative price of the non-traded good depends crucially upon whether the ratio of the cost share of oil to the cost share of labor is higher for the traded or non-traded sector. If the ratio is smaller (higher) for the traded sector then a policy that fully stabilizes non-traded ination causes the nominal exchange rate to appreciate (depreciate) and the relative price of the non-traded good to rise (fall) when there is a surprise rise in the price of oil. Similar results can hold for a policy that stabilizes CPI ination. Under a policy that xes the nominal exchange rate, non-traded ination rises (falls) if the ratio is smaller (larger) for the traded sector. Analytical results show that a policy of xing the exchange rate always produces a unique solution and that a policy of stabilizing non-traded ination produces a unique solution so long as the nominal interest rate is raised more than one-for-one with rises in non-traded ination. A policy that stabilizes CPI ination, however, produces multiple equilibria for a wide range of calibrations of the policy rule.

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File URL: http://www.iub.edu/~caepr/RePEc/PDF/2009/CAEPR2009-016.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 2009-016.

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Length: 37 pages
Date of creation: Aug 2009
Date of revision:
Handle: RePEc:inu:caeprp:2009-016

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