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 in ation, 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 in ation 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 in ation. Under a policy that xes the nominal exchange rate, non-traded in ation 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 in ation produces a unique solution so long as the nominal interest rate is raised more than one-for-one with rises in non-traded in ation. A policy that stabilizes CPI in ation, however, produces multiple equilibria for a wide range of calibrations of the policy rule.
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Publisher 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.