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Inflation Premium and Oil Price Volatility

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Author Info
Paul Castillo () (London School of Economics)
Carlos Montoro

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Abstract

In this paper we establish a link between the volatility of oil price shocks and a positive expected value of inflation in equilibrium (inflation premium). In doing so, we implement the perturbation method to solve up to second order a benchmark New Keynesian model with oil price shocks. In contrast with log linear approximations, the second order solution relaxes certainty equivalence providing a link between the volatility of shocks and inflation premium. First, we obtain analytical results for the determinants of the level of inflation premium. Thus, we find that the degree of convexity of both the marginal cost and the phillips curve is a key element in accounting for the existence of a positive inflation premium. We further show that the level of inflation premium might be potentially large even when a central bank implements an active monetary policy. Second, we evaluate numerically the second order solution of the model to explain the episode of high and persistent inflation observed in the US during the 70's. We find, in contrast with Clarida, Gali and Gertler (QJE, 2000), that even when there is no difference in the monetary policy rules between the pre-Volcker and post-Volcker periods, oil price shocks can generate high inflation levels during the 70's through a positive high level of inflation premium. As by product, our analysis shows that oil price shocks along with a distorted steady state can generate a time-varying endogenous trade-off between inflation and deviations of output from its efficient level. The previous trade-off, once uncertainty is taking into account, implies that a positive level of inflation premium is an optimal response to oil price shocks

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2006 with number 18.

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Date of creation: 04 Jul 2006
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Handle: RePEc:sce:scecfa:18

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

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Find related papers by JEL classification:
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian
C63 - Mathematical and Quantitative Methods - - Mathematical Methods and Programming - - - Computational Techniques

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References listed on IDEAS
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Montoro Carlos, 2007. "Oil Shocks and Optimal Monetary Policy," Working Papers 2007-010, Banco Central de Reserva del Perú. [Downloadable!]
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