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Monerary Policy Response to Oil Price Shocks

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  • Jean-Marc Natal

Abstract

How should monetary authorities react to an oil price shock? The New Keynesian literature has concluded that ensuring perfect price stability is optimal. Yet, the contrast between theory and practice is striking: Inflation targeting central banks typically favor a longer run approach to price stability. The first contribution of this paper is to show that because oil cost shares vary with oil prices, policies that perfectly stabilize prices entail large welfare costs, which explains the reluctance of policymakers to enforce them. The policy trade-off faced by monetary authorities is meaningful because oil (energy) is an input to both production and consumption. Welfare-based optimal policies rely on unobservables, which makes them hard to implement and communicate. The second contribution of this paper is thus to analytically derive a simple interest rate rule that mimics the optimal plan in all dimensions but that only depends on observables: core inflation and the growth rates of output and oil prices. It turns out that optimal policy is hard on core inflation but cushions the economy against the real consequences of an oil price shock by reacting strongly to output growth and negatively to oil price changes. Following a Taylor rule or perfectly stabilizing prices during an oil price shock are very costly alternatives.

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Bibliographic Info

Paper provided by Swiss National Bank in its series Working Papers with number 2010-15.

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Length: 67 pages
Date of creation: 2010
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Handle: RePEc:snb:snbwpa:2010-15

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Keywords: optimal monetary policy; oil shocks; divine coincidence; simple rules;

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Cited by:
  1. Stephen Snudden, 2013. "Cyclical Fiscal Rules for Oil-Exporting Countries," IMF Working Papers, International Monetary Fund 13/229, International Monetary Fund.
  2. Nikolaos Antonakakis & Ioannis Chatziantoniou & George Filis, 2014. "Dynamic Spillovers of Oil Price Shocks and Policy Uncertainty," Department of Economics Working Papers, Vienna University of Economics, Department of Economics wuwp166, Vienna University of Economics, Department of Economics.
  3. Montoro Carlos, 2007. "Oil Shocks and Optimal Monetary Policy," Working Papers, Banco Central de Reserva del Perú 2007-010, Banco Central de Reserva del Perú.
  4. Kang, Wensheng & Ratti, Ronald A., 2013. "Oil shocks, policy uncertainty and stock market return," Journal of International Financial Markets, Institutions and Money, Elsevier, Elsevier, vol. 26(C), pages 305-318.
  5. Sharma, Susan Sunila & Thuraisamy, Kannan, 2013. "Oil price uncertainty and sovereign risk: Evidence from Asian economies," Journal of Asian Economics, Elsevier, Elsevier, vol. 28(C), pages 51-57.
  6. Ano Sujithan, Kuhanathan & Koliai, Lyes & Avouyi-Dovi, Sanvi, 2013. "Does Monetary Policy Respond to Commodity Price Shocks?," Economics Papers from University Paris Dauphine, Paris Dauphine University 123456789/11718, Paris Dauphine University.
  7. Kang, Wensheng & Ratti, Ronald A., 2013. "Structural oil price shocks and policy uncertainty," Economic Modelling, Elsevier, Elsevier, vol. 35(C), pages 314-319.
  8. Michael Dooley & John C Williams, 2010. "Wrap-up Discussion," 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.
  9. Carlo Rosa, 2013. "The high-frequency response of energy prices to monetary policy: understanding the empirical evidence," Staff Reports, Federal Reserve Bank of New York 598, Federal Reserve Bank of New York.
  10. Isaac Gross & James Hansen, 2013. "Reserves of Natural Resources in a Small Open Economy," RBA Research Discussion Papers, Reserve Bank of Australia rdp2013-14, Reserve Bank of Australia.

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