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Inflation premium and oil price volatility

  • Paul Castillo
  • Carlos Montoro
  • Vicente Tuesta

This paper provides a fully micro-founded New Keynesian framework to study the interaction between oil price volatility, pricing behavior of firms and monetary policy. We show that when oil has low substitutability, firms find it optimal to charge higher relative prices as a premium in compensation for the risk that oil price volatility generates on their marginal costs. Overall, in general equilibrium, the interaction of the aforementioned mechanisms produces a positive relationship between oil price volatility and average inflation, which we denominate inflation premium. We characterize analytically this relationship by using the perturbation method to solve the rational expectations equilibrium of the model up to second order of accuracy. The solution implies that the inflation premium is higher when: a) oil has low substitutability, b) the Phillips Curve is convex, and c) the central bank puts higher weight on output fluctuations. We also provide some quantitative evidence showing that a calibrated model for the US with an estimated active Taylor rule produces a sizable inflation premium, similar to the levels observed in the US during the 70s.

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File URL: http://eprints.lse.ac.uk/19750/
File Function: Open access version.
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Paper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 19750.

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Length: 47 pages
Date of creation: Mar 2007
Date of revision:
Handle: RePEc:ehl:lserod:19750
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