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Inflation-output gap trade-off with a dominant oil supplier

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  • Anton Nakov
  • Andrea Pescatori

Abstract

An exogenous oil price shock raises inflation and contracts output, similar to a negative productivity shock. In the standard New Keynesian model, however, this does not generate any trade-off between inflation and output gap volatility: under a strict inflation-targeting policy, the output decline is exactly equal to the efficient output contraction in response to the shock. Modeling the oil sector from optimizing first principles rather than assuming an exogenous oil price, we show that the presence of a dominant oil supplier (OPEC) leads to inefficient fluctuations in the oil price markup. The latter reflects a dynamic distortion of the production process, and as a result, stabilizing inflation does not automatically stabilize the distance of output from first-best. Our model is a step away from discussing the effects of exogenous oil price changes and toward analyzing the implications of the underlying shocks that cause the oil price to change in the first place.

Suggested Citation

  • Anton Nakov & Andrea Pescatori, 2007. "Inflation-output gap trade-off with a dominant oil supplier," Working Paper 0710, Federal Reserve Bank of Cleveland.
  • Handle: RePEc:fip:fedcwp:0710
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    References listed on IDEAS

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    Cited by:

    1. Lutz Kilian, 2010. "Oil Price Shocks, Monetary Policy and Stagflation," RBA Annual Conference Volume,in: Renée Fry & Callum Jones & Christopher Kent (ed.), Inflation in an Era of Relative Price Shocks Reserve Bank of Australia.
    2. Anton Nakov & Andrea Pescatori, 2010. "Oil and the Great Moderation," Economic Journal, Royal Economic Society, vol. 120(543), pages 131-156, March.
    3. Lutz Kilian & Logan T. Lewis, 2011. "Does the Fed Respond to Oil Price Shocks?," Economic Journal, Royal Economic Society, vol. 121(555), pages 1047-1072, September.
    4. Jean‐Marc Natal, 2012. "Monetary Policy Response to Oil Price Shocks," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44(1), pages 53-101, February.
    5. Vipin Arora, 2011. "Asset Value, Interest Rates and Oil Price Volatility," The Economic Record, The Economic Society of Australia, vol. 87(s1), pages 45-55, September.
    6. Hassan, Syeda Anam & Zaman, Khalid, 2012. "Effect of oil prices on trade balance: New insights into the cointegration relationship from Pakistan," Economic Modelling, Elsevier, vol. 29(6), pages 2125-2143.

    More about this item

    Keywords

    Monetary policy ; Petroleum products - Prices ; Business cycles;

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • Q43 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Energy - - - Energy and the Macroeconomy

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