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How Should Monetary Policy Respond to Changes in the Relative Price of Oil? Considering Supply and Demand Shocks

  • MICHAEL PLANTE

    ()

    (Federal Reserve Bank of Dallas)

This paper examines optimal monetary policy in a New Keynesian model where the relative price of oil is affected by exogenous supply shocks and a productivity-driven demand shock. When wages are flexible, stabilizing core infation is optimal and the nominal rate rises (falls) in response to a demand (supply) shock. When both prices and wages are sticky, core inflation falls (rises) in response to the demand (supply) shock. Stabilizing CPI inflation generates small welfare losses only if the demand shock is the main driver of oil prices. Based on a VAR estimated using post-1986 data for the U.S., both shocks have had minimal impacts on core inflation. The federal funds rate rises in response to the demand shock but falls in response to the supply shock, consistent with the predictions of the theoretical model for a policy that stabilizes core inflation.

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File URL: http://www.iub.edu/~caepr/RePEc/PDF/2009/CAEPR2009-013.pdf
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Paper provided by Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington in its series Caepr Working Papers with number 2009-013.

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Length: 35 pages
Date of creation: Aug 2009
Date of revision:
Handle: RePEc:inu:caeprp:2009-013
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  1. Michael Plante, 2012. "How should monetary policy respond to changes in the relative price of oil? considering supply and demand shocks," Working Papers 1202, Federal Reserve Bank of Dallas.
  2. Martin Bodenstein & Christopher J. Erceg & Luca Guerrieri, 2008. "Optimal monetary policy with distinct core and headline inflation rates," International Finance Discussion Papers 941, Board of Governors of the Federal Reserve System (U.S.).
  3. Sylvain Leduc & Keith Sill, 2001. "A quantitative analysis of oil-price shocks, systematic monetary policy, and economic downturns," Working Papers 01-9, Federal Reserve Bank of Philadelphia.
  4. Rajeev Dhawan & Karsten Jeske, 2007. "Taylor rules with headline inflation: a bad idea," Working Paper 2007-14, Federal Reserve Bank of Atlanta.
  5. Anton Nakov & Andrea Pescatori, 2010. "Monetary Policy Trade-Offs with a Dominant Oil Producer," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(1), pages 1-32, 02.
  6. 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, 09.
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