Fiscal and Monetary Policy Responses to Oil Price Shocks in Oil Importing Low Income Countries

This paper considers monetary and fiscal policy responses to oil price shocks in low income oil importing countries. I examine the dynamic properties and the welfare implications of a set of inflation targeting policies and a group of policies where the government provides a subsidy on household purchases of oil products and finances this subsidy through some combination of printing money and raising non-distortionary lump sum taxes. Even in the case where lump sum taxes finance the subsidy, it distorts household behavior in important ways leading to over consumption of oil products, increased trade deficits, and distortions to the labor supply. Resorting to the inflation tax to finance the subsidy leads to significant macroeconomic issues when exchange rates are flexible. The welfare gains from a policy that finances the subsidy through lump sum taxation are small compared to the policy with full pass through. For most calibrations the losses from financing the policy through the inflation tax are substantial. The welfare generated by the inflation targeting policies is close to the baseline policy with full pass through so long as the response to inflation is strong enough.