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Oil Shocks and Optimal Monetary Policy

  • Montoro Carlos

    ()

    (Banco Central de Reserva del Perú and LSE)

This paper investigates how monetary policy should react to oil shocks in a microfounded model with staggered price-setting and oil as a non-produced input in the production function. We extend Benigno and Woodford (2005) to obtain a second order approximation to the expected utility of the representative household when the steady state is distorted and the economy is hit by oil price shocks. The main result is that oil price shocks generate a trade-off between inflation and output stabilisation when oil has low substitutability in production. Therefore, it becomes optimal to the monetary authority to stabilise partially the effects of oil shocks on inflation and some inflation is desirable. We also find, in contrast to Benigno and Woodford (2005), that this trade-off remains even when we eliminate the effects of monopolistic distortions from the steady state. Our results also shed light on how technological improvements which reduces the dependence on oil, also reduce the impact of oil shocks on the economy. This can explain why oil shocks have lower impact on inflation in the 2000s in contrast to the 1970s. Since oil has become easier to substitute with other renewable resources, the impact of oil shocks has been dampened.

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Paper provided by Banco Central de Reserva del Perú in its series Working Papers with number 2007-010.

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Date of creation: Aug 2007
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Handle: RePEc:rbp:wpaper:2007-010
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  1. 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, 02.
  2. Andrew B. Abel, . "Asset Prices Under Habit Formation and Catching Up With the Jones," Rodney L. White Center for Financial Research Working Papers 1-90, Wharton School Rodney L. White Center for Financial Research.
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  4. Paul Castillo & Carlos Montoro, 2006. "Inflation Premium and Oil Price Volatility," Computing in Economics and Finance 2006 18, Society for Computational Economics.
  5. Drora Karotkin, 1996. "Justification of the simple majority and chairman rules," Social Choice and Welfare, Springer, vol. 13(4), pages 479-486.
  6. Olivier Blanchard & Jordi Galí, 2005. "Real wage rigidities and the New Keynesian model," Working Papers 05-14, Federal Reserve Bank of Boston.
  7. Woodford, M., 1999. "Optimal Monetary Policy Inertia.," Papers 666, Stockholm - International Economic Studies.
  8. De Paoli, Bianca, 2009. "Monetary policy and welfare in a small open economy," Journal of International Economics, Elsevier, vol. 77(1), pages 11-22, February.
  9. Julio J. Rotemberg & Michael Woodford, 1996. "Imperfect Competition and the Effects of Energy Price Increases on Economic Activity," NBER Working Papers 5634, National Bureau of Economic Research, Inc.
  10. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers.
  11. Pierpaolo Benigno & Michael Woodford, 2004. "Optimal monetary and fiscal policy: a linear-quadratic approach," International Finance Discussion Papers 806, Board of Governors of the Federal Reserve System (U.S.).
  12. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, vol. 115(1), pages 147-180, February.
  13. Michael Woodford & Pierpaolo Benigno, 2004. "Inflation Stabilization and Welfare: The Case of a Distorted Steady State," 2004 Meeting Papers 481, Society for Economic Dynamics.
  14. Pierpaolo Benigno & Michael Woodford, 2005. "Optimal stabilization policy when wages and prices are sticky: the case of a distorted steady state," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 127-180.
  15. Kilian, Lutz, 2006. "Not All Oil Price Shocks Are Alike: Disentangling Demand and Supply Shocks in the Crude Oil Market," CEPR Discussion Papers 5994, C.E.P.R. Discussion Papers.
  16. Leduc, Sylvain & Sill, Keith, 2004. "A quantitative analysis of oil-price shocks, systematic monetary policy, and economic downturns," Journal of Monetary Economics, Elsevier, vol. 51(4), pages 781-808, May.
  17. Robert E. Lucas, Jr. & N. Gregory Mankiw & Michael Woodford, 2005. "Panel discussion: understanding price determination: where are we now? where should we be going?," Proceedings, Board of Governors of the Federal Reserve System (U.S.).
  18. King, Robert G & Plosser, Charles I & Rebelo, Sergio T, 2002. "Production, Growth and Business Cycles: Technical Appendix," Computational Economics, Society for Computational Economics, vol. 20(1-2), pages 87-116, October.
  19. Bernanke, Ben S & Gertler, Mark & Watson, Mark W, 2004. "Oil Shocks and Aggregate Macroeconomic Behavior: The Role of Monetary Policy: Reply," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 36(2), pages 287-91, April.
  20. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
  21. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  22. Hamilton, James D & Herrera, Ana Maria, 2004. "Oil Shocks and Aggregate Macroeconomic Behavior: The Role of Monetary Policy: Comment," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 36(2), pages 265-86, April.
  23. Tack Yun, 2005. "Optimal Monetary Policy with Relative Price Distortions," American Economic Review, American Economic Association, vol. 95(1), pages 89-109, March.
  24. James D. Hamilton, 2000. "What is an Oil Shock?," NBER Working Papers 7755, National Bureau of Economic Research, Inc.
  25. Rotemberg, Julio J, 1982. "Sticky Prices in the United States," Journal of Political Economy, University of Chicago Press, vol. 90(6), pages 1187-1211, December.
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