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Inflation, Oil Price Volatility and Monetary Policy

  • Castillo, Paul

    (Banco Central de Reserva del Perú)

  • Montoro, Carlos

    (Banco Central de Reserva del Perú
    CENTRUM-Catolica)

  • Tuesta, Vicente.

    (CENTRUM-Catolica)

In a fully micro-founded New Keynesian framework, we characterize analytically the relation between average inflation and oil price volatility by solving the rational expectations equilibrium of the model up to second order of accuracy. Higher oil price volatility induces higher levels of average inflation. We also show that when oil has low substitutability and the central bank responds to output fluctuations, oil price volatility matters for the level of average inflation. The model shows that when oil price volatility increases, average inflation increases whereas average output falls: this implies a trade-off also between average inflation and that of output. The analytical solution further indicates that for a given level of oil price volatility, average inflation is higher when marginal costs are convex in oil prices, the Phillips Curve is convex, and the degree of relative price dispersion is also higher. We perform a numerical exercise showing that the model with a empirically plausible Taylor rule can replicate the level of average inflation observed in the U.S. in 2000s.

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Paper provided by Banco Central de Reserva del Perú in its series Working Papers with number 2010-002.

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Date of creation: Jan 2010
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Handle: RePEc:rbp:wpaper:2010-002
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  1. Patrick J. Kehoe & Andrew Atkeson, 1999. "Models of Energy Use: Putty-Putty versus Putty-Clay," American Economic Review, American Economic Association, vol. 89(4), pages 1028-1043, September.
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  3. Aruoba, S. Boragan & Fernandez-Villaverde, Jesus & Rubio-Ramirez, Juan F., 2006. "Comparing solution methods for dynamic equilibrium economies," Journal of Economic Dynamics and Control, Elsevier, vol. 30(12), pages 2477-2508, December.
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  6. Blanchard, Olivier J & Galí, Jordi, 2005. "Real Wage Rigidities and the New Keynesian Model," CEPR Discussion Papers 5375, C.E.P.R. Discussion Papers.
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  8. Stephanie Schmitt-Grohé & Martín Uribe, 2006. "Optimal Inflation Stabilization in a Medium-Scale Macroeconomic Model," Working Papers Central Bank of Chile 410, Central Bank of Chile.
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  10. Kim, In-Moo & Loungani, Prakash, 1992. "The role of energy in real business cycle models," Journal of Monetary Economics, Elsevier, vol. 29(2), pages 173-189, April.
  11. Montoro, Carlos, 2012. "Oil Shocks And Optimal Monetary Policy," Macroeconomic Dynamics, Cambridge University Press, vol. 16(02), pages 240-277, April.
  12. Collard, Fabrice & Juillard, Michel, 1999. "Accuracy of stochastic perturbuation methods: the case of asset pricing models," CEPREMAP Working Papers (Couverture Orange) 9922, CEPREMAP.
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  15. Judd, Kenneth L., 1992. "Projection methods for solving aggregate growth models," Journal of Economic Theory, Elsevier, vol. 58(2), pages 410-452, December.
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