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Oil Price Shocks, Monetary Policy Rules and Welfare

  • Fiorella de Fiore

    (Monetary Policy Research, ECB)

  • Giovenni Lombardo

    (Monetary Policy Research, ECB)

  • Viktors Stebunovs

    (Boston College)

Sudden and protracted oil-price increases are generally accompanied by economic contractions and high inflation. How should monetary policy react to oil-price shocks in order to minimize such adverse macroeconomic effects? We build a DSGE model characterized by two oil-importing countries and one oil-exporting country. Oil-importing countries use oil for consumption and as input in production. The oil-exporting country consumes imported goods and produces oil. We calibrate the model and evaluate the performance of simple Taylor-type interest rate rules, on the basis of a micro-founded welfare metric. We search for rules that i) maximize welfare to a second order of approximation, ii) satisfy the zero-lower-bound for the nominal interest rate and iii) produce either a Nash or a cooperative equilibrium. We show that the optimal reaction of monetary policy is strongly influenced by the presence of energy taxes. For calibrated values of energy taxes, we find that monetary policy should partially accommodate oil-price increases. The optimal interest rate rule is inertial, it reacts strongly and positively to inflation and output deviations from the steady state, while it reacts negatively to deviations of the real price of oil from its steady-state value

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2006 with number 402.

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Date of creation: 04 Jul 2006
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Handle: RePEc:sce:scecfa:402
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