Monetary Policy Response to Oil Price Shocks

Abstract

How should monetary authorities react to an oil price shock? This paper shows that in a noncompetitive economy, policies that perfectly stabilize prices entail large welfare costs, hence explaining the reluctance of policymakers to enforce them. The policy trade-off is nontrivial because oil (energy) is an input to both production and consumption. As welfaremaximizing policies are hard to implement and communicate, I derive a simple interest rate rule that depends only on observables but mimics the optimal plan in all dimensions. The optimal rule is hard on core inflation but accommodates oil price changes.JEL codes: E32, E52, E58

Dynamic spillovers of oil price shocks and economic policy uncertainty

“…On one hand, higher oil prices exert negative impacts on the economy, such as lower productivity and/or higher inflation (see, inter alia, Filis and Chatziantoniou, 2013;Montoro, 2012;Natal, 2012;Rahman and Serletis, 2011;Balke et al, 2010;Elder and Serletis, 2010;Tang et al, 2010;Du et al, 2010;Filis, 2010;Cologni and Manera, 2008;Cunado and Pérez de Gracia, 2005;Peter Ferderer, 1997;Hamilton, 1983). Such economic conditions put pressure on policy makers to mitigate the negative effects of increased oil prices, which in turn, raises concerns regarding the success of these policies.…”

“…Furthermore, authors such as, Rahman and Serletis (2011), Elder and Serletis (2010), Cologni and Manera (2008), Cunado and Pérez de Gracia (2005), Lee et al (1995) and Hamilton (1983) confirm that the US economic activity has been significantly affected by rises in oil prices, as well as, by the uncertainty about future oil price changes. Along a similar vein, Montoro (2012) and Natal (2012) also establish the link between increased inflation and low production output given an oil price increase. As it is understood, this trade-off raises the concerns of and creates pressure to policymakers with regard to choosing the most appropriate response towards these oil price effects.…”

Monetary Policy Responses to Oil Price Fluctuations

“…Another key question has been the existence, or not, of a trade-off between stabilizing inflation and the welfare relevant output gap. For example, Bodenstein, Erceg, and Guerrieri (2008) and Natal (2012) largely agree that dual mandate instrument rules based on core inflation measures come close to replicating welfare maximizing policies, as long as they are not overly aggressive in stabilizing core inflation. In related research, Plante (2009a) finds that optimal monetary policy should stabilize a weighted average of core and nominal wage inflation.…”

“…Much of the existing analysis on the conduct of monetary policy in the face of oil price fluctuations relies on the counterfactual premise that the real price of crude oil is exogenous with respect to the U.S. economy (see, for example, Leduc and Sill, 2004;Carlstrom and Fuerst, 2006;Dhawan and Jeske, 2007;Plante, 2009a, b;Winkler, 2009;Montoro, 2010;Kormilitsina, 2011;Natal, 2012). Even those DSGE studies that have endogenized the real price of oil have made strong and unrealistic simplifying assumptions about the determination of the price of oil in global markets (see, for example, Backus and Crucini, 1998), have ignored monetary policy (see, for example, Backus and Crucini, 1998;Balke, Brown, and Yu¨cel, 2010;Bodenstein, Erceg, and Guerrieri, 2011;Nakov and Nun˜o, 2011), or have ignored the open economy aspect of the transmission of oil price shocks (see, for example, Bodenstein, Erceg, and Guerrieri, 2008;Nakov and Pescatori, 2010a, b).…”

Macroeconomic Implications of Oil Price Fluctuations: A Regime-Switching Framework for the Euro Area

“…3 See, for instance, Bernanke et al (1997); Barsky and Kilian (2001); Bodenstein et al (2008); Nakov and Pescatori (2010); Kormilitsina (2011);Bodenstein et al (2012);and Natal (2012). 4 The importance of time-variation in the variance of key macroeconomic aggregates has most clearly emerged from the analysis of competing explanations for the steep decline in inflation and output volatility since the mid1980s (often referred to as the Great Moderation); see, for instance, Primiceri (2005); Sims and Zha (2006).…”