Monetary Policy Response to Oil Price Shocks

Abstract

How should monetary authorities react to an oil price shock? The New Keynesian literature has concluded that ensuring complete price stability is the optimal thing to do. In contrast, this paper argues that a meaningful trade-off between stabilizing inflation and the welfare relevant output gap arises in a distorted economy once one recognizes (i) that oil (energy) cannot be easily substituted by other factors in the short-run, (ii ) that there is no fiscal transfer available to policymakers to neutralize the steady-state distortion due to monopolistic competition, and (iii ) that increases in oil prices also directly affect consumption by raising the price of fuel, heating oil, and other energy sources. While the first two conditions are necessary to introduce a microfounded monetary policy trade-off, the third one makes it quantitatively significant.The optimal precommitment monetary policy relies on unobservables and is therefore hard to implement. To address this concern, I derive a simple interest rate feedback rule that mimics the optimal plan in all relevant dimensions but that depends only on observables, namely core inflation, oil price inflation, and the growth rate of output.

Oil Shocks and Optimal Monetary Policy

“…There are a few exceptions. For instance, Natal (2009) showed that extending our work, including oil in the consumption goods bundle in a CES form, amplifies the trade-off between stabilizing inflation and the welfare output gap. In a different approach, Nakov and Pescaroti (2010) also find a trade-off when modeling explicitly the oil production in the global economy, which is generated by a dynamic distortion due to imperfect competition in the oil market.…”

Monetary and Macroprudential Policies in a Leveraged Economy

“…The general rule relies on a reasonable 16 See Ad ao et al (2003) for a formal analysis in the context of a monetary model with cash-in-advance constraints and firms that set prices one period in advance. Natal (2012) show that the flexible price allocation is not optimal either in models where oil enters as an imperfect substitute for other production factors and consumption goods. 17 Note that this result holds even for larger than one-standard-deviation shocks.…”

External Sector Responses to Oil Price Shocks: A Structural System Model for Nigeria

“…In this study, the authors showed that these estimates are invalid using structural models that include both symmetric and asymmetric considerations. [7] Focused on how monetary authorities should react to an oil price shock. The New Keynesian literature has concluded that ensuring complete price stability is the optimal thing to do.…”

“…There is ample evidence to suggest that oil price shocks do matter, as its accompanied windfall revenues may be beneficial or detrimental [4] [5]. To this end, different studies have looked into the role of oil price shocks and the uncertainty caused by oil price shocks on possible responses of selected macroeconomic variables; the effects on economic growth [6], monetary and fiscal policy responses [7] [8] and financial markets [9] [10].…”