Oil Shocks and Optimal Monetary Policy

Abstract

This paper studies how monetary policy should react to oil shocks in a microfounded model with staggered price-setting and oil as an input in a CES production function. In particular, we extend Benigno and Woodford [Journal of the European Economic Association 3 (6) (2005), 1–52] 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 an endogenous trade-off between inflation and output stabilization when oil has low substitutability in production. We also find, in contrast to Benigno and Woodford, that this trade-off is reduced, but not eliminated, when we get rid of the effects of monopolistic distortions in the steady state. Moreover, the size of the endogenous “cost-push” shock generated by fluctuations in the oil price increases when it is more difficult to substitute other factors for oil.

Oil price shocks and uncertainty: How stable is their relationship over time?

“…Against this backdrop, we maintain that it is important to extend the studies by Kang and Rati (2013), Bekiros et al (2015), Aloui et al (2016), and Kang et al (2017) and to assess how oil price shocks could also trigger changes in other sources 3 For instance, recent literature shows that when there is an increase in the price of oil, this causes inflationary pressures and lower household consumption in an oil-importing country, which forces the monetary authority to face a trade-off of either stabilizing inflation or output gap, leading to higher uncertainty (Natal, 2012;Montoro, 2012). In addition, El Anshasy and Bradley (2012) claim that higher oil prices lead to greater government size for the oil-exporting countries.…”

Monetary Policy Response to Oil Price Shocks

“…6 6 Montoro (2007) also considers an environment with flexible real wages but where oil enters the model as a nonproduced input in the production function only. He finds that when oil is a gross complement to labor, an optimal monetary policy trade‐off arises as oil shocks affect output and labor differently, generating a wedge between the effects on the utility of consumption and the disutility of labor.…”

Notes on the Underground: Monetary Policy in Resource‐Rich Economies

“…Note that, differently from models in which oil is an input in the production stage (e.g., Montoro , Natal ), oil price movements do not directly affect marginal costs and, hence, domestic inflation (see equations and ). For example, as we show in Section 3, a fall in the price of oil leads to a depreciation of the terms of trade ( increases) and a recession in the mainland economy ( falls).…”

“…This viewpoint has naturally led to an emphasis on oil as a final consumption good and/or as an intermediate input to production. In the normative analyses of Kormilitsina (), Montoro (), Nakov and Pescatori (), and Natal (), for example, fluctuations in the price of oil may induce trade‐offs for monetary policy through a production cost channel . By contrast, only a few studies investigate monetary policy issues from the perspective of oil exporters.…”