Working Paper

Monetary policy response to oil price shocks

Abstract: How should monetary authorities react to an oil price shock? 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 (1) that oil (energy) cannot be easily substituted by other factors, (2) that monopolistic competition implies that production is suboptimally low in the steady state, and (3) 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 for all practical purposes but that depends only on observables, namely core inflation, oil price inflation, and the growth rate of output.

Keywords: Monetary policy; Petroleum products - Prices;

Bibliographic Information

Provider: Federal Reserve Bank of San Francisco

Part of Series: Working Paper Series

Publication Date: 2009

Number: 2009-16