Oil shocks and optimal monetary policy

No 307, BIS Working Papers from Bank for International Settlements

Abstract: In practice, central banks have been confronted with a trade-off between stabilising inflation and output when dealing with rising oil prices. This contrasts with the result in the standard New Keynesian model that ensuring complete price stability is the optimal thing to do, even when an oil shock leads to large output drops. To reconcile this apparent contradiction, this paper investigates how monetary policy should react to oil shocks in a microfounded model with staggered price-setting and with oil as an input in a CES production function. In particular, we extend Benigno and Woodford (2005) 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 stabilisation when oil has low substitutability in production. Therefore, it becomes optimal for the monetary authority to stabilise partially the effects of oil shocks on inflation and some inflation is desirable. We also find, in contrast to Benigno and Woodford (2005), 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 oil is more difficult to substitute by other factors.

Keywords: optimal monetary policy; welfare; second order solution; oil price shocks; endogenous trade-off (search for similar items in EconPapers)
Pages: 40 pages
Date: 2010-04
New Economics Papers: this item is included in nep-cba, nep-dge, nep-ene and nep-mon
References: Add references at CitEc
Citations: View citations in EconPapers (6)

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Related works:
Journal Article: OIL SHOCKS AND OPTIMAL MONETARY POLICY (2012)
Working Paper: Oil Shocks and Optimal Monetary Policy (2007)
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Persistent link: https://EconPapers.repec.org/RePEc:bis:biswps:307

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