Inflation-Output Gap Trade-Off With a Dominant Oil Supplier

54 Pages Posted: 16 Jul 2007 Last revised: 11 Aug 2010

See all articles by Anton Nakov

Anton Nakov

European Central Bank (ECB); CEPR

Andrea Pescatori

Federal Reserve Bank of Cleveland

Date Written: October 1, 2007

Abstract

An exogenous oil price shock raises inflation and contracts output, similar to a negative productivity shock. In the standard New Keynesian model, however, this does not generate a tradeoff between inflation and output gap volatility: under a strict inflation targeting policy, the output decline is exactly equal to the efficient output contraction in response to the shock. We propose an extension of the standard model in which the presence of a dominant oil supplier (OPEC) leads to inefficient fluctuations in the oil price markup, reflecting a dynamic distortion of the economy´s production process. As a result, in the face of oil sector shocks, stabilizing inflation does not automatically stabilize the distance of output from first-best, and monetary policymakers face a tradeoff between the two goals.

Keywords: oil shocks, inflation-output gap tradeoff, dominant firm

JEL Classification: E31, E32, E52, Q43

Suggested Citation

Nakov, Anton A. and Pescatori, Andrea, Inflation-Output Gap Trade-Off With a Dominant Oil Supplier (October 1, 2007). FRB of Cleveland Working Paper No. 07-10, Banco de España Research Paper No. WP-0723, Available at SSRN: https://ssrn.com/abstract=1000852 or http://dx.doi.org/10.2139/ssrn.1000852

Anton A. Nakov (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

CEPR ( email )

London
United Kingdom

Andrea Pescatori

Federal Reserve Bank of Cleveland ( email )

1455 E 6th ST
Cleveland, OH 44114
United States

HOME PAGE: http://clevelandfed.org/Research/Economists/index.cfm?action=ShowAuthorPubs&author=676&pagetype=6

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