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How Should Monetary Policy Respond to Changes in the Relative Price of Oil? Considering Supply and Demand Shocks

35 Pages Posted: 19 Aug 2009 Last revised: 19 Jul 2015

Michael Plante

Federal Reserve Bank of Dallas; Indiana University Bloomington - Center for Applied Economics and Policy Research

Date Written: August 14, 2009

Abstract

This paper examines optimal monetary policy in a New Keynesian model where the relative price of oil is affected by exogenous supply shocks and a productivity driven demand shock. When wages are flexible, stabilizing core inflation is optimal and the nominal rate rises (falls) in response to a demand (supply) shock. When both prices and wages are sticky, core inflation falls (rises) in response to the demand (supply) shock. Stabilizing CPI inflation generates small welfare losses only if the demand shock is the main driver of oil prices. Based on a VAR estimated using post-1986 data for the U.S., both shocks have had minimal impacts on core inflation. The federal funds rate rises in response to the demand shock but falls in response to the supply shock, consistent with the predictions of the theoretical model for a policy that stabilizes core inflation.

Keywords: oil prices, optimal monetary policy, inflation

JEL Classification: E31, E52, Q43

Suggested Citation

Plante, Michael, How Should Monetary Policy Respond to Changes in the Relative Price of Oil? Considering Supply and Demand Shocks (August 14, 2009). CAEPR Working Paper No. 013-2009. Available at SSRN: https://ssrn.com/abstract=1456384 or http://dx.doi.org/10.2139/ssrn.1456384

Michael D. Plante (Contact Author)

Federal Reserve Bank of Dallas ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States

Indiana University Bloomington - Center for Applied Economics and Policy Research ( email )

100 South Woodlawn Avenue, Wylie Hall 250
Bloomington, IN 47405-1704
United States

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