Exchange Rates, Oil Price Shocks, and Monetary Policy In an Economy with Traded and Non-Traded Goods

37 Pages Posted: 19 Aug 2009 Last revised: 17 Dec 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 monetary policy responses to oil price shocks in a small open economy that produces traded and non-traded goods. When only labor and oil are used in production and prices are sticky in the non-traded sector the behavior of inflation, the nominal exchange rate, and the relative price of the non-traded good depends crucially upon whether the ratio of the cost share of oil to the cost share of labor is higher for the traded or non-traded sector. If the ratio is smaller (higher) for the traded sector then a policy that fully stabilizes non-traded inflation causes the nominal exchange rate to appreciate (depreciate) and the relative price of the non-traded good to rise (fall) when there is a surprise rise in the price of oil. Similar results can hold for a policy that stabilizes CPI inflation. Under a policy that flexes the nominal exchange rate, non-traded inflation rises (falls) if the ratio is smaller (larger) for the traded sector. Analytical results show that a policy of fixing the exchange rate always produces a unique solution and that a policy of stabilizing non-traded inflation produces a unique solution so long as the nominal interest rate is raised more than one-for-one with rises in non-traded inflation. A policy that stabilizes CPI inflation, however, produces multiple equilibria for a wide range of calibrations of the policy rule.

Keywords: oil prices, monetary policy, inflation, exchange rates

JEL Classification: F41, E52, Q43

Suggested Citation

Plante, Michael, Exchange Rates, Oil Price Shocks, and Monetary Policy In an Economy with Traded and Non-Traded Goods (August 14, 2009). CAEPR Working Paper No. 016-2009. Available at SSRN: https://ssrn.com/abstract=1456396 or http://dx.doi.org/10.2139/ssrn.1456396

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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