Oil shocks and optimal monetary policy, April 2010

In practice, central banks have been confronted with a trade-o¤ between stabilising in‡ation 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-o¤ between in‡ation and output stabilisation when oil has low substitutability in production. Therefore, it becomes optimal for the monetary authority to stabilise partially the e¤ects of oil shocks on in‡ation and some in‡ation is desirable. We also …nd, in contrast to Benigno and Woodford (2005), that this trade-o¤ is reduced, but not eliminated, when we get rid of the e¤ects of monopolistic distortions in the steady state. Moreover, the size of the endogenous “costpush”shock generated by ‡uctuations in the oil price increases when oil is more di¢ cult to substitute by other factors. JEL Classi…cation: D61, E61.