Federal Reserve Bank of Philadelphia

Are the recessionary consequences of oil-price shocks due to oil-price shocks themselves or to contractionary monetary policies that arise in response to inflation concerns engendered by rising oil prices? Can systematic monetary policy be used to alleviate the consequences of oil shocks on the economy? This paper builds a dynamic general equilibrium model of monopolistic competition in which oil and money matter to study these questions. The economy's response to oil-price shocks is examined under a variety of monetary policy rules in environments with flexible and sticky prices. We find that easy-inflation policies amplify the negative output response to positive oil shocks and that systematic monetary policy accounts for up to two thirds of the fall in output. On the other hand, we show that a monetary policy that targets the (overall) price level substantially alleviates the impact of oil-price shocks.