Inflation Premium and Oil Price VolatilityPaul G. Castillo (), Carlos Montoro () and Vicente Tuesta () CEP Discussion Papers from Centre for Economic Performance, LSE Abstract: This paper provides a fully micro-founded New Keynesian framework to study the interactionbetween oil price volatility, pricing behavior of firms and monetary policy. We show that when oilhas low substitutability, firms find it optimal to charge higher relative prices as a premium incompensation for the risk that oil price volatility generates on their marginal costs. Overall, in generalequilibrium, the interaction of the aforementioned mechanisms produces a positive relationshipbetween oil price volatility and average inflation, which we denominate inflation premium. Wecharacterize analytically this relationship by using the perturbation method to solve the rationalexpectations equilibrium of the model up to second order of accuracy. The solution implies that theinflation premium is higher when: a) oil has low substitutability, b) the Phillips Curve is convex, andc) the central bank puts higher weight on output fluctuations. We also provide some quantitativeevidence showing that a calibrated model for the US with an estimated active Taylor rule produces asizable inflation premium, similar to the levels observed in the US during the 70s. Keywords: Second Order Solution; Oil Price Shocks; Endogenous Trade-off (search for similar items in EconPapers) Downloads: (external link) Related works: Access Statistics for this paper More papers in CEP Discussion Papers from Centre for Economic Performance, LSE |
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