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Inflation Premium and Oil Price Volatility

Paul 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 interaction between oil price volatility, pricing behavior of firms and monetary policy. We show that when oil has low substitutability, firms find it optimal to charge higher relative prices as a premium in compensation for the risk that oil price volatility generates on their marginal costs. Overall, in general equilibrium, the interaction of the aforementioned mechanisms produces a positive relationship between oil price volatility and average inflation, which we denominate inflation premium. We characterize analytically this relationship by using the perturbation method to solve the rational expectations equilibrium of the model up to second order of accuracy. The solution implies that the inflation premium is higher when: a) oil has low substitutability, b) the Phillips Curve is convex, and c) the central bank puts higher weight on output fluctuations. We also provide some quantitative evidence showing that a calibrated model for the US with an estimated active Taylor rule produces a sizable 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)
JEL-codes: E52 E42 E12 C63 (search for similar items in EconPapers)
Date: 2007-03
New Economics Papers: this item is included in nep-cba, nep-ene, nep-mac and nep-mon
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Related works:
Working Paper: Inflation premium and oil price volatility (2007) Downloads
Working Paper: Inflation Premium and Oil Price Volatility (2006) Downloads
Working Paper: Inflation Premium and Oil Price Volatility (2006) Downloads
Working Paper: Inflation Premium and Oil Price Volatility (2005) Downloads
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