Inflation-output gap trade-off with a dominant oil supplier

Anton Nakov and Andrea Pescatori ()

No 710, Working Papers (Old Series) from Federal Reserve Bank of Cleveland

Abstract: An exogenous oil price shock raises inflation and contracts output, similar to a negative productivity shock. In the standard New Keynesian model, however, this does not generate any trade-off between inflation and output gap volatility: under a strict inflation-targeting policy, the output decline is exactly equal to the efficient output contraction in response to the shock. Modeling the oil sector from optimizing first principles rather than assuming an exogenous oil price, we show that the presence of a dominant oil supplier (OPEC) leads to inefficient fluctuations in the oil price markup. The latter reflects a dynamic distortion of the production process, and as a result, stabilizing inflation does not automatically stabilize the distance of output from first-best. Our model is a step away from discussing the effects of exogenous oil price changes and toward analyzing the implications of the underlying shocks that cause the oil price to change in the first place.

Keywords: Monetary policy; Petroleum products - Prices; Business cycles (search for similar items in EconPapers)
Date: 2007
New Economics Papers: this item is included in nep-cba, nep-ene, nep-mac and nep-mon
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Citations: View citations in EconPapers (7)

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DOI: 10.26509/frbc-wp-200710

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