Exchange Rates, Oil Price Shocks, and Monetary Policy in an Economy with Traded and Non-Traded Goods

Michael Plante

No 2009-016, CAEPR Working Papers from Center for Applied Economics and Policy Research, Department of Economics, Indiana University Bloomington

Abstract: This paper examines monetary policy responses to oil price shocks in a small open economy that produces traded and non-traded goods. When only labor and oil are used in production and prices are sticky in the non-traded sector the behavior of inflation, the nominal exchange rate, and the relative price of the non-traded good depends crucially upon whether the ratio of the cost share of oil to the cost share of labor is higher for the traded or non-traded sector. If the ratio is smaller (higher) for the traded sector then a policy that fully stabilizes non-traded in flation causes the nominal exchange rate to appreciate (depreciate) and the relative price of the non-traded good to rise (fall) when there is a surprise rise in the price of oil. Similar results can hold for a policy that stabilizes CPI inflation. Under a policy that fixes the nominal exchange rate, non-traded inflation rises (falls) if the ratio is smaller (larger) for the traded sector. Analytical results show that a policy of fixing the exchange rate always produces a unique solution and that a policy of stabilizing non-traded inflation produces a unique solution so long as the nominal interest rate is raised more than one-for-one with rises in non-traded inflation. A policy that stabilizes CPI inflation, however, produces multiple equilibria for a wide range of calibrations of the policy rule.

Keywords: Oil Prices; Monetary Policy; Inflation; Exchange Rates (search for similar items in EconPapers)
JEL-codes: E52 F41 Q43 (search for similar items in EconPapers)
Pages: 37 pages
Date: 2009-08
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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