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Optimal Monetary Responses to News of an Oil Discovery

Samuel Wills ()

No 121, OxCarre Working Papers from Oxford Centre for the Analysis of Resource Rich Economies, University of Oxford

Abstract: How should monetary policy respond to an oil discovery? Oil discoveries provide news that the natural level of output will rise in the future, which lowers the natural real rate of interest. Optimal monetary policy must accommodate these changes in natural output, and is well-approximated by a Taylor rule that responds to the natural real rate. Failure to accommodate these changes, as in a currency peg or naive Taylor rule, can cause forward-looking inflation and a recession. To prove this I incorporate oil and news shocks into a standard DSGE model of a small open economy that permits an analytical solution for optimal policy. I then use the model to present a novel explanation for the UK’s recessions of the 1970s and 80s, based on the discovery of North Sea oil.

Keywords: News shock; oil; optimal monetary policy; small open economy (search for similar items in EconPapers)
JEL-codes: E52 E62 F41 O13 Q30 Q33 (search for similar items in EconPapers)
Date: 2013-08-26
New Economics Papers: this item is included in nep-ene, nep-mac, nep-mon and nep-opm
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Working Paper: Optimal Monetary Responses to Oil Discoveries (2014) Downloads
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