How Should Monetary Policy Respond to Exogenous Changes in the Relative Price of Oil?
) (Indiana University, Ball State University) Abstract This paper examines welfare maximizing optimal monetary policy and simple mon- etary policy rules in a New Keynesian model that incorporates oil as an intermediate input and as a consumption good. I show under several di erent assumptions that the optimal policy focuses on stabilizing some combination of nominal wage and core in ation while allowing for signi cant movements in value added and CPI (headline) in- ation. Wage indexation to headline in ation does not change this result. The optimal response of the nominal rate is sensitive to the assumptions of the model. For all cases examined the optimal policy is well approximated, in welfare terms, by a simple policy rule that su ciently stabilizes core in ation. Empirical evidence using data from after 1986 supports the hypothesis that the Federal Reserve has been responding to real oil price changes in a manner similar to what the model says is optimal. Download InfoTo download:
