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How Should Monetary Policy Respond To Exogenous Changes In The Relative Price Of Oil?

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Executive Summary

This paper examines welfare maximizing optimal monetary policy and simple monetary policy rules in a New Keynesian model that incorporates oil as an intermediate input and as a consumption good. The author shows under several different assumptions that the optimal policy focuses on stabilizing some combination of nominal wage and core inflation while allowing for significant movements in value added and CPI (headline) inflation. Wage indexation to headline inflation 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 sufficiently stabilizes core inflation.

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