DP8928 Monetary policy responses to oil price fluctuations

Author(s): Martin Bodenstein , Luca Guerrieri , Lutz Kilian

Publication Date: April 2012

Keyword(s): oil price , endogeneity , monetary policy , policy rule , welfare , open economy , global economy

JEL(s): E32 , E43 , F32 , Q43

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP8928.asp.asp

The recent volatility in global commodity prices and in the price of oil, in particular, has created renewed interest in the question of how monetary policy makers should respond to oil price fluctuations. In this paper, we discuss why this question is ill-posed and has no general answer. The central message of our analysis is that the best central bank policy response to oil price fluctuations depends on why the price of crude oil has changed. For example, an unexpected oil supply disruption in the Middle East calls for a different policy response than an unexpected increase in Chinese productivity or oil intensity. This means that policy makers need to disentangle the structural shocks that are jointly driving the price of oil and the macroeconomy and tailor their response to the observed mix of shocks. We use a multi-country DSGE model to quantify the appropriate policy responses and to analyze the optimal responses from a welfare point of view. We also reexamine the welfare gains from global monetary policy coordination in a world with trade in oil.