A Quantitative Analysis of Oil-Price Shocks, Systematic Monetary Policy, and Economic Downturns

Can systematic monetary policy be used to alleviate the consequences of oil shocks on the economy? This paper builds a dynamic general equilibrium model of monopolistic competition in which oil and money matter to study these questions. The economy's response to oil-price shocks is examined under a variety of monetary policy rules in environments with flexible and sticky prices. The authors find that easy-inflation policies amplify the negative output response to positive oil shocks and that systematic monetary policy accounts for up to two-thirds of the fall in output. On the other hand, the authors show that a monetary policy that targets the (overall) price level substantially alleviates the impact of oil-price shocks.