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Inflation-Output Gap Trade-off with a Dominant Oil Supplier

An exogenous oil price shock raises inflation and contracts output, similar to a negative productivity shock. In the standard New Keynesian model, however, this does not generate any trade-off between inflation and output gap volatility: under a strict inflation targeting policy, the output decline is exactly equal to the efficient output contraction in response to the shock. Modeling the oil sector from optimizing rst principles rather than assuming an exogenous oil price, we show that the presence of a dominant oil supplier (OPEC) leads to inefficient fluctuations in the oil price markup. The latter reflects a dynamic distortion of the production process, and as a result stabilizing inflation does not automatically stabilize the distance of output from rst-best. Our model is a step away from discussing the effects of exogenous oil price changes and towards analyzing the implications of the underlying shocks that cause the oil price to change in the first place.

JEL code: E52, E32, F0, D4

Keywords: Monetary Policy, Oil industry, OPEC, Competitive Fringe, Business Cycle.

Suggested citation: Nakov, Anton, and Andrea Pescatori, 2007. "Inflation-Output Gap Trade-off with a Dominant Oil Supplier," Federal Reserve Bank of Cleveland, Working Paper no. 07-10.

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