Three essays on monetary policy responses to oil price shocks

This dissertation contains three chapters which explore the question of how monetary policy should respond to changes in the price of oil. Each chapter explores the question from the perspective of a different economic environment.;The first chapter examines welfare maximizing optimal monetary policy in a closed economy New Keynesian model that is extended to include household and firm demand for oil products, sticky wages, and capital accumulation. When households and firms demand oil products a natural difference arises between the Consumer Price Index (CPI), the core CPI, and the GDP deflator. I show that when nominal wages are flexible then the optimal policy places a heavy emphasis on stabilizing the inflation rate of the core CPI. If aggregate nominal wages are sticky then the central bank should focus on stabilizing some combination of core inflation and nominal wage inflation. Under no case examined is it optimal to stabilize either GDP deflator or CPI inflation.;The second chapter examines monetary policy responses to oil price shocks in a small open economy with traded and non-traded goods. Oil and labor are used to produce the traded and non-traded goods and prices are sticky in the non-traded sector. I show analytically that the ratio of the oil and labor cost shares in the traded and non-traded sectors is crucial for determining the dynamic behavior of many macroeconomic variables after a rise in the price of oil. A policy of fixed exchange rates can produce higher or lower inflation in the non-traded sector depending upon the ratio. Likewise, a policy that stabilizes the inflation rate of prices in the non-traded sector can cause the nominal exchange rate to appreciate or depreciate. For the proper calibration, a policy that stabilizes core inflation produces results very close to the one that stabilizes non-traded inflation. Analytical results show that the fixed exchange rate always produces a unique solution. The policy of stabilizing non-traded inflation produces a unique solution so long as the nominal interest rate is raised more than one for one with increases in non-traded inflation. A policy of stabilizing core inflation, however, produces a unique solution only if the response is greater than one for one and less then one divided by one minus the share of the non-traded good in the CPI.;In the third chapter I consider monetary and fiscal policy responses to oil price shocks in a low income oil importing country. The model used in this chapter differs from the model in the second chapter in that there is currency substitution, household demand for oil products, and a potential subsidy on the purchase of oil products by households. I examine the dynamic properties and the welfare implications of a set of inflation targeting policies and a group of policies that subsidize the price of oil and finance the subsidy through a combination of raising lump sum taxes and printing money. The dynamic properties of the inflation targeting policies are similar in many regards to those in the second chapter as the key assumptions driving the results are the same in the two models. For the policies which subsidize the price of oil I show that both the choice to have the subsidy and how to finance it matter a great deal for the behavior of the macroeconomic variables. In terms of welfare, for most calibrations there are only minor differences between the inflation targeting polices, the policy with a subsidy funded by lump sum taxes, and the baseline policy with no subsidy. The policy with a subsidy financed by the inflation tax generally causes significant welfare losses compared to the policy with no pass through.