Inflation-Output Gap Trade-Off With a Dominant Oil Supplier

Abstract

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 a tradeoff 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. We propose an extension of the standard model in which the presence of a dominant oil supplier (OPEC) leads to inefficient fluctuations in the oil price markup, reflecting a dynamic distortion of the economy´s production process. As a result, in the face of oil sector shocks, stabilizing inflation does not automatically stabilize the distance of output from first-best, and monetary policymakers face a tradeoff between the two goals.

Keywords: oil shocks, inflation-output gap tradeoff, dominant firm

JEL Classification: E31, E32, E52, Q43