Monetary Policy in Oil-Producing Economies

Most oil-producing economies have a strong dependence on oil revenues for their economic performance and stability. This paper develops a general equilibrium model of an oil-producing economy that takes into account a new transmission channel for oil price shocks. This transmission channel can be described as an income effect generated by oil revenues, and the model shows that its role is important to fully understand monetary policy in these economies. I first present a static model that illustrates that a tension is present in such economies when faced with increases in oil prices. This tension arises, on the one hand, from the contractionary effects of higher oil prices and, on the other hand, from the income effect generated by the increased oil revenues. I then present and solve a dynamic model with price rigidities in a two-sector economy with an oil sector. I find that the Phillips curve includes a measure of oil income that is responsible for additional inflationary pressures. Impulse response functions show that, in terms of consumption and inflation stabilization, the economy responds better to a Taylor rule that reacts to both final goods production and oil production than to a Taylor rule that reacts to final goods production only, although in the former the volatility implied for non-oil output is higher. I also explore welfare-based optimal monetary policy in this framework and conclude that a central bank can stabilize both inflation and output without trade-o§ by reacting optimally to inflation and the output gap. Additionally, among Taylor-type rules, a rule that reacts to consumption and not only to final goods production is welfare superior.