WP/01/14 IMF Working Paper The Macroeconomic Effects of Higher Oil Prices Benjamin Hunt, Peter Isard, and Douglas Laxton INTERNATIONAL MONETARY FUND‘© 2001 International Monetary Fund wera IMF Working Paper Research Department ‘The Macroeconomic Effects of Higher Oil Prices Prepared by Benjamin Hunt, Peter Isard, and Douglas Laxton ' January 2001 Abstract “The views expressed inthis Working Paper are those of the author) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progres by the author(s) and ate published to elicit comments nd to further debate. ‘The paper uses MULTIMOD to analyze the macroeconomic effects of oil price shocks, distinguishing between temporary, more persistent, and permanent shocks. It provides perspectives on several findings in the literature and the key role of monetary policy in influencing macroeconomic outcomes. Specific attention is paid to the channels through which oil price increases can pass through into core inflation, a possible explanation of the asymmetric relationship between oil prices and economic activity, the role of monetary policy credibility, the implications of delayed policy responses, and the relative merits of leaning in different directions when the correct policy response is uncertain. JEL Classification Numbers:E3, E52 Keywords: oil price shocks, MULTIMOD, monetary policy Author's E-Mail Address: bhunt@imf.org; pisard@imf org; dlaxton@imf.org ' We are grateful to John Helliwell and Warwick McKibbin for helpful discussions and to Victoria Ashiru and Dawn Heaney for their creative work on the charts.Contents Page I. Introduction IL. Oil Prices IIL. The Transmission of Oil Price Shocks in MULTIMOD A. The Effects of Oil Price Shocks on CPI and Core Inflation in MULTIMOD B. Direct Contemporancous Effects of Oil Price Shocks on the CPI C. Direct Dynamic Effects of Oil Price Shocks on the CPI and Core Inflation. No pass-through into core inflatior Base-case pass-through into core inflation in MULTIMOD.. How does pass-through differ across countries in MULTIMOD? IV. MULTIMOD Simulations A. Responses to Shocks of Different Duration. 20 B, The Strength of the Pass-Through into Core Inflation 23 C. Asymmetry in Real-Income Catch-Up Effects ... 27 D. The Implications of a Delayed Monetary Policy Response. 28 E, Comparative Costs of Potential Policy Errors..... V. Concluding Remarks... Text Tables ‘Table 1: MULTIMOD Base-Case Parameters. Table 2: Contemporaneous Direct Effects on Annual CPI Inflation of a 50 Percent Increase in the Price of Cit. Table 3. Temporary Versus Persistent Increases in Oil Prices Table 4. The Effects of Permanent Oil Price Shocks with Asymmetry in the Real Wage Catch-Up Effect. Table 5. The Effects of Persistent Oil Price Shocks with a Delayed Policy Response ~ ‘Symmetric Real-Wage Catch-Up Table 6. The Effects of Persistent Oil Price Shocks with a Delayed Policy Response — Asymmetric Real-Wage Catch-Up Table 7. Summary Statistics from Delayed Policy Response Simulations. Table 8. Costs of Possible Policy Errors. 15