Abstract
This paper incorporates inventory shocks and market expectations in OPEC's oil pricing mechanism and applies the target zone and speculative attack literatures to oil price dynamics. The paper examines the oil price behavior in the two-sided target zone model and the asymmetric tolerance zone model. It focuses on the characteristics of the smooth-pasting and speculative-attack solutions that are associated with credible and noncredible intervention policies. The analysis shows that credibility of OPEC's intervention policy declines as its output ceiling is reduced to a low level, which makes the price vulnerable to speculative attacks, and increases as the ceiling rises. The credibility is directly related to sensitivity of the market price to changes in the output and the sensitivity of this price to changes in the price expectations, and is inversely related to the positive intertemporal bias in the size of the random shocks in the quantity.
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