Monetary policy and oil price shocks: empirical implications of alternative responses

Abstract

Large swings in the price of oil which have occurred during tha past two decades have substantially affected US inflation, unemployment and economic growth. In the light of those experiences, a debate has arisen over how monetay policy should respond. This study contributes to that debate by evaluating empirically the economy's performance under three realistic monetary policy response rules. By doing so, it advances what has largely been a theoretical discussion. The policy rules studied – money growth targets, nominal GDP growth targets and interest rate targets – are evaluated by estimating how closely the resulting economic outcomes approximate an ‘optimal’ outcome. The optimal outcome arises when the Fed follows a well-defined optimal response rule. Of the three strategies, a nominal GDP target is found to be mose desirable, while an interest rate target is least desirable.