Monetary Policy Response to Oil Price Shocks

How should monetary authorities react to an oil price shock? This paper shows that in a noncompetitive economy, policies that perfectly stabilize prices entail large welfare costs, hence explaining the reluctance of policymakers to enforce them. The policy trade-off is nontrivial because oil (energy) is an input to both production and consumption. As welfare-maximizing policies are hard to implement and communicate, I derive a simple interest rate rule that depends only on observables but mimics the optimal plan in all dimensions. The optimal rule is hard on core inflation but accommodates oil price changes.