Optimal Monetary Responses to Oil Discoveries

OxCarre WP by Sam Wills: Monetary policy can play an important role in managing oil discoveries. Ideally
governments will use fiscal policy to smooth consumption of oil income. In practice this often does not happen, as governments delay spending until oil revenues are received. This induces changes in the economy, both at discovery and when spending begins. In this paper we consider how monetary policy should respond. The paper makes three contributions. The first is to show that an oil discovery causes the real exchange rate to appreciate twice: when forward-looking households and then the government increase their consumption. This can cause a recession under standard monetary regimes, as firms anticipate the second appreciation. The second contribution is to micro-found the objective of monetary policy. The central bank should stabilise inflation, the output gap and the fiscal gap. It will also try to appreciate the non-oil terms of trade, to exploit the asymmetry from owning oil wealth. The third is to derive a closed form for optimal monetary policy, which will respond in advance to expected changes in government demand. This will delay the second real appreciation until the government can take up the slack left by private demand. Optimal policy significantly improves welfare relative to standard monetary regimes, and is well approximated by a simple Taylor rule that responds to expected changes in the natural level of output.