Exchange Rates, Oil Price Shocks, and Monetary Policy in an Economy with Traded and Non-Traded Goods.

This paper examines monetary policy responses to oil price shocks in a small open economy that produces traded and non-traded goods. When only labor and oil are used in production and prices are sticky in the non-traded sector the behavior of ination, the nominal exchange rate, and the relative price of the non-traded good depends crucially upon whether the ratio of the cost share of oil to the cost share of labor is higher for the traded or non-traded sector. If the ratio is smaller (higher) for the traded sector then a policy that fully stabilizes non-traded ination causes the nominal exchange rate to appreciate (depreciate) and the relative price of the non-traded good to rise (fall) when there is a surprise rise in the price of oil. Similar results can hold for a policy that stabilizes CPI ination. Under a policy that xes the nominal exchange rate, non-traded ination rises (falls) if the ratio is smaller (larger) for the traded sector. Analytical results show that a policy of xing the exchange rate always produces a unique solution and that a policy of stabilizing non-traded ination produces a unique solution so long as the nominal interest rate is raised more than one-for-one with rises in non-traded ination. A policy that stabilizes CPI ination, however, produces multiple equilibria for a wide range of calibrations of the policy rule.