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1 Draft Strictly Not for Quotation Oil Prices and the Exchange Rate: Optimal Monetary Policy for Oil Exporting Countries By Ragnar Torvik Day 1 Paper SC1 Presented at REPOAs 23 rd Annual Research Workshop held at the Ledger Plaza

  1. 1 Draft – Strictly Not for Quotation Oil Prices and the Exchange Rate: Optimal Monetary Policy for Oil Exporting Countries By Ragnar Torvik Day 1 Paper SC1 Presented at REPOA’s 23 rd Annual Research Workshop held at the Ledger Plaza Bahari Beach Hotel, Dar es Salaam, Tanzania; April 4 – 5, 2018 This preliminary material / interim, or draft research report is being disseminated to encourage discussion and critical comment amongst the participants of REPOA’s Annual Research Workshop. It is not for general distribution. This paper has not undergone REPOA’s formal review and editing process. Any views expressed are of the author(s) and do not necessarily 1 represent the views of REPOA or any other organization

  2. Oil Prices and the Exchange Rate: Optimal Monetary Policy for Oil Exporting Countries Ragnar Torvik Tanzania April 4 2018 2

  3. World petroleum supply since january 2015 – growth in millions barrels per day 14 14 Rest of world 12 12 Shale USA 10 10 OPEC 8 8 Total 6 6 4 4 2 2 0 0 -2 -2 2007 2009 2011 2013 2015 2005 3

  4. Oil supply and the US • This is a permanent supply shock • What will their marginal cost be? < 60 USD • New discoveries, new techniques, new countries 4

  5. How will this affect oil prices? • New technology – when is it replaced? • Will it spread? • Yes: Top 5 shale oil as percentage of US: -Russia 129 -China 55 -Argentine 47 -Libya 45 -Venezuela 22 Source: US Energy Administration Information • What about shale gas? 5

  6. The model • Consider an economy with a traded and a non- traded sector • For now let wages be nominally given (short run) • The non-traded demand is decreasing in price, while the supply is increasing in price • The traded sector is a price taker, while the 6 domestic supply is increasing in the price

  7. The model Price non-traded Price traded Demand Supply Supply Price Production non-traded Production traded

  8. The model • Fiscal and monetary policy in the model • Expansionary fiscal policy • Expansionary monetary policy • Suppy side fiscal policy 8

  9. Fiscal policy Price non-traded Price traded Demand Supply Supply B Price A A,B Production non-traded Production traded

  10. Fiscal policy + wage resonse Price non-traded Price traded Demand Supply Supply C B C Price A A,B Production non-traded Production traded

  11. Fiscal policy + flexible inflation targeting Price non-traded Price traded Demand Supply Supply C D B C Price A A,B D Production non-traded Production traded

  12. Expansionary monetary policy Price non-traded Price traded Demand Supply Supply B B Price A A Production non-traded Production traded

  13. Supply side fiscal policy Price non-traded Price traded Demand Supply Supply C Price C A B A B Production non-traded Production traded

  14. The extended model • Let us extend the approach by including not only the spending effect, but also the resource movement effect • Merge the above model with Corden and Neary (1982) 14

  15. The extended model Price oil supply industry Price traded Price non-traded Production non-traded Production traded Production oil supply industry

  16. The extended model • Now consider a lower oil price or lower investments in the oil sector • The demand in the oil industry falls. The resource movement effect implies lower incomes in that sector. This adds to the income effect and implies lower demand in the rest of the economy • So we move from A to B 16

  17. Lower price of oil Price non-traded Price traded Price oil supply industry A A,B B A B Production non-traded Production traded Production oil supply industry

  18. The extended model • Now consider trying to fix this with expansionary fiscal policy • This moves the economy from B to C: 18

  19. Expansionary fiscal policy Price non-traded Price traded Price oil supply industry C A A,B,C B,C A B Production non-traded Production traded Production oil supply industry

  20. The extended model • Now consider a flexible inflation targeting • This moves the economy from C to D: 20

  21. Expansionary fiscal policy + inflation targeting Price non-traded Price traded Price oil supply industry C A D A,B,C B,C A D B D Production non-traded Production traded Production oil supply industry

  22. The extended model • Now consider instead that monetary policy through a flexible inflation target is the policy response to lower oil prices 22

  23. Lower oil price + inflation targeting Price oil supply industry Price non-traded Price traded C A A,B C A C B B Production oil supply industry Production non-traded Production traded

  24. The extended model Medium run dynamics • Now consider investment functions in the sectors that may depend on the real exchange rate, activity, and/or the interest rate • Fiscal policy expansion: Three channels push traded sector investments down • Monetary policy expansion: Three channels push traded sector investments up 24

  25. Conclusions • So the point is that even if monetary policy may be neutral in the long run, it should respond to a permanent shock which alters the long run equilibrium of the economy • When you walk to a new place it matters a lot which path you choose to go there • How does this square with the macro models most used today? 25 …. pretty bad

  26. Conclusions • A permanent fall in oil prices implies a long run structural transformation • Monetary policy being the first line of defense in the macroeconomic policy framework helps this transformation • If fiscal policy is used it should be directed at the supply side 26

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