EVENT: Economics Research Seminar

Abstract- I study how monetary policy should optimally respond to an oil discovery. Oil discoveries provide news that the natural level of output will increase in the future. Anticipated increases in natural output lower the natural real interest rate. Optimal monetary policy must accommodate these changes, and is well-approximated by a Taylor rule that responds to the natural rate of interest. Failure to accommodate these changes, as in a peg or naive Taylor rule, can cause forward-looking inflation and a recession. To illustrate this I incorporate a government, oil and news into a standard DSGE model of a small open economy that permits an analytical solution for optimal policy. I then use the model to present a novel explanation for UK stagflation in the 1980s based on North Sea oil production.