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Oil Price Shocks and the Monetary Policy

By Ying-te Huang

Essentially all US recessions have been preceded by oil price shocks and subsequently tighter monetary policies. (Bernanke, Gertler and Watson, 1997). Whereas some scholars, including Herrera and Hamilton (2001) claimed that such oil price shocks contributed to the recession that followed, others, including, Bernanke et al. (1997), believed that the Fed‘s endogenous reaction to the monetary policy, rather than oil price per se, led to the contraction of the economy. Which had a greater influence on gross domestic product (GDP) — oil price shocks or a change in monetary policy—has been debated for years. One of the most prominent debates is between Bernanke et al. (1997), and Herrera and Hamilton (2001). In the debate, Bernanke et al. and Herrera and Hamilton used the same model but with different lag lengths and came to different conclusions. In the current study, we contribute to the resolution of this issue by using a new methodology to examine the effects of monetary policy to the economy in response to oil price shocks. Specifically, we determine the contemporaneous causal order empirically in structural vector-autoregression (SVAR). We then examine the economic responses in counterfactual schemes where the Fed does not respond to the oil price shocks. Contrary to Bernanke et al.‘s finding, in which the economy would have done better had the Fed not held its interest rate constant during an oil price shock, we found that the Fed‘s response generates higher output but a less steady price level. This suggests that the results are dependent upon prior assumptions of the model specifications.

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Advisor: Kevin Hoover

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