Oil Price Shock and Optimal Monetary Policy in a Model of Small Open Oil Exporting Economy - Case of Iran

Oil price shocks are the main source of macroeconomic fluctuations in oil exporting countries. It is believed that appropriate monetary policy can help to stabilize these unwanted variations toward optimal allocations. A stochastic dynamic general equilibrium model featuring the properties of both cost push and wealth effect transmission channels is developed for the Iranian economy. In this context, it is possible to evaluate the role of monetary policy measures to accommodate supply side cost push effects and demand side wealth effect of oil price shock. This paper is intended to investigate the optimal monetary policy strategy for the economy of Iran and calibrated for its structural characteristics and patterns of external shocks. The comparative analysis of alternative monetary policies in terms of Ramsey, and optimal simple rules is performed based on key nominal and real variables variance reductions and the linear quadratic loss (LQ) function. Our findings show that domestic inflation targeting rule is the optimal monetary policy both in terms of stabilization performance and welfare costs. It must be mentioned that the addition of exchange rate to domestic inflation targeting rule has failed to improve the welfare measure and stabilization in comparison to domestic inflation targeting rule