Abstract

This paper examines how central banks respond to supply-side shocks and
investigates the trade-offs they face in stabilizing inflation and output. To do
so we develop a dual external instrument proxy structural vector autoregressive
(SVAR) model to disentangle the macroeconomic effects of oil supply
news and monetary policy shocks. Our identification strategy, which combines
multiple external instruments with sign restrictions, enables a sharp
distinction between structural shocks, allowing us to analyze their dynamic
effects and construct policy counterfactuals for different central bank objectives.
We find that both oil supply and monetary policy shocks significantly
influence U.S. output and inflation. Moreover, while monetary policy can
mitigate some of the output losses caused by oil price shocks, it cannot fully
offset their inflationary effects. Finally, we estimate that the Federal Reserve’s
historical response aligns closely with a policy that places twice as
much weight on inflation stabilization than on output stabilization.