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Oil and Inflation Compensation

Oil and Inflation Compensation PDF Author: Hao Chang
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ISBN:
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Languages : en
Pages : 85

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Book Description
Why did the correlation between oil prices and 10-year TIPS Break-even Inflation, a measure of long-term inflation compensation, increase dramatically after the financial crisis? Using a shadow-rate no-arbitrage term structure model, we demonstrate that this is because when nominal interest rates bind at the zero lower bound (ZLB), investors doubt the effectiveness of monetary policy to control deflation. As a result, investors adjust their long-term inflation expectations more rapidly after negative oil price changes and pay higher premiums to hedge long-run deflation risks. We explain these findings by a stylized dynamic stochastic general equilibrium model including oil supply shocks, oil demand shocks, and a Taylor rule with the ZLB constraint.