ANTON NAKOV ANDREA PESCATORI Monetary Policy Trade-Offs with a Dominant Oil Producer We model oil production decisions from optimizing principles rather than as- suming exogenous oil price shocks and show that the presence of a dominant oil producer leads to sizable static and dynamic distortions of the production process. Under our calibration, the static distortion costs the U.S. around 1.6% of GDP per year. In addition, the dynamic distortion, reflected in in- efficient fluctuations of the oil price markup, generates a trade-off between stabilizing inflation and aligning output with its efficient level. Our model is a step away from discussing the effects of exogenous oil price variations and toward analyzing the implications of the underlying shocks that cause oil prices to change in the first place. JEL codes: E31, E32, E52, Q43 Keywords: OPEC, dominant producer, oil shocks, monetary policy, trade-off. A LONG LIST of articles propose models of the transmission of oil shocks in which oil price movements are given exogenously, typically in the form of an AR(1) driving process (e.g., Kim and Loungani 1992, Leduc and Sill 2004, Carlstrom and Fuerst 2005, De Walque, Smets, and Wouters 2005). Yet, start- ing with Barsky and Kilian (2004) and Kilian (2008), overwhelming evidence has been compiled against the assumption of exogenous oil prices and in support of the notion that the oil price is affected significantly by global economic conditions. Even though the empirical literature on oil shocks has abandoned the exogeneity We are grateful for helpful comments from and discussions with Jordi Gal´ ı, Max Gillman, Fernando Restoy, Charles Carlstrom, Pau Rabanal, Fabio Canova, Morten Ravn, Wouter den Haan, Bruce Preston, and Thijs van Rens, as well as to seminar participants at Universitat Pompeu Fabra, Dynare Conference Paris, ESEM Budapest, and EEA Milan. The views expressed in this paper are those of the authors and do not necessarily reflect the views of Banco de Espa˜ na or the Federal Reserve Bank of Cleveland. ANTON NAKOV, Ph.D., is at Divisi ´ on de Investigaci´ on, Estudios Monetarios y Financieros, Banco de Espa˜ na, Alcal´ a 48, 28014 Madrid, Spain (E-mail: anton.nakov@bde.es). ANDREA PESCATORI, Ph.D., is at Federal Reserve Bank of Cleveland (E-mail: andrea.pescatori@ clev.frb.org). Received February 8, 2008; and accepted in revised form August 17, 2009. Journal of Money, Credit and Banking, Vol. 42, No. 1 (February 2010) C  2010 The Ohio State University