This paper proposes a New Keynesian dynamic stochastic general equilibrium model of the Chinese economy incorporating the demand of oil to study the effects of oil price shocks on the business cycle. The model answers several questions, including how monetary policy should respond to the disturbances from such shocks, and whether monetary authorities should use core inflation or headline inflation including oil price inflation as the monetary policy rule. The contributions could be summarized as follows: First, the model reveals that the oil transmission mechanism is determined by the nominal inertia, income effect, and the portfolio allocation effect. Second, both noncore inflation monetary policy and core inflation monetary policy that are simultaneously pegged to oil prices fluctuations are inferior to the monetary policy purely pegged to core inflation. Our findings suggest that the monetary policy should focus on core inflation instead of headline inflation.
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