How should monetary policy respond to an oil discovery? Oil discoveries provide news that the natural level of output will rise in the future, which lowers the natural real rate of interest. Optimal monetary policy must accommodate these changes in natural output, and is well-approximated by a Taylor rule that responds to the natural real rate. Failure to accommodate these changes, as in a currency peg or naive Taylor rule, can cause forward-looking inflation and a recession. To prove this I incorporate oil and news shocks into a standard DSGE model of a small open economy that permits an analytical solution for optimal policy. I then use the model to present a novel explanation for the UK's recessions of the 1970s and 80s, based on the discovery of North Sea oil.
