This paper discusses how to build a simple model of the optimal policy responses to a temporary rise in energy prices, a situation like that caused by the war in Ukraine. The objective is to avoid the emergence of a wage price spiral, in the presence of the kind of real-wage resistance which has been shown to be empirically important, and yet also to avoid large increases in interest rates. We believe that this outcome might have been achieved by means of a very large cut in consumption taxes (or a very large subsidy to energy supply). That action would moderate (or in the limit completely remove) the energy price-induced cost-push pressures, thereby meaning that interest rates would have needed to be raised very little (and in the limit not at all) to control inflation. But such tax cuts would both stimulate aggregate demand and increase the government budget deficit. It is therefore important to prevent such a policy strategy from creating excess demand in the short run, or Ponzi-game-like fiscal outcomes in the long run. We show that, in order to study this question with a simple formal model, we will need to abandon two features which have been central to the benchmark new-Keynesian DSGE model, namely the use of a forward-looking Phillips curve and the neglect of investment and capital accumulation. We have not yet done this work. But the simulation results in our paper points suggest that it will be possible to demonstrate that there might be large benefits in using a combination of fiscal policy and monetary policy to deal with supply-side shocks.
About the speaker
David Vines is Professor of Economics, and a Fellow of Balliol College, at the University of Oxford. He is also a Research Fellow of the Centre for Economic Policy Research.
From 2008 to 2012 he was the Research Director of the European Union’s Framework Seven PEGGED Research Program, which analysed Global Economic Governance within Europe. Professor Vines received a BA from Melbourne University in 1971, and subsequently an MA and PhD from Cambridge University. From 1985 to 1992 he was Adam Smith Professor of Political Economy at the University of Glasgow.
His research interests are in macroeconomics, including financial frictions, fiscal and monetary interactions, and financial crisis. His recent books include: The Leaderless Economy: Why the World Economic System Fell Apart and How to Fix It (Princeton University Press, 2013, with Peter Temin); The IMF and its Critics: Reform of Global Financial Architecture (Cambridge University Press, 2004, with Christopher Gilbert) and The Asian Financial Crisis: Causes, Contagion and Consequences (Cambridge University Press, 1999, with Pierre-Richard Agénor, Marcus Miller, and Axel Weber).
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