War in the Ukraine and global inflationary pressures: learning about how to study fiscal and monetary cooperation in the face of supply side shocks

Abstract:

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.