Managing an Energy Shock: Fiscal and Monetary Policy

This paper studies the macroeconomic effects of energy price shocks on energy-importing economies using a heterogeneous-agent New Keynesian small open economy model, extending Auclert, Rognlie, Souchier and Straub (2021b) to add an imported energy good. Its central finding is that once households have realistically high marginal propensities to consume (MPCs) and the short-run elasticity of substitution between energy and other goods is realistically low, a rise in world energy prices depresses real income enough to cause a domestic recession, even if the central bank keeps the real interest rate constant – in sharp contrast to complete-markets representative-agent models, where the same shock is always expansionary because it only triggers expenditure switching toward domestic goods. Building on this framework, the paper studies three questions in turn: whether the shock triggers a self-reinforcing wage-price spiral (it can, but this never actually protects real wages, which fall by the amount the shock dictates regardless); how effective unilateral versus coordinated monetary tightening is at curbing imported inflation (largely ineffective alone, materially effective in coordination, creating a free-rider problem among energy-importing central banks); and how fiscal policy – energy subsidies, and targeted or untargeted transfers – can shield an individual country from the shock (effectively, especially via subsidies) while imposing negative externalities on other energy importers through the world energy market (again, especially via subsidies, which blunt the substitution away from energy that would otherwise restrain world energy demand).

Hugo Monnery | Macro Paper Warehouse

Managing an Energy Shock: Fiscal and Monetary Policy