Working Paper: CEPR ID: DP16814
Authors: Ricardo Caballero; Alp Simsek
Abstract: We study optimal monetary policy during temporary supply contractions when aggregate demand has inertia and the central bank is concerned about future constraints on expansionary policy. In this environment, it is optimal to run the economy hot until supply recovers. However, the policy does not remain loose throughout the low-supply phase. Overall, when the initial aggregate demand is low, the goal is to frontload the rate cuts to raise demand in anticipation of the recovery of supply. If inflation also has inertia, the central bank still overheats the economy during the low-supply phase but gradually cools it down over time.
Keywords: monetary policy; backward guidance; COVID-19
JEL Codes: E21; E32; E43; E44; E52; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Low aggregate demand (E19) | Frontloading interest rate cuts (E52) |
| Frontloading interest rate cuts (E52) | Increase aggregate demand (E00) |
| Running the economy hot (E65) | Positive output gaps (E23) |
| Positive output gaps (E23) | Faster recovery from supply constraints (D25) |
| Running the economy hot (E65) | Higher aggregate demand in high-supply state (R22) |
| Higher aggregate demand in high-supply state (R22) | Alleviating anticipated negative output gaps (E24) |
| Overheating the economy (E65) | Inflationary pressures (E31) |
| Quick normalization of interest rates (E43) | Desired positive output level (H21) |