Working Paper: NBER ID: w29815
Authors: Ricardo J. 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; Supply Shocks; Aggregate Demand Inertia
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 |
|---|---|
| initial low aggregate demand (E00) | frontloaded interest rate cuts (E43) |
| frontloaded interest rate cuts (E43) | stimulate aggregate demand (E00) |
| stimulate aggregate demand (E00) | influences recovery of supply (Q21) |
| aggregate demand inertia and anticipated future policy constraints (E00) | overheats the economy (E62) |
| overheats the economy (E62) | positive output gaps (E23) |
| positive output gaps (E23) | prepares the economy for higher aggregate demand (E00) |
| maintaining low interest rates too long (E43) | overheating beyond optimal output gap (E23) |