A Note on Temporary Supply Shocks with Aggregate Demand Inertia

49 Pages Posted: 5 Feb 2022 Last revised: 1 Jul 2022

See all articles by Ricardo J. Caballero

Ricardo J. Caballero

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Alp Simsek

Yale School of Management; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 4 versions of this paper

Date Written: June 30, 2022

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, interest rates, temporary supply shocks, aggregate demand inertia, inflation, divine coincidence, policy frontloading, backward guidance, momentum, output and inflation gaps, the Phillips curve, Covid-19

JEL Classification: E21, E32, E43, E44, E52, G12

Suggested Citation

Caballero, Ricardo J. and Simsek, Alp, A Note on Temporary Supply Shocks with Aggregate Demand Inertia (June 30, 2022). Available at SSRN: https://ssrn.com/abstract=3975513 or http://dx.doi.org/10.2139/ssrn.3975513

Ricardo J. Caballero (Contact Author)

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Alp Simsek

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