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A Note on Temporary Supply Shocks with Aggregate Demand Inertia

  • Ricardo J. Caballero
  • Alp Simsek
American Economic Review: Insights
vol. 5, no. 2, June 2023
(pp. 241-58)
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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.

Citation

Caballero, Ricardo J., and Alp Simsek. 2023. "A Note on Temporary Supply Shocks with Aggregate Demand Inertia." American Economic Review: Insights, 5 (2): 241-58. DOI: 10.1257/aeri.20220109

Additional Materials

JEL Classification

  • E12 General Aggregative Models: Keynes; Keynesian; Post-Keynesian; Modern Monetary Theory
  • E21 Macroeconomics: Consumption; Saving; Wealth
  • E23 Macroeconomics: Production
  • E31 Price Level; Inflation; Deflation
  • E43 Interest Rates: Determination, Term Structure, and Effects
  • E52 Monetary Policy