DP16814 A Note on Temporary Supply Shocks with Aggregate Demand Inertia

Author(s): Ricardo Caballero, Alp Simsek
Publication Date: December 2021
Date Revised: March 2022
Keyword(s): aggregate demand inertia, aggregate demand momentum, COVID-19, divine coincidence, inflation, interest rates, monetary policy, output and inflation gaps, Taylor rule, temporary supply shocks
JEL(s): E21, E32, E43, E44, E52, G12
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16814

We study optimal monetary policy during temporary supply contractions when aggregate demand has inertia and expansionary policy is constrained. In this environment, it is optimal to run the economy hot until supply recovers. Positive output gaps in the low-supply phase lessen the negative output gaps expected to emerge once supply recovers. However, the policy does not remain loose throughout the low-supply phase: The central bank undoes the initial interest rate cuts once aggregate demand gains momentum. If inflation also has inertia, the central bank still overheats the economy during the low-supply phase but gradually cools it down over time.