Monetary policy in a gas-TANK – Bank Underground

Jenny Chan, Sebastian Diz and Derrick Kanngiesser

In recent years, increases in global energy prices have posed significant challenges for net energy importers such as the UK or the euro area. In addition to the inflationary impact, increases in the relative price of energy imply a decline in real incomes for the energy importers. In this blog post, we introduce a macroeconomic model that captures the direct adverse effects on aggregate demand caused by energy price shocks (a notion that resonates with policymakers’ concerns, ie Schnabel (2022), Broadbent (2022), Tenreyro (2022), Lane (2022)). We show how the transmission of energy price shocks differs from other supply shocks, thereby contributing to a better understanding and more effective mitigation of the disruptions caused by energy price shocks.

Standard macroeconomic models do not capture direct adverse aggregate demand effects from energy price shocks. They typically attribute the economic downturn following an energy price shock to the monetary policy response aimed at mitigating inflation. Indeed, in these models, rising energy prices can even lead to an expansion in economic activity as firms substitute towards relatively cheaper production inputs, such as labour.

In a recent paper, we highlight a channel for energy prices to directly affect aggregate demand by incorporating two key features into a small open-economy model. First, in line with models examining the macroeconomic effects of energy price shocks, our model incorporates ‘factor complementarity’ which means that labour and imported energy are difficult to substitute for one another in the production process. Second, we introduce household heterogeneity with two types of households who differ in their sources of income and access to financial markets. Constrained households consume only out of labour income, while unconstrained households earn firm profits in addition to labour income. In the presence of adverse shocks, unconstrained households can also borrow to smooth consumption. This ability to smooth consumption means unconstrained households have a lower marginal propensity to consume than constrained households. Relative to a representative agent New Keynesian (RANK) model, a two-agent New Keynesian (TANK) model allows us to highlight the distributional effects of an energy price shock due to households’ differences in income composition and ability to smooth consumption in response to shocks.

By capturing the differential impact of energy price shocks on households based on their income sources and ability to smooth consumption, we highlight the significance of distributional dynamics in shaping the aggregate response to shocks. The reallocation of resources between domestic households and the foreign sector and between the two types of domestic households in response to the shock will matter for aggregate demand and inflation. Through this channel, energy price shocks have an inherent ‘demand-side’ effect. We illustrate this effect in Chart 1, which compares the dynamics in response to an energy price shock in a RANK model to a TANK model. Using hours worked as a proxy for aggregate demand, an energy price shocks leads to a greater contraction in aggregate demand in a TANK model, relative to a RANK. The turquoise blue lines in this chart isolates the direct demand-side effect of energy price shocks, which accounts for the deeper contraction in a TANK model.

Chart 1

Note: This chart shows the IRFs of key model variables to a 100% increase in the foreign currency price of energy. The TANK model corresponds to the blue lines, while the dynamics of the RANK model are illustrated by the red lines. The turquoise line illustrates the contribution of the direct effect of energy price shocks on aggregate demand, present in a TANK model.

The magnitude of this effect hinges on the elasticity of substitution between production inputs (Bachmann et al (2022)), price flexibility, and the proportion of constrained households. Assuming production inputs are reasonably difficult to substitute, an increase in energy prices leads to a fall in the labour share of firms’ expenditures. Since households differ in their access to borrowing and sources of income, a reduction in the labour share adversely affects aggregate demand for two reasons. First, it implies a reduction in income flowing to domestic factors of production. Due to credit constraints faced by a share of households, this translates into lower demand. Second, as constrained worker households rely more heavily on labour income, a lower labour share implies a redistribution of income against agents with a high marginal propensity to consume, which further depresses aggregate demand.

The size of this effect also depends on the degree of price rigidity, as the aforementioned contraction in aggregate demand can be moderated by the behaviour of markups. If firms are unable to pass on higher energy prices, markups will be compressed. In this scenario, the energy price shock redistributes resources away from unconstrained, firm-owning households, which stimulates aggregate demand (relative to the case in which prices are more flexible). In summary, assuming labour and imported energy are reasonably complementary and conditional on a standard degree of price rigidity, energy price shocks can have an adverse effect on aggregate demand, above and beyond the contractionary effects of tighter policy that aims to contain the inflationary overshoot.

We show that this demand-side effect of energy price shocks is present even when abstracting from features that would imply a regressive impact of energy prices. For instance, a more realistic representation would feature imported energy as a consumption input, higher shares of energy in constrained households’ consumption baskets, or constrained households employed in demand-sensitive sectors. Extensions of our model to incorporate these features still feature a direct demand-side effect of energy price shocks, and an even greater adverse effect on aggregate demand.

Our results highlight that the open economy dimension of our model is crucial for explaining the dynamics of an energy price shock, and how it redistributes resources differently from other supply shocks. As is standard in the TANK literature, amplification in our model depends on the shock affecting constrained households by more, relative to the unconstrained households. However, in our open-economy TANK model with energy, the variable which captures the relative impact of the energy shock is the consumption gap, defined as the difference between unconstrained and constrained household consumption, rather than the income gap. These two variables differ since unconstrained worker households can smooth consumption by borrowing from abroad. The cyclicality of the consumption gap therefore determines the amplification of shocks in an open-economy TANK model. Unlike an energy price shock, an adverse productivity shock stimulates demand (proxied by hours-worked, Chart 2) as firms must hire more labour for each unit of output. All else equal, this leads to a fall in markups and an increase in labour income, which redistributes resources towards constrained worker households.

Chart 2

Note: This chart shows the IRFs of key model variables to a 7% drop in TFP. The TANK model corresponds to the blue lines, while the dynamics of the RANK model are illustrated by the red lines. The consumption gap is defined as the difference between unconstrained and constrained household consumption.

Although an energy price shock and a markup shock both depress aggregate demand, the underlying cause is different. Higher markups imply an increase in the profit share relative to the labour share of income, redistributing resources away from constrained worker households and depressing aggregate demand. The drop in demand is therefore fully explained by an uneven impact of the shock on households’ income, due to the unequal income composition between constrained worker households and unconstrained firm-owning households (as indicated by the income gap, a component of the consumption gap in Chart 3). In contrast, the demand effect following an energy price shock is largely explained by a redistribution of resources towards the foreign sector, which affects demand due to households’ unequal access to international credit markets (ie unconstrained agents essentially borrow from abroad to smooth their consumption).

Chart 3

Note: This chart shows the IRFs of key model variables to an inflationary price markup shock. The TANK model corresponds to the blue lines, while the dynamics of the RANK model are illustrated by the red lines. The consumption gap is defined as the difference between unconstrained and constrained household consumption.

The presence of direct demand-side effects from energy shocks under household heterogeneity adds an important dimension to the policy landscape. Optimal monetary policy must strike a balance between addressing inflationary pressures and mitigating the negative impact on aggregate demand. In the TANK framework, the negative impact of higher energy prices on demand moderates subsequent inflationary pressures. While an overall contractionary policy stance may be necessary to counteract inflationary pressures, the negative impact of higher energy prices on aggregate demand warrants a nuanced approach.

Jenny Chan works in the Bank’s External MPC Unit, Sebastian Diz is a Research Economist at the Central Bank of Paraguay and Derrick Kanngiesser works in the Bank’s Monetary Policy Outlook Division.

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