Non-Linear Response of Monetary Policy to Autonomous Demand Shock
Andreyev M.
This paper examines the specific features of the economic system that lead to a non-linear, i.e. accelerated growth of inflation and the key rate against the backdrop of positive autonomous demand shocks. Specifically, the shock of increased government spending is considered as the dominant component of autonomous demand.
The research tool is a dynamic stochastic general equilibrium model. Unlike the ‘menu costs’ and ‘attention’ approaches commonly used in the study of non-linear inflation responses, this paper describes the non-linearity of inflation in terms of the institutional constraints of individual agents. The study implements the idea that under the influence of large shocks, the economic system may temporarily shift to a state characterised by faster inflation growth.
The paper examines four features of the economic system, each of which causes an autonomous demand shock to lead to non-linear growth in inflation or interest rates. First, it demonstrates that non-linear growth can occur when there is a shortage of production factors, provided that firms increase prices to ensure profitability. This model scenario aligns with the non-linearity observed in the Phillips curve. Second, it shows that when agents develop coordinated beliefs about future inflation growth, this can lead to non-linear growth in both inflation and interest rates. At the same time, it is possible that collectively, the beliefs of agents about future events could be erroneous. Third, if an autonomous demand shock is financed exclusively through long-term government bonds that banks purchase, which come with a fixed coupon income, and if these banks face strict capital requirements and accounting standards for the bonds on their balance sheets, this can lead to non-linear growth. Then, when significant autonomous demand shocks occur, banks tend to raise their yield requirements for new debt. This can create instability in the bond market, creating a dilemma for the central bank between ensuring bond market stability and adhering to the inflation targeting goal. Fourth, inflation may accelerate due to faster growth in monetary aggregates when the financing of government consumption shifts from the use of foreign asset wealth funds to borrowing on the domestic bond market.
The findings underscore the importance for the central bank of a comprehensive assessment of the transmission channels of autonomous demand shocks and the impact of monetary policy, as well as the institutional features of the economic system, in order to improve policy efficiency.