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Looking Through Supply Shocks versus Controlling Inflation Expectations: Understanding the Central Bank Dilemma

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  • Paul Beaudry
  • Thomas J. Carter
  • Amartya Lahiri

Abstract

When countries are hit by supply shocks, central banks often face the dilemma of either looking through such shocks or reacting to them to ensure that inflation expectations remain anchored. In this paper, we propose a tractable framework to capture this dilemma and then explore optimal policy under a range of assumptions about how expectations are formed, including a form of bounded rationality involving level-k thinking (LKT). Despite modelling LKT in a way that nests both adaptive and rational expectations as special cases, we show that the optimal policy under LKT is qualitatively different and involves abrupt pivots in the policy stance. In particular, it is optimal for the central bank to initially look through supply shocks until a threshold is reached, then pivot discontinuously to a more hawkish anti-inflationary stance. We find that such pivots can, if optimally executed, be compatible with soft landings in the sense that most (or even all) of the reduction in inflation occurs through the re-anchoring of expectations rather than through economic slack. We also discuss risks and why policy errors leading to tightening too late or too slowly can be especially costly in such an environment.

Suggested Citation

  • Paul Beaudry & Thomas J. Carter & Amartya Lahiri, 2022. "Looking Through Supply Shocks versus Controlling Inflation Expectations: Understanding the Central Bank Dilemma," Staff Working Papers 22-41, Bank of Canada.
  • Handle: RePEc:bca:bocawp:22-41
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    References listed on IDEAS

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    1. Julian di Giovanni & Ṣebnem Kalemli-Özcan & Alvaro Silva & Muhammed A. Yildirim, 2022. "Global Supply Chain Pressures, International Trade, and Inflation," NBER Working Papers 30240, National Bureau of Economic Research, Inc.
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    3. Mariana García-Schmidt & Michael Woodford, 2019. "Are Low Interest Rates Deflationary? A Paradox of Perfect-Foresight Analysis," American Economic Review, American Economic Association, vol. 109(1), pages 86-120, January.
    4. Nagel, Rosemarie, 1995. "Unraveling in Guessing Games: An Experimental Study," American Economic Review, American Economic Association, vol. 85(5), pages 1313-1326, December.
    5. Ricardo Reis, 2021. "Losing the Inflation Anchors," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 52(2 (Fall)), pages 307-379.
    6. Costa-Gomes, Miguel & Crawford, Vincent P & Broseta, Bruno, 2001. "Cognition and Behavior in Normal-Form Games: An Experimental Study," Econometrica, Econometric Society, vol. 69(5), pages 1193-1235, September.
    7. Emmanuel Farhi & Iván Werning, 2019. "Monetary Policy, Bounded Rationality, and Incomplete Markets," American Economic Review, American Economic Association, vol. 109(11), pages 3887-3928, November.
    8. Guyllaume Faucher & Christopher Hajzler & Martin Kuncl & Dmitry Matveev & Youngmin Park & Temel Taskin, 2022. "Potential output and the neutral rate in Canada: 2022 reassessment," Staff Analytical Notes 2022-3, Bank of Canada.
    9. Edouard Djeutem & Mario He & Abeer Reza & Yang Zhang, 2022. "Household Heterogeneity and the Performance of Monetary Policy Frameworks," Staff Working Papers 22-12, Bank of Canada.
    10. Joel Wagner & Tudor Schlanger & Yang Zhang, 2022. "A Horse Race of Alternative Monetary Policy Regimes Under Bounded Rationality," Discussion Papers 2022-4, Bank of Canada.
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    Citations

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    Cited by:

    1. Harding, Martín & Lindé, Jesper & Trabandt, Mathias, 2023. "Understanding post-COVID inflation dynamics," Journal of Monetary Economics, Elsevier, vol. 140(S), pages 101-118.
    2. Oleksiy Kryvtsov & James (Jim) C. MacGee & Luis Uzeda, 2023. "The 2021–22 Surge in Inflation," Discussion Papers 2023-3, Bank of Canada.
    3. Donald Coletti, 2023. "A Blueprint for the Fourth Generation of Bank of Canada Projection and Policy Analysis Models," Discussion Papers 2023-23, Bank of Canada.

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    More about this item

    Keywords

    Central bank research; Economic models; Inflation and prices; Monetary policy; Monetary policy and uncertainty; Monetary policy communications;
    All these keywords.

    JEL classification:

    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian; Modern Monetary Theory
    • E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E65 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Studies of Particular Policy Episodes

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