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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

Central banks in most advanced economies have reacted similarly to the increase in inflation that started in 2021. They initially looked through the rising inflation by leaving monetary policy relatively unchanged. Then, after inflation continued to increase, central banks pivoted by quickly tightening monetary policy. The pivot was explained, at least in part, as aiming to anchor drifting inflation expectations. Why might central banks want to look through supply-driven inflation sometimes and pivot away at other times? When does a change in monetary policy stance help anchor expectations? When is a strong monetary policy tightening compatible with a soft landing? In this paper we present a simple environment that helps clarify these issues by offering an optimal policy perspective on recent central bank behaviour. In particular, we examine optimal policy in an environment where there is a risk of wage-price spirals and where the central bank views wage- and price-setters as having bounded rationality. We show how this can provide a coherent explanation of many aspects of recent central bank behaviour.

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

    as
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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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