A Heterogeneous Agent Model of Energy Consumption and Energy Conservation

In this paper, we investigate whether inflation-targeting monetary policy affects households' incentives to build resilience against energy price shocks. We utilize a stylized heterogeneous agent New Keynesian model with search and matching frictions in the labor market and nominal asset holdings. We modify the model to include energy in consumption and production, and energy conservation capital, so that energy price fluctuations affect both the supply and demand side of the economy. In such a framework, we study the responses of energy conservation to monetary policy, rising energy prices, and their interaction. We find that monetary policy influences energy intensity of consumption through both the intertemporal elasticity of substitution and labor market allocations. Our model predicts that a weaker policy response to rising energy prices is beneficial in terms of welfare to firm owners, borrowers and workers despite higher consumer price inflation. Such a policy stimulates energy conservation, and results in lower energy intensity and higher resilience against energy price fluctuations. We further find that a policy of looking through energy prices does not yield welfare benefits as it underreacts to consumer prices initially, but overreacts in later periods. Ramsey optimal policy predicts a strong immediate rise in the policy rate with a decline afterwards.