Monetary and Fiscal Coordination in the Face of Supply-Side Shocks: With an Application to the Effects of the War in Ukraine

This paper shows that coordination of monetary policy and fiscal policy can be desirable in the face of a temporary supply side shock. To calibrate our study we use the sharp rise – and subsequent reversion - of energy prices as a result of Russia’s invasion of Ukraine in early 2022. We take as the objective of policy the control of inflation, and the avoidance of a wage-price spiral, without it being necessary to greatly increase interest rates. We show how such a coordinated strategy could make use of a temporary subsidy to consumption following the energy-price shock. We demonstrate that it would be possible to follow such a strategy without creating either excess demand in the short run or Ponzi-game-like fiscal outcomes in the longer run. Our model is a modified version of the new-Keynesian DSGE model due to Christiano, Eichenbaum and Evans (2005) and Smets and Wouters (2007), to which we have added a fiscal-policy process and an energy-sector enclave. We examine the macroeconomic and welfare outcomes of our policy strategy. We show why the welfare outcomes might be better than those which would emerge in the absence of any consumption subsidy, in which case monetary policy would be the only means used to control inflation. We discuss broader implications of our results in the concluding section of the paper.