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Interest Rate Smoothing in the Face of Energy Shocks

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  • Stefano Maria Corbellini

Abstract

This paper analyzes the monetary policy trade-off between defending purchasing power of consumers and keeping moderate debt cost for borrowers, in the framework of a heterogeneous agent New Keynesian open economy hit by a foreign energy price shock. Raising the interest rate indeed combats the loss in purchasing power due to the energy shock through a real exchange rate appreciation: however, this comes at the expense of higher interest payments for debtors. The trade-off can be resolved by adopting a milder interest rate policy during the crisis in exchange for a prolonged contraction beyond the energy shock time span. This interest rate smoothing approach allows to still experience a real appreciation today, while spreading the impact on debt costs more evenly over time. This policy counterfactual is analyzed in a quantitative model of the UK economy under the 2022-2023 energy price hike, where the loss of consumers’ purchasing power and the vulnerability of mortgage costs to higher policy rates have been elements of paramount empirical relevance.

Suggested Citation

  • Stefano Maria Corbellini, 2025. "Interest Rate Smoothing in the Face of Energy Shocks," Diskussionsschriften dp2502, Universitaet Bern, Departement Volkswirtschaft.
  • Handle: RePEc:ube:dpvwib:dp2502
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    References listed on IDEAS

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    1. John H. Cochrane, 2011. "Determinacy and Identification with Taylor Rules," Journal of Political Economy, University of Chicago Press, vol. 119(3), pages 565-615.
    2. Pieroni, Valerio, 2023. "Energy shortages and aggregate demand: Output loss and unequal burden from HANK," European Economic Review, Elsevier, vol. 154(C).
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