War in the Ukraine and global inflationary pressures: a fiscal and monetary response that would avoid excessive interest-rate increases
Abstract: This paper uses a new-Keynesian DSGE model to study optimal policy responses to a temporary rise in energy prices, a situation like that caused by the war in Ukraine. The objective is to avoid the emergence of a wage price spiral, in the presence of the kind of real-wage resistance which has been shown to be empirically important, and yet also to avoid large increases in interest rates. We argue that this outcome could have been achieved by means of a very large cut in consumption taxes (or a very large subsidy to energy supply). That action would moderate (or in the limit completely remove) the energy-price-induced cost-push pressures, thereby meaning that interest rates would need to be raised very little (and in the limit not at all). Such tax cuts would greatly increase the government budget deficit. It is therefore important to prevent such a policy strategy from creating excess demand in the short run, or Ponzi-game-like fiscal outcomes in the long run. We present simulation results using our model to show that these fiscal constraints can be satisfied but that, nevertheless, inflationary pressures can be disciplined without large increases in interest rates. We argue that, especially in time of war, such a policy strategy may be desirable. Nevertheless we also show that if policy cannot be made with commitment, or if the stock of public debt is high, it may be difficult to make use of this kind of mix of fiscal and monetary policy.