Description

Recent years have highlighted the challenge of persistent supply shocks (e.g., from wars, geopolitical fragmentation) for monetary policy. This brief analyzes policy responses using a New Keynesian model where the economy can switch between ‘normal times’ and ‘bad times’ marked by sustained cost increases. We show that standard Taylor rules struggle because these persistent shocks alter the economy’s underlying ‘natural’ interest rate via household saving behaviour, leading to systematic inflation deviations. Optimal policy under discretion suffers from an inflationary bias during bad times, as policymakers are tempted to stimulate the economy. Optimal policy under commitment avoids this long-term bias. In response to these persistent supply shocks, the central bank adopts a ‘lean-against-the-wind’ approach on impact, accepting a permanent rise in the price level from persistent shocks, implying ‘bygones are bygones’.