The effect of monetary policy tightening on inflation an estimated DSGE model (working paper)

Abstract

This paper simulates of the supply side effect of monetary policy using cost channel in a New Keynesian business cycle model. I use a standard DSGE framework based on Smets & Wouters (2003) to model the effect of a contractionary monetary shock on inflation. I introduce a cost channel through Rabanal (2007) forcing some proportion of firms to borrow in order to make the wage payments. This setup increases the marginal cost following a contractionary monetary policy. This increased marginal cost puts upward pressure on inflation. I use two sample periods for estimation- pre-recession (Jan 1980-Dec 2008), and post-recession (Jan 2008- Sep 2020). In doing so, I control for the post recession interest rates- often argued to be in the zero lower bound (ZLB) regime. The estimation results from pre- and post-recession data suggests that for both time frames, the demand side effects are stronger than the supply side. Hence, the cost channel is not significant enough for the supply side to dominate the demand side. Thus, prices must fall in response to a rise in interest rates. It should also be noted that estimates suggested that the proportion of firms subject to cost channel is small for both data sets. As part of robustness check, I restrict all firms to be subject to the cost channel and it can be concluded that even with those restrictions, the supply side effects through cost channel approach was not significant enough to produce an increased prices in response to a contractionary monetary policy.

Bitaran Jang Maden

Visiting Assistant Professor

My research interests include monetary economics, time series econometrics and applied macro economics matter.