Energy shocks as Keynesian supply shocks: implications for fiscal policy

Summary

Focus

The recent energy crisis has elicited much debate about its distributional and macroeconomic consequences and the appropriate fiscal (and monetary) policy response. Accordingly, the fiscal policy debate has focused on the need to target income support (in the form of subsidies or tax rebates) to the most vulnerable households. In this paper we develop a model to investigate the economic impact of energy supply shocks and the optimal fiscal policy response to them.

Contribution

A negative energy supply shock typically has a larger impact on the ability of low-income, credit-constrained households to consume non-energy goods. We trace out the implications of this for the aggregate economy and the policy response. We investigate three questions. First, what are the effects of a negative energy supply shock? Second, what distortions, if any, does the market allocation suffer from? Third, what tools can be used to correct these distortions, and is there a role for public debt?

Findings

In this environment, negative energy supply shocks can lead to a shortage of aggregate demand, when sticky energy demand leads poor credit-constrained households to disproportionately cut demand for non-energy goods. Second, efficiency requires subsidising firms and poor households while taxing rich households – and more so (relative to incomes) when the economy suffers a negative energy shock. Finally, issuing public debt is part of the optimal fiscal policy response when the economy faces a large shock, and/or when the economy's overall energy intensity is low.

Abstract

This paper analyses the economic impact of and the optimal policy response to energy supply shocks in a flexible price model with heterogeneous households. We introduce energy as a consumption good on the demand side and as an input to production on the supply side. A distinguishing feature is that, in line with empirical evidence, we allow households' energy demand to be non-homothetic. The model provides three main insights. First, (negative) energy supply shocks act as a (negative) demand shock, or Keynesian supply shock, when three conditions are met: (i) household income heterogeneity is intermediate, neither too high nor too low; (ii) the fraction of poor and credit-constrained households is high and (iii) competition between firms is strong enough. Second, implementing the first-best allocation requires subsidising the poor and taxing the rich, and more so when the economy faces a negative energy shock. Last, issuing public debt can be part of the optimal policy response to a negative energy shock, if the shock is large and the economy's overall energy intensity is low.

JEL classification:  D31, E21, E32, E62, H3

Keywords: energy shocks, non-homothetic demand, heterogeneous households, fiscal policy, public debt