Monetary policy with profit-driven inflation

Summary

Focus

In this paper, we focus on the drivers of the recent inflation surge and argue that they are fundamentally different from those in past episodes. Back in the 1970s, unit labour costs were the main driver of inflation. But more recently, unit profits have taken this role. Empirical evidence even points to unit profits becoming a leading indicator of inflation.

Contribution

We develop a New Keynesian model with reservation profits on the supply side. In this framework, shocks that cut profits typically lead firms to retrench, thereby contracting the supply side and giving rise to so-called "profit-driven inflation". We then use this framework to investigate the positive and normative implications of cost-push shocks, focusing on energy price shocks.

Findings

We first show that energy price shocks lead to inefficiently large supply contractions and thereby inefficiently high (profit-driven) inflation. This is because firms that retrench do not internalise the social costs of doing so. We then show that optimal monetary policy follows a pecking order. It first aims at shielding the supply side from the fallout of the shock, preventing firms' retrenchement. When fully insulating the supply side is too costly, monetary policy then splits the burden of the shock, effectively contracting demand and supply. Finally, when the energy price shock is very large, monetary policy loses traction. Budget-neutral fiscal interventions, eg redistribution from high- to low-income households and/or from high- to low-profit firms, can then restore monetary policy effectiveness.

Abstract

Following evidence on the role of firm profits in the current inflation surge, we develop a New Keynesian model where profit-driven inflation stems from the presence of reservation profits on the supply side. We use this framework to investigate the positive and normative implications of cost push shocks, focusing on energy price shocks. We first show that these shocks lead to inefficiently large supply contractions and thereby inefficiently large (profit-driven) inflation, as firms which retrench do not internalise the social costs of doing so. Second, we show that optimal monetary policy follows a pecking order. It first aims at shielding the supply side from the fallout of the shock, thereby undoing the negative retrenchment externality. It then splits the burden of the shock between supply and demand, when insulating the supply side is too costly. Finally, when the energy price shock is very large, monetary policy loses traction. Budget-neutral fiscal interventions, e.g. redistribution from high- to low-income households and/or from high- to low-profit firms, can then restore monetary policy effectiveness.

JEL classification: D21, E23, E31, E32, E52, E62, H24, H25

Keywords: energy price shocks, price stickiness, reservation profits, optimal monetary policy, corporate tax