Can Energy Subsidies Help Slay Inflation?

CanEnergySubsidiesHelpSlayInflation? ChristopherErceg,MarcinKolasa,JesperLinde,andAndreaPescatori WP/24/81 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate. TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. 2024 APR ©2024InternationalMonetaryFundWP/24/81 IMFWorkingPaper MonetaryandCapitalMarketsDepartmentResearchDepartment CanEnergySubsidiesHelpSlayInflation?*ChristopherErceg,MarcinKolasa,JesperLinde,AndreaPescatori AuthorizedfordistributionbyChristopherErcegApril2024 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate.TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. ABSTRACT:Manycountrieshaveusedenergysubsidiestocushiontheeffectsofhighenergypricesonhouseholdsandfirms.AfterdocumentingthetransmissionofoilsupplyshocksempiricallyintheUnitedStatesandtheEuroArea,weuseaNewKeynesianmodelingframeworktostudytheconditionsunderwhichthesepoliciescancurbinflation.Wefirstconsideraclosedeconomymodeltoshowthataconsumersubsidymaybecounterproductive,especiallyasaninflation-fightingtool,whenappliedgloballyorinasegmentedmarket,atleastunderempiricallyplausibleconditionsaboutwage-setting.Wefindmorescopeforenergysubsidiestoreducecoreinflationandstimulatedemandifintroducedbyasmallgroupofcountrieswhichcollectivelydonothavemuchinfluenceonglobalenergyprices.However,theconditionsunderwhichconsumerenergysubsidiesreduceinflationarestillquiterestrictive,andthistypeofpolicymaywellbecounterproductiveiftheresultingincreaseinexternaldebtishighenoughtotriggersizeableexchangeratedepreciation.Sucheffectsaremorelikelyinemergingmarketswithshallowforeignexchangemarkets.Iftheprimarygoalofusingfiscalmeasuresinresponsetospikesinenergypricesistoshieldvulnerablehouseholds,thentargetedtransfersaremuchmoreefficientastheyachievetheirgoalsatlowerfiscalcostandtransmitlesstocoreinflation. JELClassificationNumbers: E32,E52,E64,H23,Q43 Keywords: EnergyPrices;EnergySubsidies;MonetaryPolicy;InternationalSpillovers Author’sE-MailAddress: CErceg@IMF.org,MKolasa@IMF.org,JLinde@IMF.org,andAPescatori@IMF.org *WethankTianchuQiandKailiChenforexcellentresearchassistanceandTobiasAdrian,JaebinAhn,GiovanniDell'Ariccia,Pierre-OlivierGourinchas,ZoltanJakab,andMathiasTrabandtforusefulcommentsanddiscussions.ThepaperalsobenefitedfromcommentsfromtheparticipantstotheCEPRParisSymposium,ESSIMinTarragona,NBU-NBPARCinCracow,CEFinNice,SummerWorkshoponEconomicsandFinanceinWarsaw,andseminarsattheEuropeanCentralBank,Bancad'Italia,andUniversityofOttawa.TheviewsexpressedhereareoursanddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. INTERNATIONALMONETARYFUNDii 1Introduction Centralbankshavetightenedmonetarypolicyaggressivelytocombathighinflation,whichsurgedtomulti-decadepeaksinmanyeconomies.Whiletheinflationrunuphasbeendrivenbyanumberoffactors,includingsupplydisruptionsandmassivefiscalandmonetarystimu-lus,sharpincreasesinenergypriceshavebeenamajorcatalyst.Manycountriesrespondedbyusingvariousformsofenergysubsidies,oftentargetedmainlytohouseholds,tohelpcurbinflationaswellastocushiontheeffectsonhouseholdpurchasingpower(Arreguietal.,2022;Sgaravattietal.,2023).Energysubsidiesareviewedbymanypolicymakersashelpfulinthefightagainstinflationonthegroundsthattheyarelikelytolimitbothfirstandsecondroundeffects,includingbyreducingpassthroughtowages. Buttherearemanyopenquestionsabouttheconditionsunderwhichenergysubsidiesareactuallylikelytobeeffectiveinloweringinflation,or,conversely,whentheymaybecoun-terproductive.Whilewagestickinesshaslongbeenrecognizedaspivotalinthetransmissionofenergyshockstooverallpriceinflation(e.g.,BlanchardandGali,2007),therehasbeenlittleanalysisofhowtheeffectsofenergysubsidiesoninflationdependonthemodalitiesofwage-setting,includingthedegreeofindexation.Similarly,itisunclearhowtheeffectsofsubsidiesdependonthestructureoftheenergymarket:couldinsulatingconsumersfromtheeffectsofhigherpricesinahighlysegmentedmarket–suchastheonefornaturalgasinEurope–hurtfirmsenoughtocausecoreinflationtorise?Andhowdotheeffectsofsubsidiesdependonwhethertheyareusedbyasingle“smalleconomy”orabroadsetofcountries? Inthispaper,weuseaNewKeynesianmodelingframeworktohelpanalyzetheseques-tions,butfirstseekempiricalgroundingbyestimatinghowoilshockstransmittotheeconomyintheUnitedStates(US)andeuroarea(EA).Specifically,weuseaproxySVARapproachwheretheinstrumentisgivenbysurprisechangesinoilpricesfollowingtheannouncementofOPECmeetingdecisions.TheseriesofsurprisesisadoptedfromKa¨nzig(2021)andaggre-gatedtoquarterlyfrequencyoverthe1983to2019sampleperiod.Fortheseidentifiedshocks,wefindthatanegativeoilsupplyshockwhichdrivesupthepriceofoilleadstohighercoreandheadlineinflation,lowerGDP,andhigherpolicyratesinitiallyinboththeUSandtheeuroarea.Importantly,wefindsignificantdifferencesinthetransmissiontowagesbetweenthes