IMF Working Papers

The Consequences of Falling Behind the Curve: Inflation Shocks and Policy Delays Under Rational and Behavioral Expectations

By Mai Hakamada, Carl E. Walsh

March 1, 2024

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Mai Hakamada, and Carl E. Walsh The Consequences of Falling Behind the Curve: Inflation Shocks and Policy Delays Under Rational and Behavioral Expectations, (USA: International Monetary Fund, 2024) accessed October 14, 2024

Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary

Central banks in major industrialized economies were slow to react to the surge in inflation that began in early 2021. The proximate causes of this surge were the supply chain disruptions associated with the easing of COVID restrictions, fiscal policies designed to cushion the economic impact of COVID, and the impact on commodity prices and supply chains of the war in Ukraine. We investigate the consequences of policy delay in responding to inflation shocks. First, using a simple three-period model, we show how policy delay worsens inflation outcomes, but can mitigate or even reverse the output decline that occurs when policy responds without delay. Then, using a calibrated new Keynesian framework and two measures of loss that incorporate a “balanced approach” to weigh inflation and the output gap, we find that loss is monotonically increasing in the length of the delay. Loss is reduced if policy, when it does react, is more aggressive. To investigate whether these results are sensitive to the assumption of rational expectations, we consider cognitive discounting as an alternative assumption about expectations. With cognitive discounting, forward guidance is less powerful and results in a reduction in the costs of delay. Under either assumption about expectations, the costs of a short delay can be eliminated by adopting a less inertial policy rule and a more aggressive response to inflation.

Subject: Central bank policy rate, Economic theory, Financial services, Inflation, Output gap, Prices, Production, Rational expectations, Real interest rates

Keywords: Behavioral expectations, Central bank policy rate, Falling behind the curve, Inflation, Inflation outcome, Inflation policy delay, Inflation shock, Monetary policy, Output gap, Policy delay, Rational expectations, Real interest rates, Supply chain disruption, Trend inflation

Publication Details

  • Pages:

    52

  • Volume:

    ---

  • DOI:

    ---

  • Issue:

    ---

  • Series:

    Working Paper No. 2024/042

  • Stock No:

    WPIEA2024042

  • ISBN:

    9798400269097

  • ISSN:

    1018-5941