Ms.
BANQUE DE FRANCE
es

EUROSYSTEME

Speech

Monetary policy

The policy mix in a world of supply
shocks

Published on 6 November 2024

Agnés Bénassy-Quéré, Deputy Governor of the Banque de France
University of Bordeaux, 3 October 2024

Ladies and Gentlemen, dear Students,

Today I would like to discuss with you the policy mix in a world of supply
shocks, a subject of growing importance in the global economic
landscape. I will share my views on how monetary and fiscal policy
should adapt to this new macroeconomic environment.

The conventional policy mix

Let me start by recalling what the conventional policy mix is. Imagine a
funnel, like the one described by James Tobin (1987). Above, we have
monetary policy, represented by the M-tap, and fiscal policy, denoted by
the F-tap. These two policies feed into the funnel, which represents
aggregate demand. This demand flows into a container below, whose
water level symbolises supply. The splashes represent production (Y)
and the general price level (P).

Chart 1: James Tobin's funnel

Note: F stands for fiscal policy; M for monetary policy; Y for economic activity; and P for
the general price level.
Source: B.Q., for Bartsch et al. (2020).

This conventional view of the policy mix shows how the combination of
monetary and fiscal policies influences activity and prices through its
impact on aggregate demand. However, these two 'demand-side'
policies are not entirely substitutable. Table 1 summarises their
differences.

Table 1. Main differences between monetary policy and fiscal policy

Monetary policy Fiscal policy

Affects demand indirectly Affects demand directly and indirectly

Quick decision, slow transmission Long decision (aside automatic
stabilizers), fast transmission

Affects government debt directly (interest Affects government debt directly through

rate) and indirectly (nominal GDP) primary balance and indirectly through
nominal GDP

General instrument Can be targeted to specific sectors or
households

More powerful in a flexible exchange-rate More powerful in a fixed exchange-rate

regime regime or monetary union

Impact depends on expectations of future Impact depends on expectations of future

inflation and policy rates taxes

May be constrained by effective lower bound May be constrained by state of public
(monetary space) finances, fiscal rules or market pressure.

Table 1

Monetary policy affects demand indirectly, via interest rates, while fiscal
policy acts directly, via public spending such as investment or
intermediate consumption by general government, or indirectly, via taxes
and transfers. Monetary policy decisions can be taken rapidly, but their
transmission to the economy is slow, generally taking around 18 months.
Conversely, the discretionary part of fiscal policy is subject to a slow
legislative process but, once implemented, can have a faster impact on
demand. Automatic stabilisers, on the other hand, by definition do not
require decisions: if scales remain unchanged, taxes and transfers vary
automatically over the economic cycle.

To give a concrete example: if the government decides to send cheques
to households (a discretionary policy), these cheques can be spent
immediately, having a swift impact on demand. By contrast, when the
European Central Bank (ECB) lowers interest rates, the impact on the
real economy takes time to manifest.

Another important aspect to consider is the impact of these policies on
government debt. Monetary policy influences debt accumulation directly
through interest rates, and indirectly through the impact of this policy on
activity and prices. Fiscal policy directly affects the primary balance. Like
monetary policy, it also affects the accumulation of government debt
through its impact on nominal GDP.

It should also be noted that monetary policy is almost always a blunt
instrument, affecting the economy as a whole, whereas fiscal policy can
be more targeted, affecting specific sectors or groups of the population.
During the pandemic, the ECB intervened in the short-term corporate
bond market to unlock this specific market segment, but this was an
exception rather than the rule. In general, the ECB acts through policy
rates, which affect all lender and borrower interest rates at the same
time.

In an open economy with a high degree of international capital mobility,
the Mundell-Fleming model teaches us that monetary policy is reinforced
by its external transmission channel (e.g.an unanticipated interest rate
cut by the ECB leads to a depreciation of the euro). Similarly, the fact
that exchange rates are fixed within the euro area (by construction ina

monetary union) increases the impact of the fiscal policy implemented
by individual Member States.

How effective both policies are depends very much on their credibility:
monetary easing has a greater impact if the markets consider it to be
sustainable, because in this case long-term interest rates fall, and not
just policy rates. Fiscal policy, on the other hand, has a greater impact on
activity if government debt is considered to be sustainable, because
here fiscal expansion is not offset by a rise in the household savings rate
(neo-Ricardian effect).

Finally, both policies can be constrained. As regards monetary policy,
interest rates cannot fall below a slightly negative level. As regards fiscal
policy, European rules and market pressure can prevent a government
from responding to a negative shock to activity.

The European policy mix under
pressure from supply shocks

The implementation of the policy mix is specific to the euro area in that
monetary policy is defined for the area as a whole, while fiscal policies
are decided at the Member State level. The policy mix corresponds to
the first diagonal in Table 2: monetary policy reacts to 'symmetric'
shocks, which affect aggregate demand in the euro area as a whole,
aiming to stabilise prices; fiscal policies react to specific (or
'idiosyncratic') shocks, aiming to stabilise the national output gap (the
gap between actual and potential output at country level).

During the decade of too-low inflation that followed the global financial
crisis and the euro area sovereign debt crisis (2009-19), the European
Commission and the European Fiscal Board tried to promote the
coordination of fiscal policies so as to steer the overall fiscal stance and
thus bolster monetary policy action (top left-hand cell of Table 2). In
2014, Mario Draghi himself, the then President of the ECB, called for
fiscal policy to support the efforts of monetary policy to raise the level of
aggregate demand and the rate of inflation: "It would be helpful for the
overall stance of economic policy if fiscal policy could play a greater role
alongside monetary policy".1 However, these appeals went unheeded, as
governments are bound by their national constituencies.

Coordination of fiscal policies may also be useful where shocks differ
across Member States. During the euro area sovereign debt crisis of the
early 2010s, many experts argued in favour of coordinated but
differentiated fiscal policies, to ensure that the countries affected by the
crisis did not simultaneously suffer from a loss of external demand from
other European countries. These appeals met with the same obstacles:
the coordination of decentralised fiscal policies is no substitute for a
federal budget, which is very limited in the euro area.

The bottom right-hand cell in Table 2 (price stabilisation in the face of
specific shocks) remained empty until the energy crisis erupted in 2021.

[rrr arr

Symmetric Idiosyncratic
oo Output (Aggregate fiscal stance) National fiscal stance
stabilization
Price stabilization Monetary policy @

Table 2

While demand shocks cause activity and prices to move in the same
direction, supply shocks cause them to move in opposite directions. For
example, a rise in energy prices leads to an increase in inflation and a fall
in production and consumption. If this type of shock occurs, there is a
risk of a conflict between monetary policy and fiscal policy: the central
bank would tighten monetary policy to fight inflation, while governments
would stimulate the economy to support production.

The energy crisis of 2021-22 provided us with a concrete example of this
problem. European governments, including France, responded to the rise
in energy prices by supporting household purchasing power and
providing aid to businesses (fiscal expansion). At the same time, the ECB
raised its policy rates by 450 basis points (4.5 percentage points)
between July 2022 and September 2023 (monetary tightening).

The impact of this cocktail was initially uncertain. In reality, fiscal
measures have often taken the form of "tariff shields" which have
directly curbed consumer prices. According to Lemoine, Petrovich and
Zhutova (2024), tariff shields reduced inflation by around 2.6 percentage
points (pp) in France in 2022, before raising inflation by a cumulative 2.2
pp over the 2023-25 period (Chart 2), with a fiscal cost of around 1.1% of
GDP in 2022 and 2023. These measures have had a significant impact
on inflation. For the euro area as a whole, Dao et al (2023) find that the
measures also had an impact of around -2 pp on inflation in 2022.

However, governments have benefited from the drop in energy prices in
2023-24, but this temporary increase in revenues was not sufficient to
offset spending in 2021-22. Going forward, because of the level of
government debt, euro area governments may not be able to implement
such massive support again should another inflationary episode occur,
particularly in the event of persistent shocks..

Chart 2:

(2 Impact of the tariff shield on HICP inflation in France
(year-on-year % change)

- Observed HICP inflation

- Counterfactual HICP inflation (without the toriff shield)

- ny we nen oro

0
2021 2022 2023 2024 2025

Sources: INSEE data for 2021 and 2022, Banque de France
Macroeconomic projections - France, December 2023 for
2023 onwards.

Notes: HICP, Harmonised Index of Consumer Prices. Counterfactual
HICP inflation is calculated using the FR-BDF model.

Source: Lemoine, Petronevich and Zhutova (2024).

Can the policy mix ignore supply
shocks?

Would it be possible for the policy mix to stick to its traditional roadmap
of responding only to demand shocks, leaving the economy to adjust to
supply shocks on its own? This question differs when it comes to fiscal
policy or monetary policy.

Fiscal policy

When prices rise, particularly energy prices, one might assume that the
government has no need to intervene, particularly in France where the
minimum wage and means-tested social benefits are index-linked.
Furthermore, the savings accumulated by households during the
pandemic should have enabled them, by 2021-22, to cushion the impact
of the shock on their consumption. However, a number of factors justify
government intervention:

e First, the ratchet effect must be taken into account. There is a risk
that people who lost their jobs during the crisis will remain
unemployed, even after the level of energy prices, purchasing power
and consumption has returned to its initial level. This phenomenon
can create structural unemployment that is difficult to reverse.

e Second, indexation can lead to second-round effects. Increasing
wages and benefits in response to inflation can fuel an inflationary
spiral, where price and wage rises are mutually reinforcing. The
government may decide to mitigate these second-round effects.

e Third, there is a political economy aspect to consider. The
government is increasingly seen as an insurer against economic
risks. Citizens expect the state to intervene to mitigate the impact of
economic shocks, creating political pressure for government
intervention.

e Lastly, household perceptions must be taken into account. Surveys
carried out by the Banque de France show that individuals focus
their attention on a small number of prices, generally energy and
food products, which are also the most volatile (see Bignon and
Gautier, 2023). This perception bias may make people feel poorer,
even when real purchasing power is preserved, prompting the
government to take action to limit the most salient price rises.

These factors explain why governments often have to intervene in
response to supply shocks, even when indexation mechanisms are in
place for the most vulnerable households.

Monetary policy

The European Central Bank defines price stability as an inflation rate
'close to 2% over the medium term'. This definition allows for temporary
deviations from the 2% target.

According to Dupraz and Marx (2023), the optimal response to a
temporary shock in commodity prices would be to 'look through' without
reacting forcefully, provided that inflation expectations remain
'anchored', which assumes that the 2% target remains credible over the
medium term. However, short-term deviations in the inflation rate can
have lasting effects that can undermine this general principle.

e First, the pass-through of input prices is often asymmetric,
particularly in the food sector: price rises are passed on more quickly
and more significantly than price falls, which can lead to persistent
inflation.

e Second, sudden price adjustments, particularly in the energy and

food sectors, can cause inflation expectations to become de-

anchored. As households and businesses pay much greater attention
to these visible price changes, they could raise their expectations of
inflation in the longer term, which could prove to be a self-fulfilling
prophecy.

Third, the forecasting errors resulting from these shocks can lead to

a misallocation of economic resources and therefore, ultimately, to a

weakening of potential growth, which can reinforce inflationary

pressures. A study by Ropele, Gorodnichenko and Coibion (2024)

focusing on Italy highlighted this phenomenon during the last

inflationary episode.

Given these challenges, Reichlin and Zettelmeyer (2024) suggest that
we should accept a longer stabilisation period for supply shocks than for
demand shocks. This approach would allow monetary policy to adapt
with greater flexibility to different types of economic shock, while
maintaining its price stability objective over the medium term.

Towards a new policy mix

There is no consensus on the impact of climate change and the green
transition on activity and inflation, as this largely depends on how the
transition is implemented. However, it is likely that supply shocks -
whether temporary or persistent - will become more frequent than in the
past. In order to address this challenge, a more flexible policy mix may
be required.

Fiscal policy could become more targeted and flexible. In the event of a
negative supply shock, for example, the government may wish to
prioritise support for investment, so as not to delay the transition and
thus protect itself against future supply shocks. In the same vein,
Fornaro and Wolf (2023) propose temporarily subsidising corporate
investment when monetary policy is tightened. This could mitigate the
adverse impact of monetary tightening on economic activity while
promoting long-term growth. Cox et al (2024), for their part, argue that
in the event of a supply shock, fiscal policy should be targeted at the
sectoral level and neutral at the aggregate level. What all these
proposals have in common is that monetary policy should be left with the
task of stabilisation at the aggregate level, giving priority to price
stability.

Monetary policy, meanwhile, could adopt a more differentiated approach
to supply shocks. For example, the ECB could focus more on core
inflation (excluding energy and food) rather than headline inflation during
temporary energy shocks. However, as it is generally not known at the
outset whether shocks will be temporary or persistent, a hybrid
approach will probably be necessary.

Debates on the green transition generally focus on their comparative
costs in terms of activity. The above discussion suggests that models
should be developed to compare the impact of different strategies in
terms of inflation too. A study by the Banque de France (Allen et al.,
2023) shows that, depending on the instruments used, the transition
could be inflationary or disinflationary.

The idea of using monetary policy to support the green transition itself
raises a number of questions:

e First, adding a new objective to the central bank mandate could
weaken its ability to achieve its primary objective of price stability.
This would run counter to the Tinbergen rule, which states that an
economic policy instrument should have a single objective. This
principle is currently reflected in very concrete terms: with central
banks normalising their balance sheets (quantitative tightening),
'green quantitative easing' (whereby the central bank buys 'green'
assets on the financial markets) seems contradictory.

e Second, the greening of monetary policy could open up a Pandora's
Box: why limit ourselves to the ecological transition, leaving aside the
digital transition, reindustrialisation and financing population ageing?

e Lastly, it is important to remember the Fisher equation: in the
medium term, the real interest rate (nominal interest rate minus
inflation rate) is independent of the nominal rate. Thus, aside from in
the very short term, keeping policy rates low in order to foster the
transition would be ineffective. Rather, the resulting inflation could
cause expectations to become de-anchored, term premia to rise
and, ultimately, long-term real interest rates to increase, which are
those that count for investment.

This does not mean that central banks should have no involvement in the
green transition. On the contrary, global warming and the transition may
have drastic consequences for price stability and financial stability, both
of which are at the core of their missions. In this regard, their
contribution is primarily to:

e Firmly anchor inflation expectations, in order to limit price
uncertainty in the medium term and thus help flatten the real interest
rate curve.

e As part of banking supervision, monitor the disclosure of climate
risks and conduct "green" stress tests to assess the resilience of the
financial system to the risks associated with climate change.

The Banque de France and the Autorité de Contrdéle Prudentiel et de
Résolution are strongly committed to this strategy, within the framework
of the Eurosystem and its Single Supervisory Mechanism, via the
Network for Greening the Financial System (NGFS), whose Secretariat is
provided by the Banque de France. Moreover, thanks to the development
of a 'climate indicator', it will be possible to assess the position of each
significant French company in relation to the climate transition trajectory,
and thus better steer investments. Lastly, the Banque de France actively
strives to green its own activities and its non-monetary investment
portfolios. It is ranked first by Positive Money in terms of greening, out of
all the G20 central banks.

The fact remains that central banks are not in the forefront in this area:
they can support the transition but not initiate it, since the instruments
for influencing private investors' incentives (carbon pricing, regulations)

are in the hands of governments.

Thank you for your attention.

References

Allen, Th., Boullot, M., Dées, S., de Gaye, A., Lisack, N., Thubin, C. and O.
Wegner (2023), "Using Short-Term Scenarios to Assess the
Macroeconomic Impacts of Climate Transition", Banque de France
working paper No. 922, wp922_0.pdf (banque-france.fr)

Bartsch, E., Bénassy-Quéré, A., Corsetti, G., and X. Debrun (2020, « I'ts
all in the mix: how monetary policy and fiscal policy can work or fail
together », Geneva Report on the World Economy 3, geneva23.pdf
(cimb.ch).

Bignon, V., and E. Gautier (2023), 'French housholds and inflation in
2023', Banque de France Bulletin No.242, November, French households
and inflation in 2023 - The virtuous triangle of "information, knowledge and

trust" contributes to price stability I Banque de France (banque-france.fr)

Cox, L., Feng, J., Muller, G., Pasten, E., Schoenle, R., and M. Weber,
(2024), "Optimal monetary and fiscal policies in disaggregated
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(imf.org).

Draghi, M. (2014), Luncheon Address: "Unemployment in the Euro Area",
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Dupraz, S., and M. Marx (2023), « Anchoring Boundedly Rational
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Fornaro, L. and M. Wolf (2023), « The scars of supply shocks:
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Lemoine, M., Petronevich, A. and A. Zhutova (2024), "Energy tariff shield
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Energy tariff shield in France: what is the outcome? I Banque de France

(banque-france.fr)

Positive Money (2024), Green Central Banking Scoreboard, Green Central
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Reichlin, L., and J. Zettelmeyer (2024), « The European Central Bank
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