The scars of supply shocks: Implications for monetary policy

We study the effects of supply disruptions - for instance due to energy price shocks or the emergence of a pandemic - in an economy with Keynesian unemployment and endogenous productivity growth. By temporarily disrupting investment, negative supply shocks generate permanent output losses - or scarring effects. By inducing a negative wealth effect, scarring effects depress aggregate demand, which may even fall below the exogenous fall in supply. However, that scarring effects depress aggregate demand does not necessarily translate into low rates of inflation. On the contrary, scarring effects may reinforce and prolong the inflationary impact of supply disruptions. A contractionary monetary policy response may end up deepening scarring effects and increasing inflation in the medium run. A successful disinflation may require a policy mix of monetary tightening and fiscal interventions aiming at supporting business investment and the economy’s productive capacity.