Energy shocks as Keynesian supply shocks: Implications for fiscal policy

Abstract

This paper analyses the economic impact of and the optimal policy response to energy supply shocks in a flexible price model with heterogeneous households. We introduce energy as a consumption good on the demand side and as an input to production on the supply side. A distinguishing feature is that, in line with empirical evidence, we allow households’ energy demand to be non-homothetic. The model provides three main insights. First, (negative) energy supply shocks act as a (negative) demand shocks, or Keynesian supply shocks, when two conditions are met: On the demand side household income inequality needs to be large, while on the supply side, the price elasticity of consumption goods needs to be high. Second, the social planner can implement the first-best allocation by subsidising firms and poor households while taxing rich households. Energy shocks then act as standard supply shocks. Last, issuing public debt can help implement the first best allocation when energy shocks are large and/or the economy’s overall energy intensity is low.