The role of adverse supply shocks in the post-pandemic euro area inflation surge: A DSGE approach

Abstract

The economy has faced unprecedented shocks during the past four years as the world was first shaken by the Covid-19 pandemic and shortly after the Russian invasion of Ukraine. These shocks created a difficult environment for policymakers to act in and eventually most central bankers failed to predict the resulting inflation surge.

This thesis aims to add to the on-going discussion on the drivers of the inflation surge by examining the inflationary effects of adverse supply shocks that the economy faced as a consequence of the pandemic and war. This thesis will examine this through a linear New Keynesian dynamic stochastic general equilibrium (DSGE) model adapted from \citet{harding}. The model is calibrated to represent the euro area in the beginning of 2021, a time when the initial lockdowns had begun to ease, increasing demand but supply constraints remained and inflation began to increase.

Through the DSGE simulations, this thesis is able to show that two types of adverse supply shocks, a negative productivity shock and positive cost-push shock, both create a positive inflation response. The simulations highlight the role of cost-push shocks in euro area inflation. To test the robustness of the results, the persistence of the shocks are varied. Furthermore, in light of the policy implications, this thesis briefly explores and highlights the trade-off between inflation and the output gap that monetary policy encounters when faced with adverse supply shocks.