Conference and Seminars


SEA 91st Annual Meeting

This paper estimates the significance of the supply side effect of monetary policy using cost channel in a New Keynesian business cycle model. I use a standard DSGE framework based on Smets and Wouters(2003) to model the effect of a negative monetary shock on inflation. I introduce a cost channel through Rabanal(2007) forcing some proportion of firms to borrow in order to make the wage payments. This setup increases the marginal cost following a contractionary monetary policy. This increased marginal cost puts upward pressure on inflation. I use two sample periods for estimation- pre-recession (Jan 1980-Dec 2008), and post-recession (Jan 2008- Sep 2020). In doing so, I control for the post recession interest rates- often argued to be in the zero lower bound (ZLB) regime. The estimation results from pre- and post-recession data suggests that for both time frames, the demand side effect is stronger than the supply side. Hence, introduction of cost channels is not enough for the supply side to dominate the demand side. Hence, price must fall in response to a rise in interest rates. It should also be noted that estimates suggested only around 9 percentage and approximately 0 percentage of the firms are subject to cost channel before and after the great recession. As part of robustness check, I restrict all firms and no firms to be subject to the cost channel and it can be concluded that even with those restrictions, the supply side effects are minimal.