The Effect of Adverse Supply Shocks on Monetary Policy and Output

Abstract

The aim of the present research is to use a model economy built for Brazil, based on an optimizing dynamic general equilibrium model, in order to perform numerical simulations to derive the ability of the artificial economy to explain the impact of monetary policy interventions on short run economic performance in terms of the inflation rate, output gap, interest rate and level of economic activity in the face of an adverse supply shock. Alternative specification of monetary reaction functions are introduced into the model economy in order to perform a sensitivity analysis of derived impulse responses to those interventions facing the negative productivity shock. The preliminary results suggest that the introduction of habit persistence into the consumption hypothesis does not make much difference. However the introduction of different monetary reaction functions does alter the impulse response of output, inflation rate, and nominal interest rate. A common result is the decline in potential output for all models. Additionally, the only case where a reduction in the output gap is observed is when using the Taylor rule that takes into consideration the output gap and past interest rates with high persistence.