BIS Working Papers No 1167 Monetary Policy with Profit-Driven Inflation by Enisse Kharroubi and Frank Smets Monetary and Economic Department February 2024 JEL classification: D21, E23, E31, E32, E52, E62, H24, H25 Keywords: energy price shocks, price stickiness, reservation profits, optimal monetary policy, corporate tax BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS. This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2024. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISSN 1020-0959 (print) ISSN 1682-7678 (online) Monetary Policy with Profit-Driven Inflation*Enisse Kharroubi†andFrank Smets‡AbstractFollowing evidence on the role of firm profits in the current inflation surge, wedevelop a New Keynesian model where profit-driven inflation stems from the presenceof reservation profits on the supply side. We use this framework to investigate thepositive and normative implications of cost push shocks, focusing on energy priceshocks. We first show that these shocks lead to inefficiently large supply contractionsand thereby inefficiently large (profit-driven) inflation, as firms which retrench do notinternalise the social costs of doing so. Second, we show that optimal monetary policyfollows a pecking order. It first aims at shielding the supply side from the fallout ofthe shock, thereby undoing the negative retrenchment externality. It then splits theburden of the shock between supply and demand, when insulating the supply side istoo costly. Finally, when the energy price shock is very large, monetary policy losestraction. Budget-neutral fiscal interventions, e.g. redistribution from high- to low-income households and/or from high- to low-profit firms, can then restore monetarypolicy effectiveness.Keywords: Energy price shocks, price stickiness, reservation profits, optimal monetarypolicy, corporate tax.JEL Classification codes: D21, E23, E31, E32, E52, E62, H24, H25.*Corresponding author’s email: enisse.kharroubi@bis.org. The views expressed here do not necessarilyrepresent the views of the BIS or the ECB. Part of this paper was developed while Frank Smets was visitingthe BIS, as a Lamfallussy Research Fellow. We are grateful for comments and suggestions from seminarparticipants at the BIS, the Bank of Canada, the US Council of Economic Advisers, the IMF and the LSE. Allremaining errors are ours.†Bank for International Settlements‡European Central Bank, Ghent University11IntroductionThe current inflation surge bears many resemblances with the e...
