Energy Shock and Expectations in Caldera
In the small open economy of Caldera, a 60% rise in imported energy prices and a 15% currency depreciation push headline consumer price inflation to 11%. Core inflation, excluding food and energy, is 4.5%. Food has a 30% weight in the CPI. Wage settlements in the public sector are indexed to last year's CPI, and a survey shows households expect 8% inflation next year. Firms in the retail sector have raised margins, citing uncertainty. The central bank has an inflation target of 3% and a policy rate of 6%. Output is 2% below potential, and household debt is high. The finance ministry argues that raising rates would deepen a recession; the central bank argues that failing to act would embed expectations. The exchange rate is floating.
1. Distinguish the cost-push and demand-pull elements of Caldera's inflation, and explain how second-round effects could arise.
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Headline inflation of 11% is driven initially by cost-push factors: imported energy +60% and depreciation +15% raise input costs. Core inflation of 4.5% shows some pass-through beyond energy and food. Second-round effects appear through public-sector wage indexation to past CPI and household expectations of 8%. If workers and firms set wages and prices on expected inflation, a wage-price spiral can keep inflation above target even after the energy shock fades. Retail margin increases may reflect demand-pull in some segments or uncertainty premia, but with output 2% below potential, excess demand is unlikely. The real policy rate is 6% − 11% = −5%, which is highly accommodative. The central bank faces a trade-off: raising rates reduces expectations but may deepen the output gap and raise debt-service burdens.
2. Evaluate whether the central bank should raise interest rates sharply now.
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Sharply raising rates is justified if expectations are becoming unanchored. With expected inflation at 8% and indexation, the central bank needs a positive real rate to signal resolve. But with output below potential and high household debt, aggressive tightening could cause a deep recession and loan defaults. A gradual but credible path, combined with fiscal support for low-income households and a clear communication that the energy shock is temporary, may be better. If the central bank does nothing, inflation expectations may persist, requiring even higher rates later. Judgement: raise rates, but in a sequenced way and alongside targeted fiscal policy; the appropriate speed depends on the credibility of the target and the debt structure.
3. Explain the likely distributional consequences of this inflation episode.
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Unanticipated inflation hurts savers and those on fixed nominal incomes, and helps borrowers if nominal wages and prices adjust. Indexed public-sector workers are protected, but private informal workers are not. Food and energy have high weights for low-income households, so their real incomes fall more. Firms face menu costs and uncertainty, which may reduce investment. Exporters may gain from depreciation but importers lose. The overall welfare effect depends on whether inflation is anticipated and on the distribution of nominal assets and liabilities.