Interest Rate Smoothing in the Face of Energy Shocks

Stefano Maria Corbellini ()
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Stefano Maria Corbellini: School of Economics, University of Sheffield, Sheffield S10 2TU, UK

No 2025014, Working Papers from The University of Sheffield, Department of Economics

Abstract: This paper analyzes the monetary policy trade-off between defending purchasing power of consumers and keeping moderate debt cost for borrowers, in the framework of a heterogeneous agent New Keynesian open economy hit by a foreign energy price shock. Raising the interest rate indeed combats the loss in purchasing power due to the energy shock through a real exchange rate appreciation: however, this comes at the expense of higher interest payments for debtors. The trade-off can be resolved by adopting a milder interest rate policy during the crisis in exchange for a prolonged contraction beyond the energy shock time span. This interest rate smoothing approach allows to still experience a real appreciation today, while spreading the impact on debt costs more evenly over time. This policy counterfactual is analyzed in a quantitative model of the UK economy under the 2022-2023 energy price hike, where the loss of consumers’ purchasing power and the vulnerability of mortgage costs to higher policy rates have been elements of paramount empirical relevance.

Keywords: monetary policy; energy; heterogeneity; inequality; household debt (search for similar items in EconPapers)
JEL-codes: D14 D31 E52 G21 G51 Q43 (search for similar items in EconPapers)
Pages: 54 pages
Date: 2025-12
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