Optimal Stabilization Policy Responses to Necessity Supply Shocks

Abstract
I study the effects of supply shocks in a two-sector business cycle model with nominal rigidities and (intratemporally) non-homothetic preferences. A negative shock to the supply of the necessity good -- i.e., the good with expenditure elasticity smaller than one (think: energy, food) -- creates excess demand and inflation in the necessity sector. A contractionary response of monetary policy reduces aggregate demand, but luxury demand is more sensitive to aggregate demand than is the demand for necessities. Thus, the contractionary policy primarily creates a demand shortage and unemployment in the luxury sector instead of reducing excess demand and inflation in the necessity sector. Lowering inflation becomes more costly in terms of unemployment and the optimal policy in response to an inflationary shock must accept a higher rate of inflation than in a benchmark case with homothetic preferences. These conclusions are reversed for shocks to the supply of luxuries. I briefly discuss the scope for more targeted interventions, by means of fiscal policy and others.