Production networks amplify foreign shocks, worsen monetary policy trade-offs
A new working paper from Banco de España and ECB economists analyzes how production networks transmit foreign price shocks and reshape monetary policy trade-offs. The research finds that these networks significantly amplify cumulative headline inflation and substantially worsen monetary policy trade-offs.
Networks reshape inflation dynamics
The paper examines how production networks shape the transmission of foreign price shocks and their implications for monetary policy.
Analytical results in a New Keynesian small open-economy model with domestic and international input-output (IO) linkages show that these networks introduce a novel monetary policy trade-off.
This arises from inefficient movements in sectoral terms-of-trade (ToT), which directly feed into domestic inflation through marginal costs and indirectly through sectoral trade imbalances.
International production networks also steepen the Phillips curve relative to a closed economy.
Movements in the output gap induce shifts in sector-level net exports, requiring larger increases in domestic real wages to sustain employment and output.
This increases the elasticity of domestic prices with respect to output-gap movements, meaning domestic inflation can deviate from target even when the output gap is closed.
Amplified inflation, tougher choices
The study quantifies the importance of production networks using a model calibrated to major euro area countries and their trading partners, encompassing 44 sectors per country across six regions.
Focusing on an international energy price shock, the research finds that production networks significantly amplify the cumulative headline inflation response.
Without national and international production networks, cumulative headline inflation would be roughly 60% of the baseline, stabilizing much faster.
Furthermore, these IO linkages substantially worsen monetary policy trade-offs, as measured by the sacrifice ratio.
The paper concludes that in a one-sector economy, the sacrifice ratio would be 20% smaller, implying that ignoring the network dimension underestimates the cost of strict inflation control in an open economy facing foreign shocks.
Beyond simple models
This paper offers crucial insights into the real-world complexities of inflation transmission, moving beyond simplified one-sector models.
Its quantitative findings underscore the significant, often underestimated, impact of global supply chains on monetary policy effectiveness.
Policymakers must integrate these network effects into their frameworks to accurately assess inflation dynamics and the true costs of disinflation.