Welfare costs of external shocks in the medium-scale model with shifting moderate trend inflation

Abstract

We aim at investigating welfare costs of shocks as well as dynamics of business and financial cycle due to these shocks. By using the theoretical model and parameters calibrated jointly to match the selected moments for the U.S. data during 1954Q3–2018Q4 period, our findings emphasise interaction between trend inflation and shocks. In the one side, welfare costs of these shocks in the Rotemberg model are modest but these costs increase when central banks raise their inflation targets to the higher level. Under impacts of these shocks, the economy gets more volatile reflected by higher dynamics of business and financial cycles. On the other hand, we investigate impacts of trend inflation on impulse response of key macroeconomic as well as financial variables to these shocks. In almost cases, these variables reacts more strongly to the shocks for higher trend inflation levels. Importantly, there are long-lasting debt response and short-lived equity response to unexpected changes in financial conditions.