The fast rise in inflation destroys trust in the Fed, forcing a hard landing.

We extended the Mark-0 model used in Sharma et al. (2020) in two directions (Section 2): First, a dynamically evolving trust in the Central Bank’s ability to control inflation, such that expected inflation remains anchored to the Central Bank’s target if trust is high, but persistent off-target inflation realisations lead to a loss of trust in the Central Bank. Second, a simple “exogenous” energy sector from which firms buy energy that allows us to introduce an energy price, and slowly re-inject the energy profits into the economy as dividend payouts. This slightly expanded Mark-0 model allows us to investigate several policy channels (Section 3): (a) monetary policy via the management of interest rates and expectations, (b) an Easy-Credit regulatory policy, and fiscal policies such as (c) Helicopter Money and (d) a Windfall Tax.

The Mark-0 steady state economy is then perturbed by three calibrated shocks (Section 5): a consumption propensity drop (representing lockdowns), a productivity drop (representing supply chains disruptions), and an energy price shock (first a drop, representing reduced demand during lockdowns, followed by a rise due do demand recovery exacerbated by the Russian invasion of Ukraine). We show in Section 5 that the Easy-Credit policy, which was one of the first emergency responses to the COVID pandemic, is able to alleviate the impact of the shocks, but at the price of high and sustained inflation, as observed in the data and predicted as early as June 2020 by Sharma et al. (2020) within the Mark-0 framework.

We investigated whether monetary policy alone can control a surge of inflation, and at what cost to unemployment (Section 6). Our results show that if agents’ expectations remain fully anchored, inflation remains closer to the Central Bank target, but at the price of a strong recession leading to a wave of unemployment. Meanwhile, if agents’ expectations evolve dynamically, inflation rises well above target during the shock leading to de-anchored expectations. Monetary policy is then essentially ineffective in controlling inflation while causing unemployment to increase in comparison to a baseline case with no monetary policy at all. This is robust to variations in parameters related to the channels of monetary policy. Our framework thus supports the view that the efficacy of monetary policy comes at the cost of unnecessarily high unemployment (Stiglitz & Regmi, 2022).

Within Mark-0, trust anchoring is thus a crucial determinant of the success of the Central Bank inflation mitigation policy, far more important than the direct economic impact of higher interest rates (noting that we do not model in detail a financial sector). This resonates with Bernanke’s statement: “Expectations matter so much that a Central Bank may be able to help make policy more effective by working to shape those expectations”,25 and points to the importance of narratives in shaping expectations (Shiller, 2020). In turn, fine-tuned fiscal policy combined with monetary policy can be successful in controlling inflation while keeping unemployment around acceptable levels (Section 7). However, this requires a high degree of precision to be effective: too weak a fiscal stimulus is ineffective, and too large a stimulus leads to further high inflation. Finally, in Section 8 we show that the pricing power of firms and the bargaining power of workers play a crucial role. Depending on their relation, the economy can experience a runaway hyperinflation wage-price spiral. This points to an additional difficulty in properly calibrating monetary and fiscal policy due to a variety of possible tipping points or “dark corners” lurking around.

Overall, this study of the Mark-0 economy shows that (i) the economic recovery can be very sluggish due to self-fulfilling expectations and other non-linear feedback loops, (ii) there is a tension between inflation and unemployment that is robustly captured by the model, (iii) in the Mark-0 economy, monetary policy is effective at controlling inflation provided trust is anchored (but not because of real economic effects of higher interest rates), and (iv) fiscal policy can alleviate some of the negative unemployment effects of inflation-focused monetary policy. While our study did not exhaust all possible cases and parameters, we believe that it illustrates both the realism and the richness of the Mark-0 economy. It offers a versatile tool with which policy makers can easily play in order to forge their intuition about what may happen if they turn this knob or add that policy measure. Indeed, almost all possible narratives that emerged during the recent debate about post-COVID inflation can be captured and reproduced by our model with proper choices of parameters and shock specifications. Furthermore, the procedure proposed in Section 8 can be used to rigorously establish which predictions of the model are robust to the choice of parameters, most of which are difficult to properly calibrate on data.