Monetary and fiscal policy responses to fossil fuel price shocks

We use a dynamic equilibrium model featuring different sources of energy to assess the macroeconomic effects, in the euro area, of a temporary reduction in excise taxes on fossil fuels and an increase in lump-sum transfers to the poorest ('hand-to-mouth') households, and of raising the monetary policy rate in response to a temporary increase in the global prices of fossil fuels. In the model, the central bank should raise the monetary policy rate to stabilize inflation even if excise taxes are lowered, in particular if price- and wage-setting decisions are not strongly anchored to the central bank's inflation target. Lump-sum transfers to hand-to-mouth households can stabilize their consumption with limited inflationary effects.