Monetary policy with profit-driven inflation

Following evidence on the role of firm profits in the current inflation surge, we develop a New Keynesian model where profit-driven inflation stems from the presence of reservation profits on the supply side. We use this framework to investigate the positive and normative implications of cost push shocks, focusing on energy price shocks. We first show that these shocks lead to inefficiently large supply contractions and thereby inefficiently large (profit-driven) inflation, as firms which retrench do not internalise the social costs of doing so. Second, we show that optimal monetary policy follows a pecking order. It first aims at shielding the supply side from the fallout of the shock, thereby undoing the negative retrenchment externality. It then splits the burden of the shock between supply and demand, when insulating the supply side is too costly. Finally, when the energy price shock is very large, monetary policy loses traction. Budget-neutral fiscal interventions, e.g. redistribution from high- to low income households and/or from high- to low-profit firms, can then restore monetary policy effectiveness.