How Monetary Shocks Spread Through the Economy in Russia

A recent paper published by the Russian Central Bank delves into how monetary shocks spread through the economy using a network model based on input-output data from the Russian economy. This research is crucial in understanding how changes in money supply influence various sectors, shedding light on the broader economic impact of monetary policy decisions.

The study aims to investigate the dynamics of monetary shocks, which occur when there are sudden changes in the money supply. Such shocks can have wide-ranging effects on inflation and prices across different industries. To analyze this, the researchers use two key concepts: the Cantillon Effect and Price Stickiness.

The study of the relationship between the network structure of the economy and the transmission of monetary shocks plays a significant role in modern economic literature. This problem is sometimes called the ‘Cantillon effect’ in honour of the work of the 18th century French economist Cantillion (1755).

The Cantillon Effect explains that when new money enters the economy, it does not spread evenly; certain sectors feel the impact sooner than others. For example, if banks receive new money, industries directly connected to them benefit first, while other sectors experience the effects later. On the other hand, Price Stickiness refers to the idea that not all prices adjust immediately when there is an economic shock. Some industries may change their prices quickly, while others take time to react due to factors like long-term contracts or slower information flow. An example of this might be the fast adjustment of prices in grocery stores versus the slower change in housing prices. Together, these two concepts help explain how different sectors of the economy react at varying speeds to changes in money supply.

The authors designed a network-based model to reflect the structure of the economy, where industries and firms are represented as nodes and the flow of goods and capital between them as links. This network is created using input-output tables that show the interdependencies between different sectors. Within this network, various agents—such as industries, households, the government, and the external sector—interact. Changes in money supply influence the flow of goods and services between these agents, affecting prices and production levels throughout the economy. This model allows the researchers to simulate how different types of monetary shocks affect economic behavior, a crucial aspect of their analysis.

In the context of this study, a monetary shock refers to a sudden and unexpected change in the money supply. These shocks are not uniform and can enter the economy in several ways. The study examines four types of monetary shocks: regular lending, household consumption, investment demand, and government consumption. Regular lending involves banks providing loans to businesses, which in turn spend this money on goods and services. In the case of household consumption, money enters the economy through consumers purchasing goods. Investment demand refers to money being used for long-term investments, like purchasing machinery or infrastructure. Finally, government consumption shocks occur when the government spends money on public services or infrastructure projects. Each of these types of monetary injections impacts the economy in different ways, leading to varying outcomes.

To understand these impacts, the researchers conducted simulations. They found that shocks to specific industries, particularly those with significant weight in household consumption, can cause large fluctuations in the Consumer Price Index (CPI). This means that when industries producing everyday goods, like food or energy, are impacted by a monetary shock, the prices of these goods tend to rise sharply. However, most industries experience temporary price changes following a shock, with prices eventually stabilizing. The degree of volatility in price changes depends on the industry and the type of shock.

One of the study’s key findings is that how new money enters the economy plays a crucial role in determining its effects. For instance, regular lending, which spreads money more evenly across sectors, results in smoother price adjustments. This means that prices change gradually without causing major disruptions. However, when new money enters through household consumption, it leads to a sharp and immediate rise in the CPI because consumer goods markets are directly affected. In contrast, shocks related to investment and government spending take longer to influence prices, but they can still cause significant price overshooting, where prices rise more than expected before stabilizing.

Aggregate consumer price index response to monetary shocks (price level)

The graphic illustrates how various shocks affect the consumer price index in Russia over time. Four types of shocks—investment demand, government consumption, household consumption, and regular lending—are tracked across 13 periods. The household consumption shock shows the most volatility, with large initial fluctuations likely reflecting the sensitivity of Russian consumers to economic disruptions, such as sanctions or currency devaluation. Government consumption shocks and investment demand shocks display moderate impacts initially, suggesting that state interventions and investment fluctuations also play a significant role in short-term inflation. In contrast, regular lending shocks remain the most stable, indicating that credit markets in Russia may provide a more controlled influence on inflationary pressures. The convergence of all shocks towards stabilization after period 7 suggests that these inflationary effects gradually subside, highlighting the resilience of the Russian economy in adjusting to monetary disruptions over time.

The conclusion of the study highlights the complexity of the economy’s network structure. The way monetary shocks propagate depends heavily on where and how the new money is injected. Concentrated inflows of money into specific sectors can lead to short-term inflationary risks, which policymakers must consider when making decisions about monetary policy. This research underscores the importance of understanding the interconnected nature of industries and how money moves through the economy. It provides valuable insights for predicting inflation and managing price stability in response to monetary shocks.

Overall, this study serves as a reminder of the need for careful planning in monetary policy. By understanding how different sectors respond to changes in money supply, economists and policymakers can better predict inflation and implement strategies to stabilize prices in the face of economic shocks.