Energy price surges and inflation: Non-monetary policy to the rescue?

Drawing inspiration from the fiscal responses deployed by euro area governments amid the 2021–2022 energy price shock, this paper investigates the capacity of fiscal tools to mitigate inflation driven by rising energy costs in economies that rely on energy imports. The analysis employs a calibrated small open economy framework under a fixed exchange rate regime. The findings highlight energy subsidies — both at the retail level and directed at firms' input costs — as particularly potent instruments, as they compress marginal costs and dampen the transmission of the external price shock to domestic inflation, output, and the current account balance. When prices are indexed to inflation, the shock's adverse effects are amplified; however, indexation simultaneously enhances the effectiveness of consumption tax reductions by curtailing the domestic propagation of the original disturbance.