Economics and Business Economics Seminar (ECO): Momo Komatsu, Oxford University

Abstract:
During the recent energy crisis some Euro Area countries introduced price caps on energy, while others did not, leading to about 30 percentage points higher energy inflation in uncapped countries. This paper investigates the trade-offs policymakers face with energy price caps in a two-country currency union model with shared energy supply. The cooperative, optimal outcome is for neither country to impose a price cap, since the cap is a costly market distortion. However, capping allows a country to avoid a crisis at the cost of negative spillovers on the uncapped country, characterized by high inflation and lower output. The quantitative model with nonhomothetic preferences and substitutability of energy sources shows that the cost of the price cap exceeds the cost of such spillovers, explaining why some countries capped prices while others did not. Moreover, I show that the spillovers from price caps contributed to about 10 (0.5) percentage points of energy (headline) inflation in the uncapped Euro Area countries in 2022. Targeted transfers, an alternative policy to the price cap, is a cheaper and more effective way to boost consumption of the poor without creating divergence within the union.