Inflation and Quantitative Tightening - A theoretical assessment of contractionary monetary policy and real economic activity

Sammanfattning: Following the associated lockdown measures of the Covid-19 pandemic in 2020, the world economy started facing inflationary pressures from a surge in energy prices and supply chain disruptions at the end of 2021. Given the economic environment with low inflation and expansionary monetary policy following the Great Financial Crisis (GFC), central banks around the world have built up large balance sheets following the unconventional measure called Quantitative Easing (QE). Now when inflation is on the rise, a debate regarding whether to sell off these assets as a contractionary measure, dubbed Quantitative Tightening (QT), has emerged. In this thesis, I will use a Dynamic Stochastic General Equilibrium (DSGE) model estimated to U.S data and with financial frictions to evaluate the impact on real economic activity from an inflation shock and assess how different monetary policy strategies can dampen the adverse impact. The main findings are that a more conventional monetary policy strategy is to prefer over QT when it comes to dampening the fall in output. Furthermore, a more persistent inflation exacerbates the adverse impact on the real economy and the model simulations also show that gradual increases of the federal funds rate is favorable compared to more aggressive increases.