Bond Pricing with a Time‐Varying Price of Risk in an Estimated Medium‐Scale Bayesian DSGE Model

New Keynesian model in which households have Epstein–Zin preferences with time‐varying risk aversion and the central bank has a time‐varying inflation target can match the dynamics of nominal bond prices in the U.S. economy well. The model generates a large steady‐state term spread and its fitting errors for bond yields are comparable to those obtained from a nonstructural three‐factor model, and one‐third smaller than in models with a constant inflation target or risk aversion. Including data on interest rates has large effects on variance decompositions, making investment technology shocks much less important than found in other recent papers.     

Trend Inflation, Taylor Principle, and Indeterminacy

Positive trend inflation shrinks the determinacy region of a basic New Keynesian dynamic stochastic general equilibrium model when monetary policy is conducted by a contemporaneous interest rate rule. Neither the Taylor principle, which requires the inflation coefficient to be greater than one, nor the generalized Taylor principle, which requires that the nominal interest rate to be raised by more than the increase in inflation in the long run, is a sufficient condition for local determinacy of equilibrium. This finding holds for different types of Taylor rules, inertial policy rules, and price indexation schemes. Therefore, regardless of the theoretical setup, the monetary literature on interest rate rules cannot disregard average inflation in both theoretical and empirical analyses.     

Raise Rates to Raise Inflation? Neo‐Fisherianism in the New Keynesian Model

Increasing the inflation target in a New Keynesian (NK) model may require increasing, rather than decreasing, the nominal interest rate in the short run. We refer to this positive short‐run comovement between the nominal rates and inflation conditional on a nominal shock as Neo‐Fisherianism. We show that the NK model is more likely to be Neo‐Fisherian the more persistent is the change in the inflation target and the more flexible are prices. Neo‐Fisherianism is driven by the forward‐looking nature of the model. Modifications that make the framework less forward‐looking make it less likely for the model to exhibit Neo‐Fisherianism.     

Interest‐Rate Pegs in New Keynesian Models

The conventional policy perspective is that lowering the interest rate increases output and inflation in the short run, while maintaining inflation at a higher level requires a higher interest rate in the long run. In contrast, it has been argued that a Neo‐Fisherian policy of setting an interest‐rate peg at a fixed higher level will increase the inflation rate. We show that adaptive learning argues against the Neo‐Fisherian approach. Pegging the interest rate at a higher level will induce instability and most likely lead to falling inflation and output over time. Eventually, this would precipitate a change of policy.     

Learning about the Term Structure and Optimal Rules for Inflation Targeting

In this paper, we incorporate the term structure of interest rates in the New Keynesian model and analyze optimal policy under uncertainty about private sector expectations and the degree of inflation persistence. The novel result of our paper is that for large deviations of inflation from its target, the active learning policy is less activist—in the sense of responding less aggressively to the state of the economy—than a myopic policy, which ignores the learning channel. Moreover, for most initial beliefs, the incentive for active learning increases as monetary policy’s leverage over the long‐term interest rate increases.     

Using a long-term interest rate as the monetary policy instrument

Using a short-term interest rate as the monetary policy instrument can be problematic near its zero bound constraint. An alternative strategy is to use a long-term interest rate as the policy instrument. We find when Taylor-type policy rules are used by the central bank to set the long rate in a standard New Keynesian model, indeterminacy—that is, multiple rational expectations equilibria—may often result. However, a policy rule with a long-rate policy instrument that responds in a “forward-looking” fashion to inflation expectations can avoid the problem of indeterminacy.     

Inflation targeting,credibility, and non-linear Taylor rules

In this paper we systematically evaluate how central banks respond to deviations from the inflation target. We present a stylized New Keynesian model in which agents' inflation expectations are sensitive to deviations from the inflation target. To (re-) establish credibility, monetary policy under discretion sets higher interest rates today if average inflation exceeded the target in the past. Moreover, the central bank responds non-linearly to past inflation gaps. This is reflected in an additional term in the central bank's instrument rule, which we refer to as the ”credibility loss.” Augmenting a standard Taylor (1993) rule with the latter term, we provide empirical evidence for the interest rate response for a sample of five inflation targeting (IT) economies. We find, first, that past deviations from IT feed back into the reaction function and that this influence is economically meaningful. Deterioration in credibility (ceteris paribus) forces central bankers to undertake larger interest rate steps. Second, we detect an asymmetric reaction to positive and negative credibility losses, with the latter dominating the former.     

Endogenous Price Stickiness,Trend Inflation,and Macroeconomic Stability

Previous studies show that higher trend inflation is more likely to induce indeterminacy of equilibrium in sticky‐price models based on micro evidence that each period a fraction of prices is kept unchanged. This paper demonstrates that when the degree of price stickiness is endogenously determined in a Calvo model, indeterminacy caused by higher trend inflation is less likely. A key factor for determinacy is the long‐run inflation elasticity of output implied by the New Keynesian Phillips curve. This elasticity declines substantially with higher trend inflation in the case of exogenously given price stickiness, whereas in the case of endogenous price stickiness the decline in the elasticity is mitigated because higher trend inflation leads to a higher probability of price adjustment.     

Non-Atomistic Wage Setters and Monetary Policy in a New Keynesian Framework

This paper extends an otherwise standard New Keynesian (NK) model to allow for the presence of large wage setters. Building on monetary models from an earlier generation, I contribute to the NK literature by adding some new insight. It is shown that once the presence of large wage setters is taken into account, the degree of wage setting centralization and the aggressiveness of the central bank in stabilizing inflation jointly affect steady state employment. Because of this interaction, the benefits associated with inflation stabilization increase in the centralization of the wage bargaining process.     

Fiscal Consequences of Paying Interest on Reserves

We review the role of the central bank's balance sheet in a textbook monetary model and explore what changes if the central bank is allowed to pay interest on its liabilities. When the central bank (CB) cannot pay interest, away from the zero lower bound its (real) balance sheet is limited by the demand for money. Furthermore, if securities are not marked to market and the central bank holds its bonds to maturity, it is impossible for the CB to make losses, and it always obtains profits from being a monopoly provider of money. When the option of paying interest on liabilities is allowed, the limit on the CB's balance sheet is lifted. In this case, the CB is free to take on interest‐rate risk – for example, by buying long‐term securities and financing those purchases with short‐term debt that pays the market interest rate. This is a risky enterprise that can lead to additional profits but also to losses. To the extent that losses exceed the profits of the monopoly operations, the CB faces two options: either it is recapitalised by Treasury or it increases its monopoly profits by raising the inflation tax.     

Monetary Policy and the Natural Rate of Interest

It is most important for monetary policy to track the natural rate of interest when interest rates take large and sustained swings away from their long‐run equilibrium values. Here, we study two models: a standard New Keynesian model and one in which government bonds provide liquidity. Policy rules that cannot track the natural rate perform poorly in both models, but are especially bad in the second because of sustained movements in the natural rate induced by fiscal shocks. First difference rules, on the other hand, do surprisingly well. When model uncertainty is taken into account, the dominance of the first difference rule is even more pronounced.     

How Important Is Money in the Conduct of Monetary Policy?

I consider some of the leading arguments for assigning an important role to tracking the growth of monetary aggregates when making decisions about monetary policy. First, I consider whether ignoring money means returning to the conceptual framework that allowed the high inflation of the 1970s. Second, I consider whether models of inflation determination with no role for money are incomplete, or inconsistent with elementary economic principles. Third, I consider the implications for monetary policy strategy of the empirical evidence for a long‐run relationship between money growth and inflation. And fourth, I consider reasons why a monetary policy strategy based solely on short‐run inflation forecasts derived from a Phillips curve may not be a reliable way of controlling inflation. I argue that none of these considerations provides a compelling reason to assign a prominent role to monetary aggregates in the conduct of monetary policy.     

The Value of Interest Rate Stabilization Policies When Agents Are Learning

We examine the expectational stability (E-stability) of rational expectations equilibrium in the "New Keynesian" model where monetary policy is optimally derived and interest rate stabilization is added to the central bank's traditional objectives of inflation and output stabilization. We consider both the case where the central bank lacks a commitment technology and the case of full commitment. We show that for both cases, optimal policy rules yield rational expectations equilibria that are E-stable for a wide range of empirically plausible parameter values. These findings stand in contrast to Evans and Honkapohja's findings for optimal monetary policy rules in environments where interest rate stabilization is not a central bank objective.     

Reconsidering the role of money for output, prices and interest rates

New Keynesian models of monetary policy downplay the role of monetary aggregates, in the sense that the level of output, prices, and interest rates can be determined without knowledge of the quantity of money. This paper evaluates the empirical validity of this prediction by studying the effects of shocks to monetary aggregates using a vector autoregression (VAR). Shocks to monetary aggregates are identified by the restrictions suggested by New Keynesian monetary models. Contrary to the theoretical predictions, shocks to broad monetary aggregates have substantial and persistent effects on output, prices and interest rates.     

Price‐Level Targeting and Stabilization Policy

We construct a dynamic stochastic general equilibrium model to study optimal monetary stabilization policy. Prices are fully flexible and money is essential for trade. Our main result is that if the central bank pursues a price‐level target, it can control inflation expectations and improve welfare by stabilizing short‐run shocks to the economy. The optimal policy involves smoothing nominal interest rates that effectively smooths consumption across states.     

Monetary Policy Implementation: Making Better and More Consistent Use of the Federal Reserve's Balance Sheet

Since December 2015, the Federal Reserve has operated a new “floor system” in which it brings about desired changes in its targeted federal funds rate by managing the interest rate it pays on bank reserves and other short‐term liabilities. The design of this new system reflects the tendency of Fed officials to view monetary policy as affecting the economy through Keynesian” interest rate channels. From this Keynesian perspective, policy actions that change the size of the balance sheet are seen as tools for influencing credit market conditions that operate in addition to and independently of the Fed's monetary policy stance. The alternative monetarist framework proposed by the author views monetary policy and its effects as operating through the interaction between money supply and demand. Use of this framework makes clear that, even under a floor system, monetary policy actions designed to affect the aggregate price level and the rate of inflation must be accompanied sooner or later by traditional open market operations that have implications for the size and composition of the Fed's balance sheet. Use of the monetarist framework also underscores the likelihood that the Fed, by paying interest on reserves, has unknowingly contributed to the restrictiveness of its own monetary policies since the financial crisis, a period during which inflation has run consistently below target. More generally, the monetarist framework downplays the importance of the zero lower interest rate bound and suggests that monetary policy could be conducted more effectively by adopting and adhering to a consistent, rule‐like manner during good times and bad.     

Sticky Price Models,Durable Goods,and Real Wage Rigidities

The standard two‐sector New Keynesian model with durable goods is at odds with conventional wisdom and vector autoregression (VAR) evidence: Following a monetary shock, the model generates (i) either negative or no comovement across sectoral outputs and (ii) aggregate neutrality of money when durable goods' prices are flexible. We reconcile theory with evidence by incorporating real wage rigidities into the standard model: As long as durable goods' prices are more flexible than nondurable goods' prices, we obtain positive sectoral comovement and, thus, aggregate nonneutrality of money.     

Optimal monetary policy under low trend inflation

In the monetary policy literature it is common to assume that trend inflation is zero, despite overwhelming evidence that zero inflation is neither empirically relevant nor a practical objective for central bank policy. We therefore extend the standard New Keynesian model to allow for positive trend inflation, showing that even low trend inflation has strong effects on optimal monetary policy and the dynamics of inflation, output and interest rates. Under discretion, the efficient policy deteriorates and there is no guarantee of determinacy. Even with commitment, targeting non-zero trend inflation leads to substantial welfare losses. Our results serve as a warning against indiscriminate use of models assuming zero trend inflation.     

Real Effects of Money Growth and Optimal Rate of Inflation in a Cash‐in‐Advance Economy with Labor‐Market Frictions

This paper studies the consequences of labor‐market frictions for the real effects of steady inflation when cash is required for households' consumption purchases and firms' wage payments. Money growth may generate a positive real effect by encouraging vacancy creation and raising job matches. This may result in a positive optimal rate of inflation, particularly in an economy with moderate money injections to firms and with nonnegligible labor‐market frictions in which wage bargains are not efficient. This main finding holds for a wide range of money injection schemes, with alternative cash constraints, and in a second‐best world with preexisting distortionary taxes.     

Estimating Central Bank Preferences under Commitment and Discretion

This paper explains U.S. macroeconomic outcomes with an empirical New Keynesian model in which monetary policy minimizes the central bank’s loss function. The presence of expectations in the model forms a well‐known distinction between two modes of optimization, termed commitment and discretion. The model is estimated separately under each policy using maximum likelihood over the Volcker–Greenspan–Bernanke period. Comparisons of fit reveal that the data favor the specification with discretionary policy. Estimates of the loss function weights point to an excessive concern for interest rate smoothing in the commitment model but a more balanced concern relative to inflation and output stability in the discretionary model.