Stabilizing expectations at the zero lower bound: Experimental evidence

Our study demonstrates how agents’ expectations can interact dynamically with monetary and fiscal policy at the zero lower bound. We study expectation formation near the zero lower bound using a learning-to-forecast laboratory experiment under alternative policy regimes. In our experimental economy, monetary policy targets inflation around a constant or state-dependent target. We find that subjects’ expectations significantly over-react to stochastic aggregate demand shocks and historical information, leading many economies to experience severe deflationary traps. Neither quantitatively nor qualitatively communicating the state-dependent inflation targets reduce the duration or severity of economic crises. Introducing anticipated and persistent fiscal stimulus at the zero lower bound reduces the severity of the recessions. When the recovery of fundamentals is sufficiently slow, participants’ expectations become highly pessimistic and neither monetary nor fiscal policy are effective at stabilizing the economy.     

The difficulty of discerning what’s too tight: Taylor rules and Japanese monetary policy

Observers have relied increasingly on simple reaction functions, such as the Taylor rule, to assess the conduct of monetary policy. Applying this approach to deflationary or near-zero inflation environments is problematic, however, and this paper examines two shortcomings of particular relevance to the Japanese case of the last decade. One is the unusually high degree of uncertainty associated with potential output in an environment of prolonged stagnation and deflation. Consequently, reaction function-based assessments of Japanese monetary policy are so sensitive to the chosen gauge of potential output as to be unreliable. The second shortcoming is the neglect of policy expectations, which become critically important as nominal interest rates approach zero. Using long-term bond yields, we identify five episodes since 1996 characterized by abrupt declines in Japanese inflation expectations. Policies undertaken by the Bank of Japan during this period did little to stabilize expectations, and the August 2000 interest-rate increase appears to have intensified deflationary concerns.     

Alternative monetary policies and fiscal regime in new EU members

I investigate the relevance of a fiscal regime for disinflation in new EU member states (NMS). I generalize the framework of [Obstfeld, M., Rogoff, K., 1995. Exchange rate dynamics redux. Journal of Political Economy 103, 624–660] to incorporate the non-Ricardian fiscal regime and two monetary feedback rules: inflation targeting and depreciation targeting. Euro accession requires disinflation and stabilization of the exchange rate and thus restrictive monetary policy. The model illustrates that a sustainable and prudent fiscal policy is a necessary condition for successful stabilization of inflation. Thus, the lack of prudent fiscal policy, through its effects on inflation, may undermine the EMU accession of large NMS even when their fiscal outcomes fall within the Maastricht range.     

Germany — the next Japan?

The German economy is in a hole, and it can’t stop digging. The tools that normally help an economy to get out of a hole are digging Germany further in. Hamstrung by the terms of the Stability and Growth Pact, it is planning a substantial tightening of fiscal policy over the next few years. And, with inflation below the Eurozone average and falling, and nominal interest rates set by the ECB, real monetary conditions are tightening as well: this at a time when Germany is already in recession. How long before the German economy sets off on the deflationary path trodden in Japan over the last decade?     

Liquidity traps and expectation dynamics: Fiscal stimulus or fiscal austerity?

We examine global dynamics under infinite-horizon learning in New Keynesian models where the interest-rate rule is subject to the zero lower bound. The intended steady state is locally but not globally stable. Unstable deflationary paths emerge after large pessimistic shocks to expectations. For large expectation shocks that push interest rates to the zero bound, a temporary fiscal stimulus, or in some cases a policy of fiscal austerity, will insulate the economy from deflation traps if the policy is appropriately tailored in magnitude and duration. A fiscal stimulus “switching rule,” which automatically kicks in without discretionary fine-tuning, can be equally effective.     

Monetary policy with interest on reserves

I analyze monetary policy with interest on reserves and a large balance sheet. I show that conventional theories do not determine inflation in this regime, so I base the analysis on the fiscal theory of the price level. I find that monetary policy can peg the nominal rate, and determine expected inflation. With sticky prices, monetary policy can also affect real interest rates and output, though higher interest rates raise output and then inflation. The conventional sign requires a coordinated fiscal–monetary policy contraction. I show how conventional new-Keynesian models also imply strong monetary–fiscal policy coordination to obtain the usual signs. I address theoretical controversies. A concluding section places our current regime in a broader historical context, and opines on how optimal fiscal and monetary policy will evolve in the new regime.     

Monetary union: European lessons,Latin American prospects

This paper analyzes the long-run sustainability of monetary unions. We infer from the EMU experience that for monetary union to be sustainable, fiscal policy rules are necessary. That does not imply a formal Stability Pact, however. Labor market flexibility is more important for sustainability than cross-border labor mobility. Sound financial markets are another precondition. Lessons for Latin America and the Caribbean include, first, that the benefit-cost balance of a shift to monetary union is much less favorable in Latin America and the Caribbean than in Europe and, most important, that the region is some distance away from satisfying the necessary conditions for monetary union. That leaves dollarization as a limited option for small countries and floating rates combined with inflation targeting for much of the rest.     

财政政策、货币政策调控与宏观经济稳定——基于新凯恩斯主义垄断竞争模型的分析

本文基于包含金融加速器的新凯恩斯主义垄断竞争框架,研究了财政政策和货币政策冲击对我国宏观经济的影响。实证结果表明,财政政策能够解释部分就业、消费和资本存量波动;货币政策冲击则能够解释大部分通货膨胀、就业波动,以及部分产出、消费和投资波动。总体上,模型能够较好地刻画中国宏观经济波动特征。本文认为今后一段时期内,应当将财政政策更多转向民生领域和基础设施建设,重视货币政策调控,从而更有效地调控宏观经济运行。     

Dealing with a liquidity trap when government debt matters: Optimal time-consistent monetary and fiscal policy

How does the need to preserve government debt sustainability affect the optimal monetary and fiscal policy response to a liquidity trap? To provide an answer, we employ a small stochastic New Keynesian model with a zero bound on nominal interest rates and characterize optimal time-consistent stabilization policies. We focus on two policy tools, the short-term nominal interest rate and debt-financed government spending. The optimal policy response to a liquidity trap critically depends on the prevailing debt burden. While the optimal amount of government spending is decreasing in the level of outstanding government debt, future monetary policy is becoming more accommodative, triggering a change in private sector expectations that helps to dampen the fall in output and inflation at the outset of the liquidity trap.     

Do enlarged fiscal deficits cause inflation? The historical record

We survey the historical record for two centuries on the connection between expansionary fiscal policy and inflation. The relationship holds in wartime when fiscally stressed governments resorted to the inflation tax. In two peacetime episodes in the early twentieth century, bond‐financed fiscal deficits, unbacked by future taxes, may have contributed to inflation. Fiscal influence on monetary policy was important in the Great Inflation 1965–1983. Expansionary monetary and fiscal policy did not lead to inflation in the Global Financial Crisis of 2007–08 but, by contrast, the fiscal and monetary response to the COVID‐19 pandemic may involve risks of fiscal dominance and future inflation.     

The fiscal and monetary response to COVID‐19: What the Great Depression has – and hasn't – taught us

Although some regard the New Deal of the 1930s as exemplifying an aggressive fiscal and monetary response to a severe economic crisis, the US fiscal and monetary policy responses to the COVID‐19 crisis have actually been far more substantial – and, so far, much more effective in reviving aggregate spending. Although many fear that these responses, and the large‐scale increase in bank reserves especially, must eventually cause unwanted inflation, the concurrent sharp decline in money's velocity has thus far more than offset any inflationary effects of money growth, while forward bond prices reflect a general belief that inflation will remain below 2 per cent for at least another decade. Notwithstanding the growth of the Fed's balance sheet, Fed authorities can always check inflation by sufficiently raising the interest return on bank reserves. Nonetheless, recent developments have heightened the risk of ‘fiscal dominance’ of monetary policy at some point in the future.     

Do Good Institutions Promote Countercyclical Macroeconomic Policies?

The literature has argued that developing countries are unable to adopt countercyclical monetary and fiscal policies due to financial imperfections and unfavourable political‐economy conditions. Using a world sample of up to 112 industrial and developing countries for 1984–2008, we find that the level of institutional quality plays a key role in countries’ ability and willingness to implement countercyclical macroeconomic policies. Countries with strong (weak) institutions adopt countercyclical (procyclical) macroeconomic policies, reflected in extended monetary policy and fiscal policy rules. The threshold levels of institutional quality at which policies are acyclical are found to be similar for monetary and fiscal policy.     

Price‐level targeting ‐the next objective for monetary policy?

Inflation-targeting monetary policy is compared with price-level targeting. It is argued that price-level targeting offers greater certainty about the long-term inflation rate, greater economic growth, a superior response to a deflationary depression, and other advantages.     

WORLD OUTLOOK

After six years of steadily rising OECD output, fears of a significant rise in world inflation are now increasing. In the last year there has been a slight pick-up in inflation with producer prices up nearly d per cent. But prompt action by the Federal Reserve to raise interest rates before the presidential election appears to have damped inflationary expectations in the US and has given Japan and Germany an opportunity to tighten monetary policy without causing major currency fluctuations. It is also apparent that the other possible source of world inflation, commodity prices, is not a problem. OPEC over-production has ensured that the oil price remains weak and other commodity prices appear to have stopped rising after a brief acceleration at the beginning of the year. Nevertheless the major imbalances in world trade are declining only slowly and without a change in fiscal policy in the major economies it is difficult to believe that minor changes in monetary policy will be sufficient if the process of adjustment begins to falter. Despite these risks, we take a sanguine view of world prospects. Tighter monetary policy should effect a slowdown in world growth next year (already indicated by recent developments, particularly in the US) and this should be sufficient to control inflation which we expect to peak at just under 5 per cent at the beginning of next year. From 1990 onwards we see steady growth accompanied by low inflation.     

Lessons from a century of FED policy: Why monetary and credit policies need rules and boundaries

Wide operational and financial independence given to monetary and credit policies subjects the Federal Reserve to incentives detrimental for macroeconomic and financial stability. The absence of a monetary policy rule created go-stop incentives that produced inefficient volatility of both inflation and unemployment during the Great Inflation. Fed credit policy has undergone massive “mission creep” since the Fed was established. Being debt-financed fiscal policy, Fed credit policy beyond ordinary temporary lending to solvent depositories creates friction with the fiscal authorities and jeopardizes the Fed׳s independence. An ambiguous boundary of expansive Fed credit policy creates expectations of Fed accommodation in financial crisis—that blunts the incentive of private entities to take protective measures beforehand (to shrink counter-party risk and reliance on short-term finance, and build up equity capital) and blunts the incentive of the fiscal authorities to prepare procedures in advance to act systematically in times of credit turmoil. These points are illustrated with reference to the 2007–09 financial crisis. Part of the problem is that the independent Fed does not have the same incentive as the 19th century Bank of England to follow Bagehot׳s Rule. The paper concludes with a set of principles to preserve a workable, sustainable division of responsibilities between the independent central bank and the fiscal authorities.     

Impacts of Monetary, Fiscal and Exchange Rate Policies on Output in China: A Var Approach

Applying the VAR model and using the interest rate as a monetary policy variable, we find that in the long run, output in China responds negatively to a shock to the interest rate, the real exchange rate, government debt, or the inflation rate, and it reacts positively to a shock to government deficits or lagged own output. When real M2 is chosen as a monetary policy variable, long-term output in China responds positively to a shock to real M2 or lagged own output, and it reacts negatively to a shock to the real exchange rate, government debt, or government deficits. Its response to a shock to the inflation rate is negative when government debt is used and is positive when government deficits are considered. In the short run, fiscal policy is more important than monetary policy in three out of four cases. In the long run, monetary policy is more influential than fiscal policy in three out of four cases. Therefore, the government may consider conducting monetary and fiscal policies differently in the short run and long run. The government needs to be cautious in pursuing deficit spending as its long-term impacts depend on the monetary variable employed. The policy of maintaining a relatively stable exchange rate is appropriate as the depreciation of the Yuan may hurt the economy in the short run.JEL Classifications: E5, F4, H6     

Solving endogenous regime switching models

This paper solves rational expectations models in which structural parameters switch across multiple regimes according to state-dependent (endogenous) transition probabilities. Assuming small shocks and smooth transition probabilities, we apply a perturbation approach. We first provide for conditions under which a unique bounded equilibrium exists. We then compute first- and second-order approximations. In a new-Keynesian model with monetary policy switching, we document new effects of monetary policy switching when transition probabilities depend on inflation.     

Briefing Paper: The Interdependence of Fiscal and Monetary Policy under Economic and Monetary Union

This article explores the implications of Economic and Monetary Union (EMU) for the conduct of fiscal policy. Under EMU, where the European Central Bank is successful in controlling inflation, the loss of seigniorage revenues causes a potential problem for public sector deficits. To prevent the debt-income ratio from spiralling upwards, a primary budget surplus is ultimately required. EMU has usually been considered as a strong central monetary authority which forces fiscal discipline on lax national governments. But this is not the only possibility. Because the debt ratio can be reduced by surprise inflation, the price expectations of the private sector are important. Once these are taken into account, EMU can be examined in a 'game' framework in which the reputation of the authorities and the existence or otherwise of cooperation between the fiscal and monetary authorities becomes a critical factor.
The paper finds that where the authorities enjoy reputation and cooperate, a one-off reduction in public spending will lead to a permanent decline in the real interest rate and crowd in extra private spending (consumption and investment). Without reputation the cut in government spending has to be sustained. Where there is neither reputation nor cooperation, the outcome depends on the structure of the European economy and whether fiscal policy can effect the terms of trade between countries. If the terms of trade remain unchanged, the outturn is similar to the case of cooperation without reputation, but where the terms of trade can be improved in one country, there is no incentive to cut public spending. In this case the outturn is higher inflation with private spending crowded out.     

Optimal monetary policy under incomplete markets and aggregate uncertainty: A long-run perspective

This paper examines the role of monetary policy in an environment with aggregate risk and incomplete markets. In a two-period overlapping-generations model with aggregate uncertainty, optimal monetary policy attains the ex-ante Pareto optimal allocation. This policy aims to stabilize the savings rate in the economy by changing real returns of nominal bonds via variation in expected inflation. Optimal expected inflation is procylical and on average higher than without uncertainty. Simple inflation targeting rules closely approximate the optimal monetary policy.     

On the Low‐Frequency Relationship Between Public Deficits and Inflation

We estimate the low‐frequency relationship between fiscal deficits and inflation and pay special attention to its potential time variation by estimating a time‐varying vector autoregression model for US data from 1900 to 2011. We find the strongest relationship neither in times of crisis nor in times of high public deficits, but from the mid 1960s up to 1980. Employing a structural decomposition of the low‐frequency relationship and further narrative evidence, we interpret our results such that the low‐frequency relationship between fiscal deficits and inflation is strongly related to the conduct of monetary policy and its interaction with fiscal policy after World War II.Copyright © 2015 John Wiley & Sons, Ltd.