Optimal Fiscal and Monetary Policy in Customer Markets

We present a model in which some goods trade in “customer markets” and advertising facilitates long‐lived relationships. We estimate the model on U.S. data and find a large congestion externality in the pricing of customer market goods. This motivates the analysis of optimal policy. Under a complete set of taxes, fiscal policy eliminates the externalities with large adjustments in tax rates on customer markets goods, while labor tax volatility remains low. Constraining the instruments to the interest rate and labor tax, the optimal labor tax displays large and procyclical fluctuations, but monetary policy is little changed compared to a model with no customer markets.     

Optimal Monetary Policy with Labor Market Frictions: The Role of the Wage Channel

This paper introduces right‐to‐manage bargaining into a labor search model with sticky prices instead of standard efficient bargaining and examines the Ramsey‐optimal monetary policy. Without real wage rigidity, even when the steady state is inefficient, price stability is nearly optimal in response to technology or government shocks. Right‐to‐manage bargaining creates the wage channel to inflation, because there is a direct relationship between real wages and real marginal cost. In the presence of the wage channel, price markups consist of only real marginal cost, and real wages and hours per worker are determined such as in the Walrasian labor market.     

Implications of habit formation for optimal monetary policy

We study the implications for optimal monetary policy of introducing habit formation in consumption into a general equilibrium model with sticky prices. Habit formation affects the model's endogenous dynamics through its effects on both aggregate demand and households’ supply of output. We show that the objective of monetary policy consistent with welfare maximization includes output stabilization, as well as inflation and output gap stabilization. We find that the variance of output increases under optimal policy, even though it acquires a higher implicit weight in the welfare function. We also find that a simple interest rate rule nearly achieves the welfare-optimal allocation, regardless of the degree of habit formation. In this rule, the optimal responses to inflation and the lagged interest rate are both declining in the size of the habit, although super-inertial policies remain optimal.     

Ramsey monetary policy with labor market frictions

Traditional New Keynesian models prescribe that optimal monetary policy should aim at price stability. In the absence of a labor market frictions, the monetary authority faces no unemployment/inflation trade-off. The design of optimal monetary policy is analyzed here for a framework with sticky prices and matching frictions in the labor market. Optimal policy features deviations from price stability in response to both productivity and government expenditure shocks. When the Hosios [1990. On the efficiency of matching and related models of search and unemployment. Review of Economic Studies 57 (2), 279-298] condition is not met, search externalities make the flexible price allocation unfeasible. Optimal deviations from price stability increase with workers’ bargaining power, as firms incentives to post vacancies fall and unemployment fluctuates above the Pareto efficient one.     

Optimal fiscal and monetary policy with sticky prices

In this paper I consider the role of state-contingent inflation as a fiscal shock absorber in an economy with nominal rigidities. I study the Ramsey equilibrium in a monetary model with distortionary taxation, nominal non-state-contingent debt, and sticky prices. With sticky prices, the Ramsey planner must balance the shock absorbing benefits of state-contingent inflation against the associated resource misallocation costs. For government spending processes resembling post-war experience, introducing sticky prices generates striking departures in optimal policy from the case with flexible prices. For even small degrees of price rigidity, optimal policy displays very little volatility in inflation. Tax rates display greater volatility compared to the model with flexible prices. With sticky prices, tax rates and real government debt exhibit behavior similar to a random walk. For government spending processes resembling periods of intermittent war and peace, optimal policy displays extreme inflation volatility even when the degree of price rigidity is large. As the variability in government spending increases, smoothing tax distortions across states of nature becomes increasingly important, and the shock absorber role of inflation is accentuated.     

Monetary policy and distribution

A segmented markets model of monetary policy is constructed, in which a novel feature is goods market segmentation, and its relationship to conventional asset market segmentation. The implications of the model for the response of prices, interest rates, consumption, labor supply, and output to monetary policy are determined. As well, optimal monetary policy is studied, as are the costs of inflation. The model features persistent nonneutralities of money, relative price effects of increases in the money supply, persistent liquidity effects, and a negative Fisher effect from a money supply increase. A Friedman rule is in general suboptimal.     

Human capital and optimal positive taxation of capital income

This paper analyzes optimal linear and non-linear taxes on capital and labor incomes in a life-cycle model of human capital investment, financial savings, and labor supply with heterogenous individuals. A dual income tax with a positive marginal tax rate on not only labor income but also capital income is optimal. The positive tax on capital income serves to alleviate the distortions of the labor tax on human capital accumulation. The optimal marginal tax rate on capital income is lower than that on labor income if savings are elastic compared to investment in human capital, substitution between verifiable and non-verifiable inputs in human capital formation is difficult, and most investments in human capital are verifiable so that education subsidies can directly reduce the tax wedge on learning. Numerical calculations suggest that the optimal marginal tax rate on capital income is substantial.     

Tax buyouts

The paper studies a fiscal policy instrument that can reduce fiscal distortions without affecting revenues, in a politically viable way. The instrument is a private contract (tax buyout), offered by the government to each citizen, whereby the citizen can choose to pay a fixed price in exchange for a given reduction in her tax rate for a period of time. We introduce the tax buyout in a dynamic overlapping generations economy, calibrated to match several features of the US income, taxes and wealth distribution. Under simple pricing, the introduction of the buyout is revenue neutral but, by reducing distortions, benefits a significant fraction of the population and leads to sizable increases in aggregate labor supply, income and consumption.     

Optimal monetary policy in an economy with inflation persistence

This paper studies optimal monetary policy in a model where inflation is persistent. Two types of price setters are assumed to exist. One acts rationally given Calvo-type constraints on price setting. The other type sets prices according to a rule-of-thumb. This results in a Phillips curve with both a forward-looking term and a backward-looking term. The Phillips curve nests a standard purely forward-looking Phillips curve as well as a standard purely backward-looking Phillips curve as special cases. A cost push supply shock is derived from microfoundations by adding a time varying income tax and by making the elasticity of substitution between goods stochastic. A central bank loss function for this model is derived from a second-order Taylor approximation of the household's welfare function. Optimal monetary policy for different relative values of the forward- and backward-looking terms is then analyzed for both the commitment case and the case of discretion.     

Optimal monetary policy in a ‘sudden stop’

In the wake of the 1997-98 financial crises, interest rates in Asia were raised immediately, and then reduced sharply. We describe an environment in which this is the optimal monetary policy. The optimality of the immediate rise in the interest rate is an example of the theory of the second best: although high interest rates introduce an inefficiency wedge into the labor market, they are nevertheless welfare improving because they mitigate distortions due to binding collateral constraints. Over time, as the collateral constraint is less binding, the familiar Friedman forces dominate, and interest rates are optimally set as low as possible.     

External shocks, U.S. monetary policy and macroeconomic fluctuations in emerging markets

Estimated structural VARs show that external shocks are an important source of macroeconomic fluctuations in emerging markets. Furthermore, U.S. monetary policy shocks affect interest rates and the exchange rate in a typical emerging market quickly and strongly. The price level and real output in a typical emerging market respond to U.S. monetary policy shocks by more than the price level and real output in the U.S. itself. These findings are consistent with the idea that “when the U.S. sneezes, emerging markets catch a cold.” At the same time, U.S. monetary policy shocks are not important for emerging markets relative to other kinds of external shocks.     

Monetary Policy in a Forward-Looking Input–Output Economy

This paper examines the implications for monetary policy of sticky prices in both final and intermediate goods in a New Keynesian model. Both optimal policy under commitment and discretionary policy under simple loss functions are studied. Household utility losses under alternative loss functions are compared; additionally, the robustness of policy performance to model and shock misperceptions and parameter uncertainty is examined. Targeting inflation in both consumer and intermediate goods performs better than targeting inflation in one sector; targeting price levels of both final and intermediate goods performs significantly better. Moreover, targeting price levels in both sectors yields superior robustness properties.     

A Theory of Intrinsic Inflation Persistence

We propose a novel theory of intrinsic inflation persistence by introducing trend inflation and Kimball (1995)-type aggregators of individual differentiated goods and labor in a model with staggered price- and wage-setting. Under nonzero trend inflation, the non-CES (constant elasticity of substitution) aggregator of goods and staggered price-setting give rise to a variable real marginal cost of goods aggregation, which becomes a driver of inflation. This marginal cost consists of an aggregate of the goods' relative prices, which depends on past inflation, thereby generating intrinsic inertia in inflation. Likewise, the non-CES aggregator of labor and staggered wage-setting lead to intrinsic inertia in wage inflation, which enhances the persistence of price inflation. With the theory we show that inflation exhibits a persistent, hump-shaped response to monetary policy shocks. We also demonstrate that lower trend inflation reduces inflation persistence and that a credible disinflation leads to a gradual decline in inflation and a fall in output.     

Real exchange rate persistence and monetary policy rules

The objective of this paper is to analyze the effects of alternative monetary rules on real exchange rate persistence. Using a two-country stochastic dynamic general equilibrium with nominal price stickiness and local currency pricing, we will show how the persistence of purchasing power parity deviations can be related to a monetary theory of these deviations. When monetary policy lean against the wind, there is no relationship of proportionality between the time during which prices remain sticky and the persistence of the response of the real exchange rate: in this case high nominal price rigidity is not sufficient, per se, in generating any persistence following a monetary shock. Moreover, we emphasize the role of interest rates smoothing policies and relative price stickiness within countries in understanding the relationship between the real exchange rate and monetary shocks. With reasonable parameters values, a wide range of monetary policy rules can generate real exchange rate autocorrelations around the ones observed in the data.     

Equilibrium Unemployment, Job Flows, and Inflation Dynamics

In order to explain the joint fluctuations of output, inflation and the labor market, this paper develops and estimates a general equilibrium model that integrates a theory of equilibrium unemployment into a monetary model with nominal price rigidities. The estimated model accounts for the responses of employment, hours per worker, job creation, and job destruction to a monetary policy shock. Moreover, search frictions in the labor market generate a lower elasticity of marginal costs with respect to output. This helps to explain the sluggishness of inflation and the persistence of output that are observed in the data.     

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.     

Notes on the Underground: Monetary Policy in Resource‐Rich Economies

The central bank of a commodity‐exporting small open economy faces the traditional trade‐off between domestic inflation and output gap. The commodity sector introduces a terms‐of‐trade inefficiency that gives rise to an endogenous cost‐push shock, changes the target level for output, reduces the slope of the Phillips curve, and increases the importance of stabilizing the output gap. Optimal monetary policy calls for a reduction of the interest rate following a drop in the oil price. In contrast, a central bank with a mandate to stabilize consumer price inflation raises interest rates to limit the inflationary impact of an exchange rate depreciation.     

In search of the liquidity effect in a modern monetary model

This paper examines the impact of a monetary policy shock in a dynamic stochastic general equilibrium model with sticky prices and financial market frictions. First, we examine the shortcomings of monetary models emphasizing these frictions individually. The model then is specified to limit the response of prices and savings to a current period monetary disturbance. Our results show that this model can account for the following key responses to an expansionary monetary policy shock: a fall in the nominal interest rate; a rise in output, consumption, and investment; and a gradual increase in the price level. Finally, a detailed sensitivity analysis shows the model's results depend on the parameters assigned to critical structural features.     

U.S. Monetary Regimes and Optimal Monetary Policy in the Euro Area

Monetary policy in the United States has been documented to have switched from reacting weakly to inflation fluctuations during the 1970s, to fighting inflation aggressively from the early 1980s onward. In this paper, I analyze the impact of the U.S. monetary policy regime switches on the Eurozone. I construct a New Keynesian two‐country model where foreign (U.S.) monetary policy switches regimes over time. I estimate the model for the U.S. and the Euro Area using quarterly data and find that the United States has switched between those two regimes, in line with existing evidence. I show that foreign regime switches affect home (Eurozone) inflation and output volatility and their responses to shocks, substantially, as long as the home central bank commits to a time‐invariant interest rate rule reacting to domestic conditions only. Optimal policy in the home country instead requires that the home central bank reacts strongly to domestic producer‐price inflation and to international variables, such as imported goods relative prices. In fact, I show that currency misalignments and relative prices play a crucial role in the transmission of foreign monetary policy regime switches internationally. Interestingly, I show that only marginal gains arise for the Euro Area when the European Central Bank (ECB) adjusts its policy according to the monetary regime in the United States. Thus, a simple time‐invariant monetary policy rule with a strong reaction to Producer Price Index (PPI) inflation and relative prices is enough to counteract the effects of monetary policy switches in the United States.     

Monetary Policy,Trend Inflation,and Unemployment Volatility

The literature has long agreed that the DMP model (after Diamond 1982, Mortensen 1982, Pissarides 1985) with search and matching frictions in the labor market can deliver large volatilities in labor market quantities, consistent with empirical data, only if there is at least some wage stickiness. I show, however, that the model can deliver nontrivial volatilities without wage stickiness, as long as it has price dispersion and nonzero long‐run inflation rates. I find that by keeping inflation at a positive rate, monetary policy may be accountable for the large standard deviations observed on labor market variables. In addition, the Shimer (2005) puzzle disappears under monetary policy shocks.