Optimal Monetary Policy in a Model with Agency Costs

This paper integrates a fully explicit model of agency costs into an otherwise standard Dynamic New Keynesian model in a particularly transparent way. A principal result is the characterization of agency costs as endogenous markup shocks in an output‐gap version of the Phillips curve. The model's utility‐based welfare criterion is derived explicitly and includes a measure of credit market tightness that we interpret as a risk premium. The paper also fully characterizes optimal monetary policy and provides conditions under which zero inflation is the optimal policy. Finally, optimal policy can be expressed as an inflation targeting criterion that (depending upon parameter values) can be either forward or backward looking.     

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.     

Heterogeneous Expectations,Optimal Monetary Policy,and the Merit of Policy Inertia

The design and analysis of optimal monetary policy is usually guided by the paradigm of homogeneous rational expectations. Instead, we examine the dynamic consequences of design and implementation strategies, when the actual economy features expectational heterogeneity. Agents have either rational or adaptive expectations. Consequently, the central bank's ability to achieve price stability under heterogeneous expectations depends on its objective and implementation strategy. An expectations‐based reaction function, which appropriately conditions on private sector expectations, performs exceptionally well. However, once the objective introduces policy inertia, popular strategies have similar determinacy properties, but they are less operational. This finding calls for new implementation strategies under interest rate stabilization.     

Phillips Curve Instability and Optimal Monetary Policy

Empirical evidence suggests the Phillips curve has flattened over the past few decades. To capture this feature of the data, I develop a framework where firms face a changing cost of price adjustment, which produces a Phillips curve with a slope coefficient that varies over time. To evaluate the implications for monetary policy, I construct the utility‐based welfare criterion where the relative weight on output gap deviations changes synchronously with the slope of the Phillips curve. The systematic component of the rule that implements optimal policy is constant under discretion and commitment.     

Optimal Monetary Policy and Transparency under Informational Frictions

This paper examines the optimal monetary policy and central bank transparency in an economy where firms set prices under informational frictions. The economy is subject to two types of shocks determining the efficient output level and firms' desired markups. To minimize the welfare‐reducing output gap and price dispersion between firms, the central bank controls firms' incentives and expectations by using a monetary instrument and disclosing information on the realized shocks. This paper shows that an optimal policy comprises the disclosure of a linear combination of the two shocks and the adjustment of monetary instruments contingent on the disclosed information.     

Optimal Monetary Policy in an Operational Medium‐Sized DSGE Model

We show how to construct optimal policy projections in Ramses, the Riksbank’s open‐economy medium‐sized dynamic stochastic general equilibrium model for forecasting and policy analysis. Bayesian estimation of the parameters of the model indicates that they are relatively invariant to alternative policy assumptions and supports our view that the model parameters may be regarded as unaffected by the monetary policy specification. We discuss how monetary policy, and in particular the choice of output gap measure, affects the transmission of shocks. Finally, we use the model to assess the recent Great Recession in the world economy and how its impact on the economic development in Sweden depends on the conduct of monetary policy. This provides an illustration on how Rames incoporates large international spillover effects.     

Asymmetric Preferences and the Stability Problem for Optimal Monetary Policy Rules

This paper evaluates the stability properties of optimal monetary policy rules when professionals under adaptive learning have asymmetric preferences. The asymmetric preferences require volatility estimates in real time. An expectations‐based rule can stabilize the economy, while a fundamentals‐based rule leads to instability.     

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.     

Ben Bernanke in Doha: The Effect of Monetary Policy on Optimal Tariffs

Trade liberalization can imply slow and long adjustment processes. Taking account of these adjustment processes can change the evaluation of trade policy, especially when policymakers care more about the next couple of years than the infinite future. In this paper, I analyze the setting of tariffs in a two‐country model taking account of adjustment processes with special emphasis on the effects of nominal price rigidity and monetary policy. I show that nominal price rigidity induces policymakers with a short planning horizon to set lower tariffs because it enhances the short‐run drop in consumption following an increase in tariffs. Monetary policy that aggressively fights deviations from its inflation target implies even lower optimal tariffs.     

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.     

Banking Competition,Collateral Constraints,and Optimal Monetary Policy

We analyze optimal monetary policy in a model with two distinct financial frictions: monopolistically competitive banks that charge endogenous lending spreads, and collateral constraints. We show that welfare maximization is equivalent to stabilization of four goals: inflation, output gap, the “consumption gap” between borrowers and savers, and a “housing gap” that measures the distortion in the distribution of the collateralizable asset between both groups. Collateral constraints create a trade‐off between stabilization goals. Following both productivity and financial shocks, and relative to strict inflation targeting, the optimal policy implies sharper movements in the policy rate, aimed primarily at reducing fluctuations in asset prices and hence in borrowers' net worth. The policy trade‐offs become amplified as banking competition increases, due to the fall in lending spreads and the resulting increase in borrowers' leverage.     

Labor Force Participation and Monetary Policy in the Wake of the Great Recession

This paper provides compelling evidence that cyclical factors account for the bulk of the post‐2007 decline in the U.S. labor force participation rate (LFPR). We then formulate a stylized New Keynesian model in which the LFPR is practically acyclical during “normal times” but drops markedly following a large and persistent aggregate demand shock. These considerations have potentially crucial implications for the design of monetary policy, especially when interest rate adjustments are constrained by the zero lower bound; specifically, monetary policy can induce a more rapid recovery of the LFPR by allowing the unemployment rate to fall below its natural rate.     

Collateral in Monetary Policy Operations

We present a portfolio decision model for banks that permits us to estimate the costs associated with the need to collateralise loans from the central bank. This allows us to calibrate the difference between a restrictive collateral eligibility framework for open market operations, such as that applied by the FED, with a more flexible approach such as that of Eurosystem. We also document that there could potentially appear relevant cost differences between the various collateral mobilisation procedures (pooling and earmarking) that currently coexist in the eurozone.     

Sectoral Comovement,Monetary Policy Shocks,and Input–Output Structure

The comovement of output across the sector producing nondurables (i.e., nondurable goods and services) and the sector producing durables is well established in the monetary business cycle literature. However, standard sticky‐price models that incorporate sectoral heterogeneity in price stickiness (i.e., sticky nondurables prices and flexible durables prices) cannot generate this feature. We argue that an input–output (I–O) structure provides a solution to this problem. Here, we develop a two‐sector model with an I–O structure, which is calibrated to the U.S. economy. In the model, each sector’s output affects those of the others by acting as an intermediate input. This connection between the sectors provides a channel through which sectoral comovement is induced.     

On Targeting Frameworks And Optimal Monetary Policy

We show that speed limit policy, a monetary policy strategy that focuses on stabilizing inflation and the change in the output gap, consistently outperforms flexible inflation targeting and flexible price level targeting in empirical medium‐scale DSGE models under discretionary policymaking. In contrast to small‐scale New Keynesian models, this welfare ranking of the targeting frameworks is not overturned when inflation dynamics are mostly backward‐looking. Importantly, the performance of the speed limit policy shows less sensitivity to its parameterization than other frameworks that target the inflation rate or the price level.     

Optimal Monetary Policy with Countercyclical Credit Spreads

We study optimal monetary policy in a New‐Keynesian Dynamic Stochastic General Equilibrium (DSGE) model with a credit channel and relationship lending in banking. We show that borrowers' bank‐specific (deep) habits give rise to countercyclical credit spreads, which, in turn, make optimal monetary policy depart substantially from price stability, under both discretion and commitment. Our analysis shows that the welfare costs of setting monetary policy under discretion (with respect to the optimal Ramsey plan) and of using simpler suboptimal policy rules are strictly increasing in the magnitude of deep habits in credit markets and market power in banking.     

Optimal Structure of Fiscal and Monetary Authorities

Why are monetary authorities not elected like fiscal authorities are? Advanced economies pair an elected fiscal authority with an independent monetary authority. Replicating the advanced economies' structure with authorities microfounded by a political economy model shows that this structure is the solution to a constrained mechanism design problem that overcomes time inconsistency and results in the highest possible welfare. Goal and instrument independence, singly and in combination, are insufficient to minimize time inconsistency, though their combination is necessary.     

Fiscal and Monetary Policy Coordination,Macroeconomic Stability,and Sovereign Risk Premia

In standard macroeconomic models, equilibrium stability and uniqueness require monetary policy to actively target inflation and fiscal policy to ensure long‐run debt sustainability. We show analytically that these requirements change, and depend on the cyclicality of fiscal policy, when government debt is risky. In that case, budget deficits raise interest rates and crowd out consumption. Consequently, countercyclical fiscal policies reduce the parameter space supporting stable and unique equilibria and are feasible only if complemented with more aggressive debt consolidation and/or active monetary policy. Stability is more easily achieved, however, under procyclical fiscal policies.     

Monetary Policy Response to Oil Price Shocks

How should monetary authorities react to an oil price shock? This paper shows that in a noncompetitive economy, policies that perfectly stabilize prices entail large welfare costs, hence explaining the reluctance of policymakers to enforce them. The policy trade‐off is nontrivial because oil (energy) is an input to both production and consumption. As welfare‐maximizing policies are hard to implement and communicate, I derive a simple interest rate rule that depends only on observables but mimics the optimal plan in all dimensions. The optimal rule is hard on core inflation but accommodates oil price changes.     

Managing Beliefs about Monetary Policy under Discretion

In models of monetary policy, discretionary policymaking is typically constrained in its ability to manage public beliefs. However, when a policymaker possesses private information, policy actions serve as signals to the public about unobserved economic conditions and belief management becomes an integral part of optimal discretion policies. This article derives the optimal time‐consistent policy for a general linear‐quadratic setting. The optimal policy is illustrated in a simple New Keynesian model, where analytical solutions can be derived as well. In this model, imperfect information about the policymaker's output target leads to lower policy losses.