Optimal fiscal and monetary policy under sticky prices

This paper studies optimal fiscal and monetary policy under sticky product prices. The theoretical framework is a stochastic production economy. The government finances an exogenous stream of purchases by levying distortionary income taxes, printing money, and issuing nominal non-state-contingent bonds. The main findings of the paper are: First, for a miniscule degree of price stickiness (i.e., many times below available empirical estimates) the optimal volatility of inflation is near zero. Second, small deviations from full price flexibility induce near random walk behavior in government debt and tax rates. Finally, price stickiness induces deviation from the Friedman rule.     

The financial accelerator and monetary policy rules

Comparing Bernanke et al.’s (1999) financial accelerator model to a comparable model without an operational financial accelerator mechanism, we find that financial acceleration is reduced when monetary policy reacts to the output gap and when firm-specific volatility rises.     

Budget deficits and inflation feedback

This paper reinterprets the mixed evidence of the relationship between budget deficits and inflation in high inflation economies. The main finding is that recurrent outbursts of extreme inflation in these economies can be explained by a certain hysteresis effect associated with public finance. This interpretation meets the evidence that dramatic shifts between regimes of moderately high and extremely high (hyper-) inflation often occur without visible deterioration in public finance or abrupt shifts in fiscal or monetary policies. The existence of this hysteresis effect is explicitly explained by the action of two mechanisms: the arithmetic associated with the wrong side of the inflation tax Laffer curve and the Patinkin effect (the reverse of the much oftener cited Olivera-Tanzi effect). It is also shown that the division of the operational budget deficit into the part that is subject to negative inflation feedback and the part that is inflation-proof has implications for both the discussion of the inflationary consequences of budget deficits and the design of stabilization policy.     

Data uncertainty and the role of money as an information variable for monetary policy

In this study, we perform a quantitative assessment of the role of money as an indicator variable for monetary policy in the euro area. We document the magnitude of revisions to euro area-wide data on output, prices, and money, and find that monetary aggregates have a potentially significant role in providing information about current real output. We then proceed to analyze the information content of money in a forward-looking model in which monetary policy is optimally determined subject to incomplete information about the true state of the economy. We show that monetary aggregates may have substantial information content in an environment with high variability of output measurement errors, low variability of money demand shocks, and a strong contemporaneous linkage between money demand and real output. As a practical matter, however, we conclude that money has fairly limited information content as an indicator of contemporaneous aggregate demand in the euro area.     

Household debt,macroprudential rules,and monetary policy

Today's Canadian economy features a historic high of household debt and persistently low growth rate. The average debt-to-GDP ratio has reached the level experienced in the U.S. just prior to the recent financial crisis. In this paper, we ask whether monetary policy should lean against the household indebtedness or macroprudential policies are better suited for the task. To provide a quantitative answer, we develop a small open economy dynamic stochastic general equilibrium model featuring a micro-founded banking sector. We estimate the model using Canadian data and conduct policy experiments. Our findings favor macroprudential approach to reining in indebtedness: using monetary policy that reacts to household debt increases inflation volatility and lowers borrowers' welfare, while using macroprudential policies such as lowering the loan-to-value ratio limit increases borrowers' welfare.     

Barro-Gordon revisited: Reputational equilibria with inferential expectations

We incorporate inferential expectations into the Barro-Gordon model (Barro and Gordon, 1983a) of time inconsistency and consider reputational equilibria. The range of sustainable equilibria shrinks as the private sector becomes more belief-conservative.     

Optimal versus realized policy rules in a regime-switching framework

In this paper we compare a deterministic model and a Markov switching model to analyze the behavior of the US economy and the Federal Reserve. We examine both optimal and empirical monetary policies for the US Federal Reserve between 1960 and 2008. We compare the optimal monetary policy to the actual interest rates and to the empirical reaction function. We also evaluate the sensitivity of the results to the preferences assigned to each objective. We find that there is no unique optimal solution that fits the Federal Reserve behavior over the entire period. The best fit to the actual interest rates is obtained by an optimal policy with preference switches following the rule: a high-volatility regime coincides with a priority on inflation alone while in a low-volatility regime there is equal policy priority on output stabilization and inflation.     

Jointly optimal monetary and fiscal policy rules under liquidity constraints

We study the welfare properties of an economy where both monetary and fiscal policies follow simple rules, and where a subset of agents is liquidity constrained. The welfare benefits of optimizing the fiscal rule are far larger than those of optimizing the monetary rule. The optimized fiscal rule implements strong automatic stabilizers that primarily stabilize the income of liquidity-constrained agents, rather than output. Transfers targeted to liquidity-constrained agents are the preferred fiscal instrument. The optimized monetary rule exhibits super-inertia and a weak inflation response. Optimized simple rules perform as well as the optimal policy under the timeless perspective.     

Fiscal policy institutions and history

This paper shows that historical variables can explain a significant part of discretionary government spending across countries. We argue that these results provide evidence in favor of Besley and Persson’s (2009) hypothesis that institutional quality or state capacity is historically determined and further that institutional quality determines, in part, economic policy.     

Fiscal policy under loose commitment

Due to time-inconsistency or political turnover, policymakers' promises are not always fulfilled. We analyze an optimal fiscal policy problem where the plans made by the benevolent government are periodically revised. In this loose commitment setting, the properties of labor and capital income taxes are significantly different than under the full-commitment and no-commitment assumptions. Because of the occasional reoptimizations, the average capital income tax is positive even in the long-run. Also, the autocorrelation of taxes is lower, their volatility with respect to output increases and the correlation between capital income taxes and output changes sign. Our method can be used to analyze the plausibility and the importance of commitment in a wide-class of dynamic problems.     

Taylor rules in the open economy

Taylor rules, which link short-term interest rates to fluctuations in inflation and output, have been shown to be a good guide (both positively and normatively) to the conduct of monetary policy. As a result they have been used extensively to model policy in the context of both closed and open economy models. Their determinacy properties have also been analysed in the context of closed and, to a more limited degree, in small open economy models. In this paper, we extend the analysis of the determinacy properties of Taylor rules to the case of a benchmark two-country model. When the rules are specified in terms of output-price inflation we confirm and extend the conventional results from the closed economy literature—satisfying the Taylor principle is the key to ensuring determinacy, although the presence of backward-looking price-setting can affect the determinacy properties of the two-country model. However, the conventional results do not hold when we replace output-price inflation with consumer price inflation in the specification of the rule. In this case, Taylor rules which satisfy the Taylor principle will be indeterminate, unless there is an unusually large home bias in consumption. Similar indeterminacy problems arise when one country targets CPI inflation and the other output-price inflation. In this case we show that, even if determinacy is achieved, large spillovers may occur between countries.     

Inflation targeting regimes

This paper divides the monetary frameworks of countries that use an inflation target to define their monetary framework into three different regimes: (i) full-fledged inflation targeting, (ii) implicit price stability anchor, and (iii) inflation targeting lite. The regimes are differentiated by the clarity and credibility of the commitment to the inflation target. The revealed preference for different regimes is related empirically to cross-country structural differences in economic and financial development. Policy implications of moving from one regime to another are drawn, especially for emerging market countries aiming at full-fledged inflation targeting.     

Sustainability, flexibility, and inflation targeting

This paper examines sustainability of an inflation-targeting policy regime in terms of sustainable equilibrium using a canonical model in the recent literature. Overly flexible inflation targeting is not sustainable. Strict inflation targeting is sustainable only when shock persistence is high enough.     

A simple and flexible alternative to Stability and Growth Pact deficit ceilings. Is it at hand?

We model a monetary union where fiscal discretion generates excessive debt accumulation in steady state and inefficiently delayed debt adjustment following shocks. By setting a debt target and raising the political cost of deviating from the optimal pace of debt reversal¸ institutional design induces fiscal policymakers to implement unbiased responses to shocks. This is partly achieved by increasing the transparency of the decision-making process. We therefore call for more focused supervision tasks for the European Commission and for parliamentary discussion whenever a disagreement arises between the Commission and a national government.     

Distortionary fiscal policy and monetary policy goals

We reconsider the role of an inflation conservative central banker in a setting with distortionary taxation. To do so, we assume monetary and fiscal policy are decided by independent authorities that do not abide to past commitments. If the two authorities make policy decisions simultaneously, inflation conservatism causes fiscal overspending. But if fiscal policy is determined before monetary policy, inflation conservatism imposes fiscal discipline. These results clarify that in our setting the value of inflation conservatism depends crucially on the timing of policy decisions.     

The interaction between monetary and fiscal policies in Turkey: An estimated New Keynesian DSGE model

This paper estimates a New Keynesian open economy DSGE model for Turkey by using Bayesian estimation technique for the period of 2002:q1–2009:q3. It studies fiscal and monetary policy interactions and their role in stabilisation of the economy using a small-scale model following the methodology outlined in Lubik and Schorfheide (2007). The general features of the model can be summarised as follows: Calvo style nominal price rigidities, perfect exchange rate pass-through, complete international asset markets, rule of thumb price setters and distortionary taxation.     

Are Central Bank Preferences Asymmetric? A Comment

A recent paper by Ruge-Murcia (2004) on asymmetric central bank objectives provides a new perspective on the policy roots of inflation in developed economies. More precisely, the paper demonstrates that if the distribution of the supply shocks is normal, then the reduced-form solution for inflation implies a positive (or negative) relation between average inflation and the variance of shocks. We argue that the evidence offered in support of this hypothesis suffers from lack of identification because Phillips curve nonlinearity combined with quadratic central bank preferences yield the same reduced-form solution for inflation. If so, estimating reduced form for inflation will not be able to discriminate between these models. Yet they have quite different implications for policy. Other, structural, evidence is needed.     

Endogenous monetary commitment

We develop an asynchronous framework in which each player can optimally select the frequency of his moves based on cost-benefit considerations. To demonstrate how such ability to commit can alleviate coordination problems, we apply the framework to monetary policy.     

Credit spread and monetary policy

We show that the spread-adjusted Taylor rule including a response to the credit spread is a theoretically optimal monetary policy under heterogeneous loan contracts. However, the optimal response to the credit spread is ambiguous, given the financial market structure.     

Fiscal leadership and central bank design

Abstract.  This article investigates the impact, on economic performance, of the timing of moves in a policy game between the government and the central bank for a government that has both redistributional and stabilization objectives. It is shown that both inflation and income inequality are reduced without sacrificing output growth if the government assumes a leadership role compared with a regime in which monetary and fiscal policy are determined simultaneously. Further, it is shown that government leadership benefits both the fiscal and monetary authorities through the enhanced coordination that this arrangement implies.