Incomplete Markets, Allocative Efficiency, and the Information Revealed by Prices

We compare rational expectations equilibria with different degrees of information revelation through prices. These equilibria arise in a two-period exchange economy with finitely many states and signals, multiple commodities and incomplete financial markets for nominal assets. We show that there are always equilibria where information is redundant in the sense of being of no value to the uninformed traders. We give conditions under which for a generic set of economies, parametrized by endowments and utilities, there exist open sets of equilibria for which allocative and informational efficiency are independent, with implications for monetary policy. Journal of Economic Literature Classification Numbers: D52, D60, D82, E52.     

Expectations and optimal monetary policy: A stability problem revisited

A landmark result in the optimal monetary policy design literature is that fundamental-based interest rate rules invariably lead to rational expectations equilibria (REE) that are not stable under adaptive learning. In this paper, we make a novel information assumption that private agents cannot observe aggregate fundamental shocks, and use simple linear forecasting rules for learning. We find that with fundamental-based rules, there exist limited information equilibria that are stable under learning. Moreover, there are multiple equilibria. Learning can be used as a selection tool to identify a unique equilibrium.     

Term structure and forward guidance as instruments of monetary policy

This paper studies a simple monetary model with a Ricardian fiscal policy in which equilibria are indeterminate if monetary policy consists solely of a rule for fixing the short-term interest rate. We introduce explicitly into the model the agents’ expectations of inflation which create the indeterminacy and show that there are two types of policies—a term structure rule or a forward guidance rule for the short rate—which lead to determinacy. The first consists in fixing the interest rates on a family of bonds of different maturities as function of realized inflation; the second consists in fixing the short-term interest rate and the expected values of the short-term interest rate for a sequence of periods into the future as a function of realized inflation. If the monetary authority chooses an inflation process that satisfies conditions derived in the paper and applies one of these rules, it anchors agents’ expectations to this process, in the sense that it is the unique inflation process compatible with equilibrium when the interest rates or expected future values of the short rate are those specified by the term structure or forward guidance rule.     

Regional debt in monetary unions: Is it inflationary?

This paper studies the inflationary implications of interest bearing regional debt in a monetary union. Is this debt simply backed by future taxation with no inflationary consequences? Or will the circulation of region debt induce monetization by a central bank?We argue here that both outcomes can arise in equilibrium. In the model economy, there are multiple equilibria which reflect the perceptions of agents regarding the manner in which the debt obligations will be met. In one equilibrium, termed Ricardian, the future obligations are met with taxation by a regional government while in the other, termed Monetization, the central bank is induced to print money to finance the region's obligations. The multiplicity of equilibria reflects a commitment problem of the central bank. A key indicator of the selected equilibrium is the distribution of regional debt holdings. We show that regional governments, anticipating central bank financing of their debt obligations, have an incentive to create excessively large deficits. We use the model to assess the impact of some policy measures within a monetary union as well as dollarization.     

Monetary Neutrality and Optimality with Symmetric Partial Information

The neutrality and optimality of countercyclical monetary policy are examined in a representative economy featuring competitive equilibria in multiple markets and rational expectations based on a form of private information about current stochastic innovations in the economy. A necessary and sufficient condition for the neutrality of monetary policy is stated in terms of restrictions on the parameters of the linear rule describing prospective monetary feedback. Optimal monetary policy is fully characterized in terms of an alternative set of parameter restrictions. Optimal monetary feedback completely stabilizes deviations in commodity output by eliminating the influence of those current innovations about which agents cannot directly observe from the rational expectations of agents. [311]     

Learning and Equilibrium Selection in a Monetary Overlapping Generations Model with Sticky Prices

We study adaptive learning in a monetary overlapping generations model with sticky prices and monopolistic competition for the case where learning agents observe current endogenous variables. Observability of current variables is essential for informational consistency of the learning setup with the model setup but generates multiple temporary equilibria when prices are flexible and prevents a straightforward construction of the learning dynamics. Sticky prices overcome this problem by avoiding simultaneity between prices and price expectations. Adaptive learning then robustly selects the determinate (monetary) steady state independent from the degree of imperfect competition. The indeterminate (non-monetary) steady state and non-stationary equilibria are never stable. Stability in a deterministic version of the model may differ because perfect foresight equilibria can be the limit of restricted perceptions equilibria of the stochastic economy with vanishing noise and thereby inherit different stability properties. This discontinuity at the zero variance of shocks suggests one should analyse learning in stochastic models.     

Quantification and characteristics of household inflation expectations in Switzerland

Inflation expectations are a key variable in conducting monetary policy. However, these expectations are generally unobservable and only certain proxy variables exist, such as surveys on inflation expectations. This article offers guidance on the appropriate quantification of household inflation expectations in the Swiss Consumer Survey, where answers are qualitative in nature. We apply and evaluate different variants of the probability approach and the regression approach; we demonstrate that models that include answers on perceived inflation and allow for time-varying response thresholds yield the best results; and we show why the originally proposed approach of Fluri and Spörndli (1987) has resulted in heavily biased inflation expectations since the mid-1990s. Furthermore, we discuss some of the key features of Swiss household inflation expectations, i.e. the fact that there has been a shift in expectation formation since 2000 (expectations are better anchored and less adaptive, and there is lower disagreement of expectations). We suggest that this may be linked to the Swiss National Bank’s adjustment of its monetary policy framework around this time. In addition, we outline how expectation formation in Switzerland is in line with the sticky information model, where information disseminates slowly from professional forecasters to households.     

Understanding Markov-switching rational expectations models

We develop a set of necessary and sufficient conditions for equilibria to be determinate in a class of forward-looking Markov-switching rational expectations models and we develop an algorithm to check these conditions in practice. We use three examples, based on the new-Keynesian model of monetary policy, to illustrate our technique. Our work connects applied econometric models of Markov-switching with forward looking rational expectations models and allows an applied researcher to construct the likelihood function for models in this class over a parameter space that includes a determinate region and an indeterminate region.     

Monetary Policy,Expectations and Commitment*

Commitment in monetary policy leads to equilibria that are superior to those from optimal discretionary policies. A number of interest‐rate reaction functions and instrument rules have been proposed to implement or approximate commitment policy. We assess these rules in terms of whether they lead to a rational expectations equilibrium that is both locally determinate and stable under adaptive learning by private agents. A reaction function that appropriately depends explicitly on private sector expectations performs particularly well on both counts.     

Estimating the effects of forward guidance in rational expectations models

Simulations of forward guidance in rational expectations models should be assessed using the “modest policy interventions” framework introduced by Eric Leeper and Tao Zha. That is, the estimated effects of a policy intervention should be considered reliable only if that intervention is unlikely to trigger a revision in private sector beliefs about the way that monetary policy will be conducted. I show how to constrain simulations of forward guidance to ensure that they are regarded as modest policy interventions and illustrate the technique using a medium-scale DSGE model estimated on US data. I find that many experiments that generate the large responses of macroeconomic variables deemed implausible by many economists – the so-called “forward guidance puzzle” – are not modest policy interventions. Those experiments should therefore be treated with caution, since they may prompt agents to believe that there has been a change in the monetary policy regime that is not accounted for within the model. More reliable results can be obtained by constraining the experiment to be a modest policy intervention. In the cases I study, the quantitative effects on macroeconomic variables are more plausible when this constraint is imposed.     

Price stabilizing, Pareto improving policies

One possible justification for a stabilization policy is that there is volatility in macro variables that individual agents cannot insure against. We study the simplest possible extension of the stochastic two-period, one agent and one commodity OLG model, where we have added one more period, with only one potential activity, namely, trading of contingent commodities. We assume, however, that markets are incomplete. In this case the Monetary equilibrium is not Pareto Optimal and for an open set of economies an allocation where fluctuations in realized savings are removed, Pareto dominates the monetary equilibrium. This allocation may be implemented by means of a monetary/fiscal policy. The policy considered has a simple rationale, namely that it removes some of the uncertainty that agents face by reducing price, i.e interest rate volatility. We consider two fundamental sources of such volatility, namely, respectively an objective and a subjective signal about the distribution of future endowments. The first case is when agents have rational expectations while the second case is studied in the context of agents having rational beliefs, beliefs which are consistent with empirical observations but not (necessarily) correct.     

General equilibrium and the new neoclassical synthesis

We present a general equilibrium model of the new neoclassical synthesis that has the same level of generality as the Arrow–Debreu model. This involves a stochastic multi-period economy with a monetary sector and sticky commodity prices. We formulate the notion of a sticky price equilibrium where all agents form rational expectations on prices for commodities and assets, interest rates, and rationing. We present a general result showing that monetary policy imposes no restrictions whatsoever on nominal equilibrium price levels and that the set of sticky price equilibria has a dimension equal to the number of terminal date-events. Stickiness of prices implies that this indeterminacy is real.     

Money,activity and prices: Some inter-country evidence

The paper explores the relationships between monetary variables and real economic activity and prices in the six largest industrialized economies. Univariate and multivariate time series forecasting models are used to break down monetary policy variables into anticipated and unanticipated components. Overall monetary policy variables, particularly domestic credit expansion, appear to be significant leading indicators for subsequent real economic activity and prices. Additionally, anticipated components of monetary policy are shown to have as much forecasting ability for subsequently realized economic variables as unanticipated components. This does not appear to be consistent with the implications of pure rational expectations models. It was also noted that results differed significantly according to the choice of monetary variable and across individual countries. In particular the results implied no contradiction with previous findings for the impact of unanticipated money supply in the U.S., though such contradictions would have appeared if DCE had been used as the monetary variable.     

Endogenous contract structure and monetary policy

We analyze the co-determination of monetary policy and the labor contracts chosen by members of the public, who can either fix or index their nominal wages. Fixed nominal wages allow the central bank to offset productivity shocks, while the public fix nominal wages in response to the central bank offsetting shocks; so there is an equilibrium in which, realistically, nominal wages are fixed and shocks offset: a result which holds in single- as well as in multi-period games. In addition, there may be equilibria in which agents index their nominal wages, and the central bank optimally responds by stabilizing price. In contrast to conventional models, the Ramsey rule may be implemented in a finitely repeated game. The central bank does not deviate for fear that agents would change their labor contracts such that the central bank's least favored equilibrium will subsequently be played.     

Money-Hoarding as a Behaviour Towards Uninsured Idiosyncratic Risk

This paper explores the implications of the presence of uninsured idiosyncratic risks for the hoarding of intrinsically useless fiat money in an overlapping-generations model. It is shown that: (a) monetary equilibria exist in almost all cases; (b) the valuation of money is not necessarily Pareto-improving since the non-monetary steady state may Pareto-dominate the monetary one; and (c) the accelerating inflation may, moreover, reduce the long-run capital stock.
JEL Classification Number: E41.     

Walras' Law and Keynesian Macroeconomics

This paper examines the claim that Keynesian models violate Walras' law. Walras' law is founded in the logic of exchange. Standard statements misrepresent it, as it pertains to a monetary economy. Keynesian models are consistent with Walras' law once this misrepresentation is corrected. The law holds for both notional and effective demands. It also holds in unconstrained Walrasian equilibria, constrained Walrasian equilibria, and constrained non-Walrasian equilibria. The latter corresponds to a Keynesian conception of equilibrium: markets need not clear, but agents expectations must be fulfilled.     

Robust control and central banking behaviour

This paper seeks to explain the recent behaviour of the two main central banks in the recent financial crisis, applying a robust control tool through a Neo-Keynesian monetary policy model. The direct forbearer of this paper is the Giordani and Söderlind (2004) study. It begins with the origin, purpose and theoretical grounds of robust control, indicating that it is one way to face model uncertainty, as an alternative to the Bayesian approach. In the middle section, we seek to obtain the course of the model's main variables: interest rates, inflation and output. The model constructor also wants the participating agents to have the same doubts that he has regarding its validity; therefore, robust control is considered as a “fine-tuning” of the rational expectations approach. The impulse-response functions are obtained, with the monetary authority acting as a Stackelberg-type leader, affected by a perturbation on the supply side. The two relevant equilibria are obtained and compared in robust control with dynamic economy (the reference equilibrium and the worst possible case equilibrium) with that obtained when operating with rational expectations. The alternative course for the reference model set forth in the paper by Dennis (2008) is also analysed. We mainly find that the different results depend on the behaviour of the law of motion of the state variables, specifically the shadow prices that influence the private sector's expectations. Lastly, the paper relates the recent monetary policy performance when facing the financial crisis that began in the summer of 2007.     

General equilibrium with nonconvexities and money

In a general-equilibrium economy with nonconvexities, there are sunspot equilibria with good welfare properties; sunspots can ameliorate the effects of the nonconvexities. For these economies, we show that agents act as if they have quasi-linear utility functions. We use this result to construct a new model of monetary exchange along the lines of Lagos and Wright, where trade occurs in both centralized and decentralized markets, but instead of quasi-linear preferences we assume general preferences but with indivisible labor. This suggests that modern monetary theory is more robust than one might have thought. It also constitutes progress on the classic problem of integrating monetary economics and general-equilibrium theory.     

Learning to choose a commodity-money: Carl Menger's theory of imitation and the search monetary framework

This paper studies Carl Menger's theory of the emergence of a commodity money. We propose an interpretation of Menger's learning by imitation process based on the search theoretical formal framework. We show that there exists a tension between the importance of intrinsic properties of commodities and the pure conventional self-fulfilling expectations of agents. This confirms the role of imitation in the emergence of monetary equilibria in search theory. We conclude that Menger's approach may support the idea that the fundamental property of a commodity-money (namely its great liquidity) is the result of its emergence process and not necessarily of its original intrinsic properties.     

Endogenous public policy and multiple equilibria

One of the well known roles of public policy in models with indeterminacy is to reduce the set of equilibria. However, agents' expectations regarding future policy may be self fulfilling when public policy is endogenized. We show that a simple overlapping generations economy with public education may yield multiple equilibria. Under a laissez-faire system, our model has a unique equilibrium. Thus, the presence of public policy may generate, rather than eliminate, multiple equilibria.