Analyzing the Interaction of Monetary and Fiscal Policy: Does Fiscal Policy Play a Valuable Role in Stabilisation?

This paper provides an overview of recent papers which use estimatedNew Keynesian models to study the extent to which fiscal policycan be used to stabilize the economy. We use a variety of differentNew Keynesian models, estimated on data for both the US andfor the Euro area, and highlight the diverse transmission channelsthrough which fiscal policy acts in these models. Although wefind that fiscal policy can provide a useful complement to monetarypolicy, especially in models where consumers have finite horizons,there are important limitations to the value added of fiscalpolicy. (JEL E58, E62, E63)     

A tale of two traditions: Pierre Force's Self-interest before Adam Smith

Abstract

The paper compares different strands of New Keynesian Economics with regard to Keynes' original work. Two issues are analysed in detail. First, the explanations provided by Keynes and New Keynesians of nominal and real wage behaviour. Second, the different theories concerning the ability of flexible nominal wages in assuring full employment. It is argued that, although involuntary unemployment is a central problem both in Keynes' and New Keynesians' views, referring to the role of nominal and real wages in explaining unemployment, New Keynesians theories present important features that differ, sometimes substantially, from the concepts developed by Keynes in his General Theory.     

The Phillips Curve, the IS Curve and Monetary Transmission: Evidence for the US and the Euro Area

In this paper we assess the empirical performance of commonlyused empirical specifications of the baseline New Keynesianmodel for the US and the euro area. We estimate standard specificationsof the model and extended specifications also including non-standarddeterminants of aggregate supply and demand. The results suggestthat based on the standard specifications it is often not possibleto establish a significant link between the monetary policyinstrument and output and inflation. Based on the extended specificationsof the model, which take into account the significant effectof commodity prices on inflation and of house prices on theoutput gap, we are generally able to restore a significant monetarytransmission channel. (JEL E3, E52, C22)     

Fair wages in a New Keynesian model of the business cycle

We build a New Keynesian model of the business cycle with sticky prices and real wage rigidities motivated by efficiency wages of the gift exchange variety. Compared to a standard sticky price model, our Fair Wage model provides an explanation for structural unemployment and generates more plausible labor market dynamics—notably accounting for the low correlation between wages and employment. The fair wage induced real wage rigidity also significantly reduces the elasticity of marginal cost with respect to output. The smoother dynamics of real marginal cost increase both amplification and persistence of output responses to monetary shocks, thus remedying the well-known lack of internal propagation of standard sticky price models. We take these improvements as a strong endorsement of the addition of real wage rigidities to nominal price rigidities and conclude that the fair wage extension of this paper constitutes a promising platform for an enriched New Keynesian synthesis.     

Inflation targets and endogenous wage markups in a New Keynesian model

Empirical contributions show that wage re-negotiations take place while expiring contracts are still in place. This is captured by assuming that nominal wages are pre-determined. As a consequence, wage setters act as Stackelberg leaders, whereas in the typical New Keynesian model the wage-setting rule implies that they play a Nash game. We present a DSGE New Keynesian model with pre-determined wages and money entering the representative household’s utility function and show how these assumptions are sufficient to identify an inverse relationship between the inflation target and the wage markup (and thus employment) both in the short and the long run. This is due to the complementary effects that wage claims and the inflation target have on money holdings. Model estimates suggest that a moderate long-run inflation rate generates non-negligible output gains.     

Labor Market Institutions, Wages, and Investment: Review and Implications

Labor market institutions, via their effect on the wage structure,affect the investment decisions of firms in labor markets withfrictions. This observation helps explain rising wage inequalityin the US, but a relatively stable wage structure in Europein the 1980s. These different trends are the result of differentinvestment decisions by firms for the jobs typically held byless skilled workers. Firms in Europe have more incentives toinvest in less skilled workers, because minimum wages or unioncontracts mandate that relatively high wages have to be paidto these workers. I report some empirical evidence for investmentsin training and physical capital across the Atlantic, whichis roughly in line with this theoretical reasoning. (JEL E22,E24, J23, J24, J31)     

Endogenous employment rate in the efficiency wage shirking approach

The aim of New Keynesian theorists is to obtain Keynesian results on the basis of maximizing behavior. Accordingly, the New Keynesian shirking models depict a world of fully rational maximizing agents where equilibrium unemployment is the main consequence of the payment of efficiency wages. The problem is that oversimplified nature of most shirking models has until now prevented a full investigation of the interdependence of unemployment, the effort supplied by workers and labor demand. This article shows that the existence of this interdependence weakens the whole approach. In particular, when the unemployment rate is considered a truly endogenous variable, the stability of the macroeconomic equilibrium is generally incompatible with the existence of unemployment ascribed to the fact that firms pay efficiency wages.     

The Cambridge School of Keynesian Economics

There have been strong ties between the Cambridge Journal ofEconomics (CJE) and the Cambridge School of Keynesian Economics,from the very beginning. In this paper, the author investigatesthe environment that saw the birth of the CJE at Cambridge (UK),in 1977, and the relationship that linked it to the direct pupilsof Keynes. A critical question is explicitly examined: why didn'tthe ‘Keynesian revolution’ succeed in becoming apermanent winning paradigm? Some behavioural mistakes of themembers of the Keynesian School may explain this lack of success,but only to a certain extent. In any case, there were and therestill are remedies too. But what we are inheriting is a uniqueset of analytical building blocks (the paper lists eight ofthem) that makes this School of economics a viable (and in somedirections definitely superior) alternative to mainstream economics.Admittedly, there is some important work still to be done. Thepaper highlights the need for a two-stage approach, addressingpure theory and extensive institutional analysis. It is arguedthat a combination of the two would strengthen the coherenceof the theoretical foundations, and at the same time would providea fruitful extension of economic analysis to empirical, institutionaland economic dynamics investigations.     

EU Enlargement, Migration and the New Constitution

The paper deals with the effects of migration resulting fromEU Eastern enlargement on the welfare states of Western Europe.Although migration is good in principle, as it yields gainsfrom trade and specialization for all countries involved, itdoes so only if it meets with flexible labour markets and ifit is not artificially induced by gifts of the welfare state.This is not the present state of affairs in Western Europe.In addition to measures that make labour markets more flexible,the introduction of delayed integration of working migrantsand the home country principle for nonworking migrants is arational reaction of the state. The proposed new EU constitution,which contains far-reaching rules for a European social union,should be amended accordingly. (JEL E2, F2, H0, J3, J6)     

Oscillations between repressed inflation and Keynesian equilibria due to inertia in decision making

In the framework of a rationed equilibrium economy as introduced by Malinvaud, the paper studies the long term evolution of the economy around the Repressed inflation—Keynesian boundary, introducing timelags in agents' response to changes in prices and wages. Depending on the distribution of timelags we show that the economy exhibits either decreasing oscillations around the boundary, eventually converging to zero, or (semi-) stable steady oscillations between the two regions. The obtained results therefore clarify the validity of the claim that a basic feature of modern economies is the cycling motion between Repressed inflation and Keynesian equilibria.     

Disinflationary booms?

This paper shows that announced credible disinflations under inflation targeting lead to a boom in a standard New Keynesian model (i.e. a disinflationary boom). This finding is robust with respect to various parameterizations and disinflationary experiments. Thus, it differs from previous findings about disinflationary booms under monetary targeting.     

Optimal monetary policy in a New Keynesian model with endogenous growth

We study optimal monetary policy in a New Keynesian (NK) model with endogenous growth and knowledge spillovers external to each firm. We find that, in contrast with the standard NK model, the Ramsey dynamics implies deviation from full inflation targeting in response to technology and government spending shocks, while the optimal operational rule is backward looking and responds to inflation and output deviations from their long-run levels.     

Disequilibrium dynamics in a simple macroeconomic model

The dynamic behavior of a simple macroeconomic disequilibrium model is analyzed in which consumers' changes in money holdings constitute the dynamic link between any two periods. It is shown that, under constant government consumption, a constant production function (no investment), and fixed prices and wages, stationary states of Keynesian unemployment are stable whereas those of repressed inflation are globally unstable. Possibilities of unemployment and output cycles are indicated for fixed wages as well as for some very simple class of wage and price adjustment mechanisms.     

Radial basis functions neural networks for nonlinear time series analysis and time-varying effects of supply shocks

I propose a flexible Radial Basis Functions (RBFs) Artificial Neural Networks method for studying the time series properties of macroeconomic variables. To assess the validity of the RBF approach, I conduct a Monte Carlo experiment using the data generated from a nonlinear New Keynesian (NK) model. I find that the RBF estimator can uncover the structure of the NK model from the simulated data of 300 observations. Finally, I apply the RBF estimator to the quarterly US data and show that the positive supply shocks have significantly weaker expansionary effects during the periods of passive monetary policy regimes.     

Output gap measurement and the New Keynesian Phillips curve for China

The New Keynesian Phillips curve implies that the output gap, the deviation of the actual output from its natural level due to nominal rigidities, drives the dynamics of inflation relative to expected inflation and lagged inflation. This paper exploits the empirical success of the New Keynesian Phillips curve in explaining China's inflation dynamics with a new measure of the output gap. We estimate the output gap using the Bayesian multivariate Beveridge–Nelson decomposition method, based on a multivariate dynamic model featuring distinct interactions among inflation, money, and real output in China. The empirical results using quarterly data spanning 1979–2010 show that the new measure of the output gap outperforms the traditional measures in fitting the New Keynesian Phillips curve. This result provides useful insights for inflation dynamics and monetary policy analysis in China.     

Effects of government spending shocks in China,Japan, and Korea

ABSTRACT

This study investigates the effects of government spending shocks on various key macro variables in China, Korea, and Japan using structural VAR models. The main empirical findings are as follows. Government spending multipliers of all three countries are far larger than 1 in recent years. The effectiveness of fiscal expansion has not changed markedly in China but substantially increased in Korea (after the Asian financial crisis) and Japan (during zero lower bound period). Increases in the effectiveness of fiscal expansion are associated with changes in the monetary and exchange rate policy regimes and institutions of these countries. Among the three countries, the government spending multiplier is relatively large in China but relatively small in Japan in recent years. Although the effects on exchange rate and trade balance vary across countries and sample periods, real exchange rate tends to depreciate, whereas trade balance tends to improve under flexible exchange rate regimes. Some empirical findings are consistent with standard theory, but others are not.

Abbreviations: NK: New Keynesian VAR: Vector Autoregressive ZLB: Zero Lower Bound     

Keynesian models of deflation and depression revisited

This paper extends Tobin's [Tobin, J., 1975. Keynesian models of recession and depression. American Economic Review 65, 195–202] Keynesian analysis of deflation to include a range of additional channels through which deflation exacerbates Keynesian unemployment. The paper provides further theoretical reasons why downward price level adjustment may not solve the Keynesian problem. These arguments challenge the received wisdom that Keynes’ General Theory is a special case resting on downwardly rigid prices and nominal wages. This conventional wisdom has led many economists to recommend policies promoting downward flexibility. These policies have created an environment in which deflation is more likely, giving new relevance to Keynesian analysis of deflation.     

TARGETS IN THE TAYLOR RULE: INFLATION,SPEED LIMIT,OR PRICE LEVEL?

This paper explores the link between alternative targets in the Taylor rule and their empirical fit using real‐time U.S. macroeconomic data. We first study the stabilizing properties of the classical Taylor rule (inflation targeting, IT) and add either a price‐level target (PLT) or output gap quasigrowth target (speed‐limit targeting, SLT) in the context of the standard New Keynesian model. We demonstrate that, although only SLT has the same functional form as the optimal interest‐rate reaction function, both PLT and SLT stabilize the model macroeconomy against a cost‐push shock for a wide range of parameter values better than IT. We then estimate all three specifications using the Greenbook data. We find much stronger support for SLT than PLT and discuss pitfalls in estimating the latter that are present in existing literature. (JEL E52, E58)     

OUTPUT AND INFLATION IN MODELS OF THE BUSINESS CYCLE WITH NOMINAL RIGIDITIES: FURTHER COUNTERFACTUAL IMPLICATIONS

This paper examines the relationship between cyclical output and inflation in models commonly used for monetary policy analysis. This includes models that incorporate the New Keynesian, Fuhrer–Moore and backward‐looking Phillips curves. The main finding is that these models imply a strong negative relationship between inflation and output, a result that is at odds with the data. The fact that New Keynesian models yield counterfactual implications is not new; the novelty of the paper lies in the fact that the finding extends to the other variants, such as the backward‐looking Phillips Curve, which have been put forward as displaying superior dynamics.     

STATIC AND DYNAMIC EFFECTS OF CENTRAL BANK TRANSPARENCY

Using a New Keynesian framework, this paper shows that, under optimal discretion and optimal pre‐commitment in a timeless perspective, imperfect transparency about the relative weight assigned by the central bank to output‐gap stabilization generally reduces the average reaction of inflation to inflation shocks and the volatility of inflation, but increases those of the output gap in static and dynamic terms, and more so when inflation shocks are highly persistent. When inflation shocks are moderately persistent, opacity could improve social welfare if the weight assigned to output‐gap stabilization is low and this is more likely under pre‐commitment than under discretion.