Fiscal Policy in a Currency Union at the Zero Lower Bound

This paper constructs a two‐country core–periphery New Keynesian model of a currency union to address the interaction between the objectives of regionally directed fiscal policy constrained by a single currency and the aggregate use of fiscal policy in face of the zero lower bound (ZLB) on policy interest rates. We identify an optimal path of aggregate and relative fiscal policy responses to a negative region‐specific demand shock. Our results show that (i) in a monetary union, the optimal policy response to an asymmetric reduction in demand concentrated in the periphery always entails a relative shift of fiscal expenditure toward the worse‐affected regions, (ii) though no aggregate fiscal response is required outside the ZLB, and (iii) optimal union‐wide fiscal policy is expansionary at the ZLB. Therefore, optimal policy always entails an expansion in the periphery at the ZLB, but the optimal fiscal response in the core regions can be either expansionary or contractionary depending on the parameters of the model. However, (iv) fiscal expansion in the core is warranted if the periphery cannot implement an expansion due to constraints on public spending.     

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.     

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.     

The Interaction of Monetary and Macroprudential Policies

I analyze a New Keynesian dynamic stochastic general equilibrium (DSGE) model where the financing of productive investment is affected by a moral hazard problem. I solve for jointly Ramsey‐optimal monetary and macroprudential policies. I find that when a financial friction is present in addition to the standard nominal friction, the optimal policy can replicate the first‐best allocation if the social planner can conduct both monetary and macroprudential policy. Using monetary policy alone is not enough: a policy trade‐off between stabilizing inflation and output gap emerges. When policy follows simple rules, the source of fluctuations is relevant for the choice of the appropriate policy mix.     

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.     

Price‐Level Targeting and Stabilization Policy

We construct a dynamic stochastic general equilibrium model to study optimal monetary stabilization policy. Prices are fully flexible and money is essential for trade. Our main result is that if the central bank pursues a price‐level target, it can control inflation expectations and improve welfare by stabilizing short‐run shocks to the economy. The optimal policy involves smoothing nominal interest rates that effectively smooths consumption across states.     

In Old Chicago: Simons,Friedman, and the Development of Monetary‐Policy Rules

This paper examines the different policy rules proposed by Henry Simons, who, beginning in the mid‐1930s, advocated a price‐level stabilization rule, and by Milton Friedman, who, beginning in the late‐1950s, advocated a rule that targeted a constant growth rate of the money supply. Although both rules shared the objective of eliminating the policy uncertainty emanating from discretion, they differed because of the different views of Simons and Friedman about the stability of secular relationships. Simons’ rule relates to modern rules that emphasize the pursuit of price stability as representing optimal monetary policy.     

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.     

Consumer Search,Incomplete Exchange Rate Pass‐Through,and Optimal Interest Rate Policy

This paper studies utility‐maximizing monetary policy in a two‐country economy with consumer search frictions. Search frictions provide a microfoundation for incomplete exchange rate pass‐through and international deviations from the law of one price (LOP). I show that optimal interest rate policy targets deviations from the LOP and acts to mitigate the effect of search frictions. In a quantitative setting, with internationally correlated technology and preference shocks, optimal policy generates positive cross‐country correlation of nominal interest rates.     

Central Bank Transparency and the Crowding Out of Private Information in Financial Markets

We use an asset market model based on Diamond (1985) to demonstrate that increased central bank transparency may lead to crowding out of costly private information, which can result in a market that is less able to predict monetary policy. Consequently, for intermediate levels of public information precision, it is optimal for the central bank to actually disclose less than it knows. We show that such crowding out can occur, even in the likely scenario that public information is more precise than private information, under the plausible assumption that traders are nearly risk neutral. Central banks should be aware of possible adverse effects of transparency and take note if market participants reduce investment in information.     

Optimal Monetary and Fiscal Policy with a Zero Bound on Nominal Interest Rates

I characterize optimal monetary and fiscal policy in a stochastic New Keynesian model when nominal interest rates may occasionally hit the zero lower bound. The benevolent policymaker controls the short‐term nominal interest rate and the level of government spending. Under discretionary policy, accounting for fiscal stabilization policy eliminates to a large extent the welfare losses associated with the presence of the zero bound. Under commitment, the gains associated with the use of the fiscal policy tool remain modest, even though fiscal stabilization policy is part of the optimal policy mix.     

Price Stability in Economies with Habit Persistence

This paper shows that the divine‐coincidence does not hold in a sticky price model with external habit if a time‐varying tax rate on labor income is not implemented to fully eliminate the time‐varying distortions associated with external habit and monopoly power in goods market. The required labor income tax rate is inversely related to the risk‐free real interest rate and the markup in the goods market, but it is proportional to the degree of external habit. Under this circumstance, the optimal monetary policy commands a countercyclical interest rate, having a perfect negative correlation with tax rate in the sticky price model with external habit. If a time‐invariant tax is the only fiscal instrument, then the degree of external habit entails a gap between the private marginal rate of substitution between consumption and labor and the social marginal rate of substitution, generating an endogenous trade‐off between the stabilization of welfare‐relevant output gap and inflation. Under this circumstance, price stability is not the optimal policy. The monetary policy authority should optimally try to undo the time‐varying distortions associated with external habit and monopoly power in goods market by deviating from price stability.     

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.     

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.     

Rational Inattention in Uncertain Business Cycles

The paper proposes endogenous information choice as a channel through which uncertainty affects price dynamics. I consider a rational inattention model with volatility uncertainty and endogenous information processing capability. According to the model, firms' learning and optimal attention exhibits inertia and asymmetry in response to volatility changes. Firms choose to process more information when uncertainty rises, especially about aggregate conditions, and their pricing behavior changes accordingly. Using a Markov‐switching factor‐augmented vector autoregression (MS‐FAVAR), the paper also documents a significant positive correlation between volatility and firms' responsiveness to macro‐ and microlevel shocks, consistent with model predictions.     

Fiscal Sustainability in a New Keynesian Model

Recent work on optimal monetary and fiscal policy in New Keynesian models suggests that it is optimal to allow steady‐state debt to follow a random walk. In this paper we consider the nature of the time inconsistency involved in such a policy and its implication for discretionary policymaking. We show that governments are tempted, given inflationary expectations, to utilize their monetary and fiscal instruments in the initial period to change the ultimate debt burden they need to service. We demonstrate that this temptation is only eliminated if following shocks, the new steady‐state debt is equal to the original (efficient) debt level even though there is no explicit debt target in the government's objective function. Analytically and in a series of numerical simulations we show which instrument is used to stabilize the debt depends crucially on the degree of nominal inertia and the size of the debt stock. We also show that the welfare consequences of introducing debt are negligible for precommitment policies, but can be significant for discretionary policy. Finally, we assess the credibility of commitment policy by considering a quasi‐commitment policy, which allows for different probabilities of reneging on past promises.     

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.     

FOMC Forecasts as a Focal Point for Private Expectations

We explore empirically the theoretical prediction that public information acts as a focal point in the context of the U.S. monetary policy. We aim at establishing whether the publication of Federal Open Market Committee (FOMC) inflation forecasts affects the cross‐sectional dispersion of private inflation expectations. Our main finding is that publishing FOMC inflation forecasts has a negative effect on the cross‐sectional dispersion of private current‐year inflation forecasts. This effect is found to be robust to another survey data set and to various macroeconomic controls. Moreover, we find that the dispersion of private inflation forecasts is not affected by the dispersion of views among FOMC members.     

Treasury Bond Volatility and Uncertainty about Monetary Policy

We show that dispersion‐based uncertainty about the future course of monetary policy is the single most important determinant of Treasury bond volatility across all maturities. The link between Treasury bond volatility and uncertainty about macroeconomic variables is much stronger than for the more traditional time series measures of macroeconomic volatility and adds beyond the information contained in lagged bond market volatility. Uncertainty about monetary policy subsumes the uncertainty about future inflation (consumer price index and the deflator) and economic activity (unemployment, real and nominal gross domestic product and industrial production). In addition, causality clearly runs one way: from monetary policy uncertainty to Treasury bond volatility.