Money, Neutrality of Consumption Taxes, and Growth in Intertemporal Optimizing Models

This paper considers the effects of a proportional consumption tax with the same rate over time on the real growth path of a monetary economy. The analysis uses a variety of stylized monetary growth models in which the individual's consumption-saving decision is based on intertemporal utility maximization (e.g. the money-in-utility, transaction-costs, and cash-in-advance models). The neutrality of consumption taxation depends on the assumed role of money in the respective models, even though the tax revenue collected is fully rebated to consumers as lump-sum transfers. The consumption tax is generally superior to inflation tax (i.e. the rate of monetary growth) in terms of steady-state welfare, as long as the labour supply is fixed.
JEL Classification Numbers: E21, E41, E62, H24     

Inflationary finance, capital mobility, and monetary coordination

This paper compares the inflation rate before and after monetary coordination between two benevolent governments. Many authors have previously argued that monetary coordination will reduce inflation [e.g., Aizenman, 1992; Beetsma & Bovenberg, 1998; Jensen, 1997; Kimbrough, 1993; Sibert, 1992; Tori, 1997]. Unlike these studies, the present paper introduces a mobile factor, which is capital. While capital may move freely between countries, it is subject to the inflation tax of the country in which it is located. This is because of a cash-in-advance type constraint governing investment expenditures. Since capital is perfectly mobile, inflation tax competition between governments leads to suboptimally low inflation. When countries coordinate their monetary policies, they can raise the inflation tax simultaneously without fear of capital flight. Hence, inflation tends to increase rather than decrease after monetary coordination.     

Capital Trading,Stock Trading,and the Inflation Tax on Equity

A market for used capital goods, or financial instruments that represent the ownership of the used capital goods, induces inflation taxes on wealth and on the nominal income flows that they provide. This paper explicitly introduces trading in either used capital goods or financial instruments into the standard stochastic growth model with money and production. These two monetary economies are equivalent. The value of the firm is equal to the firm's capital stock divided by inflation. The resulting asset-pricing conditions indicate that the effect of inflation on asset returns differs from the effects found in the literature by the addition of a significant wealth tax. Journal of Economic Literature Classification Numbers: E0, E4, E5.     

Should a central bank react to food inflation? Evidence from an estimated model for Chile

We examine whether food price shocks are a major source of macroeconomic fluctuations. We estimate a small open economy DSGE model using an alternative Taylor rule applied to Chilean data. The empirical evidence suggests that food inflation played a non-trivial role in shaping Chile's de facto monetary policy actions. Consistent with its commitment to price stability, the central bank increases the policy rate in reaction to food inflation. Despite an immediate monetary policy reaction to a food price shock, the policy rate gradually tapers off. This is due to a second-round effect on non-food inflation propagated by the food price shock. A main finding is that monetary policy that targets headline inflation is welfare improving.     

Monetary policy,endogenous transactions,and financial market segmentation

An endogenous financial market segmentation model is constructed to explore the role of costly credit as a medium of exchange in the monetary policy elasticity of financial market activity. Against inflation risk, credit is an alternative insurance device to a cash transfer from the financial market. In equilibrium, credit reduces the financial market activity rate. Monetary policy has redistributive effects across economic individuals. Inflation may not tax financial market non-participants. However, it may tax financial market participants by increasing the financial market activity rate. Welfare may increase and the optimal money growth rate can be positive.     

Monetary policy and fiscal limits with no-default

This paper discusses monetary and fiscal policy interactions that stabilize government debt. Two distortions prevail in the model economy: income taxes and liquidity constraints. Possible obstructions to fiscal policy include a ceiling on the equilibrium debt-to-GDP ratio, zero or negative elasticity of tax revenues, and a political intolerance of raising tax rates. At the fiscal limit two mechanisms restore solvency: fiscal inflation, which reduces the real value of nominal debt, and open market operations, which diminish the size of government debt held by the private sector. Three regimes achieve this goal. In all regimes monetary policy is passive. In all regimes a muted tax response to government debt is consistent with equilibrium. The propensity of a fiscal authority to smooth output is found to determine what is an acceptable response (in the form of tax rate changes) to the level of government debt, while monetary policy determines the timing and magnitude of fiscal inflation. Impulse responses show that the inflation and tax hikes needed to offset a permanent shock to transfers are lowest under nominal interest rate pegs. In this regime, most of the reduction in the real value of government debt comes from open market purchases.     

Inflation Targeting: Some Extensions

Previous analyses of the implementation of inflation targeting are extended to monetary policy responses to different shocks, consequences of model uncertainty, and effects of interest rate smoothing and stabilization. Model uncertainty, output stabilization, and interest rate stabilization or smoothing all call for a more gradual adjustment of the conditional inflation forecast toward the inflation target. The conditional inflation forecast is the natural intermediate target during inflation targeting. The optimal way of reacting to shocks is hence to check how they affect the inflation forecast and then take the appropriate action.
JEL classification : E 42; E 52; E 58     

Evaluating inflation targeting as a monetary policy objective for India

This study formulates a small open economy model for India with exchange rate as a prominent channel of monetary policy. The model is estimated using the Instrumental Variable-Generalized Methods of Moments (IV-GMM) estimator and evaluated through simulations. This study compares different cases of domestic and CPI inflation targeting, strict and flexible inflation targeting, and simple Taylor type rules. The analysis highlights the unsuitability of simple Taylor-type monetary rules in stabilizing the Indian economy and suggests that discretionary optimization works better in stabilizing this economy. There seems to be a trade-off between output gap stabilization and exchange rate stabilization in flexible domestic inflation targeting and CPI inflation targeting respectively. However, flexible domestic inflation targeting seems a better alternative from an overall macro stabilization perspective in India where financial markets are still not sufficiently integrated to ensure quick transmission of interest rate impulses and existence of rigidities in the economy.     

The unbearable tightness of being in a monetary union: Fiscal restrictions and regional stability

We study how constrained fiscal policy can affect macroeconomic stability and welfare in a two-region model of a monetary union with sticky prices and distortionary taxation. Both government spending and taxes can be used to stabilize regional variables; however, the best welfare outcome is obtained under some tax variability and constant regional inflations. We use a variety of rules to characterize constrained fiscal policy and find that strict fiscal rules coupled with a monetary policy that targets union-wide inflation result in regional inflation stability and the welfare costs of such rules are not as unbearable as one would expect. Fiscal authorities can enhance welfare by targeting the regional output gap, while targeting regional inflation is less successful since inflation stability is guaranteed by the central bank.     

Fiscal and Monetary Policies in a Transactions‐Based Endogenous Growth Model with Imperfect Competition

This paper's model is capable of explaining the empirical evidence on the mixed growth‐rate effects of fiscal and monetary policies and a nonlinear inflation–growth relation. When monopoly power in the product market is strong/weak, an increase in the money growth rate or the income tax rate promotes/reduces the output growth rate through lowering/raising the equilibrium gross markup and increasing/reducing the net rate of return on capital. The fact that money can generate a positive growth rate effect allows for the appearance of a nonlinear inflation–growth relation. Such a nonlinear relation cannot be caused by changes in the income tax rate.     

Index-linked bonds from an academic,market and policy-making standpoint

The view put forward in this paper is that the index-linking of long-term public debt today represents a financial instrument thatfostersa low average rate of inflation. In particular, bonds that are fully linked to the prices of a representative basket of goods and services permit a reduction in the inflation risk premium, which weighs significantly on the nominal cost of the public debt and,ex post, gives rise to substantial real costs that distort the mechanisms of allocation and distribution and, ultimately, could lead to the debt becoming unsustainable. After re-examining the reasons for the “orthodox ” aversion to index-linking —notably on the part of the monetary authorities of the more stable countries and especially the Bundesbank —the case is put for the leading industrial countries, and notably Italy, to issue index-linked government bonds. By issuing such bonds, the Treasuries of the various countries would send a strong stabilizing signal to the markets because recourse to the inflation tax in the future would no longer be advantageous, reduce the real cost of government borrowing by eliminating the inflation risk premium that currently has to be paid on issues with fixed nominal interest rates, benefit from the positive correlation between the quality of revenue and expenditure, and obtain valuable information on forward inflation rates and the real interest rates implicit in the prices of the bonds. The long-term real interest rate offered by index-linked bonds would act as a sort of “lighthouse ” set up by the monetary authorities to illuminate the path of economic growth and enable operators and markets to co-ordinate their actions more effectively.     

On the Use of the Inflation Tax When Nondistortionary Taxes Are Available

Using a pure-exchange overlapping generations model in which money is valued because of a legal restriction, we show the following: (a) a benevolent government may make some use of the inflation tax in conjunction with a lump-sum tax on the young but not if lump-sum taxes on the old are available, and (b) the welfare-maximizing monetary policy may deviate from the Friedman rule (contract the money supply so as to equate the real return on money and other competing stores of value) in either case. Journal of Economic Literature Classification Numbers: E58, E63, H21.     

Monetary policy channels in Brazil through the lens of a semi-structural model

We develop and estimate a medium-sized, semi-structural model for the Brazilian economy during the inflation targeting period. The model describes fairly well key features of the economy and allows us to decompose the transmission mechanism of monetary policy. In the baseline decomposition, the transmission mechanism is broken down into household interest rate, firm interest rate, and exchange rate channels. In addition, we carry out an alternative decomposition that allows us to evaluate the expectations channel as well. In both procedures, the household interest rate channel is the most important for explaining the response of output to a monetary policy shock. In the baseline decomposition of inflation, both the household interest rate and the exchange rate channels are the main transmission channels. However, in the alternative decomposition, the expectations channel accounts for the bulk of the inflation response.     

Optimal fiscal and monetary policy with sticky wages and sticky prices

We determine the optimal degree of price inflation volatility when nominal wages are sticky and the government uses state-contingent inflation to finance government spending. We address this question in a well-understood Ramsey model of fiscal and monetary policy, in which the benevolent planner has access to labor income taxes, nominally risk-free debt, and money creation. Our main result is that sticky wages alone make price stability optimal in the face of shocks to the government budget, to a degree quantitatively similar as sticky prices alone. Key for our results is an equilibrium restriction between nominal price inflation and nominal wage inflation that holds trivially in a Ramsey model featuring only sticky prices. Our results thus show that when nominal wages are sticky, setting real wages as close as possible to their efficient path is a more important goal of optimal monetary policy than is financing innovations in the government budget via state-contingent inflation. A second important result is that the nominal interest rate can be used to indirectly tax the rents of monopolistic labor suppliers. Taken together, our results uncover features of Ramsey fiscal and monetary policy in the presence of a type of labor market imperfection that is widely-believed to be important.     

Monetary policy arithmetic: reconciling theory with evidence

Abstract.  Empirical evidence indicates that, in countries with low inflation rates, a permanent decrease in inflation rate either has no impact on capital stock and output (superneutrality) or causes them to fall moderately. Existing budget arithmetic models of monetary policy cannot deliver superneutrality. In this paper, we conduct a budget arithmetic analysis of monetary policy using a money demand specification – money in the utility function – that is new to this literature. We find that one simple assumption about utility from money delivers superneutrality, while a more general assumption delivers departures from superneutrality in the direction consistent with the evidence. JEL classification: E60, E13     

The impact of fiscal-monetary policy interactions on government size and macroeconomic performance

This paper analyzes the relationship between inflation, output and government size by reexamining the time inconsistency of optimal monetary and fiscal policies in a general equilibrium model with staggered timing structure for the acquisition of nominal money à la Neiss (Neiss, Katharine S. (1999), Discretionary Inflation in a General Equilibrium Model, Journal of Money, Credit and Banking, 31(3), pp. 357–374.), and public expenditure financed by means of a distortive tax. It is shown that, with predetermined wages, the equilibrium rate of inflation is above the Friedman rule and the equilibrium tax rate is below the efficient level. In particular, the discretionary rate of inflation is nonmonotonically related to the natural output, positively related to government size, and negatively related to the degree of central bank conservatism. Finally, a regime with commitment leads to welfare improvements over a regime with discretion.     

Fiscal expansion, monetary policy, interest rate risk premia, and wage reactions

We examine the macroeconomic implications of fiscal policy in a small open economy, with emphasis on the interactions between fiscal, monetary and labour market policies. The paper uses the NBNZ-DEMONZ macroeconometric model. Novel features of the model are that it includes an endogenous interest rate risk premium (IRRP), and forward-looking monetary and fiscal policy reaction functions which capture the essence of New Zealand's Reserve Bank and Fiscal Responsibility Acts. The most important empirical result is that the postulated IRRP, proxying financial market mechanisms, can contribute at least as much as the monetary policy reaction function to maintaining price stability. Also of significance are that an income tax cuts package shows more damped real GDP and underlying inflation paths than does an expenditure increases equivalent; and that the inflationary and real sector impacts of a personal income tax cut package depend heavily on how the cut is `shared' between firms and workers. The nature and interdependence of monetary and fiscal policies and labour market conditions are therefore crucial to the macroeconomic outcomes.     

CURRENCY AREAS AND MONETARY COORDINATION*

We integrate a monetary search model into open‐economy macro to analyze the gains from coordinating on inflation. Search frictions and local congestion lead to a determinate exchange rate between two currencies. Relative prices deviate from the law of one price. Because the deviations depend on the cross‐country differential in money growth, each country is tempted to inflate to exploit the deviations. Policy coordination reduces inflation and improves welfare for all countries. In contrast to traditional models, the gains from coordination continue to exist even after each country optimally sets a direct tax on the foreign use of the country's currency.     

The Perils of Taylor Rules

Since John Taylor's (1993, Carnegie–Rochester Conf. Ser. Publ Policy39, 195–214), seminal paper, a large literature has argued that active interest rate feedback rules, that is, rules that respond to increases in inflation with a more than one-for-one increase in the nominal interest rate, are stabilizing. In this paper, we argue that once the zero bound on nominal interest rates is taken into account, active interest rate feedback rules can easily lead to unexpected consequences. Specifically, we show that even if the steady state at which monetary policy is active is locally the unique equilibrium, typically there exist an infinite number of equilibrium trajectories originating arbitrarily close to that steady state that converge to a liquidity trap, that is, a steady state in which the nominal interest rate is near zero and inflation is possibly negative. Journal of Economic Literature Classification Numbers: E52, E31, E63.