Optimal fiscal and monetary policy with sticky prices

In this paper I consider the role of state-contingent inflation as a fiscal shock absorber in an economy with nominal rigidities. I study the Ramsey equilibrium in a monetary model with distortionary taxation, nominal non-state-contingent debt, and sticky prices. With sticky prices, the Ramsey planner must balance the shock absorbing benefits of state-contingent inflation against the associated resource misallocation costs. For government spending processes resembling post-war experience, introducing sticky prices generates striking departures in optimal policy from the case with flexible prices. For even small degrees of price rigidity, optimal policy displays very little volatility in inflation. Tax rates display greater volatility compared to the model with flexible prices. With sticky prices, tax rates and real government debt exhibit behavior similar to a random walk. For government spending processes resembling periods of intermittent war and peace, optimal policy displays extreme inflation volatility even when the degree of price rigidity is large. As the variability in government spending increases, smoothing tax distortions across states of nature becomes increasingly important, and the shock absorber role of inflation is accentuated.     

Optimal simple and implementable monetary and fiscal rules

Welfare-maximizing monetary- and fiscal-policy rules are studied in a model with sticky prices, money, and distortionary taxation. The Ramsey-optimal policy is used as a point of comparison. The main findings are: the size of the inflation coefficient in the interest-rate rule plays a minor role for welfare. It matters only insofar as it affects the determinacy of equilibrium. Optimal monetary policy features a muted response to output. Interest-rate rules that feature a positive response to output can lead to significant welfare losses. The welfare gains from interest-rate smoothing are negligible. Optimal fiscal policy is passive. The optimal monetary and fiscal rule combination attains virtually the same level of welfare as the Ramsey-optimal policy.     

Monetary–Fiscal Policy Interactions under Implementable Monetary Policy Rules

This paper examines the implications of forward- and backward-looking monetary policy rules in an environment with monetary–fiscal interactions. We find that the unique stationary rational expectations equilibrium (REE) is always non-Ricardian under simple implementable monetary policy rules.     

Monetary policy for inattentive economies

We offer a contribution to the analysis of optimal monetary policy. We begin with a critical assessment of the existing literature, arguing that most work is based on implausible models of inflation-output dynamics. We then suggest that this problem may be solved with some recent behavioral models, which assume that price setters are slow to incorporate macroeconomic information into the prices they set. A specific such model is developed and used to derive optimal policy. In response to shocks to productivity and aggregate demand, optimal policy is price level targeting. Base drift in the price level, which is implicit in the inflation targeting regimes currently used in many central banks, is not desirable in this model. When shocks to desired markups are added, optimal policy is flexible targeting of the price level. That is, the central bank should allow the price level to deviate from its target for a while in response to these supply shocks, but it should eventually return the price level to its target path. Optimal policy can also be described as an elastic price standard: the central bank allows the price level to deviate from its target when output is expected to deviate from its natural rate.     

Optimal fiscal policy under multiple equilibria

We study optimal fiscal policy in an economy where (i) search frictions create a coordination problem and generate multiple, Pareto-ranked equilibria and (ii) the government finances the provision of a public good by taxing market activity. The government must choose the tax rate before it knows which equilibrium will obtain, and therefore an important part of the problem is determining how the policy will affect the equilibrium selection process. We show that when the equilibrium selection rule is based on the concept of risk dominance, higher tax rates make coordination on the Pareto-superior outcome less likely. As a result, taking equilibrium-selection effects into account leads to a lower optimal tax rate.     

Monetary Policy with Heterogeneous and Misspecified Expectations

In the recent literature on monetary policy and learning, it has been suggested that private sector's expectations should play a role in the policy rule implemented by the central bank, as they could improve the ability of the policymaker to stabilize the economy. Private sector's expectations, in these studies, are often taken to be homogeneous and rational, at least in the limit of a learning process. In this paper, instead, we consider the case in which private agents are heterogeneous in their expectations formation mechanisms and hold heterogeneous expectations in equilibrium. We investigate the impact of this heterogeneity in expectations on central bank's policy implementation and on the ensuing economic outcomes, and the general result that emerges is that the central bank should disregard inaccurate private sector expectations and solely base its policy on the accurate ones.     

Monetary policy implementation and the federal funds rate

This paper investigates how the implementation of monetary policy affects the dynamics and the volatility of the federal funds rate. Since the early 1980s, the most important changes in the Fed’s conduct of monetary policy refer to the role of the federal funds rate target and the reserve requirement system. We show that the improved communication and transparency regarding the federal funds rate target has significantly increased the Fed’s influence on the federal funds rate since 1994. By contrast, the declining role of required reserves in the US has contributed to higher federal funds rate volatility. Our results suggest that the introduction of remunerated required reserves will further enhance the controllability of the federal funds rate.     

Optimal Fiscal Policy Rules in a Monetary Union

This paper investigates the importance of fiscal policy in providing macroeconomic stabilization in a monetary union. We use a microfounded New Keynesian model of a monetary union, which incorporates persistence in inflation and non-Ricardian consumers, and derive optimal simple rules for fiscal authorities. We find that fiscal policy can play an important role in reacting to inflation, output, and the terms of trade, but that not much is lost if national fiscal policy is restricted to react, on the one hand, to national differences in inflation and, on the other hand, to either national differences in output or changes in the terms of trade. However, welfare is reduced if national fiscal policy responds only to output, ignoring inflation.     

Coordination between monetary policy and fiscal policy for an inflation targeting emerging market

Several studies including Blanchard (2004) and Favero and Giavazzi (2004) imply that in emerging market economies, a tight monetary policy within an inflation-targeting framework could actually increase the price level due to the lack of fiscal discipline and the associated high risk premium. We extend their arguments in two ways. First, we introduce a semi structural model with time-varying parameters, where the risk premium is ‘unobserved’ and it is derived within the system. Such an approach fits better with the volatile nature of emerging market economies by allowing us to track down the time-varying effects of macroeconomic dynamics on both the model-consistent risk premium and the other key variables. Second, we obtain impulse response functions and analyze the implications of a tight monetary policy on major macroeconomic variables. Taking the Turkish economy as our reference point, we find that the arguments of Blanchard (2004) and Favero and Giavazzi (2004) seem to be valid.     

The Friedman rule: Old and new

In overlapping generations models, money growth creates intergenerational wealth effects and leads to the breakdown of the Friedman rule; the rule can be restored via lump-sum tax and transfers that neutralize these wealth transfers. Additionally, and in contrast to money-in-the-utility-function models, the Friedman rule is not the unique first-best solution in cash-in-advance-constraint models of money: a continuum of combinations of money growth rates and consumption taxes implement the first-best allocation. This paper traces through the intellectual origins of the first (old) result, which was recently restated in Bhattacharya, et al. [2005. Monetary policy, fiscal policy, and the inflation tax: equivalence results. Macroeconomic Dynamics 7, 647-669.] and formally demonstrates the second (new) result.     

Accrual accounting and Australian fiscal policy

Australian governments have recently moved from cash accounting to accrual accounting. Accrual accounting has been accompanied at the national government level by the introduction of a new key fiscal policy measure: the ‘fiscal balance’. This paper explains and evaluates this new fiscal measure. It concludes that, given the present fiscal policy of the Australian government, fiscal balance is a superior fiscal policy measure to the ‘cash’ budget balance measure which it replaced. However, from the alternative ‘golden rule’ policy standpoint, fiscal balance is not a meaningful fiscal policy measure — although its stock counterpart, net financial liabilities, certainly is.     

Monetary policy transmission in vector autoregressions: A new approach using central bank communication

In this paper, we study the role played by central bank communication in monetary policy transmission. We employ the Swiss Economic Institute’s Monetary Policy Communicator to measure the future stance of the European Central Bank’s monetary policy. Our results indicate, first, that communication has an influence on inflation (expectations) similar to that of actual target rate changes. Communication also plays a noticeable role in the transmission of monetary policy to output. Consequently, future work on monetary policy transmission should incorporate both a short-term interest rate and a communication indicator. A second finding is that the monetary policy transmission mechanism changed during the financial crisis as the overall effect of monetary policy on (expected) inflation and output is weaker and of shorter duration during this period compared to the overall sample period.     

Interest rate deregulation: Monetary policy efficacy and rate rigidity

This paper examines the effects of interest rate regulation, and subsequent deregulation, on the efficacy of monetary policy and rigidity of retail bank deposit rates in Hong Kong. Using an error-correction model, we find that interest rate deregulation increases the efficacy of monetary policy by improving the correlation between retail bank deposit rates and market interest rates and increasing the degree of long-term pass-through for retail bank deposit rates. Our study also shows that the adjustments in retail bank deposit rates are asymmetric and rigid upwards during the regulated period, but tend to be rigid downwards during the deregulated period. The spreads between retail bank deposit rates and market rates have also tightened sharply after the removal of interest rate controls.     

Optimal Structure of Fiscal and Monetary Authorities

Why are monetary authorities not elected like fiscal authorities are? Advanced economies pair an elected fiscal authority with an independent monetary authority. Replicating the advanced economies' structure with authorities microfounded by a political economy model shows that this structure is the solution to a constrained mechanism design problem that overcomes time inconsistency and results in the highest possible welfare. Goal and instrument independence, singly and in combination, are insufficient to minimize time inconsistency, though their combination is necessary.     

Fiscal and Monetary Policy Coordination,Macroeconomic Stability,and Sovereign Risk Premia

In standard macroeconomic models, equilibrium stability and uniqueness require monetary policy to actively target inflation and fiscal policy to ensure long‐run debt sustainability. We show analytically that these requirements change, and depend on the cyclicality of fiscal policy, when government debt is risky. In that case, budget deficits raise interest rates and crowd out consumption. Consequently, countercyclical fiscal policies reduce the parameter space supporting stable and unique equilibria and are feasible only if complemented with more aggressive debt consolidation and/or active monetary policy. Stability is more easily achieved, however, under procyclical fiscal policies.     

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.     

Monetary policy,accounting conservatism and trade credit

Using a sample of A-share listed firms in China during the 2003–2012 period,this paper investigates the effect of accounting conservatism on trade credit,taking...     

Quantitative Goals for Monetary Policy

We study empirically the macroeconomic effects of an explicit de jure quantitative goal for monetary policy. Quantitative goals take three forms: exchange rates, money growth rates, and inflation targets. We analyze the effects on inflation of both having a quantitative target and hitting a declared target. Our empirical work uses an annual data set covering 42 countries between 1960 and 2000, and takes account of other determinants of inflation (such as fiscal policy, the business cycle, and openness to international trade) and the endogeneity of the monetary policy regime. We find that both having and hitting quantitative targets for monetary policy is systematically and robustly associated with lower inflation. The exact form of the monetary target matters somewhat (especially for the sustainability of the monetary regime) but is less important than having some quantitative target. Successfully achieving a quantitative monetary goal is also associated with less volatile output.     

Monetary policy and distribution

A segmented markets model of monetary policy is constructed, in which a novel feature is goods market segmentation, and its relationship to conventional asset market segmentation. The implications of the model for the response of prices, interest rates, consumption, labor supply, and output to monetary policy are determined. As well, optimal monetary policy is studied, as are the costs of inflation. The model features persistent nonneutralities of money, relative price effects of increases in the money supply, persistent liquidity effects, and a negative Fisher effect from a money supply increase. A Friedman rule is in general suboptimal.