How much inflation is necessary to grease the wheels?

Tobin's proposition that inflation “greases” the wheels of the labor market is studied using a simple dynamic stochastic general equilibrium model with asymmetric wage adjustment costs. The simulated method of moments is used to estimate the nonlinear model based on its second-order approximation. Optimal inflation is determined by a benevolent government that maximizes the households’ welfare. Econometric results indicate that nominal wages are downwardly rigid and that the optimal level of grease inflation for the U.S. economy is about 0.35% per year, with a 95% confidence interval ranging from 0.04% to 0.87%.     

Labor Selection,Turnover Costs,and Optimal Monetary Policy

We study optimal monetary policy and welfare properties of a dynamic stochastic general equilibrium (DSGE) model with a labor selection process, labor turnover costs, and Nash bargained wages. We show that our model implies inefficiencies that cannot be offset in a standard wage bargaining regime. We also show that the inefficiencies rise with the magnitude of firing costs. As a result, in the optimal Ramsey plan, the optimal inflation volatility deviates from zero and is an increasing function of firing costs.     

Optimal inflation persistence: Ramsey taxation with capital and habits

Ramsey models of fiscal and monetary policy featuring time-separable preferences and a fixed supply of capital predict highly volatile inflation with no serial correlation. In this paper, we show that an otherwise-standard Ramsey model that incorporates capital accumulation and habit persistence predicts highly persistent inflation. The result depends on increases in either the ability to smooth consumption or the preference for doing so. The effect operates through the Fisher relationship: a smoother profile of consumption implies a more persistent real interest rate, which in turn implies persistent optimal inflation. Our work complements a recent strand of the Ramsey literature based on models with nominal rigidities. In these latter models, inflation volatility is lower than in the baseline model but continues to exhibit little persistence. We quantify the effects of habit and capital on inflation persistence and also relate our findings to recent work on optimal fiscal policy with incomplete markets.     

Nominal GDP Targeting with Heterogeneous Labor Supply

We study nominal gross domestic product (GDP) targeting as optimal monetary policy in a model with a credit market friction following Azariadis et al. (2018), henceforth ABSS. We extend the ABSS framework to allow for heterogeneous labor supply. We show that nominal GDP targeting continues to characterize optimal monetary policy in this setting. We also analyze the incomplete markets equilibrium that exists when the monetary policymaker pursues a suboptimal policy, and show how an extension to more general preferences can limit the ability of the policymaker to provide full insurance to households in this setting.     

Optimal exchange rate flexibility with large labor unions

We study the optimal volatility of the exchange rate in a two-country model with sectoral non-atomistic wage setters, non-traded goods, nominal rigidities and alternative pricing assumptions – producer or local currency pricing. Labor unions internalize the sectoral impact of their wage settlements through firms' labor demand. With local currency pricing, exchange rate depreciation raises sales revenue, which in turn boosts domestic consumption and labor demand. Unions anticipate this effect and set higher wages accordingly. With small unions and low wage markup, optimal monetary policy enhances exchange rate movements to improve its terms of trade. With large unions and high wage markup, optimal monetary policy curbs exchange rate movements to restrain inflationary wage demands and to stabilize employment.     

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.     

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.     

Monetary Policy,Trend Inflation,and Unemployment Volatility

The literature has long agreed that the DMP model (after Diamond 1982, Mortensen 1982, Pissarides 1985) with search and matching frictions in the labor market can deliver large volatilities in labor market quantities, consistent with empirical data, only if there is at least some wage stickiness. I show, however, that the model can deliver nontrivial volatilities without wage stickiness, as long as it has price dispersion and nonzero long‐run inflation rates. I find that by keeping inflation at a positive rate, monetary policy may be accountable for the large standard deviations observed on labor market variables. In addition, the Shimer (2005) puzzle disappears under monetary policy shocks.     

Quantifying tax effects under policy foresight

Studies of tax effects make the conventional information assumption that changes in period-t taxes become known at t. Legislative lags, however, imply that news arrives before tax changes take place. Under policy foreknowledge, the conventional information structure is therefore misspecified. Simulations of a standard neoclassical growth model suggest that foresight of only one quarter can distort substantially the estimates of tax effects obtained under the no-foresight assumption. Also, it is crucial to model capital and labor taxes separately: anticipated changes in these two tax policies have opposite effects on consumption, investment, labor, and output before policy realization.     

Downward Nominal Wage Rigidities Bend the Phillips Curve

We introduce a model of monetary policy with downward nominal wage rigidities and show that both the slope and curvature of the Phillips curve depend on the level of inflation and the extent of downward nominal wage rigidities. This is true for the both the long‐run and the short‐run Phillips curve. Comparing simulation results from the model with data on U.S. wage patterns, we show that downward nominal wage rigidities likely have played a role in shaping the dynamics of unemployment and wage growth during the last three recessions and subsequent recoveries.     

Optimal foreign exchange-rate policy for a small open economy

This paper examines optimal exchange-rate policy for a small open economy which faces temporary and pemanent, real and nominal disturbances. It demonstrates that exchange-rate stabilization is desirable if most diturbances are nominal. If most disturbances are real, then stabilization should be greater: (1) the greater the fraction of exchange-rate variance accounted for by permanent disturbances; (2) the greater the information available to firms in setting the wage; (3) the greater the fraction of exchange-rate variance attributed to domestic productivity shocks compared with foreign relative price shocks; and (4) the more elastic is labor supply.     

Trend inflation, wage and price rigidities, and productivity growth

What are the steady-state implications of inflation in a general-equilibrium model with real per capita output growth and staggered nominal price and wage contracts? Surprisingly, a benchmark calibration implies an optimal inflation rate of -1.9 percent. The analysis also shows that trend inflation has important effects on the economy when combined with nominal contracts and real output growth. Steady-state output and welfare losses are quantitatively important even for low values of trend inflation. Further, nominal wage contracting is found to be quantitatively more important than nominal price contracting in generating the results. This conclusion does not arise from price dispersion per se, but from an effect of nominal output growth on the optimal markup of monopolistically competitive labour suppliers. Finally, accounting for productivity growth is found to be important for calculating the welfare costs of inflation. Indeed, the presence of 2 percent productivity growth increases the welfare costs of inflation in the benchmark specification by a factor of four relative to the no-growth case.     

Exchange market pressure and absorption by international reserves: Emerging markets and fear of reserve loss during the 2008–2009 crisis

This paper evaluates how the global financial crisis emanating from the U.S. was transmitted to emerging markets. Our focus is on the extent that the crisis caused external market pressures (EMP), and whether the absorption of the shock was mainly through exchange rate depreciation or the loss of international reserves. Controlling for variety of factors associated with EMP, we find clear evidence that emerging markets with higher total foreign liabilities, including short- and long-term debt, equities, FDI and derivative products—had greater exposure and were much more vulnerable to the financial crisis. Countries with large balance sheet exposure – high external portfolio liabilities exceeding international reserves—absorbed the global shock by allowing greater exchange rate depreciation and comparatively less reserve loss. Despite the remarkable buildup of international reserves by emerging markets during the period prior to the financial crisis, countries relied primarily on exchange rate deprecation rather than reserve loss to absorb most of the exchange market pressure shock. This could reflect a deliberate choice (“fear of reserve loss”) or market actions that caused very rapid exchange rate adjustment, especially in emerging markets with open capital markets, overwhelming policy actions.     

Exact Utilities under Alternative Monetary Rules in a Simple Macro Model with Optimizing Agents

We construct an optimizing-agent model of a closed economy which is simple enough that we can use it to make exact utility calculations. There is a stabilization problem because there are one-period nominal contracts for wages, or prices, or both and shocks that are unknown at the time when contracts are signed. We evaluate alternative monetary policy rules using the utility function of the representative agent. Fully optimal policy can attain the Pareto-optimal equilibrium. Fully optimal policy is contrasted with both naive and sophisticated simple rules that involve, respectively, complete stabilization and optimal stabilization of one variable or a combination two variables. With wage contracts, outcomes depend crucially on whether there are also price contracts. For example, if labor supply is relatively inelastic, for productivity shocks, nominal income stabilization yields higher welfare when there are no price contracts. However, with price contracts, outcomes are independent of whether there are wage contracts, except, of course, for the nominal wage.     

Optimal taxation and OECD labor taxes

We derive simple expressions for optimal labor taxes under different assumptions about government bond markets. We use these to examine OECD labor taxes, estimate the excess burden of taxation and assess the ability of optimal tax models to match the data.Optimal labor taxes are driven by: (i) a term reflecting Ramsey considerations which makes labor taxes vary positively with employment and (ii) a martingale component, reflecting the excess burden of tax, which shows persistent responses to shocks to the government's intertemporal budget constraint. Under complete markets (when governments can issue a full set of contingent securities) only the first factor is relevant. We find substantial evidence that incorporating incomplete markets into the optimal taxation model is critical for empirical success. However, we find strongest support for the martingale component and only weak evidence for the Ramsey component.     

When is discretion superior to timeless perspective policymaking?

The monetary policy literature assumes increasingly that policy is formulated according to the timeless perspective (Woodford, 1999a). However, by treating appropriately the auxiliary state variables that characterize the timeless perspective equilibrium when evaluating policy performance, this paper shows that discretionary policymaking can be superior to timeless perspective policymaking and identifies model features that make this outcome more likely. Using standard New Keynesian DSGE models, discretion is found to dominate timeless perspective policymaking when the price/wage Phillips curves are relatively flat, due, perhaps, to firm-specific capital (or labor) and/or Kimball (1995) aggregation in combination with nominal rigidities. These results suggest that studies applying the timeless perspective might also usefully compare its performance to discretion, paying careful attention to how policy performance is evaluated.     

Returns to Scale,Market Power,and the Nature of Price Rigidity in New Keynesian Models with Self‐Fulfilling Expectations

Increasing returns to scale and firms' market power are two potential sources of sunspot expectations in neoclassical models. We show that in New Keynesian models, returns to scale and market power can have fundamentally different implications for broad macroeconomic issues, including self‐fulfilling expectations, depending on the nature of price rigidity. Our findings suggest that the design of stabilization monetary policy can depend on precise knowledge about the economy's real and nominal features. Therefore, a clear understanding of the specific economic environment and its relevance to monetary policymaking for ensuring macroeconomic stability can be an integrated part of monetary policy practice.     

Inflation targeting: What inflation rate to target?

In an economy with nominal rigidities in both an intermediate good sector and a finished good sector, and thus with a natural distinction between CPI and PPI inflation rates, a benevolent central bank faces a tradeoff between stabilizing the two measures of inflation, a final output gap and, unique to our model, a real marginal cost gap in the intermediate sector, so that optimal monetary policy is second-best. We discuss how to implement the optimal policy with minimal information requirement and evaluate the robustness of these simple rules when the central bank may not know the exact sources of shocks or nominal rigidities. A main finding is that a simple hybrid rule under which the short-term interest rate responds to CPI inflation and PPI inflation results in a welfare level close to the optimum, whereas policy rules that ignore PPI inflation or PPI sector shocks can result in significant welfare losses.     

Using a long-term interest rate as the monetary policy instrument

Using a short-term interest rate as the monetary policy instrument can be problematic near its zero bound constraint. An alternative strategy is to use a long-term interest rate as the policy instrument. We find when Taylor-type policy rules are used by the central bank to set the long rate in a standard New Keynesian model, indeterminacy—that is, multiple rational expectations equilibria—may often result. However, a policy rule with a long-rate policy instrument that responds in a “forward-looking” fashion to inflation expectations can avoid the problem of indeterminacy.