Currency substitution,inflation, and welfare

Currency substitution affects the mapping between social welfare and inflation by altering the underlying money demand function and influencing interest rates. In order to explore the essence of this effect, I build a model with working capital under which foreign currency is substituted with the less liquid components of domestic money. The framework closely mimics the actual pattern of currency substitution across varying rates of inflation and enables the study of an additional channel that works through the impact of currency substitution on interest rates. It is found that there is a threshold inflation rate, which turns out to be 44% under baseline calibration, below which currency substitution decreases welfare and vice versa. A practical implication is that, at inflation rates lower (greater) than the threshold, the potential welfare gains from disinflation to a near-zero inflation rate are higher (lower) if there is currency substitution than otherwise.     

Future fiscal and budgetary shocks

We study the effects of future tax and budgetary shocks in a non-monetary and possibly non-Ricardian economy. An (unanticipated) temporary labor tax cut to be effective on a given future date—a delayed “debt bomb”—causes at once a drop in the (unit) value placed on the firms' business asset, the customer, with the result that share prices, the hourly wage, and employment drop in tandem. This paradox of reduced activity through announcement of future “stimulus” does not hinge on an upward jump of long interest rates. A future tax-rate cut lacking a “sunset” provision has the same negative effects.     

Sticky prices and moderate inflation

Recent evidence shows that there is great heterogeneity in the price setting frequency across sectors, and that those changing prices frequently do so even under low inflation. What happens to price setting strategies of sticky price goods under moderate inflation? We built a dataset of monthly newspaper and magazine prices for Colombia, for the period 1960–2005, an exceptional example of prolonged moderate inflation. Within this macroeconomic scenario, and the novel database, we study the frequency of price adjustment, the relative importance of time- and state-dependent theories, and their evolution as inflation declined from moderate rates to single digits.     

Rent-seeking distortions and fiscal procyclicality

Recent research has demonstrated that while government expenditures are countercyclical in most industrialized countries, they tend to be procyclical in developing countries. We develop a dynamic political-economy model to explain this phenomenon. In the model, public expenditures provide insurance to uninsured households, and optimal fiscal policy is countercyclical. The introduction of a political friction, in which successive governments disagree on the desired distribution of public spending, can lead to procyclical fiscal policies. Numerical simulations of the model allow us to compare quantitatively the relative role of common explanations for fiscal procyclicality. We conclude that political distortions in the fiscal process can explain fiscal procyclicality better than other common explanations, such as borrowing constraints and macroeconomic volatility.     

On graduation from fiscal procyclicality

In the past, industrial countries have tended to pursue countercyclical or, at worst, acyclical fiscal policy. In sharp contrast, emerging and developing countries have followed procyclical fiscal policy, thus exacerbating the underlying business cycle. We show that, over the last decade, about a third of the developing world has been able to escape the procyclicality trap and actually become countercyclical. We then focus on the role played by the quality of institutions, which appears to be a key determinant of a country’s ability to graduate. We show that, even after controlling for the endogeneity of institutions and other determinants of fiscal procyclicality, there is a causal link running from stronger institutions to less procyclical or more countercyclical fiscal policy.     

Elections, exchange rates and reform in Latin America

In this paper, we study the link between real exchange rate (RER) depreciation and elections in Latin America. Our contribution is threefold. First, we employ a statistical model that takes into account the pervasive conditional heteroskedasticity found in financial data and includes a wide range of macroeconomic variables as regressors. Second, we test whether the wave of central bank reform that swept the region has had any effect on the existence or strength of the electoral cycle in exchange rates. Third, we test an additional hypothesis, namely, that financial liberalization may also be an important variable explaining changes in electoral effects on the real exchange rate. In a panel of 9 Latin American countries with available macroeconomic data and a history of exogenous election dates, we confirm the previous findings that real depreciation intensifies after elections even when modeling the significant conditional heteroskedasticity in these data. We also show, for the first time in the literature, that post-election exchange rates are significantly less predictable. We go on to test whether central bank reform has influenced the way in which elections affect the RER in Latin America. If reform has been effective at reducing political manipulation of the exchange rate, then any relationship we see between elections and the RER before central bank reform should be mitigated in the post-reform era. We find that the relationship disappears after reform and that post-reform real exchange rates are also significantly less volatile. Finally, we show that financial liberalization seems to have a stronger effect on the conditional variance of the RER than does central bank reform, but reform has a stronger impact on the conditional mean.     

Budget deficits and inflation feedback

This paper reinterprets the mixed evidence of the relationship between budget deficits and inflation in high inflation economies. The main finding is that recurrent outbursts of extreme inflation in these economies can be explained by a certain hysteresis effect associated with public finance. This interpretation meets the evidence that dramatic shifts between regimes of moderately high and extremely high (hyper-) inflation often occur without visible deterioration in public finance or abrupt shifts in fiscal or monetary policies. The existence of this hysteresis effect is explicitly explained by the action of two mechanisms: the arithmetic associated with the wrong side of the inflation tax Laffer curve and the Patinkin effect (the reverse of the much oftener cited Olivera-Tanzi effect). It is also shown that the division of the operational budget deficit into the part that is subject to negative inflation feedback and the part that is inflation-proof has implications for both the discussion of the inflationary consequences of budget deficits and the design of stabilization policy.     

Exchange rate policy under sovereign default risk

We examine monetary policy options for a small open economy where sovereign default might occur due to intertemporal insolvency. Under interest rate policy and floating exchange rates the equilibrium is indetermined. Under a fixed exchange rate the equilibrium is uniquely determined and independent of sovereign default.     

Fiscal decentralization,fiscal rules and fiscal discipline

Fiscal decentralization (FD) and fiscal rules (FR) are institutional mechanisms that are implemented by varying degrees in increasing number of countries. This paper investigates empirically the effect of FR on the effectiveness of FD in achieving fiscal discipline. Panel evidence strongly supports that balanced budget and expenditure rules help FD to achieve this goal, while debt rule has a direct disciplinary effect.     

Search, money, and inflation under private information

I study monetary exchange and inflation when buyers have private information about their willingness to pay for certain goods. Introducing imperfect information in the Lagos-Wright [A unified framework for monetary theory and policy analysis, J. Polit. Economy 113(3) (2005) 463-484] economy shows that the existence of monetary equilibrium is a more robust feature of the environment. In general, my model has a monetary steady state in which only a proportion of the agents hold money. Agents who do not hold money cannot participate in trade in the decentralized market. The proportion of agents holding money is endogenous and depends (negatively) on the level of expected inflation. As in Lagos and Wright's model, in equilibrium there is a positive welfare cost of expected inflation, but the origins of this cost are very different.     

Exchange rate pass-through in deflation: The case of Taiwan

This paper incorporates deflation in an analysis of the relationship between the exchange rate pass-through and inflation. Using a nonlinear model based on monthly data of Taiwan's import prices from 1981 to 2008, we find that the degree of exchange rate pass-through is increasing in deflation. The increase becomes smaller when the price of oil is excluded. Evidence for pass-through increasing in deflation has not previously been found in the existing literature and presents a new understanding of the pricing behavior of firms. Poor profits in deflation cause firms to pass through most of the cost of exchange rate changes to their products to avoid exiting the market.     

Income distribution, borrowing constraints and redistributive policies

This paper sheds light on the relationship between income inequality and redistributive policies and provides possible guidance in the specification of empirical tests of such a relationship. We model a two-period economy where capital markets are imperfect and agents vote over the level of taxation to finance redistributive policies that enhance future productivity. In this context, we show that the pivotal voter is not necessarily the agent (class) with median income. In particular, the poor, who are more likely to be liquidity constrained, may form a coalition with the rich and vote for low redistribution. The effects of an increase in income inequality on the level of redistribution turn out to depend on whether the increase in inequality is concentrated among the poor or the middle class. Empirical results from a panel of 22 OECD countries provide preliminary evidence consistent with our main theoretical implications.     

Distortionary fiscal policy and monetary policy goals

We reconsider the role of an inflation conservative central banker in a setting with distortionary taxation. To do so, we assume monetary and fiscal policy are decided by independent authorities that do not abide to past commitments. If the two authorities make policy decisions simultaneously, inflation conservatism causes fiscal overspending. But if fiscal policy is determined before monetary policy, inflation conservatism imposes fiscal discipline. These results clarify that in our setting the value of inflation conservatism depends crucially on the timing of policy decisions.     

Globalization, the output-inflation tradeoff and inflation

This paper provides comprehensive evidence on the relation between inflation and globalization, defined here as trade and financial openness, using a large cross-section of 91 countries over the period 1985-2004. We establish two main empirical regularities: both higher trade and financial openness (i) reduce central banks’ inflation bias, yielding lower average inflation and (ii) are associated with a larger output-inflation tradeoff. This evidence is at odds with the standard Barro-Gordon framework, which would require globalization to have a negative effect on the output-inflation tradeoff to yield lower equilibrium inflation, but it is consistent with a recent strand of new Keynesian models emphasizing the role of imperfect competition and nominal rigidities. Our findings also support the relevance of the time-inconsistency hypothesis, which underlies the theoretical models predicting a relation between globalization and inflation. For the OECD subsample, however, we do not find an effect of openness on inflation (the output-inflation tradeoff), suggesting that these countries have created an institutional framework for central banks that eliminates distortions due to the time-inconsistency problem.     

Supply side inflation persistence

We explore the role of the cost channel in accounting for inflation persistence in the New Keynesian model with Calvo pricing. Hump-shaped responses of inflation to monetary shocks are obtained under purely nominal rigidities.     

Financial markets’ behavior around episodes of large changes in the fiscal stance

Using a panel of OECD countries from 1960 to 2002, this paper shows that interest rates, particularly those of long-term government bonds, decrease when countries’ fiscal position improves and increase around periods of budget deteriorations. Stock market prices surge around times of substantial fiscal tightening and plunge in periods of very loose fiscal policy. In addition, the paper shows that results depend on countries’ initial fiscal conditions and on the type of fiscal consolidations: Fiscal adjustments that occur in country-years with high levels of government deficit, that are implemented by cutting government spending, and that generate a permanent and substantial decrease in government debt are associated with larger reductions in interest rates and increases in stock market prices.     

Social polarization, fiscal instability and growth

We present a dynamic model of fiscal policy in a simple growth framework where social polarization (of preferences) plays a central role in the evolution of fiscal instability and growth collapse. In a highly polarized society, a deficit occurs endogenously, fiscal spending path becomes more volatile, output collapses, and economic growth rate is reduced along the transition path to a new lower level of output. One novel feature is that the size of fiscal deficit, the magnitude of fiscal volatility, and the size of reduction in output and growth rate are explicitly shown to be increasing functions of the degree of social polarization. This is because of the positive relationship between the polarization of preferences and the incentive for policymakers (or socio-economic groups) to overexploit the government resources in a common pool setting (polarization effect). Thereby, we offer a fiscal instability channel that negatively links social polarization and growth, which is an alternative yet distinct explanation for the empirical finding that social polarization is harmful to growth. Moreover, we fully distinguish the incentive to engage in such short-term policies under political uncertainty from that under polarization. Polarization and political uncertainty are shown to be distinct yet critical to the dynamic coordination failure in the common pool setting.     

Exchange Rate Unification Under Non-Credibility: The Haïtian Economy

This paper builds on three strands of literature—Early Warning Systems (EWS), parallel exchange rates, and collapsing exchange rate regimes—by addressing the issue of credibility in the context of unification of the exchange rate in the Haïtian economy. It takes the view that when policymakers are perceived as non-credible, economic agents resort to observation of the economy's performance to assess the imminence of reforms. They then readjust their own behavior, particularly in the area of asset holdings. This paper models the adjustment process using the EWS ratios. Data supports the idea that credibility of the reform mounts over time reaching 85 percent on the eve of the reform.Winston-Salem State University—U.S.A. I would like to thank Mina Baliamoune and an anonymous referee of this journal for helpful comments and suggestions. All remaining errors are my responsibility.     

Growth, income distribution, and fiscal policy volatility

The relationship between income distribution and economic growth has long been an important economic research subject. Despite substantial evidence on the negative impact on long-term growth of inequality in the literature, however, there is not much consensus on the specific channels through which inequality affects growth. The empirical validity of two most prominent political economy channels - redistributive fiscal spending and taxes, and sociopolitical instability - has recently been challenged. We advance a new political economy channel for the negative link between inequality and growth, a fiscal policy volatility channel, and present strong supporting econometric evidence in a large sample of countries over the period of 1960-2000. Our finding also sheds light on another commonly observed negative relation between macroeconomic volatility and growth. We carefully address the robustness of the results in terms of data, estimation methods, outlier problem, and endogeneity problem that often plague the standard OLS (ordinary least squares) regression.