Identifying fiscal inflation

Fiscal theorists warn about the risk of future inflation as a consequence of fiscal imbalances in the US. Because actual inflation remains historically low and data on inflation expectations do not corroborate such risks, warnings for fiscal inflation are often ignored in policy and academic circles. This paper shows that a canonical NK-DSGE model enables identifying an anticipated component of inflation expectations that is closely related to fiscal policy. Estimation results suggest that fiscal inflation concerns have induced a 1.6%-points increase in long-run inflation since 2001. The model also rationalizes why data on inflation expectations do not reveal such concerns outright.     

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.     

An empirical investigation of US fiscal expenditures and macroeconomic outcomes

In addition to containing stable information to explain inflation, state-local expenditures also have a larger share of the forecast error variance of US inflation than the federal funds rate. Non-defense federal expenditures are useful in predicting real output variations and, starting from the early 1980s, also present a larger share of the forecast error variance of US real output than the federal funds rate.     

Exchange rate and inflation dynamics in dollarized economies

We use a panel of a hundred-plus countries with differing degrees of dollarization to perform an empirical analysis of the effects on inflation of exchange rate depreciations. The results qualify the common view that countries with higher dollarization exhibit higher inflation pass-through. We show that large depreciations tend to generate a negative impact on the pass-through coefficient, this impact being more intense the higher the level of dollarization of the economy. We interpret this as evidence that, in highly dollarized economies, the classic inflationary effects of a real depreciation—higher internal demand and imported inflation—can be offset or diminished by both the larger financial costs and the balance-sheet effect, especially if the depreciation is “large”. Additionally, the exchange rate regime is shown to matter: countries with fixed exchange rates suffer more noticeably the balance-sheet effects of large depreciations.     

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.     

Public health spending, tax reform, and long-run growth

Public health spending is introduced into an endogenous growth model to examine the effect of a tax reform on the growth and learning time. Unlike previous studies, the calibrated model produces an increase in the learning time, consistent with the US data.     

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.     

Price‐level versus inflation targeting with financial market imperfections

Abstract Price‐level targeting (PT) is compared with inflation targeting (IT) in a DSGE model augmented with imperfections in both debt and equity markets. The PT regime outperforms the IT regime, and the gain depends on the degree of financial market frictions. This is because inflation is better anchored under PT, owing to the expectation channel, and therefore the monetary authority has more leverage to deal with the financial market distortions. We also find that the gain is higher if the optimal rule reacts to asset prices instead of the output gap, and the rule requires a positive response to asset prices.     

Monetary shocks,exchange rates and trade balances: Evidence from inflation targeting countries

This paper investigates the relationship among monetary policy shocks, exchange rates and trade balances in five Inflation Targeting Countries (ITCs). The investigation is based on Structural Vector Error Correction Models (SVECMs) with long run and short run restrictions. The findings reveal that a contractionary monetary policy shock leads to a decrease in price level, a decrease in output, an appreciation in exchange rate, and an improvement in trade balance in the very short run. Our findings contradict the findings of price, output, exchange rate and trade puzzles that have been found in many empirical studies. Furthermore they are consistent with the theoretical expectations regarding the effect of a contractionary policy. The only long run restriction that we imposed on our models is that money does not affect real macroeconomic variables in the long run, which is consistent with both Keynesian and monetarist approaches.     

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.     

Central bank secrecy in the foreign exchange market

This paper argues that with sticky goods prices and a forward-looking exchange rate, the central bank will only want a partial dissemination of its information about shocks to the economy. It is shown that, in such a model, the central bank may prefer to intervene secretly in the foreign exchange markets when responding in anticipation of future shocks, but openly when reacting to current shocks. The model thus provides a rationale for secrecy in central bank foreign exchange operations. The model also elucidates the relationship between the signaling and portfolio balance channels of sterilized intervention.     

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.