Monetary Policy Challenges from Falling Natural Interest Rates, chapter in: ECB Sintra Forum 2020 Conference Proceedings, p. 186-209, published in May 2021
This paper summarizes recent academic research that analyses the monetary policy implications of lower natural rates and rising asset price volatility in a setting where policy is constrained by a lower bound on nominal rates. It focuses on the implications for (1) the optimal inflation target and (2) the question of how monetary policy should respond to asset price movements.
Do Survey Expectations of Returns Reflect Risk Adjustments? with Stefan Nagel & Dmitry Matveev,
Journal of Monetary Economics, pp. 723-749, January 2021
Checks whether the puzzling behavior of survey expectations about future stock returns can be explained by respondents reporting (i) risk-neutral or (ii) pessimistically-tilted expectations (ambiguity aversion/robustness concerns). Shows that survey epectations are inconsistent with both of these explanations: stock returns expectations are much higher than risk-free interest returns, which refutes (i), and are unconditionally unbiased and fluctuate predictably between optimism and pessimism, which is inconsistent with (ii).
Optimal Trend Inflation, with Henning Weber, American Economic Review , Vol. 109(2), pp. 702-737, 2019 , working paper version
The optimal rate of steady state inflation in sticky price models is positive once one incorporates firm heterogeneity and plausible firm-level productivity trends. We provide closed-form expressions for the optimal inflation rate and estimate the optimal US inflation rate to range between 1 and 3 % per year.
Stock Price Booms and Expected Capital Gains, with Albert Marcet and Johannes Beutel, American Economic Review, Vol. 107(8), 2352–2408, 2017
Shows that variations in investors’ subjective capital gains expectations are a key driver of fluctuations in postwar US stock prices.
Dropbox link to MatLab code and documentation here.
Optimal Sovereign Default (with Applications to the Greek Case), joint with Michael Grill, American Economic Journal: Macroeconomics, Vol. 9(1), pp. 128–164, 2017, working paper version
Determines a normative benchmark for optimal sovereign default in a setting in which default is costly and government bond markets are incomplete. Argues that the observed sovereign default in Greece has been too small and not timely enough. Excel data file with Greek data and calibration.
Price Level Changes and the Redistribution of Nominal Wealth Across the Euro Area, with Junyi Zhu, Journal of the European Economic Association, Vol 14(4), pp. 871-906, 2016, working paper version
Shows how unexpected price level decreases redistribute wealth across the Euro area. Determines the countries, economic sectors and households that win and lose. Stata data documentation files available here. Excel data appendix is available available here.
The standard consumption-based asset pricing model with time-separable preferences generates realistic amounts of stock price volatility if one allows for small deviations from rational expectations. MatLab programs here.
Distributional Consequences of Asset Price Inflation in the Euro Area, with Panagiota Tzamourani, European Economic Review, Vol 89, pp. 172–192, 2016, working paper version
Determines who wins from bond price, equity price and housing price increases in the Euro Area and how these gains correlate with the wealth and income distributions.
Can a Financial Transaction Tax Prevent Stock Price Booms?, with Johannes Beutel, Albert Marcet and Sebastian Merkel, Journal of Monetary Economics, Vol. 76, S90–S109, 2015, (working paper version here)
Shows how financial transaction taxes increase the likelihood of stock price boom and bust cycles in in a model that quantitatively replicates stock price behavior and the behavior of trading volume.
Distortionary Fiscal Policy and Monetary Policy Goals, with Roberto Billi, Economics Letters, 122, 1–6, 2014
We evaluate the role of an inflation conservative central bank in a setting with distortionary taxation, assuming that 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. The value of inflation conservatism thus crucially depends on the timing of policy decisions.
Robustly Optimal Monetary Policy in a Microfounded New Keynesian Model, with Michael Woodford, Journal of Monetary Economics, 59, 468–487, 2012, (working paper version here)
Determines optimal monetary stabilization policy, when the central bank recognizes that private-sector expectations need not be precisely model-consistent. Shows how to determine optimal policy without restricting consideration a priori to a particular parametric family of belief deviations or candidatee policy rules. Concerns about the model-consistency of private-sector expectations make greater resistance to surprise inflation optimal, compared to the case where the policymaker assumes the private sector to have ´rational expectations´.
House Price Booms and the Current Account, with Pei Kuang and Albert Marcet, NBER Macroeconomics Annual 2011, volume 26, pages, 77–122. MIT Press, 2012.
Constructs a model that can replicate the heterogeneous house price and current account dynamics in the G7 economies over the recent house price boom and bust period. The model implies that low interest rates can significantly contribute to house price booms amd current account deficits and that the U.S. boom would have been largely avoided if interest rates had fallen by less after the year 2000.
Inflation Dynamics and Subjective Expectations in the United States, with Mario Padula, Economic Inquiry, Vol. 49, pp. 13-25, 2011.
Estimates a forward-looking Ney Keynesian Phillips Curve for the United States using data from the Survey of Professional Forecasters as proxy for expected inflation. One then obtains significant and plausible estimates for the structural paramters independently of wheter the output gap or unit labor costs are uses as a measure of marginal costs.
Internal Rationality, Imperfect Market Knowledge and Asset Prices, with Albert Marcet, Journal of Economic Theory, 146, 1224-1252, 2011,(working paper version here)
Develops a decision theoretic framework in which agents are learning about market behavior and that provides microfoundations for models of adaptive learning. We apply this approach to a simple asset pricing model and show that the equilibrium stock price is then determined by investors' expectations of the price and dividend in the next period, rather than by their expectations of the discounted sum of dividends.
Government Debt and Optimal Monetary and Fiscal Policy, European Economic Review, Vol. 55, 57–74, 2011. working paper version
Studies how different levels of government debt affect the optimal conduct of monetary and fiscal policies and what these policies imply for the optimal evolution of government debt over time. It shows that larger government debt gives rise to larger risks to the fiscal budget in response to technology shocks and that this makes it optimal to reduce debt over time. The optimal speed of debt reduction can be quantitatively important but is entirely missed when restricting consideration to linearized model solutions.
Monetary Policy and Aggregate Volatility, Journal of Monetary Economics, Volume 56, pp. S1-S18, 2009
Warns that discretionary monetary stabilization policy can increase aggregate real and nominal volatility by arbitrary amounts when firms pay limited attention to aggregate shocks. An inflation conservative central bank which focuses more on inflation stabilization delivers much less volatile outcomes - produces a 'Great Moderation' - because its policy greatly facilitates firms' information processing problem. Consistent with empirical evidence, the ‘Great Moderation’ manifests itself through reduced residual variance in vector autoregressions (VARs) involving macroeconomic variables.
Monetary Conservatism and Fiscal Policy, with Roberto Billi, Journal of Monetary Economics, Vol. 55(8), 1376-1388, 2008
Asks whether an inflation conservative central bank remains desirable in a setting with endogenous fiscal policy in which lack of fiscal commitment gives rise to excessive public spending. Although the optimal inflation rate internalizing the fiscal distortion is positive, lack of monetary commitment generates too much inflation: close to exclusive focus on inflation by the central bank thus remains desirable. In a follow up (Distortionary Fiscal Policy and Monetary Policy Goals) we show that this conclusion is partly sensitive to assuming non-distortionary taxation.
Experimental Evidence on the Persistence of Output and Inflation, Economic Journal, Vol. 117, 603-635, 2007
Shows that expectations can be a great source of persistence in dynamic economic settings. Specifically, studies an experimental economy in which output and inflation do not show persistence in response to monetary shocks under rational expectations. In the experimental sessions, however, output and inflation are persistent and subjects' expectations are described surprisingly well by optimal but simple forecast functions consistent with a Restricted Perceptions Equilibrium (RPE). When the RPE does not exist, output and inflation are more in line with the rational expectations predictions.
Discretionary Monetary Policy and the Zero Lower Bound on Nominal Interest Rates, with Roberto Billi, Journal of Monetary Economics, Vol. 54(3), 728-752, 2007
Shows that one severely understateds the value of monetary commitment in New Keynesian models if one ignores the zero lower bound (ZLB) on nominal interest rates. A stochastic forward looking model with occasionally binding ZLB, calibrated to the U.S., suggests that low values for the natural rate of interest lead to sizeable output losses and deflation. These are much larger than under commitment because private sector expectations and the discretionary policy response to these expectations reinforce each other and cause the ZLB to be reached much earlier than under commitment.
Optimal Monetary Policy with Imperfect Common Knowledge, Journal of Monetary Economics, Vol. 54(2), 276-301, 2007
Solves an optimal policy problem for an economy in which agents have imperfect common knowledge about shocks. Specifically, determines optimal monetary policy in a flexible price setting in which real effects arise because firms pay limited attention to aggregate variables. When firms’ prices are strategic complements and economic shocks display little persistence, monetary policy has strong real effects, making it optimal to stabilize the output gap. Weak complementarities or sufficient shock persistence, however, cause price level stabilization to become increasingly optimal. Monetary policy then optimally shifts from output gap stabilization in initial periods to price level stabilization in later periods, potentially rationalizing the medium-term approach to price stability adopted by some central banks.
Are Hyperinflation Paths Learnable?, with George Evans and Seppo Honkapohja, Journal of Economic Dynamics and Control, Vol. 30, 2725-2748, 2006
Studies the monetary seigniorage model of inflation and reconsiders the issue of whether the high-inflation steady state is stable under learning. Unlike previous studies we look at the full set of solutions and show that stationary hyperinflationary paths near the high-inflation steady state are stable under learning if agents have access to contemporaneous data.
Optimal Monetary Policy under Commitment with a Zero Bound on Nominal Interest Rates, with Roberto Billi, Journal of Money Credit and Banking, Vol. 38(7), 1877-1905, 2006
Determines optimal monetary policy under commitment in a stochastic and forward-looking New Keynesian model when nominal interest rates are occasionally bounded below by zero. A calibration to the U.S. economy suggests that in response to a drop in the natural rate of interest policy should reduce nominal interest rates more aggressively than suggested by a model without lower bound. This is useful because rational agents anticipate the possibility of reaching the lower bound in the future and this amplifies the effects of adverse shocks well before the bound is reached.
Learning to Forecast and Cyclical Behavior of Output and Inflation, Macroeconomic Dynamics, Vol. 9(1), 1-27, 2005
Studies the limit outcomes of a setting in which agents estimate and select between two competing forecast models. Although one model is consistent with rational expectations once learning is complete, agents may asymptotically prefer to use the inconsistent forecast model. This gives rise to an equilibrium in which forecasts are only constrained rational and in which output and inflation display persistence, inflation responds only sluggishly to nominal disturbances, and the dynamic correlations of output and inflation match U.S. data surprisingly well. Still one of my favourite papers....
On the Relation between Bayesian and Robust Decision Making, Journal of Economic Dynamics and Control, Vol. 28(10), 2105-2117, 2004
Shows how one can interpret optimal robust decisions (max min decisions) as optimal Bayesian decisions by a decisionmaker who has infinite risk aversion. From a Bayesian perspective choices are then independent (robust) to prior beliefs.
Learning and Equilibrium Selection in a Monetary Overlapping Generations Model with Sticky Prices, Review of Economic Studies, Vol. 70(4), 887-908, 2003, (get WP version here)
Extends the monetary seignorage model of inflation to a setting with sticky prices and monopolistically competitive firms. Studies the stability of the low and high inflation steady states under learning and shows that independently from the degree of price stickiness and monopolistic competition, learning always selects the low inflation steady state.
Learning While Searching for the Best Alternative, Journal of Economic Theory, Vol. 101, 252-280, 2001
Determines the optimal strategy for a search problen in which the searcher is presented with several search alternatives and is learning about the offer distribution of the respective alternatives from the search outcomes. Provides simple criteria/indices characterizing the optimal strategy and generalizes papers that determine optimal search with learning when there is only a single alternative and papers studying search from several alternatives without learning.