Expectations, Learning and Monetary Policy: An Overview of Recent Research

Expectations about the future are central for determination of current macroeconomic outcomes and the formulation of monetary policy. Recent literature has explored ways for supplementing the benchmark of rational expectations with explicit models of expectations formation that rely on econometric learning. Some apparently natural policy rules turn out to imply expectational instability of private agents’ learning. We use the standard New Keynesian model to illustrate this problem and survey the key results about interest-rate rules that deliver both uniqueness and stability of equilibrium under econometric learning. We then consider some practical concerns such as measurement errors in private expectations, observability of variables and learning of structural parameters required for policy. We also discuss some recent applications including policy design under perpetual learning, estimated models with learning, recurrent hyperinflations, and macroeconomic policy to combat liquidity traps and deflation.

Countercyclical Fiscal Policy and Cyclical Factor Utilization

In a neoclassical growth model with monopolistic competition in the product market, the presence of cyclical factor utilization enhances the stabilization role of countercyclical taxes. The costs of varying capital utilization take the form of varying rates of depreciation, which in turn have amplifying effect on investment decisions as well as the volatility of most aggregate variables. This creates an additional channel through which taxes affect the economy, a channel that enhances the stabilization role of countercyclical taxes, with particularly strong effects in the labor market. However, in terms of welfare, countercyclical taxes are welfare inferior due to reduced precautionary saving motives.

Electoral Uncertainty and the Deficit Bias in a New Keynesian Economy

Recent attempts to incorporate optimal fiscal policy into New Keynesian models subject to nominal inertia, have tended to assume that policy makers are benevolent and have access to a commitment technology. A separate literature, on the New Political Economy, has focused on real economies where there is strategic use of policy instruments in a world of political conflict. In this paper we combine these literatures and assume that policy is set in a New Keynesian economy by one of two policy makers facing electoral uncertainty (in terms of infrequent elections and an endogenous voting mechanism). The policy makers generally share the social welfare function, but differ in their preferences over fiscal expenditure (in its size and/or composition). Given the environment, policy shall be realistically constrained to be time-consistent. In a sticky-price economy, such heterogeneity gives rise to the possibility of one policy maker utilising (nominal) debt strategically to tie the hands of the other party, and influence the outcome of any future elections. This can give rise to a deficit bias, implying a sub-optimally high level of steady-state debt, and can also imply a sub-optimal response to shocks. The steady-state distortions and inflation bias this generates, combined with the volatility induced by the electoral cycle in a sticky-price environment, can significantly

Hawtreyan “Credit Deadlock” or Keynesian “Liquidity Trap”? Lessons for Japan from the Great Depression

This paper outlines the ideas of Ralph Hawtrey and Lauchlin Currie on the need for monetised fiscal deficit spending in 1930s USA to combat the deep depression into which the economy had been allowed to sink. In such exceptional circumstances of “credit deadlock” in which banks were afraid to lend and households and business afraid to borrow, the deadlock could best be broken through the spending of new money into circulation via large fiscal deficits. This complementarity of fiscal and monetary policy was shown to be essential, and as such indicates the potential power of monetary policy – in contrast to the Keynesian “liquidity trap” view that it is powerless This lesson was not learned by the Japanese authorities in their response to the asset price collapse of 1991-92, resulting in a lost decade as ballooning fiscal deficits were neutralised throughout the 1990s by unhelpfully tight monetary policy with the Bank of Japan refusing to monetise the deficits.

Analysing the impact of public capital stock using the NEG wage equation: a panel data approach

This paper examines the relationship between the level of public infrastructure and the level of productivity using panel data for the Spanish provinces over the period 1984-2004, a period which is particularly relevant due to the substantial changes occurring in the Spanish economy at that time. The underlying model used for the data analysis is based on the wage equation, which is one of a handful of simultaneous equations which when satisfied correspond to the short-run equilibrium of New Economic Geography theory. This is estimated using a spatial panel model with fixed time and province effects, so that unmodelled space and time constant sources of heterogeneity are eliminated. The model assumes that productivity depends on the level of educational attainment and the public capital stock endowment of each province. The results show that although changes in productivity are positively associated with changes in public investment within the same province, there is a negative relationship between productivity changes and changes in public investment in other regions.

Who Ultimately Bears the Burden of Greater Non-Wage Labour costs?

We investigate the effect of a rise in non-wage labour costs (NWLC) on real anufacturing labour costs in OECD countries, taking into account the degree of coordination in the wage bargaining process. We find that, in countries in which wage bargaining is not highly coordinated, 55% of an increase in NWLC appears to be shifted to workers in the long run, whereas in countries operating under a highly coordinated bargaining regime, full shifting occurs. Overall, our results suggest that high NWLC can be associated with a high equilibrium unemployment rate, but only in those OECD countries that do not have highly coordinated wage bargaining.

Local Currency Pricing, Foreign Monetary Shocks and Exchange Rate Policy

The implications of local currency pricing (LCP) for monetary regime choice are analysed for a country facing foreign monetary shocks. In this analysis expenditure switching is potentially welfare reducing. This contrasts with the existing LCP literature, which focuses on productivity shocks and thus analyses a world where expenditure switching is welfare enhancing. This paper shows that, when home and foreign producers follow LCP, expenditure switching is absent and a floating rate is preferred by the home country. But when only home producers follow LCP, expenditure switching is present and a fixed rate can be welfare enhancing for the home country.

Monetary Policy and Heterogeneous Expectations

This paper studies the implications for monetary policy of heterogeneous expectations in a New Keynesian model. The assumption of rational expectations is replaced with parsimonious forecasting models where agents select between predictors that are underparameterized. In a Misspecification Equilibrium agents only select the best-performing statistical models. We demonstrate that, even when monetary policy rules satisfy the Taylor principle by adjusting nominal interest rates more than one for one with inflation, there may exist equilibria with Intrinsic Heterogeneity. Under certain conditions, there may exist multiple misspecification equilibria. We show that these findings have important implications for business cycle dynamics and for the design of monetary policy.

Global Warming And Extreme Events: Rethinking The Timing And Intensity Of Environmental Policy

The possibility of low-probability extreme events has reignited the debate over the optimal intensity and timing of climate policy. In this paper we therefore contribute to the literature by assessing the implications of low-probability extreme events on environmental policy in a continuous-time real options model with “tail risk”. In a nutshell, our results indicate the importance of tail risk and call for foresighted pre-emptive climate policies.

“Policy Scepticism” and the Impact of Scottish Higher Education Institutions (HEIs) on their Host Region: Accounting for Regional Budget Constraints under Devolution

A “policy scepticism” has emerged that challenges the results of conventional regional HEI impact analyses. Its denial of the importance of the expenditure impacts of HEIs appears to be based on a belief in either a binding regional resource constraint or a regional public sector budget constraint. In this paper we provide a systematic critique of this policy scepticism. However, while rejecting the extreme form of policy scepticism, we argue that it is crucial to recognise the importance of the public-sector expenditure constraints that are binding under devolution. We show how conventional impact analyses can be augmented to accommodate regional public sector budget constraints. While our results suggest that conventional impact studies overestimate the expenditure impacts of HEIs, they also demonstrate that the policy scepticism that treats these expenditure effects as irrelevant neglects some key aspects of HEIs, in particular their export intensity.

The Timing of Asset Trade and Optimal Policy in Dynamic Open Economies

Using a standard open economy DSGE model, it is shown that the timing of asset trade relative to policy decisions has a potentially important impact on the welfare evaluation of monetary policy at the individual country level. If asset trade in the initial period takes place before the announcement of policy, a national policymaker can choose a policy rule which reduces the work effort of households in the policymaker’s country in the knowledge that consumption is fully insured by optimally chosen international portfolio positions. But if asset trade takes place after the policy announcement, this insurance is absent and households in the policymaker’s country bear the full consumption consequences of the chosen policy rule. The welfare incentives faced by national policymakers are very different between the two cases. Numerical examples confirm that asset market timing has a significant impact on the optimal policy rule.

The Living Wage: Reducing inequality in the UK?

The revival of support for a living wage has reopened a long-run debate over the extent to which active regulation of labour markets may be necessary to attain desired outcomes. Market failure is suggested to result in lower wages and remuneration for low skilled workers than might otherwise be expected from models of perfect competition. This paper examines the theoretical underpinning of living wage campaigns and demonstrates that once we move away from idealised models of perfect competition to one where employers retain power over the bargaining process, such as monopsony, it is readily understandable that low wages may be endemic in low skilled employment contracts. The paper then examines evidence, derived from the UK Quarterly Labour Force Survey, for the extent to which a living wage will address low pay within the labour force. We highlight the greater incidence of low pay within the private sector and then focus upon the public sector where the Living Wage demand has had most impact. We examine the extent to which addressing low pay within the public sector increases costs. We further highlight the evidence that a predominance of low pay exists among public sector young and women workers (and in particular lone parent women workers) but not, perhaps surprisingly, among workers from ethnic minority backgrounds. The paper then builds upon the results from the Quarterly Labour Force Survey with analysis of the British Household Panel Survey in order to examine the impact the introduction of a living wage, within the public sector, would have in reducing household inequality. The paper concludes that a living wage is indeed an appropriate regulatory response to market failure for low skilled workers and can act to reduce age and gender pay inequality, and reduce household income inequality among in-work households below average earnings.

“Policy Scepticism” and the Impact of Welsh Higher Education Institutions (HEIs) on their Host Region: Accounting for Regional Budget Constraints

This paper replicates the analysis of Scottish HEIs in Hermannsson et al (2010b) for the case of Wales in order to provide a self-contained analysis that is readily accessible by those whose primary concern is with the regional impacts of Welsh HEIs. A “policy scepticism” has emerged that challenges the results of conventional regional HEI impact analyses. This denial of the importance of the expenditure impacts of HEIs appears to be based on a belief in either a binding regional resource constraint or a regional public sector budget constraint. In this paper we provide a systematic critique of this policy scepticism. However, while rejecting the extreme form of policy scepticism, we argue that it is crucial to recognise the importance of the publicsector expenditure constraints that are binding under devolution. We show how conventional impact analyses can be augmented to accommodate regional public sector budget constraints. While our results suggest that conventional impact studies overestimate the expenditure impacts of HEIs, they also demonstrate that the policy scepticism that treats these expenditure effects as irrelevant neglects some key aspects of HEIs, in particular their export intensity.

Discretionary Policy in a Monetary Union with Sovereign Debt

This paper examines the interactions between multiple national fiscal policy- makers and a single monetary policy maker in response to shocks to government debt in some or all of the countries of a monetary union. We assume that national governments respond to excess debt in an optimal manner, but that they do not have access to a commitment technology. This implies that national fi scal policy gradually reduces debt: the lack of a commitment technology precludes a random walk in steady state debt, but the need to maintain national competitiveness avoids excessively rapid debt reduction. If the central bank can commit, it adjusts its policies only slightly in response to higher debt, allowing national fiscal policy to undertake most of the adjustment. However if it cannot commit, then optimal monetary policy involves using interest rates to rapidly reduce debt, with signifi cant welfare costs. We show that in these circumstances the central bank would do better to ignore national fiscal policies in formulating its policy.

“Policy Scepticism” and the Impact of Northern Irish Higher Education Institutions (HEIs) on their Host Region: Accounting for Regional Budget Constraints

This paper replicates the analysis of Scottish HEIs in Hermannsson et al (2010b) for the case of Northern Ireland. The motivation is to provide a self-contained analysis that is readily accessible by those whose primary concern is with the regional impacts of Northern Irish HEIs. A comparative analysis will follow in due course. A “policy scepticism” has emerged that challenges the results of conventional regional HEI impact analyses. This denial of the importance of the expenditure impacts of HEIs appears to be based on a belief in either a binding regional resource constraint or a regional public sector budget constraint. In this paper we provide a systematic critique of this policy scepticism. However, while rejecting the extreme form of policy scepticism, we argue that it is crucial to recognise the importance of the public sector expenditure constraints that are binding under devolution. We show how conventional impact analyses can be augmented to accommodate regional public sector budget constraints. While our results suggest that conventional impact studies overestimate the expenditure impacts of HEIs, they also demonstrate that the policy scepticism that treats these expenditure effects as irrelevant neglects some key aspects of HEIs, in particular their export intensity.