Fiscal Sustainability in a New Keynesian Model

Recent work on optimal monetary and fiscal policy in New Keynesian models suggests that it is optimal to allow steady-state debt to follow a random walk. Leith and Wren-Lewis (2012) consider the nature of the timeinconsistency involved in such a policy and its implication for discretionary policy-making. We show that governments are tempted, given inflationary expectations, to utilize their monetary and fiscal instruments in the initial period to change the ultimate debt burden they need to service. We demonstrate that this temptation is only eliminated if following shocks, the new steady-state debt is equal to the original (efficient) debt level even though there is no explicit debt target in the government’s objective function. Analytically and in a series of numerical simulations we show which instrument is used to stabilize the debt depends crucially on the degree of nominal inertia and the size of the debt-stock. We also show that the welfare consequences of introducing debt are negligible for precommitment policies, but can be significant for discretionary policy. Finally, we assess the credibility of commitment policy by considering a quasi-commitment policy which allows for different probabilities of reneging on past promises. This on-line Appendix extends the results of this paper.

Stock Market Reaction to Fed Funds Rate Surprises: State Dependence and the Financial Crisis

This paper examines the impact of Federal Funds rate (FFR) surprises on stock returns in the United States over the period 1989-2009, focusing on the impact of the recent financial crisis. We find that prior to the crisis, stock prices increased as a response to unexpected FFR cuts. State dependence is also identified with stocks exhibiting larger increases when interest rate easing coincided with recessions, bear stock markets, and tightening credit market conditions. However, an important structural shift took place during the financial crisis, which changed the stock market response to FFR shocks, as well as the nature of state dependence. Specifically, during the crisis period stock market participants did not react positively to unexpected FFR cuts. Our results highlight the severity of the recent financial turmoil episode and the ineffectiveness of conventional monetary policy close to the zero lower bound for nominal interest rates.

Bayesian forecasting with highly correlated predictors

This paper considers Bayesian variable selection in regressions with a large number of possibly highly correlated macroeconomic predictors. I show that by acknowledging the correlation structure in the predictors can improve forecasts over existing popular Bayesian variable selection algorithms.

Fiscal Sustainability in a New Keynesian Model

Recent work on optimal monetary and fiscal policy in New Keynesian models suggests that it is optimal to allow steady-state debt to follow a random walk. Leith and Wren-Lewis (2012) consider the nature of the timeinconsistency involved in such a policy and its implication for discretionary policy-making. We show that governments are tempted, given inflationary expectations, to utilize their monetary and fiscal instruments in the initial period to change the ultimate debt burden they need to service. We demonstrate that this temptation is only eliminated if following shocks, the new steady-state debt is equal to the original (efficient) debt level even though there is no explicit debt target in the government’s objective function. Analytically and in a series of numerical simulations we show which instrument is used to stabilize the debt depends crucially on the degree of nominal inertia and the size of the debt-stock. We also show that the welfare consequences of introducing debt are negligible for precommitment policies, but can be significant for discretionary policy. Finally, we assess the credibility of commitment policy by considering a quasi-commitment policy which allows for different probabilities of reneging on past promises. This on-line Appendix extends the results of this paper.

On the causes of the African Slave Trade

This paper offers an integrated analysis of the forces shaping the emergence of the African slave trade over the early modern period. We focus our attention on two questions. First, why most of the increase in the demand for slaves during this period came exclusively from western Europeans. Second, and of most relevance for present-day development outcomes, why was the overwhelming majority of slaves of African origin. Technological differences in manufacturing technology, the specificities of sugar (and other crops’) production, and the cultural fragmentation of the African continent all play a role in the analysis. Supporting evidence for each of our claims is provided from a broad corpus of relevant literature.

Infrequent Fiscal Stabilization

This paper studies discretionary non-cooperative monetary and fiscal policy stabilization in a New Keynesian model, where the fiscal policymaker uses a distortionary taxe as the policy instrument and operates with long periods between optimal time-consistent adjustments of the instrument. We demonstrate that longer fiscal cycles result in stronger complementarities between the optimal actions of the monetary and fiscal policymakers. When the fiscal cycle is not very long, the complementarities lead to expectation traps. However, with a sufficiently long fiscal cycle — one year in our model — no learnable time-consistent equilibrium exists. Constraining the fiscal policymaker in its actions may help to avoid these adverse effects.

Expectations Traps and Coordination Failures with Discretionary Policymaking

Discretionary policymakers cannot manage private-sector expectations and cannot coordinate the actions of future policymakers. As a consequence, expectations traps and coordination failures can occur and multiple equilibria can arise. To utilize the explanatory power of models with multiple equilibria it is first necessary to understand how an economy arrives to a particular equilibrium. In this paper we employ notions of learnability and self-enforceability to motivate and identify equilibria of particular interest. Central among these criteria are whether the equilibrium is learnable by private agents and jointly learnable by private agents and the policymaker. We use two New Keynesian policy models to identify the strategic interactions that give rise to multiple equilibria and to illustrate our methods for identifying equilibria of interest. Importantly, unless the Pareto-preferred equilibrium is learnable by private agents, we find little reason to expect coordination on that equilibrium.

Aggregate and welfare effects of long run inflation risk under inflation and price-level targeting

This paper presents a DSGE model in which long run inflation risk matters for social welfare. Aggregate and welfare effects of long run inflation risk are assessed under two monetary regimes: inflation targeting (IT) and price-level targeting (PT). These effects differ because IT implies base-level drift in the price level, while PT makes the price level stationary around a target price path. Under IT, the welfare cost of long run inflation risk is equal to 0.35 percent of aggregate consumption. Under PT, where long run inflation risk is largely eliminated, it is lowered to only 0.01 per cent. There are welfare gains from PT because it raises average consumption for the young and lowers consumption risk substantially for the old. These results are strongly robust to changes in the PT target horizon and fairly robust to imperfect credibility, fiscal policy, and model calibration. While the distributional effects of an unexpected transition to PT are sizeable, they are short-lived and not welfare-reducing.

No Good Deals - No Bad Models

Faced with the problem of pricing complex contingent claims, an investor seeks to make his valuations robust to model uncertainty. We construct a notion of a model- uncertainty-induced utility function and show that model uncertainty increases the investor's eff ective risk aversion. Using the model-uncertainty-induced utility function, we extend the \No Good Deals" methodology of Cochrane and Sa a-Requejo [2000] to compute lower and upper good deal bounds in the presence of model uncertainty. We illustrate the methodology using some numerical examples.

Beyond Intermediates: The Role of Consumption and Commuting in the Construction of Local Input-Output Tables

It is a well-established fact in the literature on simulating Input-Output tables that mechanical methods for estimating intermediate trade lead to biased results where cross-hauling is underestimated and Type-I multipliers are overstated. Repeated findings to this effect have led to a primary emphasis on advocating the accurate estimation of intermediate trade flows. This paper reviews previous research and argues for a qualification of the consensus view: When simulating IO tables, construction approaches need to consider spill-over effects driven by wage and consumption flows. In particular, for the case of metropolitan economies, wage and consumption flows are important if accurate Type-II multipliers are to be obtained. This is demonstrated by constructing an interregional Input-Output table, which captures interdependencies between a city and its commuter belt, nested within the wider regional economy. In addition to identifying interdependencies caused by interregional intermediate purchases, data on subregional household incomes and commuter flows are used to identify interdependencies from wage payments and household consumption. The construction of the table is varied around a range of assumptions on intermediate trade and household consumption to capture the sensitivity of multipliers.

On the time-varying relationship between EMU sovereign spreads and their determinants

We use a dynamic multipath general-to-specific algorithm to capture structural instability in the link between euro area sovereign bond yield spreads against Germany and their underlying determinants over the period January 1999 – August 2011. We offer new evidence suggesting a significant heterogeneity across countries, both in terms of the risk factors determining spreads over time as well as in terms of the magnitude of their impact on spreads. Our findings suggest that the relationship between euro area sovereign risk and the underlying fundamentals is strongly timevarying, turning from inactive to active since the onset of the global financial crisis and further intensifying during the sovereign debt crisis. As a general rule, the set of financial and macro spreads’ determinants in the euro area is rather unstable but generally becomes richer and stronger in significance as the crisis evolves.

A New Index of Financial Conditions

We use factor augmented vector autoregressive models with time-varying coefficients to construct a financial conditions index. The time-variation in the parameters allows for the weights attached to each financial variable in the index to evolve over time. Furthermore, we develop methods for dynamic model averaging or selection which allow the financial variables entering into the FCI to change over time. We discuss why such extensions of the existing literature are important and show them to be so in an empirical application involving a wide range of financial variables.

Commitment vs. Discretion in the UK: An Empirical Investigation of the Monetary and Fiscal Policy Regime

This paper investigates the conduct of monetary and fiscal policy in the post-ERM period in the UK. Using a simple DSGE New Keynesian model of non-cooperative monetary and fiscal policy interactions under fiscal intra-period leadership, we demonstrate that the past policy in the UK is better explained by optimal policy under discretion than under commitment. We estimate policy objectives of both policy makers. We demonstrate that fiscal policy plays an important role in identifying the monetary policy regime.

How Optimal is US Monetary Policy?

Most of the literature estimating DSGE models for monetary policy analysis assume that policy follows a simple rule. In this paper we allow policy to be described by various forms of optimal policy - commitment, discretion and quasi-commitment. We find that, even after allowing for Markov switching in shock variances, the inflation target and/or rule parameters, the data preferred description of policy is that the US Fed operates under discretion with a marked increase in conservatism after the 1970s. Parameter estimates are similar to those obtained under simple rules, except that the degree of habits is significantly lower and the prevalence of cost-push shocks greater. Moreover, we find that the greatest welfare gains from the ‘Great Moderation’ arose from the reduction in the variances in shocks hitting the economy, rather than increased inflation aversion. However, much of the high inflation of the 1970s could have been avoided had policy makers been able to commit, even without adopting stronger anti-inflation objectives. More recently the Fed appears to have temporarily relaxed policy following the 1987 stock market crash, and has lost, without regaining, its post-Volcker conservatism following the bursting of the dot-com bubble in 2000.

Monetary Policy Delegation and Equilibrium Coordination

This paper revisits the argument that the stabilisation bias that arises under discretionary monetary policy can be reduced if policy is delegated to a policymaker with redesigned objectives. We study four delegation schemes: price level targeting, interest rate smoothing, speed limits and straight conservatism. These can all increase social welfare in models with a unique discretionary equilibrium. We investigate how these schemes perform in a model with capital accumulation where uniqueness does not necessarily apply. We discuss how multiplicity arises and demonstrate that no delegation scheme is able to eliminate all potential bad equilibria. Price level targeting has two interesting features. It can create a new equilibrium that is welfare dominated, but it can also alter equilibrium stability properties and make coordination on the best equilibrium more likely.