optimal interest rate rules asset prices and credit frictions we study optimal taylor type interest rate rules in an economy with credit market imperfections our analysis builds on the agency cost framework of carlstrom and fuerst 1997 agency costs net worth and business fluctuations a computable general equilibrium analysis american economic review 87 893 910 which we extend in two directions first we embed monopolistic competition and sticky prices second we modify the stochastic structure of the model in order to generate a countercyclical premium on external finance this is achieved by linking the mean distribution of investment opportunities faced by entrepreneurs to aggregate total factor productivity we model monetary policy in terms of simple welfare maximizing interest rate rules we find that monetary policy should respond to increases in asset prices by lowering interest rates however when monetary policy responds strongly to inflation the marginal welfare gain of responding to asset prices vanishes within the class of linear interest rate rules that we analyze a strong anti inflationary stance always attains the highest level of welfare

the inflation output trade off with downward wage rigidities the macroeconomic implications of downward nominal wage rigidi ties are analyzed via a dynamic stochastic general equilibrium model featuring aggregate and idiosyncratic shocks a closed form solution for a long run phillips curve relates average output gap to average wage inflation it is virtually vertical at high inflation and flattens at low inflation macroeconomic volatility shifts the curve outwards and reduces output the results imply that stabilization policies play an important role and that optimal inflation may be positive and dif fer across countries with different macroeconomic volatility results are robust to relaxing the wage constraint for example when large idiosyncratic shocks arise jel e23 e24 e31 e63

macroeconometric equivalence microeconomic dissonance and the design of monetary policy abstract macroeconometric equivalence means that estimates of dsge models using first order approximations to equilibrium conditions fail to distinguish between alternative preference technology configurations microeconomic dissonance means that the underlying microeconomic differences between ostensibly equivalent models become important when optimal monetary policy is derived the relevance of these concepts is established by analysis of optimal monetary policy using a small scale new keynesian model microeconomic and financial datasets are promising tools with which to overcome the equivalence dissonance problem

compatibility between monetary and fiscal policy under emu the debate over the stability and growth pact sgp as a part of european monetary union has highlighted the need to assess the extent to which fiscal policies of union members should be constrained as a pre requisite for price stability within the union in this paper we develop a two country open economy model where each country has overlapping generations of finitely lived consumers who supply labour to imperfectly competitive firms which can only change their prices infrequently we examine the case where the two countries have formed a monetary union but where the fiscal authorities remain independent we show that the fiscal response required to ensure stability of the real debt stock is greater when consumers are not infinitely lived in principle this allows for some compensating behaviour between governments but we show that the scope for compensation is limited the monetary authority can abandon its active targeting of inflation to stabilise the debt of at most one fiscal authority and any other combination of policies will either result in price level indeterminacy and or indefinite transfers of wealth between the two economies finally in a series of simulations we show that fiscal shocks have limited impact on output and inflation provided the fiscal authorities meet the weak requirements of fiscal solvency however when monetary policy is forced to abandon its active targeting of inflation then fiscal shocks have a much greater impact on both output and inflation

optimal fiscal and monetary policy with occasionally binding zero bound constraints abstract this paper studies optimal fiscal and monetary policy when the nominal interest rate is subject to the zero lower bound zlb constraint in a stochastic new keynesian economy in the baseline model calibrated to match key features of the u s economy it is optimal for the government to increase its spending when at the zlb in the stochastic environment by about 60 percent more than it would in the deterministic environment the presence of uncertainty creates a unique time consistency problem if the steady state is inefficient although access to government spending policy increases welfare in the face of a large deflationary shock it decreases welfare during normal times as the government reduces the nominal interest rate less aggressively before reaching the zlb

public debt discretionary policy and inflation persistence we describe a simple mechanism that generates inflation persistence in a standard sticky price model of optimal fiscal and monetary policy key to this mechanism is that policies are implemented under discretion the government s discretionary incentive to erode the real value of nominal public debt by means of surprise inflation renders inflation expectations and in further consequence equilibrium inflation rates highly correlated with the stock of public debt debt in turn is highly persistent allowing for tax smoothing in the face of disturbances due to the aforementioned correlation the persistence in debt carries over to inflation our analysis uncovers a non monotonic effect of nominal rigidities on inflation persistence and shows that government debt under discretion does not display the near random walk property familiar from the ramsey literature a calibrated version of the model that incorporates a moderate degree of monopolistic competition and price stickiness is quantitatively consistent with the inflation dynamics experienced in the usa since the volcker disinflation of the early 1980s

optimal monetary policy in a small open economy with home bias we analyze optimal monetary policy in a small open economy characterized by home bias in consumption peculiar to our framework is the application of a ramseytype analysis to a model of the recent open economy new keynesian literature we show that home bias in consumption is a su cient condition for inducing the monetary policy maker of an open economy to deviate from a strategy of strict markup stabilization and contemplate some optimal degree of exchange rate stabilization we focus on the optimal setting of policy both in the case of rms setting prices one period in advance and in a gradual fashion subject to adjustment costs while the rst setup allows us to analytically highlight home bias as an independent source of equilibrium

inflation and welfare in a monetary economy it is in everyone s private interest to try to get someone else to hold non interest bearing cash and reserves but someone has to hold it all so these efforts must simply cancel out all of us spend several hours per year in this effort and employ thousands of talented and highly trained people to help us these person hours are simply thrown away wasted on a task that should not have to be performed at all

openness and optimal monetary policy abstract we show that the composition of international trade has important implications for the optimal volatility of the exchange rate above and beyond the size of trade flows using an analytically tractable small open economy model we characterize the impact of the trade composition on the policy trade off and on the role played by the exchange rate in correcting for price misalignments contrary to models where openness can be summarized by the degree of home bias we find that openness can be a poor proxy of the welfare impact of alternative monetary policies using input output data for 25 countries we document substantial differences in the import and non tradable content of final demand components and in the role played by imported inputs in domestic production the estimates are used in a richer small open economy dsge model to quantify the loss from an exchange rate peg relative to the ramsey policy conditional on the composition of imports we find that the main determinant of the losses is the share of non traded goods in final demand

money and the natural rate of interest structural estimates for the united states and the euro area abstract we examine the role of money in three environments the new keynesian model with separable utility and static money demand a nonseparable utility variant with habit formation and a version with adjustment costs for holding real balances the last two variants imply forward looking behavior of real money balances with forecasts of future interest rates entering current portfolio decisions we conduct a structural econometric analysis of the u s and euro area economies fiml estimates confirm the forward looking character of money demand a consequence is that real money balances are valuable in anticipating future variations in the natural interest rate

optimal interest rate rules and inflation stabilization versus price level stabilization abstract this paper compares the properties of interest rate rules such as simple taylor rules and rules that respond to price level fluctuations called wicksellian rules in a basic forward looking model by introducing appropriate history dependence in policy wicksellian rules perform better than optimal taylor rules in terms of welfare robustness to alternative shock processes and are less prone to equilibrium indeterminacy a simple wicksellian rule augmented with a high degree of interest rate inertia resembles a robustly optimal rule i e a monetary policy rule that implements the optimal plan and that is also completely robust to the specification of exogenous shock processes

optimal fiscal and monetary policy in customer markets a growing body of evidence suggests that ongoing relationships between consumers and firms may be important for understanding price dynamics we investigate whether the existence of such customer relationships has important consequences for the conduct of both long run and short run policy our central result is that when consumers and firms are engaged in long term relationships the optimal rate of price inflation volatility is very low even though all prices are completely flexible this finding is in contrast to those obtained in first generation ramsey models of optimal fiscal and monetary policy which are based on walrasian markets echoing the basic intuition of models based on sticky prices unanticipated inflation in our environment causes a type of relative price distortion across markets such distortions stem from fundamental trading frictions that give rise to long lived customer relationships and makes pursuing inflation stability optimal

on staggered prices and optimal inflation abstract this paper computes the steady state optimal rate of inflation in a model with monopolistic competition under two different sticky price specifications calvo 1983 and taylor 1980 the optimal rate of inflation is positive and almost identical to the ratio between the rate of discount and the dixit stiglitz elasticity

the friedman rule in an overlapping generations model with nonlinear taxation and income misreporting this paper models a two period overlapping generations economy with money populated with individuals of different skills they face a nonlinear income tax schedule and can engage in tax evasion money serves two purposes the traditional one modeled through a money in the utility function it also facilitates tax evasion the main message of the paper is that income tax evasion in this framework leads to the violation of the friedman rule the paper also shows that even in the absence of tax evasion when optimality requires differential commodity taxation complementarity of real cash balances and labor supply does not guarantee the optimality of the friedman rule as a boundary solution an additional assumption is required

recursive monetary policy games with incomplete information abstract this paper provides recursive methods for analyzing the credible equilibria of an incomplete information monetary policy game the policy game is one in which a discretionary government has a short run temptation to engage in a surprise monetary expansion it also has the opportunity to imitate a government that always implements the ex ante optimal monetary policy actions we derive an algorithm for computing the set of credible equilibrium payoffs we use this algorithm to explore the idea that incomplete information monetary policy games of this kind have fewer equilibria and less indeterminacy than their complete information counterparts

the case for inflation stability abstract we evaluate the case for inflation stabilization in a new keynesian nns model that includes various frictions capital accumulation and a variety of shocks in such a model price rigidity may provide the monetary authorities with an opportunity to improve upon the inefficient flexible price equilibrium via the suitable cyclical manipulation of real marginal costs we find that such an opportunity is of limited value and that a strong case for perfect inflation stabilization remains policies that tolerate a small amount of inflation variability may outperform perfect inflation targeting when capital adjustment costs are low and the monetary distortion is substantial but only if prices are very flexible

real implications of the zero bound on nominal interest rates if monetary policy succeeds in keeping average inflation very low nominal interest rates may occasionally be constrained by the zero lower bound the degree to which this constraint has real implications depends on the monetary policy feedback rule and the structure of price setting policy rules that make the price level stationary lead to small real distortions from the zero bound if policy imparts persistence into the inflation rate the real implications of the zero bound are large in the presence of backward looking price setting and small if prices are set to maximize profits

a framework for the analysis of moderate inflations abstract optimal monetary policy is studied in a model with no contractual restrictions or physical costs of changing prices nevertheless the price level is sticky in a range of mark up indeterminacy and inflation occurs only when employment presses against capacity under full information the monetary authority can exploit price level stickiness to minimize the mark up and keep employment at a constrained optimum without inflation under uncertainty negative aggregate demand shocks produce real contractions and positive shocks raise the price level the monetary authority can raise the likelihood that aggregate demand will maximize employment but at the cost of higher expected inflation

markups and the welfare cost of business cycles a reappraisal gali et al 2007 have recently shown quantitatively that fluctuations in the efficiency of resource allocation do not generate sizable welfare costs in their economy which is distorted by monopolistic competition in the steady state we show that they underestimate the welfare cost of these fluctuations by ignoring the negative effect of aggregate volatility on average consumption and leisure as monopolistic suppliers both firms and workers aim to preserve their expected markups the interaction between aggregate fluctuations and price setting behavior results in average consumption and employment levels that are lower than their counterparts in the flexible price economy this level effect increases the efficiency cost of business cycles it is all the more sizable with the degree of inefficiency in the steady state lower labor supply elasticities and when prices instead of wages are rigid

optimal monetary policy in open economies revisited abstract this paper revisits optimal monetary policy in open economies in particular focusing on the noncooperative policy game under local currency pricing in a two country dynamic stochastic general equilibrium model we first derive the quadratic loss functions which noncooperative policy makers aim to minimize then we show that noncooperative policy makers face extra trade offs regarding stabilizing real marginal costs induced by deviations from the law of one price under local currency pricing and that optimal monetary policy seeks to stabilize cpi inflation rates and more so under noncooperation than it does under cooperation as a result of the increased number of stabilizing objectives welfare gains from cooperation emerge even when two countries face only technology shocks still gains from cooperation are not large implying that frictions other than nominal rigidities are necessary to strongly recommend cooperation as an important policy framework to increase global welfare

the demand for money financial innovation and the welfare cost of inflation an analysis with household data we use microeconomic data on households to estimate the parameters of the demand for currency derived from a generalized baumol tobin model our data set contains information on average currency deposits and other interest bearing assets the number of trips to the bank the size of withdrawals and ownership and use of atm cards we model the demand for currency accounting for adoption of new transaction technologies and the decision to hold interest bearing assets the interest rate and expenditure flow elasticities of the demand for currency are close to the theoretical values implied by standard inventory models however we find significant differences between individuals with an atm card and those without the estimates of the demand for currency allow us to calculate a measure of the welfare cost of inflation analogous to bailey s triangle but based on a rigorous microeconometric framework the welfare cost of inflation varies considerably within the population but never turns out to be very lar

state dependent pricing inflation and welfare in search economies abstract we investigate the welfare effects of inflation in economies with search frictions and menu costs we first analyze an economy where there is no transaction demand for money balances money is a mere unit of account we determine a condition under which strictly positive inflation is desirable we relate this condition to a standard efficiency condition for search economies second we consider a related economy in which there is a transaction role for money in the absence of menu costs the friedman rule is optimal in the presence of menu costs the optimal inflation rate is negative for our numerical examples provided menu costs are small a deviation from the friedman rule can be optimal depending on the extent of the search externalities

money and credit as means of payment abstract a stochastic economic environment is presented in which the mix of cash and resource costly credit used as means of payment is endogenous for reasonable values of the credit cost parameter velocity can be quite variable and sensitive to the nominal interest rate those parameter values also generate larger welfare costs of inflation than have been found previously and a sizable impact of inflation on real interest rates

the implications of inflation in an estimated new keynesian model abstract this paper studies the steady state and dynamic consequences of inflation in an estimated dynamic stochastic general equilibrium model of the u s economy it is found that 10 percentage points of inflation entail a steady state welfare cost as high as 13 of annual consumption this large cost is mainly driven by staggered price contracts and price indexation the transition from high to low inflation inflicts a welfare loss equivalent to 0 53 of annual consumption the role of nominal real frictions as well as that of parameter uncertainty is also addressed

unconditionally optimal monetary policy we develop a simple and intuitive approach for analytically deriving unconditionally optimal uo policies a topic of enduring interest in optimal monetary policy analysis the approach can be employed in both general linear quadratic problems and in the underlying non linear environments a detailed example is provided using a canonical new keynesian framework

macroeconomic stabilization in developing economies are optimal policies procyclical abstract many empirical studies provide evidence that macroeconomic policies as well as capital flows exhibit procyclical characteristics in developing economies in particular kaminsky et al 2004 when it rains it pours procyclical capital flows and macroeconomic policies nber macroeconomics annual mit press demonstrate that a large group of middle income countries run contractionary policies and experience capital flight during times of recession this paper investigates the role of international financial markets in explaining these macroeconomic policy and capital flow characteristics an optimal fiscal and monetary policy problem is formulated and solved for a small open economy that faces a country specific interest rate spread in international financial markets it is found that in the presence of the country spread optimal fiscal and monetary policies as well as capital flows are procyclical under a reasonable parametrization optimal policies and capital flows turn countercyclical in the absence of the country spread this pattern is robust to a range of alternative model specifications

the optimal inflation rate under schumpeterian growth abstract to analyze the relationship between inflation and economic growth we construct an endogenous growth model with creative destruction incorporating sticky prices due to menu costs price changes reduce the reward for innovation and thus lower the frequency of creative destruction central banks can maximize the growth rate by setting their inflation target at the negative of a fundamental growth rate while the optimal inflation rate may be greater than the growth maximizing inflation rate our calibrated model shows that the optimal inflation rate is close to the growth maximizing inflation rate and that a deviation from the optimal level has sizable impacts

financial frictions and policy cooperation a case with monopolistic banking and staggered loan contracts abstract do financial frictions call for cross border policy cooperation this paper investigates the implications of financial frictions in the form of staggered loan contracts supplied by monopolistic banks for monetary policy using the linear quadratic lq framework we show that policy cooperation yields long run gains in addition to gains from stabilizing inefficient fluctuations over the business cycle as usually found in models with price rigidities the ramsey optimal steady states differ between cooperation and noncooperation such gains from cooperation arise irrespective of capital account liberalization

the spectre of deflation a review of empirical evidence what explains the widespread fear of deflation this article reviews the history of thought economic history and empirical evidence on deflation with a view to answering this question it also outlines informally the main effects of deflation in applied monetary models the main finding is that for both historical and contemporary deflations there are many open empirical questions that could be answered using the tools economists use to study inflation and monetary policy more generally qu est ce qui explique la peur tres repandue de la deflation ce memoire fait un tour d horizon de l histoire de la pensee economique de l histoire economique et des resultats empiriques quant aux effets de la deflation en vue de repondre a cette question on fait aussi echo informellement aux effets principaux de la deflation dans les modeles monetaires appliques ce qui ressort principalement de ce travail est que tant pour les deflations dans l histoire que dans le monde contemporain il y a bien des questions empiriques encore irresolues auxquelles on pourrait donner une reponse en utilisant l outillage mental que les economistes utilisent pour etudier l inflation et la politique monetaire plus generalement sp c tre n thing that is thought to be seen but has no material existence haunting presentiment of ruin war madness etc

endogenous market structures and optimal taxation this article provides optimal labour and dividend income taxation in a general equilibrium model with oligopolistic competition and endogenous firms entry in the long run the optimal dividend income tax corrects for inefficient entry the dividend income tax depends on the form of competition and the nature of the sunk entry costs in particular it is higher in market structures characterised by competition in quantities rather than those characterised by price competition oligopolistic competition leads to an endogenous countercyclical price markup as a result offsetting the distortions over the business cycle requires deviations from full tax smoothing

trend inflation taylor principle and indeterminacy positive trend inflation shrinks the determinacy region of a basic new keynesian dynamic stochastic general equilibrium model when monetary policy is conducted by a contemporaneous interest rate rule neither the taylor principle which requires the inflation coefficient to be greater than one nor the generalized taylor principle which requires that the nominal interest rate to be raised by more than the increase in inflation in the long run is a sufficient condition for local determinacy of equilibrium this finding holds for different types of taylor rules inertial policy rules and price indexation schemes therefore regardless of the theoretical setup the monetary literature on interest rate rules cannot disregard average inflation in both theoretical and empirical analyses

singapore and the new regionalism bilateral trade linkages with japan and the us free trade areas ftas have recently become an integral part of singapore trade policy this paper discusses the reasons behind singapore s recent embracement of new regionalism with particular reference to the proposals to form ftas with japan and the us the paper goes on to examine various aspects of singapore s trade linkages with the two economic superpowers in some detail popular discussion of ftas gives one the appearance that such a trade policy is entirely benign the paper sounds a cautionary note highlighting some reasons to be concerned with singapore s recent embracement of the new regionalism

optimal discretionary monetary policy in a micro founded model with a zero lower bound on nominal interest rate abstract this paper investigates optimal discretionary monetary policy under the zero lower bound on the nominal interest rate zlb in the case of a distorted steady state due to monopoly and taxation solving a fully nonlinear micro founded fnl model using a global method i find that the central bank in a more distorted economy would cut the interest rate less aggressively under a particularly adverse demand shock this occurs because inflation and nominal interest rates are higher on average making the zlb less likely to bind and causing the economy to escape from the zlb sooner however the social planner would choose the optimal inflation rate of approximately zero the result emerges because the unconditional benefit of avoiding the zlb is not big enough to offset the cost of higher relative price dispersion when inflation is significantly positive in addition i show that the conventional linear quadratic lq method is inaccurate in the case of a sufficiently distorted steady state

intrinsic inflation persistence empirical evidence suggests that inflation determination is not purely forward looking but models of price setting have struggled to rationalize this finding without directly assuming backward looking pricing rules for firms this paper shows that intrinsic inflation persistence can be explained with no deviation from optimizing forward looking behaviour if prices that have remained fixed for longer are more likely to be changed than those set recently a relationship between the probability of price adjustment and the duration of a price spell is shown to imply a simple hybrid phillips curve including lagged and expected inflation which is estimated using macroeconomic data

risk premium shocks and the zero bound on nominal interest rates there appears to be a disconnect between the importance of the zero bound on nominal interest rates in the real world and predictions from quantitative dsge models recent economic events have reinforced the relevance of the zero bound for monetary policy whereas quantitative models suggest that the zero bound does not constrain optimal monetary policy

financial openness financial frictions and optimal monetary policy increasing financial integration challenges the optimality of inward looking strategies for optimal monetary policy those issues are analyzed in an open economy where foreign net lending and the current account are determined by a collateral constraint durables represent collateral the current account features persistent imbalances but can deliver a long run stationary equilibrium the comparison between floating and managed exchange rate regimes shows that the impossible trinity is reversed higher financial integration increases the persistence and volatility of the current account and calls for exchange rate stabilization in this context the ramsey plan too prescribes stabilization of the exchange rate alongside with domestic inflation

monetary policy and welfare in a small open economy this paper analyzes optimal monetary policy in a small open economy featuring monopolistic competition and nominal rigidities it shows that the utility based loss function for this economy can be written as a quadratic expression of domestic inflation output gap and real exchange rate the presence of an internal monopolistic distortion and a terms of trade externality drives optimal policy away from domestic inflation targeting and affects the optimal level of exchange rate volatility when domestic and foreign goods are close substitutes for each other the optimal policy rule implies lower real exchange rate volatility than a domestic inflation targeting regime the reverse is true when the elasticity of substitution between goods is low

how do nominal and real rigidities interact a tale of the second best this paper analyses the importance of real wage rigidities in particular through their interaction with price stickiness for optimal monetary policy in a calibrated small open economy dsge model including oil in production and consumption blanchard and gali 2007a show real rigidities to introduce a trade off between stabilising inflation and the welfare relevant output gap the present paper complements their findings by showing that the welfare cost of real rigidities can be substantial compared to nominal frictions in a typical tale of the second best we also show that in the presence of real wage rigidities price stickiness can be welfare enhancing

non optimality of the friedman rule and optimal taxation in a growing economy with imperfect competition abstract this paper shows that if capital generates production externality there exists a wedge between returns to money and to capital driving the friedman rule is not optimal however in the absence of capital externality the friedman rule may be valid even under imperfect competition

optimal fiscal and monetary policy in an economy without capital abstract this paper is concerned with the structure and time consistency of optimal fiscal and monetary policy in an economy without capital in a dynamic context optimal taxation means distributing tax distortions over time in a welfare maximizing way for a barter economy our main finding is that with debt commitments of sufficiently rich maturity structure an optimal policy if one exists is time consistent in a monetary economy the idea of optimal taxation must be broadened to include an inflation tax and we find that time consistency does not carry over an optimal inflation tax requires commitment by rules in a sense that has no counterpart in the dynamic theory of ordinary excise taxes the reason time consistency fails in a monetary economy is that nominal assets should from a welfare maximizing point of view always be taxed away via an immediate inflation in a kind of capital levy this emerges as a new possibility when money is introduced into an economy without capital

when is discretion superior to timeless perspective policymaking the monetary policy literature assumes increasingly that policy is formulated according to the timeless perspective woodford 1999a however by treating appropriately the auxiliary state variables that characterize the timeless perspective equilibrium when evaluating policy performance this paper shows that discretionary policymaking can be superior to timeless perspective policymaking and identifies model features that make this outcome more likely using standard new keynesian dsge models discretion is found to dominate timeless perspective policymaking when the price wage phillips curves are relatively flat due perhaps to firm specific capital or labor and or kimball 1995 aggregation in combination with nominal rigidities these results suggest that studies applying the timeless perspective might also usefully compare its performance to discretion paying careful attention to how policy performance is evaluated

trade policy reforms and the structure of protection in vietnam this paper examines the current state of the trade policy regime in vietnam against the backdrop of market oriented policy reforms undertaken over the past one and a half decades the core of the paper is an in depth analysis of the structure of protection focusing on both incentives for import competing production and the bias in the incentive structure against export production compared to import competing production it is found that despite notable reform efforts the structure of protection in vietnam is still out of line with that of the major trading nations in the region in terms of the level and the inter industry dispersion of nominal and effective protection rates there is a clear anti export bias in the incentive structure even though the degree of the bias has considerably declined over the years there is no evidence to justify the existing protection structure on grounds of infant industry protection or employment generation

inflation stabilization and welfare the case of a distorted steady state this paper considers the appropriate stabilization objectives for monetary policy in a microfounded model with staggered price setting rotemberg and woodford 1997 and woodford 2002 have shown that under certain conditions a local approximation to the expected utility of the representative household in a model of this kind is related inversely to the expected discounted value of a conventional quadratic loss function in which each period s loss is a weighted average of squared deviations of inflation and an output gap measure from their optimal values zero however those derivations rely on an assumption of the existence of an output or employment subsidy that offsets the distortion due to the market power of monopolistically competitive price setters so that the steady state under a zero inflation policy involves an efficient level of output here we show how to dispense with this unappealing assumption so that a valid linear quadratic approximation to the optimal policy problem is possible even when the steady state is distorted to an arbitrary extent allowing for tax distortions as well as market power and when as a consequence it is necessary to take account of the effects of stabilization policy on the average level of output we again obtain a welfare theoretic loss function that involves both inflation and an appropriately defined output gap though the degree of distortion of the steady state affects both the weights on the two stabilization objectives and the definition of the welfare relevant output gap in the light of these results we reconsider the conditions under which complete price stability is optimal and find that they are more restrictive in the case of a distorted steady state we also consider the conditions under which pure randomization of monetary policy can be welfare improving and find that this is possible in the case of a sufficiently distorted steady state though the parameter values required are probably not empirically realistic

optimal fiscal and monetary policy equivalence results in this article we analyze the implications of price setting restrictions for the conduct of cyclical fiscal and monetary policy we consider standard monetary economies that differ in the price setting restrictions imposed on the firms we show that independently of the degree or type of price stickiness it is possible to implement the same efficient set of allocations and that each allocation in that set is implemented with policies that are also independent of the price stickiness in this sense environments with different price setting restrictions are equivalent

optimal simple and implementable monetary and fiscal rules welfare maximizing monetary and fiscal policy rules are studied in a model with sticky prices money and distortionary taxation the ramsey optimal policy is used as a point of comparison the main findings are the size of the inflation coefficient in the interest rate rule plays a minor role for welfare it matters only insofar as it affects the determinacy of equilibrium optimal monetary policy features a muted response to output interest rate rules that feature a positive response to output can lead to significant welfare losses the welfare gains from interest rate smoothing are negligible optimal fiscal policy is passive the optimal monetary and fiscal rule combination attains virtually the same level of welfare as the ramsey optimal policy

pricing production and persistence though built with increasingly precise microfoundations modern optimizing sticky price models have displayed a chronic inability to generate large and persistent real responses to monetary shocks as recently stressed by chari kehoe and mcgrattan 2000 this is an ironic finding since taylor 1980 and other researchers were motivated to study sticky price models in part by the objective of generating large and persistent business fluctuations we trace this lack of persistence to a standard view of the cyclical behavior of real marginal cost built into current sticky price macro models using a fully articulated general equilibrium model we show how an alternative view of real marginal cost can lead to substantial persistence this alternative view is based on three features of the supply side of the economy that we believe are realistic an important role for produced inputs variable capacity utilization and labor supply variability through changes in employment importantly these real flexibilities work together to dramatically reduce the elasticity of marginal cost with respect to output from levels much larger than unity in ckm to values much smaller than unity in our analysis these real flexibilities consequently reduce the extent of price adjustments by firms in time dependent pricing economies and the incentives for paying fixed costs of adjustment in state dependent pricing economies the structural features also lead the sticky price model to display volatility and comovement of factor inputs and factor prices that are more closely in line with conventional wisdom about business cycles and various empirical studies of the dynamic effects of monetary shocks federal reserve bank of philadelphia boston university nber and frb richmond this paper builds on earlier joint work with alexander l wolman on this topic we wish to thank brian boike for providing excellent research assistance and also to thank the referees and the editor for making numerous useful suggestions the views expressed in this article are those of the authors and do not necessarily represent those of the federal reserve bank of philadelphia the federal reserve bank of richmond or the federal reserve system

central bank independence and the monetary instrument problem we study the monetary instrument problem in a dynamic noncooperative game between separate discretionary fiscal and monetary policy makers we show that monetary instruments are equivalent only if the policy makers objectives are perfectly aligned otherwise an instrument problem exists when the central bank is benevolent while the fiscal authority is short sighted relative to the private sector excessive public spending and debt emerge under a money growth policy but not under an interest rate policy despite this property the interest rate is not necessarily the optimal instrument

estimating central bank preferences under commitment and discretion this paper explains u s macroeconomic outcomes with an empirical new keynesian model in which monetary policy minimizes the central bank s loss function the presence of expectations in the model forms a well known distinction between two modes of optimization termed commitment and discretion the model is estimated separately under each policy using maximum likelihood over the volcker greenspan bernanke period comparisons of fit reveal that the data favor the specification with discretionary policy estimates of the loss function weights point to an excessive concern for interest rate smoothing in the commitment model but a more balanced concern relative to inflation and output stability in the discretionary model

inventory theoretic money demand and relative price dynamics we construct a two goods inventory theoretic money demand model and find that the model implies in a monetary contraction the decline in the prices of low cash intensity goods durables or luxuries outpaces that of high cash intensity goods nondurables or necessities using u s data we show that our model s predictions are consistent with the data

ramsey monetary policy with labor market frictions abstract traditional new keynesian models prescribe that optimal monetary policy should aim at price stability in the absence of a labor market frictions the monetary authority faces no unemployment inflation trade off the design of optimal monetary policy is analyzed here for a framework with sticky prices and matching frictions in the labor market optimal policy features deviations from price stability in response to both productivity and government expenditure shocks when the hosios 1990 on the efficiency of matching and related models of search and unemployment review of economic studies 57 2 279 298 condition is not met search externalities make the flexible price allocation unfeasible optimal deviations from price stability increase with workers bargaining power as firms incentives to post vacancies fall and unemployment fluctuates above the pareto efficient one

optimal monetary policy with relative price distortions this paper analyzes optimal monetary policy in a sticky price model with calvo type staggered price setting in the paper the optimal monetary policy maximizes the expected utility of a representative household without having to rely on a set of linearly approximated equilibrium conditions given the distortions associated with the staggered price setting it shows that the complete stabilization of the price level is optimal in the absence of initial price dispersion while optimal inflation targets respond to changes in the level of relative price distortion in the presence of initial price dispersion

sustainable international monetary policy cooperation abstract we provide new insight on international monetary policy cooperation in a familiar two country setting a country facing a relatively more volatile markup shock has an incentive to deviate from an assumed cooperation regime to a non cooperation regime a similar result obtains if countries differ in size have non unitary elasticity of substitution between domestic and foreign goods and have different degrees of trade openness home bias in consumption this motivates our study of an endogenous history dependent sustainable cooperation regime its history contingent welfare redistributions are supported by incentive compatible variations in resource transfers through the terms of trade or net exports such an endogenous cooperative solution may also provide a theoretical rationale for perceived occasional cooperation between national central banks in reality

the relation between price and marginal cost in u s industry an examination of data on output and labor input reveals that some u s industries have marginal cost well below price the conclusion rests on the finding that cyclical variations in labor input are small compared with variations in output in booms firms produce substantially more output and sell it for a price that exceeds the costs of the added inputs the paper documents the disparity between price and marginal cost where marginal cost is estimated from annual variations in cost it considers a variety of explanations of the findings that are consistent with competition but none is found to be completely plausible

addiction as a market failure using rational addiction results to justify tobacco regulation abstract tobacco regulation efforts have been criticized by some academic economists for failing to provide adequate welfare analytic justification this paper attempts to address these criticisms unlike previous research that has discussed second hand smoke and health care financing externalities this paper develops the logic for identifying the much larger market failures attributable to the failure of smokers to fully internalize the costs of their addictive behavior the focus is on teen addiction as a form of intrapersonal externality and observed adult consumption behavior consistent with partial myopia the importance of peer effects in the consideration of welfare impacts is also emphasized

modern macroeconomics in practice how theory is shaping policy over the last three decades macroeconomic theory and the practice of macroeconomics by economists have changed significantly for the better macroeconomics is now firmly grounded in the principles of economic theory we focus on the role of economic theory in shaping policy over the last several decades the united states and other countries have undertaken a variety of policy changes that are precisely what macroeconomic theory of the last 30 years suggests the evidence that theoretical advances have had a significant effect on the practice of policy is often hard to see for policymakers and advisers involved in the hurly burly of day to day policymaking but easy to see if one steps back and takes a longer term perspective examples of the effects of theory on the practice of policy include increased central bank independence adoption of inflation targeting and other rules to guide monetary policy increased reliance on consumption and labor taxes instead of capital income taxes and increased awareness of the costs of policies that distort labor markets

optimal reputation building in the new keynesian model abstract we study the optimal committed monetary policy when the private sector has imperfect information and has to infer the central banker s ability to commit the optimal policy is designed to influence learning and improve the central banker s reputation of being committed the reputation building implies that when a committed central banker first takes office he should resist the temptation to stimulate output with initially high but declining inflation he should reverse a missed inflation target rather than accommodate it and he should adopt a less accommodative inflation response to a cost push shock than a full commitment solution suggests

the optimal inflation rate in new keynesian models should central banks raise their inflation targets in light of the zero lower bound we study the effects of positive steady state inflation in new keynesian models subject to the zero bound on interest rates we derive the utility based welfare loss function taking into account the effects of positive steady state inflation and solve for the optimal level of inflation in the model for plausible calibrations with costly but infrequent episodes at the zero lower bound the optimal inflation rate is low typically less than two percent even after considering a variety of extensions including optimal stabilization policy price indexation endogenous and statedependent price stickiness capital formation model uncertainty and downward nominal wage rigidities on the normative side price level targeting delivers large welfare gains and a very low optimal inflation rate consistent with price stability these results suggest that raising the inflation target is too blunt an instrument to efficiently reduce the severe costs of zero bound episodes

optimal monetary policy with the cost channel in the standard new keynesian framework an optimizing policy maker does not face a trade off between stabilizing the inflation rate and stabilizing the gap between actual output and output under flexible prices an ad hoc exogenous cost push shock is typically added to the inflation equation to generate a meaningful policy problem in this paper we show that a cost push shock arises endogenously when a cost channel for monetary policy is introduced into the new keynesian model a cost channel is present when firms marginal cost depends directly on the nominal rate of interest besides providing empirical evidence for a cost channel we explore its implications for optimal monetary policy we show that its presence alters the optimal policy problem in important ways for example both the output gap and inflation are allowed to fluctuate in response to productivity and demand shocks under optimal monetary policy

optimal monetary policy with imperfect unemployment insurance abstract we consider an efficiency wage model with the calvo type sticky prices and analyze the optimal monetary policy when the unemployment insurance is not perfect with imperfect risk sharing the strict zero inflation policy is no longer optimal even when the zero inflation steady state equilibrium is made conditionally efficient quantitative results depend on how the idiosyncratic earning loss due to unemployment varies over business cycles if the idiosyncratic income loss is acyclical the optimal policy differs very little from the zero inflation policy however if it varies countercyclically as evidence suggests the deviation of the optimal policy from the complete price level stabilization becomes quantitatively significant furthermore the optimal policy in such a case involves stabilization of output to a much larger extent

trend inflation wage and price rigidities and productivity growth abstract what are the steady state implications of inflation in a general equilibrium model with real per capita output growth and staggered nominal price and wage contracts surprisingly a benchmark calibration implies an optimal inflation rate of 1 9 percent the analysis also shows that trend inflation has important effects on the economy when combined with nominal contracts and real output growth steady state output and welfare losses are quantitatively important even for low values of trend inflation further nominal wage contracting is found to be quantitatively more important than nominal price contracting in generating the results this conclusion does not arise from price dispersion per se but from an effect of nominal output growth on the optimal markup of monopolistically competitive labour suppliers finally accounting for productivity growth is found to be important for calculating the welfare costs of inflation indeed the presence of 2 percent productivity growth increases the welfare costs of inflation in the benchmark specification by a factor of four relative to the no growth case

south asia does preferential trade liberalisation make sense this paper systematically analyses the issue of trade liberalisation in the south asia region and offers a qualitative assessment of alternative approaches i compare two broad approaches to trade liberalisation non discriminatory and preferential the former approach can be pursued on a unilateral basis by each country in the region on a concerted basis by the countries in the region or multilateral basis under the auspices of the wto the latter approach can take the form of criss crossing bilateral free trade areas between various countries in the region or a region wide free trade area the view i take in the paper is that the move towards preferential trading is a mistake at least from the viewpoint of india india continues to have very high trade barriers so that the scope for trade diversion and the losses accompanying it are likely to be considerable business lobbies being relatively powerful in most of the countries in the region they are likely to exploit the rules of origin and sectoral exceptions in these arrangements in ways that will maximise trade diversion and minimise trade creation inasmuch as the rules of origin give bureaucrats power employment and opportunities to share in the rents created by tariff preferences they too will become active parties to the diversionary tactics of business lobbies therefore the member countries are better advised to proceed along non discriminatory lines in achieving further liberalisation

money demand heterogeneity and the great moderation abstract a forward looking model of the demand for money based on heterogeneous and sluggish portfolio adjustment can simultaneously account for the low short run and high long run semi elasticities reported in the literature the parameter estimates from the model for the short run and long run interest semi elasticities are 1 04 and 13 16 respectively a simulated version of the model suggests that the great moderation can be partially attributed to financial innovations in the late 1970s when moving toward a more flexible portfolio the model can account for almost one third of the observed decline in the volatilities of output consumption and investment

optimal monetary policy with endogenous entry and product variety deviations from long run price stability are optimal in the presence of endogenous entry and product variety in a sticky price model in which price stability would be optimal otherwise long run inflation deflation is optimal when the benefit of variety to consumers falls short of exceeds the market incentive for creating that variety the desired markup price indexation exacerbates this mechanism plausible preference specifications and parameter values justify positive long run inflation rates however short run price stability around this non zero trend is close to optimal even in the presence of endogenously time varying desired markups that distort the intertemporal allocation of resources

classifying monetary economics fields and methods from past to future we propose a simple yet sufficiently encompassing classification scheme of monetary economics it comprises three fundamental fields and six recent areas that expand within and across these fields the elements of our scheme are not found together and in their mutual relationships in earlier studies of the relevant literature neither is this an attempt to produce a relatively complete systematization our intention in taking stock is not finality or exhaustiveness we rather suggest a viewpoint and a possible ordering of the accumulating knowledge our hope is to stimulate an improved understanding of the evolving nature and internal consistency of monetary economics at large

the role of countercyclical monetary policy when firms set nominal prices in advance optimal monetary policy insulates aggregate output against shocks to demand it can do so however by following the constant money growth rule advocated by milton friedman it need not respond to the shocks in an actively countercyclical way in addition to the extent that output fluctuations are driven by shocks to supply money growth should be procyclical

poole in the new keynesian model abstract we study the properties of alternative central bank targeting procedures within the standard new keynesian model we find that poole s famous insights concerning the output stabilization properties of money and interest rate targeting obtain when intertemporal substitution is low and that output volatility rankings do not induce similar welfare rankings unlike the popular presumption money targeting always fares better for money demand shocks for fiscal shocks money targeting does better for low and worse for high degree of intertemporal substitution the opposite pattern obtains for supply shocks

optimal monetary policy optimal monetary policy maximizes the welfare of a representative agent given frictions in the economic environment constructing a model with two sets of frictions costly price adjustment by imperfectly competitive firms and costly exchange of wealth for goods we find optimal monetary policy is governed by two familiar principles first the average level of the nominal interest rate should be sufficiently low as suggested by milton friedman that there should be deflation on average yet the keynesian frictions imply that the optimal nominal interest rate is positive second as various shocks occur to the real and monetary sectors the price level should be largely stabilized as suggested by irving fisher albeit around a deflationary trend path since expected inflation is roughly constant through time the nominal interest rate must therefore vary with the fisherian determinants of the real interest rate although the monetary authority has substantial leverage over real activity in our model economy it chooses real allocations that closely resemble those which would occur if prices were flexible in our benchmark model there is some tendency for the monetary authority to smooth nominal and real interest rates

inventories and optimal monetary policy in a small open economy abstract we study how inventory investment affects the design of optimal monetary policy in a new keynesian small open economy model we find that under producer currency pricing when the intratemporal elasticity of substitution is smaller than 1 optimal monetary policy in our model with inventories is similar to a standard model without inventories however when the intratemporal elasticity of substitution is larger than 1 inventory investment increases the importance of nominal exchange rate stabilization relative to a standard model without inventories the importance of nominal exchange rate stabilization increases with the intratemporal elasticity of substitution

the welfare cost of inflation in general equilibrium abstract this paper presents a general equilibrium monetary model in which inflation distorts a variety of marginal decisions although individually none of the distortions is very large they combine to yield substantial welfare cost estimates a sustained 4 percent inflation like that experienced in the us since 1983 costs the economy the equivalent of 0 41 percent of output per year when currency is identified as the relevant definition of money and over 1 percent of output per year when m1 is defined as money the results illustrate how the traditional partial equilibrium approach can seriously underestimate the true cost of inflation

optimal monetary policy under low trend inflation abstract in the monetary policy literature it is common to assume that trend inflation is zero despite overwhelming evidence that zero inflation is neither empirically relevant nor a practical objective for central bank policy we therefore extend the standard new keynesian model to allow for positive trend inflation showing that even low trend inflation has strong effects on optimal monetary policy and the dynamics of inflation output and interest rates under discretion the efficient policy deteriorates and there is no guarantee of determinacy even with commitment targeting non zero trend inflation leads to substantial welfare losses our results serve as a warning against indiscriminate use of models assuming zero trend inflation

optimal inflation rates with the trending relative price of investment abstract i study the effect of the trending relative price of investment on the optimal target rate of inflation in an estimated dynamic general equilibrium model of the u s economy the price of investment has a decreasing trend relative to that of consumption because of investment specific technological progress if the prices of investment goods are sticky a benevolent planner puts weight on stabilizing these prices which works to raise the optimal target rate of inflation in terms of the price of consumption the estimated model shows a high degree of price stickiness in an investment sector and the resulting optimal target rate of inflation is significantly positive this result is robust to an extended model in which the prices of some categories of investment goods are flexible

house prices capital inflows and macroprudential policy this paper evaluates the monetary and macroprudential policies that mitigate the procyclicality arising from the interlinkages between current account deficits and financial vulnerabilities we develop a two country dynamic stochastic general equilibrium dsge model with heterogeneous households and collateralised debt the model predicts that external shocks are important in driving current account deficits that are coupled with run ups in house prices and household debt in this context optimal policy features an interest rate response to credit and a ltv ratio that countercyclically responds to house price dynamics by allowing an interest rate response to changes in financial variables the monetary policy authority improves social welfare because of the large welfare gains accrued to the savers the additional use of a countercyclical ltv ratio that responds to house prices increases the ability of borrowers to smooth consumption over the cycle and is pareto improving domestic and foreign shocks account for a similar fraction of the welfare gains delivered by such a policy

state dependent pricing and the general equilibrium dynamics of money and output economists have long suggested that nominal product prices are changed infrequently because of fixed costs in such a setting optimal price adjustment should depend on the state of the economy yet while widely discussed statedependent pricing has proved difficult to incorporate into macroeconomic models this paper develops a new tractable theoretical state dependent pricing framework we use it to study how optimal pricing depends on the persistence of monetary shocks the elasticities of labor supply and goods demand and the interest sensitivity of money demand

time consistent monetary policy with endogenous price rigidity abstract i characterize time consistent equilibrium in an economy with price rigidity and an optimizing monetary authority operating under discretion firms have the option to increase their frequency of price change at a cost in response to higher inflation previous studies which assume a constant degree of price rigidity across inflation regimes find two time consistent equilibria one with low inflation the other with high inflation in contrast when price rigidity is endogenous the high inflation equilibrium ceases to exist hence time consistent equilibrium is unique this result depends on two features of the analysis 1 a plausible quantitative specification of the fixed cost of price change and 2 the presence of an arbitrarily small cost of inflation that is independent of price rigidity