Policy implications of the New Keynesian Phillips curve

This article surveys recent advancements in the theory of optimal monetary policy in models with a New Keynesian Phillips curve. It identifies four policy implications. First, near price stability is optimal. Second, simple interest rate feedback rules that respond aggressively to price inflation deliver near-optimal equilibrium allocations. Third, interest rate rules that respond to deviations of output from trend may carry significant welfare costs. Fourth, the zero bound on nominal interest rates does not appear to be a significant obstacle for the actual implementation of low and stable inflation.Inflation (Finance) ; Phillips curve

On the implementation of Markov-perfect interest rate and money supply rules: global and local uniqueness

Currently there is a growing literature exploring the features of optimal monetary policy in New Keynesian models under both commitment and discretion. This literature usually solves for the optimal allocations that are consistent with a rational expectations market equilibrium, but it does not study how the policy can be implemented given the available policy instruments. Recently, however, King and Wolman (2004) have shown that a time-consistent policy cannot be implemented through the control of nominal money balances. In particular, they find that equilibria are not unique under a money stock regime. The authors of this paper find that King and Wolman's conclusion of non-uniqueness of Markov-perfect equilibria is sensitive to the instrument of choice. Surprisingly, if, instead, the monetary authority chooses the nominal interest rate there exists a unique Markov-perfect equilibrium. The authors then investigate under what conditions a time-consistent planner can implement the optimal allocation by just announcing his policy rule in a decentralized setting.Markov processes

Dollar strength, peso vulnerability to sudden stops: a perfect foresight model of Argentina's convertibility

This paper presents a model designed to study the dynamic response of the economy under a fixed peg to the dollar to an international (and exogenous) real appreciation of the dollar, when there is wage and price stickiness, perfect capital mobility subject to sudden stops, and predominantly dollar denominated foreign debts with predominantly non-dollar trade. Assuming perfect foresight, we take the simple case in which the world is composed of the U.S.A., Europe, and Argentina and while all foreign debts are dollar denominated, all foreign trade is done with Europe. Hence, an important parameter in the model is the exogenous euro/dollar real exchange rate. PPP prevails in the export sector and there is monopolistically competitive price setting in the domestic sector and monopolistically competitive wage setting by households. Both are subject to adjustment cost functions that generate stickiness and domestic price and wage gaps, which result in "Phillips curve" equations for domestic prices and wages, respectively. Money demand is generated by a transactions technology. The first order conditions for firms and households under symmetric monopolistic competition equilibriums and the budget constraints result in a four dimensional dynamical system in the multilateral real exchange rate (MRER), the real wage, the rate of domestic price inflation and the rate of wage inflation. This system has a saddle-path stable equilibrium which is dependent on the marginal utility of wealth. Under the assumption that the economy is what is called a Domestically Biased Economy in Production relative to Consumption (DBE), it is seen that strong dollar shocks, which require an inter-temporally smoothened fall in consumption (and hence an increase in the marginal utility of wealth), have perverse impact effects. The peso appreciates in real terms and the real wage increases. These effects generate foreign indebtedness and increased vulnerability to (exogenous and unexpected) sudden stops. The DBE assumption essentially entails that real depreciations require reductions in the real wage to preserve (long run) labor market equilibrium. A story is developed to explain the main features of the functioning and ultimate collapse of Convertibility in Argentina, by assuming a strong dollar shock which is believed to be temporary and has the effect of generating unemployment, recession and debt accumulation. But before the new steady state is reached it is revealed that the shock is permanent, which triggers a sudden stop, a default, a devaluation, a debt restructuring, fiscal reform, and the return to capital market access. A more flexible exchange regime could avoid the debt accumulation that triggers the sudden stop, as well as the long period of unemployment, recession, and deflation.Departamento de Economí

Neoclassical theory versus new economic geography. Competing explanations of cross-regional variation in economic development

This paper uses data for 255 NUTS-2 European regions over the period 1995-2003 to test the relative explanatory performance of two important rival theories seeking to explain variations in the level of economic development across regions, namely the neoclassical model originating from the work of Solow (1956) and the so-called Wage Equation, which is one of a set of simultaneous equations consistent with the short-run equilibrium of new economic geography (NEG) theory, as described by Fujita, Krugman and Venables (1999). The rivals are non-nested, so that testing is accomplished both by fitting the reduced form models individually and by simply combining the two rivals to create a composite model in an attempt to identify the dominant theory. We use different estimators for the resulting panel data model to account variously for interregional heterogeneity, endogeneity, and temporal and spatial dependence, including maximum likelihood with and without fixed effects, two stage least squares and feasible generalised spatial two stage least squares plus GMM; also most of these models embody a spatial autoregressive error process. These show that the estimated NEG model parameters correspond to theoretical expectation, whereas the parameter estimates derived from the neoclassical model reduced form are sometimes insignificant or take on counterintuitive signs. This casts doubt on the appropriateness of neoclassical theory as a basis for explaining cross-regional variation in economic development in Europe, whereas NEG theory seems to hold in the face of competition from its rival. (authors' abstract

Macroeconomic Analysis Without the Rational Expectations Hypothesis

This paper reviews a variety of alternative approaches to the specification of the expectations of economic decision makers in dynamic models, and reconsiders familiar results in the theory of monetary and fiscal policy when one allows for departures from the hypothesis of rational expectations. The various approaches are all illustrated in the context of a common model, a log-linearized New Keynesian model in which both households and firms solve infinite-horizon decision problems; under the hypothesis of rational expectations, the model reduces to the standard “3-equation model” used in studies such as Clarida et al. (1999). The alternative approaches considered include rationalizable equilibrium dynamics (Guesnerie, 2008); restricted perceptions equilibria (Branch, 2004); decreasing-gain and constant-gain variants of least-squares learning dynamics (Evans and Honkapohja, 2001); rational belief equilibria (Kurz, 2012); and near-rational expectations equilibria (Woodford, 2010). Issues treated include Ricardian equivalence; the determinacy of equilibrium under alternative interest-rate rules; non-fundamental sources of aggregate instability; the tradeoff between inflation stabilization and output-gap stabilization; and the possibility of a “deflation trap.

Essays on Price and Welfare

This dissertation is a collection of three essays on price and welfare. The first chapter investigates the optimal price index for central banks to stabilize in a model economy where volatile prices are harmful to welfare through monetary friction. The second chapter estimates the impact of recent technological innovation, namely the internet, on the dynamics of prices and welfare through a variety of real mechanisms. The third chapter analyzes the impact of financial regulation on the prices of financial assets and the welfare of the financial market participants. There is currently a debate about what price index central banks should target when economies are open and exposed to international price shocks. Chapter 1 derives the optimal price index by solving the Ramsey problem in a New Keynesian small open economy model with an arbitrary number of sectors. This approach improves on existing theoretical benchmarks because (1) it makes an explicit distinction between the consumer price index (CPI) and the producer price index (PPI), and (2) it allows exogenous international price shocks to play a role. Qualitatively, I use the analytical expression of the optimal price index to discuss that popular indices, such as the PPI and the core/headline CPI, are suboptimal because they ignore the heterogeneity in price stickiness and the effect of inflation on the trade surplus. Quantitatively, I calibrate a 35-sector version of the model for 40 countries and show that stabilizing the optimal price index yields significantly higher welfare than alternative indices. In Chapter 2, which is joint work with Yoon J. Jo and David Weinstein, we estimate the impact of e-commerce on Japanese prices and welfare. First, we consider the possibility that e-commerce may have lowered prices by driving down the average prices of goods available online. Second, we compute the welfare gains due to the ability of e-commerce to enable consumers to purchase goods from other regions. Third, we compute the gains that arise through e-commerce's ability to arbitrage intercity price differences. We find that all three channels produced welfare gains in Japan, but our estimates suggest that the first and second channels are by far the most important, with welfare gains through these channels being eleven to sixteen times larger than through the price arbitrage channel. Overall, we find that increased inter-city arbitrage raised Japanese welfare by 0.12 percent, the gains due to new varieties available through online shopping raised welfare 0.7 percent, and the gains due to overall price reductions for goods available online raised welfare by 1 percent. In Chapter 3, which is joint work with Sakai Ando, we analyze the impact of dealer regulation on price quality (informativeness and volatility) and its implications for the welfare of market participants. We argue that although price informativeness, volatility, and the dealer's profitability all deteriorate, against conventional wisdom, other market participants are better off due to the dealer's risk-shifting motive. A static model is used to clarify the main intuition, and the robustness of the welfare results, as well as the fragility of the conventional wisdom about price quality, are discussed by incorporating dynamics and endogenizing information acquisition

Essays in monetary economics

This dissertation can be thematically grouped into two categories: monetary theory in the so called New Monetarist search models where money and credit are essential in terms of improving social welfare, and optimal time-consistent monetary and fiscal policy in New Keynesian dynamic stochastic general equilibrium (DSGE) models when the government cannot commit. Arguably, the methodology and conceptual frameworks adopted in these two lines of work are quite different. However, they share a common goal in helping us understand how and why monetary factors can affect the real economy, and how monetary and fiscal policy should respond to developments in the economy to improve social welfare. There are two chapters in each part. In the first chapter, recent advances based on the pre-eminent Lagos-Wright (LW) monetary search model are reviewed. Against this background, chapter two introduces collateralized credit inspired by a communal responsibility system into the creditless LW model, in order to study the role of money and credit as alternative means of payment. In contrast, the third chapter revisits the classic inflation bias problem associated with optimal time-consistent monetary policy in the cashless New Keynesian framework. In this chapter, fiscal policy is trivial, due to the assumption of lump-sum tax. As a follow-up work, chapter four studies optimal time-consistent monetary and fiscal policy mix as well as debt maturity choice in an environment with only distortionary taxes, endogenous government spending and government debt of various maturities. Chapter 1 introduces the tractable and influential Lagos-Wright (LW) search-theoretic framework and reviews the latest developments in extending it to study issues concerning the role of money, credit, asset pricing, monetary policy and economic growth. In addition, potential research topics are discussed. Our main message from this review is that the LW monetary model is flexible enough to deal with numerous issues where fiat money plays an essential role as a medium of exchange. Chapter 2, based on the LW framework, develops a search model of money and credit motivated by a historical medieval institution - the community responsibility system. The aim is to examine the role of credit collateralized by the community responsibility system as a supplementary medium of exchange in long-distance trade, assuming that entry cost and the cost of using credit are proportional to distance, due to factors like direct verification and settlement cost and indirect transportation cost. We find that both money and credit are useful in the sense of improving welfare. In addition, the Friedman rule can be sub-optimal in this economy, due to the interaction between the extensive margin (that is, the range of outside villages which the representative household has trade with) and the intensive margin (that is, the scope of villages where credit is used as a supplementary medium of exchange). Finally, higher entry cost narrows down the extensive margin, and similarly, higher cost of using credit, ceteris paribus, reduces the usage of credit and hence lowers social welfare. Chapter 3 reconsiders the inflation bias problem associated with the renowned rules versus discretion debate in a fully nonlinear version of the benchmark New Keynesian DSGE model. We ask whether the inflation bias problem related to discretionary monetary policy differs quantitatively under two dominant forms of nominal rigidities - Calvo pricing and Rotemberg pricing, if the inherent nonlinearities are taken seriously. We find that the inflation bias problem under Calvo contracts is significantly greater than under Rotemberg pricing, despite the fact that the former typically exhibits far greater welfare costs of inflation. In addition, the rates of inflation observed under the discretionary policy are non-trivial and suggest that the model can comfortably generate the rates of inflation at which the problematic issues highlighted in the trend inflation literature. Finally, we consider the response to cost push shocks across both models and find these can also be significantly different. Thus, we conclude that the nonlinearities inherent in the New Keynesian DSGE model are empirically relevant and the form of nominal inertia adopted is not innocuous. Chapter 4 studies the optimal time-consistent monetary and fiscal policy when surprise inflation (or deflation) is costly, taxation is distortionary, and non-state-contingent nominal debt of various maturities exists. In particular, we study whether and how the change in nominal government debt maturity affects optimal policy mix and equilibrium outcomes, in the presence of distortionary taxes and sticky prices. We solve the fully nonlinear model using global solution techniques, and find that debt maturity has drastic effects on optimal time-consistent policies in New Keynesian models. In particular, some interesting nonlinear effects are uncovered. Firstly, the equilibrium value for debt is negative and close to zero, which implies a slight undershooting of the inflation target in steady state. Secondly, starting from high level of debt-GDP ratio, the optimal policy will gradually reduce the level of debt, but with radical changes in the policy mix along the transition path. At high debt levels, there is a reliance on a relaxation of monetary policy to reduce debt through an expansion in the tax base and reduced debt service costs, while tax rates are used to moderate the increases in inflation. However, as debt levels fall, the use of monetary policy in this way is diminished and the policy maker turns to fiscal policy to continue the reduction in debt. This is akin to a switch from an active to passive fiscal policy in rule based descriptions of policy, which occurs endogenously under the optimal policy as debt levels fall. It can also be accompanied by a switch from passive to active monetary policy. This switch in the policy mix occurs at higher debt levels, the longer the average maturity of government debt. This is largely because high debt levels induce an inflationary bias problem, as policy makers face the temptation to use surprise inflation to erode the real value of that debt. This temptation is then more acute when debt is of shorter maturity, since the inflationary effects of raising taxes to reduce debt become increasingly costly as debt levels rise. Finally, in contrast to the Ramsey literature with real bonds, in the current setting we find no extreme portfolios of short and long-term debt. In addition, optimal debt maturity, implicitly, lengthens with the level of debt

Essays on Wage Formation and Globalization

Why do some firms pay collectively agreed wages rather than to negotiate wages individually? Do exporting firms pay higher wages than non-exporting firms, and to what extent this is determined by institutional frameworks? What are the connections between the labor unit costs and a strong export performance of companies? These and other questions are addressed in this book. In several chapters the author shows a variety of interactions between wages, globalization and institutional factors.Warum zahlen manche Firmen nach Tarif, statt die Löhne individuell auszuhandeln? Zahlen Exportfirmen höhere Löhne als Firmen, die nicht exportieren und inwieweit wird dies von institutionellen Rahmenbedingungen bestimmt? Welche Zusammenhänge bestehen zwischen den Lohnstückkosten und der Exportstärke von Unternehmen? Mit diesen und weiteren Fragen befasst sich der Autor im vorliegenden Band. In mehreren Kapiteln legt er dar, dass zwischen Löhnen, Globalisierung und institutionellen Kontextfaktoren vielfältige Wechselwirkungen bestehen

Price Formation and the Measurement of Market Power on the International Dairy Markets

In the recent years, the international dairy markets have become more and more the focus of public attention. This was primarily due to a higher degree of price volatility that also spilled over to the prices in the European Union after the export subsidies were suspended. Under these circumstances, it is increasingly important to understand the price formation on the international dairy markets. Since the international supply side on these markets is highly concentrated, the price formation can be expected to be influenced by market power. In this context, especially New Zealand is worth mentioning. The New Zealand dairy co-operative Fonterra is the most important player on the dairy markets holding world market shares of more than fifty percent in some cases. In this PhD thesis – that is composed of three papers – the pricing-to-market and the residual demand approach are used to analyze the New Zealand dairy exports with regard to market power. In doing so, both approaches are extended or modified. In the first paper, simulated data is used to show that the empirical pricing-to-market model proposed by Knetter can be expected to provide biased estimates of the prevailing degree of pricing-to-market. This is because the way of how the model controls for the export country’s overall marginal cost implicitly assumes that changes in the marginal cost affect prices equally across destination countries. However, since the destination-specific pass-through of cost and exchange rates are equal for a profit-maximizing firm, the pricing-to-market coefficients of the Knetter model can be expected to be biased toward the average coefficient in the sample – around fifty percent under realistic conditions. Therefore, in the second paper, an alternative approach to control for the marginal cost is proposed – the usage of the so-called “stochastic” marginal cost; this procedure also allows the inference of pricing-to-market through changes in the marginal cost. At the same time, the Knetter model is extended to an oligopolistic model of pricing-to-market that a) provides an index of product differentiation and additionally b) identifies the source of pricing-to-market – a task that had not been solved until now. In the third paper, the concept of the stochastic marginal cost is applied to the residual demand approach in order to replace cost shifting variables that often reflect only a small proportion of the marginal cost. The results of both approaches show that Fonterra has a moderate degree of market power on the international dairy markets with estimated markups that amount to nine percent on average. These markups vary much more across destination countries than across the products analyzed. As the pattern can hardly be explained by observable factors, the prevailing degrees of market power seem to be caused by unobservable and qualitative factors. The results also show that Fonterra uses its markup in order to smooth out changes in the marginal cost – on average 40% – in order to maintain its market share in the destination countries

Monetary policy rules and economic stability when agents must learn

In most economic models used for theoretical exploration or policy analysis, there is a crucial role for agents' expectations about future outcomes. Generally, it is assumed that economic agents take their decisions according to rationality principles and that they have a fairly accurate knowledge about the economic environment. In other words, they are assumed to know the model of the economy (Rational Expectations Hypothesis). The latter assumption is somewhat extreme, given the evident lack of agreement, even among professionals, about the correct model of the economy. In this thesis I maintain the hypothesis that agents take their decisions rationally, i. e. in order to maximize their utilities given their budget constraints, but I assume that each agent has to learn about the economic environment. More specifically, I consider economic models for monetary policy analysis. The goal is to study how the introduction of learning in these models can affect the design of monetary policy. Policy recommendations that might be sound under Rational Expectations, might lead to disastrous results under learning. I also use learning as a selection device. Some economic models fail to predict a unique Rational Expectations Equilibrium. Nevertheless, a REE is a sensible prediction of the model only if it can be shown that it is the result of some learning process of the economic agents. REE that are unstable under learning are not plausible equilibria