The inflation bias under Calvo and Rotemberg pricing

New Keynesian analysis relies heavily on two workhorse models of nominal inertia – due to Calvo (1983) and Rotemberg (1982), respectively – to generate a meaningful role for monetary policy. These are often used interchangeably since they imply an isomorphic linearized Phillips curve and, if the steady-state is efficient, the same policy conclusions. In this paper we compute time-consistent optimal monetary policy in the benchmark New Keynesian model containing each form of price stickiness using global solution techniques. We find that, due to an offsetting endogenous impact on average markups, the inflation bias problem under Calvo contracts is often significantly greater than under Rotemberg pricing, despite the fact that the former typically exhibits far greater welfare costs of inflation. The nonlinearities inherent in the New Keynesian model are significant and the form of nominal inertia adopted is not innocuous

Estimated Open Economy New Keynesian Phillips Curves for the G7

In this paper we develop an open economy model of firms' pricing behaviour under imperfect competition. This allows us to introduce various terms of trade effects influencing the firm's pricing decision, in addition to labour costs which dominate most closed-economy specifications of the New Keynesian Phillips (NKPC) curve. Our analysis gives rise to a hybrid open economy NKPC which nests existing closed and open economy specifications adopted in empirical work. We estimate this specification for the G7 economies and find that the US, UK and Canada typically enjoy less inertia in price setting than the European G7 economies and Japan and that these estimates are both plausible and in line with survey evidence. We also find that the proportion of firms which use simple backward-looking rules of thumb in price setting is greater when the frequency of price change is smaller. Finally there is evidence of significant asymmetries in price setting amongst EMU members.

Estimated General Equilibrium Models for the Evaluation of Monetary Policy in the US and Europe

A persistent criticism of general equilibrium models of monetary pol-icy which incorporate nominal inertia in the form of the New Keynesian Phillips Curve (NKPC) is that they fail to capture the extent of inflation inertia in the data. In this paper we derive a general equilibrium model based on optimising behaviour, but which also implies a data consistent NKPC. Specifically our model accounts for nominal inertia in both price and wage setting as well for habits in consumption. Using US and European data from 1970 to 1998 our parameter estimates reveal that (i) there is relatively more inertia in price-setting in Europe; (ii) wage contracts last longer in the US; (iii) the extent of backward-looking behaviour in price and wage setting is statistically significant but small in both the US and Europe; and (iv) significant habits e .ects are present in European consumption. Finally we simulate the effects of monetary policy and find that while the magnitude of the impact of monetary policy on the endogenous variables in our estimated models are similar to other econometric studies, the dynamic paths for variables display less inertia than is typically found in studies which use output gaps to proxy changes in marginal costs.

Estimated Open Economy New Keynesian Phillips Curves for the G7

In this paper we develop an open economy model of firms’ pricing be-haviour under imperfect competition. This allows us to introduce various terms of trade e .ects influencing the firm’s pricing decision, in addition to labour costs which dominate most closed-economy specifications of the New Keynesian Phillips (NKPC) curve. Our analysis gives rise to a hy-brid open economy NKPC which nests existing closed and open economy specifications adopted in empirical work. We estimate this specification for the G7 economies and find that the US, UK and Canada typically enjoy less inertia in price setting than the European G7 economies and Japan andthattheseestimatesareboth plausibleand in linewith sur-vey evidence. We also find that the proportion of firms which use simple backward-looking rules of thumb in price setting is greater when the fre-quency of price change is smaller. Finally there is evidence of significant asymmetries in price setting amongst EMU members.

Estimated General Equilibrium Models for the Evaluation of Monetary Policy in the US and Europe

A persistent criticism of general equilibrium models of monetary policy which incorporate nominal inertia in the form of the New Keynesian Phillips Curve (NKPC) is that they fail to capture the extent of inflation inertia in the data. In this paper we derive a general equilibrium model based on optimising behaviour, but which also implies a data consistent NKPC. Specifically our model accounts for nominal inertia in both price and wage setting as well for habits in consumption. Using US and European data from 1970 to 1998 our parameter estimates reveal that (i) there is relatively more inertia in price-setting in Europe; (ii) wage contracts last longer in the US; (iii) the extent of backward-looking behaviour in price and wage setting is statistically significant but small in both the US and Europe; and (iv) significant habits effects are present in European consumption. Finally we simulate the effects of monetary policy and find that while the magnitude of the impact of monetary policy on the endogenous variables in our estimated models are similar to other econometric studies, the dynamic paths for variables display less inertia than is typically found in studies which use output gaps to proxy changes in marginal costs.

Monetary and fiscal policy interactions in a New Keynesian model with capital accumulation and non-Ricardian consumers

This paper develops a small New Keynesian model with capital accumulation and government debt dynamics. The paper discusses the design of simple monetary and fiscal policy rules consistent with determinate equilibrium dynamics in the absence of Ricardian equivalence. Under this assumption, government debt turns into a relevant state variable which needs to be accounted for in the analysis of equilibrium dynamics. The key analytical finding is that without explicit reference to the level of government debt it is not possible to infer how strongly the monetary and fiscal instruments should be used to ensure determinate equilibrium dynamics. Specifically, we identify in our model discontinuities associated with threshold values of steady-state debt, leading to qualitative changes in the local determinacy requirements. These features extend the logic of Leeper (1991) to an environment in which fiscal policy is non-neutral and requires us to pay equal attention to to monetary and fiscal policy in designing policy rules consistent with determinate dynamics.

Monetary and fiscal policy interactions in a New Keynesian model with capital accumulation and non-Ricardian consumers

This paper develops a small New Keynesian model with capital accumulation and government debt dynamics. The paper discusses the design of simple monetary and fiscal policy rules consistent with determinate equilibrium dynamics in the absence of Ricardian equivalence. Under this assumption, government debt turns into a relevant state variable which needs to be accounted for in the analysis of equilibrium dynamics. The key analytical finding is that without explicit reference to the level of government debt it is not possible to infer how strongly the monetary and fiscal instruments should be used to ensure determinate equilibrium dynamics. Specifically, we identify in our model discontinuities associated with threshold values of steady-state debt, leading to qualitative changes in the local determinacy requirements. These features extend the logic of Leeper (1991) to an environment in which fiscal policy is non-neutral. Naturally, this non-neutrality increases the importance of fiscal aspects for the design of policy rules consistent with determinate dynamics. JEL Classification: E52, E63fiscal regimes, monetary policy

Electoral uncertainty and the deficit bias in a New Keynesian Economy

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

Unemployment and the Productivity Slowdown: A Labour Supply Perspective

Many OECD economies suffered a productivity slowdown beginning in the early 1970s. However, the increase in unemployment that followed this slowdown was more pronounced in European economies relative to the US. In this paper we present an efficiency wage model, which enables us to identify five channels through which the productivity slowdown can affect workers’ effort incentives. We argue that this model can explain the different trends in unemployment across countries over this period in the face of a similar slowdown in productivity. We also demonstrate how the link between growth and unemployment depends upon labour market institutions in such a way that we can reconcile the mixed empirical results observed in the literature.technical progress; endogenous growth; unemployment; efficiency wages

Interactions Between Monetary and Fiscal Policy under Flexible Exchange Rates

The potential importance of fiscal policy in influencing inflation has recently been highlighted, following Woodford (1995), under the heading of the ‘Fiscal Theory of the Price Level’ (FTPL). Applications of this theory to open economies operating under flexible exchange rates has suggested that, in contrast to the closed economy FTPL, insolvent fiscal policy may lead to indeterminacy of price levels and nominal exchange rates. In this paper, we relax the assumptions underpinning the FTPL by developing a two country open economy model, where each country has overlapping generations of non-Ricardian consumers who supply labour to imperfectly competitive firms which can only change their prices infrequently. We examine the case where the two countries have independent monetary and fiscal policies. We show that the fiscal response required to ensure stability of the real debt stock, and allow each country to operate an ‘active’ inflation-targeting monetary policy is greater when consumers are not infinitely lived. One monetary authority can abandon its active targeting of inflation to stabilise the debt of another fiscal authority, and there is no requirement that these policy makers operate in the same economy. 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 one or more monetary authority is forced to abandon its active targeting of inflation, then fiscal shocks have a much greater impact on both output and inflation.Monetary Policy; Fiscal Policy; New Open Economy Macroeconomics; Fiscal Theory of the Price Level