The great inflation, limited asset markets participation and aggregate demand: FED policy was better than you think

When enough agents do not participate in asset markets, the slope of the aggregate demand curve is reversed. Monetary policy should be passive, to ensure equilibrium determinacy and to minimize variations in output and inflation. This paper presents evidence that asset markets participation in the US was limited over the Great Inflation period and the slope of the IS curve had the ’wrong’ sign. Our results may help explain the ’Great Inflation’ and give optimism for FED policy. If the economy was characterized by a relatively higher degree of financial frictions over that period: (i) policy implied a determinate equilibrium and ruled out sunspot fluctuations; (ii) policy was closer to optimal than conventional wisdom dictates; (iii) responses and variability of macroeconomic variables conditional upon fundamental shocks are close to their estimated counterparts for a wide range of reasonable parameterizations. Notably, ’cost-push’ shocks are enough to generate a Great Inflation. JEL Classification: E31, E32, E44, E58, E65limited asset markets participation, monetary policy rules, real (in)determinacy, Taylor Principle, the Great Inflation

Fiscal Policy, Business Cycles and Labor-Market Fluctuations

In this paper we study the effects and transmission of fiscal policy in a dynamic general equilibrium sticky-price model with non-Ricardian agents, distortionary taxation and a Walrasian labor market. We derive a simple analytical framework for fiscal policy similar to the workhorse 'new synthesis' model widely used in the monetary policy literature. We then explore theoretical conditions under which government spending (whether financed by lump-sum or income taxes) can increase private consumption as observed in the data. We conclude that making the model fare better in this respect necessarily makes it fare worse in what concerns real wage fluctuations. Additionally, we show that the model can generate non-Keynesian effects of fiscal policy when participation to asset markets is limited enough and the monetary policy rule is passive.Fiscal Policy; Dynamic General Equilibrium; Distortionary Taxation; Sticky Prices; Non-Ricardian Agents; Government Debt; Non-Keynesian Effects.

Optimal Monetary Policy with Endogenous Entry and Product Variety

We show that deviations from long-run stability of product prices are optimal in the presence of endogenous producer entry and product variety in a sticky-price model with monopolistic competition in which price stability would be optimal in the absence of entry. Specifically, a long-run positive (negative) rate of inflation is optimal when the benefit of variety to consumers falls short of (exceeds) the market incentives for creating that variety under flexible prices, governed by the desired markup. Plausible preference specifications and parameter values justify a long-run inflation rate of two percent or higher. Price indexation implies even larger deviations from long-run price stability. However, price stability (around this non-zero trend) is close to optimal in the short run, even in the presence of time-varying flexible-price markups that distort the allocation of resources across time and states. The central bank uses its leverage over real activity in the long run, but not in the short run. Our results point to the need for continued empirical research on the determinants of markups and investigation of the benefit of product variety to consumers.

What accounts for the changes in U.S. fiscal policy transmission?

Using vector autoregressions on U.S. time series for 1957-1979 and 1983-2004, we find government spending shocks to have stronger effects on output, consumption, and wages in the earlier sample. We try to account for this observation within a DSGE model featuring price rigidities and limited asset market participation. Specifically, we estimate the structural parameters of the model for both samples by matching impulse responses. Model-based counterfactual experiments suggest that increased asset market participation accounts for some of the changes in fiscal transmission. However, the key quantitative factor appears to be the more active monetary policy of the Volcker-Greenspan period. JEL Classification: E21, E62, E63Asset Market Participation, DSGE, Fiscal Policy, government spending, Minimum Distance Estimation, monetary policy, Vector autoregression

Endogenous Entry, Product Variety, and Business Cycles

This paper builds a framework for the analysis of macroeconomic fluctuations that incorporates the endogenous determination of the number of producers and products over the business cycle. Economic expansions induce higher entry rates by prospective entrants subject to sunk investment costs. The sluggish response of the number of producers generates a new and potentially important endogenous propagation mechanism for business cycle models. The return to investment determines household saving decisions, producer entry, and the allocation of labor across sectors. Our framework replicates several features of business cycles and predicts procyclical profits even for preference specifications that imply countercyclical markups.Economic

Optimal Monetary Policy with Endogenous Entry and Product Variety

We show that deviations from long-run stability of product prices are optimal in the presence of endogenous producer entry and product variety in a sticky-price model with monopolistic competition in which price stability would be optimal in the absence of entry. Specifically, a long-run positive (negative) rate of inflation is optimal when the benefit of variety to consumers falls short of (exceeds) the market incentives for creating that variety under flexible prices, governed by the desired markup. Plausible preference specifications and parameter values justify a long-run inflation rate of two percent or higher. Price indexation implies even larger deviations from long-run price stability. However, price stability (around this non-zero trend) is close to optimal in the short run, even in the presence of time-varying flexible-price markups that distort the allocation of resources across time and states. The central bank uses its leverage over real activity in the long run, but not in the short run. Our results point to the need for continued empirical research on the determinants of markups and investigation of the benefit of product variety to consumers.Entry, Optimal Inflation Rate, Price Stability, Product Variety, Ramsey-Optimal Monetary Policy

Monopoly Power and Endogenous Product Variety: Distortions and Remedies

We study the efficiency properties of a dynamic, stochastic, general equilibrium, macroeconomic model with monopolistic competition and firm entry subject to sunk costs, a time-to-build lag, and exogenous risk of firm destruction. Under inelastic labor supply and linearity of production in labor, the market economy is efficient if and only if symmetric, homothetic preferences are of the C.E.S. form studied by Dixit and Stiglitz (1977). Otherwise, efficiency is restored by properly designed sales, entry, or asset trade subsidies (or taxes) that induce markup synchronization across time and states, and align the consumer surplus and profit destruction effects of firm entry. When labor supply is elastic, heterogeneity in markups across consumption and leisure introduces an additional distortion. Efficiency is then restored by subsidizing labor at a rate equal to the markup in the market for goods. Our results highlight the importance of preserving the optimal amount of monopoly profits in economies in which firm entry is costly. Inducing marginal cost pricing restores efficiency only when the required sales subsidies are financed with the optimal split of lump-sum taxation between households and firms.