How inflation hawks escape expectations traps

Why did inflation increase so dramatically from the 1960s to the 1970s? One possible theory is that once people started believing inflation would rise, the Fed was forced to validate those expectations by increasing the money supply. In "How Inflation Hawks Escape Expectations Traps," Sylvain Leduc discusses this "expectations trap" hypothesis and uses a direct measure of expectations to see if the theory is consistent with the data.Inflation (Finance)

Deficit-financed tax cuts and interest rates

Why do proposals to lower taxes often meet with opposition in Congress. One argument is that lowering taxes without an equivalent fall in government spending may lead to future budget deficits, which will translate into higher long-term interest rates and a lower level of income. Sylvain Leduc discusses the theoretical arguments under which budget deficits lead to higher interest rates. He also surveys empirical studies that used data on expected budget deficits to document the possibility that increases in future budget deficits are associated with higher real long-term interest rates.Deficit financing ; Taxation ; Interest rates

Why Is the Business Cycle Behavior of Fundamentals Alike Across Exchange Rate Regimes?

This paper develops a two-country, two-sector general equilibrium business cycle model with nominal rigidities featuring deviations from the law of one price. We show that a model with such building blocks can quantitatively account for the empirical fact that, of the statistical properties of most macroeconomic variables, only the volatility of the real and nominal exchange rates has dramatically changed after the fall of the Bretton Woods system. In particular, we replicate some explicit benchmark tests proposed in the literature (for instance, by Flood and Rose (1995)) with simulated data from our artificial economy. The presence of firms pricing-to-market and different speeds of price adjustment across sectors is important in generating the results. We show that these features dampen the upward impact of monetary policy shocks, following the introduction of a flexible exchange rate regime, on the volatility of output, consumption and especially net exports. In our model, the increase in the volatility of the real exchange rate, when the currency floats is due to an increase in the covariance of relative prices across countries. Since the variance of relative prices is not affected by the exchange rate regime, neither is that of most other macroeconomic variables.

Expectations and economic fluctuations: an analysis using survey data

Using survey-based measures of future U.S. economic activity from the Livingston Survey and the Survey of Professional Forecasters, the authors study how changes in expectations, and their interaction with monetary policy, contribute to fluctuations in macroeconomic aggregates. They find that changes in expected future economic activity are a quantitatively important driver of economic fluctuations: a perception that good times are ahead typically leads to a significant rise in current measures of economic activity and inflation. The authors also find that the short-term interest rate rises in response to expectations of good times as monetary policy tightens. Their results provide quantitative evidence on the importance of expectations-driven business cycles and on the role that monetary policy plays in shaping them.Economic forecasting ; Monetary policy ; Business cycles

Why are business cycles alike across exchange-rate regimes?

Since the adoption of flexible exchange rates in the early 1970s, real exchange rates have been much more volatile than they were under Bretton Woods. However, the literature showed that the volatilities of most other macroeconomic variables have not been affected by the change in exchange-rate regime. This poses a puzzle for standard international business cycle models. In this paper, the authors study this puzzle by developing a two-country, two-sector model with nominal rigidities featuring deviations from the law of one price because a fraction of firms set prices in buyers' currencies. The authors show that a model with such building blocks can improve the match between the model and the data across exchange-rate regimes. By partially insulating goods markets across countries and thus mitigating the international expenditure-switching effect, local currency pricing considerably dampens the responses of net exports to shocks hitting the economies therefore helping to account for the puzzle.Foreign exchange rates

On exchange rate regimes, exchange rate fluctuations, and fundamentals

The authors develop a two-country, two-sector general equilibrium business cycle model with nominal rigidities featuring deviations from the law of one price. The paper shows that a model with these features can quantitatively account for the empirical fact that of the statistical properties of most macroeconomic variables, only the volatility of the real and nominal exchange rates has dramatically changed after the fall of the Bretton Woods system. In particular, the authors replicate some explicit nonstructural tests proposed in the literature with simulated data from their artificial economy. The authors find that while the variability of observed fundamentals (e.g., output, money supply, and interest rates) is barely affected by the exchange rate regime, that of the exchange rate increases substantially under flexible rates.Foreign exchange rates

Should central banks lean against changes in asset prices?

How should monetary policy be conducted in the presence of endogenous feedback loops between asset prices, firms’ financial health, and economic activity? We reconsider this question in the context of the financial accelerator model and show that, when the level of natural output is inefficient, the optimal monetary policy under commitment leans considerably against movements in asset prices and risk premia. We demonstrate that an endogenous feedback loop is crucial for this result and that price stability is otherwise quasi-optimal absent this feature. We also show that the optimal policy can be closely approximated and implemented using a speed-limit rule that places a substantial weight on the growth of financial variables.Monetary policy ; Asset pricing

Trade Integration, Competiton, and the Decline in Exchange-rate Pass-through

Over the past twenty years, U.S. import prices have become less responsive to the exchange rate. We propose that this decline is a result of increased trade integration. To illustrate this effect, we develop an open economy DGE model in which there is strategic complementarity in price setting so that a firm's pricing decision depends on the prices set by its competitors. Because of the complementarity in price setting, a foreign exporter finds it optimal to vary its markup over cost in response to shocks that change the exchange rate, which insulates import prices from exchange rate movements. With increased trade integration, exporters have become more responsive to the prices of their competitors and this change in pricing behavior accounts for a significant portion of the observed decline in the sensitivity of U.S import prices to the exchange rate. Our environment of low pass-through also has important implications for the welfare benefits of trade integration: we find that the benefits are substantially reduced compared to an environment with complete pass-through.Pass-through, Trade Integration, Strategic Complementarities

Optimal Monetary Policy and the Sources of Local-Currency Price Stability

We analyze the policy trade-offs generated by local currency price stability of imports in economies where upstream producers strategically interact with downstream firms selling the final goods to consumers. We study the effects of staggered price setting at the downstream level on the optimal price (and markup) chosen by upstream producers and show that downstream price movements affect the desired markup of upstream producers, magnifying their price response to shocks. We revisit the international dimensions of optimal monetary policy, unveiling an argument in favour of consumer price stability as the main prescription for monetary policy. Since stable consumer prices feed back into a low volatility of markups among upstream producers, this contains inefficient deviations from the law of one price at the border. However, efficient stabilization of different CPI components will not generally result into perfect stabilization of headline inflation. National policies optimally respond to the same shocks in a similar way, thus containing volatility of the terms of trade, but not necessarily of the real exchange rate. The latter will be more volatile, among other things, the larger the home bias in expenditure and the content of local inputs in consumer goods.optimal monetary policy, price discrimination, price dispersion, exchange rate pass through, real exchange rates