Fiscal Crisis Resolution: Taxation Versus Inflation

The paper presents a model of fiscal and monetary policy that evaluates the tradeoff between higher distortionary labor taxation and higher inflation in the resolution of fiscal crises. In the model government debt is domestically held and nominal. Data are presented to show that such debt is now at least as important as external government debt in many key emerging markets, and that it is a very important item on the balance sheets of domestic financial intermediaries, despite the disappearance of financial repression. In the model government debt correspondingly enters the economy's intermediation technology. The key contribution of this mechanism is that it makes unanticipated inflation costly. This permits a generalization of existing fiscal theories of the price level by making price level determination the outcome of an explicit government optimization problem over a tax distortion and an inflation distortion. Higher taxes have a distortionary effect on labor supply but a beneficial effect by lowering inflation and supporting a higher public debt stock that in turn supports intermediation and the capital stock. In such a model first period price level jumps generally do not contribute to the resolution of fiscal crises. Instead ongoing but modest inflation is used to levy seigniorage on debt. This gives rise to a fiscal theory of inflation whose transmission mechanism does not rely on base money seigniorage. It is found that a large contribution of inflation to the resolution of a fiscal crisis is only optimal when the fiscal shock is transitory, while a long-lived shock is optimally financed mostly through taxes.Fiscal Policy and Price Level / Inflation Determination

Monetary Policy in an Equilibrium Portfolio Balance Model

Portfolio balance, sterilized foreign exchange intervention

Too much of a good thing? on the effects of limiting foreign reserve accumulation

Some emerging economies have recently experienced large government surpluses and accelerating foreign exchange reserve accumulation far in excess of what would be implied by the literature on optimal reserves. China in particular has repeatedly stressed that there may be an upper limit to how many reserves it is willing to hold. Using a dynamic general equilibrium model, we show that the credible expectation of such a limit would lead to a balance of payments anti-crisis, which is characterized by an economic boom, real appreciation, growing demand for domestic currency, and domestic inflation, in the period prior to the limit being reached.Balance of payments anti-crises; foreign exchange reserves; foreign exchange intervention; inflation targeting; exchange rate targeting

We should seriously consider revisiting “The Chicago Plan” of the 1930s which separates the monetary and credit functions of the banking system

In the wake of the Great Recession, anxiety over monetary and financial systems is the highest it has been since the 1930s. Concerned with the lack of creativity of modern solutions, Michael Kumhof reexamines a monetary reform proposal from the 1930s called “The Chicago Plan.” He argues that it contains six advantages to the current system and few disadvantages, making it worthy of serious consideration

Multi-Sectoral Cascading and Price Dynamics - A Bayesian Econometric Evaluation

Recent evidence by Bils and Klenow (2004) and Klenow and Kryvstov (2003) shows that the average price duration for US CPI-basket goods is in the order of one to two quarters, challenging the monetary business cycle research to try and explain how short price durations can nevertheless generate a large degree of aggregate inflation persistence. We empirically test the relevance of a cascading structure of production as an explanation for short price durations and large aggregate inflation persistence. The final good is produced through a chain of intermediate goods, which undergo several processing stages. At each stage the price is set in nominal terms, and can be adjusted only at random intervals. Though each individual price is adjusted frequently, because the final good price embeds the intermediate price movements, it will turn out to have a large degree of stickiness. We estimate the model using Bayesian techniques to evaluate the relative role of indexation, pricing contracts length, and cascading production structure in the US postwar data. The estimation shows that short pricing contracts within the standard Calvo pricing mechanism are compatible with large inflation persistence, and inflation indexation turns out to play a much less relevant role - in other words, it ends up being a reduced-form model for the cascading production structureInflation Inertia, Monetary Policy, Bayesian Estimation, Multisectoral Cascading

Inflation Inertia and Credible Disinflation - The Open Economy Case

This paper develops a model of inflation inertia based on optimizing forward looking staggered price setting in a small open economy. Unlike in current models of sticky prices, transitions to a lower steady state inflation rate take time even if they are fully credible, and they are associated with significant output losses. There is a welfare trade-off between these output losses and the gains from smaller inflationary distortions. For reasonable parameter values inflation stabilization improves welfare. The optimal steady state is reached at the Friedman rule. Technical appendices are available at www.nber.org/data-appendix/w9557/ inert-techapp.pdf

Pricing Policies and Inflation Inertia

The paper proposes a monetary model with nominal rigidities that differs from the conventional New Keynesian model in that firms set pricing policies instead of price levels. In response to permanent or highly persistent monetary policy shocks this model generates the empirically observed slow (inertial) and prolonged (persistent) reaction of the inflation rate, and also the recession which typically accompanies moderate disinflations. The reason is that firms respond to such shocks mostly through achange in the long-run or inflation updating component of their pricing policies. With staggered pricing policies this takes time to be reflected in aggregate inflation.

Banks, Money and the Zero Lower Bound

We study a New Keynesian model where banks create deposits through loans, subject to increasing marginal cost of lending. Banks do not intermediate commodity deposits between savers and borrowers, instead they offer a payment system that intermediates ledger-entry deposits between spenders and spenders. We discuss three implications. First, non-banks’ aggregate purchasing power consists not only of their income but also of new loans/deposits. Second, near the ZLB policy rate reductions compress spreads, and thereby reduce bank profitability, deposit creation and output. Third, near the ZLB Phillips curves are flatter because lower factor cost inflation is partly offset by inflationary credit rationin

An Economy in Transition and DSGE: What the Czech National Bank’s New Projection Model Needs

Since the introduction of the inflation targeting regime in 1998 the Czech National Bank has made considerable progress in developing formal tools for supporting its Forecasting and Policy Analysis System. This paper documents the advances in the ongoing research aimed at developing a DSGE small open economy model designed to capture some of the most important features of the Czech economy - both the business-cycle regularities and the recent developments associated with the economy's transition and its convergence towards the industrialized European countries. The model in its current form is able to capture trends in relative prices, allow for medium-convergence in expenditure shares, and deal with the undercapitalization and investment inflow issues. Besides the model exhibits real and nominal rigidities that are in line with the recent New Open Economy Macroeconomics literature built fully on first principles. The innovative features of our model include the international currency pricing scheme permitting flexible calibration of import and export price elasticities along with the disconnect of the nominal exchange rate, the policy reaction function with a parameterized forecast horizon, and a generalized capital accumulation equation with imperfect intertemporal substitution of investment..