A Fiscal Theory of Sovereign Risk

This paper presents a fiscal theory of sovereign risk and default. Under certain monetary-fiscal regimes, the risk of default, and thus the emergence of sovereign risk premia, are inevitable. The paper characterizes the equilibrium processes of the sovereign risk premium and the default rate under a number of alternative monetary policy arrangements. Under some of the policy environments considered, the expected default rate and the sovereign risk premium are zero although the government defaults regularly. Under other monetary regimes the default rate and the sovereign risk premium are serially correlated and therefore forecastable. Environments are characterized under which delaying default is counterproductive.

Real Exchange Rate Targeting and Macroeconomic Instability

Using an optimizing model of a small open economy, this paper studies the macroeconomic effects of PPP rules whereby the government increases the devaluation rate when the real exchange rate defined as the price of tradables in terms of nontradables is below its long-run level and reduces the devaluation rate when the real exchange rate is above its long-run level. The paper shows that the mere existence of such a rule can generate aggregate fluctuations due to self-fulfilling revisions in expectations. The result is shown to obtain in both flexible- and sticky-price environments.

On Overborrowing

This paper characterizes the equilibrium dynamics in an economy facing an aggregate debt ceiling. This borrowing limit is intended to capture an environment in which foreign investors base their lending decisions predominantly upon macro indicators. Individual agents do not internalize the borrowing constraint. Instead, a country interest-rate premium emerges to clear the financial market. The implied equilibrium dynamics are compared to those arising from a model in which the debt ceiling is imposed at the level of each individual agent. The central finding of the paper is that the economy with the aggregate borrowing limit does not generate higher levels of debt than the economy with the individual borrowing limit. That is, there is no overborrowing in equilibrium.

Optimal Simple and Implementable Monetary and Fiscal Rules

The goal of this paper is to compute optimal monetary and fiscal policy rules in a real business cycle model augmented with sticky prices, a demand for money, taxation, and stochastic government consumption. We consider simple policy rules whereby the nominal interest rate is set as a function of output and inflation, and taxes are set as a function of total government liabilities. We require policy to be implementable in the sense that it guarantees uniqueness of equilibrium. We do away with a number of empirically unrealistic assumptions typically maintained in the related literature that are used to justify the computation of welfare using linear methods. Instead, we implement a second-order accurate solution to the model. Our main findings are: First, the size of the inflation coefficient in the interest-rate rule plays a minor role for welfare. It matters only insofar as it affects the determinacy of equilibrium. Second, optimal monetary policy features a muted response to output. More importantly, interest rate rules that feature a positive response of the nominal interest rate to output can lead to significant welfare losses. Third, the optimal fiscal policy is passive. However, the welfare losses associated with the adoption of an active fiscal stance are negligible.

Optimal Fiscal and Monetary Policy Under Imperfect Competition

This paper studies optimal fiscal and monetary policy under imperfect competition in a stochastic, flexible-price, production economy without capital. It shows analytically that in this economy the nominal interest rate acts as an indirect tax on monopoly profits. Unless the social planner has access to a direct 100 percent tax on profits, he will always find it optimal to deviate from the Friedman rule by setting a positive and time-varying nominal interest rate. The dynamic properties of the Ramsey allocation are characterized numerically. As in the perfectly competitive case, the labor income tax is remarkably smooth, whereas inflation is highly volatile and serially uncorrelated. An exact numerical solution method to the Ramsey conditions is proposed.

Optimal Fiscal and Monetary Policy in a Medium-Scale Macroeconomic Model: Expanded Version

In this paper, we study Ramsey-optimal fiscal and monetary policy in a medium-scale model of the U.S.\ business cycle. The model features a rich array of real and nominal rigidities that have been identified in the recent empirical literature as salient in explaining observed aggregate fluctuations. The main result of the paper is that price stability appears to be a central goal of optimal monetary policy. The optimal rate of inflation under an income tax regime is half a percent per year with a volatility of 1.1 percent. This result is surprising given that the model features a number of frictions that in isolation would call for a volatile rate of inflation---particularly nonstate-contingent nominal public debt, no lump-sum taxes, and sticky wages. Under an income-tax regime, the optimal income tax rate is quite stable, with a mean of 30 percent and a standard deviation of 1.1 percent. Simple monetary and fiscal rules are shown to implement a competitive equilibrium that mimics well the one induced by the Ramsey policy. When the fiscal authority is allowed to tax capital and labor income at different rates, optimal fiscal policy is characterized by a large and volatile subsidy on capital.

Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function

This paper derives a second-order approximation to the solution of a general class of discrete- time rational expectations models. The main theoretical contribution of the paper is to show that for any model belonging to the general class considered, the coefficients on the terms linear and quadratic in the state vector in a second-order expansion of the decision rule are independent of the volatility of the exogenous shocks. In other words, these coefficients must be the same in the stochastic and the deterministic versions of the model. Thus, up to second order, the presence of uncertainty affects only the constant term of the decision rules. In addition, the paper presents a set of MATLAB programs designed to compute the coefficients of the second-order approximation. The validity and applicability of the proposed method is illustrated by solving the dynamics of a number of model economies.

Country Spreads and Emerging Countries: Who Drives Whom?

A number of studies have stressed the role of movements in US interest rates and country spreads in driving business cycles in emerging market economies. At the same time, country spreads have been found to respond to changes in both the US interest rate and domestic conditions in emerging markets. These intricate interrelationships leave open a number of fundamental questions: Do country spreads drive business cycles in emerging countries or vice versa, or both? Do US interest rates affect emerging countries directly or primarily through their effect on country spreads? This paper addresses these and other related questions using a methodology that combines empirical and theoretical elements. The main findings of the paper are: (1) US interest rate shocks explain about 20 percent of movements in aggregate activity in emerging market economies at business-cycle frequency. (2) Country spread shocks explain about 12 percent of business-cycle movements in emerging economies. (3) About 60 percent of movements in country spreads are explained by country-spread shocks. (4) In response to an increase in US interest rates, country spreads first fall and then display a large, delayed overshooting; (5) US-interest-rate shocks affect domestic variables mostly through their effects on country spreads. (6) The fact that country spreads respond to business conditions in emerging economies significantly exacerbates aggregate volatility in these countries. (7) The US-interest-rate shocks and country-spread shocks identified in this paper are plausible in the sense that they imply similar business cycles in the context of an empirical VAR model as they do in the context of a theoretical dynamic general equilibrium model of an emerging market economy.

Optimal Fiscal and Monetary Policy Under Sticky Prices

This paper studies optimal .scal and monetary policy under sticky product prices. The theoretical framework is a stochastic production economy without capital. The government finances an exogenous stream of purchases by levying distortionary income taxes, printing money, and issuing one-period nominally risk-free bonds. The main findings of the paper are: First, for a miniscule degree of price stickiness (i.e., many times below available empirical estimates)the optimal volatility of in.ation is near zero. This result stands in stark contrast with the high volatility of inflation implied by the Ramsey allocation when prices are flexible. The finding is in line with a recent body of work on optimal monetary policy under nominal rigidities that ignores the role of optimal fiscal policy. Second, even small deviations from full price flexibility induce near random walk behavior in government debt and tax rates, as in economies with real non-state-contingent debt only. Finally, sluggish price adjustment raises the average nominal interest rate above the one called for by the Friedman rule.

The Business Cycles of Balance-of-Payment Crises: A Revision of Mundellan Framework

In his seminal 1960 article Robert Mundell proposed a model of balance-of-payments crises in which confidence in the continuation of a currency peg depended on the observed holdings of central bank foreign reserves. We examine the implications of a reformulation of this view from the perspective of an equilibrium business cycle model in which the probability of devaluation is an endogenous variable conditioned on foreign reserves. The model explains some business cycle regularities of exchange-rate-based stabilizations while also producing devaluation probabilities that capture some features of devaluation probabilities estimated in the data. The analysis aims to explain both the real effects and the collapse of temporary fixed-exchange-rate regimes in an unified framework, and provides an economic interpretation for the evidence that foreign reserves are a robust leading indicator of currency crises.