Optimal Fiscal Policy in a Monetary Union

We study optimal fiscal policy in a monetary union where monetary policy is decided by an independent central bank. We consider a two-country model with trade in goods and assets, augmented with sticky prices, labor income taxes and stochastic government consumption. It is optimal to finance a shock in part by running deficits and in part by raising the labor income tax, even though the latter is distortionary. The optimal speed of adjustment of budget deficits is much higher than the benchmark adjustment of 0.5 percent of GDP per year required by the recent revision of the Stability and Growth Pact (SGP). Optimal fiscal policy does not depend on the initial level of public debt. Ramsey monetary policy allows for less aggressive and more expansionary response of fiscal policy than the monetary policy implied by an interest rates rule.Monetary Policy, Monetary Union, Fiscal Policy

Exchange Rates and Fiscal Adjustments: Evidence from the OECD and Implications for EMU

This paper characterizes monetary and exchange-rate policies during successful and unsuccessful fiscal adjustments by analyzing the OECD economies over the period 1970 to 1998. We find that successful adjustments are almost always preceded by large nominal and real exchange rate depreciations while unsuccessful adjustments are preceded by revaluations and followed by depreciations. The extreme adjustments of Ireland and Denmark in the 1990s fit this pattern of depreciation for success very closely. Early depreciation is a significant and quantitatively important predictor of the persistence of adjustment: each 1 percent of depreciation in the two years preceding a fiscal adjustment leads to approximately 2 percent increase in the probability of success. Since the size of the typical pre-adjustment depreciation is 5%, this is an important effect. When compared to an indicator of the composition of the fiscal adjustment, the reliance on spending cuts, the two variables have similar quantitative impacts on the likelihood of persistence. Our results are robust to alternative definitions of the depreciation period, the persistence of the adjustment, and whether we use effective, DM or US$ exchange rates. Monetary policy does not play a significant role in fiscal adjustments. Our results suggest that attaining persistent fiscal adjustment within EMU is likely to become a more costly endeavor than it was beforehand, as EMU members have adopted a single currency and therefore abandoned the use of exchange rate policies vis-`-vis each other.

Optimal Exchange-Rate Targeting with Large Labor Unions

We study whether monetary policy should target the exchange rate in a two-country model with non-atomistic wage setters, non-traded goods and different degrees of exchange-rate pass through. Commitment to an exchange rate target reduces the labor market distortion. Large labor unions anticipate that higher wages depreciate the exchange rate, which triggers an increase in the interest rate and restrain wage demands. However, reduced exchange rate flexibility worsens the distortion stemming from preset pricing. Targeting the nominal exchange rate will be optimal when the labor market distortion is larger than the preset-pricing one. This result arises with cooperation both under producer and local currency pricing, even though the optimal degree of exchange-rate targeting is higher under local currency pricing. In the Nash equilibrium, the terms-of-trade effect raises optimal wage mark-ups thereby reducing the optimal weight on the exchange rate target. The terms-of-trade effect is stronger as openness and substitutability among Home and Foreign goods increase.Monetary policy, International Finance, Open-Economy Macroeconomics

Risky Mortgages in a DSGE Model

This paper develops a DSGE model with housing, risky mortgages and endogenous default. Housing investment is subject to idiosyncratic risk and some mortgages are defaulted in equilibrium. An unanticipated increase in the standard deviation of housing investment produces a credit crunch where delinquencies and mortgage interest rates increase, lending is curtailed, and aggregate demand for non-durable goods falls. The economy experiences a recession as a consequence of the credit crunch. The paper compares economies that differ only in the riskiness of housing investment. Economies with lower risk are characterized by lower steady-state mortgage default rates and higher loan-to-value and leverage ratios. The macroeconomic effects of an unanticipated increase in housing investment risk are amplified in high-leverage economies. Monetary policy plays an important role in the transmission of housing investment risk, as inertial interest rate rules generate deeper output contractions.Housing, Mortgage default, Mortgage Risk

Mortgage Amortization and Amplification

Mortgages characterized by negative or low early amortization schedules amplify the macroeconomic effects of a housing risk shock. We analyze the role of mortgage amortization in a two-sector DSGE model with housing risk and endogenous default. Mortgage loan contracts extend to two periods and have adjustable rates. The fraction of principal to be repaid in the first period can vary. As the fraction of principal to be paid in the first period falls, steady-state mortgages and leverage increase and the impact of a housing risk shock on consumption and output is amplified. Borrowers prefer negative amortization. If free to choose the amortization schedule, borrowers would repay most of the principal in the last period of the contract. Low early repayments of principal allow borrowers to hold on to their housing stock and postpone default to the second period having incurred small sunk costs.Housing, Mortgage default, Mortgage risk

Fiscal Policy in a Monetary Union: Can Fiscal Cooperation be Counterproductive?

We analyze the interaction of monetary and fiscal policies in a monetary union where the common central bank is more conservative than the fiscal authorities. When monetary and fiscal policies are discretionary, we find that the Nash equilibrium is sub-optimal with higher output and lower inflation than the cooperative Ramsey op- timum. In a further example of counterproductive cooperative, we find that fiscal cooperation makes matters worse. We also examine cooperative and non-cooperative fiscal policy in the case where the central bank can commit and has the same prefer- ences as the fiscal authorities.fiscal-monetary policy interactions, fiscal cooperation and non-cooperation.

Is U.S. Fiscal Policy Optimal?

We find and compare two simple fiscal rules. The first is a theoretical rule that approximates well Ramsey-optimal fiscal policy in a DSGE model calibrated to the U.S. economy over the period 1955:1 to 2007:3. The second is an empirical rule that approximates well actual U.S. fiscal policy over the same period. Our main findings are: First, Ramsey-optimal fiscal policy displays limited volatility even in the presence of sticky prices, while public debt absorbs most of the shocks. Second, actual U.S. fiscal policy is excessively counter-cyclical. Ramsey-optimal fiscal policy is negatively correlated with output over the business cycle, as expansions generate reduction in the level of public debt and the tax rate and vice versa. On the other hand, actual fiscal policy is positively correlated with output, with tax rate being raised during expansions and reduced during recessions. Third, actual fiscal policy is inconsistent with long-run debt sustainability over the period considered.fiscal policy

Expectations-Driven Cycles in the Housing Market

This paper analyzes housing market boom-bust cycles driven by changes in households'expectations. We explore the role of expectations not only on productivity but on several other shocks that originate in the housing market, the credit market and the conduct of monetary policy. We find that, in the presence of nominal rigidities, expectations on both the conduct of monetary policy and future productivity can generate housing market boom-bust cycles in accordance with the empirical findings. Moreover, expectations of either a future reduction in the policy rate or a temporary increase in the central bank's inflation target that are not fulfilled generate a macroeconomic recession. Increased access to credit generates a boom-bust cycle in most variables only if it is expected to be reversed in the near future.Credit Frictions, Boom-Bust Cycles, News Shocks, Housing Prices.

Expectations-driven cycles in the housing market

Survey data suggests that news of changes in business conditions are significantly related to house prices and consumers' beliefs of favorable buying conditions in the housing market. This paper explores the transmission of "news shocks" as a source of boom-bust cycles in the housing market. News on shocks originated in different sectors of the economy can generate booms in the housing market in accordance with the average behavior in the data; expectations on monetary policy and in inflationary shocks that are not fulfilled can also lead to the observed subsequent macroeconomic recession. Investigating the role of the credit market for house market fluctuations we find that favorable credit conditions that are expected to be reversed in the near future generate boom-bust cycle dynamics in line with the most recent episode. Further, credit conditions also affect boom-bust cycles generated by news shocks originated in other sectors of the economy. In particular, lower loan-to-value ratios reduce the severity of expectations-driven cycles and the volatility of household debt, aggregate consumption and GDP.boom-bust cycles; credit frictions; housing market

Exchange Rates and Fiscal Adjustments: Evidence from the OECD and Implications for EMU

This paper characterizes monetary and exchange-rate policies during successful and unsuccessful fiscal adjustments by analyzing the OECD economies over the period 1970 to 1998. We find that successful adjustments are almost always preceded by large nominal and real exchange rate depreciations while unsuccessful adjustments are preceded by revaluations and followed by depreciations. The extreme adjustments of Ireland and Denmark in the 1990s fit this pattern of depreciation for success very closely. Early depreciation is a significant and quantitatively important predictor of the persistence of adjustment: each 1 percent of depreciation in the two years preceding a fiscal adjustment leads to approximately 2 percent increase in the probability of success. Since the size of the typical pre-adjustment depreciation is 5%, this is an important effect. When compared to an indicator of the composition of the fiscal adjustment, the reliance on spending cuts, the two variables have similar quantitative impacts on the likelihood of persistence. Our results are robust to alternative definitions of the depreciation period, the persistence of the adjustment, and whether we use effective, DM or US$ exchange rates. Monetary policy does not play a significant role in fiscal adjustments. Our results suggest that attaining persistent fiscal adjustment within EMU is likely to become a more “costly” endeavor than it was beforehand, as EMU members have adopted a single currency and therefore abandoned the use of exchange rate policies vis-à-vis each other.N/