Computing Markov-perfect optimal policies in business-cycle models

Time inconsistency is an essential feature of many policy problems. This paper presents and compares three methods for computing Markov-perfect optimal policies in stochastic nonlinear business cycle models. The methods considered include value function iteration, generalized Euler equations, and parameterized shadow prices. In the context of a business cycle model in which a fiscal authority chooses government spending and income taxation optimally, although lacking the ability to commit, we show that the solutions obtained using value function iteration and generalized Euler equations are somewhat more accurate than that obtained using parameterized shadow prices. Among these three methods, we show that value function iteration can be applied easily, even to environments that include a risk-sensitive fiscal authority and/or inequality constraints on government spending. We show that the risk-sensitive fiscal authority lowers government spending and income taxation, reducing the disincentive to accumulate wealth that households face

Expectations Traps and Monetary Policy with Limited Commitment

We study the existence and uniqueness properties of monetary policy with limited commitment in LQ RE models. We use a New Keynesian model with debt accumulation in the spirit of Leeper (1991) as a `lab', because this model generates multiple equilibria under pure discretion, and under full commitment there are two distinct determinate regimes. We study how these properties change over the continuum of intermediate cases between commitment and discretion. We find that although multiple equilibria exist for high degrees of precommitment, even a small degree of precommitment selects a unique equilibrium for a wide range of parameters. We discuss the stability properties of policy equilibria which can be used to design an equilibrium selection criterion. We also demonstrate very different welfare implications for different policy equilibria.Limited Commitment, Commitment, Discretion, Multiple Equilibria

Expectations Traps and Coordination Failures: Selecting among Multiple Discretionary Equilibria

Discretionary policymakers cannot manage private-sector expectations and cannot coordinate the actions of future policymakers. As a consequence, expectations traps and coordination failures can occur and multiple equilibria can arise. To utilize the explanatory power of models with multiple equilibria it is �first necessary to understand how an economy arrives to a particular equilibrium. In this paper, we employ notions of learnability, self-enforceability, and properness to motivate and develop a suite of equilibrium selection criteria. Central among these criteria are whether the equilibrium is learnable by private agents and jointly learnable by private agents and the policymaker. We use two New Keynesian policy models to identify the strategic interactions that give rise to multiple equilibria and to illustrate our equilibrium selection methods. Importantly, unless the Pareto-preferred equilibrium is learnable by private agents, we �find little reason to expect coordination on that equilibrium.Discretionary policymaking, multiple equilibria, coordination, equilibrium selection

The interest rate - exchange rate nexus: exchange rate regimes and policy equilibria

We study a credible Markov-perfect monetary policy in an open New Keynesian economy with incomplete financial markets. We demonstrate the existence of two discretionary equilibria. Following a shock the economy can be stabilised either 'quickly' or 'slow', both dynamic paths satisfy conditions of optimality and time-consistency. The model can help us to understand sudden change of the interest rate and exchange rate volatility in 'tranquil' and 'volatile' regimes even under a fully credible 'soft peg' of the nominal exchange rate in developing countries.Small open economy, Incomplete ?nancial markets, Discretionary Monetary policy, Multiple Equilibria

A Comparison of National Saving Rates in the UK, US and Italy

We develop the approach of Gokhale et al. (1996), based on the life-cycle model of savings, to decompose the di?erences in the national saving rates between the UK, US and Italy. Our work suggests that the US saving rate is lower principally because Americans on average retire later. In contrast, the Italian saving rate is higher predominantly because Italians are credit constrained, particularly when young. We also found that demography and the di?erent tax and bene?t systems are able to explain little of the cross-sectional di?erences in saving rates. The study accounts for the possible importance of intergenerational private transfers in determining saving rates.Saving Rates, International Comparisons, Intergenerational Transfers, Borrowing Constraints

The Interest Rate — Exchange Rate Nexus: Exchange Rate Regimes and Policy Equilibria

We study a credible Markov-perfect monetary policy in an open New Keynesian economy with incomplete finacial markets. We demonstrate the existence of two discretionary equilibria. Following a shock the economy can be stabilised either 'quickly' or 'slow', both dynamic paths satisfy conditions of optimality and time-consistency. The model can help us to understand sudden change of the interest rate and exchange rate volatility in 'tranquil' and 'volatile' regimes even under a fully credible 'soft peg' of the nominal exchange rate in developing countries.Small Open Economy, Incomplete Financial Markets, Discretionary Monetary Policy, Multiple Equilibria.

Optimal Fiscal Feedback on Debt in an Economy with Nominal Rigidities

We examine the impact of different degrees of fiscal feedback on debt in an economy with nominal rigidities where monetary policy is optimal. We look at the extent to which different degrees of fiscal feedback enhances or detracts from the ability of the monetary authorities to stabilise output and inflation. Using an objective function derived from utility, we find the optimal level of fiscal feedback to be small. There is a clear discontinuity in the behaviour of monetary policy and welfare either side of this optimal level. As the extent of fiscal feedback increases, optimal monetary policy becomes less active because fiscal feedback tends to deflate inflationary shocks. However this fiscal stabilisation is less efficient than monetary policy, and so welfare declines. In contrast, if fiscal feedback falls below some critical value, either the model becomes indeterminate, or optimal monetary policy becomes strongly passive, and this passive monetary policy leads to a sharp deterioration in welfare.Fiscal Policy, Feedback Rules, Debt, Macroeconomic Stabilisation

Optimal fiscal feedback on debt in an economy with nominal rigidities

We examine the impact of different degrees of fiscal feedback on debt in an economy with nominal rigidities where monetary policy is optimal. We look at the extent to which different degrees of fiscal feedback enhance or detract from the ability of the monetary authorities to stabilize output and inflation. Using an objective function derived from utility, we find the optimal level of fiscal feedback to be small. A clear discontinuity exists in the behavior of monetary policy and welfare on either side of this optimal level. As the extent of fiscal feedback increases, optimal monetary policy becomes less active because fiscal feedback tends to deflate inflationary shocks. However, this fiscal stabilization is less efficient than monetary policy, so welfare declines. In contrast, if fiscal feedback falls below some critical value, optimal monetary policy becomes strongly passive, and this passive monetary policy leads to a sharp deterioration in welfare.

Choosing the Regime in an Uncertain World, the UK and Monetary Union

The UK has to take a decision on EMU membership at some point, and the costs and benefits have to be evaluated. Different policy frameworks result in differing outcomes for the means and variances of economic variables such as inflation, output, and nominal and real exchange rates and interest rates. Changing the level of uncertainty in the economy may change the equilibrium level of output and investment. Hence membership of EMU has to be evaluated in the light of its impact on the volatility of target variables and on the impact of volatility on the level of output and welfare. We discuss a theoretical framework within which we can discuss these issues, and we undertake stochastic simulation on a large, New Keynesian model including all the European economies in order to evaluate the effects of membership on the level and volatility of output. Our experiments suggest that membership of EMU would reduce volatility and as a result raise the sustainable level of output and employment in the UK.EMU, exchange rate regimes, uncertainty and investment, UK membership