Monetary Economics

March 7, 2014
John Leahy and Virgiliu Midrigan of New York University, Organizers

Xavier Gabaix and Matteo Maggiori, New York University and NBER

International Liquidity and Exchange Rate Dynamics (NBER Working Paper 19854)

Gabaix and Maggiori provide a theory of the determination of exchange rates based on capital flows in imperfect financial markets. Capital flows drive exchange rates by altering the balance sheets of financiers that bear the risks resulting from international imbalances in the demand for financial assets. Such alterations to their balance sheets cause financiers to change their required compensation for holding currency risk, thus affecting both the level and volatility of exchange rates. The authors' theory of exchange rate determination in imperfect financial markets not only rationalizes the empirical disconnect between exchange rates and traditional macroeconomic fundamentals, but also has real consequences for output and risk sharing. Exchange rates are sensitive to imbalances in financial markets and seldom perform the shock absorption role that is central to traditional theoretical macroeconomic analysis. The authors derive conditions under which heterodox government financial policies, such as currency interventions and taxation of capital flows, can be welfare improving. Their framework is flexible: it accommodates a number of important modeling features within an imperfect financial market model such as non-tradables, production, money, sticky prices or wages, various forms of international pricing-to-market, and unemployment.

Roc Armenter, Federal Reserve Bank of Philadelphia

The Perils of Nominal Targets

Armenter shows that a monetary authority can be committed to pursuing an inflation, price level, or nominal output target yet systematically fail to achieve the specified goal. Constrained by the zero lower bound on the policy rate, the monetary authority is unable to implement its objectives when private sector expectations stray from the target in the first place. Low inflation expectations become self-fulfilling, resulting in an additional Markov equilibrium in which both nominal and real variables are typically below target. Introducing a stabilization goal for long-term nominal rates anchors private sector expectations on a unique Markov equilibrium without fully compromising the policy responses to shocks.

Francesco Bianchi, Duke University, and Cosmin Ilut, Duke University and NBER

Monetary/Fiscal Policy Mix and Agents' Beliefs

Bianchi and Ilut reinterpret post-World War II U.S. economic history using an estimated microfounded model that allows for changes in the monetary/fiscal policy mix. They find that the fiscal authority was the leading authority in the 1960s and the 1970s. The appointment of Paul Volcker marked a change in the conduct of monetary policy, but inflation dropped only when fiscal policy accommodated this change two years later. In fact, a disinflationary attempt of the monetary authority leads to more inflation if not supported by the fiscal authority. If the monetary authority had always been the leading authority or if agents had been confident about the switch, the Great Inflation would not have occurred and debt would have been higher. This is because the rise in trend inflation and the decline in debt of the 1970s were caused by a series of fiscal shocks that are inflationary only when monetary policy accommodates fiscal policy. The reversal in the debt-to-GDP ratio dynamics, the sudden drop in inflation, and the fall in output of the early 1980s are explained by the switch in the policy mix itself. If such a switch had not occurred, inflation would have been high for another 15 years. Regime changes account for the stickiness of inflation expectations during the 1960s and the 1970s and for the break in the persistence and volatility of inflation.

Philippe Martin, Sciences Po, and Thomas Philippon, New York University and NBER

Inspecting the Mechanism: Leverage and the Great Recession in the Eurozone

Economists disagree about the nature of the Eurozone crisis. Some see the crisis as driven by fiscal indiscipline, others by external imbalances and sudden stops, and still others by excessive private leverage. Motivated by the comparison of the Great Recessions in the United States and the Eurozone, Martin and Philippon analyze the role of private and public leverage and ask: What are the main drivers of the recession? To what extent can private and public leverage movements explain macroeconomic outcomes in the different Eurozone countries? What are the respective roles of sudden stops of foreign capital and fiscal policies? The authors find that from 2008 to 2012 the difference in fate across Eurozone countries is well explained by the dynamics of household leverage. The dynamics of the Eurozone are similar to those of the United States. In both currency areas, regions that experience the largest increases in household leverage during the credit boom of 2000-8 experience the largest declines in output and employment during the bust of 2008-10. However, after 2010 they find a distinct role for sudden stops and sovereign risk in the Eurozone, but not in the United States. To study these questions, the authors develop a model of open economies within a monetary union where macroeconomic dynamics are driven by private and public leverage decisions. They analyze how the model can explain the cross-sectional variance in employment, output, and consumption in the Eurozone countries.

Christina Romer and David Romer, University of California at Berkeley and NBER

Transfer Payments and the Macroeconomy: The Effects of Social Security Benefit Changes, 1952-1991

From the early 1950s to the early 1990s, increases in Social Security benefits in the United States varied widely in size and timing, and were generally not undertaken in response to short-run macroeconomic developments. Romer and Romer use these benefit increases to investigate the macroeconomic effects of changes in transfer payments. They find a large, immediate, and statistically significant response of consumption to permanent changes in transfers. However, the response appears to decline at longer horizons, and there is no clear evidence of effects on industrial production or employment. These effects differ sharply from the effects of exogenous tax changes: the impact of transfers is faster but much less persistent and dramatically smaller overall. Finally, the authors find strong evidence of a sharply contractionary monetary policy response to permanent benefit increases that is not present for tax changes. This may account for the lower persistence of the consumption effects of transfers and their failure to spread to broader indicators of economic activity.

Saroj Bhattarai and Bulat Gafarov, Pennsylvania State University,and Gauti Eggertsson, Brown University and NBER

Time Consistency and the Duration of Government Debt: A Signalling Theory of Quantitative Easing

Bhattarai, Eggertsson, and Gafarov present a signalling theory of quantitative easing in which open market operations that change the duration of outstanding nominal government debt affect the incentives of the central bank in determining the real interest rate. In a time-consistent (Markov-perfect) equilibrium of a sticky price model with coordinated monetary and fiscal policy, the authors show that shortening the duration of outstanding government debt provides an incentive to the central bank to keep short-term real interest rates low in the future in order to avoid capital losses. In a liquidity trap where the current short-term nominal interest rate is up against the zero lower bound, quantitative easing can be effective in fighting deflation and a negative output gap as it leads to lower real long-term interest rates by lowering future expected real short-term interest rates. The authors present illustrative numerical examples that suggest the benefits of quantitative easing in a liquidity trap can be large in a way that is not fully captured by some recent empirical studies.