Monetary Economics Program Meeting

March 4, 2011
Valerie A. Ramey of the University of California, San Diego and Jon Steinsson of Columbia University, Organizers

Harrison Hong, Princeton University and NBER, and David Sraer, Princeton University
Quiet Bubbles

Classic speculative bubbles are loud: price is high and so are price volatility and share turnover. The credit bubble of 2003-7 is quiet: price is high, but price volatility and share turnover are low. Hong and Sraer develop a model, based on investor disagreement and short-sales constraints that explains why credit bubbles are quieter than equity ones. Because debt up-side pay-offs are bounded, debt is less sensitive to disagreement about underlying asset value than equity and hence has a smaller resale option and lower price volatility and turnover. Leverage and skewed priors also lead to quiet credit bubbles. A few extreme optimists buy the supply using leverage, resulting in high prices but little price volatility and turnover, since other traders' valuations are unlikely to exceed the extreme optimists' over time. This theory provides a first taxonomy of bubbles and offers a rationale for why banks and regulators missed the credit bubble: it was quiet!

Judith Chevalier, Yale University and NBER, and Anil K Kashyap, University of Chicago and NBER
Best Prices

Chevalier and Kashyap explore the role of strategic price discrimination by retailers for price determination and inflation dynamics. They model two types of customers, "loyals" who buy only one brand and do not strategically time purchases, and "shoppers" who seek out low-priced products both across brands and across time. Shoppers always pay the lowest price available, the "best price." In this setting, retailers optimally choose long periods of constant regular prices punctuated by frequent temporary sales. Supermarket scanner data confirm the model's predictions: the average price paid is closely approximated by a weighted average of the fixed weight average list price and the "best price." In contrast to standard menu cost models, this model implies that sales are an essential part of the price plan and the number and frequency of sales may be an important mechanism for adjustment to shocks. The authors conclude that their "best price" construct provides a tractable input for constructing price series.

Douglas Davis and Oleg Korenok, Virginia Commonwealth University
Nominal Price Shocks in Monopolistically Competitive Markets: An Experimental Analysis

Davis and Korenok report a price-setting market experiment conducted to examine the capacity of price and information frictions in order to explain real responses to nominal price shocks. As predicted by the standard dynamic models of adjustment in monopolistically competitive markets, both price and information frictions impede the response to a nominal shock. Results deviate from predictions, however, in that the observed adjustment delays far exceed predicted levels. The authors suggest that another factor, bounded rationality, exerts a predominating effect. A variant of the standard analysis, in which a subset of agents price adaptively, better organizes these results.

James D. Hamilton, University of California, San Diego and NBER, and Jing Wu, University of California, San Diego
The Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment

Hamilton and Wu review alternative options for monetary policy when the short-term interest rate is at the zero lower bound and develop new empirical estimates of the effects of the maturity structure of publicly held debt on the term structure of interest rates. They use a model of risk-averse arbitrageurs to develop measures of how the maturity structure of debt held by the public might affect the pricing of level, slope, and curvature term-structure risk. They find these Treasury factors historically were quite helpful for predicting both yields and excess returns over 1990-2007. The historical correlations are consistent with the claim that ifthe Fed were to have sold off all its Treasury holdings of less than one-year maturity (about $400 billion) in December of 2006, and use the proceeds to retire Treasury debt from the long end, this might have resulted in a 14-basis-point drop in the 10-year rate and an 11-basis-point increase in the 6-month rate. the researchers also develop a description of how the dynamic behavior of the term structure of interest rates changed after hitting the zero lower bound in 2009. Their estimates imply that at the zero lower bound, such a maturity swap would have the same effects as buying $400 billion in long-term maturities outright with newly created reserves, and could reduce the 10-year rate by 13 basis points without raising short-term yields.

Karel O. Mertens, Cornell University, and Morten Ravn, University College London
Fiscal Policy in an Expectations Driven Liquidity Trap

Mertens and Ravn examine the impact of fiscal policy interventions in an environment where the short-term nominal interest rate is at the zero bound. In the basic New Keynesian model in which the monetary authority operates a Taylor rule, globally multiple equilibriums arise, some of which display all the features of a liquidity trap. A loss in confidence can set the economy on a deflationary path that eventually prevents the monetary authority from adjusting the interest rate and can lead to potentially very large output drops. Contrary to a line of recent papers, the authors find that demand stimulating policies become less effective in a liquidity trap than in normal circumstances. The key reason is that demand stimulus leads agents to believe that things are even worse than they thought. In contrast, supply side policies, such as cuts in labor income taxes, lead to relative optimism and become more powerful.

Isabel Correia, Universidade Catolica Portuguesa; Emmanuel Farhi, Harvard University and NBER; Juan Pablo Nicolini, Federal Reserve Bank of Minneapolis; and Pedro Teles, Universidad di Tella
Unconventional Fiscal Policy at the Zero Bound

When the zero lower bound on nominal interest rates binds, monetary policy cannot provide appropriate stimulus. Correia, Farhi, Nicolini, and Teles show that in the standard New Keynesian model, tax policy can deliver such stimulus at no cost and in a time-consistent manner. There is no need to use inefficient policies, such as wasteful public spending or future commitments to inflate. The authors conclude that in the New Keynesian model, the zero bound on nominal interest rates is not a relevant constraint on fiscal and monetary policy.

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