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Working Paper
Rational Inattention via Ignorance Equivalence
We introduce the concept of the ignorance equivalent to effectively summarize the payoff possibilities in a finite Rational Inattention problem. The ignorance equivalent is a unique fictitious action that is weakly preferable to all existing learning strategies and yet generates no new profitable learning opportunities when added to the menu of choices. We fully characterize the relationship between the ignorance equivalent and the optimal learning strategies. Agents with heterogeneous priors self-select their own ignorance equivalent, which gives rise to an expected-utility analogue of the ...
Report
Does the time inconsistency problem make flexible exchange rates look worse than you think?
Lack of commitment in monetary policy leads to the well known Barro-Gordon inflation bias. In this paper, we argue that two phenomena associated with the time inconsistency problem have been overlooked in the exchange rate debate. We show that, absent commitment, independent monetary policy can also induce expectation traps-that is, welfare-ranked multiple equilibria-and perverse policy responses to real shocks-that is, an equilibrium policy response that is welfare inferior to policy inaction. Both possibilities imply higher macroeconomic volatility under flexible exchange rates than under ...
Working Paper
Sustainable monetary policy and inflation expectations
The author shows that the short-term nominal interest rate can anchor private-sector expectations into low inflation more precisely, into the best equilibrium reputation can sustain. He introduces nominal asset markets in an infinite horizon version of the Barro-Gordon model. The author then analyzes the subset of sustainable policies compatible with any given asset price system at date t = 0. While there are usually many sustainable inflation paths associated with a given set of asset prices, the best sustainable inflation path is implemented if and only if the short-term nominal bond is ...
Working Paper
Can the U.S. monetary policy fall (again) in an expectation trap?
We provide a tractable model to study monetary policy under discretion. We focus on Markov equilibria. For all parametrizations with an equilibrium inflation rate around 2%, there is a second equilibrium with an inflation rate just above 10%. Thus the model can simultaneously account for the low and high inflation episodes in the U.S. We carefully characterize the set of Markov equilibria along the parameter space and find our results to be robust.
Working Paper
On the use of market-based probabilities for policy decisions
This paper seeks to delimit conditions so that market-based probabilities provide all the information the policymaker needs to arrive at the best possible decision. Although there are practical considerations regarding how to derive market-based probabilities from financial prices, the author confines the discussion to a theoretical analysis that assumes no impediment to obtaining the market-based probabilities.
Journal Article
Output gaps: uses and limitation
The concept of resource slack is central to understanding the dynamics between employment, output, and inflation. But what amount of slack is consistent with price stability? To answer this question, economists define baseline values for unemployment and output known as the natural rate of unemployment and potential output. The concepts of output and employment gaps can be useful to economists in several ways. First, they often guide the inflation forecasts of Federal Reserve staff and other researchers and market participants. Second, some economists argue that employment gaps are a useful ...
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Endogenous productivity and development accounting
Cross-country data reveal that the per capita incomes of the richest countries exceed those of the poorest countries by a factor of thirty-five. We formalize a model with embodied technical change in which newer, more productive vintages of capital coexist with older, less productive vintages. A reduction in the cost of investment raises both the quantity and productivity of capital simultaneously. The model induces a simple relationship between the relative price of investment goods and per capita income. Using cross-country data on the prices of investment goods, we find that the model does ...
Working Paper
Rational Inattention via Ignorance Equivalence
We present a novel approach to finite Rational Inattention (RI) models based on the ignorance equivalent, a fictitious action with state-dependent payoffs that effectively summarizes the optimal learning and conditional choices. The ignorance equivalent allows us to recast the RI problem as a standard expected utility maximization over an augmented choice set called the learning-proof menu, yielding new insights regarding the behavioral implications of RI, in particular as new actions are added to the menu. Our geometric approach is also well suited to numerical methods, outperforming ...
Working Paper
The perils of nominal targets
A monetary authority can be committed to pursuing an inflation, price-level, or nominal output target yet systematically fail to achieve the specified goals. Constrained by the zero lower bound on the policy rate, the monetary authority is unable to implement its objectives when private-sector expectations stray away from the target in the first place. Low-inflation expectations become self-fulfilling, leading to multiple Markov equilibria. Private-sector expectations are anchored on a unique Markov equilibrium if the monetary authority is given a strong stabilization goal for the policy ...
Working Paper
A TRACTABLE MODEL OF THE DEMAND FOR RESERVES UNDER NONLINEAR REMUNERATION SCHEMES
We propose a tractable model of the demand for reserves under nonlinear remuneration schemes that can encompass quota systems and voluntary reserve target frameworks, among other possibilities. We show how such remuneration schemes have several favorable properties regarding interest-rate control by the central bank. In particular, wider tolerance bands can reduce rate volatility due to variations in the supply of reserves, both large and small, although they may curtail trading in the interbank market.