Monetary policy after the fall.
AUTHORS: Penalver, Adrian; Bean, Charles R.; Paustian, Matthias; Taylor, Tim
Inflation: Drivers and Dynamics 2019 Conference Summary
To provide insights into the processes that drive inflationary dynamics, the Federal Reserve Bank of Cleveland holdsan annual conference on the topic of inflation: “Inflation: Drivers and Dynamics.” This Commentary summarizes thepapers presented at the 2019 conference.
AUTHORS: Zhang, Tony; Schoenle, Raphael; Weber, Michael; Wiederholt, Mirko; Paustian, Matthias; Knotek, Edward S.; Kim, Mina; Blanco, Andres; Rich, Robert W.; Tielens, Joris; Ryngaert, Jane
Household Debt and the Heterogeneous Effects of Forward Guidance
We develop an incomplete-markets heterogeneous agent New-Keynesian (HANK) model in which households are allowed to lend and borrow, subject to a borrowing constraint. We show that, in this framework, forward guidance, that is the promise by the central bank to lower future interest rates, can be a powerful policy tool, especially when the economy is in a liquidity trap. In our model, the power of forward guidance is amplified by three redistributive channels, absent in a representative agent new- Keynesian model (RANK) or in a HANK model without private debt. First, expected lower rates imply a future transfer of wealth from savers to borrowers, reducing precautionary motives and stimulating current demand and inflation. Second, higher initial inflation lowers the path of the real rate increasing the wealth of borrowers, who have a higher marginal propensity to consume (MPC). Third, if debt is nominal, debt deflation generates also a wealth transfer towards high-MPC borrowing-constrained agents, further increasing aggregate consumption and inflation. These channels amplify each other in a liquidity trap, and can make forward guidance more powerful in a HANK model than in a RANK framework. These results contrast with previous research on HANK models, which focused on frameworks where agents were not allowed to borrow, and which found negligible effects of forward guidance.
AUTHORS: Ferrante, Francesco; Paustian, Matthias
Monetary Policy Options at the Effective Lower Bound : Assessing the Federal Reserve's Current Policy Toolkit
We simulate the FRB/US model and a number of statistical models to quantify some of the risks stemming from the effective lower bound (ELB) on the federal funds rate and to assess the efficacy of adjustments to the federal funds rate target, balance sheet policies, and forward guidance to provide monetary policy accommodation in the event of a recession. Over the next decade, our simulations imply a roughly 20 to 50 percent probability that the federal funds rate will be constrained by the ELB at some point. We also find that forward guidance and balance sheet polices of the kinds used in response to the Global Financial Crisis are modestly effective in speeding up the labor market recovery and return of inflation to 2 percent following an economic slump. However, these policies have only small effects in limiting the initial rise in the unemployment rate during a recession because of transmission lags. As with any model-based analysis, we also discuss a number of c aveats regarding our results.
AUTHORS: Chung, Hess; Gagnon, Etienne; Nakata, Taisuke; Paustian, Matthias; Schlusche, Bernd; Trevino, James; Vilan, Diego; Zheng, Wei
Indexed debt contracts and the financial accelerator
This paper addresses the positive and normative implications of indexing risky debt to observable aggregate conditions. These issues are pursued within the context of the celebrated financial accelerator model of Bernanke, Gertler and Gilchrist (1999). The principal conclusions are that the optimal degree of indexation is significant, and that the business cycle properties of the model are altered under this level of indexation.
AUTHORS: Carlstrom, Charles T.; Paustian, Matthias; Fuerst, Timothy S.
How inflationary is an extended period of low interest rates?
Recent monetary policy experience suggests a simple test of models of monetary non-neutrality. Suppose the central bank pegs the nominal interest rate below steady state for a reasonably short period of time. Familiar intuition suggests that this should be inflationary. But a monetary model should be rejected if a reasonably short nominal rate peg results in an unreasonably large inflation response. We pursue this simple test in three variants of the familiar dynamic new Keynesian (DNK) model. All of these models fail this test. Further some variants of the model produce inflation reversals where an interest rate peg leads to sharp deflations.
AUTHORS: Fuerst, Timothy S.; Carlstrom, Charles T.; Paustian, Matthias
Estimating contract indexation in a financial accelerator model
This paper addresses the positive implications of indexing risky debt to observable aggregate conditions. These issues are pursued within the context of the celebrated financial accelerator model of Bernanke, Gertler and Gilchrist (1999). The principal conclusions include: (1) the estimated level of indexation is significant, (2) the business cycle properties of the model are significantly affected by this degree of indexation, (3) the importance of investment shocks in the business cycle depends upon the estimated level of indexation, and (4) although the data prefers the financial model with indexation over the frictionless model, they have remarkably similar business cycle properties for non-financial exogenous shocks.
AUTHORS: Carlstrom, Charles T.; Ortiz, Alberto; Paustian, Matthias; Fuerst, Timothy S.
Fiscal multipliers under an interest rate peg of deterministic vs. stochastic duration
This paper revisits the size of the fiscal multiplier. The experiment is a fiscal expansion under the assumption of a pegged nominal rate of interest. We demonstrate that a quantitatively important issue is the articulation of the exit from the policy experiment. If the monetary-fiscal expansion is stochastic with a mean duration of T periods, the fiscal multiplier can be unboundedly large. However, if the monetary-fiscal expansion is for a fixed T periods, the multiplier is much smaller.
AUTHORS: Fuerst, Timothy S.; Carlstrom, Charles T.; Paustian, Matthias
Inflation persistence, inflation targeting and the Great Moderation
There is growing evidence that the empirical Phillips curve within the US has changed significantly since the early 1980?s. In particular, inflation persistence has declined sharply. The paper demonstrates that this decline is consistent with a standard Dynamic New Keynesian (DNK) model in which: (i) the variability of technology shocks has declined, and (ii) the central bank more aggressively responds to inflation.
AUTHORS: Carlstrom, Charles T.; Fuerst, Timothy S.; Paustian, Matthias
Privately optimal contracts and suboptimal outcomes in a model of agency costs
This paper derives the privately optimal lending contract in the celebrated financial accelerator model of Bernanke, Gertler and Gilchrist (1999). The privately optimal contract includes indexation to the aggregate return on capital, household consumption, and the return to internal funds. Although privately optimal, this contract is not welfare maximizing as it leads to a sub-optimally high price of capital. The welfare cost of the privately optimal contract (when compared to the planner outcome) is significant. A menu of time-varying taxes and subsidies can decentralize the planner?s allocations.
AUTHORS: Paustian, Matthias; Carlstrom, Charles T.; Fuerst, Timothy S.