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Working Paper
Should the Fed regularly evaluate its monetary policy framework?
Would a more open and regular evaluation of the monetary policy framework improve policy in the United States? Even when considering a relatively short timeframe that spans the 1960s to the present, it is possible to point to many significant changes to the framework. Some of the changes were precipitated by acute economic conditions, while others were considered and implemented only gradually as a response to long-standing problems with the framework. But the process for evaluating and changing frameworks to date has not always been transparent, and changes have not always been timely. Could a more formal, and open, review improve how well we adhere to our current framework? Could transitions to a new framework be made more effectively? We conclude that such a review might indeed be beneficial, and outline one possible review process.
AUTHORS: Fuhrer, Jeffrey C.; Olivei, Giovanni P.; Tootell, Geoffrey M. B.; Rosengren, Eric S.
DATE: 2018-10-01

Working Paper
Optimal monetary policy under model uncertainty without commitment
This paper studies the design of optimal time-consistent monetary policy in an economy where the planner trusts its own model, while a representative household uses a set of alternative probability distributions governing the evolution of the exogenous state of the economy. In such environments, unlike in the original studies of time-consistent monetary policy, managing households' expectations becomes an active channel of optimal policymaking per se, a feature that the paternalistic government seeks to exploit. We adapt recursive methods in the spirit of Abreu, Pearce, and Stacchetti (1990) as well as computational algorithms based on Judd, Yeltekin, and Conklin to fully characterize the equilibrium outcomes for a class of policy games between the government and a representative household that distrusts the model used by the government.
AUTHORS: Orlik, Anna; Presno, Ignacio
DATE: 2013-10-27

Working Paper
Designing a simple loss function for the Fed: does the dual mandate make sense?
Variable and high rates of price inflation in the 1970s and 1980s led many countries to delegate the conduct of monetary policy to "instrument-independent" central banks and to give their central banks a clear mandate to pursue price stability and instrument independence to achieve it. Advances in academic research supported a strong focus on price stability as a means to enhance the independence and credibility of monetary policymakers. An overwhelming majority of these central banks also adopted an explicit inflation target to further strengthen credibility and facilitate accountability. One exception is the U.S. Federal Reserve, which since 1977 has been assigned the so-called "dual mandate," which requires it to "promote maximum employment in a context of price stability." Although the Fed has established credibility for the long-run inflation target, an important question is whether its heavy focus on resource utilization can be justified. The authors' reading of the academic literature is that resource utilization should be assigned a small weight relative to inflation under the reasonable assumption that the underlying objective of monetary policy is to maximize the welfare of households inhabiting the economy. Woodford (1998) showed that the objective function of households in a basic New Keynesian sticky-price model could be approximated as a (purely) quadratic function in inflation and the output gap, with the weights determined by the specific features of the economy. A potential drawback with the large literature that followed is that it focused on relatively simple calibrated (or partially estimated) models. In this paper the authors revisit this issue within the context of an estimated medium-scale model of the U.S. economy, specifically the Smets and Wouters (2007) model.
AUTHORS: Kim, Jinill; Nunes, Ricardo; Linde, Jesper; Debortoli, Davide
DATE: 2015-03-10

Working Paper
Output Hysteresis and Optimal Monetary Policy
We analyze the implications for monetary policy when deficient aggregate demand can cause a permanent loss in potential output, a phenomenon we term output hysteresis. In the model, the incomplete stabilization of a temporary shortfall in demand reduces the return to innovation, thus reducing total factor productivity growth and generating a permanent loss in output. Using a purely quadratic approximation to welfare under endogenous growth, we derive normative implications for monetary policy. Away from the zero lower bound (ZLB), optimal commitment policy sets interest rates to eliminate output hysteresis. A strict inflation targeting rule implements the optimal policy. However, when the nominal interest rate is constrained at the ZLB, strict inflation targeting is suboptimal and admits output hysteresis. A new policy rule that targets output hysteresis returns output to its pre-shock trend and approximates the welfare gains under optimal commitment policy. A central bank that is unable to commit to future policy actions suffers from hysteresisbias, as the bank’s inconsistent policy does not offset past losses in potential output.
AUTHORS: Singh, Sanjay R.; Garga, Vaishali
DATE: 2019-12-01

Working Paper
Communicating Monetary Policy Rules
Sixty-two countries around the world use some form of inflation targeting as their monetary policy framework, though none of these countries express explicit policy rules. In contrast, models of monetary policy typically assume policy is set through a rule such as a Taylor rule or optimal monetary policy formulation. Central banks often connect theory with their practice by publishing inflation forecasts that can, in principle, implicitly convey their reaction function. We return to this central idea to show how a central bank can achieve the gains of a rule-based policy without publicly stating a specific rule. {{p}} The approach requires central banks to specify an inflation target, tolerance bands, and provide economic projections. Thus, when inflation moves outside the band, inflation forecasts provide a time frame over which inflation will return to within the band. We show how this approach replicates and provides the same information as a rule-based policy.
AUTHORS: Foerster, Andrew T.; Davig, Troy A.
DATE: 2017-04-01

Working Paper
Is optimal monetary policy always optimal?
No. And not only for the reason you think. In a world with multiple inefficiencies the single policy tool the central bank has control over will not undo all inefficiencies; this is well understood. We argue that the world is better characterized by multiple ine?ciencies and multiple policy makers with various objectives. Asking the policy question only in terms of optimal monetary policy effectively turns the central bank into the residual claimant of all policy and gives the other policymakers a free hand in pursuing their own goals. This further worsens the tradeoffs faced by the central bank. The optimal monetary policy literature and the optimal simple rules often labeled ?exible in?ation targeting assign all of the cyclical policymaking duties to central banks. This distorts the policy discussion and narrows the policy choices to a suboptimal set. We highlight this issue and call for a broader thinking of optimal policies.
AUTHORS: Gurkaynak, Refet S.; Davig, Troy A.
DATE: 2015-07-30

Working Paper
Saving Europe?: The Unpleasant Arithmetic of Fiscal Austerity in Integrated Economies
What are the macroeconomic effects of tax adjustments in response to large public debt shocks in highly integrated economies? The answer from standard closed-economy models is deceptive, because they underestimate the elasticity of capital tax revenues and ignore cross-country spillovers of tax changes. Instead, we examine this issue using a two-country model that matches the observed elasticity of the capital tax base by introducing endogenous capacity utilization and a partial depreciation allowance. Tax hikes have adverse effects on macro aggregates and welfare, and trigger strong cross-country externalities. Quantitative analysis calibrated to European data shows that unilateral capital tax increases cannot restore fiscal solvency, because the dynamic Laffer curve peaks below the required revenue increase. Unilateral labor tax hikes can do it, but have negative output and welfare effects at home and raise welfare and output abroad. Large spillovers also imply that unilateral capital tax hikes are much less costly under autarky than under free trade. Allowing for one-shot Nash tax competition, the model predicts a ?race to the bottom? in capital taxes and higher labor taxes. The cooperative equilibrium is preferable, but capital (labor) taxes are still lower (higher) than initially. Moreover, autarky can produce higher welfare than both Nash and Cooperative equilibria.
AUTHORS: Mendoza, Enrique G.; Tesar, Linda L.; Zhang, Jing
DATE: 2014-10-06

Working Paper
A Quantitative Theory of Time-Consistent Unemployment Insurance
During recessions, the U.S. government substantially increases the duration of unemployment insurance (UI) benefits through multiple extensions. This paper seeks to understand the incentives driving these increases. Because of the trade-off between insurance and job search incentives, the classic time-inconsistency problem arises. During recessions, the U.S. government substantially increases the duration of unemployment insurance (UI) benefits through multiple extensions. This paper seeks to understand the incentives driving these extensions. Because of the trade-off between insurance and job search incentives, the classic time-inconsistency problem arises. We endogenize a time-consistent UI policy in a stochastic equilibrium search model, where a government without commitment to future policies chooses the UI benefit level and expected duration each period. A longer duration increases the unemployed workers? consumption but reduces their job search incentives, leading to higher future unemployment. We use the framework to evaluate the effects of the 2008-2013 benefit extensions on unemployment and welfare.
AUTHORS: Pei, Yun; Xie, Zoe
DATE: 2016-11-01

Working Paper
Decentralization and Overborrowing in a Fiscal Federation
We build an infinite horizon equilibrium model of fiscal federation, where anticipation of transfers from the central government creates incentives for local governments to overborrow. Absent commitment, the central government over-transfers, which distorts the central-local distribution of resources. Applying the model to fiscal decentralization, we find when decentralization widens local governments? fiscal gap, borrowings by both local and central governments rise. Quantitatively, fiscal decentralization accounts for from 19 percent to 40 percent of changes in general government debt in Spain during 1988?2006. A macroprudential tax on local borrowing that implements Pareto optimal allocation would reduce debt by 27 percent and raise welfare by 3.75 percent.
AUTHORS: Guo, Si; Pei, Yun; Xie, Zoe
DATE: 2018-08-23

Working Paper
What drives economic policy uncertainty in the long and short runs? European and U.S. evidence over several decades
Economic policy uncertainty (EPU) has increased markedly in recent years in the U.S. and Europe, and some have posited a link between this phenomenon and subpar economic growth in advanced economies (see Baker, Bloom, and Davis, 2015). But methodological and data concerns have thus far raised doubts about whether EPU contains marginal and exogenous information about other economic phenomena. Our work analyzes the impact on EPU of several possibly endogenous variables, such as inflation and unemployment rates in countries where EPU is measured. We also consider longer-term technological factors, such as media fragmentation, which by undermining political consensus may indirectly elevate EPU. We find that about 40 percent of EPU movements can be explained by long- and short-run movements in these determinants, which is consistent with limited evidence that de-trended movements in EPU may contain marginal information about GDP growth and other macro variables.
AUTHORS: Duca, John V.; Saving, Jason L.
DATE: 2016-12-12

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