Abstracts of Working Papers

Doves for the Rich, Hawks for the Poor? Distributional Consequences of Monetary Policy (2016), with Nils Gornemann and Makoto Nakajima, supersedes earlier Philadelphia Fed Working Paper 12-21.

We build a New Keynesian business-cycle model with rich household heterogeneity. A central feature is that matching frictions render labor-market risk countercyclical and endogenous to monetary policy. Our main result is that a majority of households prefer substantial stabilization of unemployment even if this means deviations from price stability. A monetary policy focused on unemployment stabilization helps \Main Street" by providing consumption insurance. It hurts \Wall Street" by reducing precautionary saving and, thus, asset prices. On the aggregate level, household heterogeneity changes the transmission of monetary policy to consumption, but hardly to GDP. Central to this result is allowing for self-insurance and aggregate investment. Back to main page.

The fiscal mix in the euro-area crisis -- dimensions and a model-based assessment of effects (2016), with Giovanni Callegari and Francesco Drudi.

There is a consensus that fiscal policy has played an active role in shaping euro-area macroeconomic developments in recent years. The problem is, there is little consensus how. The current paper contributes to the debate in three ways: first, it provides the facts. Namely, it documents the evolution of the fiscal mix in the euro area since 2007 both across countries and across a broad set of fiscal instruments. Second, it highlights in a model-free way how important the counterfactual is for assessing the fiscal stance. In particular, the paper documents that -- compared to past behavior -- fiscal policy in the euro area was not particularly pro-cyclical in the early phase of the financial crisis. Compared to the U.S. response in recent years, instead, it provided less tax-based relief. Third, and last, we build a two-country model of a currency union to provide a model-based assessment of how the fiscal mix, across instruments and time may have affected the "Core" countries and the "Periphery" of the euro area. The model suggests that the policy mix in the crisis may have been a key driver of rising government debt, while contributing to stabilize output and in ation. Back to main page.

The Case for Flexible Exchange Rates in a Great Recession (2016), with Giancarlo Corsetti and Gernot Müller.

We analyze macroeconomic stabilization in a small open economy which faces a large recession in the rest of the world. We show analytically that for the economy to remain insulated from the external shock, the exchange rate must depreciate not only to offset the collapse in external demand, but also to decouple domestic prices from deflation in the rest of the world. If monetary policy becomes constrained by the zero lower bound, the scope of exchange rate depreciation is limited and the economy is no longer insulated from the shock. Still, in this case there is a "benign coincidence:" government spending is particularly effective in stabilizing economic activity. Under fixed exchange rates, instead, the impact of the external shock is particularly severe and the effectiveness of fiscal policy limited. Back to main page.


Abstracts of Published Papers

Fiscal Volatility Shocks and Economic Activity (forthcoming), American Economic Review, with Jesús Fernández-Villaverde, Pablo A. Guerrón-Quintana, and Juan Rubio-Ramírez.

We study how unexpected changes in uncertainty about fiscal policy affect economic activity. First, we estimate tax and spending processes for the US with time-varying volatility to uncover evidence of time-varying volatility. Second, we estimate a VAR for the US economy using the time-varying volatility found in the previous step. Third, we feed the tax and spending processes into an otherwise standard New Keynesian model. Both in the VAR and in the model, we find that unexpected changes in fiscal volatility shocks can have a sizable adverse effect on economic activity. An endogenous increase in markups is a key mechanism. Back to main page.

Optimal Labor-Market Policy in Recessions (2015), with Philip Jung, AEJ-Macroeconomics, 7(2): 124-56.

Within a search and matching model with risk-averse workers, endogenous hiring and separation, and unobservable search effort, we show how to decentralize the constrained-efficient allocation by a combination of a production tax and three labor-market policy instruments: vacancy subsidies, layoff taxes and unemployment benefits. We derive analytical expressions for the optimal mix of these over the business cycle. Calibrating the model to the U.S. economy under the assumption that wages are rigid, we find that hiring subsidies and layoff taxes should rise considerably and persistently in recessions. The optimal variation in unemployment benefits, in contrast, is quantitatively small and short-lived. Back to main page.

Sovereign Risk and Macroeconomic Stability in the Euro Area (2014) with Giancarlo Corsetti, André Meier, and Gernot Mueller, Journal of Monetary Economics, 61(Jan), pp. 53-73.

Sovereign risk premia in several euro area countries have risen markedly since 2008, driving up credit spreads in the private sector as well. We propose a New Keynesian model of a two-region monetary union that accounts for this “sovereign risk channel.” The model is calibrated to the euro area as of mid-2012. We show that a combination of sovereign risk in one region and strongly procyclical fiscal policy at the aggregate level exacerbates the risk of belief-driven deflationary downturns. The model provides an argument in favor of coordinated, asymmetric fiscal stances as a way to prevent self-fulfilling debt crises. Back to main page.

Sovereign Risk, Fiscal Policy, and Macroeconomic Stability (2013), with Giancarlo Corsetti, André Meier, and Gernot Mueller, Economic Journal, 123(566), pp. F99-F132.

This article analyses the impact of strained government finances on macroeconomic stability and the transmission of fiscal policy. Using a variant of the model by Curdia and Woodford (2009), we study a ‘sovereign risk channel’ through which sovereign default risk raises funding costs in the private sector. If monetary policy cannot offset increased credit spreads because it is constrained by the zero lower bound or otherwise, the sovereign risk channel exacerbates indeterminacy problems: private- sector beliefs of a weakening economy may become self-fulfilling. In addition, sovereign risk may amplify the effects of cyclical shocks. Under those conditions, fiscal retrenchment can help curtail the risk of macroeconomic instability and, in extreme cases, even bolster economic activity. Back to main page.

Floats, Pegs and the Transmission of Fiscal Policy (2013), with Giancarlo Corsetti and Gernot Mueller, in Céspedes and Galí (eds) "Series on Central Banking, Analysis, and Economic Policies, Volume 17: Fiscal Policy and Macroeconomic Performance," p. 235-281, Santiago: Central Bank of Chile.

According to conventional wisdom, fiscal policy is more effective under a fixed than under a flexible exchange rate regime. In this paper we reconsider the transmission of shocks to government spending across these regimes within a standard New Keynesian model of a small open economy. Because of the stronger emphasis on intertemporal optimization, the New Keynesian framework requires a precise specification of fiscal and monetary policies, and their interaction, at both short and long horizons. We derive an analytical characterization of the transmission mechanism of expansionary spending policies under a peg, showing that the long-term real interest rate always rises in response to an increase in government spending if inflation rises initially. This response drives down private demand even though short-term real rates fall. As this need not be the case under floating exchange rates, the conventional wisdom needs to be qualified. Under plausible medium-term fiscal policies, government spending is not necessarily less expansionary under floating exchange rates. Back to main page.

The (Un)Importance of Unemployment Fluctuations for the Welfare Cost of Business Cycles (2011), with Philip Jung,
Journal of Economic Dynamics and Control, 35(10), p. 1744-1768.

This paper studies the cost of business cycles within a real business cycle model with search and matching frictions in the labor market. We endogenously link both the cyclical fluctuations and the mean level of unemployment to the aggregate business cycle risk. The key result of the paper is that business cycles are costly: fluctuations over the cycle induce a higher average unemployment rate since employment is nonlinear in the job-finding rate and the past unemployment rate. We show this analytically for a special case of the model. We then calibrate the model to U.S. data. For the calibrated model, too, business cycles cause higher average unemployment; the welfare cost of business cycles can easily be an order of magnitude larger than Lucas's (1987) estimate. The cost of business cycles is the higher the lower the value of nonemployment is, or, equivalently, the lower is the disutility of work. The ensuing cost of business cycles rises further when workers' skills depreciate during unemployment. Back to main page.

Real Price and Wage Rigidities with Matching Frictions (2010),
Journal of Monetary Economics, 57(4), p. 466-477.

Frictional unemployment means that workers, for some time, are a firm-specific factor of production. This paper models the resulting interaction of wage bargaining and price setting at the firm level in a New Keynesian model with labor market matching frictions. Real rigidities arise and the labor share ceases to be a good proxy for marginal costs. The model replicates the impulse responses of an SVAR for U.S. data better than alternatives in which the real rigidities arising at the firm level are absent. In addition, it implies reasonably low degrees of nominal rigidity whereas the alternatives do not. The interaction of wage and price setting at the firm level is important for the macroeconomic dynamics. Back to main page.

Debt Consolidation and Fiscal Stabilization of Deep Recessions (2010), with Giancarlo Corsetti, André Meier and Gernot Mueller,
American Economic Review, Papers and Proceedings, 100(2), p. 41-45.

The global financial crisis of 2008–09 has sent public debt on sharply higher trajectories. With the economic recovery gradually taking hold, the focus is now shifting to fiscal "exit" strategies. Medium-term consolidation efforts are likely to include not only tax increases but also sizeable spending cuts. Our paper uses a standard new Keynesian model to show that the anticipation of such medium-term spending cuts generally enhances the expansionary effect of short-run fiscal stimulus. This conclusion still applies when monetary policy is constrained by the zero lower bound on policy rates. In this case, however, the reversal of government spending must not occur too early on the recovery path, or at least must be suitably gradual. Back to main page.

Insurance Policies for Monetary Policy in the Euro Area (2010), with Volker Wieland,
Journal of the European Economic Association, 8(4), p. 872-912.

In this paper, we aim to design a monetary policy for the euro area that is robust to the high degree of model uncertainty at the start of monetary union and allows for learning about model probabilities. To this end, we compare and ultimately combine Bayesian and worst-case analysis using four reference models estimated with pre-EMU synthetic data. We start by computing the cost of insurance against model uncertainty, that is, the relative performance of worst-case or minimax policy versus Bayesian policy. While maximum insurance comes at moderate costs, we highlight three shortcomings of this worst-case insurance policy: (i) prior beliefs that would rationalize it from a Bayesian perspective indicate that such insurance is strongly oriented toward the model with highest baseline losses; (ii) the minimax policy is not as tolerant of small perturbations of policy parameters as the Bayesian policy; and (iii) the minimax policy offers no avenue for incorporating posterior model probabilities derived from data available since monetary union. Thus, we propose preferences for robust policy design that reflect a mixture of the Bayesian and minimax approaches. We show how the incoming EMU data may then be used to update model probabilities, and investigate the implications for policy. Back to main page.

The Role of Labor Markets for Euro Area Monetary Policy (2009), with Kai Christoffel and Tobias Linzert,
European Economic Review, 53(8), p. 908-936.

In this paper, we explore the role of labor markets for monetary policy in the euro area in a New Keynesian model in which labor markets are characterized by search and matching frictions. We first investigate to which extent a more flexible labor market would alter the business cycle behavior and the transmission of monetary policy. We find that while a lower degree of wage rigidity makes monetary policy more effective, i.e. a monetary policy shock transmits faster onto inflation, the importance of other labor market rigidities for the transmission of shocks is rather limited. Second, having estimated the model by Bayesian techniques we analyze to which extent labor market shocks, such as disturbances in the vacancy posting process, shocks to the separation rate and variations in bargaining power are important determinants of business cycle fluctuations. Our results point primarily towards disturbances in the bargaining process as a significant contributor to inflation and output fluctuations. In sum, the paper supports current central bank practice which appears to put considerable effort into monitoring euro area wage dynamics and which appears to treat some of the other labor market information as less important for monetary policy. Back to main page.

The Elasticity of the Unemployment Rate with Respect to Benefits (2009), with Kai Christoffel,
Economics Letters, 102(2), p. 102-105.

If the Mortensen and Pissarides model with efficient bargaining is calibrated to replicate the fluctuations of unemployment over the business cycle, it implies a far too strong rise of the un- employment rate when unemployment benefits rise. This paper explores an alternative, right-to- manage bargaining scheme. This also generates the right degree of fluctuations of unemployment but at the same time implies a reasonable elasticity of unemployment with respect to benefits. Back to main page.

Is the New Keynesian Phillips Curve Flat? (2009), with Gernot Mueller and Sarah Stoelting,
Economics Letters, 103(1), p. 39-41.

Microeconomic evidence implies frequent price adjustments while macroeconometric evidence based on GMM estimation points to a flat New Keynesian Phillips curve (NKPC). This paper suggests a resolution: GMM estimates of the NKPC may be biased because of autocorrelated cost-push shocks. We perform Monte Carlo experiments using an empirically plausible New Keynesian model as data-generating process and find that GMM estimates of the NKPC imply average price durations of 12 quarters while the true value is only 2 quarters. Back to main page.

Resuscitating the Wage Channel in Models with Unemployment Fluctuations (2008), with Kai Christoffel,
Journal of Monetary Economics, 55(5), p. 865-887.

Higher wages all else equal translate into higher inflation. More rigid wages imply a weaker response of inflation to shocks. This view of the wage channel is deeply entrenched in central banks' views and models of their economies. In this paper, we present a model with equilibrium unemployment which has three distinctive properties. First, using a search and matching model with right-to-manage wage bargaining a proper wage channel obtains. Second, accounting for fixed costs associated with maintaining an existing job greatly magnifies profit fluctuations for any given degree of wage fluctuations, which allows the model to reproduce the fluctuations of unemployment over the business cycle. And third, the model implies a reasonable elasticity of steady state unemployment with respect to changes in benefits. The calibration of the model implies low profits, but does not require a small gap between the value of working and the value of unemployment for the worker. Back to main page.

Value-at-Risk Prediction: A Comparison of Alternative Strategies (2006), with Stefan Mittnik and Marc Paolella,
Journal of Financial Econometrics 4(1), pp. 53-89.

Given the growing need for managing financial risk, risk prediction plays an increasing role in banking and finance. In this study we compare the out-of-sample performance of existing methods and some new models for predicting value-at-risk (VaR) in a univariate context. Usingmore than 30 years of the daily return data on the NASDAQ Composite Index, we find that most approaches perform inadequately, although several models are acceptable under current regulatory assessment rules for model adequacy. A hybrid method, combining a heavy-tailed generalized autoregressive conditionally heteroskedastic (GARCH) filter with an extreme value theory-based approach, performs best overall, closely followed by a variant on a filtered historical simulation, and a new model based on heteroskedasticmixture distributions. Conditional autoregressive VaR (CAViaR) models perform inadequately, though an extension to a particular CAViaR model is shown to outperform the others. Back to main page.

Optimal Monetary Policy Rules for the Euro Area (2005), with Alistair Dieppe and Peter McAdam,
Journal of Common Market Studies, 2005, 43(3), p. 507-537.

In this article, we analyse the conduct of optimal monetary policy for the new euro area. The aggregate euro area economy is modelled to have relatively sluggish adjustment properties and a private sector with mainly backward-looking expectations. In this economy, we assume that the central bank searches for its best-performing monetary policy rule, e.g. the optimal weight to give to inflation stabilization compared to that of output, the optimal degree of forward-looking in the planning horizon, and so on. We first find that the optimal degree of gradualism in interest rate-setting needs only be relatively mild and that the central bank should incorporate new information quickly into policy-making. Second, there is substantial gain from implementing and communicating quite forward-looking policies. The optimal forecast horizon for inflation ranges around six quarters. In contrast to deliberately simple rule-based policy recommendations, fully optimal policy is a complicated response to many different economic indicators. With regard to this we find, third, that optimal policy should be based on a broad information set, even if the resulting policy framework is hard to communicate to the outside world. Thus, the article contributes to the debate on optimal monetary policy for the euro area, as well as to the conduct of monetary policy in face of substantial persistence in the transmission mechanism. Back to main page.