with Magali Marx
How can a central bank avoid losing control over inflation expectations? Under rational expectations, respecting the Taylor principle---increasing rates more than one for one with inflation---prevents self-fulfilling inflation and defines an active monetary policy. We reconsider the issue away from rational expectations, for a large class of boundedly rational expectations featuring both limited foresight and long-term learning. We show three results. (1) When restricting monetary policy to a Taylor rule, the Taylor principle does not prevent self-fulfilling inflation but hyperinflation spirals, unless for unrealistically high degrees of foresight. (2) Against hyperinflation spirals, active monetary policy can be characterized without restricting policy to a Taylor rule, as a sufficient increase of a weighted average of present and future expected policy rates. The weights on future policy rates first increase but then decrease with the horizon, implying that delaying hikes too much requires larger hikes later, with a larger drop in output. (3) Yet, being slow in hiking rates can be optimal provided a large cost on output stabilization, as it spreads the output cost over time.
The dynamic IS curve of New-Keynesian models captures the dependence of aggregate demand on the entire yield curve, but only in the case where there is no investment and the interest rate channel originates in the savings decisions of households only. The paper derives the dynamic IS curve analytically in a model with investment, where the interest rate channel originates both in the savings decisions of households and the investment decisions of firms. The generalized dynamic IS curve shows that investment can reduce the importance of future rates for aggregate demand, but only if the intertemporal elasticity of substitution in consumption is low enough. Adding household heterogeneity, investment can also reduce the importance of future rates for aggregate consumption, in a new way that does not rely on precautionary savings. Instead, household heterogeneity makes future rates matter less by making consumption respond to interest rates primarily as a ripple effect of the response of investment, not through intertemporal substitution.
with Hervé Le Bihan and Julien Matheron
Accepted, Journal of Monetary Economics
How effective are forward-guidance and make-up strategies? Standard models find them extremely effective, but by assuming households' inflation expectations respond much more strongly than in the data. Models where households discount the future find them much less effective and match the small reaction of inflation expectations, but not the actual large reaction of asset prices. We build a model that rationalizes both. Households cognitively discount the future, but more forward-looking financial market professionals incorporate their expectations of future policy into the long-term nominal rates faced by all. We find that make-up strategies have sizably better stabilization properties than inflation targeting.
with Emi Nakamura And Jón Steinsson
R&R Journal of Monetary Economics
In standard models, economic activity fluctuates symmetrically around a “natural rate” and stabilization policies can dampen these fluctuations but do not affect the average level of activity. An alternative view—labeled the “plucking model” by Milton Friedman—is that economic fluctuations are drops below the economy’s full potential ceiling. We show that the dynamics of the unemployment rate in the US display a striking asymmetry that strongly favors the plucking model: increases in unemployment are followed by decreases of similar amplitude, while the amplitude of a decrease does not predict the amplitude of the following increase. In addition, business cycles last seven years on average and unemployment rises much faster during recessions than it falls during expansions. We augment a standard labor search model with downward nominal wage rigidity and show how it can fit the plucking property. We then show that additional non-standard features are required to match the level and asymmetry of the duration of contractions and expansions.