The dynamic IS curve of New-Keynesian models gives the dependence of aggregate demand on future interest rates, but only in the case where there is no investment and the interest rate channel only originates in the savings decision of households. The paper derives the dynamic IS curve analytically in a model with investment, where the interest rate channel originates both in the the savings decisions of households and the investment decisions of firms. This generalized dynamic IS curve sheds light on several new factors that shape the dependence of aggregate demand on interest rates. In particular, interest rates are discounted in investment and aggregate demand if and only if the intertemporal elasticity of substitution in consumption (IES) is low enough, and compounded if it is higher. The addition of household heterogeneity can generate discounting in aggregate consumption as well, in a new way that does not rely on precautionary savings. Instead, household heterogeneity creates discounting 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
R&R Journal of Monetary Economics
How effective make-up strategies such as average-inflation targeting are depends heavily on how forward-looking agents are. Workhorse models, which are much forward-looking, find them so effective as to put their realism into question—the forward-guidance puzzle. Models that discount the future further find them much less effective, but imply that agents discount the very perception of future policy rates. This only evaluates make-up strategies when financial markets do not notice them, or deem them non-credible. We amend one leading solution to the forward-guidance puzzle—Woodford’s finite planning horizons—to the assumption that financial markets have rational expectations on policy rates, and incorporate them into the long-term nominal interest rates faced by all. Agents still have a limited ability to foresee the consequences of monetary policy on output and inflation, avoiding the incredibly strong effects found in workhorse models. First, we find that make-up strategies that compensate for a past deficit of accommodation after an ELB episode have sizably better stabilization properties than inflation targeting. Second, we find that make-up strategies that always respond to past economic conditions, such as average inflation targeting, do too but that their stabilization benefits over IT can be reduced by the existence of the ELB.
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.