Research

WORKING PAPERS

When Do Persistent Supply Shocks Call for Hawkishness?

Central banks typically rely on the following heuristic: Look through transitory supply shocks to stabilize the output gap, but pivot to stabilizing inflation if shocks are persistent. Yet standard models provide little support for this heuristic. They justify it for markup shocks---a particular type of supply shock---but find that for the most common supply shocks---productivity, labor supply, energy prices---stabilizing the output gap is close to optimal even for persistent shocks. What, then, rationalizes a hawkish response to persistent supply shocks? The paper shows that, contrary to conventional wisdom, the risk of inflation expectations de-anchoring is insufficient: even with backward-looking expectations, output gap stabilization remains close to optimal. Instead, real wage rigidity, as arises from explicit or implicit cost-of-living adjustments (COLA) that index nominal wages to inflation, provides a rationale. When real wages are sufficiently rigid, stabilizing the output gap becomes much more costly and optimal policy shifts toward inflation stabilization for persistent shocks, whether or not expectations can de-anchor. This suggests that monitoring cost-of-living adjustments and real wage rigidity is at least as important as monitoring inflation expectations to assess the need for a hawkish pivot.

Fiscal Requirements for Price Stability when Households Are Not Ricardian

with Anna Rogantini Picco

Can monetary policy deliver price stability whatever fiscal policy does? With Ricardian households, no: Public debt must be backed by future fiscal surpluses. But if that fiscal backing holds, monetary policy can deliver price stability by responding sufficiently strongly to inflation. We reconsider the question when households are not Ricardian. First, although public debt need not always be backed by future surpluses, fiscal requirements still exist in a different form: Public debt cannot be so high that its wealth effect on aggregate spending prevents the existence of a natural interest rate. Second, if this condition is satisfied, monetary policy can deliver price stability, but it must respond directly to the level of public debt---not just to the inflation that higher debt creates. We conclude that in practice the main fiscal threat to price stability is institutional: even though debt-contingent rules are feasible, central banks may be reluctant to adopt them.

Keeping Control over Boundedly Rational Expectations

with Magali Marx

R&R at the Journal of Money, Credit and Banking

How can central banks avoid losing control over inflation expectations? Under rational expectations, respecting the Taylor principle is needed to ward off self-fulfilling inflation. We reconsider the issue away from rational expectations, for a class of boundedly rational expectations embedding cognitive discounting and long-term learning. (1) Self-fulfilling inflation is no longer a concern, but too passive a monetary policy leads to inflation spirals. (2) Active monetary policies can be characterized without restricting to Taylor rules, as those that sufficiently increase a weighted average of present and future policy rates. (3) The more the central bank cares about output stabilization, the more it should deliver the necessary tightening through expectations of future hikes instead of current hikes.

Putting the I Back in the IS Curve

R&R at the Journal of the European Economic Association

How do interest rates affect aggregate consumption? Baseline monetary models, including those with rich household heterogeneity, emphasize a transmission channel that originates in households' desire to substitute consumption across time. Yet empirical estimates of the intertemporal elasticity of substitution often place it close to zero. I show that, when investment interacts with household heterogeneity, a distinct transmission channel arises that operates entirely independently of intertemporal substitution in consumption and originates instead in firms' interest-sensitive investment. Neither high MPCs nor household heterogeneity alone is sufficient. The channel requires that the households providing the funds for firms’ investment have lower MPCs than the households receiving the income that higher investment generates. Through this channel, future interest rates matter less than current ones, offering a potential resolution of the forward-guidance puzzle.

PUBLICATIONS