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Working Paper
The Effects of Foreign Shocks when Interest Rates are at Zero
In a two-country DSGE model, the effects of foreign demand shocks on the home country are greatly amplified if the home economy is constrained by the zero lower bound on policy interest rates. This result applies even to countries that are relatively closed to trade such as the United States. Departing from many of the existing closed-economy models, the duration of the liquidity trap is determined endogenously. Adverse foreign shocks can extend the duration of the trap, implying more contractionary effects for the home country. The home economy is more vulnerable to adverse foreign shocks if ...
Working Paper
Social Distancing and Supply Disruptions in a Pandemic
Drastic public health measures such as social distancing or lockdowns can reduce the loss of human life by keeping the number of infected individuals from exceeding the capacity of the health care system but are often criticized because of the social and the economic cost they entail. We question this view by combining an epidemiological model, calibrated to capture the spread of the COVID-19 virus, with a multisector model, designed to capture key characteristics of the U.S. Input Output Tables. Our two-sector model features a core sector that produces intermediate inputs not easily replaced ...
Working Paper
Learning and Misperception: Implications for Price-Level Targeting
Monetary policy strategies that target the price level have been advocated as a more effective way to provide economic stimulus in a deep recession when conventional monetary policy is limited by the zero lower bound on nominal interest rates. Yet, the effectiveness of these strategies depends on a central bank's ability to steer agents' expectations about the future path of the policy rate. We develop a flexible method of learning about the central bank's policy rule from observed interest rates that takes into account the limited informational content at the zero lower bound. When agents ...
Working Paper
Global Flight to Safety, Business Cycles, and the Dollar
We develop a two-country macroeconomic model that we fit to a set of aggregate prices and quantities for the U.S. and the rest of the world. In addition to a standard array of shocks, the model includes time variation in agents’ preference for safe bonds. We allow for a component of this time variation to be common across countries and biased toward dollar-denominated safe assets, and refer to this component as global flight to safety (GFS). We find that GFS shocks are the most important shocks driving world business cycles, and are also important drivers of activity in the U.S. and ...
Working Paper
Optimal monetary policy with distinct core and headline inflation rates
In a stylized DSGE model with an energy sector, the optimal policy response to an adverse energy supply shock implies a rise in core inflation, a larger rise in headline inflation, and a decline in wage inflation. The optimal policy is well-approximated by policies that stabilize the output gap, but also by a wide array of "dual mandate" policies that are not overly aggressive in stabilizing core inflation. Finally, policies that react to a forecast of headline inflation following a temporary energy shock imply markedly different effects than policies that react to a forecast of core, with ...
Report
Can U.S. monetary policy fall (again) into an expectation trap?
We provide a tractable model to study monetary policy under discretion. We restrict our analysis to Markov equilibria. We find that for all parametrizations with an equilibrium inflation rate of about 2 percent, there is a second equilibrium with an inflation rate just above 10 percent. Thus, the model can simultaneously account for the low and high inflation episodes in the United States. We carefully characterize the set of Markov equilibria along the parameter space and find our results to be robust, suggesting that expectation traps are more than just a theoretical curiosity.
Working Paper
Of nutters and doves
We argue that there are conditions such that any inflation targeting regime is preferable to full policy discretion, even if long-run inflation rates are identical across regimes. The key observation is that strict inflation targeting outperforms the discretionary policy response to sufficiently persistent shocks. Under full policy discretion, inflation expectations over the medium term respond to the shock and thereby amplify its impact on output. As a result, little output stabilization is achieved at the cost of large and persistent inflation fluctuations.
Working Paper
International Asset Markets and Real Exchange Rate Volatility
The real exchange rate is very volatile relative to major macroeconomic aggregates and its correlation with the ratio of domestic over foreign consumption is negative (Backus-Smith puzzle). These two observations constitute a puzzle to standard international macroeconomic theory. This paper develops a two country model with complete asset markets and limited enforcement for international financial contracts that provides a possible explanation of these two puzzles. The model performs better than a standard incomplete markets model with a single non-contingent bond unless very tight borrowing ...