Behzad Diba

Relative Labor Productivity and the Real Exchange Rate in the Long Run: Evidence for a Panel of OECD Countries

The Balassa-Samuelson model, which explains real exchange rate movements in terms of sectoral productivities, rests on two components. First, for a class of technologies including Cobb-Douglas, the model implies that the relative price of nontraded goods in each country should reflect the relative productivity of labor in the traded and nontraded goods sectors. Second, the model assumes that purchasing power parity holds for traded goods in the long-run. We test each of these implications using data from a panel of OECD countries. Our results suggest that the first of these two fits the data quite well. In the long run, relative prices generally reflect relative labor productivities. The evidence on purchasing power parity in traded goods is considerably less favorable. When we look at US dollar exchange rates, PPP does not appear to hold for traded goods, even in the long run. On the other hand, when we look at DM exchange rates purchasing power parity appears to be a somewhat better characterization of traded goods prices.

Fiscal Multipliers in Recessions

The Great Recession, and the fiscal response to it, has revived interest in the size of fiscal multipliers. Standard business cycle models have difficulties generating multipliers greater than one. And they also cannot produce any significant state-dependence in the size of the multipliers over the business cycle. In this paper we employ a variant of the Curdia-Woodford model of costly financial intermediation and show that fiscal multipliers can be strongly state dependent in a countercyclical manner. In particular, a fiscal expansion during a recession may lead to multiplier values exceeding two, while a similar expansion during an economic boom would produce multipliers falling short of unity. This pattern obtains if the spread (the financial friction) is more sensitive to fiscal policy during recessions than during expansions, a feature that is present in the data. Our results are consistent with recent empirical work documenting the state contingency of multipliers.

Optimal Monetary and Prudential Policies

The recent financial crisis has highlighted the interconnectedness between macroeconomic and financial stability and has raised the question of whether and how to combine the corresponding main policy instruments (interest rate and bank-capital requirements). This paper offers a characterization of the jointly optimal setting of monetary and prudential policies and discusses its implications for the business cycle. The source of financial fragility is the socially excessive risk-taking by banks due to limited liability and deposit insurance. We characterize the conditions under which locally optimal (Ramsey) policy dedicates the prudential instrument to preventing inefficient risk-taking by banks; and the monetary instrument to dealing with the business cycle, with the two instruments co-varying negatively. Our analysis thus identifies circumstances that can validate the prevailing view among central bankers that standard interest-rate policy cannot serve as the first line of defense against financial instability. In addition, we also provide conditions under which the two instruments might optimally co-move positively and countercyclically.

The Interaction Between Monetary and Fiscal Policy

Our chapter reviews positive and normative issues in the interaction between monetary and fiscal policy, with an emphasis on how views on policy coordination have changed over the last 25 five years. On the positive side, noncooperative games between a government and its central bank have given way to an examination of the requirements on monetary and fiscal policy to provide a stable nominal anchor. On the normative side, cooperative solutions have given way to Ramsey allocations. The central theme throughout is on the optimal degree of price stability and on the coordination of monetary and fiscal policy that is necessary to achieve it.

The inflation discipline of currency substitution

Abstract We examine the argument that currency substitution should be encouraged since it provides an inflation discipline. In highly stylized games of national welfare maximization, we find that as currency substitution increases, currency survival comes to dominate all other considerations, and inflation rates do indeed come down. However, we find no reason to think that these competitive inflation rates will be optimal. The discipline embodied in currency substitution may be too weak, or too strong. It may be a poor substitute for direct coordination of monetary (and fiscal) policies. We try to relate our analysis to recent U.K. proposals.

The SGP: Delicate Balance or Albatross?

The Stability and Growth Pact tried to strike a delicate balance. On the one hand, it imposed constraints on national fiscal policy that were deemed necessary to protect the new European Central Bank (ECB) from outside pressures, especially during the period in which it tried to establish credibility.1 At the same time, the Pact allowed some flexibility for a counter-cyclical fiscal policy. This too was deemed necessary in European Monetary Union (EMU): a stable ECB policy might be expected to create stable macroeconomic conditions for the euro zone as a whole, but it could not be expected to iron out regional cyclical imbalances. Did the Pact strike a workable balance? Or is the Pact an unnecessary albatross that could seriously hamper the whole EMU project?

Currency substitution and exchange rate volatility in the European Community

Abstract Some proponents of a European monetary union worry that capital mobility and currency substitution will result in unmanageable exchange rate volatility during the transition to monetary union. In this paper we analyze stylized models of exchange rate fluctuation in response to monetary disturbances. We find that if monetary policies within the Community are convergent, higher currency substitution either reduces or does not significantly change the volatility of exchange rates unless there are anticipations of a final realignment.

Money, Output, and the Expected Real Interest Rate

This paper tests the exclusion of lagged growth rates of money and output from regression equations, with serially correlated disturbances, for the expected real interest rate. The authors empirical approach is an extension of the empirical strategies of Eugene F. Fama (1975) and Frederic S. Mishkin (1981)--which invoke the orthogonality of the inflation forecast error to predetermined regressors under the maintained hypothesis of rational expectations. They discuss the implications of their tests for simple real-business-cycle models. Copyright 1991 by MIT Press.

Liquidity Shocks, Equity-Market Frictions, And Optimal Policy

In this paper, we study the positive and normative implications of financial shocks in a standard New Keynesian model that includes banks and frictions in the market for bank capital. We show how such frictions influence materially the effects of bank liquidity shocks and the properties of optimal policy. In particular, they limit the scope for countercyclical monetary policy in the face of these shocks. A fiscal policy instrument can complement monetary policy by offsetting the balance-sheet effects of these shocks, and jointly optimal policies attain the same equilibrium that monetary policy (alone) could attain in the absence of equity-market frictions.

Equity as a call option on assets: Some tests for failed banks

Abstract We report some preliminary evidence on the equity-call model — postulating that the stock market prices a firms equity like a call option on the firms assets — for a sample of failed banks. The model implies that these banks had positive net worth close to their failure dates, while subsequent FDIC estimates of resolution costs suggest large negative net worth figures.