Campbell Leith

Monetary and Fiscal Policy Interactions in a New Keynesian Model with Capital Accumulation and Non-Ricardian Consumers

The paper examines simple monetary and fiscal policy rules consistent with determinate equilibrium dynamics in the absence of Ricardian equivalence. Under this assumption, government debt turns into a relevant state variable which needs to be accounted for in the analysis of equilibrium dynamics. The key analytical finding is that without explicit reference to the level of government debt it is not possible to infer how strongly the monetary and fiscal instruments should be used to ensure determinate equilibrium dynamics. Specifically, we identify bifurcations associated with threshold values of steady-state debt, leading to qualitative changes in the local determinacy requirements.

Monetary and Fiscal Policy Interaction: The Current Consensus Assignment in the Light of Recent Developments*

In the last few years papers have begun to analyse optimal monetary and fiscal policy in models incorporating nominal rigidities where social welfare is derived from the utility of agents. This article examines whether this analysis provides support for the consensus assignment, where monetary policy controls demand and inflation and fiscal policy controls government debt. We argue that the basic structure of New Keynesian models implies that monetary policy dominates fiscal policy as a means of controlling inflation. No similar dominance appears to operate for fiscal policy and debt, if debt has to return to its initial level after shocks. Copyright

A Sectoral Analysis of Price-Setting Behavior in US Manufacturing Industries

In this paper we estimate New Keynesian Phillips curves (NKPC) for U.S. manufacturing industries defined at the SIC two digit level over the period 1959 to 1996. This enables us to measure the extent of nominal inertia across industrial sectors. A key innovation in this research is the use of intermediate-goods costs rather than labor costs as a measure of marginal costs. Intermediate-goods costs are a more significant element of costs for the firms populating our sample and are not subject to the criticism that wage rates are nonallocative. We find that there is statistically significant variability in estimates of price stickiness, ranging from eight months to two years. We also find that estimates of backward-looking price-setting behavior vary, with some industries characterized by 81 of pricing decisions made in a purely forward-looking manner, while in others only 52 of pricing decisions are made that way. Market concentration (as captured by the Herfindahl-Hirschman index) appears to be associated with increased price stickiness, but reduced rule-of-thumb behavior, in setting prices. Finally, firms are also more likely to follow simple rules of thumb when output in their industry is more volatile.

Optimal Debt Policy, and an Institutional Proposal to Help in Its Implementation

Paper prepared for a workshop organised by the DG Ecfin of the European Commission on The role of national fiscal rules and institutions in shaping budgetary outcomes, Brussels, 24 November 2006.

The Costs of Fiscal Inflexibility

Extending Gali and Monacelli (2004), we build an N-country open economy model, where each economy is subject to sticky wages and prices and, potentially, has access to sales and income taxes as well as government spending as fiscal instruments. We examine an economy either as a small open economy operating under flexible exchange rates or as a member of a monetary union. In a small open economy when all three fiscal instruments are freely available, we show analytically that the welfare impact of technology and mark-up shocks can be completely eliminated (in the sense that policy can replicate the efficient flex price equilibrium), whether policy acts with discretion or commitment. However, once any one of these fiscal instruments is excluded as a stabilisation tool, costs can emerge. Using simulations, we find that the useful fiscal instrument in this case (in the sense of reducing the welfare costs of the shock) is either income taxes or sales taxes. In constrast, having government spending as an instrument contributes very little. The results for an individual member of a monetary union facing an idiosyncratic technology shock (where monetary policy in the union does not respond) are very different. First, even with all fiscal instruments freely available, the technology shock will incur welfare costs. Government spending is potentially useful as a stabilisation device, because it can act as a partial substitute for monetary policy. Finally, sales taxes are more effective than income taxes at reducing the costs of a technology shock under monetary union. If all three taxes are available, they can reduce the impact of the technology shock on the union member by around a half, compared to the case where fiscal policy is not used. Finally we consider the robustness of these results to two extensions. Firstly, introducing government debt, such that policy makers take account of the debt consequences of using fiscal instruments as stabilisation devices, and, secondly, introducing implementation lags in the use of fiscal instruments. We find that the need for debt sustainability has a very limited impact on the use of fiscal instruments for stabilisation purposes, while implementation lags can reduce, but not eliminate, the gains from fiscal stabilisation.

Fiscal Policy, Macroeconomic Stability and Finite Horizons

In this paper we analyse the stabilisation properties of distortionary taxes in a New Keynesian model with overlapping generations of finitely-lived consumers. In this framework, government debt is part of net wealth and this adds a number of interesting channels through which fiscal policy could affect output and inflation. Output volatility, in presence of technology shocks, is not substantially affected by the operation of automatic stabilisers but we find interesting composition effects. While the presence of finitely-lived households strengthens the stabilisation performance of distortionary taxes through the reduction of the volatility of consumption, it does so at the cost of more volatile investment and real balances. These conflicting responses add up to a very small overall welfare losses associated with distortionary taxation.

Interest Rate Feedback Rules in an Open Economy with Forward Looking Inflation

With the adoption of an explicit inflation target in the UK, there has been renewed interest in the properties of alternative interest rate feedback rules. Following Svensson (1999), a literature examining the relative merits of inflation and price level targeting has also developed. In this paper, we compare the stabilization properties of the two forms of feedback rule that have been used most frequently in the literature and that give rise to price level and inflation targeting, respectively. The model in which we embed our rules is significantly richer than those considered in the price level targeting literature and this allows us to explain why the relative performance of the rules is dependent upon the nature of the shock considered and whether or not excess inflation is defined in terms of consumer or output price inflation. Copyright 2001 by Blackwell Publishing Ltd

An Empirical Assessment of Optimal Monetary Policy Delegation in the Euro Area

We estimate a New Keynesian DSGE model for the Euro area under alternative descriptions of monetary policy (discretion, commitment or a simple rule) after allowing for Markov switching in policy maker preferences and shock volatilities. This reveals that there have been several changes in Euro area policy making, with a strengthening of the anti-inflation stance in the early years of the ERM, which was then lost around the time of German reunification and only recovered following the turnoil in the ERM in 1992. The ECB does not appear to have been as conservative as aggregate Euro-area policy was under Bundesbank leadership, and its response to the financial crisis has been muted. The estimates also suggest that the most appropriate description of policy is that of discretion, with no evidence of commitment in the Euro-area. As a result although both ‘good luck’ and ‘good policy’ played a role in the moderation of inflation and output volatility in the Euro-area, the welfare gains would have been substantially higher had policy makers been able to commit. We consider a range of delegation schemes as devices to improve upon the discretionary outcome, and conclude that price level targeting would have achieved welfare levels close to those attained under commitment, even after accounting for the existence of the Zero Lower Bound on nominal interest rates.

Optimal Time-Consistent Monetary, Fiscal and Debt Maturity Policy

The textbook optimal policy response to an increase in government debt is simple—monetary policy should actively target inflation, and fiscal policy should smooth taxes while ensuring debt sustainability. Such policy prescriptions presuppose an ability to commit. Without that ability, the temptation to use inflation surprises to offset monopoly and tax distortions, as well as to reduce the real value of government debt, creates a state-dependent inflationary bias problem. High debt levels and short-term debt exacerbate the inflation bias. But this produces a debt stabilization bias because the policy maker wishes to deviate from the tax smoothing policies typically pursued under commitment, by returning government debt to steady-state. As a result, the response to shocks in New Keynesian models can be radically different, particularly when government debt levels are high. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Should the Exchange Rate be in a Monetary Policy Objective Function

Following from Woodford’s derivation of a benevolent monetary policy maker’s objective function from agents utility, a number of papers have suggested that policy in an open economy should have the same objectives as in a closed economy, and in particular that the exchange rate should play no role. We show that this conclusion is not robust to the presence of any shocks to International Risk Sharing. When such shocks are important, the exchange rate appears alongside output and inflation in the social welfare function. However the form of this target is rather different from that used by a number of authors.