Martin Ellison

A Defence of the FOMC

We defend the forecasting performance of the FOMC from the recent criticism of Christina and David Romer. Our argument is that the FOMC forecasts a worst-case scenario that it uses to design decisions that will work well enough (are robust) despite possible misspecification of its model. Because these FOMC forecasts are not predictions of what the FOMC expects to occur under its model, it is inappropriate to compare their performance in a horse race against other forecasts. Our interpretation of the FOMC as a robust policymaker can explain all the findings of the Romers and rationalises differences between FOMC forecasts and forecasts published in the Greenbook by the staff of the Federal Reserve System.

Learning, uncertainty and central bank activism in an economy with strategic interactions

In this paper we examine the optimal level of central bank activism in a standard model of monetary policy with uncertainty, learning and strategic interactions. We calibrate the model using G7 data and find that the presence of strategic interactions between the central bank and private agents implies that optimality unambiguously recommends caution in monetary policy. An active policy designed to help learning and reduce future uncertainty creates extra volatility in inflation expectations and is detrimental to welfare.

Sticky prices and volatile output

This paper examines the effect of introducing a specific type of price stickiness into a stochastic growth model subject to a cash-in-advance constraint. As in previous studies, it is found that the introduction of price rigidities provides a substantial source of monetary non-neutrality that contributes significantly to output volatility. It is shown that the introduction of this form of sticky prices improves the models performance at explaining inflation, but worsens it for output. The most dramatic failure of the model is the extremely high-frequency fluctuations in output that it generates. Sticky prices not only fail to produce persistent business cycle fluctuations but they generate volatility at very high frequencies.

Learning by Disinflating

Disinflationary episodes are a valuable source of information for economic agents trying to learn about the economy. In this paper we are particularly interested in how policymakers can themselves learn by disinflating. The approach differs from the existing literature, which typically focuses on the learning of private agents during a disinflation. We build a model where both the policymaker and private agents learn, and ask what happens if the policymaker has to disinflate to satisfy a new central bank mandate specifying greater emphasis on inflation stabilisation. In this case, our results show that inflation may fall dramatically before it gradually rises to its new long run level. The potential for inflation to undershoot its long run level during a disinflationary episode suggests that caution should be exercised when assessing the success of any change in the policymakers mandate. JEL classification: D83, E52, E58 Keywords: Disinflation, Escape Dynamics, Learning, Monetary Policy

Welfare Cost of Business Cycles in Economies with Individual Consumption Risk

The welfare cost of random consumption fluctuations is known from De Santis (2007) to be increasing in the level of individual consumption risk in the economy. It is also known from Barillas et al. (2009) to increase if agents in the economy care about robustness to model misspecification. In this paper, we combine these two effects and calculate the cost of business cycles in an economy with consumers who face individual consumption risk and who fear model misspecification. We find that individual risk has a greater impact on the cost of business cycles if agents already have a preference for robustness. Correspondingly, we find that endowing agents with concerns about a preference for robustness is more costly if there is already individual risk in the economy. The combined effect exceeds the sum of the individual effects.

Unconventional Government Debt Purchases as a Supplement to Conventional Monetary Policy

In response to the Great Financial Crisis, the Federal Reserve and the Bank of England have adopted unconventional monetary policy instruments. We investigate if one of these, purchases of long-term government debt, could be a valuable addition to conventional short-term interest rate policy even if the main policy rate is not constrained by the zero lower bound. To do so we add a stylised financial sector and central bank asset purchases to an otherwise standard New Keynesian DSGE model. Asset quantities matter for interest rates through a preferred habitat channel. If conventional and unconventional monetary policy instruments are coordinated appropriately then the central bank is better able to stabilise both output and inflation.

Unemployment and Market Size

Without strong empirical support, labour market matching models typically assume constant returns to scale in matching. We construct a tractable equilibrium random matching model with a general matching technology, introducing market size effects: the job‐finding rate varies with unemployment. Stable steady‐states may occur in regions of increasing or decreasing returns, and multiple equilibria are welfare‐ranked by market size. While the standard model relies on high‐frequency shocks to the steady state to explain the co‐movement of unemployment and job‐finding, locally decreasing returns in matching generate plausible adjustment dynamics and slower convergence. Lastly, an extension of the Hosios condition internalises search externalities.

Monetary policy and learning in an open economy

In this paper, we examine the incentives for central bank activism and caution in a two-country open-economy model with uncertainty and learning. We find that the presence of a strategic interaction between the home and foreign central banks creates an additional motivation for caution in monetary policy. An activist policy designed to help the learning of the home central bank is suboptimal since it generates a strong reaction from the foreign central bank. As joint learning by the home and foreign central banks is shown to be detrimental to welfare, the optimal policy is cautious.

Escaping Nash and volatile inflation

Why is inflation so much lower and at the same time more stable in developed economies in the 1990s, compared with the 1970s? This paper suggests that the United Kingdom, United States and other countries may have escaped from a volatile inflation equilibrium. Our argument builds on the story proposed by Tom Sargent in The conquest of American inflation, where the fall in inflation in the 1980s was attributed to the changing beliefs informing monetary policy. To explain the escape in inflation volatility, we unwind one of Sargents simplifications and allow the monetary authority to react to some of the shocks in the economy. In this new model, a revised account of recent history is that when the evidence turned against the existence of a long-run inflation-output trade-off in the 1980s there was an escape from high inflation, but the authorities were also persuaded to stop using changes in inflation to offset shocks. Inflation and inflation volatility therefore escaped in tandem. Our analysis also sheds some light on why the escape in inflation occurred at the time it did. Our model, like the Sargent model it derives from, omits the revolution in institutional design and understanding that underpins monetary policy. So the gloomy predictions for the future derived from a literal reading of it are likely to be unfounded.

Stabilisation Bias in Monetary Policy Under Endogenous Price Stickiness

This paper investigates the consequences of introducing endogenous price stickiness into a standard monetary policy model. We find that the modification reduces the optimal degree of inflation stabilization to which the central bank should commit. The reason is that less inflation stabilization encourages firms to review their prices more frequently. The economy becomes more flexible and the Phillips-curve tradeoff is improved, making it easier for the central bank to control inflation. This reduces, and may even reverse, the stabilization bias that is present in models with exogenous price stickiness and that recommends that the central bank generally commit to tighter stabilization of inflation than it would in a discretionary policy regime.