Matthias Paustian

Inflation and output in New Keynesian models with a transient interest rate peg

A familiar result in the canonical Dynamic New Keynesian (DNK) model is that policymakers constrained by the zero bound can improve outcomes by promising to keep rates low after the zero bound is not binding. We examine a general class of interest rate pegs in a variety of DNK models. Standard versions of the model produce counterintuitive reversals where the effect of the interest rate peg can switch from highly expansionary to highly contractionary for modest changes in the length of the interest rate peg. This unusual behavior does not arise in sticky information models of the Phillips curve.

Fiscal Multipliers under an Interest Rate Peg of Deterministic versus Stochastic Duration

This paper revisits the size of the fiscal multiplier. The experiment is a fiscal expansion under the assumption of a pegged nominal rate of interest. We demonstrate that a quantitatively important issue is the articulation of the exit from the policy experiment. If the monetary-fiscal expansion is stochastic with a mean duration of T periods, the fiscal multiplier can be unboundedly large. However, if the monetary-fiscal expansion is for a fixed T periods, the multiplier is much smaller.

Optimal Contracts, Aggregate Risk, and the Financial Accelerator

This paper derives the optimal lending contract in the financial accelerator model of Bernanke, Gertler and Gilchrist (BGG). The optimal contract includes indexation to the aggregate return on capital, household consumption, and the return to internal funds. This triple indexation results in a dampening of fluctuations in leverage and the risk premium. Hence, compared to the contract originally imposed by BGG, the privately optimal contract implies essentially no financial accelerator.

The Role of Contracting Schemes for the Welfare Costs of Nominal Rigidities Over the Business Cycle

This paper asks the following two questions: First, can a model with nominal rigidities in wage and price setting account for the average welfare costs of business cycle fluctuations identified in Gali, Gertler, and Lopez- Salido (2003)? Second, what is the role of contracting schemes for the welfare costs of business cycle fluctuations? We compute a quadratic approximation to agents expected lifetime utility and evaluate welfare for different modeling schemes of nominal rigidities that all have the same average duration of contracts. Calvo (1983) wage and price contracts can deliver sizeable welfare costs, but other contracts of the same average stickiness cannot. Calvo (1983) contracts can imply welfare costs that are up to 4 times higher than those implied by overlapping contracts in the spirit of Taylor (1980) or Wolman (1999). Furthermore, the sticky information framework of Mankiw and Reis (2002) may generate welfare costs that are even smaller. This paper calls for more research into the origins of wage and price stickiness

The pitfalls of speed-limit interest rate rules at the zero lower bound

We show that interest rate rules that feed back on the growth rates of target variables (such as output or asset prices) may induce recessions in the presence of a zero lower bound, through purely self-fulfilling dynamics. This pathology is illustrated in a small New Keynesian model with interest rates responding to the growth rate of output, and in a version of a model by Matteo Iacoviello where interest rates respond to the growth rate of house prices and credit. Our results provide a cautionary note, contrasting with previous work which has suggested several desirable properties of speed-limit rules, namely that they are devices enabling the policymaker (i) to side-step uncertainty about natural rates, (ii) to counter booms and busts in asset prices or (iii) to implement optimal commitment policies.

Indexed Debt Contracts and the Financial Accelerator

This paper addresses the positive and normative implications of indexing risky debt to observable aggregate conditions. These issues are pursued within the context of the celebrated financial accelerator model of Bernanke, Gertler and Gilchrist (1999). The principal conclusions are that the optimal degree of indexation is significant, and that the business cycle properties of the model are altered under this level of indexation.

Inflation Persistence, Inflation Targeting, and the Great Moderation

There is growing evidence that the empirical Phillips curve within the US has changed significantly since the early 1980’s. In particular, inflation persistence has declined sharply. The paper demonstrates that this decline is consistent with a standard Dynamic New Keynesian (DNK) model in which: (i) the variability of technology shocks has declined, and (ii) the central bank more aggressively responds to inflation.

When Do Sign Restrictions Work

This paper addresses the following question: A researcher imposes sign restrictions on impulse responses in a VAR and leaves the response of some variable of interest to some structural shock unconstrained. Under which conditions do the imposed restrictions uniquely pin down the correct sign of the unconstrained response? To answer this question, two DSGE models are used to back the VAR representation of certain observables and apply the sign restriction method: the Erceg, Henderson, and Levin (2000) model as well as the Smets and Wouters (2003) model. Two conditions must be met for the method to unambiguously deliver the correct sign of unconstrained impulse responses. First, a sufficiently large number of restrictions must be imposed - more than what is typically employed in applied work. Second, the variance of the shock under study must be sufficiently large - larger than the estimates provided from the Bayesian DSGE models. Hence, sign restrictions can be a useful tool to recover structural shocks from VAR residuals.

Can Wage and Price Stickiness Account for Sizeable Costs of Business Cycle Fluctuations

This paper asks the following two questions: First, can a model with nominal rigidities in wage and price setting account for the average welfare costs of business cycle fluctuations identified in Gali, Gertler, and Lopez- Salido (2003)? Second, do we need to agree on a particular scheme for nominal rigidities to answer that question? We compute a quadratic approximation to agents expected lifetime utility and evaluate welfare for different modeling schemes of nominal rigidities that all have the same average duration of contracts. Calvo (1983) wage and price contracts can deliver sizeable welfare costs, but other contracts of the same average stickiness cannot. Calvo (1983) contracts can imply welfare costs that are up to 4 times higher than those implied by overlapping contracts in the spirit of Taylor (1980) or Wolman (1999). Furthermore, the sticky information framework of Mankiw and Reis (2002) may generate welfare costs that are even smaller. This paper calls for more research into the origins of wage and price stickiness.