Michael Dotsey

State-Dependent Pricing and the General Equilibrium Dynamics of Money and Output

Economists have long suggested that nominal product prices are changed infrequently because of fixed costs. In such a setting, optimal price adjustment should depend on the state of the economy. Yet, while widely discussed, statedependent pricing has proved difficult to incorporate into macroeconomic models. This paper develops a new, tractable theoretical state-dependent pricing framework. We use it to study how optimal pricing depends on the persistence of monetary shocks, the elasticities of labor supply and goods demand, and the interest sensitivity of money demand.

The Welfare Cost of Inflation in General Equilibrium

This paper presents a general equilibrium monetary model in which inflation distorts a variety of marginal decisions. Although individually none of the distortions is very large, they combine to yield substantial welfare cost estimates. A sustained 4% inflation like that experienced in the U.S. since 1983 costs the economy the equivalent of 0.41% of output per year when currency is identified as the relevant definition of money and over 1% of output per year when M1 is defined as money. The results illustrate how the traditional, partial equilibrium approach can seriously underestimate the true cost of inflation.

Inflation Uncertainty And Growth In A Cash-In-Advance Economy

This paper analyzes the effects of inflation variability on economic growth in a model where money is introduced via a cash-in-advance constraint. In this setting, we find that inflation adversely affects long-run growth, even when the cash-in-advance constraint applies only to consumption. At the same time, we find that inflation and growth are positively related in the short run. Furthermore, variability increases average growth through a precautionary savings motive. Since inflation and inflation variability tend to be highly correlated, the presence of uncertainty attenuates the negative long-run relationship between inflation and real growth. It also provides a partial rationale for the apparent lack of robustness in cross-country regressions of growth and inflation. Keyword(s): Economic growth; Inflation; Uncertainty

Structure from Shocks

Arguments in favor of Keynesian models as opposed to real business cycle models are often made on the grounds that the correlations and impulse response patterns found in the latter are inconsistent with the data. A recent and prominent example of this reasoning is Gali (1999). But certain conclusions involve a certain joint hypothesis that implicitly assumes a certain characterization of monetary policy. This paper shows just how crucial the systematic portion of monetary policy is for interpreting many of the correlations and impulse response functions emphasized in the literature. Basically, the featured empirical facts are not useful for discerning the underlying price setting behavior of firms.

Some unpleasant supply side arithmetic

Abstract Existing macroeconomic theory predicts that cuts in the distortionary tax rate on capital financed by increases in government debt lead to increases in investment and output. These results are generally obtained under the unrealistic assumption that government debt is financed by nondistorting future fiscal policy. However, when current government deficits are financed by future distortionary taxation this paper shows that lower tax rates and higher deficits lead to reductions in investment and output.

Should a monetary policymaker look at money

Abstract This paper examines whether monetary indicators are useful in implementing optimal discretionary monetary policy when the policymaker has incomplete information about the environment. We find that money does not contain useful information for the policymaker, if we calibrate the model to the U.S. economy. If money demand were to be appreciably less variable, observations on money could be useful in response to productivity shocks but would be harmful in response to money-demand shocks. We provide an incomplete information example where equilibrium welfare declines when the money-demand volatility decreases.

Monetary Policy, Secrecy, and Federal Funds Rate Behavior

The behavior of the Federal Reserve System can be characterized as secretive with respect to its control of monetary aggregates. One common justification for this secrecy is that markets will overreact to information, causing undue variability in interest rates. However, the consequences of keeping policy objectives hidden has received little formal attention. This paper takes an initial step by examining the variability of the federal funds rate and total reserves under nonborrowed reserve targeting. The major result is that the disclosure of operating procedures will generally increase the unconditional variability of both the funds rate and total reserves, but will decrease the variance of the forecasting error of the federal funds rate.

Nontraded goods, market segmentation, and exchange rates☆

Empirical evidence suggests that movements in international relative prices (such as the real exchange rate) are large and persistent. Nontraded goods, both in the form of final consumption goods and as an input into the production of final tradable goods, are an important aspect behind international relative price movements. In this paper we show that nontraded goods have important implications for exchange rate behavior, even though fluctuations in the relative price of nontraded goods account for a relatively small fraction of real exchange rate movements. In our quantitative study nontraded goods magnify the volatility of exchange rates when compared to the model without nontraded goods. Cross-country correlations and the correlation of exchange rates with other macro variables are closer in line with the data. In addition, contrary to a large literature, standard alternative assumptions about the currency in which firms price their goods are virtually inconsequential for the properties of aggregate variables in our model, other than the terms of trade.

How well do linear approximation methods work? : The production tax case

Abstract In this paper we investigate the accuracy of approximating policy functions for three different approximation methods in the context of a neoclassical model with a production tax. We find that a variant of the King, Plosser, and Rebelo procedure yields the best approximations overall, but that in certain instances researchers may be better off using a discrete state space solution to the Euler equations of the model.

The Demand for Currency in the United States

The idea of totally deregulating the financial system and implementing monetary policy through currency control has received renewed attention. An important aspect concerning the desirability of using currency as the instrument of policy is the behavior of the demand for currency. If currency demand is not well behaved, then a policy of controlling the nominal supply of currency could produce drastic swings in the price level and interest rates. The adverse consequence of such effects could outweigh the benefits of deregulation. It is therefore crucial that the behavior of currency demand be well understood before unequivocally advocating total financial deregulation and currency control. This paper takes a step in that direction by analyzing the demand for currency over the period 1921-1980.