Stephanie Schmitt-Grohé

Monetary Policy and Multiple Equilibria

In this paper, we characterize conditions under which interest rate feedback rules whereby the nominal interest rate is set as an increasing function of the inflation rate generate multiple equilibria. We show that these conditions depend not only on the fiscal regime (as emphasized in the fiscal theory of the price level) but also on the way in which money is assumed to enter preferences and technology. We analyze this issue in flexible and sticky price environments. We provide a number of examples in which, contrary to what is commonly believed, active monetary policy in combination with a fiscal policy that preserves government solvency gives rise to multiple equilibria and passive monetary policy renders the equilibrium unique.

Balanced-Budget Rules, Distortionary Taxes, and Aggregate Instability

A traditional argument against a balanced‐budget fiscal policy rule is that it amplifies business cycles by stimulating aggregate demand during booms via tax cuts and higher public expenditures and by reducing demand during recessions through a corresponding fiscal contraction. This paper suggests an additional source of instability that may arise from this type of fiscal policy rule. It shows that, within the standard neoclassical growth model, a balanced‐budget rule can make expectations of higher tax rates self‐fulfilling if the fiscal authority relies heavily on changes in labor income taxes to eliminate short‐run fiscal imbalances. Calibrated versions of the model show that indeterminacy occurs for income tax rates that are empirically plausible for the U.S. economy and other Group of Seven countries.

Optimal Fiscal and Monetary Policy in a Medium-Scale Macroeconomic Model

In this paper, we study Ramsey-optimal fiscal and monetary policy in a medium-scale model of the U.S. business cycle. The model features a rich array of real and nominal rigidities that have been identified in the recent empirical literature as salient in explaining observed aggregate fluctuations. The main result of the paper is that price stability appears to be a central goal of optimal monetary policy. The optimal rate of inflation under an income-tax regime is 1/2 percent per year, with a volatility of 1.1 percent. This result is surprising given that the model features a number of frictions-particularly nonstate-contingent nominal public debt, no lump-sum taxes, and sticky wages-that, in isolation, would call for a volatile rate of inflation. Under an income-tax regime, the optimal income-tax rate is quite stable, with a mean of 30 percent and a standard deviation of 1.1 percent. Simple monetary and fiscal rules are shown to implement a competitive equilibrium that mimics well the one induced by the Ramsey policy. When the fiscal authority is allowed to tax capital and labor income at different rates, optimal fiscal policy is characterized by a large and volatile subsidy on capital.

Avoiding Liquidity Traps

Once the zero bound on nominal interest rates is taken into account, Taylor-type interest-rate feedback rules give rise to unintended self-fulfilling decelerating inflation paths and aggregate fluctuations driven by arbitrary revisions in expectations. These undesirable equilibria exhibit the essential features of liquidity traps, as monetary policy is ineffective in bringing about the governments goals regarding the stability of output and prices. This paper proposes several fiscal and monetary policies that preserve the appealing features of Taylor rules, such as local uniqueness of equilibrium near the inflation target, and at the same time rule out the deflationary expectations that can lead an economy into a liquidity trap.

Price Level Determinacy and Monetary Policy Under a Balanced-Budget Requirement

This paper analyzes the implications of a balanced-budget fiscal policy rule for price-level determination in a cash-in-advance economy under three alternative monetary policy regimes. It shows that the price level is indeterminate under a nominal interest rate peg and determinate under a money growth rate peg. Under a feedback rule that sets the nominal interest rate as a non-negative and non-decreasing function of the inflation rate, the price level is indeterminate for both low and high values of the inflation elasticity of the feedback rule and determinate for intermediate values. We also study balanced-budget rules that allow for bounded secondary surpluses or deficits. Comparing our results to those emphasized in the fiscal theory of the price level, it becomes clear that a key consideration for price-level determination is whether fiscal policy is specified as an exogenous sequence of primary surpluses/deficits or, alternatively, as an exogenous sequence of secondary surpluses/deficits.

The International Transmission Of Economic Fluctuations: Effects Of U.S. Business Cycles On the Canadian Economy

This paper examines whether asset and goods market trade alone can explain the transmission of short term economic fluctuations between national economies. Three alternative mechanisms by which disturbances are transmitted are analyzed. One mechanism operates through variations in the rate of return on international financial assets, the second through changes in the terms of trade due to variations in the export demand and in the third mechanism variations in export demand affect not only the terms of trade but also equilibrium markups, because export producers have market power and collude as in (Rotemberg and Woodford, 1992). Empirically testable quantitative models of the effects on Canadian output, investment and employment of shocks to the U.S. economy are developed. The empirical success of the three mechanisms is tested by comparing impulse responses estimated from vector autoregressions to the quantitative predictions of the theoretical models for hypothetical parameter configurations suggested in the literature on (international) real business cycles. For all transmission channels considered, a central discrepancy between predicted and observed transmission is that the models can explain quantitatively the observed increase in real variables like investment, output and hours only in combination with a substantially higher terms of trade appreciation than is in fact observed.

Downward Nominal Wage Rigidity, Currency Pegs, and Involuntary Unemployment

This paper analyzes the inefficiencies arising from the combination of fixed exchange rates, nominal rigidity, and free capital mobility. We document that nominal wages are downwardly rigid in emerging countries. We develop an open-economy model that incorporates this friction. The model predicts that the combination of a currency peg and free capital mobility creates a negative externality that causes overborrowing during booms and high unemployment during contractions. Optimal capital controls are shown to be prudential. For plausible calibrations, they reduce unemployment by around 5 percentage points. The optimal exchange rate policy eliminates unemployment and calls for large devaluations during crises.

Chaotic Interest Rate Rules

A growing empirical and theoretical literature argues in favor of specifying monetary policy in the form of Taylor-type interest rate feedback rules. That is, rules whereby the nominal interest rate is set as an increasing function of inflation with a slope greater than one around an intended inflation target. This paper shows that such rules can easily lead to chaotic dynamics. The result is obtained for feedback rules that depend on contemporaneous or expected future inflation. The existence of chaotic dynamics is established analytically and numerically in the context of calibrated economies. The battery of fiscal policies that has recently been advocated for avoiding global indeterminacy induced by Taylor-type interest-rate rules (such as liquidity traps) are shown to be unlikely to provide a remedy for the complex dynamics characterized in this paper.

Optimal Fiscal and Monetary Policy Under Imperfect Competition

This paper studies optimal fiscal and monetary policy under imperfect competition in a stochastic, flexible-price, production economy without capital. It shows analytically that in this economy the nominal interest rate acts as an indirect tax on monopoly profits. Unless the social planner has access to a direct 100 percent tax on profits, he will always find it optimal to deviate from the Friedman rule by setting a positive and time-varying nominal interest rate. The dynamic properties of the Ramsey allocation are characterized numerically. As in the perfectly competitive case, the labor income tax is remarkably smooth, whereas inflation is highly volatile and serially uncorrelated. An exact numerical solution method to the Ramsey conditions is proposed.

Liquidity Traps: An Interest‐Rate‐Based Exit Strategy

This paper proposes a strategy for escaping liquidity traps based on an augmented Taylor-type interest-rate feedback rule that differs from usual specifications in that when inflation falls below a threshold, the central bank temporarily deviates from the traditional Taylor rule by following a deterministic path for the nominal interest rate that reaches the intended target for this policy instrument in finite time. The proposed policy is designed to set a floor on inflationary expectations. Importantly, the effectiveness of the proposed exiting strategy does not rely on the existence of an accompanying fiscalist (or non-Ricardian) fiscal stance.