Willem Van Zandweghe

On-the-job search, sticky prices, and persistence

Models of the monetary transmission mechanism often generate empirically implausible business fluctuations. This paper analyzes the role of on-the-job search in the propagation of monetary shocks in a sticky price model with labor market search frictions. Such frictions induce long-term employment relationships, such that the real marginal cost is determined by real wages and the cost of an employment relationship. On-the-job search opens up an extra channel of employment growth that dampens the response of these two components. Because real marginal cost rigidity induces small price adjustments, on-the-job search gives rise to a strong propagation of monetary shocks that increases output persistence.

Learning about monetary policy rules when labor market search and matching frictions matter

This paper examines the implications of labor market search and matching frictions for determinacy and E-stability of rational expectations equilibrium (REE) in a sticky price model with interest rate policy. When labor adjustment takes place solely at the extensive margin, forecast-based policy that meets the Taylor principle is likely to induce indeterminacy and E-instability, regardless of whether it is strictly or flexibly inflation targeting. When labor adjustment takes place at both the extensive and intensive margins, the strictly inflation-forecast targeting policy remains likely to induce indeterminacy, but it generates a unique E-stable fundamental REE as long as the Taylor principle is satisfied. Therefore, the presence of search and matching frictions changes the determinacy properties of a strictly inflation-forecast targeting policy, and alters its E-stability properties when only an extensive margin is present but not when labor adjustment takes place at both margins.

Discretionary Monetary Policy in the Calvo Model

We study discretionary equilibrium in the Calvo pricing model for a monetary authority that chooses the money supply. The steady-state inflation rate is above 8 percent for a baseline calibration, but it varies substantially with alternative structural parameter values. If the initial condition involves inflation higher than steady state, discretionary policy generates an immediate drop in inflation followed by a gradual increase to the steady state. Unlike the two-period Taylor model, discretionary policy in the Calvo model does not accommodate predetermined prices in a way that inevitably leads to multiple private-sector equilibria.

Labor Market Search and Interest Rate Policy

We investigate implications of search and matching frictions in the labor market for in ation targeting interest rate policy in terms of equilibrium stability. When the interest rate is set in response to past or present in ation, determinacy of equilibrium is ensured similarly to comparable previous studies with frictionless labor markets. In stark contrast to these studies, indeterminacy is very likely if the interest rate is adjusted in response solely to expected future in ation. This is due to a vacancy channel of monetary policy that stems from the labor market frictions and renders in ation expectations self-ful lling. The indeterminacy can be overcome once the interest rate is adjusted in response also to output or the unemployment rate or if the policy contains interest rate smoothing. When E-stability is adopted as an equilibrium selection criterion, a unique E-stable fundamental rational expectations equilibrium is generated under active, but not too strong, policy responses only to expected future in ation. This suggests that the problem is not critical from the perspective of learnability of the fundamental equilibrium.

Firm-Specific Labor, Trend Inflation, and Equilibrium Stability

The present paper explores the implications for monetary policy of different labor market structures. In one labor market workers are identical and thus easily interchangeable between firms, while in another labor market workers are specialized to fill the needs of specific firms. The labor market structure turns out to be a crucial determinant of the effectiveness of monetary policies guided by the Taylor principle in an environment of high trend inflation. ; According to the Taylor principle, an undesirable rise in inflation requires a disproportionately strong response of interest rates. Otherwise, self-fulfilling private-sector expectations of inflation may push prices upward. It is widely believed that the Federal Reserve’s approach to setting interest rates did not conform to the Taylor principle prior to the early 1980s, but since then has done so, to good effect. Recent research, however, has suggested that when trend inflation is high—about four percent or higher—the Taylor principle may become less effective. ; Studies on the subject have made varying assumptions about the structure of the labor market, with some presuming that all firms hire the same type of labor, while others assume that firms need specialized labor. These differing assumptions matter: the need for specialized labor affects the way firms’ costs adjust in reaction to shifts in demand, and that has implications for inflation dynamics and for the Taylor principle. ; We find that in a model economy with specialized labor, a policy rule for setting interest rates cannot ensure keeping inflation stable even if it satisfies the Taylor principle, if trend inflation is high. This differs from a model where workers are identical, in which adhering to the Taylor principle does achieve stability of inflation, whether trend inflation is high or low. The finding suggests that whether the Federal Reserve’s policy shift in the early 1980s was sufficient, alone, to bring about the period of stable inflation that followed, or whether it also depended on a decline in trend inflation, depends on the structure of the labor market.

Determinacy Under Inflation Targeting Interest Rate Policy in a Sticky Price Model with Investment (and Labor Bargaining)

In a sticky price model with investment spending, recent research shows that inflation-forecast targeting interest rate policy makes determinacy of equilibrium essentially impossible. We examine a necessary and sufficient condition for determinacy under interest rate policy that responds to a weighted average of an inflation forecast and current inflation. This condition demonstrates that the average-inflation targeting policy ensures determinacy as long as both the response to average inflation and the relative weight of current inflation are large enough. We also find that interest rate policy which responds solely to past inflation guarantees determinacy when its response satisfies the Taylor principle and is not large. These results still hold even when wages and hours worked are determined by Nash bargaining.

TREND INFLATION AND EQUILIBRIUM STABILITY: FIRM-SPECIFIC VERSUS HOMOGENEOUS LABOR

In sticky price models based on micro evidence that each period a fraction of prices are kept unchanged, recent studies reach the qualitatively equivalent conclusion that higher trend inflation is a more serious source of indeterminacy of rational expectations equilibrium, regardless of whether labor is firm-specific or homogeneous. This paper shows that the model with firm-specific labor is more susceptible to indeterminacy induced by high trend inflation than the model with homogeneous labor, because these two different specifications of labor lead to distinct representations of inflation dynamics. In addition, the model with firm-specific labor is more susceptible to expectational instability of the equilibrium caused by high trend inflation.

Monetary Policy, Trend Inflation, and the Great Moderation: An Alternative Interpretation: Comment Based on System Estimation

What caused the U.S. economys shift from the Great Inflation era to the Great Moderation era? {{p}} A large literature shows that the shift was achieved by the change in monetary policy from a passive to an active response to inflation. However, Coibion and Gorodnichenko (2011) attribute the shift to a fall in trend inflation along with the policy change, based on a solely estimated Taylor rule and a calibrated staggered-price model. We estimate the Taylor rule and the staggered-price model jointly and demonstrate that the change in monetary policy responses to inflation and other variables suffices for explaining the shift.

A Pitfall of Expectational Stability Analysis

A pitfall of expectational stability (E-stability) analysis can arise in models with multiperiod expectations: if an auxiliary variable is introduced as substitute for an expectational endogenous variable in such a model, this shrinks the region of the model parameters that guarantee E-stability of a fundamental rational expectations equilibrium. Moreover, in the model representation with no auxiliary variable, the same E-stability region as in that with the auxiliary variable is obtained if economic agents are assumed to make multiple forecasts in an inconsistent manner. Therefore, we argue that the introduction of an auxiliary variable as substitute for an expectational endogenous variable in models with multi-period expectations can induce misleading implications that are biased toward E-instability.

Price Dispersion and Inflation Persistence

Persistent responses of inflation to monetary policy shocks have been difficult to explain by existing models of the monetary transmission mechanism without embedding controversial intrinsic inertia of inflation. Our paper addresses this issue using a staggered price model with trend inflation, a smoothed-off kink in demand curves, and a fixed cost of production. In this model, inflation exhibits a persistent response to a policy shock even in the absence of its intrinsic inertia, because the kink causes a measure of price dispersion, which is intrinsically inertial, to become a key source of inflation persistence under the positive trend inflation rate. {{p}} In addition, output and labor productivity both rise after an expansionary policy shock as in an estimated structural vector autoregression model. Moreover, credible disinflation induces a gradual decline in inflation and a fall in output as observed during the Volcker disinflation era.