A Goldilocks Theory of Fiscal Deficits

Previous articleNext article FreeDiscussionPDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinked InRedditEmailQR Code SectionsMoreMark Gertler and Martin Eichenbaum followed up on comments made by one of the discussants, Ben Bernanke. Gertler noted that the zero lower bound (ZLB) on the nominal interest rate might have played its biggest role from late 2008 to 2010, before quantitative easing and forward guidance produced their full effects. This period was also characterized by a rise in aggregate uncertainty, he argued, which might have interacted with the binding ZLB. Gertler identified two channels through which increased uncertainty could have operated. First, increased precautionary savings further reduce the neutral interest rate, bringing it closer to the ZLB. Second, higher uncertainty raises the spread between short- and long-term interest rates, because the ZLB creates an option value by putting a lower bound on future short-term rates. Gertler encouraged the authors to quantify these channels using their model. Eichenbaum pointed out that the binding ZLB took place during a period of large changes in fiscal spending. According to the Hutchins Center Fiscal Impact Measure, fiscal policy was strongly expansionary until 2011, he argued, before turning very contractionary until 2014. Eichenbaum wondered whether the authors could investigate the interplay between fiscal policy and the ZLB by repeating their empirical exercise using the pre- and post-2011 subsamples. He admitted that there might be power issues with such a short sample. The authors acknowledged that strongly countercyclical fiscal policy could in theory explain the empirical irrelevance of the ZLB that they document in the paper. However, this explanation is hard to reconcile with their evidence on the response of long-term interest rates. Fiscal policy alone could not explain why the behavior of these rates did not change during the ZLB period, they argued. This is suggestive of a dominant role for monetary policy in the form of quantitative easing and forward guidance, according to the authors.The rest of the discussion focused on three topics: the role of deflation, the open economy implications of a binding ZLB, and the ability of monetary policy to offset shocks using unconventional monetary policy instruments.On the first topic, Benjamin Friedman noted that deflation might be the major risk associated with the ZLB. He argued that neither the standard New Keynesian model nor the FRB/US model (the Fed’s large-scale macro model) used by one of the discussants, Ben Bernanke, creates room for strong deflationary effects. The authors agreed that the incidence of deflation depends on the specifics of the model. In particular, they argued that their New Keynesian model is more forward-looking than the models used by Bernanke in his discussion, namely the FRB/US model and the one of Hess Chung et al. (“Monetary Policy Options at the Effective Lower Bound: Assessing the Federal Reserve’s Current Policy Toolkit” [Finance and Economics Discussion Series (Fed Board), No. 2019-003, Board of Governors of the Federal Reserve System, Washington, DC, 2019]). The authors suggested that this fact could explain some of the discrepancies between Bernanke’s simulations and the authors’, particularly when it comes to the response of long-term interest rates. Bernanke clarified that price and wage setting are forward-looking in the model of Chung et al. (“Monetary Policy Options at the Effective Lower Bound”) and so are financial markets. However, consumption and investment are backward-looking. Friedman offered a second comment. The paper’s findings suggest that unconventional monetary policy instruments had a powerful effect and helped mitigate the importance of the ZLB, he reminded. This raises the possibility that these instruments could be used as a substitute for the federal funds rate even when the ZLB does not bind, he argued.Laura Veldkamp emphasized the role of expectations about inflation and the duration of the ZLB episode. Survey evidence and bond-implied inflation risk premia reveal that agents expected this episode to be short-lived and inflation to take off, she mentioned. Veldkamp suggested that these expectations could have mitigated the effect of the binding ZLB. The authors shared Veldkamp’s view. They used their model to explore the effect of expectations about the duration of the ZLB episode. The authors noted that these expectations are key for the response to shocks, especially when it comes to movements in long-term rates. They clarified that their baseline simulation assumes that the ZLB is binding for three quarters in expectation. The authors noted that the actual ZLB episode lasted for 28 quarters and that such a long duration was arguably unexpected. A version of their model calibrated with an expected duration of 28 quarters produces unrealistically large responses to shocks. This exercise suggests that expectations about the duration of the ZLB episode play a crucial role, they argued. Thomas Philippon followed up briefly on Veldkamp’s comment. He noted that the case of Japan is interesting in that the expected duration of the ZLB episode was much longer than in the United States. This could allow the authors to verify some of their predictions, he suggested.Turning to the second topic, Philippon emphasized that the authors adopted a closed economy framework. He noted that a binding ZLB typically modulates the exchange rate response to shocks in the class of models that the authors work with. Philippon wondered whether this prediction is verified in the data. They responded by referring to existing work of theirs. In Jordi Galí (“Uncovered Interest Parity, Forward Guidance and the Exchange Rate” [Mimeo, CREI, Barcelona, May 2019]), they found that the exchange rate response to expected changes in interest rates is muted when the ZLB binds, which suggests that the effect of monetary policy is dampened.Christopher Erceg suggested decomposing the impulse response for output in terms of each component of aggregate demand. A binding ZLB might not affect the response of output to shocks, he argued, but it could affect its composition and the international spillovers. In particular, accommodative monetary policy should mostly operate through domestic demand if the exchange rate response is dampened at the ZLB—as the authors suggested.On the third topic, Erceg reminded the audience that the issue of the ZLB is not specific to the United States. He agreed with the authors’ assessment that quantitative easing had been effective in the United States. However, Erceg noted that the effects of unconventional monetary policy might be more limited in economies where interest rates are low across all maturities, as in Germany. The authors agreed with Erceg’s comment. They emphasized that the paper does not claim that the ZLB itself is irrelevant. Rather, it concludes that policy was conducted in such a way that the ZLB was effectively irrelevant.Gabriel Chodorow-Reich noted that two types of shocks can hit an economy: diffusion shocks and jump shocks. Chodorow-Reich agreed that the monetary authority might be able to offset small diffusion shocks, even when the ZLB binds. However, central banks might lack the proper tools to respond to large jump shocks, he noted. The authors responded that they found that large shocks actually took place when the ZLB was binding. The corresponding responses of inflation, output, and long-term interest rate are still proportional to those obtained for the pre-ZLB period. This finding suggests that monetary policy was able to mitigate the effect of a binding ZLB despite large shocks.Mark Gertler agreed with the authors’ overall conclusion, arguing that policy largely circumvented the ZLB constraint from 2010 onward. However, the ZLB might have been more constraining during the 2008–9 period, according to Gertler. He noted that the decrease in nominal interest rates during the Great Recession relative to the decrease in output was similar to previous recessions. A much larger decrease in nominal interest rates was needed to compensate for the increase in credit costs due to the financial crisis, he argued. This suggests that the ZLB might have played a significant role in the aftermath of the financial crisis, according to Gertler. The authors suggested that they could use long-term rates in their vector autoregression specifications, instead of 10-year government bonds, to investigate this point.The participants concluded the general discussion with a more informal exchange on the experiences of Europe and Japan at the ZLB. Martin Eichenbaum noted that the European Central Bank’s (ECB) response was less aggressive than that of the Federal Reserve. He wondered whether this was responsible for more volatility in Europe. Ben Bernanke and Valerie Ramey pointed out that sovereign debt crises and different fiscal responses in Europe might be confounding factors. Frederic Mishkin argued that the ECB’s response was actually as aggressive as the Fed’s before 2010 but was more timid afterward. The authors cited the case of Japan as having larger responses to aggregate shocks during the ZLB episode compared with the United States. They suggested that the Bank of Japan was less accommodative than the Fed, which could explain the higher volatility of aggregate variables. Previous articleNext article DetailsFiguresReferencesCited by NBER Macroeconomics Annual Volume 342019 Sponsored by the National Bureau of Economic Research (NBER) Article DOIhttps://doi.org/10.1086/707180 Views: 82Total views on this site © 2020 by the National Bureau of Economic Research. All rights reserved.PDF download Crossref reports no articles citing this article.

Japan’s encounter with deflation and near‐zero‐interest short‐term interest rates in the 1990s led to a surge in research on the implications of the zero lower bound (ZLB) on nominal interest rates for monetary policy around the end of that decade. Based on model simulations, the literature at that time identified a number of key implications of the ZLB (see Orphanides and Wieland [2000], Reifschneider and Williams [2000, 2002], Eggertsson and Woodford [2003], and references therein). First, with low inflation targets of the kind followed by many central banks, the ZLB will frequently be a binding constraint on monetary policy. That is, Japan’s example is not an outlier but rather a harbinger for the future. Second, at inflation targets of 1% or lower, lowering the inflation target comes at a cost of higher variability of output and inflation, although the effects on inflation variability are relatively small. This analysis provides an argument for maintaining a positive inflation target cushion above 1%. Third, in rare instances of severe prolonged recessions accompanied by deflation, standard open market operations will be insufficient to bring the inflation rate back to target, andalternative sources of stimulus to the economy, such as fiscal policy, will be needed. Fourth, central banks can significantly reduce the effects of the ZLB onmacroeconomic stability by modifying their policy actions and communication to the public when the ZLB threatens to constrain policy. Specifically, policies that cut rates aggressively when deflation is a risk and promise to temporarily target a higher rate of inflation following episodes where the ZLB binds were found to greatly reduce the effects of the ZLB in model simulations. In the decade since this researchwas initiated, the ZLB has gone froma theoretical issue applying to Japan to one that plagues many industrialized economies. Indeed, an era of overwhelming confidence in monetary policy’s power to tame the business cycle while delivering low and stable inflation has been replaced by fears that the global economy could

This paper analyzes the reaction of interest rates and the stock market to macroeconomic news announcements (MNAs) at the zero lower bound (ZLB). I start by using a shadow rate term structure model to formulate three predictions for the sensitivity of interest rates to MNAs. First, “better”-than-expected macroeconomic data increases interest rates. Second, as the expected duration of the ZLB increases, whether because economic conditions are worse or because monetary policy changes, interest rates become less sensitive to macroeconomic data. Third, this attenuation in the sensitivity of interest rates is largest for intermediate-maturity rates. I verify these predictions by using a broad sample of MNAs and high-frequency intraday futures data on interest rates. Turning to stocks, I show that the stock market's reaction to MNAs can be decomposed into an interest rate news term that is directly related to interest rates' reaction to MNAs and a cash flow plus risk premium news term. Using the same sample of MNAs and high-frequency intraday futures data on the stock market, I empirically estimate the stock market's sensitivity to macroeconomic data as well as that of the constituent news terms. Based on the interest rate news term alone, the expected duration of the ZLB should increase the sensitivity of stocks to macroeconomic news. The data furthermore suggests that the expected duration of the ZLB decreases the magnitude of the cash flow plus risk premium news term.

Summary: A rapid recovery from deflationary shocks that result in transition to the Zero Lower Bound (ZLB) requires that policy generate an inflationary counter-force. Monetary policy cannot achieve it and the lesson of the 2007-2015 Great Recession is that growing debt give rise to a political gridlock which prevents restoration to full employment with deficit financed public spending. Even optimal investments in needed public projects cannot be undertaken at a zero interest rate. Hence, failure of policy to arrest the massive damage of eight year’s Great Recession shows the need for new policy tools. I propose such policy under the ZLB called “Stabilizing Wage Policy” which requires public intervention in markets instead of deficit financed expenditures. Section 1 develops a New Keynesian model with diverse beliefs and inflexible wages. Section 2 presents the policy and studies its efficacy.The integrated New Keynesian (NK) model economy consists of a lower sub-economy under a ZLB and upper sub-economy with positive rate, linked by random transition between them. Household-firm-managers hold heterogenous beliefs and inflexible wage is based on a four quarter staggered wage structure so that mean wage is a relatively inflexible function of inflation, of unemployment and of a distributed lag of productivity. Equilibrium maps of the two sub-economies exhibit significant differences which emerge from the relative rates at which the nominal rate, prices and wage rate adjust to shocks. Two key results: first, decline to the ZLB lower sub-economy causes a powerful debt-deflation spiral. Second, output level, inflation and real wages rise in the lower sub-economy if all base wages are unexpectedly raised. Unemployment falls. This result is explored and explained since it is the key analytic result that motivates the policy.A Stabilizing Wage Policy aims to repair households’ balance sheets, expedite recovery and exit from the ZLB. It raises base wages for policy duration with quarterly cost of living adjustment and a prohibition to alter base wages in order to nullify the policy. I use demand shocks to cause recession under a ZLB and a deleveraging rule to measure recovery. The rule is calibrated to repair damaged balance sheets of US households in 2007-2015. Sufficient deleveraging and a positive rate in the upper sub-economy without a wage policy are required for exit hence at exit time inflation and output in the lower sub-economy are irrelevant for exit decision. Simulations show effective policy selects high policy intensity at the outset and given the 2007-2015 experience, a constant 10% increased base wages raises equilibrium mean wage by about 5.5%, generates a controlled inflation of 5%-6% at exit time and attains recovery in a fraction of the time it takes for recovery without policy. Under a successful policy inflation exceeds the target at exit time and when policy terminates, inflation abates rapidly if the inflation target is intact. I suggest that a stabilizing wage policy with a constant 10% increased base wages could have been initiated in September 2008. If controlled inflation of 5% for 2.25 years would have been politically tolerated, the US would have recovered and exited the ZLB in 9 quarters and full employment restored by 2012. Lower policy intensity would have resulted in smaller increased mean wage, lower inflation but increased recession’s duration. The policy would not have required any federal budget expenditures, it would have reduced public deficits after 2010 and the US would have reached 2015 with a lower national debt.The policy negates the effect of demand shocks which cause the recession and the binding ZLB. It attains it’s goal with strong temporary intervention in the market instead of generating demand with public expenditures. It does not solve other long term structural problems that persist after exit from the ZLB and which require other solutions.

This article presents global solutions to standard New Keynesian models to show how economic dynamics change when the nominal interest rate is constrained at its zero lower bound (ZLB). We focus on the canonical New Keynesian model without capital, but we also study the model with capital, with and without investment adjustment costs. Our solution method emphasizes accuracy to capture the expectational effects of hitting the ZLB and returning to a positive interest rate. We find that the response to a technology shock has perverse consequences when the ZLB binds, even when a discount factor shock drives the interest rate to zero. Although we do not model the large scale asset purchases used by the Fed since 2009, our results suggest that the economy may have trouble recovering if the interest rate remains at zero. Given the perverse dynamics at the ZLB, we evaluate how monetary policy affects the likelihood of encountering the ZLB. We find that the probability of hitting the ZLB depends importantly on the monetary policy rule. A policy rule based on a dual mandate, such as the one proposed by Taylor (1993), is more likely to cause ZLB events when the central bank places greater emphasis on the output gap.

THE CONVENTIONAL INSTRUMENT of monetary policy in most major industrial economies is the very short term nominal interest rate, such as the overnight federal funds rate in the case of the United States. The use of this instrument, however, implies a potential problem: Because currency (which pays a nominal interest rate of zero) can be used as a store of value, the short-term nominal interest rate cannot be pushed below zero. Should the nominal rate hit zero, the real short-term interest rate--at that point equal to the negative of prevailing inflation expectations--may be higher than the rate needed to ensure stable prices and the full utilization of resources. Indeed, an unstable dynamic may result if the excessively high real rate leads to downward pressure on costs and prices that, in turn, raises the real short-term interest rate, which depresses activity and prices further, and so on. Japan has suffered from the problems created by the zero lower bound (ZLB) on the nominal interest rate in recent years, and short-term rates in countries such as the United States and Switzerland have also come uncomfortably close to zero. As a consequence, the problems of conducting monetary policy when interest rates approach zero have elicited considerable attention from the economics profession. Some contributions have framed the problem in a formal general equilibrium setting; another strand of the literature identifies and discusses the policy options available to central banks when the zero bound is binding. (1) Although there have been quite a few theoretical analyses of alternative monetary policy strategies at the ZLB, systematic empirical evidence on the potential efficacy of alternative policies is scant. Knowing whether the proposed alternative strategies would work in practice is important to central bankers, not only because such knowledge would help guide policymaking in extremis, but also because the central bank's choice of its long-run inflation objective depends importantly on the perceived risks created by the ZLB. The greater the confidence of central bankers that tools exist to help the economy escape the ZLB, the less need there is to maintain an inflation buffer, and hence the lower the inflation objective can be. (2) This paper uses the methods of modern empirical finance to assess the potential effectiveness of so-called nonstandard monetary policies at the zero bound. We are interested particularly in whether such policies would work in modern industrial economies (as opposed to, for example, the same economies during the Depression era), and so our focus is on the recent experience of the United States and Japan. The paper begins by noting that, although the recent improvement in the global economy and the receding of near-term deflation risks may have reduced the salience of the ZLB today, this constraint is likely to continue to trouble central bankers for the foreseeable future. Central banks in the industrial world have exhibited a strong commitment to keeping inflation low, but inflation can be difficult to predict. Although low inflation has many benefits, it also raises the risk that adverse shocks will drive interest rates to the ZLB. Whether hitting the ZLB presents a minor annoyance or a major risk for monetary policy depends on the effectiveness of the policy alternatives available when prices are declining. Following a recent paper by two of the present authors, (3) we group these policy alternatives into three classes: using communications policies to shape public expectations about the future course of interest rates; increasing the size of the central bank's balance sheet; and changing the composition of the central bank's balance sheet. We discuss how these policies might work, and we cite existing evidence on their utility from historical episodes and recent empirical research. The paper's main contribution is to provide new empirical evidence on the possible effectiveness of these alternative policies. …

Editors’ Introduction

This paper examines the importance of the zero lower bound (ZLB) constraint on the nominal interest rate by estimating three variants of a small-scale New Keynesian model: (1) a nonlinear model with an occassionally binding ZLB constraint; (2) a constrained linear model, which imposes the constraint in the filter but not the solution; and (3) an unconstrained linear model, which never imposes the constraint. The posterior distributions are similar, but important differences arise in their predictions at the ZLB. The nonlinear model fits the data better at the ZLB and primarily attributes the ZLB to a reduction in household demand due to discount factor shocks. In the linear models, the ZLB is due to large contractionary monetary policy shocks, which is at odds with the Fed’s expansionary policy during the Great Recession. Posterior predictive analysis shows the nonlinear model is partially able to account for the increase in output volatility and the negative skewness in output and inflation that occurred during the ZLB period, whereas the linear models predict almost no changes in those statistics. We also compare the results from our nonlinear model to the quasi-linear solution based on OccBin. The quasi-linear model fits the data better than the linear models, but it still generate too little volatility at the ZLB and predicts that a large policy shock caused the ZLB to bind in 2008Q4.

This paper examines the importance of the zero lower bound (ZLB) constraint on the nominal interest rate by estimating three variants of a small-scale New Keynesian model: (1) a nonlinear model with an occassionally binding ZLB constraint; (2) a constrained linear model, which imposes the constraint in the filter but not the solution; and (3) an unconstrained linear model, which never imposes the constraint. The posterior distributions are similar, but important differences arise in their predictions at the ZLB. The nonlinear model fits the data better at the ZLB and primarily attributes the ZLB to a reduction in household demand due to discount factor shocks. In the linear models, the ZLB is due to large contractionary monetary policy shocks, which is at odds with the Fed?s expansionary policy during the Great Recession. Posterior predictive analysis shows the nonlinear model is partially able to account for the increase in output volatility and the negative skewness in output and inflation that occurred during the ZLB period, whereas the linear models predict almost no changes in those statistics. We also compare the results from our nonlinear model to the quasi-linear solution based on OccBin. The quasi-linear model fits the data better than the linear models, but it still generate too little volatility at the ZLB and predicts that a large policy shock caused the ZLB to bind in 2008Q4.

We find empirical evidence of a possible structural break in the relationship between the foreign holdings of U.S. Treasury securities and the U.S. long-term interest rate occurring at the time when U.S. monetary policy became constrained at the zero-lower bound (ZLB). The estimated marginal effect of the foreign holdings ratio on the U.S. long-term interest rate, particularly its long-run effect, appears to have become stronger during the ZLB regime than it was before. We argue that the leading explanation of this apparent break is the nonlinearity introduced by the ZLB. Motivated by theory, we propose a flexible nonlinear specification to deal with the ZLB — a threshold single-equation error-correction model splitting the sample in two regimes, pre-ZLB and ZLB, which replaces the observed Fed Funds rate with a shadow Fed Funds rate derived from a Tobit-IV model to incorporate a broader measure of the stance of monetary policy. With this setup, we find no significant structural break in the relationship between foreign holdings and long-term rates at the ZLB. Therefore, we argue that the ZLB is a leading cause of the apparent shift in the empirical relationship. We also show that the estimated effects are not just statistically-significant, but also economically-significant. Through counterfactual analysis, we show that changes in China’s holdings of U.S. Treasury securities played an important role in explaining the 2004-2006 interest rate conundrum period and kept the long-term interest rate from going ever lower in the recent ZLB period.

Motivated by the recent experience of the U.S. and the Eurozone, we describe the quantitative properties of a New Keynesian model with a zero lower bound (ZLB) on nominal interest rates, explicitly accounting for the nonlinearities that the bound brings. Besides showing how such a model can be efficiently computed, we find that the behavior of the economy is substantially affected by the presence of the ZLB. In particular, we document 1) the unconditional and conditional probabilities of hitting the ZLB; 2) the unconditional and conditional probabilty distributions of the duration of a spell at the ZLB; 3) the responses of output to government expenditure shocks at the ZLB, 4) the distribution of shocks that send the economy to the ZLB; and 5) the distribution of shocks that keep the economy at the ZLB.

Motivated by the recent experience of the U.S. and the Eurozone, we describe the quantitative properties of a New Keynesian model with a zero lower bound (ZLB) on nominal interest rates, explicitly accounting for the nonlinearities that the bound brings. Besides showing how such a model can be efficiently computed, we find that the behavior of the economy is substantially affected by the presence of the ZLB. In particular, we document 1) the unconditional and conditional probabilities of hitting the ZLB; 2) the unconditional and conditional probabilty distributions of the duration of a spell at the ZLB; 3) the responses of output to government expenditure shocks at the ZLB, 4) the distribution of shocks that send the economy to the ZLB; and 5) the distribution of shocks that keep the economy at the ZLB.

When monetary policy faces a zero lower bound (ZLB) constraint on the nominal interest rate, a minimum state variable (MSV) solution may not exist even if the Taylor principle holds when the ZLB does not bind. This paper shows there is a clear tradeoff between the expected frequency and average duration of ZLB events along the boundary of the convergence region --- the region of the parameter space where our policy function iteration algorithm converges to an MSV solution. We show this tradeoff with two alternative stochastic processes: one where monetary policy follows a 2-state Markov chain, which exogenously governs whether the ZLB binds, and the other where ZLB events are endogenous due to discount factor or technology shocks. We also show that small changes in the parameters of the stochastic processes cause meaningful differences in the decision rules and where the ZLB binds in the state space.

Before the recent recession, the consensus among researchers was that the zero lower bound (ZLB) probably would not pose a significant problem for monetary policy as long as a central bank aimed for an inflation rate of about 2 percent; some have even argued that an appreciably lower target inflation rate would pose no problems. This paper reexamines this consensus in the wake of the financial crisis, which has seen policy rates at their effective lower bound for more than two years in the United States and Japan and near zero in many other countries. We conduct our analysis using a set of structural and time series statistical models. We find that the decline in economic activity and interest rates in the United States has generally been well outside forecast confidence bands of many empirical macroeconomic models. In contrast, the decline in inflation has been less surprising. We identify a number of factors that help to account for the degree to which models were surprised by recent events. First, uncertainty about model parameters and latent variables, which were typically ignored in past research, significantly increases the probability of hitting the ZLB. Second, models that are based primarily on the Great Moderation period severely understate the incidence and severity of ZLB events. Third, the propagation mechanisms and shocks embedded in standard DSGE models appear to be insufficient to generate sustained periods of policy being stuck at the ZLB, such as we now observe. We conclude that past estimates of the incidence and effects of the ZLB were too low and suggest a need for a general reexamination of the empirical adequacy of standard models. In addition to this statistical analysis, we show that the ZLB probably had a first-order impact on macroeconomic outcomes in the United States. Finally, we analyze the use of asset purchases as an alternative monetary policy tool when short-term interest rates are constrained by the ZLB, and find that the Federal Reserve's asset purchases have been effective at mitigating the economic costs of the ZLB. In particular, model simulations indicate that the past and projected expansion of the Federal Reserve's securities holdings since late 2008 will lower the unemployment rate, relative to what it would have been absent the purchases, by 1-1/2 percentage points by 2012. In addition, we find that the asset purchases have probably prevented the U.S. economy from falling into deflation.

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