Output Gap Stabilization Research Articles

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Hysteresis in Potential Output and Monetary Policy

AbstractWe show that actively stabilizing economic activity plays a more prominent role in the conduct of monetary policy when potential output is subject to hysteresis. We augment a basic New Keynesian model by hysteresis in potential output and contrast simulation outcomes of this extended model to the standard model. We find that considering hysteresis allows for a more realistic amplification of macroeconomic shocks and persistent movements in output after monetary shocks. Our central policy implication of active output gap stabilization arises from stability analyses and welfare considerations.

Monetary and Macroprudential Policies in an Estimated Model with Financial Intermediation

We estimate the Smets and Wouters (2007) model augmented with the Gertler and Karadi (2011) financial intermediation sector on US data by using real and financial observables. Given the framework of the estimated model, we address the question whether and how standard monetary policy should interact with macroprudential policy in order to safeguard real and financial stability. For this purpose, monetary policy is described by a flexible inflation targeting regime using the interest rate as instrument, while the macroprudential regulator adopts a tax/subsidy on bank capital in a countercyclical manner in order to stabilize nominal credit growth and the output gap. We look at the gains from coordination between the central bank and the macroprudential regulator under alternative assumptions regarding the degree of importance assigned to output gap fluctuations in the macroprudential mandate. The results suggest that there can be considerable gains from coordination if the macroprudential regulator has been assigned a sufficiently high weight on output gap stabilization, i.e. the common objective with monetary policy. If, on the other hand, the main focus of the macroprudential mandate is on credit growth, the macroprudential policy maker can reach better outcomes, while the central bank does worse, in the absence of coordination. Therefore, whether and to which extent monetary policy gains from coordination with the macroprudential regulator depends on the relative weight assigned to output fluctuations in the macroprudential mandate. Our counterfactual analysis further confirms the effectiveness of the countercyclical macroprudential tax/subsidy in containing the amplification effects triggered by a financial shock, and suggests that having a macroprudential regulatory tool at work could have successfully avoided the massive drop in credit such as the one observed at the onset of the Great Recession.

Monetary policy for rationally inattentive economies with staggered price setting

The paper examines the optimal monetary policy when firms are constrained by information processing capability and infrequent price adjustments. Firms' information processing limit gives rise to imperfect knowledge about macroeconomic aggregates and endogenous information learning contingent on the monetary policy. Staggered price setting introduces the observed price duration and additional policy tradeoffs resulting from the interactions between nominal rigidities and imperfect information processing. The integrated model implies an optimal policy that commits to complete price stabilization in response to natural rate shocks but not in response to markup shocks. In the presence of markup shocks, it is optimal for the central bank to focus on price stabilization in the initial periods following markup shocks and shifts the emphasis to output gap stabilization later. Moreover, larger information capacity, stronger complementarities and more persistent shocks require more aggressive price stabilization in the short-run.

Monetary policy with heterogeneous households and imperfect risk-sharing

This paper considers a sticky-price model with heterogeneous households and financial frictions. Financial frictions lead to imperfect risk-sharing among households with idiosyncratic labor incomes. I study implications of imperfect risk-sharing for optimal monetary policy by documenting its impacts on the monetary transmission mechanism, the inflation–output tradeoff faced by the central bank, the policy objective function, and the resulting targeting rule. The main finding is that while the central bank continues to have the conventional dual mandate — the output gap and inflation stabilization — it should place a greater weight on the later as the degree of financial frictions increases because price stability provides the additional benefit of reducing undesired consumption dispersion.

Leverage, investment, and optimal monetary policy

We study optimal monetary policy in an economy where the debt overhang of firms leads to underinvestment and underproduction. The magnitude of this debt-induced distortion varies over the business cycle, rising significantly during recessions. When debt is contracted in nominal terms, this distortion gives rise to a balance sheet channel for monetary policy. In the presence of real and financial shocks, the monetary authority faces a trade-off between inflation and output gap stabilization. The optimal monetary policy rule prescribes that the anticipated component of inflation should be set equal to a target level, while the unanticipated component should rise in response to adverse shocks, smoothing the debt overhang distortion and the output gap.

Monetary policy, parameter uncertainty and welfare

This paper derives optimal robust monetary policy in a standard microfounded new Keynesian model with uncertainty about the degree of price stickiness and the autocorrelation of the cost-push shock. The uncertain degree of price stickiness spills over to the endogenous objective function pursued by the central bank. In a min–max approach, the model is solved under discretion and under a Taylor rule which implements the optimal robust equilibrium under discretion. It is shown that with a welfare-based loss function, robust optimal monetary policy can neutralize the uncertainty surrounding the relative weight to assign to output-gap stabilization. Moreover, welfare improves when the endogeneity of the loss function is recognized by the central bank. Under discretion, the central bank reacts more aggressively to uncertainty about the degree of price stickiness and the autocorrelation of the cost-push shock. On the other hand, if the central bank implements the optimal discretionary robust equilibrium with a Taylor rule, under uncertainty the interest rate reacts to inflation in a less aggressive way.

Price subsidies and the conduct of monetary policy

This paper investigates optimized monetary policy rules in the presence of government intervention to stabilize prices of certain categories of goods and services. The paper estimates a small-scale, structural equilibrium model with a sticky-price sector and a subsidized-price sector for a large number of countries using Bayesian methods. The main result of this paper is that strict headline inflation targeting could be outperformed by sectoral inflation targeting, output gap stabilization, or a combination of these. In addition, several country cases exhibit lower performance of both headline and core inflation stabilization, the two most common policies in modern central banks’ practices. For practical monetary policy design, we numerically identify country specific thresholds for the degree of government intervention in price setting under which core inflation targeting turns out to be the optimal choice in the context of implementable Taylor rules.

Evaluating inflation targeting as a monetary policy objective for India

This study formulates a small open economy model for India with exchange rate as a prominent channel of monetary policy. The model is estimated using the Instrumental Variable-Generalized Methods of Moments (IV-GMM) estimator and evaluated through simulations. This study compares different cases of domestic and CPI inflation targeting, strict and flexible inflation targeting, and simple Taylor type rules. The analysis highlights the unsuitability of simple Taylor-type monetary rules in stabilizing the Indian economy and suggests that discretionary optimization works better in stabilizing this economy. There seems to be a trade-off between output gap stabilization and exchange rate stabilization in flexible domestic inflation targeting and CPI inflation targeting respectively. However, flexible domestic inflation targeting seems a better alternative from an overall macro stabilization perspective in India where financial markets are still not sufficiently integrated to ensure quick transmission of interest rate impulses and existence of rigidities in the economy.

Price Subsidies and the Conduct of Monetary Policy

This paper investigates optimized monetary policy rules in the presence of government intervention to stabilize prices of certain categories of goods and services. The paper estimates a small-scale, structural equilibrium model with a sticky-price sector and a subsidized price sector for a large number of countries using Bayesian methods. The main result of this paper is that strict headline inflation targeting could be outperformed by sectoral inflation targeting, output gap stabilization, or a combination of these. In addition, several country cases exhibit lower performance of both headline and core inflation stabilization, the two most common policies in modern central banks' practices. For practical monetary policy design, we numerically identify country specific thresholds for the degree of government intervention in price setting under which core inflation targeting turns out to be the optimal choice in the context of implementable Taylor rules.

Customer markets and the welfare effects of monetary policy

A customer market model in which firms and customers form long-term relations is developed and integrated into the canonical New Keynesian framework. This leads to two important differences compared to the standard model. First, the purely forward-looking Phillips curve is replaced by a hybrid variant where current inflation also depends on past inflation. Second, the welfare cost of inflation is much lower, which leads to an optimal monetary policy where relatively more weight is put on output gap stabilization than previously found in the literature.

Evolving Perceptions of Central Bank Credibility: The European Central Bank Experience

What are the preferences of a central bank over inflation and output-gap stabilization objectives, and what is its preferred long-run inflation rate? While statements of priorities and goals are important, the credibility of such statements and the market perception of the policy reaction function of a central bank play a key role in determining economic outcomes. This point, early on described as the “credibility” of central bank policies, is a standard theoretical result with recent interpretation in the New Keynesian paradigms. It is also received wisdom among practitioners. The importance of the market perception of the central bank’s acceptable trade-offs between inflation and output goals as well its specific targets naturally leads to the question of how the market acquires this perception and whether and how it evolves over time. One view is that establishing an appropriate institutional structure is the key element in insulating the monetary authority from political pressure and thereby convincing markets that a central bank has a strong and unvarying aversion to inflation. A second, more dynamic, view focuses on the role that actual policy conduct plays in building the reputation of a central bank. These two different views have distinct implications for the relative importance of the institutional structure of a central bank, as compared to its conduct, for attaining and maintaining its credibility. A survey of the heads of central banks and prominent monetary economists reflects a belief that the credibility of a central bank is based more on its past actions than on institutional structures that afford it independence by insulating it from political concerns, although there is also a consensus that structurematters (Blinder 2000). Empirical research has found that institutional features related to central bank independence are associated with economic performance in cross sections of

Does Inflation Targeting Matter for Output and Inflation Volatility? A Conditional Analysis

We address this question by examining the conditional dynamics of inflation and output growth in response to markup shocks for 14 industrialized countries. Markup shocks create a trade-off between output gap and inflation stabilization purposes, and the theory predicts that conditional on such shocks output growth should be more volatile than inflation in inflation targeting countries. Data suggest no differences between targeting and non-targeting countries in the post 1990s. Moreover, we document a similar increase in the conditional relative variability of output growth after the adoption of inflation targeting for both groups of countries. We argue that changes in the conduct of monetary policy can explain this pattern.

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Is there a case for domestic inflation target?

This paper evaluates the consequences of a central bank stabilizing alternative measures of inflation in a model with several exchange rate channels of transmission for the monetary policy. The real exchange rate affects the equilibrium conditions and the utility-based welfare objective places higher weight on output gap stabilization. There is an endogenous stabilization trade-off and policy rules derived from private agents’ optimizing behavior perform better than alternative monetary policy arrangements. The optimal policy is PPI inflation target, under which the exchange rate follows a controlled floating. Contrary to central bank practices, CPI target should be considered only by highly open economies.

Optimal Monetary Policy in a Financially Fragile Economy

This paper studies optimal monetary policy in an economy where firms rely heavily on external funds to finance operational costs. In the model, financial contracts are subject to agency problems and firms can possibly default on borrowed funds. Financial frictions have two separate effects on the model. First, they introduce an indirect cost channel to the monetary transmission mechanism. Second, they exacerbate the welfare costs of output gap fluctuations. The indirect cost channel implies that a given reduction in inflation can be achieved with a smaller output loss. This effect encourages the policy maker to emphasize inflation stabilization. At the same time, agency costs also make output gap fluctuations more costly in terms of economic welfare. This second effect encourages the policy maker to place more emphasis on output gap stabilization. Whether the optimal policy requires greater inflation stabilization or output gap stabilization depends on the balance of these two effects. Under a reasonable parametrization, the first effect dominates the second and the optimizing policy maker adopts a stricter anti-inflationary stance.

Optimal monetary policy for a small open economy

This paper focuses on the design of monetary policy rules for a small open economy. The model features optimizing behavior, general equilibrium and price stickiness. The real exchange rate is shown to affect the firm's real marginal cost, aggregate supply and aggregate demand. The welfare objective depends on the openness of the economy, and the optimal policy rule differs from that which obtains in a closed economy. The inflation versus output gap stabilization trade-off is caused by the real exchange rate. The implied optimal monetary policy regime is domestic inflation target coupled with controlled floating of the real exchange rate.

Endogenous Persistence and the Performance of Inertial Targeting Rules

We investigate the optimality of monetary policy targeting rules in a macroeconomic model based on explicit micro-foundations for intrinsic persistence in inflation and real output. For the corresponding social welfare loss function to be minimized by the central bank, inertia arises endogenously in both the inflation and output gap stabilization objectives. In this framework, inflation targeting closely approximates the optimal precommitment policy for empirically relevant parameter values. Alternative policy rules, such as nominal income growth targeting, "speed-limit" targeting, or price level targeting, do not perform as well. Previous research has demonstrated lower social welfare losses with these alternative targeting rules; such findings are shown to be primarily a consequence of assuming the central bank minimizes a simple social loss function that is not consistent with the micro-foundations of a model with intrinsic persistence.

Endogenous Persistence and the Performance of Inertial Targeting Rules

We investigate the optimality of monetary policy targeting rules in a macroeconomic model based on explicit micro-foundations for intrinsic persistence in inflation and real output. For the corresponding social welfare loss function to be minimized by the central bank, inertia arises endogenously in both the inflation and output gap stabilization objectives. In this framework, inflation targeting closely approximates the optimal precommitment policy for empirically relevant parameter values. Alternative policy rules, such as nominal income growth targeting, “speed-limit” targeting, or price level targeting, do not perform as well. Previous research has demonstrated lower social welfare losses with these alternative targeting rules; such findings are shown to be primarily a consequence of assuming the central bank minimizes a simple social loss function that is not consistent with the micro-foundations of a model with intrinsic persistence.

Optimal monetary policy with imperfect common knowledge

This paper determines optimal nominal demand policy in a flexible price economy in which firms pay limited attention to aggregate variables. Firms’ inattentiveness gives rise to idiosyncratic information errors and imperfect common knowledge about the shocks hitting the economy. This is shown to have strong implications for optimal nominal demand policy. In particular, if firms’ prices are strategic complements and economic shocks display little persistence, monetary policy has strong real effects, making it optimal to stabilize the output gap. Weak complementarities or sufficient shock persistence, however, cause price level stabilization to become increasingly optimal. With persistent shocks, optimal monetary policy shifts from output gap stabilization in initial periods following the shock to price level stabilization in later periods, potentially rationalizing the medium-term approach to price stability adopted by some central banks.