Presence Of Nominal Rigidities Research Articles

Optimal Monetary Policy in Production Networks

This paper studies the optimal conduct of monetary policy in a multisector economy in which firms buy and sell intermediate goods over a production network. We first provide a necessary and sufficient condition for the monetary policy's ability to implement flexible‐price equilibria in the presence of nominal rigidities and show that, generically, no monetary policy can implement the first‐best allocation. We then characterize the optimal policy in terms of the economy's production network and the extent and nature of nominal rigidities. Our characterization result yields general principles for the optimal conduct of monetary policy in the presence of input‐output linkages: it establishes that optimal policy stabilizes a price index with greater weights assigned to larger, stickier, and more upstream industries, as well as industries with less sticky upstream suppliers but stickier downstream customers. In a calibrated version of the model, we find that implementing the optimal policy can result in quantitatively meaningful welfare gains.

Fiscal Cyclicality and Currency Risk Premia

Abstract I develop a model of real exchange rate determination that attributes a central role to the intertemporal government budget condition, which equates the market value of government debt to the present value of government surpluses. To enforce this equilibrium condition in the presence of nominal rigidities, the real exchange rate has to adjust in response to shocks to government surpluses. The model predicts that fiscal shocks account for real exchange rate movements, and the factor structure in fiscal shocks aligns with the factor structure in currency returns. Both predictions are confirmed in the sample of developed countries.

Optimal Monetary Policy in Production Networks

This paper studies the optimal conduct of monetary policy in a multi-sector economy in which firms buy and sell intermediate goods over a production network. We first provide a necessary and sufficient condition for the monetary policy's ability to implement flexible-price equilibria in the presence of nominal rigidities and show that, generically, no monetary policy can implement the first-best allocation. We then characterize the constrained-efficient policy in terms of the economy's production network and the extent and nature of nominal rigidities. Our characterization result yields general principles for the optimal conduct of monetary policy in the presence of input-output linkages: it establishes that optimal policy stabilizes a price index with higher weights assigned to larger, stickier, and more upstream industries, as well as industries with less sticky upstream suppliers but stickier downstream customers. In a calibrated version of the model, we find that implementing the optimal policy can result in quantitatively meaningful welfare gains.

Understanding the Aggregate Effects of Credit Frictions and Uncertainty

We examine the interaction of uncertainty and credit frictions in a New Keynesian framework. To do so, uncertainty is modeled as time-varying stochastic volatility – the product of monetary policy uncertainty, financial risk (micro-uncertainty), and macrouncertainty. The model is solved using a pruned third-order approximation and estimated by the Simulated Method of Moments. We find that: 1) Micro-uncertainty aggravates the information asymmetry between lenders and borrowers, worsens credit conditions, and has first-order effects on real economic activity. 2) When credit conditions are poor, as indicated by elevated credit spreads, additional micro-uncertainty shocks produce even larger real effects. 3) Poor credit conditions notably affect the transmission mechanism of monetary policy amplifying the real effects of monetary shocks while mitigating the economic boost from TFP shocks. 4) While macro-uncertainty and policy uncertainty exert relatively little direct impact on aggregate economic activity, policy uncertainty accounts for around 40% of the business cycle volatility by affecting the size of monetary policy shocks in the presence of nominal rigidities.

Optimal Monetary Policy in Production Networks

This paper studies the optimal conduct of monetary policy in a multisector economy in which firms buy and sell intermediate goods over a production network. We first provide a necessary and sufficient condition for the monetary policy's ability to implement flexible‐price equilibria in the presence of nominal rigidities and show that, generically, no monetary policy can implement the first‐best allocation. We then characterize the optimal policy in terms of the economy's production network and the extent and nature of nominal rigidities. Our characterization result yields general principles for the optimal conduct of monetary policy in the presence of input‐output linkages: it establishes that optimal policy stabilizes a price index with greater weights assigned to larger, stickier, and more upstream industries, as well as industries with less sticky upstream suppliers but stickier downstream customers. In a calibrated version of the model, we find that implementing the optimal policy can result in quantitatively meaningful welfare gains.

Fiscal Risks and Currency Returns

I develop a model of real exchange rate determination that attributes a central role to the intertemporal government budget condition, which equates the market value of government debt to the present value of government surpluses. To enforce this equilibrium condition in the presence of nominal rigidities, the real exchange rate has to adjust in response to shocks to government surpluses. The model predicts that fiscal shocks account for real exchange rate movements, and the factor structure in fiscal shocks aligns with the factor structure in currency returns. Both predictions are confirmed in the sample of developed countries.

Nonlinearity and asymmetry in the exchange rate pass‐through: What role for nominal price stickiness?

AbstractThis paper examines the importance of nominal rigidity for nonlinearity and asymmetry of exchange rate pass‐through. For this purpose, we rely on company‐level data of French importing firms. We find that the well established fact that “prices rise faster than they fall,” which is characterized by the convex import price reaction function, lies primarily with the presence of nominal rigidity. Once price stickiness is controlled for, there is empirical evidence that the import price reaction function is rather concave if the linearity assumption can be rejected, indicating that firms aim primarily to protect their market share.

Understanding the Aggregate Effects of Credit Frictions and Uncertainty

We examine the interaction of uncertainty and credit frictions in a New Keynesian framework. To do so, uncertainty is modeled as time-varying stochastic volatitlity - the product of monetary policy uncertainty, financial risk (micro-uncertainty), and macrouncertainty. The model is solved using a pruned third-order approximation and estimated by the Simulated Method of Moments. We find that: 1) Micro-uncertainty aggravates the information asymmetry between lenders and borrowers, worsens credit conditions, and has first-order effects on real economic activity. 2) When credit conditions are poor, as indicated by elevated credit spreads, additional micro-uncertainty shocks produce even larger real effects. 3) Poor credit conditions notably affect the transmission mechanism of monetary policy amplifying the real effects of monetary shocks while mitigating the economic boost from TFP shocks. 4) While macro-uncertainty and policy uncertainty exert relatively little direct impact on aggregate economic activity, policy uncertainty accounts for around 40% of the business cycle volatility by affecting the size of monetary policy shocks in the presence of nominal rigidities.

Uncertainty shocks are aggregate demand shocks

Search frictions in the labor market give rise to a new option-value channel through which uncertainty affects aggregate economic activity, and the effects of which are reinforced by the presence of nominal rigidities. With these features, an increase in uncertainty resembles an aggregate demand shock because it increases unemployment and lowers inflation. Using a new empirical measure of uncertainty based on the Michigan survey and a VAR model, we show that these theoretical patterns are consistent with US data. Using a calibrated DSGE model, we show that combining search frictions and nominal rigidities can match the qualitative VAR pattern and account for about 70percent of the empirical increase in unemployment following an uncertainty shock.

A Theory of Macroprudential Policies in the Presence of Nominal Rigidities

We propose a theory of monetary policy and macroprudential interventions in financial markets. We focus on economies with nominal rigidities in goods and labor markets and subject to constraints on monetary policy, such as the zero lower bound or fixed exchange rates. We identify an aggregate demand externality that can be corrected by macroprudential interventions in financial markets. Ex post, the distribution of wealth across agents affects aggregate demand and output. Ex ante, however, these effects are not internalized in private financial decisions. We provide a simple formula for the required financial interventions that depends on a small number of measurable sufficient statistics. We also characterize optimal monetary policy. We extend our framework to incorporate pecuniary externalities, providing a unified approach to both externalities. Finally, we provide a number of applications which illustrate the relevance of our theory. [web URL: http://onlinelibrary.wiley.com/doi/10.3982/ECTA11883/abstract]

Matching Efficiency and Business Cycle Fluctuations

A large decline in the efficiency of the U.S. labor market in matching unemployed workers and vacant jobs has been documented during the Great Recession. We use a simple New Keynesian model with search and matching frictions in the labor market to study the propagation of matching efficiency shocks. We show that the transmission of these disturbances and their importance for business cycle fluctuations depend crucially on the form of hiring costs and on the presence of nominal rigidities.

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Matching Efficiency and Business Cycle Fluctuations

A large decline in the efficiency of the US labor market in matching unemployed workers and vacant jobs has been documented during the Great Recession. We use a simple New Keynesian model with search and matching frictions in the labor market to study the macroeconomic implications of matching efficiency shocks. We show that the propagation of these disturbances and their importance for business cycle fluctuations depend crucially on the form of hiring costs and on the presence of nominal rigidities.

Trade Liberalization, Macroeconomic Adjustment, and Welfare: How Costly Are Nominal Rigidities?

It has long been argued that the presence of nominal rigidities could cause adverse macroeconomic adjustment to trade liberalization and thus reduce the benefits of freer trade. The paper explores the welfare cost of macroeconomic adjustment within the framework of new open economy macroeconomic models. The welfare effect of trade liberalization is decomposed into a steady-state efficiency gain and a transitional loss associated with wage-price stickiness and is estimated for a wide range of parameter values. The paper finds that while the transitional loss can be a substantial proportion of steady-state gains under fixed exchange rates, it is relatively small under a flexible exchange rate regime supported by a simple Taylor-type rule.

The Yield Curve and Macroeconomic Dynamics*

We show that microfounded DSGE models with nominal rigidities can be successful in replicating features of bond yield data, including sizeable term premia and volatile long-term yields, which have previously been considered puzzling in general equilibrium frameworks. At the same time, sample moments of consumption growth and inflation can be fit relatively well. The improved model performance does not arise directly from the presence of nominal rigidities. However, this feature introduces (short-run) monetary non-neutrality, so that monetary policy affects consumption dynamics and bond prices. A high degree of 'interest rate smoothing' in the policy rule is essential for our results. At the core of dynamic macroeconomic models, we find equilibrium relationships which describe the allocation of quantities (e.g. consumption and investment) and, when imperfect competition prevails, the setting of prices. These equations are typically valid across time and across states of nature, and financial assets form the tool that is supposed to ensure their validity. Financial assets are therefore an integral part of macroeconomic models. Any well-specified model should be able to match financial data as well as macro data. It is therefore problematic that microfounded models have had a hard time explaining key features of asset prices. The most famous example of this difficulty is the equity premium puzzle but various features of bond yield data have also been char acterised as puzzling in the literature. A number of papers, including Backus et al. (1989), Donaldson et al. (1990), Den Haan (1995) and Chapman (1997), have con cluded that general equilibrium models cannot generate term premia of a magnitude comparable to what we observe in actual data - and may not even be capable of producing positive term premia. For equity, one could argue that fundamentals (the expected future profitability of individual firms) are unobservable and difficult to evaluate. Equity prices may therefore be thought to be subject to fluctuations disconnected from the real economy (information acquisition, fads, etc.) and one could hope that the inability of macroeconomic models to match equity prices does not represent a signal of misspecification. This argument is more difficult to construct for bonds. Bond yields should ultimately reflect expectations of future monetary policy decisions which, at least in recent years, are arguably more predictable than equity fundamentals. Thus, the ability of macroeconomic models to explain bond prices represents an important test of their empirical performance. In this article, we revisit the relationship between bond prices and macroeconomic fundamentals. Contrary to the papers cited above, that rely on flexible price models, we

Nominal rigidities and the optimal rate of inflation

Inflation may enhance the efficiency of the price system in the presence of nominal rigidities. For the price system to function efficiently, nominal prices need to adjust both to real and nominal shocks for relative prices to disseminate the appropriate signals. Since the incentive for price setters to change nominal prices depends not only on the costs of changing prices but also on the realized shocks, it follows that the rate of inflation may affect the incentive to change nominal prices. The higher the rate of inflation, the larger the incentive to change nominal prices, and in the presence of real shocks requiring adjustment of relative prices, this can lead to a better functioning price system. Empirical evidence supports that nominal rigidities are more prevalent at low rates of inflation. It follows that there can be welfare costs of targeting inflation at too low a level.

Coping with Terms of Trade Shocks: Pegs versus Floats

The choice of the exchange-rate regime has always been an area of great controversy and debate. The discussion has once again taken center stage in the developing world. The sequence of currency crises in the 1990's, the success of culTency-board arrangements, the dollarization plan of Ecuador, and the apparent swing toward flexible regimes of many emerging economies has revived interest in this debate. Milton Friedman (1953) argued that one of the most important advantages of flexible regimes over fixed regimes is that they can smooth adjustment to real shocks even in the presence of nominal rigidities. Ever since, this has been one of the least disputed benefits attributed to fully flexible exchange-rate regimes. Subsequent to Friedman, many theories of the international transmission of real shocks have confirmed the original intuition that the shortrun responses to terms-of-trade shocks should be different across exchange-rate regimes. Here I look at a post-Bretton Woods sample of 74 developing countries to test whether flexible regimes can buffer terms-of-trade shocks better than fixed regimes.

Nominal Rigidities and the Optimal Rate of Inflation

Inflation may enhance the efficiency of the price system in the presence of nominal rigidities. For the price system to function efficiently there is a need for nominal prices to adjust both to real and nominal shocks for relative prices to disseminate the appropriate signals. Since the incentive for price setters to change prices depends not only on the costs of changing prices but also on the realized shocks, it follows that the rate of inflation may affect the incentive to change prices. The higher the rate of inflation the larger the incentive to change prices, and in the presence of real shocks requiring adjustment of relative prices this may lead to a better functioning price system. Empirical evidence supports that nominal rigidities are more prevalent at low rates of inflation. It follows that there can be welfare costs of targeting inflation at too low a level.

MACROECONOMIC PRICE AND QUANTITY RESPONSES WITH HETEROGENEOUS PRODUCT MARKETS

THIS paper examines some of the implications of imperfect competition in product markets for the macroeconomic properties of the economy. Most, if not all, economies are composed of a variety of product (and labour) markets that function in different ways. At the partial equilibrium level, the different sectors of the economy may respond in different ways to changes, such as an increase in demand. However, the overall response of the macroeconomy to (say) an increase in the money supply will depend very much on the generalequilibrium interactions between these different sectors. Most papers on imperfect competition and macroeconomics have tended to make assumptions about household preferences which greatly limit the possible interactions across sectors (e.g. by assuming constant budget shares or elasticities of demand). Furthermore, it is also common to adopt a representative sector methodology in which relative output prices cannot vary. I will argue that the macroeconomic externalities across different types of markets can be particularly signficant when those markets are heterogeneous. As such, this paper extends the approach of Blanchard and Kiyotaki (1987) and Cooper and John (1988) which tackle the issue of macroeconomic externalities in a 'representative sector' framework. The paper presents a simple stylized model which focuses on a key macroeconomic issue: how an increase in nominal aggregate demand is divided between price and quantity changes. There are two general lessons to be drawn from this exercise. First, that the macroeconomic response of the economy to an increase in the money supply depends on the precise composition of the economy: in our model, we provide scenarios that range from a Keynesian Pareto-improving pure output response (Propositions 1, 2), to a classical pure price response (Proposition 3). Secondly, we argue that the presence of nominal rigidities in some sectors can spill over to the rest of the economy, leading to prices becoming more rigid in other sectors. This would indicate that the new Keynesian menu-cost theory of economic fluctuations (see Akerlof and Yellen 1985; Mankiw 1985; Rotemberg, 1982; inter alia) does not require menu-costs in all industries; it may be enough to have menu-costs in only some (possibly small) proportion of sectors to generate significant price rigidity.