Review of Economic Dynamics, Volume 31, January 2019
Abstract: This paper shows that under a strict inflation targeting regime, the government spending multiplier at the zero lower bound (ZLB) is larger under sticky information than under sticky prices. Similarly, well known paradoxes, e.g., the paradox of toil and the paradox of ﬂexibility become more severe under sticky information. For the case of sticky information it is important to assume that the ﬁscal policy intervention coincides with the duration of zero interest rates, while such a distinction is less important for sticky prices. We unify and clarify results that may appear to contradict each other in the literature.
Output Hysteresis & Optimal Monetary Policy (with Sanjay R. Singh)
Journal of Monetary Economics, Forthcoming
Abstract: We derive a fully quadratic approximation to welfare under endogenous growth and study optimal monetary policy. Away from the ZLB, optimal commitment policy sets interest rates to eliminate output hysteresis. A strict inﬂation targeting rule implements the optimal policy. At the ZLB, strict inﬂation targeting is sub-optimal and admits output hysteresis, deﬁned as a permanent loss in potential output. A new policy rule that targets output hysteresis returns the output to the pre-shock trend and approximates the welfare gains under optimal commitment policy. A central bank unable to commit to future policy actions suﬀers from hysteresis bias: it does not oﬀset past losses in potential output.
Policy citation: Tobias Adrian, Director of Monetary and Capital Markets Department at the IMF (September 7, 2018)
Previously circulated as: Fiscal Expansions in Secular Stagnation: What if it isn't Secular?
Abstract: Low natural real interest rates limit the power of monetary policy to revive the economy due to the zero lower bound (ZLB) on the nominal interest rate. Fiscal stabilization via higher government debt is frequently recommended as a policy to raise the natural real interest rate. This paper builds a non-Ricardian framework to study the trade-offs associated with a debt-financed fiscal expansion to show that even in a low real interest rate environment, higher debt doesn’t necessarily raise the real interest rate. The effect of the expansion is non-monotonic—increasing debt raises the natural real interest rate at low levels of debt, while at high levels it perversely decreases the natural real interest rate. This threshold level of debt, beyond which the effect becomes perverse, is a function of the expected duration of the low interest rate state. In a calibrated 60-period quantitative lifecycle model with aggregate uncertainty, if the low state is expected to last for 2 years, this threshold level of debt is at 250% of the GDP. The insights from the paper are directly applicable to a ZLB episode in a model with nominal frictions.