The Dire Effects of the Lack of Monetary and Fiscal Coordination 1 Francesco Bianchi and Leonardo Melosi Duke University and FRB of Chicago The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of Chicago or any other person associated with the Federal Reserve System Bianchi and Melosi
Recessions, Fiscal Imbalances, and Inflation Legacies of the Great Recession include a large public debt Some scholars have argued that fiscal imbalances have implications for price dynamics Sargent and Wallace (1981), Leeper (1991), Sims (1994), Woodford (1994), Cochrane (2001), Bassetto (2002) Emphasis on monetary and fiscal coordination This paper is mainly about the consequences of lack of coordination Bianchi and Melosi
Is Lack of Coordination a Possibility? Federal Debt Held by the Public 140 Actual Projected 120 100 80 60 40 20 0 1940 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 CBO projections imply that debt is on an unstable path Bianchi and Melosi
Is Lack of Coordination a Possibility? Federal Debt Held by the Public 140 Actual Projected 120 100 80 60 40 20 0 1940 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 CBO projections imply that debt is on an unstable path Fed ha insisted that inflation stability remains a central goal Bianchi and Melosi
Is Lack of Coordination a Possibility? Federal Debt Held by the Public 140 Actual Projected 120 100 80 60 40 20 0 1940 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 CBO projections imply that debt is on an unstable path Fed ha insisted that inflation stability remains a central goal Suggestive of possibility of conflict between the two authorities : Ability of the Fed to control inflation requires fiscal backing Bianchi and Melosi
This Paper We develop a NK model that features Large contractionary shocks that trigger large recessions and debt accumulation Agents understand that: Fiscal adjustments would be needed after the large recession 1 Government might be unable or unwilling to make such adjustments 2 Absent these fiscal adjustments, central bank could let inflation rise to stabilize debt 3 Central bank might oppose such a change in policy 4 We use the model to study: The consequences of the conflict between the two authorities A policy proposal that resolves the conflict by separating short-run and long-run fiscal stabilizations Bianchi and Melosi
Main Results Lack of coordination has dire effects A spiral of low output, high inflation, and high debt arises 1 Expectation of conflict jeopardizes attempts to mitigate the recession 2 Bianchi and Melosi
Main Results Lack of coordination has dire effects A spiral of low output, high inflation, and high debt arises 1 Expectation of conflict jeopardizes attempts to mitigate the recession 2 Absent fiscal backing, the Fed loses control of inflation. Hawkish monetary policy is counterproductive Bianchi and Melosi
Main Results Lack of coordination has dire effects A spiral of low output, high inflation, and high debt arises 1 Expectation of conflict jeopardizes attempts to mitigate the recession 2 Absent fiscal backing, the Fed loses control of inflation. Hawkish monetary policy is counterproductive Coordinated strategy to inflate away only debt accumulated during the recession = ⇒ Milder recession and rather stable inflation Bianchi and Melosi
Main Results Lack of coordination has dire effects A spiral of low output, high inflation, and high debt arises 1 Expectation of conflict jeopardizes attempts to mitigate the recession 2 Absent fiscal backing, the Fed loses control of inflation. Hawkish monetary policy is counterproductive Coordinated strategy to inflate away only debt accumulated during the recession = ⇒ Milder recession and rather stable inflation This coordinated strategy also useful to rule out liquidity traps Bianchi and Melosi
Private Sector: Households The representative household maximizes expected utility � � � � ∑ ∞ t = 0 β t exp ¯ E 0 d ξ d [ log C t − h t ] t subject to the budget constraint: P t C t + P m t B m t + P s t B s P t W t h t + B s t − 1 + ( 1 + ρ P m t ) B m = t t − 1 + P t D t − T t + TR t Discount factor shock, ¯ d ξ d t , can assume two values, high or low ( d H or d L ) ξ d t follows a Markov-switching process: � � p hh 1 − p ll H d = 1 − p hh p ll Bianchi and Melosi
Private Sector: Firms Representative firm faces: Monopolistic competition Sticky prices (Quadratic adjustment cost) TFP shocks Production function in which labor is the only input Bianchi and Melosi
The Government Budget Constraint The government budget constraint b m t = b m t − 1 R m t − 1 , t / ( Π t Y t / Y t − 1 ) − τ t + e t where all variables are normalized with nominal output Government expenditures: e t = g t + tr t with Government purchases (exogenous) as a fraction of output: g t Transfers-to-output ratio: tr t � � ρ tr � Y t � ( 1 − ρ tr ) φ y tr t tr t − 1 = tr ∗ tr ∗ Y ∗ t t t − 1 Bianchi and Melosi
Policy Rules Fiscal Rule � � � � � b m y ∗ t − 1 + δ y ( � y t − � τ t = ρ τ , ξ p � t � τ t − 1 + 1 − ρ τ , ξ p δ b , ξ p t ) t t Monetary Rule � � ( 1 − ρ R , ξ p t ) ρ R , ξ p ψ π , ξ p ψ y , ξ p t ( Y t / Y ∗ R t / R = ( R t − 1 / R ) ( Π t / Π ) t ) t t The Markov-switching process ξ p t determines the policy mix conditional on the state of demand ξ d t Bianchi and Melosi
Monetary/Fiscal Policy Mix When policy regimes are taken in isolation, the two policy rules and the linearized budget constraint are key to determine existence and uniqueness of a REE: ˆ R t = ψ π ˆ π t + ... τ t = δ b � b m t − 1 + ... � t − 1 + ... + b m β − 1 � � � b m β − 1 � b m ˆ = R t − 1 − ... − � − � π t τ t t � � t − 1 + ... + b m β − 1 ( ψ π ˆ β − 1 − δ b � � b m b m → t = π t − 1 − ... − � π t ) Bianchi and Melosi
Policy Regimes High state of demand ( ξ d t = H ): Coordination: Monetary led policy mix ( AM / PF ): b > β − 1 − 1 ψ π = ψ M δ b = δ M π > 1 Coordination: Fiscally led policy mix ( PM / AF ): b = 0 < β − 1 − 1 ψ π = ψ F δ b = δ F π < 1 Non-Coordination: Conflict Regime ( AM / AF ): b = 0 < β − 1 − 1 ψ π = ψ C δ b = δ C π > 1 Low state of demand ( ξ d t = L ): Fiscally-led policy mix ( PM / AF ) Bianchi and Melosi
Evolution of Regimes The matrix Q H controls the evolution of regimes in the high state of demand: p MM 1 − p FF 1 − p CC 0 1 − p MM p FF 0 1 − p CC Q H = 0 0 p CC 0 0 0 0 p CC The matrix Q governs the overall evolution of regimes: � � p hh Q H ( 1 − p ll ) · I 4 Q = ( 1 − p hh ) 0 . 25 · 1 4 × 4 p ll · I 4 ⇒ Agents take into account the possibility of large recessions and the consequent changes in policy makers’ behavior Back Bianchi and Melosi
Solution We solve the MS DSGE model using the method proposed by Farmer, Waggoner, and Zha (2009): S t = C ( ξ t , θ , Q ) + T ( ξ t , θ , Q ) S t − 1 + R ( ξ t , θ , Q ) ε t Agents are aware of regime changes and their beliefs matter for the solution of the model Temporary explosive dynamics are allowed, as long as the model is overall stationary This important feature allows us to study the properties of the conflict regime Bianchi and Melosi
Parameters (Bianchi and Melosi AER 2017) Parameter Value Parameter Value Parameter Value ψ π , M 1 . 7890 ρ τ , F 0 . 6501 p hh 0 . 9999 0 . 4413 2 . 0000 p ll 0 . 9465 ψ y , M ψ π , C ρ R , M 0 . 8697 ρ τ , C 0 . 6501 p MM 0 . 9902 0 . 0778 0 . 2814 p FF 0 . 9932 δ b , M δ y ρ τ , M 0 . 9666 φ y − 2 . 0000 κ 0 . 0072 b m 0 . 6903 0 . 4620 0 / 4 0 . 7700 ψ π , F ρ tr ψ y , F 0 . 2655 d h 0 . 0429 100 γ 0 . 4120 ρ R , F 0 . 6576 d l − 0 . 1300 100 π 0 . 5000 Bianchi and Melosi
Conflict with Fiscally-led Resolution Output Gap Inflation 5 2 4 0 3 -2 2 1 -4 0 0 10 20 30 0 10 20 30 FFR Debt-to-GDP Ratio 120 LD->FL LD->Conflict(FL)->FL 6 110 100 4 90 2 80 0 0 10 20 30 0 10 20 30 Bianchi and Melosi
Vicious Circle Key mechanism: Large recession generates debt accumulation: b ↑ 1 Expectation that eventually debt will be inflated away: π ↑ 2 Central bank increases interest rate more than one-to-one: Real interest rate ↑ 3 Real activity goes down: y ↓ 4 Low real activity + high real interest rate induce further debt accumulation: b ↑ 5 Spiral of low growth, high(er) inflation, debt accumulation Vicious Circle ends when one of the two authorities gives up Bianchi and Melosi
Conflict with Monetary-led Resolution Output Gap Inflation 5 2 4 0 3 2 -2 1 -4 0 0 10 20 30 0 10 20 30 FFR Debt-to-GDP Ratio 120 6 110 100 4 90 2 LD->Conflict(ML)->ML 80 LD->Conflict(FL) ->FL 0 0 10 20 30 0 10 20 30 Bianchi and Melosi
Conflict with Uncertain Resolution Output Gap Inflation 5 2 4 0 3 2 -2 1 -4 0 0 10 20 30 0 10 20 30 FFR Debt-to-GDP Ratio 120 6 110 100 4 90 2 LD->Conflict(ML)->ML LD->Conflict(FL) ->FL 80 LD->Conflict(Uncertain Outcome) 0 0 10 20 30 0 10 20 30 Bianchi and Melosi
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