Debt Maturity Management, Monetary and Fiscal Policy Interactions

Save this PDF as:
 WORD  PNG  TXT  JPG

Size: px
Start display at page:

Download "Debt Maturity Management, Monetary and Fiscal Policy Interactions"

Transcription

1 Debt Maturity Management, Monetary and Fiscal Policy Interactions Hao Jin April 22, 23 Abstract This paper examines the interactions of debt maturity management, monetary and fiscal policy in a DSGE model. When the economy reaches either the zero lower bound of nominal interest rates or a fiscal limit in which fiscal policy becomes exogenous, inflation must be used to finance government liabilities which include both budget deficits and capital gains/losses on government debt. Fiscal policy determines the budget deficits, monetary policy and debt maturities jointly control the capital gains/losses, and then monetary policy allocates inflation across time. More aggressive monetary policy with long-term debt buffers more inflation into the future at higher roll-over cost. Longer average debt maturities mitigates this cost because a smaller proportion of debt is rolled over each period. On the other hand, long-term debt amplifies the impacts of monetary policy shocks on bond prices so that a contractionary monetary policy could generate either a current inflation or deflation depending on the outstanding debt maturity structure. Lengthening the average maturities has real effects which raises current inflation and output. Keywords: Debt Maturity Management, Monetary and Fiscal Policy Interactions, Long-term Bond Prices JEL Classification Numbers: E62, E63, E43, H6 Preliminary Department of Economics, Indiana University, Bloomington.

2 Introduction Recently, much attention is drawn to the public debt maturity structure as governments intervene the economy by altering the compositions of public debt. Figure documents that outstanding government debt maturities vary significantly both across countries and over time. Despite its empirical importance, debt maturity structure has been largely neglected in the monetary and fiscal policy analysis framework, which makes most of the existing literature silent on the policy implications of debt maturity management and its interactions with monetary and fiscal policy. 6 4 years UK US Japan Italy Germany France Canada Figure : Average Term to Maturity of Outstanding Government Debt in G7 countries An important question then is how does the maturity structure of government debt affect the conduct of monetary and fiscal policy? Moreover, does debt maturity management has real effect on the economy? Earlier works on monetary and fiscal policy interactions abstract from the maturity structure by assuming the only debt instrument government can issue is one-period bond, such as Leeper (99) and Woodford (996) among others. They show that monetary and fiscal policy interacts with each other in a very generic way. While the monetary policy targets inflation only if fiscal policy adjusts to stabilize debt, which is called Active Monetary/Passive Fiscal or AM/PF regime in Leeper s (99) term, a different policy mix can achieve the same goal, called Passive Monetary/Active Fiscal or PM/AF regime. In the latter regime, fiscal policy controls inflation and monetary policy stabilizes debt. Cochrane (2) extends the framework incorporating long-term debt and studies the policy 2

3 implications of maturity structure in PM/AF regime. Eusepi and Preston (22) examine effects of altering debt level and maturity in AM/PF regime under learning environment. This paper takes a comprehensive view of debt maturity structure, monetary and fiscal policy interactions and shed some new light on the consequences of debt maturity management. The main findings of this paper are the following: First, the debt maturities do not matter for determinacy as long as there is no real risk premium on long-term debt. In other words, the determinacy conditions with long-term debt collapses to the ones with one-period debt. More specifically, for the monetary policy to control inflation, the fiscal authority must adjust surplus at a speed greater than the one-period real interest rate no matter what debt maturities are. Otherwise, the monetary authority must allow inflation rises to prevent debt from exploding. Second, when fiscal instruments are unwilling or unable to stabilize debt, inflation must rise to make the debt level sustainable. This scenario is plausible particularly after the recent financial crisis when many advanced countries face the peak of the laffer curve or for political and economic reasons not willing to enforce austerity policy. Under such a condition, fiscal policy determines budget deficits that need to be financed, meanwhile the monetary policy and average debt maturities pin down the capital gains/losses. The sum of deficits and capital gains/losses is the total government liabilities. Then monetary policy allocates inflation across time to bring the total liabilities back to its steady state level. More aggressive monetary policy spreads more inflation into the future at the cost of higher present value of roll-over cost. Longer average debt maturities reduces this cost because a smaller proportion of debt is rolled over each period, hence realized roll-over cost is lower. Sticky price allows more inflation to be postponed into the future. Third, the impacts of monetary policy shocks on bond prices are amplified by longer average maturities since longer term debt is more sensitive to monetary policy shocks. A contractionary monetary policy has two channels to affect the current inflation in a sticky price model. One channel is that it increases the real interest rates and discounted future fiscal surpluses more heavily, therefore reduces the fiscal backing of government debt. The other channel is that it also lowers the bond prices, hence devalues the government outstanding debt. The total effect on the current price level depends on the average 3

4 maturities. When the average maturities is sufficiently long, the bond prices channel dominates and leads to a current deflation. This is because when taxes are exogenous, Ricardian equivalence breaks down and households view debt holding as their net wealth so that a reduction in debt value generates a negative wealth effect driving down aggregate demand and price level. Finally, a lengthening in debt maturities has no real impact in AM/PF regime since Ricardian equivalence holds and debt management is irrelevant for agent s decision making. On the other hand, lengthening in debt maturities raises current inflation in PM/AF regime since longer term debt portfolio generates higher coupon payments to the bond holder as net wealth. Households feel wealthier and want to convert these bond holdings into consumption until this wealth effect disappears. 2 Simple Analytic: Constant Endowment Economy 2. A constant endowment Economy Suppose there is a simple constant endowment cashless economy. A representative household which is endowed each period with a constant quantity of nonstorable goods, y, maximize lifetime utility subject to a budget constraint. s.to : c t + P M,t B M,t max : E β t u(c t ), (2.) t= + τ t = y + ( + ρp M,t ) B M,t. (2.2) The agent consumes c t and invests in risk-free government bonds, plus he has to pay a lump-sum tax τ t every period. is the current price level. There is a general portfolio of government bond, B M,t, in non-zero net supply with price P M,t. The household clears the bond holding each period. Following Woodford (2), the general bond portfolio is defined as a consol with a coupon decay factor ρ. The debt issued at time t is assumed to pay ρ j dollars j + periods in the future. When ρ is high, it means the coupon payments decay slowly and the cash flows are more spread out into the far future. On the other hand, when ρ is low, the coupon payments decay fast and the cash flows are concentrated in the near future. I use this specification to mimic the cash flow streams of bonds with 4

5 different maturities. Bonds with higher ρ represents longer maturities. Hence, by altering the value of ρ, we can model the maturity structure of outstanding government debt using only one parameter. In extreme case ρ =, the debt portfolio collapses to one-period debt and if ρ =, it becomes a consol. In later analysis, we are going to generalize the parameter ρ to be time-varying and examine the policy implications of debt maturity management. The first-order-condition with respect to B M,t is: β P M,t = E t ( + ρp M,t+ ), (2.3) π t+ And the Fisher equation that connects one-period nominal and real interest rates and expected inflation is: β = E t, (2.4) R t π t+ Combining the above two equations yields the no-arbitrage condition: P M,t = E t + ρp M,t+ R t. (2.5) The government collects a lump sum tax τ t and government spending is assumed to be zero each period, so the government budget constraint is the following: P M,t B M,t + τ t = ( + ρp M,t ) B M,t. (2.6) 2.2 Policy Rules The monetary authority is assumed to set a Taylor type feedback rule in which nominal interest responds to the contemporaneous inflation: R t = ϕ π π t + u R t, (2.7) 5

6 Where u R t is an AR() process with stochastic disturbance ε R t. u R t = ρ R u R t + εr t. The fiscal authority is assumed to collect lump-sum tax in response to the outstanding real government debt level: τ t = ϕ b ( + ρp M,t ) B M,t + u τ t, (2.8) where u τ t is an AR() process with stochastic disturbance ε τ t. u τ t = ρ τ u τ t + ετ t. We log-linearize the model around steady state reduce the model into a dynamic system in (π t, b M,t, P M,t ). Write in matrix form as the following: Γ EX t+ = Γ X t + Φ Z t+ + Φ Z t, (2.9) where the vector of endogenous variables X t (ˆπ t, ˆb M,t, ˆP M,t ), the vector of exogenous variables Z t (û R t, û τ t, û ρ t ). ˆx denotes deviation from the deterministic steady state. Proposition. The following conditions are necessary and sufficient for a unique bounded equilibrium: AM/PF regime: ϕ π, ϕ b > β, PM/AF regime: ϕ π <, ϕ b β. Detailed Proof can be found in the Appendix A. These results are identical to the Leeper(99) conditions in the sense that the determinacy of the solution depends on the policy parameters ϕ π and ϕ b and the deep behavior parameter β. Although we relax the assumption of government issuing only one-period debt, maturity structure plays no role in the determinant conditions. The speed of fiscal responsiveness to stabilize debt depends only on one-period real interest rate. And because there is no uncertainty on the real interest rate, the real interest rates of short- and long-term bonds are the same. 6

7 Nevertheless, the total amount of taxes needed to stabilize debt are different under various maturity structures since different coupon payment schedules affect the total value of outstanding debt. Leeper(99) provides an intuitive interpretation for these two regimes. In the AM/PF regime, central banks fight inflation aggressively by setting nominal interest rate response to inflation more than oneto-one. This anchors household s inflation expectation and brings inflation back to its target level. The fiscal policy then needs to adjust lump-sum tax in order to at least pay back real interest rate, preventing explosive debt path. Introducing long-term debt does not change the speed of fiscal adjustment, but needs a higher level of total amount of taxes to be collected. In the PM/AF regime, fiscal policy is unable to raise sufficient taxes to service debt interest, so that the monetary policy must allow inflation above target level to accommodate fiscal policy. Higher inflation revalues the outstanding debt, which acts as an inflation tax to help pay back debt interests. In the AM/PF regime, inflation is uniquely determined by the monetary policy, altering current debt maturities does not change the expected future policies hence does not affect the equilibria. This is analog to the Ricardian Equivalence which states that a tax change has no effect on household s consumption streams since household would expect future taxes to adjust so that the present value of taxes is the same. Altering debt maturities would incur expected future taxes adjustment so that it has no real impact. However, if the monetary policy cannot anchor the inflation on its target because of the crisis, then Ricardian Equivalence breaks down and debt maturity management has real impacts Fixed Maturity Structure We have the following Fisher relation by taking FOC with respect to B S,t, P S,t = βe t ( ), (2.) π t+ And the FOC with respect to B M,t implies an arbitrage condition given by P M,t = E t P S,t ( + ρp M,t+ ), (2.) 7

8 Iterate on (2.) and impose transversality condition to obtain P M,t = β (βρ) j E t j= i= j ( ), (2.2) π t+i+ The price of multi-period bond equals the present value of all the future coupon payments discounted by the nominal interest rates. Combining Fisher equation (2.) with this bond pricing equation yields P M,t = E t j= ρ j j ( ), (2.3) R t+j Iterate on the GBC and impose the no arbitrage condition and transversality condition to yield the intertemporal equilibrium condition ( + ρp M,t ) B M,t = i= β j E t τ t+j. (2.4) Consider the case that monetary policy has full control over inflation, both current and future, by setting the short-term nominal interest rate path. In this case, fiscal policy has to adjust government surpluses to accommodate interest payment changes, so that government budget constraint is separated from the dynamic system and the economy exhibits Ricardian Equivalence or AM/PF. Suppose there is a surprise shock to the current nominal interest rate that affect the current inflation level. Compare to the economy with only one-period debt, long-term debt enables the monetary policy to absorb part of the current inflation shift and spread it to the future. Hence, for countries with longer debt maturity, it is less likely to see large variations in inflations. If an economy hits a fiscal limit or the zero-lowerbound of interest rate,i.e. operates in the PM/AF regime, then monetary policy loses control of the current inflation, and fiscal shocks have impacts on the current price level through the intertemporal equilibrium condition (2.4). Ricardian Equivalence breaks down and a change of the present value of fiscal backing of government debt imposes restrictions on the inflation path. However, central banks still face the trade-off between current inflation and future inflation in response to a surplus shock as j= in the AM/PF regime. As a negative tax shock hits the economy, the intertemporal equilibrium condition (2.4) requires a jump in the current price to equate, but the long-term debt could act as a cushion by decreasing its nominal market value. The decline in market value represents future inflation. 8

9 Another policy experiment is that the central bank announces a shift in inflation target today. For example, the Japanese central bank increases its inflation target in February 23. This announcement devalues the outstanding debt portfolio since households will discount future coupon payments more heavily. Without any fiscal policy adjustment, households feel less wealthier and consume less, this in turn reduces aggregate demand and drives down the current price level until this wealth effect disappears. To prevent current deflation, fiscal policy must accommodate by committing to cut taxes in the future so that monetary policy controls current inflation as well. Longer average maturity amplifies this effect since it is more sensitive to the changes in future expected inflations. Until now, we have fixed the average maturity of government debt portfolio to understand the mechanisms of maturity structure to affect the conduct of monetary and fiscal policy. Next, we are going to allow the average maturity to be time-varying, then we can to analyze the impacts of debt maturity management as a policy tool Time-varying Debt Maturity The arbitrage condition is now P M,t = E t P S,t ( + ρ t P M,t+ ), (2.5) Iterate forward and impose transversality condition to obtain the bond pricing equation β P M,t = E t ( + π t+ = E t R t ( + i= β i i i= j= i j= ρ t+j π t+j+ ) (2.6) ρ t+j R t+j ), (2.7) And we can obtain the intertemporal equilibrium condition by iterating the GBC and imposing transversality condition. ( + ρ t P M,t ) B M,t = E t β i τ t+i. (2.8) i= Holding fixed the taxes and short-term interest rate streams, under an exogenous debt management rule, an extension of current or future average maturities, ρ t+j, will raise the bond price. A higher bond 9

10 price would then raise the current inflation in order to equate the intertemporal equilibrium condition (2.8). This model prediction undermines the effectiveness of Federal Reserve s recent quantitative easing operation that sells short-term Treasuries to purchase long-term Treasuries. Such an operation shortens the average maturities hold by the households and generates a negative wealth effect which is contractionary to the economy. Utilizing the debt management as an additional policy tool gives the monetary authority more flexibility in controlling the inflation path. While always facing a current and future inflation trade-off in the presence of long-term debt, the central bank can manage a sequence of lower expected interest rate, which will in turn result a higher inflation today holding other exogenous process fixed. However, even when the short-term nominal interest rate reaches its zero lower bound and can not be further reduced, active debt management can still transfer future inflation into current by extending the average debt maturities. This can be seen clearly from equation (2.6) and (2.8). Although a pegged short-term nominal interest rate sequence holds constant the expected inflation, an extension in average maturities ρ t+j could lead to a raise in the current inflation. 3 Debt Management in New Keynesian Model With the basic transforming mechanism understood from a constant endowment economy model, we now move to a basic New Keynesian sticky price model. Under the New Keyesian sticky price model, monetary policy has real effect. Under sticky price setting, inflation rises with lags so that future inflation will play a more significant role in terms of deficit financing. 3. The Model 3.. Households An infinitely lived representative household derives utility from consumption, c t, and real money balance, M t. The household derives disutility from hours worked. Specifically, the household chooses sequences of consumption, real money balance, hours worked and government debt

11 to maximizes E β t [ c t σ t= σ N t +ν + ν + (M t/ ) θ θ ], (3.) where c t is a consumption index given by ( c t c t (i) ϵ di ) ϵ ϵ. with c t (i) representing the quantity of good i consumed by the household in period t. < β < is the discount factor, σ > is the household s risk aversion, ν > is the inverse of the Frisch labor elasticity, and θ > determines the interest elasticity of real money demand. The general portfolio of government debt, B M,t, in non-zero net supply with price P M,t is the same as in the constant endowment model The household clears the bond holding each period. The price of short-term nominal bonds satisfies P S,t = Rt, where R t is the gross nominal interest rate. Following Woodford (2), long-term debt issued at time t is assumed to pay ρ j t dollars j + periods in the future, for j and ρ t. The average duration of this long-term bond is ( βρ t ). The household s flow budget constraint is given by c t + M t B S,t B M,t + P S,t + P M,t + τ t = y t + M t + B S,t + ( + ρ t P M,t ) B M,t. (3.2) Taking prices and B S, >, B M, >, and M as given. The household pays lump-sum taxes, τ t, each period Firms A continuum of monopolistically competitive firms produce goods using labor. Production of good j is given by the following production function. Y t (j) = N t (j), (3.3)

12 Following Calvo (983), each firm may reset its price only with probability ω in any given period Fiscal Policy The government issues nominal bonds, one period bond B S,t, and multi periods bond B M,t, prints money M t and collects lump-sum taxes τ t. Government spending is assumed to be zero in all periods. The government s flow budget constraint is M t B M,t + P M,t + τ t = M t + ( + ρ t P M,t ) B M,t, (3.4) The fiscal authority is assumed to collect lump-sum tax in response to the outstanding real government liability level: log τ t = log τ + ϕ b log b M,t P M,t + log u τ t, (3.5) where τ is the target tax level, and u τ t is an AR() process with stochastic disturbance ε τ t. u τ t = δ τ u τ t + ετ t Monetary Policy The monetary authority is assumed to set the nominal interest in response to the contemporaneous inflation: log R t = log R + ϕ π log π t + log u R t, (3.6) Where log R is the target interest rate level, and u R t is an AR() process with stochastic disturbance ε R t. u R t = δ R u R t + εr t debt management policy To ensure that the coupon payment parameter ρ t always be bounded between zero and one, we assume ρ t is a logistic function of a latent policy variable h t. The 2

13 functional form is: ρ t = + e h t, (3.7) Notice that ρ t is a monotone transformation of the latent policy variable h t and always lies between zero and one, so we can specify rules on h t and shock on it to examine the effects of altering debt compositions have on the economy. Debt Maturity management follows an exogenous mean-reverting rule:. log h t = log h + log ε h t, (3.8) (3.9) where h is the target maturity structure of government debt, and ε h t is a stochastic disturbance. The linearized system of equations is derived in the Appendix. 3.2 Calibration and impulse responses The model is calibrated to a annually frequency to examine the impacts of policy shocks over a horizon of 4 years. All the parameter values are in the range of standard values in the literature. The real interest rate is set to percent(β =.99). The preference over consumption is assumed to be logarithmic, so σ =. We set the inverse of the Frisch labor supply elasticity ν =. The parameter θ, which determines the interest elasticity of real money balance, is set to 2.6. Two thirds of firms cannot reset their price each period, so ω =.66. The monetary,fiscal and maturity shocks are AR() process with the persistence parameter set to.8. For simplicity, the steady state inflation is set to zero. The steady state debt-to-gdp ratio(s b ) is set to.4 and we consider a cash-less limit version of the model. The lump-sum tax rate(s τ ) is set to.2 in steady state. The implied steady state nominal interest rate R =.. 3

14 To study the policy implications when the economy reaches zero lower bound and fiscal limit, we only allow weak response of short-term nominal interest rate to inflation and exogenous lump-sum taxation. Particularly, we set the policy parameters ϕ π =,.3 and.8 respectively and ϕ b =. These policy specifications characterize PM/AF equilibrium. Then we vary the outstanding debt average maturities to year, 5 years and years. The model is solved using Sims (22) gensys algorithm A tax cut Two central equations in this system are the bond pricing equation (3.) and Intertemporal Equilibrium Condition (3.). Detailed derivation is given in the Appendix. ˆP M,t = E t (βρ) i [ ˆR t+i + βρˆρ t+i ], (3.) i= ( β ) β i+ E tˆτ t+i β i+ ( ρ)e t ˆPM,t+i + βρ β i+ E t ˆρ t+i i= } {{ } PV of Taxes ( ˆb M,t βρˆρ t ) } {{ } = i= } {{ } PV of Roll-Over Cost + ˆπ }{{} t + Surprise Revaluation i= i= } {{ } PV of Coupon Payments β i+ˆπ t+i+ } {{ } PV of Future Inflation, = (3.) The IEC (3.) must hold in equilibrium. In the case of exogenous taxes and fixed average maturities, a tax cut today and the capital gains or losses induced by the tax cut must be financed by either current inflation or future inflation. How the deficit financing is allocated across time depends on both the monetary policy and the maturity structure. The following Table shows the impacts of a tax cut on inflation under different policy combinations. The left panel illustrates the deficits financing decompositions under flexible prices as benchmark and the right panel is for sticky price case. The mechanism for long-term debt to buffer fiscal shocks is to use long-term bond prices as a cushion. When fiscal shock hits, the bond-prices will absorb part 4

15 Table : Deficit Impacts Decomposition Flexible Price Sticky Price ˆπ t PV( ˆP M ) PV(ˆπ future ) P V (ˆπ future) ˆπ t ˆπ t PV( ˆP M ) PV(ˆπ future ) P V (ˆπ future) ˆπ t ϕ π = year % 6.8% 39.2% year % 6.8% 39.2%.645 year % 6.8% 39.2%.645 ϕ π =.3 year % -4.6% 4.6% % -4.6% 74.8%.2 5 year 76.4% -8.3% 32.9% % -.8% 58.5%.2 year 73.% -3.7% 3.6% % -5.4% 55.7%.2 ϕ π =.8 year % % 362.9% % % 378.% year 36.5% -69.% 32.5% % -78.6% 45.9% 4.46 year 28.6% -32.7% 4.% % -37.9% 2.6% 4.46 of the shock and release it in the future by changing the prices. The part is not absorbed becomes current inflation and the absorbed part becomes future inflation. Hence, the ability to adjust bond price is necessary for the cushion effect to work. More aggressive monetary policy with long-term debt enhances the cushion effect, but leads to higher roll-over cost. Longer average debt maturities reduces this cost since a smaller proportion of debt is rolled over each period. When the central bank pegs nominal interest rate, as ϕ π = in the top of Table, then to satisfy the IEC (3.) with flexible price, the current price has to adjust upward to accommodate this negative tax shock. Intuitively, a tax cut today produces a positive wealth effect, which stimulates aggregate demand and pushes up the current price level. When price is sticky, future inflation will increase as well to reduce the future real interest rate and revalue the government s present value of deficits. Debt maturity structure does not play a role here since the monetary policy fixes the bond prices by pegging interest rates. The middle part of the table shows the decomposition when allowing nominal interest rate to weakly respond to the inflation level. Since a tax cut causes deficit which then raises inflation, a Taylor type monetary policy to raise nominal interest rate imposes higher roll-over cost on the government. Longer maturity mitigates this problem by rolling over debt less frequently. For example, with average debt maturities of year, the government will suffer 4.6% of additional roll-over cost at present value sense, but with average maturities of 5 year, the roll-over cost decreases to.8%. At the same time, long-term bond cushions the impacts of deficit shocks on current inflation as reduced from 5

16 % to 76.4% as average maturities goes from year to 5 year. The total inflation is determined by the fiscal shock and the magnitude of roll-over cost which depends both on the monetary policy and the debt maturity structure. The allocation of total inflation between current and future inflation is controlled by the monetary policy. As shown in the fourth column, the ratio of P V (ˆπ future) π t is constant under such monetary policy configuration. This is because monetary policy controls the evolution path of all future inflation. We see a similar pattern of inflation trade-offs when monetary policy is more aggressive as ϕ π =.8. The sticky price setting enables even more cushion than flexible price environment as a further reduction in current inflation happened. The reason is that when inflation is sluggish, full financing through current inflation is no longer available. There has to be some part of the inflation to be postponed into the future. Therefore, all the decomposed percentages in P V (ˆπ future ) under sticky prices contains two effects. The long-term debt cushion effect and the sticky price delaying effect. In sum, how the tax cut is financed depends on the interactions of debt maturity, monetary and fiscal policy. Holding fixed the tax stream, more aggressive monetary policy generates larger capital losses which needs to be financed by current and future inflation. Long-term debt reduces the capital losses by rolling over debt less frequently. Therefore the magnitude of the roll-over cost is determined by both monetary policy and debt maturity structure. A more aggressive monetary policy spreads out more current inflation into the future at higher roll-over cost, while longer maturities mitigate this problem by rolling over debt less frequently. Sticky price setting builds up another channel that current inflation can be postponed into the future An extension of average debt maturities Figure 2 shows the effects of an operation of the government to extend the average maturities of outstanding government debt. For example, a lengthening of average maturities could be that the government sells short-term and to purchase longterm bond. This action raises the bond average maturity parameter ρ at time t. Higher ρ also represents a higher debt coupon payment, so the government s liabilities rise. Initially, the real government debt is not backed up by enough expected tax revenues, so households will convert their liability holdings 6

17 2 Inflation 2 4 Government Real Liabilities Output Nominal Interest Rate 2 4 Bond Price Labor Hours Real interest rate 2 4 Lump sum Tax 2 4 Weighted Average Maturities.5 year debt year debt 2 4 Figure 2: responses to a shock that lengthens the average outstanding debt maturities into consumption, which increases the aggregate demand of goods and then pushes up the current price level, which dilutes the government liabilities and restores the equilibrium. Monetary authority holds the nominal interest rate fixed which in turn leads real interest rate to fall. The bond pricing relation (3.) states that a longer average debt maturities with constant short-term interest rate, without expected future maturities changes, increases the bond prices. Lower real interest rates distort the saving incentives for households, the wealth effect in this case dominates the substitution effect, so that households work more to consume. This result opposes the recent quantitative easing operations by many central banks that sell short-term and purchase long-term government securities. This operation is likely to generate negative wealth effect when the fiscal policy is exogenous because households will take holdings of government securities as net wealth. If the central bank reduces the average maturities of public holdings, negative wealth effect will cause a recession in contrast of an expansion A contractionary monetary policy Next, the effects of a contractionary monetary policy are summarized in Figure 3. The most striking result is that there could be either a current inflation 7

18 or a current deflation depending on the average debt maturities in the economy. This is because a rise in nominal interest rate has two effects on the intertemporal equilibrium condition (3.). It increases the real interest rate due to sticky price which means the government tax revenues are discounted more heavily. This will require a current inflation to devalue the outstanding government debt if there is only one-period debt. With multi-period debt, a higher nominal interest rate also leads to decrease in the bond prices, and the longer the maturities, the more sensitive is the price to the nominal interest rate. When the average maturities are sufficiently long, the decrease in bond price may exceeds the decrease in present value of government tax revenues and price level has to go down to re-establish the equilibrium. Empirically, one will expect countries with different maturity structures to have different inflation response to monetary policy under PM/AF regime. Assuming only one-period debt, the results are similar to Kim (23) study of monetary policy shock under PM/AF regime. Output and labor supply decline since real interest rate decreases. Inflation Nominal Interest Rate 2 Real interest rate Government Real Liabilities Output Bond Price Labor Hours Lump sum Tax Weighted Average Maturities year debt year debt Figure 3: responses to a positive shock to the nominal interest rate 8

19 4 Conclusion This paper introduces multi-period debt into a standard New Keyesian sticky price model to study the interactions among debt maturity management, monetary and fiscal policy. We find that first, the debt maturities do not matter for determinacy as long as there is no real risk premium associated with long-term debt. In other words, the determinacy conditions with long-term debt collapses to the ones with one-period debt. Second, Fiscal policy determines the total deficits, monetary policy and debt maturities jointly influence the capital gains/losses, then monetary policy allocates inflation across time. More aggressive monetary policy with long-term debt cushions more inflation into the future at higher roll-over cost. Longer average debt maturities mitigates this cost because a smaller proportion of debt is rolled over each period. Third, longer average debt maturities amplifies the impacts of monetary policy shocks on bond prices, which would generate either a current inflation or deflation depending on the debt maturity structure. Finally, Lengthening the average maturities has real effects which raises current inflation and output. 9

20 A Proof of Proposition The equilibrium is completely characterized by three equations. The first one is the no-arbitrage condition (2.5). The second equation comes from combining fisher equation (2.4) and the monetary policy (2.7) and the last equation comes from imposing fiscal policy (2.8) on GBC (2.6). The equilibrium dynamic system is summarized below: P M,t = E t + ρp M,t+ R t, (A.) E t π t+ = ϕ π βπ t + βu R t, P M,t b M,t + ϕ b ( + ρp M,t )b M,t + u τ t = ϕ b ( + ρp M,t )b M,t π t. (A.2) (A.3) where b M,t B M,t denotes real debt. Linearize the above system and write in matrix form: } {{ λ } Γ E t ˆπ t+ ˆbM,t+ ˆP M,t+ + } {{ } Φ ûr t+ û τ t+ ϕ π ˆπ t = λ 2 λ 2 ˆbM,t ˆP M,t, } {{ } Γ + ûr t û τ t } {{ } Φ (A.4) where λ = βρ π, λ 2 = ϕ b β. All the variables without time index refer to the steady state values. 2

21 The above system has two forecast errors, η π t+ and ηp M t+, which are defined as: η π t+ = π t+ E t π t+, (A.5) η P M t+ = P M,t+ E t P M,t+. (A.6) so that two of eigenvalues of the transition matrix Γ Γ should be greater than one in absolute value in order for a unique equilibrium to exist. The transition matrix is given below: Γ Γ = ϕ π ϕ π λ λ λ 2 λ 2 = ϕπ λ λ 2 ϕ π λ λ, λ λ (A.7) The eigenvalues of the transition matrix can be directly read off from the diagonal elements. The three eigenvalues are: (ϕ π, λ 2, λ ). Notice that the discount factor β and the average maturity parameter ρ are bounded between and, and the steady state inflation is greater than, so that the eigenvalue λ > always. Then for a unique equilibrium to exist, we need one of the remaining roots to be outside unit circle and the other one to be inside. Plug in the value of λ and λ 2, we can write the determinacy conditions as: ϕ π, ϕ b β < or ϕ π <, ϕ b β. Ignoring the cases of negative response coefficients, we can rewrite the conditions as in Proposition. For exogenous time-varying debt management rule ρ t = ϕ ρ π t + u ρ t, t, plug this rule into the dynamic equilibrium system, the coefficient matrix Γ is unchanged, the eigenvalues of this system are unchanged, therefore, the determinacy conditions are also unchanged. 2

22 B Log-Linearized System of Equations for the New Keynesian Model Let ˆx t log x t log x represents the log deviation of a variable from its steady state value x. For simplicity, we assume the steady state inflation is zero. ARC: ĉ t ŷ t =, (B.) Production: ŷ t ˆn t =, (B.2) No arbitrage: βρe t ˆρ t + βρe t ˆPM,t+ = ˆP M,t + ˆR t, (B.3) Money demand: β ˆR t σ ( β)ĉ t + θ( β) ˆm t =, (B.4) NK Phillips Curve: βe tˆπ t+ = ˆπ t + ( ωβ)( ω) ( νˆn t ω σ ĉt), (B.5) GBC: ˆbM,t + βρˆρ t = sm β P M b M ˆµ t + ( β )ˆτ t + βˆb M,t + ( ρ)β ˆP M,t + ˆπ t, (B.6) where ˆµ t = ˆm t ˆm t + ˆπ t is the seigniorage revenue. 22

23 Fisher Equation: σ E tĉ t+ + E tˆπ t+ = ˆR t + σ ĉt, (B.7) Fiscal Policy: ˆτ t = ϕ b (ˆb M,t + ˆP M,t ) + û τ t, (B.8) Fiscal Policy shock: û τ t = ρ τ û τ t + ε τ t, (B.9) Monetary Policy: ˆR t = ϕ π ˆπ t + û R t, (B.) Monetary Policy shock: û R t = ρ R û R t + ε R t, (B.) latent policy variable: ( + e h )ˆρ t = he h ĥ t, (B.2) exogenous debt maturity management rule: ĥ t = û h t, (B.3) 23

24 C Derivation of Bond Pricing Equation and IEC for the New Keynesian Model The no-arbitrage condition comes from combining the FOCs of c t, B s,t and B M,t : P M,t = E t ( + ρ t+ P M,t+ ) R t, (C.) Rewrite this no-arbitrage condition as: P M,t = R t + E t ρ t+ R t P M,t+, (C.2) Iterating on P M,t and imposing transversality condition yields the bond pricing equation: P M,t = E t R t ( + i i= j= ρ t+j R t+j ). (C.3) Impose equilibrium no-arbitrage condition and rewrite the GBC (3.4) as: M t + ( + ρ t P M,t )B M,t = M t + E t ( + ρ t+ P M,t+ ) R t B M,t + τ t, (C.4) adding and subtracting β( c t+ c t ) σ Mt + relation R t = βe t ( c t+ c t ) σ π t+ yields: and using the short-term nominal interest rate no-arbitrage M t + ( + ρ t P M,t )B M,t = M t + ( + ρ t+ P M,t+ )B M,t + β( c t+ c t ) σ + ( R t ) M t + τ t, (C.5) Iterate and impose transversality condition to get the IEC: M t + ( + ρ t P M,t )B M,t = i= [ β i E t η i τ t+i + ( ) M ] t+i. (C.6) R t+i +i where η i = ( c t+i+ c t ) σ for i and η = 24

25 References [] Cochrane, J.H. (2): Long Term Debt and Optimal Policy in the Fiscal Theory of the Price Level, Econometrica. [2] Cochrane, J.H. (2): Understanding Policy in the Great Recession: Some Unpleasant Fiscal Arithmetic, European Economic Review. [3] Davig, T., Leeper, E. M. and Walker, T. B. (2): Inflation and the Fiscal Limit, European Economic Review. [4] Eggertsson, G., and Woodford, M. (23): The Zero Bound on Interest Rates and Optimal Monetary Policy, Brookings Papers on Economic Activity. [5] Eusepi, S., and Preston, B. (2): Learning the Fiscal Theory of the Price Level: Some Consequences of Debt Management Policy, Journal of the Japanese and International Economies [6] Eusepi, S., and Preston, B. (22): Fiscal Foundations of Inflation: Imperfect Knowledge, Working Paper, Monash University [7] Galí, J. (28): Monetary Policy, Inflation, and the Business Cycle. Princeton University Press, Princeton. [8] Kim, S. (23): Structural Shocks and the Fiscal Theory of the Price Level in the Sticky Peice Model, Macroeconomic Dynamics. [9] Leeper, E.M. (99): Equilibria under active and passive monetary and fiscal policies, Journal of Monetary Economics. [] Leeper, E. M. and Walker, T.B. (2): Perceptions and Misperceptions of Fiscal Inflation, Manuscript, Indiana University. [] Sims, C.A. (22): Solving Linear Rational Expectations Models, Computational Economics. [2] Woodford, M. (996): Control of Public Debt: A Requirement for Price Stability?, NBER working paper

26 [3] Woodford, M. (2): Fiscal Requirement for Price Stability, Journal of Money, Credit, and Banking. 26

Money and Public Finance

Money and Public Finance Money and Public Finance By Mr. Letlet August 1 In this anxious market environment, people lose their rationality with some even spreading false information to create trading opportunities. The tales about

More information

Long-Term Debt Pricing and Monetary Policy Transmission under Imperfect Knowledge

Long-Term Debt Pricing and Monetary Policy Transmission under Imperfect Knowledge Long-Term Debt Pricing and Monetary Policy Transmission under Imperfect Knowledge Stefano Eusepi, Marc Giannoni and Bruce Preston The views expressed are those of the authors and are not necessarily re

More information

6. Budget Deficits and Fiscal Policy

6. Budget Deficits and Fiscal Policy Prof. Dr. Thomas Steger Advanced Macroeconomics II Lecture SS 2012 6. Budget Deficits and Fiscal Policy Introduction Ricardian equivalence Distorting taxes Debt crises Introduction (1) Ricardian equivalence

More information

Real Business Cycle Theory. Marco Di Pietro Advanced () Monetary Economics and Policy 1 / 35

Real Business Cycle Theory. Marco Di Pietro Advanced () Monetary Economics and Policy 1 / 35 Real Business Cycle Theory Marco Di Pietro Advanced () Monetary Economics and Policy 1 / 35 Introduction to DSGE models Dynamic Stochastic General Equilibrium (DSGE) models have become the main tool for

More information

Money and Capital in an OLG Model

Money and Capital in an OLG Model Money and Capital in an OLG Model D. Andolfatto June 2011 Environment Time is discrete and the horizon is infinite ( =1 2 ) At the beginning of time, there is an initial old population that lives (participates)

More information

The Real Business Cycle Model

The Real Business Cycle Model The Real Business Cycle Model Ester Faia Goethe University Frankfurt Nov 2015 Ester Faia (Goethe University Frankfurt) RBC Nov 2015 1 / 27 Introduction The RBC model explains the co-movements in the uctuations

More information

. In this case the leakage effect of tax increases is mitigated because some of the reduction in disposable income would have otherwise been saved.

. In this case the leakage effect of tax increases is mitigated because some of the reduction in disposable income would have otherwise been saved. Chapter 4 Review Questions. Explain how an increase in government spending and an equal increase in lump sum taxes can generate an increase in equilibrium output. Under what conditions will a balanced

More information

ECON 5110 Class Notes Overview of New Keynesian Economics

ECON 5110 Class Notes Overview of New Keynesian Economics ECON 5110 Class Notes Overview of New Keynesian Economics 1 Introduction The primary distinction between Keynesian and classical macroeconomics is the flexibility of prices and wages. In classical models

More information

VI. Real Business Cycles Models

VI. Real Business Cycles Models VI. Real Business Cycles Models Introduction Business cycle research studies the causes and consequences of the recurrent expansions and contractions in aggregate economic activity that occur in most industrialized

More information

Federal Reserve Bank of New York Staff Reports

Federal Reserve Bank of New York Staff Reports Federal Reserve Bank of New York Staff Reports Deficits, Public Debt Dynamics, and Tax and Spending Multipliers Matthew Denes Gauti B. Eggertsson Sophia Gilbukh Staff Report No. 551 February 2012 This

More information

Towards a Structuralist Interpretation of Saving, Investment and Current Account in Turkey

Towards a Structuralist Interpretation of Saving, Investment and Current Account in Turkey Towards a Structuralist Interpretation of Saving, Investment and Current Account in Turkey MURAT ÜNGÖR Central Bank of the Republic of Turkey http://www.muratungor.com/ April 2012 We live in the age of

More information

Graduate Macro Theory II: The Real Business Cycle Model

Graduate Macro Theory II: The Real Business Cycle Model Graduate Macro Theory II: The Real Business Cycle Model Eric Sims University of Notre Dame Spring 2011 1 Introduction This note describes the canonical real business cycle model. A couple of classic references

More information

MA Advanced Macroeconomics: 7. The Real Business Cycle Model

MA Advanced Macroeconomics: 7. The Real Business Cycle Model MA Advanced Macroeconomics: 7. The Real Business Cycle Model Karl Whelan School of Economics, UCD Spring 2015 Karl Whelan (UCD) Real Business Cycles Spring 2015 1 / 38 Working Through A DSGE Model We have

More information

Fiscal Theory of the Price Level

Fiscal Theory of the Price Level Fiscal Theory of the Price Level Marco Bassetto Federal Reserve Bank of Chicago, University of Minnesota, and NBER Abstract The fiscal theory of the price level (FTPL) describes fiscal and monetary policy

More information

A Theory of Capital Controls As Dynamic Terms of Trade Manipulation

A Theory of Capital Controls As Dynamic Terms of Trade Manipulation A Theory of Capital Controls As Dynamic Terms of Trade Manipulation Arnaud Costinot Guido Lorenzoni Iván Werning Central Bank of Chile, November 2013 Tariffs and capital controls Tariffs: Intratemporal

More information

ECON20310 LECTURE SYNOPSIS REAL BUSINESS CYCLE

ECON20310 LECTURE SYNOPSIS REAL BUSINESS CYCLE ECON20310 LECTURE SYNOPSIS REAL BUSINESS CYCLE YUAN TIAN This synopsis is designed merely for keep a record of the materials covered in lectures. Please refer to your own lecture notes for all proofs.

More information

Ifo Institute for Economic Research at the University of Munich. 6. The New Keynesian Model

Ifo Institute for Economic Research at the University of Munich. 6. The New Keynesian Model 6. The New Keynesian Model 1 6.1 The Baseline Model 2 Basic Concepts of the New Keynesian Model Markets are imperfect: Price and wage adjustments: contract duration, adjustment costs, imperfect expectations

More information

Financial Development and Macroeconomic Stability

Financial Development and Macroeconomic Stability Financial Development and Macroeconomic Stability Vincenzo Quadrini University of Southern California Urban Jermann Wharton School of the University of Pennsylvania January 31, 2005 VERY PRELIMINARY AND

More information

Current Accounts in Open Economies Obstfeld and Rogoff, Chapter 2

Current Accounts in Open Economies Obstfeld and Rogoff, Chapter 2 Current Accounts in Open Economies Obstfeld and Rogoff, Chapter 2 1 Consumption with many periods 1.1 Finite horizon of T Optimization problem maximize U t = u (c t ) + β (c t+1 ) + β 2 u (c t+2 ) +...

More information

External Debt and Stabilizing Macroeconomic Policies

External Debt and Stabilizing Macroeconomic Policies External Debt and Stabilizing Macroeconomic Policies Alessandro Piergallini University of Rome Tor Vergata November 10, 2015 Abstract This paper investigates the dynamic effects of fiscal and monetary

More information

On the irrelevance of government debt when taxes are distortionary

On the irrelevance of government debt when taxes are distortionary On the irrelevance of government debt when taxes are distortionary Marco Bassetto a,b,, Narayana Kocherlakota c,b a Department of Economics, University of Minnesota, 271 19th Ave. S., Minneapolis, MN 55455,

More information

Macroeconomic Effects of Financial Shocks Online Appendix

Macroeconomic Effects of Financial Shocks Online Appendix Macroeconomic Effects of Financial Shocks Online Appendix By Urban Jermann and Vincenzo Quadrini Data sources Financial data is from the Flow of Funds Accounts of the Federal Reserve Board. We report the

More information

Working Paper SerieS. Dealing with a Liquidity Trap when Government Debt Matters Optimal Time-Consistent Monetary and Fiscal Policy

Working Paper SerieS. Dealing with a Liquidity Trap when Government Debt Matters Optimal Time-Consistent Monetary and Fiscal Policy Working Paper SerieS NO 6 / december 3 Dealing with a Liquidity Trap when Government Debt Matters Optimal Time-Consistent Monetary and Fiscal Policy Matthias Burgert and Sebastian Schmidt In 3 all ECB

More information

Lecture 2 Dynamic Equilibrium Models : Finite Periods

Lecture 2 Dynamic Equilibrium Models : Finite Periods Lecture 2 Dynamic Equilibrium Models : Finite Periods 1. Introduction In macroeconomics, we study the behavior of economy-wide aggregates e.g. GDP, savings, investment, employment and so on - and their

More information

A Classical Monetary Model - Money in the Utility Function

A Classical Monetary Model - Money in the Utility Function A Classical Monetary Model - Money in the Utility Function Jarek Hurnik Department of Economics Lecture III Jarek Hurnik (Department of Economics) Monetary Economics 2012 1 / 24 Basic Facts So far, the

More information

Capital Constraints, Lending over the Cycle and the Precautionary Motive: A Quantitative Exploration (Working Paper)

Capital Constraints, Lending over the Cycle and the Precautionary Motive: A Quantitative Exploration (Working Paper) Capital Constraints, Lending over the Cycle and the Precautionary Motive: A Quantitative Exploration (Working Paper) Angus Armstrong and Monique Ebell National Institute of Economic and Social Research

More information

Lecture 3: Growth with Overlapping Generations (Acemoglu 2009, Chapter 9, adapted from Zilibotti)

Lecture 3: Growth with Overlapping Generations (Acemoglu 2009, Chapter 9, adapted from Zilibotti) Lecture 3: Growth with Overlapping Generations (Acemoglu 2009, Chapter 9, adapted from Zilibotti) Kjetil Storesletten September 10, 2013 Kjetil Storesletten () Lecture 3 September 10, 2013 1 / 44 Growth

More information

The Basic New Keynesian Model

The Basic New Keynesian Model The Basic New Keynesian Model January 11 th 2012 Lecture notes by Drago Bergholt, Norwegian Business School Drago.Bergholt@bi.no I Contents 1. Introduction... 1 1.1 Prologue... 1 1.2 The New Keynesian

More information

Friedman Redux: Restricting Monetary Policy Rules to Support Flexible Exchange Rates

Friedman Redux: Restricting Monetary Policy Rules to Support Flexible Exchange Rates Friedman Redux: Restricting Monetary Policy Rules to Support Flexible Exchange Rates Michael B. Devereux Department of Economics, University of British Columbia and CEPR Kang Shi Department of Economics,

More information

Cash in advance model

Cash in advance model Chapter 4 Cash in advance model 4.1 Motivation In this lecture we will look at ways of introducing money into a neoclassical model and how these methods can be developed in an effort to try and explain

More information

Government Debt Management: the Long and the Short of it

Government Debt Management: the Long and the Short of it Government Debt Management: the Long and the Short of it E. Faraglia (U. of Cambridge and CEPR) A. Marcet (IAE, UAB, ICREA, BGSE, MOVE and CEPR), R. Oikonomou (U.C. Louvain) A. Scott (LBS and CEPR) ()

More information

INVESTMENT PLANNING COSTS AND THE EFFECTS OF FISCAL AND MONETARY POLICY. Susanto Basu and Miles S. Kimball. University of Michigan and NBER

INVESTMENT PLANNING COSTS AND THE EFFECTS OF FISCAL AND MONETARY POLICY. Susanto Basu and Miles S. Kimball. University of Michigan and NBER INVESTMENT PLANNING COSTS AND THE EFFECTS OF FISCAL AND MONETARY POLICY Susanto Basu and Miles S. Kimball University of Michigan and NBER MAIN RESULTS. Show that a model with capital accumulation and sticky

More information

Leveraged purchases of government debt and deflation

Leveraged purchases of government debt and deflation Leveraged purchases of government debt and deflation R. Anton Braun Federal Reserve Bank of Atlanta Tomoyuki Nakajima Kyoto University October 5, 2011 Abstract We consider a model in which individuals

More information

Sovereign Defaults. Iskander Karibzhanov. October 14, 2014

Sovereign Defaults. Iskander Karibzhanov. October 14, 2014 Sovereign Defaults Iskander Karibzhanov October 14, 214 1 Motivation Two recent papers advance frontiers of sovereign default modeling. First, Aguiar and Gopinath (26) highlight the importance of fluctuations

More information

Lecture 14 More on Real Business Cycles. Noah Williams

Lecture 14 More on Real Business Cycles. Noah Williams Lecture 14 More on Real Business Cycles Noah Williams University of Wisconsin - Madison Economics 312 Optimality Conditions Euler equation under uncertainty: u C (C t, 1 N t) = βe t [u C (C t+1, 1 N t+1)

More information

The Cost of Financial Frictions for Life Insurers

The Cost of Financial Frictions for Life Insurers The Cost of Financial Frictions for Life Insurers Ralph S. J. Koijen Motohiro Yogo University of Chicago and NBER Federal Reserve Bank of Minneapolis 1 1 The views expressed herein are not necessarily

More information

Optimal Consumption with Stochastic Income: Deviations from Certainty Equivalence

Optimal Consumption with Stochastic Income: Deviations from Certainty Equivalence Optimal Consumption with Stochastic Income: Deviations from Certainty Equivalence Zeldes, QJE 1989 Background (Not in Paper) Income Uncertainty dates back to even earlier years, with the seminal work of

More information

Real Business Cycle Models

Real Business Cycle Models Phd Macro, 2007 (Karl Whelan) 1 Real Business Cycle Models The Real Business Cycle (RBC) model introduced in a famous 1982 paper by Finn Kydland and Edward Prescott is the original DSGE model. 1 The early

More information

Chapter 11. Keynesianism: The Macroeconomics of Wage and Price Rigidity. 2008 Pearson Addison-Wesley. All rights reserved

Chapter 11. Keynesianism: The Macroeconomics of Wage and Price Rigidity. 2008 Pearson Addison-Wesley. All rights reserved Chapter 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity Chapter Outline Real-Wage Rigidity Price Stickiness Monetary and Fiscal Policy in the Keynesian Model The Keynesian Theory of Business

More information

2.5 Monetary policy: Interest rates

2.5 Monetary policy: Interest rates 2.5 Monetary policy: Interest rates Learning Outcomes Describe the role of central banks as regulators of commercial banks and bankers to governments. Explain that central banks are usually made responsible

More information

PRESENT DISCOUNTED VALUE

PRESENT DISCOUNTED VALUE THE BOND MARKET Bond a fixed (nominal) income asset which has a: -face value (stated value of the bond) - coupon interest rate (stated interest rate) - maturity date (length of time for fixed income payments)

More information

Lending in Last Resort to Governments

Lending in Last Resort to Governments Olivier Jeanne, Johns Hopkins University Indiana University, March 2015 Introduction Fiscal fundamentals in 2009: an international comparison Net debt/gdp (%) 40 50 60 70 80 90 100 110 120 US JAP UK EUR

More information

Econ 330 Exam 1 Name ID Section Number

Econ 330 Exam 1 Name ID Section Number Econ 330 Exam 1 Name ID Section Number MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 1) If during the past decade the average rate of monetary growth

More information

Cash-in-Advance Model

Cash-in-Advance Model Cash-in-Advance Model Prof. Lutz Hendricks Econ720 September 21, 2015 1 / 33 Cash-in-advance Models We study a second model of money. Models where money is a bubble (such as the OLG model we studied) have

More information

At t = 0, a generic intermediary j solves the optimization problem:

At t = 0, a generic intermediary j solves the optimization problem: Internet Appendix for A Model of hadow Banking * At t = 0, a generic intermediary j solves the optimization problem: max ( D, I H, I L, H, L, TH, TL ) [R (I H + T H H ) + p H ( H T H )] + [E ω (π ω ) A

More information

Federal Reserve Bank of New York Staff Reports. Deficits, Public Debt Dynamics, and Tax and Spending Multipliers

Federal Reserve Bank of New York Staff Reports. Deficits, Public Debt Dynamics, and Tax and Spending Multipliers Federal Reserve Bank of New York Staff Reports Deficits, Public Debt Dynamics, and Tax and Spending Multipliers Matthew Denes Gauti B. Eggertsson Sophia Gilbukh Staff Report No. 551 February 2012 Revised

More information

Topic 2. Incorporating Financial Frictions in DSGE Models

Topic 2. Incorporating Financial Frictions in DSGE Models Topic 2 Incorporating Financial Frictions in DSGE Models Mark Gertler NYU April 2009 0 Overview Conventional Model with Perfect Capital Markets: 1. Arbitrage between return to capital and riskless rate

More information

Graduate Macroeconomics 2

Graduate Macroeconomics 2 Graduate Macroeconomics 2 Lecture 1 - Introduction to Real Business Cycles Zsófia L. Bárány Sciences Po 2014 January About the course I. 2-hour lecture every week, Tuesdays from 10:15-12:15 2 big topics

More information

WORKING PAPER SERIES 09-2013. Government Debt, the Real Interest Rate and External Balance in an Endogenous Growth Model of a Small Open Economy

WORKING PAPER SERIES 09-2013. Government Debt, the Real Interest Rate and External Balance in an Endogenous Growth Model of a Small Open Economy ATHENS UNIVERSITY OF ECONOMICS AND BUSINESS DEPARTMENT OF ECONOMICS WORKING PAPER SERIES 09-2013 Government Debt, the Real Interest Rate and External Balance in an Endogenous Growth Model of a Small Open

More information

11.2 Monetary Policy and the Term Structure of Interest Rates

11.2 Monetary Policy and the Term Structure of Interest Rates 518 Chapter 11 INFLATION AND MONETARY POLICY Thus, the monetary policy that is consistent with a permanent drop in inflation is a sudden upward jump in the money supply, followed by low growth. And, in

More information

Intermediate Macroeconomics: The Real Business Cycle Model

Intermediate Macroeconomics: The Real Business Cycle Model Intermediate Macroeconomics: The Real Business Cycle Model Eric Sims University of Notre Dame Fall 2012 1 Introduction Having developed an operational model of the economy, we want to ask ourselves the

More information

Suggested Answers for Mankiw Questions for Review & Problems

Suggested Answers for Mankiw Questions for Review & Problems Suggested Answers for Mankiw & Problems The answers here will not have graphs, I encourage to refer to the text for graphs. There is a some math, however I don t expect you to replicate these in your exam,

More information

crowding out Crowding out at full employment

crowding out Crowding out at full employment C000452 Crowding out refers to all the things which can go wrong when debtfinanced fiscal policy is used to affect output. While the initial focus was on the slope of the LM curve, now refers to a multiplicity

More information

Self-fulfilling debt crises: Can monetary policy really help? By P. Bacchetta, E. Van Wincoop and E. Perazzi

Self-fulfilling debt crises: Can monetary policy really help? By P. Bacchetta, E. Van Wincoop and E. Perazzi Self-fulfilling debt crises: Can monetary policy really help? By P. Bacchetta, E. Van Wincoop and E. Perazzi Discussion by Luca Dedola (ECB) Nonlinearities in Macroeconomics and Finance in Light of the

More information

Can we rely upon fiscal policy estimates in countries with a tax evasion of 15% of GDP?

Can we rely upon fiscal policy estimates in countries with a tax evasion of 15% of GDP? Can we rely upon fiscal policy estimates in countries with a tax evasion of 15% of GDP? Raffaella Basile, Ministry of Economy and Finance, Dept. of Treasury Bruno Chiarini, University of Naples Parthenope,

More information

The relationship between exchange rates, interest rates. In this lecture we will learn how exchange rates accommodate equilibrium in

The relationship between exchange rates, interest rates. In this lecture we will learn how exchange rates accommodate equilibrium in The relationship between exchange rates, interest rates In this lecture we will learn how exchange rates accommodate equilibrium in financial markets. For this purpose we examine the relationship between

More information

Optimal Debt Management in a Liquidity Trap

Optimal Debt Management in a Liquidity Trap Optimal Debt Management in a Liquidity Trap H. Bouakez, R. Oikonomou and R. Priftis Discussion Paper 26-5 Optimal Debt Management in a Liquidity Trap Hafedh Bouakez Rigas Oikonomou Romanos Priftis January

More information

2. Real Business Cycle Theory (June 25, 2013)

2. Real Business Cycle Theory (June 25, 2013) Prof. Dr. Thomas Steger Advanced Macroeconomics II Lecture SS 13 2. Real Business Cycle Theory (June 25, 2013) Introduction Simplistic RBC Model Simple stochastic growth model Baseline RBC model Introduction

More information

Real Business Cycles. Federal Reserve Bank of Minneapolis Research Department Staff Report 370. February 2006. Ellen R. McGrattan

Real Business Cycles. Federal Reserve Bank of Minneapolis Research Department Staff Report 370. February 2006. Ellen R. McGrattan Federal Reserve Bank of Minneapolis Research Department Staff Report 370 February 2006 Real Business Cycles Ellen R. McGrattan Federal Reserve Bank of Minneapolis and University of Minnesota Abstract:

More information

Monetary Theory of Inflation and the LBD in Transactions Technology.

Monetary Theory of Inflation and the LBD in Transactions Technology. Monetary Theory of Inflation and the LBD in Transactions Technology. Constantin T. Gurdgiev Department of Economics, Trinity College, Dublin. The Open Republic Institute, Dublin. gurdgic@tcd.ie Draft 1/2003.

More information

New Keynesian Dynamics in a Low Interest Rate Environment.

New Keynesian Dynamics in a Low Interest Rate Environment. New Keynesian Dynamics in a Low Interest Rate Environment. R. Anton Braun University of Tokyo Lena Mareen Körber German Institute for Economic Research July 14, 2010 Abstract Recent research has found

More information

Principles and Trade-Offs when Making Issuance Choices in the UK

Principles and Trade-Offs when Making Issuance Choices in the UK Please cite this paper as: OECD (2011), Principles and Trade-Offs when Making Issuance Choices in the UK, OECD Working Papers on Sovereign Borrowing and Public Debt Management, No. 2, OECD Publishing.

More information

Prep. Course Macroeconomics

Prep. Course Macroeconomics Prep. Course Macroeconomics Intertemporal consumption and saving decision; Ramsey model Tom-Reiel Heggedal tom-reiel.heggedal@bi.no BI 2014 Heggedal (BI) Savings & Ramsey 2014 1 / 30 Overview this lecture

More information

CHAPTER 11. AN OVEVIEW OF THE BANK OF ENGLAND QUARTERLY MODEL OF THE (BEQM)

CHAPTER 11. AN OVEVIEW OF THE BANK OF ENGLAND QUARTERLY MODEL OF THE (BEQM) 1 CHAPTER 11. AN OVEVIEW OF THE BANK OF ENGLAND QUARTERLY MODEL OF THE (BEQM) This model is the main tool in the suite of models employed by the staff and the Monetary Policy Committee (MPC) in the construction

More information

Optimal Chinese Monetary Policy Under Low Global Interest Rates

Optimal Chinese Monetary Policy Under Low Global Interest Rates 1 / 33 Optimal Chinese Monetary Policy Under Low Global Interest Rates Chun Chang 1,Zheng Liu 2, and Mark M. Spiegel 2 1 Shanghai Advanced Institute of Finance 2 Federal Reserve Bank of San Francisco March

More information

i = nominal interest rate earned by alternative nonmonetary assets

i = nominal interest rate earned by alternative nonmonetary assets Chapter 7 Addendum Demand for Money: the quantity of monetary assets people choose to hold. In our treatment of money as an asset we need to briefly discuss three aspects of any asset 1. Expected Return:

More information

10. When monetary policy becomes ineffective: liquidity traps.

10. When monetary policy becomes ineffective: liquidity traps. 10. When monetary policy becomes ineffective: liquidity traps. A liquidity trap is a situation in which monetary policy becomes ineffective because the policymaker s attempt to influence nominal interest

More information

Predicting the US Real GDP Growth Using Yield Spread of Corporate Bonds

Predicting the US Real GDP Growth Using Yield Spread of Corporate Bonds International Department Working Paper Series 00-E-3 Predicting the US Real GDP Growth Using Yield Spread of Corporate Bonds Yoshihito SAITO yoshihito.saitou@boj.or.jp Yoko TAKEDA youko.takeda@boj.or.jp

More information

Investments Analysis

Investments Analysis Investments Analysis Last 2 Lectures: Fixed Income Securities Bond Prices and Yields Term Structure of Interest Rates This Lecture (#7): Fixed Income Securities Term Structure of Interest Rates Interest

More information

= C + I + G + NX ECON 302. Lecture 4: Aggregate Expenditures/Keynesian Model: Equilibrium in the Goods Market/Loanable Funds Market

= C + I + G + NX ECON 302. Lecture 4: Aggregate Expenditures/Keynesian Model: Equilibrium in the Goods Market/Loanable Funds Market Intermediate Macroeconomics Lecture 4: Introduction to the Goods Market Review of the Aggregate Expenditures model and the Keynesian Cross ECON 302 Professor Yamin Ahmad Components of Aggregate Demand

More information

Internet Appendix for Money Creation and the Shadow Banking System [Not for publication]

Internet Appendix for Money Creation and the Shadow Banking System [Not for publication] Internet Appendix for Money Creation and the Shadow Banking System [Not for publication] 1 Internet Appendix: Derivation of Gross Returns Suppose households maximize E β t U (C t ) where C t = c t + θv

More information

12.1 Introduction. 12.2 The MP Curve: Monetary Policy and the Interest Rates 1/24/2013. Monetary Policy and the Phillips Curve

12.1 Introduction. 12.2 The MP Curve: Monetary Policy and the Interest Rates 1/24/2013. Monetary Policy and the Phillips Curve Chapter 12 Monetary Policy and the Phillips Curve By Charles I. Jones Media Slides Created By Dave Brown Penn State University The short-run model summary: Through the MP curve the nominal interest rate

More information

Ch.6 Aggregate Supply, Wages, Prices, and Unemployment

Ch.6 Aggregate Supply, Wages, Prices, and Unemployment 1 Econ 302 Intermediate Macroeconomics Chul-Woo Kwon Ch.6 Aggregate Supply, Wages, rices, and Unemployment I. Introduction A. The dynamic changes of and the price adjustment B. Link between the price change

More information

Fourth Edition. University of California, Berkeley

Fourth Edition. University of California, Berkeley Fourth Edition University of California, Berkeley Introduction Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Epilogue References

More information

Discussion of. Public Debt and Changing Inflation Targets. Guido Ascari, University of Pavia

Discussion of. Public Debt and Changing Inflation Targets. Guido Ascari, University of Pavia Discussion of Public Debt and Changing Inflation Targets by M. Krause and S. Moyen Guido Ascari, University of Pavia Bundesbank and Banque de France Conference Fiscal and Monetary Policy Challenges in

More information

Chapter 1. Vector autoregressions. 1.1 VARs and the identi cation problem

Chapter 1. Vector autoregressions. 1.1 VARs and the identi cation problem Chapter Vector autoregressions We begin by taking a look at the data of macroeconomics. A way to summarize the dynamics of macroeconomic data is to make use of vector autoregressions. VAR models have become

More information

Sharing Online Advertising Revenue with Consumers

Sharing Online Advertising Revenue with Consumers Sharing Online Advertising Revenue with Consumers Yiling Chen 2,, Arpita Ghosh 1, Preston McAfee 1, and David Pennock 1 1 Yahoo! Research. Email: arpita, mcafee, pennockd@yahoo-inc.com 2 Harvard University.

More information

In recent years, Federal Reserve (Fed) policymakers have come to rely

In recent years, Federal Reserve (Fed) policymakers have come to rely Long-Term Interest Rates and Inflation: A Fisherian Approach Peter N. Ireland In recent years, Federal Reserve (Fed) policymakers have come to rely on long-term bond yields to measure the public s long-term

More information

Research Division Federal Reserve Bank of St. Louis Working Paper Series

Research Division Federal Reserve Bank of St. Louis Working Paper Series Research Division Federal Reserve Bank of St. Louis Working Paper Series Scarcity of Safe Assets, Inflation, and the Policy Trap David Andolfatto and Stephen Williamson Working Paper 2015-002A http://research.stlouisfed.org/wp/2015/2015-002.pdf

More information

Topic 5: Stochastic Growth and Real Business Cycles

Topic 5: Stochastic Growth and Real Business Cycles Topic 5: Stochastic Growth and Real Business Cycles Yulei Luo SEF of HKU October 1, 2015 Luo, Y. (SEF of HKU) Macro Theory October 1, 2015 1 / 45 Lag Operators The lag operator (L) is de ned as Similar

More information

Sharing Online Advertising Revenue with Consumers

Sharing Online Advertising Revenue with Consumers Sharing Online Advertising Revenue with Consumers Yiling Chen 2,, Arpita Ghosh 1, Preston McAfee 1, and David Pennock 1 1 Yahoo! Research. Email: arpita, mcafee, pennockd@yahoo-inc.com 2 Harvard University.

More information

Econ 303: Intermediate Macroeconomics I Dr. Sauer Sample Questions for Exam #3

Econ 303: Intermediate Macroeconomics I Dr. Sauer Sample Questions for Exam #3 Econ 303: Intermediate Macroeconomics I Dr. Sauer Sample Questions for Exam #3 1. When firms experience unplanned inventory accumulation, they typically: A) build new plants. B) lay off workers and reduce

More information

Safe Asset Scarcity and Aggregate Demand

Safe Asset Scarcity and Aggregate Demand Safe Asset Scarcity and Aggregate Demand Ricardo J. Caballero MIT Emmanuel Farhi Harvard University Pierre-Olivier Gourinchas University of California at Berkeley January 26, 2016 This paper was presented

More information

SUSTAINABLE PLANS AND DEBT

SUSTAINABLE PLANS AND DEBT 1 Federal Reserve Bank of Minneapolis Research Department (JV SR125) ONE GRAPH SUSTAINABLE PLANS AND DEBT V. V. Chari Patrick J. Kehoe* Federal Reserve Bank of Minneapolis Federal Reserve Bank of Minneapolis

More information

Dynamics of Small Open Economies

Dynamics of Small Open Economies Dynamics of Small Open Economies Lecture 2, ECON 4330 Tord Krogh January 22, 2013 Tord Krogh () ECON 4330 January 22, 2013 1 / 68 Last lecture The models we have looked at so far are characterized by:

More information

Agenda. The IS LM Model, Part 2. The Demand for Money. The Demand for Money. The Demand for Money. Asset Market Equilibrium.

Agenda. The IS LM Model, Part 2. The Demand for Money. The Demand for Money. The Demand for Money. Asset Market Equilibrium. Agenda The IS LM Model, Part 2 Asset Market Equilibrium The LM Curve 13-1 13-2 The demand for money is the quantity of money people want to hold in their portfolios. The demand for money depends on expected

More information

Asymmetry and the Cost of Capital

Asymmetry and the Cost of Capital Asymmetry and the Cost of Capital Javier García Sánchez, IAE Business School Lorenzo Preve, IAE Business School Virginia Sarria Allende, IAE Business School Abstract The expected cost of capital is a crucial

More information

This paper is not to be removed from the Examination Halls

This paper is not to be removed from the Examination Halls This paper is not to be removed from the Examination Halls UNIVERSITY OF LONDON EC2065 ZA BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the Social Sciences, the Diplomas

More information

Do High Interest Rates Stem Capital Outflows? Michael R. Pakko

Do High Interest Rates Stem Capital Outflows? Michael R. Pakko WORKING PAPER SERIES Do High Interest Rates Stem Capital Outflows? Michael R. Pakko Working Paper 1999-002A http://research.stlouisfed.org/wp/1999/1999-002.pdf PUBLISHED: Economic Letters, April 2000,

More information

An Approach to Stress Testing the Canadian Mortgage Portfolio

An Approach to Stress Testing the Canadian Mortgage Portfolio Financial System Review December 2007 An Approach to Stress Testing the Canadian Mortgage Portfolio Moez Souissi I n Canada, residential mortgage loans account for close to 47 per cent of the total loan

More information

Discussion of Capital Injection, Monetary Policy, and Financial Accelerators

Discussion of Capital Injection, Monetary Policy, and Financial Accelerators Discussion of Capital Injection, Monetary Policy, and Financial Accelerators Karl Walentin Sveriges Riksbank 1. Background This paper is part of the large literature that takes as its starting point the

More information

MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.

MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. Suvey of Macroeconomics, MBA 641 Fall 2006, Final Exam Name MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 1) Modern macroeconomics emerged from

More information

Monetary Theory and Policy

Monetary Theory and Policy Monetary Theory and Policy Third Edition Carl E. Walsh The MIT Press Cambridge Massachusetts 6 2010 Massachusetts Institute of Technology All rights reserved. No part of this book may be reproduced in

More information

The Term Structure of Interest Rates and the Monetary Transmission Mechanism

The Term Structure of Interest Rates and the Monetary Transmission Mechanism The Term Structure of Interest Rates and the Monetary Transmission Mechanism Massimiliano Marzo Ulf Söderström Paolo Zagaglia November 6, 7 Preliminary and Incomplete Please do not circulate without the

More information

Economic Systems. 1. MARKET ECONOMY in comparison to 2. PLANNED ECONOMY

Economic Systems. 1. MARKET ECONOMY in comparison to 2. PLANNED ECONOMY Economic Systems The way a country s resources are owned and the way that country takes decisions as to what to produce, how much to produce and how to distribute what has been produced determine the type

More information

2.If actual investment is greater than planned investment, inventories increase more than planned. TRUE.

2.If actual investment is greater than planned investment, inventories increase more than planned. TRUE. Macro final exam study guide True/False questions - Solutions Case, Fair, Oster Chapter 8 Aggregate Expenditure and Equilibrium Output 1.Firms react to unplanned inventory investment by reducing output.

More information

ANNEX 1 - MACROECONOMIC IMPLICATIONS FOR ITALY OF ACHIEVING COMPLIANCE WITH THE DEBT RULE UNDER TWO DIFFERENT SCENARIOS

ANNEX 1 - MACROECONOMIC IMPLICATIONS FOR ITALY OF ACHIEVING COMPLIANCE WITH THE DEBT RULE UNDER TWO DIFFERENT SCENARIOS ANNEX 1 - MACROECONOMIC IMPLICATIONS FOR ITALY OF ACHIEVING COMPLIANCE WITH THE DEBT RULE UNDER TWO DIFFERENT SCENARIOS The aim of this note is first to illustrate the impact of a fiscal adjustment aimed

More information

Optimal Money and Debt Management: liquidity provision vs tax smoothing

Optimal Money and Debt Management: liquidity provision vs tax smoothing 1 2 Optimal Money and Debt Management: liquidity provision vs tax smoothing 3 Matthew Canzoneri Robert Cumby Behzad Diba 4 5 First Draft: April 10, 2013 This Draft: 11/13/14 6 7 8 9 10 11 12 13 14 Abstract

More information

Practice Problems on the Capital Market

Practice Problems on the Capital Market Practice Problems on the Capital Market 1- Define marginal product of capital (i.e., MPK). How can the MPK be shown graphically? The marginal product of capital (MPK) is the output produced per unit of

More information

3 The Standard Real Business Cycle (RBC) Model. Optimal growth model + Labor decisions

3 The Standard Real Business Cycle (RBC) Model. Optimal growth model + Labor decisions Franck Portier TSE Macro II 29-21 Chapter 3 Real Business Cycles 36 3 The Standard Real Business Cycle (RBC) Model Perfectly competitive economy Optimal growth model + Labor decisions 2 types of agents

More information