Monetary Economics Program Meeting

Markus K. Brunnermeier, Princeton University and NBER, and Yuliy Sannikov, Princeton University

The I Theory of Money

Brunnermeier and Sannikov provide a theory of money where value depends on the functioning of the intermediary sector, along with a unified framework for analyzing the interaction between price and financial stability. Households that happen to be productive in this period finance their capital purchases with credit from intermediaries and from their own savings. Less productive household save by holding deposits with intermediaries (inside money) or holding outside money. Intermediation involves risk-taking, and intermediaries' ability to lend is compromised when they suffer losses. After an adverse productivity shock, credit and inside money shrink, and the value of (outside) money increases, causing deflation that hurts borrowers even further. An accommodating monetary policy in downturns can mitigate these destabilizing adverse feedback effects. Lowering short-term interest rates increases the value of long-term bonds, recapitalizes the intermediaries by redistributes wealth. While this policy helps the economy ex-post, it can lead to excessive risk-taking by the intermediary sector ex-ante.

Jesus Fernandez-Villaverde, University of Pennsylvania and NBER; Pablo A. Guerrón-Quintana, North Carolina State University; Keith Kuester, Federal Reserve Bank of Philadelphia; and Juan Rubio-Ramírez, Duke University

Fiscal Volatility Shocks and Economic Activity

Fernandez-Villaverde, Guerrón-Quintana, Kuester, and Rubio-Ramírez study the effects of changes in uncertainty about future fiscal policy on aggregate economic activity. In light of large fiscal deficits and high public debt levels in the United States, a fiscal consolidation seems inevitable. However, there is notable uncertainty about the policy mix and timing of such a budgetary adjustment. To evaluate the consequences of the increased uncertainty, the authors first estimate tax and spending processes for the United States that allow for time varying volatility. They then feed these processes into an otherwise standard New Keynesian business cycle model calibrated to the U.S. economy. They find that fiscal volatility shocks can have a sizable adverse effect on economic activity.

Emmanuel Farhi and Gita Gopinath, Harvard University and NBER, and Oleg Itskhoki, Princeton University and NBER

Fiscal Devaluations

Farhi, Gopinath, and Itskhoki show that even when the exchange rate cannot be devalued, a small set of conventional fiscal instruments can robustly replicate the real allocations attained under a nominal exchange rate devaluation in a standard New Keynesian open economy environment. The authors perform their analysis: under alternative pricing assumptions, such as producer or local currency pricing, along with nominal wage stickiness; under alternative asset market structures; and for anticipated and unanticipated devaluations. Two types of fiscal policies are equivalent to an exchange rate devaluation: a uniform increase in import tariffs and export subsidy, and a value-added tax increase with a uniform payroll tax reduction. When the devaluations are anticipated, these policies need to be supplemented by a consumption tax reduction and an income tax increase. These policies have no impact on fiscal revenues. In certain cases, equivalence also requires a partial default on foreign bond holders. The authors discuss the issues of implementation of these policies, particularly under the circumstances of a currency union.

Eric T. Swanson and John Williams, Federal Reserve Bank of San Francisco

Measuring the Effect of the Zero Lower Bound on Medium- and Longer-Term Interest Rates

The zero lower bound on nominal interest rates has constrained the Federal Reserve's setting of the overnight federal funds rate for more that three years now. According to many macroeconomic models, such an extended period of being stuck at the zero bound has important implications for the effectiveness of monetary and fiscal policies. However, economic theory also implies that households' and firms' decisions depend on the entire path of expected future short-term interest rates, not just the current level of the overnight rate. Thus, interest rates with a year or more to maturity are arguably the most relevant for the private sector, and it is unclear to what extent the zero lower bound has affected those rates. Swanson and Williams propose a novel approach for measuring when and to what extent the zero lower bound affects interest rates of any maturity. They compare the sensitivity of interest rates of various maturities to macroeconomic news in periods when short-term interest rates are very low to that during normal times. They find that yields on Treasury securities with six months or less to maturity have been strongly affected by the zero bound during most or all of the period when the federal funds rate was near zero. In stark contrast to this finding, yields with more than two years to maturity have responded to economic news during the past three years in their usual way. One- and two-year Treasury yields represent an intermediate case, being partially constrained by the zero bound over part of the period when the funds rate was near zero. They provide two explanations for these results. First, market participants have consistently expected the zero bound to constrain policy for only about a year into the future, minimizing its effect on longer-term yields. Second, the Federal Reserve's unconventional policy actions may be offsetting the effects of the zero bound on longer-term yields.

Fernando E. Alvarez, University of Chicago and NBER, and Francesco Lippi, University of Sassari

Price Setting with Menu Cost for Multi-product Firms

Alvarez and Lippi model the pricing decisions of a multi-product firm that faces a fixed "menu" cost: once the cost is paid, the firm can adjust the price of all its products. The authors analytically characterize the steady state firm's decision in terms of the structural parameters: the variability of the flexible prices, the curvature of the profit function, the size of the menu cost, and the number of products that are sold. They provide expressions for the steady state frequency of adjustment, the hazard rate of price adjustments, and the size distribution of price changes, all in terms of the structural parameters. Then they analyze the impulse response of aggregate prices and output to a monetary shock. They find that the cumulative response of output to a monetary shock is the product of three terms: the steady state standard deviation of price changes, the average time elapsed between price changes, and a function of the number of products and the size of the monetary shock. The size of the cumulative response of output and the length of the half-life of the response of aggregate prices to a monetary shock both increase with the number of products: they more than double as the number of products goes from one to ten, quickly converging to those of Taylor's staggered price model.

Carola Frydman, Boston University and NBER, and Eric Hilt, Wellesley College and NBER

The Panic of 1907: JP Morgan, Trust Companies, and the Impact of the Financial Crisis

The outbreak of the Panic of 1907 occurred following a series of scandalous revelations about the investments of some prominent New York financiers, which triggered widespread runs on trust companies throughout New York City. The connections between the trust companies that came under severe strain during the crisis and their client firms may have transmitted the financial crisis to non-financial companies. Using newly collected data, Frydman and Hilt investigate whether corporations with close ties to trust companies were differentially affected during the panic. Their results indicate that firms connected to trust companies that faced severe runs performed worse in the years following 1907. The data also suggest that many of the rescue efforts organized by J.P. Morgan may have been motivated by self-interest.