The Fiscal Theory of the Price Level in Overlapping Generations Models

February 6, 2019

By Roger Farmer and Pawel Zabczyk

We demonstrate that the Fiscal Theory of the Price Level (FTPL) cannot be used to determine the price level uniquely in the overlapping generations (OLG) model. We provide two examples of OLG models, one with three 3-period lives and one with 62-period lives. Both examples are calibrated to an income profile chosen to match the life-cycle earnings process in U.S. data estimated by Guvenen et al. (2015). In both examples, there exist multiple steady-state equilibria. Our findings challenge established views about what constitutes a good combination of fiscal and monetary policies. As long as the primary deficit or the primary surplus is not too large, the fiscal authority can conduct policies that are unresponsive to endogenous changes in the level of its outstanding debt. Monetary and fiscal policy can both be active at the same time.

This is intriguing and further opens the discussion about possibly multiple regimes in the economy, which has dramatic implications for the conduct of policy.


What Hides behind the German Labor Market Miracle? Unemployment Insurance Reforms and Labor Market Dynamics

February 2, 2019

By Benjamin Hartung, Philip Jung and Moritz Kuhn

A key question in labor market research is how the unemployment insurance system affects unemployment rates and labor market dynamics. We revisit this old question studying the German Hartz reforms. On average, lower separation rates explain 76% of declining unemployment after the reform, a fact unexplained by existing research focusing on job finding rates. The reduction in separation rates is heterogeneous, with long-term employed, high-wage workers being most affected. We causally link our empirical findings to the reduction in long-term unemployment benefits using a heterogeneous-agent labor market search model. Absent the reform, unemployment rates would be 50% higher today

I am really puzzled by the paper. Usually, when you have an economy with high unemployment rate, the job finding rate and the separation rate are both really low. A labor market reform then typically involves allowing the separation rate to increase, and then the job finding rate increases as well. But here, the separation rate decreased even further, with little consequence for the job finding rate. In other words, the labor market became even less flexible, yet the unemployment rate decreased substantially.

Endogenous forward guidance

February 1, 2019

By Boris Chafwehé, Rigas Oikonomou, Romanos Priftis and Lukas Vogel

We propose a novel framework where forward guidance (FG) is endogenously determined. Our model assumes that a monetary authority solves an optimal policy problem under commitment at the zero-lower bound. FG derives from two sources: 1. from commiting to keep interest rates low at the exit of the liquidity trap, to stabilize inflation today. 2. From debt sustainability concerns, when the planner takes into account the consolidated budget constraint in optimization. Our model is tractable and admits an analytical solution for interest rates in which 1 and 2 show up as separate arguments that enter additively to the standard Taylor rule. In the case where optimal policy reflects debt sustainability concerns (satisfies the consolidated budget) monetary policy becomes subservient to fiscal policy, giving rise to more volatile inflation, output and interest rates. Liquidity trap (LT) episodes are longer, however, the impact of interest rate policy commitments on inflation and output are moderate. ’Keeping interest rates low’ for a long period, does not result in positive inflation rates during the LT, in contrast our model consistently predicts negative inflation at the onset of a LT episode. In contrast, in the absence of debt concerns, LT episodes are shorter, but the impact of commitments to keep interest rates low at the exit from the LT, on inflation and output is substantial. In this case monetary policy accomplishes to turn inflation positive at the onset of the episode, through promising higher inflation rates in future periods. We embed our theory into a DSGE model and estimate it with US data. Our findings suggest that FG during the Great Recession may have partly reflected debt sustainability concerns, but more likely policy reflected a strong commitment to stabilize inflation and the output gap. Our quantitative findings are thus broadly consistent with the view that the evolution of debt aggregates may have had an impact on monetary policy in the Great Recession, but this impact is likely to be small.

I do not think we yet a good theory of forward guidance, even less of forward guidance policy formation. This paper offers an interesting perspective in this respect. It may also offer an answer as to how forward guidance could have contributed to avoiding significant inflation despite the large increase in money supply.