Working Papers

Optimal (Un)Conventional Monetary Policy

We study the optimal joint interest rate and central bank balance sheet policies in a macro model with financial sector, sticky prices, aggregate and idiosyncratic risk. The optimal policy mix ensures an efficient path of aggregate consumption, as well as its efficient distribution across agents. With a fixed balance sheet composition, interest rate policy alone can close the output gap and implement the efficient path of aggregate consumption. It can also ensure its (near) efficient distribution, but only in a small vicinity around the stochastic steady state. Distributional efficiency away from the steady state requires active balance sheet management. The role of balance sheet policy is preparatory – it ensures that the effects of future shocks are distributed efficiently across agents, given the intended interest rate responses to those shocks.  

The Misallocation Costs of Inflation: A Sufficient Statistics Approach

The misallocation costs associated with different aggregate inflation rates can be estimated from micro price data via a set of sufficient statistics. We show that this works for a broad class of price-setting models and in the presence of unobserved product-level heterogeneity in pricing frictions and flexible prices. Applying the sufficient statistics approach to the micro price data underlying the U.K. consumer price index, we find large misallocation costs: aggregate productivity falls by about 1% if aggregate inflation is 8 percentage points above or below its optimal rate of 1.8%. Our findings provide important lessons for the calibration of sticky-price models: standard calibration targets can be uninformative about the sufficient statistics characterizing misallocation costs. To correctly capture these costs, models should be directly calibrated to the sufficient statistics that we uncover.  

The Effects of Trend Inflation on Aggregate Dynamics and Monetary Stabilization

I derive a set of new analytic results for the effects of trend inflation on aggregate price and output dynamics in menu cost models. I find that positive trend inflation: (1) induces asymmetry in price and output responses to monetary shocks, (2) leads to price overshooting after large shocks, and (3) overturns the monetary neutrality result for large shocks. Under positive trend inflation, large expansionary monetary interventions lead to output contractions, and smaller expansionary interventions have substantially lower potency. I show that these model predictions are empirically supported by U.S. sectoral data. Calibrating a general equilibrium model to the U.S. economy, I find sizable effects of trend inflation on the effectiveness of monetary stabilization policy. A rise in trend inflation from 2% to 4% increases the economy's sensitivity to an adverse markup shock and worsens the trade-off between price and output stability.  

Understanding Leverage Determinants

The Great Recession induced violent fluctuations in leverage on secured loans and led to adaption of new asset purchase policies by the central banks. To understand the drivers of leverage and the effects of these policies, I set up a general equilibrium model with an endogenous leverage constraint, stemming from agents’ disagreement about the asset value. The model features default in equilibrium and a continuum of borrowing contracts written against the same asset used as collateral. Each contract is traded by a single borrower-lender pair and offers a unique combination of leverage and promised interest. Numerical simulations show that leverage, unlike the price of the asset, is not sensitive to changes in the average optimism of traders but is very sensitive to changes in uncertainty. An asset purchase program that absorbs the risky asset has a positive effect on the asset price but also leads to higher leverage and default risk by distorting the equilibrium sorting of agents into borrowers and lenders.