Working Papers

The Monetary/Fiscal Policy Mix: Note and Slides
Overview of my research on the Monetary/Fiscal Policy Mix prepared for the G20 Framework Working Group March 2021 meeting.

Fiscal Influences on Inflation in OECD Countries, 2020-2022 with Robert Barro (November 2023)
The fiscal theory of the price level (FTPL) has been active for 30 years, and the interest in this theory grew with the recent global surges in inflation and government spending. This study applies the FTPL to 37 OECD countries for 2020-2022. The theory’s centerpiece is the government’s intertemporal budget constraint, which relates a country’s inflation rate in 2020 2022 (relative to a baseline rate) to a composite government-spending variable. This variable equals the cumulative increase in the ratio of government expenditure to GDP from 2020 to 2022, divided by the ratio of public debt to GDP in 2019 and the duration of the debt in 2019. This specification has substantial explanatory power for recent inflation rates across 20 non-Euro-zone countries and an aggregate of 17 Euro-zone countries. The estimated coefficients of the composite spending variable are significantly positive, implying that 40-50% of effective government financing came from the inverse effect of unexpected inflation on the real value of public debt, whereas 50 60% reflected conventional public finance (increases in current or future taxes or cuts in future spending). Within the Euro area, inflation reacts mostly to the area-wide government-spending variable, not to individual values. 

Monetary-Based Asset Pricing: A Mixed-Frequency Structural Approach with Sydney Ludvigson and Sai Ma (May 2022)
We integrate a high-frequency monetary event study into a mixed-frequency macro-finance model and structural estimation. The model and estimation allow for jumps at Fed announcements in investor beliefs, providing granular detail on why markets react to central bank communications. We find that the reasons involve a mix of revisions in investor beliefs about the economic state and/or future regime change in the conduct of monetary policy, and subjective reassessments of financial market risk. However, the structural estimation also finds that much of the causal impact of monetary policy on markets occurs outside of tight windows around policy announcements. 

What Hundreds of Economic News Events Say About Belief Overreaction in the Stock Market
with Sydney Ludvigson and Sai Ma (February 2024)
We measure the nature and severity of a variety of belief distortions in market reactions to hundreds of economic news events using a new methodology that synthesizes estimation of a structural asset pricing model with algorithmic machine learning to quantify bias. Distortions apply to a system of macroeconomic dynamics, rather than to a univariate process. We estimate that investors overreact to perceptions about multiple fundamental shocks, creating asymmetric compositional effects when several counteracting shocks happen simultaneously. These effects imply that overreaction to each perceived shock individually often generates overall market under reaction to real-world events. 

Who is Afraid of Eurobonds? with Leonardo Melosi and Anna Rogantini-Picco (July 2023)
The current Euro Area policy framework exposes its members to the opposite risks of deflation and high inflation because it does not separate the need for short-run macroeconomic stabilization from the issue of long-run fiscal sustainability. We study a new policy framework that addresses this deficiency. A centralized Treasury issues Eurobonds to finance stabilization policies, while national governments remain responsible for the country-level long-term spending programs. The centralized Treasury can run larger primary deficits during recessions, followed by primary surpluses during expansions. However, following an exceptionally large contractionary shock, the centralized Treasury can coordinate with the monetary authority to reflate the economy and avoid the zero lower bound. The policy acts as an automatic stabilizer and removes the risk of deflation. At the same time, the proposed policy framework removes the risk of high inflation and fiscal stagflation because it does not require suspending the fiscal rules designed to preserve long-run fiscal sustainability.

Inflation and Real Activity over the Business Cycle with Gianni Nicolo' and Dongho Song (March 2024)
We study the relation between inflation and real activity over the business cycle. We employ a Trend-Cycle VAR model to control for low-frequency movements in inflation, unemployment, and growth that are pervasive in the post-WWII period. We show that cyclical fluctuations of inflation are related to cyclical movements in real activity and unemployment, in line with what is implied by the New Keynesian framework. We then discuss the reasons for which our results relying on a Trend-Cycle VAR differ from the findings of previous studies based on VAR analysis. We explain empirically and theoretically how to reconcile these differences.

Monetary and Fiscal Policies in Times of Large Debt: Unity is Strength with Renato Faccini and Leonardo Melosi (July 2022)
The COVID pandemic found policymakers facing constraints on their ability to react to an exceptionally large negative shock. The current low interest rate environment limits the tools the central bank can use to stabilize the economy, while the large public debt curtails the efficacy of fiscal interventions by inducing expectations of costly fiscal adjustments. Against this background, we study the implications of a coordinated fiscal and monetary strategy aiming at creating a controlled rise of inflation to wear away a targeted fraction of debt. Under this coordinated strategy, the fiscal authority introduces an emergency budget with no provisions on how it will be balanced, while the monetary authority tolerates a temporary increase in inflation to accommodate the emergency budget. In our model the coordinated strategy enhances the efficacy of the fiscal stimulus planned in response to the COVID pandemic and allows the Federal Reserve to correct a prolonged period of below-target inflation. The strategy results in only moderate levels of inflation by separating long-run fiscal sustainability from a short-run policy intervention. Vox article

Smooth Diagnostic Expectations with Cosmin Ilut and Hikaru Saijo (February 2024)
We introduce “smooth diagnosticity.” Under smooth diagnosticity, agents over-react to new information defined as the difference between the current information set and a previous information set. Since new information typically changes not just the conditional mean, but also the conditional uncertainty, changes in uncertainty surrounding current and past beliefs affect the severity of the Diagnostic Expectations (DE) distortion. Smooth DE nests the baseline DE of Bordalo et al. (2018) and implies a joint and parsimonious micro-foundation for various properties of survey data: (1) over-reaction of conditional mean to news, (2) stronger over-reaction for weaker signals and longer forecast horizons, and (3) over-confidence in subjective uncertainty. We embed Smooth DE in an analytical RBC model. The model accounts for over-reaction and over-confidence in surveys, as well as three salient properties of the business cycle: (1) asymmetry, (2) countercyclical micro volatility, and (3) countercyclical macro volatility.

Publications