Research

This paper investigates the optimal fiscal and monetary policies in a New-Keynesian model with preferences over safe assets (POSA). Relative  to a model with standard preferences,   the Ramsey planner facing POSA uses inflation more actively to absorb   fiscal and demand shocks despite inflation being costly. The optimal response of inflation to the shocks  departs from the traditional prescription observed in standard New-keynesian models with sticky prices in which inflation volatility is near zero.    Moreover,  under POSA  taxes are not as smooth, as they are under standard preferences, and are more frontloaded, an outcome that brings the model closer to  optimal policy with flexible prices. With POSA, debt issuance depresses the liquidity premium, reducing revenues collected by the government and tightening the budget constraint. Therefore the planner is much less willing to issue debt in response to (say) a fiscal shock, which explains the excess tax volatility observed. These results do not dramatically change when private capital (a non-liquid asset), is introduced to the economy,  the planner stills finds optimal to use inflation to absorb the shocks. Moreover, in spite of the fact that optimal debt issuance is  now lower,   private investment is   crowded out more under POSA due to the  stronger reaction of distortionary taxes to shocks. Finally, the planner faced with POSA outperforms the   New-Keynesian planner  (with standard preferences) in terms of stabilizing the economy to a negative demand disturbance,  but underperforms in terms of  the  government spending shock. The negative demand shock increases the demand for government debt and  relaxes the tradeoff facing the  planner. The opposite holds in the case of a spending shock. 

It is well known that in standard DSGE models where fiscal policy follows ad hoc rules, switching from an active to a passive monetary regime, brings about a considerable increase in macroeconomic volatility, mainly due to inflation fluctuations reflect debt sustainability. We ask whether optimal fiscal policy would choose to set fiscal variables irresponsibly when debt is subject to fiscal inflation in the passive money case. We do so by studying optimal fiscal policy in a standard New-Keynesian model in which the optimizing government can issue nominal non-contingent debt and is subject to an independent monetary policy setting the nominal interest rate according to an inflation targeting rule.  The fiscal  authority  can stabilize the economy  having several  tools at its disposal, including   government consumption, public investment and distortionary taxes.  We focus on the case where the monetary authority sets the nominal interest rate to respond weakly to inflation, the so called passive money regime. We compare the outcome of optimal fiscal policy in that case with the polar opposite, when the monetary authority aggressively responds to inflation. We find that the differences in the optimal policy allocation under active/passive monetary policies  are small when the fundamental disturbances that hit the economy are standard demand shocks. We show that this result holds both under full commitment and  in the case where a time-consistent policy maker cannot   commit to the future path of its fiscal variables.  In both cases changing the monetary regime from active to passive only has a small effect on equilibrium outcomes.

Should public investment increase when the economy is hit by an inflationary shock? We argue that the recent fiscal plans implemented during the inflation episode of 2021–2024, such as the Bipartisan Infrastructure Law, can be the prescription of a no-committed planner dealing with a shock raising marginal costs. The planner’s inability to credibly commit to future policies, combined with the supply-side nature of public investment, creates incentives to expand public capital as a way to boost overall supply and reduce the output gap arising from an exogenous increase in mark-ups. Under no commitment, the planner is unable to credibly promise future raises in public spending once the shock has passed, thus it expand public capital to increase marginal productivity of private inputs. These policies mitigates the decline in output, albeit at the cost of higher inflation—almost twice as high as under commitment—and a higher real interest rate. Indeed, under a Taylor rule, the higher real interest rate observed under time-consistency contributes to a severe decline in private consumption relative to the commitment case.  We show the result does not change when the Taylor rule targets also output, when there is an implementation delay in public investment of 6 quarters (nearly one year and a half) as in Ramey and when monetary policy is optimal. Interestingly, from the perspective of a no-committed planner, these so-called “inflationary” fiscal packages approved during the peak of the inflation episode, may emerge as an optimal policy prescription.

This paper analyzes the normative implications  of a model with uninsurable idiosyncratic risk, domestic and external sovereign debt and default. More precisely, it investigates the constrained efficient   allocation,     according to which the planner is constrained by market structure, but is  able to correct for potential externalities arising from   decentralized equilibrium household choices. We show analytically that the market outcome in this model is in general constrained inefficient. When households do not consider the effects that own savings choices have on  aggregates,  externalities emerge affecting  the bond price and  the default propensity. A quantitative   two-period model  shows that domestic debt is lower in the competitive equilibrium than in the social optimum when  income risk is low and debt is risky. When income risk increases, domestic debt also increases due to a precautionary savings motive, but remains lower in the competitive equilibrium than in the constrained planner.  Moreover, for lower levels of wealth inequality, aggregate debt is lower in the competitive equilibrium mainly due to lower levels of domestic debt. The gap between the efficient equilibrium and the market economy, however, shrinks with wealth inequality and total debt becomes higher in the competitive equilibrium for higher levels of wealth inequality. As a consequence of the externalities, the relatively lower levels of domestic debt observed in the competitive equilibrium makes the government to exercise the default option more frequently than what would be socially desirable.