Paper # Author Title
Quantitative analysis of a New Keynesian model with the Bernanke-Gertler accelerator and risk shocks shows that violations of Tinbergen’s Rule and strategic interaction between policy-making authorities undermine significantly the effectiveness of monetary and financial policies. Separate monetary and financial policy rules, with the latter subsidizing lenders to encourage lending when credit spreads rise, produce higher welfare and smoother business cycles than a monetary rule augmented with credit spreads. The latter yields a tight money-tight credit regime in which the interest rate responds too much to inflation and not enough to adverse credit conditions. Reaction curves for the choice of policy-rule elasticity that minimizes each authority’s loss function given the other authority’s elasticity are nonlinear, reflecting shifts from strategic substitutes to complements in setting policy-rule parameters. The Nash equilibrium is significantly inferior to the Cooperative equilibrium, both are inferior to a first-best outcome that maximizes welfare, and both produce tight money-tight credit regimes. Download Paper
Macroprudential policy holds the promise of becoming a powerful tool for preventing financial crises. Financial amplification in response to domestic shocks or global spillovers and pecuniary externalities caused by Fisherian collateral constraints provide a sound theoretical foundation for this policy. Quantitative studies show that models with these constraints replicate key stylized facts of financial crises, and that the optimal financial policy of an ideal constrained-efficient social planner reduces sharply the magnitude and frequency of crises. Research also shows, however, that implementing effective macroprudential policy still faces serious hurdles. This paper highlights three of them: (i) complexity, because the optimal policy responds widely and non-linearly to movements in both domestic factors and global spillovers due to regime shifts in global liquidity, news about global fundamentals, and recurrent innovation and regulatory changes in world markets, (ii) lack of credibility, because of time-inconsistency of the optimal policy under commitment, and (iii) coordination failure, because a careful balance with monetary policy is needed to avoid quantitatively large inefficiencies resulting from violations of Tinbergen’s rule or strategic interaction between monetary and financial authorities. Download Paper
Infrequent but turbulent episodes of outright sovereign default on domestic creditors are considered a “forgotten history” in Macroeconomics. We propose a heterogeneous-agents model in which optimal debt and default on domestic and foreign creditors are driven by distributional incentives and endogenous default costs due to value of debt for self-insurance, liquidity and risk-sharing. The government’s aim to redistribute resources across agents and through time in response to uninsurable shocks produces a rich dynamic feedback mechanism linking debt issuance, the distribution of government bond holdings, the default decision, and risk premia. Calibrated to Spanish data, the model is consistent with key cyclical co-movements and features of debt-crisis dynamics. Debt exhibits protracted fluctuations. Defaults have a low frequency of 0.93 percent, are preceded by surging debt and spreads, and occur with relatively low external debt. Default risk limits the sustainable debt and yet spreads are zero most of the time. Download Paper
We study optimal macroprudential policy in a model in which unconventional shocks, in the form of news about future fundamentals and regime changes in world interest rates, interact with collateral constraints in driving the dynamics of financial crises. These shocks strengthen incentives to borrow in good times (i.e. when \good news" about future fundamentals coincide with a low-world-interest-rate regime), thereby increasing vulnerability to crises and enlarging the pecuniary externality due to the collateral constraints. Quantitatively, an optimal schedule of macroprudential debt taxes can lower the frequency and magnitude of financial crises, but the policy is complex because it features significant variation across interest-rate regimes and news realizations. Download Paper
The question of what is a sustainable public debt is paramount in the macroeconomic analysis of fiscal policy. This question is usually formulated as asking whether the outstanding public debt and its projected path are consistent with those of the government's revenues and expenditures (i.e. whether fiscal solvency conditions hold). We identify critical flaws in the traditional approach to evaluate debt sustainability, and examine three alternative approaches that provide useful econometric and model-simulation tools to analyze debt sustainability. The first approach is Bohn's non-structural empirical framework based on a fiscal reaction function that characterizes the dynamics of sustainable debt and primary balances. The second is a structural approach based on a calibrated dynamic general equilibrium framework with a fully specified fiscal sector, which we use to quantify the positive and normative effects of fiscal policies aimed at restoring fiscal solvency in response to changes in debt. The third approach deviates from the others in assuming that governments cannot commit to repay their domestic debt, and can thus optimally decide to default even if debt is sustainable in terms of fiscal solvency. We use these three approaches to analyze debt sustainability in the United States and Europe after the recent surge in public debt following the 2008 crisis, and find that all three raise serious questions about the prospects of fiscal adjustment and its consequences in advanced economies. Download Paper
Collateral constraints widely used in models of financial crises feature a pecuniary externality: Agents do not internalize how borrowing decisions taken in “good times" affect collateral prices during a crisis. We show that agents in a competitive equilibrium borrow more than a financial regulator who internalizes this externality. We also find, however, that under commitment the regulator's plans are time-inconsistent, and hence focus on studying optimal, time-consistent policy without commitment. This policy features a state-contingent macroprudential debt tax that is strictly positive at date t if a crisis has positive probability at t + 1. Quantitatively, this policy reduces sharply the frequency and magnitude of crises, removes fat tails from the distribution of returns, and increases social welfare. In contrast, constant debt taxes are ineffective and can be welfare-reducing, while an optimized macroprudential Taylor rule" is effective but less so than the optimal policy. Download Paper
Europe’s debt crisis resembles historical episodes of outright default on domestic public debt about which little research exists. This paper proposes a theory of domestic sovereign default based on distributional incentives affecting the welfare of risk-averse debt and non debtholders. A utilitarian government cannot sustain debt if default is costless. If default is costly, debt with default risk is sustainable, and debt falls as the concentration of debt ownership rises. A government favoring bond holders can also sustain debt, with debt rising as ownership becomes more concentrated. These results are robust to adding foreign investors, redistributive taxes, or a second asset. Download Paper