Innovations to total factor productivity are thought
to be an important determinant of business cycles. We investigate whether
innovations to quarterly HP-filtered Solow residuals are symmetric over time
for eleven OECD countries. Our model modifies classical stochastic frontier
analysis to accommodate the strong serial correlation in macro data. The
results have implications for whether business cycles are symmetric, with the
economy responding in a linear way to normal iid
shocks, or asymmetric with recessions fundamentally different from booms.
Likelihood ratio
tests imply that nine of eleven countries have significant
asymmetries. We also consider structural differences in economies with and
without asymmetries and find that asymmetries tend to be stronger the less oil
production per worker in the economy. Non-linear conditioning of the
HP-filtered Solow residual on the relative price of oil removes or reduces
asymmetries for most countries which otherwise exhibit them, implying that much
asymmetry is due to the response of the economy to oil prices.
Exchange Rate Crises and Fiscal Solvency (slides) (Journal of Money, Credit, and Banking September, 2010)
Diverse fiscal policies, which are subject to
fiscal limits and stochastic shocks, can threaten a monetary union. The fiscal
limits arise due to distortionary taxation and political will. Stochastic
shocks are random and could push a fiscally sound policy towards its limit. In
equilibrium agents refuse to lend along a path which violates the fiscal
limits, creating a crisis. The crisis requires a policy response to restore
lending. We focus on two responses, default and policy switching, both of which
must be designed to restore fiscal solvency. Under the assumption that agents
know the policy response, we show that a monetary union can avoid price
instability if it is willing to tolerate member country default. Alternatively,
policy switching creates price instability. We simulate the model to quantify
fiscal risk in the European Monetary Union with fiscal variables at end of 2009
values. Our model predicts the Greek crisis which occurred and warns of an
Italian one.
The Fiscal Theory of the Price Level and Initial Government Debt (April, 2007), Review of Economic Dynamics
It is widely believed that the Fiscal Theory of the Price Level (FTPL) does not work in an environment in which initial government debt is zero. This paper demonstrates that this view is incorrect when asset markets are incomplete and fiscal policy is stochastic. In particular, it is possible to define a stochastic non-Ricardian fiscal policy for which the set of equilibrium stochastic price processes under non-Ricardian fiscal policy is a subset of the set of equilibrium stochastic price processes under Ricardian fiscal policy.
Financial Liberalization and Banking Crises in Emerging Economies
co-authored with John Jones (May, 2007), Journal of International Economics.
Financial liberalization often leads to financial crises. This link has usually been attributed to poorly designed banking systems, an explanation that is largely static. In this paper we develop a dynamic explanation, by modeling the evolution of a newly-liberalized bank's opportunities and incentives to take on risk over time. The model reveals that even if a banking system is well-designed, in the sense of having good long-run properties, many countries will enjoy an initial period of rapid, low-risk growth and then enter a period with an elevated risk of banking crisis. This transition emerges because of the way in which the degree of foreign competition, the marginal product of capital, and the bank's own net worth simultaneously evolve.
Public Default Dynamics (revised –August 2006)
This paper provides a dynamic model of a
public debt crisis in which fiscal insolvency is the cause. The insolvency is
created by a combination of a passive fiscal policy with an upper bound on the
long-run budget surplus, yielding risky government debt, and a string of bad
luck. As debt rises and a crisis approaches, the interest rate rises, due to a
risk premium on debt in anticipation of possible default. A position, in which
the contractual value of debt under passive fiscal policy exceeds the maximum
expected present-value surplus, is infeasible. Should passive fiscal policy
require such a point, a crisis occurs. Crisis resolution includes a promise of
fiscal reform, with a switch to active fiscal policy as in the Fiscal Theory of
the Price Level (FTPL). The switch creates larger near-term surpluses, which
serve to raise the expected present-value surplus, and greater exchange rate
flexibility, which eliminates the default premium on debt. If the present-value
surplus is still too low relative to debt after the policy switch, default is
necessary.
Monetary Policy in a Fiscal
Theory Regime (June 2004)
This paper considers the behavior of monetary
policy in a regime in which the "Fiscal Theory of the Price Level"
(FTPL) applies and in which the government issues long-term debt. Cochrane
(2001) shows that the fiscal authority can use a commitment to maintain a fixed
maturity structure of government debt to fully determine the impact and dynamic
effects of present-value-surplus shocks on inflation in a cashless economy. We
show that in a monetary economy, in which Cochrane’s fiscal commitment to
maturity structure is replaced with a monetary commitment to a state-contingent
interest rate rule, the monetary authority becomes responsible for the timing
of inflation. We derive interest rate rules, which minimize the variance of
inflation around a target, and show that the interest rate will respond
positively to shocks raising inflation and to shocks raising output above
trend, as with a Taylor Rule.