Abstracts of Published Papers


The (Un)Importance of Unemployment Fluctuations for the Welfare Cost of Business Cycles (2011), with Philip Jung,
Journal of Economic Dynamics and Control, 35(10), p. 1744-1768.

This paper studies the cost of business cycles within a real business cycle model with search and matching frictions in the labor market. We endogenously link both the cyclical fluctuations and the mean level of unemployment to the aggregate business cycle risk. The key result of the paper is that business cycles are costly: fluctuations over the cycle induce a higher average unemployment rate since employment is nonlinear in the job-finding rate and the past unemployment rate. We show this analytically for a special case of the model. We then calibrate the model to U.S. data. For the calibrated model, too, business cycles cause higher average unemployment; the welfare cost of business cycles can easily be an order of magnitude larger than Lucas's (1987) estimate. The cost of business cycles is the higher the lower the value of nonemployment is, or, equivalently, the lower is the disutility of work. The ensuing cost of business cycles rises further when workers' skills depreciate during unemployment. Back to main page.


Real Price and Wage Rigidities with Matching Frictions (2010),
Journal of Monetary Economics, 57(4), p. 466-477.

Frictional unemployment means that workers, for some time, are a firm-specific factor of production. This paper models the resulting interaction of wage bargaining and price setting at the firm level in a New Keynesian model with labor market matching frictions. Real rigidities arise and the labor share ceases to be a good proxy for marginal costs. The model replicates the impulse responses of an SVAR for U.S. data better than alternatives in which the real rigidities arising at the firm level are absent. In addition, it implies reasonably low degrees of nominal rigidity whereas the alternatives do not. The interaction of wage and price setting at the firm level is important for the macroeconomic dynamics. Back to main page.


Debt Consolidation and Fiscal Stabilization of Deep Recessions (2010), with Giancarlo Corsetti, André Meier and Gernot Mueller,
American Economic Review, Papers and Proceedings, 100(2), p. 41-45.

The global financial crisis of 2008–09 has sent public debt on sharply higher trajectories. With the economic recovery gradually taking hold, the focus is now shifting to fiscal "exit" strategies. Medium-term consolidation efforts are likely to include not only tax increases but also sizeable spending cuts. Our paper uses a standard new Keynesian model to show that the anticipation of such medium-term spending cuts generally enhances the expansionary effect of short-run fiscal stimulus. This conclusion still applies when monetary policy is constrained by the zero lower bound on policy rates. In this case, however, the reversal of government spending must not occur too early on the recovery path, or at least must be suitably gradual. Back to main page.


Insurance Policies for Monetary Policy in the Euro Area (2010), with Volker Wieland,
Journal of the European Economic Association, 8(4), p. 872-912.

In this paper, we aim to design a monetary policy for the euro area that is robust to the high degree of model uncertainty at the start of monetary union and allows for learning about model probabilities. To this end, we compare and ultimately combine Bayesian and worst-case analysis using four reference models estimated with pre-EMU synthetic data. We start by computing the cost of insurance against model uncertainty, that is, the relative performance of worst-case or minimax policy versus Bayesian policy. While maximum insurance comes at moderate costs, we highlight three shortcomings of this worst-case insurance policy: (i) prior beliefs that would rationalize it from a Bayesian perspective indicate that such insurance is strongly oriented toward the model with highest baseline losses; (ii) the minimax policy is not as tolerant of small perturbations of policy parameters as the Bayesian policy; and (iii) the minimax policy offers no avenue for incorporating posterior model probabilities derived from data available since monetary union. Thus, we propose preferences for robust policy design that reflect a mixture of the Bayesian and minimax approaches. We show how the incoming EMU data may then be used to update model probabilities, and investigate the implications for policy. Back to main page.


The Role of Labor Markets for Euro Area Monetary Policy (2009), with Kai Christoffel and Tobias Linzert,
European Economic Review, 53(8), p. 908-936.

In this paper, we explore the role of labor markets for monetary policy in the euro area in a New Keynesian model in which labor markets are characterized by search and matching frictions. We first investigate to which extent a more flexible labor market would alter the business cycle behavior and the transmission of monetary policy. We find that while a lower degree of wage rigidity makes monetary policy more effective, i.e. a monetary policy shock transmits faster onto inflation, the importance of other labor market rigidities for the transmission of shocks is rather limited. Second, having estimated the model by Bayesian techniques we analyze to which extent labor market shocks, such as disturbances in the vacancy posting process, shocks to the separation rate and variations in bargaining power are important determinants of business cycle fluctuations. Our results point primarily towards disturbances in the bargaining process as a significant contributor to inflation and output fluctuations. In sum, the paper supports current central bank practice which appears to put considerable effort into monitoring euro area wage dynamics and which appears to treat some of the other labor market information as less important for monetary policy. Back to main page.


The Elasticity of the Unemployment Rate with Respect to Benefits (2009), with Kai Christoffel,
Economics Letters, 102(2), p. 102-105.

If the Mortensen and Pissarides model with efficient bargaining is calibrated to replicate the fluctuations of unemployment over the business cycle, it implies a far too strong rise of the un- employment rate when unemployment benefits rise. This paper explores an alternative, right-to- manage bargaining scheme. This also generates the right degree of fluctuations of unemployment but at the same time implies a reasonable elasticity of unemployment with respect to benefits. Back to main page.


Is the New Keynesian Phillips Curve Flat? (2009), with Gernot Mueller and Sarah Stoelting,
Economics Letters, 103(1), p. 39-41.

Microeconomic evidence implies frequent price adjustments while macroeconometric evidence based on GMM estimation points to a flat New Keynesian Phillips curve (NKPC). This paper suggests a resolution: GMM estimates of the NKPC may be biased because of autocorrelated cost-push shocks. We perform Monte Carlo experiments using an empirically plausible New Keynesian model as data-generating process and find that GMM estimates of the NKPC imply average price durations of 12 quarters while the true value is only 2 quarters. Back to main page.


Resuscitating the Wage Channel in Models with Unemployment Fluctuations (2008), with Kai Christoffel,
Journal of Monetary Economics, 55(5), p. 865-887.

Higher wages all else equal translate into higher inflation. More rigid wages imply a weaker response of inflation to shocks. This view of the wage channel is deeply entrenched in central banks' views and models of their economies. In this paper, we present a model with equilibrium unemployment which has three distinctive properties. First, using a search and matching model with right-to-manage wage bargaining a proper wage channel obtains. Second, accounting for fixed costs associated with maintaining an existing job greatly magnifies profit fluctuations for any given degree of wage fluctuations, which allows the model to reproduce the fluctuations of unemployment over the business cycle. And third, the model implies a reasonable elasticity of steady state unemployment with respect to changes in benefits. The calibration of the model implies low profits, but does not require a small gap between the value of working and the value of unemployment for the worker. Back to main page.


Value-at-Risk Prediction: A Comparison of Alternative Strategies (2006), with Stefan Mittnik and Marc Paolella,
Journal of Financial Econometrics 4(1), pp. 53-89.

Given the growing need for managing financial risk, risk prediction plays an increasing role in banking and finance. In this study we compare the out-of-sample performance of existing methods and some new models for predicting value-at-risk (VaR) in a univariate context. Usingmore than 30 years of the daily return data on the NASDAQ Composite Index, we find that most approaches perform inadequately, although several models are acceptable under current regulatory assessment rules for model adequacy. A hybrid method, combining a heavy-tailed generalized autoregressive conditionally heteroskedastic (GARCH) filter with an extreme value theory-based approach, performs best overall, closely followed by a variant on a filtered historical simulation, and a new model based on heteroskedasticmixture distributions. Conditional autoregressive VaR (CAViaR) models perform inadequately, though an extension to a particular CAViaR model is shown to outperform the others. Back to main page.


Optimal Monetary Policy Rules for the Euro Area (2005), with Alistair Dieppe and Peter McAdam,
Journal of Common Market Studies, 2005, 43(3), p. 507-537.

In this article, we analyse the conduct of optimal monetary policy for the new euro area. The aggregate euro area economy is modelled to have relatively sluggish adjustment properties and a private sector with mainly backward-looking expectations. In this economy, we assume that the central bank searches for its best-performing monetary policy rule, e.g. the optimal weight to give to inflation stabilization compared to that of output, the optimal degree of forward-looking in the planning horizon, and so on. We first find that the optimal degree of gradualism in interest rate-setting needs only be relatively mild and that the central bank should incorporate new information quickly into policy-making. Second, there is substantial gain from implementing and communicating quite forward-looking policies. The optimal forecast horizon for inflation ranges around six quarters. In contrast to deliberately simple rule-based policy recommendations, fully optimal policy is a complicated response to many different economic indicators. With regard to this we find, third, that optimal policy should be based on a broad information set, even if the resulting policy framework is hard to communicate to the outside world. Thus, the article contributes to the debate on optimal monetary policy for the euro area, as well as to the conduct of monetary policy in face of substantial persistence in the transmission mechanism. Back to main page.

 

Abstracts of Working Papers

Optimal Labor-Market Policy in Recessions (2011), with Philip Jung, Philadelphia Fed Working Paper 11-48.

We examine the optimal labor market-policy mix over the business cycle. In a search and matching model with risk-averse workers, endogenous hiring and separation, and unobservable search effort we first show how to decentralize the constrained-efficient allocation. This can be achieved by a combination of a production tax and three labor-market policy instruments, namely, a vacancy subsidy, a layoff tax and unemployment benefits. We derive analytical expressions for the optimal setting of each of these for the steady state and for the business cycle. Our propositions suggest that hiring subsidies, layoff taxes and the replacement rate of unemployment insurance should all rise in recessions. We find this confirmed in a calibration targeted to the U.S. economy. Back to main page.

Fiscal Volatility Shocks and Economic Activity (2011), with Jesús Fernández-Villaverde, Pablo A. Guerrón-Quintana, and Juan Rubio-Ramírez, NBER Working Paper 17317.

We study the effects of changes in uncertainty about future fiscal policy on aggregate economic activity. Fiscal deficits and public debt have risen sharply in the wake of the financial crisis. While these developments make fiscal consolidation inevitable, there is considerable uncertainty about the policy mix and timing of such budgetary adjustment. To evaluate the consequences of this increased uncertainty, we first estimate tax and spending processes for the U.S. that allow for time-varying volatility. We then feed these processes into an otherwise standard New Keynesian business cycle model calibrated to the U.S. economy. We find that fiscal volatility shocks have an adverse effect on economic activity that is comparable to the effects of a 25-basis-point innovation in the federal funds rate. Back to main page.

Sovereign Risk and the Effects of Fiscal Retrenchment in Deep Recessions (2011), with Giancarlo Corsetti, André Meier, and Gernot Mueller, Philadelphia Fed Working Paper 11-43.

We analyze the effects of government spending cuts on economic activity in an environment of severe fiscal strain, as reflected by a sizeable risk premium on government debt. Specifically, we consider a "sovereign risk channel," through which sovereign default risk spills over to the rest of the economy, raising funding costs in the private sector. Our analysis is based on a variant of the model suggested by Cúrdia and Woodford (2009). It allows for costly financial intermediation and inter-household borrowing and lending in equilibrium, but maintains the tractability of the baseline New Keynesian model. We show that, if monetary policy is constrained in offsetting the effect of higher sovereign risk on private-sector borrowing conditions, the sovereign risk channel exacerbates indeterminacy problems: private-sector beliefs of a weakening economy can become self-fulfilling. Under these conditions, fiscal retrenchment can limit the risk of macroeconomic instability. In addition, if fiscal strain is very severe and monetary policy is constrained for an extended period, fiscal retrenchment may actually stimulate economic activity. Back to main page.

Floats, Pegs and the Transmission of Fiscal Policy (2011), with Giancarlo Corsetti and Gernot Mueller, Philadelphia Fed Working Paper 11-9.

According to conventional wisdom, fiscal policy is more effective under a fixed than under a flexible exchange rate regime. In this paper we reconsider the transmission of shocks to government spending across these regimes within a standard New Keynesian model of a small open economy. Because of the stronger emphasis on intertemporal optimization, the New Keynesian framework requires a precise specification of fiscal and monetary policies, and their interaction, at both short and long horizons. We derive an analytical characterization of the transmission mechanism of expansionary spending policies under a peg, showing that the long-term real interest rate always rises in response to an increase in government spending if inflation rises initially. This response drives down private demand even though short-term real rates fall. As this need not be the case under floating exchange rates, the conventional wisdom needs to be qualified. Under plausible medium-term fiscal policies, government spending is not necessarily less expansionary under floating exchange rates. Back to main page.

Inflation Dynamics with Labour Market Matching: Assessing Alternative Specifications (2009), with Kai Christoffel, James Costain, Gregory de Walque, Tobias Linzert, Stephen Millard, and Olivier Pierrard, Philadelphia Fed Working Paper 09-6.

This paper reviews recent approaches to modeling the labour market and assesses their implications for inflation dynamics through both their effect on marginal cost and on price-setting behavior. In a search and matching environment, we consider the following modeling setups: right-to-manage bargaining vs. efficient bargaining, wage stickiness in new and existing matches, interactions at the firm level between price and wage-setting, alternative forms of hiring frictions, search on-the-job and endogenous job separation. We find that most speci.cations imply too little real rigidity and, so, too volatile inflation. Models with wage stickiness and right-to-manage bargaining or with firm-specific labour emerge as the most promising candidates. Back to main page.