Timothy S. Fuerst

University of Notre Dame | ND · Department of Economics

This paper develops a model of segmented financial markets in which the net worth of financial institutions limits the degree of arbitrage across the term structure. The model is embedded into the canonical Dynamic New Keynesian (DNK) framework. We estimate the model using data on the term premium. Our principal results include the following. First...

This paper derives the optimal lending contract in the financial accelerator model of Bernanke, Gertler, and Gilchrist (1999), henceforth, BGG. The optimal contract includes indexation to the aggregate return on capital, household consumption, and the return to internal funds. This triple indexation results in a dampening of fluctuations in leverag...

The term premium has become increasingly important in discussions of monetary policy formulation. This paper reviews two approaches to embedding a variable term premium into an otherwise standard modern DSGE model. The first approach maintains frictionless asset trade but alters preferences so that agents are more averse to the risk in long bonds....

A Taylor rule captures the historical behavior of the federal funds rate better when it also includes a partial-adjustment factor. Typically, the type of partial adjustment added is consistent with the FOMC avoiding large jumps in the level of the funds rate. We add another type of partial adjustment—consistent with the FOMC avoiding changes in the...

This paper derives the optimal lending contract in the financial accelerator model of Bernanke, Gertler and Gilchrist (1999), hereafter BGG. The optimal contract includes indexation to the aggregate return on capital, household consumption, and the return to internal funds. This triple indexation results in a dampening of fluctuations in leverage a...

This paper revisits the size of the fiscal multiplier. The experiment is a fiscal expansion under the assumption of a pegged nominal rate of interest in linearised sticky price model. We demonstrate that a quantitatively important issue is the articulation of the exit from the policy experiment. If the monetary-fiscal expansion is stochastic with a...

There are many possible formulations of the Taylor rule. We consider two that use different measures of economic activity to which the Fed could react, the output gap and the growth rate of GDP, and investigate which captures past movements of the fed funds rate more closely. Looking at these rules through the lens of a partial-adjustment Taylor ru...

This paper revisits the size of the fiscal multiplier. The experiment is a fiscal expansion under the assumption of a pegged nominal rate of interest. We demonstrate that a quantitatively important issue is the articulation of the exit from the policy experiment. If the monetary-fiscal expansion is stochastic with a mean duration of T periods, the...

This paper addresses the positive implications of indexing risky debt to observable aggregate conditions. These issues are pursued within the context of the celebrated financial accelerator model of Bernanke et al. (1999). The principal conclusions include: (1) the estimated level of indexation is significant, (2) the business cycle properties of t...

This paper derives the privately optimal lending contract in the celebrated financial accelerator model of Bernanke, Gertler and Gilchrist (1999). The privately optimal contract includes indexation to the aggregate return on capital and household consumption. Although privately optimal, this contract is not welfare maximizing as it exacerbates fluc...

Recent monetary policy experience suggests a simple test of models of monetary non-neutrality. Suppose the central bank pegs the nominal interest rate below steady state for a reasonably short period of time. Familiar intuition suggests that this should be inflationary. But a monetary model should be rejected if a reasonably short nominal rate peg...

This paper addresses the positive and normative implications of indexing risky debt to observable aggregate conditions. These issues are pursued within the context of the celebrated financial accelerator model of Bernanke, Gertler and Gilchrist (1999). The principal conclusions are that the optimal degree of indexation is significant, and that the...

Evidence suggests that durable goods and residential housing are more flexibly priced than nondurables and services. Using a standard sticky price general equilibrium model, Barsky, House, and Kimball [American Economic Review 97(3) (2007), 984 998] demonstrate that if durable goods are flexibly priced and nondurables are sticky, then a monetary co...

Banks have long been required to hold reserves equal to a percentage of their net transactions accounts (checkable deposits, for example), but until recently, they earned no interest on those reserves. The Fed now pays interest on required and excess reserve balances, having been granted the authority by Congress and putting the policy into place a...

A popular identifying assumption in structural VAR studies is that the monetary policy shock does not affect macroeconomic variables contemporaneously. We examine the consequences of using this identification strategy when the data-generating process is a basic Dynamic New Keynesian (DNK) model but without these assumed time delays. The principle c...

There is growing evidence that the empirical Phillips curve within the United States has changed significantly since the early 1980s. In particular, inflation persistence has declined sharply. This paper demonstrates that this decline is consistent with a standard dynamic New Keynesian (DNK) model in which: (i) the variability of technology shocks...

"We document increased central bank independence within the set of industrialized nations. This increased independence can account for nearly two-thirds of the improved inflation performance of these nations over the past two decades. "("JEL "E42, E58) Copyright (c) 2008 Western Economic Association International.

This paper integrates a fully explicit model of agency costs into an otherwise standard Dynamic New Keynesian model in a particularly transparent way. A principal result is the characterization of agency costs as endogenous markup shocks in an output-gap version of the Phillips curve. The model's utility-based welfare criterion is derived explicitl...

We document increased central bank independence within the set of industrialized nations. This increased independence can account for nearly two-thirds of the improved inflation performance of these nations over the past two decades. (JEL E42, E58)

This article traces the consequences of an energy shock on the economy under two different monetary policy rules: (i) a standard Taylor rule, where the Fed responds to inflation and the output gap, and (ii) a Taylor rule with inertia, where the Fed moves slowly to the rate predicted by the standard rule. The authors show that, with both sticky wage...

Observations that the Phillips curve may be deviating from historical norms are important to policymakers because deviations would imply that more or less output has to be sacrificed to achieve a permanent reduction in long-term inflation. But we argue that recent economic shocks and a shift in the Fed’s response to inflation may be leading economi...

Monetary policymakers look to the Phillips curve—an expression of the relationship between inflation and the degree to which the economy is operating relative to its potential—for information about the cost of actions undertaken to lower inflation. Recent estimations of the curve suggest it is deviating from historical norms. We argue that changes...

There is growing evidence that the empirical Phillips curve within the US has changed significantly since the early 1980’s. In particular, inflation persistence has declined sharply. The paper demonstrates that this decline is consistent with a standard Dynamic New Keynesian (DNK) model in which: (i) the variability of technology shocks has decline...

Should monetary policy respond to asset prices? This paper analyzes this question from the vantage point of equilibrium determinacy. A central bank responding to asset prices is indirectly responding to firm profits. In a model with sticky prices, increases in inflation tend to lower firm profits so that a central bank responding to share prices im...

What inflation rate should the central bank target? We address determinacy issues related to this question in a two-sector model in which prices can differ in equilibrium. We assume that the degree of nominal price stickiness can vary across the sectors and that labor is immobile. The contribution of this paper is to demonstrate that a modified Tay...

Nobel laureate Milton Friedman, who died on November 16, 2006, made monumental contributions to economics and changed the course of modern central banking. Many of his proposals for the conduct of monetary policy were controversial at the time he made them but are now widely accepted. This Commentary reviews some of them.

In an interesting paper Barsky, House, and Kimball (2005) demonstrate that in a standard sticky price model a monetary contraction will lead to a decline in nondurable goods production but an increase in durable goods production, so that aggregate output is little changed. This lack of co-movement between nondurables and durables is wildly at odds...

Recessions are associated with both rising oil prices and increases in the federal funds rate. Are recessions caused by the spikes in oil prices or by the sharp tightening of monetary policy? This paper discusses the difficulties in disentangling these two effects.

Low inflation over long periods is the sign of an effective central bank. The authors suggest that a large fraction of the worldwide decline in inflation since the early 1980s results from an international movement toward more independent central banks.

The papers in this symposium address the issue of multiple equilibria that can be induced by monetary policy in models with capital accumulation. In particular they examine how the “Taylor Principle”, under which interest rates respond more than proportionately to increases in inflation, can generate multiple equilibria. They also explore the desig...

There has been a remarkable increase in the FOMC’s communication over the last decade. Perhaps the most dramatic change was the inclusion of language indicating the possible direction of future policy. One example is the now famous “considerable-period” language that was inserted in August 2003. This forward-looking language was remarkable in that...

Every U.S. recession since 1971 has been preceded by two things: an oil price shock and an increase in the federal funds rate. Bernanke, Gertler, and Watson (1997,2004) investigated how much oil price shocks have contributed to output growth by asking the following counterfactual question: Empirically how much would we expect oil price increases to...

It is well known that hyperinflationary equilibria typically exist in an infinite-horizon monetary model with an exogenous money growth rule. This note demonstrates the effect of money demand timing on the nature of these equilibria.

It is well known that sunspot equilibria may arise under an interest rate operating procedure in which the central bank varies the nominal rate with movements in future inflation (a forward-looking Taylor rule). This paper demonstrates that these sunspot equilibria may be learnable in the sense of E-stability.

Books reviewed: Ben S. Bernanke and Michael Woodford, (eds), Inflation Targeting Carl E. Walsh, Monetary Theory and Policy Michael Woodford, Interest and Prices

When inflation-indexed Treasury securities were first introduced, economists hoped that they could be used to measure expected inflation easily. The only difference between securities that were indexed to inflation and those that were not was thought to be the extra compensation regular securities had to pay for what the market thought inflation wo...

This paper reviews three recent books. Two books, one by Carl Walsh and one by Michael Woodford, focus on the development of monetary theory. In contrast, the third book is a collection of papers in an NBER volume on inflation targeting. This volume outlines some of the issues that arise when applying the tools described by Walsh and Woodford to th...

This paper analyzes the restrictions necessary to ensure that the interest rate policy rule used by the central bank does not introduce local real indeterminacy into the economy. It conducts the analysis in a Calvo-style sticky price model. A key innovation is to add investment spending to the analysis. In this environment, local real indeterminacy...

In "Capital Trading, Stock Trading, and the Inflation Tax on Equity," Chami, Cosimano, and Fullenkamp (2001) (hereafter, CCF) analyze a cash-in-advance model in which capital goods are explicitly traded. The authors show that there is more responsiveness of consumption and output to changes in the money supply than exists in the standard neoclassic...

Benhabib, Schmitt-Grohe, and Uribe are to be commended for writing a clear and thoughtful paper. Most researchers simply look at local analysis when analyzing different monetary policy rules. The present authors, however, have consistently worried about the global properties of different interest-rate rules. In this paper, they argue that if you re...

Do exogenous money growth rules produce price level determinacy? This is a classic topic in monetary theory. This paper contributes to this literature by examining the effect of money demand timing. The paper demonstrates how conditions for determinacy vary depneding upon whether the theoretical model uses 'cash-in-advance' timing or 'cash-when-I'm...

(Copyright: Elsevier)

The Taylor rule, which once was mentioned only in scholarly economics journals, now is popping up regularly in newsmagazines, finance journals, and central bankers' speeches. Does the Fed follow the rule? Should it? This Commentary explains what the Taylor rule is, discusses why it seems to describe Fed interest-rate setting, and argues that the ru...

Benhabib, Schmitt-Grohe, and Uribe (2003) argue that if you relied solely on local analysis you would be led to believe that aggressive, backward-looking interest rate rules are sufficient for determinacy. But from the perspective of global analysis, backward-looking rules do not guarantee uniqueness of equilibrium and indeed may lead to cyclic and...

One measure of the health of the Social Security system is the difference between the market value of the trust fund and the present value of benefits accrued to date. How should present values be computed for this calculation in light of future uncertainties? We think it is important to use market value. Since claims on accrued benefits are not cu...

Monetary policy rules help central banks exercise the discipline necessary to achieve their long-term goals. The type of rule many banks are turning to these days is inflation targeting, which has several advantages. But because banks base their actions on forecasts of future inflation, following the rule can lead to inflation-rate instability in s...

are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded official Federal Reserve Bank of Cleveland publications. The views stated herein are those of the authors and are not necessarily those of the Federal Reserve Bank of Cleve...

When stock market values fall, we know that investors expect lower economic growth in the future. But can stock market declines actually affect future growth? There is some evidence that they can-through the credit channel.

This paper integrates money into a real model of agency costs. Money is introduced by imposing a cash-in-advance constraint on a subset of transactions. The underlying real model is a standard real business cycle model modified to include endogenous agency costs. The chief contribution of the paper is to demonstrate how the monetary transmission me...

An increasingly common approach to the theoretical analysis of monetary policy is to ensure that a proposed policy does not introduce real indeterminacy and thus sunspot fluctuations into the model economy. Policy is typically conducted in terms of directives for the nominal interest rate. This paper uses a discrete-time money-in-the-utility functi...

This paper demonstrates that in a standard flexible-price monetary model there exists real indeterminacy whenever the nominal interest rate moves too closely with either current or forecasted inflation. However, an aggressive response to lagged inflation will ensure determinacy. These conclusions are robust to a wide range of calibrations, and a mo...

What rule should a central bank interested in inflation stability follow? Because monetary policy tends to work with lags, it is tempting to use inflation forecasts to generate policy advice. This article, however, suggests that the use of forecasts to drive policy is potentially destabilizing. The problem with forecast-based policy is that the eco...

The Modigliani-Miller theorem is fundamental to the theory of corporate finance. One of the theorem's immediate implications is that there is no reason for the monetary authority to respond to asset prices. This article posits a world in which the Modigliani-Miller theorem does not hold. The authors assume that the amount of an entrepreneur's exter...

This working paper examines a theoretical model in which an entrepreneur’s net worth affects his ability to finance current activity. Net worth, in turn, is determined by asset prices, which can be affected by monetary policy. In this environment, the central bank plays a welfare-improving role by responding to asset price and technology shocks.

If a central bank adopted a zero inflation target, it would, in practice, occasionally deviate up and down from that rate, and the economy would experience episodes of mild inflation and deflation. Is deflation-a decrease in the level of prices-a cause for concern? Deflation can cause output to decline, but to what extent? This Economic Commentary...

This paper analyzes the restrictions necessary to ensure that the policy rule used by the central bank does not introduce real indeterminacy into the economy. It conducts this analysis in a flexible price economy and a sticky price model. A robust conclusion is that to ensure determinacy, the monetary authority should follow a backward-looking rule...

A traditional function of the central bank is to control the price level. The fiscal theory of the price level challenges this assumption, arguing instead that the fiscal authority's budgetary policy is the primary determinant of the price level. The authors provide a critical review of the fiscal theory and its implications for monetary policy.

: This paper uses a small open economy model to address two outstanding issues in monetary policy: (1) what restrictions on the policy rule ensure that the central bank does not introduce real indeterminacy into the economy, and (2) what is the optimal long run rate of inflation. The small open economy model provides unique insights on both fronts....

To head off inflation before it gets started, central banks must use forecasts to determine monetary policy actions. But doing so introduces the possibility that inflation will increase just because the public expects it to. This Economic Commentary explains how random events (sunspots) can affect economic systems and create price volatility. The a...

This paper uses a small open economy model to address two outstanding issues in monetary policy: (1) what restrictions on the policy rule ensure that the central bank does not introduce real indeterminacy into the economy, and (2) what is the optimal long run rate of inflation. The small open economy model provides unique insights on both fronts. I...

: This paper examines a standard sticky price monetary model. The equilibrium conditions of the model are perturbed relative to the canonical real business cycle model by two varying distortions: marginal cost and the nominal rate of interest. The paper explores the implications of two monetary policies that are frequently advocated: (1) an inflati...

: This paper demonstrates that in a standard monetary model there exists real indeterminacy whenever the nominal interest rate moves too closely with the real rate. A particular example of such a policy is if the central bank were to target the inflation rate. This is not a knife-edge result. The conclusion is robust to (1) a wide range of calibrat...

Is inflation (in the often-quoted words of Milton Friedman) "always and everywhere a monetary phenomenon"? Some say no, arguing that inflation is controlled not only by the central bank but also by the fiscal authority. This Commentary authors explore their argument, known as the fiscal theory of the price level.

This paper develops a model with endogenous agency costs that is otherwise quite similar to the canonical real business cycle model. The traditional assumption in the literature is that these agency costs arise in the production of investment goods. In contrast, this paper assumes that these costs are all encompassing in the sense that they arise i...

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This paper develops a computable general equilibrium model in which endogenous agency costs can potentially alter business-cycle dynamics. A principal conclusion is that the agency-cost model replicates the empirical fact that output growth displays positive autocorrelation at short horizons. This hump-shaped output behavior arises because househol...

In this paper we consider the potential gain of a government pursuing a two-part trade policy: an import license for entry, along with a per-unit tariff on imports. The model is a two-stage game of complete but imperfect information. In the first stage, the domestic government sets trade policy, while in the second stage the home and foreign produc...

During hyperinflation the amount of real cash balanced changes drastically. At first sight these changes may appear to reflect changes in individuals' preferences for real cash balances--that is, shifts in the demand function for the balances. But these changes in real cash balanced may reflect instead changes in the variables that affect the desir...

This article revisits Poole's original question. It argues that there are clear benefits to interest rate targeting, independent of what types of shocks hit the economy. Furthermore, these benefits arise even though money growth must be procyclical in order to keep interest rates constant, which increases the variability of output. The reason a con...

An argument that the Federal Reserve System's current approach to seasonal cycles--pegging the nominal interest rate--could successfully be applied to the business cycle as well.

This paper considers the welfare consequences of two particularly simple rules for monetary policy: an interest rate peg and a money growth peg. The model economy consists of a real side that is the standard real business cycle model and a monetary side that amounts to imposing cash-in-advance constraints on certain market transactions. The paper a...

This paper develops a computable general equilibrium model in which endogenous agency costs can potentially alter business cycle dynamics. The model resembles the influential theoretical work of Ben Bernanke and Mark Gertler (1989). Two sources of shocks are considered: productivity shocks and monetary shocks. The model is parametrized to match key...

This article examines the relationship between financial liberalization and stock market volatility in Indonesia. By looking at the time series properties of the Jakarta Composite Index (JCI) we identify breaks in stock market volatility which coincide with the timing of major policy events. Our main findings are (i) a significant decrease in volat...

This paper develops a general equilibrium model of monetary nonneutrality that is a natural result of three basic assumptions: (1) financial intermediaries face reserve requirements on deposits, (2) financial intermediaries are the conduit for central bank monetary injections, and (3) monetary injections are not initially subject to reserve require...

The issue of optimal monetary policy within a particular general equilibrium model of the monetary transmission mechanism is addressed. The model analyzed is a member of the recent class of liquidity models of the monetary business cycle. The nature of the trading frictions that define these models introduces a role for activist monetary policy. In...

I modify the uniform-price auction rules in allowing the seller to ration bidders. This allows me to provide a strategic foundation for underpricing when the seller has an interest in ownership dispersion. Moreover, many of the so-called "collusive-seeming" equilibria disappear.

This paper develops a general equilibrium model of two traditional explanations of the monetary ‘black box’ linking money and real activity: the liquidity effect and the loanable funds effect. These effects are modeled with a monetary production economy in which central bank injections of cash are funnelled into the economy through the credit marke...

This paper develops a general equilibrium model of two traditional explanations of the monetary "black box" linking money and real activity: the liquidity effect and the loanable funds effect. These effects are modeled with a monetary production economy in which central bank injections of cash are funnelled into the economy through the credit marke...

We explore the role of relative prices in the dynamics of a two-sector, New Keynesian model with heterogeneous nominal rigidity, immobile labor, and endogenous interest rate setting. We show that labor immobility is necessary to generate endogenously persistent dynamics in our model, but it is not sufficient. When labor is immobile, aggregate infla...