[Show abstract][Hide abstract] ABSTRACT: We study alternative scenarios for exiting the post-crisis fiscal and monetary accommodation using the model of Angeloni and Faia (2010), that combines a standard DSGE framework with a fragile banking sector, suitably modified and calibrated for the euro area. Credibly announced and fast fiscal consolidations dominate - based on simple criteria - alternative strategies incorporating various degrees of gradualism and surprise. The fiscal adjustment should be based on spending cuts or else be relatively skewed towards consumption taxes. The phasing out of monetary accommodation should be simultaneous or slightly delayed. We also find that, contrary to widespread belief, Basel III may well have an expansionary macroeconomic effect.
Preview · Article · Aug 2014 · European Economic Review
[Show abstract][Hide abstract] ABSTRACT: We study the design of optimal monetary policy in a New Keynesian model with labor turnover costs in which wages are set according to a collective bargaining agreement, where the …rms'counterpart is given by currently employed workers. Our model captures well the salient features of European labor market, as it leads to sclerotic dynamics of worker ows. Our labour market features a time-varying wedge, which, by co-existing with nominal rigidities, gives rise to non-trivial policy trade-o¤s. In this framework, …rms and current employees extract rents and the policy maker …nds it optimal to use state contingent ination taxes/subsidies to smooth those rents. Hence, in the optimal Ramsey plan, ination deviates from zero and the optimal volatility of ination is an increasing function of …ring costs. The optimal rule should react to employment alongside ination. JEL Codes: E52, E24 Keywords: optimal monetary policy, hiring and …ring costs, labor market frictions, policy trade-o¤.
Preview · Article · Feb 2014 · Journal of money credit and banking
[Show abstract][Hide abstract] ABSTRACT: Currency fluctuations are an important determinant of labor market dynamics. Vice versa, relative labor costs affect real exchange rate dynamics. The optimal choice of exchange rate regimes cannot neglect this nexus. We assess such a choice using a two-country model with frictional labor markets. The monetary authority faces a tension between the classical insulating property of floating exchange rates and the destabilizing effects of currency fluctuations on (relative) job flows. Results show that the second motive is important: optimal monetary policy prescribes (some) response to the exchange rate. We also reexamine the conditions for optimal policy in a currency area whose members experience asymmetries in labor market institutions.
No preview · Article · Jan 2014 · Macroeconomic Dynamics
[Show abstract][Hide abstract] ABSTRACT: This paper makes a conceptual contribution to the effect of monetary policy on �financial stability. We develop a microfounded network model with endogenous network formation to analyze the impact of central banks' monetary policy interventions on systemic risk. Banks choose their portfolio, including their borrowing and lending decisions on the interbank market, to maximize profit subject to regulatory constraints in an asset-liability framework. Systemic risk arises in the form of multiple bank defaults driven by common shock exposure on asset markets, direct contagion via the interbank market, and �firesale spirals. The central bank injects or withdraws liquidity on the interbank markets to achieve its desired interest rate target. A tension arises between the bene�ficial effects of stabilized interest rates and increased loan volume and the detrimental effects of higher risk taking incentives. We fi�nd that central bank supply of liquidity quite generally increases systemic risk.
No preview · Article · Jan 2014 · SSRN Electronic Journal
[Show abstract][Hide abstract] ABSTRACT: Optimizing banks subject to runs are introduced in a macro model to study the transmission of monetary policy and its interplay with bank capital regulation when banks are risky. A monetary expansion and a positive productivity shock increase bank leverage and risk. Risk-based capital requirements amplify the cycle and are welfare detrimental. Within a class of simple policy rules, the best combination includes mildly anticyclical capital ratios (as in Basel III) and a response of monetary policy to asset prices or bank leverage.
No preview · Article · Apr 2013 · Journal of Monetary Economics
[Show abstract][Hide abstract] ABSTRACT: Several contributions have recently assessed the size of fiscal multipliers both in RBC models and in New Keynesian models. This paper computes fiscal multipliers within a labor selection model with turnover costs and Nash bargained wages. We find that demand stimuli yield small multipliers, as they have little impact on hiring and firing decisions. By contrast, hiring subsidies, and short-time work (German "Kurzarbeit") deliver large multipliers, as they stimulate job creation and employment. (c) 2012 Elsevier B.V. All rights reserved.
No preview · Article · Mar 2013 · Journal of Economic Dynamics and Control
[Show abstract][Hide abstract] ABSTRACT: We develop a dynamic network model whose links are governed by banks' optmizing decisions and by an endogenous tâtonnement market adjustment. Banks in our model can default and engage in firesales: risk is transmitted through direct and cascading counterparty defaults as well as through indirect pecuniary externalities triggered by firesales. We use the model to assess the evolution of the network configuration under various prudential policy regimes, to measure banks' contribution to systemic risk (through Shapley values) in response to shocks and to analyze the effects of systemic risk charges. We complement the analysis by introducing the possibility of central bank liquidity provision.
No preview · Article · Mar 2013 · SSRN Electronic Journal
[Show abstract][Hide abstract] ABSTRACT: The efficacy of monetary authority actions depends primarily on the ability of the monetary authority to affect inflation expectations, which ultimately depend on agents' trust. We propose a model embedding trust cycles, as emerging from sequential coordination games between atomistic agents and the policy maker, in a monetary model. Trust affects agents' stochastic discount factor, namely the price of future risk, and their expectation formation process: these effects in turn interact with the monetary transmission mechanism. Using data from the Eurobarometer survey we analyze the link between trust on the one side and the transmission mechanism of shocks and of the policy rate on the other: data show that the two interact significantly and in a way comparable to the obtained in our model.
No preview · Article · Feb 2013 · SSRN Electronic Journal
[Show abstract][Hide abstract] ABSTRACT: In this paper Bruegel Visiting Scholar Ignazio Angeloni (European Central Bank), Ester Faia (Goethe University Frankfurt, Kiel IfW and CEPREMAP) and Marco Lo Duca (European Central Bank) examine the links between monetary policy, financial risk and the business cycle, combining data evidence and a new DSGE model with banks. The model includes banks (modeled as in Diamond and Rajan, JF 2000 and JPE 2001) and a financial accelerator (Bernanke et al., 1999 Handbook). A monetary expansion increases the propensity of banks to assume risks. In turn, financial risks affect economic activity and prices. This "risk-taking" channel of monetary transmission, absent in pure financial accelerator models, operates via the leverage decisions of banks. The model results match certain features of the data, as emerged in recent panel data studies and in our own time series estimates for the US and the euro area.
Preview · Article · Jan 2013 · Journal of Economic Dynamics and Control
[Show abstract][Hide abstract] ABSTRACT: We study the design of optimal monetary policy (Ramsey policies) in a model with sticky prices and unionized labour markets. Collective wage bargaining and unions monopoly power tend to dampen wage fluctuations and to amplify employment fluctuations relatively to a DNK model with walrasian labour markets. The optimal monetary policy must trade-off counteracting forces. On the one side deviations from zero inflation allow the policy maker to smooth inefficient employment fluctuations. On other side, the presence of wage mark-ups and wage stickiness produce inflationary pressures that require aggressive inflation targeting. Overall we find that the Ramsey planner deviates from full price stability and that an optimal rule targets inflation the real economic activity alongside inflation.
[Show abstract][Hide abstract] ABSTRACT: Euro area data show a positive connection between sovereign and bank risk, which increases with banks’ and sovereign long run fragility. We build a macro model with banks subject to incentive problems and liquidity risk (in the form of liquidity based banks’ runs) which provides a link between endogenous bank capital and macro and policy risk. Our banks also invest in risky government bonds used as capital buffer to self-insure against liquidity risk. The model can replicate the positive connection between sovereign and bank risk observed in the data. Central bank liquidity policy, through full allotment policy, is successful in stabilizing the spiraling feedback loops between bank and sovereign risk.
No preview · Article · Dec 2012 · SSRN Electronic Journal
[Show abstract][Hide abstract] ABSTRACT: This paper quantifies the costs of adhering to a fixed exchange rate arrangement, such as a currency union, for emerging economies. To this end it develops a dynamic stochastic disequilibrium model of a small open economy with downward nominal wage rigidity. In the model, a negative external shock causes persistent unemployment be-cause the fixed exchange rate and downward wage rigidity stand in the way of real depreciation. In these circumstances, optimal exchange rate policy calls for large de-valuations. In a calibrated version of the model, a large contraction, defined as a two-standard-deviation decline in tradable output, causes the unemployment rate to rise by more than 20 percentage points under a peg. The required devaluation under the optimal exchange rate policy is more than 50 percent. The median welfare cost of a currency peg is shown to be large, between 4 and 10 percent of lifetime consumption. Fixed exchange rate arrangements are found to be more costly when initial fundamen-tals are characterized by high past wages, large external debt, high country premia, or unfavorable terms of trade.
[Show abstract][Hide abstract] ABSTRACT: Increasing financial integration challenges the optimality of inward-looking strategies for optimal monetary policy. Those issues are analyzed in an open economy where foreign net lending, and the current account, are determined by a collateral constraint. Durables represent collateral. The current account features persistent imbalances, but can deliver a long run stationary equilibrium. The comparison between floating and managed exchange rate regimes shows that the impossible trinity is reversed: higher financial integration increases the persistence and volatility of the current account and calls for exchange rate stabilization. In this context, the Ramsey plan too prescribes stabilization of the exchange rate, alongside with domestic inflation.
Full-text · Article · Nov 2011 · Journal of Economic Dynamics and Control
[Show abstract][Hide abstract] ABSTRACT: We study optimal monetary policy rules in an economy where capital accumulation is subject to credit frictions, prices are sticky and goods markets are monopolistic competitive. In this context, credit frictions act as a tax on capital. We model monetary policy in terms of welfare maximizing interest rate rules. We find that responding to variables that mark the cyclical movements of financial frictions (e.g., leverage ratio) is more important - welfare wise - than reacting to asset prices. In the former case, deviations from a strict price stability policy are more pronounced. We suggest that, for monetary policy, focussing on the role of asset prices, rather than financial frictions per se, may be misleading.
[Show abstract][Hide abstract] ABSTRACT: We construct a dynamic general equilibrium model of a small open economy where domestic entrepreneurs face borrowing constraints and finance their investment projects both in domestic and international capital markets. We parametrize the degree of fi- nancial exposure as the fraction of borrowing expressed in foreign units of denomina- tion, and study its interaction with alternative exchange rate regimes. We find that a regime of flexible exchange rates greatly amplifies, relative to fixed rates, the response to domestic shocks. However, when financial exposure is high investment can fall and financial conditions can worsen in response to favorable productivity shocks, due to detrimental balance-sheets effects. Asset price volatility and overall financial instabil- ity are found to be monotonically increasing in financial exposure. In response to a rise in world interest rates, higher financial exposure greatly worsens the performance of flexible exchange rates (relative to the case with no exposure), so that the acclaimed insulating role of the latter (relative to fixed) barely applies to output and vanishes for financial variables. In general, the higher the degree of financial exposure, the closer the resemblance between flexible and fixed exchange rates, a result that provides a theoretical background for a fear-of-floating argument.
[Show abstract][Hide abstract] ABSTRACT: It is well documented that since the mid-1980s there has been a surge in capital flows due to an increased integration of world financial markets. Absent limited commitment, the increase in financial linkages should improve risk-sharing opportunities and foster consumption smoothing. However the data show that for several countries financial liberalization leads to enhanced consump tion volatility. This fact can be rationalized using a small open economy model where foreign lending to households is constrained by a borrowing limit motivated by limited enforcement. Borrowing is secured by collateral in the form of durable investment whose accumulation is subject to adjustment costs. In this economy an increase in the degree of capital account lib eralization increases consumption volatility (even relative to output volatility) as agents are unable to exploit risk-sharing opportunities. In presence of riskaverse agents an increase in financial integration reduces welfare.
Preview · Article · May 2011 · Journal of Applied Economics
[Show abstract][Hide abstract] ABSTRACT: Despite having had the same currency for many years, EMU countries still have quite different inflation dynamics. In this paper we explore one possible reason: country specific labor market institutions, giving rise to different inflation volatilities. When unemployment insurance schemes differ, as they do in EMU, reservation wages react differently in each country to area-wide shocks. This implies that real marginal costs and inflation also react differently. We report evidence for EMU countries supporting the existence of a cross-country link over the cycle between labor market structures on the one side and real wages and inflation on the other. We then build a DSGE model that replicates the data evidence. The inflation volatility differentials produced by asymmetric labor markets generate welfare losses at the currency area level of approximately 0.3% of steady state consumption.
Full-text · Article · May 2011 · Journal of Economic Dynamics and Control
[Show abstract][Hide abstract] ABSTRACT: The endorsement of expansionary fiscal packages has often been based on the idea that large multipliers can counteract rising and persistent unemployment. We explore the effectiveness of fiscal stimuli in a model with matching frictions and endogenous participation. Results show that hiring subsidies, contrary to increase in government spending, deliver large multipliers, even with distortionary taxation. Those policies increase the incentives to post vacancies, hence employment. Furthermore, by reducing marginal costs they also reduce inflation and increase private consumption.
Full-text · Article · Jan 2011 · The B E Journal of Macroeconomics
[Show abstract][Hide abstract] ABSTRACT: We compare three alternative post-crisis public debt consolidation policies (respectively based on expenditure cuts, labour tax or consumption tax increases) in their effects on key macro variables and on bank stability. Labor tax-based policies attain a rapid debt adjustment and low intertemporal debt costs, but at the expense of higher oscillations in bank leverage and risk. Expenditure based and consumption tax-based strategies perform better and similarly between themselves.
[Show abstract][Hide abstract] ABSTRACT: Firs draft: March 2011. Abstract The monitoring and assessment of systemic risk in complex financial systems has become paramount in the design of reforms devoted to safeguard financial stability. Against this back-ground stands the lack of proper models devoted to such a task and used to analyze the optimal design of financial regulation. In this paper we propose an agent based model of banks featuring network externalities, endogenous asset markets and firesale. Systemic risk, measured by the Shapley value, is reduced with lower balance sheet inter-linkages and higher capital require-ments. Risk charges, a form of Pigouvian taxation, help to mitigate network externalities and contagion.