Monetary Policy and Prices

‘Financial Heterogeneity and Monetary Union,’ Gilchrist, S. (with R. Schoenle, J. Sim, E. Zakrajsek), 2018.

We analyze the economic consequences of forming a monetary union among countries with varying degrees of financial distortions, which interact with the firms’ pricing decisions because of customer-market considerations. In response to a financial shock, firms in financially weak countries (the periphery) maintain{{p}}cashflows by raising markups–in both domestic and export markets–while firms in financially strong countries (the core) reduce markups, undercutting their financially constrained competitors to gain market share. When the two regions are experiencing different shocks, common monetary policy results in a substantially higher macroeconomic volatility in the periphery, compared with a flexible exchange rate regime; this translates into a welfare loss for the union as a whole, with the loss borne entirely by the periphery. By helping firms from the core internalize the pecuniary externality engendered by the interaction of financial frictions and customer markets, a unilateral fiscal devaluation by the periphery can improve the union’s overall welfare.

‘A framework for the analysis of self-confirming policies,’ Sargent, T. (with P. Battigalli, S. Cerreia-Vioglio, F. Maccheroni, M. Marinacci), 2017.

This paper provides a general framework for the analysis of self-confirming policies. We first study self-conforming equilibria in recurrent decision problems with incomplete information about the true stochastic model. Next we illustrate the theory with a characterization of stationary monetary policies in a linear-quadratic setting.

‘An Empirical Study of Trade Dynamics in the Fed Funds Market,’ Lagos, R. (with G. Afonso), 2014.

We use minute-by-minute daily transaction-level payments data to document the cross-sectional and time-series behavior of the estimated prices and quantities negotiated by commercial banks in the fed funds market. We study the frequency and volume of trade, the size distribution of loans, the distribution of bilateral fed funds rates, and the intraday dynamics of the reserve balances held by commercial banks. We find evidence of the importance of the liquidity provision achieved by commercial banks that act as de facto intermediaries of fed funds.

‘Monetary Exchange in Over-the-Counter Markets: A Theory of Speculative Bubbles, the Fed Model, and Self-fulfilling Liquidity Crises,’ Lagos, R. (with S. Zhang), 2015.

We develop a model of monetary exchange in over-the-counter markets to study the effects of monetary policy on asset prices and standard measures of financial liquidity, such as bid-ask spreads, trade volume, and the incentives of dealers to supply immediacy, both by participating in the market-making activity and by holding asset inventories on their own account. The theory predicts that asset prices carry a speculative premium that reflects the asset’s marketability and depends on monetary policy as well as the microstructure of the market where it is traded. These liquidity considerations imply a positive correlation between the real yield on stocks and the nominal yield on Treasury bonds—an empirical observation long regarded anomalous. The theory also exhibits rational expectations equilibria with recurring belief driven events that resemble liquidity crises, i.e., times of sharp persistent declines in asset prices, trade volume, and dealer participation in market-making activity, accompanied by large increases in spreads and abnormally long trading delays.

‘Turnover Liquidity and the Transmission of Monetary Policy,’ Lagos, R. (with S. Zhang), 2018.

We provide empirical evidence of a novel liquidity-based transmission mechanism through which monetary policy influences asset markets, develop a model of this mechanism, and assess the ability of the quantitative theory to match the evidence.

‘Can heterogeneity in price stickiness account for the persistence and volatility of good-level real exchange rates?,’ Midrigan, V. (with P. Kehoe), 2007.

The classic explanation for the persistence and volatility of real exchange rates is that they are the result of nominal shocks in an economy with sticky goods prices. A key implication of this explanation is that if goods have differing degrees of price stickiness then relatively more sticky goods tend to have relatively more persistent and volatile good-level real exchange rates. Using panel data, we find only modest support for these key implications. The predictions of the theory for persistence have some modest support: in the data, the stickier is the price of a good the more persistent is its real exchange rate, but the theory predicts much more variation in persistence than is in the data. The predictions of the theory for volatility fare less well: in the data, the stickier is the price of a good the smaller is its conditional variance while in the theory the opposite holds. We show that allowing for pricing complementarities leads to a modest improvement in the theory’s predictions for persistence but little improvement in the theory’s predictions for conditional variances.

‘Domestic Price Dollarization in Emerging Economies,’ Perez, D. (with A. Drenik), 2019.

This paper provides an empirical investigation of the currency of denomination of prices in domestic markets of various emerging economies. Using data from the largest e-trade platform in Latin America, we document that a significant fraction of prices is set in dollars. Across countries, price dollarization is positively correlated with asset dollarization, and negatively correlated with the size of the economy. At the micro level, larger sellers are more likely to price in dollars, and more tradeable goods are more likely to be posted in dollars. We show that prices are sticky, and hence the currency of prices determines the short-run reaction of prices to a nominal exchange rate shock. More importantly, we document that these shocks ultimately impact the quantities sold differentially, depending on the currency of prices. Finally, our findings are relevant for the dynamics of the CPI. Keywords: prices, dollar, exchange rate, pass-through..

‘Currency Choice in Contracts,’ Perez, D. (with A. Drenik, and R. Kirpalani), 2019.

We study a model in which agents choose the currency in which to denominate contracts, and the government chooses the inflation rate. The optimal choice of currency trades-off the price risk of each currency with how this risk covaries with the relative consumption needs of the agents signing the contract. When a larger share of private contracts are denominated in local currency, the government can use inflation to redistribute resources more effectively within the economy which, in turn, makes local currency more attractive as a unit of account for private contracts. The use of local currency is more likely when there is low domestic policy risk. Consistent with recent policy initiatives, policies that encourage the denomination of contracts exclusively in local currency can be desirable, since private agents do not internalize the complementarities between private actions and those of the government. We also use our model to explain the wide use of the dollar in international trade contracts and the observed hysteresis of dollarization that occurred in several Latin American countries.

‘Price Setting Under Uncertainty About Inflation,’ Perez, D. (with A. Drenik), 2018.

We use the manipulation of inflation statistics that occurred in Argentina starting in 2007 to test the relevance of informational frictions in price setting. We estimate that the manipulation of statistics had associated a higher degree of price dispersion. This effect is analyzed in the context of a quantitative general equilibrium model in which firms use information about the inflation rate to set prices. Consistent with empirical evidence, we find that monetary policy becomes more effective with less precise information about inflation. Not reporting accurate measures of the CPI entails significant welfare losses, especially in economies with volatile monetary policy.

‘How federal reserve discussions respond to increased transparency,’ Rotemberg, M. (with M. Egesdal and M. Gill), 2016.

We analyze how the behavior of the Federal Open Market Committee changed after the statutory enforcement of transparency laws in 1993. To do this, we develop techniques to describe how language use changes over time. For a set of widely used vector space metrics, we demonstrate how to decompose aggregate changes into each individual dimension’s contribution (such as a particular word’s influence). Our approach can be generalized to account for associations between document dimensions (such as word definitions or meanings). Using various documents released by the Federal Reserve from 1976–2007, covering both years in which the FOMC knew its deliberations would eventually be made public, and years in which it believed no records were kept, we find that FOMC deliberations became more similar to the always-public press releases in the transparency regime. FOMC members shifted their comments towards popular economic subjects, such as “inflation” and “growth,” and away from personal opinions, like “think.” In this setting, the observed changes are not purely substitution across words with the same meaning, as the results are robust to accounting for semantic relations.

‘Inequality, Business Cycles and Fiscal-Monetary Policy,’ Sargent, T. (with A. Bhandari, D. Evans and M. Golosov), 2018.

We study optimal monetary and scal policy in a model with heterogeneous agents, incomplete markets, and nominal rigidities. We develop numerical techniques to approximate Ramsey plans and apply them to a calibrated economy to compute optimal responses of nominal interest rates and labor tax rates to aggregate shocks. Responses dier qualitatively from those in a representative
agent economy and are an order of magnitude larger. Taylor rules poorly approximate the Ramsey optimal nominal interest rate. Conventional price stabilization motives are swamped by an across person insurance motive that arises from heterogeneity and incomplete markets.

‘Commodity and Token Monies,’ Sargent, T., 2017.

A government defines a dollar as a list of quantities of one or more precious metals. If issued in limited amounts, token money is a perfect substitute for precious metal money. Atemporal equilibrium conditions determine how quantities of precious metal and token monies affect an equilibrium price level. Under some circumstances, a government can peg the relative price of two precious metals, confirming Fisher’s (1911) response to a classic criticism of bimetallism. Monometallism dominates bimetallism according to a natural welfare criterion.