The ability of monetary policy to stabilize business cycles depends on the flexibility of the aggregate price level. Even if only a few individual prices adjust, monetary policy can be ineffective when these price changes are disproportionately large and make the aggregate price level flexible. We use micro price data to show that the probability of price adjustments increases with price misalignments, that is, the gap between optimal and actual prices. Systematic selection of large price changes is absent, however, in response to aggregate monetary and credit shocks. Instead, aggregate shocks bring about a uniform shift between price increases and price decreases. These results are consistent with a particular class of state-dependent pricing models and imply a sizable impact of monetary policy on the real economy.
We compare supermarket price settings in the US and the euro area and assess their impact on food inflation. We introduce a novel scanner dataset of Germany, the Netherlands, France, and Italy (EA4) and contrast it with an equivalent dataset from the US. We find that both the higher frequency and the stronger state dependence of price changes contribute to the higher flexibility of supermarket inflation in the US relative to the euro area. We argue that the driving force behind both factors is higher cross-sectional volatility in the US. Larger product-level fluctuations both (i) force retailers to adjust prices more frequently and (ii) raise price misalignments, which increase the selection of large price changes. Both facts are well-represented by a mildly state-dependent price-setting model, and they jointly explain over a third of the difference in food inflation volatility between the US and the euro area, and also around a third of the difference between the inflation response to the Covid shock in Germany and Italy.
Effectiveness and Addictiveness of Quantitative Easing, with Anton Nakov, 2020, Journal of Monetary Economics; CEPR Discussion Paper No. 14951.
This paper analyses optimal asset-purchase policies in a macroeconomic model with banks, which face occasionally-binding balance-sheet constraints. It proves analytically that asset-purchase policies are effective in offsetting large financial disturbances, which impair banks' capital position. It warns, however, that the policy is addictive because it flattens the yield curve, reduces the profitability of the banking sector, and therefore slows down its recapitalization. Consequently, optimal exit from large central bank balance sheets is gradual.
Deconstructing Monetary Policy Surprises - The Role of Information Shocks, with Marek Jarocinski, 2020, AEJ:Macroeconomics, 12(2); VoxEU; CEPR Discussion Paper 12765
Central bank announcements simultaneously convey information about monetary policy and the central bank's assessment of the economic outlook. This paper disentangles these two components and studies their effect on the economy using a structural vector autoregression. It relies on the information inherent in high-frequency comovement of interest rates and stock prices around policy announcements: a surprise policy tightening raises interest rates and reduces stock prices, while the complementary positive central bank information shock raises both. These two shocks have intuitive and very different effects on the economy. Ignoring the central bank information shocks biases the inference on monetary policy non-neutrality. We make this point formally and offer an interpretation of the central bank information shock using a New Keynesian macroeconomic model with financial frictions.
Menu Costs, Aggregate Fluctuations, and Large Shocks, with Adam Reiff, 2019, AEJ:Macroeconomics, 11(3): 111-146; CEPR Discussion Paper 10138
We document that the aggregate price level responds flexibly and asymmetrically to large positive and negative value-added tax changes. We present a price-setting model with menu costs, trend inflation and fat-tailed product-level shocks that is consistent with these observations. The model predicts a flexible price-level response to standard monetary policy shocks because it anticipates a large number of firms on the verge of price adjustment and far from their optimal prices when the shock hits.
Monetary Policy Surprises, Credit Costs, and Economic Activity, with Mark Gertler, 2015, AEJ: Macroeconomics, 7(1): 44-76; VoxEU; CEPR Discussion Paper 9824; Data and code
We provide evidence on the nature of the monetary policy transmission mechanism. To identify policy shocks in a setting with both economic and financial variables, we combine traditional monetary vector autoregression (VAR) analysis with high frequency identification (HFI) of monetary policy shocks. We first show that the shocks identified using HFI surprises as external instruments produce responses in output and inflation consistent with those obtained in the standard monetary VAR analysis. We also find, however, that monetary policy responses typically produce "modest" movements in short rates that lead to "large" movements in credit costs and economic activity. The large movements in credit costs are mainly due to the reaction of both term premia and credit spreads that are typically absent from the baseline model of monetary transmission. Finally, we show that forward guidance is important to the overall strength of policy transmission.
Global Implications of National Unconventional Policies, with Luca Dedola and Giovanni Lombardo, 2013, Journal of Monetary Economics, 60(1): 66-85.
Financial integration in the markets for banks' assets and liabilities makes balance sheet constraints highly correlated across countries, resulting in a high degree of financial and macroeconomic interdependence. Likewise, under financial integration unconventional policies aimed at stabilizing domestic financial and credit conditions could entail large international spillovers. Therefore, stabilization by one country will also benefit other countries, reducing incentives to implement credit policies in a classic free-riding problem, especially when these policies entail domestic costs. We show that this outcome can emerge in an open economy model featuring financial intermediaries that face endogenously determined balance sheet constraints.
QE1 vs. 2 vs. 3: A Framework to Analyze Large Scale Asset Purchases as a Monetary Policy Tool, with Mark Gertler, International Journal of Central Banking, 9(S1): 5-53.
We introduce large-scale asset purchases (LSAPs) as a monetary policy tool within a macroeconomic model. We allow for purchases of both long-term government bonds and securities with some private risks. We argue that LSAPs should be thought of as central bank intermediation that can affect the economy to the extent there exist limits to arbitrage in private intermediation. We then build a model with limits to arbitrage in banking that vary countercyclically and where the frictions are greater for private securities than for government bonds. We use the framework to study the impact of LSAPs that have the broad features of the different quantitative easing (QE) programs the Federal Reserve pursued over the course of the crisis. We find that (i) LSAPs work in the model in a way mostly consistent with the evidence; (ii) purchases of securities with some private risk have stronger effects than purchases of government bonds; (iii) the effects of the LSAPs depend heavily on whether the zero lower bound is binding. Our model does not rely on the central bank having more efficient intermediations technology than the private sector: We assume the opposite.
The paper develops a quantitative monetary DSGE model that allows for financial intermediaries that face endogenous balance sheet constraints. It uses the model to simulate a crisis that has some basic features of the current economic downturn. The model, then is used to quantitatively assess the effect of direct central bank intermediation of private lending, which is the essence of the unconventional monetary policy that the Federal Reserve has developed to combat the subprime crisis. It is shown numerically how central bank credit policy might help moderate the simulated crisis. Then the optimal degree of central bank credit intervention and the welfare gains are calculated in this scenario.
We explain the role of the Phillips Curve in the analysis of the economic outlook and the formulation of monetary policy at the ECB. First, revisiting the structural Phillips Curve, we highlight the challenges in recovering structural parameters from reduced-form estimates and relate the reduced-form Phillips Curve to the (semi-)structural models used at the ECB. Second, we identify the slope of the structural Phillips Curve by exploiting cross-country variation and by using high-frequency monetary policy surprises as instruments. Third, we present reduced-form evidence, focusing on the relation between slack and inflation and the role of inflation expectations. In relation to the recent weakness of inflation, we discuss the role of firm profits in the pass-through from wages to prices and the contribution of external factors. Overall, the available evidence supports the view that the absorption of slack and a firm anchoring of inflation expectations remain central to successful inflation stabilisation.
Macroprudential Policy Measures: Macroeconomic Impact and Interaction with Monetary Policy, with Gabriele Cozzi, Matthieu Darracq Paries, Jenny Korner, Christoffer Kok, Falk Mazelis, Kalin Nikolov, Elena Rancoita, Alejandro Van der Ghote, Julien Weber, February 2020, ECB Working Paper No. 2376
This paper examines the impact of higher bank capital requirements on the real economy. We find, using a range of macroeconomic models used at the European Central Bank, that, in the long run, a 1% bank capital requirement increase has a small impact on real activity. In the short run, GDP declines by 0.15-0.35%. When banks are able to reduce their voluntary capital buffers and dividend payouts and when monetary policy reacts strongly to inflation deviations from target, the real impact of higher capital requirements is significantly reduced.
The New Area-Wide Model II: An Extended Version of the ECB's Micro-Founded Model for Forecasting and Policy Analysis with a Financial Sector, with Guenter Coenen, Sebastian Schmidt, Anders Warne, November 2018, ECB Working Paper No 2200.
This paper provides a detailed description of an extended version of the ECB’s New Area-Wide Model (NAWM) of the euro area (cf. Christoffel, Coenen, and Warne 2008). The extended model—called NAWM II—incorporates a rich financial sector with the threefold aim of (i) accounting for a genuine role of financial frictions in the propagation of economic shocks and policies and for the presence of shocks originating in the financial sector itself, (ii) capturing the prominent role of bank lending rates and the gradual interest-rate pass-through in the transmission of monetary policy in the euro area, and (iii) providing a structural framework useable for assessing the macroeconomic impact of the ECB’s large-scale asset purchases conducted in recent years. In addition, NAWM II includes a number of other extensions of the original model reflecting its practical uses in the policy process over the past ten years.
The Reanchoring Channel of QE: The ECB Asset Purchase Programme and Long-Term Inflation Expectations, with Philippe Andrade, Johannes Breckenfelder, Fiorella de Fiore and Oreste Tristani, October 2016, revision requested from International Journal of Central Banking; working paper version: The ECB's Asset Purchase Programme: An Early Assessment, ECB Working Paper No 1956.
This paper analyses the impact of the European Central Bank’s asset purchase programme on long-term inﬂation expectations. It documents that the announcements related to the launch of the programme have raised long-term inﬂation expectations towards the ECB’s medium-term inﬂation objective. It argues that such a ‘reanchoring channel’ can enhance the eﬀectiveness of the programme, especially when the policy rate is stuck at its lower bound. The channel can account for a third of the programme’s inﬂation impact in a calibrated macroeconomic model with balance sheet constrained banks and uncertainty about the central bank’s inﬂation target.
work in progress
We introduce location choice in a multi-sector general equilibrium model to study how it affects development accounting. Producers in agriculture, manufacturing and services choose their location to trade off land rents with transport costs to the city center. We show how space affects the aggregate production function and decompose output per worker into productivity, land per worker, and a term adjusting for sector location. In our model, services are luxury goods. As a result, richer cities have larger service cores, higher service prices, and relatively less output per worker in services. These predictions are broadly consistent with the data. We calibrate our model to data on cities in OECD countries and show that land and location explain 10-30 percentage points of the variation in output per worker.
We propose a simple spatial model to explain why the price level is higher in rich countries. There are two sectors: manufacturing, which is freely tradable, and non-tradable services, which have to locate near customers in big cities. As countries develop, total factor productivity increases simultaneously in both sectors. However, because services compete with the population for scarce land, labor productivity will grow slower in services than in manufacturing. Services become more expensive, and the aggregate price level becomes higher. The model hence provides a theoretical foundation for the Balassa-Samuelson assumption that productivity growth is slower in the non-tradable sector than in the tradable sector. Empirical results confirm two key implications of the theory. First, we compare countries where land is scarce (densely populated, highly urban countries) to rural countries. The Balassa-Samuelson effect is stronger among urban countries. Second, we compare sectors that locate at different distance to consumers. The Balassa-Samuelson effect is stronger within sectors that locate closer to consumers.