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  3. 2022
  4. Preliminary Program
  5. Interactions between Fiscal and Monetary Policy
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Interactions between Fiscal and Monetary Policy

Paper Session

Friday, Jan. 7, 2022 3:45 PM - 5:45 PM (EST)

Hosted By: Econometric Society
  • Chair: Jennifer La'O, Columbia University

Fiscal Policy at the Zero Lower Bound without Rational Expectations

Martin Eichenbaum
,
Northwestern University
Joao Guerreiro
,
Northwestern University
Riccardo Bianchi Vimercati
,
Northwestern University

Abstract

We address the question of how sensitive is the power of fiscal policy in the ZLB to the assumption of rational expectations. We do so through the lens of a standard NK model in which people are level-k thinkers. Our analysis weakens the case for using government spending to stabilize the economy when the ZLB binds. The less sophisticated people are, the smaller is the size of the government-spending multi plier. Our analysis strengthens the case for using tax policy to stabilize output when the ZLB is binding. The power of tax policy to stabilize the economy during the ZLB period is essentially undiminished when agents don’t have rational expectations. Finally we show that when people have limited cognitive abilities, how tax policy is communicated becomes critical to its effectiveness.

Redistribution and the Monetary--Fiscal Policy Mix

Saroj Bhattarai
,
University of Texas-Austin
Jae Won Lee
,
University of Virginia
Choongryul Yang
,
Federal Reserve Board

Abstract

We show that the effectiveness of redistribution policy in stimulating the economy and improving welfare is directly tied to how much inflation it generates, and thereby, to monetary-fiscal adjustments that ultimately finance the transfers. We compare two such monetary-fiscal adjustments: In the monetary regime, taxes eventually increase to finance transfers while in the fiscal regime, inflation rises, effectively imposing inflation taxes on public debt holders. We show analytically in a simple model that the fiscal regime generates larger and more persistent inflation than the monetary regime. In a quantitative application, we use a two-sector, two-agent New-Keynesian model, situate the model economy in a COVID-19 recession, and quantify the effects of the CARES Act. We find that transfer multipliers are significantly larger under the fiscal regime than under the monetary regime, as inflationary pressures counteract the deflationary forces during the recession. Moreover, redistribution produces a Pareto improvement under the fiscal regime.

The Treasury Market in Spring 2020 and the Response of the Federal Reserve

Annette Vissing-Jorgensen
,
University of California-Berkeley

Abstract

Treasury yields spiked during the initial phase of COVID. The 10-year yield increased by 64 bps from March 9 to 18, 2020, leading the Federal Reserve to purchase $1T of Treasuries in 2020Q1. Fed Treasury purchases were causal for reducing Treasury yields based on (1) the timing of purchases (which increased on March 19), (2) evidence against confounding factors, and (3) the timing of yield reversal and Fed purchases in the MBS market. Treasury-QE worked more via purchases than announcements. The yield spike was driven by liquidity needs of mutual funds, foreign official agencies, and hedge funds that were unaffected by the March 15, 2020 Treasury-QE announcement.

The Risks of Safe Assets

Yang Liu
,
University of Hong Kong
Lukas Schmid
,
University of Southern California
Amir Yaron
,
University of Pennsylvania

Abstract

How much safety and liquidity can the US government provide? Should it accommodate demand for these attributes because high convenience yields in Treasuries lower its cost of borrowing? We evaluate a novel fiscal risk channel limiting the government’s capacity to provide such services. Rising government debt lowers liquidity premia, but creates excess tax volatility through fiscal amplification, raising risk premia and credit spreads as well as firms’ cost of capital thereby crowding out real activity. Our general equilibrium model suggests that this channel leads to significantly depressed growth prospects and rising Treasury yields. We use our model to quantitatively evaluate current proposals on unconventional stabilization policies and find that these effects are exacerbated in times of fiscal stress. Increasing safe asset supply can thus be risky, and have a significant fiscal cost.
JEL Classifications
  • E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit
  • E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook