New Approaches in Macroeconomic Theory

Paper Session

Friday, Jan. 6, 2017 2:30 PM – 4:30 PM

Hyatt Regency Chicago, McCormick
Hosted By: Econometric Society
  • Chair: Xavier Gabaix, Harvard University

A Behavioral New Keynesian Model

Xavier Gabaix
,
Harvard University

Abstract

This paper presents a framework for analyzing how bounded rationality affects monetary and fiscal policy. The model is a tractable and parsimonious enrichment of the widely-used New Keynesian model – with one main new parameter, which quantifies how poorly agents understand future policy and its impact. That myopia parameter, in turn, affects the power of monetary and fiscal policy in a microfounded general equilibrium.

A number of consequences emerge. (i) Fiscal stimulus or “helicopter drops of money” are powerful and, indeed, pull the economy out of the zero lower bound. More generally, the model allows for the joint analysis of optimal monetary and fiscal policy. (ii) The Taylor principle is strongly modified: even with passive monetary policy, equilibrium is determinate, whereas the traditional rational model yields multiple equilibria, which reduce its predictive power, and generates indeterminate economies at the zero lower bound (ZLB). (iii) The ZLB is much less costly than in the traditional model. (iv) The model helps solve the “forward guidance puzzle”: the fact that in the rational model, shocks to very distant rates have a very powerful impact on today's consumption and inflation: because agents are partially myopic, this effect is muted. (v) Optimal policy changes qualitatively: the optimal commitment policy with rational agents demands “nominal GDP targeting”; this is not the case with behavioral firms, as the benefits of commitment are less strong with myopic firms. (vi) The model is “neo-Fisherian” in the long run, but Keynesian in the short run: a permanent rise in the interest rate decreases inflation in the short run but increases it in the long run. The non-standard behavioral features of the model seem warranted by the extant empirical evidence.

Mirrlees Meets Diamond-Mirrlees

Florian Scheuer
,
Stanford University
Ivan Werning
,
Massachusetts Institute of Technology

Abstract

We show that the Diamond and Mirrlees (1971) linear tax model contains the Mirrlees (1971) nonlinear tax model as a special case. In this sense, the Mirrlees model is an application of Diamond-Mirrlees. We also derive the optimal tax formula in Mirrlees from the Diamond-Mirrlees formula. In the Mirrlees model, the relevant compensated cross-price elasticities are zero, providing a situation where an inverse elasticity rule holds. We provide four extensions that illustrate the power and ease of our approach, based on Diamond-Mirrlees, to study nonlinear taxation. First, we consider annual taxation in a lifecycle context. Second, we include human capital investments. Third, we incorporate more general forms of heterogeneity into the basic Mirrlees model. Fourth, we consider an extensive margin labor force participation decision, alongside the intensive margin choice. In all these cases, the relevant optimality condition is easily obtained as an application of the general Diamond-Mirrlees tax formula.

Dampening General Equilibrium: (i) From Micro Elasticities to Macro Effects; (ii) Forward Guidance

Chen Lian
,
Massachusetts Institute of Technology
George-Marios Angeletos
,
Massachusetts Institute of Technology

Abstract

Paper 1: We formalize the notion that general-equilibrium adjustment takes time by considering two alternative modifications. The one abandons the rational-expectation concept and models the GE adjustment according to a Tâtonnement process. The other maintains the standard solution concept but relaxes the assumption that the state of the economy is common knowledge. While conceptually distinct, these modifications are shown to be observationally equivalent vis-a-vis the response of aggregate outcomes to aggregate shocks. We discuss how this upset existing predictions and how it enhances the relevance of recent empirical work that exploits cross-sectional variation in an attempt to quantify aggregate effects.

Paper 2: A related application to the context of the so-called "forward guidance puzzle". We show how the power of forward guidance hinges on expectations of income and inflation that operate through general-equilibrium effect. We show how relaxing common knowledge anchors these expectations, attenuates the GE mechanism, and reduces the puzzle.
JEL Classifications
  • E0 - General