How should monetary authorities react to an oil price shock? This paper shows that in a noncompetitive economy, policies that perfectly stabilize prices entail large welfare costs, hence explaining the reluctance of policymakers to enforce them. The policy trade-off is nontrivial because oil (energy) is an input to both production and consumption. As welfaremaximizing policies are hard to implement and communicate, I derive a simple interest rate rule that depends only on observables but mimics the optimal plan in all dimensions. The optimal rule is hard on core inflation but accommodates oil price changes.JEL codes: E32, E52, E58
We examine the optimal monetary policy in the presence of endogenous feedback loops between asset prices and economic activity when macroprudential policies can also be pursued. Absent macroprudential policies, the optimal monetary policy leans against asset prices and can be closely approximated, using a speed‐limit rule that responds to the growth of financial variables. An endogenous feedback loop is crucial for this result: price stability is otherwise quasi‐optimal. Similarly, a simple macroprudential rule that links reserve requirements to credit growth dampens the endogenous feedback loop and leads to near price stability. State‐contingent taxes on lending are shown to be welfare‐improving.
How should monetary authorities react to an oil price shock? The New Keynesian literature has concluded that ensuring complete price stability is the optimal thing to do. In contrast, this paper argues that a meaningful trade-off between stabilizing inflation and the welfare relevant output gap arises in a distorted economy once one recognizes (i) that oil (energy) cannot be easily substituted by other factors in the short-run, (ii ) that there is no fiscal transfer available to policymakers to neutralize the steady-state distortion due to monopolistic competition, and (iii ) that increases in oil prices also directly affect consumption by raising the price of fuel, heating oil, and other energy sources. While the first two conditions are necessary to introduce a microfounded monetary policy trade-off, the third one makes it quantitatively significant.The optimal precommitment monetary policy relies on unobservables and is therefore hard to implement. To address this concern, I derive a simple interest rate feedback rule that mimics the optimal plan in all relevant dimensions but that depends only on observables, namely core inflation, oil price inflation, and the growth rate of output.
We examine the optimal monetary policy in the presence of endogenous feedback loops between asset prices and economic activity. We reconsider this issue in the context of the financial accelerator model and when macroprudential policies can be pursued. Absent macroprudential policy, we first show that the optimal monetary policy leans considerably against movements in asset prices and risk premia. We show that the optimal policy can be closely approximated and implemented using a speed-limit rule that places a substantial weight on the growth of financial variables. An endogenous feedback loop is crucial for this result, and price stability is otherwise quasi-optimal. Similarly, introducing a simple macroprudential rule that links reserve requirements to credit growth dampens the endogenous feedback loop, leading the optimal monetary policy to focus on price stability.
We study the properties of the IMF-WEO estimates of real-time output gaps for countries in the euro area as well as the determinants of their revisions over 1994-2017. The analysis shows that staff typically saw economies as operating below their potential. In real time, output gaps tend to have large and negative averages that are largely revised away in later vintages. Most of the mis-measurement in real time can be explained by the difficulty in predicting recessions and by overestimation of the economy’s potential capacity. We also find, in line with earlier literature, that real-time output gaps are not useful for predicting inflation. In addition, countries where slack (and potential growth) is overestimated to a larger extent primary fiscal balances tend to be lower and public debt ratios are higher and increase faster than projected. Previous research suggests that national authorities’ real-time output gaps suffer from a similar bias. To the extent these estimates play a role in calibrating fiscal policy, over-optimism about long-term growth could contribute to excessive deficits and debt buildup.
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