Academic Papers

1. Unemployment, Credit Rationing, and Capital Accumulation: A Tale of Two Frictions (with Caroline Betts ), Economic Theory, Jan 1999

Abstract: This paper develops a model in which two information frictions are embedded into an otherwise conventional neoclassical growth model; an adverse selection problem in the labor market and a costly state verification problem in the credit market. The former allows equilibrium unemployment to arise endogenously while the latter is responsible for equilibrium credit rationing. This structure is used to investigate a theoretical link between the level of unemployment and the extent of credit rationing (and capital formation). The presence of the labor market friction is enough to generate scope for multiple steady state equilibria. The model also generates a large class of endogenous cyclical and chaotic dynamical equilibria. Development trap phenomena may also appear.

2. Price Level Volatility: A Simple Model of Money Taxes and Sunspots (with M. Guzman , and K. Shell ), Journal of Economic Theory, 81 (2) August 1998, 431-461

Abstract: We investigate sunspot equilibria in a static, one-commodity model with taxes and transfers denominated in money units. Volatility in this economy is purely monetary, since the only uncertainty is about the price level. We construct simple, robust examples of sunspot equilibria that are not mere randomizations over certainty equilibria. We also identify the source of these SSEs: equilibrium in the securities market is determined as if there were no restricted consumers and the unrestricted consumers face intrinsic uncertainty. Perfect securities markets eliminate allocation uncertainty, but they exacerbate price-level volatility.

3. Credit Market Imperfections, Income Distribution, and Capital Accumulation, Economic Theory, 11, Jan (1998), 171-200

Abstract: This paper builds a model in which the distribution of income matters for capital formation, and uses it to analyze the effects of a simple policy intended to create a more equal distribution of income on the severity of certain credit market imperfections and, through this channel, capital accumulation. A neoclassical growth model is developed in which some capital investment must be externally financed, and external finance is subject to a standard costly state verification (CSV) problem. In particular, some fraction of the population is "capitalists'', who have access to risky but high return capital production technologies. Successful capitalists leave bequests to their offspring, thereby permitting them to internally finance some fraction of their own investment projects. However some external finance is also required. This is provided by "workers'' who save out of labor income. As is well known, the greater the capability of capitalists to provide internal finance, the less severe is the CSV problem. Thus bequests mitigate credit market frictions and, in that sense, promote financial market efficiency and capital accumulation. However, they also perpetrate income inequality. The structure is used to show that a policy that taxes the bequests of capitalists, and transfers the proceeds to workers, necessarily reduces the steady state capital stock. Indeed, when this effect is sufficiently strong, these redistributive tax/transfer schemes can reduce the total (wage plus transfer) incomes of workers, as well as their welfare. Thus some simple policies intended to redistribute income can be highly counterproductive.

4. Some Even More Unpleasant Monetarist Arithmetic (with M. G. Guzman and (late) B. D. Smith ), Canadian Journal of Economics (Aug 1998)

Abstract: Does monetizing a deficit result in a higher or a lower rate of inflation than does bond financing the same deficit? Sargent and Wallace (1981) produced conditions under which bond finance leads to a higher rate of inflation than deficit monetization ("unpleasant monetarist arithmetic''). However, it has been argued that unpleasant arithmetic is unlikely to obtain in practice, as it requires a number of conditions to hold that are rarely satisfied empirically. We develop a model essentially identical to that of Sargent and Wallace, and modify it to allow for a simple type of financial intermediation that they exogenously precluded. In the presence of reserve requirements, unpleasant arithmetic arises even when the real rate of growth exceeds the real return on bonds. Moreover, under a very mild restriction on the interest elasticity of savings, there exists a unique equilibrium to which unpleasant arithmetic results necessarily apply. No "Laffer curve'' considerations arise. We also discuss various tensions that arise between determinacy and efficiency of monetary equilibria.

5. Monetary, Fiscal, and Bank Regulatory Policy in a Simple Monetary Growth Model (with E. Huybens , M.G. Guzman, and B. D. Smith), International Economic Review , 38 (2) May (1997)

Abstract: We consider an otherwise conventional monetary growth model in which spatial separation and limited communication create a transactions role for currency, and stochastic relocation gives rise to financial intermediaries. In this framework we consider how changes in fiscal and monetary policy, and in reserve requirements, affect inflation, capital formation, and nominal interest rates. There is also considerable scope for
multiple equilibria; we show how reserve requirements that never bind along actual equilibrium paths can play an important role in avoiding undesirable equilibria. Finally, we demonstrate that changes in (apparently) nonbinding reserve requirements can have significant real effects.

6. Monetary Policy Arithmetic: Some Recent Contributions (with Joe Haslag); Dallas Fed Economic Review, 3rd qtr, 1999

Abstract: Sargent and Wallace (1981) studied the feasibility of a bond-financed increase in government spending. In their "unpleasant monetarist arithmetic", Sargent and Wallace showed how using bonds to finance a permanent deficit today may necessitate faster money growth in the future, yielding higher inflation today. The logic behind this "spectacular'' result is predicated on the satisfaction of one crucial condition: the real interest rate offered on bonds has to exceed the real growth rate of the economy. In this article, Joydeep Bhattacharya and Joseph Haslag review some recent contributions to this literature in light of the contentious nature of this stricture. Most notably, the authors demonstrate that the conditions under which the unpleasant monetarist arithmetic holds may be even weaker than what Sargent and Wallace had originally envisioned. In addition, the authors consider the possibility of financing the deficit by changing reserve requirements instead of raising money growth rates. Interestingly, a pleasant version of the financing arithmetic emerges.

7. Reliance, Composition, and Inflation (with Joe Haslag ), Federal Reserve Bank of Dallas, Economic and Financial Review) 4th qtr, 2000

Abstract: In this article, we explore the role of fiscal policy actions on long-run prices and the inflation rate.   We study a model economy in which the central bank is not independent.  Indeed, the government explicitly relies on the central bank to account for a pre-determined fraction of its revenue needs.  Despite the absence of independence, the central bank does unilaterally control the composition of government paper.  We show that changes in reliance and composition have long-run impacts on prices and inflation. Separately the two policy experiments suggest one way in which non-independent central bank can retain substantial control over the inflation rate and still meet the revenue requirements set for it by the government.

8. On the Use of the Inflation Tax when Non-Distortionary Taxes are Available (with Joe Haslag ), 4, 823-841, 2001 Review of Economic Dynamics

Abstract: Using a pure-exchange overlapping generations model in which money is valued because of a legal restriction, we show the following: a) a benevolent government may make some use of the inflation tax in conjunction with a lump-sum tax on the young but not if lump-sum taxes on the old are available, and b) the welfare-maximizing monetary policy may deviate from the Friedman rule (contract the money supply so as to equate the real return on money and other competing stores of value) in either case.


9.  Tight Money Policies and Inflation Revisited (with N. Kudoh ),  May 2002 Canadian Journal of Economics

Abstract: This paper reconsiders the link between tight money policies and inflation in the spirit of Sargent and Wallace's (1981) influential paper "Some Unpleasant Monetarist Arithmetic''. A standard neoclassical model with production, capital, bonds, and return-dominated currency is used to study the long-run effects on inflation of a tightening of monetary policy engineered via a open market sale of bonds. The potential for tight money policies to be inflationary (unpleasant arithmetic) is shown to exist even when the real interest rate is below the growth rate of the economy. Equilibria exhibiting unpleasant arithmetic can be stable. In contrast, when monetary policy is conducted via an inflation target rule, the only stable equilibrium is the one that exhibits pleasant arithmetic. The two monetary policy rules therefore produce sharply different predictions about the likely observability of unpleasant arithmetic in real-world economies.

10.  Is Reserve-Ratio Arithmetic More Pleasant? (with Joseph Haslag ); 70(3), 471-491, Economica, 2003

Abstract: Does it matter in a revenue-neutral setting if the government changes the inflation tax base or the inflation tax rate? We answer this question within the context of an overlapping generations model in which government bonds, capital, and cash reserves coexist. We consider experiments that parallel those studied in Sargent and Wallace's "unpleasant monetarist arithmetic;" the government uses seigniorage to service its debt, choosing between changing either the money growth rate (the inflation-tax rate) or the reserve requirement ratio (the inflation-tax base). In the former case, we obtain standard unpleasant arithmetic; in the long run, a permanent open market sale results in higher money growth, and higher long run inflation. Somewhat surprisingly, it turns out that for a given money growth rate, lower reserve requirements fund the government's interest expense. Associated with the lower reserve requirements is lower long-run inflation and higher welfare when compared to the money growth case. The broad message is that reserve-ratio arithmetic can be pleasant even when money growth arithmetic is not.


11.  Monetary Policy, Fiscal Policy, and the Inflation Tax: Equivalence Results (with Joseph Haslag and Steven Russell ) 7(5), 647-669, Macroeconomic Dynamics, 2003

 Abstract:This paper clarifies and extends previous work on the equivalence between monetary regimes and fiscal regimes involving social security systems.  We show that monetary regimes of the type we study are equivalent to two alternative types of social security regimes.  This result has two important implications.  One is that financing a real expenditure by increasing the inflation rate is equivalent, across regimes, to financing the expenditure by increasing the tax rate on social security benefits.  The other is that a wide range of monetary policy actions are equivalent, across regimes, to fiscal policy actions that change the scale of the social security system and the tax rates on social security benefits and/or bank deposits.
12.  Two-Period Cycles in a Three-Period Overlapping Generations Model (joint with Steven Russell );  Journal of Economic Theory, 109 (2), 378-401, April 2003

Abstract: We study the properties of two-period monetary cycles in simple pure exchange overlapping generations economies in which the households live for three periods.  We demonstrate that these economies can support cycles under a much broader -- and, arguably, more plausible -- range of assumptions than the analogous two-period economies.  We show that economies that fail the well-known Grandmont [1985] condition can have cycles, and that economies that satisfy the condition can fail to have cycles.  In addition, we show that economies can have monetary cycles when they do not have conventional monetary steady states, and when aggregate demand for assets is not decreasing in the real return rate at a gross real rate of unity.
13.    Labor Market Search and Optimal Retirement Policy (with Casey Mulligan and Robert R. Reed ) forthcoming Economic Inquiry Also slightly earlier version as NBER working paper # W-8591

Abstract: A popular view about social security, dating back to its early days of inception, is that it is a means for young, unemployed workers to “purchase” jobs from older, employed workers. The question we ask is: Can social security, by encouraging retirement and hence creating job vacancies for the young, improve the allocation of workers to jobs? Using a standard model of labor market search, we find that public retirement programs pay the elderly substantially more than their jobs are worth. Our results therefore imply that recent reforms aimed at reducing retirement incentives are likely to improve labor market efficiency.

14.  Dynamics of the Planning Solution in the Discrete-Time Textbook Model of Labor Market Search and Matching (joint with H. Bunzel)  Economics Bulletin [online version]

Abstract: This paper takes a discrete-time adaptation of the continuous-time matching economy described in Pissarides (1990, 2000), and computes the solution to the dynamic planning problem. The solution is shown to be completely characterized by a first-order, non-linear map. We show that the map admits a unique stationary solution which is dynamically unstable. Oscillatory solutions are possible but there is no possibility of periodic solutions. The planner picks the initial condition that places the economy directly on the steady state. Our results are in sharp contrast to received wisdom on out-of-steady-state dynamics in the continuous-time decentralized version of the Pissarides model where adjustment to the steady state is non-instantaneous, and overshooting of vacancies is possible.
15.  Can Financial Intermediation Induce Endogenous Fluctuations? (joint with S. Banerji and Van Ngo Long); forthcoming Journal of Economic Dynamics and Control

Abstract: This paper studies the possibility of endogenous fluctuations caused by activities of financial intermediaries. Risk-averse agents borrow from banks and invest in a risky two-state capital technology. The probability of success with the technology is assumed to be decreasing in the amount of capital invested. In a complete information setting with intermediation, the efficient loan contract achieves complete risk sharing but the amount invested in the risky project is smaller than the loan size. This "income effect" is responsible for the endogenous generation of complex dynamics. In the absence of intermediation, the economy studied cannot exhibit any cyclical fluctuations.
16. What do Information Frictions Do? (joint with Shankha Chakraborty); forthcoming Economic Theory

Abstract: Researchers have incorporated labor or credit market frictions in isolation within simple neoclassical models to open up a role for institutions, inject realism into their models and examine the impact of these distortions on output and employment. We present an overlapping generations model with production in which a labor market friction (moral hazard) coexists with a credit market friction (costly state verification). The simultaneous presence and interaction of these two frictions is studied. Our main results are: (i) while credit market frictions affect real activity and employment both in the short and long run, labor market frictions typically have only short-run effects unless they also affect the volume of investment per worker, (ii) the two frictions amplify each other to produce higher long-run unemployment than would result from only labor market frictions, (iii) these distortions have the ability to prolong the effect of temporary shocks, and (iv) the dynamical properties of economies with both frictions are, somewhat surprisingly, qualitatively similar to their frictionless counterparts.
17.  The Non-Monotonic Relationship Between Seigniorage and Inequality (with J. Haslag and H. Bunzel ); forthcoming Canadian Journal of Economics

Abstract: Central banks typically find it difficult to turn off the “political pressure valve”. This has important consequences for the types of monetary policies they implement. This paper presents an analysis of how political factors may come into play in the equilibrium determination of inflation. We employ a standard overlapping generations model with heterogenous young-age endowments, and a government that funds an exogenous spending via a combination of nondistortionary income taxes and the inflation tax. Agents have access to two stores of value: fiat money and an inflation-shielded, yet costly, asset. The model predicts that the relationship between elected reliance on the inflation tax (for revenue) and income inequality is non-monotonic; in particular, the reliance on seigniorage may decrease as income inequality rises above a threshold. We find robust empirical backing for this hypothesis from a cross-section of countries.

18. Heterogeneity, redistribution, and the Friedman rule (with Antoine Martin and Joseph Haslag); International Economic Review, May 2005; see discussion of this paper by Peter Ireland

Abstract: We study several popular monetary models which generate a non-degenerate stationary distribution of money holdings. Across these environments, our principal finding is as follows: a monetary policy that sets long run nominal interest rates to zero (the Friedman rule) does not typically maximize ex-post social welfare if it can generate redistributive effects. An increase in the rate of growth of the money supply has the standard partial-equilibrium effect of making money a less desirable asset thereby decreasing the utility of all moneyholders. A second, general-equilibrium effect, is a transfer from one type of agent to the other. For each environment, when the rate of growth of the money supply is not too high, an increase in the latter away from the Friedman rule may produce a transfer effect that dominates the partial equilibrium effect thereby rendering the Friedman rule ex-post suboptimal.
19.  The Role of Money in Two Alternative Models: When is the Friedman Rule Optimal, and Why? (with J. Haslag and S. Russell); forthcoming, Journal of Monetary Economics

Abstract: In models of money with an infinitely-lived representative agent (ILRA models), the optimal monetary policy is almost always the Friedman rule.  In overlapping generations (OG) models, by contrast, the Friedman rule may not be optimal.  In this paper, we use this difference in monetary policy prescriptions to help us identify and study the key difference between these two models as models of money.  We study the welfare properties of monetary policy in a simple OG model under two very different money demand specifications and two alternative assumptions about the generational timing of taxes for money retirement. We conclude that the key difference between ILRA and OG monetary models is that in the latter, the standard method for constructing a monetary regime causes transactions involving money to become intergenerational transfers.  Under alternative government fiscal/monetary regimes that offset these intergenerational transfers, the Friedman rule is always optimal.
20. Sub-optimality of the Friedman rule in Townsend's turnpike and stochastic relocation models of money: Do finite lives and initial dates matter? (with A. Martin and J. Haslag); forthcoming Journal of Economic Dynamics and Control

Abstract: The Friedman rule, a widely studied prescription for monetary policy, is optimal in Townsend's turnpike model of money; it is not so in the overlapping generations version of his stochastic relocation model of money. We investigate these monetary models in the light of this disparity. To that end, we create a modified version of the turnpike model that generates the same stationary monetary equilibria as does the two-period overlapping generations model with random relocation. We exploit this equivalence to explain the aforementioned disparity. We also discuss the importance of whether or not the economy has an initial date.


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Updated May 10, 2005