nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2020‒04‒20
23 papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Health Risk and the Welfare Effects of Social Security By Shantanu Bagchi; Juergen Jung
  2. Fiscal transfers in a two-level fiscal framework: stabilizing properties according to the fiscal instrument By Thierry BETTI
  3. Should Germany Have Built a New Wall? Macroeconomic Lessons from the 2015-18 Refugee Wave By Christopher Busch; Dirk Krueger; Alexander Ludwig; Irina Popova; Zainab Iftikhar
  4. Macroeconomic Implications of COVID-19: Can Negative Supply Shocks Cause Demand Shortages? By Veronica Guerrieri; Guido Lorenzoni; Ludwig Straub; Iván Werning
  5. Estimating Macroeconomic Models of Financial Crises: An Endogenous Regime-Switching Approach By Gianluca Benigno; Andrew Foerster; Christopher Otrok; Alessandro Rebucci
  6. Higher-order income risk over the business cycle By Busch, Christopher; Ludwig, Alexander
  7. On shadow banking and fiÂ…nancial frictions in DSGE modeling By Philipp Kirchner
  8. Rebalancing the euro area: Is wage adjustment in Germany the answer? By Hoffmann, Mathias; Kliem, Martin; Krause, Michael; Moyen, Stephane; Sauer, Radek
  9. The Political (In)Stability of Funded Pension Systems By Roel Beetsma; Oliwia Komada; Krzysztof Makarski; Joanna Tyrowicz
  10. Political Economy of Taxation, Debt Ceilings, and Growth By Uchida, Yuki; Ono, Tetsuo
  11. Trends in aggregate employment, hours worked per worker, and the long-run labor wedge By Epstein, Brendan; Mukherjee, Rahul; Finkelstein Shapiro, Alan; Ramnath, Shanthi
  12. Macroeconomic Fluctuations Under Natural Disaster Shocks in Central America and he Caribbean By Allan Wright; Patrice Borda
  13. A Fisherian Approach to Financial Crises: Lessons from the Sudden Stops Literature By Javier Bianchi; Enrique G. Mendoza
  14. Indebted Demand By Atif R. Mian; Ludwig Straub; Amir Sufi
  15. Household responses to disability shocks: Spousal labor supply, caregiving, and disability insurance By Lee, Siha
  16. Are the liquidity and collateral roles of asset bubbles different? By Lise Clain-Chamosset-Yvrard; Xavier Raurich; Thomas Seegmuller
  17. The Murder-Suicide of the Rentier: Population Aging and the Risk Premium By Joseph Kopecky; Alan M. Taylor
  18. Involuntary unemployment with divisible labor supply with a three-periods overlapping generations model under monopolistic competition By Tanaka, Yasuhito
  19. Does the Selfish Life-Cycle Model Apply in the Case of Japan? By Charles Yuji Horioka
  20. Price setting frequency and the Phillips Curve By Gasteiger, Emanuel; Grimaud, Alex
  21. The Macroeconomics of Epidemics By Martin S. Eichenbaum; Sergio Rebelo; Mathias Trabandt
  22. Heterogeneous Credit Constraints and Optimal Monetary Policy By Marco Ortiz; Gerardo Herrera
  23. Average inflation targeting and the interest rate lower bound By Flora Budianto; Taisuke Nakata; Sebastian Schmidt

  1. By: Shantanu Bagchi (Department of Economics, Towson University); Juergen Jung (Department of Economics, Towson University)
    Abstract: We examine the welfare effects of Social Security in a general equilibrium environment with realistic labor income, mortality, and health risks. We construct an overlapping generations model with rational-expectations households facing idiosyncratic health risk, profit maximizing firms, incomplete insurance markets, and a government that provides pensions and health insurance. We calibrate this model to the U.S. economy and perform two sets of computational experiments: (i) modifying the progressivity of the Social Security's benefit-earnings rule, and (ii) cutting Social Security's payroll tax. We find that both experiments have a larger effect on overall welfare in the presence of health risk, because health risk increases the importance of short-term consumption smoothing, both within work-life and retirement. Increased progressivity allows households to better smooth old-age consumption risk, and the payroll tax cut increases disposable income and allows better self-insurance against early-life health risk. We also find that labor supply is an important self-insurance tool in the presence of health risk, as increasing Social Security's progressivity has a smaller effect on overall welfare and cutting the payroll tax has a larger effect on overall welfare when labor supply is fixed. Finally, low-income households experience larger welfare gains both from increasing Social Security's progressivity and cutting the payroll tax, because of their relatively low ability to self-insure against health risk in general.
    Keywords: Health risk, Social Security, benefit-earnings rule, consumption smoothing, general equilibrium.
    JEL: E62 E21 H31 H55 I14
    Date: 2020–04
  2. By: Thierry BETTI
    Abstract: In a two-country Dynamic and Stochastic General Equilibrium (DSGE) model, I document the stabilizing properties of fiscal transfers between currency union members according to the nature of public spending allowed by these transfers for the recipient economy. To do this, I model a two-level fiscal framework for the monetray union in which the central autority collects one share of national fiscal revenues and determine how these revenues are redistributed among countries following a simple fiscal transfer rule. We assume that the central autority is allowed to decide how the recipient economy use these funds. The main result of this paper is that the stabilizing properties of fiscal transfer schemes strongly depend on the way the recipient economy uses the funds following the fiscal transfer. Public consumption, transfers and VAT are more effective to stabilize macroeconomic differentials between both economies of the currency union when asymmetric demand shocks occur while the labor income tax and the social protection tax are more effective in the case of an asymmetric productivity shock.
    Keywords: Fiscal policy, new-Keynesian model, fiscal transfer mechanism, currency unions.
    JEL: E62 F41 F42 F J20
    Date: 2020
  3. By: Christopher Busch; Dirk Krueger; Alexander Ludwig; Irina Popova; Zainab Iftikhar
    Abstract: In 2015-2016 Germany experienced a wave of predominantly low-skilled refugee immigration. We evaluate its macroeconomic and distributional effects using a quantitative overlapping generations model calibrated using German micro data to replicate education and productivity differentials between foreign born and native workers. Workers are modelled as imperfect substitutes in aggregate production leading to endogenous wage differentials. We simulate the dynamic effects of this refugee wave, with specific focus on the welfare impact on low skilled natives. Our results indicate that the small losses this group suffers can be compensated by welfare gains of other parts of the native population.
    Keywords: Immigration, refugees, overlapping generations, demographic change
    JEL: F22 E20 H55
    Date: 2020–04
  4. By: Veronica Guerrieri; Guido Lorenzoni; Ludwig Straub; Iván Werning
    Abstract: We present a theory of Keynesian supply shocks: supply shocks that trigger changes in aggregate demand larger than the shocks themselves. We argue that the economic shocks associated to the COVID-19 epidemic—shutdowns, layoffs, and firm exits—may have this feature. In one-sector economies supply shocks are never Keynesian. We show that this is a general result that extend to economies with incomplete markets and liquidity constrained consumers. In economies with multiple sectors Keynesian supply shocks are possible, under some conditions. A 50% shock that hits all sectors is not the same as a 100% shock that hits half the economy. Incomplete markets make the conditions for Keynesian supply shocks more likely to be met. Firm exit and job destruction can amplify the initial effect, aggravating the recession. We discuss the effects of various policies. Standard fiscal stimulus can be less effective than usual because the fact that some sectors are shut down mutes the Keynesian multiplier feedback. Monetary policy, as long as it is unimpeded by the zero lower bound, can have magnified effects, by preventing firm exits. Turning to optimal policy, closing down contact-intensive sectors and providing full insurance payments to affected workers can achieve the first-best allocation, despite the lower per-dollar potency of fiscal policy.
    JEL: E21 E32 E60 I18
    Date: 2020–04
  5. By: Gianluca Benigno; Andrew Foerster; Christopher Otrok; Alessandro Rebucci
    Abstract: We estimate a workhorse DSGE model with an occasionally binding borrowing constraint. First, we propose a new specification of the occasionally binding constraint, where the transition between the unconstrained and constrained states is a stochastic function of the leverage level and the constraint multiplier. This specification maps into an endogenous regime-switching model. Second, we develop a general perturbation method for the solution of such a model. Third, we estimate the model with Bayesian methods to fit Mexico's business cycle and financial crisis history since 1981. The estimated model fits the data well, identifying three crisis episodes of varying duration and intensity: the Debt Crisis in the early-1980s, the Peso Crisis in the mid-1990s, and the Global Financial Crisis in the late-2000s. The crisis episodes generated by the estimated model display sluggish and long-lasting build-up and stagnation phases driven by plausible combinations of shocks. Different sets of shocks explain different variables over the business cycle and the three historical episodes of sudden stops identified.
    JEL: C11 E30 F41 G01
    Date: 2020–04
  6. By: Busch, Christopher; Ludwig, Alexander
    Abstract: We extend the canonical income process with persistent and transitory risk to shock distributions with left-skewness and excess kurtosis, to which we refer as higherorder risk. We estimate our extended income process by GMM for household data from the United States. We find countercyclical variance and procyclical skewness of persistent shocks. All shock distributions are highly leptokurtic. The existing tax and transfer system reduces dispersion and left-skewness of shocks. We then show that in a standard incomplete-markets life-cycle model, first, higher-order risk has sizable welfare implications, which depend crucially on risk attitudes of households; second, higher-order risk matters quantitatively for the welfare costs of cyclical idiosyncratic risk; third, higher-order risk has non-trivial implications for the degree of self-insurance against both transitory and persistent shocks.
    Keywords: Labor Income Risk,Business Cycle,GMM Estimation,Skewness,Persistent and Transitory Income Shocks,Risk Attitudes,Life-Cycle Model
    JEL: D31 E24 E32 H31 J31
    Date: 2020
  7. By: Philipp Kirchner (University of Kassel)
    Abstract: At the forefront of macroeconomic research on the causes of the Great Financial Crisis (GFC) was and still is the usage of dynamic stochastic general equilibrium (DSGE) models. To capture the nonlinearities of the GFC, these models were enriched with a variety of fiÂ…nancial frictions. This paper focuses on a special subset of these frictions, the shadow banking system. We provide a structured review of the strand of literature that considers shadow banking in DSGE setups and draw particular attention to the modeling approach as well as impact of shadow banking. Our analysis allows the following conclusions: fiÂ…rstly, models featuring shadow banking are better able to simulate realistic movements in the business cycle that are of comparable magnitude to the GFC. Secondly, the models consider ampliÂ…cation channels between the fiÂ…nancial sector and the real economy that proved to be of importance during the crisis. Thirdly, the models display a good explanatory power of Â…financial stability measures in the light of shadow banking.
    Keywords: Shadow Banking, DSGE, Financial Frictions, Financial Intermediation, Great Financial Crisis.
    JEL: E10 E44 E32
    Date: 2020
  8. By: Hoffmann, Mathias; Kliem, Martin; Krause, Michael; Moyen, Stephane; Sauer, Radek
    Abstract: We assess to what extent wage inflation policies in Germany could contribute to an economic rebalancing in the euro area and the rest of the world. We find that a rise in nominal wage inflation has positive short-run effects on inflation and output in Germany and the rest of the euro area. The duration of constant interest rates and expectations about the monetary policy stance matter to the magnitude of the results obtained. We establish that the modelling of the trade relationships with the rest of the world is of particular importance, as it allows to capture the induced relative price movements and hence changes in competitiveness within the three regions. Our results are obtained from an estimated DSGE model which consists of Germany, the rest of the euro area, and the rest of the world.
    Keywords: DSGE model,Bayesian estimation,Monetary policy,Trade balance
    Date: 2020
  9. By: Roel Beetsma; Oliwia Komada; Krzysztof Makarski; Joanna Tyrowicz
    Abstract: We analyze the political stability of capital funded social security. In particular, using a stylized theoretical framework we study the mechanisms behind governments capturing pension assets in order to lower current taxes. This is followed by an analysis of the analogous mechanisms in a fully-edged overlapping generations model with intra-cohort heterogeneity. Funding is efficient in a Kaldor-Hicks sense. Individuals vote on capturing the accumulated pension assets and replacing the funded pension pillar with a pay-as-you-go scheme. We show that even if capturing assets reduces welfare in the long run, it always has sufficient political support from those alive at the moment of the vote.
    Keywords: funded pensions, asset capture, majority voting, welfare
    JEL: H55 D72 E17 E27
    Date: 2020
  10. By: Uchida, Yuki; Ono, Tetsuo
    Abstract: This study presents voting on policies including labor and capital income taxes and public debt in an overlapping-generations model with physical and human capital accumulation, and it then analyzes the effects of a debt ceiling on a government's policy formation and its impact on growth and welfare. The debt ceiling induces the government to shift the tax burdens from the older to younger generations, but stimulates physical capital accumulation and may increase public education expenditure, resulting in a higher growth rate. Alternatively, the debt ceiling is measured from the viewpoint of a benevolent planner; lowering the debt ceiling (i.e., tightening fiscal discipline) makes it possible for the government to approach the planner's allocation in an aging society.
    Keywords: Debt ceiling; Probabilistic voting, Public debt, Economic growth, Overlapping generations
    JEL: D70 E24 H63
    Date: 2020–03–31
  11. By: Epstein, Brendan; Mukherjee, Rahul; Finkelstein Shapiro, Alan; Ramnath, Shanthi
    Abstract: Hours worked are fundamentally important for aggregate economic activity, yet canonical macroeconomic models fail dramatically at tracking its long-run trends. We develop an intuitive and tractable extension of the canonical model that decomposes trend hours into extensive and intensive margins via household-side employment-attainment costs and firm-side employment adjustment costs. Its predictions track very well the trend behavior of hours, and its two underlying margins, in the United States and a host of OECD countries. Our framework is relevant for analyzing the long run labor-market effects of a number of factors such as productivity growth, and tax or labor-market reforms.
    Keywords: CLM model; DLM model; Europe; hours worked per population; labor-market policy; long-run labor wedge; OECD countries; taxes; United States; U.S. tax puzzle.
    JEL: E60 H20 J20
    Date: 2020–03
  12. By: Allan Wright; Patrice Borda (CREDDI - Centre de Recherche en Economie et en Droit du Développement Insulaire - UA - Université des Antilles)
    Date: 2020–04–04
  13. By: Javier Bianchi; Enrique G. Mendoza
    Abstract: Sudden Stops are financial crises defined by a large, sudden current-account reversal. They occur in both advanced and emerging economies and result in deep recessions, collapsing asset prices, and real exchange-rate depreciations. They are preceded by economic expansions, current-account deficits, credit booms, and appreciated asset prices and real exchange rates. Fisherian models (i.e. models with credit constraints linked to market prices) explain these stylized facts as an outcome of Irving Fisher's debt-deflation mechanism. On the normative side, these models feature a pecuniary externality that provides a foundation for macroprudential policy (MPP). We review the stylized facts of Sudden Stops, the evidence on MPP use and effectiveness, and the findings of the literature on Fisherian models. Quantitatively, Fisherian amplification is strong and optimal MPP reduces sharply the size and frequency of crises, but it is also complex and potentially time-inconsistent, and simple MPP rules are less effective. We also provide a new MPP analysis incorporating investment. Using a constant debt-tax policy, we construct a crisis probability-output frontier showing that there is a tradeoff between financial stability and long-run output (i.e., reducing the probability of crises reduces long-run output).
    JEL: E3 E37 E44 F41 G01 G18
    Date: 2020–03
  14. By: Atif R. Mian; Ludwig Straub; Amir Sufi
    Abstract: We propose a theory of indebted demand, capturing the idea that large debt burdens by households and governments lower aggregate demand, and thus natural interest rates. At the core of the theory is the simple yet under-appreciated observation that borrowers and savers differ in their marginal propensities to save out of permanent income. Embedding this insight in a two-agent overlapping-generations model, we find that recent trends in income inequality and financial liberalization lead to indebted household demand, pushing down natural interest rates. Moreover, popular expansionary policies—such as accommodative monetary policy and deficit spending—generate a debt-financed short-run boom at the expense of indebted demand in the future. When demand is sufficiently indebted, the economy gets stuck in a debt-driven liquidity trap, or debt trap. Escaping a debt trap requires consideration of less standard macroeconomic policies, such as those focused on redistribution or those reducing the structural sources of high inequality.
    JEL: D31 E21 E32 E43 E44 E52 E62
    Date: 2020–04
  15. By: Lee, Siha
    Abstract: This paper examines married women's time allocation to market hours and spousal care in the event of their husbands' disability and its implications for evaluating the insurance value of the Social Security Disability Insurance (SSDI) program. First, I find that while spousal labor supply responses to husbands' disability are small, wives spend a sizable amount of time in spousal care after their husbands become disabled. Motivated by these facts, I develop a dynamic model of married households that incorporates husbands' disability status, wives' time allocation choices, health state dependent utility, and the institutional features of SSDI. Counterfactual experiments indicate that caregiving needs substantially attenuate spousal labor supply responses and increase the insurance value of SSDI relative to its costs. Furthermore, policy
    Keywords: disability,social security,spousal labor supply,caregiving
    JEL: D13 H53 H55 I38 J22
    Date: 2020
  16. By: Lise Clain-Chamosset-Yvrard (GATE Lyon Saint-Étienne - Groupe d'analyse et de théorie économique - ENS Lyon - École normale supérieure - Lyon - UL2 - Université Lumière - Lyon 2 - UCBL - Université Claude Bernard Lyon 1 - Université de Lyon - UJM - Université Jean Monnet [Saint-Étienne] - Université de Lyon - CNRS - Centre National de la Recherche Scientifique); Xavier Raurich (University of Barcelona, Department of Economics); Thomas Seegmuller (AMSE - Aix-Marseille Sciences Economiques - EHESS - École des hautes études en sciences sociales - AMU - Aix Marseille Université - ECM - École Centrale de Marseille - CNRS - Centre National de la Recherche Scientifique)
    Abstract: Several recent papers introduce different mechanisms to explain why asset bubbles are observed in periods of larger growth. These papers share common assumptions, heterogeneity among traders and credit market imperfection , but differ in the role of the bubble, used to provide liquidities or as collateral in a borrowing constraint. In this paper, we introduce heterogeneous traders by considering an overlapping generations model with households living three periods. Young households cannot invest in capital, while adults have access to investment and face a borrowing constraint. Introducing bubbles in a quite general way, encompassing the different roles they have in the existing literature, we show that the bubble may enhance growth when the borrowing constraint is binding. More significantly, our results do not depend on the-liquidity or collateral-role attributed to the bubble. We finally extend our analysis to a stochas-tic bubble, which may burst with a positive probability. Because credit and bubble are no more perfectly substitutable assets, the liquidity and collateral roles of the bubble are not equivalent. Growth is larger when bubbles play the liquidity role, because the burst of a bubble used for liquidity is less damaging to agents who invest in capital.
    Keywords: Liquidity,Bubble,Collateral,Crowding-in effect,Growth
    Date: 2020–04–07
  17. By: Joseph Kopecky; Alan M. Taylor
    Abstract: Population aging has been linked to global declines in interest rates. A similar trend shows that equity risk premia are on the rise. An existing literature can explain part of the decline in the trend in safe rates using demographics, but has no mechanism to speak to trends in relative asset prices. We calibrate a heterogeneous agent life-cycle model with equity markets, showing that this demographic channel can simultaneously account for both the majority of a downward trend in the risk free rate, while also increasing premium attached to risky assets. This is because the life cycle savings dynamics that have been well documented exert less pressure on risky assets as older households shift away from risk. Under reasonable calibrations we find declines in the safe rate that are considerably larger than most existing estimates between the years 1990 and 2017. We are also able to account for most of the rise in the equity risk premium. Projecting forward to 2050 we show that persistent demographic forces will continue push the risk free rate further into negative territory, while the equity risk premium remains elevated.
    JEL: E21 E43 G11 J11
    Date: 2020–04
  18. By: Tanaka, Yasuhito
    Abstract: We show the existence of involuntary unemployment without assuming wage rigidity. We derive involuntary unemployment by considering utility maximization of consumers and profit maximization of firms in an overlapping generations model under monopolistic competition with increasing or constant returns to scale technology and homothetic preferences of consumers. Indivisibility of labor supply may be a ground for the existence of involuntary unemployment. However, we show that there exists involuntary unemployment even when labor supply is divisible. The existence involuntary unemployment in our model is due to that we use an overlapping generations model of consumptions and labor supply. In a two-periods overlapping generations model it is possible that a reduction of the nominal wage rate reduces unemployment. However, if we consider a three-periods overlapping generations model including a childhood period, a reduction of the nominal wage rate does not necessarily reduce unemployment.
    Keywords: involuntary unemployment, monopolistic competition, divisible labor supply, three-periods overlapping generations model.
    JEL: E12 E24
    Date: 2020–01–31
  19. By: Charles Yuji Horioka (Research Institute for Economics and Business Administration, Kobe University, Osaka University, Asian Growth Research Institute, and National Bureau of Economic Research)
    Abstract: In this paper, we first provide a brief exposition of the simplest version of the selfish life cycle model or hypothesis, which is undoubtedly the most widely used theoretical model of household behavior in economics, and then survey the literature on household saving behavior in Japan (with emphasis on the author's own past research) to shed light on whether or not the selfish life-cycle model applies in the case of Japan. In particular, we survey the literature on the impact of the age structure of the population on the saving rate, the saving behavior of retired households, saving motives, the prevalence of bequests, bequest motives, tests of altruism, and the importance of borrowing (liquidity) constraints and show that almost all of the available evidence suggests that the selfish life-cycle model applies to a greater extent in Japan than it does in other countries. Finally, we discuss the policy implications of our findings.
    Keywords: Age structure of the population; Aged; Altruism; Bequests; Bequest motives; Borrowing constraints; Consumption; Dissaving; Elderly; Estates; Household behavior; Household saving; Households; Inheritances; Intergenerational transfers; Japan; Lifecycle hypothesis; Life-cycle model; Life-cycle theory; Liquidity constraints; Old age; Retirees; Saving; Saving motives; Selfishness
    JEL: D11 D12 D14 D64 E21 J14
    Date: 2020–03
  20. By: Gasteiger, Emanuel; Grimaud, Alex
    Abstract: We develop a New Keynesian (NK) model with endogenous price setting frequency. Whether a firm updates its price in a given period depends on an analysis of expected cost and benefits modelled by a discrete choice process. A firm decides to update the price when expected benefits outweigh expected cost and then resets the price optimally. As markups are countercyclical, the model predicts that prices are more flexible during expansions and less flexible during recessions. Our quantitative analysis shows that contrary to the standard NK model, the assumed price setting behaviour: is consistent with micro data on price setting frequency; gives rise to an accelerating Phillips curve that is steeper during expansions and flatter during recessions; explains shifts in the Phillips curve associated with different historical episodes without relying on implausible high cost-push shocks and nominal rigidities.
    Keywords: Price setting,inflation dynamics,monetary policy,Phillips curve
    JEL: E31 E32 E52
    Date: 2020
  21. By: Martin S. Eichenbaum; Sergio Rebelo; Mathias Trabandt
    Abstract: We extend the canonical epidemiology model to study the interaction between economic decisions and epidemics. Our model implies that people’s decision to cut back on consumption and work reduces the severity of the epidemic, as measured by total deaths. These decisions exacerbate the size of the recession caused by the epidemic. The competitive equilibrium is not socially optimal because infected people do not fully internalize the effect of their economic decisions on the spread of the virus. In our benchmark scenario, the optimal containment policy increases the severity of the recession but saves roughly half a million lives in the U.S.
    JEL: E1 H0 I1
    Date: 2020–03
  22. By: Marco Ortiz (Universidad del Pacífico); Gerardo Herrera (Universidad del Pacífico)
    Abstract: The optimal response to adverse external shocks in an economy involves the choice of a exchange rate policy. While the traditional Mundell-Flemming inspired theories support a floating exchange rate, evidence shows that central banks intervene in foreign exchange markets regularly. One of the reasons for these interventions relies on the consequences of large depreciations triggering negative balance sheet effects in economies with dollarized liabilities as shown by Benigno et al. (2013) and Devereux and Poon (2011). This paper extends this literature by introducing heterogeneity in credit constraints across sectors. Our findings support that "leaning against the wind" policy responses are optimal even when only a sector of the economy is affected by the credit constraints. Thus, relative price distortions provide an additional justification for these policies. We show that the vulnerability of the economy to large negative external shocks depends not only on the overall unhedged foreign debt, but also on its distribution across sectors.
    JEL: E5 F3 G15
    Date: 2020–02
  23. By: Flora Budianto; Taisuke Nakata; Sebastian Schmidt
    Abstract: Assigning a discretionary central bank a mandate to stabilize an average inflation rate - rather than a period-by-period inflation rate - increases welfare in a New Keynesian model with an occasionally binding lower bound on nominal interest rates. Under rational expectations, the welfare-maximizing averaging window is infinitely long, which means that optimal average inflation targeting (AIT) is equivalent to price level targeting (PLT). However, AIT with a finite, but sufficiently long, averaging window can attain most of the welfare gain from PLT. Under boundedly-rational expectations, if cognitive limitations are sufficiently strong, the optimal averaging window is finite, and the welfare gain of adopting AIT can be small.
    Keywords: monetary policy objectives, makeup strategies, liquidity trap, deflationary bias, expectations
    JEL: E31 E52 E58 E61
    Date: 2020–04

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