We extend the theoretical frameworks traditionally used to analyze monetary policy and investment to examine firms' decisions regarding labor input. Specifically, we consider a model with financing constraints and firms that vary in their degree of exposure to these constraints. The model incorporates key features such as a working capital constraint, the financial accelerator effect of monetary policy, and an upward-sloping marginal cost curve-elements typically employed to study the impact of monetary policy on investment. Our analysis introduces the wage effect, an input cost absent in traditional studies on monetary policy and investment. The findings reveal that uniform wage changes can produce heterogeneous employment responses between financially constrained and unconstrained firms, operating through the wage channel.

We study a DSGE model with “massive” heterogeneity, enough to approach Gini coefficients for income, wealth, and consumption in the U.S. data. The economy features three aggregate shocks as well as both permanent and temporary idiosyncratic risk. We introduce policymakers that can mitigate these risks for households, and a welfare theorem outlines how the proposed policies imply an optimal allocation of resources. The proposed policies include achieving the Wicksellian natural real rate of interest, social insurance, and a set of taxes and transfers designed to reduce consumption inequality. We calibrate the model to U.S. data from 1995 to 2023 assuming the optimal set of policies and argue that the model fit is promising. This suggests that, broadly speaking, U.S. macroeconomic policy has in recent decades been close to optimal. Improvements beyond this set of policies requires design of responses to very large shocks, and we suggest some directions in which such a design may proceed.

We study the heterogeneous effects of monetary policy on the labor market of large and small firms in the United States. We uncover the following facts: (i) Expansionary monetary policy boosts employment and hiring growth in small firms more than in large firms; however, a monetary contraction shrinks small firms’ employment and hiring growth less than in large firms. As a result, monetary policy has a countervailing effect on the employment concentration in large firms. (ii) There is an asymmetry in the effects of monetary contractions versus expansions with respect to firms’ employment and hiring growth. Not accounting for such asymmetry leads to the fallacious conclusion that small firms respond more than large firms to monetary policy shocks. This asymmetry also reveals that contractionary monetary policy shocks have immediate effects on the labor market while the effects of expansionary shocks are slower to manifest. (iii) The response of employment is weaker than that of hiring, highlighting the importance of using labor market flows. (iv) The growth of earnings of new hires decreases similarly across large and small firms in contractions but reacts more for small firms in expansions. We use a heterogeneous firms model with a working capital constraint, an upward-sloping marginal cost curve, and a financial accelerator effect. We augment this model with the wage effect summarized in fact (iv) and demonstrate how the additional wage effect can explain the differential response of the hiring and employment growth of small and large firms of fact (i).

We study the effects of monetary policy on the labor market across different sectors. We find that the employment response is stronger for firms in manufacturing and construction relative to firms in services. The result also holds within small and large firms. Moreover, within sectors, the employment growth in large firms responds more than it does in small firms after monetary contractions; it does so less after monetary expansions. Finally, we find that the differences in employment growth between small and large firms are greater for firms in the manufacturing and construction sectors compared to those in the service sector.

The paper studies the implication of initial beliefs and associated confidence on the system’s dynamics under adaptive learning. We first illustrate how prior beliefs determine learning dynamics and the evolution of endogenous variables in a small DSGE model with credit-constrained agents, in which rational expectations are replaced by constant-gain adaptive learning. We then examine how discretionary experimenting with new macroeconomic policies is affected by expectations that agents have in relation to these policies. More specifically, we show that a newly introduced macro-prudential policy that aims at making leverage counter-cyclical can lead to substantial increase in fluctuations under learning, when the economy is hit by financial shocks, if beliefs reflect imperfect information about the policy experiment. This is in the stark contrast to the effects of such policy under rational expectations.

The paper studies the implication of initial beliefs and associated confidence on the system’s dynamics under adaptive learning. We first illustrate how prior beliefs determine learning dynamics and the evolution of endogenous variables in a small DSGE model with credit-constrained agents, in which rational expectations are replaced by constant-gain adaptive learning. We then examine how discretionary experimenting with new macroeconomic policies is affected by expectations that agents have in relation to these policies. More specifically, we show that a newly introduced macro-prudential policy that aims at making leverage counter-cyclical can lead to substantial increase in fluctuations under learning, when the economy is hit by financial shocks, if beliefs reflect imperfect information about the policy experiment. This is in the stark contrast to the effects of such policy under rational expectations.

We study the effects of monetary policy shocks on the growth rates of hiring, employment and earnings of new hires across firms of different sizes. We find that contractionary and expansionary monetary policy shocks have different effects on hiring and employment growth for small and large firms. Relative to large firms, small firms are less responsive to contractionary monetary policy shocks while they are more responsive to expansionary shocks. We also find that, as a consequence of monetary policy shocks, the earnings of new hires changes, and this wage effect depends on the sign of the shock and the size of the firm. We use a heterogeneous firm model with a working capital constraint, an upward sloping marginal cost curve and a financial accelerator effect, and augment it with the wage effect. We find that our empirical results are consistent with the model as long as the combined effect due to varying steepness of the marginal cost curve and the wage effect is stronger than the financial accelerator channel.

In this paper we respond to the recent critique of Dynamic Stochastic General Equilibrium (DSGE) models. We present the most recent developments in the DSGE literature and show that it has gone a long way to accommodate many sources of criticism.

We study monetary policy when private credit markets are incomplete. The macroeconomy we study has a large private credit market, in which participant households use non-state contingent nominal contracts (NSCNC). A second, small group of households only uses cash, supplied by the monetary authority, and cannot participate in the credit market. There is an aggregate shock. We find that, despite the substantial heterogeneity, the monetary authority can provide for optimal risk-sharing in the private credit market and thus overcome the NSCNC friction via a counter-cyclical price level rule. The countercyclical price level rule is not unique. To pin down a unique monetary policy rule, we consider two secondary goals for the monetary authority, (i) expected inflation targeting and, (ii) nominal GDP targeting. We examine the impact of each of these approaches on the price level rule and other nominal variables in the economy.

This paper develops a simple business-cycle model in which financial shocks have large macroeconomic effects when private agents are gradually learning the uncertain environment. Agents update their beliefs about the reduced-form structure of the economy. Because the persistence of leverage is overestimated by adaptive learners, the responses of output, investment, and other aggregates under adaptive learning are significantly larger than under rational expectations. In our benchmark case calibrated using US data on leverage, debt-to-GDP and land value-to-GDP ratios for 1996Q1–2008Q4, learning amplifies leverage shocks by a factor of about three, relative to rational expectations. When fed with actual leverage innovations observed over that period, the learning model predicts that the persistence of leverage shocks is increasingly overestimated after 2002 and that a sizeable recession occurs in 2008–2010, while its rational expectations counterpart predicts a counter-factual expansion. In addition, we show that procyclical leverage reinforces the amplification due to learning and, accordingly, that macro-prudential policies that enforce countercyclical leverage dampen the effects of leverage shocks.

We study monetary policy when private credit markets are incomplete. The macroeconomy we study has a large private credit market, in which participant households use non-state contingent nominal contracts (NSCNC). A second, small group of households only uses cash, supplied by the monetary authority, and cannot participate in the credit market. There is an aggregate shock. We find that, despite the substantial heterogeneity, the monetary authority can provide for optimal risk-sharing in the private credit market and thus overcome the NSCNC friction via a counter-cyclical price level rule. The counter-cyclical price level rule is not unique. To pin down a unique monetary policy rule, we consider two secondary goals for the monetary authority, (i) expected inflation targeting and, (ii) nominal GDP targeting. We examine the impact of each of these approaches on the price level rule and other nominal variables in the economy.

I study the role of shocks to beliefs combined with Bayesian learning in a standard equilibrium business cycle framework. In particular, I examine how a prior belief arising from the Great Depression may have influenced the macroeconomy during the last 75 years. In the model, households hold twisted beliefs concerning the likelihood and persistence of recession and boom states that are affected by the Great Depression. These initial beliefs are substantially different from the true data generating process and are only gradually unwound during subsequent years. Even though the driving stochastic process for technology is unchanged over the entire period, the nature of macroeconomic performance is altered considerably for many decades before eventually converging to the rational expectations equilibrium. This provides some evidence of the lingering effects of beliefs-twisting events on the behavior of macroeconomic variables.

We study abstract macroeconomic systems in which expectations play an important role. Consistent with the recent literature on recursive learning and expectations, we replace the agents in the economy with econometricians. Unlike the recursive learning literature, however, the econometricians in the analysis here are Bayesian learners. We are interested in the extent to which expectational stability remains the key concept in the Bayesian environment. We isolate conditions under which versions of expectational stability conditions govern the stability of these systems just as in the standard case of recursive learning. We conclude that Bayesian learning schemes, while they are more sophisticated, do not alter the essential expectational stability findings in the literature.

We study whether monetary authorities in the G7 countries were changing their responses to inflation in a similar manner during and following the Great Inflation era. We find that the common to the G7 countries inflation pattern during the Great Inflation period could be associated with a common pattern in the monetary policy response to inflation: we find that until the early 1980s monetary authorities in the G7 countries responded mildly to inflation, systematically fought it throughout the 1980s and lessened again their response during the 2000s. The estimated Taylor rule coefficients on inflation are co-integrated, implying the existence of a long-run relationship in the responses to inflation during and after the Great Inflation period. At the same time, principal component analysis of the residuals of the estimated Taylor rules indicates that the shocks' structure cannot account enough for the monetary policies' co-movements. We interpret these findings as suggestive of common monetary policy patterns.

We study optimal monetary policy at the zero lower bound. The macroeconomy we study has considerable income inequality which gives rise to a large private sector credit market. Households participating in this market use non-state contingent nominal contracts (NSCNC). A second, small group of households only uses cash and cannot participate in the credit market. The monetary authority supplies currency to cash-using households in a way that changes the price level to provide for optimal risk-sharing in the private credit market and thus to overcome the NSCNC friction. For sufficiently large and persistent negative shocks the zero lower bound on nominal interest rates may threaten to bind. The monetary authority may credibly promise to increase the price level in this situation to maintain a smoothly functioning (complete) credit market. The optimal monetary policy in this model can be broadly viewed as a version of nominal GDP targeting.

In this paper we study whether central banks should react to financial sector variables in their policy rules. We find that responding to asset prices does not affect the determinacy conditions. However, responding to entrepreneurial net worth increases the likelihood of determinacy.

We study a theory in which households borrow during the first half of a 241-period life cycle as part of a DSGE. Households confront a persistent regime-switching process on aggregate labor productivity growth. When the economy switches to the high growth regime, there is more borrowing based on expectations of higher future income. When the economy switches back to the low growth regime, some households will have borrowed too much given contemporaneous income levels–the hallmark of debt overhang. A powerful central bank can intervene in private credit markets to influence real yields. If the central bank does intervene to keep real rates lower, consumption will be reallocated relative to a laissez faire case. The reallocation will generally be away from those households saving for retirement and possibly away from those households that are heavy users of money to smooth income fluctuations.

I study the role of shocks to beliefs combined with Bayesian learning in a standard equilibrium business cycle framework. By adapting ideas from Cogley and Sargent (2008b) to the general equilibrium setting, I am able to study how a prior belief arising from the Great Depression may have influenced the macroeconomy during the last 75 years. In the model, households hold twisted beliefs concerning the likelihood and persistence of recession and boom states, beliefs which are only gradually unwound during subsequent years. Even though the driving stochastic process for technology is unchanged over the entire period, the nature of macroeconomic performance is altered considerably for many decades before eventually converging to the rational expectations equilibrium. This provides some evidence of the lingering effects of beliefs-twisting events on the behavior of macroeconomic variables.