A macroeconomic setting characterized by higher inflation represents an opportunity to increase a central bank’s inflation target, which can mitigate the risk of future liquidity traps. We show that the gains generated by this strategy are not one-to-one: Because a higher inflation target leads to a steeper Phillips curve, to effectively get, for instance, 2 percentage points of extra room away from the zero lower bound on the interest rate, policymakers need to raise their inflation target from 2% to 5%. Taking this mechanism into consideration changes the optimal inflation target. When the natural rate is near zero, the optimal inflation target is 1 percentage point higher than the optimal target obtained by conventional, earlier, calculations.

A growing literature debates the explanations for the cyclical properties of emerging markets based on the RBC small open economy model. Two leading explanations are considered: trend shocks (Aguiar and Gopinath 2007), and financial frictions (Neumeyer and Perri 2004; Garcia-Cicco, Pancrazi, and Uribe 2010). We provide analytical parameter restrictions that, within this class of models, favor the trend shocks explanation. This effort centers the debate on two issues. First, the trend shocks explanation crucially requires the interest rate to be very insensitive to changes in the stock of debt. This raises concerns about robustness, and quantitative results confirm that the trend shocks explanation is fragile even in the original model specification. Second, it is difficult to obtain a realistic and powerful propagation of trend shocks in the RBC framework: Using the parameter restrictions generates a fall of labor supply after a positive trend shock. Lastly, even when the analytical restrictions are satisfied, trend shocks are still not able to compete against other shocks introduced into the RBC framework in terms of variance decomposition. ∗Georgetown University; Einaudi Institute for Economics and Finance (EIEF); University of Lausanne. We thank Daniele Terlizzese for detailed comments on an earlier draft. We are also grateful to Mark Aguiar, Luigi Bocola, Pascal Michaillat, Claudio Michelacci, Juan Passadore, Fabrizio Perri, Facundo Piguillem, Raphael Schoenle, Kirill Shakhnov and Anton Tsoy for their reactions. Dan thanks EIEF for hospitality.

Motivated by behavioral evidence, we develop a tractable method for incorporating competition neglect in a general equilibrium firm investment problem. Competition neglect causes firms to systematically underestimate the investment of their competitors. When we introduce competition neglect into a canonical RBC model, this friction acts like an investment wedge that causes overinvestment at first, and underinvestment later on. In contrast to a model with exogenous investment shocks, these dynamics are accompanied by realistic variation in equity premia, even in the absence of financial frictions. Investment booms raise stock prices in general equilibrium, predicting periods of low excess returns going forward. The model can generate realistic comovement of real and financial variables.

Empirical estimates find that the relationship between inflation and the output gap is close to nonexistent—a so-called flat Phillips curve. We show that standard pricing frictions cannot simultaneously produce a flat Phillips curve and meaningful inflation from plausible supply shocks. This is because imposing a flat Phillips curve immediately implies that the price level is also rigid with respect to supply shocks. In quantitative versions of the New Keynesian model, price markup shocks need to be several orders of magnitude bigger than other shocks in order to fit the data, leading to unreasonable assessments of the magnitude of the increase in costs during inflationary episodes. Hence, we propose a strategic microfoundation of price stickiness in which prices are sticky with respect to demand shocks but flexible with respect to supply shocks. In our model, the friction leading to rigidities is demand-intrinsic, in line with narrative accounts for the imperfect adjustment of prices. Firms can credibly justify a price increase due to a rise in costs, whereas it is harder to do so when demand increases. This has natural implications for inflation dynamics and crucial implications for the conduct of monetary policy.

Big technological improvements in a new, secondary sector lead to a period of excitement about the future prospects of the overall economy, generating boom-bust dynamics that propagate through credit markets. Increased future capital prices relax collateral constraints today, leading to a boom before the realization of the shock. But reallocation of capital toward the secondary sector when the shock hits leads to a bust going forward. These cycles are perfectly foreseen in our model, making them markedly different from the typical narrative about unexpected financial shocks that is used to explain crises. In fact, these cycles echo Minsky’s original narrative for financial cycles, according to which, “financial trauma occur as normal functioning events in a capitalistic economy.” (Minsky, 1980, p. 21)

This Economic Commentary provides an overview of several frictions and the channels through which they affect economic welfare under elevated trend inflation above 2 percent. These frictions, associated with financial transactions, price and wage stickiness, and cognitive limitations, suggest that inflation imposes significant costs on society. Higher inflation may lead to a steeper Phillips curve, a situation which increases the volatility of inflation and interest rates.

Diagnostic expectations constitute a realistic behavioral model of inference. This paper shows that this approach to expectation formation can be productively integrated into the New Keynesian framework. Diagnostic expectations generate endogenous extrapolation in general equilibrium. We show that diagnostic expectations generate extra amplification in the presence of nominal frictions; a fall in aggregate supply generates a Keynesian recession; fiscal policy is more effective at stimulating the economy. We perform Bayesian estimation of a rich medium-scale model that incorporates consensus forecast data. Our estimate of the diagnosticity parameter is in line with previous studies. Moreover, we find empirical evidence in favor of the diagnostic model. Diagnostic expectations offer new propagation mechanisms to explain fluctuations.

We illustrate an intuitive channel through which price stickiness limits the ability of a central bank to improve welfare through stabilization policy. If the central bank uses infl ation to obtain information about nominal spending, sticky prices impair the learning ability of the central bank and hence its ability to implement the right stabilization policy. Infl ation targeting makes prices stickier, and worsens this learning problem. The key is a microfounded information-based model for price stickiness: taking into account how agents react to the adoption of infl ation targeting makes explicit a basic confl ict between in flation targeting and stabilization policy.

We propose a strategic microfoundation for sticky prices. We model an environment in which a firm has better information than its consumers and show that, when many consumers are uninformed, it is optimal for the firm to offer sticky contracts or sticky prices. We establish this result in a general mechanism design framework that allows for non-linear pricing and screening. A virtue of our microfoundation is that it is compatible with a dynamic general equilibrium model. We then discuss the implications of this microfounded friction for welfare.

Diagnostic expectations have emerged as an important departure from rational expectations in macroeconomics and finance. We present a first treatment of diagnostic expectations in linear macroeconomic models. To this end, we establish a strong additivity property for diagnostic expectations. The solution method and stability properties are discussed in full generality. Under some conditions, diagnostic expectations generate higher volatility than rational expectations. We show that this is true in standard New Keynesian models, as in medium-scale DSGE models; in real business cycle models output and investment are char- acterized by dampening, instead. Finally, we discuss how the combination of diagnosticity with imperfect information can rationalize under- and over-reaction in macroeconomics.

We offer a structural interpretation of survey measures of consumer confidence. Our approach is based on a simple forward-looking model of consumption. The model decomposes observed consumption fluctuations in changes due to fundamentals, and changes due to temporary errors caused by noisy information. Our model-based measure, estimated using national accounts, closely mimics out-of-sample survey data in the U.S. and a majority of European countries. The results provide a theoretical foundation for the use of survey-based consumer confidence indices. In addition, since national accounts are an internationally consistent measure of activity, our structural method provides an alternative and internationally consistent measure of consumer confidence.

The relationship between the Phillips curve and inflation has become weaker over time, producing questions regarding how policymakers might connect inflation to the rest of the economy. Presentations given during the “Inflation: Drivers and Dynamics” session of the Central Bank Research Association’s annual meeting focused on the intersection of monetary policy and inflation dynamics to examine the ways in which policy might impact inflation and related expectations and processes. This Economic Commentary summarizes the papers presented during this session.

This paper studies the propagation of monetary shocks in an economy featuring a strategic microfoundation for price rigidities. Following an aggregate shock to money, most consumers are initially uninformed. The market for goods is decentralized. Firms are better off delaying the adjustment of prices until enough consumers learn. At the same time, consumers learn from firms that have adjusted prices. The implied endogenous information diffusion follows a Bernoulli differential equation, implying a nonlinear path of learning. Nonlinear learning implies hump-shaped dynamics of output and inflation. A quantitative exercise suggests that these dynamics can be sizable and persistent. (JEL D11, D21, D40, D82, E23, E31)

Some, but less than intended. The reason is a shift in the behavior of the private sector: Prices adjust more frequently, lowering the potency of monetary policy. We quantitatively investigate this channel across different models, based on a calibration using micro data. By raising the target from 2 percent to 4 percent, the monetary authority gets only between 0.51 and 1.60 percentage points of effective extra policy room for monetary policy (not 2 percentage points as intended). Getting 2 percentage points of effective extra room requires raising the target to more than 4 percent. Taking this channel into consideration raises the optimal inflation target by roughly 1 percentage points relative to earlier computations.

We analyze the optimal macroprudential policy under the presence of persistent permanent shocks, which convey information about future growth. In this context, crises are characterized by long periods with positive shocks that eventually revert, rendering the collateral constraint binding and triggering deleveraging. In this environment it is optimal to tax borrowing during good times, and let agents act freely leaving the allocations undistorted, including borrowing and lending, when the economy reverts to a bad state. We contrast our findings to the case of standard shocks to the level of income, where it is optimal to tax debt in bad times, when agents need to borrow the most for precautionary savings motives. Also, taxes are used much less often and are around one-tenth of those under level shocks.

We offer a partial equilibrium perspective on the behavior of consumption in dynamic stochastic general equilibrium (DSGE) models. We consider a benchmark dynamic general equilibrium model and show that a standard calibration implies that the real interest rate is essentially fixed. One manifestation of this feature is that, with separable preferences, the reaction of consumption to total factor productivity (TFP) shocks is flat: the random-walk permanent income hypothesis holds almost exactly, pretty much as in a partial equilibrium consumption-savings problem. These results help explain the prominent role of aggregate demand, and how it is achieved, in modern DSGE analysis.

Catholics and Protestants differ in terms of social autonomy versus heteronomy. We propose that the regulation of behavior in accordance with social norms depends on the social control exercised by an authority for Catholics more than it does for Protestants. Two experiments measured cheating behavior (the transgression of a social norm) as a function of the religious group (Protestant vs. Catholic) and social control (with vs. without). Catholics were found to be more responsive to social control, that is, to cheat less when social control was salient, whereas Protestants' behavior did not depend on this dimension. In Study 2, intrinsic-extrinsic religiousness was found to mediate this difference. Results are discussed in the context of the effects of public policies based on social control.