Do households really save today in anticipation of tomorrow’s taxes—or does fiscal policy pack more punch than standard theory predicts?

This paper compares inflation in true price indices to inflation in fixed-weight price indices. We construct model-based inflation measures in time-dependent pricing models that are analogous to measures of inflation in the data, e.g., the Consumer Price Index. In the standard new Keynesian model, when inflation rises rapidly, the differences between inflation in those indices and true price indices are increasing in the degree of price stickiness and the elasticity of substitution across goods. For commonly used parameter values, those differences are large and persistent for increases in inflation of the size seen after 2020 in the U.S.

In 1997, the American Economic Association convened a panel to address whether a core of usable macroeconomics exists. The consensus about monetary policy has not changed since then. However, in a sharp reversal, there is now widespread consensus that fiscal policy can be a useful stabilization tool. I discuss why the latter consensus broke down and what form countercyclical fiscal policy should take in a world marked by two constraints: (i) The benefits of the policy ought to be robust to deviations from rational expectations and the presence of liquidity-constrained consumers, and (ii) expanded fiscal stabilization policies are temporary.

This paper addresses the question: how sensitive is the power of fiscal policy at the Zero Lower Bound (ZLB) to the assumption of rational expectations? We do so through the lens of a standard New Keynesian model in which people are dynamic level-k thinkers. Our analysis weakens the case for using government spending to stabilize the economy when the ZLB binds. The less sophisticated people are, the smaller the government-spending multiplier is. Our analysis strengthens the case for using tax policy to stabilize output when the ZLB is binding. The power of tax policy to stabilize the economy during the ZLB period is essentially undiminished when agents do not have rational expectations. Our results are robust to whether or not Ricardian equivalence holds. Finally, we show that the way in which tax policy is communicated is critical to its effectiveness.

Researchers typically compare inflation in the new Keynesian (NK) model to published inflation measures constructed from indices like the CPI. Inflation in the standard NK model without price indexation is bounded above. The model analogue of fixed-weight inflation measures, like the CPI, is not. When inflation is in the range of values observed after 2021, there is a substantial difference between model-based and fixed-weight measures of inflation. This finding poses a challenge to using linear approximations to the NK model in environments with moderately high inflation and implies that analysts should construct data-consistent model analogues when assessing the NK model.

The Covid epidemic had a large impact on economic activity. In contrast, the dramatic decline in mortality from infectious diseases over the past 120 years had a small economic impact. We argue that people’s response to successive Covid waves helps reconcile these two findings. Our analysis uses a unique administrative data set with anonymized monthly expenditures at the individual level that covers the first three Covid waves. Consumer expenditures fell by about the same amount in the first and third waves, even though the risk of getting infected was larger in the third wave. We find that people had pessimistic prior beliefs about the case-fatality rates that converged over time to the true case-fatality rates. Using a model where Covid is endemic, we show that the impact of Covid is small when people know the true case-fatality rate but large when people have empirically-plausible pessimistic prior beliefs about the case-fatality rate. These results reconcile the large economic impact of Covid with the small effect of the secular decline in mortality from infectious diseases estimated in the literature. JEL Classification: E1, I1, H0.

This paper provides an analytic characterization of the speed of convergence under learning to a rational expectations equilibrium (REE) for a large class of multivariate models. We show that learning is slower when people's beliefs about model outcomes are more self-fulfilling. The paper also investigates which features of a model economy make beliefs more self-fulfilling, using variants of the simple new-Keynesian model and a medium-scale DSGE model. For empirically plausible specifications of these models, convergence of a learning equilibrium to the REE is so slow that analysis based on rational expectations can be misleading.

In this lecture, I review work addressing three questions. First, are predictions about macro stabilization policies robust to reasonable departures from rational expectations? Second, do people's expectations converge to a particular set of rational expectations? Third, if they do converge, how quickly? I discuss examples from the literature where the answer to the first question is no. The answer to the second question is that learning equilibria converge to the "standard" rational equilibria analyzed in new Keynesian models. Finally, I discuss circumstances under which the answer to the third question is very slowly. In the examples, learning is slowest and policy analysis based on rational expectations is least robust in the face of shocks that render the stakes of getting policy "right" the highest.

We develop a SIR-based macroeconomic model to study the impact of testing/quarantining and social distancing/mask use on health and economic outcomes.These policies can dramatically reduce the costs of an epidemic.Absent testing/quarantining, the main effect of social distancing and mask use on health outcomes is to delay, rather than reduce, epidemic-related deaths.Social distancing and mask use reduce the severity of the epidemic-related recession but prolong its duration.There is an important synergy between social distancing and mask use and testing/ quarantining.Social distancing and mask use buy time for testing and quarantining to come to the rescue.The benefits of testing/quarantining are even larger when people can get reinfected, either because the virus mutates or immunity is temporary.

This paper documents the behavior of key macro aggregates in the wake of the Covid epidemic.We show that a unique feature of the Covid recession is that the peak-to-trough decline is roughly the same for consumption, investment, and output.In contrast to the 2008 recession, there was only a short-lived rise in financial stress that quickly subsided.Finally, there was mild deflation between the peak and the trough of the Covid recession.We argue that a New Keynesian model that explicitly incorporates epidemic dynamics captures these qualitative features of the Covid recession.A key feature of the model is that Covid acts like a negative shock to the demand for consumption and the supply of labor.

This paper studies how the impact of monetary policy depends on the distribution of savings from refinancing mortgages. We show that the efficacy of monetary policy is state dependent, varying in a systematic way with the pool of potential savings from refinancing. We construct a quantitative dynamic life-cycle model that accounts for our findings and use it to study how the response of consumption to a change in mortgage rates depends on the distribution of savings from refinancing. These effects are strongly state dependent. We also use the model to study the impact of a long period of low interest rates on the potency of monetary policy. We find that this potency is substantially reduced both during the period and for a substantial amount of time after interest rates renormalize. (JEL D15, E21, E43, E52, G21, G51, R31)

Epidemiology models used in macroeconomics generally assume that people know their current health status. In this paper, we consider a more realistic environment in which people are uncertain about their health status. We use our model to study the impact of testing with and without quarantining infected people. We find that testing without quarantines can worsen the economic and health repercussions of an epidemic. In contrast, a policy that uses tests to quarantine infected people has very large social benefits. Critically, this policy ameliorates the sharp tradeoff between declines in economic activity and health outcomes that is associated with broad-based containment policies like lockdowns. This amelioration is particularly dramatic when people who recover from an infection acquire only temporary immunity to the virus. Martin S. Eichenbaum Department of Economics Northwestern University 2003 Sheridan Road Evanston, IL 60208 and NBER eich@northwestern.edu Sergio Rebelo Northwestern University Kellogg School of Management Department of Finance Leverone Hall Evanston, IL 60208-2001 and CEPR and also NBER s-rebelo@northwestern.edu Mathias Trabandt Freie Universität Berlin School of Business and Economics Boltzmannstrasse 2

This article studies how the monetary policy regime affects the relative importance of nominal exchange rates and inflation rates in shaping the response of real exchange rates to shocks. We document two facts about inflation-targeting countries. First, the current real exchange rate predicts future changes in the nominal exchange rate. Second, the real exchange rate is a poor predictor of future inflation rates. We estimate a medium-size, open-economy DSGE model that accounts quantitatively for these facts as well as other empirical properties of real and nominal exchange rates. The key estimated shocks that drive the dynamics of exchange rates and their covariance with inflation are disturbances to the foreign demand for dollar-denominated bonds.

We extend the canonical epidemiology model to study the interaction between economic decisions and epidemics. Our model implies that people cut back on consumption and work to reduce the chances of being infected. These decisions reduce the severity of the epidemic but exacerbate the size of the associated recession. 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 model, the best simple containment policy increases the severity of the recession but saves roughly half a million lives in the United States.

We argue that wage inertia plays a pivotal role in allowing empirically plausible variants of the standard search and matching model to account for the large countercyclical response of unemployment to shocks.

We address the question of how sensitive is the power of fiscal policy in the ZLB to the assumption of rational expectations. We do so through the lens of a standard NK model in which people are level-k thinkers. Our analysis weakens the case for using government spending to stabilize the economy when the ZLB binds. The less sophisticated people are, the smaller is the size of the government-spending multiplier. Our analysis strengthens the case for using tax policy to stabilize output when the ZLB is binding. The power of tax policy to stabilize the economy during the ZLB period is essentially undiminished when agents do not have rational expectations. Finally, we show that the way in which tax policy is communicated is critical to its effectiveness. ∗We thank Bence Bardóczy, Lawrence Christiano, Benjamin Johannsen, Guido Lorenzoni, Pooya Molavi, Matthew Rognlie, Miguel Santana, Thomas Sargent, Pedro Teles and Michael Woodford for helpful comments. We also thank George-Marios Angeletos and John Leahy for excellent discussions that helped improve the paper. †Northwestern University; rbianchiv@u.northwestern.edu. ‡Northwestern University and NBER; eich@northwestern.edu. §Northwestern University; jguerreiro@u.northwestern.edu.

We argue that the COVID epidemic disproportionately affected the economic well-being and health of poor people. To disentangle the forces that generated this outcome, we construct a model that is consistent with the heterogeneous impact of the COVID recession on low- and high-income people. According to our model, two-thirds of the inequality in COVID deaths reflect preexisting inequality in comorbidity rates and access to quality health care. The remaining third stems from the fact that low-income people work in occupations where the risk of infection is high. Our model also implies that the rise in income inequality generated by the COVID epidemic reflects the nature of the goods that low-income people produce. Finally, we assess the health–income trade-offs associated with fiscal transfers to the poor and mandatory containment policies.