Working Papers

1. Incorporating Diagnostic Expectations into the New Keynesian Framework

(with Jean-Paul L'Huillier and Donghoon Yoo)

August 2022​. Revise and Resubmit at The Review of Economic Studies

​Diagnostic expectations constitute a realistic behavioral model of inference. This paper shows that this approach for expectation formation can be productively integrated into the New Keynesian framework. To this end, we start by offering a first technical treatment of diagnostic expectations in linear macroeconomic models. 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; with imperfect information, diagnostic expectations generate delayed overreaction of aggregate variables. Bayesian estimation of a rich medium-scale model delivers estimates of the diagnosticity parameter that is in line with previous studies. Moreover, we find strong empirical evidence in favor of the diagnostic model.

Supersedes the January 2021 version titled "Diagnostic Expectations and Macroeconomic Volatility"

2. Understanding Persistent ZLB: Theory and Assessment (with Pablo Cuba-Borda)

December 2021. Revise and Resubmit at American Economic Journal: Macroeconomics

Abstract: Concerns of prolonged stagnation periods with near-zero interest rates and deflation have become widespread in many advanced economies. We build a theoretical framework that rationalizes two theories of low interest rates: expectation traps and secular stagnation in a unified setting. We analytically derive contrasting policy implications under each hypothesis and identify robust policies that eliminate expectation traps and reduce the severity of secular stagnation episodes. Using our framework, we provide a quantitative assessment of the Japanese experience from 1998:Q1-2020:Q4. We find evidence favoring the expectations trap hypothesis and show that equilibrium indeterminacy is essential to distinguish between theories of low interest rates in the data.

February 2019 version title "Understanding Persistent Stagnation" available as FRB-IFDP 1243

April 2020 draft version

3. The Long-run Effects of Monetary Policy (with Òscar Jordà and Alan M. Taylor)

September 2021

​Does monetary policy have persistent effects on the productive capacity of the economy? Yes, we find that such effects are economically and statistically significant and last for over a decade based on: (1) identification of exogenous monetary policy fluctuations using the trilemma of international finance; (2) merged data from two new international historical cross-country databases reaching back to the nineteenth century; and (3) econometric methods robust to long-horizon inconsistent estimates. Notably, the capital stock and total factor productivity (TFP) exhibit strong hysteresis, while labor does not. Allowing for asymmetry, we find these effects are present when interest rates tighten, but not when they loosen. There is no free lunch: the monetary authority can destroy, but cannot expand the productive capacity of the economy

Available as FRBSF WP 2020-01, NBER WP 26666, CEPR DP 14338

​Media Coverage: FT Free Lunch, WSJ Central Banking, Financial Times

Policy Citation: Masazumi Wakatabe (Bank of Japan), Reserve Bank of India, ECB Strategy Review Papers 268 and 275 (Sep 2021), Catherine Mann (Bank of England)

Awarded the Dr. Subir V Gokarn Best Paper Award at 19th Macroeconomics and Finance Conference

4. The Financial Origins of Non-Fundamental Risk (with Sushant Acharya and Keshav Dogra)

November 2021

Abstract: We formalize the idea that the financial sector can be a source of non-fundamental risk for the rest of the economy. In the model, households’ desire to hedge against price volatility can actually lead to price volatility emerging in equilibrium, even absent fundamental risk. Fearing that asset prices may fall, risk-averse households demand safe assets from risk-neutral financial intermediaries. Issuance of safe assets by leveraged intermediaries, in turn, exposes the economy to self-fulfilling asset price crashes. Policy can eliminate this non-fundamental risk either (i) by increasing the supply of publicly backed safe assets, through issuing government debt or bailing out intermediaries, or (ii) by reducing the demand for safe assets, through social insurance or a commitment to act as a market maker of last resort.

Available as CEPR DP 16793

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5. Supply or Demand? Policymakers' Confusion in the Presence of Hysteresis (with Antonio Fatás)

April 2022. Reject and Resubmit at the European Economic Review

Abstract: Policy makers need to separate between temporary demand-driven shocks and permanent shocks in order to design optimal aggregate demand policies. In this paper we study the case of a central bank that ignores the presence of hysteresis when identifying shocks. By assuming that all low-frequency output fluctuations are driven by permanent technology shocks, monetary policy is not aggressive enough in response to demand shocks. In addition, we show that errors in assessing the state of the economy can be self-perpetuating if seen through the lens of the mistaken views of the policy maker. We show that a central bank that mistakes a demand shock for a supply shock, will produce permanent effects on output through their suboptimal policies. Ex-post, the central bank will see an economy that resembles what they had forecast when designing their policies. The shock is indeed persistent and this persistence validates their assumption that the shock was a supply-driven one. The interaction between forecasts, policies and hysteresis creates the dynamics of self-perpetuating errors that is the focus of this paper.

6. Currency Areas, Labor Markets, and Regional Cyclical Sensitivity (with Katheryn N Russ and Jay C Shambaugh)

September 2022. Prepared for the 23^rd Jacques Polak Annual Research Conference – The Global Economy: Looking Back, Moving Forward

Abstract: In his papers during the lead up to the birth of the European Monetary Union, Obstfeld considered whether the countries forming the EMU were sufficiently similar to survive a single monetary policy—and more importantly, whether they had the capacity to adjust to asymmetric shocks given a single monetary and exchange rate policy. The convention at the time was to take the United States as the baseline for a smoothly functioning currency union. We document the evolution of the literature on regional labor market adjustment within the United States, expanding on stylized facts illustrating how local shocks appear far more persistent today than they did 30 years ago in the context of what Obstfeld and Peri (1998) call non-adjustment in unemployment rates. We then extend the currency union literature by adding an additional consideration: differences in regional cyclical sensitivity. Using measures of cyclicality and Obstfeld-Peri-type non-adjustment, we explore the characteristics of places that can get left behind when local labor markets respond differently to national shocks and discuss implications for policy.