Skip to main content

Design of Fiscal and Monetary Policies: Central Bank Objectives and Public Debt Management

Final Report Summary - MONFISCPOL (Design of Fiscal and Monetary Policies: Central Bank Objectives and Public Debt Management)

The research project has focused on the development of novel theoretical and quantitative frameworks for the design of monetary and fiscal policies, and in particular for the design of central bank objectives, for assessing the role of credibility in monetary policy, and to study how governments should structure the maturity of debt holdings.

The first part of the project entitled “Designing a Simple Loss Function for Central Banks: Does a Dual Mandate Make Sense?” —in collaboration with J. Kim (Korea University), J. Lindé (Sveriges Riksbank), and Ricardo Nunes (Federal Reserve of Boston), currently published as a working paper of the International Monetary Fund— investigates what should be the objectives of central banks. The global financial crisis and the European sovereign debt crisis stimulated an intense debate about what is the role of central banks. Should central banks be responsible for price stability, for the stability of economic activity, or both? For example, while the European Central Bank’s primary objective is to maintain price stability without any explicit responsibility for economic activity, the U.S. Federal Reserve’s main objective is to promote employment in a context of price stability. Is this dual mandate beneficial for the society? The literature to date has suggested that a focus on inflation stabilization is enough to stabilize other macroeconomic variables, and that focusing on economic activity can be even harmful. The research project revisits these results. The main difference with respect to previous works is to consider an economic model similar to those actually in use at central banks and policy institutions. That model is used as a laboratory to study the welfare implications of increasing the weight on economic activity in the central bank’s objective. Welfare is quantified in terms of the Consumption Equivalent Variation (CEV), which indicates the percent increase in consumption that would be needed to make households equally well off under the simple mandate and under the fully optimal policy. In contrast to previous studies, through a series of quantitative exercises it is shown that stabilizing measures of economic activity should be one of the primary objectives of central banks, in some cases even more important than stabilizing inflation. The result is robust to the presence of substantial measurement errors in the size of economic activity, to the presence of large shocks that generate a trade-off between stabilizing inflation and economic activity, and also when ensuring a low probability of hitting the zero lower bound on interest rates. All in all, the key point of the paper is that the academic consensus that central banks should primary focus on price stability may not be right. Whenever the economy is affected by non-trivial rigidities and inefficient shocks, a central bank maximizing welfare should look at measures of economic activity, and not only at price stabilization. This result could be important for the ongoing debate, especially in Europe, about what should be the main goal of central banks.

The second part of the project entitled “How Credible is the Federal Reserve: A Structural Estimation of Policy Reoptimizations” —in collaboration with A. Lakdawala (Michigan State University), published in the American Economic Journal: Macroeconomics—proposes a novel way to measure the degree of credibility of the central banks, with an application to the case to the Federal Reserve. After the high-inflation episodes of the 1970s, economists and policymakers have recognized the importance of having credible central banks that functions independently of the executive and legislative branches of government. Yet, measuring whether central banks are credible or not remains a largely open question. A key problem in measuring credibility is identifying whether a change in interest rates is due to an unexpected shock (such as a sudden increase in oil prices) or an arbitrary deviation by the central bank from its announced plan. This paper proposes a novel framework to distinguish between these two factors, which makes it possible to estimate how often central banks did not fulfill their previous commitments. The resulting estimates indicate that there have been periods where the Fed honored its commitments, but also episodes when it did not. These episodes sometimes line up closely with changes of the Fed chairmen, and at other times with changes in the operational procedures of the Federal Reserve. Overall, these results challenge the conventional approach in the monetary policy literature, where it is typically assumed that central banks are either fully credible or not credible at all. Also, it is shown that there would be significant welfare gains (equivalent to a 1% permanent change in annual inflation) from building credibility. The methodology and the results of this paper are particularly useful for researcher and policymakers for assessing the performance of central banks and the scope for enhancing credibility in monetary policy.

The third part of the project, entitled “Optimal Time-Consistent Government Debt Maturity” —in collaboration with R. Nunes (Federal Reserve of Boston) and P. Yared (Columbia Business School), published in the Quarterly Journal of Economics—studies how governments should structure the maturity of debt holdings between short- and long-term securities. The accurate management of the debt maturity structure is fundamental to reduce the cost of financing public deficits, and will ultimately result in lower taxes and in a lower risk of default, with obvious economic, political and social implications (as witnessed by the recent events in southern European countries like Italy, Greece, Spain and Portugal). The previous literature on government debt maturity concluded that governments should use the maturity of debt to insulate from economic shocks. This insulation is accomplished by choosing a maturity structure with a large long-term debt, and a large short-term asset positions. This paper shows that those conclusions strongly rely on the assumption of full-commitment by the government. Once lack of commitment is taken into account, the government faces a tradeoff between the benefit of hedging and the cost of funding. The main result of the paper, shown both analytically and through quantitative exercises, is that structuring government debt maturity to resolve the problem of lack of commitment is more important than structuring it to insulate from economic shocks. The debt maturity structure under lack of commitment is nearly flat –meaning a nearly identical quantity of debt maturing at different horizons. This implies that the optimal maturity structure can be approximately achieved by confining government debt instruments to consols (a perpetual bond paying coupons at regular time intervals). The use of consols has been pursued historically, most notably by the British government in the Industrial Revolution, when consols were the largest component of the British government's debt. This analysis provides an argument for reintroducing consols as a tool for optimal debt management, an option that has recently received support in the press and in policymaking circles.