NBER Macroeconomics Annual 2013: Volume 28

Contents

Editors’ Introduction

Jonathan A. Parker and Michael Woodford

Abstracts

Dormant Shocks and Fiscal Virtue

Francesco Bianchi and Leonardo Melosi

Comment

Bruce Preston

Comment

Christopher A. Sims

Discussion

Understanding Noninflationary Demand-Driven Business Cycles

Paul Beaudry and Franck Portier

Comment

Giorgio E. Primiceri

Comment

Martín Uribe

Discussion

Reference Dependence and Labor Market Fluctuations

Kfir Eliaz and Ran Spiegler

Comment

Robert E. Hall

Comment

Giuseppe Moscarini

Discussion

Pledgability and Liquidity: A New Monetarist Model of Financial and Macroeconomic Activity

Venky Venkateswaran and Randall Wright

Comment

V. V. Chari

Comment

Jean Tirole

Discussion

Shocks and Crashes

Martin Lettau and Sydney C. Ludvigson

Comment

John Y. Campbell

Comment

Mark W. Watson

Discussion

It Takes a Regime Shift: Recent Developments in Japanese Monetary Policy through the Lens of the Great Depression

Christina D. Romer

Editors’ Introduction

Jonathan A. Parker

MIT and NBER

Michael Woodford

Columbia and NBER

The twenty-eighth edition of the NBER Macroeconomics Annual continues with its tradition of featuring theoretical and empirical research on central issues in contemporary macroeconomics. As in previous years, this year’s papers not only address key recent developments in macroeconomics, but also take up important policy-relevant questions and open new debates that we expect to continue in the years to come. Accompanying each paper are two excellent discussions of the paper, each written by a leading scholar in the area.

The papers in this year’s issue tackle fiscal and monetary policy—how it is that interest rates and inflation can remain low despite fiscal policy behavior that appears inconsistent with a monetary policy regime focused only on inflation and output and not on fiscal balances; money and inflation—both the long-run inflation rate and the coexistence of money with pledgeable and money-like assets and why there are not increases in inflation in response to business-cycle fluctuations in productivity; the labor market—the implications of reference dependent preferences and moral hazard in employment fluctuations; and finally, the stock market and how it relates to the real economy.

Turning to the specific contributions in order, many economists have been puzzled that interest rates in the United States have remained low despite dramatic increases in public debt, official unfunded pension liabilities, and other implicit liabilities and guarantees. Francesco Bianchi and Leonardo Melosi provide an answer in Dormant Shocks and Fiscal Virtue. The idea is that, if a government followed one fiscal rule forever, it could either follow a rule that leads to balanced budgets absent monetary policy reacting to debt levels—an active money/passive fiscal regime in which monetary policy could simply follow a Taylor rule—or follow a rule that does not respond enough to past debt to satisfy the government budget constraint absent changes in nominal interest rates—a passive money/active fiscal regime in which the monetary authority would allow inflation and interest rates to adjust in order to maintain fiscal solvency. But in the paper, the fiscal rules are stochastic. Households perfectly observe the current fiscal policy rule, but must learn whether a deviation from a fiscal rule consistent in the long run with active money/passive fiscal is transitory, thus unlikely to ever require passive-type monetary policy, or whether it is highly persistent, and so likely to lead to high interest rates and inflation. As a result, in a country in which lapses in fiscal discipline are mostly transitory, even quite long-lasting lapses are still perceived as likely to be transitory, so that interest rates and inflation can remain quite low. In a sense then, a country’s credibility determines in part their debt capacity.

The central contribution of the paper is to use this model to interpret the history of US inflation, including the recent history of accelerating debt and low inflation and interest rates. The paper is not only an insightful analysis of the interactions of fiscal and monetary policy, but also a methodological contribution. In the model, policy rules are completely observed but the true state of the economy also includes the persistence of the rule in place, which is unobserved and must be learned by agents. By judiciously modeling the state transitions, the state space of the household problem remains finite and the model can be solved with agents that optimize, completely understanding their future learning behavior.

During the last few decades, recessions in the United States have been characterized by productivity that rises when output falls and by very little variability in inflation. While the cyclicality of productivity is inconsistent with productivity or supply driving business cycles, as in the real business cycle model, the acyclicality of inflation is inconsistent with demand driving cycles in a quantitative New Keynesian model of the business cycle. Our second paper, Understanding Noninflationary Demand Driven Business Cycles by Paul Beaudry and Franck Portier, starts by documenting these business cycle facts. More interestingly, the paper shows that the acyclicality of inflation does not follow from the current quantitative version of the New Keynesian Phillips curve—this equation predicts that if demand drives cycles, the inflation rate should have been much more cyclical and volatile than it was. The paper argues that this puzzle is not simply resolved by productivity shocks, investment-specific technological change, or slight changes in parameterizations.

Instead, the authors propose a novel modeling feature that provides a deflationary counteracting force in the model to a demand shock, and the paper provides microeconomic evidence supporting this channel. The idea is that labor is specialized and demand shocks have differential impacts across sectors and so lead to reallocation of workers, which, given frictions, leads to heterogeneous wage impacts. The second friction is that these wage impacts matter for demand because consumption insurance/asset markets are incomplete. In this case, a negative demand shock for one industry becomes a negative demand shock for the other—trade between sectors declines, and this trade decline can happen without pressure on the aggregate price level. The mechanics of this insight are elucidated nicely in a set of models. Finally, the authors use data from the Panel Study of Income Dynamics to show that, first, sectors are specialized in that demand increases for a sector feed through to wage increases for workers in that sector, and, second, that these wage changes feed through to consumption increases. These results are not surprising given existing work on wages and consumption, but is it important to highlight that the channel proposed in the paper not only solves the puzzle of acyclical inflation in the New Keynesian model, but does so with mechanisms that are qualitatively consistent with behavior observed in the disaggregated wage and consumption data.

One of the most debated topics in business cycle theory in recent years has been what drives cyclical variation in the unemployment rate. As Robert Shimer in particular has emphasized, the leading model of equilibrium unemployment (the Diamond-Mortensen-Pissarides model of labor market search and matching), when calibrated in ways considered empirically realistic in other respects, implies relatively small fluctuations in equilibrium unemployment even in response to productivity variations large enough to account for the cyclical variation in aggregate output. This occurs because the standard model (based on Nash bargaining over the wage when unemployed workers are matched with firms with vacancies to fill) implies that productivity changes result in immediate changes in the wage bargain that are large enough to imply little incentive for firms to vary their efforts to recruit workers. The obviously counterfactual nature of this prediction has led to increased interest in alternative accounts of wage determination.

Our third paper, Reference Dependence and Labor-Market Fluctuations by Kfir Eliaz and Ran Spiegler, proposes a novel explanation for insensitivity of wages to productivity shocks based on an alternative model of labor supply. Interviews with personnel managers suggest that they are reluctant to cut wages during recessions (even though the alternative is to lay off workers) because of the effects that they expect such cuts to have on worker morale, and consequently productivity. The authors propose a formal model that captures this hypothesis, in which worker productivity falls in response to a wage lower than a reference point determined by their prior wage expectations. They then offer a careful strategic analysis of a dynamic game with labor market search, matching, and wage bargaining, taking this behavioral reaction as a constraint. The authors establish the existence of a unique subgame-perfect equilibrium, and characterize its properties. Among other results, they show that reference-dependence implies downward nominal wage rigidity, and inefficient loss of output in response to negative shocks; the authors discuss how this is consistent with optimal contracting (owing to contractual incompleteness). They also show that a measure of labor market tightness is more volatile in equilibrium as a result of the reference-dependent behavior than it would be in the case of standard (non-reference-dependent) worker preferences. While the authors do not attempt a quantitative analysis, their model offers the prospect of at least a partial resolution to the Shimer puzzle. The paper is also groundbreaking in showing how insights from the behavioral economics literature can be fruitfully applied to a central issue in business-cycle theory.

Our fourth paper, Pledgeability and Liquidity: A New Monetarist Model of Financial and Macroeconomic Activity, by Venky Venkateswaran and Randall Wright, is a contribution to the longstanding discussion of the real effects of inflation. A critical issue in most such discussions is the role of money (an asset the real return on which is reduced by inflation) in the economy, and the extent to which it is possible for people and firms to substitute away from the use of money in response to the incentive provided by a reduction in its real return. The authors propose microeconomic foundations for the use of money that build upon the well-known model of Lagos and Wright, in which exchange takes place in an alternating sequence of markets (centralized and decentralized markets, following each other in succession), and purchases in the decentralized markets can be made only by transferring money (a generally acceptable means of payment, that is as a consequence more liquid than other assets). The variation on this theory pursued in the current paper is to allow purchases in the decentralized markets to also be made using other assets, to the extent that they can be pledged as collateral for debts contracted to the seller. The pledgeability of assets is, however, assumed to differ across assets, and to generally be imperfect. The result is a model in which, rather than a sharp distinction between liquid and illiquid assets (as in the case of a pure cash-in-advance model, or the Lagos-Wright model), there is a spectrum of assets of differing degrees of liquidity, with money only distinguished as the most liquid of all.

An important consequence of this theory is that equilibrium returns on many different assets (and not just money) should reflect in part a liquidity premium; the authors propose that this may account for a substantial part of the well-known equity premium puzzle (the surprisingly large differential between the average returns on stocks and those on riskless Treasury debt). The authors also revisit the question of the real effects of inflation. Contrary to the classic superneutrality result obtained in the Sidrauski monetary growth model, the authors find that in their model, higher-inflation steady states are associated with higher capital-labor and capital-output ratios; the fact that the returns to capital, like those of other assets, involve a liquidity premium in their model, is responsible for this result. (In a higher-inflation environment, liquidity is more scarce; when capital is another source of liquidity, this provides an incentive for capital accumulation.) More generally, this paper opens an important discussion about the way in which the pricing and supply of assets is affected by the role of assets in allowing the production of privately-supplied money substitutes, arguably an important function of modern financial systems.

Our fifth paper, Shocks and Crashes by Martin Lettau and Sydney C. Ludvigson, analyzes the relative contributions of changes in productivity, factor shares, and effective risk aversion both to expansions and recessions and to stock market booms and crashes. The paper uses vector autoregression techniques to analyze the joint dynamic behavior of consumption, labor income, and a broad measure of financial wealth. Productivity shocks are identified as having permanent effects on all three variables. Changes in factor shares are identified as shocks that leave consumption unchanged but that move labor income and stock market wealth in opposite directions. Finally, the remaining purely transitory shock accounts for most of the transitory fluctuations in wealth but explains little variation in consumption or labor income, and as such appears to largely capture time-variation in effective risk aversion.

What does this decomposition tell us about fluctuations in wealth and output? While there are many interesting findings in the paper, a few stand out. First, the factor shares shock explains most of the variation in quarterly labor income. That is, the addition of financial variables uncovers a central role for a shock that is missing from most macroeconomic models. This shock is also central to the lower frequency (decadal) changes in stock market valuation. Second, the effective risk aversion shock accounts for most short-run asset market volatility, having a half-life of about four years, consistent with a common view among financial economists. But this shock is almost unrelated to consumption contemporaneously or in the future, inconsistent with most modern asset pricing theories. Third, these effective risk aversion shocks played a large role in the technology boom and of the late 1990s, the following crash of 2000 to 2001, and the credit boom of the 2000s. Thus wealth changes were largely transitory with little relation to income and consumption. But the crash of 2008 is different, due not only to an increase in effective risk aversion but also to a large permanent negative shock to consumption coming from the productivity shock. Thus, an integrated analysis of the history of these three variables is consistent with a permanently lower level of output following the Great Recession. Worryingly, the paper’s estimates imply that the ratio of wealth to consumption at the end of the sample in the third quarter of 2012 lies well above its equilibrium level, a deviation that in the past has typically been equilibrated largely by a change in wealth rather than a boom in output or consumption.

The final chapter is a speech by Christina Romer, longtime NBER member and director of the Program in Monetary Economics, recent chair of the Council of Economic Advisers under President Obama, and regular columnist for the New York Times. Romer addresses the large and well-publicized shift toward more expansionary monetary policy that has recently occurred in Japan. Economists have long been concerned about the coincidence of deflation and depression, and recent analyses have shown that when interest rates are at the zero lower bound, expansionary monetary policy is largely about managing expectations of future inflation. Romer points out that a large monetary expansion—a regime change when President Roosevelt took office in 1933—was associated with a large turnaround in the US economy with industrial production rising by 57 percent in the first four months of the year. Her talk discusses historical evidence that this was perceived as a regime change and the types of evidence that show that this regime change, rather than other policies or economic disturbances, were the cause of the rapid, if incomplete, recovery. She concludes by drawing out the implications of this view of the efficacy of regime change in the Great Depression for both the impact of the recent dramatic policy shift in Japan associated with Abenomics, and for the effects of more modest shifts in forward guidance undertaken by the US monetary authorities during the current slow recovery.

Finally, the authors and the editors would like to take this opportunity to thank Jim Poterba and the National Bureau of Economic Research for their continued support for the NBER Macroeconomics Annual and the associated conference. We would also like to thank the NBER conference staff, particularly Rob Shannon, for his continued excellent organization and support. Financial assistance from the National Science Foundation is gratefully acknowledged. Kyle Jurado and Mariana Garcia Schmidt provided invaluable help in preparing the summaries of the discussions. And last but far from least, we are grateful to Helena Fitz-Patrick for her invaluable assistance in editing and producing the volume.

Endnote

For acknowledgments, sources of research support, and disclosure of the authors’ material financial relationships, if any, please see http://www.nber.org/chapters/c12922.ack.

© 2014 by the National Bureau of Economic Research. All rights reserved.

978-0-226-16540-0/2014/2013-0001$10.00

Abstracts

1. Dormant Shocks and Fiscal Virtue

Francesco Bianchi and Leonardo Melosi

We develop a theoretical framework to account for the observed instability of the link between inflation and fiscal imbalances across time and countries. Current policymakers’ behavior influences agents’ beliefs about the way debt will be stabilized. The standard policy mix consists of a virtuous fiscal authority that moves taxes in response to debt and a central bank that has full control over inflation. When policymakers deviate from this virtuous regime, agents conduct Bayesian learning to infer the likely duration of the deviation. As agents observe more and more deviations, they become increasingly pessimistic about a prompt return to the virtuous regime and inflation starts drifting in response to a fiscal imbalance. Shocks that were dormant under the virtuous regime now start manifesting themselves. These changes are initially imperceptible, can unfold over decades, and accelerate as agents’ beliefs deteriorate. Dormant shocks explain the run-up of US inflation and uncertainty in the 1970s. The currently low long-term interest rates and inflation expectations might hide the true risk of inflation faced by the US economy.

2. Understanding Noninflationary Demand-Driven Business Cycles

Paul Beaudry and Franck Portier

During the last thirty years, US business cycles have been characterized by countercyclical technology shocks and almost constant inflation. While the first fact runs counter to an RBC view of fluctuation and calls for demand shocks as a source of fluctuations, the second fact is difficult to reconcile with a New Keynesian model in which demand shocks, when accommodated, should be inflationary. In this paper we show that noninflationary demand-driven business cycles can be very easily explained if one moves away from the representative agent framework on which both the New Keynesian model and the RBC model are based. In particular, we first show how changes in demand induced by changes in perceptions about the future can cause business cycle type fluctuations in a Walrasian setting when agents’ skills are specialized in different sectors. Such a model is able to generate demand-driven positive comovements of consumption, investment, and hours together with procyclical real wages and relative price of investment. To illustrate how the real mechanism we put forward works in the presence of sticky prices, we present a modified New Keynesian model with specialized agents where noninflationary demand-driven fluctuations arise as the outcome. We also document the relevance of the assumptions underlying our framework using PSID data over the period 1968 to 2007.

3. Reference Dependence and Labor Market Fluctuations

Kfir Eliaz and Ran Spiegler

We incorporate reference-dependent worker behavior into a search-matching model of the labor market, in which firms have all the bargaining power and productivity follows a log-linear AR(1) process. Motivated by Akerlof (1982) and Bewley (1999), we assume that existing workers’ output falls stochastically from its normal level when their wage falls below a reference point, which (following Köszegi and Rabin 2006) is equal to their lagged-expected wage. We formulate the model game-theoretically and show that it has a unique subgame perfect equilibrium that exhibits the following properties: existing workers experience downward wage rigidity, as well as destruction of output following negative shocks due to layoffs or loss of morale; newly hired workers earn relatively flexible wages, but not as much as in the benchmark without reference dependence; market tightness is more volatile than under this benchmark. We relate these findings to the debate over the Shimer puzzle (Shimer 2005).

4. Pledgability and Liquidity: A New Monetarist Model of Financial and Macroeconomic Activity

Venky Venkateswaran and Randall Wright

When limited commitment hinders credit, assets help by serving as collateral. We study models where assets differ in pledgability, and hence liquidity. Previous analyses focus on producers; we emphasize consumers. Household debt limits are determined by having assets seized after default. The framework, which nests standard growth and asset-pricing theory, is calibrated to analyze monetary policy and financial innovation. Inflation can raise output, employment, and investment, plus improve housing and stock markets. For the baseline calibration, optimal inflation is positive. Increases in pledgability can generate booms and busts in economic activity, but may still be good for welfare.

5. Shocks and Crashes

Martin Lettau and Sydney C. Ludvigson

Three shocks, distinguished by whether their effects are permanent or transitory, are identified to characterize the postwar dynamics of aggregate consumer spending, labor earnings, and household wealth. The first shock accounts for virtually all of the variation in consumption; we argue that it can be plausibly interpreted as a permanent total factor productivity shock. The second shock, which underlies the vast bulk of quarterly fluctuations in labor income growth, permanently reallocates rewards between shareholders and workers but leaves consumption unaffected. Over the last twenty-five years, the cumulative effect of this shock has persistently boosted stock market wealth and persistently lowered labor earnings. We call this a factor share shock. The third shock is a persistent but transitory innovation that accounts for the vast majority of quarterly fluctuations in asset values but has a negligible impact on consumption and labor earnings at all horizons. We call this an exogenous risk aversion shock. We show that the 2000 to 2002 asset market crash and recession surrounding it was characterized by a negative transitory wealth (positive risk aversion) shock, predominantly affecting stock market wealth. By contrast, the 2007 to 2009 crash and recession was characterized by a string of large negative productivity shocks, as well as positive risk aversion shocks.

© 2014 by the National Bureau of Economic Research. All rights reserved.

978-0-226-16540-0/2014/2013-0002$10.00

Dormant Shocks and Fiscal Virtue

Francesco Bianchi

Duke University and CEPR

Leonardo Melosi

Federal Reserve Bank of Chicago

I. Introduction

The importance of modeling the interaction between fiscal and monetary policies goes back to the seminal contribution of Sargent and Wallace (1981). However, in many of the models that are routinely used to investigate the sources of macroeconomic fluctuations, fiscal policy plays only a marginal role. The vast majority of papers resolve the problem of monetary/fiscal policy coordination assuming that the fiscal authority stands ready to accommodate the behavior of the monetary authority, keeping the process for debt on a stable path. This is a strong assumption as a casual observation of the data shows that countries often experience prolonged periods of severe fiscal imbalance. Quite interestingly, these episodes are frequently followed by significant increases in inflation. In some cases, such increases are short lasting and remarkably violent. In other cases, they unfold over many years, generally starting small and then gaining momentum. In this paper, we develop a theoretical framework that can quantitatively account for persistent and accelerating increases in inflation and for the heterogeneity, across countries and over time, of the link between inflation and fiscal discipline.

We model an economy populated by a continuum of agents that are fully rational and understand that debt can be stabilized through movements in taxes or movements in inflation. When the fiscal authority is virtuous and moves primary surpluses in response to fluctuations in the ratio of debt to gross domestic product (GDP), the Central Bank has full control over inflation. Under the assumption of nondistortionary taxation, fiscal shocks do not have any effect on the real economy as they only redistribute the timing of taxation. When policymakers deviate from the virtuous regime, with the fiscal authority not reacting to debt fluctuations and the Central Bank disregarding the Taylor principle, two situations can arise. If agents expect the return to the virtuous regime to be close enough in time, inflation stability is preserved. On the other hand, if the deviation is expected to last for a long period of time, high levels of debt require an increase in inflation.

We build on this basic intuition and assume that when facing a deviation from the virtuous rule, agents do not know how long it will take to move back. Instead, they have to conduct Bayesian learning to infer the nature of the deviation. As they observe more and more deviations, they get increasingly convinced that a prompt return to the virtuous regime is very unlikely. Given that agents are fully rational and understand that debt has to be financed in one way or the other, the drift in agents’ beliefs determines a progressive increase in inflation. The initial movement can be almost undetectable, but as initially optimistic agents become relatively pessimistic, inflation accelerates, gaining momentum and getting out of control. At the same time, expected and realized volatilities go up as shocks that are dormant under the virtuous regime slowly start manifesting themselves. Therefore, if an external observer were monitoring the economy focusing exclusively on output and inflation, he would detect a run-up in inflation and an increase in volatility without any apparent explanation. The observer might then conclude that the volatility of the exogenous shocks and the target for inflation have both increased.

Dormant shocks are undetectable when policymakers are virtuous or agents are optimistic that they will be virtuous in the future because agents understand that any imbalance in the debt-to-GDP ratio will be followed by a fiscal adjustment. As agents become discouraged about policymakers’ future behavior, the effects of dormant shocks arise. Therefore, dormant shocks can have effects many years after they occurred, as long as the fiscal imbalance that they generated is not totally reabsorbed by the time the deviation from the virtuous regime takes place. Furthermore, even after a regime change, their effects can barely be detected if agents find it extremely unlikely that policymakers will engage in a long-lasting deviation from the virtuous regime. In other words, depending on policymakers’ fiscal virtue, inflation can stay low for many periods, as it takes time for agents to become convinced that the economy has entered a long-lasting deviation. According to the same logic, if on average policymakers spend a lot of time in the virtuous regime, agents might remain confident about ultimately responsible fiscal behavior even when observing a long sequence of deviations. However, no matter how optimistic agents are or how virtuous policymakers have been in the past, if a deviation lasts for an extended period of time, agents will eventually become convinced that a quick return to the virtuous regime is unlikely. In other words, following a deviation, fiscal virtue can delay the effects of dormant shocks, but it cannot eliminate them.

The interaction between dormant shocks and fiscal virtue also provides an appealing explanation for why countries with different levels of debt might have similar levels of inflation for prolonged periods of time, but then experience very different outcomes during hard times. When a virtuous regime prevails or agents are confident that it will prevail in the future, the level of debt is substantially irrelevant. However, if agents become convinced that the economy has entered a long-lasting deviation, then the differentials between the interest rate and inflation open up. The larger the difference in fiscal virtue, the larger the difference in the speed of learning, the faster the opening of the differentials between the interest rate and inflation.

Therefore, our theoretical framework is capable of accounting for the instability of the link between fiscal discipline and inflation. In our model, agents are fully rational, but uncertain about the way the trade-off between inflation and taxation will be resolved. This creates a continuum of regimes indexed according to agents’ beliefs and a smooth transition from the law of motion that prevails under the virtuous regime to the one that characterizes a long-lasting deviation. Therefore, the strict distinction between Ricardian and non-Ricardian regimes typical of the fiscal theory of price level literature (Leeper 1991; Sims 1994; Woodford 1994, 1995, 2001; Schmitt-Grohe and Uribe 2000; Bassetto 2002; and Cochrane 1998, 2001, among others) breaks down and is replaced by a series of intermediate regimes that reflect the evolution of agents’ expectations about the future conduct of fiscal and monetary policies.¹

Furthermore, agents know that they do not know. Therefore, when forming expectations, they take into account that their beliefs will evolve according to what they observe. Given this feature, our approach is clearly different from the one used in the traditional literature about learning, which assumes anticipated utility; that is, that agents form expectations conditional on their beliefs without taking into account that these are likely to change in the future. In our context, it is possible to go beyond the anticipated utility assumption because there is only a finite number of relevant beliefs and they are strictly linked to policymakers’ behavior through the learning mechanism, in a way that we can keep track of their evolution.

In this respect, our paper is related to Eusepi and Preston (2012), who study the problem of macroeconomic stability in a model in which agents use adaptive learning to make forecasts about the future evolution of fiscal and monetary variables. In their model, there are not regime changes. If agents were fully rational, fiscal policy and the maturity structure of debt would be irrelevant because the Taylor principle always holds and fiscal policy is always Ricardian. However, agents do not know the parameters of the model and they erroneously believe that the economy is subject to regime changes. For this reason they use a constant gain learning algorithm in which recent observations receive more weight than observations that are far into the past. In this context, non-Ricardian effects arise because agents might erroneously regard bonds as net-wealth as in Barro (1974). Instead, in this paper non-Ricardian effects arise in the moment fully rational agents, in response to changes in policymakers’ behavior, become discouraged about debt sustainability being guaranteed by movements in primary surpluses.

Given that the underlying mechanism relies on uncertainty around the source of financing for the debt-to-GDP ratio, all shocks that move this variable are potentially candidates for dormant shocks. In an environment with nondistortionary taxation, shocks to transfers and taxes are particularly interesting, given that they do not have any effect on the macroeconomic variables when the virtuous regime is in place but can generate large fluctuations in inflation once policymakers start deviating. Furthermore, given that agents are forward-looking, even announced changes in expenditure or taxation would trigger the inflationary mechanism.

We illustrate the key properties of the model using the basic three-equations new-Keynesian model used by Clarida, Gali, and Gertler (2000), Woodford (2003), and Lubik and Schorfheide (2004), augmented with a fiscal block. We then conduct a quantitative analysis building on the empirical results obtained by Bianchi and Ilut (2012). The estimates from that paper are used to calibrate a richer model and to provide guidance in characterizing the evolution of policymakers’ behavior: A prolonged deviation from the virtuous regime started in the late 1950s and ended with the appointment of Paul Volcker as Federal Reserve Chairman. The transition matrix controlling the evolution of policymakers’ behavior is then chosen in a way to match the stylized facts regarding the US Great Inflation: inflation started increasing in the mid-1960s, gained momentum in the early 1970s, got out of control toward the end of that same decade, and experienced a sudden drop in the early 1980s. The entire run-up of inflation of the 1970s can be obtained by considering only two shocks. The first rise of inflation would be the result of the announcement of the Great Society initiatives of President Lyndon Johnson around 1964, while the second acceleration would be caused by the tax cuts enacted by President Gerald Ford’s administration. The progressive deterioration of agents’ beliefs explains why inflation seemed to gain momentum over time. The appointment of Volcker at the end of the 1970s marks the return to the virtuous regime and determines the sudden drop in inflation of the early 1980s.

We then use the model to analyze the current situation. Given that dormant shocks might take a long time to unfold, we should not interpret the current low levels of inflation expectations and long-term interest rates as reflecting a low risk of high inflation for the US economy. We show that if US policymakers were to follow the current policy mix for a prolonged period of time, inflation might quickly accelerate and get out of control. In other words, the low inflation expectations and long-term interest rates reflect the reputation that US policymakers have built in the past twenty to thirty years since the Volcker disinflation. This stock of reputation is not unlimited, and it slowly deteriorates as policymakers keep deviating. This also suggests that if inflation is the result of a lack of fiscal discipline, central bankers cannot simply wait to see inflation in order to decide to worry about that. At that point, only an immediate change in both fiscal and monetary policies would be able to cut the inflation spiral.

This paper is part of a broader research agenda that aims at understanding the role of fiscal policy in explaining changes in the reduced form properties of the macroeconomy. In this regard, the current paper is related to Bianchi and Ilut (2012), who estimate a dynamic stochastic general equilibrium (DSGE) model for the US economy that allows for a structural break from a non-Ricardian regime to a Ricardian one. The main contribution of that paper is to identify the timing of the structural break, occurring a few quarters after the appointment of Volcker, and to show that the policy change can account for the rise and fall of inflation and the changes in the reduced form properties of the macroeconomy. The current paper does not present a fully specified estimation exercise. Instead, we use the results obtained by Bianchi and Ilut (2012) to fix parameter values and the timing of regime changes. That said, the current paper contributes to this research agenda in several ways. First, it introduces the notion of dormant shocks. This resolves an apparent puzzle of the fiscal theory of price level; that is, the fact that in the data fiscal shocks do not seem to cause an immediate increase in inflation. Instead, thanks to the learning mechanism, dormant shocks can cause accelerating and persistent increases in inflation that unfold over decades. Second, it illustrates how the interaction between dormant shocks and fiscal virtue can account for the heterogeneity across countries in the link between fiscal discipline and inflation. Finally, it puts the theory to work to discuss its implications for the future behavior of inflation.

Our paper is related to the extensive literature that explores the evolution of output and inflation over the past sixty years using micro-founded models. Fernandez-Villaverde, Guerron-Quintana, and Rubio-Ramirez (2010) consider models with time-varying structural parameters and find substantial evidence of parameter instability. Using a large-scale DSGE model augmented with stochastic volatilities, Justiniano and Primiceri (2008) find that changes in the volatility of investment shocks play a key role in explaining the evolution of the reduced form properties of the economy. Davig and Leeper (2007), Bianchi (2013), and Davig and Doh (2008) allow for heteroskedasticity and changes in monetary policy. Bianchi and Melosi (2012a) develop a theoretical framework to quantitatively assess the general equilibrium effects and welfare implications of central bank reputation and transparency. Finally, Ireland (2007), Liu, Waggoner, and Zha (2011), and Schorfheide (2005) consider models in which the target for inflation is moving over time. Our model is able to account for changes in the low-frequency component of inflation and in the volatility of the endogenous variables.

Our work is also related to Benati (2008); Cogley, Primiceri, and Sargent (2010); Cogley, Sargent, and Surico (2011); and Coibion and Gorodichenko (2011). Benati (2008) documents that inflation persistence is not stable across time and across countries. Cogley et al. (2010) study changes in the persistence of the inflation gap measured in terms of short- to medium-term predictability. Cogley et al. (2011) show that the Gibson’s paradox (i.e., low correlation between inflation and nominal interest rates) vanished during the Great Inflation and reappeared after 1995. Coibion and Gorodichenko (2011) point out that the determinacy region in a model with positive trend inflation could be smaller than what is implied by the Taylor principle. They conclude that the US economy was still at risk of indeterminacy in the 1970s, even if the Taylor principle was likely to be satisfied, because of the high level of trend inflation. Our model is able to generate variability in the persistence and low frequency component of inflation as a result of the evolution of agents’ beliefs about policymakers’ future behavior. Finally, our work is also linked to papers that study the impact of monetary policy decisions on inflation and inflation expectations, such as Mankiw, Reis, and Wolfers (2004); Nimark (2008); Del Negro and Eusepi (2011); and Melosi (2012, 2013).

This paper can be summarized as follows. In section II, we describe the model, outlining its properties under fixed coefficients. In section III, we introduce regime changes and learning. In section IV, we introduce the notion of dormant shocks and explain how they are related to fiscal virtue. We put the theory to work in section V: first, we look at the past; and then we look at the current situation and beyond under the same theoretical framework. We present our conclusions in section VI.

II. The Model

In order to illustrate the key properties of the model, we consider the basic new-Keynesian model employed by Clarida, Gali, and Gertler (2000), Woodford (2003), and Lubik and Schorfheide (2004), augmented with a fiscal rule. This model has very little built-in persistence, given that it features a purely forward-looking Phillips curve. This will allow us to isolate the effects of the learning mechanism.

A. A New-Keynesian Model

The economy consists of a continuum of monopolistic firms, a representative household, and a monetary policy authority. The household derives utility from consumption Ct and disutility from labor ht:

where β is the household’s discount factor and the preference shock dt follows an autoregressive process: dt = ρddt−1 + σd∈d,t, ∈d,t ∼ N (0, 1). The household budget constraint is given by

where Bt represents nominal bond holdings, Dt captures dividends paid by firms, Wt is the real wage, Tt is a net lump sum tax, Pt is the price level, and Rt is the one-period gross nominal interest rate.

Each of the monopolistically competitive firms faces a downward-sloping demand curve:

where Pt(j) is the price chosen by firm j and the parameter1/υ is the elasticity of substitution between two differentiated goods. The firms take as given the general price level, Pt, and level of real activity Yt. Whenever a firm wants to change its price, it faces quadratic adjustment costs represented by an output loss:

The firm’s problem consists in choosing the price Pt(j) to maximize the present value of future profits:

where Qs is the household’s stochastic discount factor. Labor is the only input in a linear production function, Yt(j) = Atht(j), where total factor productivity zt = ln(At/A) follows an autoregressive process: zt = ρzzt−1 + ∈z,t, ∈z,t ∼ N (0, 1).

The government budget