NBER Reporter: Fall 2001

Economic Fluctuations and Growth

Roughly one hundred academic macroeconomists from all over the world gathered in Cambridge on July 21 to attend the summer research meeting of NBER's Program on Economic Fluctuations and Growth. The meeting was organized by Mark Bils, NBER and University of Rochester, and Christopher Sims, NBER and Princeton University. These papers were discussed:

Thomas Cooley and Vincenzo Quadrini, New York University, and Ramon Marimon, NBER and European University Institute, "Aggregate Consequences of Limited Contract Enforceability"

Discussant: Stephen Williamson, University of Iowa

John H. Cochrane, NBER and University of Chicago, "Money as Stock"

Discussant: Bennett T. McCallum, NBER and Carnegie-Mellon University

Stephanie Schmitt-Grohe, Rutgers University, and Martin Uribe, University of Pennsylvania, "Optimal Fiscal and Monetary Policy Under Sticky Prices"

Discussant: V.V. Chari, University of Minnesota

Raquel Fernandez, NBER and New York University, Nezih Guner, Queen's University, and John Knowles, University of Pennsylvania, "Love and Money: A Theoretical and Empirical Analysis of Household Sorting and Inequality"

Discussant: Michael Kremer, NBER and Harvard University

Muhammet Fatih Guvenen, Carnegie-Mellon University, "Mismeasurement of the Elasticity of Intertemporal Substitution: The Role of Limited Stock Market Participation"

Discussant: Robert E. Hall, NBER and Stanford University

Athanasios Orphanides, Federal Reserve Board, "Monetary Policy Rules, Macroeconomic Stability and Inflation: A View from the Trenches"

Discussant: Eric Leeper, Indiana University

Cooley, Marimon, and Quadrini develop a general equilibrium model in which entrepreneurs finance investment by signing long-term contracts with a financial intermediary. Because of the enforceability problems, financial contracts are constrained to be efficient. After showing that the micro structure of the model captures some of the observed features of the investment policy and dynamics of firms, the authors demonstrate that limited enforceability makes the diffusion of new technologies to the economy sluggish and amplifies their impact on aggregate output.

Nominal government debt is a residual claim to government surpluses. Thus, the value of fiat money, just like the price of stock, can be determined in a completely frictionless economy. Cochrane's main theoretical objection to this fiscal theory of the price level is that it mistreats the government's intertemporal budget constraint. He shows that the valuation equation for nominal government debt is not, in fact, a budget constraint. Most clearly, a corporation can double shares without changing earnings. This is a stock split and halves the stock price. Similarly, the government can double debt with no change in surpluses. This is a currency reform, and doubles the price level. Thus, if a currency reform is possible, the nominal debt valuation equation is not a budget constraint. Cochrane anchors this analysis in a simple cash-in-advance model. He makes one small modification: he reopens the security market at the end of the day. With this modification, overnight money demand is precisely zero. Cochrane shows that the price level is still determined by the government debt valuation equation, though. His model shows that the value of unconvertible fiat money can be determined with no money demand as well as with elastic supply.

Schmitt-Grohe and Uribe study optimal fiscal and monetary policy under sticky product prices. Their theoretical framework is a stochastic production economy without capital. The government finances an exogenous stream of purchases by levying distortionary income taxes, printing money, and issuing one-period nominally risk-free bonds. The main findings of the paper are: First, for a minuscule degree of price stickiness (that is, many times below available empirical estimates) the optimal volatility of inflation is near zero. This result stands in stark contrast with the high volatility of inflation implied by the Ramsey allocation when prices are flexible. The finding is in line with a recent body of work on optimal monetary policy under nominal rigidities that ignores the role of optimal fiscal policy. Second, even small deviations from full price flexibility induce behavior in government debt and tax rates that is close to a random walk, as in economies with real non-state-contingent debt only. Finally, sluggish price adjustment raises the average nominal interest rate above the one called for by the Friedman rule.

Fernandez and Guner examine the interactions between household matching, inequality, and per capita income. They develop a model in which agents decide whether to become skilled or unskilled, form households, consume, and have children. The authors show that matches increasingly are correlated (sorted) in skill type as a function of the skill premium. In the absence of perfect capital markets, depending on initial conditions, the economy can converge to steady states with a high degree of marital sorting, high inequality, and large fertility differentials, or to states with low sorting, low inequality, and small fertility differentials. Using 34 country household surveys from the Luxembourg Income Study and the Inter-American Development Bank to construct several measures of the skill premium and of the degree of correlation of spouses' education (marital sorting), the authors find a positive and significant relationship between the two variables.

Guvenen reconciles two opposing views about the elasticity of intertemporal substitution (EIS), a parameter that plays a key role in macroeconomic analysis. On the one hand, empirical studies using aggregate consumption data typically find that the EIS is close to zero. On the other hand, calibrated macroeconomic models designed to match growth and business cycle facts typically require that the EIS be close to one. Guvenen shows that this apparent contradiction arises from ignoring two kinds of heterogeneity across individuals. First, a large fraction of households in the United States do not participate in stock markets. Second, a variety of microeconomic studies using individual-level data conclude that an individual's EIS increases with his wealth. In a dynamic economy which incorporates both kinds of heterogeneity, limited participation creates substantial wealth inequality. Consequently, the dynamic behavior of output and investment is almost entirely determined by the preferences of the wealthy minority of households. At the same time, since consumption is much more evenly distributed across households than is wealth, estimation using aggregate consumption uncovers the low EIS of the majority of households (that is, the poor). Finally, using simulated data generated by a heterogeneous-agent model, the author shows that the econometric methods used by Hall and others produce biased estimates of the average EIS across individuals. In particular, ignoring the correlation of instruments with (the omitted) conditional variances in the log-linearized Euler equation biases the estimate of the EIS downward by as much as 60 percent.

Orphanides estimates a forward-looking monetary policy reaction function for the Federal Reserve for the periods before and after Paul Volcker's appointment as Chairman in 1979, using information that was available to the FOMC in real time from 1966 to 1995. The results suggest broad similarities in policy and point to a forward looking approach to policy consistent with a strong reaction to inflation forecasts during both periods. This contradicts the hypothesis, based on analysis with ex post constructed data, that the instability of the Great Inflation was the result of weak FOMC policy responses to expected inflation. One difference is that, prior to Volcker's appointment, policy was too activist in reacting to perceived output gaps that proved retrospectively to be overambitious. Drawing on contemporaneous accounts of FOMC policy, Orphanides discusses the implications of the findings for alternative explanations of the Great Inflation and the improvement in macroeconomic stability since then.

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