INTRODUCTION

TO THE SERIES

The aim of the Handbooks in Economics series is to produce Handbooks for various
branches of economics, each of which is a definitive source, reference, and teaching
supplement for use by professional researchers and advanced graduate students. Each
Handbook provides self-contained surveys of the current state of a branch of economics
in the form of chapters prepared by leading specialists on various aspects of this
branch of economics. These surveys summarize not only received results but also
newer developments, from recent journal articles and discussion papers. Some original
material is also included, but the main goal is to provide comprehensive and accessible
surveys. The Handbooks are intended to provide not only useful reference volumes for
professional collections but also possible supplementary readings for advanced courses
for graduate students in economics.
KENNETH J. ARROW and MICHAEL D. INTRILIGATOR

PUBLISHER'S

NOTE

For a complete overview of the Handbooks in Economics Series, please refer to the
listing at the end of this volume.

CONTENTS OF THE HANDBOOK

VOLUME 1A
PART 1 - E M P I R I C A L A N D H I S T O R I C A L P E R F O R M A N C E

Chapter 1
Business Cycle Fluctuations in US Macroeconomic Time Series
JAMES H. STOCK and MARK W WATSON

Chapter 2
Monetary Policy Shocks: What Have we Learned and to What End?
LAWRENCE J. CHRISTIANO, MARTIN EICHENBAUM and CHARLES L. EVANS

Chapter 3
Monetary Policy Regimes and Economic Performance: The Historical Record
MICHAEL D. BORDO AND ANNA J. SCHWARTZ

Chapter 4
The New Empirics of Economic Growth
STEVEN N. DURLAUF and DANNY T. QUAH
PART 2 - M E T H O D S O F D Y N A M I C A N A L Y S I S

Chapter 5
Numerical Solution of Dynamic Economic Models
MANUEL S. SANTOS

Chapter 6
Indeterminacy and Sunspots in Macroeconomics
JESS BENHABIB and ROGER E.A. FARMER

Chapter 7
Learning Dynamics
GEORGE W. EVANS and SEPPO HONKAPOHJA

Chapter 8
Micro Data and General Equilibrium Models
MARTIN BROWNING, LARS PETER HANSEN and JAMES J. HECKMAN

vii

viii
PART 3 - M O D E L S O F E C O N O M I C G R O W T H

Chapter 9
Neoclassical Growth Theory
ROBERT M. SOLOW

Chapter 10
Explaining Cross-Country Income Differences
ELLEN R. McGRATTAN and JAMES A. SCHMITZ, Jr.

VOLUME 1B
PART 4 - C O N S U M P T I O N A N D I N V E S T M E N T

Chapter 11
Consumption
ORAZIO R ATTANASIO

Chapter 12
Aggregate Investment
RICARDO J. CABALLERO

Chapter 13
Inventories
VALERIE A. RAMEY and KE;NNETH D. WEST
PART 5 - M O D E L S O F E C O N O M I C F L U C T U A T I O N S

Chapter 14
Resuscitating Real Business Cycles
ROBERT G. KING AND SERG10 T. REBELO

Chapter 15
Staggered Price and Wage Setting in Macroeconomics
JOHN B. TAYLOR

Chapter 16
The Cyclical Behavior of Prices and Costs
JULIO J. ROTEMBERG and MICHAEL WOODFORD

Chapter 17
Labor-Market Frictions and Employment Fluctuations
ROBERT E. HALL

Chapter 18
Job Reallocation, Employmant Fluctuations and Unemployment
DALE T. MORTENSEN and CHRISTOPHER A. PISSARIDES

Contents of the Handbook

Contents of the Handbook

VOLUME 1C
PART 6 - F I N A N C I A L M A R K E T S A N D T H E M A C R O E C O N O M Y

Chapter 19
Asset Prices, Consumption, and the Business Cycle
JOHN Y. CAMPBELL

Chapter 20
Human Behavior and the Efficiency of the Financial System
ROBERT J. SHILLER

Chapter 21
The Financial Accelerator in a Quantitative Business Cycle Framework
BEN S. BERNANKE, MARK GERTLER and SIMON G1LCHRIST
PART 7 - M O N E T A R Y A N D F I S C A L P O L I C Y

Chapter 22
Political Economics and Macroeconomic Policy
TORSTEN PERSSON and GUIDO TABELLINI

Chapter 23
Issues in the Design of Monetary Policy Rules
BENNETT T. McCALLUM

Chapter 24
Inflation Stabilization and BOP Crises in Developing Countries
GUILLERMO A. CALVO and CARLOS A. VI~GH

Chapter 25
Government Debt
DOUGLAS W ELMENDORF AND N. GREGORY MANKIW

Chapter 26
Optimal Fiscal and Monetary Policy
V.V CHARI and PATRICK J. KEHOE

ix

PREFACE TO THE HANDBOOK

Purpose
The Handbook of Macroeconomics aims to provide a survey of the state of knowledge
in the broad area that includes the theories and facts of economic growth and economic
fluctuations, as well as the consequences of monetary and fiscal policies for general
economic conditions.

Progress in Macroeconomics
Macroeconomic issues are central concerns in economics. Hence it is surprising that
(with the exception of the subset of these topics addressed in the Handbook of
Monetary Economics) no review of this area has been undertaken in the Handbook
of Economics series until now.
Surprising or not, we find that now is an especially auspicious time to present such a
review of the field. Macroeconomics underwent a revolution in the 1970's and 1980's,
due to the introduction of the methods of rational expectations, dynamic optimization,
and general equilibrium analysis into macroeconomic models, to the development of
new theories of economic fluctuations, and to the introduction of sophisticated methods
for the analysis of economic time series. These developments were both important
and exciting. However, the rapid change in methods and theories led to considerable
disagreement, especially in the 1980's, as to whether there was any core of common
beliefs, even about the defining problems of the subject, that united macroeconomists
any longer.
The 1990's have also been exciting, but for a different reason. In our view, the
modern methods of analysis have progressed to the point where they are now much
better able to address practical or substantive macroeconomic questions - whether
traditional, new, empirical, or policy-related. Indeed, we find that it is no longer
necessary to choose between more powerful methods and practical policy concerns.
We believe that both the progress and the focus on substantive problems has led to
a situation in macroeconomics where the area of common ground is considerable,
though we cannot yet announce a "new synthesis" that could be endorsed by most
scholars working in the field. For this reason, we have organized this Handbook around
substantive macroeconomic problems, and not around alternative methodological
approaches or schools of thought.

xi

xii

Prefiwe

The extent to which the field has changed over the past decade is considerable, and
we think that there is a great need for the survey of the current state ofmacroeconomics
that we and the other contributors to this book have attempted here. We hope that the
Handbook of Macroeconomics will be useful as a teaching supplement in graduate
courses in the field, and also as a reference that will assist researchers in one area of
macroeconomics to become better acquainted with developments in other branches of
the field.
Overview

The Handbook of" Macroeconomics includes 26 chapters, arranged into seven parts.
Part 1 reviews evidence on the Empirical and Historical PerJbrmance of the
aggregate economy, to provide factual background for tile modeling efforts and
policy discussion of the remaining chapters. It includes evidence on the character
of business fluctuations, on long-run economic growth and the persistence of crosscountry differences in income levels, and on economic performance under alternative
policy regimes.
Part 2 on Methods of Dynamic Analysis treats several technical issues that arise in
the study of economic models which are dynamic and in which agents' expectations
about the future are critical to equilibrium determination. These include methods for
the calibration and computation of models with intertemporal equilibria, the analysis
of the determinacy of equilibria, and the use of "learning" dynamics to consider the
stability of such equilibria. These topics are important for economic theory in general,
and some are also treated in the Handbook of Mathematical Economics, The Handbook
of Econometrics, and the Handbook of Computational Economics, for example, from
a somewhat different perspective. Here we emphasize results - such as the problems
associated with the calibration of general equilibrium models using microeconomic
studies - that have particular application to macroeconomic models.
The Handbook then turns to a review of theoretical models of macroeconomic
phenomena. Part 3 reviews Models" of Economic Growth, including both the
determinants of long-run levels of income per capita and the sources of cross-country
income differences. Both "neoclassical" and "endogenous" theories of growth are
discussed. Part 4 treats models of Consumption and Investment demand, from the
point of view of intertemporal optimization. Part 5 covers Models" of Economic
Fluctuations. In the chapters in this part we see a common approach to model
formulation and testing, emphasizing intertemporal optimization, quantitative general
equilibrium modeling, and the systematic comparison of model predictions with
economic time series. This common approach allows for consideration of a variety
of views about the ultimate sources of economic fluctuations and of the efficiency of
the market mechanisms that amplify and propagate them.
Part 6 treats Financial Markets and the Macroeconomy. The chapters in this part
consider the relation between financial market developments and aggregate economic

Preface

xiii

activity, both from the point of view of how business fluctuations affect financial
markets, and how financial market disturbances affect overall economic activity. These
chapters also delve into the question of whether financial market behavior can be
understood in terms of the postulates of rational expectations and intertemporal
optimization that are used so extensively in modern macroeconomics-an issue of
fundamental importance to our subject that can be, and has been, subject to special
scrutiny kn the area of financial economics because of the unusual quality of available
data.
Finally, Part 7 reviews a number of Monetary and Fiscal Policy issues. Here we
consider both the positive theory (or political economics) of government policymaking
and the normative theory. Both the nature of ideal (or second-best) outcomes according
to economic theory and the choice of simple rules that may offer practical guidance
for policymakers are discussed. Lessons from economic theory and from experience
with alternative policy regimes are reviewed. None of the chapters in this part
focus entirely on international, or open economy, macroeconomic policies, because
many such issues are addressed in the Handbook of International Economics.
Nevertheless, open-economy issues cannot be separated from closed-economy issues
as the analysis of disinflation policies and currency crises in this part of the Handbook
of Macroeconomics, or the analysis of policy regimes in the Part I of the Handbook
of Macroeconomics make clear.

Acknowledgements
Our use of the pronoun "we" in this preface should not, of course, be taken to
suggest that much, if any, of the credit for what is useful in these volumes is due
to the Handbook's editors. We wish to acknowledge the tremendous debt we owe to
the authors of the chapters in this Handbook, who not only prepared the individual
chapters, but also provided us with much useful advice about the organization of the
overall project. We are grateful for their efforts and for their patience with our slow
progress toward completion of the Handbook. We hope that they will find that the
final product justifies their efforts. We also wish to thank the Federal Reserve Bank of
New York, the Federal Reserve Bank of San Francisco, and the Center for Economic
Policy Research at Stanford University for financial support for two conferences on
"Recent Developments in Macroeconomics" at which drafts of the Handbook chapters
were presented and discussed, and especially to Jack Beebe and Rick Mishkin who
made these two useful conferences happen. The deadlines, feedback, and commentary
at these conferences were essential to the successful completion of the Handbook.
We also would like to thank Jean Koentop for managing the manuscript as it neared
completion.
Stanford, California
Princeton, New Jersey

John B. Taylor
Michael Woodford

Chapter 19

A S S E T PRICES, C O N S U M P T I O N , A N D THE BUSINESS

CYCLE *
JOHN Y. CAMPBELL
Harvard University and NBER. Department of Economics, Littauer Center, Harvard University,
Cambridge, MA 02138, USA

Contents
Abstract
Keywords
1. Introduction
2. International asset market data
3. The equity p r e m i u m puzzle
3.1. The stochastic discount factor
3.2. Consumption-based asset pricing with power utility
3.3. The riskfree rate puzzle
3.4. Bond returns and the equity premium and riskfrce rate puzzles
3.5. Separating risk aversion and intertemporal substitution
4. The d y n a m i c s o f asset returns and c o n s u m p t i o n
4.1. Time-variation in conditional expectations
4.2. A loglinear asset pricing framework
4.3. The stock market volatility puzzle
4.4. Implications for the equity premium puzzle
4.5. What does the stock market forecast?
4.6. Changing volatility in stock returns
4.7. What does the bond market forecast?
5. C y c l i c a l variation in the price o f risk
5.1. Habit formation
5.2. Models with heterogeneous agents

1232
1232
1233
1238
1245
1245
1249
1252
1255
1256
1260
1260
1264
1268
1272
1275
1277
1280
1284
1284
1290

* This chapter draws heavily on John Y. Campbell, "Consumption and the Stock Market: Interpreting
International Experience", Swedish Economic Policy Review 3:251-299, Autumn 1996. I am grateful
to the National Science Foundation for financial support, to Tim Chue, Vassil Konstantinov, and Luis
Viceira for able research assistance, to Andrew Abel, Olivier Blanchard, Ricardo Caballero, Robert
Shiller, Andrei Shleifer, John Taylor, and Michael Woodford for helpful comments, and to Barclays
de Zoete Wedd Securities Limited, Morgan Stanley Capital International, David Barr, Bjorn Hansson,
and Paul S6derlind for providing data.
Handbook of Mactveconomics, Volume 1, Edited by J.B. lhylor and M. WoodJbrd
1999 Elsevier Science B.V. All tqghts reserved
1231

1232
5.3. Irrational expectations
6. Some implications for macroeconomics
References

J..Y Campbell
1293
1296
1298

Abstract
This chapter reviews the behavior of financial asset prices in relation to consumption.
The chapter lists some important stylized facts that characterize US data, and relates
them to recent developments in equilibrium asset pricing theory. Data from other
countries are examined to see which features of the US experience apply more
generally. The chapter argues that to make sense of asset market behavior one needs
a model in which the market price of risk is high, time-varying, and correlated with
the state of the economy. Models that have this feature, including models with habitformation in utility, heterogeneous investors, and irrational expectations, are discussed.
The main focus is on stock returns and short-term real interest rates, but bond returns
are also considered.

Keywords
JEL classification: G12

Ch. 19." Asset Prices, Consumption, and the Business Cycle

1233

1. Introduction

The behavior of aggregate stock prices is a subject of enduring fascination to investors,

policymakers, and economists. In recent years stock markets have continued to show
some familiar patterns, including high average returns and volatile and procyclical
price movements. Economists have struggled to understand these patterns. If stock
prices are determined by fundamentals, then what exactly are these fundamentals and
what is the mechanism by which they move prices? Researchers, working primarily
with US data, have documented a host of interesting stylized facts about the stock
market and its relation to short-term interest rates and aggregate consumption:
(1) The average real return on stock is high. In quarterly US data over the period
1947.2 to 1996.4, a standard data set that is used throughout this chapter, the
average real stock return has been 7.6% at an annual rate. (Here and throughout
the chapter, the word return is used to mean a log or continuously compounded
return unless otherwise stated.)
(2) The average riskless real interest rate is low. 3-month Treasury bills deliver a
return that is riskless in nominal terms and close to riskless in real terms because
there is only modest uncertainty about inflation at a 3-month horizon. In the
postwar quarterly US data, the average real return on 3-month Treasury bills
has been 0.8% per year.
(3) Real stock returns are volatile, with an annualized standard deviation of 15.5%
in the US data.
(4) The real interest rate is much less volatile. The annualized standard deviation
of the ex post real return on US Treasury bills is 1.8%, and much of this is
due to short-run inflation risk. Less than half the variance of the real bill return
is forecastable, so the standard deviation of the ex ante real interest rate is
considerably smaller than 1.8%.
(5) Real consumption growth is very smooth. The annualized standard deviation
of the growth rate of seasonally adjusted real consumption of nondurables and
services is 1.1% in the US data.
(6) Real dividend growth is extremely volatile at short horizons because dividend
data are not adjusted to remove seasonality in dividend payments. The annualized
quarterly standard deviation of real dividend growth is 28.8% in the US data.
At longer horizons, however, the volatility of dividend growth is intermediate
between the volatility of stock returns and the volatility of consumption growth.
At an annual frequency, for example, the volatility of real dividend growth is
only 6% in the US data.
(7) Quarterly real consumption growth and real dividend growth have a very weak
correlation of 0.06 in the US data, but the correlation increases at lower
frequencies to just over 0.25 at a 4-year horizon.
(8) Real consumption growth and real stock returns have a quarterly correlation of
0.22 in the US data. The correlation increases to 0.33 at a 1-year horizon, and
declines at longer horizons.

1234

J.Y. Campbell

(9)

Quarterly real dividend growth and real stock returns have a very weak correlation
of 0.04 in the US data, but the correlation increases dramatically at lower
frequencies to reach 0.51 at a 4-year horizon.
(10) Real US consumption growth is not well forecast by its own history or by
the stock market. The first-order autocorrelation of the quarterly growth rate of
real nondurables and services consumption is a modest 0.2, and the log pricedividend ratio forecasts less than 5% of the variation of real consumption growth
at horizons of 1 to 4 years.
(11) Real US dividend growth has some short-run forecastability arising from the
seasonality of dividend payments. But it is not well forecast by the stock market.
The log price-dividend ratio forecasts no more than about 8% of the variation
of real dividend growth at horizons of 1 to 4 years.
(12) The real interest rate has some positive serial correlation; its first-order autocorrelation in postwar quarterly US data is 0.5. However the real interest rate is not
well forecast by the stock market, since the log price-dividend ratio forecasts less
than 1% of the variation of the real interest rate at horizons of 1 to 4 years.
(13) Excess returns on US stock over Treasury bills are highly forecastable. The log
price-dividend ratio forecasts 18% of the variance of the excess return at a 1-year
horizon, 34% at a 2-year horizon, and 51% at a 4-year horizon.
These facts raise two important questions for students of macroeconomics and
finance:
Why is the average real stock return so high in relation to the average short-term
real interest rate?
Why is the volatility of real stock returns so high in relation to the volatility of the
short-term real interest rate?
Mehra and Prescott (1985) call the first question the "equity premium puzzle". 1
Finance theory explains the expected excess return on any risky asset over the riskless
interest rate as the quantity of risk times the price of risk. In a standard consumptionbased asset pricing model of the type studied by Hansen and Singleton (1983), the
quantity of stock market risk is measured by the covariance of the excess stock return
with consumption growth, while the price of risk is the coefficient of relative risk
aversion of a representative investor. The high average stock return and low riskless
interest rate (stylized facts 1 and 2) imply that the expected excess return on stock, the
equity premium, is high. But the smoothness of consumption (stylized fact 5) makes
the covariance of stock returns with consumption low; hence the equity premium can
only be explained by a very high coefficient of risk aversion.
Shiller (1982), Hansen and Jagannathan (1991), and Cochrane and Hansen (1992)
have related the equity premium puzzle to the volatility of the stochastic discount
factor, or equivalently the volatility of the intertemporal marginal rate of substitution
of a representative investor. Expressed in these terms, the equity premium puzzle is

I For excellent recent surveys, see Cochrane and l-lansen (1992) or Kocherlakota(1996).

Ch. 19:

Asset Prices, Consumption, and the Business Cycle

1235

that an extremely volatile stochastic discount factor is required to match the ratio of
the equity premium to the standard deviation of stock returns (the Sharpe ratio of the
stock market).
Some authors, such as Kandel and Stambaugh (1991), have responded to the equity
premium puzzle by arguing that risk aversion is indeed much higher than traditionally
thought. However this can lead to the "riskfree rate puzzle" of Weil (1989). If investors
are very risk averse, then they have a strong desire to transfer wealth from periods with
high consumption to periods with low consumption. Since consumption has tended to
grow steadily over time, high risk aversion makes investors want to borrow to reduce
the discrepancy between future consumption and present consumption. To reconcile
this with the low real interest rate we observe, we must postulate that investors are
extremely patient; their preferences give future consumption almost as much weight
as current consumption, or even greater weight than current consumption. In other
words they have a low or even negative rate of time preference.
I will call the second question the "stock market volatility puzzle". To understand
the puzzle, it is helpful to classify the possible sources of stock market volatility.
Recall first that prices, dividends, and returns are not independent but are linked by an
accounting identity. If an asset's price is high today, then either its dividend must be
high tomorrow, or its return must be low between today and tomorrow, or its price must
be even higher tomorrow. If one excludes the possibility that an asset price can grow
explosively forever in a "rational bubble", then it follows that an asset with a high price
today must have some combination of high dividends over tile indefinite future and low
returns over the indefinite future. Investors must recognize this fact in forming their
expectations, so when an asset price is high investors expect some combination of high
future dividends and low future returns. Movements in prices must then be associated
with some combination of changing expectations ("news") about future dividends and
changing expectations about future returns; the latter can in turn be broken into news
about future riskless real interest rates and news about future excess returns on stocks
over short-term debt.
Until the early 1980s, most financial economists believed that there was very little
predictable variation in stock returns and that dividend news was by far the most
important factor driving stock market fluctuations. LeRoy and Porter (1981) and Shiller
(1981) challenged this orthodoxy by pointing out that plausible measures of expected
future dividends are far less volatile than real stock prices. Their work is related to
stylized facts 6, 9, and 11.
Later in the 1980s Campbell and Shiller (1988), Fama and French (1988a,b, 1989),
Poterba and Summers (1988) and others showed that real stock returns are highly
forecastable at long horizons. The variables that predict returns are ratios of stock
prices to scale factors such as dividends, earnings, moving averages of earnings, or
the book value of equity. When stock prices are high relative to these scale factors,
subsequent long-horizon real stock returns tend to be low. This predictable variation
in stock returns is not matched by any equivalent variation in long-term real interest
rates, which are comparatively stable and do not seem to move with the stock market.

1236

J.Y. Campbell

in the late 1970s, for example, real interest rates were unusually low yet stock prices
were depressed, implying high forecast stock returns; the 1980s saw much higher real
interest rates along with buoyant stock prices, implying low forecast stock returns. Thus
excess returns on stock over Treasury bills are just as forecastable as real returns on
stock. This work is related to stylized facts 12 and 13. Campbell (1991) uses this
evidence to show that the great bulk of stock market volatility is associated with
changing forecasts of excess stock returns. Changing forecasts of dividend growth and
real interest rates are much less important empirically.
The stock market volatility puzzle is closely related to the equity premium puzzle. A
complete model of stock market behavior must explain both the average level of stock
prices and their movements over time. One strand of work on the equity premium
puzzle makes this explicit by studying not the consumption covariance of measured
stock returns, but the consumption covariance of returns on hypothetical assets whose
dividends are determined by consumption. The same model is used to generate both
the volatility of stock prices and the implied equity premium. This was the approach of
Mehra and Prescott (1985), and many subsequent authors have followed their lead.
Unfortunately, it is not easy to construct a general equilibrium model that fits all
the stylized facts given above. The standard model of Mehra and Prescott (1985) gets
variation in stock price-dividend ratios only from predictable variation in consumption
growth which moves the expected dividend growth rate and the riskless real interest
rate. The model is not consistent with the empirical evidence for predictable variation
in excess stock returns. Bond market data pose a further challenge to this standard
model of stock returns. In the model, stocks behave very much like long-term real
bonds; both assets are driven by long-term movements in the riskless real interest rate.
Thus parameter values that produce a large equity premium tend also to produce a large
term premium on real bonds. While there is no direct evidence on real bond premia,
nominal bond premia have historically been much smaller than equity premia.
Since the data suggest that predictable variation in excess returns is an important
source of stock market volatility, researchers have begun to develop models in which
the quantity of stock market risk or the price of risk change through time. ARCH
models and other econometric methods show that the conditional variance of stock
returns is highly variable. If this conditional variance is an adequate proxy for
the quantity of stock market risk, then perhaps it can explain the predictability of
excess stock returns. There are several problems with this approach. First, changes in
conditional variance are most dramatic in daily or monthly data and are much weaker
at lower frequencies. There is some business-cycle variation in volatility, but it does not
seem strong enough to explain large movements in aggregate stock prices [Bollerslev,
Chou and Kroner (1992), Schwert (1989)]. Second, forecasts of excess stock returns do
not move proportionally with estimates of conditional variance [Harvey (1989, 1991),
Chou, Engle and Kane (1992)]. Finally, one would like to derive stock market volatility
endogenously within a model rather than treating it as an exogenous variable. There
is little evidence of cyclical variation in consumption or dividend volatility that could
explain the variation in stock market volatility.

Ch. 19:

Asset Prices, Consumption, and the Business Cycle

1237

A more promising possibility is that the price of risk varies over time. Time-variation
in the price of risk arises naturally in a model with a representative agent whose utility
displays habit-formation. Campbell and Cochrane (1999), building on the work of Abel
(1990), Constantinides (1990), and others, have proposed a simple asset pricing model
of this sort. Campbell and Cochrane suggest that assets are priced as if there were
a representative agent whose utility is a power function of the difference between
consumption and "habit", where habit is a slow-moving nonlinear average of past
aggregate consumption. This utility fi.mction makes the agent more risk-averse in bad
times, when consumption is low relative to its past history, than in good times, when
consumption is high relative to its past history. Stock market volatility is explained
by a small amount of underlying consumption (dividend) risk, amplified by variable
risk aversion; the equity premium is explained by high stock market volatility, together
with a high average level of risk aversion.
Time-variation in the price of risk can also arise from the interaction of heterogeneous agents. Constantinides and Duffle (l 996) develop a simple framework with many
agents who have identical utility functions but heterogeneous streams of labor income;
they show how changes in the cross-sectional distribution of income can generate any
desired behavior of the market price of risk. Grossman and Zhou (1996) and Wang
(1996) move in a somewhat different direction by exploring the interactions of agents
who have different levels of risk aversion.
Some aspects of asset market behavior could also be explained by irrational
expectations of investors. If investors are excessively pessimistic about economic
growth, for example, they will overprice short-term bills and underprice stocks; this
would help to explain the equity premium and riskfree rate puzzles. If investors
overestimate the persistence of variations in economic growth, they will overprice
stocks when growth has been high and underprice them when growth has been low,
producing time-variation in the price of risk [Barsky and DeLong (1993)].
This chapter has three objectives. First, it tries to summarize recent work on stock
price behavior, much of which is highly technical, in a way that is accessible to a
broader professional audience. Second, the chapter summarizes stock market data from
other countries and asks which of the US stylized facts hold true more generally.
The recent theoretical literature is used to guide the exploration of the international
data. Third, the chapter systematically compares stock market data with bond market
data. This is an important discipline because some popular models of stock prices are
difficult to reconcile with the behavior of bond prices.
The organization of the chapter is as follows. Section 2 introduces the international
data and reviews stylized facts 1-9 to see which of them apply outside the USA.
(Additional details are given in a Data Appendix available on the author's web page
or by request from the author.) Section 3 discusses the equity premium puzzle, taking
the volatility of stock returns as given. Section 4 discusses the stock market volatility
puzzle; this section also reviews stylized facts 10-13 in the international data.
Sections 3 and 4 drive one towards the conclusion that the price of risk is both
high and time-varying. It must be high to explain the equity premium puzzle, and it

1238

J. Y Campbell

must be time-varying to explain the predictable variation in stock returns that seems
to be responsible for the volatility o f stock returns. Section 5 discusses models which
produce this result, including models with habit-formation in utility, heterogeneous
investors, and irrational expectations. Section 6 draws some implications for other
topics in macroeconomics, including the modelling of investment, labor supply, and
the welfare costs o f economic fluctuations.

2. International asset market data

The stylized facts described in the previous section apply to postwar quarterly US data.
Most empirical work on stock prices uses this data set, or a longer annual US time
series originally put together by Shiller (1981). But data on stock prices, interest rates,
and consumption are also available for many other countries.
In this chapter I use an updated version o f the international developed-country data
set in Campbell (1996a). The data set includes Morgan Stanley Capital International
(MSCI) stock market data covering the period since 1970. ! combine the MSCI data
with macroeconomic data on consumption, short- and long-term interest rates, and
the price level from the International Financial Statistics (IFS) of the International
Monetary Fund. For some countries the IFS data are only available quarterly over a
shorter sample period, so I use the longest available sample for each country. Sample
start dates range from 1970.1 to 1982.2, and sample end dates range from 1995.1 to
1996.4. I work with data from 11 countries: Australia, Canada, France, Germany, Italy,
Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United
States 2.
For some purposes it is useful to have data over a much longer span of calendar
time. I have been able to obtain annual data for Sweden over the period 1920-1994 and
the U K over the period 1919-1994 to complement the US annual data for the period
1891-1995. The Swedish data come from Frennberg and Hansson (1992) and Hassler,
Lundvik, Persson and S6derlind (1994), while the UK data come from Barclays de
Zoete Wedd Securities (1995) and The Economist (1987) 3.
In working with international stock market data, it is important to keep in mind
that different national stock markets are o f very different sizes, both absolutely and in

2 The first version of this paper, following Campbell (1996a), also presented data for Spain. However
Spain, unlike the other countries in the sample, underwent a major political change to democratic
government during the sample period, and both asset returns and inflation show dramatic shifts fi'om the
1970s to the 1980s. It seems more conservative to consider Spain as an emerging market and exclude
it from the developed-countrydata set.
3 1 acknowledge the invaluable assistance of Bjorn Hansson and Paul S6derlind with the Swedish data,
and David Barr with the UK data. Full details about the construction of the quarterly and annual data
are given in a Data Appendix available on the attthor's web page or by request fi'om the author.

1239

Ch. 19." Asset Prices, Consumption, and the Business Cycle

Table 1
MSCI market capitalization, 1993a
Country

V/
(Bill. of US$)

--

vl

(%)

GDPi

v,

- -

VusMxcl

(%)

vi
-

(%)

~f';4 Vi

AUL

117.9

41.55

4.65

1.85

CAN

167.3

30.62

6.60

2.63

FR

272.5

22.49

10.75

4.29

GER

280.7

16.83

11.07

4.41

ITA

86.8

9.45

3.42

1.37

JAP

1651.9

39.74

65.16

25.98

NTH

136.7

45.91

5.39

2.15

SWD

62.9

36.22

2.48

0.99

SWT

205.6

87.46

8.12

3.23

758.4

79.52

29.91

11.93

USA

UK
MSCI

2535.3

37.25

100.00

39.88

USA

CRSP

4875.6

71.64

192.30

a vi is the stock index market capitalization in billions of 1993 US dollars. All stock index data are

from Morgan Stanley Capital International(MSCI), except for USA-CRSP which is from the Center for
Research in Security Prices. Vi/GDP i is the index market capitalization as a percentage of 1993 GDP,
Vi/VtjsMscI is the index market capitalization as a percentage of the market capitalization of the US
MSCI index, and V i / ( ~ i Vi) is the percentage share of the index market capitalization in the total
market capitalization of all the MSCI indexes.
Abbreviations: AUL, Australia; CAN, Canada; FR, France; GER, Germany; 1TA, Italy; JPN, Japan;
NTH, Netherlands; SWD, Sweden; SWT, Switzerland; UK, United Kingdom; USA, United States of
America.
proportion to national GDP's. Table 1 illustrates this by reporting several measures of
stock market capitalization for the quarterly MSCI data. Column 1 gives the market
capitalization for each country's MSCI index at the end of 1993, in billions of $US.
Column 2 gives the market capitalization for each country as a fraction of its GDP.
Column 3 gives the market capitalization for each country as a fraction of the US MSCI
index capitalization. Column 4 gives the market capitalization for each country as a
fraction of the value-weighted world MSCI index capitalization. Since the MSCI index
for the United States is only a subset of the US market, the last row of the table
gives the same statistics for the value-weighted index of New York Stock Exchange
and American Stock Exchange stocks reported by the Center for Research in Security
Prices (CRSP) at the University of Chicago.
Table 1 shows that most countries' stock markets are dwarfed by the US market.
Column 3, for example, shows that the Japanese MSCI index is worth only 65% of
the US MSCI index, the U K MSCI index is worth only 30% of the US index, the
French and German MSCI indexes are worth only 11% of the US index, and all

1240

J.Y. Campbell

other countries' indexes are worth less than 10% o f the US index. Column 4 shows
that the U S A and Japan together account for 66% o f the world market capitalization,
while the USA, Japan, the UK, France, and Germany together account for 86%. In
interpreting these numbers one must keep in mind that the M S C I indexes do not cover
the whole market in each country (the US M S C I index, for example, is worth about
h a l f the US CRSP index), but they do give a guide to relative magnitudes across
countries.
Table 1 also shows that different countries' stock market values are very different
as a fraction o f GDP. I f one thinks that total wealth-output ratios are likely to be
fairly constant across countries, then this indicates that national stock markets are
very different fractions o f total wealth in different countries. In highly capitalized
countries such as the UK and Switzerland, the MSCI index accounts for about 80%
o f GDP, whereas in Germany and Italy it accounts for less than 20% o f GDR The
theoretical convention o f treating the stock market as a claim to total consumption, or
as a proxy for the aggregate wealth o f an economy, makes much more sense in the
highly capitalized countries 4.
Table 2 reports summary statistics for international asset returns. For each country
the table reports the mean, standard deviation, and first-order autocorrelation o f the
real stock return and the real return on a short-term debt instrument 5.
The first line o f Table 2 gives numbers for the standard postwar quarterly US data
set summarized in the introduction. The next panel gives numbers for the 11-country
quarterly MSCI data, and the bottom panel gives numbers for the long-term annual
data sets. The table shows that the first four stylized facts given in the introduction are
fairly robust across countries.
(1) Stock markets have delivered average real returns o f 5% or better in almost every
country and time period. The exceptions to this occur in short-term quarterly
data, and are concentrated in markets that are particularly small relative to GDP
(Italy), or that predominantly represent claims on natural resources (Australia and
Canada).
(2) Short-term debt has rarely delivered an average real return above 3%. The
exceptions to this occur in two countries, Germany and the Netherlands, whose
sample periods begin in the late 1970s and thus exclude much o f the surprise
inflation o f the oil-shock period.

4 Stock ownership also tends to be much more concentrated in the countries with low capitalization.
La Porta, Lopez-de-Silanes, Shleifer and Vishny (1997) have related these international patterns to
differences in the protections afforded outside investors by different legal systems.
5 As explained in the Data Appendix, the best available short-term interest rate is sometimes a Treasury
bill rate and sometimes another money market interest rate. Both means and standard deviations are
given in almualized percentage points. To annualize the raw quarterly numbers, means are multiplied by
400 while standard deviations are multiplied by 200 (since standard deviations increase with the square
root of the time interval in serially uncorrelated data).

Ch. 19." Asset Prices, Consumption, and the Business Cycle

1241

Table 2
International stock and bill returns a
Country

Sample period

re

o(r~)

p(rc)

-~
rj

a(rf )

p(rj )

USA

1947.2-1996.4

7.569

15.453

0.104

0.794

1.761

0.501

AUL

1970.1 1996.3

2.633

23.459

0.008

1.820

2,604

0.636

CAN

1970.1-1996.3

4,518

16,721

0.119

2.738

1.932

0.674

FR

1973.2-1996.3

7.207

22.877

0,088

2.736

1.917

0.714

GER

1978.4-1996.3

8.135

20.326

0,066

3.338

1.161

0.322

ITA

1971.2-1995.3

0.514

27.244

0.071

2.064

2.957

0.681

JPN

1970.2--1996.3

5.831

21,881

0,017

1.538

2.347

0.493

NTH

1977.2-1996.2

12.721

15.719

0.027

3.705

1.542

SWD

1970.1-1995.1

7.948

23.867

0.053

1.520

2.966

SWT

1982.~1996,3

11.548

20.431

0.112

1.466

1.603

0.255

UK

1970.1-1996,3

7,236

21,555

0,103

1,081

3.067

0,474

USA

1970.1-1996.4

5.893

17.355

0.076

1.350

1,722

0.568

SWD

1920-1994

6.219

18.654

0.064

2.073

5.918

0,708

UK

1919-1994

7.314

22.675

-0.024

1.198

5.446

0.591

USA

1891 1995

6.697

18.634

0.025

1.955

8.919

0.338

-0.099
0.218

a ~ is the mean log real return on the stock market index, multiplied by 400 in quarterly data or 100 in
annual data to express in annualized percentage points, tY(re) is the standard deviation of the log real
return on the market index, multiplied by 200 in quarterly data or 100 in annual data to express in
annualized percentage points, p(re) is the first-order autocorrelation of the log real return on the market
index, rT, o(rf), and p(t).) are defined in the same way for the real return on a 3-month money market
instrument. The money market instruments vary across countries and are described in detail in the Data
Appendix.
Abbreviations: AUL, Australia; CAN, Canada; FR, France; GER, Germany; ITA, Italy; JPN, Japan;
NTH, Netherlands; SWD, Sweden; SWT, Switzerland; UK, United Kingdom; USA, United States of
America.

(3) The annualized standard deviation o f stock returns ranges from 15% to 27%. It
is striking that the market w i t h the highest volatility, Italy, is the smallest market
relative to G D P and the one w i t h the lowest average return,
(4) In quarterly data the annualized volatility o f real returns on short debt is around
3 % for the UK, Italy, and Sweden, around 2 . 5 % for Australia and Japan, and below
2 % for all other countries. Volatility is higher in l o n g - t e r m annual data because
o f large swings in inflation in the interwar period, particularly in t 9 1 9 - 2 1 . M u c h
o f the volatility in these real returns is probably due to unanticipated inflation and
does not reflect volatility in the ex ante real interest rate.

1242

J Y. Campbell

These numbers show that high average stock returns, relative to the returns on shortterm debt, are not unique to the United States but characterize many other countries as
well. Recently a number o f authors have suggested that average excess returns in the
U S A may be overstated by sample selection or survivorship bias. i f economists study
the U S A because it has had an unusually successful economy, then sample average US
stock returns may overstate the true mean US stock return. Brown, Goetzmann and
Ross (1995) present a formal model o f this effect. While survivorship bias m a y affect
data from all the countries included in Table 2, it is reassuring that the stylized facts
are so consistent across these countries 6.
Table 3 turns to data on aggregate consumption and stock market dividends. The
table is organized in the same way as Table 2. It illustrates the robustness o f two more
o f the stylized facts given in the introduction.
(5) In the postwar period the annualized standard deviation of real consumption
growth is never above 3%. This is true even though data are used on total
consumption, rather than nondurables and services consumption, for all countries
other than the USA. Even in the longer annual data, which include the turbulent
interwar period, consumption volatility slightly exceeds 3% only in the USA.
(6) The volatility o f dividend growth is much greater than the volatility o f consumption growth, but generally less than the volatility o f stock returns. The exceptions
to this occur in countries with highly seasonal dividend payments; these countries
have large negative autocorrelations for quarterly dividend growth and much
smaller volatility when dividend growth is measured over a full year rather than
over a quarter.
Table 4 reports the contemporaneous correlations among real consumption growth,
real dividend growth, and stock returns. It turns out that these correlations are
somewhat sensitive to the timing convention used for consumption. A timing
convention is needed because the level o f consumption is a flow during a quarter
rather than a point-in-time observation; that is, the consumption data are timeaveraged 7. If we think o f a given quarter's consumption data as measuring consumption
at the beginning o f the quarter, then consumption growth for the quarter is next
quarter's consumption divided by this quarter's consumption. If on the other hand

6 Goetzmalm and Jorion (1997) consider imernational stock-price data from earlier in the 20th Century
and argue that the long-term average real growth rate of stock prices has been higher in the US than
elsewhere. However they do not have data on dividend yields, which are an important component of
total return and are likely to have been particularly important in Europe dtmng the troubled intei~ar
period.
7 Tilne-averaging is one of a number of interrelated issues that arise in relating measured consumption
data to the theoretical concept of consumption. Other issues include measurement error, seasonal
adjustment, and the possibilitythat some goods classified as nondurable in the national income accounts
are in fact durable. Grossman, Melino and Shiller (1987), Wheatley (1988), Miron (1986), and Heaton
(1995) handle time-averaging, measurement error, seasonality, and dinability, respectively, in a much
more careful way than is possible here, while Wilcox (1992) provides a detailed account of the sampling
procedures used to constxuct US consumption data.

1243

Ch. 19." Asset Prices, Consumption, and the Business Cycle

Table 3
International consumption and dividends a
Country

Sample period

Ac

o(Ac)

p(Ac)

Ad

~r(Ad)

p(Ad)

USA

1947.2-1996.4

1.921

1.085

0.221

2.225

28.794

-0.544

AUL

1970.1-1996.3

1.886

2.138

0.351

0.883

36.134

-0.451

CAN

1970.1 1996.3

1.853

2.083

0.113

-0.741

5.783

FR

1973.2 1996.3

1.600

2.121

--0.093

1.214

GER

1978.4 1996.3

1.592

2.478

-0.328

1.079

8.528

0.018

ITA

1971.2-1995.3

2.341

1.724

0.253

-4.919

19.635

0.294

JPN

1970.2-1996.3

3.384

2.347

-0.225

2.489

4.504

0.363

NTH

1977.2 1996.2

1.661

2.772

-0.265

4.007

4.958

0.277

SWD

1970.1-1995.1

0.705

1.920

0.305

1.861

13.595

0.335

SWT

1982.2-1996.3

0.376

2.246

-0.4t9

4.143

6.156

0.165

13.383

0.540
-0.159

UK

1970.1-1996.3

1.991

2.583

-0.017

0.681

7.125

0.335

USA

1970.1 1996.4

1.722

0.917

0.390

0.619

17.229

0.581
0.214

SWD

1920 1994

1.790

2.866

0.159

0.423

12.215

UK

1919-1994

1.443

2.898

0.281

1.844

7.966

USA

1891-1995

1.773

3.256

-0.117

1.485

14.207

0.225
-0.087

a Ac is the mean log real consumption growth rate, multiplied by 400 in quarterly data or 100 in
annual data to express in annualized percentage points, cr(Ac) is the standard deviation of the log
real consumption growth rate, multiplied by 200 in quarterly data or 100 in annual data to express in
annualized percentage points, p(Ac) is the first-order autocorrelation of the log real consumption growth
rate. Ad, a(Ad), and p(Ad) are defined in the same way for the real dividend growth rate. Consumption
is nondurables and selwices consumption in the USA, and total consumption elsewhere.
Abbreviations: AUL, Australia; CAN, Canada; FR, France; GER, Germany; ITA, Italy; JPN, Japan;
NTH, Netherlands; SWD, Sweden; SWT, Switzerland; UK, United Kingdom; USA, United States of
America.
we think o f the c o n s u m p t i o n data as m e a s u r i n g c o n s u m p t i o n at the end o f the
quarter, then c o n s u m p t i o n growth is this quarter's c o n s u m p t i o n divided by last quarter's
consumption. Table 4 uses the former, " b e g i n n i n g - o f - q u a r t e r " timing convention
because this p r o d u c e s a higher c o n t e m p o r a n e o u s correlation b e t w e e n c o n s u m p t i o n
growth and stock returns.
The t i m i n g convention has less effect on correlations w h e n the data are m e a s u r e d
at l o n g e r horizons. Table 4 also shows h o w the correlations a m o n g real c o n s u m p t i o n
growth, real dividend growth, and real stock returns v a r y w i t h the horizon. Each
pairwise correlation a m o n g these series is calculated for h o r i z o n s o f 1, 4, 8, and 16
quarters in the quarterly data and for horizons o f 1, 2, 4, and 8 years in the l o n g - t e r m
annual data. The table illustrates three m o r e stylized facts f r o m the introduction.

J.Y. Campbell

1244

I l l

II

II

[I

I I

', ~
'~
, .o ~" ~b
o

m
0

I I

I I

II

I I

fa,

>~

;a4zaaza;a

d e m ~ : d ~ d ~ d o

NN~

a
ca

Ch. 19: AssetPrices', Consumption, and the Business Cycle

1245

(7) Real consumption growth and dividend growth are generally weakly positively
correlated in the quarterly data. In many countries the correlation increases
strongly with the measurement horizon. However long-horizon correlations remain
close to zero for Australia and Switzerland, and are substantially negative for Italy
(with a very small stock market) and Japan (with anomalous dividend behavior).
The correlations of consumption and dividend growth are positive and often quite
large in the longer-term annual data sets.
(8) The correlations between real consumption growth rates and stock returns are quite
variable across countries. They tend to be somewhat higher in high-capitalization
countries (with the notable exception of Switzerland), which is consistent with the
view that stock returns proxy more accurately for wealth returns in these countries.
Correlations typically increase with the measurement horizon out to 1 or 2 years,
and are moderately positive in the longer-term annual data sets.
(9) The correlations between real dividend growth rates and stock returns are small at
a quarterly horizon but increase dramatically with the horizon. This pattern holds
in every country. The correlations also increase strongly with the horizon in the
longer-term annual data.
After this preliminary look at the data, I now use some simple finance theory to
interpret the stylized facts.

3. The equity premium puzzle

3.1. The stochastic discount factor
To understand the equity premium puzzle, consider the intertemporal choice problem
of an investor, indexed by k, who can trade freely in some asset i and can obtain a
gross simple rate of return (1 +Ri, t+l) o n the asset held from time t to time t + 1. If
the investor consumes Ck~ at time t and has time-separable utility with discount factor
6 and period utility U(Ckt), then her first-order condition is

g'((~t) = 6E~ [(1 +Ri, l+l)Ut(Ck,t+l)].

(1)

The left-hand side of Eqnation (1) is the marginal utility cost of consuming one real
dollar less at time t; the right-hand side is the expected marginal utility benefit from
investing the dollar in asset i at time t, selling it at time t + 1, and consuming the
proceeds. The investor equates marginal cost and marginal benefit, so Equation (1)
must describe the optimum.
Dividing Equation (1) by U'(C~) yields

v'(G,,+,)]j

1 = Et (1 +Ri,,~,)6 ~

--E, [(1 +Ri,,+,)Ma,,+lJ,

(2)

where Mk,t.~l = 6U'(Ck, t+l)/U/(Ct) is the intertemporal marginal rate of substitution

of the investor, also known as the stochastic discountjdctor. This way of writing the

1246

J..Y Campbell

model in discrete time is due originally to Grossman and Shiller (1981), while the
continuous-time version of the model is due to Breeden (1979). Cochrane and Hansen
(1992) and Hansen and Jagannathan (1991) have developed the implications of the
discrete-time model in detail.
The derivation just given for Equation (2) assumes the existence of an investor
maximizing a time-separable utility function, but in fact the equation holds more
generally. The existence of a positive stochastic discount factor is guaranteed by the
absence of arbitrage in markets in which non-satiated investors can trade freely without
transactions costs. In general there can be many such stochastic discount factors for example, different investors k whose marginal utilities follow different stochastic
processes will have different M~, t+l - but each stochastic discount factor must satisfy
Equation (2). It is common practice to drop the subscript k from this equation and
simply write

1 = E, [(1 +&t+,lMi+~].

(3)

In complete markets the stochastic discount factor Mt+l is unique because investors
can trade with one another to eliminate any idiosyncratic variation in their marginal
utilities.
To understand the implications of Equation (3) it is helpful to write the expectation
of the product as the product of expectations plus the covariance,

E1[(1 +Ri,,~l)m~+l] = Et[(l + Ri,,+I)]E~[M,+I] + Covt[R~,l.~,M,+~].

(4)

Substituting into Equation (3) and rearranging gives

1 + E,[R~,,+I] -

1 - Covt[Ri, +1,Mr+l]
Et[Mt+l]

(5)

An asset with a high expected simple return must have a low covariance with the
stochastic discount factor. Such an asset tends to have low retunas when investors have
high marginal utility. It is risky in that it fails to deliver wealth precisely when wealth
is most valuable to investors. Investors therefore demand a large risk premium to hold
it.
Equation (5) must hold for any asset, including a riskless asset whose gross simple
return is 1 + Ry;t ~1. Since the simple riskless return has zero covariance with the
stochastic discount factor (or any other random variable), it is just the reciprocal of
the expectation of the stochastic discount factor:
1
1 +R/;,+t - Et[M,+I]"

(6)

This can be used to rewrite Equation (5) as

1 +Et[Ri,,+t] = (1 +RLt+I)(1 -Cov,[Ri,~+L,Mi+l]).

(7)

For simplicity I now follow Hansen and Singleton (1983) and assume that the joint
conditional distribution of asset returns and the stochastic discount factor is lognormal

Ch. 19." Asset Prices, Consumption, and the Business Cycle

1247

and homoskedastic. While these assumptions are not literally realistic - stock returns
in particular have fat-tailed distributions with variances that change over time - they do
make it easier to discuss the main forces that should determine the equity premium.
When a random variable X is conditionally lognormally distributed, it has the
convenient property that
log E t X

E~ l o g X + Vart logX,

(8)

where VartlogX = G [ ( l o g X - E t l o g X ) 2 ] . I f in addition X is conditionally

homoskedastic, then Var, l o g X = E[(logX - E, l o g X ) 2] = Var(logX - Et logX).
Thus with joint conditional lognormality and homoskedasticity of asset returns and
consumption, I can take logs of Equation (3) and obtain
2
0 = Etri, t+l + Etmt+l + (1) [02 + O,
+ 20,m].

(9)

Here rnt - log(Mr) and r , - - log(1 + Ri,), while 02 denotes the unconditional variance
of log return innovations Var(r/, t+t - G r i , t+l), a 2 denotes the unconditional variance
of innovations to the stochastic discount factor Var(mt~l Etmt+l), and G,, denotes the
unconditional covariance of innovations Cov(ri, t+l - Elri, t v l , rntel - Etmt+l).
Equation (9) has both time-series and cross-sectional implications. Consider first an
asset with a riskless real return rt; ) 1. For this asset the return innovation variance c~2
and the covariance aim are both zero, so the riskless real interest rate obeys

rj;l+l = - E t m t + l

02

(10)

This equation is the log counterpart of Equation (6).

Subtracting Equation (10) from Equation (9) yields an expression for the expected
excess return on risky assets over the riskless rate:

o.2
Et[ri,/+1 - 9; tM] + ~ - - - o i ....

(ll)

The variance term on the left-hand side of Equation (11) is a Jensen's Inequality
adjustment arising from the fact that we are describing expectations of log returns.
This term would disappear if we rewrote the equation in terms of the log expectation
of the ratio of gross simple returns: log G [(1 + Ri, t + I ) / ( 1 + Rf, ~+1)] = - a i m . The righthand side of Equation (11) says that the log risk premium is determined by the negative
of the covariance of the asset with the stochastic discount factor. This equation is the
log counterpart of Equation (7).
The covariance O,m can be written as the product of the standard deviation of the
asset return a,., the standard deviation of the stochastic discount factor (7,,,, and the

J Y. Campbell

1248

V~=7

>,~ ~

~ ,.=

03 r.~

L)
'~

:~

q,

~P

~ =
o
f~

,.~

~'"

~o

II

rm ~ .

o,~o

2~=~

<z~

.~#

.-

&S .o~ <

Ch. 19: Asset Prices, Consumption, and the Business Cycle

1249

correlation between the asset return and the stochastic discount factor Pim. Since
Pim ~ - 1 , - ~ m <, ~YiOrn. Substituting into Equation (11),
Om >1

Et[ri, t+l - rl;t-, 1] + 0,2/2

(12)

This inequality was first derived by Shiller (1982); a multi-asset version was derived
by Hansen and Jagannathan (1991) and developed further by Cochrane and Hansen
(1992). The right-hand side of Equation (12) is the excess return on an asset, adjusted
for Jensen's Inequality, divided by the standard deviation of the asset's return - a
logarithmic Sharpe ratio for the asset. Equation (12) says that the standard deviation of
the log stochastic discount factor must be greater than this Sharpe ratio for all assets i,
that is, it must be greater than the maximum possible Sharpe ratio obtainable in asset
markets.
Table 5 uses Equation (12) to illustrate the equity premium puzzle. For each data
set the first column of the table reports the average excess return on stock over shortterm debt, adjusted for Jensen's inequality by adding one-half the sample variance
of the excess log return to get a sample estimate of the numerator in Equation (12).
This adjusted average excess return is multiplied by 400 to express it in annualized
percentage points. The second column of the table gives the aunualized standard
deviation of the excess log stock return, a sample estimate of the denominator in
Equation (12). This standard deviation was reported earlier in Table 2. The third
column gives the ratio of the first two columns, multiplied by 100; this is a sample
estimate of the lower bound on the standard deviation of the log stochastic discount
factor, expressed in annualized percentage points. In the postwar US data the estimated
lower bound is a standard deviation greater than 50% a year; in the other quarterly data
sets it is below 10% for Italy, between 15% and 20% for Australia and Canada, and
above 30% for all the other countries, in the long-run annual data sets the lower bound
on the standard deviation exceeds 30% for all three countries.
3.2. Consumption-based asset p r i c i n g with p o w e r utility

To understand why these numbers are disturbing, I now follow Mehra and Prescott
(1985) and other classic papers on the equity premium puzzle and assume that there
is a representative agent who maximizes a time-separable power utility function defined
over aggregate consumption G:

u(G)

C-Y-1

- - ,

1-7

(13)

where y is the coefficient of relative risk aversion. This utility function has several
important properties. First, it is scale-invariant; with constant return distributions,
risk premia do not change over time as aggregate wealth and the scale of the

1250

J g CampbeH

economy increase. Related to this, if different investors in the econonW have different
wealth levels but the same power utility function, then they can be aggregated
into a single representative investor with the same utility function as the individual
investors. A possibly less desirable property of power utility is that the elasticity of
intertemporal substitution, which I write as ~p, is the reciprocal of the coefficient
of relative risk aversion y. Epstein and Zin (1989, 1991) and Weil (1989) have
proposed a more general utility specification that preserves the scale-invariance of
power utility but breaks the tight link between the coefficient of relative risk aversion
and the elasticity of intertemporal substitution. I discuss this form of utility in
section 3.4 below.
Power utility implies that marginal utility UI(C,) = Ct r, and the stochastic discount
factor Mt+l = CS(Ct+t/CI) -r. The assumption made previously that the stochastic
discount factor is conditionally lognormal will be implied by the assumption that
aggregate consumption is conditionally lognormal [Hansen and Singleton (1983)].
Making this assumption for expositional convenience, the log stochastic discount factor
is mt+l = log(cS)- 7Ac,+1, where c, --- log(Q), and Equation (9) becomes
0 = Etri,,+l +log (5- yE, Act~l + () [a,.2+ y20~2-

2ro, c].

(14)

Here a 2 denotes Var(ct+l -Etct+l), the unconditional variance of log consumption

innovations, and eric denotes Cov(ri, t + l - Etri, t Fl, ct+l - EtCt+l), the unconditional
covariance of innovations.
Equation (10) now becomes
tj/;,+t =

log C5+

]/EtAct+l

~,2at2
2

(15)

This equation says that the riskless real rate is linear in expected consumption growth,
with slope coefficient equal to the coefficient of relative risk aversion. The conditional
variance of consumption growth has a negative effect on the riskless rate which can
be interpreted as a precautionary savings effect.
Equation (11) becomes
Et[ri, t+~ --rj;t+l] + ~ - = 7oic.

(16)

The log risk premium on any asset is the coefficient of relative risk aversion times
the covariance of the asset return with consumption growth. Intuitively, an asset with
a high consumption covariance tends to have low returns when consumption is low,
that is, when the marginal utility of consumption is high. Such an asset is risky and
commands a large risk premium.
Table 5 uses Equation (16) to illustrate the equity premium puzzle. As already
discussed, the first column of the table reports a sample estimate of the left-hand

Ch. 19." Asset Prices, Consumption, and the Business Cycle

1251

side of Equation (16), multiplied by 400 to express it in annualized percentage points.

The second column reports the annualized standard deviation of the excess log stock
return (given earlier in Table 2), the fourth column reports the annualized standard
deviation of consumption growth (given earlier in Table 3), the fifth column reports the
correlation between the excess log stock return and consumption growth, and the sixth
column gives the product of these three variables which is the annualized covariance
a,~. between the log stock return and consumption growth.
Finally, the table gives two columns with implied risk aversion coefficients. The
column headed RRA(1) uses Equation (16) directly, dividing the adjusted average
excess return by the estimated covariance to get estimated risk aversion 8. The column
headed RRA(2) sets the correlation of stock returns and consumption growth equal to
one before calculating risk aversion. While this is of course a counterfactual exercise,
it is a valuable diagnostic because it indicates the extent to which the equity premium
puzzle arises from the smoothness of consumption rather than the low correlation
between consumption and stock returns. The correlation is hard to measure accurately
because it is easily distorted by short-term measurement errors in consumption, and
Table 4 indicates that the sample correlation is quite sensitive to the measurement
horizon. By setting the correlation to one, the RRA(2) column indicates the extent
to which the equity premium puzzle is robust to such issues. A correlation of one
is also implicitly assumed in the volatility bound for the stochastic discount factor,
Equation (12), and in many calibration exercises such as Mehra and Prescott (1985),
Campbell and Cochrane (1999), or Abel (1999).
Table 5 shows that the equity premium puzzle is a robust phenomenon in
international data. The coefficients of relative risk aversion in the RRA(1) column are
generally extremely large. They are usually many times greater than 10, the maximum
level considered plausible by Mehra and Prescott (1985). In a few cases the risk
aversion coefficients are negative because the estimated covariance of stock returns
with consumption growth is negative, but in these cases the covariance is extremely
close to zero. Even when one ignores the low correlation between stock returns and
consumption growth and gives the model its best chance by setting the correlation to
one, the RRA(2) column still has risk aversion coefficients above 10 in most cases.
Thus the fact shown in Table 4, that for some countries the correlation of stock returns
and consumption increases with the horizon, is unable by itself to resolve the equity
premium puzzle.
The risk aversion estimates in Table 5 are of course point estimates and are subject
to sampling error. No standard errors are reported for these estimates. However authors
such as Cecchetti, Lam and Mark (1993) and Kocherlakota (1996), studying the long-

8 The calculation is done correctly, in natural units, even though the table reports averageexcess returns
and covafiances in percentage point units. Equivalently, the ratio of the quantities given in the table is
multiplied by 100.

1252

J E Campbell

run annual US data, have found small enough standard errors that they can reject risk
aversion coefficients below about 8 at conventional significance levels.
O f course, the validity o f these tests depends on the characteristics o f the data set in
which they are used. Rietz (1988) has argued that there may be a peso problem in these
data. A peso problem arises when there is a small positive probability of an important
event, and investors take this probability into account when setting market prices. If
the event does not occur in a particular sample period, investors will appear irrational
in the sample and economists will mis-estimate their preferences. While it may seem
unlikely that this could be an important problem in 100 years of annual data, Rietz
(1988) argues that an economic catastrophe that destroys almost all stock-market value
can be extremely unlikely and yet have a major depressing effect on stock prices.
One difficulty with this argument is that it requires not only a potential catastrophe,
but one which affects stock market investors more seriously than investors in short-term
debt instruments. Many countries that have experienced catastrophes, such as Russia
or Germany, have seen very low returns on short-term government debt as well as
on equity. A peso problem that affects both asset returns equally will affect estimates
o f the average levels of returns but not estimates of the equity premium 9. The major
example of a disaster for stockholders that did not negatively affect bondholders is
the Great Depression of the early 1930s, but o f course this is included in the long-run
annual data for Sweden, the UK, and the USA, all of which display an equity premium
puzzle.
Also, the consistency o f the results across countries requires investors in all countries
to be concerned about catastrophes. I f the potential catastrophes are uncorrelated across
countries, then it becomes less likely that the data set includes no catastrophes; thus the
argument seems to require a potential international catastrophe that affects all countries
simultaneously.

3.3. The riskf?ee rate puzzle

One response to the equity premium puzzle is to consider larger values for the
coefficient of relative risk aversion ~/. Kandel and Stambaugh (1991) have advocated

9 This point is relevant for the study of Goetzmann and Jorion (1997). These authors measure average
growth rates &real stock prices, as a proxy for real stock returns, bnt they do not look at real returns on
short-term debt. They find low real stock-price growth rates in many countries in the early 20th Century;
in some cases these may have been accompanied by low returns to holders of short-term debt. Note also
that stock-price growth rates are a poor proxy for total stock returns in periods where investors expect
low growth rates, since dividend yields will tend to be higher in such periods.

Ch. 19:

Asset Prices, Consumption, and the Business Cycle

1253

this l. However this leads to a second puzzle. Equation (15) implies that the
unconditional mean riskless interest rate is

Er];t+l = - l o g 6 + g g -

y2~
2 '

(17)

where g is the mean growth rate o f consumption. Since g is positive, as shown in

Table 3, high values o f 7 imply high values o f 7g. Ignoring the term -y2o~2/2 for
the moment, this can be reconciled with low average short-term real interest rates,
shown in Table 2, only if the discount factor 6 is close to or even greater than one,
corresponding to a low or even negative rate of time preference. This is the riskfree
rate puzzle emphasized by Weil (1989).
Intuitively, the riskfree rate puzzle is that if investors are risk-averse then with
power utility they must also be extremely unwilling to substitute intertemporally. Given
positive average consumption growth, a low riskless interest rate and a high rate of
time preference, such investors would have a strong desire to borrow from the future to
reduce their average consumption growth rate. A low riskless interest rate is possible
in equilibrium only if investors have a low or negative rate o f time preference that
reduces their desire to borrow 11
O f course, if the risk aversion coefficient g is high enough then the negative
quadratic term -V2a~/2 in Equation (17) dominates the linear term and pushes the
riskless interest rate down again. The quadratic term reflects precautionary savings;
risk-averse agents with uncertain consumption streams have a precautionary desire to
save, which can work against their desire to borrow. But a reasonable rate o f time
preference is obtained only as a knife-edge case.
Table 6 illustrates the riskfree rate puzzle in international data. The table first shows
the average riskfree rate from Table 2 and the mean consumption growth rate and
standard deviation o f consumption growth from Table 3. These moments and the risk
aversion coefficients calculated in Table 5 are substituted into Equation (17), and the
equation is solved for an implied time preference rate. The time preference rate is
reported in percentage points per year; it can be interpreted as the riskless real interest
rate that would prevail if consumption were known to be constant forever at its current
level, with no growth and no volatility. Risk aversion coefficients in the RRA(2) range
imply negative time preference rates in every country except Switzerland, whereas
larger risk aversion coefficients in the RRA(I) range imply time preference rates that
are often positive but always implausible and vary wildly across countries.

J0 One might think that introspection would be sufficient to rule out very large values of V, but Kandel
and Stambaugh (1991) point out that introspection can deliver very different estimates of risk aversion
depending on the size of the gamble considered. This suggests that introspection can be misleading or
that some more general model of utility is needed.
I~ As Abel (1999) and Kocherlakota (1996) point out, negative time preference is consistent with finite
utility in a time-separable model provided that consumption is growing, and marginal utility shrinking,
sufficiently rapidly. The question is whether negative thne preference is plausible.

J.Y. Campbell

1254
Table 6
The riskfree rate puzzle a
Country

Sample period

r~

Ac

o(Ae)

RRA(1)

USA

1947.2-1996.3

0.794

1 . 9 0 8 1.084

246.556

112.474

47.600

-76.710

AUL

1970.1 1996.2

1.820

1 . 8 5 4 2.142

45.704

-34.995

7.107

-10.196

CAN

1970.1-1996.2

2.738

1 . 9 4 8 2.034

56.434

8.965

-13.066

FR
GER

1973.~1996.2
1978.4-1996.2

2.736
3.338

1 . 5 8 1 2.130
1.576 2.495

<0
343.133

ITA

1971.2 1995.2

2.064

2.424

JPN
NTH

1970.2-1996.2
1977.2-1996.1

1.538
3.705

3.416 2.353
1 . 4 6 6 2.654

SWD

1970.1 1994.4

1.520

0.750

1.917 >1000

SWT

1982.2-1996.2

1.466

0.414

2.261

UK
USA

1970.1 1996.2
1970.1-1996.3

1.08i
1.350

2.025 2.589
1 . 7 1 0 0.919

SWD

1920 1993

2.073

1 . 7 4 8 2.862

65.642

63.778

11.091 -12.274

UK
USA

1919-1993
1891-1994

1.198
1.955

1 . 3 5 8 2.820
1 . 7 4 2 3.257

39.914
20.861

10.364
11.305

14.174
10.366

1.684 >1000

TPR(1)

41.346
N/A
>1000
>1000

14.634 -15.536
13.327 12.142
4.703

-9.021

13.440
23.970

-39.375
-11.201

>1000

20.705

-6.126

N/A

26.785

8.698

134.118
41.222
>1000
>1000
<0

RRA(2) TPR(2)

1 5 6 . 3 0 8 503.692
1 5 0 . 1 3 6 -160.275

14.858 -21.600
37.255 -56.505

-10.057
10.406

a ~: is the mean money market return from Table 2, in annualized percentage points. Ae and cr(Ae)
are the mean and standard deviation of consmnption growth from Table 3, in annualized percentage
points. RRA(1) and RRA(2) are the risk aversion coefficients from Table 5. TPR(1)= 7 - RRA(1)Ac +
RRA(1)2g2(Ac)/200, and TPR(2) = ~ - RRA(2)Ac + RRA(2)2oZ(Ac)/200. From Equation (17), these
time preference rates give the real interest rate, in annualized percentage points, that would prevail
if consumption growth had zero mean and zero standard deviation and risk aversion were RRA(1) or
RRA(2), respectively.
Abbreviations: AUL, Australia; CAN, Canada; FR, France; GER, Germany; ITA, Italy; JPN, Japan;
NTH, Netherlands; SWD, Sweden; SWT, Switzerland; UK, United Kingdom; USA, United States of
America.

A n interesting issue is h o w m i s m e a s u r e m e n t o f average inflation m i g h t affect these

calculations. There is a g r o w i n g consensus that in recent years conventional price
indices have overstated true inflation by failing to fully capture the effects o f quality
improvements, c o n s u m e r substitution to cheaper retail outlets, and price declines in
n e w l y introduced goods. I f inflation is overstated by, say, 1%, the real interest rate
is understated by 1%, w h i c h by itself m i g h t help to explain the riskfree rate puzzle.
U n f o r t u n a t e l y the real growth rate o f c o n s u m p t i o n is also understated by 1%, w h i c h
worsens the riskfree rate puzzle. W h e n y > 1, this second effect d o m i n a t e s and
understated inflation m a k e s the riskfree rate p u z z l e even harder to explain.

Ch. 19." Asset Prices, Consumption, and the Business Cycle

1255

Table 7
International yield spreads and bond excess returns
Country

Sample period

USA

1947.2-1996.4

AUL

1970.1-1996.3

a(s)

p(s)

er~

1.199

0.999

0.783

0.938

1.669

a(erb)

p(erb)

0.011

8.923

0.070

0.750

0.156

8.602

0.162

CAN

1970.1 1996.3

1.057

1.651

0.819

0.950

9.334

-0.009

FR
GER

1973.2 1996.3
1978.4-1996.3

0.917
0.99l

1.547
1.502

0.733
0.869

1.440
0.899

8.158
7.434

0.298
0.117

ITA

197t.~1995.3

0.200

2.025

0.759

1.386

9.493

0.335

JPN
NTH

1970.2-1996.3
1977.2-1996.2

0.593
1.212

1.488
1.789

0.843
0.574

1.687
1549

9.165
7.996

-0.058
0.032

SWD

1970.1-1995.1

0.930

2.046

0.724

0.212

7.575

0.244

SWT

1982.2 1996.3

0.471

1.655

0.755

1.071

6.572

0.268

UK
USA

1970.1 1996.3
1970.1-1996.4

1.202
1.562

2.106
1.190

0.893
0.737

0.959
1.504

11.611
10.703

0.057
0.033

SWD
UK

1920-1994
1919-1994

0.284
1.272

1.140
1.505

0.280
0.694

-0.075
0.318

6.974
8.812

0.185
-0.098

USA

1891 1995

0.720

1.550

0.592

0.172

6.499

0.153

a S is the mean of the log yield spread, the difference between the log yield on long-term bonds and the log
3-month money market return, expressed in annualized percentage points. ~7(s) is the standard deviation
of the log yield spread and p(s) is its first-order autocorrelation, erh, a(ert,), and p(erb) are defined in
the same way for the excess 3-month return on long-term bonds over money market instruments, where
the bond return is calculated from the bond yield using the par-bond approximation given in Campbell,
Lo and MacKinlay (1997), Chapter 10, equation (10.1.I9). Full details of this calculation are given in
thc Data Appendix.
Abbreviations: AUL, Australia; CAN, Canada; FR, France; GER, Germany; ITA, Italy; JPN, Japan;
NTH, Netherlands; SWD, Sweden; SWT, Switzerland; UK, United Kingdom; USA, United States of
America.

3.4. Bond returns and the equity premium and riskfree rate puzzles
S o m e authors have argued that the riskfree interest rate is low because short-term
g o v e r n m e n t debt is m o r e liquid than l o n g - t e r m financial assets. Short-term debt is
" m o n e y l i k e " in that it facilitates transactions and can be traded at m i n i m a l cost. The
liquidity advantage o f debt reduces its e q u i l i b r i u m return and increases the equity
p r e m i u m [Bansal and C o l e m a n (1996), H e a t o n and Lucas (1996)].
The difficulty with this argument is that it implies that all l o n g - t e r m assets should
have large excess returns over short-term debt. L o n g - t e r m g o v e r n m e n t bonds, for
example, are not m o n e y l i k e and so the liquidity a r g u m e n t implies that they should
offer a large t e r m p r e m i u m . But historically, the t e r m p r e m i u m has been m a n y times
smaller than the equity p r e m i u m . This point is illustrated in Table 7, which reports two

1256

J g Campbell

alternative measures of the term premium. The first measure is the average log yield
spread on long-term bonds over the short-term interest rate, while the second is the
average quarterly excess log return on long bonds. In a long enough sample these two
averages should coincide if there is no upward or downward drift in interest rates.
The average yield spread is typically between 0.5% and 1.5%. A notable outlier
is Italy, which has a negative average yield spread in this period. Average long
bond returns are quite variable across countries, reflecting differences in inflationary
experiences; however in no country does the average excess bond return exceed 1.7%
per year. Thus both measures suggest that term premia are far smaller than equity
premia.
Table 8 develops this point further by repeating the calculations of Table 5, using
bond returns rather than equity returns. The average excess log return on bonds over
short debt, adjusted for Jensen's Inequality, is divided by the standard deviation of
the excess bond return to calculate a bond Sharpe ratio which is a lower bound on
the standard deviation of the stochastic discount factor. The Sharpe ratio for bonds is
several times smaller than the Sharpe ratio for equities, indicating that term premia
are small even after taking account of the lower volatility of bond returns.
This finding is not consistent with a strong liquidity effect at the short end of the term
structure, but it is consistent with a consumption-based asset pricing model if bond
returns have a low correlation with consumption growth. Table 8 shows that sample
consumption correlations often are lower for bonds, so that RRA(1) risk aversion
estimates for bonds, which use these correlations, are often comparable to those for
equities.
A direct test of the liquidity story is to measure excess returns on stocks over long
bonds, rather than over short debt. If the equity premium is due to a liquidity effect
on short-term interest rates, then there should be no "equity-bond premium" puzzle.
Table 9 carries out this exercise and finds that the equity-bond premium puzzle is just
as severe as the standard equity premium puzzle 12.

3.5. Separating risk aversion and intertemporal substitution

Epstein and Zin (1989, 1991) and Weil (1989) use the theoretical framework of Kreps
and Porteus (1978) to develop a more flexible version of the basic power utility model.
That model is restrictive in that it makes the elasticity of intertemporal substitution,
% the reciprocal of the coefficient of relative risk aversion, 7. Yet it is not clear that
these two concepts should be linked so tightly. Risk aversion describes the consumer's
reluctance to substitute consumption across states of the world and is meaningful even

12 The excess return of equities over bonds must be measured with the appropriate correction for
Jensen's Inequality. From Equation (16), the appropriate measure is the log excess return on equities
over short-term debt, less the log excess return on bonds over short-term debt, plus one-halfthe variance
of the log equity return, less one-half the variance of the log bond return.

1257

Ch, 19. Asset Prices, Consumption, and the Business Cycle

~,
~

~,,

r3
t'4

,.n

~.

~..
V

,.~

t-'q

t" ~

rz

t'-q

,,6 ~6 ,,6

"

r~

JK Campbell

1258

S"~ ~

o
O9
oo
~

<~

~o
~ ,

~~

~
.~q

L~
i ~~

_ ~
~2

<%

"~'"
"~

~
~.~

I!~ ~
-~

<
~.~

,~ ~.~

1259

Ch. 19: Asset Prices, Consumption, and the Business Cycle

in an atemporal setting, whereas the elasticity of intertemporal substitution describes

the consumer's willingness to substitute consumption over time and is meaningful even
in a deterministic setting. The Epstein-Zin--Weil model retains many of the attractive
features of power utility but breaks the link between the parameters y and ~p.
The Epstein-Zin-Weil objective function is defined recursively by
0

U,=

(1-6)C 7+6

G_.f\

(18)

where 0 = (1 - y ) / ( l - l/W). When y - I/W, 0 = 1 and Equation (18) becomes

linear; it can then be solved forward to yield the familiar time-separable power utility
model.
The integemporal budget constraint for a represemative agent can be written as
V/t+1 - (1 + Rw, t+l) (J4zt CI),

(19)

- -

where Wt+l is the representative agent's wealth, and (1 + Rw, t+l) is the gross simple
return on the portfolio of all invested wealth 13. This form of the budget constraint is
appropriate for a complete-markets model in which wealth includes human capital as
well as financial assets. Epstein and Zin use dynamic programming arguments to show
that Equations (18) and (19) together imply an Euler equation of the form

I=G

\CT-t /

(1 +Rw, t < )

(1 +R,,,+I)

1
.

(20)

If I assume that asset returns and consumption are homoskedastic and jointly
lognormal, then this implies that the riskless real interest rate is
rj;t+l = - l o g 6 +

0-1
2
0
E,[Act+l] + ~ 2 - - cG - ~ 2

2
o~.

(21)

The riskless interest rate is a constant, plus 1/~p times expected consumption growth.
In the power utility model, 1/ip = y and 0 = 1, so Equation (21) reduces to
Equation (15).
The premium on risky assets, including the wealth portfolio itself, is
62
o,,
E,[ri,,+l] - rj;,+l + " - 0
+(1 - O)oiw.
2
~0

(22)

The risk premium on asset i is a weighted combination of asset i's covariance with
consumption growth (divided by the elasticity of intertemporal substitution W) and

13 This is often called the "market" return and written Rm,t~ i, but l have already used m to denote the
stochastic discount factor so I write R,,,t~l to avoid confusion.

J.Y. Campbell

1260

asset i's covariance with the return on wealth. The weights are 0 and 1 - 0 respectively.
The Epstein-Zin-Weil model thus nests the consumption CAPM with power utility
(0 = 1) and the traditional static CAPM (0 = 0).
Equations (21) and (22) seem to indicate that Epstein-Zin-Weil utility might
be helpful in resolving the equity premium and riskfree rate puzzles. First, in
Equation (21) a high risk aversion coefficient does not necessarily imply a low average
riskfree rate, because

Erj;t+l = - l o g 6 +

g +

0--1

~rw -

or2.

(23)

The average consumption growth rate is divided by ~p here, and in the Epstein-ZinWell framework ~p need not be small even if ~ is large.
Second, Equation (22) suggests that it might not even be necessary to have a high
risk aversion coefficient to explain the equity premium. I f 0 ~ 1, then the risk premium
on an asset is determined in part by its covariance with the wealth portfolio, a/w. If the
return on wealth is more volatile than consumption growth, as implied by the common
use of a stock index return as a proxy for the return on wealth, then Oiw may be much
larger than oic, and this may help to explain the equity premium.
Unfortunately, there are serious difficulties with both these potential escape routes
from the equity premium and riskfree rate puzzles. The difficulty with the first is that
there is direct empirical evidence for a low elasticity of intertemporal substitution in
consumption. The difficulty with the second is that consumption and wealth are linked
through the intertemporal budget constraint; if consumption is smooth and wealth is
volatile, this itself is a puzzle that must be explained, not an exogenous fact that can
be used to resolve other puzzles. I now develop these points in detail by analyzing
the dynamic behavior of stock returns and short-term interest rates in relation to
consumption.

4. The dynamics of asset returns and consumption

4.1. Time-variation in conditional expectations

Equations (21) and (22) imply a tight link between rational expectations of asset
returns and of consumption growth. Expected asset returns are perfectly correlated
with expected consumption growth, with a standard deviation 1/~p times as large.
Equivalently, the standard deviation of expected consumption growth is ~p times as
large as the standard deviation of expected asset returns.

Ch. 19: Asset Prices', Consumption, and the Business Cycle

1261

This suggests a way to estimate % Hansen and Singleton (1983), followed by

Campbell and Mankiw (1989), Hall (1988), and others, have proposed an instrumental
variables (IV) regression approach. I f we define an error term
t/i, t+l ~ ri, t+l

- -

Et[ri, t+l] - 7(Act+t - Et[ACt+l]),

then we can rewrite Equations (21) and (22) as a regression equation,

(24)
In general the error term t/i,t+l will be correlated with realized consumption growth
so OLS is not an appropriate estimation method. However t/i,t+l is uncorrelated with
any variables in the information set at time t. Hence any lagged variables correlated
with asset returns can be used as instruments in an IV regression to estimate 1/%
Table 10 illustrates two-stage least squares estimation o f Equation (24). In each panel
the first set o f results uses the short-term real interest rate, while the second set uses the
real stock return. The instruments are the asset return, the consumption growth rate,
and the log price-dividend ratio. The instruments are lagged twice to avoid difficulties
caused by time-aggregation of the consumption data ]Campbell and Mankiw (1989,
1991), Wheatley (1988)].
For each asset and set o f instruments, the table first reports the R 2 statistics and
significance levels for first-stage regressions o f the asset return and consumption
growth rate onto the instruments. The table then shows the IV estimate of 1/~p with its
standard error, and (in the column headed "Test (1)") the R 2 statistic for a regression
of the residual on the instruments together with the associated significance level of a
test o f the over-identifying restrictions o f the model.
The quarterly results in Table 10 show that the short-term real interest rate is highly
forecastable in every country except Germany. The real stock return is also forecastable
in many countries, but there is weaker evidence for forecastability in consumption
growth. In fact the R 2 statistic for forecasting consumption growth is lower than the
R 2 statistic for stock returns in all but four of the quarterly data sets. The IV estimates
of 1/~p are very imprecise; they are sometimes large and positive, often negative, but
they are almost never significantly different from zero. The overidentifying restrictions
of the model are often strongly rejected, particularly when the short-term interest rate
is used in the model. Results are similar for the annual data sets in Table 10, except
that twice-lagged instruments have almost no ability to forecast real interest rates or
stock returns in the annual US data 14

14 Campbell, Lo and MacKinlay (1997), Table 8.2, shows much greater fbrecastability of returns using
once-lagged instruments in a similar annual US data set. Even with twice-lagged hlstruments, US annual
returns become forecastable once one increases the return horizon beyond one year, as shown in Table 12
below.

1262

J Y. Campbell

Table 10
Predictable variation in returns and consumption growth a
Count~2

USA

AUL

CAN

FR

GER

ITA

JPN

NTH

SWD

Sample period

1947.~1996.3

1970.2 1996.2

1970.2 1996.2

1973.2-1996.2

1978.4-1996.2

1971.2-1995.2

1970.~1996.2

1977.2-1996.1

1970.2 1994.4

Asset

First-stage
regressions

(1/~--~)
(s.e.)

Test b
(s.e.)

ri

Ac

rf

0.160
0.000

0.037
0.077

0.260
0.740

0.025
0.114

0.165
0.000

0.037
0.027

re

0.065
0.003

0.037
0.077

-8.187
7.069

0.021
0.028

0.035
0.033

0.025
0.090

rf

0.404
0.000

0.013
0.432

4.450
2.973

0.099
0.107

0.017
0.419

0,008
0,676

r,,

0.060
0.034

0.013
0.432

20.250
13.145

0.038
0.026

0.004
0.828

0.003
0.856

rf

0.292
0.000

0.048
0.042

-0.970
0.677

-0.174
0.177

0.142
0.001

0.041
0.123

r~

0.040
0.269

0.048
0,042

6.635
4.536

0.130
0.092

0.004
0.822

0.004
0.819

r!

0.519
0.000

0.010
0.751

-2.189
2.170

-0.051
0.133

0.073
0.037

0.009
0,667

r~

0.111
0.006

0.010
0.751

-27.662
29.994

-0.021
0.026

0.006
0,750

0.004
0.833

1)-

0.062
0.328

0.057
0.085

0.481
0.354

1.773
1.141

0.005
0.840

0.005
0.841

r~

0.046
0.050

0.057
0.085

-6.117
4.992

0.079
0.066

0.017
0.569

0.018
0.547

rj

0.405
0.000

0.010
0.877

-2.432
3.353

-0.019
0.113

0.171
0.000

0.010
0,624

re

0.048
0.278

0.010
0.877

19.919
26.244

0.016
0.034

0.013
0.540

0.007
0.734

rf

0.203
0.002

0.044
0.081

-0.446
0.464

-0.093
0.266

0.162
0.000

0.04 l
0.121

r~

0.115
0,001

0.044
0.081

11.028
5.458

0.047
0.027

0.026
0.260

0.019
0.376

rj

0.248
0.000

0.024
0.373

0,167
0.385

0.052
0.428

0.218
0,000

0.023
0.428

re

0.021
0.756

0.024
0.373

-4.532
6.571

-0.138
0.162

0.005
0,835

0,005
0.832

rj

0.262
0.000

0.005
0.806

-1.056
2,949

-0.007
0.085

0.197
0000

0.005
0,779

r~,

0.110
0.039

0.005
0.806

15.210
21.187

0.004
0.017

0.047
0.107

0.005
0.790

continued on next page

1263

Ch. 19." Asset Prices, Consumption, and the Business Cycle

Table 10, continued

Country

SWT

UK

USA

SWD

UK

USA

Sample period

1982.2 1996.2

1970.~1996.2

1970.2-1996.3

1920-1993

1920-1993

1891-1994

Asset

First-stage
regressions

(1/~-~)
(s.e.)

~
(s.e.)

Test b
2

ri

Ac

rf

0.194
0.000

0.007
0.887

0.731
1.273

0.065
0.397

0.074
0.136

0.006
0.844

re

0.033
0.270

0.007
0.887

20.084
31.100

0.048
0.070

0.000
0.996

0.000
0.996

rf

0.306
0.000

0.057
0.042

1.992
0.988

0.260
0.136

0.047
0.090

0.028
0.238

re

0.097
0.094

0.057
0.042

-4.493
3.793

0.038
0.034

0.056
0.058

0.040
0.132

J)

0.307
0.000

0.071
0.015

1.573
0.704

0.t02
0.111

0.188
0.000

0.062
0.041

rC

0.069
0.095

0.071
0.015

4.977
7.677

0.016
0.023

0.069
0.029

0.071
0.025

rf

0.302
0.000

0.052
0.202

2.740
1.466

0.194
0.t61

0.037
0.266

0.023
0.437

r~

0.041
0.342

0.052
0.202

-1.537
3.349

0.043
0.082

0.034
0.304

0.041
0.236

r~/

0.265
0.000

0.061
0.140

2.499
1.509

0.197
0.123

0.056
0.139

0.033
0.314

r~,

0.147
0.096

0.061
0.140

5.861
4.569

0.037
0.021

0.115
0.017

0.055
0.144

~/

0.013
0.783

0.065
0.004

-0.293
0.892

-0.202
0.341

0.012
0.552

0.049
0.085

r,,

0.037
0.184

0.065
0.004

0.723
2.003

0.038
0.070

0.040
0.132

0.074
0.024

a This table reports two-stage least squares eshination results for Equations (24) and (25). The first set
of results for each country uses the short-term real interest rate, while the second set uses the real stock
return. The instruments are the asset return, the consumption growth rate, and the log price-dividend
ratio, lagged twice. For each asset and set o f instruments, the first two colunms show the R 2 statistics,
with significance levels below, lbr first-stage regressions o f the asset return and consumption growth
rate onto the instruments. The third column shows the IV estimate of 1/~p from Equation (24) with its
standard error below, and the fourth column shows the IV estimate of ~p from Equation (25) with its
standard error below. The fifth column, headed "Test (1)", shows the R 2 statistic for a regression of the
residual from Equation (24) on the instruments, with the associated significance level below of a test of
the over-identifying restrictions of the model. The sixth column, headed "Test (2)" is the equivalent of
the fifth column for Equation (25).
Abbreviations: AUL, Australia; CAN, Canada; FR, France; GER, Germany; ITA, Italy; JPN, Japan;
NTH, Netherlands; SWD, Sweden; SWT, Switzerland; UK, United Kingdom; USA, United States of
America.
b Tests: (1)ri,t~ j =t, ti-t-(1/~O)Act+t+rli,t+l;
(2) Act+t - Ti + ~/)1~,1~1 +~z,t41.

J E Campbell

1264

Campbell and Mankiw (1989, 1991) have explored this regression in more detail,
using both US and international data, and have found that predictable variation in
consumption growth is often associated with predictable variation in income growth.
This suggests that some consumers keep their consumption close to their income,
either because they follow "rules of thumb", or because they are liquidity-constrained,
or because they are "buffer-stock" savers [Deaton (1991), Carroll (1992)]. After
controlling for the effect of predictable income growth, there is little remaining
predictable variation in consumption growth to be explained by consumers' response
to variation in real interest rates.
One problem with IV estimation of Equation (24) is that the instruments are only
very weakly correlated with the regressor because consumption growth is hard to
forecast in this data set. Nelson and Startz (1990) have shown that in this situation
asymptotic theory can be a poor guide to inference in finite samples; the asymptotic
standard error of the coefficient tends to be too small and the overidentifying
restrictions of the model may be rejected even when it is true. To circumvent this
problem, one can reverse the regression (24) and estimate
A c t + 1 = ~ -t- ~gri, t+ 1 + ~i,t+l.

(25)

If the orthogonality conditions hold, then the estimate of 'qJ in Equation (25) will
asymptotically be the reciprocal of the estimate of 1/~p in Equation (24). In a finite
sample, however, if ~p is small then IV estimates of Equation (25) will be better
behaved than IV estimates of Equation (24).
In Table 7 ~p is almost always estimated to be close to zero. The estimates are
much more precise than those for 1/% The overidentifying restrictions of the model
are sometimes rejected, but less often and less strongly than when Equation (24) is
estimated. These results suggest that the elasticity of intertemporal substitution ~p is
small, so that the generality of the Epstein-Zin-Weil model, which allows ~p to be
large even if ~/is large, does not actually help one fit the data on consumption and
asset returns 15.

4.2. A loglinear asset pricing J?amework

in order to understand the second momems of stock returns, it is essential to have
a framework relating movements in stock prices to movements in expected future
dividends and discount rates. The present value model of stock prices is intractably
nonlinear when expected stock returns are time-varying, and this has forced researchers
to use one of several available simplifying assumptions. The most common approach
is to assume a discrete-state Markov process either for dividend growth [Mehra and

15 Attanasio and Weber (1993) and Beaudry and van Wincoop (1996) have argued that this conclusion
depends on the use of aggregate consumption data. They work with cohort-level and state-level data,
respectively, and fred some evidence for a larger elasticity of intertemporal substitution.

Ch. 19: Asset Prices', Consumption, and the Business Cycle

1265

Prescott (1985)] or, following Hamilton (1989), for conditionally expected dividend
growth [Abel (1994, 1999), Cecchetti, Lam and Mark (1990, 1993), Kandel and
Stambaugh (1991)]. The Markov structure makes it possible to solve the present value
model, but the derived expressions for returns tend to be extremely complicated and
so these papers usually emphasize numerical results derived under specific numerical
assumptions about parameter values 16.
An alternative framework, which produces simpler closed-form expressions and
hence is better suited for an overview of the literature, is the loglinear approximation
to the exact present value model suggested by Campbell and Shiller (1988). Campbell
and Shiller's loglinear relation between prices, dividends, and returns provides an
accounting framework: High prices must eventually be followed by high future
dividends or low future returns, and high prices must be associated with high expected
future dividends or low expected future returns. Similarly, high returns must be
associated with upward revisions in expected future dividends or downward revisions
in expected future returns. The loglinear approximation starts with the definition of
the log return on some asset i, ri, t+l ~ log(Pi, t+l + Di, t+l) - log(Pit). The timing
convention here is that prices are measured at the end of each period so that they
represent claims to next period's dividends. The log return is a nonlinear function of
log prices Pit and pi, t+l and log dividends di, t+l, but it can be approximated around
the mean log dividend-price ratio, (dit - P a ) , using a first-order Taylor expansion. The
resulting approximation is
ri, t+l ~ k +/)Pi, t tl +(1 -/))di, t + l - P i t ,

(26)

where/) and k are parameters of linearization defined b y / ) = 1/(1 + e x p ( ~ ) )

and k log(/)) - (1 - / ) ) l o g ( l / / ) - 1). When the dividend-price ratio is constant,
then p
P i / ( P i + Di), the ratio of the ex-dividend to the cum-dividend stock price.
In the postwar quarterly US data shown in Table 3, the average price-dividend ratio
has been 26.4 on an annual basis, implying that/) should be about 0.964 in annual
data 17 The Taylor approximation (26) replaces the log of the sum of the stock price
and the dividend in the exact relation with a weighted average of the log stock price
and the log dividend. The log stock price gets a weight/) close to one, while the log
dividend gets a weight 1 - p close to zero because the dividend is on average much
smaller than the stock price, so a given percentage change in the dividend has a much
smaller effect on the return than a given percentage change in the price.
=

Ic, A partial exception to this statement is that Abel (1994) derives several analytical results for the first
moments of retarns in a Markov model for expected dividend growth.
17 Strictly speaking both p and k should have asset subscripts i, but 1 omit these for simplicity. The
asset pricing formulas later in this chapter assume that all assets have the samep, which simplifiessome
expressions but does not change any of the qualitative conclusions.

1266

JE Campbe#

Equation (26) is a linear difference equation for the log stock price. Solving forward,
imposing the terminal condition that limj~o~ PJPi, t+j = 0 , taking expectations, and
subtracting the current dividend, one gets
0<3

pit-d#-

k
1 -p

kE~ Zp.i[Adi,~+l+j-ri,,+l+j].

(27)

.i=o

This equation says that the log price-dividend ratio is high when dividends are expected
to grow rapidly, or when stock returns are expected to be low. The equation should
be thought of as an accounting identity rather than a behavioral model; it has been
obtained merely by approximating an identity, solving forward subject to a terminal
condition, and taking expectations. Intuitively, if the stock price is high today, then
from the definition of the return and the terminal condition that the stock price is
non-explosive, there must either be high dividends or low stock returns in the future.
hwestors must then expect some combination of high dividends and low stock returns
if their expectations are to be consistent with the observed price.
The terminal condition used to obtain Equation (27) is perhaps controversial. Models
of "rational bubbles" do not impose this condition. Blanchard and Watson (1982)
and Froot and Obstfeld (1991) have proposed simple, explicit models of explosive
bubbles in asset prices. There are however several reasons to rule out such bubbles. The
theoretical circumstances under which bubbles can exist are quite restrictive; Tirole
(1985), for example, uses an overlapping generations framework and finds that bubbles
can only exist if the economy is dynamically inefficient, a condition which seems
unlikely on prior grounds and which is hard to reconcile with the empirical evidence
of Abel, Mankiw, Summers and Zeckhauser (1989). Santos and Woodford (1997) also
conclude that the conditions under which bubbles can exist are fragile. Empirically,
bubbles imply explosive behavior of prices in relation to dividends and other measures
of fundamentals; there is no evidence of this, although nonlinear bubble models are
hard to reject using standard linear econometric methods is
Equation (27) describes the log price-dividend ratio rather than the log price
itself. This is a useful way to write the model because in many data sets dividends
appear to follow a loglinear unit root process, so that log dividends and log prices
are nonstationary. In this case changes in log dividends are stationary, so from
Equation (27) the log price-dividend ratio is stationary provided that the expected
stock return is stationary. Thus log stock prices and dividends are cointegrated, and
the stationary linear combination of these variables involves no unknown parameters
since it is just the log ratio.
Table 11 reports some summary statistics for international stock prices in relation
to dividends. The table gives the average price-dividend ratio, the standard deviation

t8 Campbell,Lo and MacKinlay (1997), Chapter 7, gives a somewhatmore detailedtextbook discussion

of the literature on rational bubbles.

1267

Ch. 19." Asset Prices, Consumption, and the Business Cycle

Table 11
International stock prices and dividends a
Country

Sample period

P/D

a(p-d)

ADF(1)

Ap

Ad

USA

1947.~1996.4

27.121

0.265

0.941

-1.752

3.547

2.225

1.688

AUL
CAN
FR
GER
ITA
JPN
NTH
SP
SWD
SWT
UK
USA

1970.1 1996.3
1970.1-1996.3
1973.2-1996.3
1978.4-1996.3
1971.2-1995.3
1970.2-1996.3
1977.2 1996.2
1984.2 1996.2
1970.1-1995.1
1982.2-1996.3
1970.1 1996.3
1970.1 1996.4

25.919
30.108
22.718
27.787
41.345
91.251
21.139
22.509
35.021
47.320
18.434
27.882

0.267
0.221
0.541
0.300
0.318
0.642
0.272
0.319
0.439
0.217
0.280
0.235

0.856
0.902
0.971
0.922
0.882
0.964
0.932
0.823
0.941
0.814
0.913
0.904

3.273
-1.900
-1.3t0
-1.660
-3.743
-1.574
-0.727
-3.075
-1.632
-1.588
-1.657
-1.372

-1.410
0.754
1.358
4.186
2.172
4.192
7.540
6.843
4.922
9.291
1.464
2.034

0.883
-0.741
-1.214
1.079
4.919
2.489
4.007
-3.086
1.861
4.143
0.681
0.619

-2.477
1.200
2.538
3.853
3.531
6.974
3.637
10.078
3.499
6.074
0.579
1.582

SWD
UK
USA

1920-1994
1919 1994
1891-1995

26.706
20.806
22.733

0.333
0.238
0.279

0.746
0.514
0.778

0.768
4.093
-1.868

2.129
2.064
2.064

0.423
1.844
1.485

2.054
0.220
0.477

p(p

d)

Ap-d

a P/D is the mean price-dividend ratio, c~(p - d ) is the standard deviation of the log price-dividend ratio
in natural units (not annualized percentage points), p(p - d) is the first-order autocorrelation of the log

price-dividend ratio. ADF(1) is the augmented Dickey-Fuller t-ratio for the lagged log price--dividend
ratio when the change in the log price-dividend ratio is regressed on a constant, four lagged changes,
and the lagged log price dividend ratio. Ap, Ad, and A p - d are the mean changes in log prices, log
dividends, and the log price-dividend ratio respectively, in annualized percentage points.
Abbreviations: AUL, Australia; CAN, Canada; FR, France; GER, Germany; ITA, Italy; JPN, Japan;
NTH, Netherlands; SWD, Sweden; SWT, Switzerland; UK, United Kingdom; USA, United States of
America.

of the log p r i c e - d i v i d e n d ratio in natural units, the first-order autocorrelation o f the

log p r i c e - d i v i d e n d ratio, average growth rates o f prices, dividends, and the log p r i c e dividend ratio in percentage points per year, and a test statistic for the null hypothesis
that the log p r i c e - d i v i d e n d ratio has a unit root. Following standard practice, the p r i c e dividend ratio is m e a s u r e d as the ratio o f the current stock price to the total o f dividends
paid during the past year.
Average p r i c e - d i v i d e n d ratios vary considerably across countries but generally lie
b e t w e e n 20 and 30. The extreme outlier is Japan, w h i c h has a n average p r i c e - d i v i d e n d
ratio o f 91. The volatility and first-order autocorrelation o f the log p r i c e - d i v i d e n d ratio
are also unusually high for Japan, reflecting an u p w a r d trend in the Japanese log p r i c e -

J.Y. Campbell

1268

dividend ratio for much of the sample period which is also visible in the average growth
rates of prices and dividends at the right of the table.
Other countries in the quarterly data set, with the exception of France, have firstorder autocorrelation coefficients for the log price-dividend ratio of between 0.85
and 0.95. Unit root tests do not reject the unit root null hypothesis for most of
these countries, but this may reflect low power of the tests in short data samples.
Equation (27) implies that the log price-dividend ratio must be stationary if real
dividend growth and stock returns are stationary, so this gives some reason to assume
stationarity for the series.
So far I have written asset prices as linear combinations of expected future dividends
and returns. Following Campbell (1991), I can also write asset returns as linear
combinations of revisions in expected future dividends and returns. Substituting
Equation (27) into Equation (26), I obtain
OO

ri, l+l - E t ri, t+l = (Et+l - E t ) ~ P J A ~ , t , 1

.i- o

OO

pJri, t +l+j.

i:j- (Et ~l - E t ) ~
j -

(28)

This equation says that unexpected stock returns must be associated with changes
in expectations of future dividends or real returns. An increase in expected future
dividends is associated with a capital gain today, while an increase in expected future
returns is associated with a capital loss today. The reason is that with a given dividend
stream, higher future returns can only be generated by future price appreciation from
a lower current price.

4.3. The stock market oolatility puzzle

I now use this accounting framework to illustrate the stock market volatility puzzle.
The intertemporal budget constraint for a representative agent, Equation (19), implies
that aggregate consumption is the dividend on the portfolio of all invested wealth,
denoted by subscript w:

dwt = ct.

(29)

Many authors, including Grossman and Shiller (1981), Lucas (1978), and Mehra and
Prescott (1985), have assumed that the aggregate stock market, denoted by subscript
e for equity, is equivalent to the wealth portfolio and thus pays consumption as its
dividend. Here I follow Campbell (1986) and Abel (1999) and make the slightly more
general assumption that the dividend on equity equals aggregate consumption raised
to a power )~. In logs, we have

det - ,~ct.

(30)

Abel (1999) shows that the coefficient )~ can be interpreted as a measure of leverage.
When )~ > 1, dividends and stock returns are more volatile than the returns on the

Ch. 19." AssetPrices, Consumption, and the Business Cycle

1269

aggregate wealth portfolio. This framework has the additional advantage that a riskless
real bond with infinite maturity - an inflation-indexed consol, denoted by subscript b can be priced merely by setting )~ = 0.
The representative-agent asset pricing model with Epstein-Zin-Weil utility, conditional lognormality, and homoskedasticity [Equations (21) and (22)] implies that

Etre, t+l=~e+(@)EtAct+l,

(31)

where g~ is an asset-specific constant term. The expected log return on equity, like the
expected log return on any other asset, is just a constant plus expected consumption
growth divided by the elasticity of intertemporal substitution % Power utility is the
special case where the coefficient of relative risk aversion y is the reciprocal of ~p so
the effect of expected consumption growth on expected asset returns is proportional
to y; but this is not true in general.
Substituting Equations (30) and (31) into Equations (27) and (28), I find that

~-t-

(32)

)~-- ~)) Et ZpJmct+lf,

j=0

and

re, t+l -Et re, t+l = Z(Act+l -E/AG+I)+

Z-

(Et+l - E t )

Zp/Act+I+j.

(33)

j=[

Expected future consumption growth has offsetting effects on the log price-dividend
ratio. It has a direct positive effect by increasing expected future dividends X-forone, but it has an indirect negative effect by increasing expected future real interest
rates (1/~0)-for-one. The unexpected log return on the stock market is X times contemporaneous unexpected consumption growth (since contemporaneous consumption
growth increases the contemporaneous dividend X-for-one), plus (3,- 1/~p) times the
discounted sum of revisions in expected future consumption growth.
For future reference I note that Equation (33) can be inverted to express consumption
growth as a function of tile unexpected return on equity and revisions in expectations
about future returns on equity. Rearranging Equation (33) and using Equation (31),
ACt+l - Et Act+l =

(re, t ~q- Efre, t+l) +

-~P (Et~l-Et)ZpJr.,t+l+j.
j=l

(34)
An innovation in the equity return raises wealth by a factor (1/;~), and this raises
consumption by the same factor. Increases in expected future equity returns have
offsetting income and substitution effects on consumption; the positive income effect
is (t/)~), and the negative substitution effect is - %

1270

1 Y. Campbell

These equations can be simplified if I assume that expected aggregate consumption

growth, which I write as zt, follows an AR(1) process with mean g and positive
persistence O:
Act+l = zt + Cc, t+l,

(35)

zt+l = (1 - O)g + ~zt + ez, t+l.

(36)

This is a linear version o f the model used by Cecchetti, Lam and Mark (1990, 1993)
and Kandel and Stambaugh (1991), in which expected consumption growth follows
a persistent discrete-state Markov process. The contemporaneous shocks to realized
consumption growth ~c,t+~ and expected future consumption growth c~,t+~ may be
positively or negatively correlated. The correlation between these contemporaneous
shocks controls the univariate autocovariances of consumption growth; the first-order
autocovariance is ~bVar(zt)+ Cov(ez, t ~1, co, t+l), and higher-order autocovariances die
out geometrically at rate ~b. Thus consumption growth inherits the positive serial
correlation of the zt process unless the contemporaneous shocks are sufficiently
negatively correlated. An important special case of the model sets Cz,t+l = ~ec, t+l
to make consumption growth itself an AR(1) process; this is a linear version of the
model of Mehra and Prescott (1985) 19
From Equation (21), the riskless interest rate is linear in expected consumption
growth zs, so this model implies a homoskedastic AR(1) process for the riskless interest
rate, with persistence 0. It is a discrete-time version of the Vasicek (1977) model o f
the term structure o f interest rates. Campbell, Lo and MacKinlay (1997), Chapter 11,
gives a detailed textbook exposition of this model following Backus (1993), Singleton
(1990), and Sun (1992).
Equations (35) and (36) allow me to rewrite Equations (32) and (33) as
_Pc, - det

1-p

,~-

(37)

1-p~bJ '

and
=

ez,~+l.

(38)

Equation (38) shows why it is difficult to match the volatility of stock returns within
this standard framework. The most obvious way to generate volatile stock returns is

19 The empirical evidence on univariate serial correlation in consumption growth is mixed. Table 4 shows
small negative autocorrelation in 8 out of 12 quarterly data sets, but only 1 out of 3 annual data sets.
Measurement problems may bias these autocorrelations in either direction. Durability of consumption
tends to bias autocorrelation downwards, but time-averaging and seasonal adjustment tend to bias it
upwards. Empirical estimates of discrete-state Markov models by Cecchetti, Lain and Mark (1990,
1993), Kandel and Stambaugh (1991), and Mehra and Prescott (1985) find some evidence for modest
but persistent predictable variation in consumption growth.

Ch. 19: Asset Prices', Consumption, and the Business Cycle

1271

to assume a large ,t, that is, a volatile dividend, increasing )~, however, has mixed
effects; it increases the volatility of the first term in Equation (38) proportionally,
but as long as '1 < 1/*p it diminishes the volatility of the second term because the
dividend and real interest rate effects of expected consumption growth offset each
other more exactly. The overall volatility of stock returns may actually fall, or grow
only slowly, with '1 until the point is reached where '1 > 1/~p. The empirical evidence
for small ~p presented in Table 10 suggests that very high ,t will be needed to generate
volatile stock returns. A similar point has been made by Abel (1999), who emphasizes
that predictable variation in expected consumption growth can dampen stock market
volatility and exacerbate the equity premium puzzle.
This model also tends to produce highly volatile returns on real (inflation-indexed)
bonds. By setting '1 = 0 in Equations (37) and (38), the log yield and unexpected return
on a real consol bond, denoted by a subscript b, are

Ybt = db~ Pbt -

kl, ~
1- p

1 - p~ ] '

(39)

and

rb, t+l-Etrb, t + l - - - ( ; )

( 1 P _ ~ ) e z , t+l .

(40)

When ~p is small, even modest variation in zt will tend to produce large variation in
the riskffee interest rate and in the yields and returns on long-term real bonds. The
correlation of stock and real bond returns is positive if )~ < 1/% but turns negative if
'1 is large enough so that ,~ > 1/~p.
Of course, all these calculations are dependent on the assumption made at the
beginning of this subsection, that the log dividend on stocks is a multiple )~ of log
aggregate consumption. More general models, allowing separate variation in dividends
and consumption, can in principle generate volatile stock returns without excessive
variation in real interest rates. For example, we might modify Equation (30) to allow
a second autonomous component of the dividend:
det -'1c~ ~ at,

(41)

where Aat ~q has a similar structure to consumption growth, being forecast by an AR(1)
state variable:

Aat~l - Yt + ~a,t+l,

(42)

Yt+l = (1 - 0)v + Oy, -~ ey,~+l.

(43)

This modification of the basic model would add a term v/(1 ---p) + (Yt v)/(1 -pO) to
the formula for the log price-dividend ratio, Equation (37), and would add a term

JY. Campbell

1272

~a,t+l + p~y,t+l/(l - p O ) to the formula for the unexpected log stock return, (38).
Cecchetti, Lain and Mark (1993) estimate a discrete-state Markov model allowing
for this sort of separate variability in consumption and dividends. While such a
model provides a more realistic description of dividends, it requires large predictable
movements in dividends to explain stock market volatility. Unfortunately, as section 4.5
shows, there is little evidence for this.

4.4. Implications Jbr the equity premium puzzle

I now return to the basic model in which the log dividend is a multiple of log aggregate
consumption, and use the formulas derived in the previous subsection to gain a deeper
understanding of the equity premium puzzle. The discussion of the puzzle in section 3
treated the covariance of stock returns with consumption as exogenous, but given a
tight link between stock dividends and consumption the covariance can be derived from
the stochastic properties of consumption itself. This is the approach of many papers
including Abel (1994, 1999), Kandel and Stambaugh (1991), Mehra and Prescott
(1985), and Rietz (1988).
An advantage of this approach is that it clarifies the implications of Epstein-ZinWeil utility. The Epstein-Zin-Weil Euler equation is derived by imposing a budget
constraint that links consumption and wealth, and it explains risk premia by the
covariances of asset returns with both consumption growth and the return on the
wealth portfolio. The stochastic properties of consumption, together with the budget
constraint, can be used to substitute either consumption or wealth out of the EpsteinZin-Weil model.
To understand this point, note that Equation (33) applies to the return on the wealth
portfolio when ,~ = 1. Setting e = w and )~ = 1, Equation (33) becomes
rw, t+~-Etrw, t+l

Act+l-EtAct~l +

1-

(Et+~-Et)ZpJAc~+l~/,

(44)

j=l

an equation derived by Restoy and Weil (1998) applying the approach of Campbell
(1993). It follows that the covariance of any asset return with the wealth portfolio
must satisfy

aiw- o~c+ ( 1 - ~ )

ai~,

(45)

where agz denotes the covariance of asset return i with revisions in expectations of
future consumption growth:
oc

aig =~ Coy (ri, t +~- E~ri, t +1, (Et+ l - Et) Z pJ Act+ l+j).
j-1

The letter g is used here as a mnemonic for consumption growth.

(46)

Ch. 19." Asset Prices, Consumption, and the Business Cycle

1273

Substituting this expression into the formula for risk premia in the Epstein-Zin-Weil
model, Equation (22), that formula simplifies to

Et[ri,t+l]-rj;t+l + ~- = ]/(Yic-~ Y-

Oig.

(47)

The risk premium on any asset is the coefficient of risk aversion 3/times the covariance
of that asset with consumption growth, plus ( 7 - 1/~p) times the covariance of the
asset with revisions in expected future consumption growth. The second term is zero
if X = 1/% the power utility case, or if there are no revisions in expected future
consumption growth 20.
I now return to the assumption made in the previous subsection that expected
consumption growth is an AR(1) process given by Equation (36). Under this
assumption,
(E,+I - Et) Z
j=l

pJAct+L+j=

ez, t +1.

(48)

Equations (38), (47) and (48) imply that

E,[r~,,t+l]-

rf, l+l + -~

(49)
This expression nests many of the leading cases explored in the literature on the
equity premium puzzle. To understand it, it is helpful to break the equity premium
into two components, the premium on real consol bonds over the riskless interest rate,
and the premium on equities over real consol bonds:

4
E,[rt,,,+ll-rt,t+l+T=7[-~
(1 P--@)

_}_(~/_~) [_@{1_~)20z21 "

Et[re,,+l- r<,+I] + 022

(50)

~-Y'~Ia~2+(<p~)aczJ
2

(51)
20 Using a continuous-time model, Svensson (1989) also emphasizes that risk premia in the Epstein
Zin Weil model are determined only by risk aversion when investment opportunities and expected
consumption growth are constant.

1274

J. Z Campbell

Equations (50) and (51) add up to Equation (49). The first term in each of
these expressions represents the premium under power utility, while the second term
represents the effect on the premium of moving to Epstein-Zin utility and allowing the
coefficient of risk aversion to differ from the reciprocal of the intertemporal elasticity
of substitution. Given the evidence for small ~p presented in section 4.1, the key issue
is whether Epstein-Zin utility allows y to be smaller than 1/lp and in this sense helps
resolve the equity premium puzzle.
Under power utility, the real bond premium in Equation (50) is determined by the
covariance oc., of realized consumption growth and innovations to expected future
consumption growth. If this covariance is positive, then an increase in consumption is
associated with higher expected future consumption growth, higher real interest rates,
and lower bond prices. Real bonds accordingly have hedge value and the real bond
premium is negative. If oc~ is negative, then the real bond premium is positive 21. Under
Epstein-Zin utility with g < 1/% assets that covary negatively with expected future
consumption growth have higher risk premia. Since real bonds have this characteristic,
Epstein-Zin utility with ]/ < 1/~p tends to produce large term premia. This runs
counter to the empirical observation in Tables 7 and 8 that term premia are only
modest; while the term premia measured in the tables are on nominal rather than
real bonds, nominal term premia should if anything be larger than real term premia
because they include a reward for bearing inflation risk which is unlikely to be
negative.
The premium on equities over real bonds is proportional to the coefficient )~ that
governs the volatility of dividend growth. Under power utility the equity-bond premium
is just risk aversion y times 7~times terms in G2 and ocz. Since both G.2 and G.z must be
small to match the observed moments of consumption growth, it is hard to rationalize
the large equity-bond premium shown in Table 9. Epstein-Zin utility with g < 1/~p
adds a second term in oc~ and 62. Unfortunately the o~2 term is negative, which makes
it even harder to rationalize the equity-bond premium.
In conclusion, the consumption-based model with Epstein-Zin-Weil utility is no
more successful than the consumption-based model with power utility in fitting equity
and bond premia with a small coefficient of relative risk aversion. Given the time-series
evidence for a small intertemporal elasticity of substitution % relative risk aversion
y must be large - close to the reciprocal of ~p as implied by power utility - in order
to produce the large equity premia and small bond premia that are measured in the
data.
Campbell (1993) uses these relations in a different way. Instead of substituting the
wealth return out of the Epstein-Zin-Weil model, Campbell substitutes consumption

21 Calnpbetl(1986) developsthis intuition in a univariatemodel for consumptiongrowth.

Ch. 19." Asset Prices, Consumption, and the Business Cycle

1275

out of the model to get a discrete-time version of the intertemporal CAPM o f Merton
(1973). Setting e = w and )~ = 1 in Equation (34), the innovation in consumption is
O(3

A c , ~- Et ACt+l = rw, t+l - Etr,~,/+1 + (1 - ~P)(E/+I - Et) ~

pJrw, t+l+j.

(52)

j=l
Thus the covariance o f any asset return with consumption growth must satisfy
~c = ~w + (1 - ap)~.h,

(53)

where oih denotes the covariance o f asset return i with revisions in expected future
returns on wealth:
(X3

Oih

Cov(ri, t+l

- -

Elri, t+l, (Et+l - E~) ZpJrw,/+l+])-

(54)

j=l

The letter h here is used as a mnemonic for hedging demand [Merton (1973)], a term
commonly used in the finance literature to describe the component o f asset demand
that is determined by investors' responses to changing investment opportunities.
@ can now be substituted out o f Equation (22) to obtain

Et[ri, t+l]

<

rj;t+l + ~ - = y~riw+(y- 1)~h.

(55)

The risk premium on any asset is the coefficient o f risk aversion y times the covariance
of that asset with the return on the wealth portfolio, plus (y - 1) times the covariance of
the asset with revisions in expected future returns on wealth. The second term is zero
if y - 1; in this case it is well known that intertemporal asset demands are zero and
asset pricing is myopic. Campbell (1996b) uses this formula to study US stock price
data, assuming that the log return on wealth is a linear combination of the stock return
and the return on human capital (proxied by innovations to labor income). He argues
that mean-reversion in US stock prices implies a positive covariance O~w between US
stock returns and the current return on wealth, but a negative covariance a~h between
US stock returns and revisions in expected future returns on wealth. Equation (55)
then implies that increases in y above one have only a damped effect on the equity
premium, so high risk aversion is needed to explain the equity premium puzzle. This
conclusion is reached without any reference to measured aggregate consumption data.

4.5. What does the stock market Jorecast?

All the calculations in sections 4.3 and 4.4 rely heavily on the assumptions of
the representative-agent model with power utility, lognormal distributions, constant
variances, and a deterministic link between stock dividends and consumption. They

1276

J.Y. Campbell

leave open the possibility that the stock market volatility puzzle could be resolved by
relaxing these assumptions, for example to allow independent variation in dividends in
the manner discussed at the end of Section 4.3. A more direct way to understand the
stock market volatility puzzle is to use the loglinear asset pricing framework to study
the empirical relationships between log price-dividend ratios and future consumption
or dividend growth rates, real interest rates, and excess stock returns. According to
Equation (27), the log price-dividend ratio embodies rational forecasts of dividend
growth rates and stock returns, which in turn are the sum of real interest rates and
excess stock returns, discounted to an infinite horizon. One can compare the empirical
importance of these different forecasts by regressing long-horizon consumption and
dividend growth rates, real interest rates,and excess stock returns onto the log price
dividend ratio.
Table 12 (p. 1278) reports the results of this exercise. For comparative purposes
real output growth, realized stock market volatility, and the excess bond return are also
included as dependent variables. For each quarterly data set the dependent variables are
computed in natural units over 4, 8, and 16 quarters (1, 2, and 4years) and regressed
onto the log price-dividend ratio divided by its standard deviation. Thus the regression
coefficient gives the effect of a one standard deviation change in the log price-dividend
ratio on the cumulative growth rate or rate of return in natural units. The table reports
the regression coefficient, heteroskedasticity- and autocorrelation-consistent t statistic,
and R 2 statistic.
In the benchmark postwar quarterly US data, the log price-dividend ratio has no
clear ability to forecast consumption growth, output growth, dividend growth, or the
real interest rate at any horizon. What it does forecast is the excess return on stocks,
with t statistics that start above 4 and increase, and with R 2 statistics that start at
0.20 and increase to 0.55 at a 4-year horizon. In the introduction these results were
summarized as stylized facts 10, 11, 12, and 13. Table 12 extends them to international
data.
(10) Regressions of consumption growth on the log price-dividend ratio give
very mixed results across countries. There are statistically significant positive
coefficients in Germany and the Netherlands, but statistically significant negative
coefficients in Australia, Canada, Italy, Japan, and Switzerland. The other
countries resemble the USA in that they have no statistically significant
consumption growth forecasts. The regressions with output growth as the
dependent variable show a similar pattern across countries.
(11) Results are somewhat more promising for real dividend growth in many countries.
Positive and statistically significant coefficients are fotmd in Canada, France,
Germany, Italy, Japan, the Netherlands, Sweden, and the UK. It seems clear that
changing forecasts of real dividend growth have some role to play in explaining
stock market movements.
(12) The short-term real interest rate does not seem to be a promising candidate for
the driving force behind stock market fluctuations. One would expect to find
high price-dividend ratios forecasting low real interest rates, but the regression

Ch. 19: Asset Prices, Consumption, and the Business Cycle

1277

coefficients are significantly positive in France, Italy, Japan, the Netherlands,

Sweden, Switzerland, and the UK. This presumably reflects the fact that stock
markets in most countries were depressed in the 1970s, when real interest rates
were low, and buoyant during the 1980s, when real interest rates were high.
(13) Finally, the log price-dividend ratio is a powerful forecaster of excess stock
returns in almost every country. The regression coefficients are uniformly
negative and statistically significant.
In the long-term annual data for Sweden, the UK, and the USA, I use horizons of
1 year, 4 years, and 8 years. In the US data the log price-dividend ratio fails to forecast
real dividend growth, suggesting that authors such as Barsky and DeLong (t993)
overemphasize the role of dividend forecasts in interpreting long-run US experience.
Consistent with the quarterly results, the log price-dividend ratio also fails to forecast
consumption growth, output growth, or the real interest rate, but does forecast excess
stock returns.
The UK data are similar, although here the 8-year regression coefficients for
consumption growth and dividend growth are even statistically significant with the
wrong (negative) sign. The 8-year regression coefficient for the real interest rate is
also significantly negative, consistent with the idea that the UK stock market is related
to the real interest rate. But much the strongest relation is between the log pricedividend ratio and future excess returns on the UK stock market. The Swedish data are
quite different; here the log price-dividend ratio forecasts short-run dividend growth
positively but has no predictive power for consumption growth, output growth, the real
interest rate, or the excess log stock return.
The rightmost column of Table 12 considers one more dependent variable, the excess
bond return. The predictive power of the stock market for excess stock returns does not
generally carry over to excess bond returns; there are significant negative coefficients
only in Australia and the UK (and in Germany and Switzerland at long horizons).
Overall, these results suggest that a new model of stock market volatility is needed.
The standard model of section 4.3 drives all stock market fluctuations from changing
forecasts of long-run consumption growth, dividend growth, and real interest rates;
forecasts of excess stock returns are constant. The data for many countries suggest
instead that forecasts of consumption growth, dividend growth, and real interest rates
are variable only in the short run, so that long-run forecasts of these variables are
almost constant; stock market fluctuations seem to be driven largely by changing
forecasts of excess stock returns.

4.6. Changing volatility in stock returns

One reason why excess stock returns might be predictable is that the risk of stock
market investment, as measured for example by the volatility of stock returns, might
vary over time. With a constant price of risk, shifts in the quantity of risk will lead to
changes in the equity risk premium.

1278

J. Y Campbell

RR

RR

I I I

R R R

R~

o R o R R

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I I I

RR

R R R

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g ~ g g g ~ g g g g ~ g ~ g ~ g ~ g ~ g g g g g g
R R R

@RR

RR

RR

RR

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R o o

R R R R R

%
dd

d 5 5

d d d d 5

5 5 5 d d

5 d d S o S d d

5 5 d

eq "~

,~

o o ~ 2 ~

?
w

. . . .

o~-2

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0002

. . . . . . . . . . . . .

. . . . . . . . . . . . . . .

2<-o
.

g
o

R o R

,~

~ o
II

,~

22o

c~

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l ] l l

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RR

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tt

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Ch. 19." Asset Prices, Consumption, and the Business Cycle

I l J l l l l

d
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d
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1279

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d d d d
1 1 1 1

d d d d
I I 1 [ I

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d d
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oo
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t280

J. g Campbell

There is a vast literature documenting the fact that stock market volatility does
change with time. However, the variation in volatility is concentrated at high
frequencies; it is most dramatic in daily or monthly data and is much less striking at
lower frequencies. There is some business-cycle variation in volatility, but it does not
seem strong enough to explain large movements in aggregate stock prices [Bollerslev,
Chou and Kroner (1992), Schwert (1989)].
A second difficulty is that there is only weak evidence that periods of high
stock market volatility coincide with periods of predictably high stock returns.
Some papers do find a positive relationship between conditional first and second
moments of returns [Bollerslev, Engle and Wooldridge (1988), French, Schwert and
Stambaugh (1987), Harvey (1989)], but other papers find that when short-term nominal
interest rates are high, the conditional volatility of stock returns is high while the
conditional mean stock return is low [Campbell (1987), Glosten, Jagannathan and
Runkle (1993)].
French, Schwert and Stambaugh (1987) emphasize that innovations in volatility
are strongly negatively correlated with innovations in returns. This could be indirect
evidence for a positive relationship between volatility and expected returns, but it could
also indicate that negative shocks to stock prices raise volatility, perhaps by raising
financial or operating leverage of companies [Black (1976)].
Some researchers have built models that allow for independent variation in the
quantity and price of risk. Harvey (1989, 1991) uses "the Generalized Method of
Moments to estimate such a system, and finds that the price of risk appears to vary
countercyclically. Chou, Engle and Kane (1992) find similar results using a GARCH
framework.
Within the confines of this chapter it is not possible to do justice to the sophistication
of the econometrics used in this literature. Instead i illustrate the empirical findings
of the literature by constructing a crude measure of ex post volatility for excess
stock returns - the average over 4, 8, or 16 quarters of the squared quarterly excess
stock return - and regressing it onto the log price-dividend ratio. The results of this
regression are reported in the sixth data column of Table 12. There are nmnerous
significant coefficients in these regressions, but they are all positive, indicating that
high price-dividend ratios predict high, not tow volatility in these data.
These results reinforce the conclusion of the literature that the price of risk seems to
vary over time in relation to the level of aggregate consumption. Section 5 discusses
economic models that have this property.
4.7. What does the bond market forecast?

I conclude this section by briefly comparing the results of Table 12 with those that
carl be obtained using bond market data. Table 13 repeats the regressions of Table 12
using the yield spread between long-term and short-term bonds as the regressor. Many
authors have found that in US data, yield spreads have some ability to forecast excess
bond returns [Campbell (1987), Campbell and Shiller (199l), Fama and Bliss (1987)].

Ch. 19:

Asset Prices', Consumption, and the Business Cycle

1281

This contradicts the expectations hypothesis of the term structure, the hypothesis that
excess bond returns are unforecastable. Other authors have found that yield spreads are
powerful forecasters of macroeconomic conditions, particularly output growth [Chen
(1991), Estrella and Hardouvelis (1991)]. Fama and French (1989) have argued that
both price-dividend ratios and yield spreads capture short-term cyclical conditions,
although yield spreads are more highly correlated with conventional measures of the
US business cycle.
The results of Table 13 are strikingly different from those of Table 12. In the
quarterly data, yield spreads forecast positive output growth in almost every country,
and positive consumption growth in many countries. Outside the USA, there is also a
strong tendency for yield spreads to forecast low real interest rates. Thus the findings
of Chen (1991) and Estrella and Hardouvelis (1991) carry over to international data.
Yield spreads are much less successful as forecasters of excess stock returns, stock
market volatility, or even excess bond returns; the ability of the yield spread to
forecast excess bond returns appears to be primarily a US rather than an international
phenomenon 2~. Similar conclusions are reported by Hardouvelis (1994) and B ekaert,
Hodrick and Marshall (1997). While these authors do report some evidence for
predictability of excess bond returns in international data, the evidence is much weaker
than in US data.
These results are consistent with the view that there is some procyclical variation
in tile short-term real interest rate which is not matched by the long-term real interest
rate. Thus yield spreads tend to rise at business cycle troughs when real interest rates
are predictably low and future output and consumption growth are predictably high.
This interpretation is complicated by the fact that yields are measured on nominal
bonds rather than real bonds. Inflationary expectations and monetary policy therefore
have a large impact on yield spreads. The particular characteristics of US monetary
policy may help to explain why previously reported US results do not carry over
to other countries in Table 13. US monetary policy has tended to smooth real and
nominal interest rates, which reduces the forecastability of real interest rates and
increases the sensitivity of the yield spread to changes in bond-market risk premia.
Mankiw and Miron (1986) have found that the yield spread was a better forecaster
of US interest rates in the period before the founding of the Federal Reserve, while
Kugler (1988) has found that the yield spread is a better forecaster of interest
rates in Germany and Switzerland and has related this to the characteristics of
German and Swiss monetary policy. The findings in Table 13 are consistent with this
literature.

22 Results at a one-quarter horizon, not reported in the table, are qualitatively consistent with the longhorizon results.

1282

d E Campbell
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Ch. 19." Asset Prices, Consumption, and the Business Cycle

1283

ad
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1284

J E Campbell

5. Cyclical variation in the price of risk

In previous sections I have documented a challenging array of stylized facts and have
discussed the problems they pose for standard asset pricing theory. Briefly, the equity
premium puzzle suggests that risk aversion must be high on average to explain high
average excess stock returns, while the stock market volatility puzzle suggests that risk
aversion must vary over time to explain predictable variation in excess returns and the
associated volatility of stock prices. This section describes some models that display
these features.

5.1. Habit formation

Constantinides (1990), Ryder and Heal (1973), and Sundaresan (1989) have argued
for the importance of habit formation, a positive effect of today's consumption on
tomorrow's marginal utility of consumption.
Several modeling issues arise at the outset. Writing the period utility function as
U(Ct,Xt), where Xt is the time-varying habit or subsistence level, the first issue is the
functional form for U(.). Abel (1990, 1999) has proposed that U(.) should be a power
function of the ratio CJX~, while Boldrin, Christiano and Fisher (1995), Campbell and
Cochrane (1999), Constantinides (1990), and Sundaresan (1989) have used a power
function of the difference Ct-Xt. The second issue is the effect of an agent's own
decisions on future levels of habit. In standard "internal habit" models such as those
in Constantinides (1990) and Sundaresan (1989), habit depends on an agent's own
consumption and the agent takes account of this when choosing how much to consume.
In "external habit" models such as those in Abel (1990, 1999) and Campbell and
Cochrane (1999), habit depends on aggregate consumption which is unaffected by
any one agent's decisions. Abel calls this "catching up with the Joneses". The third
issue is the speed with which habit reacts to individual or aggregate consumption.
Abel (1990, 1999), Durra and Singleton (1986), and Ferson and Constantinides (1991)
make habit depend on one lag of consumption, whereas Boldrin, Christiano and Fisher
(1995), Constantinides (1990), Sundaresan (1989), Campbell and Cochrane (1999),
and Heaton (1995) assume that habit reacts only gradually to changes in consumption.
The choice between ratio models and difference models of habit is important because
ratio models have constant risk aversion whereas difference models have time-varying
risk aversion. To see this, consider Abel's (1990, 1996) specification in which an agent's
utility can be written as a power function of the ratio CSXt,
C~

U~ = Z

6t

j-O

(Ct+/X,~I) 1
1-y

(56)

where Xt summarizes the influence of past consumption levels on today's utility. For
simplicity, specify X~ as an external habit depending on only one lag of aggregate
consumption:

Xt = C,~-t,

(57)

Ch. 19: Asset Prices, Consumption, and the Business Cycle

1285

where Ct i is aggregate past consumption and the parameter t governs the degree of
time-nonseparability. Since there is a representative agent, in equilibrium aggregate
consumption equals the agent's own consumption, so in equilibrium

x,=c5_1.

(58)

With this specification of utility, in equilibrium the first-order condition is

1 = OEt [(1 +Ri, t+I)(Ct/Ct_I)~V(Y-1)(CI_I/Ct)Y].

(59)

Assuming homoskedasticity and joint lognonnality of asset returns and consumption

growth, this implies the following restrictions on risk premia and the riskless real
interest rate:
rJ; t+l

- -

log 6 - 720"~2/2 + 7EtAct+l

Et [ri,, + 1 - rj; t + 1 ] -k 0,2/2 = 7oi~.

tc(y

1)Ac.

(60)
(61)

Equation (60) says that the riskless real interest rate equals its value under power
utility, less t c ( y - 1)Act. Holding consumption today and expected consumption
tomorrow constant, an increase in consumption yesterday increases the marginal utility
of consumption today. This makes the representative agent want to borrow from the
future, driving up the real interest rate. Equation (61) describing the risk premium
is exactly the same as Equation (16), the risk premium formula for the power utility
model. The external habit simply adds a term to the Euler equation (59) which is
known at time t, and this does not affect the risk premium.
Abel (1990, 1999) nevertheless argues that catching up with the Joneses can help
to explain the equity premium puzzle. This argument is based on two considerations.
First, the average level of the riskless rate in Equation (60) is - l o g 6 - y2o~.2/2+
(y - tc(y - 1))g, where g is the average consumption growth rate. When risk aversion
y is very large, a positive t reduces the average riskless rate. Thus catching up
with the Joneses enables one to increase risk aversion to solve the equity premium
puzzle without encountering the riskless rate puzzle. Second, a positive t is likely to
make the riskless real interest rate more variable because of the term -tc(y-1)Ac, in
Equation (60). If one solves for the stock returns implied by the assumption that stock
dividends equal consumption, a more variable real interest rate increases the covariance
of stock returns and consumption oic and drives up the equity premium.
The second of these points can be regarded as a weakness rather than a strength
of the model. The puzzle illustrated in Table 5 is that the ratio of the measured
equity premium to the measured covariance oic is large; increasing the consumption
covariance oic does not by itself help to explain the size of this ratio. Also, Table 2
shows that the real interest rate is fairly stable ex post, while Table 7 shows that at
most half of its variance is forecastable. Thus the standard deviation of the expected

1286

J. Y C a m p b e l l

real interest rate is quite small, and this is not consistent with large values of t and
y in Equation (60).
This difficulty with the riskless real interest rate is a fundamental problem for habit
formation models. Time-nonseparable preferences make marginal utility volatile even
when consumption is smooth, because consumers derive utility from consumption
relative to its recent history rather than from the absolute level of consumption. But
unless the consumption and habit processes take particular forms, time-nonseparability
also creates large swings in expected marginal utility at successive dates, and this
implies large movements in the real interest rate. I now present an alternative
specification in which it is possible to solve this problem, and in which risk aversion
varies over time.
Campbell and Cochrane (1999) build a model with external habit formation in which
a representative agent derives utility from the difference between consumption and a
time-varying subsistence or habit level. They assume that log consumption follows
a random walk. This fits the observation that most countries do not have highly
predictable consumption or dividend growth rates (Tables 7 and 9). The consumption
growth process is
Act+l = g + ~c, t+l,

(62)

where co, t+1 is a normal homoskedastic innovation with variance ao2. This is just the
ARMA(1,1) model (35) of the previous section, with constant expected consumption
growth.
The utility function of the representative agent takes the form
oc

Et

[C

V ' 6J ~ t+j-

X~

1-y

j-0

,~ 1 .y

t+jj

-1

(63)

Here Xt is the level of habit, 6 is the subjective discount factor, and 7 is the utility
curvature parameter. Utility depends on a power function of the difference between
consumption and habit; it is only defined when consumption exceeds habit.
It is convenient to capture the relation between consumption and habit by the surplus
consumption ratio St, defined by
St =-

G-X,
C,

(64)

The surplus consumption ratio is the fraction of consumption that exceeds habit and
is therefore available to generate utility in Equation (63). If habit Xt is held fixed as
consumption Ct varies, the local coefficient of relative risk aversion is
-Cute_
uc

7
St'

(65)

where uc and ucc are the first and second derivatives of utility with respect to
consumption. Risk aversion rises as the surplus consumption ratio St declines, that

Ch. 19." Asset Prices, Consumption, and the Business Cycle

1287

is, as consumption approaches the habit level. Note that y, the curvature parameter in
utility, is no longer the coefficient of relative risk aversion in this model.
To complete the description of preferences, one must specify how the habit Xt
evolves over time in response to aggregate consumption. Campbell and Cochrane
suggest an AR(1) model for the log surplus consumption ratio, st -= log(St):
s~+l = (1 - q0)~+ q)st + Z (st) ~c,t+l.

(66)

The parameter q0 governs the persistence of the log surplus consumption ratio, while
the "sensitivity function" Z(st) controls the sensitivity of st~-i and thus of log habit xt+l
to innovations in consumption growth ce, t+l.
Equation (66) specifies that today's habit is a complex nonlinear function of current
and past consumption. A linear approximation may help to understand it. If I substitute
the definition st =- log(1 - exp(xt - ct)) into Equation (66) and linearize around the
steady state, I find that Equation (66) is approximately a traditional habit-formation
model in which log habit responds slowly and linearly to log consumption,
CxD

xM ,-~ (1-q0)a+qvxt+(1

q))~cpJct=i.

q0)ct= a + ( l

(67)

j-0

The linear model (67) has two serious problems. First, when consumption follows an
exogenous process such as Equation (62) there is nothing to stop consumption falling
below habit, in which case utility is undefined. This problem does not arise when one
specifies a process for st, since any real value for st corresponds to positive S~ and
hence Ct > Xt. Second, the linear model typically implies a highly volatile riskless
real interest rate. The process (66) with a non-constant sensitivity function Z(st) allows
one to control or even eliminate variation in the riskless interest rate.
To derive the real interest rate implied by this model, one first calculates the marginal
utility of consumption as

d(Ct) = ( G - X , ) 7 = S r C r .

(68)

The gross simple risktess rate is then

(i +RIll) = (0E, UU'(Q)
t ( G ' l ) ~) ' = (OEt ( ~ t i J

,/(C'4~-Y)'
\-GI.
' .

(69)

Taking logs, and using Equations (62) and (66), the log riskless real interest rate is
2

r/) 1 = - log(0) + yg - y(1 - cp)(s, - s) - -7~G'

[Z(s,) + 1]2 .

(70)

The first two terms on the right-hand side of Equation (70) are familiar from the
power utility model (17), while the last two terms are new. The third term (linear in

1288

JY. Campbell

(st -~)) reflects intertemporal substitution. If the surplus consumption ratio is low, the
marginal utility of consumption is high. However, the surplus consumption ratio is
expected to revert to its mean, so marginal utility is expected to fall in the future.
Therefore, the consumer would like to borrow and this drives up the equilibrium
riskfree interest rate. Note that what determines intertemporal substitution is meanreversion in marginal utility, not mean-reversion in consumption itself. In this model
consumption follows a random walk so there is no mean-reversion in consumption; but
habit formation causes the consumer to adjust gradually to a new level of consunlption,
creating mean-reversion in marginal utility.
The fourth term (linear in D~(s~)+ l] 2) reflects precautionary savings. As uncertainty
increases, consumers become more willing to save and this drives down the
equilibrium riskless interest rate. Note that what determines precautionary savings
is uncertainty about marginal utility, not uncertainty about consumption itself. In
this model the consumption process is homoskedastic so there is no time-variation
in uncertainty about consumption; but habit formation makes a given level of
consumption uncertainty more serious for marginal utility ,when consumption is low
relative to habit.
Equation (70) can be made to match the observed stability of real interest rates in two
ways. First, it is helpful if the habit persistence parameter q~ is close to one, since this
limits the strength of the intertemporal substitution effect. Second, the precautionary
savings effect offsets the intertemporal substitution effect if A(s~) declines with st. In
fact, Campbell and Cochrane parametrize the ,~(st) function so that these two effects
exactly offset each other everywhere, implying a constant riskless interest rate. With
a constant riskless rate, real bonds of all maturities are also riskless and there are no
real term premia. Thus in the Campbell-Cochrane model the equity premium is also
an equity-bond premium.
The sensitivity function ,~(st) is not fully determined by the requirement of a constant
riskless interest rate. Campbell and Cochrane choose the function to satisfy three
conditions: (1) The riskless real interest rate is constant. (2) Habit is predetermined
at the steady state s~ = 3. (3) Habit is predetermined near the steady state, or,
equivalently, positive shocks to consumption may increase habit but never reduce it. To
understand conditions (2) and (3), recall that the traditional notion of habit makes it a
predetermined variable. On the other hand habit cannot be predetermined everywhere,
or a sufficiently low realization of consumption growth would leave consumption
below habit. To make habit "as predetermined as possible", Campbell and Cochrane
assume that habit is predetermined at and near the steady state. This also eliminates
the counterintuitive possibility that positive shocks to consumption cause declines in
habit.
Using these three conditions, Campbell and Cochrane show that the steady-state
surplus consumption ratio must be a function of the other parameters of the model, and
that the sensitivity function )~(st) must take a particular form. Campbell and Cochrane
pick parameters for the model by calibrating it to fit postwar quarterly US data. They
choose the mean consumption growth rate g = 1.89% per year and the standard

Ch. 19:

Asset Prices, Consumption, and the Business Cycle

1289

deviation of consumption growth oc = 1.50% per year to match the moments of the
US consumption data.
Campbell and Cochrane follow Mehra and Prescott (1985) by assuming that the
stock market pays a dividend equal to consumption. They also consider a more realistic
model in which the dividend is a random walk whose innovations are correlated with
consumption growth. They show that results in this model are very similar because
the implied regression coefficient of dividend growth on consumption growth is close
to one, which produces similar asset price behavior. They use numerical methods to
find the price-dividend ratio for the stock market as a function of the state variable st.
They set the persistence of the state variable, ~, equal to 0.87 per year to match the
persistence of the log price-dividend ratio. They choose y = 2.00 to match the ratio of
unconditional mean to unconditional standard deviation of return in US stock returns.
These parameter values imply that at the steady state, the surplus consumption ratio
= 0.057 so habit is about 94% of consumption. Finally, Campbell and Cochrane
choose the discount factor 6 = 0.89 to give a riskless real interest rate of just under
1% per year.
It is important to understand that with these parameter values the model uses high
average risk aversion to fit the high unconditional equity premium. Steady-state risk
aversion is y/S = 2.00/0.057 = 35. In this respect the model resembles a power utility
model with a very high risk aversion coefficient.
There are however two important differences between the model with habit
formation and the power utility model with high risk aversion. First, the model with
habit formation avoids the riskfree rate puzzle. Evaluating Equation (70) at the steadystate surplus consumption ratio and using the restrictions on the sensitivity function
)~(&), the constant riskless interest rate in the Campbell-Cochrane model is

r/+j

- log(6) + y g -

~-.

(71)

In the power utility model the same large coefficient y would appear in the consumption
growth term and the consumption volatility term [Equation (17)]; in the CampbellCochrane model the curvature parameter ]e appears in the consumption growth term,
and this is much lower than the steady-state risk aversion coefficient y/5: which appears
in the consumption volatility term. Thus a much lower value of the discount factor 6
is consistent with the average level of the risk free interest rate, and the model implies
a less sensitive relationship between mean consumption growth and interest rates.
Second, the model with habit formation has risk aversion that varies with the level
of consumption, whereas a power utility model has constant risk aversion. The time.variation in risk aversion generates predictable movements in excess stock returns like
those documented in Table 12, enabling the Campbell-Cochrane model to match the
volatility of stock prices even with a smooth consumption series and a constant riskless
interest rate.

1290

J Y. Campbell

5.2. Models' with heterogeneous agents

All the models considered so far assume that assets can be priced as if there is a
representative agent who consumes aggregate consumption. An alternative view is that
aggregate consumption is not an adequate proxy for the consumption of stock market
investors.
One simple explanation for a discrepancy between these two measures of consumption is that there are two types of agents in the economy: constrained agents
who are prevented from trading in asset markets and simply consume their labor
income each period, and unconstrained agents. The consumption of the constrained
agents is irrelevant to the determination of equilibrium asset prices, but it may be
a large fraction of aggregate consumption. Campbell and Mankiw (1989) argue that
predictable variation in consumption growth, correlated with predictable variation in
income growth, suggests an important role for constrained agents, while Mankiw
and Zeldes (1991) and Brav and Geczy (1996) use US panel data to show that the
consumption of stockholders is more volatile and more highly correlated with the stock
market than the consumption of non-stockholders. Such effects are likely to be even
more important in countries with low stock market capitalization and concentrated
equity ownership.
The constrained agents in the above model do not directly influence asset prices,
because they are assumed not to hold or trade financial assets. Another strand of
the literature argues that there may be some investors who buy and sell stocks for
exogenous, perhaps psychological reasons. These "noise traders" can influence stock
prices because other investors, who are rational utility-maximizers, must be induced
to accommodate their shifts in demand. If utility-maximizing investors are risk-averse,
then they will only buy stocks from noise traders who wish to sell if stock prices fall
and expected stock returns rise; conversely they will only sell stocks to noise traders
who wish to buy if stock prices rise and expected stock returns fall. Campbell and
Kyle (1993), Cutler, Poterba and Summers (1991), DeLong, Shleifer, Summers and
Waldmalm (1990), and Shiller (1984) develop this model in some detail. The model
implies that rational investors do. not hold the market portfolio - instead they shift in
and out of the stock market in response to changing demand from noise traders - and
do not consume aggregate consumption since some consumption is accounted for by
noise traders. This makes the model hard to test without having detailed information
on the investment strategies of different market participants 23.
It is also possible that utility-maximizing stock market investors are heterogeneous
in important ways. If investors are subject to large idiosyncratic risks in their labor
income and can share these risks only indirectly by trading a few assets such as stocks

23 Recent work surveyed by Shiller (1999) attempts to place the behavior of noise traders on a firmer
psychologicalfolmdation. Benartzi and Thaler (1995), fbr example, argue that psychologicalbiases make
noise traders reluctant to hold stocks, and that this helps to explain the equity premium puzzle.

Ch. 19: Asset Prices, Consumption, and the Business Cycle

1291

and Treasury bills, their individual consumption paths may be much more volatile
than aggregate consumption. Even if individual investors have the same power utility
function, so that any individual's consumption growth rate raised to the power - y would
be a valid stochastic discount factor, the aggregate consumption growth rate raised to
the power - y may not be a valid stochastic discount factor.
This problem is an example of Jensen's Inequality. Since marginal utility is
nonlinear, the average of investors' marginal utilities of consumption is not generally
the same as the marginal utility of average consumption. The problem disappears when
investors' individual consumption streams are perfectly correlated with one another as
they will be in a complete markets setting. Grossman and Shiller (1982) point out
that it also disappears in a continuous-time model when the processes for individual
consumption streams and asset prices are diffusions.
Recently Constantinides and Duffle (1996) have provided a simple framework within
which the effects of heterogeneity can be understood. Constantinides and Duffle
postulate an economy in which individual investors k have different consumption levels
Ckt. The cross-sectional distribution of individual consumption is lognormal, and the
change from time t to time t + 1 in individual log consumption is cross-sectionally
uncorrelated with the level of individual log consumption at time t. All investors have
the same power utility function with time discount factor 6 and coefficient of relative
risk aversion y,
In this economy each investor's own intertemporal marginal rate of substitution
is a valid stochastic discount factor. Hence the cross-sectional average of investors'
intertemporal marginal rates of substitution is a valid stochastic discount factor. I write
this as

M,+~ = 6E,\~ L \ ~ - k , )

'

(72)

where E[ denotes an expectation taken over the cross-sectional distribution at time t.

That is, for any cross-sectionally random variable Xk~,

E:x,,

- lim

K
1 ~Xkt,
k-I

the limit as the number of cross-sectional units increases of the cross-sectional sample
average of Xkt 24. Note that E[Xkt will in general vary over time and need not be
lognormally distributed conditional on past information.

24 Constantinides and Duffle (1996) present a more rigorous discussion.

J.Y. Campbell

1292

The assumption of cross-sectional lognormality means that the log stochastic

discount factor, m[+1 = log(M~ 1), can be written as a function of the cross-sectional
mean and variance of the change in log consumption:
mr+ t

= - l o g ( b ) - yEt+jAck, t+1 +

Var~+lAck,
t+l,

(73)

where Var[ is defined analogously to E[ as

K

Var/Xl, = lim 1
K--,oo K

~(X~ lEt&,)2 '

k=l

and like E[ will in general vary over time.

An economist who knows the underlying preference parameters of investors but
does not understand the heterogeneity in this economy might attempt to construct a
representative-agent stochastic discount factor, M/~, using aggregate consumption:
/E/+l[G,t+l] )

-'uF+'l - b k

(74)

The log of this stochastic discount factor can also be related to the cross-sectional
mean and variance of the change in log consumption:
me+]=-log(b)-yEt+,Ack, t + l - (~)[Vart+lck, t+ 1 - Var/c?,l]

(7s)
- - l o g ( O ) - y E 2 i . , A c k , , + , - (7)[Var,*~_iAc'k,,+,],
where the second equality follows from the relation ck, tH ckf + Ack,t+l and the fact
that Ack, t+l is cross-sectionally uncorrelated with ckt.
The diflbrence between these two variables can now be written as
m/~ 1 - m " lI~A = Y(Y2+ 1)Vart+lACk,
.
t kl.

(76)

The time series of this difference can have a nonzero mean, helping to explain
the riskfree rate puzzle, and a nonzero variance, helping to explain the equity
premium puzzle. If the cross-sectional variance of log consumption growth is
negatively correlated with the level of aggregate consumption, so that idiosyncratic risk
increases in economic downturns, then the true stochastic discount factor m[+1 will be
more strongly countercyclical than the representative-agent stochastic discount factor
constructed using the same preference parameters; this has the potential to explain the
high price of risk without assuming that individual investors have high risk aversion.
Mankiw (1986) makes a similar point in a two-period model.

Ch. 19: Asset Prices, Consumption, and the Business Cycle

1293

An important unresolved question is whether the heterogeneity we can measure

has the characteristics that are needed to help resolve the asset pricing puzzles. In
the Constantinides-Duffie model the heterogeneity must be large to have important
effects on the stochastic discount factor; a cross-sectional standard deviation of log
consumption growth of 20%, for example, is a cross-sectional variance of only 0.04,
and it is variation in this number over time that is needed to explain the equity premium
puzzle. Interestingly, the effect of heterogeneity is strongly increasing in risk aversion
since Var~*+lAck,t+l is multiplied by y(g + 1)/2 in Equation (76). This suggests that
heterogeneity may supplement high risk aversion but cannot altogether replace it as
an explanation for the equity premium puzzle 25.
It is also important to note that idiosyncratic shocks have large effects in the
Constantinides-Duffie model because they are permanent. Heaton and Lucas (1996)
calibrate individual income processes to micro data from the Panel Study of Income
Dynamics (PSID). Because the PSID data show that idiosyncratic income variation
is largely transitory, Heaton and Lucas find that investors can minimize its effects on
their consumption by borrowing and lending. This prevents heterogeneity from having
any large effects on aggregate asset prices.
To get around this problem, several recent papers have combined heterogeneity with
constraints on borrowing. Heaton and Lucas (1996) and Krusell and Smith (1997) find
that borrowing constraints or large costs of trading equities are needed to explain the
equity premium. Constantinides, Donaldson and Mehra (1998) focus on heterogeneity
across generations; in a stylized three-period overlapping generations model they find
that they can match the equity premium if they prevent young agents from borrowing
to buy equities.
All of these models assume that agents have identical preferences. But heterogeneity
in preferences may also be important. Several authors have recently argued that trading
between investors with different degrees of risk aversion or time preference, possibly
in the presence of market frictions, can lead to time-variation in the market price of
risk [Aiyagari and Gertler (1998), Grossman and Zhou (1996), Sandroni (1997), Wang
(1996)]. This seems likely to be an active research area in the next few years.
5.3. Irrational expectations

So far I have maintained the assumption that investors have rational expectations and
understand the time-series behavior of dividend and consumption growth. A number of
papers have explored the consequences of relaxing this assumption. [See for example

25 Lettau (1997) reaches a similar conclusion by assuming that individuals consume their income,
and calculating the risk-aversion coefficients needed to put model-based stochastic discount factors
inside the Hansen-Jagannathan volatility bounds. This procedure is conservative in that individuals
trading in financial markets are normally able to achieve some smoothing of consumption relative to
income. Nevertheless Lettau finds that high individual risk aversion is still needed to satisfy the Hansen,~
Jagannathan bounds.

1294

JY

CampbeH

Barberis, Shleifer and Vishny (1998), Barsky and DeLong (1993), Cecchetti, Lam and
Mark (1998), Chow (1989), or Hansen, Sargent and Tallarini (1997)] 26
In the absence of arbitrage, there exist positive state prices that can rationalize the
prices of traded financial assets. These state prices equal subjective state probabilities
multiplied by ratios of marginal utilities in different states. Thus given any model of
utility, there exist subjective probabilities that produce the necessary state prices and
in this sense explain the observed prices of traded financial assets. The interesting
question is whether these subjective probabilities are sufficiently close to objective
probabilities, and sufficiently related to known psychological biases in behavior, to be
plausible.
Many of the papers in this area work in partial equilibrium and assume that stocks
are priced by discounting expected future dividends at a constant rate. This assumption
makes it easy to derive any desired behavior of stock prices directly from assumptions
on dividend expectations. Barsky and DeLong (1993), for example, assume that
investors believe dividends to be generated by a doubly integrated process, so that
the dividend growth rate has a unit root. These expectations imply that rapid dividend
growth increases stock prices more than proportionally, so that the price-dividend ratio
rises when dividends are growing strongly. If dividend growth is in fact stationary, then
the high price-dividend ratio is typically followed by dividend disappointments, low
stock returns, and reversion to the long-run mean pric~dividend ratio. Thus Barsky
and DeLong's model can account for the volatility puzzle and the predictability of
stock returns.
In general equilibrium, dividends are linked to consumption so investors' irrational
expectations about dividend growth should be linked to their irrational expectations
about consumption growth, interest rates are not exogenous, but like stock prices, are
determined by investors' expectations. Thus it is significantly harder to build a general
equilibrium model with irrational expectations.
To see how irrationality can affect asset prices, consider first a static model in which
log consumption follows a random walk (q} = 0) with drift g. Investors understand
that consumption is a random walk, but they expect it to grow at rate ~ instead of g.
Equation (37) implies that the log price-dividend ratio is

P e t - d e t -- i - p +

(77)

~ --

Equation (21) implies that the riskless imerest rate is

0-1

rL ,+1 - - log 6 + ~ + ~ - -

26 There is also import.

ow - ~-~- o7,

(78)

Ch. 19: Asset Prices, Consumption, and the Business Cycle

1295

and the rationally expected equity premium is

Et[r~,,+,l

- rf, t-t-1 -t- T

(79)

= ~I-~0"2 -I- ~L(M- D)"

The first term on the right-hand side of Equation (79) is the standard formula for
the equity premium in a model with serially uncorrelated consumption growth. This is
investors' irrational expectation o f the equity premium. The second term arises because
dividend growth is systematically different from what investors expect.
This model illustrates that irrational pessimism among investors @ < g) can lower
the average riskfree rate and increase the equity premium. Thus pessimism has the
same effects on asset prices as a low rate o f time preference and a high coefficient o f
risk aversion, and it can help to explain both the riskfree rate puzzle and the equity
premium puzzle 27.
To explain the volatility puzzle, a more complicated model o f irrationality is needed.
Suppose now that log consumption growth follows an AR(1) process, a special case
of Equation (35), but that investors believe the persistence coefficient to be ~} when in
fact it is q)28. In this case the riskfree interest rate is given by
^

(80)

r/;t+l = / ~ f + ~ ( A c t - g ) ,
while the rationally expected equity premium is

<

E,fr~,,~,I-,r~;,,,+T=~-(,}-O)

,~-

+,~ (A<-g),

(81)

where/~f and/J~ are constants. If 0 is larger than ~b, and if the term in square brackets
in Equation (81) is positive, then the equity premium falls when consumption growth
has been rapid, and rises when consumption growth has been weak. This model, which
can be seen as a general equilibrium version of Barsky and DeLong (1993), fits the
apparent cyclical variation in the market price of risk.
One difficulty with this explanation for stock market behavior is that it has strong
implications for bond market behavior. Consumption growth drives up the riskless

27 The effect of pessimism on the average price-dividend ratio is ambiguous, for the usual reason that
lower riskfree rates and lower expected dividend growth have offsetting effects. Hansen, Sargent and
Tallarini (1997) also emphasize that irrational pessimism can be observationally equivalent to lower time
preference and higher risk aversion.
28 All alternative formulation would be to assume, following Equation (35), that log consumption growth
is predicted by a state variable x~ that investors observe, but that investors misperceive tile persistence of
this process to be ~ rather than ~. In this case investors correctly forecast consumption growth over the
next period, but incorrectly forecast subsequent consumption growth. Their irrationality has no effect
on the riskfiee interest rate but causes time-variation in equity and bond premia.

JY. Campbell

1296

interest rate and the real bond premium even while it drives down the equity premium.
Barsky and DeLong (1993) work in partial equilibrium so they do not confront
this problem. Cecchetti, Lain and Mark (1998) handle it by allowing the degree of
investors' irrationality itself to be stochastic and time-varying 29.
6. Some implications tbr m a c r o e c o n o m i c s
The research summarized in this chapter has important implications for various aspects
of macroeconomics. I conclude by briefly discussing some of these.
A first set of issues concerns the modelling of production, and hence of investment.
This chapter has followed the bulk of the asset pricing literature by concentrating on
the relation between asset prices and consumption, without asking how consumption is
determined in relation to investment and production. Ultimately this is unsatisfactory,
and authors such as Cochrane (1991, 1996) and Rouwenhorst (1995) have argued that
asset pricing should place a renewed emphasis on the investment decisions of firms.
Standard macroeconomic models with production, such as the canonical real
business cycle model of Prescott (1986), imply that asset prices are extremely stable.
The real interest rate equals the marginal product of capital, which is perturbed only by
technology shocks and changes in the quantity of capital; when the model is calibrated
to US data the standard deviation of the real interest rate is only a few basis points.
The return on capital is equally stable because capital can costlessly be transformed
into consumption goods, so its price is always fixed at one and uncertainty in the return
comes only from uncertainty about dividends.
If real business cycle models are to generate volatile asset returns, they must be
modified to include adjustment costs in investment so that changes in the demand for
capital cause changes in the value of installed capital, or Tobin's q, rather than changes
in the quantity of capital. Baxter and Crucini (1993), Jermann (t998), and Christiano
and Fisher (1995), among others, show how this can be done. The adjustment costs
affect not only asset prices, but other aspects of the model; the response of investment
to shocks falls, for example, so larger shocks are needed to explain the cyclical
behavior of investment.
The modelling of labor supply is an equally difficult problem. Any model in which
workers choose their labor supply implies a first-order condition of the form

OU
OC~G~-

OU
ON,'

(82)

where Gt is the real wage and Nt is labor supply. A well-known difficulty in business
cycle theory is that with a constant real wage, the marginal utility of consumption

29 The work of Rietz (1988) can be understood in a similar way.Rictz argues that investors are concerned
about an unlikely but serious event that has not actually occurred. Given the data we have, investors
appear to be irrational but in fact, with a long enough data sample, they will prove to be rational.

Ch. 19: Asset Prices, Consumption, and the Business Cycle

1297

OU/OCt will be perfectly correlated with the marginal disutility of work -OU/ON~. Since
the marginal utility of consumption is declining in consumption while the marginal
disutility of work is increasing in hours, this implies that consumption and hours
worked will be negatively correlated. In the data, of course, consumption and hours
worked are positively correlated since they are both procyclical.
This problem can be resolved if the real wage is procyclical; then when consumption
and hours increase in an expansion the decline in marginal utility of consumption
is more than offset by an increase in the real wage. In a standard model with log
utility of consumption only a 1% increase in the real wage is needed to offset the
decline in marginal utility caused by a 1% increase in consumption. But preferences
of the sort suggested by the asset pricing literature, with high risk aversion and
low intertemporal elasticity of substitution, have rapidly declining marginal utility
of consumption. These preferences imply that a much larger increase in the real
wage will be needed to offset the effect on labor supply of a given increase in
consumption. Boldrin, Christiano and Fisher (1995) and Lettau and Uhlig (1996)
confront this problem; Boldrin, Christiano and Fisher try to resolve it by using
a two-sector framework with limited mobility of labor between sectors. In their
framework the first-order condition (82) does not hold contemporaneously, but only
in expectation.
Models with production also help one to move away from the common assumption
that stock market dividends equal consumption or equivalently, that the aggregate stock
market equals total national wealth. This assumption is clearly untrue even for the
United States, and is even less appropriate for countries with smaller stock markets.
While one can relax the assumption by writing down exogenous correlated timeseries processes for dividends and consumption in the manner of section 4.3, it will
ultimately be more satisfactory to derive both dividends and consumption within a
general equilibrium model.
Another important set of issues concerns the links between different national
economies and their financial markets. In this chapter I have treated each national
stock market as a separate entity with its own pricing model. That is, I have assumed
that national economies are entirely closed so that there is no integrated world capital
market. This assumption may be appropriate for examining long-term historical data,
but it seems questionable under modern conditions. There is much work to be done on
the pricing of national stock markets in a model with a perfectly or partially integrated
world capital market.
Finally, the asset pricing literature is important in understanding the welfare costs
of macroeconomic fluctuations. There has recently been a tendency for economists
to downplay the importance of economic fluctuations in favor of an emphasis on
long-term economic growth. But models of habit formation imply that consumers
take fluctuations extremely seriously. Fluctuations have important negative effects on
welfare because they move consumption in the short term, when agents have little time
to adjust; reductions in long-term growth, on the other hand, allow agents' habit levels
to adjust gradually.

1298

J. E Campbell

This conclusion is not an artifact o f a particular utility function and habit formation
process. As A t k e s o n and Phelan (1994) emphasize, it m u s t result from any utility
function that explains the level o f the equity p r e m i u m . The choice b e t w e e n risky stocks
and stable m o n e y market instruments offers investors a tradeoff b e t w e e n the m e a n
growth rate o f their wealth and the volatility o f this growth rate. The fact that so m u c h
extra m e a n growth is available from volatile stock market investments implies that
investors find volatility to be a serious threat to their welfare. E c o n o m i c policymakers
should take this into account w h e n they face policy tradeoffs between e c o n o m i c growth
and m a c r o e c o n o m i c stability.

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Asset Prices', Consumption, and the Business Cycle

1301

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J.Y. Campbell

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Ch. 19:

Asset Prices, Consumption, and the Business Cycle

1303

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Chapter 20

HUMAN

BEHAVIOR

EFFICIENCY

AND

THE

OF THE FINANCIAL

SYSTEM*

ROBERT J. SHILLER
Yale Unioersity

Contents

Abstract
1306
Keywords
1306
Introduction
1307
1. Prospect theory
1308
2. Regret and cognitive dissonance
1313
3. Anchoring
1314
4. Mental compartments
1317
Overconfidence, over- and under-reaction and the representativeness heuristic 1318
1324
6. The disjunction effect
1325
7. Gambling behavior and speculation
1325
8. The irrelevance o f history
1328
9. Magical thinking
1329
10. Quasi-magical thinking
1330
11. Attention anomalies and the availability heuristic
1331
12. Culture and social contagion
1332
13. A global culture
1333
14. Concluding remarks
1334
References
.

* An earlier version was presented at a conference Recent Developments in Maclveconomics at the

Federal Reselwe Bank of New York, February 27-28, 1997. The author is indebted to Ricky Lain for
research assistance, and to Michael Krause, Virginia Shiller, Andrei Shleifer, David Wilcox, and the
editors for helpful comments. This research was supported by the National Science Foundation.
Handbook o f Macroeconomics, Volume 1, Edited by ~B. ~l~ylor and M. WoodJbrd
1999 Elsevier Science B. l( All rights reserved

1305

1306

R.J. Shiller

Abstract

Recent literature in empirical finance is surveyed in its relation to underlying

behavioral principles, principles which come primarily from psychology, sociology,
and anthropology. The behavioral principles discussed are: prospect theory, regret
and cognitive dissonance, anchoring, mental compartments, overconfidence, over- and
under-reaction, representativeness heuristic, the disjunction effect, gambling behavior
and speculation, perceived irrelevance of history, magical thinking, quasi-magical
thinking, attention anomalies, the availability heuristic, culture and social contagion,
and global culture.

Keywords
efficient markets, random walk, excess volatility, anomalies in finance, stock market,
prospect theory, regret and cognitive dissonance, anchoring, mental compartments,
overconfidence, overreaction, underreaction, representativeness heuristic, the
disjunction effect, gambling behavior and speculation, irrelevance of history, magical
thinking, quasi-magical thinking, attention anomalies, the availability heuristic,
culture and social contagion, global culture
JEL classification: G10

Ch. 20." Human Behavior and the Efficiency of the Financial System

1307

Introduction

Theories of human behavior from psychology, sociology, and anthropology have helped
motivate much recent empirical research on the behavior of financial markets. In this
paper I will survey some of the most significant theories (for empirical finance) in
these other social sciences and the empirical finance literature itself.
Particular attention will be paid to the implications of these theories for the efficient
markets hypothesis in finance. This is the hypothesis that financial prices efficiently
incorporate all public information and that prices can be regarded as optimal estimates
of true investment value at all times. The efficient markets hypothesis in turn is
based on more primitive notions that people behave rationally, or accurately maximize
expected utility, and are able to process all available information. The idea behind
the term "efficient markets hypothesis", a term coined by Harry Roberts (1967) l,
has a long history in financial research, a far longer history than the term itself has.
The hypothesis (without the words efficient markets) was given a clear statement in
Gibson (1889), and has apparently been widely known at least since then, if not long
before. All this time there has also been tension over the hypothesis, a feeling among
many that there is something egregiously wrong with it; for an early example, see
Mackay (1841). In the past couple of decades the finance literature has amassed a
substantial number of observations of apparent anomalies (from the standpoint of the
efficient markets hypothesis) in financial markets. These anomalies suggest that the
underlying principles of rational behavior underlying the efficient markets hypothesis
are not entirely correct and that we need to look as well at other models of human
behavior, as have been studied in the other social sciences.
The organization of this paper is different from that of other accounts of the literature
on behavioral finance [for example, De Bondt and Thaler (1996) or Fama (1997)]:
this paper is organized around a list of theories from the other social sciences that are
used by researchers in finance, rather than around a list of anomalies. I organized the
paper this way because, in reality, most of the fundamental principles that we want to
stress here really do seem to be imported from the other social sciences. No surprise
here: researchers in these other social sciences have done most of the work over the
last century on understanding less-than-perfectly-rational human behavior. Moreover,
each anomaly in finance typically has more than one possible explanation in terms of
these theories from the other social sciences. The anomalies are observed in complex
real world settings, where many possible factors are at work, not in the experimental
psychologist's laboratory. Each of their theories contributes a little to our understanding
of the anomalies, and there is typically no way to quantify or prove the relevance of
any one theory: It is better to set forth the theories from the other social sciences
themselves, describing when possible the controlled experiments that demonstrate their
validity, and give for each a few illustrations of applications in finance.
I The Roberts (1967) paper has never been published; the fame of his paper apparently owes to the
discussion of it in Fama (1970).

1308

R.A Shiller

Before beginning, it should be noted that theories of human behavior from these
other social sciences often have underlying motivation that is different from that of
economic theories. Their theories are often intended to be robust to application in a
variety of everyday, unstructured experiences, while the economic theories are often
intended to be robust in the different sense that, even if the problems the economic
agents face become very clearly defined, their behavior will not change after they
learn how to solve the problems. Many of the underlying behavioral principles from
psychology and other social sciences that are discussed below are unstable and the
hypothesized behavioral phenomena may disappear when the situation becomes better
structured and people have had a lot of opportunity to learn about it. Indeed, there are
papers in the psychology literature claiming that many of the cognitive biases in human
judgment under uncertainty uncovered by experimental psychologists will disappear
when the experiment is changed so that the probabilities and issues that the experiment
raises are explained clearly enough to subjects [see, for example, Gigerenzer (1991)].
Experimental subjects can in many cases be convinced, if given proper instruction, that
their initial behavior in the experimental situation was irrational, and they will then
correct their ways.
To economists, such evidence is taken to be more damning to the theories than it
would be by the social scientists in these other disciplines. Apparently economists at
large have not fully appreciated the extent to which enduring patterns can be found in
this "unstable" human behavior. Some examples below will illustrate the application
of theories from other social sciences to understanding anomalies in financial markets
will illustrate.
Each section below, until the conclusion, refers to a theory taken from the literature
in psychology, sociology or anthropology. The only order of these sections is that I have
placed first theories that seem to have the more concrete applications in finance, leaving
some more impressionistic applications to the end. in the conclusion, I attempt to put
these theories into perspective, and to recall that there are also important strengths in
conventional economic theory and in the efficient markets hypothesis itself.

1. Prospect theory
Prospect theory [Kahneman and Tversky (1979), Tversky and Kahneman (1992)j has
probably had more impact than any other behavioral theory on economic research.
Prospect theory is very influential despite the fact that it is still viewed by much of
the economics profession at large as of far less importance than expected utility theory.
Among economists, prospect theory has a distinct, though still prominent, second place
to expected utility theory for most research.
I should say something first about the expected utility theory that still retains the
position of highest honor in the pantheon of economic tools, it has dominated much
economic theory so long because the theory offers a parsimonious representation of
truly rational behavior under uncertainty. The axioms [Savage (1954)] from which

Ch. 20." Human Behavior and the Efficiency of the Financial System

1309

expected utility theory is derived are undeniably sensible representations of basic

requirements of rationality. For many purposes, it serves well to base an economic
theory on such assumptions of strictly rational behavior, especially if the assumptions
of the model are based on simple, robust realities, if the model concerns wellconsidered decisions of informed people, and if the phenomenon to be explained is
one of stable behavior over many repetitions, where learning about subtle issues has
a good chance of occurring.
Still, despite the obvious attractiveness of expected utility theory, it has long been
known that the theory has systematically mispredicted human behavior, at least in
certain circumstances. Allais (1953) reported examples showing that in choosing
between certain lotteries, people systematically violate the theory. Kahneman and
Tversky (1979) give the following experimental evidence to illustrate one of Allais'
examples. When their subjects were asked to choose between a lottery offering a
25% chance of winning 3000 and a lottery offering a 20% chance of winning 4000,
65% of their subjects chose the latter, while when subjects were asked to choose
between a 100% chance of winning 3000 and an 80% chance of winning 4000,
80% chose the former. Expected utility theory predicts that they should not choose
differently in these two cases, since the second choice is the same as the first except
that all probabilities are multiplied by the same constant. Their preference for the first
choice in the lottery when it is certain in this example illustrates what is called the
"certainty effect", a preference for certain outcomes.
Prospect theory is a mathematically-formulated alternative to the theory of expected
utility maximization, an alternative that is supposed to capture the results of such
experimental research. (A prospect is the Kahneman-Tversky name for a lottery as in
the Allais example above.) Prospect theory actually resembles expected utility theory in
that individuals are represented as maximizing a weighted sum of "utilities", although
the weights are not the same as probabilities and the "utilities" are determined by what
they call a "value function" rather than a utility function.
The weights are, according to Kalmeman and Tversky (1979) determined by a
function of true probabilities which gives zero weight to extremely low probabilities
and a weight of one to extremely high probabilities. That is, people behave as if they
regard extremely improbable events as impossible and extremely probable events as
certain. However, events that are just very improbable (not extremely improbable) are
given too much weight; people behave as if they exaggerate the probability. Events that
are very probable (not extremely probable) are given too little weight; people behave
as if they underestimate the probability. What constitutes an extremely low (rather
than very low) probability or an extremely high (rather than very high) probability is
determined by individuals' subjective impression and prospect theory is not precise
about this. Between the very low and very high probabilities, the weighting function
(weights as a function of true probabilities) has a slope of less than one.
This shape for the weighting function allows prospect theory to explain the Allais
certainty effect noted just above. Since the 20% and 25% probabilities are in the range
of the weighting function where its slope is less than one, the weights people attach to

1310

R.~ Shiller

the two outcomes are more nearly equal than are the probabilities, and people tend just
to choose the lottery that pays more if it wins. In contrast, in the second lottery choice
the 80% probability is reduced by the weighting function while the 100% probability
is not; the weights people attach to the two outcomes are more unequal than are the
probabilities, and people tend just to choose the outcome that is certain.
If we modify expected utility function only by substituting the Kahneman and
Tversky weights for the probabilities in expected utility theory, we might help explain a
number of puzzling phenomena in observed human behavior toward risk. For a familiar
example, such a modification could explain the apparent public enthusiasm for highprize lotteries, even though the probability of winning is so low that expected payout
of the lottery is not high. It could also explain such a phenomenon as the observed
tendency for overpaying for airline flight insurance (life insurance policies that one
purchases before an airline flight, that has coverage only during that flight), Eisner
and Strotz (1961).
The Kahneman-Tversky weighting function may explain observed overpricing of
out-of-the-money and in-the-money options. Much empirical work on stock options
pricing has uncovered a phenomenon called the "options smile" [see Mayhew (1995)
for a review]. This means that both deep out-of-the-money and deep in-the-money
options have relatively high prices, when compared with their theoretical prices using
Black-Scholes formulae, while near-the-money options are more nearly correctly
priced. Options theorists, accustomed to describing the implied volatility of the stock
implicit in options prices, like to state this phenomenon not in terms of option prices
but in terms of these implied volatilities. When the implied volatility for options of
various strike prices at a point in time derived using the Black-Scholes (1973) formula
are plotted, on the vertical axis, against the strike price on the horizontal axis, the curve
often resembles a smile. The curve is higher both for low strike price (out-of-themoney) options and for high strike price (in-the-money) options than it is for middlerange strike prices. This options smile might possibly be explained in terms of the
distortion in probabilities represented by the Kahneman-Tversky weighting function,
since the theory would suggest that people act as if they overestimate the small
probability that the price of the underlying crosses the strike price and underestimate
the high probability that the price remains on the same side of the strike price. The
Kahneman-Tversky weighting function might even explain the down-turned corners
of the mouth that some smiles exhibit [see Fortune (1996)] if at these extremes the
discontinuities at the extremes of the weighting fi.mction become relevant 2.

2 There are other potential explanations of the options smile in terms of nonnormality or jump processes
for returns, and these have received the attention in the options literature. Such explanations might even
provide a completerational basis for the smile, though it ishard to know for sure. Since the 1987 stock
market crash, the options smile has usually appeared distorted into an options "leer", with the left side
of the mouth higher (e.g., the deep out-of-the-moneyputs are especially overpriced), see Bates (1995),
Jackwcrth and Rubinstein (1995) and Bates (1991). Public memories of the 1987 crash are apparently
at work in producing this "leer"

Ch. 20:

Human Behaoior and the Efficiency o f the Financial System

1311

We now turn to the other foundation of prospect theory, the Kahneman and Tversky
(1979) value function. The value function differs from the utility function in expected
utility theory in a very critical respect: the function (of wealth or payout) has a kink
in it at a point, the "reference point", the location of which is determined by the
subjective impressions of the individual. The reference point is the individual's point of
comparison, the "status quo" against which alternative scenarios are contrasted. Taking
value as a function of wealth, the Kahneman-Tversky (1979) value function is upward
sloping everywhere, but with an abrupt decline in slope at the reference point (today's
wealth or whatever measure of wealth that is psychologically important to the subject).
For wealth levels above the reference point, the value function is concave downward,
just as are conventional utility functions. At the reference point, the value function may
be regarded, from the fact that its slope changes abruptly there, as infinitely concave
downward. For wealth levels below the reference point, Kahneman and Tversky found
evidence that the value function is concave upward, not downward. People are risk
lovers for losses, they asserted.
Perhaps the most significant thing to notice about the Kahneman-Tversky value
function is just the discontinuity in slope at the reference value, the abrupt downward
change in slope as one moves upward past the reference value. Prospect theory does
not nail down accurately what determines the location of the reference point, just as
it does not nail down accurately, for the weighting function, what is the difference
between very high probabilities and extremely high probabilities. The theory does not
specify these matters because experimental evidence has not produced any systematic
patterns of behavior that can be codified in a general theory. However, the reference
point is thought to be determined by some point of comparison that the subject finds
convenient, something readily visible or suggested by the wording of a question.
This discontinuity means that, in making choices between risky outcomes, people
will behave in a risk averse manner, no matter how small the amounts at stake are.
This is a contrast to the prediction of expected utility theory with a utility function of
wealth without kinks, for which, since the utility function is approximately linear for
small wealth changes, people should behave as if they are risk neutral for small bets.
That people would usually be risk neutral for small bets would be the prediction of
expected utility theory even if the utility function has such a slope discontinuity, since
the probability that wealth is currently at the kink is generally zero. With prospect
theory, in contrast, the kink always moves with wealth to stay at the perceived current
level of wealth (or the current point of reference); the kink is always relevant.
Samuelson (1963) told a story which he perceived as demonstrating a violation of
expected utility theory, and, although it came before Kahneman and Tversky's prospect
theory, it illustrates the importance of the kink in the value function. Samuelson
reported that he asked a lunch colleague whether he would accept a bet that paid
him $200 with a probability of 0.5 and lost him $100 with a probability of 0.5. The
colleague said he would not take the bet, but that he would take a hundred of them.
With 100 such bets, his expected total winnings are $5000 and he has virtually no
chance of losing any money. It seems intuitively compelling to many people that

13t2

R.J. Shiller

one would readily take the complete set o f bets, even if any element o f the set is
unattractive. Samuelson proved that if his colleague would answer the same way at
any wealth level, then he necessarily violates expected utility theory.
Samuelson's colleague is not, however, in violation o f prospect theory. When
viewing a single bet, the kink in the value function is the dominant consideration. If he
were to judge 100 bets sequentially, the kink would always be relevant (the reference
point would move with each successive bet) and he would reject all o f them. But if he
were to judge 100 bets together, the collective outcomes would be far above today's
value function kink, and the bet is, by prospect theory, clearly desirable.
The failures to accept many such bets when one considers them individually has
been called "myopic loss aversion" by Benartzi and Thaler (1995). They argue that,
assuming estimated values for the magnitude of the kink in tbe Kahneman-Tversky
value function, the "equity premium puzzle" of Mehra and Prescott (1985) can be
resolved; see also Siegel and Thaler (1997).
Today, the term "equity premium puzzle", coined by Mehra and Prescott (1985),
is widely used to refer to the puzzlingly high historical average returns o f stocks
relative to bonds 3. The equity premium is the difference between the historical average
return in the stock market and the historical average return on investments in bonds or
treasury bills. According to Siegel (1998), the equity premium of US stocks over shortterm government bonds has averaged 6.1% a year for the United States for 1926-1992,
and so one naturally wonders why people invest at all in debt if it is so outperformed by
stocks 4. Those who have tried to reconcile the equity premium with rational investor
behavior commonly point out the higher risk that short-run stock market returns show:
investors presumably are not fully enticed by the higher average returns o f stocks since
stocks carry higher risk. But, such riskiness o f stocks is not a justification o f the equity
premium, at least assuming that investors are mostly long term. Most investors ought
to be investing over decades, since most o f us expect to live for many decades, and
to spend the twilight o f their lives living off savings. Over long periods o f times, it
has actually been long-term bonds (whose payout is fixed in nominal terms), not the
stocks, that have been more risky in real terms, since the consumer price index has
been, despite its low variability from month to month, very variable over long intervals
o f time, see Siegel (1998). Moreover, stocks appear strictly to dominate bonds: there is

3 Mehra and Prescott did not discover the equity premium. Perhaps that honor should go to Smith (1925),
although there must be even earlier antecedents in some forms. Mehra and Prescott's original contribution
seems to have been, in the context of present-value investor intertemporal optimizing models, to stress
that the amount of risk aversion that would justify the equity premium, given the observed correlation
of stocks with consumption, would imply much higher riskless interest rates than we in fact see.
4 Siegel (1998, p. 20). However, Siegel notes that the US equity premium was only 1.9% per year
18161870 and 2.8% per year 1871-1925.

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Human Behavior and the Ejficiency o/'the Financial System

1313

no thirty-year period since 1861 in which a broad portfolio o f stocks was outperformed
either by bonds or treasury bills 5.
Benartzi and Thaler (1995) show that if people use a one-year horizon to evaluate
investments in the stock market, then the high equity premium is explained by myopic
loss aversion. Moreover, prospect theory does not suggest that in this case riskless
real interest rates need be particularly high. Thus, if we accept prospect theory and
that people frame stock market returns as short-term, the equity premium puzzle is
solved.
Benartzi and Thaler (1996) demonstrated experimentally that when subjects are
asked to allocate their defined contribution pension plans between stocks and fixed
incomes, their responses differed sharply depending on how historical returns were
presented to them. If they were shown 30 one-year returns, their median allocation
to stocks was 40%, but if they were shown 30-year returns their median allocation
to stocks was 90%. Thaler, Tversky, Kahneman and Schwartz (1997) show further
experiments confirming this response.
Loss aversion has also been used to explain other macroeconomic phenomena~
savings behavior [Bowman, Minehart and Rabin (1993)] and job search behavior
[Bryant (l 990)].

2. Regret and cognitive dissonance

There is a human tendency to feel the pain of regret at having made errors, even small
errors, not putting such errors into a larger perspective. One "kicks oneself" at having
done something foolish. If one wishes to avoid the pain of regret, one may alter one's
behavior in ways that would in some cases be irrational unless account is taken of the
pain o f regret.
The pain o f regret at having made errors is in some senses embodied in the
Kahneman-Tversky notion o f a kink in the value function at the reference point.
There are also other ways of representing how people behave who feel pain o f regret.
Loomes and Sugden (1982) have suggested that people maximize the expected value
of a "modified utility function" which is a function o f the utility they achieve from a
choice as well as the utility they would have achieved from another choice that was
considered. Bell (1982) proposed a similar analysis.
Regret theory may apparently help explain the fact that investors defer selling stocks
that have gone down in value and accelerate the selling o f stocks that have gone up in
value, Shefrin and Statmau (1985). Regret theory may be interpreted as implying that

5 Siegel (1998). It should be noted that one must push the investor horizon up to a fairly high number,
around 30 years, before one finds that historically stocks have always outperformed bonds since 1861;
for ten-year periods of time one finds that bonds oRen outperform stocks. There are not many thirty-year
periods in stock market history, so this information might be judged as insubstantial. Moreover, Siegel
notes that even with a thirty-year period stocks did not always outperform bonds in the US before 1861.

1314

R.,~ Shiller

investors avoid selling stocks that have gone down in order not to finalize the error
they make and not to feel the regret. They sell stocks that have gone up in order that
they cannot regret failing to do so before the stock later fell, should it do so. That such
behavior exists has been documented using volume of trade data by Ferris, Haugen and
Makhija (1988) and Odean (1996).
Cognitive dissonance is the mental conflict that people experience when they are
presented with evidence that their beliefs or assumptions are wrong; as such, cognitive
dissonance might be classified as a sort of pain of regret, regret over mistaken beliefs.
As with regret theory, the theory of cognitive dissonance [Festinger (1957)] asserts
that there is a tendency for people to take actions to reduce cognitive dissonance
that would not normally be considered fully rational: the person may avoid the new
information or develop contorted arguments to maintain the beliefs or assumptions.
There is empirical support that people often make the errors represented by the theory
of cognitive dissonance. For example, in a classic study, Erlich, Guttman, Schopenback
and Mills (1957) showed that new car purchasers selectively avoid reading, after the
purchase is completed, advertisements for car models that they did not choose, and
are attracted to advertisements for the car they chose.
McFadden (1974) modeled the effect of cognitive dissonance in terms of a
probability of forgetting contrary evidence and showed how this probability will
ultimately distort subjective probabilities. Goetzmann and Peles (1993) have argued
that the same theory of cognitive dissonance could explain the observed phenomenon
that money flows in more rapidly to mutual funds that have performed extremely well
than flows out from mutual funds that have performed extremely poorly: investors in
losing funds are unwilling to confront the evidence that they made a bad investment
by selling their investments.

3. Anchoring
It is well-known that when people are asked to make quantitative assessments their
assessments are influenced by suggestions. An example of this is found in the results
survey researchers obtain. These researchers often ask people about their incomes
using questionnaires in which respondents are instructed to indicate which of a number
of income brackets, shown as choices on the questionnaire, their incomes fall into. It
has been shown that the answers people give are influenced by the brackets shown
on the questionnaire. The tendency to be influenced by such suggestions is called
"anchoring" by psychologists.
In some cases, at least, anchoring may be rational behavior for respondents. They
may rationally assume that the deviser of the questionnaire uses some information (in
this case, about typical people's incomes) when devising the questionnaire. Not fully
remembering their own income, they may rely on the information in the brackets to
help them answer better. If the brackets do contain information, then it is rational for
subjects to allow themselves to be influenced by the brackets.

Ch. 20:

Human Behavior and the EJficiency of the Financial System

1315

While anchoring undoubtedly has an information-response component in many

circumstances, it has also been shown that anchoring behavior persists even when
information is absent. In one experiment Tversky and Kahneman (1974), subjects were
given simple questions whose answers were in percentages, e.g., the percentage of
African nations in the United Nations. A wheel of fortune with numbers from 1 to 100
was spun before the subjects. Obviously, the number at which the wheel of fortune
stopped had no relevance to the question just asked. Subjects were asked whether their
answer was higher or lower than the wheel of fortune number, and then to give their
own answer. Respondents' answers were strongly influenced by the "wheel of fortune."
For example, the median estimates of the percentage of African countries in the United
Nations were 25 and 45 for groups that received 10 and 65, respectively, as starting
points (p. 184).
Values in speculative markets, like the stock market, are inherently ambiguous. Who
would know what the value of the Dow Jones Industrial Average should be? Is it
really "worth" 6000 today? Or 5000 or 7000? or 2000 or 10000? There is no agreed~
upon economic theory that would answer these questions. In the absence of any better
information, past prices (or asking prices or prices of similar objects or other simple
comparisons) are likely to be important determinants of prices today.
That anchoring affects valuations, even by experts, was demonstrated by Northcraft
and Neale (1987) in the context of real estate valuation. All subjects were taken to
a house for sale, asked to inspect the house for up to 20 minutes, and were given
a ten-page packet of information about the house and about other houses in the
area, giving square footage and characteristics of the properties, and prices of the
other properties. The same packet was given to all subjects except that the asking
price of the property under consideration and its implied price per square foot were
changed between subjects. Subjects were asked for their own opinions of its appraisal
value, appropriate listing price, purchase price, and the lowest offer the subject would
accept for the house if the subject were the seller. The real estate agents who were
given an asking price of $119900 had a mean predicted appraisal value of $114204,
listing price of $1 l 7 745, purchase price of $111454 and a lowest acceptable offer of
$11l 136, while the real estate agents who were given an asking price of $149900
had a mean appraisal value of $128 754, listing price of $130 981, predicted purchase
price of $127318, and a lowest offer of $123818. The changed asking prices thus
swayed their valuations by 11% to 14% of the value of the house. Similar results
were found with amateur subjects. While this experiment does not rule out that the
effect of the asking price was due to a rational response to the assumed information in
the asking price, the effects of asking price are remarkably large, given that so much
other information on the house was also given. Moreover, when subjects were asked
aftelwards to list the items of information that weighed most heavily in their valuations,
only 8% of the expert subjects and only 9% of the amateur subjects listed asking price
of the property under consideration among the top three items. Note that the valuation
problem presented to these subjects is far less difficult or ambiguous than the problem
of determining the "correct" value for the stock market, since here they are implicitly

1316

R.J. Shiller

being asked to assume that the comparable properties are correctly valued. [See also
McFadden (1974) and Silberman and Klock (1989).]
One might object that the notion that anchoring on past prices helps determine
present prices in the stock market might be inconsistent with the low serial correlation
of stock price changes, that is with the roughly random-walk behavior of daily or
monthly stock prices that has been widely noted 6. This conclusion is not warranted
however. Models of "smart money" (i.e., people who are unusually alert to profit
opportunities in financial markets) seeking to exploit serial correlation in price, models
which also include ordinary investors, are consistent with the implications that serial
correlation is low and yet the anchoring remains important for the level of stock prices
[see Shiller (1984, 1990)].
By extension from these experimental results, it is to be presumed that very many
economic phenomena are influenced by anchoring. Gruen and Gizycki (1993) used
it to explain the widely observed anomaly 7 that forward discounts do not properly
explain subsequent exchange rate movements. The anchoring phenomenon would
appear relevant to the "sticky prices" that are so talked about by macroeconomists.
So long as past prices are taken as suggestions of new prices, the new prices will tend
to be close to the past prices. The more ambiguous the value of a commodity, the more
important a suggestion is likely to be, and the more important anchoring is likely to
be for price determination.
The anchoring phenomenon may help to explain certain international puzzles
observed in financial markets. US investors who thought in the late 1980s that Japanese
stock price-earnings ratios were outrageously high then may have been influenced
by the readily-available anchor of (much lower) US price-earnings ratios. By the
mid 1990s, many US investors felt that the Tokyo market is no longer overpriced [see
Shiller, Kon-Ya and Tsutsui (1996)]. The price-earnings ratios remain much higher
than in the US perhaps because of the anchor of the widely-publicized high Tokyo
price-earnings ratios of the late 1980s.
Anchoring may also be behind certain forms of money illusion. The term money
illusion, introduced by Fisher (1928), refers to a human tendency to make inadequate
allowance, in economic decisions, for the rate of inflation, and to confuse real and
nominal quantities. Shafir, Diamond and Tversky (1997) have shown experimentally
that people tend to give different answers to the same hypothetical decision problem
depending on whether the problem was presented in a way that stressed nominal

6 The notion that speculative prices approximately describe "random walks" was tirst proposed by
Bachelier (1900). It became widely associated with the efficientmarkets hypothesis, the hypothesis that
market prices efficientlyincorporate all availablehlformation, with the work of Fama (1970). For further
information on the literature on the random walk and efficient markets theory see also Cootner (1964),
Malkiel (1981), and Fama (1991).
7 For a discussion of the anomaly, see Backus et al. (1995) and Froot and Thalcr (1990)

Ch. 20." Human Behavior and the Efficiency o f the Financial System

1317

quantities or in a way that stressed real quantities. The quantities that were shown
in the question (whether nominal or real) may have functioned as anchors 8.

4. Mental compartments
Related to the anchoring and framing phenomena is a human tendency to place
particular events into mental compartments based on superficial attributes. Instead of
looking at the big picture, as would be implied by expected utility theory, they look
at individual small decisions separately.
People may tend to place their investments into arbitrarily separate mental
compartments, and react separately to the investments based on which compartment
they are in. Shefrin and Statman (1994) have argued that individual investors think
naturally in terms o f having a "safe" part of their portfolio that is protected from
downside risk and a risky part that is designed for a chance o f getting rich. Shefrin and
Thaler (1988) have argued that people put their sources of income into three categories,
current wage and salary income, asset income, and future income, and spend differently
out of the present values of these different incomes. For example, people are reluctant
to spend out of future income even if it is certain to arrive.
The tendency for people to allow themselves to be influenced by their own mental
compartments might explain the observed tendency for stock prices to jump up when
the stock is added to the Standard and Poor Stock Index [see Shleifer (1986)]. It might
also help explain the widely noted "January effect" anomaly. This anomaly, that stock
prices tend to go up in January, has been observed in as many as 15 different countries
[Gultekin and Gultekin (1983)]. The anomaly cannot be explained in terms o f effects
related to the tax year, since it persists also in Great Britain (whose tax year begins
in April) and Australia (whose tax year begins in July), see Thaler (1987). If people
view the year end as a time of reckoning and a new year as a new beginning, they
may be inclined to behave differently at the turn o f the year, and this may explain the
January effect.
A tendency to separate out decisions into separate mental compartments may also
be behind the observed tendency for hedgers to tend to hedge specific trades, rather
than their overall profit situation. Ren6 Stulz (1996, p. 8), in summarizing the results of
his research and that o f others on the practice o f risk management by firms, concludes
that:
It immediately follows from the modern theory of risk management that one should be concerned
about factors that affect the present value of future cash flows. This is quite different from much
of the current practice of risk management where one is concerned about hedging transaction
risk or the risk of transactions expected to occur in the short rtm.

s There appears to be much more to money illusion than just anchoring; people associate nominal
quantities with opinions about the economy, anticipated behavior of the government, fairness, and
prestige, opinions that are not generally shared by economists, see Shiller (1997a,b).

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R.J. Shiller

The Wharton/CIBC Wood Gundy 1995 Survey of Derivatives Usage by US

Non-Financial Firms [Bodnar and Marston (1996)] studied 350 firms: 176 firms in
the manufacturing sector, 77 firms in the primary products sector, and 97 firms
in the service sector. When asked by the Wharton surveyors what was the most
important objective of hedging strategy, 49% answered managing "volatility in
cashflows", 42% answered managing "volatility in accounting earnings", and only 8%
answered managing "the market value o f the firm" (1% answered "managing balance
sheet accounts and ratios"). Fifty percent o f the respondents in the survey reported
frequently hedging contractual commitments, but only 8% reported frequently hedging
competitive/economic exposure.
It is striking that only 8% reported that their most important objective is the
market value of the firm, since maximizing the market value of the firm is, by
much financial theory, the ultimate objective of the management of the firm. It is o f
course hard to know just what people meant by their choices of answers, but there
is indeed evidence that firms are driven in their hedging by the objective o f hedging
specific near-term transactions, and neglect consideration o f future transactions or other
potential factors that might also pose longer run risks to the firm. In the Wharton
study, among respondents hedging foreign currency risks, 50% reported hedging
anticipated transactions less than one year off, but only 11% reported frequently
hedging transactions more than one year off. This discrepancy is striking, since most
o f the value of the firm (and most o f the concerns it has about its market value) must
come in future years, not the present year 9.

5. Overconfidence, over- and under-reaction and the representativeness

heuristic
People often tend to show, in experimental settings, excessive confidence about their
own judgments. Lichtenstein, Fischhoff and Phillips (1977) asked subjects to answer
simple factual questions (e.g., "Is Quito the capital o f Ecuador?") and then asked them
to give the probability that their answer was right: subjects tended to overestimate the
probability that they were right, in response to a wide variety of questions.
Such studies have been criticized [see Gigerenzer (1991)] as merely reflecting
nothing more than a difference between subjective and frequentist definitions o f

9 Recent surveys of hedging behavior of firms indicates that despite extensive development of derivative
products, actual use of these products for hedging is far from optimal. Of the firms cited in the Wharton
study, only 40.5% reported using derivatives at all. On the other hand, Dolde (1993) surveyed 244
Fortune 500 companies and concluded that over 85% used swaps, forwards, futures or options in
managing financial risk. Nance et al. (1993) in a survey of 194 farms reported that 62% used hedging
instruments in 1986. These studies concentrated on rather larger companies than did the Wharton study.
Overall, these studies may be interpreted as revealing a suq~risingly low fraction of respondents who
do any hedging, given that firms are composed of many people, any one of whom might be expected to
initiate the use of derivatives at least tbr some limited purpose.

Ch. 20:

Human Behavior and the Efficiency of the Financial System

1319

probability, i.e., critics claimed that individuals were simply reporting a subjective
degree of certainty, not the fraction times they are right in such circumstances.
However, in reaction to such criticism, Fischhoff, Slovic and Lichtenstein (1977)
repeated the experiments asking the subjects for probability odds that they are right and
very clearly explaining what such odds mean, and even asking them to stake money on
their answer. The overconfidence phenomenon persisted. Moreover, in cases where the
subjects said they were certain they were right, they were in fact right only about 80%
of the time: there is no interpretation o f subjective probability that could reconcile this
result with correct judgments.
A tendency towards overconfidence among ordinary investors seems apparent when
one interviews them. One quickly hears what seem to be overconfident statements. But
how can it be that people systematically are so overconfident? Why wouldn't people
learn from life's experiences to correct their overconfidence?
Obviously, people do learn substantially in circumstances when the consequences
of their errors are repeatedly presented to them, and sometimes they even overreact
and show too little confidence. But still there seems to be a common bias towards
overconfidence. Overconfidence is apparently related to some deep-set psychological
phenomena: Ross (1987) argues that much overconfidence is related to a broader
difficulty with "situational construal", a difficulty in making adequate allowance for
the uncertainty in one's own view o f the broad situation, a more global difficulty
tied up with multiple mental processes. Overconfidence may also be traced to the
"representativeness heuristic", Tversky and Kahneman (1974), a tendency for people
to try to categorize events as typical or representative of a well-known class, and then,
in making probability estimates, to overstress the importance o f such a categorization,
disregarding evidence about the underlying probabilities 10. One consequence o f this
heuristic is a tendency for people to see patterns in data that are truly random, to feel
confident, for example, that a series which is in fact a random walk is not a random
walk l l
Overconfidence itself does not imply that people overreact (or underreact) to all
news. In fact, evidence on the extent o f overreaction or underreaction of speculative
asset prices to news has been mixed.
There has indeed been evidence of overreaction. The first substantial statistical
evidence for what might be called a general market overreaction can be found in
the literature on excess volatility o f speculative asset prices, Shiller (1979, 1981a,b)
and LeRoy and Porter (1981). We showed statistical evidence that speculative asset
prices show persistent deviations from the long-term trend implied by the presentvalue efficient markets model, and then, over horizons o f many years, to return to this

l0 People tend to neglect "base rates", the unconditional probabilities or frequencies of events, see
Meehl and Rosen (1955).
tt Rabin (1998) characterizes this judgment error as a tendency to over-intbr the probability distribution
from short sequences. Part of overconfidence may be nothing more than simple tbrgetting of contrary
evidence; a tendency to forget is by its very nature not something that one can learn to prevent.

1320

R.J Shiller

trend. This pattern o f price behavior, it was argued, made aggregate stock prices much
more volatile than would be implied by the efficient markets model. It appears as i f
stock prices overreact to some news, or to their own past values, before investors come
to their senses and correct the prices. Our arguments led to a spirited debate about the
validity o f the efficient markets model in the finance literature, a literature that has too
many facets to summarize here, except to say that it confirms there are many potential
interpretations o f any statistical results based on limited data 12. M y own view o f the
outcome o f this debate is that it is quite likely that speculative asset prices tend to be
excessively volatile. Certainly, at the very least, one can say that no one has been able
to put forth any evidence that there is not excess volatility in speculative asset prices.
For an evaluation o f this literature, see Shiller (1989), Campbell and Shiller (1988,
1989), West (1988), and Campbell, Lo and MacKinlay (1997, ch. 7).
Since then, papers by De Bondt and Thaler (1985), Fama and French (1988), Poterba
and Summers (1988), and Cutler, Poterba and Summers (1991) have confirmed the
excess volatility claims by showing that returns tend to be negatively autocorrelated
over horizons o f three to five years, that an initial overreaction is gradually corrected.
Moreover, Campbell and Shiller (1988, 1989) show that aggregate stock market
dividend yields or earnings yields are positively correlated with subsequently observed
returns over similar intervals; see also Dreman and Berry (1995)13. Campbell and
Shiller (1998) connect this predictive power to the observed stationarity o f these ratios.
Since the ratios have no substantial trend over a century and appear mean reverting
over nmch shorter time intervals, the ratio must predict future changes in either the
numerator (the dividend or earnings) or the denominator (the price); we showed that it
has been unequivocally the denominator, the price, that has restored the ratios to their
mean after they depart from it, and not the numerator. La Porta (1996) found that
stocks for which analysts projected low earnings growth tended to show upward price
j u m p s on earnings announcement dates, and stocks for which analysts projected high
earnings growth tended to show downward price jumps on earnings announcement
dates. He interprets this as consistent with a hypothesis that analysts (and the market)
excessively extrapolated past earnings movements and only gradually correct their
errors as earnings news comes in. The behavior o f initial p u n i c offerings around

t2 There has been some confusion about the sense in which the present=value efficient markets model
puts restrictions on tile short-run (or high-frequency) movements in speculative asset prices. The issues
are laid out in Shiller (1979), (appendix). Kleidon (1986) rediscovered the same ideas again but gave a
markedly different interpretation of the implications for tests of market efficiency.
13 An extensive summary of the literature on serial correlation of US stock indcx returns is in Campbell
et al. (1997). Chapter 2 documents the positive serial correlation of returns over short horizons but
concludes that the evidence for negative serial correlation of returns over long horizons is weak.
Chapter 7, however, shows evidence that long-horizon returns are negatively correlated with the price
earnings ratio and price-dividend ratio. Recent critics of claims that long-horizon returns can be
forecasted include Goctzmann and Jorion (1993), Nelson and Kim (1993) and Kirby (1997). In my
view, they succeed in reducing the force of the evidence, but not the conclusion that long-horizon
returns are quite probably forecastab/e.

Ch. 20:

Human Behavior and the Efficiency of the Financial System

1321

announcement dates appears also to indicate some overreaction and later rebound, see
Ibbotson and Ritter (1988) and Ritter (1991).
On the other hand, there has also been evidence o f what might be called
underreaction. Most days when big news breaks have been days o f only modest stock
market price movements, the big movements tending to come on days when there is
little news, see Cutler, Poterba and Summers (1989). Cutler, Poterba and Summers
(1991) also found that for a number o f indices o f returns on major categories o f
speculative assets there has been a tendency for positive autocorrelation o f short-run
returns over short horizons, less than a year; see also Jegadeesh and Titman (1993) and
Chart, Jegadeesh and Lakonishok (1996)14. This positive serial correlation in return
indices has been interpreted as implying an initial underreaction o f prices to news, to be
made up gradually later. Bernard and Thomas (1992) found evidence o f underreaction
of stock prices to changes, from the previous year, in company earnings: prices react
with a lag to earnings news; see also Ball and Brown (1968)15. Irving Fisher (1930,
ch. XXI, pp. 493-494) thought that, because o f human error, nominal interest rates
tend to underreact to inflation, so that there is a tendency for low real interest rates in
periods o f high inflation, and high real rates in periods o f low inflation. More recent
data appear to confirm this behavior o f real interest rates, and data on inflationary
expectations also bear out Fisher's interpretation that the phenomenon has to do with
human error; see De Bondt and Bange (1992) and Shefrin (1997) tr.
Does the fact that securities prices sometimes underreact pose any problems for the
psychological theory that people tend to be overconfident? Some observers seem to
think that it does. In fact, however, overconfidence and overreaction are quite different
phenomena. People simply cannot overreact to everything: if they are overconfident
they will make errors, but not in any specified direction in all circumstances. The
concepts o f overreaction or underreaction, while they may be useful in certain contexts,
are not likely to be good psychological foundations on which to organize a general
theory o f economic behavior.
The fact that both overreaction and underreaction are observed in financial markets
has been interpreted b y Fama (1997) as evidence that the anomalies from the standpoint

14 Lo and MacKinlay (1988) and Lehmann (1990), however, find evidence of negative serial corrclation
of individual weekly stock returns between successive weeks. As explained by Lo and MacKinlay (1990),
weekly returns on portfolios of these same stocks still exhibit positive serial correlation from week to
week because the cross-covariances between returns of individual stocks arc positive. They conclude
that this pattern of cross-covariances is not what one would expect to find based on theories of investor
inertia. Lehmann, however, has a different interpretation of the negative week-to-week serial correlation
of individual weekly stock returns, that the negative serial correlation reflects nothing more than the
behavior of market makers facing order imbalances and asymmetric information.
~5 Firms' management appear acutely aware that earnings growth has a psychological impact on prices,
and so attempt to manage earnings accotmting to provide a steady growth path. Impressive evidence
that they do so is found in Degeorge et al. (1999).
16 Modigliani and Cohn (1979) argue that public failure to understand the relation of interest rates to
inflation has caused the stock market to overreact to nominal interest rate changes.

1322

R.J. Shiller

of efficient markets theory are just "chance results", and that therefore the theory
of market efficiency survives the challenge of its critics. He is right, of course, that
both overreaction and underreaction together may sometimes seem a little puzzling.
But one is not likely to want to dismiss these as "chance results" if one has an
appreciation for the psychological theory that might well bear on these phenomena.
In his survey of behavioral finance Fama (1997) makes no more than a couple of
oblique references to any literature from the other social sciences. In fact, Fama
states that the literature on testing market efficiency has no clearly stated alternative,
"the alternative hypothesis is vague, market inefficiency" (p. 1). Of course, if one
has little appreciation of these alternative theories then one might well conclude
that the efficient markets theory, for all its weaknesses, is the best theory we have.
Fama appears to believe that the principal alternative theory is just one of consistent
overreaction or underreaction, and says that "since the anomalies literature has not
settled on a testable alternative to market efficiency, to get the ball rolling, I assume
that reasonable alternatives must predict either over-reaction or under-reaction" (p. 2).
The psychological theories reviewed here cannot be reduced to such simple terms,
contrary to Fama's expectations.
Barberis, Shleifer and Vishny (1997) provide a psychological model, involving the
representativeness heuristic as well as a principle of conservatism [Edwards (1968)],
that offers a reconciliation of the overreaction and underreaction evidence from
financial markets; see also Daniel, Hirshleifer and Subrahmanyam (1997) and Wang
(1997). More work could be done in understanding when it is that people overreact in
financial markets and when it is that they underreact. Understanding these overreaction
and underreaction phenomena together appears to be a fertile field for research at
the present time. There is neither reason to think that it is easy obtain such an
understanding, nor reason to despair that it can ever be done.
Overconfidence may have more clear implications for the volume of trade in
financial markets than for any tendency to overreact. If we connect the phenomenon of
overconfidence with the phenomenon of anchoring, we see the origins of differences of
opinion among investors, and some of the source of the high volume of trade among
investors. People may fail to appreciate the extent to which their own opinions are
affected by anchoring to cues that randomly influenced them, and take action when
there is little reason to do so.
The extent of the volume of trade in financial markets has long appeared to be
a puzzle. The annual turnover rate (shares sold divided by all shares outstanding) for
New York Stock Exchange Stocks has averaged 18% a year from the 1950s through the
1970s and has been much higher in certain years. The turnover rate was 73% in 1987
and 67% in 1930. It does not appear to be possible to justify the number of trades
in stocks and other speculative assets in terms of the normal life-cycle ins and outs
of the market. Theorists have established a "nonspeculation theorem" that states that
rational agents who differ from each other only in terms of information and who have
no reason to trade in the absence of information will not trade [Milgrom and Stokey
(1982), Geanakoplos (1992)].

Ch. 20:

Human Behaoior and the Efficiency of the Financial System

1323

Apparently, many investors do feel that they do have speculative reasons to trade
often, and apparently this must have to do with some tendency for each individual
to have beliefs that he or she perceives as better than others' beliefs. It is as if most
people think they are above average.
Odean (1998), in analyzing individual customer accounts at a nationwide discount
brokerage house, examined the profits that customers made on trades that were
apparently not motivated by liquidity demands, tax loss selling, portfolio rebalancing,
or a move to lower-risk securities. On the remaining trades, the returns on the stocks
purchased was on average lower, not higher, than on those sold. This appears to be
evidence of overconfidence among these investors.
Within the week of the stock market crash of October 19, 1987 1 sent out
questionnaires to 2000 wealthy individual investors and 1000 institutional investors,
asking them to recall their thoughts and reasons for action on that day; see Shiller
(1987b). There were 605 completed responses from individuals and 284 responses
from institutions. One of the questions I asked was: "Did you think at any point on
October 19, 1987 that you had a pretty good idea when a rebound was to occur?" Of
individual investors, 29.2% said yes, of institutional investors, 28.0% said yes. These
numbers seem to be surprisingly high: one wonders why people thought they knew
what was going to happen in such an unusual situation. Among those who bought
on that day, the numbers were even higher, 47.1% and 47.9% respectively. The next
question on the questionnaire was "If yes, what made you think you knew when a
rebound was to occur?" Here, there was a conspicuous absence of sensible answers;
often the answers referred to "intuition" or "gut feeling." It would appear that the
high volume of trade on the day of the stock market crash, as well as the occurrence,
duration, and reversal of the crash was in part determined by overconfidence in such
intuitive feelings 17
If people are not independent of each other in forming overconfident judgments
about investments, and if these judgments change collectively through time, then these
"noisy" judgments will tend to cause prices of speculative assets to deviate from their
true investment value. Then a "contrarian" investment strategy, advocated by Graham
and Dodd (1934) and Dreman (1977) among many others, a strategy of investing in
assets that are currently out of favor by most investors, ought to be advantageous.
Indeed, there is much evidence that such contrarian investment strategy does pay off,
see for example, De Bondt and Thaler (1985), Fama and French (1988, 1992), Fama
(1991), and Lakonishok, Shleifer and Vislmy (1994). That a simple contrarian strategy
may be profitable may appear to some to be surprising: one might think that "smart
money", by competing with each other to benefit from the profit opportunities, would
ultimately have the effect of eliminating any such profit opportunities. But, there are

17 See also Case and Shiller (1988) ~br a similar analysis of recent real estate booms and busts. On the
other hand, Garber (1990) analyzes some famous speculative bubbles, including the tulipomania in the
17th century, and concludesthat they may have been rational.

1324

R.J. Shiller

reasons to doubt that such smart money will indeed have this effect; see Shiller (1984),
DeLong et al. (1990a,b), and Shleifer and Vishny (1995)Is.

6. The disjunction effect

The disjunction effect is a tendency for people to want to wait to make decisions until
information is revealed, even if the information is not really important for the decision,
and even if they would make the same decision regardless o f the information. The
disjunction effect is a contradiction to the "sure-tbing principle" of rational behavior
[Savage (1954)].
Experiments showing the disjunction effect were performed by Tversky and Shafir
(1992). They asked their subjects whether they would take one o f the bets that
Samuelson's lunch colleague, discussed above, had refused a coin toss in which one has
equal chances to win $200 or lose $100. Those who took the one bet were then asked
whether they wanted to take another such bet. If they were asked after the outcome
o f the first bet was known, then it was found that a majority o f respondents took the
second bet whether or not they had won the first. However, a majority would not take
the bet if they had to make the decision before the outcome of the bet was known.
This is a puzzling result: if one's decision is the same regardless of the outcome of the
first bet, then it would seem that one would make the same decision before knowing
the outcome. Tversky and Shafir gave their sense of the possible thought patterns that
accompany such behavior: if the outcome o f the first bet is known and is good, then
subjects think that they have nothing to lose in taking the second, and if the outcome
is bad they want to try to recoup their losses. But if the outcome is not known, then
they have no clear reason to accept the second bet.
The disjunction effect might help explain changes in the volatility of speculative
asset prices or changes in the volume o f trade of speculative asset prices at times
when information is revealed. Thus, for example, the disjunction effect can in principle
explain why there is sometimes low volatility and low volume of trade just before an
important announcement is made, and higher volatility or volume of trade after the
announcement is made. Shafir and Tversky (1992) give the example o f presidential
elections, which sometimes induce stock market volatility when the election outcome
is known even though many skeptics may doubt that the election outcome has any
clear implications for market value.

18 Even public expectations of a stock market crash does not prevent the stock market fiom rising;
there is evidence from options prices that the stock market crash of 1987 was in some sense expected
before it happened; see Bates (1991, 1995). Lee et al. (1991) argue that investor expectations, or rather
"sentiment" can be measured by closed-end mutual fund discounts, which vary through time.

Ch. 20:

Human Behavior and the Ejficiency of the Financial System

1325

7. Gambling behavior and speculation

A tendency to gamble, to play games that bring on unnecessary risks, has been found to
pervade widely divergent human cultures around the world and appears to be indicative
of a basic human trait, Bolen and Boyd (1968). Kallick et al. (1975) estimated that
61% of the adult population in the United States participated in some form of gambling
or betting in 1974. They also estimated that 1.1% of men and 0.5% of women are
"probably compulsive gamblers", while an additional 2.7% of men and 1% of women
are "potential compulsive gamblers." These figures are not trivial, and it is important
to keep in mind that compulsive gambling represents only an extreme form of the
behavior that is more common.
The tendency for people to gamble has provided a puzzle for the theory of human
behavior under uncertainty, since it means that we must accommodate both riskavoiding behavior (as evidenced by people's willingness to purchase insurance) with
an apparent risk-loving behavior. Friedman and Savage (1948) proposed that the
co-existence of these behaviors might be explained by utility functions that become
concave upward in extremely high range, but such an explanation has many problems.
For one thing, people who gamble do not appear to be systematically risk seekers in any
general sense, instead they are seeking specific forms of entertainment or arousal 19.
Moreover, the gambling urge is compartmentalized in people's lives, it tends to take
for each individual only certain forms: people specialize in certain games. The favored
forms of gambling tend to be associated with a sort of ego involvement: people may
feel that they are especially good at the games they favor or that they are especially
lucky with these.
The complexity of human behavior exemplified by the gambling phenomenon has to
be taken into account in understanding the etiology of bubbles in speculative markets.
Gamblers may have very rational expectations, at some level, for the likely outcome of
their gambling, and yet have other feelings that drive their actual behavior. Economists
tend to speak of quantitative "expectations" as if these were the only characterization
of people's outlooks that mattered. It is my impression, from interviews and survey
results, that the same people who are highly emotionally involved with the notion that
the stock market will go up may give very sensible, unexciting forecasts of the market
if asked to make quantitative forecasts.
8. The irrelevance of history
One particular kind of overconfidence that appears to be common is a tendency to
believe that history is irrelevant, not a guide to the future, and that the future must
19 According to the American Psychiatric Association's DSM-1V (1994), "Most individuals with
Pathological Gambling say that they are seeking 'action' (an aroused, euphoric state) even more than
money. Increasinglylarger bets, or greater risks, may be needed to continue to produce the desired level
of excitement" (p. 616).

1326

R.A Shiller

be judged afresh now using intuitive weighing only of the special factors we see now.
This kind of overconfidence discourages taking lessons from past statistics; indeed
most financial market participants virtually never study historical data for correlations
or other such statistics; they take their anchors instead from casual recent observations.
Until academic researchers started collecting financial data, most was just thrown away
as irrelevant.
One reason that people may think that history is irrelevant is a human tendency
toward historical determinism, a tendency to think that historical events should have
been known in advance. According to historian Florovsky (1969, p. 364):
in retrospect we seem to perceive the logic of events, which unfold themselves in a regular order,
according to a recognizable pattern, with an alleged inner necessity, so that we get the impression
that it really could not have happened otherwise.
Fischhoff (1975) attempted to demonstrate this tendency towards historical determinism by presenting experimental subjects with incomplete historical stories, stories
that are missing the final outcome o f the event. The stories were from historical periods
remote enough in time that the subjects would almost certainly not know the actual
outcome. Subjects were asked to assign probabilities to each of four different possible
conclusions to the story (only one of which was the true outcome). There were two
groups of subjects, one of which was told that one of the four outcomes had in fact
happened. The probability given to the outcomes was on average 10% higher when
people were told it was the actual outcome.
Fischhoff's demonstration o f a behavior consistent with belief in historical determinism may not demonstrate the full magnitude of such behavior, because it does
not capture the effects of social cognition o f past events, a cognition that may tend
to remember historical facts that are viewed as causing subsequent historical events,
or are comaected to them, and to forget historical facts that seem not to fit in with
subsequent events. It will generally be impossible to demonstrate such phenomena of
social cognition in short laboratory experiments.
A human tendency to believe in historical determinism would tend to encourage
people to assume that past exigencies (the stock market crash of 1929, the great
depression, the world wars, and so on) were probably somewhat known in advance, or,
at least, that before these events people had substantial reason to worry that they might
happen. There may tend to be a feeling that there is nothing definite on the horizon
now, as there presumably was before these past events 2o. It is in this human tendency
toward believing history is irrelevant that the equity premium puzzle, discussed above,
may have its most important explanation. People may tend just not to think that the
past stock market return history itself gives any indication of the future, at least not
until they perceive that authorities are in agreement that it does.

20 This ~belmg can of course be disrupted, if a sudden event calls to mind parallels to a past event, or
if the social cognition memorializes and interprets a past event as likely to be repeated.

Ch. 20:

Human Behavior and the EJficiency o f the Financial System

1327

According to the representativeness heuristic, discussed above, people may see past
return history as relevant to the future only if they see the present circumstances as
representative in some details o f widely remembered past periods. Thus, for example,
the public appears to have made much, just before the stock market crash o f 1987, o f
similarities in that period to the period just before the crash o f 1929. Newspapers,
including the Wall S t r e e t J o u r n a l on the morning o f the stock market crash o f
October 19, 1987, showed plots o f stock prices before October 1929 superimposed
on a plot o f stock prices before October 1987, suggesting comparisons. In this way,
historical events can be remembered and viewed as relevant, but this is not any
systematic analysis o f past data.
Lack o f learning from historical lessons regarding financial and economic uncertainties may explain why many investors show little real interest in diversification around
the world and why most investors appear totally uninterested in the correlation o f their
investments with their labor income, violating with their behavior one o f the most
fundamental premises o f financial theory. Most people do not make true diversification
around the world a high priority, and virtually no one is short the company that he or
she works for, or is short the stock market in one's own country, as would be suggested
by economic theory 21 .
A prominent reason that most people appear apathetic about schemes to protect
them from price level uncertainty in nominal contracts is that they just do not seem to
think that past actual price level movements are any indicator o f future uncertainty. In
a questionnaire I distributed [Shiller (1997a)] to a random sample from phone books
in the U S A and Turkey, the following question was posed:
We want to know how accurately you think that financial experts in America (Turkey) can predict
the price level in 2006, ten years from now. Can you tell us, if these experts think that a "market
basket" of goods and services that the typical person buys will cost $1,000 (100 million TL)
in 2006, then you think it will probably actually cost:
(Please fill in your lower and upper bounds on the price:)
Between $
(TL) and $
(TL)
The median ratio between high and low was 4/3 for US respondents and 3/2 for
Turkish respondents. Only a few respondents wrote numbers implying double- or tripledigit ratios, even in Turkey. The ratios not far from one that most respondents revealed
would seem to suggest excessive confidence in the predictability o f price levels. Note
that in Turkey the CPI increased three-fold between 1964 and 1974, 31-fold between
1974 and 1984, and 128-fold between 1984 and 1994. But, Turkish respondents appear
to connect the price level movements with prior political and social events that may be
perceived as having largely predicted the price movements, events that are themselves

2~ Kusko et al. (1997) showed, using data on 10000 401k plan participants in a manufacturing firm,
found that barely 20% of participants directed any of their own balances into an S&P index fund, while
nearly 25% of participants directed all of their discretionary balances into a fund invested completely
in the own company stock.

R.J. Shiller

1328

not likely to be repeated in the same way. While these people have apparently learned
to take certain steps to protect themselves from price level uncertainty (such as not
investing in long-term nominal bonds), they do not appear to have a well-developed
understanding of the potential uncertainty of the Turkish Lira that would allow them
to deal systematically with such uncertainty. For example, they have shown relatively
little interest in government indexed bonds.

9. Magical thinking
B.E Skinner (1948) in what is now regarded as a classic experiment fed starved
experimental pigeons small quantities of food at regular fifteen-second intervals with
no dependence whatsoever on the bird's behavior. Even though the feeding was
unaffected by their behavior, the birds began to behave as if they had a "superstition"
that something in their behavior caused the feeding [see also McFadden (1974)]. Each
pigeon apparently conditioned itself to exhibit a specific behavior to get the food,
and because each bird exhibited its characteristic behavior so reliably, it was never
deconditioned:
One bird was conditioned to turn counter-clockwise in the cage, making two or three turns
between reinforcements. Another repeatedly thrust its head into one of the upper corners of the
cage. A third developed a " tossing" response, as if placing its head beneath an invisible bar and
lifting it repeatedly ...
Skinner (1948, p. 168)

Arbitrary behaviors that are so generated are referred to with the term "magical
thinking" by psychologists.
A wide variety of economic behaviors are likely to be generated in exactly the same
way that the arbitrary behaviors of the pigeons are generated. Thus, for example, firms'
investment or management decisions that happened to precede increases in sales or
profits may tend to be repeated, and if this happens in a period of rising profits (as
when the economy is recovering from a recession) the notion that these decisions were
the cause of the sales or profit increase will be reinforced. Because firms are similar
to each other and observe each other, the magical thinking may be social, rather than
individual, and hence may have aggregate effects.
Roll (1986), with his hubris hypothesis concerning corporate takeovers, aigued that
managers of bidder firms may become overconfident of their own abilities to judge
firms, because of their luck in their first takeovers. This overconfidence can cause
them to overbid in subsequent takeover attempts.
The tendency for speculative markets to respond to certain news variables may be
generated analogously. The US stock market used often to be buoyed by positive news
about the economy, but in recent years it appears to tend to be moved in the opposite
direction by such news. This new "perverse" movement pattern for the stock market is
sometimes justified in the media by a theory that the good news will cause the Federal
Reserve to tighten monetary policy and that then the higher interest rates will lower
the stock market. But the whole belief could be the result of a chain of events that was

Ch. 20:

Human Behavior and the Efficiency of the Financial System

1329

set off by some initial chance movements of the stock market. Because people believe
these theories they may then behave so that the stock price does indeed behave as
hypothesized, the initial correlations will persist later, and thereby reinforce the belief.

10. Quasi-magical thinking

The term quasi-magical thinldng, as defined by Shafir and Tversky (1992), is used to
describe situations in which people act as if they erroneously believe that their actions
can influence an outcome (as with magical thinking) but in which they in fact do not
believe this. It includes acting as if one thinks that one can take actions that will, in
effect, undo what is obviously predetermined, or that one can change history.
For example, Quattrone and Tversky (1984) divided subjects into a control and
experimental group and then asked people in both groups to see how long they could
bear to hold their hands in some ice water. In the experimental group, subjects were
told that people with strong hearts were better able to endure the ice water. They found
that those in the experimental group in fact held their hands in the ice water longer.
If indeed, as appears to be the case, those in the experimental group held their hands
in the ice water longer to prove that they had strong hearts, then this would be quasimagical, since no notion was involved that there was any causal link from holding
hands in ice water to strengthening the heart.
While this particular experimental outcome might also be explained as the
result of a desire for self deception, Shafir and Tversky report as well as other
experiments that suggest that people do behave as if they think they can change
predetermined conditions. Shafir and Tversky (1992) show, with an experimental
variant of Newcomb's Paradox, that people behave as if they can influence the amount
of money already placed in a box.
Quasi-magical thinking appears to operate more strongly when outcomes of future
events, rather than historical events, are involved. Langer (1975) showed that people
place larger bets if invited to bet before a coin is tossed than after (where the outcome
has been concealed), as if they think that they can better influence a coin not yet
tossed.
It appears likely that such quasi-magical thinking explains certain economic
phenomena that would be difficult to explain the basis of strictly rational behavior. Such
thinking may explain why people vote, and why shareholders exercise their proxies.
In most elections, people must know that the probability that they will decide the
election must be astronomically small, and they would thus rationally decide not to
vote. Quasi-magical thinking, thinking that in good societies people vote and so if
I vote I can increase the likelihood that we have a good society or a good company,
might explain such voting. The ability of labor union members or oligopolists to act
in concert with their counterparts, despite an incentive to free-ride, or defect, may also
be explained by quasi-magical thinking~

1330

R.J. Shiller

The disposition effect [Shefrin and Statman (1985)] referred to above, the tendency
for individuals to want to hold losers and sell winners might also be related to quasimagical thinking, if people feel at some level that holding on to losers can reverse
the fact that they have already lost. Public demand for stocks at a time when they are
apparently overvalued may be influenced by quasi-magical thinking, a notion that if
I hold, then the stocks will continue to rise.

11. Attention anomalies and the availability heuristic

William James (1890, p. 402) criticized earlier psychologists, who in their theories
effectively assumed that the human mind takes account o f all sensory input, for taking
no note of the phenomenon o f selective attention:
But the moment one thinks of the matter, one sees how false a notion of experience that is which
would make it tantamount to the mere presence to the senses of an outward order. Millions of
items of the outward order are present to nay senses which never properly enter into my experience.
Why? Because they have no interest for me. My experience is what 1 agree to attend to. Only
those items which l notice shape my mind - without selective interest, experience is utter chaos.
The same criticism might equally well be applied to expected utility maximization
models in economics, for assuming that people attend to all facts that are necessary
for maximization o f the assumed objective function [Berger (1994) elaborates on this
point].
Attention is associated with language; the structure of our language invites attention
to categories that are represented in the language. Taylor (1989) showed, for example,
that certain concepts o f "the self" were apparently absent from languages in the time o f
Augustine. The language shapes our attention to even the most inward o f phenomena.
In economics, certain terms were apparently virtually absent from popular discourse
fifty or more years ago: gross national product, the money supply, the consumer price
index. Now, many economists are wont to model individual attention to these concepts
as if they were part o f the external reality that is manifest to all normal minds.
Attention may be capricious because it is affected by the "salience" o f the
object; whether it is easily discerned or not [Taylor and Thompson (1982)] or by
the "vividness" o f the presentation, whether the presentation has colorful details.
Judgments may be affected, according to the "availability heuristic", that is, by the
"ease with which instances or associations come to mind" [Tversky and Kahneman
(1974)].
Investment fashions and fads, and the resulting volatility o f speculative asset prices,
appear to be related to the capriciousness o f public attention [Shiller (1984, 1987a)].
Investor attention to categories o f investments (stocks versus bonds or real estate,
investing abroad versus investing at home) seems to be affected by alternating waves
o f public attention or inattention. Investor attention to the market at all seems to
vary through time, and major crashes in financial markets appear to be phenomena

Ch. 20:

Human Behavior and the Efficiency of the Financial System

1331

of attention, in which an inordinate amount of public attention is suddenly focused on

the markets 22
Economic theories that are most successful are those that take proper account of
the limitations and capriciousness of attention. One reason that the hypothesis of no
unexploited arbitrage opportunities (a hypothesis that has led to the Black-Scholes
(1973) option pricing theory, the Ross (1976) arbitrage pricing theory, and other
constructs of finance) has been so successful is that it does not rely on pervasive public
attention. The essence of the no-arbitrage assumption, when it is used successfully to
produce theories in finance, is that the arbitrage opportunities, were they to ever exist,
would be exploited and eliminated even if only a tiny fraction of investors were paying
attention to the opportunity.

12. Culture and social contagion

The concept of culture, central to sociology and cultural anthropology ever since the
work of Tylor (1871), Durkheim (1893) and Weber (1947), is related to the selective
attention that the human mind exhibits. There is a social cognition, reenforced by
conversation, ritual and symbols, that is unique to each interconnected group of people;
to each nation, tribe, or social group. People tend not to remember well facts or ideas
that are not given attention in the social cognition, even though a few people may be
aware of such facts. If one speaks to groups of people about ideas that are foreign to
their culture, one may find that someone in the group will know of the ideas, and yet
the ideas have no currency in the group and hence have no influence on their behavior
at large.
The array of facts, suppositions, symbols, categories of thought that represent a
culture have subtle and far-reaching affects on human behavior. For a classic example,
Durkheim (1897), in a careful study of differing suicide rates across countries, found
that there was no apparent explanation for these differing rates other than cultural
differences.
Cultural anthropologists have used methods of inferring elements of primitive
culture by immersing themselves in the society, observing their everyday life, and
talking and listening to them nonjudgmentally, letting them direct the conversation.
From such learning, for example, Ltvy-Strauss (1966, pp. 9-10) wrote persuasively
that the customs of primitive people that we may tend to view as inexplicably savage
actually arise as a logical consequence of a belief system common to all who belong
to the society, a belief system which we can grow to understand only with great
difficulty:

22 There is evidence that the stock market crash of 1987 can be viewed in these terms, see Shiller
(1989).

1332

R.J Shiller

The real question is not whether the touch of a woodpecker's beak does in fact cure toothache. It
is rather whether there is a point of view from which a woodpecker's beak and a man's tooth can
be seen as "going together" (the use of this congruity for therapeutic purposes being only one of
its possible uses) and whether some initial order can be introduced into the universe by means
of these groupings.... The thought we call primitive is founded on this demand for order.
The same methods that cultural anthropologists use to study primitive peoples can
also be used to study modern cultures. O ' B a r r and C o N e y (1992) studied pension
fund managers using personal interviews and cultural anthropological methods. They
concluded that each pension fund has its own culture, associated often with a colorful
story o f the origin o f their own organization, akin to the creation myths o f primitive
peoples. The culture o f the pension fund is a belief system about investing strategy and
that culture actually drives investment decisions. Cultural factors were found to have
great influence because o f a widespread desire to displace responsibility for decisions
onto the organization, and because o f a desire to maintain personal relationships within
the organization 23.
Psychological research that delineates the factors that go into the formation o f
culture has been undertaken under the rubric o f social psychology and attitude change,
or under social cognition. There is indeed an enormous volume o f research in these
areas. For surveys, one may refer to McGuire (1985) for attitude change or Levine and
Resnick (1993) for social cognition.
One difficulty that these researchers have encountered with experimental work is
that o f disentangling the "rational" reasons for the imitation o f others with the purely
psychological. Some recent economic literature has indeed shown the subtlety o f
the informational influences on people's behavior (learning from each other), see
Bannerjee (1992), Bikhchandani et al. (1992), Leahy (1994), and Shiller (1995).

13. A global culture

We see many examples o f imitation across countries apparently widely separated by
both physical and language barriers. Fashions o f dress, music, and youthful rebellion,
are obvious examples. The convergence o f seemingly arbitrary fashions across nations
is evidence that something more is at work in producing internationally-similar human
behavior than just rational reactions to c o m m o n information sets relevant to economic
fundamentals, see Featherstone (1990).
A n d yet it will not be an easy matter for us to decide in what avenues global culture
exerts its influence [Hannerz (1990), p. 237]:
There is now a world culture, but we had better make sure that we understand what this means.
it is marked by an organization of diversity rather than by a replication of uniformity. No total

23 The psychologist Janis (1972) has documented with case studies how social patterns ("groupthink")
within decision making groups can cause even highly intelligent people to make disastrously wrong
decisions.

Ch. 20:

Human Behaoior and the Efficiency of the Financial System

1333

homogenizationof systems of meaning and expression has occurred, nor does it appear likely that
there will be one any time soon. But the world has become one network of social relationships,
and between its different regions there is a flow of meanings as well as of people and goods.
Sociologists have made it their business to study patterns of influence within
cultures, and we ought to be able to learn something about the nature of global culture
from their endeavors. For example, one study of patterns of influence regarded as a
classic among sociologists is the in-depth study of the town of Rovere by sociologist
Robert Merton (1957). After extensive study of the nature of interpersonal influence,
he sought meaningful ways to categorize people. He found that it was meaningful
to divide people into two broad categories: locals (who follow local news and derive
status by their connectedness with others) and cosmopolitans (who orient themselves
instead to world news and derive status from without the community). He found that
the influence of cosmopolitans on locals transcended both their numbers and their stock
of useful information. We must bear this conclusion in mind when deciding how likely
it is that incipient cultural trends are pervasive across many different nations.
Reading such sociological studies inclines us to rather different interpretations of
globally similar behaviors than might occur naturally to many traditional economists.
Why did the real estate markets in many cities around the world rise together into
the late 1980s and fall in the early 1990s? [See Goetzmarm and Wachter (1996)
and Hendershott (1997).] Why have the stock markets of the world moved somewhat
together? Why did the stock markets of the world show greater tendency to move
together after the stock market crash of 1987? [See von Furstenberg and Jeon (1989)
and King, Sentana and Wadhwani (1994).] If we recognize the global nature of culture,
there is no reason to assume that these events have anything to do with genuine
information about economic fundamentals.

14. Concluding remarks

Since this paper was written in response to an invitation to summarize literature on
behavioral theory in finance, it has focused exclusively on this topic, neglecting the
bulk of finance literature. Because of its focus on anomalies and departures from
conventional notions of rationality, I worry that the reader of this paper can get
a mistaken impression about the place of behavioral theory in finance and of the
importance of conventional theory.
The lesson from the literature surveyed here, and the list of varied behavioral
phenomena, is not that "anything can happen" in financial markets. Indeed, while the
behavioral theories have much latitude for interpretation, when they are combined with
observations about behavior in financial markets, they allow us to develop theories that
do have some restrictive implications. Moreover, conventional efficient markets theory
is not completely out the window. I could have, had that been the goal of this paper,
found very many papers that suggest that markets are impressively efficient in certain
respects.

1334

R.J. Shiller

Financial anomalies that intuitive assessments of human nature might lead one
to expect to find, or anomalies one hears casually about, often turn out to be tiny,
ephemeral, or nonexistent. There is, for example, virtually no Friday the thirteenth
effect [Chamberlain et al. (199 l), Dyl and Maberly (1988)]. Investors apparently aren't
that foolish.
Heeding the lessons of the behavioral research surveyed here is not going to
be simple and easy for financial researchers. Doing research that is sensitive to
lessons from behavioral research does not mean entirely abandoning research in the
conventional expected utility framework. The expected utility framework can be a
workhorse for some sensible research, if it is used appropriately. It can also be a starting
point, a point of comparison from which to frame other theories.
It is critically important for research to maintain an appropriate perspective about
h u m a n behavior and an awareness of its complexity. When one does produce a model,
in whatever tradition, one should do so with a sense of the limits of the model, the
reasonableness of its approximations, and the sensibility of its proposed applications.

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Chapter 21

THE FINANCIAL ACCELERATOR IN A QUANTITATIVE

BUSINESS CYCLE FRAMEWORK*
BEN S. BERNANKE, MARK GERTLER and SIMON GILCHRIST
Princeton University, New York University, and Boston Unicersity**

Contents
Abstract
Keywords
1. Introduction
2. The model: o v e r v i e w and basic assumptions
3. The d e m a n d for capital and the role o f net worth
3.1. Contract terms when there is no aggregate risk
3.2. Contract terms when there is aggregate risk
3.3. Net worth and the optimal choice of capital
4. General e q u i l i b r i u m
4.1. The entrepreneurial sector
4.2. The complete log-linearized model
4.2.1. Two extensions of the baseline model
4.2.1.1. Investment delays
4.2.1,2. Heterogeneous firms
5. M o d e l simulations
5.1. Model parametrization
5.2. Results
5.2.1. Response to a monetary policy shock
5.2.2. Shock to technology, demand, and wealth
5.2.3. Investment delays and heterogeneous firms
6. A h i g h l y selected r e v i e w o f the literature
7. D i r e c t i o n s for furore w o r k
A p p e n d i x A. The o p t i m a l financial contract and the d e m a n d for capital
A. 1. The partial equilibrium contracting problem
A.2. The log-normal distribution
A.3. Aggregate risk

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* Thanks to Michael Woodford, Don Morgan and John Taylor for helpful conanents, and to the NSF
and C.M Starr Center for financial support.
** Each author is also affiliated with the National Bmeau of Economic Research.
Handbook of Macroeconomics, Volume 1, Edited by J..B. laylor and M. WoodJb~d
1999 Elsevier Science B.V. All rights reserved
1341

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Appendix B. Household, retail and government sectors

B. 1. Households
B.2. The retail sector and price setting
B.3. Government sector

References

B.S. B e r n a n k e et al.

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Abstract
This chapter develops a dynamic general equilibrium model that is intended to
help clarify the role of credit market frictions in business fluctuations, from both
a qualitative and a quantitative standpoint. The model is a synthesis of the leading
approaches in the literature. In particular, the framework exhibits a "financial
accelerator", in that endogenous developments in credit markets work to amplify and
propagate shocks to the macroeconomy. In addition, we add several features to the
model that are designed to enhance the empirical relevance. First, we incorporate
money and price stickiness, which allows us to study how credit market frictions
may influence the transmission of monetary policy. In addition, we allow for lags in
investment which enables the model to generate both hump-shaped output dynamics
and a lead-lag relation between asset prices and investment, as is consistent with the
data. Finally, we allow for heterogeneity among firms to capture the fact that borrowers
have differential access to capital markets. Under reasonable parametrizations of
the model, the financial accelerator has a significant influence on business cycle
dynamics.

Keywords
financial accelerator, business fluctuations, monetary policy

JEL classification: E30, E44, E50

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1. Introduction

The canonical real business cycle model and the textbook Keynesian IS-LM model
differ in many fundamental ways. However, these two standard frameworks for
macroeconomic analysis do share one strong implication: Except for the term structure
of real interest rates, which, together with expectations of future payouts, determines
real asset prices, in these models conditions in financial and credit markets do not
affect the real economy. In other words, these two mainstream approaches both adopt
the assumptions underlying the Modigliani-Miller (1958) theorem, which implies that
financial structure is both indeterminate and irrelevant to real economic outcomes.
Of course, it can be argued that the standard assumption of financial-structure
irrelevance is only a simplification, not to be taken literally, and not harmful if the
"frictions" in financial and credit markets are sufficiently small. However, as Gertler
(1988) discusses, there is a long-standing alternative tradition in macroeconomics,
beginning with Fisher and Keynes if not earlier authors, that gives a more central role to
credit-market conditions in the propagation of cyclical fluctuations. In this alternative
view, deteriorating credit-market conditions - sharp increases in insolvencies and
bankruptcies, rising real debt burdens, collapsing asset prices, and bank failures are not simply passive reflections of a declining real economy, but are in themselves
a major factor depressing economic activity. For example, Fisher (1933) attributed
the severity of the Great Depression in part to the heavy burden of debt and ensuing
financial distress associated with the deflation of the early 1930s, a theme taken up
half a century later by Bernanke (1983). More recently, distressed banking systems and
adverse credit-market conditions have been cited as sources of serious macroeconomic
contractions in Scandinavia, Latin America, Japan, and other East Asian countries. In
the US context, both policy-makers and academics have put some of the blame for
the slow recovery of the economy from the 1990-1991 recession on heavy corporate
debt burdens and an undercapitalized banking system [see, e.g., Bernanke and Lown
(1992)]. The feedbacks from credit markets to the real economy in these episodes
may or may not be as strong as some have maintained; but it must be emphasized that
the conventional macroeconomic paradigms, as usually presented, do not even give us
ways of thinking about such effects.
The principal objective of this chapter is to show that credit-market imperfections
can be incorporated into standard macroeconomic models in a relatively straightforward yet rigorous way. Besides our desire to be able to evaluate the role of creditmarket factors in the most dramatic episodes, such as the Depression or the more recent
crises (such as those in East Asia), there are two additional reasons for attempting to
bring such effects into mainstream models of economic fluctuations. First, it appears
that introducing credit-market frictions into the standard models can help improve
their ability to explain even "garden-variety" cyclical fluctuations. In particular, in
the context of standard dynamic macroeconomic models, we show in this chapter
that credit-market frictions may significantly amplify both real and nominal shocks
to the economy. This extra amplification is a step toward resolving the puzzle of how

1344

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relatively small shocks (modest changes in real interest rates induced by monetary
policy, for example, or the small average changes in firm costs induced by even
a relatively large movement in oil prices) can nevertheless have large real effects.
Introducing credit-market frictions has the added advantage of permitting the standard
models to explain a broader class of important cyclical phenomena, such as changes
in credit extension and the spreads between safe and risky interest rates.
The second reason for incorporating credit-market effects into mainstream models
is that modern empirical research on the determinants of aggregate demand and (to
a lesser extent) of aggregate supply has often ascribed an important role to various
credit-market frictions. Recent empirical work on consumption, for example, has
emphasized the importance of limits on borrowing and the closely-related "buffer
stock" behavior [Mariger (1987), Zeldes (1989), Jappelli (1990), Deaton (1991), Eberly
(1994), Gourinchas and Parker (1995), Engelhardt (1996), Carroll (1997), Ludvigson
(1997), Bacchetta and Gerlach (1997)]. In the investment literature, despite some recent
rehabilitation of a role for neoclassical cost-of-capital effects [Cummins, Hassett and
Hubbard (1994), Hassett and Hubbard (1996)], there remains considerable evidence
for the view that cash flow, leverage, and other balance-sheet factors also have
a major influence on investment spending [Fazzari, Hubbard and Petersen (1988),
Hoshi, Kashyap and Scharfstein (1991), Whited (1992), Gross (1994), Gilchrist and
Himmelberg (1995), Hubbard, Kashyap and Whited (1995)] 1. Similar conclusions
are reached by recent studies of the determinants of inventories and of employment
[Cantor (1990), Blinder and Maccini (1991), Kashyap, Lamont and Stein (1994),
Sharpe (1994), Carpenter, Fazzari and Petersen (1994)]. Aggregate modeling, if it is
to describe the dynamics of spending and production realistically, needs to take these
empirical findings into account 2.
How does one go about incorporating financial distress and similar concepts into
macroeconomics? While it seems that there has always been an empirical case
for including credit-market factors in the mainstream model, early writers found it
difficult to bring such apparently diverse and chaotic phenomena into their formal
analyses. As a result, advocacy of a role for these factors in aggregate dynamics
fell for the most part to economists outside the US academic mainstream, such as
Hyman Minsky, and to some forecasters and financial-market practitioners, such as
Otto Eckstein and Allen Sinai (l 986), Albert Wojnilower (1980), and Henry Kaufma~
(1986). However, over the past twenty-five years, breakthroughs in the economics
of incomplete and asymmetric information [beginning with Akerlof (1970)] and
the extensive adoption of these ideas in corporate finance and other applied fields
[e.g., Jensen and Meckling (1976)], have made possible more formal theoretical
1 A critique of the cash-flowliterature is given by Kaplan and Zingales (1997). See Chirinko (1993)
for a broad survey of the empirical literature in inveslment.
2 Contemporarymacroeconometricforecasting models, such as the MPS model used by the Federal
Reserve, typicallydo incorporatefactors such as borrowing constraints and cash-flow effects. See for
example Braytonet al. (1997).

Ch. 21." The Financial Accelerator in a Quantitative Business Cycle Framework

1345

analyses of credit-market imperfections. In particular, it is now well understood that

asymmetries of infonnaIion play a key role in borrower-lender relationships; that
lending institutions and financial contracts typically take the forms that they do in
order to reduce the costs of gathering information and to mitigate principal-agent
problems in credit markets; and that the common feature of most of the diverse
problems that can occur in credit markets is a worsening of informational asymmetries
and increases in the associated agency costs. Because credit-market crises (and less
dramatic malfunctions) increase the real costs of extending credit and reduce the
efficiency of the process of matching lenders and potential borrowers, these events
may have widespread real effects. In short, when credit markets are characterized
by asymmetric information and agency problems, the Modigliani-Miller irrelevance
theorem no longer applies.
Drawing on insights from the literature on asymmetric information and agency costs
in lending relationships, in this chapter we develop a dynamic general equilibrium
model that we hope will be useful for understanding the role of credit-market frictions
in cyclical fluctuations. The model is a synthesis of several approaches already in the
literature, and is partly intended as an expository device. But because it combines
attractive features of several previous models, we think the framework presented here
has something new to offer, hnportantly, we believe that the model is of some use in
assessing the quantitative implications of credit-market frictions for macroeconomic
analysis.
In particular, our framework exhibits a "financial accelerator" [Bernanke, Gertler
and Gilchrist (1996)], in that endogenous developments in credit markets work to
propagate and amplify shocks to the macroeconomy. The key mechanism involves the
link between "external finance premium" (the difference between the cost of funds
raised externally and the opportunity cost of funds internal to the firm) and the net
worth of potential borrowers (defined as the borrowers' liquid assets plus collateral
value of illiquid assets less outstanding obligations). With credit-market frictions
present, and with the total amount of financing required held constant, standard models
of lending with asymmetric information imply that the external finance premium
depends inversely on borrowers' net worth. This inverse relationship arises because,
when borrowers have little wealth to contribute to project financing, the potential
divergence of interests between the borrower and the suppliers of external funds is
greater, implying increased agency costs; in equilibrium, lenders must be compensated
~br higher agency costs by a larger premium. To the extent that borrowers' net worth is
procyclical (because of the procyclicality of profits and asset prices, for example), the
external finance premium will be countercyclical, enhancing the swings in borrowing
and thus in investment, spending, and production.
We also add to the framework several features designed to enhance the empirical
relevance. First, we incorporate price stickiness and money into the analysis, using
modeling devices familiar from New Keynesian research, which allows us to study
the effects of monetary policy in an economy with credit-market frictions. In addition,
we allow for decision lags in investment, which enables the model to generate both

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hump-shaped output dynamics and a lead-lag relationship between asset prices and
investment, as is consistent with the data. Finally, we allow for heterogeneity among
firms to capture the real-world fact that borrowers have differential access to capital
markets. All these improvements significantly enhance the value of the model for
quantitative analysis, in our view.
The rest of the chapter is organized as follows. Section 2 introduces the model
analyzed in the present chapter. Section 3 considers the source of the financial
accelerator: a credit-market friction which evolves from a particular form of asymmetric information between lenders and potential borrowers. It then performs a partial
equilibrium analysis of the resulting terms of borrowing and of firms' demand for
capital, and derives the link between net worth and the demand for capital that is
the essence of the financial accelerator. Section 4 embeds the credit-market model
in a Dynamic New Keynesian (DNK) model of the business cycle, using the device
proposed by Calvo (1983) to incorporate price stickiness and a role for monetary
policy; it also considers several extensions, such as allowing for lags in investment and
for differential credit access across firms. Section 5 presents simulation results, drawing
comparisons between the cases including and excluding the credit-market friction. Here
we show that the financial accelerator works to amplify and propagate shocks to the
economy in a quantitatively significant way. Section 6 then gives a brief and selective
survey that describes how the framework present fits in the literature. Section 7 then
describes several directions for future research. Two appendices contain additional
discussion and analysis of the partial-equilibrium contracting problem and the dynamic
general equilibrium model in which the contracting problem is embedded.

2. The model: overview and basic assumptions

Our model is a variant of the Dynamic New Keynesian (DNK) framework, modified
to allow for financial accelerator effects on investment. The baseline DNK model
is essentially a stochastic growth model that incorporates money, monopolistic
competition, and nominal price rigidities. We take this framework as the starting point
for several reasons. First, this approach has become widely accepted in the literature 3
It has the qualitative empirical appeal of the IS-LM model, but is motivated from first
principles. Second, it is possible to study monetary policy with this framework. For our
purposes, this means that it is possible to illustrate how credit market imperfections
influence the transmission of monetary policy, a theme emphasized in much of the
recent literature 4. Finally, in the limiting case of perfect price flexibility, the cyclical
properties of the model closely resemble those of a real business cycle framework. In

3 See Goodfriend and King (1997) for an exposition of the DNK approach.
4 For a review of the recent literature on the role of credit market fiqctions in the transmission of
monetary policy, see Bernanke and Gertler (1995).

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The Financial Accelerator in a Quantitatiue Business Cycle Framework

1347

this approximate sense, the DNK model nests the real business cycle paradigm as a
special case. It thus has the virtue of versatility.
Extending any type of contemporary business cycle model to incorporate financial
accelerator effects is, however, not straightforward. There are two general problems:
First, because we want lending and borrowing to occur among private agents in
equilibrium, we cannot use the representative agent paradigm but must instead grapple
with the complications introduced by heterogeneity among agents. Second, we would
like the financial contracts that agents use in the model to be motivated as far as
possible from first principles. Since financial contracts and institutions are endogenous,
results that hinge on arbitrary restrictions on financial relationships may be suspect.
Most of the nonstandard assumptions that we make in setting up our model are
designed to facilitate aggregation (despite individual heterogeneity) and permit an
endogenous financial structure, thus addressing these two key issues.
The basic structure of our model is as follows: There are three types of agents, called
households, entrepreneurs, and retailers. Households and entrepreneurs are distinct
from one another in order to explicitly motivate lending and borrowing. Adding
retailers permits us to incorporate inertia in price setting in a tractable way, as we
discuss. In addition, our model includes a government, which conducts both fiscal and
monetary policy.
Households live forever; they work, consume, and save. They hold both real money
balances and interest-bearing assets. We provide more details on household behavior
below.
For inducing the effect we refer to as the financial accelerator, entrepreneurs play the
key role in our model. These individuals are assumed to be risk-neutral and have finite
horizons: Specifically, we assume that each entrepreneur has a constant probability y
of surviving to the next period (implying an expected lifetime of 1@)" The assumption
of finite horizons for entrepreneurs is intended to capture the phenomenon of ongoing
births and deaths of firms, as well as to preclude the possibility that the entrepreneurial
sector will ultimately accumulate enough wealth to be fully self-financing. Having
the survival probability be constant (independent of age) facilitates aggregation. We
assume the birth rate of entrepreneurs to be such that the fraction of agents who are
entrepreneurs is constant.
In each period t entrepreneurs acquire physical capital. (Entrepreneurs who "die"
in period t are not allowed to purchase capital, but instead simply consume their
accumulated resources and depart from the scene.) Physical capital acquired in period
t is used in combination with hired labor to produce output in period t + 1, by
means of a constant-returns to scale technology. Acquisitions of capital are financed
by entrepreneurial wealth, or "net worth", and borrowing.
The net worth of entrepreneurs comes from two sources: profits (including capital
gains) accumulated from previous capital investment and income from supplying labor
(we assume that entrepreneurs supply one unit of labor inelastically to the general
labor market). As stressed in the literature, entrepreneurs' net worth plays a critical role
in the dynamics of the model. Net worth matters because a borrower's financial position

1348

B.S. B e r n a n k e et al.

is a key determinant of his cost of external finance. Higher levels of net worth allow
for increased self-financing (equivalently, collateralized external finance), mitigating
the agency problems associated with external finance and reducing the external finance
premium faced by the entrepreneur in equilibrium.
To endogenously motivate the existence of an external finance premium, we
postulate a simple agency problem that introduces a conflict of interest between
a borrower and his respective lenders. The financial contract is then designed to
minimize the expected agency costs. For tractability we assume that there is enough
anonymity in financial markets that only one-period contracts between borrowers and
lenders are feasible [a similar assumption is made by Carlstrom and Fuerst (1997)].
Allowing for longer-term contracts would not affect our basic results 5. The tbrm of
the agency problem we introduce, together with the assumption of constant returns
to scale in production, is sufficient (as we shall see) to generate a linear relationship
between the demand for capital goods and entrepreneurial net worth, which facilitates
aggregation.
One complication is that to introduce the nominal stickiness intrinsic to the
DNK framework, at least some suppliers must be price setters, i.e., they must
face downward-sloping demand curves. However, assuming that entrepreneurs are
imperfect competitors complicates aggregation, since in that case the demand for
capital by individual firms is no longer linear in net worth. We avoid this problem by
distinguishing between entrepreneurs and other agents, called' retailers. Entrepreneurs
produce wholesale goods in competitive markets, and then sell their output to retailers
who are monopolistic competitors. Retailers do nothing other than buy goods from
entrepreneurs, differentiate them (costlessly), then re-sell them to households. The
monopoly power of retailers provides the source of nominal stickiness in the economy;
otherwise, retailers play no role. We assume that profits from retail activity are
rebated lump-sum to households. Having described the general setup of the model,
we proceed in two steps. First, we derive the key microeconomic relationship of the
model: the dependence of a firm's demand for capital on the potential borrower's net
worth. To do so, we consider the firm's (entrepreneur's) partial equilibrium problem of
jointly determining its demand for capital and terms of external finance in negotiation
with a competitive lender (e.g., a financial intermediary). Second, we embed these
relationships !n an othe1~ise conventional DNK model. Our objective is to show how
fluctuations in borrowers' net worth can act to amplify and propagate exogenous shocks
to the system. For most of the analysis we assume that there is a single type of
firm; however, we eventually extend the model to allow for heterogeneous firms with
differential access to credit.

So long as borrowers have finite horizons, net worth influences the terms of borrowing, even ai~er
allowing for nmlti-period contracts. See, for example, Gertter (1992).

Ch. 21:

The Financial Accelerator in a Quantitative Business Cycle Framework

1349

3. The demand for capital and the role of net worth

We now study the capital investment decision at the firm level, taking as given the
price of capital goods and the expected return to capital. In the subsequent section we
endogenize capital prices and returns as part of a general equilibrium solution.
At time t, the entrepreneur who manages firm j purchases capital for use at t + I.
The quantity of capital purchased is denoted K/+I, with the subscript denoting the
period in which the capital is actually used, and the superscript j denoting the firm.
The price paid per unit of capital in period t is Qt. Capital is homogeneous, and so
it does not matter whether the capital the entrepreneur purchases is newly produced
within the period or is "old", depreciated capital. Having the entrepreneur purchase
(or repurchase) his entire capital stock each period is a modeling device to ensure,
realistically, that leverage restrictions or other financial constraints apply to the firm
as a whole, not just to the marginal investment.
The return to capital is sensitive to both aggregate and idiosyncratic risk. The ex post
gross return on capital for firmj is t'~JPk
* ' t + l , where coy is an idiosyncratic disturbance to
firmj's return and Rk+l is the ex post aggregate return to capital (i.e., the gross return
averaged across firms). The random variable (.0j is i.i.d, across time and across firms,
with a continuous and once-differentiable c.d.f., F(~o), over a non-negative support,
and E{{oJ} = 1. We impose the following restriction on the corresponding hazard
rate h((o):

O(coh(o)))
0a)

> 0,

(3.1)

where h(co) _= ~dF(~o)

F(o~" This regularity condition is a relatively weak restriction that is
satisfied by most conventional distributions, including for example the log-normal.
At the end of period t (going into period t + 1) entrepreneur j has available net
worth, N/+ 1. To finance the difference between his expenditures on capital goods and
his net worth he must borrow an amount BJ<, given by
BtJl = Q, K ,+,
j -N,+J 1.

(3.2)

The entrepreneur borrows from a financial intermediary that obtains its funds from
households. The financial intermediary faces an opportunity cost of funds between t
and t + 1 equal to the economy's riskless gross rate of return, Rt+l. The riskless rate is
the relevant opportunity cost because in the equilibrium of our model, the intermediary
holds a perfectly safe portfolio (it perfectly diversifies the idiosyncratic risk involved
in lending). Because entrepreneurs are risk-neutral and households are risk-averse, the
loan contract the intermediary signs has entrepreneurs absorb any aggregate risk, as
we discuss below.
To motivate a nontrivial role for financial structure, we follow a number of previous
papers in assuming a "costly state verification" (CSV) problem of the type first

B.S. B e r n a n k e et al.

1350

analyzed by Townsend (1979), in which lenders must pay a fixed "auditing cost"
in order to observe an individual borrower's realized return (the borrower observes
the return for free). As Townsend showed, this assumption allows us to motivate
why uncollateralized external finance may be more expensive than internal finance
without imposing arbitrary restrictions on the contract structure. There are many other
specifications of the incentive problem between the entrepreneur and outside lenders
that can generate qualitatively similar results. The virtues of the Townsend formulation
are its simplicity and descriptive realism.
Following the CSV approach, we assume that the lender must pay a cost if he or
she wishes to observe the borrower's realized return on capital. This auditing cost is
interpretable as the cost of bankruptcy (including for example auditing, accounting,
and legal costs, as well as losses associated with asset liquidation and interruption
of business). The monitoring cost is assumed to equal a proportion/~ of the realized
k
.i I.
gross payoff to the firm's capital, i.e., the monitoring cost equals /~ ~oi Rt+lQtKi+
Although one might expect that there would be economies of scale in monitoring, the
proportionality assumption is very convenient in our context and does not seem too
unreasonable.
3.1. Contract terms when there is no aggregate risk
To describe the optimal contractual arrangement, it is useful to first work through the
case where the aggregate return to capital Rt:'+l is known in advance. In this instance
the only uncertainty about the project's return is idiosyncratic to the firm, as in the
conventional version of the CSV problem.
Absent any aggregate uncertainty, the optimal contract under costly state verification
looks very much like standard risky debt (see Appendix A for a detailed analysis of
the contracting problem): In particular, the entrepreneur chooses the value of firm
capital, QtKi+J t, and the associated level of borrowing, B/+L, prior to the realization
of the idiosyncratic shock. Given QtKi+l,
/ B[+I, and Rt+
k l, the optimal contract may
be characterized by a gross non-default loan rate, Z/~I, and a threshold value of the
idiosyncratic shock ~)i, call it ~sJ, such that for values of the idiosyncratic shock
greater than or equal to ~J, the entrepreneur is able to repay the loan at the contractuai
rate, Z j 1. That is, N./ is defined by
....j ~
- j
./
.J
~ R~+lQtKi~ 1 = Zt ~lBt ~1

(3.3)

When ~o/ ) c~-j, under the optimal contract the entrepreneur repays the lender the
r j
j
j /~
j
,- j
j
promised amount Zi+lBt+ 1 and keeps the difference, equal to co Rt+l QtKi~. ~ - Zi +~B:, 1.
If coy < N:, the entrepreneur cannot pay the contractual return and thus declares
default, in this situation the lending intermediary pays the auditing cost and gets to
keep what it finds. That is, the intermediary's net receipts are (1 -l~)v)R~+~ Q~K/+ 1. A
defaulting entrepreneur receives nothing.

Ch. 21:

The t,3nancial Accelerator in a Quantitative Business Cycle Framework

1351

The values o f NJ and Z/~ 1 under the optimal contract are determined by the
requirement that the financial intermediary receive an expected return equal to the
opportunity cost o f its funds. Because the loan risk in this case is perfectly diversifiable,
the relevant opportunity cost to the intermediary is the riskless rate, Rt+l. Accordingly,
the loan contract must satisfy
P

[ 1 - F ( ~ S ) I Z / + I B" / + ," + ( 1 - ~ t )

/~

~oJ

k
j
'
~oRt+lQtKi+
1 dF(~o)= R,+,S/+t,

(3.4)

where the left-hand side o f Equation (3.4) is the expected gross return on the loan to
the entrepreneur and the right side is the intermediary's opportunity cost o f lending.
Note that F ( ~ j) gives the probability o f default.
Combining Equations (3.2) and (3.3) with Equation (3.4) yields the following
expression for ~5i:
p

[1 - F ( ~ J ) ] ~ j -+-(1-:-~) ./0

(o dF(co) R~+IQtK/+ , -- Rt+I(QtKJ1 - N,{ 1).

(3.5)

By using Equation (3.4) to eliminate Z~I, we are able to express the lender's expected
return simply as a function of the cutoff value o f the firm's idiosyncratic productivity
shock, k5s. There are two effects o f changing ~ J on the expected return, and they
work in opposite directions. A rise in NJ increases the non-default payoff; on the
other hand, it also raises the default probability, which lowers the expected payoff.
The assumed restrictions on the hazard function given by Equation (3.1) imply that
the expected return reaches a maximum at an unique interior value of N i : As NJ
rises above this value the expected return declines due to the increased likelihood
of default 6. For values of ~Os below the maxinmm, the function is increasing and
concave 7. I f the lender's opportunity cost is so large that there does not exist a value
of NJ that generates the required expected return, then the borrower is "rationed" from
the market. Appendix A provides details. For simplicity, in what follows, we consider
only equilibria without rationing, i.e., equilibria in which the equilibrium value of b5j
always lies below the maximum feasible value a. Under the parametrizations we use
later, this condition is in fact satisfied.
r' Flb see that the maximmn must be in the interior of the support of co, note that as cO/ approaches its
upper bound, the default probability converges to unity. Appendix A shows that the interior optimum is
unique.
7 The change in the expected payoff fl'om a unit increase m cOJ is {[ 1 -F(cOJ)] -#cO/dF(cOJ)}R~+IQtKii 1
The first term in the expression in brackets reflects the rise in the non-default payoff. The second
term reflects the rise in expected default costs. Note that we can rewrite this expression as
{1 - ~SJh(USJ)}[1 - F(?O/)]RI+1QtK/+I, where h(a0 = VdF(co)
- ~ is the hazard rate. Given Equation (3.i),
the derivative of this expression is negative for values of COj below the maxinmm one feasible, implying
that the expected payoff is concave in this range.
8 Note also that since we are restricting attention to non-rationing equilibria, the lender's expected return
is always increasing in COJ.

1352

B.S. Bernanke et al.

3.2. Contract terms when there is aggregate risk

With aggregate uncertainty present, NJ will in general depend on the ex post realization
of R)+~. Our assumption that the entrepreneur is risk-neutral leads to a simple contract
structure, despite this complication. Because he cares only about the mean return on his
wealth, the entrepreneur is willing to bear all the aggregate risk 9. Thus he is willing to
guarantee the lender a return that is free o f any systematic risk, i.e., conditional on the
ex post realization ofR~+l, the borrower offers a (state-contingent) non-default payment
that guarantees the lender a return equal in expected value to the riskless rate. (Note
that the only residual risk the lender bears arises from the idiosyncratic shock o)/+1, and
is thus diversifiable.) Put differently, Equation (3.5) now implies a set of restrictions,
k 1. The result is a schedule for 75j, contingent on the
one for each realization o f Rt+
realized aggregate state. As we are restricting attention to non-rationing equilibria,
we consider only parametrizations where there in fact exists a value o f N / for each
aggregate state that satisfies Equation (3.5). Diversification by intermediaries implies
that households earn the riskless rate on their saving.
Descriptively, the existence o f aggregate uncertainty effectively ties the risky
loan rate Z/+~to macroeconomic conditions. In particular, the loan rate adjusts
countercyclically. For example, a realization o f R~k+l that is lower than expected raises

Zi/~ ; that is, to compensate for the increased default probability due to the low average
return to capital, the non-default payment must rise. This in turn implies an increase in
the cutoff value o f the idiosyncratic productivity shock, ~5j. Thus the model implies,
reasonably, that default probabilities and default premia rise when the aggregate return
to capital is lower than expected ~0

3.3. Net worth and the optimal choice o f capital

Thus far we have described how the state-contingent values of N / and ziJ~ are
determined, given the ex post realization of R~/'+l and the ex ante choices of Q:K j i and
B/~ I. We now turn to the entrepreneur's general problem o f determining his demand
for capital.

9 The entrepreneur's value function can be shown to be linear in wealth because (i) his utility is linear in
consumption and (ii) the project he is investing in exhibits constant returns to scale. [See, e.g., Bernanke
and Gertler (1989, 1990).]
10 This kind of state-contingent financial arrangement is a bit stylized, but may be thought of as
corresponding to the following scenario: Let the maturity of the debt be shorter than the maturity of the
firm's project. The debt is then rolled over after the realization of the aggregate m~certainty. If there is
bad aggregate news, then the new loan rate is higher than would be otherwise. To implement the sort of
risk-sharing arrangement implied by the model, therefore, all that is necessary is that some component
of the financing have a shorter maturity than that of the project.

Ch. 21." The Financial Accelerator in a Quantitative Business Cycle Framework

1353

Given the state-contingent debt form of the optimal contract, the expected return to
the entrepreneur may be expressed as
E

{fi
/

o)Rt+ 1QtKi+ 1 dF(co) - (1 - F ( ~ J ) ) N J R ~ I QtK/+ l

(3.6)

k
where expectations are taken with respect to the random variable, Rt+l,
and it is
understood that ~ / may be made contingent on the realization of this variable.
Combining this relation with Equation (3.5) allows us to simplify the entrepreneur's
objective to maximization of

{ Jo

O9 )

L1 -

-U;+O,J

(3.7)

k
k 1} is the ratio of the realized return to capital to the expected
where U[a~I =_ Rt+j/E{Rt+
return. Given that the intermediary must receive a competitive return, the entrepreneur
internalizes the expected default costs, as Equation (3.7) suggests.
The formal investment and contracting problem then reduces to choosing K/+I and
a schedule for N/ (as a function of the realized values of R)+I) to maximize Equation (3.7), subject to the set of state-contingent constraints implied by Equation (3.5).
The distributions of the aggregate and idiosyncratic risks to the return to capital, the
price of capital, and the quantity of net worth that the entrepreneur brings to the table
are taken as given in the maximization.
Let st ~ E{R~+I/Rt+I } be the expected discounted return to capital. For entrepreneurs
to purchase capital in the competitive equilibrium it must be the case that st ~> 1. Given
s: ~> 1, the first-order necessary conditions yield the following relation for optimal
capital purchases (see Appendix A for details):
QaK/~, = *p(st)N/+j,

with

W(1) == l, W:(') > O.

(3.8)

Equation (3.8) describes the critical link between capital expenditures by the firm and
financial conditions, as measured by the wedge between the expected the return to
capital and the safe rate, st, and by entrepreneurial net worth, Art/1 JL. Given the value
o f K/+ l that satisfies Equation (3.8), the schedule for NJ is pinned down uniquely by the
state-contingent constraint on the expected return to debt, defined by Equation (3.5).
Equation (3.8) is a key relationship in the model: It shows that capital expenditures
by each firm are proportional to the net worth of the owner/entrepreneur, with a
proportionality factor that is increasing in the expected discounted return to capital,
st. Everything else equal, a rise in the expected discounted return to capital reduces
the expected default probability. As a consequence, the entrepreneur carl take on more

l J In the costly enforcememmodel of Kiyotakiand Moore (1997), ~p(.)- 1, implyingQ,K,. t - Ni+j .

B.S. Bernanke et al.

1354

Demandf 0 ~ , i .

,,///,, .,.'"

E
.2
o

c~

c5
--f

10

~ - - T - -

11

12

CapitalStock
Fig. 1. Effect of an increase in net worth.
debt and expand the size o f his firm. He is constrained from raising the size o f the firm
indefinitely by the fact that expected default costs also rise as the ratio of borrowing
to net worth increases.
An equivalent way of expressing Equation (3.8) is

/
E{Rf,.l} = s[

Nj \
~',+1. | R,~,,

\ o,K/+,]

s'(.) < 0.

(3.9)

For an entrepreneur who is not fully self-financed, in equilibrium the return to capital
will be equated to the marginal cost of external finance. Thus Equation (3.9) expresses
the equilibrium condition that the ratio s o f the cost of external finance to the safe
rate - which we have called the discounted return to capital but may be equally well
interpreted as the external finance premium - depends inversely on the share of the
finn's capital investment that is financed by the entrepreneur's own net worth.
Figure 1 illustrates this relationship using the actual contract calibrated for model
analysis in the next section. Firm j ' s demand for capital is on the horizontal axis
and the cost o f funds normalized by the safe rate of return is on the vertical axis.
For capital stocks which can be financed entirely by the entrepreneur's net worth,
in this case K < 4.6, the firm faces a cost of funds equal to the risk free rate. As
capital acquisitions rise into the range where external finance is necessary, the costof-funds curve becomes upward sloping, reflecting the increase in expected default
costs associated with the higher ratio o f debt to net worth. While the supply o f
funds curve is -upward sloping, owing to constant returns to scale, the demand for
capital is horizontal at an expected return 2 percentage points above the risk free rate.

Ch. 21:

The Financial Accelerator in a Quantitative Business Cycle Framework

1355

Point E, where the firm's marginal cost of funds equals the expected return to capital
yields the optimal choice of the capital stock K = 9.2. For this contract, the leverage
ratio is 50%.
It is easy to illustrate how a shift in the firm's financial position affects its demand
for capital. A 15% increase in net worth, Ni~ L, for example, causes the rightward shift
in the cost-of-funds curve depicted by the hatched line in Figure 1. At the old level
of capital demand, the premium for external finance declines: The rise in net worth
relative to the capital stock reduces the expected default probability, everything else
equal. As a consequence, the firm is able to expand capacity to point U . Similarly, a
decline in net worth reduces the firm's effective demand for capital.
In the next section we incorporate this firm-level relation into a general equilibrium
framework. Before proceeding, however, we note that, in general, when the firm's
demand for capital depends on its financial position, aggregation becomes difficult. The
reason is that, in general, the total demand for capital will depend on the distribution
of wealth across firms. Here, however, the assumption of constant returns to scale
throughout induces a proportional relation between net worth and capital demand at
the firm level; further, the factor of proportionality is independent of firm-specific
factors. Thus it is straightforward to aggregate Equation (3.8) to derive a relationship
between the total demand for capital and the total stock of entrepreneurial net worth.

4. General equilibrium
We now embed the partial equilibrium contracting problem between the lender and
the entrepreneur within a dynamic general equilibrium model. Among other things,
this will permit us to endogenize the safe interest rate, the return to capital, and the
relative price of capital, all of which were taken as given in the partial equilibrium.
We proceed in several steps. First we characterize aggregate behavior for the
entrepreneurial sector. From this exercise we obtain aggregate demand curves for labor
and capital, given the real wage and the riskless interest rate. The market demand for
capital is a key component of the model since it reflects the impact of financial market
imperfections. We also derive how the aggregate stock of entrepreneurial net worth,
an important state variable determining the demand for capital, evolves over time.
We next place our "non-standard" entrepreneurial sector within a conventional
Dynamic New Keynesian framework. To do so, we add to the model both households
and retailers, the latter being included only in order to introduce price inertia in a
t~cactable manner. We also add a government sector that conducts fiscal and monetary
policies. Since much of the model is standard, we simply write the log-linearized
framework used for computations and defer a more detailed derivation to Appendix B.
Expressing the model in a log-linearized form makes the way in which the financial
accelerator influences business cycle dynamics reasonably transparent.

B.X Bernanke et al.

1356

4.1. The entrepreneurial sector

Recall that entrepreneurs purchase capital in each period for use in the subsequent
period. Capital is used in combination with hired labor to produce (wholesale) output.
We assume that production is constant returns to scale, which allows us to write the
production function as an aggregate relationship. We specify the aggregate production
function relevant to any given period t as

Yt = AtKaL]-a,

(4.1)

where Yt is aggregate output o f wholesale goods, Kt is the aggregate amount of capital

purchased by entrepreneurs in period t - 1, L~ is labor input, and At is an exogenous
technology parameter.
Let It denote aggregate investment expenditures. The aggregate capital stock evolves
according to

K,+I =

k,K, j K t + ( 1 - 6 ) K t ,

(4.2)

where /5 is the depreciation rate. We assume that there are increasing marginal
adjustment costs in the production o f capital, which we capture by assuming that
aggregate investment expenditures of L yield a gross output of new capital goods
(I~/Kt)Kt, where q~(.) is increasing and concave and q~(0) = 0. We include
adjustment costs to permit a variable price o f capital. As in Kiyotaki and Moore (1997),
the idea is to have asset price variability contribute to volatility in entrepreneurial net
worth. In equilibrium, given the adjustment cost function, the price o f a unit o f capital
in terms of the numeraire good, Qt, is given by 12

(4.3)

We normalize the adjustment cost function so that the price of capital goods is unity
in the steady state.
Assume that entrepreneurs sell their output to retailers. Let 1/X~ be the relative price
o f wholesale goods. Equivalently, Xt is the gross markup of retail goods over wholesale

~2 1b implement investment expenditures in the decentralized equilibrium, think of there being

competitive capital producing firms that purchase raw output as a materials input, I~ and combine it
with rented capital, Kt to produce new capital goods via the production function q3(g~
I, )Kt. These capital
goods are then sold at the price Qt. Since the capital-producing technology assumes constant returns to
scale, these capital-producing firms earn zero profits in equilibrium. Equation (4.3) is derived from the
first-order condition for investment for one of these firms.

Ch. 21: The Financial Accelerator in a Quantitative Business Cycle Framework

1357

goods. Then the C o b b - D o u g l a s production technology implies that the rent paid to a
unit o f capital in t + 1 (for production o f wholesale goods) is 13

1 aYl+l
Xt+l Kt+l
The expected gross return to holding a unit o f capital from t to t + 1 can be written
k
E{Rz+ 1} = E

1 aYt+l

x,2, x,+~ + Q t + l ( 1 - 6 )
Ot

}
'

(4.4)

Substitution o f Equations (4.1) and (4.3) into Equation (4.4) yields a reasonably
conventional demand curve for new capital. As usual, the return on capital depends
inversely on the level o f investment, reflecting diminishing returns.
The supply curve for investment finance is obtained by aggregating Equation (3.8)
over firms, and inverting to obtain:
l,
I: Nt+l
E{Rt+ I } = s

(4.5)

As in Equation (3.9), the function s(.) is the ratio o f the costs o f external and internal
finance; it is decreasing in Nt+l/QtKt+l for Nt~l < QtKt+l. The unusual feature o f
this supply curve, o f course, is the dependence o f the cost o f funds on the aggregate
financial condition o f entrepreneurs, as measured by the ratio Nt+l/QtI(t+l.
The dynamic behavior o f capital demand and the return to capital depend on
the evolution o f entrepreneurial net worth, N:+l. N:+I reflects the equity stake that
entrepreneurs have in their firms, and accordingly depends on firms' earnings net o f
interest payments to lenders. As a technical matter, however, it is necessary to start
entrepreneurs off with some net worth in order to allow them to begin operations.
Following Bernanke and Gertler (1989) and Carlstrom and Fuerst (1997), we assume

t~ To be consistent with our assumption that adjustment costs are external to the firm, we assume that
entrepreneurs sell their capital at the end of period t + 1 to the investment sector at price Q~+I. Thus
capital is then used to produce new investment goods and resold at the price Q,j. The "rental rate"
(Q, 1- Qt+l) reflects the influence of capital accumulation on adjustment costs. This rate is determhled
by the zero-profit condition

Q,~2 /

1t \

It

Q,)=o.

In steady state q~( ~ ) = 6 and ~ ' ( U~

:t ) = 1, implying that Q = Q = 1. Around tile steady state,
the diffbrence between Qt~l and Qt is second order. We therefore omit the rental term and express
Equation (4.4) using Q:~ I rather than Qt+l-

1358

B.X Berv~anke et al.

that, in addition to operating firms, entrepreneurs supplement their income by working

in the general labor market. Total labor input Lt is taken to be the following composite
of household labor, HI, and "entrepreneurial labor", HI:

L, =Ht++(H/)t-+.

(4,6)

We assume further that entrepreneurs supply their labor inelastically, and we normalize
total entrepreneurial labor to unity 14. In the calibrations below we keep the share
of income going to entrepreneurial labor small (on the order of .01), so that this
modification of the standard production function does not have significant direct effects
on the results.
Let Vt be entrepreneurial equity (i.e., wealth accumulated by entrepreneurs from
operating firms), let W[ denote the entrepreneurial wage, and let ?st denote the state+
contingent value of ?5 set in period t. Then aggregate entrepreneurial net worth at the
end of period t, N1+1, is given by

N++I = yVt + W[

(4.7)

with

gt=R)Qt 1Kt-(Rt

~fO' ~R)Qt-IKtdF(o)~
~~-t5
] (Qt-IK" - ~Vt-1)'
\ 4-

(4.8)

where g V~ is the equity held by entrepreneurs at t - 1 who are still in business

at t. (Entrepreneurs who fail in t consume the residual equity (1 - 7)V, That is,
C 7 = (1 - y)V,) Entrepreneurial equity equals gross earnings on holdings of equity
from t - 1 to t less repayment of borrowings. The ratio of default costs to quantity
borrowed,

# f~, (eRrk Qt jKt dF(co)

Qt 1Kt

-- Nt-i

reflects the premium for external finance.

Clearly, under any reasonable parametrization, entrepreneurial equity provides the
main source of variation in Nt+l. Further, this equity may be highly sensitive to
unexpected shifts in asset prices, especially if firms are leveraged. To illustrate, let
U[k =- R) - E t j{R~} be the unexpected shift in the gross return to capital, and let

14 Note that entrepreneurs do not have to work only on their own projects (such an assumiption would
violate aggregate returns to scale, given that individual projccts can be of different sizes).

Ch. 21." The Financial Accelerator in a Quantitative Business Cycle Framework

1359

U/p =-- f o ' o)Q~_~Kt dF( co) - Et .i { ~ ' ~oQt 1Kt dF(~o)} be the unexpected shift in the
conditional (on the aggregate state) default costs. We can express Vt as
V, = [U~k(1-ttU/P)]Qt 1Kt+E, l{V~}.

(4.9)

Now consider the impact of a unexpected increase in the ex post return to capital.
Differentiating Equation (4.9) yields an expression for the elasticity of entrepreneurial
equity with respect to an unanticipated movement in the return to capital:

ovt/E, l{v,} _ Et I{R~}Qt-IKt

/> 1.
or;kin, 1{R? }
E,, { )

(4.10)

According to Equation (4.10), an unexpected one percent change in the ex post return
to capital leads to a percentage change in entrepreneurial equity equal to the ratio
of gross holdings of capital to equity. To the extent that entrepreneurs are leveraged,
this ratio exceeds unity, implying a magnification effect of unexpected asset returns
on entrepreneurial equity. The key point here is that unexpected movements in asset
prices, which are likely the largest source of unexpected movements in gross returns,
can have a substantial effect on firms' financial positions.
In the general equilibrium, further, there is a kind of multiplier effect, as we shall
see. An unanticipated rise in asset prices raises net worth more than proportionately,
which stimulates investment and, in turn, raises asset prices even further. And so on.
This phenomenon will become evident in the model simulations.
We next obtain demand curves for household and entrepreneurial labor, found by
equating marginal product with the wage for each case:

(1 - a ) ~

= x, N,

(1 -a)(1 - ~ ) ~

(4.11)

= x, wf,

(4.12)

where W~ is the real wage for household labor and Wf is the real wage for
entrepreneurial labor.
Combining Equations (4.1), (4.7), (4.8), and (4.12) and imposing the condition that
entrepreneurial labor is fixed at unity, yields a difference equation for Nt+l:

(4.13)
+ (1 - a)(1

O)AtK~H~ l-")o.

Equation (4.13) and the supply curve tbr investment funds, Equation (4.5), are the
two basic ingredients of the financial accelerator. The latter equation describes how

1360

B.S. Bernanke et al.

movements in net worth influence the cost of capital. The former characterizes the
endogenous variation in net worth.
Thus far we have determined wholesale output, investment and the evolution of
capital, the price of capital, and the evolution of net worth, given the riskless real
interest rate Rt+l, the household real wage Wt, and the relative price of wholesale
goods I/X, To determine these prices and complete the model, we need to add the
household, retail, and government sectors.
4.2. The complete log-linearized model

We now present the complete macroeconomic framework. Much of the derivation is

standard and not central to the development of the financial accelerator. We therefore
simply write the complete log-linearized model directly, and defer most of the details
to Appendix B.
As we have emphasized, the model is a DNK framework modified to allow for
a financial accelerator. In the background, along with the entrepreneurs we have
described are households and retailers. Households are infinitely-lived agents who
consume, save, work, and hold monetary and nonmonetary assets. We assume that
household utility is separable over time and over consumption, real money balances,
and leisure. Momentary utility, further, is logarithmic in each of these arguments is.
As is standard in the literature, to motivate sticky prices we modify the model to
allow for monopolistic competition and (implicit) costs of adjusting nominal prices.
It is inconvenient to assume that the entrepreneurs who purchase capital and produce
output in this model are monopolistically competitive, since that assumption would
complicate the analyses of the financial contract with lenders and of the evolution of
net worth. To avoid this problem, we instead assume that the monopolistic competition
occurs at the "retail" level. Specifically, we assume there exists a continuum of retailers
(of measure one). Retailers buy output from entrepreneur-producers in a competitive
market, then slightly differentiate the output they purchase (say, by painting it a unique
color or adding a brand name) at no resource cost. Because the product is differentiated,
each retailer has a bit of market power. Households and firms then purchase CES
aggregates of these retail goods. It is these CES aggregates that are converted into
consumption and investment goods, and whose price index defines the aggregate price
level. Profits from retail activity are rebated lump-sum to households (i.e., households
are the ultimate owners of retail outlets.)
To introduce price inertia, we assume that a given retailer is free to change his price
in a given period only with probability 1 - 0. The expected duration of any price change
is 1@0- This device, following Calvo (1983), provides a simple way to incorporate
staggered long-term nominal price setting. Because the probability of changing price
is independent of history, the aggregation problem is greatly simplified. One extra

~5 In particular, householdatilityis givenby {~;~ 0[3~[ln(C~,k) + _~ln(Mt.JP, .-/~) + ~ In{1 l[,+i,)]}.

Ch. 21." The Financial Accelerator in a Quantitative Business Cycle Framework

1361

twist, following Bernanke and Woodford (1997), is that firms setting prices at t are
assumed to do so prior to the realization of any aggregate uncertainty at time t.
Let lower case variables denote percent deviations from the steady state, and let
ratios of capital letters without time subscript denotes the steady state value of the
respective ratio. Further, let ~ denote a collection of terms of second-order importance
in the equation for any variable z, and let e[ be an i.i.d, disturbance to the equation
for variable z. Finally, let Gt denote government consumption, :rt =-p~ - p t - i the rate
of inflation from t - 1 to t, and r'/+1 ==- r~+~ + E { p t + l - P t } be the nominal interest
rate. It is then convenient to express the complete log-linearized model in terms of
four blocks of equations: (1) aggregate demand; (2) aggregate supply; (3) evolution
of the state variables; and (4) monetary policy rule and shock processes. Appendix B
provides details.
(1) Aggregate d e m a n d
C

Ce

y~ = ]7c, + ~ i t + ~ g t + --c~'yt + "

+ q~,

(4.14)

ct = -rt+L + Et {ct+l },

(4.15)

c~ = nt,l + " " +0~:~,

(4.16)

Et{r~I}

-Fz+I

-"-u[1t+l

r ) + t - ( 1 -- e ) @ t kl -

(qt +ktl)],

kt--i Xt+l) @ eqt~ 1 q ,

qt = cp(it - kt).

(4.17)
(4.18)
(4.19)

(2) Aggregate Supply

yt = a, + a k t + (1 - a ) g 2 h ,

(4.20)

Yt- ht-xt -ct

(4.21)

~-Iht,

YL) : E t l{l~(-Xt)+ ~2Tt+l }.

(4.22)

(3) Evolution of State Variables

kt+l = 6it + (1 - 6 ) k ,

yRK

t,

(4.23)

(4.24)

B.X Bernanke et al.

1362
(4) M o n e t a r y Policy R u l e a n d S h o c k P r o c e s s e s

r, - p r t 1 + gac~ I + el",

17 I

t~

(4.25)

& = pggt-i + ~ ,

(4.26)

aL = p,,at-i + g/,

(4.27)

with

(;

log Iz

~
P

# j)

e)dF(~o)R~Qt_IK/DK

)l

?O

6o dF(~o)R/',

O~'e = log(1-Ce+l/Ni+~ )
i T c~T;/N
'
q~t" =

(Ri'lR-

N 1)K (r~"+q~-i +kt)+

lp(Rk/R)
~'(Rk/R) '
1),,'

[2)(Y/X)

Yt-x~,

1- b
(1 - cs) + a Y / ( X K ) '

( ~ ( I / K ) 1)t
q) ~ ((D(I/K)

(1 - a)(1 -

(1~_)
K" ~

(1 -- 0/~).

Equation (4.14) is the log-lineafized version of the resource constraint. The

primary determinants of the variation in aggregate expenditures Yt are household
consumption ct, investment it, and government consumption gL. Of lesser importance
is variation in entrepreneurial consumption c~ 16. Finally, variation in resources devoted
monitoring cost, embedded in the term ~ , also matters in principle. Under reasonable
parametrizations, however, this factor has no perceptible impact on dynamics.
Household consumption is governed by the consumption Euler relation, given by
Equation (4.15). The unit coefficient on the real interest rate (i.e., the intertemporal
elasticity of substitution) reflects the assumption of logarithmic utility over con.sumption. By enforcing the standard consumption Euler equation, we are effectively
assuming that financial market frictions do not impede household behavior. Numerous
authors have argued, however, that credit constraints at the household level influence
a non-trivial portion of aggregate consumption spending. An interesting extension of

16 Note that each variable in the log-lmearizedresource constraint is weighted by the variable's share
of output in the steady state. Under any reasonableparametrizationof the model, c~ has a relativelylow
weight.

Ch. 21."

The Financial Accelerator in a Quantitatiee Business Cycle Framework

1363

this model would be to incorporate household borrowing and associated frictions. With
some slight modification, the financial accelerator would then also apply to household
spending, strengthening the overall effect.
Since entrepreneurial consumption is a (small) fixed fraction of aggregate net worth
(recall that entrepreneurs who retire simply consume their assets), it simply varies
proportionately with aggregate net worth, as Equation (4.16) indicates.
Equations (4.17), (4.18), and (4.19) characterize investment demand. They are
the log-linearized versions of Equations (4.5), (4.4) and (4.3), respectively. Equation (4.17), in particular, characterizes the influence of net worth on investment. In
/,
the absence of capital market frictions, this relation collapses to Et{rf+~ } -rt+l = 0:
Investment is pushed to the point where the expected return on capital, Et{r~+ 1 }, equals
the opportunity cost of funds rt+117. With capital market frictions present, however, the
cost of external funds depends on entrepreneurs' percentage equity holding, i.e., net
worth relative to the gross value of capital, nt~l - (qr + ktf-l). A rise in this ratio reduces
the cost of external funds, implying that investment will rise. While Equation (4.17)
embeds the financial accelerator, Equations (4.18) and (4.19) are conventional (loglinearized) relations for the marginal product of capital and the link between asset
prices and investment.
Equations (4.20), (4.21) and (4.22) constitute the aggregate supply block. Equation (4.20) is the linearized version of the production function (4.1), after incorporating
the assumption that the supply of entrepreneurial labor is fixed. Equation (4.21)
characterizes labor market equilibrium. The left side is the marginal product of
labor weighted by the marginal utility of consumption 18. In equilibrium, it varies
proportionately with the markup of retail goods over wholesale goods (i.e., the inverse
of the relative price of wholesale goods.)
Equation (4.22) characterizes price adjustment, as implied by the staggered price
setting formulation of Calvo (1983) that we described earlier [along with the
modification suggested by Bernanke and Woodford (1997)]. This equation has the
flavor of a traditional Phillips curve, once it is recognized that the markup xt varies
inversely with the state of demand. With nominal price rigidities, the retail firms that
hold their prices fixed over the period respond to increased demand by selling more. To
accommodate the rise in sales they increase their purchases of wholesale goods from
entrepreneurs, which bids up the relative wholesale price and bids down the markup.
it is tbr this reason that - x t provides a measure of demand when prices are sticky. In
turn, the sensitivity of inflation to demand depends on the degree of price inertia: The
slope coefficient t can be shown to be decreasing in 0, the probability an individual
price stays fixed from period to period. One difference between Equation (4.22) and
17 In the absence of capital market frictions, the first-ordercondition from the entrepreneur'spartial
equilibrium capital choice decision yields E{R)+ I } = Rt+ L. In this instance if E{R~'4 l} > R , j, the
entrepreneurwould buy an infinite amount of capital, and if E{R~+1} < R~+l,he wouldbuy none. When
E{Rt+ I } - R ~ 1, he is indifferentabout the scale of operation of his firm.
i~ Given logarithmicpreferences,the marginal utility of consumption is simply -%.

1364

B.S. Bernanke et al.

a traditional expectations-augmented Phillips curve is that it involves expected future

inflation as opposed to expected current inflation. This alteration reflects the forwardlooking nature of price setting 19
Equations (4.23) and (4.24) are transition equations for the two state variables,
capital kt and net worth nt. The relation for capital, Equation (4.23), is standard, and
is just the linearized version of Equation (4.2). The evolution of net worth depends
primarily on the net return to entrepreneurs on their equity stake, given by the first
term, and on the lagged value of net worth. Note again that a one percent rise in the
return to capital relative to the riskless rate has a disproportionate impact on net worth
due to the leverage effect described in the previous section. In particular, the impact of
r) - r~ on nt+l is weighted by the coefficient y R K / N , which is the ratio of gross capital
holdings to entrepreneurial net worth.
How the financial accelerator augments the conventional D N K model should now be
fairly transparent. Net worth affects investment through the arbitrage Equation (4.17).
Equation (4.24) then characterizes the evolution of net worth. Thus, among other
things, the financial accelerator adds another state variable to the model, enriching
the dynamics. All the other equations of the model are conventional for the
D N K framework [particularly King and Wohnan's (1996) version with adjustment costs
of capital].
Equation (4.25) is the monetary policy rule 2. Following conventional wisdom, we
take the short-term nominal interest rate to be the instrument of monetary policy. We
consider a simple rule, according to which the central bank adjusts the current nominal
interest rate in response to the lagged inflation rate and the lagged interest rate. Rules o f
this form do a reasonably good job of describing the variation of short term interest
rates [see Clarida, Gali and Gertler (1997)]. We also considered variants that allow
for responses to output as well as inflation, in the spirit of the Taylor (1993) rule.
Obviously, the greater the extent to which monetary policy is able to stabilize output,
the smaller is the role of the financial accelerator to amplify and propagate business
cycles, as would be true for any kind o f propagation mechanism. With the financial
accelerator mechanism present, however, smaller countercyclical movements in interest
rates are required to dampen output fluctuations.
Finally, Equations (4.26) and (4.27) impose that the exogenous disturbances to
government spending and technology obey stationary autoregressive processes.
We next consider two extensions of the model.

-~oc
k
t9 Iterating Equation (4.22) forward yields zct = ~,z=0/3
~c(p,w ~ -Pt+k)- With forward-looking price
setting, how fast prices adjust depends on the expected discounted stream of future demand.
2o The interest rate rule may be thought of as a money supply equation. The associated money demand
equation is given by m, -Pt = ct - ( ~ ) r~l~. Note that under interest-rate targeting this relation simply
determines the path of the nominal money stock. To implement its choice of the nominal interest rate~
the central bank adjusts the money stock to satisfy this equation.

Ch. 21:

The tqnancial Accelerator" in a Quantitatioe Business Cycle Framework

1365

4.2.1. Two extensions o f the baseline model

Two modifications that we consider are: (1) allowing for delays in investment; and
(2) allowing for firms with differential access to credit. The first modification permits
the model to generate the kind of hump-shaped output dynamics that are observed in
the data. The second is meant to increase descriptive realism.
4.2.1.1. Inoestment delays. Disturbances to the economy typically appear to generate a

delayed and hump-shaped response of output. A classic example is the output response
to a monetary policy shock [see, e.g., Christiano, Eichenbaum and Evans (1996) and
Bernanke and Mihov (1998)]. It takes roughly two quarters before an orthogonalized
innovation in the federal funds rate, for example, generates a significant movement
in output. The peak of the output response occurs well after the peak in the funds
rate deviation. Rotemberg and Woodford (1997) address this issue by assuming that
consumption expenditures are determined two periods in advance (in a model in which
non-durable consumption is the only type of private expenditure). We take an approach
that is similar in spirit, but instead assume that it is investment expenditures rather than
consumption expenditures that are determined in advance.
We focus on investment for two reasons. First, the idea that investment expenditures
take time to plan is highly plausible, as recently documented by Christiano and Todd
(1996). Second, movements in consumption lead movements in investment over the
cycle, as emphasized by Bernanke and Gertler (1995) and Christiano and Todd (1996).
For example, Bernanke and Gertler (1995) show that in response to a monetary policy
shock household spending responds fairly quickly, well in advance of business capital
expenditures.
Modifying the model to allow for investment delays is straightforward. Suppose that
investment expenditure are chosenj periods in advance. Then the first-order condition
relating the price of capital to investment, Equation (4.3), is modified to
I

(4.28)
Note that the link between asset prices and investment now holds only in expectation.
With the time4o-plan feature, shocks to the economy have an immediate effect on
asset prices, but a delayed effect on investment and output 21.
To incorporate the investment delay in the model, we simply replace Equation (4.19)
with the following log-linearized version of Equation (4.28):
Et{qt+j - q)(it+j - kt+j)} - 0.

In our simulations, we take j = 1.

21 Asset prices move inunediately since the return to capital depends on the expected capital gain.

B.S. Bernanke et ai.

1366

4.2.1.2. Heterogeneous firms. The baseline model assumes that all firms are alike
ex ante, except for initial net worth. In practice, o f course, there is considerable
heterogeneity among firms along many dimensions, in particular in access to credit
[see, e.g., the discussion in Gertler and Gilchrist (1994)]. To see how heterogeneity
affects the results, we add to our model the assumption that there are two types o f
firms, those that have easy access to credit, ceteris paribus, and those that (for various
informational or incentive reasons, for example) have less access to credit.
To accommodate two different types o f firms, we assume that there are two types
o f intermediate goods (one produced by each type o f firm) which are combined into
a single wholesale good via a CES aggregator. Production of the intermediate good is
given by

Yit =A itKaI-[~tH
it it t i~(1
J a 2),

i = 1,2.

(4.29)

Aggregate wholesale output is composed o f sectoral output according to

(4.30)

= [ . Y ~ + (1 - . ) Y 2 ] ('/"~

We also assume that capital is sector-specific, and that there are costs of adjusting the
capital stock within each sector:
(4.31)

Ki, t , 1 - Kit = ()(Ii#K.)K. - 6K..

Let ji denote the number of periods in advance that investment expenditures must be
chosen in sector i (note that the lag may differ across sectors): Then the link between
asset prices and investment in each sector is given by

Note that the price of capital may differ across sectors, but that arbitrage requires that
each sector generate the same expected return to capital
k
Et{ IRkk1,t+l - R2,t+I]
[3CI/Cg+I}

=0,

where

~1P5

x,,t+~ + Q,,,+I(I - ,5) /Q,~.

and

Pit
p~=a\

(Y1L) p-1
r, j
'

Pzt
Py

(l_a)(Y2t)P
\ r, j

are the relative (wholesale) prices of goods produced in sectors t and 2 respectively.

Ch. 21:

The Financial Accelerator in a Quantitative Business Cycle Framework

1367

As we discuss in the next section, it is easy to parametrize the model so that firms in
each sector face differential costs o f credit. Further, as we illustrate below, the financial
accelerator can still be quite potent, even if only a portion o f firms face significant
capital market frictions. Indeed, there may spillover effects from constrained to nonconstrained firms.
it is straightforward to log-linearize these equations and append them to the general
model. Modified will be the aggregate supply block, to allow for the two types of
intermediate output, and the law o f motion for capital, to allow for two distinct types
of capital.

5. Model simulations

In this section we present the results of some quantitative experiments to illustrate

how the financial accelerator influences business cycle dynamics within the DNK
framework. Specifically, we consider how credit-market imperfections amplify and
propagate various shocks to the economy. We also examine the effects of allowing
for delays in investment and of allowing for some firms to have better access to credit
market than others.
5.1. M o d e l parametrization

We choose fairly standard values for the taste and technology parameters. We set
the quarterly discount factor fi to 0.99 (which also pins down the steady state
quarterly riskless rate, R = [3-1). We fix the labor supply elasticity, t/, at 3.0, in
keeping with much o f the literature 22. As is also within convention, the capital share,
a, is 0.35, and the household labor share, (1 - a)(1 - g2), is 0.64. The share of
income accruing to entrepreneurs' labor is accordingly equal to 0.01. The quarterly
depreciation rate for capital, 6, is assigned the usual value of 0.025. We take the steadystate share o f government expenditures in total output, G / Y , to be 0.2, the approximate
historical average. The serial correlation parameters for the technology and government
expenditure shocks, pa and pg, are assumed to be 1.0 and 0.95, respectively. Finally,
the elasticity o f the price of capital with respect to the investment capital ratio, q), is
taken to be 0.25. There is no firm consensus in the literature about what this parameter
value should be 23. Reasonable assumptions about adjustment costs suggest that the
value should lie within a range from 0.0 to 0.50.

22 in particular, we fix average hours worked relative to total hours available at a value that, in
conjunction with logarithmic preferences over leisure, generates the desired labor supply elasticity.
23 King and Wolman (1996) use a value of 2.0, based on estimates fi-om aggregate data by Chirinko
(1993). Because this value implies implausibly high adjustment costs, we do not use it.

1368

B.S. Bernanke et aL

The non-standard parameters of our model pertain to the interplay between real and
financial factors within the entrepreneurial sector 24. Specifically, we choose parameters
to imply the following three steady state outcomes: (1) a risk spread, R ~ - R , equal
to two hundred basis points, approximately the historical average spread between the
prime lending rate and the six-month Treasury bill rate; (2) an annualized business
failure rate, F(N), of three percent, the approximate rate in the data; (3) a ratio of
capital to net worth, ~,
K of 2 (or equivalently, a leverage ratio of 0.5), the approximate
value in the data. l b obtain these steady state values we choose the "death rate" of
entrepreneurs, 1 - y, to be 0.0272 (quarterly), we take the idiosyncratic productivity
variable, log(o)), to be log-normally distributed with variance equal to 0.28, and we set
the fraction of realized payoffs lost in bankruptcy,/~, to 0.12. We note that our choice
for/~ is within the reasonable set of estimates for bankruptcy costs 25.
The final parameters to be selected are those related to the rate of price adjustment
and to the policy rule. We let the probability a firm does not change its price
within a given period, 0, equal to 0.75, implying that the average period between
price adjustments is four quarters. In the policy rule, Equation (4.25), we set the
autoregressive parameter, p, to 0.9 and the coefficient on inflation equal to 0.11
(implying a long-run rise in the nominal interest rate of one hundred and ten basis
points in response to a permanent one hundred basis point increase in inflation.) These
numbers are roughly in line with the evidence, allowing for the fact that there have been
shifts in the actual feedback rule over time [see Clarida, Gali and Gertler (1997)].
5.2. Results

In our experiments we consider four types of aggregate shocks: (1) a monetary policy
shock, (2) a technology shock, (3) a government expenditure shock, and (4) a one
time, unanticipated transfer of wealth from households to entrepreneurs. We first study
the response of the economy to these shocks in our model, excluding and including
the financial accelerator. We then consider the implications of allowing for investment
delays and heterogeneous firms.
5.2.1. Response to a monetary policy shock

The first experiment we consider is a monetary policy shock, specifically an

unanticipated exogenous movement in the short-term interest rate. Analyzing the
response of the model economy to a monetary policy disturbance provides a good
way to evaluate our framework since a lengthy literature has produced a consensus of

24 Ore parameter choices here follow closely Fisher (1996) and Carlstrom and Fuerst (t997).
2s See the discussion of bankruptcy costs in Carlstrom and Fuerst (1997). They actually use a higher
number than we do (0.20 versus 0.12).

Ch. 21."

The Financial Accelerator in a Quantitative Business Cycle I~)'amework

1369

03

c5
q
,:5
c5

. . . .
0

"'",-'-"'",'-'~
3

, "-,'-",

10

Log(GDP)
Log(GDP,Def[ator )
12

14

16

Quarters

,,., ....

....~.-.~

....

\\//
0

10

P r i m e R a t e - Tbill
C P R a t e - Tbill

Funds Rate
12

14

16

Quarters

Fig. 2. Impulse response to a funds rate shock.

opinion about how the economy responds to this kind o f shock 26. Figure 2 summarizes
this evidence, and also presents some new evidence on the behavior of several rate
spread variables that proxy for premium for external funds, a key element o f our
model.
The results in Figure 2 are based on a five-variable quarterly VAR that includes
four "standard" macroeconomic variables - the log o f real GDR the log o f the GDP
deflator, the log o f a commodity price index, the federal funds rate -- along with
two rate spread variables. To identify the policy shock, we order the funds rate after
the price and output variables, based on the view that monetary policy can respond
contemporaneously to these variables but can affect them only with a lag. We order tile
spread variable after the funds rate based on the assumption that innovations in these
variables do not contain any marginal information that is useful for setting current
monetary policy. The two rate spread variables we consider are the difference between
the six-month commercial paper rate and the six-month T-bill rate and the difference
between the prime lending rate and the six-month T-bill rate.

26 See, for example, Ctmstiano, Eichenbaum and Evans (t996), Bernanke m~d Gertler (1995), Bernal~e
and Mihov (1998), and Leeper, Sims and Zha (1996).

1370

B.X B e r n a n k e et al.

Figure 2 illustrates the impulse responses of several variables to a negative

innovation in the federal funds rate. As is typically found in the literature, output
declines after about two quarters, and the price level declines after about six quarters.
The output decline, further, persists well after the funds rate reverts to trend. Finally,
each of the spread variables rises fairly quickly, leading the downturn in output 27.
Figure 3 reports the impact of the same experiment, but this time using the model
economy. As in all the subsequent figures, the time units on the graphs are to be
interpreted as quarters. In each picture the hatched line designates the "baseline"
impulse response, generated by fixing the external finance premium at its steady state
level instead of allowing it to respond to changes in the capital-net worth ratio. In
other words, the baseline simulations are based on a model with the same steady
state as the complete model with imperfect credit markets, but in which the additional
dynamics associated with the financial accelerator have been "turned off". The solid
line in each picture indicates the response observed in the complete model, with the
financial accelerator included.
The figure shows the impact of an unanticipated 25 basis point (on an annual basis)
decline in the nominal interest rate. Although the addition of credit-market frictions
does not substantially affect the behavior of the nominal rate of interest, it does lead
to a stronger response of real variables. In particular, with the financial accelerator
included, the initial response of output to a given monetary impulse is about 50%
greater, and the effect on investment is nearly twice as great. Further, the persistence of
the real effects is substantially greater in the presence of the credit-market factors, e.g.,
relative to trend, output and investment in the model with credit-market imperfections
after four quarters are about where they are in baseline model after only two quarters.
The impact of the financial accelerator is mirrored in the behavior of the external
finance premium, which is passive in the baseline model (by assumption) but declines
sharply in the complete model, slowly reverting to trend. The unanticipated decline in
the funds rate stimulates the demand for capital, which in turn raises investment and
the price of capital. The unanticipated increase in asset prices raises net worth, forcing
down the external finance premium, which in turn further stimulates investment. A
kind of multiplier effect arises, since the burst in investment raises asset prices and
net worth, further pushing up investment. Entrepreneurial net worth reverts to trend
as firms leave the market, but the effect is slow enough to make the external finance
premium persist below trend. This persistence in net worth and the external finance
premium provides the additional source of dynamics. It is interesting to observe that
the response of the spread in the model economy matches the VAR evidence reasonably
well.

27 It is worth noting that the impulse response of the prime-rate spread is twice as large as the impulse
response of the commercial-paperspread. Since commercial paper issuers are high quality firms, this
result is consistent with our model's implication that lower-quality borrowers experience larger spread
movementsin response to business cycle shocks.

1371

Ch. 21." The Financial Accelerator in a Quantitative Business Cycle Framework

\
e'~

-With Financial Accelerator

\ - - - ' - W i t h o u t
FinancialAccelerator

""\\.\.N.X
.
~

(o
,:5
c,l

O
0

9 10

....
0 1 2 3 4 5 6 7 8 9 10
,

12

12

investment

Output
o
ci

g
o,

g
o,

//'/i.i./ / /'/ ". . / ' ~ " ~ , ~ . ~ . . . . . . . . . . . . . . . .

--

o,

fl

9 10

Nominal Interest R a t e

12

With Financial Accelerator

Without Financial Accelerator

-'~._

With Financial Accelerator

"7"-, With,out Financial Accelerato,r

10

12

Premium

Fig. 3. Monetary shock -- no investment delay. All panels: time horizon in quarters.

It is worth emphasizing that this experiment generates substantial output persistence

without relying on an unusually high labor supply elasticity, as is required for the
baseline model [see, e.g., the discussion in Chari, Kehoe and McGrattan (1996)]. The
countercyclical movement in the premium for external funds (which is the essence
of the financial accelerator) serves to flatten the marginal cost curve, as does making
labor supply elastic in the baseline model.
Overall, these results lend some supports to the claims of Bernanke and Gertler
(1995), that credit-market effects can help explain both the strength of the economy's
response to monetary policy and the tendency for policy effects to linger even after
interest rates have returned to normal. The fact that the model economy replicates the
VAR evidence reasonably well is particularly encouraging. The one major point of
discrepancy is that the response of output to a monetary shock is delayed in the data,
but occurs immediately in the model economy 28. We show shortly, however, that this
problem can be fixed by allowing for investment delays.

2~ It is also true that the output response is large relative to the interest rate shock. This partly reflects
the high degree of intertemporal substitution embedded in the household savings decision, It may also
reflect unreasonably short investment delays.

1372

B.S. B e r n a n k e et al.

nFiAcCel
.nAcc~el
~\--....
~ Wi
WitthhFiout
. erateoralr or

, ~ Wi~ht FinAccel
. erator
d

-- WithFinAccelerator

~D
,:5
(:5

......

(:5
0

10 12

Technology Shock

Fig. 4. Output response

10 12

Demand Shock

10 12

Wealth Shock

alternative shocks. All panels: time horizon in quarters.

5.2.2. Shock to technology, demand, and wealth

Figure 4 displays the effects on output of three alternative shocks: a technology shock,
a demand shock (specifically a shock to government expenditures), and a redistribution
of wealth between entrepreneurs and households. Once again, the hatched lines show
impulse responses from the baseline model with the financial accelerator shut off, and
the solid lines show the results from the full model.
As the figure shows, the financial accelerator magnifies and propagates both the
technology and demand shocks. Interestingly, the magnitude of the effects is about
the same as for the monetary policy shock. Again, the central mechanism is the rise
in asset prices associated with the investment boom, which raises net worth and thus
reduces the external finance premium. The extra persistence comes about because net
worth is slow to revert to trend.
A positive shock to entrepreneurial wealth (more precisely, a redistribution fi:om
households to entrepreneurs) has essentially no effect in the baseline model, but
has both significant impact and propagation effects when credit-market frictions are
present. The wealth shock portrayed is equal in magnitude to about 1% of the initial
wealth of entrepreneurs and about 0.05% of the wealth of households. The transfer of
wealth drives up the demand for investment goods, which raises the price of capital
and thus entrepreneurs' wealth, initiating a positive feedback loop; thus, although
the exogenous shock increases entrepreneurial net worth directly by only 1%, the
total effect on entrepreneurs' wealth including the endogenous increase in asset prices
exceeds 2%. Output rises by 1% at an annual rate, and substantial persistence is
generated by the slow decay of entrepreneurial net worth.
Thus the addition of credit-market effects raises the possibility that relatively small
changes in entrepreneurial wealth could be an important source of cyclical fluctuations.
This case is an interesting one, as it is reminiscent of(and motivated by) Fisher's (1933)
"debt-deflation" argument, that redistributions between creditors and debtors arising
from unanticipated price changes can have important real effects. Indeed, Fisher argued

Ch. 21:

The Financial Accelerator in a Quantitative Business Cycle Framework

1373

that this kind of mechanism accounted for the depth and protractedness of the Great
Depression 29. The same kind of reasoning, further, helps explain why the recent spate
of currency crises have had devastating real effects. To the extent loans from abroad
are denominated in units of a foreign currency, an exchange rate collapse redistributes
wealth from domestic borrowers to foreign lenders.
5.2.3. Investment delays and heterogeneous firms

We now suppose that investment expenditures must be planned one quarter in advance,
as in Section 5.2, and consider the effect of a monetary shock. As Figure 5 illustrates,
an expansionary monetary policy shock (again, an unanticipated 25 basis point decline
in the funds rate) now generates a hump-shaped response of output, as in the data. This
hump-shaped response is considerably more accentuated when the financial accelerator
is allowed to operate. The initial response of output is still too strong, suggesting that
it may be desirable to build in other types of lags. On the other hand, the persistence
of the response of output is considerably greater than in the case without investment
delays, and comes much closer to matching the data. Interestingly, there remains an
immediate response of the external funds premium as the data suggest. The reason is
that asset prices rise immediately, in anticipation of the investment boom.
We next consider the model with heterogeneous firms. We choose parameters so that
firms in sector 2 face a steady-state premium for external finance of 3% per year, while
firms in sector l face a premium of only 1%. We set a = .5125 to generate an average
steady-state premium of 2%. As a consequence of this assumption, roughly half of
the economy's output is produced by credit-constrained firms, a breakdown which is
in accord with the rough evidence summarized in Bernanke, Gertler and Gilctu'ist
(1996). We set p = 0.9, implying that the goods produced in the two sectors are
close substitutes. Assuming a high degree of substitutability biases the results against
finding important aggregate effects of credit-market frictions in this setup; however,
our results turned out to be not very sensitive to the choice o f p . With sector-specific
adjustment costs, the effective marginal cost of adjusting the aggregate capital stock
is dramatically increased owing to the additional curvature implied by the two sector
model. To achieve the same degree of overall capital adjustment as in the one-sector
model we lower the adjustment cost elasticity q) from 0.25 to 0.1. Finally, we allow
for a one-period delay in the investment of sector-2 firms and a two period delay for
sector-1 firms. This choice is based on the observation that credit-constrained firms
tend to be smaller, and rims likely more flexible [see, e.g., Gertler and Gilchrist (1994)].
All other parameters are the same as in the baseline DNK model.
Figure 6 shows the results of a shock to monetary policy in the model with
heterogeneous firms. The top left panel shows the response of output (the solid line),

29 Bernanke and Gertler (1989, 1990) argue that the tinancial accelerator mechanismprovides a tormal
rationale for Fisher's debt-deflationtheory of the Great Depression.

B.S. B e r n a n k e et al.

1374
[

--

....

./"

WithFinancialAccelerator
WithoutFinancialAccelerator

/~

wWItthoFui~~ncia/(iAa~c~lecre~
c trator

"\.

0 1 2 3 4 5 6 7 8 9 1 0

12

1 2

5 6

9 10

12

12

Investment

Output

ci '
o

//
. . . . .
0

With FinancialAccelerator
. . . . WithoutFinancialAccelerator
, . . . . .
-r'---r
3

N o m i n a l Interest R a t e

Fig. 5. Monetary shock

10

12

~
0

r
1

10

Premium

one period investment delay, All panels: time horizon in quarters.

relative to the baseline case with the financial accelerator shut off (the hatched line).
In response to an unanticipated fall in the funds rate, output rises by approximately
the same amount as it did in the aggregative New Keynesian model with investment
delays, both for the baseline model without credit-market frictions and for the complete
model with differential access of firms to credit. One interesting difference is that the
differential investment delays across sectors smooth out the hump-shaped response of
output, adding to the overall persistence of the output response. Thus, the effect of
credit-market frictions on the propagation of shocks is roughly the same in the onesector and two-sector versions of the model.
The two-sector model also has cross-sectional implications, of course. The top and
bottom panels on the right side of Figure 6 show the sectoral responses of output and
investment. The solid line corresponds to the sector facing the relatively higher cost
of external finance and the dotted line corresponds to the other sector. We find that, in
response to an expansionary monetary policy shock, investment by firms with relatively
poor access to external credit markets rises by nearly three times as much as the
investment of firms with better access to credit. This "excess sensitivity" of the more
constrained firms is consistent with evidence reported by Gertler and Gilchrist (1994),
Kashyap, Lamont and Stein (1994), Oliner and Rudebusch (1994), Morgan ( 1998), and

Ch. 21:
c~
co

c5
to

,:5
c5

Sector2
1375

The Financial Accelerator in a Quantitative Business Cycle Framework

..

---: glLFu,r ~,n'~"n'c,~%eo%%,cr

'/

'

'

Sector

oq

c5
I

0 1 2 3 4 5 6 7 8 9 1 0

0 1 2 3 4 5 6 7 8 9 1 0

12

sectoral Output

Aggregate Output
co

o,

-I
- - - -

/
/

tD

o,

j J

-r-

, ---r-

---. . . . .

12

Premium
Nora.I n t

t9

10

12

it

Premium and Nominal Interest Rate

Sector
Sector

2
1

01

10

12

Sectoral Investment

Fig. 6. Monetaryshock multisectormodel with investmentdelays. All panels: time horizon in quarters.
Aggregate output: models with and without financial accelerator; other panels: model with financial
accelerator.
others. Although investment differs sharply across firrns in the simulation, changes in
output are similar for the two types of firms. Differing output effects could be produced,
for example, by introducing inventories or inputs to production that must be financed
by borrowing.
Our finding that constrained firms' investment spending reacts more strongly to
monetary policy contrasts with that of Fisher (1996), who obtains an ambiguous
result. We suspect that the main source of the difference in predictions is that, in
our setting, borrowers' net worth is endogenous and is a key channel through which
monetary policy affects credit availability. In Fisher's model, in contrast, borrowers'
equity positions are exogenously fixed and are unaffected by changes in policy.

6. A highly selected review of the literature

The theoretical and empirical literatures on credit-market imperfections are immense,
Until recently, the great bulk of this research has been partial equilibrium in nature,
e.g., theoretical analyses of equilibria in credit markets with asymmetric information

1376

B.S. B e r n a n k e et al.

and agency costs, or empirical studies of the effects of credit-market imperfections on

various types of spending, including consumption, housing, business investment, and
inventory investlnent. Some leading recent examples of the latter category are cited
in the introduction; see, e.g., Bernanke, Gertler and Gilchrist (1996) tbr additional
references. Other surveys of these literatures which the reader may find useful include
Gertler (1988), Gertler and Hubbard (1988), Jaffee and Stiglitz (1990), Bernanke
(1993), Calomiris (1993), Gertler and Gilchrist (1993), Kashyap and Stein (1994),
Oliner and Rudebusch (1994), Bernanke and Gertler (1995), and Hubbard (1995).
To keep our survey of relevant literature brief, we limit consideration to the more
recent work that, like the present research, studies the implications of credit-market
frictions for macroeconomic dynamics. Even within this limited field our review must
necessarily be selective; we focus on the work that bears the closest relationship to
the model we have presented. In particular, we do not discuss the burgeoning related
literature on the role of financial markets in economic growth [see, e.g., Levine (1997)
for a survey of this topic] or in economic development [see, e.g., Townsend (1995)].
Nor do we consider research focusing on the role of banks in business cycles, primarily
because there has been little work on the "bank lending channel" and related effects
in an explicitly dynamic context 3o. We do believe however that the incorporation of a
banking sector into our model would be a highly worthwhile exercise. Indeed, given
that commercial banks borrow to order to fund investments in information-intensive,
risky projects, and in this way bear resemblance to the entrepreneurs in our model,
one could envision a relatively straightforward that allows for agency frictions int tile
intermediary sector.
On the theoretical side, the two principal antecedents of the approach used in the
present chapter are Bernanke and Gertler (1989) and Kiyotaki and Moore (1997).
Bernanke and Gertler (1989) analyze an overlapping-generations model in which
borrowers/firms with fixed-size investment projects to finance face the "costly state
verification" problem of Townsend (1979) and Gale and Hellwig (1985) 31. As we
discussed in detail in the presentation of our model above, the optimal contract in this
setting has the features of a standard debt contract. As we noted earlier, the principal
virtue of this setup, other than simplicity, is that it motivates an inverse relationship
between the potential borrower's wealth and the expected agency costs of the lenderborrower relationship (here, the agency costs are equated with monitoring/bankruptcy
costs). In particular, a potential borrower with high net worth needs to rely relatively
little on external finance; he thus faces at most a small risk of bankruptcy and a small

3o Interestingrecent exceptions are Gersbach (t997) and Krishnamurthy (t997). Holmstrom and Tirole
(1997) analyzethe role of bank collateral and monitoring in a static context. Severalpapers have studied
the role of banks in the context of "limited participation" models, see for example Fisher (1996) and
Cooley and Quadrini (1997).]
31 Williamson (1987) also incorporates the costly state verification assanaption into a modified real
business cycle naodel.

Ch. 21:

The Financial Accelerator in a Quantitative Business Cycle Framework

1377

premium on external finance. A borrower with less resources of his own to invest, in
contrast, faces a high bankruptcy risk and a high external finance premium.
In the Bernanke-Gertler model, shocks to the economy are amplified and propagated
by their effects on borrowers' cash flows. For example, an adverse productivity shock
lowers current cash flows, reducing the ability of firms to finance investment projects
from retained earnings. This decline in net worth raises the average external finance
premium and the cost of new investments. Declining investment lowers economic
activity and cash flows in subsequent periods, amplifying and propagating the effects
of the initial shock. Bernanke and Gertler show that this effect can generate serially
correlated movements in aggregate output, even though the exogenous shocks to the
system are i.i.d. They also show that in their model the dynamics of the cycle are
nonlinear; in particular, the weaker the initial financial condition of borrowers, the more
powerful is the propagation effect through cash flows. A number of subsequent papers
have shown that this basic analysis can be extended and deepened without affecting
the qualitative results: For example, Gertler (1992) considers the case of multi-period
financial contracts. Aghion and Bolton (1997) give an extensive analysis of the shortrun and long-run dynamic behavior of a closely-related model. And Aghion, Banerjee
and Piketty (1997) show how the dynamics of this sort of model are affected when
interest rate movements are endogenous (Bernanke and Gertler assume that the real
interest rate is fixed by the availability of an alternative technology.) The model that we
presented utilizes a number of the features of the Bernanke-Gertler model, notably the
overlapping-generations assumption for entrepreneurs and the costly state verification
model of intermediation. As in Bernanke and Gertler (1989), our model here implies
a central role for the endogenous evolution of borrowers' net worth in macroeconomic
dynamics.
Other authors have developed dynamic macroeconomic models in which cash flows
play a critical role in the propagation mechanism. Notably, Greenwald and Stiglitz
(1993) construct a model in which, as in Bernanke and Gertler (1989), firms have
access only to debt financing (equity finance is ruled out by assumption). Because
bankruptcy is costly, firms are reluctant to become highly levered; their initial equity
or net worth thus effectively constrains the quantity of funds that they can raise in
capital markets. Greenwald and Stiglitz assume that there is a one-period lag between
the use of variable inputs and the production of output. A firm that suffers a decline
in cash flow is able to finance fewer inputs and less production. Lower production
implies lower profits, which propagates the effects of the initial fall in cash flow. The
Greenwald-Stiglitz model thus illustrates that financial factors may affect the level of
inputs, such as employment or inventories, as well as the level of capital investment (as
in Bernanke-Gertler). The basic intuition concerning how credit-market imperfections
propagate the cycle is similar in the two models, however.
The net worth of borrowers changes not only in response to variations in cash flow,
but also (and often, more dramatically) to changes in the valuation of the real and
financial assets that they hold. Indeed, changes in asset values are taken by Fisher
(1933) and other classical writers on the subject to be the principal means by which

1378

B.S. B e r n a n k e et al.

financial forces propagate an economic decline. This element was added to the formal
literature by Kiyotaki and Moore (1997), who develop a dynamic equilibrium model in
which endogenous fluctuations in the market prices o f an asset (land, in their example)
are the main source o f changes in borrowers' net worth and hence in spending and
production 32.
Kiyotaki and Moore analyze a stylized example in which land serves both as a factor
o f production and as a source o f collateral for loans to producers, in this economy,
a temporary shock (to productivity, for example) lowers the value o f land and hence
o f producers' collateral. This leads in turn to tightened borrowing constraints, less
production and spending, and finally to still further reductions in land values, which
propagates the shock further through time 33. We consider the asset-price channel
to be an important one, and it plays an important role in generating the significant
quantitative effects we obtained in our calibration exercises 34.
Turning from theoretical to empirical research, we note that there are very few
examples o f fully articulated macro models including capital-market imperfections
that have been estimated by classical methods (the major exception being some large
macroeconometric forecasting models, as noted in the introduction). The quantitative
research most closely related to the present chapter uses the calibration technique.
Our work here is particularly influenced by Carlstrom and Fuerst (1997), which in
turn draws from analyses by Fisher (1996), Fuerst (1995) and Gertler (1995), as well
as from the theoretical model o f Bernanke and Gertler (1989) discussed above.
As we do in the model presented in this chapter, Carlstrom and Fuerst (1997) study
the optimal lending contract between financial intermediaries and entrepreneurs when
verifying the return to entrepreneurs' projects is costly for the lender. They then embed
the resulting representation o f credit markets in an otherwise conventional real business
cycle model. They find that the endogenous evolution o f net worth plays an important
role in the simulated dynamic responses o f the model to various types o f shock.

32 Suarez and Sussman (1997) present a dynamic model in which asset price declines, induced by "fire
sales" by bankrupt firms, contribute to cyclical fluctuations.
33 In the model we presented earlier, entrepreneurs do not obtain insurance against aggregate shocks
because their indirect utility functions are linear in wealth (due to the assumptions of risk neutrality
and constant returns to scale), while households are risk-averse. Krishnamurthy (1997) points out that
in more general settings entrepreneurs are likely to want to obtain this kind of insurance, which raises
the question of why the posited credit-market effects should be empirically relevant. Krishnamurthy's
answer is that the ability of lenders or other insurers to insure against large aggregate shocks depends
in turn on the insurers' own net worth, which may be reduced during a severe recession. He goes on to
develop a model with implications similar to that of Kiyotaki and Moore (1997), except that it is the
net worth of lenders or insurers, rather than that of borrowers, that plays the crucial role. See Kiyotaki
and Moore (1998) tbr a related argument.
34 Another potentially interesting chatmel, emphasized by Kiyotaki and Moorc (1998), involves the
interdependency that arises from credit chains, where firms are simultaneously lending and borrowing.
These authors show that small shocks can induce a kind of domino effect, due to the chain, that leads
to big effects on the economy.

Ch. 21:

The Financial Accelerator in a Quantitative Business Cycle Framework

1379

An interesting finding of their research is that the model with credit-market frictions
generates a hump-shaped output response, consistent with most empirical findings. Our
model presented above has many features in comrnon with that of Carlstrom and Fuerst
(1997). Putting aside some technical details, there are however two major differences
between the two models. First, we consider a sticky-price setting in the Dynamic New
Keynesian tradition, while Carlstrom and Fuerst restrict themselves to a model with
flexible prices. Thus we are able to examine the interaction of credit-market frictions
with shocks to monetary policy, or to other nominal variables. The second difference
is more subtle but is also important: Carlstrom and Fuerst assume that the agency
problem applies only to producers of investment goods, who produce capital directly
from the output good. The output good is produced, using both capital and labor, by
separate firms who do not face agency problems in external finance. As a result of
these assumptions, in the Carlstrom-Fuerst model, changes in net worth affect the
economy primarily by affecting the supply price of capital (when net worth is low,
less capital is produced at any given price). In our model, in contrast, the agency
problem applies to producers of final output, who own the economy's durable capital
stock. Since borrowers own the economy's capital stock, changes in the price of capital
directly affect their net worth; that is, our model more directly incorporates the asset
price effects stressed by Kiyotaki and Moore (1997). As a result, we find that creditmarket frictions amplify shocks to the economy to a greater degree than do Carlstrom
and Fuerst. On the other hand, a clear virtue of Carlstrom-Fuerst model is that the
credit-mechanism helps able to explain the real world auto-correlation properties of
output.

7. Directions ti)r future work

In subsequent research we hope to consider several extensions to the work so far:
First, as noted above, we have not addressed the role of banks in cyclical fluctuations,
despite considerable attention to banking in the previous theoretical and empirical
literatures. There are several ways to incorporate a nontrivial role for banks into
our framework; one possibility is to allow the financial intermediaries which lend to
entrepreneurs to face financial frictions in raising funds themselves. In this case, the
net worth of the banking sector, as well as the net worth of entrepreneurs, will matter
for the models' dynamics.
Second, an important institutional fact is that debt contracts in low-inflation
countries are almost always set in nominal terms, rather than in real terms as in this
chapter. It would be relatively easy to incorporate nominal contracting into this model,
in order to evaluate whether the redistributions among debtors and creditors associated
with unanticipated changes in the price level are of quantitative significance. Doing so
would enable us to critically assess recent arguments that deflation may pose a serious
threat to the US economy.

1380

B.S. Bernanke et aL

Third, we have restricted the analysis to a closed economy. It would be interesting

to extend the analysis to the open economy. By doing so it would be possible to
analyze how a currency crisis may induce financial distress that is transmitted to the
real sector 35. As we discussed in Section 5, to the extent an exchange rate collapse
redistributes wealth from domestic borrowers to domestic lenders (owing to the fact
that loans are denominated in units o f foreign currency), the model o f our chapter
predicts a contraction in real activity.
Finally, in this chapter we have restricted the credit-market frictions to the investment
sector. It would be interesting to study how the results might be affected if these
frictions affect other components o f spending, such as consumption, inventory
investment, and housing.

Appendix A. The optimal financial contract and the demand for capital
In this appendix we provide a detailed analysis of the partial equilibrium costly-stateverification problem discussed in Section 3. We start with the case of no aggregate risk
and show that under the assumptions made in the text, the optimal contract provides a
monotonically increasing relationship between the capital/wealth ratio and the premium
on external funds: QK/N = ~(RX/R) with ~p/(.) > 0. We also establish that the default
probability N is a strictly increasing function o f the premium RX/R, implying that the
optimal contract guarantees an interior solution and therefore does not involve quantity
rationing of credit. This appendix also provides functional forms for the contract
structure. In particular, for the case o f the log-normal distribution we provide exact
analytical expressions for the payoff functions to the lender and entrepreneur. In the
final section of this appendix we extend the analysis to the case of aggregate risk and
show that the previously established results continue to hold.

A. L The partial equilibrium contracting problem

Let profits per unit of capital equal coRk, where co ~ [0, ec) is an idiosyncratic shock
with E(co) = 1. We assume F(x) = Pr[co < x] is a continuous probability distribution
with F(0) = 0. We denote b y f ( c o ) the pdf o f o . Given an initial level o f net worth N,
and a price of capital Q, the entrepreneur borrows QK - N, to invest K units o f
capital in the project. The total return on capital is thus o)RkQK. We assume co is
unknown to both the entrepreneur and the lender prior to the investment decision.
After the investment decision is made, the lender can only observe co by paying the
monitoring cost l~coR~QK, where 0 < ~ < 1. Let the required return on lending equal
R, with R < R K,

35 See Mishkin (1997) for a discussion of how the financial accelerator mechanism may be useful ~br
understanding the recent currency crises in Mexico and Southeast Asia.

Ch, 21." The Financial Accelerator in a Quantitative Business Cycle b)amework

1381

The optimal contract specifies a cutoffvalue N such that i f co ~> N, the borrower pays
the lender the fixed amount NR KQK and keeps the equity (co - - ~ ) R K QK. Alternatively;
if co < N, the borrower receives nothing, while the lender monitors the borrower and
receives (1 - IJ)coRK QK in residual claims net o f monitoring costs, in equilibrium, the
lender earns an expected return equal to the safe rate R implying
[NPr(co ~> N ) + (1 -/OE(colco < N) Pr(co < N)]RKQK = R ( Q K - N ) .
Given constant returns to scale, the cutoff N determines the division o f expected
gross profits RXQK between borrower and lender. We define F(~5) as the expected
gross share o f profits going to the lender:
F(~) =

f0

cof(co) d o + N

f(co) dco,
,]co

and note that

F'(~) = 1-F(~),

F'(N)

-f(N),

implying that the gross payment to the lender is strictly concave in the cutoff value
N. We similarly define g G ( N ) as the expected monitoring costs:

14G (~) ==-p

f0~ col(co) do,

and note that

~ c ' (~) -: p~f(~).

The net share o f profits going to the lender is F(~0) - t~G(N), and the share going to
the entrepreneur is 1 - F(N), where by definition F(o--) satisfies 0 < F ( N ) < 1.
The assumptions made above imply:
F(bS)-pG(~)>0

for

N C ( 0 , oo)

and
lim F ( N ) - p G ( N ) = 0,
~ 0

lim F(cd) - #G(bS) = l - ~.

75 .---* o c

We therefore assume that Rk(1 - #) < R, otherwise the firm could obtain unbounded
profits under monitoring that occurs with probability one s6.

36 The bound on F(~5) can be easily seen 17oii1the Ihct that both F(N) = E(~@~ < W)Pr(w < (~).-~
NPr(co ~>N) and 1 F(N) = (E(~o!(o >~~) -N)Pr(~o/> N) are positive. The limits on F(~5) -/~G(~])
can be seen by recognizing that G(?5) = E(co[~o < ~)Pr(m < N) so that lim~o~ G(N) = E(~o) = 1.

B.S. Bernanke et al.

1382

Let h(N) = (f(~o)/(1 - F ( N ) ) , the hazard rate. We assume that Nh(N) is increasing
in N 37. There are two immediate implications from this assumption regarding the shape
of the net payoff to the lender. First, differentiating F(N) - #G(N), there exists an ~*
such that

F'(~5)--t~G'(N) = (1 - F ( N ) ) ( 1 -/~Nh(N)) > 0

for

N < o) ,

implying that the net payoff to the lender reaches a global maximum at N*.
The second implication of this assumption is that

F'(~)G"(~)-r"(~)6'(co)

- d(--d@T0)))(1- F ( e ) ) ) 2 > 0

for all

These two implications are used to guarantee a non-rationing outcome.

The optimal contracting problem with non-stochastic monitoring may now be written
as

F (N) )Rk QK

max(1
K,~O

subject to [F(N) - pG(o)]RI'QK = R(QK - N).

It is easiest to analyse this problem by first explicitly defining the premium on external
funds s = Rk/R and then, owing to constant returns to scale, normalizing by wealth
and using k = Q K / N the capital/wealth ratio as the choice variable 3s. Defining 2 as
the Lagrange multiplier on the constraint that lenders earn their required rate of return

37 Any monotonically increasing transformation of the normal distribution satisfies this condition. To
see this, define the inverse transformation z = z(?5), z'(N) > 0, with z ~ N(0, 1). The hazard rate for the
standard normal satisfies h(z) = O(z)/(t - qS(z)), implying

(1

~o0(z(co))
~(z(~)))

Difl'erentiating Nh(N) we obtain

d(o~h((o))

h(z(N)) + Oh'(z(N)) z'(N) > O,

dN
where the inequality follows from the fact that the hazard rate for the standard normal is positive and
strictly increasing.
3s It is worth noting that the basic contract structure as well as the non-rationing outcome extends in a
straightforward manner to the case of non-constant returns to capital, as long as monitoring costs remain
proportional to capital returns.

Ck. 21:

The Financial Accelerator in a Quantitative Business Cycle Framework

1383

in expectation, the first-order conditions for an interior solution to this problem may
be written:
: r ' ( ~ - ~ [ r ' ( @ - ~ G ' ( ~ ) ] = 0,
k " [(1 - F(o~)) + ,~(F(o---)- # 6 ( 0 ) ]
;t" [ F ( N ) -

yG(N)lsk

- (k -

s - )~ = 0,

1) = 0.

Since F ( ~ k~G(N) is increasing on (0,N*) and decreasing on (N*, oo), the lender
would never choose N > N*. We first consider the case 0 < co < N* which implies
an interior solution 39. As we will show below, a sufficient condition to guarantee an
interior solution is
1

s < F ( ~ * ) - ~tG(~*) - s * .
We will argue below that s / > s* cannot be an equilibrium.
A s s u m i n g an interior solution, the EO.C. with respect to the cutoff-(5 implies we
can write the Lagrange multiplier )~ as a function o f N:

Z(~) =

r,(~

F'(~)
~G'(~)

Taking derivatives we obtain

~,(~)

~ [r'(~)a"(@
[r'(~

- F"(~)G'(@]
-

~G'(~] 2

>0

for

~C(0,~*),

where the inequality follows directly from the assumption that ~ h ( ~ ) is increasing.
Taking limits we obtain
lim 2 ( ~ )

1,

~/--~0

lim )~(~o)= +oo.

?5 --~ i5"

Now define
X(@
p(~5) =_ (1 - F(?~) + 3,(F(~) - / ~ G ( ~ ) ) '
then the EO.C. imply that the cutoff ~ satisfies
s = p(N)

(A. 1)

so that p ( N ) is the wedge between the expected rate o f return on capital and the safe
return demanded by lenders. Again, computing derivatives we obtain
2~ ( )
1 - C(~)
p'(?~-) = p ( ~
' ~. . ( 1 - F ( ~ ) + J ~ ( F ( ~ ) - ~ G ( ~ ) )

> 0

for

N 5 (0, N~),

and taking limits:

lim p ( ~ ) - - 1,
~-~0

lim p ( ~ ) =
.,-.,~3"

1
1
( F ( N * ) - # G ( N * ) ) ~ s* < -1--. / 2

Thus, for s < s*, these conditions guarantee a one-to-one mapping between the optimal
cutoff N and the premium on external fhnds s. By inverting Equation (A.1) we may
39 Obviously, 65 = 0 cannot be a solution if s > 1.

B.X Bernanke et al.

1384

express this relationship as N = ~(s), where N~(s) > 0 for s E (1,s*). Equation (A.1)
thus establishes the monotonically increasing relationship between default probabilities
and the premium on external funds.
Now define
T ( ~ ) -- 1 +

x(r(~)

- ~G(~))

1 - r(~

Then, given a cutoff N C (0, ~*) the EO.C. imply a unique capital/wealth (and hence
leverage) ratio:
k

kv(~.

(A.2)

Computing derivatives we obtain

~'(~)
r'(~)
~'(~): ~
(~(~)-- 1)+
q~(~5) > 0
1- r ( ~ )

for

co E (0, ~*),

and taking limits:

lim ~ ( N ) = 1,
~--+0

lim

tp(N) = +oc.

o) ---~ a~*

Combining Equation (A. 1) with Equation (A.2) we may express the capital/wealth ratio
as an increasing function of the premium on external funds:
k - ~p(s),

(A.3)

with

'q/(s) > 0 tbr s c (I,s*).

Since lim~o~o, q-t(~o) - +oc and lim~o--+~o*p(~5) - s*, as s approaches s* from
below, the capital stock becomes unbounded. In equilibrium this will lower the excess
return s.
Now consider the possibility that the lender sets o) - co*. The lender would only do
so if the excess return s is greater than s*. In this case, the lender receives an expected
excess return equal to

(c(~*)

~G(~*)) sk k =

--

S*

S*

k >0.

Since the expected excess return is strictly positive for all k, the lender is willing
to lend out an arbitrary large amount, and both the borrower and lender can obtain
unbounded profits. Again, such actions would drive down the rate o f return on capital

Ch. 21:

The Financial Accelerator in a Quantitative Business Cycle Framework

1385

in equilibrium, ensuring s < s* and guaranteeing an interior solution for the cutoff
~ (o, ~*).
A.2. The l o g - n o r m a l d i s t r i b u t i o n

In this section, we provide analytical expressions for F(~--) and _F(N) - /~G(N),
for the case where co is distributed log-normally 4. Under the assumption that
ln(co) ~ N(-cr 2, cr2) we have E(co) = 1 and
1 -

E(co]co/> ~ ) -

4,(~
1 -

a)

(z)

'

where @(.) is the c.d.f, of the standard normal and z is related to N through
z - 0n(N) + 0.502)/o ". Using the fact that 1 - F ( N ) = (E(co]co ~> 05) - co) Pr(co ~> ~)),
we obtain

r ( m ) - O(z

c0 + m[l - o(~)1

and
r(co)-

~ G ( m ) = (l - ~ ) q , ( ~ -

,J) + co[1 - O(z)].

A.3. A g g r e g a t e r i s k

To accommodate the possibility o f aggregate risk, we modify the contracting

framework in the following manner. Let profits per unit o f capital expenditures now
equal rcoR k where co represents the idiosyncratic shock, r represents an aggregate
shock to the profit rate, and E(co) = E ( r ) = 1. Since entrepreneurs are risk neutral, we
assume that they bear all the aggregate risk associated with the contract. Again, letting
Rk the ex ante premium on external funds, and k = Q K / N , capital per dollar of
s = ~self-financing, the optimal contracting problem may be now be written:
m a x E { ( 1 - F(zoD)risk ~ X [(F(N)

t~G(~5))risk - ( k - 1)1},

where ,l is the ex post value (after the realization of the aggregate shock r) of the
Lagrange multiplier on the constraint that lenders earn their required return and E{ }
refers to expectations taken over the distribution o f the aggregate shock ~.
We wish to establish that with the addition of aggregate risk, the capital/wealth ratio
k is a still an increasing function o f the ex ante premium on external funds. Define

40 Since the log-normal is a monotonic transformation of the normal, it satisfies the condition
d(~h((~)))/d?~ > O.

B.S. Bernankeet al.

1386

F ( N ) -= I - F ( ~ ) + )~(F(co) - # G ( N ) ) . T h e first-order conditions for the contracting

p r o b l e m m a y be written as

N - r ' ( N ) - z [ r ' ( ~ ) -- ~ c ' ( N ) ]

= 0,

k : E { F ( o ) ~s - ,t(N)} = 0,
Z : (r(~

- ~G(~)

~s - (k - l) = 0.

A g a i n , under no rationing, the first-order condition with respect to ~) defines the

f u n c t i o n 3,(N). This function is identical to )~(N) defined in the case o f no a g g r e g a t e
risk. The constraint that lenders earn their required rate o f return defines an implicit
function for the c u t o f f N = N(fi, s, k) 41 . C o m p u t i n g derivatives we obtain
0F

-(F(N)--- ~G(N))

Os

<0

(r,(~-

~a,(N))s

(r,(o)-

~a,(N))(~s)

and
0F

ok

1
--

>0.

To obtain a relationship o f the f o r m k = ~p(s), ~p'(s) > 0 we totally differentiate the

first-order condition with respect to capital:

E ~D"(N)ds+~tsFt(N) Os-dS+o~dk

-)~'(~)

~-sdS+~dk

=0.

R e a r r a n g i n g gives

dk

E/(~sr'(N)--

OF + ~F(N)}
X'(~o)) N

U s i n g the fact that

F ' ( N ) --- ~ ' ( N ) ( F ( N ) - ~ O ( N ) )

41 As a technical matter, it is possible that the innovation in aggregate returns is sufficiently low that
N(/~, s, k) > N*, in which case the lender would set N = N* and effectively absorb some of the aggregate
risk. We rule out this possibility by assumption. An alternative interpretation is that we solve a contracting
problem that is approximately correct and note that in our parametrized model aggregate shocks would
have to be implausibly large before such distortions to the contract could be considered numerically
relevant.

Ch. 21:

The Financial Accelerator in a Quantitative Business Cycle Framework

1387

we obtain
= ~'(~)k

~,

implying that dk/ds simplifies to the expression

d k _ E{fisF(~) - ~ ' ( ~ ) ~
ds

t -- OF

Since ON/Os < O, Oo)/Ok > 0, and U(N) > 0, the numerator and denominator of
this expression are positive, thus establishing the positive relationship between the
capital/wealth ratio k and the premium on external funds s.
Appendix B. Household, retail and government sectors

We now describe the details of the household, retail, and govermnent sectors that,
along with details of the entrepreneurial sector presented in Section 4, underlie the
log-linearized macroeconomic framework.
B.1. Households

Our household sector is reasonably conventional. There is a continuum of households

of length unity. Each household works, consumes, holds money, and invests its savings
in a financial intermediary that pays the riskless rate of return. Ct is household
consumption, Mt/P~ is real money balances acquired at t and carried into t + 1,
H/ is household labor supply, W~ is the real wage for household labor, Tt is lump
sum taxes, Dt is deposits held at intermediaries (in real terms), and Ht is dividends
received from ownership of retail firms. The household's objective is given by
OG

max Et Z

[3k [ln(Ct+:~)+ ~ ln(Mt,/~/P~ k) + ~ ln( 1 Ht ~k)]-

(B. 1)

k-0

The individual household budget constraint is given by

Ct = WtH: - Tt +17: + RtD~- Dt+l +

(M,-I - iV/:)
P:

(B.2)

The household chooses C/, D~+I, Hi and Mt/Pr to maximize Equation (B. 1) subject to
Equation (B.2). Solving the household's problem yields standard first-order conditions
for consumption/saving, labor supply, and money holdings:
1

E f

B.S. Bernanke et al.

1388

W, 1

(B.4)

* Ct = b 1 - ~ '

Mt

~Ct ( R ; + I ~ I ) - I

Pt

(t3.5)

Rt+l

where R~ 1 is the gross nominal interest, i.e.,

n Pt~.l _ 1.
it+ I -7_ Rt+ 1 Pt

Note that the first-order condition for M,/Pt implies that the demand for real money
balances is positively related to consumption and inversely related to the net nominal
interest rate.
Finally, note that in equilibrium, household deposits at intermediaries equal total
loanable funds supplied to entrepreneurs:

D l -- Bt.
B.2. The retail sector and price setting

As is standard in the literature, to motivate sticky prices we modify the model to allow
for monopolistic competition and (implicit) costs of adjusting nominal prices. As is
discussed in the text, we assume that the monopolistic competition occurs at the "retail"
level.
Let Y,(z) be the quantity of output sold by retailer z, measured in units of wholesale
goods, and let Pt(z) be the nominal price. Total final usable goods, Y{, are the following
composite of individual retail goods:

=E/01
with e > 1. The corresponding price index is given by

Final output may then be either transformed into a single type of consumption good,
invested, consumed by the government or used up in monitoring costs. In particular,
the economy-wide resource constraint is given by

Y[=Ct+C[+L+Gt+/J

J0 ~odF(co)R~Q,~K~,

where C[ is enta'epreneurial consumption and # fo~)'o)dF(co)RfQ

gate monitoring costs.

(B.8)
1It reflects aggre=

Ch. 21." The Financial Accelerator in a Quantitative Business Cycle Framework

1389

Given the index (B.6) that aggregates individual retail goods into final goods, the
demand curve facing each retailer is given by
r,(z) =

(P,(z) /

yi

(B9)

The retailer then chooses the sale price Pt(z), taking as given the demand curve and
the price of wholesale goods, P~.
To introduce price inertia, we assume that the retailer is free to change its price
in a given period only with probability 1 - 0, following Calvo (1983). Let P[ denote
the price set by retailers who are able to change prices at t, and let Yt*(z) denote the
demand given this price. Retailer z chooses his price to maximize expected discounted
profits, given by

o~
r
p . pw
-[
/a
t_ ~ t + k
*
/~=o Ol'Et-I [l,t,/, Pt+k Yt+lc(z)~ ,

(B.10)

where the discount rate A,/, = fiCJ(Ct~/,) is the household (i.e., shareholder)
intertemporal marginal rate of substitution, which the retailer takes as given, and where
P ~ =-- PriNt is the nominal price of wholesale goods.
Differentiating the objective with respect to P[ implies that the optimally set price
satisfies

~OkE,

1 At,k \Pt+k/

kp.k -

p~+~j

:0.

(B.11)

k=0

Roughly speaking, the retailer sets his price so that in expectation discounted marginal
revenue equals discounted marginal cost, given the constraint that the nominal price
is fixed in period k with probability Ok. Given that the fraction 0 of retailers do not
change their price in period t, the aggregate price evolves according to

Pt = [OP~_~ + (10)(P;)(I-~)] ~/(t c),

(B.12)

where P[ satisfies Equation (B.11). By combining Equations (B.11) and (B.12),

and then log-linearizing, it is possible to obtain the Phillips curve in the text,
Equation (4.22).

B.3. Government sector

We now close the model by specifying the government budget constraint. We assume
that government expenditures are financed by lump-sum taxes and money creation as
follows:

Gt-

M,-M,~
Pt

4 Tt.

The government adjusts the mix of financing between money creation and lnmp-sum
taxes to support the interest rate rule given by Equation (4.25).

1390

B.S. B e r n a n k e et al.

This, in conjunction with the characterization in Section 5 o f the entrepreneurial

sector and the m o n e t a r y policy rule and shock processes, completes the description o f
the model.

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Chapter 22

POLITICAL ECONOMICS AND MACROECONOMIC POLICY*

TORSTEN PERSSON
Institute for International Economic Studies, Stockholm University, S-106 91 Stockholm, Sweden.
E-mail: Torsten.Persson@iies.su.se.
GUIDO TABELLINI
IGIER, Bocconi University, via Salasco 3/5, 20136 Milano, Italy.
E-mail: guido.tabellini@uni-bocconi.it

Contents
Abstract
Keywords
1. I n t r o d u c t i o n

Part A. Monetary Policy

2. C r e d i b i l i t y o f m o n e t a r y p o l i c y
2.1. A simple positive model of monetary policy
2.2. Ex ante optimal monetary policy
2.3. Discretion and credibility
2.4. Reputation
2.5. Notes on the literature
3. Political cycles
3.1. Opportunistic governments
3.1.1. Moral hazard in monetary policy
3.1.2. The equilibrium
3.1.3. Adverse selection
3.2. Partisan governments
3.2.1. The model
3.2.2. Economic equilibrium
3.2.3. Political equilibrium
3.3. Notes on the literature

1399
1399
1400
1404
1405
1405
1407
1409
1412
1415
1416
1416
1417
1418
1420
1422
1422
1423
1423
1425

* We are grateful to participants in the Handbook conference at the Federal Reserve Bank of New
York, to our discussant Adam Posen and to Roel Beetsma, Jon Faust, Francesco Lippi, Ken Rogofl, Lars
Svensson and Jolm Taylor for helpful comments. The research was supported by Harvard University,
by a grant fi:om the Bank of Sweden Tercentenary Foundation and by a TMR Grant fi:om the Europema
Commission. We are grateful to Christina Lrnnblad and Alessandra Startari for editorial assistance.
Handbook of Macroeconomics, Volume 1, Edited by J.B. Taylor" and M. WoodJbrd
1999 Elsevier Science B. I( All tights reserved
1397

1398
4. Institutions and incentives
4.1. Fixed exchange rates: simple rules and escape clauses
4.2. Central bank independence
4.3. Inflation targets and inflation contracts
4.4. Notes on the literature

Part B. Fiscal Policy

5. Credibility o f fiscal policy
5.1. The capital levy problem
5.1.1. The model
5.1.2. The e x a n w optimal policy
5.1.3. Equilibrium under discretion
5.1.4. Extensions
5.2. Multiple equilibria and confidence crises
5.3. Public debt management
5.4. Reputation and enforcement
5.5. Notes on the literature
6. Politics o f public debt
6.1. Political instability in a two-party system
6.1.1. Economic equilibrium
6.1.2. The political system
6.1.3. Equilibrium policy
6.1.4. Endogenous election outcomes
6.1.5. Discussion
6.2. Coalition governments
6.2.1. Equilibrium debt issue
6.2.2. A stronger budget process
6.3. Delayed stabilizations
6.4. Debt and intergenerationat politics
6.5. Notes on the literature

Part C. Politics and Growth

7. Fiscal policy and growth
7.1. Inequality and growth
7.2. Political instability and growth
7.3. Property rights and growth
7.4. Notes on the literature
References

77. P e r s s o n a n d G. Tabellini

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1437
1439
1440
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Ch. 22:

Political Economics and Macroeconomic Policy

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Abstract

This chapter surveys the recent literature on the theory of macroeconomic policy. We
study the effect of various incentive constraints on the policy making process, such as
lack of credibility, political opportunism, political ideology, and divided government.
The survey is organized in three parts. Part I deals with monetary policy in a simple
Phillips curve model: it covers credibility issues, political business cycles, and optimal
design of monetary institutions. Part II deals with fiscal policy in a dynamic general
equilibrium set up: the main topics here are credibility of tax policy, and political
determinants of budget deficits. Part II! studies economic growth in models with
endogenous fiscal policy.

Keywords
politics, monetary policy, fiscal policy, credibility, budget deficits
J E L classification: E5, E6, H2, H3, O1

1400

T. Persson a n d G. Tabellini

1. Introduction

Traditional macroeconomic policy analysis asks the positive question of how the
economy responds to alternative, but exogenous, policy actions or rules. Knowing these
responses, the analyst can go on to the normative problem of policy advice. The best
action or rule is selected, given a specific objective function.
But as macroeconomists, we should also be able to shed light on a more ambitious
set of questions. Why is it that we observe such different inflation rates across countries
and time? Why did we not observe peace-time accumulations of government debt
until the seventies, and why did they arise only in some countries? Why are growth
rates so different in different parts of the world? To answer such questions, we need
a positive theory, explaining why different countries choose different macroeconomic
policies. Early steps towards such a theory were taken about twenty years ago; the
credibility problem in macroeconomic policy was introduced by Kydland and Prescott
(1977) and Calvo (1978), and the first models of electoral and partisan motivations
in policymaking were suggested by Nordhaus (1975) and Hibbs (1977). The literature
did not really take off until ten years later. But since then "political economy", or
"political economics" as we prefer to call it, has been one of the most active fields in
macroeconomics as well as in other branches of economics 1. With its emphasis on
institutions as important determinants of policy, this literature has taken the normative
analysis one step further, replacing the question: Which policies should be followed?
with the question: What policymaking institutions produce better policy outcomes?
In surveying this literature, we split the material into three parts: Part I deals
with monetary policy, Part II with fiscal policy, and Part III with growth. Following
the conventional approach in the literature, this division is based both on substance
and on methodology. The monetary policy part relies on quadratic loss functions
over macroeconomic outcomes and on models incorporating rational expectations,
but assuming an ad hoc Phillips Curve. The fiscal policy and growth parts have
better microfoundations: agents' preferences, technologies and endowments govern
their economic and political interactions in simple, but complete, two-period general
equilibrium models. Each part emphasizes the credibility and politics ofpolicymaking,
and includes a normative evaluation of different institutions.
The general approach of this line of research is to explain deviations in observed
economic policies from a hypothetical social optimum by appealing to specific
incentive constraints in the decision problem of optimizing policymakers. The positive
analysis focuses on identifying the relevant incentive constraints, while the normative
analysis focuses on institutional reforms which may relax them. Despite the separation
into three parts, several common themes run throughout the chapter, reflecting similar
incentive constraints. It is useful to summarize already here the nature of these
incentive constraints, when they arise, and their positive and normative implications.

Many recent contributionshave been collectedin Persson and 'labellini (1994a).

Ch. 22: Political Economics' and Macroeconomic Policy

1401

Desirable policies may suffer from lack o f credibility when policy decisions are
taken sequentially over time (under "discretion") and the government lacks a nondistorting policy instrument, so that the socially optimal policy (the optimal policy
in the absence of the incentive constraint) yields a second-best outcome. Lack of
credibility has several positive implications, and arises both in monetary and in fiscal
policy. When the government takes private expectations embodied in private economic
decisions as given, it neglects the policy effects rumfing through expectation formation.
This way, equilibrium average inflation or wealth taxes become too high. Moreover, in a
Natural Rate world, monetary policy and inflation respond to all shocks, and not only to
those over which the monetary authority has an information advantage, as the optimal
policy should do. Losing control of private expectations also makes the governanen~
a prospective victim of confidence crises: runs on public debt, capital flight, or
speculative attacks on the currency. All these events stem from the same fundamental
problem: the government is forced to react to self-fulfilling private expectations.
Finally, lack of credibility breaks a Modigliani-Miller theorem of government finance,
in the same way as incentive constraints in the relationship between owners and
managers break the Modigliani-Miller theorem of corporate finance. The composition
of the outstanding public debt into nominal or real securities (i.e. indexed to the price
level) affects the propensity of a govenmaent to rely on unexpected inflation as a source
of government revenue. Similarly, the maturity composition o f government debt affects
the likelihood of debt runs or the interest rate policies that future governments want
to pursue. Thus, public debt management can relax future incentive constraints and
thereby affect private sector expectations.
Lack of credibility also has implications for institution design. First, it makes
delegation to an independent policymaker desirable. Second, it makes it desirable
to restrict the tasks of the policymaker. Rather than pursuing loosely defined social
welfare, the central bank should target a specific variable, such as inflation, or the
money supply, or the exchange rate. I f a sufficiently rich incentive mechanism - a
complete contract - can be designed and enforced, the credibility problem can be
eliminated completely. If state-contingent payments are not feasible, however, or if
narrowly defined tasks are inappropriate, as in fiscal policy, incentive mechanisms
are necessarily incomplete. But in order to gain credibility, strategic delegation of the
decision-making authority to a policymaker with "distorted" preferences may still be
desirable. This insight has been exploited in monetary policy, to advocate the benefit
of an independent and "conservative" central bank. It also applies to the election of a
conservative policymaker facing the task of selecting a wealth tax, or to the delegation
of certain policy choices to a foreign government, as in the case of multilateral
exchange rate arrangements, or currency boards 2.
2 International competition is another institutional device %r coping with credibility which is
emphasized in the literature but not in this survey. Tax competition, or exchange rate competition,
conhibute to overcoming a domestic credibility problem because they can reduce the ex-post incentives
to unilaterally increase tax rates or inflation.

1402

T Persson and G. Tabellini

A second incentive constraint is political opportunism, by which we mean that

the incumbent government is prepared to introduce distorted policies to increase its
chances of re-election. This incentive constraint typically applies when politicians
value holding office p e r se and voters, although rational, are uninformed. We
study the consequences of political opportunism in monetary policy only, but the
empirical implications for fiscal policy have been spelled out in the literature. The
main prediction is an electoral cycle in aggregate demand policies: the incumbent
government has an incentive to stimulate the economy just before elections to appear
more competent in the eyes of uninformed voters, thus boosting of the probability of
re-election. This always leads to an electoral cycle in inflation which, depending on the
information advantage of the government, could also increase output volatility at the
time of elections. The normative implications tend to reinforce those of the credibility
literature: central bank independence and monetary or inflation targets reduce the scope
for electoral cycles in monetary policy. Other, deeper reforms, such as who should have
the right to call the elections and at what time, remain to be investigated.
Political ideology may shape policy formation if different parties pursue different
"partisan" (i.e. ideological) platforms once in oNce, and if the election outcome is
uncertain. Political polarization and political instability thus induce another incentive
constraint, which also gives rise to an electoral cycle in aggregate demand, output
or public spending. But here the cycle takes place after, rather than before, elections
and reflects the winning party's desire to influence economic outcomes. In a dynamic
context, this incentive constraint may generate "strategic myopia". The government
in office realizes that it may be replaced by a policymaker with different ideological
preferences. This gives an incentive to accumulate public debt or postpone investment,
so as to influence the future behavior of the opponent. Political ideology also implies
strategic manipulation of state variables to influence the voters; for instance, an
extremist incumbent may restrain his own future behavior by appropriate institutional
reforms to increase his own electability. The strategic manipulation of future opponents
and voters are both stronger, the more unstable and polarized the political system. From
a normative point of view, the benefits of delegation and targeting in monetary policy
are further reinforced. More generally, there may be advantages of institutional checks
and balances and institutions that moderate political conflict and policy extremism.
The discussion, so far, applies to a single decision-maker facing static or dynamic
incentive constraints. Often, however, decision-making power is dispersed among
several political actors. This creates another incentive constraint, which we may call
divided government. Examples include coalition governments, soft budget constraints
on public enterprises or local governments, veto rights held by key individuals
in government or by organized groups in society, or the lobbying activities of
special interests. Divided government arises almost exclusively in fiscal policy. In a
static context its central implication is over-spending, as every decision-maker fully
internalizes the benefits of public spending but only a fraction of the cost: this
is the so called "common pool" problem. In a dynamic context, myopic behavior
emerges: each decision-maker has an incentive not only to over-spend, but also to spend

Ch. 22:

Political Economics and Macroeconomic Policy

1403

sooner rather than later. Leaving tax revenues for tomorrow can be counter-productive,
because they are partly appropriated by other decision-makers. Hence, models of
divided government also predict debt accumulation and/or under-investment. In some
circumstances, the dispersion of veto rights delays stabilization in an unsustainable
fiscal situation.
The most straightforward institutional remedy is to centralize power in the hands
of a single decision-maker (a prime minister, or a president, or the Secretary of the
Treasury). Alternatively, one might rely on two-stage budgeting, with a decision on
aggregate items (total spending, or total borrowing) preceding the decision on how
spending is allocated. Such budgetary solutions entail a trade-offbetween an allocative
distortion (a lopsided spending result from centralized decision-making power) and
an aggregate distortion (over-spending resulting from inadequate centralization). At
a deeper political level, the incentive constraints induced by divided government and
political ideology can be traded off. Political reforms that centralize power in the hands
of single parties or individuals also exacerbate polarization between the majority and
the opposition, and may thus imply that political instability becomes a more binding
incentive constraint.
The last incentive constraint considered in this chapter arises when there is income
heterogeneity, so that tax policies are motivated by pressure .for redistribution. The
positive implication is that the overall size of government is determined by the extent
of inequality in pre-tax income or, in the case of social insurance policies, by inequality
in risk. This, in turn, has implications for the link between inequality and measures of
economic performance. But the redistributive motive is also an important force shaping
the composition of spending or the structure of taxation. Public financial policies
that redistribute along different dimensions become non-equivalent, because they are
supported by different coalitions of voters. For instance, public debt and social security
redistribute across generations in the same way; nevertheless in a political equilibrium
they give rise to different allocations, because they redistribute between rich and poor
in different ways. A similar non-equivalence result holds with regard to alternative
instruments of geographic redistribution. As in the case of lacking credibility, an
incentive constraint on policy formation breaks the Modigliani-Miller theorem of
government finance.
Some of the topics covered in this survey partly overlap with a companion survey,
Persson and Tabellini (1999). There we cover the literature on public economics and
public choice, dealing with static allocation issues in fiscal policy, rather than the
intertemporal policy issues emphasized here. Neither do we cover the literature on
monetary and fiscal policy in an international context, which is surveyed in Persson
and Tabellini (1995).
Each part starts with a separate introduction, in which we highlight a number of
empirical regularities, motivating the sections to follow, and provide a more detailed
road map. We comment on the original literature both as we go along and in separate
"Notes on the Literature" at the end of each section.

1404

Z Persson and G. Tabellini

Part A. Monetary Policy

The empirical evidence for the (democratic) OECD countries in the post-war period
suggests the following stylized facts:
(i) Inflation rates vary greatly across countries and time. But there is a common time
pattern: in most countries inflation was low in the 1960s, but very high in the
1970s; it came down in the 1980s and 1990s in all countries, though at different
speeds and to different extents 3.
(ii) Inflation rates are correlated with real variables, such as growth or unemployment,
in the short run. But there is little evidence o f a systematic correlation over
longer periods. Across countries, average inflation and average growth tend to
be negatively correlated or not correlated at all 4.
(iii) There is little evidence o f systematic spillover effects between monetary and fiscal
policy. Specifically, higher budget deficits are not systematically associated with
higher inflation rates 5.
(iv) Inflation increases shortly after elections; budget deficits tend to be larger during
election years; there is also some (not very strong) evidence that monetary policy
is more expansionary before elections. On the other hand, real variables such as
growth or unemployment are not systematically correlated with election dates.
(v) Output displays a temporary partisan cycle just after elections: newly appointed
left-wing governments are associated with expansions, right-wing governments
with recessions. This cycle tends to occur in the first half o f the inter-election
period and is more pronounced in countries with two-party systems. Inflation
displays a permanent partisan cycle: higher inflation is associated with left-wing
governments 6
(vi) Average inflation rates and measures of central bank independence are negatively
correlated; this holds up when controlling for other economic and institutional
variables (even though the correlation is less robust). There is also some evidence
that fixed exchange rates are associated with lower inflation. Real variables, on the
other hand, have no systematic correlation with the monetary regime (although
the variance o f the real exchange rate is lower under fixed than floating exchange
rates) 7
These stylized facts will be taken as the starting point for Part I. Fact (i) clearly calls
tbr a positive model of inflation. Fact (ii) is not well understood and the profession
See, for instance, Bordo and Schwartz (1999).
4 Time-series evidence (for the USA) can be found in Stock and Watson (1999), whereas (broad)
cross-country evidence can be found in Barro (1997) and in Fischer (1991).
s See for instance Grilli et al. (1991). This fact no longer applies if one considers the interwar period
or developing countries. In particular hyperinflations are typically associated with fiscal problems.
6 Statements (iv) and (v) are suggested by the comprehensive study by Alesina and Roubini (t997).
7 See Grilli et al. (1991), Cukierman (1992), Jonsson (1995), Eijffinger and de Haan (1996), Mussa
~1986), Baxter and Stockman (1989). The robusmess of these findings has been questioned by Posen
(1993, 1995), however.

Ch. 22: Political Economics" and Macroeconomic Policy

1405

is still searching for a satisfactory model of the joint determination of nominal and
real variables. But it suggests that a plausible model would encompass the natural
rate hypothesis that the Phillips curve is vertical and monetary policy is neutral in
the long run, while preserving some scope for aggregate demand policies to affect
output in the short run. Fact (iii) suggests that abstracting from fiscal policy may not
be a bad first approximation. Facts (iv) and (v) indicate that political variables might
be important ingredients in successful positive models of inflation and macroeconomic
policy. Fact (vi) finally suggests that the institutional features of the monetary regime particularly the statutes regulating the central bank - should also play a role in a
successful model.
In Section 2 we formulate and discuss a model of macroeconomic policy and
inflation which has been the workhorse in much of the recent literature. We illustrate
how credibility problems in monetary policy may arise and how these may be fully
or partly resolved by reputation. Section 3 extends the simple model with political
institutions and incentives. We illustrate how political business cycles and partisan
cycles, consistent with the stylized facts above, may come about. Designing nqonetary
institutions to tackle the distortions created by credibility problems and political cycles
is the topic of Section 4.

2. Credibility of monetary policy

In this section, we first formulate and discuss a model of macroeconomic policy and
inflation, in the spirit of Kydland and Prescott (1977), Fischer (1977) and Barro and
Gordon (1983a), which has been the starting point for much of the recent literature.
In subsection 2.1 we set up the model and make general comments. Subsection 2.2
derives a normative benchmark. In subsection 2.3 we emphasize how the credibility
problems tied to the central banks' ability to temporarily boost the economy result in
excessively high equilibrium inflation - the celebrated "inflation bias". Subsection 2.4
briefly illustrates how reputation may provide full or partial solutions to such credibility
problems, drawing on the work by Barro and Gordon (1983b), Backus and Driffill
(1985), Canzoneri (1985) and others that - in turn - borrow heavily from the literature
on repeated games.
2.1. A simple positive model o f monetary policy

The demand side of our model economy is represented by

:~: = m + v + # ,

(2.1)

where o~ is inflation, m is the money growth rate, v is a demand (or velocity) shock,
and ?2 is a "control error" in monetary policy. Letting output enter the implicit money
demand function underlying Equation (2.1) complicates the algebra, but does not yield

1406

T. Persson and G. Tabellini

important additional insights. The supply side of the model assumes that nominal
wage setting (unilaterally by firms, unilaterally by labor unions, or bilaterally by
bargaining between these actors) aims at implementing an exogenous, but stochastic,
real wage growth target ~o 8. Letting er denote rationally expected inflation, nominal
wage growth w then becomes
w = (o + :r e.

(2.2)

Employment (or output growth), x, satisfies

x= y-(w-er)-e,

where 7 is a (potentially stochastic) parameter, and e is a supply shock. Combining this

relation with Equation (2.2), we obtain an expectations-augmented short-run Phillips
curve

x = 0 + (er

ere)_ e,

(2.3)

where 0 - 7 - ~o can be interpreted as the stochastic natural rate of employment

(output growth). We assume that all shocks are i.i.d., orthogonal to each other, have
(unconditionally) expected values of zero, well-defined variances ~7~,~ { , and so on.
The timing of events is as follows: (0) rules of the monetary regime may be
laid down at an institution design stage; (1) the value of 0 is observed both by the
private sector and the policymaker; (2) er~ is formed, given the information about 0;
(3) the values of v and e are observed; (4) the policymaker determines m; (5) /~ is
realized together with er and x.
The assumed timing captures the following concerns: Some shocks, related to the
labor market, are commonly observable and can therefore be embodied in privatesector wage-setting decisions, here captured by expectations formation. Other shocks
can only be embodied in policy. This distinction is best interpreted as reflecting the ease
with which monetary policy decisions are made, relative to the laborious wage-setting
process, but could also reflect a genuine information advantage of the policymaker
(which is perhaps only plausible for financial sector shocks). O f course, it is this
advantage that allows monetary policy to stabilize the economy. Finally, there is some
unavoidable noise in the relation between policy and macroeconomic outcomes.

As is well-!~lown, the "surprise supply" formulation wc end up with below could also be derived
from a model of price-setting finns, or from a Lucas-style "island model".

Ch. 22:

Political Economics and Macroeconomic Policy

1407

Clearly, Equation (2.1) and the assumed information implies that rationally expected
inflation is
Jr --E(ar ] 0 ) = E(m I 0),

(2.4)

where E is the expectations operator. Substituting Equations (2.1) and (2.4) into (2.3),
we have
x=O+m-E(m[

O)+v~-~

&

(2.5)

The model thus entails the usual neutrality result: only unanticipated aggregate demand
policy affects real variables. But if policy responds to shocks, it can still stabilize
employment.
2.2. Ex ante optimal monetary policy

We follow the rational expectations literature in thinking about policy as a rule.

Suppose society has the quadratic loss function
E[L(0r, x)] : E[(ar - yg*)2+ ~(X --

X*)2],

(2.6)

where a~* and x* are society's most preferred values for inflation and employment,
and ,~ is the relative weight on fluctuations in these two variables. As the objective
is quadratic in macroeconomic outcomes, which in turn are linear in the shocks, the
optimal policy rule is of the form
m - k + k O + k V v ~k%';

(2.7)

that is, policy potentially responds to all shocks observable to the policymaker. Suppose
furthermore that the policymaker can make a binding commitment to the rule (2.7) at
the institution design stage (0), i.e. before the observation of 0.
Clearly, since E(v) = E(E) = 0, this implies private sector expectations:
E(m [ O) = k + kO.

(2.8)

By Equations (2.1), (2.5), (2.7) and (2.8), macroeconomic equilibrium under the rule
is

Jc - k +kO+ (k ~ + 1) v + U E + t~,
x - O+(k~+ 1) v + g + ( k e - 1)e.

(2.9)
(2.10)

What is the optimal rule? Substitute Equations (2.9) and (2.10) into (2.6), take
expectations over all shocks, and set the derivatives of the resulting expression with
regard to the intercept and the slope coefficients in Equation (2.7) equal to zero. The
following results emerge:

1408

T. Persson and G. Tabellini

(i)

k - :~* and k = 0. The optimal rule provides an "anchor for inflationary

expectations". Expectations are right where society wants them to be, namely
at the preferred rate o f inflation: E(Jv [ 0) - zc*. The optimal rule is thus
neither conditional on the observable shock to the natural rate, 0, nor on society' s
output target, x*. Such conditionality would be embodied in expectations; it would
therefore do nothing to stabilize employment, only add costly noise to inflation.
(ii) k ~ = - 1 . Demand (velocity) shocks are fully stabilized. As policy also operates
via aggregate demand, a complete stabilization o f demand shocks nullifies their
effects on inflation as well as on employment.
(iii) k e = ~ / ( i + 30. Supply shocks are stabilized according to the policymaker's tradeoff between inflation and employment fluctuations. The higher the weight on
employment, the more these shocks are stabilized.
The optimal state-contingent policy rule can thus be written as
/l
m = Yg* - v + ( 1 ~ 6 .
Macroeconomic omcomes -- indexed by R - when the rule is ~bllowed are
Jr j~ = ~* + ~ - ~ e q
1
xa = 0- ~e+/~.

/~,

(2.11)
(2.12)

Results such as these have been - and continue to be - very influential for academic
economists' thinking about policy. They suggest that delivering low inflation and stable
employment is essentially a technical (not a strategic) problem: inflation can be kept
low by clearly announcing a rule aiming at low average inflation. Demand shocks
should be completely stabilized. The inflation and employment consequences o f supply
shocks should be traded off according to society's preferences. Control errors are
unavoidable, but can perhaps be reduced by better forecasting or operating procedures
in monetary policy. Even though this picture is too rosy for a realistic positive model
o f macroeconomic policy, it still provides a useful normative benchmark that we can
use to evaluate the outcome in the positive models below.
In the remainder o f the chapter, we simplify the stochastic structure by setting
v = /~ = 0. Demand shocks, as we saw, present no problem for the policymaker
in this class o f models, provided that they can be identified in time and that there
are no other policy goals such as interest-rate smoothing. Control errors do present
problems, but are unavoidable 9. With these simplifications, there is no meaningful

9 Abstracting from conUol errors is irmocuous as long as the public can monitor monetary policy
perfectly and as long as policymaker competency and efforts are exogenous. Below, we comment on
where control errors would matter. Moreover, in a richer (dynamic) setting with expectations entering
the aggregate demand function, demand shocks and control errors may give rise to incentive problems
similar to those discussed below.

Ch. 22:

Political Economics and Macroeconomic Policy

1409

distinction in the model between m and st. For simplicity, we therefore assume that
the policymaker sets .re directly. Why don't we eliminate the shocks to the natural
rate 0, with a similar motivation? The answer is that such shocks do not affect the
solution under commitment, whereas they do affect policy in an interesting way under
alternative assumptions about the policymaking process.
2.3. Discretion and credibility

In reality, decisions on monetary policy are taken sequentially over time, rather than
once and for all. Assuming ex ante commitment to a state-contingent policy rule
rhymes badly with this practice. In our static model, reality is better captured by an
alternative timing: policy is chosen under "discretion" when the policy instruments
are set at stage (4) above, after wages have been set (37e formed) and shocks have
been realized. This adds an ex post incentive compatibility condition to our positive
model: policy has to be optimal ex post - when it is actually enacted. This additional
credibility constraint makes the solution less advantageous for the policymaker (and
society).
The policymaker still sets sr (that is, m), seeking to minimize the loss in
Equation (2.6). But all uncertainty has been resolved at the new decision stage, so the
expectations operator is redundant. Consider how the loss is affected by a marginal
expansion, for given :U and e. Using Equations (2.3) and (2.6), we have
dL(yG x)

d~

-Ljr(zc, x)+L~(Jv, x)-~2 - ( z r - ~ * ) + ) ~ ( O + ( z C

(lJ~

~)-~'-x*),

(2.13)

where a subscript denotes a partial derivative. By Equation (2.13), the benchmark

policy rule is not incentive compatible under discretion. Suppose that wage setters
believed in an announcement of that rule, implying that :ve - sT*. Using the
optimal-rules outcome in Equations (2.1 1)-(2.12), and evaluating the derivative in
Equation (2.13) at the point prescribed by the ex ante optimal policy rule, we get
dL(~R'Xa)dz z~::z* = X(O x*).
If preferred employment (output) exceeds tile natural rate (if x* > 0), ar~ expansioii
reduces the loss, rendering the ex ante sub-optimal policy rule ex post inoptimal.
Once wages have been set, the marginal inflation cost - the first term on the RHS
of Equation (2.13) - is always smaller than the marginal employment benefit - the
second term on the RHS 10. Thus, the ex post incentive-compatibility constraint is
binding and the low-inflation rule is not credible.

l0 To make this more clear, consider the case when c - 0, such that tile optima| rule prescribes the
policy sTR = ~*, implying xR = 0. Then, by Equation (2.13) the marginal inflation cost is acmalty zero
(to first order), whereas the marginal employment benefit is positive (if x* > 0).

1410

17 Persson and G. Tabellini

A credible policy must simultaneously fulfill two conditions: (i) the policy is e x
optimal, ~y
dL = 0, given :re and e; (ii) expectations are rational, i.e. ~e = E(s~ I 0).
In game-theoretic terms, those are the conditions for a Nash Equilibrium in a game
with many atomistic private wage setters (desiring to minimize the deviation of
the realized real wage w - ~e, from the targeted real wage co) moving before the
policymaker 11. Condition (i) requires that the expression in Equation (2.13) equals
zero. Taking expectations of that expression, condition (ii) can be expressed as
E(zc ] 0) = ~* + 3,(x* - 0). Combining the two conditions, we get

post

a -D = st* + ,~(x* - 0) + ~ e ,
+A,

(2.14)

where the D superscript stands for discretion. The employment outcome remains as
in Equation (2.12) except that /~ = 0 by assumption, if we assume x* - 0 > 0,
the discretionary policy outcome in Equation (2.14) and the commitment outcome
in Equations (2.11)-(2.12) illustrate the celebrated "inflation bias" result: equilibrium
inflation is higher under discretion than under commitment to a rule, whereas
employment is the same, independently of the policy regime. The bias is more
pronounced the higher is ;, (the more valuable is employment on the margin) and the
higher is x* relative to 0 (the higher is preferred employment relative to the natural
rate); both factors contribute to a greater "temptation" for the policymaker to exploit
his short-run ability to boost employment by expansionary policy once wages are fixed.
Since the natural rate 0 is random, whereas the employment target x* presumably is
constant (or at least more stable than 0), inflation is also more variable under discretion
than under the rule.
The inflation bias is due to two key assumptions. The first is the sequential timing of
monetary policy decisions. The second is the assumption that the employment target is
higher than the natural rate, that is: x* - 0 > 0. This assumption must reflect a lack of
policy instruments: some distortion in the labor or product market keeps employment
too low. The government does not remove this distortion; either because it does not
have enough policy instruments or because the distortion is kept in place by some other
incentive problem in the policy-making process. These assumptions capture important
features of monetary policymaking in the real world.
In this static model, the policy response to the supply shock e is not distorted:
shocks are stabilized in the same way under discretion and commitment. This
equivalence does not, however, carry over to a dynamic model where employment
(but not the employment target) is serially correlated. In such a dynamic model, the
future inflation bias depends on current employment (since the future equilibrium
employmem depends on current employment). To reduce the future inflation bias, the

1 The equilibrium would also apply identically to a simultaneous game between the government and a
single trade union. If the union moved before the government, the equilibrium might differ slightly, but
the fundamental incentive problem would not be affected.

Ch. 22: Political Economics and Macroeconomic Policy

1411

policymaker thus responds more aggressively to supply shocks under discretion than
under commitment. Moreover, the systematic inflation bias increases, as an ex post
expansion today expands both current and future employment 12
The "distortion" in the policymaking process can be described as follows: under
discretion, the policymaker (correctly) fails to internalize the mapping from actual
policy to expected policy. He is not being foolish: he really cannot influence private
sector expectations. This is what we mean when saying that a (low inflation) policy
"lacks credibility". Yet, actual policy maps into expected policy in equilibrium when
private agents have rational expectations. Under commitment, on the contrary, the
policymaker internalizes this equilibrium mapping; indeed announcing the optimal
policy rule brings rationally expected inflation down precisely to the preferred rate
of inflation. The conclusions are pretty stark. First, a desirable policy rule does
not become credible just by announcing it; is thus pointless to recommend a noncredible policy rule. Second, the inability to commit to a policy rule has obvious costs.
Institutional reforms that give policymakers greater commitment ability can thus be
desirable.
This simple model of monetary policy credibility is often criticized with reference
to the plausible objection that "real world policymakers are not trying to surprise the
private sector with unexpected inflation". But this criticism misses the point of the
analysis. The model does not predict that the policymaker tries to generate policy
surprises in equilibrium. On the contrary, in equilibrium the policymaker would like
to bring inflation down but refrains from doing so as his lack of credibility would
turn any anti-inflationary policy into a recession, in other words, the model predicts
an inertia of expectations to a suboptimally high inflation rate, and a difficulty in
curbing these expectations down to the socially efficient rate. What the model does
rely on, however, is an assumption that the policymaker would want to generate policy
surprises outside o f equilibrium to a more favorable outcome. Is this a plausible
positive model of inflation? Some observers, like McCallum (1996), apparently do not
think so. A convincing rebuttal should address the question already posed by Taylor
(1983), who - in his discussion of Barro and Gordon (1983b) - asked why society has
not found ways around the credibility problem in monetary policy, when it has found
ways around the credibility problem of granting property rights to patent holders. This
question is best addressed in connection with a closer discussion of the institutions of
monetary policymaking, so we come back to it in Section 4.
What are the observable implications of the analysis so far? One implication is that
a binding credibility problem would show up by the central bank reacting to variables
that entered the private sector's information set (before policy is set), whereas the

12 Svensson (1997a) proves this result formally, drawing on earlier work by Lockwood et al. (1998)
and Jonsson (1997). See also Obstfeld (1997b) for a related result in a dynamic model of seignorage.
Beetsma and Bovenberg (1998) show that stabilizationbias mises also when monetary and fiscal policy
are pursued by different authorities with diverging objectives.

14t2

T. Persson and G. Tabellini

reaction function would not include such variables under commitment. Hence, the
unconditional variance of inflation is higher under discretion. If the credibility problem
is caused by a high )~, the model indeed predicts a positive correlation between average
inflation and the variance of inflation, in conformity with international evidence.
The discretionary model also suggests a plausible explanation of the secular
trend in inflation experienced by the industrialized countries and mentioned in the
introduction. The 1950s and 1960s were a period without serious supply shocks and
with a low natural rate of unemployment (low variance of e, high realizations of 0),
which made it easy to keep inflation low. Enter the 1970s with severe supply
shocks (high realizations of E) pushing up the natural rate (to capture this in the
model would require serial correlation in employment) and inflation; we may then
interpret the rise in inflation as the result of policymakers maintaining their earlier
high employment objectives (x* staying constant or falling by less than 0). The
gradual decline in inflation from the mid-1980s and onward, despite continued high
natural rates (in Europe), can be understood to derive from policymakers gradually
adapting their employment ambitions to the structural problems in the labor market
(x* drifting downwards over time) and from the institutional reforms in central banking
arrangements in a number of countries in the recent decade. Naturally, learning from
past policy mistakes is also likely to have played an important role. To date, time-series
implications of this type have received too little attention in the credibility literature 13.
Instead, the literature has focused on normative issues of institutional reform, and to
some extent on explaining cross-sectional differences in macroeconomic outcomes by
different institutions.
2.4. Reputation

One can criticize the simple model discussed so far for being static and failing to
capture the repeated nature of policymaking. Specifically, the model rejects repeated
interaction with the public and hence ignores reputational forces. A branch of the
literature has studied reputational forces in detail. The main result is that a link
from current observed policy to future expected policy can indeed discipline the
policymaker and restore credibility. With repeated interaction, a policymaker operating
under discretion faces an intertemporal trade-off: the future costs of higher expected
inflation, caused by expansion today, may more than outweigh the current benefits of
higher employment.
To illustrate the idea, consider the model of subsection 2.3, repeated over an infinite
horizon. The policymaker's intertemporal loss function, from the viewpoint of some
arbitrary period s, can be written as
E~.

6' "L(JG xt)

(2.15)

[=S

1.~ See,however,the recentpapers by Parkin(1993), Barro and Broadbent(1997) and Broadhent(1996).

Ch. 22: Political Economics and Macroeconomic Policy

1413

where 6 is a discount factor. To simplify the algebra, we assume the static loss function
to be linear, not quadratic, in employment:
(2.16)

L(Tg, x) = ~2rl 2 _ /~.,x.

With the simpler loss function, the ex ante optimal policy rule is simply to have
zero inflation all the time and to accept employment x = 0 - e (since ~* = 0 and
employment volatility is not costly), while the static equilibrium under discretion has
inflation equal to )~ and employment still at x = 0 - e.
We now show that, even under discretion, reputation can indeed create strong enough
incentives to enforce zero inflation. As an example, assume that wage setters set wages
on the basis o f the following expectations:
~[=

0 iff ~ = ~ [ ,
3, otherwise.

u= t-1 ..... t-T,

(2.17)

Equation (2.17) says that wage setters trust a policymaker who sticks to zero inflation
in period t to continue with this same policy in the next period. But if they observe any
other policy in period t, they lose this trust and instead expect the discretionary policy
to be pursued for the next T periods. A policymaker confronted with such expectation
formation, in effect, faces a non-linear incentive scheme: he is "rewarded" for sticking
to the rule, but he is "punished" if deviating from it. Consider a policymaker that enjoys
the trust of the public (i.e. :Vs~ = 0). When is the punishment strong enough to outweigh
the immediate benefit of cheating on the rule?
To answer formally, note that the optimal deviation (found by minimizing the static
loss function, given e and COs
~ = 0) is simply ~. = 3,, thus implying employment
x~. = )~ + Os - es. After some algebra, the current benefit from cheating can then be
expressed as
B = L(0, 0s -- e,) - L(,~, ,~ + 0~ - e,) = ~,~.~
2

(2.18)

Due to the simpler loss function, the benefit is independent o f the realizations of 0
and e. The punishment comes from having to live with higher expected and actual
inflation in the next T periods. Why higher actual inflation? As the expectations
in Equation (2.17) are consistent with the static Nash Equilibrium outcome in
subsection 2.3, it is indeed optimal for the policymaker to bear the punishment if it is
ever imposed. In other words, the private sector's expectations will be fulfilled, both
in and out o f equilibrium 14. Thus, the cost of a deviation is
C=Es

6 t "(L(.,t, 0,-et)--L(O, Ot-e,))

~
Lt=s+

.... 6

)-Z2,

(2.19)

14 By this argument the analysis identifies a sequentially rational (subgame perfect) equilibrium. For
other expectation formation schemes, in which expectations changed more drastically after a deviation,
we would have to impose a separate incentive-compatibility constraint, namely that it is indeed optimal
to carry out and bear the ptmishment after a deviation [see Persson and Tabellini (1990, ch. 3) on this
point].

1414

T. Persson and G. Tabellini

which is clearly stationary if we assume that 0 is i.i.d, over time. Obviously, the
policymaker finds it optimal to stick to the zero-inflation rule as long as B ~< C.
Inspection of Equations (2.19) and (2.18) reveals that this is more likely the higher
the discount factor c5 and the longer the horizon T for which inflationary expectations
go up after a deviation.
Many extensions of this basic framework are feasible; and some have been pursued
in the literature. For instance, if we retained the quadratic loss function of the previous
subsection, the benefit of cheating would be an increasing function of the actual
realization of 0, while the cost would depend on the variance and the expected
value of 0. As a result, even with reputation, equilibrium inflation would continue
to depend on the actual realization of 0: a high value of 0 makes the incentivecompatibility condition more binding, as it increases the benefit B but not the cost C.
The lowest sustainable inflation rate (defined by the condition that B = C) would be an
increasing function of 0. Thus, reputation would reduce average inflation but would
not change the main positive implications of the model of the previous section.
Canzoneri (1985) studied a framework with shocks to inflation that are unobservable
to private agents both ex ante and ex p o s t ; an example could be the /~ shocks in
Equation (2.1) above. If observed inflation exceeds some threshold, such monitoring
problems give rise to temporary outbreaks of actual and expected inflation, because
the public cannot clearly infer whether high inflation is due to large shocks or
to deliberate cheating. Backus and Driffill (1985), Barro (1986), Tabellini (1985,
1987) and Vickers (1986) studied reputational models where the private agents are
uncertain about the policymakers "type" (as his )~ in the model above). They use the
information embodied in current observations of policy to learn about this type, and
the policymaker sets policy optimally with a view to this private learning process. Such
models illustrate how a "dovish" policymaker (someone with a high )~ or without access
to a commitment technology) can temporarily borrow the reputation of a "hawkish"
policymaker (someone with a low )~ or with access to a commitment technology). They
also illustrate how a hawkish policymaker may have to impose severe output costs
on the economy to credibly establish a reputation. This differs from the equilibrium
considered above, where the policymaker merely maintains a reputation he is lucky
enough to have.
Cukierman and Meltzer (1986) also studied credibility and private learning but in a
richer dynamic setting, where parameters in the central bank's objective function vary
stochastically over time.
The central insight of the reputation literature is that ongoing interaction between
a policymaker and private agents can mitigate the inflation bias and restores some
credibility to monetary policy. Whether the problem is entirely removed is more
controversial, however, and depends on details of the model and the expectations
formation mechanism. Even though the insight is important, the reputation literature
suffers from three weaknesses. As in the theory of repeated games, there is a multipleequilibrium problem, which strikes with particular force against a p o s i t i v e model
of monetary policy. Moreover, the problem of how the players somehow magically

Ch. 22:

Political Economics and Macroeconomic Policy

1415

coordinate on one of the many possible equilibria is worse when the ganle involves a
large number of private agents rather than a few oligopolists. Finally, the normative
implications are unclear. The existence of reputational equilibria with good outcomes
is not helpful to a country where inflation is particularly high at a given moment
in time. The lack of suggestions for policy improvements is another reason why
researchers largely turned away from reputational models, towards an analysis of the
policy incentives entailed in different monetary policy institutions Js
2.5. N o t e s on the literature

Textbook treatments of the general material in this section can be found in Persson and
Tabellini (1990, Chs. 1-4), and in Cukierman (1992, Chs. 9-11, 16), both covering the
literature up to around 1990. The literature on credibility in monetary policy starts with
Kydland and Prescott (1977), who included a brief section with the basic insight of
the static model in subsection 2.3. Barro and Gordon (1983a) formulated a linearquadratic version and pushed its use as a positive model of monetary policy. Calvo
(1978) studied the credibility problem of monetary policy in a dynamic model, where
the short-run temptation to inflate arises for public-finance reasons. Obstfeld (1997b)
provides an insightful analysis of the credible policies in a dynamic seignorage model.
Dynamic models of the employment motive to inflate were developed by Lockwood
and Philippopoulus (1994), Lockwood et al. (1998), and Jonsson (1997). Parkin (1993)
argues that the great inflation of the 1970s can be explained by an increase in the
natural rate in the kind of model dealt with here. Ball (1996) points to indirect evidence
that many disinflationary episodes in the 1980s lacked credibility.
Barro and Gordon (1983b) started the theoretical literature on reputation in monetary
policy, drawing on the work on trigger strategies in repeated games with complete
information. Backus and Driffill (1985), Tabellini (1985, 1987) and Barro (1986)
developed incomplete information models of reputation, emphasizing how a dovish
policymaker can borrow a reputation from a super-hawkish policymaker who only
cares about inflation and not at all about employment. Vickers (1986) instead
emphasized how a policymaker who seriously wants to fight inflation may have
to engage in costly recessionary policies in order to signal his true identity to an
incompletely informed public. Reputation with imperfect monitoring of monetary
policy was first studied by Canzoneri (1985). Grossman and Van Huyck (1986) and
Horn and Persson (1988) studied reputational models dealing with the inflation tax
and exchange rate policy, respectively. Rogoff (1987) includes an insightful discussion
about the pros and cons of the reputational models of monetary policy.

15 Some interesting recent work, however, suggests an institutional interpretation of some of these
reputational equilibria arguing that some institutional arguments are more conducive to reputation
building than others; see Jensen (1997), al Nowaihi and Levine (1996) and Herrendorf(1996). The ideas
are related to Schotter (1981) and to the view that international institutions may facilitate cooperation
in hade policy [see Staiger (1995) tbr a survey].

1416
3o Political

T Persson and G. Tabellini

cycles

The empirical evidence for the democratic OECD countries during the post-war period
suggests systematic pre-electoral expansionary policies - fact (iv) in the introduction as well a post-election partisan cycle in real variables and inflation - fact (v). These
"facts" vary somewhat depending on the country and the time period considered, and
their robustness has not been checked with the same standards as, say, in the modern
macroeconometric literature attempting to identify innovations in monetary policy 16
But they are interesting enough to motivate this line of research.
The empirical evidence also indicates that there is so-called "retrospective voting":
the likelihood of election victory for the incumbent government or legislature depends
largely on the state of the economy; as expected, a higher growth rate boosts the reelection probability of the incumbent iv. It is then tempting to "explain" fact (iv)
the political business cycle - by opportunistic governments seeking re-election by
taking advantage of the voters' irrationality. But how can we claim that the same
individuals act in a rational and forward-looking way as economic agents, but become
fools when casting their vote? One of the puzzles any rational theory o f political
business cycles must address is thus how to reconcile retrospective voting with the
evidence of systematic policy expansions before elections. This puzzle is addressed in
subsection 3.1, under the assumption that voters are rational but imperfectly informed,
and that 'the government is opportunistic and mainly motivated by seeking re-election.
This section builds on work by Lohman (1996), Rogoff and Sibert (1988) and Persson
and Tabellini (1990).
The correlations between macroeconomic outcomes and the party in office are easier
to explain, provided that we are willing to assume policymakers to be motivated by
ideology (have preferences over outcomes) and, once in office, prepared to carry out
their own agenda. These assumptions lead to a theory of "partisan" political business
cycles, which is summarized in subsection 3.2, following the pioneering work by
Alesina (1987).
3.1. Opportunistic gooernments

Throughout this section~ we discuss political business cycles in the simple monetary
policy model of Section 2, as does most of the literature. But the ideas generally apply
to aggregate demand management, including fiscal policy. We deal in turn with "moral

~ Faust and Irons (1999) criticize the literature on partisan cycles in the USA tot failing to control for
simultaneity- and omitted-variable bias and argue that the support for a partisan cycle in output is much
weaker than what a cursory inspection of the data would suggest. Mishra (1997) uses modern panel data
estimation techniques trying to control for similar biases in a panel of 10 OECD countries. He finds
strong support for a post-electoral partisan cycle and weaker support for a pre-electoral cycle.
J; See, for instance, Fair (1978).

Ch. 22: Political Economics and Macroeconomic Policy

1417

hazard" and "adverse selection", where the labels refer to the informational asymmetry
between voters and the elected policymaker.
3.1.1. Moral hazard in monetary policy

The model in this first subsection is adapted from Lohman (1996), whose work builds
on that by Persson and Tabellini (1990) and Holmstrom (1982). Its main insight is that
elections aggravate the credibility problem of monetary policy, because they raise the
benefit of surprise inflation for the incumbent.
Consider a version of the model in subsection 2.4. Voters are rational, have an
infinite horizon and are all identical. Their preferences are summarized by a loss
function defined over inflation and employment, identical to Equations (2.15) and
(2.16) above - and are thus linear in employment. Political candidates have the same
objectives, defined over output and inflation, as the voters. In addition, they enjoy being
in office: their loss is reduced by K units each period they hold office.
Candidates differ in their ability to solve policy problems. One candidate may be
particularly able to deal with trade unions, another to deal with an oil-price shock,
a third is better able to organize his administration. This competence is reflected
in output growth (employment): a more competent candidate brings about higher
growth, ceteris paribus. To capture this, we write the Phillips curve exactly as in
Equation (2.3), except that we set 0 to zero; we thus consider only e shocks, but
change their interpretation. Throughout this section, e captures the competence of the
incumbent policymaker, not exogenous supply shocks. We assume that the competence
of a specific policymaker follows a simple MA-process: e, = -~h - /~t-1, where
~/ is a mean zero, i.i.d, random variable, with distribution F(.) and density f ( . ) (in
this formulation a positive realization of ~/ leads to high output). Competence is
assumed to be random, as it depends on the salient policy problems, but partially
lasting, as the salient policy problems change slowly and as competence may also
depend on talent. Serially correlated competence is the basis of retrospective voting:
as competence lasts over time, rational voters are more likely to re-elect an incumbent
who brought about a high growth rate. In the very first period of this repeated game,
we assume r/0 = 0.
The timing in a given period t is as follows. The previous period's policy instrument
and inflation & 1 are observed. Wages (and expected inflation) are determined. The
policymaker sets the policy instrument for t. Competence is realized and output
growtb xt is observed by everybody. Finally, if t is an election year - which happens
every other year -~ elections are heldo
Two remarks should be made about these assumptions. First, unlike in Section 2,
the policymaker does not have any information advantage over private agents:
when policy is set, the current competence shock ~/i is unknown to everyone,
including the incumbent. The voters do not face an adverse selection problem in
that the policymaker cannot deliberately "signal" his competence. This assumption
distinguishes the model in Lohman (1996) from the earlier work by Rogoff and

1418

71 Persson and G. Tabellini

Sibert (1988), Rogoff (1990) and Persson and Tabellini (1990). The voters still face
a moral hazard problem: through his monetary policy action, the incumbent can
appear better than he really is. The voters understand these incentives, but can do
nothing about them, as policy is unobservable. A model o f this kind was first studied
by Holmstrom (1982) in a standard principal-agent set-up, where the agent has
career concerns, subsection 3.1.3 discusses the alternative, and more complicated,
setting when the policymaker is better informed about his own competence than
the voters.
Second, at the time o f the elections, voters only observe output growth and wages
(expected inflation), but not inflation or policy. This assumption is not as bad as
it may first appear. Inflation typically lags economic activity. A n d even though
monetary policy instruments are immediately and costlessly observed, this information
is meaningless unless the voters also observe other relevant information that the
policymaker has about the state o f the economy. To properly understand an expansion
o f the money supply six months before the elections, voters would have to know the
policymaker's forecasts o f money demand and other relevant macroeconomic variables.
Assuming that policy itself is unobservable is just a convenient shortcut to keep the
voters signal-extraction problem as simple as possible is
Finally, we make two other simplifying assumptions. Once voted out o f office, an
incumbent can never be reappointed. The opponent in any election is drawn at random
from the population and his pre-election competence is not known. Thus the expected
competence o f any opponent is zero.
3.1.2.

The equilibrium

First, consider wage-setters. They have the same information as the policymaker
and Call thus compute equilibrium policy and perfectly predict inflation. Hence, in
equilibrium sr - Jv~ in every period. Next, consider voters. By observing output and
knowing the previous period shock to competence, tk 1, they can correctly infer the
current competence o f the incumbent by using Equation (2.3): tlt = xt - rlt i 19. The
equilibrium voting rule is then immediate. Voters always prefer the policymaker with
the highest expected competence. As the opponent has zero expected competence,
the voters re-elect the incumbent with probability one i f and only i f xt > r/t--l, as
in this c a s e t h > 0 (if xf --= rk 1, we can assume that the voters randomize, as
they are indifferent). To an outside econometrician, who observes x~ but not t/l-l,

18 As Lohman (1996) observes, however, this assumption is not easily made consistent with a surprise
supply formulation (like in Section 2) where employment (output growth) is determined by realized real
wages in a one-sector setting. Lohman instead formulates her model as a Lucas island model where
firms observe tile local inflation but not economy-wide inflation (the policy instrument).
i9 Voters know that Jr = JU. Also, recall that in period 0 we have, by assumption, tl0 0. Hence in
period 1: x I = t/l, and output fully reveals the policymaker's competence. Knowing r/l , in period 2,
voters can intbr r/2 from x2 = t12+ th, and so on.

Ch. 22:

1419

Political Economics and Macroeconomic Policy

this voting rule appears consistent with retrospective voting: the probability of reelection, Pr(~h i ~< x t ) - F ( x ~ ) , increases with output growth in the election
period.
Next, consider the policymaker's optimization problem. In @ e l e c t i o n years, he can
do nothing to enhance future re-election probability, as competence shocks last only
one period and are observed with the same lag. Hence, the equilibrium inflation rate
minimizes the static loss in Equation (2.1 6) with respect to ~, subject to Equation (2.3)
and taking yL"e as given. As in subsection 2.4, this yields 76 = X. O n - e l e c t i o n years
entail different incentives: by raising output growth through unexpected inflation, the
incumbent policymaker would increase his election probability. In equilibrium, wagesetters correctly anticipate these incentives, and raise expected inflation accordingly,
so that output continues to grow at its natural rate.
To formally derive these results, we first compute the equilibrium probability of
re-election from the point of view of the incumbent. Recall that he is re-elected iff
[xt > t/t_,], or - by Equation (2.3) and our definition of E - iff [tit > gete - Jrt I When
setting policy, the incumbent has not yet observed t/t. His perceived probability of reelection is 1 - Prob(r/t ~< xe _ ~ ) ~ 1 -- F(aVre - a~t), where F(.) is the cumulative
distribution of t/. This probability is clearly an increasing function of unexpected
inflation.
Next, we need some additional notation. Let V R and V N be the expected equilibrium
continuation values of reappointment and no reappointment, at the point when policy
in an on-election year is chosen. Furthermore, let ~ be equilibrium inflation during
on-election years, to be derived below. Simple algebra establishes that:
VN _

~2 q_ 6~-g2

2(1 - 62) ,

K(1 + 6)

vR _ VN _

~2(1

(3.1)

F(0))'

where 1 F(O) is the equilibrium probability of re-election perceived by the incumbent

in all . f u t u r e elections (he recognizes that future inflation surprises are not possible in
equilibrium). Intuitively, the expected value of winning the elections - the difference
V R - V N - depends on K, the benefits from holding office, but not on the equilibrium
policies, ,~ and Yv, since those are the same irrespective of who wins. Note also
that these continuation values do not depend on the policymaker's competence, as
competence is not known when policy is set.
We are now ready to formulate the problem of an incumbent during an on-election
year. The incumbent takes expected inflation as given and chooses current inflation to
minimize
E[L t ]

[yc 2 - )~(Jv - off) - K + 6(1 - - F ( s r ? - Jvt)) V ~ + 6F(c~ - Jrt) V N I .

(3.2)
The first two terms in Equation (3.2) capture the expected loss in the current period.
The last two terms capture the expected value of future losses, as determined by
reappointment or not in the upcoming elections. Taking the first-order condition for a

Persson and G. Tabellini

1420

given ~e and then imposing the equilibrium condition Jr - :re yields the equilibrium
inflation rate during on-election years:
6(1 + 6)f(O)
= ~q-(~f(O)(VN - v R ) = "~ q - K 1 - 6 2 ( 1 - F(0))'

(3.3)

where the last equality follows from Equation (3.1). The LHS of Equation (3.3)
is the marginal cost of inflation. The RHS is the marginal benefit: 3. is the usual
benefit of higher output growth~ present at all times; the second term is tile additional
on-election-year benefit; higher output growth increases the chance of re-election.
This additional benefit of surprise inflation undermines credibility and makes policy
more expansionary during on-election years. Thus, equilibrium inflation right after
the election is higher, the more the policymaker benefits from holding office, as
measured by K, and the more surprise inflation raises the probability of reappoinmlent,
as measured by the density f(0). Finally, as the incentives to inflate before elections
are perfectly understood by private agents, expected inflation is also higher, and
equilibrium output growth is not affected. Thus, the equilibrium is consistent with
stylized fact (iv) in the introduction. Elections aggravate the credibility problem, as
the incumbent cares even more than usual about output growth.
3.1.3. A d v e r s e s e l e c t i o n

What happens when policy is instead chosen after the incumbent has observed the
realization of current competence th, but the sequence of events is otherwise exactly
as before? In this setting, studied by Rogoff and Sibert (1988), Rogoff (1990) and
Persson and Tabellini (1990), the policymaker enjoys an information advantage over
wage-setters, who do not know the realization of t/t when forming expectations. Output
fluctuations can still reveal the policymaker's type, but in a less straightforward fashion:
voters have to deal with an adverse selection problem, where output can be used as a
deliberate signal of the incumbent's competence.
To cope with this more intricate problem, we postulate that in each period tl can only
take one of two values: ~ > 0 and tl < 0 with probabilities P and (1 - P ) , respectively.
As before, ;'/is i.i.d, and has an expected value E(t/) = P ~ + (1 - P)~ = 0. We refer
to an incumbent with a high (low) realization of t/as competent (incompetent). The
opponent's competence is still unknown to everyone.
In the moral hazard model, all incumbent types choose the same action, because e x
a n t e they were all identical. Here, a more competent incumbent has stronger incentives
to surprise with higher inflation. There are two reasons for this. First, a more competent
incumbent cares more about winning the elections, since he knows that he can do a
better job than his opponem. Second, a more competent incumbent also has a lower
cost of signalling his competence through high output growth. Here, we only sketch
the arguments needed to characterize the equilibrium A full derivation is provided by

Ch. 22.. Political Economics' and Macroeconomic Policy

1421

Persson and Tabellini (1990, Ch. 5). As a first step, compute the expected net value
o f winning the elections:

(1 + 6 ) K
V R - V N = A,r/+ 1 - 62(1 - P )

(3.4)

Comparing Equations (3. l) and (3.4), the net value of winning now depends on the
competence o f the incumbent: a competent incumbent knows he is more likely to bring
about higher future output growth than his opponent, and hence values office more.
A incompetent incumbent realizes the converse - and is less eager to be re-elected 2.
The equilibrium inflation rate trades off this net value of winning against the short-run
cost o f signalling. Both types want to appear competent and are prepared to artificially
boost the economy through unexpected inflation to increase the chances of winning.
But the competent type can signal at a lower cost: he needs to inflate less to produce any
level o f output growth. As the value o f winning is also higher for the competent type,
a "separating equilibrium" generally emerges: rational voters re-elect the incumbent
only if output growth exceeds a minimum threshold. The threshold is so high that
only a competent incumbent finds it optimal to reach it through unexpected inflation.
The incompetent type instead prefers to keep inflation low, knowing he will not be
re-elected.
Recall that wage-setters have to form inflation expectations without knowing which
incumbent type they face. expost, they will always be wrong, even though their ex ante
inflation forecast is rational. If the incutnbent is incompetent, he chooses the short-run
optimal inflation rate Uv = X in the model), which is lower than expected; hence, the
economy goes through a recession. If the incumbent is competent, inflation is higher
than expected and the economy booms.
How do the conclusions o f this model compare with the stylized facts? Clearly,
retrospective voting applies: voters reward pre-electoral booms with reappointment and
punish pre-electoral recessions. Output is not systematically higher before elections;
on average, inflation is higher just after the elections, but this cycle is weaker than in
the moral hazard model, as only the competent type now raises equilibrium inflation.
Overall, the predictions of this model are not inconsistent with the stylized facts.
Which model is more satisfactory? The moral hazard model has more clear-cut
predictions and makes less demanding assumptions about the rationality of the voters.
Moreover, multiplicity of equilibria is an additional problem in the adverse selection
model. With enough data, one could discriminate between the two models: output

2o We assume that K is sufficiently high that even an incompetent incmnbent values being re-elected.
Note also that here the equilibrium probability of winning future elections coincides with P, the
probability of a high realization of~t. That is, in equilibrium a competent incumbent is alwaysreappointed
and an incompetent one is not. This is a feature of all separating equilibria, that will be discussed below;
some equilibria may exist that are not separating, but we neglect them here. Persson m~d Tabellini (1990)
contains a more general discussion of this issue.

17.Persson and G. Tabellini

1422

volatility before the elections and inflation volatility after the elections are higher
only in the adverse selection model. Note that these two models also have different
normative implications. With moral hazard, the political cycle is entirely wasteful,
whereas it conveys valuable information to voters in the adverse selection model 21 .
3.2. Partisan gooernments

The prior section relied on two crucial assumptions. All voters are alike and
policymakers are opportunistic: their main purpose is re-election to enjoy the
rents from office. Elections serve only one purpose: to select the most competent
policymaker. But voters are not alike, and policymakers are also motivated by their
own "ideological" view of what ought to be done and which group o f voters to
represent. Therefore, elections serve another goal: they resolve conflicts and aggregate
preferences. The policy outcome then hinges on the partisan interests o f the elected
government. In monetary policy, and more generally aggregate demand policies, one
crucial concern is the relative weight assigned to stabilizing output. For left-wing
governments output and employment may weigh more heavily than prices; if so,
they will also pursue more expansionary aggregate demand policies than right-wing
governments. Elections thus create uncertainty about economic policy. This uncertainty
is greater in a two-party system with very polarized parties. It may create a post-electoral cycle in the policy instruments, and a resulting macroeconomic cycle. We
now extend our simple monetary policy model to illustrate these ideas, showing how
one can account for stylized fact (v) in the introduction. The ideas originate with the
work o f Alesina (1987, 1988).
3.2.1. The model

Consider the same model as in the previous section, but suppose that individual voters
differ in their relative evaluation o f output and inflation. The preferences o f voter i
are still described by an intertemporal loss function like (2.15), but the static loss o f
individual i has an idiosyncratic relative weight on output:
Li(zc, x) = ~:vl 2

)~ix.

(3.5)

Two political candidates or parties, called D and R, have the same general loss function
as the voters, with relative weights )LD > )~R. The D candidate thus cares more

21 Rogoff (1990) shows in a closely related adverse selection model of fiscal policy that society may
actually be worse off if one tries to curtail pre-election signalling through, say, a balanced budget
amendment (the loss of losing the information may more than outweigh the gain of eliminating the
distortions associated with signalling).
In a recent paper, however, al Nowaihi and Levine (1998) demonstrate that political cycles can be
avoided and social welfare increased by delegating monetary policy to an independent central bmlk faced
with an inflation contract of the type discussed in subsection 4.3 below.

Ch. 22." Political Economics and Macroeconomic Policy

1423

about output growth and less about inflation than the R candidate. The candidates'
preferences are known by everybody, but the outcome of the election is uncertain.
For simplicity, there are no competence or supply shocks: output growth is described
by Equation (2.3), without any e so that x = 0 + c - ce. The timing of events is as
follows: Wages are set at the beginning of each period. Elections are held every other
period, just after wages are set for that period. Thus, wage contracts last through half
the legislature and cmmot be conditioned on the election outcome. Finally, to capture
the electoral uncertainty about policy, we assume that candidates can only set policy
once in office. In other words, electoral promises are not binding and the policy must
be ex post optimal, given the policymaker's pret~rences.
3.2.2. Economic equilibrium

Under these assumptions, voters are perfectly informed and the state of the economy
does not reveM anything to them. Hence, policymaker I chooses the same inflation
rate in office whether it is an on- or off-election period. Given the assumed timing,
it is easy to verify that d = )~I, I = D, R. In off-election periods, this inflation rate
is perfectly anticipated by wage-setters, and output grows at the natural rate: x = 0.
But just before the elections, wage-setters do not know which policymaker type will
win. Suppose they assign probabilities P and (1 - P ) to the events that D and R
win. During on-election periods, expected inflation is thus :ve = )~R + p()~o _ )~R).
If party R wins, it sets 7c = XR < ce and causes a recession in the first period of
office: output is x = -P(3. D -tlR). If D wins, the opposite happens: actual inflation is
higher than expected and a boom occurs: x = (1 - P ) ( ) ~ - 3.R). Thus, uncertain election
outcomes may cause economic fluctuations. But this political output cycle occurs after
the election and is due to different governments having different ideologies, in contrast
to the previous model where the political output cycle is due to signalling and occurs
beJore elections.
interpreting these ideological differences along a left-right political dimension, we
get a possible explanation for stylized fact (v). The model predicts that left-wing
governments stimulate aggregate demand and cause higher inflation throughout their
tenure, while the opposite happens under right-wing governnaents. An election victory
of the left brings about a temporary boom just after the elections; victory of the right
is instead tbllowed by a recession. These partisan effects are more pronounced under
a more polarized political system (i.e. with large differences between tlD and )~R in the
model), or more generally if the elections identify a clear winner, like in two-party
systems. Alesina and Roubini (1997) argue that these predictions are consistent with
the evidence for industrial countries.
3.2.3. Political equilibrium

The partisan model tbcuses on the role of party preterences in elections. Voters
anticipate what each party would do if elected, and choose the party closest to their

1424

17. Pe~5'son and G. Tabellini

ideal point. Thus, the probability that one party or the other wins is entirely determined
by fluctuations in the distribution of voters' preferences for the two parties. Moreover,
as electoral promises are not binding and voters are rational and forward-looking, the
policy platforms of the two candidates do not converge towards the median voter.
In the model, voters face a trade-off. If R wins, inflation is lower but output is
temporarily lower, while the opposite happens if D wins. How voters evaluate this
trade-off depends on their relative weight parameter )~i. Computing the losses to a
generic voter after an R and a D victory, respectively, and taking differences, it is easy
to verify that voter i strictly pret~rs R to win if

,V < (1 + 6)(,~ R + X~)).

(3.6)

The probability (1 ~-P) that R wins is the probability that the relative weight of the
median voter ~" satisfies inequality (3.6). Electoral uncertainty thus ultimately relies
on the identity of the median voter being unknown, because of random shocks to the
voters' preferences or to the participation rate.
Ceteris paribus, right-wing governments enjoy an electoral advantage: because all
policymakers suffer from an inflation bias, a high value of )~ is a political handicap 22.
Inequality (3.6) implies that a voter whose ideological view is right in between R and D
[that is, such that ,~i _ (3j~+ )j))] votes for the right-wing candidate. This suggests that
an incumbent can act strategically to increase its chances of re-election. Specifically,
a right-wing government can make its left-wing opponent less appealing to the voters
by increasing the equilibrium inflation bias. This could be done by reducing wage
indexation, by issuing nominal debt (to raise the benefits of surprise inflation), or
by creating more monetary policy discretion, via a less disciplining exchange rate
regime or weaker legislation regarding central bank independence, or even by current
monetary policy if unemployment is serially correlated. These ideas have their roots
in the literature on strategic public debt policy, further discussed in Section 6 below.
On the normative side, electoral uncertainty and policy volatility are inefficient, and
voters would be better off ex-ante by electing a middle-of-the-road government that
enacted an intermediate policy. But in the assumed two-party system, there is no way
of eliminating this unnecessary volatility. The stark result that there is no convergence
to the median position, is weakened under two circumstances. One, studied by Alesina
and Cukierwian (1988), is uncertainty about the policymaker type. Then each candidate
has an incentive to appear more moderate, so as to raise the probability of winning the
next election. The second, studied by Alesina (1987), is repeated interactions. Then the
two candidates can sustain self-enforcing cooperative agreements: a deviation from a
moderate policy would be punished by the opponent who also reverts to more extreme
behavior once in office. Alternatively, cooperation could be enforced by the v o t e r s

22 This observation is related to the argument about the benefits of appointing a conservative central
banker discussed in subsection 4.3 below.

Ch. 22:

Political Economics and Macroeconomic Policy

1425

punishing a government that enacted extreme policies. Naturally, there is the same
problem of multiple equilibria as in the reputational equilibria of subsection 2.4.
Institutional checks and balances can also moderate policy extremism. In a
presidential system, for instance, actual policies often result from a compromise
between the legislature and the executive. The model of partisan policymakers suggests
that the voters would take advantage of these institutional checks and balances to
moderate the behavior of the majorities. Alesina and Rosenthal (1995) argue that
the voters' attempt to moderate policy extremism can explain split ticket voting
in Presidential systems (i.e., the same individuals voting for different parties in
Presidential and Congressional elections) and the mid-term election cycle (the party
who won the last general elections loses the interim election).
3.3. N o t e s on the litetz~ture

Alesina and Roubini (1997) present existing and new evidence on electoral cycles in
OECD countries. They also survey the theoretical work on political cycles in aggregate
demand policy. Alesina and Rosenthal (1995) focus on the United States in particular.
The evidence for a partisan cycle is scrutinized by Faust and Irons (1999) (for the USA)
and by Mishra (1997) (for a panel of OECD countries). Fair (1978), Fiorina (1981)
and Lewis-Beck (1988) discuss the evidence on retrospective voting in the USA and
elsewhere.
The first models of political business cycles with opportunistic government are due
to Nordhaus (1975) and Lindbeck (1976). The first theory of a partisan political cycle
is due to Hibbs (1977). All these papers relied on the assumption that private agents
are backward-looking, both in their economic and voting decisions.
The model of an opportunistic govermnent and adverse selection with rational
voters, summarized in subsection 3.1.3, was developed by Rogoff and Sibert (1988)
in the case of fiscal policy, and adapted to monetary policy by Persson and
Tabellini (1990). Rogoff (1990) generalized the fiscal policy results to two-dimensional
signalling by the incumbent. Ito (1990) and Terrones (1989) considered political
systems in which the election date is endogenous and chosen by the incumbent himself,
after having observed his own competence.
The moral hazard model studied in subsection 3.1.1 is very similar to a principalagent problem with career concerns developed by Holmstrom (1982). It was studied in
the context of monetary policy by Lohman (1996) and, in a somewhat different set-up,
by Milesi-Ferretti (1995b). Ferejohn (1986) and Barro (1973) study a more abstract
moral hazard problem where an incumbent is disciplined by the voters through the
implicit reward of reappointment.
The model of partisan politics with rational voters is due to Alesina (1987, 1988).
This model is extended by Alesina et al. (1993) and by Alesina and Rosenthal (1995) to
allow for ideological parties who also differ in their competence. Milesi-Ferretti (1994)
discusses how a right-wing incumbent might increase his popularity by reducing the
extent of wage indexation; similar points with regard to nominal debt and the choice of

1426

T. Persson and G. Tabellini

an exchange rate regime were investigated by Milesi-Ferretti (1995a,b). Jonsson (1995)

discusses strategic manipulation of monetary policy for political purposes when there
is autoregression in employment. Uncertainty about the policymaker's ideological type
is considered in Alesina and Cukierman (1988). The role of moderating elections, in
theory and in the US data, is studied by Alesina and Rosenthal (1995).

4. Institutions and incentives

Theoretical work on institutions and incentives in monetary policy has developed over
the last ten years. Below, we give a selective account of key ideas in that development.
We do not follow the actual course of the literature over time, but we exploit what,
in retrospect, appear to be the logical links between different ideas. The main issue is
how the design of monetary institutions can remedy the incentive problems discussed
in Sections 2 and 3. Even though we focus on lack of credibility, some results extend
to the political distortions of Section 3.
The ideas in this section rely on a common premise: institutions "matter". A
constitutional or institution-design stage lays down some fundamental aspects of the
rules of the game, which cannot be easily changed. Once an independent central bank
has been set up, an international agreement over the exchange rate has been signed,
or an inflation target has been explicitly assigned to the central bank, it has some
such staying power, in the sense that changing the institution e x p o s t is costly or takes
time. This premise is questioned by some critics [in particular by McCallum (t996) and
Posen (1993)], who argue that some of the proposed institutional remedies discussed in
this section "do not fix the dynamic inconsistency" that is at the core of this literature,
they "merely relocate it". The criticism is correct, in that the institutions are assumed
to enforce a policy which is e x p o s t suboptimal from society's (or the incumbent government) point of view. Hence, there is always a temptation to renege on the institution.
But the staying power of institutions need not be very long to be effective. In the model
that dominates the literature, what is needed is a high cost for changing the institution
within the time horizon of existing nominal contracts. Beyond the contracting horizon,
expectations would reflect any constitutional change, which removes the distinction
between e x p o s t and e x a n t e optimality. As already remarked in subsection 2.4, the
cost of suddenly changing the institution could also be a loss of reputation. By focusing
political attention on specific issues and commitments, institutions alert private
individuals if govermnents explicitly renege on their promises. To pick up the thread
from Section 2, one purpose of successful monetary institutions is to make monetary
policy a bit more like patent legislation. In our view, real-world monetary institutions
do have such staying power. They can be changed, but the procedure for changing
them often entails delays and negotiations between different parties or groups that were
purposefully created when the institution was designed. We thus think that the premise
of the literature is generally appropriate. But it would be more convincing to derive

Ch. 22." Political Economics and Macroeconomic Policy

1427

the institutional inertia as the result o f a well-specified non-cooperative strategic interaction between different actors, something the literature - so far - has failed to do 23.
4.1. Fixed exchange rates." simple rules and escape clauses

Pegging the value o f the exchange rate to gold or to some reserve currency has been a
common device, particularly in smaller countries, to anchor inflationary expectations,
discipline domestic price and wage setting, or prevent political interference in
monetary policy. Such attempts have met with mixed success. A m o n g the industrialized
countries during the post-war period, the Bretton Woods system and (part of)
the European Exchange Rate Mechanism (ERM) were reasonably successful. But
unilateral attempts o f some European countries to peg their exchange rates in the 1970s
and 1980s often ended up in failure: with lack o f credibility generating a spiral of
repeated devaluations, domestic wages and prices running ahead of foreign inflation.
What can explain such differences?
To shed light on this question, let us study a slight modification of the static model
in Section 2. A small open economy is specialized in the production o f a single good
which is also produced by the rest o f the world. The central bank controls 37 through
the exchange rate, given a foreign inflation rate denoted 37*. The rest of the model,
including the expectations-augmented Phillips curve (2.3), the rational-expectations
assumption, the objective function o f the policy maker (2.6), and the timing o f events
are as in subsection 2.2 or 2.3; except that we assume not only 0, but also 37* to be
known when wages are set (7c are formed). Note that 37* denotes both foreign and
target inflation, as pegging the exchange rate to a low-inflation currency can be seen
as an explicit or implicit attempt to target a low inflation rate.
Under discretion, the model is formally identical to that in subsection 2.3 and thus
generates the inflation and employment outcomes in Equations (2.12) and (2.14). As
E(37) > 37*, the model is consistent with the idea o f a devaluation spiral, fuelled by
low credibility among wage-setters and a devaluing exchange rate.
Consider now the following institution. At stage (0), society commits to a simple
rule o f holding the exchange rate fixed, or of letting it depreciate at a fixed rate k.
There is commitment, in the sense that the rate o f depreciation k is chosen at the start
of each period, and cannot be abandoned until one period later. The rule is simple,
because it cannot incorporate any contingencies. In practice, simple commitments of
this kind can be enforced by multilateral agreements such as the Bretton Woods system
or the ERM, where the short-rnn interests of other countries are hurt if one country
devalues. Policy commitments to complex contingent rules would require implausible
assumptions on verifiability and foresight.

23 Jensen (1997) in tact studies a simple model related to the contracting solution to be studied
in subsection 4.3 - where the government can renege on the initial institution at a continuous (nonlump sum) cost. In this setting institution design generally improves credibility, but cannot remove the
credibility problem cmnpletely.

T. Persson and G. Tabeltini

1428

What is the optimal rule? As the depreciation rate is known in advance of wage
setting and expectation formation and is not contingent on the e shocks, it is neutral
with respect to real variables. Hence, the optimal rule has k = 0. Under this simplicity
constraint, a fixed exchange rate is thus the optimal commitment. This results in the
following equilibrium outcome: ~s = jr., x s _ 0 - e, where the S superscript stands
for simple rule.
Is the simple rule better than discretion? It depends. The rule brings about lower
average inflation, but employment is more variable. A formal comparison of the
two regimes can be made by substituting Equations (2.12)-(2.14), and the previous
expression for ~s and x s, into Equation (2.6) and taking expectations o f the difference
in their payoffs. Recalling that E(O) = 0, this gives

E[L(~t)'xD)]-E[L(~S'xS)] = 2)'2- {E(x*)2 + o~ - -(1- ~ 2 ; ).

The first two "terms on the RHS capture the benefit of credibility under the simple rule the sum of the squared average inflation bias and its variance. The last term is the loss
from not being able to stabilize employment. A simple rule is better than discretion
if the gain o f credibility is larger than the loss o f stabilization policies. This trade-off
between credibility and flexibility is a recurrent theme in the literature on institution
design. The benefit o f the simple rule is further enhanced if, under discretion, monetary
policy is also distorted by the electoral incentives discussed in Section 3.
Another monetary regime, often advocated though harder to enforce, is a commitmerit to a k% money growth rule. Suppose we add a simple quantity-theory equation to
our model, where money demand depends on output growth (or employment), so that
+ x = m + v. The policy instrument is m, like in Section 2. Under a simple money
growth rule, velocity shocks v destabilize employment and prices. A simple exchange
rate peg, on the other hand, automatically offsets velocity shocks. But a money supply
rule might better stabilize supply shocks; as these destabilize both output and prices,
the price response acts as an automatic output stabilizer. In the limit, if ~, = 1, a
k% money rule mimics the optimal policy response to a supply shock 24.
The assumption that an exchange rate peg, once announced, cannot be abandoned
until next period, may be too stark. Multilateral exchange rate agreements often
have escape ,clauses: European countries have temporarily left the ERM or realigned
their central parities when exceptional circumstances made it difficult to keep the
exchange rate within the band. An escape clause can be thought o f as follows.
Define normal times as a range of possible realizations o f the unobservable supply
shock: e C [eL(o), EU(o)]. Inside this interval, the central bank remains committed to
the simple rule. During exceptional times, defined by the complementary event, an
24 A literature dating back to the 1970s has studied the choice between alternative rules in richer
models - for surveys, see Genberg (t989) and Flood and Mussa (1994). Recent contributions to the
comparison of exchange rate versus money based stabilizations of inflation are surveyed by Calvo and
V6gh (1999).

Ch. 22.. Political Economics and Macroeconomic Policy

1429

escape clause is invoked. The central bank abandons the simple rule and pursues a
discretionary (ex p o s t optimal) policy, given inflationary expectations.
At normal times, the exchange rate is fixed and output is destabilized by (small)
supply shocks. There is also a p e s o problem: as the escape clause will be invoked
with positive probability, expected inflation is always positive. Normal times with
actual inflation at zero, thus has some unexpected deflation and employment below
the natural rate. At exceptional times, on the other hand, the central bank abandons
the rule and sets an ex p o s t optimal policy to stabilize (unusually large) supply shocks.
But less inflation is now needed compared to the regime with pure discretion, because
expected inflation is lower. Hence, a simple rule with an escape clause strikes a better
balance between credibility and flexibility, by allowing for flexibility when it is most
needed. Indeed, Flood and Isard (1989) have shown that a rule with an escape clause
always dominates pure discretion and, if supply shocks are sufficiently volatile, it also
dominates a simple rule. As Obstfeld (1997a) has stressed, however, escape-clause
regimes can give rise to multiple equilibria. Intuitively, expected inflation depends on
how often the escape clause is invoked. At the same time, the e x p o s t decision whether
or not to invoke the escape clause depends on expected inflation. As higher inflationary
expectations make it more tempting to abandon the rule, high inflationary expectations
may become self-fulfilling.
How can a regime with an escape clause be implemented? In a multilateral exchange
rate regime where realignments have to be approved by an international body, the
bounds would depend on the bargaining power of the devaluing (revaluing) country,
which, in turn, would depend on the details of the institution (the prospective sanctions,
the procedure for making the decisions, etc.). In a domestic context, we could suppose
that at the institution design stage (before 0 is realized) society sets a pair of fixed
costs [ct'(0), cU(0)] incurred whenever the escape clause is invoked. These costs would
capture the public image loss for the central banker from not fulfilling his mandate, or
the costs for the government of overriding a central bank committed to the simple rule.
They would implicitly define bounds eL(0) and eu(0), that leave the central bank indifferent between sticking to the simple rule and bearing the cost of no stabilizing policies,
or paying tile cost and invoking the escape clause, in neither of these interpretations it
is reasonable to assume that the costs could be calibrated very carefully ex ante. For
instance, costs may have to be state-dependent or symmetric; cL(O) = c j~, cU(O) = c ~j
or c u = c1" = c. Such plausible constraints would prevent society from reaping the
full value of the escape-clause regime, but still generally improve on the discretionary
outcome. Flood and Marion (1997) point out that an important consideration behind
the ex ante choice of c might be to prevent multiple equilibria.
4.2. Central b a n k independence

The first example of strategic delegation in monetary policy is the independent and
conservative central banker, suggested by Rogoff (1985). To illustrate the idea in our
simple model, we continue to make a formal distinction between society and the central
bank. Society's true preferences take the form (2.6). At the institution design stage (0)

T. Persson and G. Tabellini

1430

o f the model, society appoints a central banker. The central banker is independent:
once appointed, society can no longer interfere with his decisions. (Towards the end
o f this subsection, we ask how reasonable this assumption really is.) Prospective central
bankers have loss functions o f the form (2.6), but differ in their personal values of)L 25.
The appointment thus boils down to the choice o f a parameter, say )~. The private
sector observes )~B and forms its inflationary expectations accordingly.
The appointed central banker sets monetary policy freely at stage (4), according to
his own private preferences. As already discussed in subsection 2.3, this choice gives
the equilibrium outcomes

XB
~(2, B, 0, e) - :v* + ,~B(x* -- 0) + 1 ~ - - ~ E,
1

x(,!, B, O, e) -- 0 - 1 + ~,R e.
Note that the outcomes do not only depend on the realized shocks, but also on the
bankers' preferences. These expressions illustrate a basic trade-off in the strategic delegation: a central banker more hawkish on inflation, i.e. someone with a lower 2,B, has
more credibility in keeping inflation low, but is less willing to stabilize supply shocks.
To formally study delegation, consider society's expected loss function, as a function
of the central banker type:
E[L(~B)] = 1E[(x()~ B, O, e ) - go*) 2 + ~ ( x ( ) f , O, e) -x*)21,

(4.1)

where the expectation is tal{en over 0 and E, for any 3~~. Next, insert the expressions
for equilibrium inflation and employment into Equation (4.1) and take expectations.
The derivative of the resulting expression with regard to At is
dE[L(Jf)]
d)~~

)~(x .2 + a0) + ( ) f - "~)(1 +a~)~B)3 '

(4.2)

The first term is the expected credibility loss of choosing a central banker with
a higher ,~B. The second term measures the expected stabilization gain. The
optimal appointment involves setting this expression equal to zero. Evaluating the
derivative (4:2) at the extreme points implies that ~, > 3,~ > 0 26
Thus, by optimally choosing an independent central banker, society strikes a different
compromise between credibility and flexibility than in the fixed exchange rate regime.
25 This suggests a heterogeneity in the population with regard to the relative weight placed on inflation
versus employment, which ore formal model abstracts from. As discussed in Section 3, however, such
heterogeneity can be formally introduced in the model without any difficulties. Alesina and Grilli (1992)
indeed show that strategic delegation of the type to be discussed below would take place endogenously
in a model where heterogeneous voters elect the central banker directly.
26 Equation (4.7) is a ~burth-order equation in ,~B, which is difficult to solve. But as the derivative is
negative at )f = 0, positive for all 2~ > 2~, and the second-order condition is fulfilled for any ,~e in the
interval (0, ,~), we kaaowthat the solution must be inside the interval (0,)~).

Ch. 22:

Political Economics and Macroeconomic Policy

1431

But it is still a compromise: it is optimal to appoint a central banker who is more

conservative on inflation than society itself (to address the inflation bias), but still not
ultraconservative (to preserve some of the benefits of stabilization). Note also that fluctuations in the inflation bias arising from observable 0 shocks remain. If 3~8 could be
chosen after the realization of 0, society would want to meet a more serious incentive
problem - a smaller 0 - with a more hawkish central banker - a smaller XB. In practice,
the extent of the incentive problem is serially correlated over time, so that making
appointments at discrete points is probably a good way of dealing with this problem.
Like in the escape-clause model, we could give society or government the option
of overriding the central bank decision in exceptional circumstances. The override
option could involve firing the central banker, introducing ad-hoc legislation or an
explicit override clause under a prespecified procedure (the latter arrangement is
indeed observed in the central bank legislation of many countries). An implicit escape
clause mitigates the ex p o s t suboptimality of central bank behavior, inducing even
a conservative central banker to stabilize extreme supply shocks to the same extent
as society would do 27. This option should not be overemphasized, however; escape
clauses can hardly be optimally designed ex ante. Moreover, as already noted in the
introduction, if the government has an override option, why does it not use it all the
time to get the policy it wants ex p o s t ?
We may also note that having an independent central bank also protects society from
the distortions introduced by the electoral business cycles discussed in Section 3. In
this case, however, only independence is required, and no special emphasis on inflation
relative to other macroeconomic goals. Waller (1989) was probably first in formulating
a model of central bank independence under partisan politics 2s. Waller and Walsh
(1996) study the optimal term length of central bankers in the context of partisan
cycles, where society's objectives may change over time.
The literal interpretation that society picks a central banker type is not very
satisfactory: individual priorities or attitudes towards inflation and employment are
often unknown and vaguely defined. Moreover, individual attitudes are probably less
important than the general character and tradition of the institution itself. A better interpretation is that, at the constitutional stage, society drafts a central bank statute spelling
out the "mission" of the institution. Thus, the parameter ,~ reflects the priority assigned
to price stability relative to other macroeconomic goals. As instrument independence is
a necessary condition for delegation to work, we should expect such a strategic setting
of goals to work better if combined with institutional and legislative features, lending
independence to the central bank and shielding it from short-run political pressures.
In this interpretation, the model yields observable implications: countries or time
periods in which the central bank statute gives priority to price stability and protects
central bank independence should have lower average inflation and higher employmem
27 This is indeed proved by Lohman (1992).
28 Fratianni et al. (1997) formally analyze the role of central bank independence in the absence of a
traditional credibility problem, but in the presence of explicit electoral incentives.

1432

Z Persson and G. Tabellini

(or output) volatility - since if )~B < )~, stabilization policies are pursued less
vigorously. Moreover, electoral business cycles in inflation or output should be less
pronounced with greater central bank independence. By now, a number o f studies have
constructed measures o f central bank independence based on central bank statutes,
also taking the priority given to the goal o f price stability into account 29. Crosscountry data for industrial countries show a strong negative correlation between those
measures of central bank independence and inflation, but no correlation between
output or employment volatility and central bank independence. Thus, central bank
independence seems to be a free lunch: it reduces average inflation, at no real cost.
Different interpretations o f this result have been suggested. Alesina and Gatti (1996)
note that an independent central bank could reduce electorally induced output volatility,
as would be predicted by the models of Section 3, and Lippi (1998) provides evidence
that could support this proposition. Posen (1993, 1995) argues that the cross-country
correlation between central bank independence and lower inflation is not causal, and
suggests that both may be induced by society's underlying preferences for low and
stable inflation.
Finally, Rogoff (1985) also suggests another interpretation o f the model: the
conservative central banker might be interpreted as a targeting scheme supported
by a set of punishments and rewards. Having a conservative central banker is
formally equivalent to having an additional term in inflation in his loss function,
0 ( B -- X)(J'g -- 3"g*) 2, where Z ~ > Z. The central banker thus has the same objective
function as everybody else, but faces additional sanctions if actual inflation exceeds
the target. In this simple model, a conservative central banker is thus equivalent to an
inflation target 3o. This alternative interpretation has been picked up by a more recent
literature, asking which targets are more efficient, and more generally how a targeting
scheme should be designed to optimally shape the central bank ex-post incentives.
4.3. Inflation targei~ and inflation contracts'

Central banks have traditionally operated with intermediate targets, like money or the
exchange rate. in the 1990s, several central banks started to target inflation: whereas
some central banks imposed the procedure on themselves, the transition has been
mandated by some governments 31. Such targeting schemes have recently been studied
29 See in particular Bade and Parkin (1988), Grilli et al. (1991), Alesina and Summers (1993), Cukierman
(1992) and Eijffmger and Schaling (1993).
30 Rogoff (1985) compares an inflation target to other nominal targets, such as money and nominal
income. He shows that strategic concerns of the type considercd here, can indeed overturn the ranldng
of intermediate targets, based on parameter values and relative variance of shocks, in the traditional
non-strategic literature on monetary targeting.
31 A substantial literature discusses real-world inflation targeting. See in particular Leiderman and
Svensson (t995), Haldane (1995), McCallum (I996), Mishkin and Posen (1997) and Ahneida and
Goodhart (1996). In practice, an inflation target means that the central bank is using its own inflation
Jorecast as ml intermediate target; see Svensson (1997b) for instance

Ch. 22." Political Economics and Macroeconomic Policy

1433

from the point of view of the theory of optimal contracts. Society, or whoever is the
principal of the central bank, presents its agent - the central b a n k with punisbments
or rewards conditional on its performance. The question is what constitutes an optimal
contract, and what kind of behavior it induces on the agent. We illustrate the basic
ideas of this recent literature in our simple model of credibility. The optimal contract
can easily be modified so as to implement the optimal monetary policy even in the
presence of political distortions, but we do not pursue this extension. Much of the
discussion in this subsection is based on results in Persson and Tabellini (1993) and
Walsh (1995a).
The central bank holds the same quadratic preferences as everybody in society. It
operates under discretion, setting policy at stage (4). At the constitutional stage (0), the
government formulates a publicly observable complete contract for the central bank
which formulates state-contingent punishments (or rewards) conditional on realized
inflation:
P(2C; O, e) -po(O, e) +Pl (0, e) ~ + P2(O, e) at;2.

(4.3)

Our goal is to optimally set the terms pi(O, 0, i = 0, l, 2, that define the contract. We
only include up to second-order terms in the contract, since that is sufficient for our
purposes. Units are normalized so that, at stage (4), the central bank minimizes the sum
of the loss function and its punishment with respect to inflation: L(zc, x)+ P(jr; 0, e).
Going through the same steps as in subsection 2.3 (deriving the central bank
optimum condition for inflation, given the contract and expected inflation, solving
for rationally expected inflation, and combining the resulting expressions), we get the
equilibrium condition
( l + p 2 ( 0 , e))jr

,~(1 + p2(0, e))

Jr* pj(O,e)+X(x*--O)+ l + + p 2 ( O , e ) e .

(4.4)

The benchmark optimum in Equation (2.11) can be implemented by settingp2(0, e) = 0

and pl(O, e) = pl(O) = X(x* - 0). Since the constant po(O, e) does not afl?ct any of
the central bank marginal incentives, it can be set freely - for instance, it can be set
negative enough that the participation constraint is satisfied: the central bank leadership
finds it attractive enough in expected terms to take on the job.
Thus a remarkably simple linear performance contract - imposing a linear penalty
on inflation - removes the inflation bias completely. The credibility-flexibility trade-off
has disappeared: average inflation is brought down to the target, at no cost of output
volatility. Once the simple contract has been formulated, the central bank has the right
incentives to implement ex ante optimal policy. Note that the optimal contract is not
conditional on e; this is because the marginal incentives to stabilize the economy are
correct under discretion (in the terminology of Section 2, there is an inflation bias but
no stabilization bias). But the slope of the penalty for inflation is conditional on 0; as
the incentive to inflate the economy also varies linearly with 0. To see the intuition for
this result, think about the punishment for inflation as a Pigovian corrective tax. As

T. Persson and Ca. Tabellini

1434

discussed in subsection 2.3, the distortion we want to address is that the central bank
does not internalize the effect o f its policy on inflationary expectations, when acting
expost. Since expected inflation E ( ~ I 0) is a linear projection o f Jr, a linear penalty for
inflation makes the central bank correctly internalize the marginal cost o f its policy 32.
To see this formally, substitute Equation (2.3) into the objective function (2.6) and
calculate the equilibrium marginal cost o f expected inflation in state 0 as:

dE[L(~,x) l O]
d~ e

= ,Vx* - O) =p~(O, e).

That there is no credibility-flexibility trade-off with an optimal contract contrasts

with the previous subsection, where - under a quadratic inflation target - lower
expected inflation was associated with distorted stabilization policy. A quadratic
inflation target is thus not an optimal contract. The Rogoff (1985) targeting solution,
discussed at the end o f the last section, is equivalent to an inflation contract with
1
B
P2 = (X ~ - 2'), Pl = (2"B _ 2")st*, and P0 = ~(X
- 2")(zc*)2. This clearly gives the
central banker incorrect marginal incentives.
Nevertheless, the optimal linear inflation contract can be reinterpreted as similar to
an inflation target. As the intercept can be set freely, we can write the optimal contract
as

P ( x ; O)

=~o + pL ( O)(x - zc*);

(4.5)

the central banker is punished linearly, but only for upward deviations from society's
preferred inflation rate. Walsh (1995b) shows that the marginal penalty on inflation
can be interpreted as resulting from an arrangement where the governor o f the central
bank faces a probability o f being fired which increases linearly in inflation. Such
an arrangement resembles the Price Targeting Agreement in force in New Zealand
since 1990. Other looser interpretations would be to associate the penalty with altered
central-bank legislation, a lower central-bank budget, or a loss o f prestige of the
institution and the individuals heading it, for failing to deliver on a publicly assigned or
self-imposed "mission". Naturally, it may be impossible to specify the penalty exactly
as a linear function o f inflation. But to approximate an optimal incentive scheme, the
punishment for upward deviations from an inflation target should not increase too
rapidly with the size of the deviation. In fact, if the central bank is risk averse, the
optimal contract entails a diminishing marginal penalty on inflation (to reintroduce
linearity in the incentive scheme).
Svensson (1997a) has proposed an alternative interpretation o f inflation targets,
related to - but somewhat different from - the optimal performance contract
interpretation. In his formulation the central bank is not assumed to have any generic

32 Indeed, tinearity of the optimal contract is preserved for any general loss ~unctions~ and not just for
the quadratic one.

C7l. 22:

Political Economics and Macroeconomic Policy

1435

preferences over macroeconomic outcomes; instead society can impose a specific

quadratic objective function on the central bank o f the form in Equation (2.6). Suppose
that society manages to assign a loss function with a lower goal for inflation, say avB(0)
rather than ~*, to the central bank. Then the optimal central bank goal for inflation is
~ ( 0 ) = 0c* - ,a.(x* - 0). Pursuing this goal would eliminate the inflation bias, without
giving up on stabilization policies. That is, the lower inflation goal is equivalent to
our previous setting with a central bank minimizing L + P, where L is society's loss
function and P is an inflation contract o f the form in Equation (4.3), with parameters
p2 = 0, p~ = )~(x* - 0) and P0 = [)~(x* - 0) 2 - 2~*)~(x* - 0)]. This representation
of an inflation target suggests an alternative explanation for the empirical observation
discussed in the previous subsection. A lower zce is associated with lower inflation but
not with higher output variability, as in the data.
It is not without problems to associate this scheme with real-world institutions,
however. Suppose that the optimal inflation rate for society, sT*, is about 2%, and that
the average inflation bias, )~(x* - 0), is about 5% (not an outrageous number, given the
recent monetary history of many European countries). The central bank should then be
given an inflation goal, S~(0), o f - 3 % . But in equilibrium, tile central bank would not
take any action to bring inflation below 2%, which may present it with some problems
when explaining its policy to the public. A second, more important, problem relates
to enforcement. How can we ensure that the central bank accepts to evaluate the costs
and benefits o f the policy according to the imposed objective function, rather than
according to society's preferences? A plausible answer is that the central bank is held
accountable for its actions and that there is a performance based scheme o f rewards
or punishments that makes the central bank behave in the desired fashion. But then
we are back to the performance contract interpretation o f inflation targets explicitly
suggested by Equation (4.5) 33
A natural question is whether to base the contract on inflation or on other measures
of performance, such as money, the exchange rate, or nominal income. Persson and
Tabellini (1993) show that if the central bank is risk neutral, if the constraints faced by
the central bank (i.e. the behavioral equations o f the economy) are linear, as assumed
so far, and if the marginal penalties under the contract can be contingent on 0, there
is an equivalence result: alternative targets yield the same equilibrium. With relevant
non-linearities, however, an inflation-based contract is simpler; to replicate the ex ante
optimal policy with other measures o f performance, the contract must be contingent on
a larger set of variables, such as shocks to money demand, or to the money multiplier.
In this sense, an inflation target dominates targeting schemes based on other nominal
variables: simplicity implies enhanced accountability and thus easier enforcement.
Intuitively, the whole purpose of optimal contracts is to remove an inflation bias.
This is most easily done by means o f a direct penalty on inflation, rather than in a

3~ The best assignment if society could really freely impose an objective f~nction on CB, would be to
set x*(O) = 0, thereby eliminating the inflation bias completely.

1436

Z Persson and G. Tabellini

more rotmd about way, by targeting other variables that are only loosely related to
inflation.
What happens if the contract cannot be made state-contingent, so that P0, pl and p2
in Equation (4.3) each have to be constant across 0? This question and its answer are
related to the problem in Herrendorf and Lockwood (1997), who study delegation in
a model with observable shocks, and to the problem in Beetsma and Jensen (1998),
who study delegation via an optimal contract when the central banker's preferences
are tmcertain e x ante. To find the optimal incomplete contract in this case, we first
plug the solution for Jr in Equation (4.4) with the slope coefficients constant, as well
as the associated solution for x, namely
x= 0-

1 +P2

1 +~+P2

E,

into the quadratic objective function. We then take expectations o f the resulting
expression over 0 and e and maximize with regard to Pl and P2. After tedious but
straightforward algebra, we can write the optimality conditions as
~.
/!)1 -- ~x* --P2

(l +/92) 3 -- a2
P2 (1 + ~t,+p2) 3
02.

(4.6)

These conditions are both intuitive. It is easy to show that the first condition says
E(3r) = 3:*: unconditionally expected inflation should coincide with society's preferred
rate o f inflation. The second condition says that the coefficient on the quadratic term
in the contract should be a positive hacreasing function o f the relative importance
o f observable to unobservable shocks (the left-hand side is increasing in p2). Thus,
when fluctuations in the observable incentives to inflate cannot be handled by a statecontingent linear punishment, the constrained optimum gives up a little bit on (firstbest) stabilization in order to diminish the costly fluctuations in Jr.
Asp~ contains a term in Jr*, we can rewrite the optimal non-state contingent contract
as

P(~c) - p o + P l ~ +p2(a: - ~.)2,

with P2 given by Equation (4.6) and Pl - ( ~,x* +P2g~) According to this expression,
the central bank should be targeting society's preferred rate of inflation and face
an extra reward for low inflation. It is perhaps not too far-fetched to interpret the
inflation targeting schemes enacted in the 1990s in many countries as an instance o f
this arrangement 34.
The simple contracting model discussed here has been extended in several directions.
I f some shocks are observable, but not verifiable and hence not contractible, the central
:~ In the model of Beetsma and Jenscn (1998) with uncertain CB pre~brences, the optimal inflation
target may instead be above society's target.

Ch. 22:

Political Economics and Macroeconomic Policy

1437

bank can be required to report the value of these shocks. Persson and Tabellini (1993)
show that the optimal contract is related both to the inflation outcome and to the central
bank announcement; it is structured in such a way as to induce optimal behavior as well
as truth telling. Policy announcements matter not because they convey information to
the private sector (that already observes everything), but because they change central
bank incentives, by providing a benchmark against which performance can be assessed
e x p o s t 35. Walsh (1995a) shows that the optimal contract can also handle costly effort
by the central bank. Dolado et al. (1994) as well as Persson and Tabellini (1996) extend
the contract approach to the international policy coordination problems that arise
when central banks fail to internalize the international externalities of their monetary
policies, al Nowaihi and Levine (1998) show how delegation via inflation contracts
may eliminate political monetary cycles.
McCallum (1996) and others have argued that the contracting solution makes little
sense, because it just replaces one commitment problem with another: who enforces the
optimal contract? This question reintroduces the general question about institutional
reforms raised at the beginning of this section, although it might apply more forcefully
to a more ambitious incentive scheme such as the optimal contract. As in the case
of the fixed-exchange rate regimes of subsection 4.1, enforcement is more likely if
agents have heterogenous ex p o s t benefits of inflation and agents hurt by inflation are
given a prominent role in the enforcement. Interestingly, Faust (1996) argues that a
desire to balance redistributive interests for and against surprise inflation was a clear
objective in the mind of the framers of the Federal Reserve. As stated before, we also
do believe that changing institutions takes time. The public image of a policymaker
who emphatically announces an inflation target, would be severely tarnished, if he
explicitly abandoned it shortly afterwards. This is one of the main reasons why in
the real world inflation targets can alter the ex p o s t incentives of policymakers. The
emphasis of the contracting solution on accountability and transparency is helpful for
thinking more clearly about these issues, and about the trade-offs that emerge if the
reward scheme cannot be perfectly tailored to mimic the optimal contract. We cannot
demand much more than that from simple theoretical models. But where the literature
should go next is probably not to other variations of the objective function in the
simple linear-quadratic problem. Instead it would be desirable to model the different
steps and the incentives in the enforcement procedure as a well-defined extensive-form,
non-cooperative game.
4.4. Notes on the literatuFe

The literature on institutions in monetary policy has been surveyed in textbook fbrm
by Persson and Tabeltini (1990), Cukierman (1992) and Schaling (1995).

3s In the reputationat model of Cukierman and Liviatan (1991), by contrast, atmouncements matter
because they convey information about the policymaker'stype.

1438

Z Pelwson and (7. Tabellini

The formal theoretical literature on central bank independence starts with Rogoff
(1985), whose analysis of the conservative central banker is the basis of the model
in subsection 4.3, although the treatment of society's problem as a principal agent
problem is suggested by Barro and Gordon (1983b) in an anticipatory footnote.
Giavazzi and Pagano (1988) discuss the commitment ability in multilateral fixed
exchange rate regimes, although their analysis is carried out in a richer dynamic
framework than the simple model of subsection 4.1. Flood and Isard (1989) introduce
the formal analysis of the rules with escape clauses. Lohman (1992) discusses the
implementation of an escape clause, by costly government override, in a monetary
policy model that also includes delegation to a Rogoff-type central banker. Obstfeld
(1997a) applies an escape-clause model in his analysis of realignments within the
ERM, emphasizing the possibility of multiple equilibria. Bordo and Kydland (1995)
argue that the classical gold standard worked like a rule with escape clauses. Flood
and Marion (1997) include an insightful discussion of escape-clause models and
speculative attacks. The optimal contracting solution to the credibility problem, in
subsection 4.3, was developed by Walsh (1995a) and by Persson and Tabellini
(1993), and was further extended by Beetsma and Jensen (1998) and by Herrendorf
and Lockwood (1997).
Insightful recent general discussions about the appropriate institutional framework
for monetary policy can be found in Fischer (1995), McCallum (1996) and Goodhart
and Vinals (1994). Cukierman and Lippi (1998) study theoretically and empirically
how the optimal central banking arrangement varies with the structure of labor markets.
The early real-world experience with inflation targeting is surveyed in Leiderman
and Svensson (1995). More recent surveys include Haldane (1995) and Mishkin
and Posen (1996).
A number of studies - including Bade and Parkin (1988), Alesina (1988), Grilli
et al. (199 l), Cukierman (1992) and Eijffinger and Schaling (1993) - have developed
empirical measures of central bank independence and studied their relation to inflation
and other macroeconomic outcomes in a cross-section of countries during the last few
decades. Capie et al. (1994) study historical evidence on inflation before and after
major central bank reforms in twelve countries since the end of the 19th century.
Jonsson (1997) uses pooled time-series and cross-section data from the OECD
countries since the early 1960s and finds that the negative relation between central bank
independence and inflation is robust to the control of a number of other institutional
and economic variables. Posen (1993) criticizes this kind of finding and argues that it
is caused by an omitted variable problem, the causal variable for both independence
and inflation being the resistance against inflation in the financial community. A survey
of empirical studies is found in Eijffinger and de ttaan (1996).
Each subsection above refers to additional relevant studies on specific topics.

Ch. 22:

Political Economics" and Macroeconomic Policy

1439

Part B. Fiscal Policy

This part o f the chapter focuses mainly on intertemporal aspects of fiscal policy,
such as government debt issue and taxation o f wealth. A companion piece [Persson
and Tabellini (1999)] surveys the research on static "public finance" problems. The
main stylized facts regarding the intertemporal aspects o f post-war fiscal policy in the
industrialized countries include:
(i) Tax rates on capital vary considerably across countries and fluctuate over time,
with an upward trend. In many countries, estimates of effective tax rates on capital
are quite high and often higher than tax rates on consumption or labor 36.
(ii) Many countries have accumulated large debts, even in peace time. For most
countries, debt accumulation in the post-war period started in the early 1970s.
The cross-sectional pattern o f deficits is far from homogeneous; some countries
have been endemically in deficit and built up massive debts, whereas others have
not 37
(iii) Large deficits and debts have been more common in countries with proportional
rather than majoritarian and presidential electoral systems, in countries with
coalition governments and frequent government turnovers, and in countries with
lenient rather than stringent government budget processes 3s.
It is difficult to account for these regularities by the theory of optimal taxation
or, more generally, any theory that assumes policy to be set by a benevolent social
planner. According to Chamley (1986), the optimal capital tax should decline over
time, asymptotically approaching zero, as the long-run elasticity o f investment is very
high compared to that of other tax bases. Similarly, Barro's (1979) tax-smoothing
model o f deficits can successfully explain war-time deficits, but not the persistent
accumulation o f debt that has occurred in many industrial countries since the 1970s.
Moreover, the correlations between policies and political institutions suggest that
political and institutional factors play an important role in shaping fiscal policy.
In this second part o f the chapter, we survey some recent literature that speaks to
these stylized facts on the basis o f positive models o f fiscal policy. As in monetary
policy, these recent contributions try to explain departures from socially optimal
outcomes by various incentive constraints in the policy formation process. In Section 5
we discuss credibility again, abstracting from politics and individual heterogeneity.
In Section 6 we add politics to our basic model o f fiscal policy and discuss alternative
explanations for large government borrowing.
3~ Mendoza et al. (1996), building on earlier work by Mendoza et al. (1994), compute effective tax rates
for a sample of 14 industrial countries, during the period 1965-1991. For the most recent six-year period,
the average capital tax rate for these countries was close to 40%, higher than both the average labor tax
rate and the average consumption tax rate. Furthemmre, the average tax rate on capital was higher than
that on labor and consumption during every five-year period since 1965, and kept rising over time.
37 See ibr instance Elmendorf and Mankiw (1999) and Alesina and Perotti (1995b).
3s See von Hagen and Harden (1995), Alesina and Perotti (1995b), Grilli et al. (1991), Roubffli and
Sachs (1989).

1440

17 Persson and G. Tabellini

5. Credibility of fiscal policy

We first discuss the ex p o s t incentive compatibility constraints that imply a lack
of credibility for desirable tax policies. Many insights parallel those in monetary
policy. But by adding microeconomic foundations, we can now make more meaningful
welfare statements. And by adding an explicitly dynamic setting, we can investigate
how state variables link policy decisions over time. As in monetary policy, sequential
(or discretionary) decision-making and a lack of policy instruments may imply that
the government lacks credibility and loses control of private sector expectations.
The economy gets trapped in a third-best equilibrium, where the government relies
excessively on a highly distorting policy instrument. The most obvious example is the
"capital levy problem". But credibility problems are not confined to capital taxation:
they are the norm rather than the exception in a dynamic economy. These issue are
discussed in subsection 5.1. Subsection 5.2 treats another consequence of lack of
credibility: the possibility of multiple equilibria and confidence crises, features often
observed in countries with high punic debts. In a dynamic economy current policy
credibility depends on previous policy decisions; for instance, it depends on the size
and denomination of the outstanding public debt; this new dimension is discussed
in subsection 5.3. Finally, as in monetary policy, reputation can mitigate the adverse
effects of the ex p o s t incentive constraint and institutions can be designed to relax it.
These remedies are briefly discussed in subsection 5.4.
5.1. The capital l e w problem

According to the standard theory of optimal taxation, capital should be taxed at a

much lower rate than labor or consumption. Moreover, the tax rate on capital income
should generally decrease over time and approach zero asymptotically. The reason is
that the elasticity of investment tends to be higher than those of labor supply and
consumption, and it is even higher over longer horizons, as there are more opportunities
for intertemporal substitution. This prescription sharply contrasts with stylized fact (i)
above. Lack of credibility offers a reason why even a benevolent government can end
up with such a suboptimal tax structure 39.
5.1.1. The m o d e l

Consider a two-period closed economy, t -- 1,2, with one storable commodity. A

representative consumer has preferences defined over consumption in both periods, ca,
and leisure in the second period, x, represented by
u - U ( c l ) + c 2 + V(x).

(5.1)

In the first period, the consumer either consumes his exogenous and untaxed
endowment, e, or invests a non-negative amount in a linear storage technology with
39 The next two subsections draw oil Persson and Tabellini (1990, ch. 6).

Ch. 22: Political Economics and Macroeconomic Policy

1441

unitary gross returns. In the second period, he devotes his unitary time endowment to
labor l, or leisure time x, and consumes all his income and wealth after having paid
taxes. His budget constraints are
cl + k = e,

(5.2)

c2 = (1 - 0) k + (1 - r) l,

(5.3)

where k is the investment in the storage technology, 0 and r are the capital and labor
income tax rates, and the real wage is unity.
Finally, the government must finance a given amount o f second-period per-capita
public consumption, g. Thus, the government budget constraint is
(5.4)

g = rl + Ok.

Taxes are only paid in the second period, and lump-sum (i.e. non-distorting) taxes are
not available. We follow the public-finance tradition o f treating the set o f available
Ramsey taxes as exogenous; but ultimately, the non-availability of (personalized)
lump-sum taxes must be due to some heterogeneity that can only be imperfectly
observed by the government. What is the optimal tax structure in this economy? And
what is the equilibrium tax structure if the government lacks credibility? We address
both questions in turn.
5.1.2. The ex ante optimal policy

To derive a normative benchmark, we assume that at the start of period 1 - before

any private decision is made - the government commits to a tax structure (0, r) for
period 2. The decision is observed by the private sector, and cannot be changed. There
is no uncertainty, and period-2 public consumption, g, is known already in period 1.
We first describe how the private sector responds to the tax rates. The private sector
first-order conditions are:
U c ( e - k ) >~ 1 - 0 ;

Vx(l-l) = l-r,

(5.5)

where the equality in the first condition applies at an interior optimum with positive
investment. Each tax rate thus drives a wedge between the relevant marginal rates
of transformation and substitution. Optimal policy seeks to minimize the resulting
distortions. Inverting these two expressions, we obtain the private sector savings
function k = Max[O,K(1 - 0)], where K(1 - O) ~- e - Ucl(1 - 0), and labor supply
function l = L(1 - r) _--_ 1 - vxl(1 - r). The partial derivatives Ko and Lr are
both negative. By the separability and quasi-linearity o f the utility function, each tax
base depends on its own tax rate only. For future reference, it is useful to define the

1442

T. Persson and G. Tabellini

elasticities of these two tax bases with respect to their own net of tax returns, as ek(0)
and el(O, respectively 4.
The optimal tax structure maximizes consumer welfare, subject to the private
sector and government budget constraint (5.2)-(5.4), and the private sector first-order
conditions (5.5). Solving this optimization problem yields the following version of the
Ramsey Rule41:
0

(5.6)

1 - 0 ek(O) = ~ e l ( r ) .

Equation (5.6) implicitly defines the ex a n t e optimal tax structure. What are its general
properties? First, optimal tax rates are higher on the more inelastic tax base. Second,
it is always optimal to tax both bases, as long as both elasticities are finite and strictly
positive. Finally, both tax rates move in the same direction if the revenue requirements
change; higher public consumption drives up both tax rates, in proportion to their
elasticities. If, as empirically plausible, labor supply is much more inelastic than
investment, the optimal tax rate on labor is much higher than that on capital. As taxes
are distorting, the economy reaches a second best - not a first best.
5.1.3. E q u i l i b r i u m u n d e r d i s c r e t i o n

Suppose instead that the policy decision is taken at the start of period 2, after
period-1 investment decisions have been made. This timing is much more plausible,
as a sovereign country can change its tax structure at any time, under a normal
legislative procedure. Under this timing, however, every tax structure promised in
period 1 is not credible. A credible tax structure must be optimal e x p o s t ; from the
vantage point of period 2. More precisely, a credible equilibrimn tax structure satisfies
three requirements. (i) Individual economic decisions are optimal, given the expected
policies and the decisions of all other individuals in the economy. (ii) The tax structure
is e x p o s t optimal, given outstanding aggregate capital and individual equilibrium
responses to the tax structure. (iii) Individual expectations are fulfilled and markets
clear in every period. Let us consider each of these requirements.
(i) Optimal individual behavior is still summarized by the functions K and L and by
the corresponding elasticities. But the investment function and the corresponding
elasticity are now defined over the expected, not the actual, capital tax rate, as
the tax structure is decided in period 2, after the investment decision. Thus,
k = K(1
0 e) and ei~(0e). We call this elasticity the ex a n t e elasticity of
investment, since it is defined over 0 e rather than 0.
4o These elasticities are, respectively:
(1 0)
ek(O) -

dK
d(1 - 0)

U,~
KUcc > 0,

el(r) ~

(1 r) dL
L d(1 v)

41 See Persson and Tabellini (1990, ch. 6), for a derivation.

V~

LV~ >0.

Ch. 22:

Political Economics and Macroeconomic Policy

1443

(ii) The ex p o s t optimal tax structure also continues to be described by the Ramsey
Rule (5.6), but with one important proviso. The investment elasticity that enters
Equation (5.6) is the ex p o s t elasticity, that is the elasticity with respect to the
actual tax rate 0, since that is what the government is choosing. By the argument
at point (i), this e x p o s t elasticity is zero: k depends on 0 e, not on 0. Equation (5.6)
then implies that for any given capital stock k the ex p o s t optimal capital tax rate,
0", must satisfy
0* - Min[1, g / k l .

(5.7)

The optimal labor tax rate r follows from the govenmaent budget constraint. In
particular, r - 0 if 0* = g / k < 1. This result is very intuitive. When tax policy is
chosen, the supply of capital is completely inelastic at k, whereas the supply of
labor continues to have a positive elasticity, as it is chosen by the private sector
after observing tax policy. Hence, the government finds it ex p o s t optimal to set
either a fully expropriating capital tax rate of 1, or a tax rate sufficiently high to
finance all of public consumption with capital taxes, driving labor taxes to 0.
(iii) Rational individuals correctly anticipate government policy. Hence, 0 e = 0* and
k = K(1 - 0"). Combining this last result with Equation (5.7), the equilibrium
tax rate is defined by 0* = M i n [ 1 , g / K ( 1 - 0")].
We illustrate the possible equilibria in Figure 1. The solid curve is the ex a n t e revenue
function for different values of 0. Tax revenues first grow with the tax rate, but at a
decreasing rate, since the tax base shrinks as 0 rises. Once we reach the "top of the
Laffer Curve", tax revenue begins to shrink, as the reduction in the tax base more than
offsets the higher tax rate.
l f g is sufficiently high (higher than point G) only one equilibrium exists, in which
0* = 1 and k = 0 (point C in the diagram). Irrespective of private expectations,
the government fully expropriates any outstanding capital stock. Anticipating this,
nobody invests. It is easy to verify that all three requirements for an equilibrium are
fulfilled. Private individuals optimize and have correct expectations about policy. And
the government also optimizes, for even with no capital outstanding, 0 = 1 is (weakly)
optimal, as confirmed by Equation (5.7). This equilibrium is disastrous: there is a
prohibitive tax on capital, but still a large tax on labor which is the only available
tax base. Yet, the government can do nothing to change the outcome. No promise to
tax capital at a rate lower than 1 would be believed, because it would not be ex p o s t
optimal for the government to fulfill it.
If g is below point G in Figure 1, this disastrous outcome continues to exist
together with two other equilibria. Suppose that government spending corresponds to
the horizontal line in Figure 1. Then points A and B are also equilibrium outcomes.
At point A, every consumer expects 0 e = 0 a and invests K(1 - 0a). Hence, the
government can just finance g by setting 0 exactly at 0 A, while keeping the labor
tax equal to 0. Thus, the government is at an ex p o s t optimum. The same argument
establishes that point B is also an equilibrium.

1444

z Persson and G. Tabellini

oK(1 -o)
G

C
0

0A

0B

Fig. 1.

These equilibria are clearly Pareto ranked: A is better than B which is better than C.
They are all worse than the e x a n t e optimal tax structure, since they tax capital too
heavily and labor too lightly (except at point C where both bases are taxed too heavily).
If the government is unable to commit, the economy is trapped in a third-best, or worse,
allocation.
5.1.4. E x t e n s i o n s

Results similar to those above, apply to the taxation o f other forms o f wealth, in
particular to public debt and real money balances; in the case of money, naturally,
the tax takes the form of inflation. The logic is always the same. Once an investment
decision has been made, the tax base is fixed and it becomes ex p o s t optimal to tax it
as much as needed, or as much as possible.
Moreover, credibility problems are not confined to wealth taxes, but are generic in a
dynamic economy with sequential policy decisions. The reason is that the e x p o s t and
e x a n t e elasticity o f tax bases generally differ from each other. In general this difference
is not as stark as with wealth taxes, where the ex p o s t elasticity is zero. In the case
o f other tax bases than wealth, we can no longer conclude that the optimal tax rate is
always higher e x p o s t than e x ante. To gain some intuition for why, consider an increase
in a labor tax rate in a given period t. If the tax increase is u n a n t i c i p a t e d , the household
substitutes from labor into leisure in the current period. But if the tax increase was
a n t i c i p a t e d in period t - 1, some intertemporal substitution has already taken place:
the household works less in period t, but has already worked more in period t - 1.
We cannot generally tell whether an anticipated or an unanticipated tax hike is more
distorting, however. Intertemporal substitution increases the distortion at time t, the
period of higher taxes, as the tax base is more elastic. But this greater distortion is
offset by a larger tax base in period t 1, when the household is working more in

Ch. 22: Political Econornics and Macroeconornic Policy

1445

anticipation of higher future taxes. In general, therefore, we can say that optimal tax
rates are different, but not whether they are higher ex ante or e x post 42.
We close this discussion with two remarks. First, characterizing the equilibrium
with sequential government decisions is relatively easy in a two-period economy, and
doable in a finite-horizon economy. But it becomes very difficult in an infinite-horizon
economy 43. Second, so far we have considered a representative consumer economy in
which the government lacks a non-distorting tax and has incentives to raise revenues
in less distorting ways. Lump-sum taxation may, however, not be enough to avoid lack
of credibility. If the goverlmaent also has distributive goals, but not enough lump-sum
taxes and transfers to reach its desired income distribution, the optimal tax policy may
still lack credibility despite the availability of (non-personalized) lump-sum taxation.
What matters ultimately is thus a scarcity of policy instruments relative to objectives.
5.2. Multiple equilibria and confidence crises'

When discussing reputational equilibria in monetary policy, we argued that multiple

equilibria indicated an incomplete theory. Here, multiplicity of equilibria instead
reflects an indeterminacy in the economy, and helps explain the occurrence of sudden
speculative attacks or capital flights that have plagued many economies. Absent a
commitment technology, policy is driven by private expectations rather than the other
way around. Equilibria under discretion thus become intrinsically fragile, as investors
face a difficult coordination problem. The ex post optimal policy depends on aggregate
investment. But aggregate investment depends on the simultaneous decisions of many
atomistic individuals, which in turn depend on expectations about policy. Thus, there is
a strategic complementarity. A single investor expecting nobody else to invest also finds
it optimal not to invest: he realizes that aggregate capital will be small, and hence full
expropriation is inevitable. Thus, individual expectations are self-fulfilling and, as they
are not nailed down by any economic fundamentals, can fluctuate widely. The resulting
policy uncertainty is yet another drawback of a discretionary policy environment.
These problems arise in many policy decisions. Consider public-debt repayment in
a two-period economy, and suppose that in the second period debt can be partially
defaulted or taxed away, at a cost proportional to the size of the default. Calvo (1988)
shows that we then get multiple equilibria, in a good equilibrium, every investor
expects the debt to be fully repaid and demands a low interest rate. To avoid the cost
of default, the government indeed services the outstanding debt. In a bad equilibrium,
every investor expects partial default and demands a higher interest rate. The cost of
servicing this debt is now higher, and with distorting taxes the government prefers
a partial default; hence, default expectations are self-fulfilling. The equilibrium with
default is Pareto inferior, as the net amount serviced is the same, but default costs are
borne.
42 For a further &scussion, see Persson and Tabellini (1990, ch. 8).
43 See also the survey by Krusell et al. (1997).

1446

T Persson and G. Tabellini

Another example, studied by Velasco (1994) and Giavazzi and Pagano (1990),
concerns exchange-rate crises in a high public debt economy. By assumption, the
cost o f outright default is prohibitive, but the outstanding debt could be monetized
away. In a good equilibrium, investors expect the exchange rate peg to be viable and
the domestic interest rate equals the foreign interest rate; at this low interest rate,
it is optimal to service the outstanding public debt by tax revenue alone. In a bad
equilibrium, investors expect the peg to collapse. They demand a higher interest rate,
which raises the cost o f servicing the debt through tax revenue; at the higher
interest rate, it becomes optimal to fulfill the expectations, the peg is abandoned and
the debt is partially monetized through higher inflation 44.
Related coordination problems arise in s e q u e n t i a l (as opposed to simultaneous)
investment decisions. Alesina et al. (1990) and Cole and Kehoe (1996a,b) study an
infinite-horizon economy with a large public debt. Like in Calvo (1988), default is
costly, but the cost is assumed to be a lump sum cost. In the good equilibrium, the
debt is rolled over forever at low interest rates, and distorting taxes are raised to pay
interest on the debt. In the bad equilibrium, there is a debt run, as nobody wants to buy
the outstanding debt for fear that - next period - investors will refuse to roll it over.
Faced with such a situation, it is indeed e x p o s t optimal for the government to default
on the debt, rather than repaying it all at once. Thus the investors' fears are indeed
rational and self-fulfilling. Here, the coordination problem thus concerns investment
decisions at different points in time.
5.3. P u b l i c d e b t m a n a g e m e n t

The papers discussed in the previous subsection have implications for debt management policies, as the occurrence of a confidence crisis depends on the maturity
structure or currency denomination o f outstanding debt. For instance, tile debt-run
equilibrium discussed by Alesina et al. (1990) disappears if the outstanding debt has a
long enough maturity, whereas it is more likely with a short-maturity debt that must be
rolled over every period. Similarly, the results in Giavazzi and Pagano (1990) suggest
that issuing foreign currency debt can reduce the risk o f capital flight, as investors are
already protected against depreciation.
More generally, public debt management policies alter the future incentives of the
monetary and fiscal authorities in many subtle ways, even if the ex a n t e and ex p o s t
elasticities o f all tax bases are the same. This point was first noted in the seminal
paper by Lucas and Stokey (1983) with regard to the maturity structure o f public debt.
They start from the observation that fiscal policy typically alters real interest rates.
The resulting wealth effect can benefit or harm the government, depending on the
composition o f its balance sheet. With a lot of long-term debt, a higher long-term
44 A high cost of servicing the debt is not the only reason why an exchange rate peg may not be credible~
in a related argument, Bensaid and Jeanne (1997) show that multiple equilibria can arise if raising the
interest rate to det?nd an exchange-rate peg is too costly lbr the government.

Ch. 22:

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1447

real interest rate depreciates the outstanding debt and acts like a non-distorting capital
levy. Alternatively, if it has long-term assets and short-term liabilities, the government
benefits from a policy that reduces the short-term real interest rate. Under sequential
decision making, the government's ex a n t e optimal policy may not be credible: the
government may have an incentive to deviate from it e x p o s t , in order to change
the value o f its outstanding assets and liabilities. Conversely, these incentives give an
additional role for public debt management policies: if the maturity and contingency
structure o f the debt is rich enough, it can be revised over time so as to maintain
credibility o f the e x a n t e optimal tax policy under sequential decision making, even if
ex a n t e and e x p o s t elasticities of relevant tax bases differ from each other 45. Naturally,
these results only hold if the economy is closed or large enough to affect intertemporal
world prices.
Not only the maturity structure o f the public debt shapes policy incentives. Its
composition into nominal and indexed debt plays a similar role, as the real value of
the former, but not the latter, depends on the price level 46. Based on this observation,
Persson et al. (1987) show that the capital-levy incentive for the government to dilute
the real value o f its outstanding nominal liabilities - such as the money stock - can be
relaxed if the govermnent holds claims on the private sector, denominated in nominal
terms, if the nominal claims and liabilities are balanced, the e x a n t e Ramsey solution
may be sequentially sustained. But nominally denominated liabilities can also offer
valuable insurance against unanticipated fluctuations in government spending, if the
government does not have access to contingent debt. Calvo and Guidotti (1990) study
the choice between nominal and indexed debt as a trade-off between credibility and
flexibility.
The upshot is thus that the structure of the public debt becomes a strategic variable
that can be manipulated by a government to relax incentive constraints which it will
meet in the future. As a result, the "government capital structure" again becomes nonneutral, even if a Modigliani-Miller theorem about the irrelevance of the govenmaent
financial structure would apply in the absence o f these incentive constraints. In this
section, we have only considered governments that continue to make decisions in the
future with full certainty. But the idea of using public financial policies strategically
to influence future fiscal policy decisions, obviously extends to the case which is
more relevant for real-world democracies (dictatorships), where elections (coups and
revolutions) shift the identity and policy preferences o f governments over time.
Strategic public financial policies have indeed received attention in the literature on
the politics of public debt that we survey in Section 6.

45 "Rich enough" generally means that there are as many goverrmlent debt instruments as there are
policy instruments.
,16 Public debt denominated in foreign currency is similar to indexed debt in this regard, but will not be
considered here.

1448

T. Persson and G. Tabellini

5.4. R e p u t a t i o n a n d e n J b r c e m e n t

As in monetary policy, repeated interaction creates incentives to maintain a reputation,

which may mitigate the capital-levy problem. Suppose that future expected capital tax
rates depend on the current tax structure. Even though existing capital is taken as given
by the government, it still perceives future investment to respond to current tax rates,
through expected future tax rates, and this discourages overtaxation. Chari and Kehoe
(1990) have studied this reputation mechanism in an infinitely repeated version of the
simple two-period model of subsection 5.1. The equilibrium with reputation comes
arbitrarily close to the ex a n t e optimal Ramsey rule, under appropriate assumptions
about the government discount factor and the length of the punishment period.
Kotlikoff et al. (1988) show that a related enforcement mechanism may be available
in an overlapping-generations economy. A misbehaving government is not deterred
by investors' expectations, but by the threat that future generations of tax payers
will withdraw their intergenerational transfers to a generation that breaks "the social
contract" by overtaxing capital. Naturally, multiplicity of equilibria remains in both
models.
When we consider default on public debt, however, reputational equilibria encounter
additional difficulties. Suppose that a defaulting government is "punished" by savers,
who refuse to buy public debt in the future. The punishment thus consists of not being
able to smooth tax distortions overtime, in the face of fluctuating public spending
or tax bases. Is this sufficiently strong to deter default? Bulow and Rogoff (1989)
argue that it is not. Suppose that a defaulting government can never borrow again,
but can nevertheless still invest budget surpluses in assets earning the market rate
of return (for instance, by accumulating reserves of a foreign asset). Then, a simple
arbitrage argument implies that the government is always better off defaulting rather
than repaying its debt 47. Thus, simple reputation models cannot explain public debt
repayment. There must be other reasons why governments honor their debts: either
reputational spillovers across policy instruments, or other costs in a default, such as
distress in the banking system, arbitrary redistributions, or sanctions credibly enforced
by the international community.
In Part I, we discussed various institutional reforms that might raise the credibility of
desirable policies. In the case of fiscal policy, such reforms are less effective, however,
as the tasks of a sovereign legislature cannot be narrowly defined. Nevertheless, some
institutional devices could mitigate the capitaMevy problem. Political delegation to
a conservative policymaker is one way. International tax competition is another. As
discussed in a companion survey [Persson and Tabellini (1995)], capital controls
or international tax agreements that limit tax competition exacerbate the domestic
credibility problems, and could thus be counterproductive.
47 Bulow and Rogoff (1989) develop their argument in the case of sovereign loans that finance
consumption or investment, with no tax distortions, for arbitrary concave utility and production function.
But their result generalizes to a model with tax distortions.

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1449

5.5. Notes' on the literature

Much of this section is based on Persson and Tabellini (1990, chs. 6-8). There is a
large game-theoretic literature on dynamic games with sequential decision-making.
What started this line of research are again the papers by Kydland and Prescott (1977)
and Calvo (1978). The book by Basar and Olsder (1982) provides a game-theoretic
analysis of these problems in an abstract setting.
The "capital levy problem" has a long history in economics. Eichengreen (1990)
provides a historical account. It has been formally analyzed (although with numerical
solutions) in a two-period economy by Fischer (1980). An early treatment of surprise
inflation to tax real money balances is Auernheimer (1974), but Calvo (1978) is the
classic here.
A large literature deals with speculative attacks and multiple equilibria. In this
section we have only focused on multiple equilibria that arise when policy is
endogenous and there is a credibility problem. Confidence crises on public debt have
been studied by many authors; in particular by Calvo (1988), Alesina et al. (1990),
Cole and Kehoe (1996a,b) and Giavazzi and Pagano (1990). Multiple equilibria with
discretionary monetary policy have also been extensively treated in the literature, in
particular by Obstfeld (1997a), Bensaid and Jeanne (1997), Chari et al. (1996) and
Velasco (1994).
Reputation and capital taxation is discussed by Kotlikoff et al. (1988), Chari and
Kehoe (1990) and, more recently, by Benhabib and Rustichini (1996), while Grossman
and Van Huyck (1988) and Chari and Kehoe (1993) applied reputation to a model
of public debt repayment. The idea that reputation can fail in the case of sovereign
debt repayment is due to Bulow and Rogoff (1989), whereas Chari and Kehoe (1993)
show that enforcement problems on both sides of the market can restore a role for
reputation. Reputational spillovers across contracts are discussed by Cole and Kehoe
(1994). Political delegation and capital levies are modeled in Persson and Tabellini
(1994c) and discussed by North and Weingast (1989) in a fascinating historical context.
The literature on international tax competition and credibility is surveyed by Persson
and Tabellini (1995).
The credibility of optimal tax structures in a general intertemporal context and
without capital has been studied by Lucas and Stokey (1983). Their seminal paper
discusses both debt management and the credibility of tax policy. Subsequently,
Persson and Svensson (1984) and Rogers (1987) reinterpret and clarify some of the
general issues concerning the credibility of optimal intertemporal taxation. The debt
management implications of the Lucas and Stokey paper are also generalized and
interpreted, by Chari et al. (1992) and by Persson and Svensson (1986). Persson et al.
(1987) extend the Lucas and Stokey result to a monetary economy, whereas M. Persson
et al. (1997) show that the temptation to generate surprise inflation may be much
stronger than the theoretical literature suggests, once the full set of nominal rigidities in
public expenditure and tax programs are taken into account. Rogers (1987) discusses
strategic debt management and credible tax policy in an economy with endogenous

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Persson and G. Tabellini

government consumption, while Rogers (1986) considers distributive goals. Missale

and Blanchard (1994) study how the maturity structure required to make a low-inflation
policy incentive compatible varies with the level of debt. Calvo and Guidotti (1990)
study the credibility-flexibility trade-off in the optimal decomposition of public debt
into indexed and non-indexed securities. Finally, Missale et al. (1997) as well as Drudi
and Prati (1997) have studied public debt management as a signal of the government
resolution to enact stabilization policies.

6. Politics of public debt

As noted in the introduction to Part II, many industrial countries have accumulated
large debts in peace time. Moreover, debt and deficits appear to be correlated with
specific political and institutional features. The goal of this section is to survey the
literature that addresses these issues.
We begin with the idea that deficits may be a by-product of political instability.
Section 5 emphasized that governments can manipulate their debt structure to resolve
their own future credibility problems. Subsection 6.1 takes up this thread, showing
how the debt level itself can be used strategically to bind the hands of succeeding
governments with different political preferences, in a way first suggested by Alesina
and Tabellini (1990) and Persson and Svensson (1989). This idea typically applies to
political systems with two parties and a government that clearly represents the view of
a cohesive political majority. The debt level can also be used to enhance the incumbent
government's re-election probability, in a way first suggested by Aghion and Bolton
(1990) and also discussed in Section 3. We construct a simple two-period example that
incorporates both of these mechanisms.
The remainder of the section then looks at political systems with more dispersed
political powers, as in the case of coalition govermnents or powerful political interest
groups. In subsection 6.2, we discuss why such a situation may be particularly prone
to generate deficits. The argument is a dynamic version of the common-pool problem
formulated by Levhari and Mirman (1980) - in the context of natural resources and applied to government debt by Velasco (1999). In subsection 6.3 we follow the
approach of Alesina and Drazen (1991), showing how the struggle between powerful
groups, about who will bear the cost of necessary cuts in spending, may lead to a
war of attrition delaying the elimination of existing deficits. In both these subsections,
we reduce the full-blown dynamic models found in the literature to simple two-period
examples.
In subsection 6.4, finally, we discuss briefly how the politics of intergenerational
redistribution may trigger government deficits, as suggested by Cukierman and Meltzer
(1989), Tabellini (1991) and others.

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6.1. Political instability in a two-party system

6.1.1. Economic equilibrium

Consider a two-period economy without capital, but otherwise similar to that

of subsection 5.1. A continuum of individuals have identical preferences over
consumption and leisure. First we describe their preferences over private economic
outcomes and their private economic behavior, for a given economic policy. Individual
preferences over public policy and different parties are described later.
Preferences over private economic outcome are given by the utility function:
(6.1)

U = C 1 + C 2 + V ( X l ) + V(x2).

Every consumer faces the same constraints. Leisure and labor in period t, xt and lt,
must sum to unity. Budget constraints are
c2=(1

cl+b=(1-rl)ll,

rz)12+Rb,

where Tt is a labor tax rate, R is the gross interest rate, and b is the holding of
public debt - the only available form of saving. By the absence of discounting and
the linearities in the utility function, an interior equilibrium f o r b requires R = 1.
Recognizing this, we can write the equilibrium consolidated budget constraint as
Cl +C2 = (1 - ' g l ) l l

+ ( 1 - T 2 ) I 2.

Solving the consumer problem, leads to labor supply functions L(1 - rt) identical to
those of subsection 5.1.
Public spending only takes place in period 2. Let g denote total per capita public
consumption. Using R = 1, the government budget constraints are
- b = rill,

b+g-

T212.

It is useful to re-express private utility as an indirect utility function defined over

the policy variables b and g. Private equilibrium utility is only a function of the
two tax rates T~ and r2. From the govermment budget constraints, these tax rates
can be expressed as functions of b and g. Thus we can rewrite Equation (6.1) as
J ( b , g ) - Max[c1 + c2 + V(xl) + V(x2)]. This indirect utility function has intuitive
properties. First, Jg < 0, is the private marginal cost of government spending which is
increasing in g: Jgg < 0. Second, Jb is the private marginal cost of government debt.
The symmetry of labor supply implies
> O as
Jt, ~

1
b ~< -~g.

(6.2)

That is, when tax rates are equal over time, tax distortions are optimally smoothed out
(orb = 0). But if more (less) than half the revenue necessary to finance g is raised in

T Persson and G. Tabellini

1452

period 1, so that b < - g (> -g), private utility could be enhanced by higher (lower)
debt issue. Finally, as taxes are distortionary and as higher b adds to the government's
tax bill in period 2, the cross-derivative Jbg is negative 48.

6.1.2. The political system

Individuals belong to two different groups, which we label d and r, o f given sizes s
and (1 - s ) . The two groups are identified with the supporters of two political parties:
D and R. Individuals and parties differ in their preferred allocation of public spending
over two types o f public consumption: gd and gr. The two types of public consumption
each require one unit o f output, but they provide different utilities to the two parties
and their individual supporters. For simplicity we assume that individuals belonging
to group d (r) only care about gd (g,.) and that each party only cares about the utility
o f its own supporters. If elected, party I thus maximizes the utility function

u1 = J(b, g) + H(gi).

(6.3)

Thus, party I correctly internalizes the welfare effects of economic policy on private
economic outcomes, according to the indirect utility function J defined over debt and
total spending, and evaluates the benefits o f public consumption for its constituency
according to the (concave) H function, defined over gi. Political parties are "outcome
motivated" rather than "office motivated". It is easy, however, to amend the model with
a separate benefit o f holding office, as in Section 3.
Finally, we assume that relative group size s is a random variable, the realization o f
which determines the election outcome. We define P = Pr(s ~< 0.5) as the probability,
from the viewpoint of period 1, that party R wins. This electoral uncertainty can be
due to a random participation rate, or to uncertainty about the relative popularity of
parties on other policy dimensions. Below we suggest an explicit model for P, but for
now we take it as exogenous.

6.1.3. Equilibrium policy

Events in the model unfold as follows: (1) One o f the parties holds office in period 1;
this party sets debt (tax) policy b. (2) Economic decisions in period 1 are made.
(3) The elected party takes office and sets public spending. (4) Economic decisions in
period 2 are made. As before, we consider a sequentially rational equilibrium, and we
characterize it by backward induction.

48 Note that our formulation of the model rules out credibility problems of the type discussed in
Section 5. The asstuned preferences imply that labor supply fimctions depend on the current after-tax
wage only, so that there is no difference between ex ante and ex post elasticities. Also, incentives for
debt repudiation do not arise, because the government is a creditor and has no opportunity to manipulate
the equilibrium interest rate.

Ch. 22: Political Economics and Macroeconomic Policy

1453

Optimal private decisions at stages (2) and (4) are already subsumed in the indirect
utility function. Suppose party I holds office in period 2. It chooses g so as to maximize
its objective in Equation (6.3), given the outstanding debt level b. The first-order
condition for good i is
Jg(b, g) + Hg(g i) = O.

(6.4)

Thus party I spends on good i only (good j # i has only costs and no benefits) and
equates the marginal cost of supplying good i to its marginal benefit (to group i).
Clearly, this condition defines a reaction function gi = G(b) which is the same for
both parties. Since higher debt implies higher period-2 tax distortions, any government
type is less willing to spend on public goods if it inherits a higher public debt;
hence: Gb < 0.
We can look at the period-1 incentives to issue debt at stage (1). The identity of that
government does not matter for the results, but to fix ideas we suppose that party D
is the incumbent. Its expected payoff, given the expected election outcome, depends
on debt policy according to the incentive constraint imposed by equilibrium policy
choices in period 2:
E(uD (b)) - J (b, G( b)) + (1 - P ) H ( G ( b ) ] .
Optimal debt policy thus has to satisfy
& + [Jg + (1 - P ) Hg]@, : & - P H g G b : O,

(6.5)

where the second equality follows once we impose condition (6.4). Condition (6.5)
has an intuitive interpretation. To strengthen the intuition, first consider the special
case in which party R stands no chance at winning - that is, P - 0 for any b. Then
Equation (6.5) reduces to Jh = 0. In words, a government that is certain of re-election
chooses the efficient debt policy, smoothing completely over time the tax distortions
from the financing of its preferred public good.
When re-election is not certain, however, other incentives come into play. The larger
is the probability that the opponent will win, the more party D deviates from the
efficient debt policy, as is evident from the second term. As this term is positive,
party D sets Jt~ < 0 whenever P > 0. A positive probability of losing the election
leads to excessive debt issue - or more precisely to an insufficient surplus today [recall
Equation (6.2)]. Whereas the incumbent government fully internalizes the benefits of
borrowing associated with tax smoothing, it does not fully internalize the cost of lower
public spending in the future, because these costs are borne only if the government
is re-elected. Thus, the over-issue of debt is larger the slimmer is the re-election
probability. To express the intuition in an alternative way: it is optimal for the party-D
government to tie the hands of a prospective party-R government, as that party will
spend on a good not valued by the natural constituency. This strategic motive, creating

77.Persson and G. Tabellini

1454

facts for a successor with different preferences, was first stressed by Persson and
Svensson (1989) and Alesina and Tabellini (1990).
6.1.4. Endogenous election outcomes
As mentioned already in Section 3, governments also manipulate state variables to
increase their chances of re-election. We now modify our model to show how this
incentive applies to public debt, illustrating an idea first stressed by Aghion and
Bolton (1990). Consider the same model, but suppose that parties and individuals
also differ along a second - not explicitly modeled - dimension capturing aspects
of public policy that do not directly affect the economy. Specifically, we assume that
individual utility depends on the identity of the party holding office, in addition to the
public good it provides. But we allow individuals belonging to the same group to have
different preferences over policymakers in this second dimension. Thus, we postulate
the following overall preferences for individual j in group i, for i = D, R:
u ij = J ( b , g ) + H ( g i) + ( U +/3)K o,

(6.6)

where H(.) is the same concave function as in Equation (6.3), and the dummy variable
K z) equals 1 if party D holds office in period 2, and 0 if party R holds office. The
parameter aJ is distributed around a mean value of 0 in the population of each group,
according to the symmetric and unimodal distribution function F(-). In period 1 the
precise value of/3 is not known, but only its expected value E(/3). The aJ parameter
thus measures an idiosyncratic "ideological" (and exogenous) bias for party D, and to
the extent that/3 is positive, party D enjoys a popularity advantage.
That is, individuals evaluate public consumption according to their group affiliation,
and each party cares about its natural constituency. But voters also trade off
the economic benefits obtained from their party against other (exogenous or noneconomic) aspects of public policy, according to the parameters a and [3. These "non~
economic" determinants of political preferences are not related to group affiliations in
any precise way. This specification of political preferences implies that group affiliation
does not completely determine how individuals vote, so that the vote share of each
party is endogenous.
Finally, we assume that the relative size of the two groups, given by s, is now a
fixed parameter, not a random variable. The timing of events is as before, except that
just before the date of elections the realization of aggregate popularity,/3, becomes
known.
What determines the election outcome? At the time of elections, debt policy b is
given by previous decisions. Consider voter j in group d. She votes for party R if
and only if J ( b , g ) + H(G(b)) + a j +/3 > J(b,g), or if aJ > - ( H ( G ( b ) ) + [3). Thus,
unless party D is generically unpopular ~3 < 0), only group-d individuals with a strong
idiosyncratic ideological bias against party D vote for party R. Next, consider voter j
in group r. She votes for party R if and only i f J ( b , g ) + aJ +/3 > J ( b , g ) + H(G(b)),

Ck. 22." Political Economics and Macroeconomic Policy

1455

or if aJ > H ( G ( b ) ) - / 3 . Not surprisingly, a group-r voter is more likely to support

party R, since she draws economic benefits from its election.
Combining these conditions and using the law of large numbers, we get the total
vote share for party R:
SR(b,/3) = s F ( - H ( G(b)) - [3) + (1 - s) F ( H ( G(b)) - [3),

where fi is a random variable; everything else is known or chosen by the incumbent

government. Thus, before knowing the realization of/3, the probability that R wins
is
P(b)

p[[se(b,/3) >~ 0.51.

We want to know how this probability depends on public debt. As a preliminary step,
note that
dSR
db - HgGh[(1 - s))C(H(G(b)) - [3) - s f l ( - H ( G ( b ) ) -/3)],
where f is the derivative (density) of F. As HgG~ is negative, the sign hinges on
the expression in square brackets. Consider first the case/3 = 0. By symmetry of F,
we see that the vote share of party R goes up for any/3 if s > (1 - s ) . Intuitively,
higher b leads to lower furore spending, which increases party R's advantage among
voters in group d, but it reduces it among voters in group r. if group d is larger, the
1 Then, by
former effect prevails. Consider next the case in which s = (1 - s) = g.
symmetry and unimodality of F, the vote share for R goes up as b increases if and
only if/3 < 0. Again the voters in group d are more important, not because the whole
group is larger, but because at the margin the voters in group d are more mobile when
party D is generally unpopular. It follows from this discussion that Pb > 0 is more
likely the larger is s and the smaller is E(/3). That is, from the point of view of a
party-D incumbent, issuing more debt reduces the probability of re-election (Pb > 0)
if its economic policies benefit a large group of voters (s is large) or if it is unpopular
among all the voters (/3 < 0).
It is now easy to characterize the equilibrium debt issued by a party-D government
Going through the same steps as in the previous subsection, the optimality condition
for public debt - the analog of (6.5) is
& - P ( b ) Hg Gb - P b H ( G ( b ) ) - O.

(6.7)

The first two terms on the left-hand side of Equation (6.7) are identical to those in
Equation (6.5) and have the same meaning. The government trades off the efficiency
considerations of public debt (captured by Jb) and the strategic effects on the future
spending decisions of its opponent (captured by P H x G v ). The last term captures the
effect of debt on the re-election probability. If issuing debt enhances the re-election

1456

Z Persson and G. Tabellini

chances for party D, so that Pb < 0, this effect adds to the incentives to issue debt, but
when Pb > 0 it pulls in the opposite direction. From the previous discussion we know
that Pb < 0 is more likely when s is small and when E([3) > 0. Intuitively, a party-D
government whose spending policies benefit only a small "minority" - one for which
s is small - enhances it re-election chances by constraining its own future spending,
that is by issuing more debt, since this makes him more attractive to swing voters in
the larger group r. Similarly, a party-D government whose non-economic policies are
generically popular finds it more beneficial to go after swing voters in the opposition
party's natural constituency, group r.
6.1.5. Discussion

What happens if the disagreement between the two parties is not as extreme as we
assumed, so that both parties always spend on both goods, g~ and gr, although the
preferred composition of public spending differs across parties? The answer depends
on the shape of the utility function: more debt forces future spending cuts, but
which public good is cut the most depends on preferences. If lower total spending
is associated with a more similar mix of the public goods by the two parties, Tabellini
and Alesina (1990) show that more instability (a lower probability of re-election) still
leads to larger equilibrium debt 49.
The model thus yields the empirical prediction that political polarization (i.e. sharp
disagreement between the majority and the opposition) and political instability (i.e.,
frequent government turnovers) lead to larger debt accumulation. The simple idea
that political instability causes government to behave myopically can be applied in
more general models. Adding government spending in period 1 does not change the
argument in any respect. Similarly, the results go through if policies are chosen directly
by the voters, rather than by the government, as long as there is a probability that
the current majority will be replaced by a future majority with different preferences.
In fact, the prediction is more general and really applies to any intertemporal aspect
of public policy, such as the choice of public investment [Glazer (1989) and Part Ill
below], or the implementation of tax reforms [Cukierman et al. (1992)].
If" political disagreement concerns the overall size of public spending, rather than
its composition, the result that public debt policy is economically inefficient continues
to apply. But-now the direction of the inefficiency depends on which government is
in office. Persson and Svensson (1989) show that a conservative government facing
a more liberal opposition has an incentive to borrow, to force future spending cuts if
the liberal is elected; but a liberal government has the opposite incentives and underissues debt (runs an excessively large surplus). Hence the empirical prediction that
on average left-wing governments are more disciplined than their opponents, because
they are more willing to raise tax revenue.
~t9 Tabellini and Alesina (1990) tbrmulate this condition in a precise way, referring to thc concavity
index of the function H.

Ch. 22." Political Economics and Macroeconomic Policy

1457

As we saw in the introduction to this part, the general idea that govenmlent turnover
is positively associated with debt issue is consistent with the stylized facts. Some of
the models' specific predictions regarding public debt issue have been taken to the
data by Ozler and Tabellini (1991) for developing countries and by Lambertini (1996)
for industrial countries, with supportive results in the first paper but not in the second
one

50 ,

Stretching the model somewhat, it also predicts that minority governments would
be more prone to issue debt, as the two strategic effects pull in this direction for a
government with a small natural constituency (a small s tends to raise P and to make Pb
negative) 51. For a government with popular candidates, the two effects pull in opposite
directions, though. The specific positive implications concerning the effect o f debt
on re-election probabilities are not necessarily robust, but depend on the assumptions
about voters' preferences in Equation (6.6). But the general idea, that public financial
policies can also be used to manipulate the relative popularity of the two parties, is
sound and has many other applications besides public debt. Clearly, these determinants
of economic policy would be even more important if parties were also opportunistic,
i.e., also cared about staying in office p e r se.
Finally, note that all of these predictions are confined to a two-party system, and
in particular to a political system in which a government, once elected, behaves as a
single decision-maker. We now turn to coalition governments.

6.2. Coalition governments

To see why coalition governments may issue debt, consider a two-period, two-group,
two-party model, silnilar to that in the previous section. As tax distortions are not
central to the argument here, we assunae taxes to be exogenous and lump-sum.
Furthermore, we abstract from elections and popularity and instead assume that the
two parties share office, both in period 1 and period 2. Public spending occurs in
each period. As before, the two groups have sharply different preferences over the
composition o f public consumption. We can write the utility of a typical group-i
individual as
u i = cl ~ c2 + H ( g { ) + H(g~) = 2 ( y -- r) + H(g{) + H ( g '2),

where y and r are exogenous per capita incomes and per capita taxes assumed to be
equal over time.

50 Petterson (1997) test the Persson-Svensson and Aleshla-Tabellini models of strategic debt issue on
panel data from Swedish municipalities. He finds support for the former model but not for the latter.
51 Questioning the stylized fact cited in the Introduction to Part II, Edin and Ohlsson (1991) argue that
minority governments, rather than coalition govermnents, are associated with larger debt issue.

T Persson and G. Tabellini

1458

To simplify further, let us assume that s = , so groups (or parties) d and r are of
equal size. The government budget constraints are
g,--(g~+g~):r+b,

g2

(g~+g~):r-b.

It is easy to see that in this setting the optimal cooperative policy (giving equal weight
to the two groups) would set b = 0, and g~ = gI T f o r i = d, r a n d t = 1,2, sincethat
would smooth the benefits of government spending optimally across groups and time.
This is not the equilibrium outcome, though, if groups do not cooperate.
In each period, the coalition partners simultaneously and non-cooperatively propose
a spending level for their constituency. Period-2 debt is always honored. I f jointly
feasible, these proposals are implemented; if infeasible, each group gets a share of
the feasible spending level in proportion to its proposal. More precisely, using p(g~)
to denote the proposal of group i in period t we assume that 52

gl

f p(g~)

if

] @

~2r

f p(gi2)

if

(p(gl)+p(gi/)) <~2r,
otherwise,

~, p(gl)+p(gi )

g~ = /

(p(g~) +p(gJ)) <~ r - b,

P(g) n ( r - b )

k P(g'2)+P(g~)

(6.8)

otherwise

Clearly, this model implicitly assumes a weak budget process, where each of the
coalition partners is given responsibility for one separate part of the government
budget, and none of them has responsibility for the overall budget constraint. We
can also interpret the model as referring to a very weak government where spending
ministers are in the hands of powerful interest groups.
Given the relation between proposals and outcomes in Equation (6.8), there is a
unique Nash equilibrium in period 2: each party proposes that the whole remaining
pool of government resources, r - b, be allocated to its own group. Bidding for the
whole pie in period 2, by setting p(g~) = (r - b), is costless. Such a proposal is a
dominant strategy, as any lower proposal reduces the share of group i. Equilibrium
spending thus satisfies
g~ = g~/= (T - b).

(6.9)

6.2.1. Equilibrium debt issue

In period 1 the situation is diffbrent, because insisting on high spending eats up future
resources. This cost is not high enough, though, to prevent equilibrium over-issue of
~ We also asstune that no group can bid for m o r e than the total available resources. Thus, P(gl) <~ 2"r
and p(g~) <~ r - b for i - r, d.

Ch. 22." Political Economics and Macroeconomic Policy

1459

debt. To see this, consider how debt links spending in periods 1 and 2. Given future
equilibrium spending in Equation (6.9) and the budget constraints (6.7), we can write
the objective of party I in period 1 as
u1 = 2(y - T) + H ( g l ) + H [ z " - (g{ + g J)/2].
When contemplating its spending proposal and taking party Y's proposal as given,
party I thus does not internalize more than half the cost of current spending. The
optimal proposal satisfies

As the proposals of both parties are identical, they are clearly feasible: the second
expression in parentheses is positive, satisfying the feasibility constraint in Equation (6.9). They are thus implemented and the equilibrium spending profile for group i
satisfies

H ~ ( g l ) - ' g H g ( g 2 ')

- 0.

AS e~l
-i > g for i = d, r, it follows from Equation (6.8) that b > 0.
This result is an instance of the familiar common pool argument: as the property
rights to future income are not well defined, each of the parties only internalizes a
fraction of the cost of current spending and debt issue. The result is a collective
irrationality, which departs radically from the cooperative solution. Naturally, with
N > 2 groups the problem becomes even worse, because now each party only
internalizes I / N of the future costs of debt issue.
This model can be generalized in several directions. Velasco (1999) studies a
genuine multi-period model. This gives richer debt dynamics, including the possibility
of delayed endogenous stabilizations. Chari and Cole (1993) study a two-period model
which combines ideas from this and the previous subsection. Legislators facing a
free-rider problem that drives spending too high try to constrain future spending and
avoid collective irrationality by issuing more debt. Lizzeri (1996) applies a related
idea to a very different model of redistribution, originally formulated by Myerson
(1993). He considers a two-period economy where elections are held every period.
Candidates can make binding promises before elections, over how to redistribute
the available resources across voters and over time. Rational voters reward myopic
behavior, however, favoring a candidate who promises to distribute all resources today.
The reason is that resources left for the future can be taken away by the opponent if
the first-period incumbent is not re-elected 53.

53 Tile commonpool problem has also been extensivelystudied in a static context. Persson and 'Ihbellini
(1999) smvey that literature.

1460

z Persson and G. Tabellini

6.2.2. A stronger budget process

The over-issue o f debt is obviously caused by a flawed government budget process,

where each party o f the coalition (each group) is given decision-making authority over
part of the budget, but nobody is given decision-making authority over the aggregate
outcome. Which institutional reforms could address this problem?
A natural idea is to centralize decision-making authority completely to one of the
parties (or perhaps to reform the electoral system, to make majority governments,
rather than coalition governments, more likely). I f the same party fully controlled all
spending decisions, it would indeed appropriately internalize the cost o f overspending
and o f debt issue. Such centralization o f decision-making power could be abused,
however. In the model o f subsection 6.1, party I would spend all the revenue evenly
over time on its own group, if it had the power to do so. The allocation o f spending
across time would thus be fine, but the allocation across groups would be terrible.
Moreover, in such a world, electoral uncertainty would re-introduce the incentives for
debt issue considered in that section. This problem could be mitigated by institutional
"checks and balances", for instance by splitting agenda-setting power between the two
groups, giving, say, party D agenda-setting power over the budget size and party R
agenda-setting power over its allocation 54.
It turns out that a simple institution can implement the socially optimal allocation
in the model. The solution is to split the decision in stages. First public debt is
chosen. Then the allocation o f g t across different types o f public goods is sequentially
determined, first in period 1 and then in period 2, with a separate budget constraint
for each period. Suppose that the allocation o f spending is made according to
Equation (6.8), except that (r + b) replaces 2 r in the expression for first-period
spending on the RHS of Equation (6.8). It is easy to see that both groups now agree to
a balanced budget (b = 0), as any other choice would be inefficient for both of them.
Since there is unanimity, any mechanism for choosing b would give the same result.
Interestingly, the empirical evidence in yon Hagen (1992), von Hagen and Harden
(1995) and Alesina et al. (1996) suggests that certain features of the budget process
makes it less likely that countries run into public debt problems. One o f the indicators
that make up the index of budget stringency in their work is precisely whether the
budget process entails a decision on the overall budget, before the decision on its
allocation 5s.

54 Fhe effects of some of these checks and balances are investigated in a difterent set up by T. Persson
et al. (1997).
s5 Hallerberg and yon Hagen (1997) argue that countries with majoritarian electoral systems (and which
thus are more likely to have one-party governments) have chosen to centralize power to the finance
minister in the budget process, whereas coantries with proportional electoral systems (more likely to
have coalitions and minority governments) instead have tried to limit their deficits by adopting formal
budget targets.

1461

Ch. 22." Political Economics and Macroeconomic Policy

6. 3. D e l a y e d stabilizations

In this section we do not focus on why budget deficits arise, but on why it may take
time to get rid of them once they have arisen. Following Alesina and Drazen (1991),
we illustrate the possibility o f delayed stabilizations when two parties in a coalition
government, or two powerful interest groups, both have an incentive to let the other
party bear the brunt o f the necessary adjustment. Alesina and Drazen's continuoustime model built on the biological war-of-attrition model o f Riley (1980) and on the
public-goods model o f Bliss and Nalebuff (1984). We adapt their analysis to our simple
two-period setting.
In the model of the previous section, assume that aggregate government spending
has got stuck at a level higher than aggregate tax revenue. In particular, assume that
gd + gr = g = r +/3, with/3 > 0. As before, tax revenue is exogenously fixed at
the same level in each period. We study two possible outcomes: (i) Stabilization is
delayed, in which c a s e g ~ + g ~ " = gl = r + / 3 , b = /3, a n d g ~ + g ~ = g2 = r - j 3 .
(ii) Stabilization occurs in period 1, in which case aggregate overspending is cut by [3
so that gl = r = g2 and hence b = 0. The allocation o f spending cuts across the
two groups in case (ii) depends on how stabilization came about. We return to this
question below. We are interested in the probability that stabilization is delayed, and
what factors make delay more likely.
To simplify the algebra, we assume that the utility o f group i is linear in gi. We
assume that the costs o f debt policy enter additively in the utility function. They can
be thought o f as either a suboptimal spending allocation over time, or other costs
associated with debt issue - perhaps part of the deficit is financed by a distortionary
inflation tax. We thus write utility o f group i as
u i = 2 ( y - z') + g{ + g i9 - lcib.

(6.10)

The parameter ti measures the cost to group i of postponing the stabilization. A crucial
assumption is that this cost is private information to group i. G r o u p j only knows that
K"i is distributed on the interval [0, ?(] according to the distribution function F(lfi). The
corresponding parameter tcJ has the same distribution, but the realizations o f ~ci and
tcJ are independent.
All political action takes place at the beginning o f period 1, when each party, simul.
taneously and non-cooperatively, makes a proposal p/ of whether to stabilize (pl = s)
or not (pI = n). If both parties propose n, the stabilization is delayed. But i f at least one
party proposes s, stabilization takes place. If only one party "gives in" and proposes s,
that party bears the main burden of the necessary cutbacks. Specifically, we assume:
gi(n,n)=(r+/3),

g ~ ( n , n ) = (r -/3),

g~(s, n) = g[(n, s) = ~i r - a ,
g~(n,s)=g~(s,n)="r+a,
g~(s, s) = gr,
'

i=d,r,

t = 1,2,
t=l,2~
t=1,2,

i=d,r,

(6.11)

1462

T. Persson and G. Tabellini

where gi(pt),pD) denotes how spending on group i depends on the two proposals, and
where a > 0 measures the advantage of not giving in. Implicit in Equation (6.11) is the
idea that the political process gives veto rights to some party or interest group. Thus,
this model applies to countries ruled by coalition governments, or more generally to
a situation where the executive is weak and faces effective opposition by organized
interests in the legislature or outside of Parliament.
Consider one of the parties, say party D. It compares expected utility when
proposing n, denoted by E[u d I pd = n], and when proposing s, denoted by
E[u d ] pd _ s]. Let q = Pr[p" = s] be the probability that party R proposes s
(q is determined in equilibrium). Then, Equations (6.10)-(6.11) and some algebra
imply
E[ ud I S = n ] - E [ ud [ S = s] = a - ( l

q)tedb.

(6.12)

Thus, it is more advantageous to propose n if the gains from not giving in are large
(a is large), if the costs of deficit finance for group d is low (k d is low), and if
the probability that party R proposes s is high (q is high). Clearly, party D says no
whenever ted is below some critical number K. But, since party R faces an identical
decision problem, it also proposes n whenever te" < K. Thus it must be the case
that (1 - q ) = F ( K ) . Using that and setting the expression in (6.12) equal to zero, we
can implicitly define the equilibrium value of K by:
X F ( K ) = all3.

The LHS of this expression is increasing in K. Therefore, K = K ( a , fi), with Ka > 0

and Kf~ < 0.
We can now answer the main questions, namely how often we would observe a
delayed stabilization and what factors make equilibrium delay more likely. Delayed
stabilization requires that both groups propose n. As teJ and te" are independently
distributed, the unconditional probability o f observing delay is
(1 - q)(1 - q) -- F ( K ( a , f i ) ) F ( K ( a , fi)).
The likelihood of delay is thus increasing in a, the gain from winning the war of
attrition when the other party gives in first. If we interpret a as a measure of cohesion
in the political system, this result thus says that delayed stabilizations and prolonged
deficits are more likely in polarized political systems. Note that if a = 0, there is never
any delay; postponing adjustment only implies losses for each party. The likelihood
of delay is also decreasing in fi, the initial fiscal problem. The model is consistent
with the general idea that a worse fiscal crisis makes adjustment more likely; here we
get that result because the expected cost of waiting becomes individually larger with
a higher ft. Thus, the model supports the general idea that financial crises and times
of economic distress resulting from budgetary instability are catalysts of reform, and

Ch. 22: Political Economics' and Macroeconomic Policy

1463

should not be feared too much [Drazen and Grilli (1993)]. The mechanism causing
delay in the model, namely a conflict over how to distribute the losses from cutbacks
in government programs, also rhymes well with casual observation. Finally, the model
can be used to study the consequences of financial aid to developing countries and
conditionality [Casella and Eichengreen (1995)]. To be effective, external financial
aid should not ease the pain of an unsustainable situation (in terms of our model, it
should not reduce fi), for this would simply delay the stabilization. Effective financial
aid should instead be conditional on a stabilization taking place and shrink over time if
the stabilization is postponed, to increase the incentives to give in early for the rivaling
parties.
6.4. Debt and intergenerational politics

The models in this section all focus on how debt redistributes tax distortions, or benefits
of government spending, over time. But they ignore another role of debt: redistribution
across generations. They also all assume any outstanding debt to be honored by the
government that inherits it. But as we have seen in Section 5, this requires a strong
form of commitment. Reputational or institutional forces facilitate commitments, but
then they should really be part of the argument; such forces may also not go all the
way.
In conventional representative-agent macroeconomics, debt issue and pay-as-yougo social security are identical policies. Several authors have addressed the political
determinants of such policies in a median-voter setting without altruism - see
Browning (1975) for an early contribution, Boadway and Wildasin (1989), and Cooley
and Soares (1999). In these papers, future social-security policies are honored by
assumption (at least in the next period); i.e. commitment is assumed. Working agents
not too far from retirement favor introducing pay-as-you-go social security, as this
allows them to free ride on younger agents. Old-age agents are, of course, also in
favor. Therefore a majority of voters typically favors social security and equilibrium
policy depends, in a predictable way, on age-earning profiles and the population growth
rate.
Cukierman and Meltzer (1989) analyze budget deficits in a similar way, but
introduce inter-generational altruism. The degree of altruism varies across households:
some households leave positive bequests, but others are bequest-constrained. Nonconstrained voters, who can undo any intergenerational redistribution, are only
concerned with the general equilibrium effects of the policy, and not on how it
redistributes across generations. But a budget deficit is favored by the bequestconstrained voters, because it allows them something they cannot do privately redistribute resources towards themselves. In a median voter equilibrium, the size of the
budget deficit depends of the efficiency effects and the number of bequest-constrained
voters.
Even though these contributions introduce important aspects of politics, they still
hinge on the commitment assumption. At any moment social security strictly benefits

1464

T. Persson and G. Tabellini

only a minority (the retired) but imposes a cost on a majority (the workers). A similar
problem exists for debt. Why then does the majority not repeal the policy? Reputational
concerns may help, if honoring the current program enhances the probability that it
will be honored in the future. But as we have already discussed in Section 5, this
argument is not without problems.
Tabellini (1990, 1991) suggests one should allow intra-generational heterogeneity
in income, when thinking about these questions. Pure intergenerational policies rarely
exist, at least when generations are altruistically linked. Social security programs thus
redistribute not only from kids to parents, but also from rich to poor. Similarly, public
debt default would have both intergenerational and intragenerational effects (as the
rich are likely to hold more debt). A policy redistributing across generations may
therefore be upheld in equilibrium, without ex ante commitments, by a coalition of
voters that contains members of different generations who belong to similar income
groups. But the coalitions that form ex p o s t to support existing social security and
outstanding debt are different. Social security is supported by the old and the kids
of poor parents, whereas debt is supported by the old and the kids of rich parents.
These two intergenerational policies are thus not equal under heterogeneity and lack
of commitment. As in Section 5, incentive constraints in policymaking violate the
Modigliani-Miller theorem of government finance.
Majority voting is not the only way of thinking about how the policy preferences
of different generations get aggregated in the political process. In many societies,
different age-groups - the old, in particular - have well-organized interest groups that
lobby and take other political action to support policies benefitting their members.
Rotemberg (1990) discusses the repayment of government debt as the outcome of
bargaining between living generations. Grossman and Helpman (1996) formulate a
dynamic model of intergenerational redistribution where policy commitments are again
not feasible. In the model, pressure groups of living generations make contributions
to the government conditional on the support given to their members. The model has
multiple expectational equilibria, which remind of the equilibria in capital taxation
studied in Section 5. But it is the expectations of the current goverm'nent - rather
than the expectations of private agents - about the policy of the next government that
introduce the self-fulfilling property. One can easily end up in a very bad equilibrium,
where the pressure groups get engaged in a very stiff and costly competition for policy
favors and Where capital formation suffers.

6.5. N o t e s on the literature

A huge literature deals with the politics on government deficits. Here we only refer to
the more recent contributions, that typically study general equilibrium models with
rational voters and politicians. A broader survey of the public choice literature is
Mueller (1989). Much of the modern macroeconomic literature on public debt is
surveyed in Alesina and Perotti (1995a).

Ch. 22:

Political Economics and Macroeconomic Policy

1465

The idea that political instability induces a govermnent to use public debt
strategically, to influence the future policies of its opponent, was first independently
studied by Alesina and Tabellini (1990) and Persson and Svensson (1989). The model
of subsection 6.1 is related to Alesina and Tabellini (1990), while Persson and Svensson
(1989) studied a model where parties disagree on the overall size (as opposed to
the composition) of public spending. Since then, many other papers have applied
this idea to intertemporal fiscal policy. In particular, Tabellini and Alesina (1990)
provide a generalization of these results, Alesina and Tabellini (1989) study capital
flight and external borrowing, Tabellini (1990) looks at these models in the context of
international policy coordination, Glazer (1989) applies the same idea to the choice of
duration in public investment, Cukierman et al. (1992) analyze tax reforms from this
point of view and provide empirical evidence that political instability is associated with
more inefficient tax systems, and Roubini and Sachs (1989), Grilli et al. (1991), Ozler
and Tabellini (1991) and Lambertini (1996) analyze the empirical evidence. Finally, the
result that public debt policies also affect the re-election probability was first studied
in this context by Aghion and Bolton (1990). Modeling the voters' preferences as
entailing a trade-off between economic and non-economic dimensions, as we do in
subsection 6.1, is a common strategy in some of this literature - see in particular
Lindbeck and Weibull (1987).
The dynamic "common pool" problem has a long history. It has been studied in
industrial organization, where it refers to dynamic games among oligopolists facing
an exhaustible resource, such as an oil field or a fishery [Levhari and Mirman (1980),
Benhabib and Radner (1992)]. In fiscal policy, it was studied by Tabellini (1987) in a
dynamic game of monetary and fiscal policy coordination, and by Velasco (1999) in
a setting more similar to that of this model. This idea is also at the core of the more
empirically oriented literature on budgetary procedures, such as Alesina and Perotti
(1995a), von Hagen and Harden (1995), and Hallerberg and yon Hagen (1997). There is
also an interesting (mainly empirical) line of research, that has investigated the effects
of various restrictions on government borrowing. Most of this literature has studied the
variety of institutional arrangements in US states. See for instance Bohn and Inman
(1996), Poterba (1994), and Eichengreen and yon Hagen (1996).
The model of delayed stabilizations is due to Alesina and Drazen (1991), who in turn
have elaborated on earlier ideas by Riley (1980) and Bliss and Nalebuff (1984). Since
then, the model has been extended in several directions, among others, by Drazen and
Grilli (1993), Casella and Eichengreen (1995) and Alesina and Perotti (1995b).
Finally, a large literature deals with intergenerational redistribution. Besides the
papers quoted in the previous subsection, a separate line of research has investigated
the sustainability of social-security systems in reputational models [Kotlikoff eta!.
(1988), Boldrin and Rustichini (1996)].

1466

T Persson and G. Tabellini

Part C. Politics and Growth

Distorted fiscal policies, such as those emerging from the political equilibria in Part II,
are likely to affect economic performance. It is therefore natural to ask whether
political factors and political institutions are correlated with long-run economic
growth. Here, too, there are some stylized facts. Most notably, after controlling for
the conventional determinants o f growth:
(i) Inequality in the distribution o f income or wealth is significantly and negatively
correlated with subsequent growth in cross-country data. On the other hand, the
evidence on the effect o f growth on the distribution o f income (the Kuznets curve)
is quite mixed, both in cross section and time series data 56.
(ii) Political instability, as measured by more frequent regime changes, or political
unrest and violence, is significantly and negatively correlated with growth in
cross-country data 57.
(iii) Better protection of property rights is positively and significantly correlated with
the growth. Whereas political rights and the incidence o f democracy are strongly
correlated with the level o f income, there are no robust findings regarding the
effect o f democracy on economic growth. 58
A recent literature has tried to explain these regularities in a setting where both
economic growth and fiscal policies are endogenous. Section 7 surveys this literature.

7. Fiscal policy and growth

Subsection 7.1 illustrates how income inequality can produce a negative effect on
investment and growth, because it provides stronger incentives for redistributive
policies that hurt growth-promoting investment. This idea was suggested by Alesina
and Rodrik (1994) and Persson and Tabellini (1994b). As in these papers - and a
great deal of subsequent work - we rely on a simple median-voter model inspired
by Roberts (1977) and Meltzer and Richards (1981). Subsection 7.2 then illustrates
how political instability can hurt growth, by inducing the incumbent government to
follow more myopic policies, as in the work by Svensson (1996) and Devereux and
Wen (1996). The argument here is closely related to that on strategic debt policy
in subsection 6.1. Finally, subsection 7.3 briefly discusses how poor protection o f
property rights may hurt investment and growth, as in Tornell and Velasco (1992)

56 This finding was first obtained by Atesina and Rodrik (1994) and Persson and Tabellmi (1994b).
For a recent and comprehensive survey of the empirical evidence on inequality and growth, see Perotti
(1996).
57 On this point see Alesina et al. (t996) and Barro (1991).
58 On the relation be~ieen property rights and growth see Knack and Keefer (1995). A survey of the
voluminous literature on the links fi-om democracy to growth can be found in Przeworski and Limongi
(1993).

Ch. 22."

Political Economics and Macroeconomic Policy

1467

and Benhabib and Rustichini (1996). The underlying ideas are closely related to the
dynamic common-pool problem discussed in subsection 6.2.
7.1. I n e q u a l i t y

and growth

Consider again a two-period economy inhabited by a continuum of heterogenous

agents. Everyone has the same quasi-linear preferences over private consumption in
periods 1 and 2 and over government (per capita) consumption in period 2. The utility
of consumer i is:

u' = u(c~)+ c~ +H(g)

(7.1)

The budget constraints are

C i1

e i - r - k i,

(7.2)

C2i = (1 - O) A ( 1 ) k i,

where k i is private investment, r and 0 lump-sum and capital taxes, and A ( I ) the
gross return to private capital, which is increasing in public investment 1. We abstract
from credibility problems; the government can commit to these policy instruments
before private capital accumulation. Finally, e i is the endowment of agent i. These
endowments are distributed in the population with mean e and a distribution function
for the idiosyncratic part F ( e i - e). To proxy empirical income distributions, we assume
that F is skewed to the right: the median value o f e i - e, labeled e" - e and defined
by F ( e " - e)
, is negative.
Assuming a balanced budget in every period, the government budget constraint in
per capita terms is:
I = "r,

(7.3)

g = OA(l)k,

(7.4)

where k denotes per capita (average) capital. Following the approach of subsection 5.1,
we can derive equilibrium private investment from Equations (7.1)-(7.3) as
k i = e - I - UcI(A(I)(1

- 0)) + ( e i - e) =~ K ( O , I )

+ ( e i - e),

where the common investment function satisfies K0 < 0 and K1 > 0. It is again
convenient to express the utility from private consumption as an indirect utility function
defined over the policy variables:
ji(o,[,

e i) --~

Max[U(ci0 + c~]

=U(e-I-K(O,I))+(I
= J(O,I)

O)A(I)K(O,I)+A(I)(t-O)(e

e)

~ A ( I ) (1 - O)(e i - e).

(7.5)
By the envelope theorem, the direct welIhre cost of the capital tax Jo = - A ( I ) K is
negative. Moreover, the welfare effect of public investment, .11 = -U~ + (1 - O ) A t K , is

1468

Z Persson and (5. Tabellini

monotonically decreasing in I (by Ucc < 0 and AH < 0). Substituting Equation (7.5)
into (7.1) and using (7.3), we obtain individual-/policy preferences over the two policy
instruments 0 and I:
u i = j i ( o , I, e i) + H ( O A ( I ) K ( O , I)).

These policy preferences are linear in the idiosyncratic variable e i. They therefore
fulfill a monotonicity (single-crossing) condition, such that the preferred policy of the
agent with endowment e m will be a Condorcet winner, even though the policy space
is two-dimensional. If we imagine that policy decisions are taken at the begilming of
period 1 by direct democracy, the winning proposal is thus the policy preferred by this
decisive voter. I f the second-order conditions are fulfilled 59, the equilibrium values for
I and 0 thus satisfy
dl + It~,O(KAI + A K D + (em -- e)(1 - O)AI = O,
Jo + H g A ( K + OKo) - (e" - e ) A = O.

(7.6)

To understand these conditions, first assume that the distribution is symmetric, so

that e m = e. Then the third terms in both conditions are zero, and Equation (7.6)
characterizes the optimal policy for the average agent, which
by quasi-linear
preferences - would be chosen by a utilitarian planner. The first condition says that
it is optimal to provide more public investment than would maximize private indirect
utility (i.e. Jr < 0) due to the beneficial effects on the future tax base and hence on
public spending (if public debt were allowed this result would be different). The second
condition equates the average private marginal cost of raising revenue (Jo < 0) with
the marginal benefit it generates via public consumption.
But if e m < e, redistributive effects come into play. The decisive voter's capital
falls short of average capital by exactly (e m - e). This implies that I is smaller and
0 is higher than in the hypothetical planning solution. The reason is that the decisive
w,ter does not benefit from public investment as much as the average capital holder,
and he also does not suffer as much from capital taxes. To see this formally, notice that
the third term in the first equation of (7.6) is negative and the third term in the second
equation is positive. By the second-order conditions, ! has to be lower and 0 has to be
higher than in the social planner's solution.
We thus see that inequality hampers growth via two different channels. The growth
rate from period 1 to period 2, given by [ A ( 1 ) K ( O , I ) / e ] - l, is increasing in I (both
directly and indirectly) and decreasing in 0. Furthermore, the higher is inequality, as
measured by the distance between median and average income, the lower is growth as
equilibrium public investment is smaller and capital taxation - as well as government
consumption - is higher.
~') As hi all optimal taxation problems, this assumption is not necessarily innocuous, but can involve
restrictive assumptions on underlying fimctional forms.

Ch. 22." Political Economics and Macroeconomic Policy

1469

Alesina and Rodrik (1994) and Persson and Tabellini (1994b) developed this kind
of reduced-form prediction in related but explicitly dynamic models. Whereas Persson
and Tabellini (as we have done) focused on the size distribution of income, Alesina
and Rodrik focused on the functional distribution of income between labor and capital.
Both papers also took the reduced-form prediction to the data - here Alesina and
Rodrik too look at the size distribution of income. And they indeed found a strong
negative effect of inequality on growth in a cross section of post-war data from a
broad sample of countries 60.
These papers stimulated a body of subsequent work scrutinizing both the empirical
and the theoretical argument. Whereas the reduced-form relation from inequality to
growth indeed seems empirically robust, the structural links implied by the theory have
not generally found support in later empirical work 61. Thus, it has been hard to identify
both the implied link from inequality to redistribution and the link from redistribution
to growth, as emphasized in the recent surveys by Perotti (1996) and Benabou (1996).
The model in this section suggests that these links could be pretty subtle, however
(with opposite effects of inequality on government consumption and investment, for
example, and ambiguous effects on total government spending). Moreover, the failure
to find a robust link from tax rates and redistribution to economic growth is a problem
for conventional growth theory, not just for political theories of growth. The literature
has also searched for other reasons why inequality and growth may be inversely related.
Perotti (1996) stresses that one link may run via political instability or via other,
non-political, channels such as education. Benabou covers a whole range of recent
theoretical work showing that the links between income distribution, policy and growth
may run in different directions. For instance, redistribution may promote growth when
agents are credit constrained, or when it promotes education.

7.2. Political instability and growth

We now modify the previous model as follows. First, every private agent has the same
first-period endowment: that is, e i = e and the average investment function K(O,I)
applies for everyone. Instead, as in subsection 6.1, agents belong to two different
groups, d and r, and public spending is of either of two types: gJ (benefitting only
group d) or g" (benefitting only group r).
Second, and again following subsection 6.1, policy is not set by majority rule but
by an incumbent government D that acts so as to maximize the utility of group-d
agents. The incumbent may be replaced by an alternative government R in the future.

r,0 Perssonand Tabellini (1994b) also round a similar relation in a small historical panel of industrialized
countries with data going back to the late 19th century.
~l Later empirical work based on better data has also questioned an empirical finding by Persson and
Tabellini (1994b) that was interpreted as giving indirect support for the theory-,namely that the relation
between inequality and growth was only present in democracies and not in dictatorships.

Z Persson and G. Tabellini

1470

For simplicity, we take the re-election probability (1 - P ) as exogenous. It is natural

to interpret P as a measure o f political instability.
Third, to introduce a meaningful policy choice in period 2, policies are chosen
sequentially. Thus, public investment I is chosen in period 1, before private capital,
and the capital tax rate 0 is chosen in period 2. To avoid the capital-levy problem
discussed in Section 5, we assume that in period 2 the private sector can still avoid
some of the tax, though at a cost, by reallocating some o f its accumulated capital to a
non-taxed asset with a lower return. We could think o f this as tax avoidance, or capital
flight. A convenient formulation, following Persson and Tabellini (1992), is to rewrite
the period-2 budget constraint as
c2 = (1 - O)A(I)(k - f ) + f - M ( f ) ,
where M ( f ) is a concave and increasing function o f the amount f shielded
from taxation and where we have recognized that everybody makes the same
savings decision. It is easy to show that average savings are still given by the
function K(O, I) and that tax avoidance is given by the function F ( O , I ) with Fo > 0
and FI < 0 62. The government's tax base can thus be written as a function
K ( O , I ) = A ( I ) K ( O , I ) - F(O,I). The ex ante properties o f this function (that is from
the viewpoint of period 1) are the same as before: decreasing in 0 and increasing in I.
in period 2, when K and I are given from previous decisions, the ex post tax base
K 2 ( 0 , I ) is still decreasing in 0 but with a smaller slope (intertemporal substitution
possibilities are eliminated).
The bottom line after these modifications is similar to the previous section: we can
write the ex ante indirect utility of an agent in group i as
u i = J(O, I) + H ( g i) - J (0, I) + H(OK(O, I)).

(7.7)

We can also define ex post indirect utility (for given K and I) as j2(O, I) + H ( O K
--2 (O,D).
Both J(O,I) and j2(0, I) have the same qualitative properties as the corresponding
function in subsection 7.1.
Any government holding power in period 2 spends all revenue on the public good
favored by its own constituency. The expost optimal tax rate is given by the condition:
+H

(K 2 +

= 0,

(7.8)

which has the same interpretation as the second condition in Equation (7.6). Thus, both
prospective governments will set the same tax rate. Condition (7.8) implicitly defines
the optimal tax rate as a function o f past public investment O(I), with slope
o, =

4 +
--2
Jgo + HggKo0

(i? The first--order condition for optimal tax avoidance is for the consumer to set A(I)(1
Mr(f) = 0. When this condition is inverted, we get the desired tax avoidance function.

O)

1 -I

Ch. 22.. PoliticalEconomics and MacroeconomicPolicy

1471

Unless H is very concave, Ol > O, as the numerator is positive and the denominator is
negative (by the second-order condition). Public investment enlarges the tax base and
this drives up the optimal tax rate.
The incumbent party-D government in period 1 chooses I so as to maximize

E ( S ) : PJ(O(1),I) + (1

P)[J(O(I),I) + H(O(1)K(O(1),I))]

= J(O(I), I) + (1 - P)[H(O(I)K(O(1), 1-))].

We can rewrite the first-order condition to this problem with Equation (7.8),
recognizing that J~ = Jo and g2 = ~ at the equilibrium tax rate. Some additional
algebra gives

Jl +Hg[OKI + O(Ko --K2o)Ol] PHg[OKI + 0I(K + OKo)] = O.

(7.9)

Suppose first that D is certain to be re-elected: P = 0. Then the optimal choice o f / b o i l s

down to the familiar weighting of private welfare (the first term) against government
revenue (the second term), where the latter are fully internalized as the government is
certain to remain in office. The resulting condition is the same as the second condition
in Equation (7.6) of the previous subsection, adjusted for the different timing of
tax policy and for the lack of heterogeneity. But when re-election is uncertain, P > 0,
future government revenue is less valuable and policy myopia sets in. As the third
term in Equation (7.9) is negative, a higher probability P of losing office makes public
investment less attractive and reduces it in equilibrium.
Higher instability not only draws down public investment, but reduces growth in
this model. Second-period income, c2 + g = A(I)K(O, I ) - M(F(O, I)), unambiguously
goes down as I falls. The direct negative effects of lower public investment and the
indirect negative effects of higher waste due to more tax avoidance always outweigh
the positive effects of the smaller equilibrium capital tax.
Much of the informal discussion of why political instability is harmful for growth
seems to suggest a direct effect of uncertainty or unpredictability on private investment.
We know, however, that uncertainty in returns has ambiguous effects on private
investment. Here a different mechanism is at work: political instability induces more
myopic fiscal policies, which in turn cause lower public investment and growth. This is
related to Svensson (1998), who shows that political instability may make a forwar&
looking government abstain fi'om improvements in the legal system that enforce private
property rights. He also finds empirical support for this idea. Political instability [as
measured by Alesina et al. (1996)] indeed reduces the protection of private property
rights [as measured by the same index as in Knack and Keefer (1995)] in a wide crosscountry sample. And controlling for property-rights protection, political instability
drops out of a cross-country investment regression. The theoretical paper by Devereux
and Wen (1996) emphasizes a somewhat different mechanism: political instability
induces incumbent governments to leave smaller assets to their successors, thereby
forcing theln to tax capital at a higher rate; the expectation of higher taxes drives down
private investment, which leaves a smaller tax base for the successor government.

1472

T. Persson and G. Tabellini

7. 3. Property rights and growth

As mentioned in the introduction, the data support the idea that poor enforcement of
property rights is harmful for investment and growth. This idea is also derived from
some recent theoretical work. Benhabib and Rustichini (1996) study a growth model
where two groups try to redistribute consumption towards themselves at the expense
of the economy's capital stock. They show how such incentives may arise both at low
and high levels of income, and how they may be exacerbated by greater inequality in
the two groups' incomes. Their model abstracts from the political mechanism and the
channels of redistribution, however.
Tornell and Velasco (1992) focus on redistribution through the fiscal policy process
in a linear (Ak) growth model. Their argument, as Benhabib and Rustichini's, is another
instance of the common pool problem discussed in subsection 6.3. The common pool
is now a part of the economy capital stock rather than the government tax base, but the
incentive to over-exploit this common pool is the same. Because the redistribution is
supposed to take place via the governlnent policy process, the poorly enforced property
rights are closely related to weak government.
Tornell (1995) studies a related model, but allows for endogenous property rights.
in particular, property rights can be created and destroyed at a cost. He shows that the
economy can go through a cycle with low property-rights protection at low and high
levels of income. I f so, this pattern is perfectly foreseen and leads to gradually falling
growth rates at intermediate levels of income.
Lane and Tornell (1996) show that an exogenous positive shock due to productivity
or the terms of trade may actually reduce the growth rate in an economy with
powerful interest groups and poorly defined property rights. The mechanism is again
a coordination failure between the interest groups, whereby the initial increase in the
incentives to invest is more than outweighed by an increase in redistributive transfers.
Svensson (1996) produces a related result, where the incentives of the interest groups
to hold back on their demand for transfers vary negatively with government income.
7.4, Notes" on the literature

Beyond the papers cited in the text, early contributions to the theory of income
distribution," investment and growth were made by Perotti (1993), who studied
human capital accumulation, and tax-financed subsidies in the presence of borrowing
constraints, by Bertola (1993) who studied tax policy and the functional distribution of
income, by Glomm and Ravikumar (1992) who studied private versus public provision
of education, and by Saint-Paul and Verdier (1993) who also studied redistributive
policies that finance public education in a setting with wealth-constrained individuals.
Perotti (1996) and Benabou (1996) provide additional references to recent empirical
work. Finally, Caballero and Hammoar (1996) focus on the rents created by factor
specificity and how the distribution of those rents affects the incentives to invest. As
stated in the text, few theoretical models spell out the mechanisms whereby political

Ch. 22:

Political Economics and Macroeconomic Policy

1473

instability is harmful for growth. As emphasized by Benabou (1996), there is thus

scope for new work to provide better theoretical underpinnings for the empirical
findings. Sharper theory is also needed to sort out the empirical channels whereby
politics interacts with growth. This is not going to be easy, however, given the
strong empirical correlations between inequality, instability and lacking enforcement
of property rights.
We want to end with a methodological note. In this section, as in the previous
one, we have relied exclusively on simple two-period examples. This avoids a major
difficulty: a full-fledged treatment o f the dynamic interactions between collectively
chosen policy decisions and income distribution rapidly becomes analytically complex.
As a result, the dynamic models studied in the literature have often relied on
simplifying assumptions: dynamic links are assumed away in the model's economic
structure, voting only takes place at an initial point in time rather than sequentially over
time, or agents are assumed to be myopic and ignore some o f the dynamic implications
of their actions. The clearest formulation of a general solution concept for dynamic
political models with heterogenous agents is made in Krusell and Rios-Rull (1996).
This paper also makes a contribution by showing how the endogenous build-up of
vested interests, as agents acquire monopoly skills in operating new technologies, can
lead to a growth cycle: the political majority at different points in time will shift
between less and more growth-promoting policies. Krusell et al. (1997) survey parts of
the literature on politics and growth from a methodological angle. They also show how
to go from their proposed solution concept to quantitative (numerical) applications.

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Chapter 23

ISSUES

IN THE

DESIGN

OF MONETARY

POLICY

RULES *

BENNETT T. McCALLUM
Carnegie Mellon University and National Bureau of Economic Research

Contents
Abstract
Keywords
1. Introduction
2. Concepts and distinctions
3. Special difficulties
4. Choice o f target variable
5. Choice o f instrument variable
6. Issues concerning research procedures
7. Interactions with fiscal policy
8. Concluding remarks
References

1484
1484
1485
1486
1490
1495
1505
1515
1518
1523
1524

The author is indebted to Peter B. Clark, 'lodd Clark, Charles Evans, Robert Flood, Marvin Goodfriend,
Charles Goodhart, An(hew Haldane, Robert Hetzel, Lars Joining, Allan Meltzer, Edward Nelson,
Christopher Sims, Lars Svensson, John Taylor, John Whittaker, and especially Michael Woodford for
helpful suggestions and criticisms.
Handbook qf Macroeconomics, Volume 1, Edited by AB. laylor and M. WoodJbrd
1999 Elsevier Science B.V. All rights reserved

1483

1484

B.T. McCallum

Abstract

This chapter begins with a number of important preliminary issues including the
distinction between rules and discretion in monetary policy; the feasibility of
committed rule-like behavior by an independent central bank; and optimal control
vs. robusmess strategies for conducting research. It then takes up the choice among
alternative target variables - with the most prominent contenders including price level,
nominal income, and hybrid (inflation plus output gap) variables - together with the
issue of growth-rate vs. growing-level target path specifications. One conclusion is that
im'tation and nominal income growth targets, but not the hybrid target, would have
induced fairly similar policy responses in the US economy over 1960-1995. With
regard to instrument choice, the chapter argues that both nominal interest rate and
monetary base measures are feasible; this discussion emphasizes the basic conceptual
distinction between nominal indeterminacy and solution multiplicity. Accordingly,
root-mean-square-error performance measures are estimated for interest rate and base
instruments (with nominal income target) in the context of a VAR model. Other topics
emphasized in the chapter include the operationality of policy-rule specifications;
stochastic vs. historical simulation procedures; interactions between monetary and
fiscal policies; and the recently-developed fiscal theory of the price level.

Keywords
JEL classification: E52, E58

Ch. 23." Issues in the Design of Monetary Policy Rules

1485

1. Introduction
The topic o f rules for the conduct o f monetary policy has a long and distinguished
history in macroeconomic analysis, with notable contributions having been made
by Thornton (1802), Bagehot (1873), Wicksell (1907), Fisher (1920, 1926), Simons
(1936), M. Friedman (1948, 1960), and others 1. A major reorientation in the focus
of the discussion was provided as recently as 1983, however. In particular, Barro and
Gordon (1983a) built upon the insights of Kydland and Prescott (1977) in a manner
that put an end to the previously widespread notion that policy rules necessarily involve
fixed settings for the monetary authority's instrument variable. This step served to
separate the "rules vs. discretion" dichotomy from the issue o f "activist vs. nonactivist" policy behavior and thus opened the door to possible interest in policy rules
on the part o f actual monetary policymakers - i.e., central bankers.
In fact there has been a great increase in apparent interest in rules by policymakers
during recent years - say, 1990-1996. Evidence in support o f that claim is provided
by several studies conducted at the Federal Reserve's Board o f Governors of the rule
introduced by John Taylor (1993b), such as Brayton et al. (1997) and Orphanides
et al. (1998), as well as by discussions of this rule in speeches by members o f the
Board [e.g., Blinder (1996)]. In the United Kingdom, interest by the Bank o f England
in Taylor's rule as well as an alternative due to McCallum (1988, 1993a) is clearly
indicated in an article by Stuart (1996) that attracted considerable attention in the
British press. Numerous analytical studies of these rules 2 have been conducted by
central bank economists from a number of countries 3. To some extent this upsurge
in interest is related to the arrival o f inflation targeting as a leading candidate for the
provision o f a practical guideline for monetary policy, significant applications having
been introduced during 1990-1993 in Canada, New Zealand, Finland, Sweden, and the
United Kingdom 4.
There are, to put it mildly, numerous issues concerning monetary policy rules on
which professional agreement is far from complete, even among academics
that
is, even neglecting the split between academic and central-bank views, which itself
has probably diminished in recent years. The main purpose o f this chapter is to
survey the most critical of these issues. The first to be discussed, which concerns
the fundamental nature of policy rules and an independent central bank's capacity to

1 For other early rule proposals, see Laidler (1996) and Humphrey (1992). Also see Jonung (1979) for
an interesting discussion of the Swedish experience of the 1930s.
2 Including proposals of Meltzer (1984, 1987), Hall (1984), Hall and Mankiw (1994), Feldstein and
Stock (1994), and Gavin and Stockman (1990).
3 An incomplete list of notable studies would include those mentioned above plus Hess, Small and
Brayton (1993), Clark (1994), Croushore and Stark (1995), Dueker (1993), Dueker and Fischer (1995),
Estrella and Mishkha (1997), Judd and Motley (1991, 1992), Haldane and Salmon (1995), King (1996),
and Jefferson (1997). Many more have been added since this chapter was written, most featuring Taylor's
rule.
4 There is a sizable and growing litcrature on inflation targeting that will be mentioned below.

1486

B.Z McCallum

behave in accordance with a rule - i.e., the commitment problem - is reviewed in

Section 2. Next, Section 3 takes up some special difficulties that bedevil all attempts to
design good policy rules and also to study ones previously proposed, namely, the lack
of agreement (especially among academics) concerning models of monetary policy
effects - and the associated social costs of inflation and unemployment - plus the
existence of ongoing changes in economic structure relevant to monetary policymaking
(e.g., improvements in payments technology).
Two major substantive areas of rule design, the specification of target and instrument
variables, are then taken up in Sections 4 and 5. In the first of these, the choice
among basic target variables - such as exchange rate, price level, or nominal income
measures - is considered along with the desirability of specifying target paths in trendstationary or difference-stationary form (i.e., levels vs. growth rates). In the second, the
classic dispute between advocates of interest-rate and monetary-base (or bank reserve)
instruments is reviewed, brief discussions being given of the rather extreme views that
one or the other is actually infeasible as an instrument.
The following pair of sections, 6 and 7, take up a number of analytical issues
involving the study of candidate rule specifications. Among these are the design
of simulation exercises; issues involving operationality (i.e., feasibility of specified
instruments and information sets); and the interaction of monetary and fiscal policy
rules. Finally, a brief conclusion is included as Section 8.
Since the author has been writing on the subject of monetary rules for well over
a decade, it would be futile to pretend that the chapter's discussion will be entirely
"balanced" or "unbiased". What is intended, rather, is that important alternative points
of view are mentioned and presented with reasonable accuracy even where agreement
is lacking. Another recent overview is provided by Clarida, Gali and Gertler (1999).

2. Concepts and distinctions

The crucial point that a policy rule can be activist has already been mentioned. Of
course this is a matter of definition; thus the use of a terminological system that
does not permit rules to be activist i.e., to involve policy instrument settings that
are conditional on the state of the economy - cannot be ruled out on strictly logical
grounds. But since the publication of Barro and Gordon (1983a), standard usage
in the profession has been virtually unanimous in permitting activist rules and in
basing the "rules vs. discretion" distinction on the manner in which (typically activist)
instrument settings are determined. Roughly speaking, discretion implies period-byperiod reoptimization on the part of the monetary authority whereas a rule calls for
period-by-period implementation of a contingency formula that has been selected to
be generally applicable for an indefinitely large number of decision periods.
The foregoing distinction is satisfying and straightforward to apply in the context
of the simple "workhorse" model that features a surprise Phillips curve as utilized by
Kydland and Prescott (1977), Barro and Gordon (1983a,b), and a host of subsequent

Ch. 23: Issues in the Design of Monetary Policy Rules

1487

writers. When it comes to practical application to the behavior o f actual central banks,
however, the distinction is not so easily drawn. Suppose that a particular central bank,
which presumably cares about both inflation and unemployment outcomes, is observed
regularly to be more stimulative when recent unemployment is high and/or current
macroeconomic shocks threaten to increase unemployment. How does one decide
whether this central bank's behavior should be classified as discretionary or rule-based
but activist? Within a simple model one can calculate the settings implied by each type
of behavior, or simply observe whether inflation exceeds its target value on average
(i.e., whether the discretionary inflation bias is present). But such steps are not possible
for an actual central bank, because there will typically not be any clear-cut agreement
concerning the nature and magnitude o f shocks that have occurred in specific historical
periods or even (in many cases) agreement as to the prevailing target inflation rate
expressed in precise quantitative terms - even for analysis within the central bank
itself.
Taylor (1993b) explicitly addressed the problem of distinguishing "rule-like" from
discretionary behavior in practice, recognizing that no actual central bank would be
likely to follow literally a simple formula for its instrument settings but contending
that the distinction could be of importance nevertheless 5. The key, Taylor suggested,
is that rule-like behavior is systematic in the sense of"methodical, according to a plan,
and not casual or at random". Clearly, being systematic is a necessary condition for
rule-like behavior, but even those central bankers who defend discretionary behavior
do not think of it as unsystematic. Accordingly, McCallum (1993b) argues that
being systematic is not sufficient and points out that discretionary behavior in the
workhorse model can, even with the inclusion o f random shock terms, be accurately
represented by systematic application o f a simple formula. The needed additional
criterion, McCallum suggests, is that the monetary authority "must also design the
systematic response pattern [so as] to take account o f the private sector's expectational
behavior" (p. 217), i.e., to optimize once, not each period. Taking such account is
basically what Barro and Gordon (1983a) specified in their characterization, within
the workhorse model with rational expectations, o f policy according to a rule. There
is then no attempt to exploit temporarily given inflationary expectations for brief output
gains 6. Qualitative knowledge of the policymaking process o f an actual central bank
may then be sufficient in some cases to determine whether or not policy responses are
designed to try to exploit temporarily given expectations.

5 Taylor, like Judd and Motley (1992), envisions the genuine possibility that central bard~ policy
committees would enrich their considerations by referring to the instrument settings suggested by a
numerical rule, e.g., taking them as a starting point for their policy deliberations.
6 It may be asked why a one-time optimization will not involve the exploitation of expectations that
happen to exist at the time. But my meaning of systematic implies that the same actions are specified
each time the same conditions are faced, so the response pattern cannot be different for the "first"
or "first few" periods. Basically, the optimization calculation must be made fi:om the perspective of a
dynamic stochastic steady state.

1488

B.T. McCallum

It is interesting to note, parenthetically, that although Milton Friedman has never

embraced the concept o f activist rules, in one o f his most carefully considered
arguments on b e h a l f o f nondiscretionary monetary policy the crucial advantage o f
a rule is said to be that decisions are made in the form o f a policy applicable to
many distinct cases, not on a case-by-case basis, with such a form o f policymaking
having favorable effects on expectations. In particular, Friedman (1962) suggests that
monetary policymaking is in important ways analogous to freedom-of-speech issues, in
the sense that adopting a rule that applies in general will on average lead to different and preferable - outcomes than those generated by decision making on a case-by-case
basis. After presenting the analogy and remarldng on "our good fortune o f having lived
in a society that did adopt the self-denying ordinance o f not considering each case o f
[contested] speech separately" (1962, p. 241), Friedman contends that:
Exactly the same considerations apply in tile monetary area. if each case is considered on its
[individual] merits, the wrong decision is likely to be made in a large fi'action of cases because
the decision-makers are ... not taking into account the cumulative consequences of the policy
as a whole. On the other hand, if a general rule is adopted for a group of cases as a bundle, the
existence of that rule has favorable effects on people's attitudes ... and expectations that would
not follow even from the discretionary adoption of precisely the same [actions] on a series of
separate occasions.
]~ Friedman (1962, p. 241)
Thus we see that the logic o f Friedman's argument is basically the same as that
identified by Barro and Gordon (1983a) and is entirely compatible with "activism,"
i.e., conditioning clauses in the rule 7.
A controversial issue is whether it is feasible for an independent central bank to
behave in a rule-like fashion. The most straightforward point o f view- is that expressed
b y Taylor (1983, 1993b), McCallum (1995b, 1997b), Kydland and Prescott (1977), and
Prescott (1977), namely, that an independent central bank is perfectly free to choose its
instrument settings as it sees fit. Since it will generate superior outcomes on average
i f it does so in a rule-like manner, and is presumably capable o f understanding that,
the well-managed central bank will in fact behave in such a maimer. This requires
it to adopt instrument settings that are different, however, from those that would
appear optimal i f it were making a fresh optimization calculation each period (i.e.,
not considering the cases as a group). Thus many authors have suggested that, since
there is no tangible "commitment technology" to guarantee that future choices will
be made similarly, independent central banks are inevitably destined to behave in a
discretionary fashion, making a fresh optimization calculation each period. One o f
the strongest explicit statements o f this position has been made by Chari, Kehoe and
Prescott (1989, p. 303), as follows: "We should emphasize that in no sense can societies
choose between commitment [and] time-consistent [i.e., discretionary] equilibria.
Commitment technologies are like teclmologies for making shoes in an A r r o w - D e b r e u

"1 An example of a conditioning clause in the fieedom-of-speech example would be one pertaining to
cases of false alarms shouted in "crowded theaters".

Ch. 23: Issues in the Design of Monetary Policy Rules

1489

model - they are either available or not". But while this form o f language is rather
extreme, the position taken is probably more representative o f academic thought over
(say) 1984-1994 than is the pragmatic Taylor-McCallum position. That is, most
analyses o f the consequences o f various issues simply presume, often without explicit
justification, that central bank behavior will be o f the uncommitted discretionary type ~.
In many cases it is contended that there is a necessary tradeoff between commitment
and flexibility, which the Taylor-McCallum position denies.
The justification typically given, explicitly or implicitly, for tile assumption o f
(suboptimal) discretionary behavior is that although rule-like behavior is superior on
average, it remains true that within each period prevailing expectations are "given" so
each extra bit o f inflation or monetary ease will add output or reduce unemployment,
implying that the discretionary choice would typically be superior from the perspective
of that single period. Furthermore, the public understands this feature o f policy choice,
according to the usual position, so individuals will expect the central bank to behave
discretionarily, thereby making the discretionary action preferable (from the singleperiod perspective). But to conclude that the central bank will therefore consistently
choose the discretionary outcome is analytically to adopt a particular equilibrium
concept - see Chart, Kehoe and Prescott (1989). The solution concept preferred
by Taylor, McCallum, Lucas (1976, 1980), and Prescott (1977) is simply rational
expectations in a competitive model with a monetary authority that behaves as a
Stackelberg leader vis-a-vis the private sector 9. To the present writer the latter concept
seems more plausible 10, but the key point here is that neither o f the two modes of
central bank behavior - rule-like or discretionary - has as yet been firmly established as
empirically relevant or theoretically appropriate. Also, it would seem to be indisputable
that there is nothing tangible to prevent a central bank from behaving in a rule-like

A particularly strildng example of tile importance of this assumption is provided by Svensson (1996),
who argues that in the workhorse model, extended to inchide persistence of output or unemployment
in the surprise Phillips relationship, price-level targeting will lead to less inflation variability (as well
as less price-level variability) than will inflation targeting. This dramatic result depends, however, upon
the presence of discretionary behavior on the part of the monetary authority. It does not obtain if the
central bank is behaving in a rule-like fashion. Svensson (1996) recognizes this point but his discussion
emphasizes the discretionary case.
This exposition does not explicitly refer to thc reputational models pioneered by Barro and Gordon
(1983b), the reason being that the author finds these models implausible. Of course the argunlent here
advanced relies upon reputational effects, but does not utilize the type of equilibria featured in the
reputation literature.
i0 Empirically it is unlike the usual position consistent with tile "free lunch" finding that increased CB
independence provides improved inflation performance without increased output employment variability.
On this finding, see Fischer (1995) or Debelle and Fischer (1995, p. 201). It should be noted, incidentally,
that my hypothesis is quite different from that of Mervyn King (1996), who suggests that CBs do not
aim for output in excess of the natural rate value (as they do in the worldlorse model). The latter implies,
since inflation and output desires are reflected in separate terms in King's loss function, that actual CBs
would not want to keep output above the natural rate value even if they could do so without generating
any inflationary tendency.

1490

B. T. McCallum

fashion 11 so that there is no necessary (i.e., inescapable) tradeoff between "flexibility

and commitment", as has often been suggested ~2. This position does not deny that
central banks are constantly faced with the temptation to adopt the discretionary
policy action for the current period; it just denies that succumbing to this temptation
is inevitable. In practice, adoption o f rule-like decision making procedures is one
mechanism for combating these temptations.

3. Special difficulties
To economists who do not specialize in monetary or macroeconomic issues, it may
seem surprising or perhaps a matter for professional embarrassment that a large volume
o f debate can be sustained on the subject o f monetary policy rules. Surely, the argument
would go, it should not be terribly difficult to conduct an optimal control exercise using
some reasonably good macroeconometric model and thereby discover what an o p t i m a l
monetary policy rule would be. This would have to be done for a number o f different
economies, o f course, but the problems involved are in principle almost negligible and
in practice are easily surmountable. Admittedly, the model would have to be one that
is structural - policy invariant - so as not to be subject to the Lucas critique (1976),
but that necessity has been well understood for many years by now 13
In fact, however, such an argument fails entirely to recognize one basic and
fundamental difficulty that underlies a large fraction o f the issues concerning monetary
policy rules. This difficulty stems from the lack o f professional agreement concerning
the appropriate specification o f a model suitable for the analysis o f monetary policy
issues. There are various aspects o f such a model that different researchers would
emphasize. Many would suggest that money demand theory is quite undeveloped
and inadequate for policy analysis. The viewpoint taken in McCallum (1997a), by
contrast, contends that it is the dynamic connection between monetary policy actions
and real aggregative responses that is the main source o f difficulty 14. Others, including

1t In the workhorse model, policy settings of both the committed and discretionary type may
be expressed as resulting from policy feedback equation of the form or, = a o + a l E ~ 1 ~ +a2u~,
with different coefficient values. Here E t lgt represents prevailing expectations and u~ is a current
macroeconomic shock. There is nothing tangible to prevent a~ choices that represent conmaitment.
t2 The absence of any inescapable tradeoffis implicit in the central bank contracting approach pioneered
by Walsh (1995) and Persson and Tabellini (1993).
13 Taylor (1979) conducted an optimal policy exercise in the context of a dynamic macro model with
rational expectations almost 20 years ago.
14 In this reference, the argument is stated as follows. It is not just that the economics profession does
not have a well-tested quantitative model of the quarter-to-quarter dynamics, the situation is much worse
than that: we do not even have any basic agreement about the qualitative nature of the mechanism.
This point can be made by mentioning some of the leading theoretical categories, which include: rcal
business cycle models; monetary misperception models; semi-classical price adjustment models; models
with overlapping nominal contracts of the Taylor variety or the Fischer variety or the Calvo Rotemberg

Ch. 23:

Issues in the Design of Monetary Policy Rules

1491

King (1993) and Fuhrer (1997) would point to weaknesses in modeling investment
or consumption behavior, and o f course empirical understanding o f exchange rates
and other open-economy influences is widely regarded as highly unsatisfactory. But
whatever the particular model component that is singled out for special criticism, it
seems extremely hard to avoid the conclusion that agreement upon macroeconomic
model specification is predominantly absent - and that different models carry highly
different alleged implications for monetary policy.
The upshot, clearly, is that in practice one cannot simply conduct an optimal
control exercise with an "appropriate" model. That approach simply collapses in
response to the question "What is the appropriate model?" In light of this mundane
but fundamental difficulty, the research strategy recommended by several writers including Blanchard and Fischer (1989, p. 582), McCallum (1988, 1997a), and to some
extent Brunner (1980) - is to search for a policy rule that possesses "robustness" in
the sense o f yielding reasonably desirable outcomes in policy simulation experiments
in a wide variety o f models. In effect, the same type o f approach is collectively utilized
by the various teams o f researchers participating in the Brookings projects directed by
Ralph Bryant [Bryant et al. 1988, 1993)] ts.
It is worth mentioning briefly that the research strategy based on robustness may
serve to some extent as a protection against failures o f the Lucas-critique type. That
critique is best thought o f not as a methodological imperative regarding model building
strategies, but as a reminder o f the need to use policy-invariant relations in sinmlation
studies and especially as a source o f striking examples in which policy invariance
is implausible. The construction o f a policy-invariant model faces a major difficulty,
however, in the above-mentioned absence o f professional agreement about model
specification. Thus it would seem sensible to consider a variety o f models in the hope
that one will be reasonably well specified - and therefore immune to the critique - and
search for a rule that will perform satisfactorily in all o f them 16. O f course, there is no
need for such a project to be carried out by a single researcher; furthermore, attempts
to make each contending model policy invariant would enhance the effectiveness

type; models with nominal contracts set as in the recent work of Fuhrer and Moore; NAIRU models;
Lucas supply function models; MPS-style markup pricing models; and so on. Not only do we have
all of these basic modeling approaches, but to be made operational each of them has to be combined
with some measure of capacity output - a step that itself involves competing approaches - and with
several critical assumptions regarding the nature of different types of unobservable shocks and the timeseries processes generating them. Thus there are dozens or perhaps hundreds of competing specifications
regarding the precise nature of the connection between monetary policy actions and their real short-term
consequences. And there is little empirical basis for much narrowing of the range of contenders.
15 For the optimal-design point of view, see Fair and Howrey (1996).
16 From the perspective of the robustness approach, there is something to be said in favor of expressing
"satisfactorily" in terms of nominal variables - even though individuals are concerned ultimately with
real magnitudes because the relationship between monetary policy instruments and nominal variables
may be less subject to Lucas-critique difficulties than is the case with real variables. An argument to
this effect is attempted in McCallum (1990b, pp. 21-22).

t492

B.T McCallum

o f the overall project. Thus there is no necessary conflict between a robustnessoriented strategy and studies by individual researchers that involve construction o f
single models [e.g., Ireland (1997), Rotemberg and Woodford (1997)].
The lack of professional agreement over model specification also makes it difficult
to reach any firm conclusions about the proper goals o f monetary policy, as is
discussed at the end o f this section, before the related but more pragmatic issue
o f target variables is taken up. Other issues that are of greater technical interest
but less fundamental importance - for example, issues concerning operationality and
the simulation techniques appropriate for investigating a rule's properties - will be
considered below, in Section 6.
In any discussion of monetary policy, but especially in ones involving the design
o f rules, it is useful to adopt a terminology regarding goals, objectives, targets,
instruments, etc., that clearly reflects basic conceptual distinctions and at the same
time is reasonably orthodox (or at least non-idiosyncratic). With those criteria in
mind, we shall below use the word goals" to refer to the ultimate but typically nonoperational objectives of the monetary authority, and the term target to refer to
an operational variable that takes precedence in the actual conduct of policy. The
leading contenders for a central bank's target variable would be some comprehensive
price index, nominal GDP or some other measure of nominal spending, a monetary
aggregate, or a foreign exchange rate - with growth rates rather than (growing) levels
perhaps pertaining in the case o f the first three. The choice among target variables will
be considered in some detail in Section 4.
At the opposite end o f the scale from goals are instrument variables, i.e., the
variables that central banks actually manipulate more or less directly on a daily or
weekly basis in their attempts to achieve specified targets. For most central banks, some
short-term interest rate would be regarded as the instrument variable, but some analysts
continue to promote the monetary base (or some other controllable narrow aggregate)
in that capacity. It must be said that a term such as "operating target" would probably
be nearer to standard for central bank economists or even policy-oriented academics,
and there is a sense - to be described momentarily - in which it is more accurate
than "instrument variable". But in an article such as the present one it would seem
desirable to employ a terminology that promotes a clear distinction between target and
instrument variables. Thus we seek to avoid ambiguous usage such as "interest rate
targeting" to refer to a central bank's weekly instrument (or operating target) settings,
rather than its policy-governing target variable.
The sense in which "operating target" would be preferable to "instrument" is
as follows. Many actual central banks choose not to manipulate their interest rate
instruments in a literally direct fashion but rather to conduct open-market operations
only once a day with quantities chosen so as to be expected to yield a market-influenced
interest rate that lies within (or close to) some rather narrow band. The USA's Federal
Reserve, for example, typically enters the Federal Funds market only once a day
(normally around 10:30-10:45 a.m.) so the end-of-day or daily average value of the
Federal Funds rate (FF rate) can depart from the open-market desk's "target value" by

Ch. 23.. Issues" in the Design of Monetary Policy Rules"

1493

20-30 basis points on any given day. Thus writers such as Cook and Hahn (1989) or
Rudebusch (1995) will distinguish between "actual" and "target" values at the daily
level. But the Fed keeps the FF rate within a few basis points o f its operating target
on average over periods as short as a week. Thus there is little harm, in a study such
as the present one, in using the term instrument variable and pretending that the Fed
controls its interest instrument directly. There is, it should be said, a significant amount
of debate over the feasibility of a central bank's using one variable or another as its
instrument (even in our sense). Those issues will be taken up in Section 5.
In our terminology, then, a policy rule might be thought o f as a formula that specifies
instrument settings that are designed to keep a target variable close to its specified
target path. If rt and xt were the instrument and target variables, then, the simplest
prototype rule might be o f the form
r, = rt-i +)~(x~ 1 xi-l),

X < 0,

(3.1)

which specifies that the instrument setting should be decreased if xt fell short o f its
target value x T in the previous period. Somewhat more realistic examples involving
more variables and other timing patterns will be considered below.
Some writers have taken the position that the specification o f a policy rule is
complete when a target variable has been selected and a target path (or perhaps a
tolerance range) has been designated. Hall and Mankiw (1994, p. 79), for example,
recommend that the central bank behave so as to keep each period's externallygenerated forecast o f future nominal income equal to a value given by a selected target
path, but beyond that "we see no need to tel! it how to go about achieving the peg."
Also, Svensson (1997a) distinguishes between "instrument rules" and "target rules"
and expresses a preference for the latter, which specify target values but not instrument
settings 17. The position taken in the present chapter, however, is that a monetary
policy rule is by definition a formula that specifies instrument settings, with the choice
of a target variable and path constituting only one ingredient. For some particular
target choices it might be the case that the problem o f designing instrument settings
would be extremely simple or uninteresting, but in general such will not be the case.
McCallum's series o f rule studies (1988, 1993a, 1995a), for example, was undertaken
partly in response to a claim by Axilrod (1985) - who was at the time a principal
monetary policy advisor at the Fed's Board of Governors - that the achievement of
nominal GNP targets was technically infeasible. From this practical perspective, the
investigation o f a rule expressed in terms of a feasible instrmnent variable becomes

J7 As a related matter, Svensson has suggested that behavior conforming to a rule of the form (3.1)
should not be referred to as involving a x t target; that terminology should be reserved (he suggests) to
cases in which the central bank's instrument is set so as to make Etxt~/= xt*+j. But a rule such as (3.1)
with 3.(x~i - E~xt~:i) on the right-hand side leads to equivalent behavior in the limit as )~---,oo,and so is
a compatible but more general formulation.

1494

B.T. McCallum

an essential portion of the selection of a desirable target. For there is little point in
designating a particular target if in fact it is not achievable.
Svensson's (1997a) preference for what he terms target rules is not based on any lack
of interest in the instrument-target relationship, but stems (apparently) from a point
of view that does not recognize the difficulty emphasized above, namely, the absence
of a satisfactory model of the economy. Thus Svensson presumes that any change in
knowledge about the economy's workings will typically require some change in an
instrument rule, whereas "with new information about structural relationships ... a
target rule implies automatic revisions of the reaction function" [Svensson (1997a),
pp. 1136-1137]. Indeed, if the central bank were conducting policy by conducting
optimal control exercises each period with a single model, it would be true that changes
in the latter would typically entail changes in the implied instrument rule. But under
the presumption presented above, that it would be unwise to design a rule optimally
on the basis of any single model, Svensson's conclusion does not follow. Instead, if an
instrument rule has been designed so as to work reasonably well in a wide variety of
models, then new information about the economy's structure is unlikely to entail any
change in rule specification even when the rule designates instrument settings.
Terminologically, moreover, it seems best to distinguish between the choice of policy
rules and policy targets. The selection of a target variable is an extremely important
aspect of systematic policy-making and may involve sophisticated analysis, as in the
work of Svensson. But nevertheless a target is just that, a target. A rule, by contrast,
is a formula that can be handed to a central banker for implementation without any
particular knowledge of the analysts' views about model specification or objectives, in
any event, in what follows it will typically be presumed that the term monetary policy
rule refers to a formula or guide such as Equation (3.1) for period-by-period setting
of instrument values in response to specified conditions.
In evaluating candidate formulas such as Equation (3. l), it would clearly be desirable
to have at hand an established specification of the appropriate ultimate goals of
monetary policy. In that regard there exist important issues, such as whether a CB
should keep actual or expected inflation close to some normative value, what that
normative value is, and precisely how variability of output - or is it output relative
to capacity (measured how?) or consumption? - should be weighed in relation to
the inflation criterion. Now, in optimizing models that are specified at the level
of individuais' tastes and technology, such as Ireland (1997) and Rotemberg and
Woodford (1997), the answers to such questions are unambiguous and implicit in
the solution to the optimal control problem. But again the fundamental difficulty
mentioned above intrudes in a crucial manner, for these answers will depend nonnegligibly upon the specification of the model at hand 18. Consequently, the marked

is One rather prominent issue is whether there exists some externality that makcsthe appropriateoutput
reference value greater than the natural-rate value that is relevant for price and wage behavior. Another
crucial issue concerns the validity or invMidityof strict natural-rate hypothesis, i.e., the proposition that

Ch. 23:

Issues in the Design of Monetary Policy Rules

1495

absence o f professional agreement regarding model specification implies that there can
be (at least at present) no consensus as to the CB goals that are appropriate from the
perspective o f an economy's individuals. In practice, nevertheless, there seems to be a
substantial anaount o f agreement about actual (not ideal) CB objectives; namely, that
many CBs strive to keep expected inflation close to zero (allowing for measurement
error) and to keep output close to a capacity or natural-rate value that is itself a variable
that grows with the capital stock, the labor force, and technical progress 19. Although it
cannot be established that these objectives are optimal, it would seem to this writer that
they probably provide a fairly good specification o f appropriate CB macroeconomic
goals.

4. Choice of target variable

After a long dose o f preliminaries, let us now finally turn to substantive issues in the
design o f a monetary rule. In this section we shall be concerned with the choice o f
a target variable - both its idemity and the question o f whether its path should be
specified in growth-rate or level form. For the reasons just outlined, our discussion
will be pragmatic rather than theoretical in nature.
In recent years, the most fashionable target variable for the monetary authority has
been a nation's inflation rate - in other words, a comprehensive price-level variable
with its target path set in growth-rate terms. A great deal has been written about
inflation targeting in policy-oriented publications, and substantial scholarly efforts have
been contributed by A l m e i d a and Goodhart (1996), Bernanke and Mishkin (1997),
Goodhart and Vinals (1994), McCallum (1997a), and others, as well as the individual
authors represented in books edited by Leiderman and Svensson (1995) and Haldane
(1995). Other leading target-variable choices are aggregate spending magnitudes such
as nominal GNP or G D P - often in growth rate form - and a "hybrid" variable that
sums inflation and real output measured relative to some sort o f trend or reference
value 2. A l l o f these choices presume, however, that the economy in question does
not have its monetary policy dedicated to an exchange rate target, so a brief prior
discussion o f exchange rate policy should be appropriate.

output cammt be kept above its natural-rate value permanently by any monetary policy strategy, even
one that features a permanently increasing (or decreasing) rate of inflation [Lucas (i972)].
J9 This variable capacity value may, however, exceed the natural-rate value, as mentioned in footnotes
10 and 18, and as is typically assumed in the CB credibility literature.
2o The magnitude of inflation rates depends upon the length of a single time period whereas the
percentage (or fractional) deviation of output from its reference path does not. The usual convention
with this hybrid variable is to add percentage inflation rates measured lbr annual periods to percentage
output deviations. It would be equivalent to use inflation over a quarter plus one-fom'th of the relative
output deviation. Use of fractional units for both variables would also be equivalent, with appropriate
adjustments in the response coefficient. This last convention will be utilized below.

1496

B. T. McCallum

Perhaps the most basic of all monetary policy choices is whether or not to adopt a
fixed exchange rate. The principal considerations involved in this choice are those
recognized in the optimal currency area literature began by Mundell (1961) and
extended by M c K i n n o n (1963) and Kenen (1969). Basically, these all boil down to
the question of whether the lnicroeconomic (i.e., resource allocation) advantages of
an extended area with a single medium of exchange outweigh the macroeconomic
(i.e., stabilization policy) disadvantages of being unable to tailor monetary policy to
local conditions 2j. Some analysts [e.g., Bruno (1993), Fischer (1986)] have contended
that there are some macroeconomic advantages of a fixed exchange rate22 but the
arguments seem actually to be based on political or public-relations considerations,
not economic costs and benefits 23. Thus in the case o f small economies for which
large fractions of their market exchanges are international in character, and which
tend frequently to experience the same macroeconomic shocks as their neighbors and
trading partners, it is clearly advantageous to forgo the flexibility of an independent
monetary policy by keeping a fixed exchange rate (and common currency) with
a specified currency or basket of currencies 24. And at the other extreme, the
macroeconomic advantages o f a floating exchange rate would seem to be clearly
dominant for pairs of nations such as the USA, Japan, and the prospective European
monetary union.
The main point of the previous paragraph is that the advantages that might lead a
nation to choose to have a fixed exchange rate, and thus to dedicate its monetary policy
actions to that criterion, are basically either microeconomic or political in nature. Thus
the type of considerations involved are quite different than those that are involved in the
selection among macroeconomic target variables such as inflation, nominal spending
growth, or the above-mentioned hybrid variable. Because of the scope of the present
chapter, we shall henceforth focus our attention on the latter type of choice 25.

21 If a set of countries is to have permanently fixed exchange rates, it would seem that from a purely
economic perspective there are extra benefits (reduced transaction costs) with no extra costs of having a
common currency. (No ongoing costs, that is; there may obviouslybe significantchangeover costs, as in
the EMU example.) As for rates that are fixed, but not permanently,the European experiences of 1992
and 1993 support Friedman's (1953) classic argmnent that such an arrangement is undesirable because
of the self;destructive speculativeimpulses that are encomaged.
22 From the monetary-policyperspective, a moving peg or narrow bm~dfalls into the same category as
a fixed exchmlge rate, since it entails the dedication of monetary policy to its maintenance.
23 This statement is applicable to much of the literature relating to the planned European monetary
union, of course.
24 A relatively clear-cut example is provided by Luxembourg, which has had a monetary union with
Belgium since 1921 (except for an intenuption during World War II), Belgian francs serving as a legal
tender in both nations, Luxembourgalso issues franc notes and coins, but has kept these interchangeable
-with their Belgian counterparts.
25 It should be recognized, however, that it would be possible to consider a target that consists of a
weighted average of (say) exchange rate changes and inflation. This example couid alternatively be
thought of as an inflation target with an unusual specificationof the price index to be utilized.

Ch. 23: Issues in the Design of Monetary Policy Rules

1497

In the literature on this subject, which is large, the most popular approach is
to determine how well the various targets would perform in terms of yielding
desirable values of postulated social and/or policy-maker objective fimctions, with
these pertaining primarily to root-mean-square (RMS) deviations from desired values
of variables such as inflation or real GDP relative to capacity 26. Such studies may
be conducted with theoretical or estimated models, but in either case need to take
account of the various types of macroeconomic shocks that may be relevant - need
to take account, that is, of the variance, covariance, and autocovariance magnitudes of
the shock processes. Some of the leading examples of theoretical studies are those of
Bean (1983), West (1986), Aizenman and Frenkel (1986), Henderson and McKibbin
(1993), Frankel and Chinn (1995), Ratti (1997), and Ireland (1998), while welllcnown simulation studies with estimated models have been conducted by Taylor (1979,
1993a), Feldstein and Stock (1994), Haldane and Salmon (1995), and the individual
authors in Bryant et al. (1988, 1993).
In some of these studies it is pretended, for the sake of the issue at hand, that
the selected target variables are kept precisely on their target path; the Bean, West,
Aizemnan-Frenkel, Frankel-Chinn, Ratti, and (in part) Henderson-McKibbin studies
are of that type. Others, however, focus on RMS deviations in simulations with policy
rules expressed in terms of instrument variables. Proponents of the first approach
would argue, presumably, that they prefer to keep the issue of whether a variable
can be controlled separate from the evaluation of its effects if well-controlled. Those
who disagree would point out that there is little need to know such properties tbr
variables that in fact can be controlled only very poorly. Indeed, they might argue
that unless controllability is taken into account, the issue is simply that of specifying
an appropriate social objective function; i.e., that "targeting" is not the matter under
investigation. In this regard it is worth keeping in mind the point emphasized above,
namely, that there is in fact no professional agreement on the appropriate specification
of a dynamic macroeconomic model. This implies not only an absence of agreelnent on
the "true" social objective function, but also the absence of agreement on a matter as
basic as the listing of relevant macroeconomic shocks. Keynesians and real-businesscycle analysts, for example, would disagree sharply as to the very nature of the relevant
shock processes.
For the candidate target variables mentioned above, other than the hybrid variable,
an important question is whether it is preferable to specify a growth-rate target or one
of the growing-levels type, i.e., whetber the target should be specified in a differencestationary or trend-stationary manner. This issue is often discussed under the heading
of "inflation vs. price-level targeting," but similar considerations would apply if the
target variable were nominal GDP, some other measure of nominal spending, or even

~' These are the two valiables that are most closely related to the utility t~mctions of individuals m
explicit optimizing models such as those of Ireland (1997) or Rotemberg and Woodtbrd (1997).

1498

B.T. McCallum

a money-stock variable 27. Specifically, the weakness o f the growth-rate choice is that
it will - by treating past target misses as bygones - introduce a random walk (or more
general unit root) component into the time-series processes for all nominal variables,
including the price level. Thus there will exist a possibility that the price level would
drift arbitrarily far away from any given value (or predetermined path) as time passes,
implying considerable uncertainty as to values that will obtain in the distant future.
By contrast, the main disadvantage with a levels-type target path is that the target
variable will be forced back toward the preset path after any disturbance that has driven
it away, even if the effect o f the disturbance is itself o f a permanent nature. Since any
such action entails general macroeconomic stimulus or restraint, this type o f targeting
procedure would tend to induce extra cyclical variability in demand conditions, which
may imply extra variability in real output i f price-level stickiness prevails. Furthermore,
variability in output and other real aggregative variables is probably more costly in
terms o f human welfare than is an equal amount o f variability in the price level
about a constant or slowly-growing path. Also, although it is not entirely clear that
fully permanent shocks are predominant, most time-series analysis seems to suggest
that the effects o f shocks are typically quite long lasting - indeed, are virtually
indistinguishable from permanent. Consequently, it would seem desirable not to drive
nominal variables back to preset paths - or at least not to do so quickly and frequently.
Thus, it seems preferable to adopt a nominal target o f the growth-rate type, rather than
the growing-levels type 28.
One reason for the foregoing conclusion is that very few transactions are based
on planning horizons as distant as 50 years. A more representative long-lasting
arrangement might be more like 20 years in duration. But price-level uncertainty
20 years into the future might not be very large even i f the (log o f the) price level
included a unit root component. Suppose that the log price level were to behave as a
pure random walk relative to a preset target path (say, a zero-inflation path). Then i f it
is assumed that the random, unpredictable component at the quarterly frequency has a
standard deviation o f 0.0045 (which is approximately the standard deviation o f one-step
ahead forecast errors for the U S A over 1954-1991) 29, it follows that a 95% confidence
interval for the (log) price level 20 years ahead would be only about 8% (plus or
minus) 3. This, it seems to the writer, represents a rather small amount o f price level

27 Here and below the language will often be stated in terms of nominal variables such as nominal GDP
or a price index when it is the natural logarithm of that variable that is actually meant.
28 For alternative argmnents that reach this conclusion, which is taken for granted by Feldstein and
Stock (1994), see Fischer (1995) and Fillion and Tetlow (1994). The opposing position is taken by Hall
and Mankiw (1994) and Svensson (1996) [but see footnote 8 above].
29 Thus it is being tentatively assumed that the control error, if inflation targeting were adopted, would
have a mean of zero and a variance equal to that of the currently-prevailing one-step-ahead forecast
error, which might be taken as an approximation of the minimum feasible control error variance.
3o I am taking the control error to be serially lmcorrelated. Then the 80-period ahead error would have
variance (80) (0.00452) -0.00162 whose square root is 0.040. Thus two standard deviations equals 0.08

Ch. 23." Issues in the Design of Monetary Policy Rules

1499

uncertainty - at least in comparison with the magnitudes that prevailed over the 1960s,
1970s, and 1980s, because of non-zero and uncertain trend rates.
The foregoing argument seems moderately persuasive to the present writer, but it is
clearly not compelling and the conclusion is certainly not accepted by all analysts.
Furthermore, even if it were accepted, it might be possible to obtain the benefits
of trend stationarity by adopting a target that is a weighted average of ones o f the
growth-rate and growing-level types 31. Accordingly, in the simulations reported below,
consideration will be given to growth-rate, growing level, and weighted average types.
Now let us consider some points regarding the comparative merits of three leading
target-variable possibilities. Because they seem at present to command the most
support, we will discuss (i) the inflation rate, (ii) the growth rate o f nominal GDP, and
(iii) the above-mentioned hybrid variable. As some notation will be useful, henceforth
let xt, Yt, and Pt denote logs of nominal GDP, real GDP, and the price level (as
represented by the deflator so that xt = Yt +Pt), with time periods referring to quarteryears. Then the three contending target variables in their simplest form are Apt,
Act, and ht - A p t + 0.253~t, where yt - y t -j~t with )Tt denoting the reference value of
real GDR
In choosing among these three contenders, a straightforward approach would be to
select the target variable that corresponds most closely to the central bank's views
about social objectives that are influenced by monetary policy. From that perspective,
it would appear that the hybrid variable ht might be the most appropriate of the three, a
point o f view taken implicitly by Blinder (1996), with Axt arguably ranking second 32
But among actual central banks that have adopted formal numerical targets, virtually
all have (as o f early 1997) opted for inflation targets. So apparently the straightforward
approach is not the only one that needs to be considered.
There are undoubtedly several reasons for this tendency for actual central banks to
choose Apt over the others as their formal target, but three o f these seem justifiable
and in any event deserve to be mentioned. First, it is believed by a large number
of policymakers and a large number o f scholars that monetary policy has, from a

so a 95% confidence interval will have width roughly 0.08 or 8 percent. If the control error is serially
correlated, then the relative effect of the unit root term will depend on the autocorrelation pattern but
is likely to be more serious.
31 If used in a rule of form (3.1), this sort of weighted-average target would be equivalent to a pure
growing-levels target with both "proportional" and "derivative" feedback.
32 The case for nominal income targeting is that it should, from a long-term perspective, provide almost
as good inflation control as direct inflation targeting, since average real outpnt growth will be virtually
independent of monetary policy and reasonably ~brecastable, while probably providing somewhat better
automatic stabilization of real variables. About the latter advantage one cannot be certain, because of
the absence of professional understanding mentioned in footnote 14. The basic logic of nominal income
targeting applies, moreover, to other aggregative measures of nominal spending, not just to nominal
GDP or GNP per se. The sharp criticism of nominal income targeting recently expressed by Ball (1997)
is, it is argued below, fundamentally misguided.

1500

B.T. McCallum

long-rml perspective, no substantial effect on fit = Y t - ) S t 33. In other words, while

monetary policy may have significant effects on output relative to capacity, these are
only temporary. Therefore, so the argument goes, central banks should concentrate
their attention on the Apt variable that their policy actions affect strongly on a longrun basis 34. Second, measurement of)Tt and therefore )~t is difficult and controversial,
even in comparison to measurement o f Aps. We have described Yt as a capacity,
trend, or reference value, but that does not define the appropriate variable even in
conceptual terms, much less in operationally measurable terms 35. in particular, errors
in measuring )Tt are likely to be much larger than errors in measuring the long-term
average value o f Ayt, which is all that is necessary for correct design o f a Axt target.
Thus the ht target is more demanding o f knowledge concerning the economy than
is either o f the other contenders under discussion. The third reason is related to the
other two, especially the first. It is that communication with the public is thought by
practitioners to be much easier when only the inflation variable is involved. Typical
citizens have an understanding o f the concept o f inflation, so the argument goes, but not
o f the national income accounting concepts xt andyt, much less the reference value)Tt.
In addition, it must be mentioned that in practice actual inflation targets are typically
based on yearly average inflation rates, and with those values forecasted to prevail
1-2 years into the future 36. Since inflation forecasts are in practice based in part on
recent levels or growth o f real output, the three target variables under consideration
may be fairly closely related to each other. Furthermore, inflation targets are usually
accompanied by provisions stating that the occurrence o f "supply shocks" - such
as crop failures, terms-of-trade changes, or indirect tax-rate changes - will entail
temporary modification o f the current inflation target measures. Thus, for example,
the New Zealand legislation includes several such escape clauses - termed "caveats"
that are built into the Reserve Bank's targeting procedures 37.
Because o f considerations such as these, it would probably be unrealistic (and
unreasonable) to expect that a truly compelling argument could be made for any one
33 This proposition, often termed the "natural rate hypotlaesis", is subscribed to by a large fraction of
macroeconomic researchers.
34 This position is explicitly expressed by McCallum (1997a) and by Reserve Bank of New Zealand
(1993).
35 In recent years there has been a tendency, most marked in media discussions but also present in
professional literature, to speak as if "natural rate" and "NAIRU" conccpts and theories were equivalent.
To the present writer that is far from being the case. The strict version of the natural rate hypothesis, due
to Lucas (1972), is the proposition that there is no monetary policy that will keep output permanently
high in relation to its natural rate (i.e., market clearing) value. By contrast, the NAIRU (non-acceleratinginflation rate of unemployment) approach posits a stable relationship between tmemployment (or output
relative to its reference value) and the "acceleration" magnitude, i.e., the change in the inflation rate.
But the latter implies that permanent acceptance of a positive acceleration magnitude (i.e., increasing
inflation) will result in a permanent increase in output relative to its reference value, in stark contradiction
to the natural rate hypothesis.
36 Of course the same sort of averaging could be applied to the Axt and h~ variables.
37 On this subject, see Reserve Bank of New Zealand (1993).

Ch. 23: Issues in the Design of Monetary Policy Rules'

1501

0.06 l

o.o4.1

0.02 -

0.00
-0.02.

-004

~
60

_
65

[--

~
70

_
75

80

~
85

DLXGAP ....... DLPGAP . . . . .

90

95

ZERO I

Fig. 1. Gap measures for inflation and nominal GDP targets, 196~1995.
of the candidate target measures. Consequently, it should be of interest to compare
actual past values of the three leading measures with those values that would have
been called for if corresponding targets had been in place. For the purpose of this
exercise, it will be assumed that the desired value of Apt is 0.005, which amounts to
approximately two percent inflation on an annual basis. Also, for simplicity it will be
assumed that 37t values are given by deterministic trends obtained by regression ofyt on
time for the sample period under consideration. This last assumption is unsatisfactory,
of course - as will be discussed again - but should suffice for the limited purpose at
hand of making comparisons.
Let us first consider the time period 1960.1-1995.4, with United States GDP data
used for xt and with Yt based on GDP in 1992 fixed-weight prices (i.e., using the fixedweight rather than the chain-weight deflator). Over this period, the 37t trend variable is
given by the expression fit = 7.520749 + 0.006881t (with t = 1 in 1947.1). Therefore,
Aft = 0.006881 is assumed and the target value for Axt is 0.011881, with 0.005 being
the target value for both Apt and h , For each of the three variables we calculate
the gap between actually observed values and these retrospective, hypothetical target
values. These gaps are denoted Ap(gap)t - Apt - 0.005, Ax(gap)t = A& - 0.011881,
and h(gap)t = Apt + 0.25yt- 0.005. Their values for the first two variables (over
1960.1-1995.4) are plotted in Figure 1 and those for the second and third are plotted
in Figure 2.
In Figure 1 we see that the Ap~ and Axt targets both suggest that monetary policy was
excessively expansive most of the time between 1965 and 1989. The Ax(gap) measure
is considerably more variable from quarter to quarter than the Ap(gap) measure,
basically because Ayt is more variable than Apt. Averaging over the whole period, the
two measures give the same signals simply because the A& target value was calculated

1502

B.T. McCallum
0.06

0.04

0.02

0,00

-0.02.

-0.0460

65
[

70

75

80

85

DLXGAP ....... HGAP . . . . .

90

95

ZERO]

Fig. 2. Gap measures for hybrid and nominal GDP targets, 1960-1995.

so as to yield the desired inflation rate given the realized average growth rate of output
over the sample period, Of course, actual policymakers could not know this rate in
advance, when choosing their target value for Axt. Thus desired inflation would tend
to differ from the average realized value to the extent that average output growth is
forecast incorrectly. The magnitude of this error would not be large, however, when
averaged over long spans of time. By and large, a striking feature of Figure 1 is that the
two target variables do not give greatly different signals when averaged over periods
as short as 2-3 years. Nevertheless, there are a few quarters when the Axt variable
suggests that policy should be loosened whereas the Apt variable suggests the opposite,
and this situation prevails for over a year during 1990-1991. Those analysts who favor
Axt targeting believe, of course, that keeping Axt values steady would result in smaller
fluctuations in Yt than would a policy of keeping Ap~ values steady. Whether such is the
case in fact will depend upon the precise nature of the economy's short-term, dynamic
Phillips relation, a point emphasized in McCallum (1988, 1997a) 3s.
Figure 2 compares gap values for ht and Axt targets. In this case there is much more
divergence in signals, with the hybrid measure calling for more monetary expansion
over lengthy periods during the early 1960s and 1990s, and tighter monetary policy
during much of the 1970s, in. comparison with the zk~ct measure. (Of course both
measures signal that policy was too inflationary from 1965-1989, as before.) These
features of the plots in Figure 2 are basically a consequence of the fact that a linear
trend line for yt implies negative residuals in the early 1960s and 1990s and many

3~ See fbotnote 14 above.

Ch. 23:

1503

Issues in the Design of Monetaly Policy Rules

0.06.
0.04.
0.02-

-0.02-

8'5' '86 '87 '88

I

DLXGAP85

89

90

91

92

93

..... HGAP85 . . . . .

94

95

ZERO]

Fig. 3. Gap measures for hybrid and nominal GDP targets, 1985 1995.
positive residuals during the 1970s, which it does because o f the sustained period o f
rapid growth in real G D P from 1960 to 1973.
To emphasize this last point, Figure 3 gives results for the same type o f exercise
but with the sample period limited to 1985.1-1995.4. Here it will be noted that the
h(gap)t values are quite different from those for 1985-1995 in Figure 2, solely because
the y~ trend line is estimated differently and yields a significantly different residual
pattern 39. Now there are no major discrepancies that persist as long as in Figure 2,
although the two measures give quite different policy signals over most o f 1990 and
1992, the Axt target calling for a relatively more expansionary monetary stance in the
former year and a more restrictive stance in the latter year.
The sizable difference between the h(gap)t figures shown in Figures 2 and 3
illustrates the main weakness o f the hybrid target variable, namely, its sensitivity to
alternative calculations o f y t reference values. Proponents o f the hybrid variable might
argue that more sophisticated measures o f f t should be used, and it is certainly true
that our linear trends are not conceptually attractive. But neither are, say, HodrickPrescott (HP) filtered series, for reasons emphasized by Cogley and Nason (1995)
plus a recognition o f what the HP filter would imply about US GNP for the period
1929-1939 4. Other measures exist, but have attracted little professional support. In

39 It also has a reduced slope, which changes the definition of Ax(gap) to Axt 0.010336.
40 If the HP filter were applied to US real GNP over a period including 1929-1939, the HP "trend"
series would turn down fairly sharply during the early 1930s. If this series were used as one's measme
of trend or capacity output, it would then be concluded that the Great Depression was not very serious i.e., that output was low over 1932 1938 largely because capacity was low. But measured unemployment
figures suggest strongly that this conclusion would be misleading.

B.T. McCallum

1504

0.06 .
0'04 t
0.024
0.00-

--7~, ~

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

-0,02-

'6's ....

7'0 ....

7'6 ....

6'0 ....

6'2 ....

9'0 ....

9's

DLXFGAP ....... DLPFGAP ..... ZERO]

Fig. 4. Gap measures for inflation and nominal GDP values forecast 4 quarters ahead, 1960-1995.
sum, there is no widely accepted and conceptually sound measure for f~, but use o f
the hybrid target variable requires such a measure and its value is rather sensitive to
the particular measure adopted.
One weakness o f the indicators presented in Figures 1-3 is that they pertain to
currently-measured values of the target gaps whereas in practice actual central banks
focus upon gaps expected to prevail several months in the future. Also, Svensson
(1997a) has argued rather convincingly that "inflation forecast targeting" has several
attractive features. Consequently, indicators o f expected future gaps were obtained by
regressing gap values on information variables observed 4 to 7 quarters in the past.
The variables used in these regressions are Axt, Apt, Ab, and Rt (four lagged values
o f each), where bt is the log of the monetary base and Rt is the 3-month Treasury
bill interest rate. Also one lagged value o f fit was included; a second lagged value
would create perfect collinearity among the regressors. Values o f these forecasted
future gaps are presented in Figures 4 and 5, where the measures should be interpreted
as giving policy signals one quarter in advance of the dates shown. Clearly, the values
are smoothed greatly for zXxt and Apt, relative to the previous graphs, but the overall
messages remain the same: that there is apparently little basis for choice between
Axt and Apt while the ha indicator appears to give signals that are quite different.
Recently, Ball (1997) has put forth, in rather strong language, some striking
propositions regarding target variables 41. Among these are claims to the effect that
efficient monetary policy 42 consists o f a special case o f a Taylor rule that is equivalent

41 Some of these have been noted favorably by Svensson (1997a,b).

42 The paper's concept of"efficient monetary policy" is one that focuses on the variances of inllation and
output (relative to capacity) while assmning tmrealistically that the central bank has full contemporaneous

Ch. 23:

1505

Issues in the Design of Monetary Policy Rules

0.06 .
0.04 t
002

,,,

',

,:

",

" ~ , ' "~" i

0.00-"

;';

", , ,"~' ',',

"\l L';, -^""

b'

,J
-'V

-0.02

i , ,615 ....

7~0 ....

I --DLXFGAP

7~5 ....

810 ....

8~5 ~

90

95

....... HFGAP ..... ZERO]

Fig. 5. Gap measures for hybrid and nominal GDP values forecast 4 quarters ahead, 1961~1995.
to a partial-adjustment variant of inflation targeting (even when output variance
is important); that efficient monetary policy requires much stronger responses to
output fluctuations than is implied by historical practice or Taylor's (1993b) suggested
weights; and that nominal income targeting would be "disastrous" as it would give rise
to non-trend-stationary behavior o f output and inflation processes. These results are
shown to hold, however, only in a single theoretical model, with no attempt being made
to determine their robustness. In fact, the last one depends sensitively upon details of
the utilized model that are not justified either theoretically or empirically. The model's
Phillips curve, in particular, has a superficial similarity in appearance to the Calvo
Rotemberg specification as exposited by Roberts (1995), but differs by being backward
rather than forward-looking. If a forward-looking version were utilized, the implied
coefficient relating inflation to current output would have the opposite sign and Ball's
instability result would be overturned, as it would be with several other prominent
Phillips curve specifications,

5. Choice of i n s t r u m e n t variable
In this section we consider the choice o f a variable to serve as the instrument through
which a central bank's policy rule will be implemented. It is well known that, although
a substantial number o f academic economists have favored use o f a monetary base or

knowledge of all variables (oil this, see Section 6 below) Thus it simply assumes away thc first-order
problem of designing an operational rule that will generate the desired mean value tbr :r~ while avoiding
explosions.

1506

B. Z McCaHum

reserve aggregate instrument, almost all actual central banks utilize some short-term
interest rate in that capacity. Before turning to a review o f their relative desirability,
however, it will be appropriate to consider the sheer feasibility o f interest rate and
monetary base instruments, since there are a few scholars who have contended that
one or the other would be infeasible in some sense.
In this category the most well-known argument is that of Sargent and Wallace
(1975). That paper put forth the claim that, in a model in which all private agents are
free of money illusion and form their expectations rationally, the economy's price level
would be indeterminate if the central bank were to use an interest rate as its instrument.
Specifically, the Sargent-Wallace (1975) paper included a result suggesting that if the
interest rate Rt were set each period by means of a policy feedback rule that specifies Rt
as a linear function o f data from previous periods, then all nominal variables would be
formally indeterminate. Sargent (1979, p. 362) summarized this conclusion as follows:
"There is no interest rate rule that is associated with a determinate price level. ''43
Subsequently, however, McCallum (1981, 1986, p. 148) showed that the SargentWallace claim was actually incorrect in such a model; instead, all nominal variables are
fully determinate provided that the policy rule utilized for the interest rate instrument
involves some nominal variable, as suggested previously by Parkin (1978) and in the
classic static discussion of Patinkin (1961). The problem with the alleged proof o f
Sargent and Wallace is that it showed that the model at hand imposed no terminal
condition on the price level, but did not consider the possibility of an initial condition.
In the present context it is important to distinguish between two quite different
types of price-level behavior that have been referred to in the literature as involving
"indeterminacy". Both involve aberrational price level behavior, but they are nevertheless very different both analytically and economically. Consequently, McCallum
(1986, p. 137) proposed that they be referred to by terms that would recognize
the distinction and thereby add precision to the discussion. The proposed terms are
"nominal indeterminacy" and "solution multiplicity (or nonuniqueness)" 44, The former
refers to a situation in which the model at hand fails for all nominal variables (i.e.,
variables measured in monetary units) to pin down their values. Thus money stock
values and values o f (say) nominal income, as well as the price level, would not be
defined by the model's conditions. Paths o f all real variables are nevertheless typically
well defined. In terms of real-world behavior, such a situation could conceivably obtain

43 Sargent and Wallace (1982) advanced arguments quite different from those of their 1975 paper, and
attributed this difference to their use in (1982) of a model with agents who solve explicit dynamic
optimization problems, in contrast to the linear IS-LM model with a Lucas supply function in (1975). in
fact, however, the main relevant difference is that the 1982 analysis is based on a model in which
monetary and nonmonetary assets cannot be distinguished and hldeterminacy does not actually
prevail in any case. On this, see McCallum (1986, pp. 144-154). An important recent contribution
is Benassy (1999).
44 Actually,McCallam (1986) proposed "indeterminacy~ for the tormer, but the addition of the adjective
is clearly desirable.

Ch. 23:

Issues in the Design of Monetary Policy Rules

1507

if the monetary authority failed entirely to provide a nominal anchor 45. This type of
phenomenon has been discussed by Gurley and Shaw (1960), Patinkin (1949, 1961),
Sargent (1979, pp. 360-363), Sargent and Wallace (1975), McCallum (1981, 1986),
and Canzoneri, Henderson and Rogoff (1983), among others.
Solution multiplicity, by contrast, refers to aberrational behavior usually described
as involving "bubbles" or "sunspots" that affect the price level. In these situations it is
typically the case that the path of the money stock - or some other nominal instrument
controlled by the monetary authority - is perfectly well specified. Nevertheless, more
than one path for the price level - often an infinity of such paths - will satisfy
all the conditions of the model. In terms of real world behavior, arbitrary yet selfjustifying expectations is the source of this type of aberration. It has been discussed
by a vast number of writers including Taylor (1977), Sargent and Wallace (1973),
McCallum (1983), Brock (1975), Black (1974), Obstfcld and Rogoff (1983), and
Flood and Hodrick (1990). Nominal indeterminacy is a static concept that concerns
the distinction between real and nominal variables whereas solution multiplicity is an
inherently dynamic concept involving expectations.
An important application of this distinction is to the "indeterminacy" results of
Brock (1975, pp. 144-147) and Woodford (1990, pp. 1119-1122). These results
pertain to cases in which (base) money is manipulated by the central bank and
involve non-uniqueness of rational expectations equilibria when the imposed money
growth rates are low, close to the Chicago Rule rate that satiates agents with the
transaction-facilitating services of money. But since these equilibria involve wellspecified paths of nominal money holdings, the non-uniqueness is clearly not of the
nominal indeterminacy type. Instead, it is of the solution multiplicity type, involving
price level bubbles or sunspots. Such theoretical multiplicities may or may not
be of practical significance 46, but in any event are not examples of "price level
indeterminacy" in the sense of Gurley and Shaw (1960), Patinkin (1949, 1961), S argent
(1979, pp. 360-363), or Sargent and Wallace (1975). To some readers, this fact may
diminish the force o f Woodford's (1990, 1994) argument in favor of an interest rate
instrument.
Let us now return to the issue of instrument feasibility, switching to the extreme
opposite side of the debate. In a recent article, Goodhart (1994) has argued not just
that monetary base control by a modern central bank is undesirable, but that it is
essentially infeasible. In particular, Goodhart states that "virtually every [academic?]
monetary economist believes that the CB can control the monetary base . . . " so that
if the CB does not do so, then "it must be because it has chosen some alternative

45 And the system lacked sufficient inertia or money illusion to make the nominal paths determinate
requirements that are actually almost inconceivable.
46 It is unclear whether there is any compelling evidence in support of tile notion that macroeconomic
bubbles or stalspots are empirically relevant [Flood and Hochick (1990)]. In any event, it is a plausible
hypothesis that, in cases with an infinity of solutions, there is a single bubble-free or fundamentals
solution that obtains in practice.

1508

B.T. McCallum

operational guide for its open market operations" (p. 1424). But, he asserts, "almost all
those who have worked in a CB believe that this view is totally mistaken; in particular
it ignores the implications o f several o f the crucial institutional features o f a m o d e r n
commercial b a n k i n g system, notably the n e e d for unchallengeable convertibility, at
par, b e t w e e n currency and deposits, and secondly that commercial b a n k reserves at
the CB receive a zero, or below-market, rate o f interest" [Goodhart (1994), p. 1424].
T h e n as the discussion proceeds it b e c o m e s clear that Goodhart is h i m s e l f taking a
position that is predominantly, if n o t entirely, supportive o f the opinions o f those who
have worked in a CB. Thus he asserts, o n his own account, that "if the CB tried to
r u n a system o f m o n e t a r y base control, it would fail" (p. 1425). A n d he goes on to
outline the putative flaws in logic or factual knowledge that invalidate the cited views
o f academic economists (pp. 1424-1426).
In fact, however, although Goodhart's discussion is apparently i n t e n d e d to be
c o n c e r n e d with feasibility, the actual a r g u m e n t a t i o n presented pertains to desirability.
Specifically, the m a i n analytical points are those made in the first three complete
paragraphs o f p. 1425, which argue that tight base control would lead in practice to
overnight interest rates that at the end o f most days would equal either the CB's penal
rate or a value "near zero ''47. H a v i n g developed that point, Goodhart concludes as
follows: "Some economists might prefer such a staccato pattern o f interest rates, b u t
it would not seem sensible to practitioners" (p. 1425). But clearly this is an a r g u m e n t
that pertains to the desirability, not the feasibility, o f tight base control 48
H a v i n g concluded, then, that neither interest rate nor m o n e t a r y base i n s t r u m e n t s
are infeasible 49, we turn to the task o f considering their relative desirability 5. In that

47 If required-reserve averaging is practiced, then the statements referred to pertain only to days near
the end of reserve maintenance periods.
48 More extensive but still inconclusive arguments are presented by Whittaker and Theunissen (1987)
and Okina (1993). The latter presumes lagged reserve requirements, an arrangement that is inappropriate
with a base instrument [McCallum (1985)].
49 A different objection to use of a base instrument is that central batiks do not literally control the stun
of currency and reserves, since currency is demand determined and only the non-borrowed component
of total reserves is directly controlled, since banks can use the discount window to add to or subtaact
from reserve holdings. But there are three flaws with this position. First, since the base can be read from
the CB's own balance sheet, it can observe it frequently and make whatever adjustments are needed to
keep the magnitude closer to its target. Second, the CB could, if it chose, close the discount window.
Third, it would be possible to consider the non-borrowed base as the instrument under discussion.
s0 Brief mention should be made of a study by Howitt (1992), who finds that an interest rate peg would
lead to dynamic instability in a model that includes a sticky-price Phillips curve and a generalized
adaptive form of dynamic "learning behavior" rather than rational expectations. Whether or not one
finds the latter feature appealing, Howitt's results do not pertain to the issue at hand since the type of
"pegging" that he is concerned with involves keeping Rt at some preset value indefinitely, not varying Rt
period by period in an instrument capacity. Several writers have shown that, under rational expectations,
nominal indeterminacy does not prevail with an interest rate peg. Canzoneri, Henderson and Rogoff
(1983) and McCallum (1986) have established this in models of the IS-LM-AS type under the assumption
that the peg is a limiting version of a money supply rule designed to reduce interest rate fluctuations.

Ch. 23." Issues in the Design of Monetary Policy Rules

1509

regard, m o s t proponents o f a base instrument do not deny that such a r e g i m e w o u l d

involve substantially m o r e variability o f short-term interest rates than is e x p e r i e n c e d
under today's typical procedures, w h i c h involve interest-rate instruments and shortterm interest rate smoothing 51. B a s e proponents w o u l d contend, however, that with
a base instrument it m a y be possible to design simple p o l i c y rules that are m o r e
effective f r o m a m a c r o e c o n o m i c perspective than are c o m p a r a b l e rules with interestrate instruments 52, 53.
In order to illustrate the plausibility o f that contention, let us consider s o m e
counterfactual historical simulations o f the general type u s e d by M c C a l l u m (1988,
1993a, 1995a) with quarterly U S data. In order to keep the m o d e l specification from
biasing the results, the m a c r o e c o n o m e t r i c m o d e l in these simulations will be an
unconstrained V A R w i t h four lags included for each o f the four variables Ayt, Apt,
Abt, and Rt 54 H e r e Rt is the t h r e e - m o n t h treasury bill rate, bt is the log o f the St. Louis
Fed adjusted m o n e t a r y base, and G N P data is utilized for Yt and Pt. The estimation
and s i m u l a t i o n p e r i o d is 1954.1-1991.4.
We have seen above that there has not b e e n a large discrepancy, historically, between
signals p r o v i d e d by Ax~ and Apt targets, when the target values are gauged so as to
imply the s a m e average inflation rate. Accordingly, let us concentrate our attention on
rules for Abt and Rt designed to keep xt close to three target paths, all o f w h i c h provide
e x p e c t e d Axe, values o f 0.01125 ( i . e , approximately 4.5 n o m i n a l G N P growth per year,

Woodford (1990, 1994) and Sims (1994) extend tlfis type of result to a "pure peg" and conduct their
analysis in general equilibrium models with explicit optimization on the part of individual agents.
51 The concept of interest rate smoothing that I have in mind is keeping R~ close to Rt 1, but there
is no major conflict here with concepts such as a tendency to minimize E(Rt-Et iRt)2 [Goodfriend
(1987)].
52 The reason why design of a simple interest rate rule may be more difficult stems fxom the ambiguity
of nominal interest rates as indicators of monetary tightness or ease. High interest rates, that is, are
associated with tight monetary policy from a short-run or point-in-time perspective, but with loose
monetary policy from a long-ran (i.e., maintained) perspective. This means that the interest rate effects of
an open market action are in opposite directions ~?omshort-term and long-term perspectives. Accordingly,
the design of a policy rule for the control of target variables would seem to be more complex and
dynamically delicate if an interest rate is the instrument variable than if a nominal quantity variable
serves in that capacity.
53 One objection to use of a base instrument lbr the USA is that much of the currency component of
the base - which is by far the larger component - is believed to be held outside the comatry. Recently,
Jefferson (1997) has indicated that use of only that portion held in the country [as estimated by Porter
and Judson (1996)] alters the estimated relationship between the base and nominal GDR and yields
improved base-rule simulation results for the period 1984-1995.
54 The use of an unconstrained VAR is undesirable because such a model is almost certainly not policy
invariant. However, the small "structural models" used in McCallum (1988) are biased in favor of the
base instrument because the real monetary base (and no interest rate) appears as an explanatory variable
in these models' common aggregate demand relation. In Hess, Small and Brayton (1993), by contrasi,
the small macro model discussed on pp. 1 4 ~ t might be considered to be biased in favor of an interest
rate instrument. The author hopes to conduct simulations with a more appropriate model in the near
future.

1510

B. Z M c C a l l u m

designed to yield 2.0 percent inflation). These three paths will be of the growth-rate,
growing level, and weighted average types. For the monetary base instrument, the rule
to be considered is

Abt = 0 . 0 1 1 2 5 - ~ ( x t

1 - b t 1 - x t 17+bt 17)-t-/~(x] 1 - x t 1),

(5.1)

where ,~ > 0 is a policy adjustment parameter and the target variable x; can be defined
in various ways 55. To yield a growing-levels target, we would have x 21 = xt11 + 0.01125
whereas a growth-rate version would use instead x23 = xt 1 + 0.01125. Besides these,
we will consider x[ 2 = 0.2x] l + 0.8x)"3, where the weights are chosen semi-arbitrarily
but so as to give more importance to the growth-rate target.
According to the policy rule (5.1), monetary base growth is set in each quarter so as
to equal the target value for nominal GNP growth minus average base velocity growth
over the past four years 56, plus a cyclical correction term that reacts to past target
misses. Note that
x~31-&l =(xt2+0.01125)-x*l

.... 0.01125

A&.I

and that
x;21 x,-1 = 0.2(x~ll

x , q ) + 0.8(0.01125-zZv, 1)

= 0.2(Xtll-Xt 1)+ 0"8(z~Xt 1 --/~Ct 1)

so that use of x22 is equivalent to having a growing-levels target but using derivative
as well as proportional feedback, in the terminology o f Phillips (1954). So as to obtain
some indication of robustness to rule specification, a range of ;. values from 0 to 1
will be examined.
For the interest instrument rule, no velocity growth term is needed so the comparable
rule can be expressed as
Rt = Rt-I -

100~.(x2

1 - xt-I).

(5.2)

Thus, the value of the interest rate instrument is lowered relative to the previous
quarter when target spending x; exceeds the actual level in the previous quarter. The
- 1 0 0 factor is inserted so as to make the same range o f )~ values as in Equation (5.1)

55 This is the type of rule studied in McCallmn (1988, 1993a, 1995a).

56 The velocity connection term serves implicitly as a forecast of the average growth rate of base
velocity over the indefinite future, i.e., the long-lasting component of velocity growth that is due to
institutional change (not growth due to cyclical effects, which are accounted for in the third telan). More
sophisticated methods of forecasting the permanent component of both velocity growth and real output
growth would be used in practice by actual central banks.

Ch. 23." Issues in the Design of Monetary Policy Rules

1511

Table 1
RMS errors with base/interest instruments, rules (5.1) and (5.2), VAR Model, US Data 1954.1-1991.4
~ = 0.00

3.=0.25

Ni 1

0.0503
1.153

0.0235
expl a

0.0376
expl

expl
expl

x~2

0.0133
0.2415

0.0ll3
expl

0.0184
expl

expl
expl

x~3

0.0097
0.0184

0.0112
expl

0.0188
expl

expl
expl

x~ I

0.0503
1.153

0.0284
0.0619

0.0232
0.0381

0.0201
0.0254

x~2

0.0133
0.2415

0.0109
0.0155

0.0106
0.0123

0.0114
0.0147

x~3

0.0097
0.0184

0.0100
0.0105

0.0105
0.0107

0.0118
0.0142

RMS
error
relative to:

~ = 0.50

,~= 1.00

Panel A: x~ 1 target

Panel B: x2 2 target

Panel C: x~ 3 target

x~J

0.0503
1.153

0.0418
0.3321

0.0361
0.t825

0.0292
0.0959

x~'2

0.0133
0.2415

0.0123
0.0680

0.0117
0.0378

0.0116
0.0217

x~3

0.0097
0.0184

0.0099
0.0104

0.0102
0.0100

0.0111
0.0123

a expl, explosive oscillations.

a p p r o p r i a t e a g a i n 57. T h e s a m e trio o f x~ definitions is e m p l o y e d as with the b a s e

instrument.
Table 1 r e p o r t s results o f c o u n t e r f a c t u a l h i s t o r i c a l s i m u l a t i o n s e a c h u s i n g rule (5.1)
or (5.2) w i t h V A R e q u a t i o n s for Ayt, Apt, a n d e i t h e r Rt or A b , In these, e s t i m a t e d
r e s i d u a l s for Aye, Ap~, a n d e i t h e r Rt or Abt are f e d into the s y s t e m as e s t i m a t e s o f
s h o c k s that o c c u r r e d historically, w i t h the s i m u l a t i o n s b e g i n n i n g w i t h initial c o n d i t i o n s

57 The factor 100 is needed because R/ is expressed in tern~ls of percentage points whereas Ab~ is in
logarithmic (i.e., fractional) units. Comparability is not complete, however, because R t is measured as
percentage points on a per annum basis. Use of -400 as the scale factor would, however~ result m
dynamically unstable behavior for most 3~values over 0.25.

B.T. McCallum

1512

as o f 1954.1 and running for 152 periods 5s. The table's entries are RMS errors, i.e.,
deviations o f xt from target values x~, with the top figure in each pair pertaining to
the Abt instrument and the bottom figure to the Rt instrument. The three panels A, B,
and C refer to simulations with the three target values (x2 l, x~ 2, x~3), and for each
simulation the RMS error performance is reported relative to each o f the three target
paths. Thus, we are able to see if performance relative to alternative criteria is sensitive
to the target utilized, for each o f the targets.
Comparing the three panels we see that when tile levels target is used (with only
proportional feedback) performance is very bad with the Rt instrument, explosive
fluctuations in xt resulting with ,~ = 0.25, 0.5, and 1.0. Even with the base instrument,
the levels target does not perform too well and leads to instability when ;~ = 1.0. With
= 0.25, somewhat better performance relative to the xj'1 target path obtains than when
x~ 2 or x~3 is the target, but the difference is not large. Panel C, by contrast, shows
that when the pure growth rate target xt 3 is adopted, successful stabilization o f x~ is
achieved for all )~ values with both instruments. Performance relative to the growing
levels path x; 1 is much better in Panel B with the x; 2 target, however, and brings about
very little deterioration in performance relative to the pure growth rate criterion (i.e.,
the x; 3 path). Accordingly, the weighted average criterion xt 2 seems quite attractive,
as was noted for Japan in McCallum (1993a). Equivalently, application o f a limited
amount o f proportional as well as derivative feedback is evidently desirable 59
As for the comparison between monetary base and interest rate instruments, the
results in Table 1 are distinctly more favorable to the former. In only one o f 30 separate
comparisons 6 is the R M S error value smaller with the Rt instrument 61. And, more
significantly, the number o f cases in which explosive oscillations result is larger with
the interest instrument. These cases, should be noted, all involve the growing-levels
target, xt ~.
Some proponents o f an interest instrument might argue that it is important that
Rt be adjusted relative to a reference level, rather than to the previous quarter's value.
Following the practice o f Taylor (1993b), therefore, let us also consider performance
o f a rule o f the following type:

R t = 10010.029 + (Pt 1 --Pt 5)] - 100~(xt-1 -xt-1).

(5.3)

s8 Stochastic simulations, with shocks generated randomly, have been conducted by Judd and Motley
(t992) in a related study mentioned below in Section 6.
59 Judd and Morley's (1992) findings with regard to the use of some proportional control are less
encouraging, evidently because their mixture is more heavily weighted toward proportional control.
Also, they do not consider performance relative to the x*lt path when x*2~ is the target utilized.
60 Note that the first-colurrm cases are the same with the three different targets, since with ~ - 0 there
is no feedback from target misses.
(,I Michael Wood~brd has emphasized to me that there is no inherent interest in comparing base and
interest instruments with equal values of k; that we want to compare entire families. These comments
are correct. But Table 1 attempts to do that by scaling the 3, values - recall that the factor -100 has been
inserted in Equation (5.2) - so that instrument instability occurs for about the same value of (scaled))~.

1513

Ch. 23: Issues' in the Design o f Monetary Policy Rules

Table 2
RMS errors with level-style interest instruments, rule (5.3), VAR Model, US Data 1954.1-1991.4
= 0.00

3,= 0.25

x~
x~,2
x~3

0.3825
0.0809
0.0118

0.1541
0.0326
0.0104

x~l
x~2
x~3

0.3825
0.0809
0.01 t 8

0.2996
0.0630
0.0111

RMS
error
relative to:

2~- 0.50

2 - 1.00

Panel A: x~ 1 target

0.0915
0.0208
0.0108

0.0551
0.0169
0.0143

0.24l 6
0.0507
0.0110

0,1702
0.0366
0.0129

Panel B: x; z target

Panel C: x~ 3 target

x~t
x~2
x~3

0.3825
0.0809
0.0118

0.3687
0.0780
0.0118

0.3559
0.0754
0.0120

0.3328
0.0711
0.0153

Here the (p~_j pt 5) term uses the past year's inflation rate as a forecast o f the next
quarter's so as to make the rule one that sets a real interest rate in relation to the
(annualized) target value o f 0.029, which is designed to be consistent with a long-run
real interest rate o f 2.9 percent. The latter follows Taylor's (1993b, p. 202) suggestion
of using the sample average rate o f growth o f real output. The feedback term is as
before.
Results are presented in Table 2 for cases using rule (5.3) that are exactly analogous
to those in Table 1. |t will be seen that the performance is better than with interest
instrument rule (5.2) for all 12 comparisons when x~ 1 is the target, i.e., when a
levels target is utilized. A m o n g the 18 remaining comparisons, however, rule (5.3)
outperforms (5.2) in only a single case. So, it is unclear whether the levels form o f
interest instrument rule is superior to the form that calls for adjustment of R~ relative
to the previous quarter's value. In comparison to the base instrument, rule (5.3) avoids
the explosive outcome in the case in which 3, = 1 and the levels target x~ 1 is used, and
also does better relative to the x23 path in two more cases (with the levels target). But
for all cases in which the growth rate target x~ 3 or the weighted average target x/"
is used, the R M S error is larger with rule (5.3) than with (5.1) - and is substantially
larger when the criterion path is either x~ 1 or x~2.
It must be emphasized that the foregoing is just a single illustration, not a study
purporting to be conclusive - especially since the model used is o f the VAR t y p e

1514

B.T.. M c C a l l u m

Nevertheless, the apparent superiority o f the base instrument gives rise to the question
o f why it is that, in actual practice, almost all central banks utilize operating procedures
that are akin to use o f an interest rate instrument. It is almost certainly the case
that use o f a base instrument would entail more short-term interest rate variability,
but it is unclear that this would have any substantial social costs 62. One hypothesis
is that interest rate instruments and interest rate smoothing are practiced because
financial communities dislike interest variability and many central banks cater to the
wishes o f financial institutions with which they have to work in the course o f their
central-banking duties. The extent o f interest-instrument preference by CBs suggests,
however, that there are additional reasons. Accordingly, Goodfriend (1991) and Poole
(199l) have made interesting efforts to understand the Fed's attachment to an interest
rate instrument. Despite their contribution o f various insights, however, the question
remains unanswered 63.
M y own thoughts on the subject suggest two intelligible reasons for a CB to prefer a
R~ instrument, one having to do with beliefs concerning possible instrument instability
and the other involving the CB's role as a lender o f last resort. Regarding the former,
consider a grossly simplified base money demand function that includes lagged as well
as current interest rates:
bz = ao + a l R t + (x2Rt ] + th,

6It < O.

(5.4)

Here the absence o f price level and income/transaction variables reflects the presumption that their movements are slow in comparison to those of bt and Rt 64. N o w suppose
that the CB were to manage bf exogenously 65. Then Rt will behave as
R~ -- [30 + [3 t Rt 1 + [32 rh + [~3

(bt determinants),

(5.5)

where/31 = - a 2 / a l . Thus, if a2 < 0, there will be oscillations in Rt. More importantly,

if la2t > lal I, then the system will be explosive.
B e l i e f that market demand for the monetary base is such that la21 > la~ I represents
the actual state of affairs would then lead one to believe that use o f a base instrument
would be disastrous, as suggested by Goodhart. And, in fact, there is some reason to

(,2 Between 19'75 and 1987 the Swiss National Bank used procedures that were akin to use of a base
instrument. [See Rich (1987, pp. 11-13).] Short-term interest rate variability in Switzerland was much
greater than in other economies, but macroeconomic performance was excellent. (In 1987 there were
two major institutional changes, involving new required-reserve structures and a new clearing system,
that seriously disrupted monetary control and resulted in altered operating procedures.)
63 It is possible that Goodhart's (t 994) belief, that a base instrument would be infeasible, is shared by
many central bankers. But why? One possible reason is developed in the next two paragraphs.
64 This simplification should not be misleading for the purposes at hand, although it would be ~5tal for
many other issues. In Equation (5.4), th is a stochastic disturbance term.
65 Here l do not literally mean exogenous, but rather that bt is varied for macroeconomic reasons, not
so as to s m o o t h R t values.

Ch. 23: Issues in the Design of Monetary Policy Rules

1515

think that such beliefs might be held by central bankers. In particular, econometric
estimates o f base money demand functions (direct or indirect) sometimes indicate that
la2l > la~l in fact. Central bank analysts would be aware o f these estimates. My own
belief is that it is not true that fa2 ] > ]ctl [ holds in reality, for time periods of one month
or longer, so that the posited CB attitude is unjustified. 66 But it could be prevalent,
nevertheless, even if my belief is correct.
A second intelligible reason for CB interest instrument preference concerns the
lender-of-last-resort (LLR) role. That role is to prevent financial crises that involve
sharply increased demands for base money [Schwartz (1986), Goodfriend and King
(1988)]. To prevent such crises, the CB needs to supply base money abundantly
in times o f stress [Bagehot (1873)]. This is usually conceived o f as occurring by
the route o f discount-window lending. But Goodfriend and King pointed out that
a policy involving interest rate smoothing
i.e., not allowing R: to change much
relative to Rt t - would amomatically provide base money in times o f high demand 67.
Then if a CB is going to practice R~ smoothing it is quite natural for it to use a
R~ instrument 6s.
This last discussion leads one to consider the possibility o f using an interest rate
instrument - and smoothing its movements at a high frequency (e.g., weekly) so as to keep monetary base values close to target levels implied by a policy rule
such as (5.1). The motivation, of course, is the notion that quarterly base rules seem
to function better macroeconomically than interest rules. The preliminary investigation
in McCallum (1995a) attempts to study this question while accounting realistically and
in quantitative terms for shock variances and market responses in the US economy. The
results suggest that the federal funds rate could be manipulated weekly to approximate
monetary base values that are designed to hit desired quarterly-average nominal
GNP targets, with considerable smoothing o f the funds rate on a weekly basis (only
about twice as much weekly variability as now obtains).

6. Issues concerning research procedures

In this section consideration will be given to a number o f issues concerning procedures
used in investigations of the properties o f monetary policy rules. One set of issues has
to do with the operationality of various rule specifications while another set focuses

G6 In part my belief stems from the fact that for base demand in period t the value ofR t 1 is an irrelevant
bygone, so Rt 1 does not belong in a properly specified demand function. There are reasons, involving
omission of expectational variables, why econometric studies would nevertheless tend to find strong
R~ ~ effects. On this, see McCallum (1985, pp. 583 585).
67 As would a practice of keeping R~ from rising above some preset penal rate.
68 Goodfriend (1991, p. 15) and Poole (1991, pp. 37-39) observe, however, that this is not a stricl
logical necessity. Also, many actual CBs apparently do not accept the Goodfriend-King argument that
the LLR role can be fulfilled by Rt smoothing without discount-window lending.

1516

B. Z McCallum

on the types of simulations used to generate model outcomes. Regarding the latter,
a weakness of the simulation results reported above in Section 5, and also those in
McCallum (1988, 1993a, 1995a), is that they are based on simulation exercises with
a single set of shock values, i.e., shocks estimated to have occurred historically. As
explained by Taylor (1988) and Bryant et al. (1993), there are several advantages
to be obtained by using true stochastic simulations with a large number of shock
realizations generated by random selection from (multivariate) distributions that have
covariance properties like those of the historical shock estimates. The studies of Judd
and Motley (1991, 1992) for example, improve upon those of McCallum (1988) by
conducting "experiments" each of which consists of 500 stochastic simulations with a
given model, policy rule, and policy parameter values, rather than a single simulation
with the historical residuals used as shocks.
One obvious advantage of stochastic simulations over historical counterfactuals is
that they avoid the possibility that the historical residuals happen to possess some
particular quirk that makes performance unrepresentative for the shock moments being
utilized. Another advantage is that sample-mean values of shocks may not equal
zero, as they must by construction in the case of historical residuals. This feature is
especially important in considering the consequences of rules that feature difference
stationarity (rather than trend-stationarity) of nominal variables. The residual values
used as shocks in the simulations in Tables 1 and 2, for example, sum to zero for each
equation's shock tenn. Thus the extent of a tendency for xt (say) to drift away from
a levels target path such as xt 1 is understated by the results in those tables 69. Bryant
et al. (1993, pp. 373-375) suggest that, in addition, stochastic simulations are helpful
from a robustness perspective.
Perhaps the most ambitious project undertaken to date on the characteristics
of alternative monetary policy rules is the Brookings-sponsored study reported in
Bryant et al. (1993). In this study, which is a follow-up to Bryant et al. (1988),
eight prominent modeling groups (or individuals) reported on policy rule simulation
exercises conducted with the following multicountry models: GEM, INTERMOD,
MSG, MX3, MULTIMOD, MPS, LIVERPOOL, and TAYLOR. These studies were
designed to explore the macroeconomic consequences of adopting different target
variables for monetary policy, with contenders including nominal GDP (in levels form)
and the hybrid variable discussed above in Section 4, as well as monetary aggregates
and the exchange 'rate. Most impressively, the conference organizers took pains to
arrange for the various modeling groups all to consider the same range of policy
alternatives, thereby creating the possibility of obtaining results that would gain m
credibility as a consequence of being relatively robust to model specification. At
the strategic level of research design, therefore, this Brookings project possessed the
potential for contributing greatly to knowledge concerning the design of monetary

69 Understated, but not entirely absent; thne plots of xt hldicate the absence of any path-restoring
behavior except toward the end of the 152-quartersimulation (and sample) period.

Ch. 23: lssues in the Design of Monetary Policy Rules

1517

and fiscal policy rules (even in the face of potential weaknesses of the models'
specifications).
It is argued in McCallum (1993b, 1994), however, that this potential was significantly undermined by the particular generic form of policy rule specified for use
by all the modeling groups. The alleged problem is that the rule form permits rule
specifications that are not operational and, in addition, suggests performance measures
that can be seriously misleading. The rule form in question, which has also been used
in several other studies, may be written as
Rt - Rbt

=/l(zt

- z~),

(6.1)

where Rt is an interest rate instrument and zt is a target variable such as nominal GDP.
Here the "b" superscripts designate baseline reference paths for the variables, baseline
paths that may be defined differently by different investigators. Also, the performance
of various targets is evaluated by measures such as E[(zt - - Z bt ~~2 l J, which pertain to target
variable(s) for the rule and perhaps also other criterion variables.
In terms of operationality there are two problems with this rule form (6.1)7o. The
more obvious is that it is unrealistic to pretend that monetary policymakers can respond
to the true value of current-period realizations of zt for several leading specifications
of the latter. It is reasonable to assume that contemporaneous observations are
available for interest rates, exchange rates, or other asset-market prices. It would be
unreasonable, however, to make such an assumption for nominal or real GDP (or GNP)
or the price level. One could make arguments pro and con in the case of monetary
aggregates such as M1 or M2, but in the case of national-income values, data are not
produced promptly enough for actual central bankers to respond to movements without
an appreciable lag. Ignoring that lag, as is done throughout the Bryant et al. (1993)
studies, clearly makes it possible for the simulated performance to be significantly
better than could be obtained in reality. Furthermore, simulations that ignore this lag
also intend to understate the danger of instrument-induced instability, a bias that is
quite important because instrument instability is one of the most serious dangers to
be avoided in the design of a policy rule.
The second and less obvious way in which rules like (6.1) are not operational
involves the baseline values R ) and z ). ttere the problem is that an actual policymaker
could not implement any rule of form (6.1) without knowledge of these reference
paths. But by definition these paths may be related to each other by the model being
investigated, so the policy rule is model-specific and therefore of reduced interest to
a practical policymaker.
In terms of misleading performance measures, the problem is that the instrumem
variable under consideration may be one that can be used to smooth out fluctua~
tions in zt but not to control the long-term growth o f z , Then by using fluctuations in z,

70 It should be noted favorablythat the instrument variable is operational and realistic.

1518

B. 717.McCallurn

relative to the baseline path z b in a performance measure like E [ ( z t - - z b ) 2 ] , the

investigator may conclude that Rt is a desirable instrument when in fact it is highly
unsuitable 71.
Another type of nonoperationality involves the specification of instrument variables
that would, in actual practice, be infeasible in this capacity. Broad monetary aggregates
such as M2 or M3 would seem clearly to fall into this category and, under typical
current institutional arrangements, probably the same applies to variants of M1. Studies
that pretend that such variables are feasible instrument have declined in frequency
in recent years, as the practice of specifying an interest instrument has gained in
popularity [e.g., Taylor (1993a), Bryant et al. (1993), Fuhrer and Moore (1995)].
Objections based on the operationality criterion have been directed at rules that use
nominal GDP or GNP targets, even when these rules refer only to values lagged by at
least one quarter. The point is that national income statistics are not produced often
enough or quickly enough, and are significantly revised after their first release. But this
criticism seems misguided since the essence of nominal income targeting is to utilize
some rather comprehensive measure of aggregate (nominal) spending; the variable does
not need to be GDP or GNP p e r se. Other measures could readily be developed on the
basis of price and quantity indices that are reported more often and more promptly -in
the USA, for example, one could in principle use the product of the CPI and the Fed's
industrial production index (both of which are published monthly). It might even be
possible to develop a monthly measure that is more attractive conceptually than GDP,
by making the price index more closely tailored to public perceptions of inflation and/or
by using a quantity measure that treats government activity more appropriately.

7. Interactions with fiscal policy

The relationship between monetary and fiscal policy has been quite an active topic
recently, possibly in part as a response to the magnitude and duration of fiscal
deficits experienced in many developed countries and/or to controversies concerning
proposed fiscal rules for the planned European monetary union. It is obviously
impossible to discuss in this chapter all of the many ramifications of monetary/fiscal
policy interactions, but it seems important to recognize some recent arguments which
suggest that it is necessary, or at least desirable, for the monetary authority to take
account of fiscal policy behavior when designing its monetary policy rule 72. Such a
recommendation is implicitly critical of the policy rules discussed in previous sections
and runs counter to the spirit of much current central-bank thinking, as expressed for
example in the practice of inflation targeting. Consequently, three strands of literature
will be considered.
:1 Some examples are described in McCallum (1994).
72 Among these contributions are papers by Alesina and Tabellini (1987), Debelle and Fischer (1995),
Leeper (1991), Sims (1994, 1995), and Woodford (1994, 1995).

Ch. 23: Issues in the Design of Monetary Policy Rules

1519

An early paper on the subject that has received a great deal of attention is the Sargent
and Wallace (1981) piece entitled "Some Unpleasant Monetarist Arithmetic". As many
readers will be aware, that paper's principal contention was that an economy's monetary
authority cannot prevent inflation by its own control of base money creation if an
uncooperative or irresponsible fiscal authority behaves so as to generate a continuing
stream of primary fiscal deficits 73. Whether the central bank has control over inflation
is viewed as depending upon, in the words of Sargent and Wallace (1981, p. 7),
"which authority moves first, the monetary authority or the fiscal authority. In other
words, who imposes discipline on whom?" Having posed the problem in that way,
the Sargent-Wallace paper then goes on to suggest that it might well be the fiscal
authority that dominates the outcome. In fact, however, the paper's analysis proceeds
by simply assuming that the fiscal authority dominates, an assumption that is implicit
in the procedure of conducting analysis with an exogenously given path of primary
deficits. Proceeding in that fashion, the Sargent-Wallace paper seems to show that
even a determined central bank could be forced by a fiscal authority to create base
money along a path that is inflationary when a non-inflationary path is intended.
It is argued by McCallum (1990a, pp. 984-985), however, that this suggestion is
unwarranted. It is of course true that fiscal authorities may be able to bring political
pressure to bear on central banks in ways that are difficult to resist. But the SargentWallace analysis is not developed along political lines; instead it seems to invite the
reader to conclude that a politically independent central bank could be dominated
in some technical sense by a stubborn fiscal authority. My basis for disputing this
is that an independent central bank is technically able to control its own path of
base money creation, but fiscal authorities cannot directly control their own primary
deficit magnitudes. The reason is that deficits are measures of spending in excess
of tax collections, so if a fiscal authority embarks on a tax and spending plan that
is inconsistent with the central bank's (perhaps non-inflationary) creation of base
money, it is the fiscal authority that will have to yield. Why? Simply because in this
circumstance, it will not have the purchasing power to carry out its planned actions 74.
In other words, the fiscal authority does not actually have control over the instrument
variable - the deficit - that it is presumed to control in the Sargent-Wallace experiment.
Thus a truly determined and independent monetary authority can always have its way,
technically speaking, in monetary versus fiscal conflicts. This simple point is one tha~
seems to the author to be of great importance in the design of central bank institutions.
The point is also intimately related to a quite recently developed body of theorizing
that takes a strongly "fiscalist" stance, leading examples of-which include Woodford

73 The result pertains to primary deficits, i.e., deficits exclusive of interest payments, but not to deficits
measured in the conventional interest-inclusive way.
74 This is directly implied by the government's budget constraint which limits purchases to revenue
raised by taxes, net bond sales, and base money creation. In this regard it should be recognized that the
government cannot compel pfivatc agents to buy its bonds (i.e., lend to it), since such would represent
taxation.

1520

B.77 McCallum

(1994, 1995), Sims (1994, 1995), and Leeper (1991). Perhaps the most dramatic
theme in this literature is the presentation o f a "fiscal theory o f the price level"
[Woodford (1995, pp. 5-13), Sims (1994)]. For an introductory exposition and
analysis, let us consider the simplest case, which involves a Sidrauski-BrockT5
model with constant output y and utility function u(ct, mr)+ [3u(ct+l, m r + t ) + . . , with
u ( c , m ) = (1 - a ) - I A l c 1-~ + (1 - rl) IA2ml-rl, where a, , / > 0 and fi = 1/(1 + p ) with
p > 0. Also we assume t / < 1, in order to facilitate presentation o f the fiscalist theory,
not the counter-argument outlined subsequently. In this setup, the households' firstorder conditions include
mt+l _ A R 1/8
Pt+l
t ,
1 P, 1

l + R, - / 3 P, '

A =

R, > 0

(7.1)

(7.2)

for all t = l, 2 . . . . . Here Pt is the money price o f output, Mt is nominal money at the
start o f period t, mt = M t / P , ca is consumption during t, and R is the rate o f interest
on government bonds, the household's budget constraint being
Pt(Y

vt) - Ptct + Mt+l - M t + (1 + Rt)-I Bt+l _ Bt '

(7.3)

where vt is lump-sum taxes and Bt is the nominal stock o f bonds at the end o f t. In
per-household terms, the government budget constraint with zero purchases is
- P t v t = Mt+j - M r + (1 + Rt) 1Bt+l - B~,

(7.4)

so vt is the per-household value o f the fiscal surplus. If the government chooses time
paths for M t and vt (or Bt), then Equations (7.1)-(7.4) give equilibrium values for ct,
Pt, Rt, and Bt (or vt) provided that two transversality conditions are satisfied, these
requiring that [3tMt/Pt and [3tB/pt approach zero as t---+ oo. Note that Equations
(7.3) and (7.4) imply ct = y , the constancy o f which is utilized in formulations
(7.1) and (7.2).
Following the fiscalist argument v6, now suppose that the value o f Mr is kept constant
at M and that vt = v > 0 for all t = 1, 2 . . . . . Then the price level is determined as
follows. The GBR can be written as

b._, = (1 +RO

[b,-v~] = B1 b , - l

(7.5)

implying that bt = B,/P~ will explode as t ~ o c , since 1/fi > l, unless it is the case that
B1/P1 = o/(1 -/~), which would induce bt to remain constant at the level bt = v / ( l [3)
75 That is, a model in which infinite-lived households with time-separablc preferences makc their
decisions in a optimizing fashion and interact with each other and the government (monetary authority
and fiscal authority) on competitive markets. Woodford's (1995) version of the model, and ours, does
not include capital goods but that feature of the setup is not relevant to the issues at hand.
76 I am indebted to Michael Woodford for special efforts to explain the argumcnt to me, bm lie is
certainly not responsible for the point of view expressed here.

Ck. 23: Issues in the Design of MonetalT Policy Rules

1521

thereafter. Therefore, so the theory says, PI = B1 (l -/3)/v is determined by the fiscal

surplus magnitude v and the initial stock of nominal debt B1. At the same time,
Equations (7.1) and (7.2) imply a difference equation relating Pt+~ to Pt in an
unambiguously explosive fashion, starting from P1, provided that PI exceeds a critical
value Pc. That explosion in Pt makes M / P t approach zero and so, with bt constant,
both transversality conditions are satisfied although Bt is exploding. Thus the fiscal
theory of the price level asserts that with a constant money stock and constant fiscal
surplus, the price level explodes as time passes, starting from a level that is directly
related to the size of the pre-existing nominal bond stock and to the magnitude of the
maintained surplus. No other path could be an equilibrium because it would imply an
exploding bt, which would violate a transversality condition.
The foregoing is an ingenious argument but, in the opinion of the writer, is open
to a crucial objection. It is that there is another equilibrium - typically ignored by
fiscalist writers that does not rely upon explosive-bubble behavior of the price level.
This more fundamental "monetarist" equilibrium features Pt+l = P t - MPl/'t/A, i.e.,
a constant price level, together with values Bt+l = 0 for all t = 1, 2 , . . . . With these
paths for Pt and Bt it is clear that Equations (7.1)-(7.3) and both transversality
conditions are satisfied. It might be objected that this solution does not satisfy the
budget constraint (7.4) for the values of vt = v specified by the fiscalist writers, but it has
been argued above that the fiscal surplus is actually not a variable that can legitimately
be specified as exogenous 77. What the monetarist solution says is that if the fiscal
authority tried to keep vt = v as in the fiscalist solution, then households would refuse
to purchase the bonds that are required to be sold by the fiscal authority. It would be
necessary to distinguish between bonds supplied in (7.4) and bonds demanded in (7.3),
with Bt = 0 in the latter. If there were an initial stock of bonds outstanding, B I ~ 0, then
they would be retired in period 1 with a resulting real primary surplus of B1/P1.
In sum, a formally correct and arguably more plausible solution than the fiscalist
candidate is one in which the price level remains constant, with a magnitude that is
proportional to the money stock. At the same time, the stock of bonds offered for sale
by the fiscal authority may be explosive bm if so these bonds will not be purchased by
optimizing households. The fiscal authority's realized surplus will then be zero after the
initial period leaving us with a traditional non-fiscalist result 78. There are, of course,
several other cases and more complex models featured in the recent fiscalist literature~
indeed, a rather bewildering variety. But it would appear to the present writer that the
sta'iking fiscalist outcomes typically result from emphasizing the possibility of bubble

77 This is also the basis for the argument hi a recem paper by Buiter (1998), which reaches conclusion,s
predominantly compatible with those presented here.
78 Note that it is not being claimed that this is the only solution, but merely that it is a solution (and
one that might be thought likely to prevail by analysts who are skeptical of the empirical importance of
macroeconomic bubbles).

1522

B.T. McCallum

solutions while ignoring the existence of a non-bubble or fundamentals solution that

would deliver an entirely traditional policy message. 79, 8o
The third strand of the monetary-fiscal interaction literature to be discussed is
represented by papers by Alesina and Tabellini (19 87) and Debelle and Fischer (1995).
In the former, the workhorse Barro-Gordon model is extended by assuming that real
government purchases are controlled by a fiscal authority (FA) that may have different
objectives - concerning the level of these purchases as well as inflation and output than those of the central bank (CB). The FA's revenues come from non-lump-sum
(distorting) taxes and money growth, government debt being excluded from the m o d e l
In this setting, Alesina and Tabellini derive outcomes pertaining to both discretionary
and rule-like behavior by the CB 81. Their most striking result is that when preferences
of the CB and the FA are sufficiently different 82, equilibrium outcomes with monetary
policy commitment can be inferior 83 to those obtained under discretion. This result is
with independent behavior by the CB and FA, so the message is that monetary-fiscal
policy cooperation is needed.
In a more recent paper, Debelle and Fischer (1995) have modified the AlesinaTabellini framework by also including a social objective function, one that can be
different from those of the CB and FA. Only the latter cares, in their setup, about the
level of government purchases. In this model, Debelle and Fischer conduct analysis
always assuming discretionary behavior by the CB but under different assumptions
regarding the Stackelberg leadership positions of the CB and FA. A major aim of the
analysis is to determine the optimal value, in terms of society's preferences, of the
"conservativeness" of the CB, i.e., the relative importance that it assigns to ilfftation.
It is not optimal, they find, for the CB's preferences to match those of society - i.e.,

79 Dotscy (1996) shows that a reahstic specificationof parameter values gives rise to a more traditional
policy message than one promoted in the fiscalist literature, for an issue concerning the responsiveness
of the CB to fiscal variables under the assumption that the fiscal anthority's policy rule tends to prevent
debt explosions.
8o One other feature of the recent fiscalist literature is its contention that pegging the nominal interest
rate at a low value will result in a correspondinglylow inflation rate and in no indeterminacyproblem,
implying that such a policy would be preferable to the maintenance of a low growth rate of the (base)
money supply. The analyticalkey to this argument is that explosive price level (bubble) solutions, which
are possible with a low money stock growth rate, would be precluded by a constant interest rate in
models with a well-behaved (possibly constmat) real rate of interest - see, e.g., Equation (7.2) above.
It has been established above, however, that when money growth is exogenous, the possible aberration
reflects multiple (bubble) solutions, not nominal indeterminacy.But the empirical relevance of bubble
solutions for macroeconomicvariables is dubious, this writer would contend, and if such solutions are
not relevant then the theoretical disadvantage for the low money growth policy is itself irrelevant.
81 In the absence of debt, the FA has no incentive for dynamic inconsistency, i.e., no commitment
problem.
82 The CB is assumed to assign at least as much weight to the inflation rate (relative to each of the
other goal variables) as does the FA.
83 Inferior in terms of both authorities' prelbrences; the private sector is assumed to care only about
real wages.

Ch. 23." Issues in the Design of iVlonetary Policy Rules

/523

the private sector. And they find that it is undesirable socially for the FA to dominate
(in a Stackelberg sense) the CB, requiring the CB bank to finance FA deficits 84
An objection to this last strand of analysis stems from its reliance on the presumption
that an economy's CB and FA will have preferences that differ from each other's and
from social (i.e., household) preferences. While such might be the case in some nations,
one would expect that in democratic societies, CBs and FAs will be aware of and tend
to reflect the basic preferences of the population. That tendency might be combatted
by various devices, but it seems likely that (e.g.) attempts to appoint CB governors
with tastes more anti-inflationary than society's would often result in ex-post surprises
regarding these tastes. Also, one might expect that fiscal or monetary legislation would
be overturned fairly promptly if it were to yield results that are truly inconsistent with
the preferences of the society's voters. In any event, it would seem that designing
institutions nnder the presumption that CB and/or FA preferences differ from those of
the society at large is unlikely to be fruitful.

8. Concluding remarks
This final section will consist of a brief and perhaps opinionated recapitulation of
conclusions obtained for the main topics of discussion. First, in actual practice the
defining characteristics of rule-like behavior are that the central bank conducts policy
in a systematic fashion, and while doing so systematically abstains from attempts to
exploit existing expectations for temporary gains in output. Central banks can behave
in this committed manner if they choose; there are dynamic-inconsistency pressures
on them to act in a more discretionary fashion, but there is nothing tangible to prevent
committed behavior. Indeed, the adoption o f a monetary policy rule is one technique
for overcoming discretionary pressures.
In terms of research strategy, the chapter's discussion has promoted the robustness
approach - i.e., searching for a rule that works reasonably well in a variety of models
rather than the more straightforward approach of deriving an optimal rule relative to
a particular model, No strong claims are made in this regard, however, and the value
of the optimal design approach is recognized. The importance of operationality of any
proposed rule is also emphasized, as well as the merits of stochastic simulations as
opposed to simpler historical counterfactual simulations.
Regarding the choice of a target variable, the chapter suggests that in practice the
difference between an inflation target and one that aims for nominal spending growth,
at a rate designed to yield the same target inflation rate on average, is unlikely to
be large. More dissimilar is the hybrid target variable that adds together inflation and
output relative to capacity. This hybrid variable is probably more closely related to

~4 Of course, it is argued above that tile FA will not be able to dominate if the CB has independence
(i.e., can choose its own base money creation rates),

1524

B. Z McCallum

actual central bank objectives, but the absence o f any reliable and agreed-upon method
o f measuring capacity or trend output creates a major drawback for this variable. Also,
it is argued that the magnitude o f future price-level uncertainty, introduced by the unit
root component that results from a growth-rate type of target, is probably rather small.
Thus growth-rate targets appear somewhat more desirable than growing-level targets
as the latter requires stringent actions to drive any nominal target variable back toward
its predetermined path after shocks have led to target misses.
Turning to the choice o f an instrument variable, the chapter presents a small bit
o f evidence designed to illustrate why it is that a number o f academic economists
are inclined to prefer quantity instruments, such as the monetary base, rather than
short-term interest rates. The exposition includes arguments against some literature
claims that either short-term nominal interest rates or the monetary base are infeasible
as instruments. In this discussion, particular emphasis is given to the distinction
between two quite different types o f abberational price level behavior, namely, nominal
indeterminacy and multiple solutions. The former has to do with the distinction
between real and nominal variables while the latter concerns self-fulfilling dynamic
expectational phenomena - i.e., bubbles. Also, the former pertains to all nominal
variables whereas the latter involves real variables.
Finally, with regard to prominent fiscalist positions two points are made. First,
the recently developed fiscal theory o f price-level determination typically leads to a
solution that is not unique; there also exists a less exotic bubble-free solution that
has a much more traditional (indeed, monetarist) flavor. This conclusion stems from
recognition that central banks can dominate in any conflicts with fiscal authorities.
Also, there are some results in the literature that suggest that monetary/fiscal
cooperation is important, but these depend upon the assumption that central banks
and fiscal authorities have fundamentally different objective fimctions. It is doubtful
whether such an assumption can play a fruitful role in the design o f desirable central
bank institutions and behavior patterns.

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1525

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Chapter 24

I N F L A T I O N STABILIZATION A N D B O P C R I S E S IN
DEVELOPING

COUNTRIES

GUILLERMO A. CALVO

University of Maryland
CARLOS A. VEGH**

UCLA

Contents
Abstract
Keywords
1. Introduction
2. Understanding chronic inflation
2.1.
2.2.
2.3.
2.4.
2.5.
2.6.

Inflation as an optimal tax

Shocks and accommodation
Multiple equilibria
The "provinces" efl~ct
Delayed stabilization
In conclusion

3. Evidence on the real effects of stabilization in chronic-inflation countries

1533
1533
1534
1536
1537
1538
1539
1540
1540

1541

1541
1543
1547

3.1. Exchange-rate-based stabilization: empirical regularities

3.1.1. Stabilization time profiles
3.1.2. Panel regressions
3.1.3. Do exchange-rate-based stabilizations sow the seeds of their own destruction?
3.2. Money-based stabilization: empirical regularities
3.3. Recession now versus recession later
3.4. A word of caution

1550
1553
1554
1557
1559

4. Exchange-rate-based stabilization I: inflation inertia and lack of credibility

1562

4.1. Inflation inertia

1562

" We are grateful to Francesco Daveri, David Gould, Amartya Lahiri, Carmen Reinhart, Sergio
Rodriguez, Jorge Roldos, Julio Santaella, John Taylor, Aaron Tornell, Martin Uribe, Sara Wong,
Mike Woodford, Carlos Zarazaga, participants at the conference on "Recent Developments i~
Macroecononomics", organized by the Federal Reserve Bank of New York (February 1997), and,
especially, Ratna Sahay and Miguel Savastano for insightful comments and discussions.
** Corresponding author. Department of Economics, UCLA, 405 Hilgard Avenue, Los Angeles~
CA 90095-1477. E-lnaih cvegh@ucla.edu. Website: http://vegh.sscnet.ucla.edu.

Handbook of Macroeconomics, Volume 1, Edited by ~B. Taylor and M, Wood~fbrd

1999 Elseuier Science B.V. All rights reserved
1531

1532

G.A. Calvo and C.A. V~gh

4,2. Lack of credibility

1569
5. Exchange-rate-based stabilization ll: durable goods, credit, and wealth effects 1573
5.1. Durable goods
1573
5,2. Credit market segmentation
1575
5,3. Supply-sideeffects
1577
5,4. Fiscalpolicy
1580
5,5. And the winner is ...
1581
6. Money-based stabilization
1582
6,1. A simple model
1582
6,2. Extensions to other money-basedregimes
1587
6,3. Money anchor versus exchange-rate anchor
1588
7. Balance-of-payments crises
1590
7,1. Liquidity
1591
7~2. The Krugman model
1592
7,3. Krugman model: critique and extensions
1595
7.3.1. Bonds
1595
7.3.2. Sterilization
1595
7.3.3. lnterest rate policy
1596
7,4. The current account approach
1597
7.5. Financial considerations
1599
7.5.1. Volatilityof monetary aggregates
1599
7.5.2. Short-matmity debt
1601
7.5.3. Domestic debt and credibility
1603
7.5.4. Credibility,the demand for money and fiscal deficits
1603
8. Concluding remarks
1604
References
1607

Ch. 24." Inflation Stabilization and BOP Crises in Developing Countries

1533

Abstract
High and persistent inflation has been one of the distinguishing macroeconomic
characteristics of many developing countries since the end of World War II. Countries
afflicted by chronic inflation, however, have not taken their fate lightly and have
engaged in repeated stabilization attempts. More often than not, stabilization plans have
failed. The end of stabilizations - particularly those which rely on a pegged exchange
rate - has often involved dramatic balance-of-payments crises. As stabilization plans
come and go, a large literature has developed trying to document the main empirical
regularities and to understand the key issues involved. This chapter undertakes a critical
review and evaluation of the literature related to inflation stabilization policies and
balance-of-payments crises in developing countries.
The chapter begins by trying to rationalize the existence of chronic inflation in
a world of rational agents. It then offers an empirical analysis of the main stylized
facts associated with stopping chronic inflation. It is shown that the real effects
of disinflation depend on the nominal anchor which is used. Exchange-rate-based
stabilizations lead to an initial output and consumption boom - which is particularly
evident in the behavior of durable goods - real exchange rate appreciation, and current
account deficits. The contractionary costs typically associated with disinflation emerge
only later in the program. In contrast, in money-based stabilizations, the contraction
occurs in the beginning of the program. The chapter then proceeds to review several
explanations for these puzzling phenomena, emphasizing the real effects of lack
of credibility, inflation inertia, and consumption cycles generated by durable goods
purchases.
The chapter also documents the fact that most exchange-rate-based stabilizations end
up in balance-of-payments crises. The Mexican crisis of December 1994 brought back
to life some of the key questions: Do exchange-rate-based stabilizations sow the seeds
of their own destruction by unleashing "unsustainable" real exchange rate appreciations
and current account deficits? Or are credibility problems and self-fulfilling prophecies
at the root of these crises? The remainder of the chapter is devoted to analyzing the
main ideas behind this unfolding literature.

Keywords
JEL classification: E52, E63, F41

1534

G.A. Caluo and C.A. V~gh

1. Introduction

High and persistent inflation has been one of the distinguishing macroeconomic
characteristics of many developing countries - particularly in Latin America - since the
end of World War II. Pazos (1972) coined the term "chronic inflation" to refer to this
phenomenon. In his view, chronic inflation is quite a different creature from the much
more spectacular hyperinftations studied by Cagan (1956). First, unlike hyperinflations
whose duration is measured in terms of months, chronic inflation may last for decades.
Second, countries learn how to live with high and persistent inflation by creating
various indexation mechanisms which, in turn, tend to perpetuate the inflationary
process. As a result, inflation does not have an inherent propensity to accelerate and,
if it does, soon reaches a new plateau.
Countries afflicted by chronic inflation, however, do not take their fate lightly. Quite
to the contrary, in the last four decades they have engaged in repeated stabilization
attempts which, more often than not, have failed. The end of stabilizations - in
particular those which rely on a pegged exchange rate - has often involved dramatic
balance-of-payments crises with costly devaluations and losses of international
reserves. With increasingly open capital markets, some of these crises now send shock
waves throughout the world, as vividly illustrated by the Mexican crisis of December
1994. In the last ten years, however, countries such as Chile, Israel, and Argentina
have succeeded in reducing inflation close to international levels. Still, most developing
countries continue to struggle through stabilization attempts, and some former socialist
economies have also begun to face similar cycles of inflation and stabilization. The
currency crises that hit South East Asia during the second half of 1997 were also a
startling reminder that no region is immune to boom-bust cycles which were once
thought as being mainly a Latin American disease.
Over the course of the last four decades, a myriad of major stabilization plans went
by, leaving behind a rich legacy of issues and puzzles. In retrospect, the stabilization
plans implemented in the late 1970s in the Southern Cone countries - Argentina, Chile,
and Uruguay - proved to be a turning point. Designed by US-trained technocrats,
these plans were in some sense the first ones to openly recognize the constraints
imposed on monetary policy by open financial markets. Trying to make the most of
such constraints, policymakers decided to abandon the "closed-economy" monetary
policies of the past - aimed primarily at controlling the money supply - and switch to
"open-economy" policies based on setting a declining rate of devaluation which would
quickly bring domestic inflation in line with tradable-goods inflation (given by world
inflation plus the rate of devaluation). To the consternation of policymakers, however,
the inflation rate failed to converge to tradable-goods inflation, which resulted in a
large real appreciation of the domestic currency. More puzzling still, in spite of the
real appreciation, real economic activity - particularly private consumption -- expanded
in the early years of the programs. Later in the programs, a recession set in, eve1~before
the programs collapsed.
In the mid-1980s, major programs in Argentina, Brazil, and Israel brought back to

Ch. 24:

Inflation Stabilization and BOP Crises in Developing Countries

1535

life some o f the same, and still mostly unresolved, issues. In spite o f the use o f wage
and price controls to supplement an exchange rate peg, real appreciation remained
an integral part o f the picture. More puzzling, however, was the reemergence o f the
pattern of an initial b o o m and a later recession. The Israeli recession was viewed as
particularly hard to rationalize because o f its occurrence in a fiscally sound and largely
successful stabilization program. Based on these new programs - and a reexamination
of older programs going back to the 1960s - Kiguel and Liviatan (1992) and V6gh
(1992) argued that the outcome observed in the Southern-Cone stabilizations is a
pattern common to most stabilization plans which have relied on the exchange rate
as opposed to a monetary aggregate - as the main nominal anchor. Specifically, the
beginning o f an exchange-rate-based stabilization is characterized by an economic
boom and sustained real appreciation. Later in the programs - and often aggravated
by the collapse o f the program - a contraction takes hold.
In contrast, the scanty evidence on money-based stabilization in chronic-inflation
countries lends support to the notion that, as in low-inflation countries, the recession
takes place at the beginning o f the program [Calvo and V6gh (1994b)]. Hence, it would
appear that under money-based stabilization, the costs (in terms o f output losses) would
be paid up-front, whereas, under exchange-rate-based stabilization, these costs would
be postponed until a later date. The intriguing idea that choosing between the two
nominal anchors may imply choosing not t f b u t w h e n to bear the costs o f disinflation
has been dubbed the "recession-now-versus-recession-later" hypothesis.
The twin puzzles o f the b o o m - r e c e s s i o n cycle in exchange-rate-based stabilizations
and the recession-now-versus-recession-later hypothesis have been the driving force
behind recent developments in the area o f inflation stabilization in developing countries. An emerging empirical literature has attempted to document these phenomena
in a systematic way, while an extensive theoretical literature has advanced various
hypotheses - such as inflation inertia and lack o f credibility - to explain the real effects
of disinflation. A critical review and evaluation o f this literature constitutes the core
of this chapter i.
A third puzzle is the fact that most exchange-rate-based stabilizations end up in
balance-of-payments (BOP) crises. The literature, however, has had precious little
to say so far about the possible links between the dynamics o f exchange-rate-based
stabilizations and BOP crises. The Mexican crisis o f December 1994 which put an
end to an exchange-rate-based stabilization plan initiated seven years earlier - brought
back to life some o f the key questions: Do exchange-rate-based stabilizations sow the
Not suprisingly, most of the literature has been respired by the experiences of chronic inflation
countries, which constitute a rich laboratory for the discussion of inflation and stabilization in developing
countries. To focus the discussion, we follow this tradition and confine our discussion on inflation and
stabilization mostly to chronic inflation countries. We will thus ignore some rare episodes of fullblown hyperinfations (like Bolivia in the mid-1980s) - which have more in common with Cagan's
classic hyperinflations [see V6gh (1992)]. We will also mostly ignore the inflationary experience of the
transition economies, as the dramatic transformation from plan to market raises some special issues [see,
for example, De Melo, Denizer and Gelb (1995), and Sahay and V6gh (1996)].

1536

G.A. Calvo and C.A~ V~gh

seeds of their own destruction by unleashing "unsustainable" real appreciations and

current account deficits? Or are credibility problems and self-fulfilling prophecies at
the root of these crises? The remainder of the chapter is devoted to analyzing the main
ideas behind this unfolding literature. O f course, the potential for BOP crises is a more
general issue, which goes back to Krugman's (1979) seminal contribution, and applies
to any pegged exchange rate system. Hence, while many of the issues to be discussed
have broader relevance, we focus on factors which may be of particular importance
for developing countries.
The chapter proceeds as follows. Section 2 focuses on how to explain the existence
of chronic inflation in a world of rational economic agents. Section 3 examines the
main empirical regularities of inflation stabilization in chronic-inflation countries.
Section 4 begins the theoretical discussion on exchange-rate-based stabilization by
focusing on two key thctors: inflation inertia and lack of credibility. Section 5 continues
the analysis of exchange-rate-based stabilization by highlighting the role of consumer
durables, credit market segmentation, supply-side effects, and fiscal policy. Section 6
examines money-based stabilization. Section 7 discusses the causes and mechanics of
balance-of-payments crises. Section 8 concludes.

2. Understanding chronic inflation

For the purposes of this chapter, the rate of inflation in period t is defined as the
proportional rate of growth of the price level (usually the consumer price index) from
period t - l to period t. An essential ingredient in the definition of inflation is the
"price level", that is to say, the relative price of goods in terms of money. Therefore,
one cannot have inflation without money, and one cannot have inflation without goods.
During high inflation - unless something very unusual is happening to the demand tot
money or to the demand t0r or supply of goods - the supply of money also grows at a
high rate. Hence, although inflation is a phenomenon that results from the interaction
of monetary and real phenomena, monetary factors are likely to dominate.
The situation, however, is not symmetric: it does not follow from the above
observations that real phenomena, like output or domestic absorption, are largely
independent of money. This would be true only under very special circumstances~
including (i) no nominal rigidities, and (ii) no effects of changes in nominal interest
rates on consumption (see below). As the ensuing analysis will reveal, the channel
from money to output is particularly relevant during stabilization programs.
The empirical evidence is quite clear about the following two points: inflation is
closely tracked by money supply, and inflation - particularly, changes in the rate of
inflation - affects real variables. The latter represents a formidable challenge faced
by stabilization programs. As will be argued below, however, the real effects of
either inflation or stopping inflation are not necessarily rooted in fundamentals but
may, to a large extent, be due to factors - like policy credibility - which suitable
institutional/political arrangements may help to modify.

Ch. 24: lnflation Stabilization and BOP Crises in Developing Countries

1537

Under ideal circumstances, stopping inflation may be a socially painless process.

Those circumstances, however, require appropriate fiscal adjustment. One serious
difficulty in that respect is that there is more than one way to effect a fiscal adjustment,
and each o f these ways has different implications for various groups in society.
Consequently, it is not easy to reach wide consensus on any particular policy. This has
two important consequences: (i) delayed stabilization, and (ii) adoption o f incomplete
stabilization programs. Point (i) rationalizes inflation persistence, while point (ii)
explains the prevalence of short-lived stabilization programs.
But what sets inflation in motion in the first place? And, in particular, how can
the phenomenon of high and persistent inflation be explained in a world of rational
economic agents? 2 Although it would seem fair to say that the profession is still
struggling to provide an answer to these questions and is far from reaching a consensus,
the existing literature provides several useful insights.
2.1. Inflation as an optimal tax

One explanation, due to Phelps (1973), is that in a world o f distorting taxes,

governments may find it optimal to depart from Friedman's (1969) celebrated optimum
quantity of money rule, which calls for setting the nominal interest rate to zero. Phelps's
(1973) result is quite intuitive. It follows from the observation that at Friedman's
optimum quantity o f money rule, the marginal cost of the inflation tax (i.e., the nominal
interest rate) is, by definition, nil. Thus, at the margin, increasing fiscal revenue thi'ough
money creation has no cost. In contrast, the marginal benefit o f lowering any distorting
tax is unambiguously positive. Therefore, starting from a zero nominal interest rate,
it is welfare-improving to increase the inflation tax and lower any other distorting tax
used to collect revenue. Thus, Phelps's result calls for a positive inflation tax 3.
A key assumption in Phelps (1973) and the ensuing literature is that there is no
fundamental difference between the inflation tax and other "conventional" taxes. It has
long been recognized, however, that the costs of collection, enforcement, and evasion
associated with the inflation tax are negligible compared to those o f other taxes. As
Keynes (1924, p. 46) put it, inflationary finance "is the form o f taxation which the
public finds hardest to evade and even the weakest Government can enforce, when it
can enforce nothing else". An inefficient tax system may make it optimal to resort to
2 An alternative explanation tbr the existence of chronic inflation is simply that policymakers in these
countries are systematically ignorant or incompetent. We find this explanation both implausible as a
description of the real world and maintercsting from a theoretical point of view (given that we do not
have good theories of "ignorance" or "incompetence"). Hence, the basic premise of this section is that
chronic inflation is a phenomenon in search of a "rational" explanation.
3 A large literature has developed which analyzes the robustness of Phelps' (1973) findings [see the
critical survey by Woodford (1990)]. Modeling money as an intermediate input, Kimbrough (1986)
shows an interesting case in which Friedman's rule holds even though all available taxes arc distorting.
Kimbrough's result, however, holds only under rather restrictive assumptions [see Woodford (1990),
Guidotti and V6gh (1993), and Correia and Teles (t996)].

1538

G.A. Calvo and C.A. V~gh

the inflation tax even in cases in which Friedman's optimum quantity of money rule
would otherwise be optimal [see Aizenman (1987) and V6gh (1989)].
The above arguments - valid as they may be as normative propositions - appear
rather insufficient to rationalize chronic high inflation in developing countries. First,
high inflation is a phenomenon that the society is typically trying to get rid of
and, thus, could hardly be expected to be optimal in accord with Phelps's (1973)
prescriptions. Second, while the evidence does show a long-run relationship between
fiscal deficits and inflation [see, for example, Fischer, Sahay and V6gh (1997)], crosscountry econometric studies for developing countries have not found support for the
main empirical implication of Phelps's (1973) hypothesis that there should be a positive
correlation between the inflation tax and other conventional taxes [see Edwards and
Tabellini (1991)]. In fact, the inflation tax appears to act more as a residual source
of government revenue. Third, empirical estimates show that inflation is often larger
than the level that maximizes revenue from inflation [see, for example, Easterly and
Schmidt-Hebbel (1994)] 4. This implies that lower inflation and higher revenues from
inflation could be simultaneously achieved - a glaring contradiction of Phelps's (1973)
prescription.
In sum, although the optimal taxation approach could explain perhaps the persistence
of low levels of inflation, it would seem that other factors are needed to explain the
actual pattern of inflation observed in chronic inflation countries.
2.2. Shocks and accommodation

While fiscal deficits may constitute the original sin that gives rise to inflation,
the persistence of inflation may involve policy accommodation which transforms
temporary domestic or external shocks into permanent increases in the inflation
rate [see, in particular, Bruno and Fischer (1986) and Bruno (1993, Chapter 3)].
For example, consider a shock which calls for a real appreciation of the domestic
currency. Authorities may dislike real appreciation because, say, it might be detrimental
to exports. Therefore, incipient real appreciation would lead authorities to devalue.
Since conditions after the shock require a more appreciated equilibrium real exchange
rate, such a policy reaction cannot provide a definitive solution to the authorities'
problem. After the first devaluation, domestic prices will rise to regain lost ground
and attempt, once again, to climb a little higher (in order to generate the equilibrium
real appreciation). Thus, another devaluation will eventually follow - and, of course~
prices will continue rising, setting in motion an inflationary process quite unrelated to
fiscal revenue considerations/t la Phelps 5.
4 Although measuring the seigniorage-maximizinginflation rate is not without problems [see Easterty~
Mauro and Schmidt-Hebbel(1995)].
5 Empirical evidence on the inflationary consequences of real exchange rate targeting in Brazil, Chile,
and Colombiamay be found in Calvo, Reinhart and V6gh (1995). At a theoretical level,the inflationary
conseqnences of real exchange rate targeting have been analyzed by Adams and Gros (1986), Lizondo

Ch. 24: Inflation Stabilization and BOP Crises in Deoeloping Countries

1539

More generally, monetary accommodation is typically reflected in the fact that

key nominal variables - the rate of devaluation, the rate of monetary growth, and
nominal wage growth - are linked to past inflation through accommodative policy rules
and institutional arrangements such as backward-looking wage indexation. A greater
degree of accommodation will be reflected in more inflation inertia. Bruno (1993)
shows how nominal variables linked to past inflation may generate an autoregressive
process for the inflation rate. Under these circumstances, temporary shocks to the
inflation rate lead to permanent increases in the inflation rate. Bruno and Melnick
(1994) further show that the higher is the degree of monetary accommodation, the
higher is the new inflation plateau.
While the process of shocks and accommodation captures some important elements
of chronic inflation processes, it is less clear whether it can be argued that inflation is
unduly high, in the sense of not being socially optimal. Presumably, policymakers accommodate shocks because not doing so would bring about undesirable consequences.
In fact, one can show simple examples in which, in response to temporary shocks, it
may be optimal to keep constant the real exchange rate by generating higher inflation
[see Calvo, Reinhart and V6gh (1995)]. In the same vein, it is often argued that
not accommodating expected inflation by printing money could bring about a severe
liquidity crunch and thus lower output. Hence, this view leaves unresolved the issue
of why society would periodically wish to get rid of inflation.
2.3.

Multiple equilibria

A more clear-cut case of socially suboptimal inflation is multiple equilibria. An

example that we find particularly relevant [Calvo (1992)] is one in which there is a
stock of public debt denominated in domestic currency, D. Let the one-period nominal
interest rate be denoted by i. Then, next period's full service of the debt (i.e., principal
plus interest) will be (1 + i)D. Let us choose units of measurement so that the present
price level equals 1, and indicate the one-period expected inflation rate by ~e. Thus, if,
say, the equilibrium real interest rate is zero, we have that i = sr e. Therefore, if actual
inflation is zero, the real burden of servicing domestic debt would be (1 + ~)D. This
could very well be a large number. On the other hand, if the government fulfills the
private sector's expectations and sets actual inflation equal to expected inflation, the
real burden of the debt is just D. Thus, the temptation not to stop inflation in its tracks
may be irresistible.
A numerical example may help bringing the above point home. Suppose that the
stock of debt is just 20 percent of GDP, and consider the case of Brazil (in the late
1980s) where the monthly rate of inflation was about 30 percent. If inflation is stopped
but the private sector expected it to continue at previous levels, the nominal interest
rate will remain at 30 percent per month. Therefore, just interest on the debt will
(1991), Montiel and Ostry (1991), Calvo, Reinhart and V6gh (1995), Uribe (1995), and Lahiri (1997)
See also Heymaimand Leijonhufvud (1995) for a more general analysis of these issues.

1540

G.A. Calvo and C.A. Vdgh

amount to 6 percent of GDP per month. This sizable cost of stopping inflation may,
quite plausibly, lead authorities to relent by either keeping inflation at the original high
levels, or adopting a very gradual stabilization program.
2.4. The "provinces" eJfect

Another explanation is what one might call the "provinces effect." Provinces,
municipalities, state enterprises, etc., are entities that, at best, attempt to maximize
social welfare by controlling a small set of levers. In particular, for these institutions,
inflation is a p u n i c good, generated by total government expenditure, to which
their individual expenditure adds an insignificant amount. Therefore, in choosing
"provincial" expenditure, each entity will overlook the adverse welfare consequences
of inflation on all other entities. Consequently, like with any other public good, too
much inflation (i.e., too little price stability) will be generated 6. While this approach
provides an attractive rationale for the existence of inflation, it still needs to explain
cross-sectional variation in inflation outcomes. In other words, why should this effect
be more relevant in, say, Argentina than in the USA?
2.5. Delayed stabilization

We now come to a more recent explanation for the persistence of high inflation; namely,
the "war of attrition". This is an extremely useful idea formally developed by Alesina
and Drazen (1991) 7. Suppose that inflation is unduly high for any of the reasons
discussed above. Thus, policymakers would know that inflation could be brought under
control if institutions were changed, or some appropriate transfers were put in place.
So, why do they not act upon this knowledge and stop inflation in its tracks? Alesina
and Drazen's (1991) explanation is that, since there is more than one way to get out of
the inflation quagmire, and each way has different welfare implications across groups,
it may be optimal for each group to wait for another group to give in. Eventually, the
most "anxious" group will give in, adjustment will take place, and inflation will stop.
In the meantime, inflation will remain high. Note, however, that Alesina and Drazen's
(1991) model per se does not rationalize the advent of high inflation. Thus, Alesina
and Drazen's model would need to be appended with some inflation-causing factor, or
factors, in order to be able to track empirical evidence.
An interestingapplication of the Alesina-Drazen tramework is the fbrmalizatlon
of the idea that, in practice, things must get worse before they get better, in other
words, oftentimes societies need to go through a truly devastating hyperinflationary
~ See Aizemnan (1992), Velasco (1993), Sanguinetti (1994), Mondino, Sturzenegger and Tommasi
(1996), Zarazaga (1996), and Jones, Sanguinetti and Tomrnasi (1997).
7 Of course, the perception of inflation as the outcome of an unresolved distributive struggle is not new,
and goes back to Hirsclmaan (1963) [see tteymann and Leijonhufvud (1995) fbr a detailed discussion].
It should also be noted that these last two factors - the "provinces" effect and delayed stabilization
are part of a large, and growing, literature on the polical economy of reform [see Tommasi and Velasco
(t996) for a survey].

Ch. 24: Inflation Stabilization and BOP Crises in Developing Countries

1541

outburst before a political consensus for a stabilization emerges. In the war-of-attrition

framework just described, Drazen and Grilli (1993) show how a higher rate of inflation
may be welfare-improving by bringing forward the expected time of resolution. The
earlier resolution of the war of attrition may thus more than offset the short-term costs
of higher inflation.
2.6. In conclusion

Based on the analysis thus far, we believe there is no single explanation for the
phenomenon of chronic inflation. In fact, we would argue that, when taken together and
in the proper dynamic sequence, the five factors discussed above probably explain the
key features of processes of chronic inflation. At a fundamental level, governmems
with inefficient tax-systems will always find it optimal to resort to some inflation
(inflation as an optimal tax). The "provinces effect" is likely to add another - socially
suboptimal - layer to the optimal public finance level of inflation. Once inflation has
emerged, the economy as a whole naturally develops various indexation mechanisms
(including accommodative policy rules) aimed at minimizing, for a given inflation rate,
the real effects of inflation. Heavy indexation of the economy makes relative prices
less responsive to various shocks, which sets the stage for temporary shocks to have
permanent effects on the rate of inflation (the "shocks and accommodation" view). At
this stage, the inflationary process will probably bear little relation to its original cause
(the fiscal deficit), fueling the perception that putting the fiscal house in order may,
after all, not help in dealing with the inflation problem.
By now, the government's incentives to tackle the problem seriously are greatly
diminished. After inflation has become entrenched in the public's mind, it may be
too costly for the government not to validate the public's expectations (multiplicity
of equilibria). In addition, and even if the government finally managed to credibly
commit to a low level of inflation, political battles over the distribution of the fiscal
adjustment needed to implement a stabilization may prolong chronic inflation (delayed
stabilization). In the end, things may indeed need to get worse - by, say, having a
hyperinflationary outburst - before they get better.

3o Evidence on the real effects of stabilization in chronic-inflation countries

It is perhaps fair to say that until recently the dominant opinion in the professioit
was that stopping inflation would bring about a sharp fall in output and domestic
absorption. In fact, the notion that disinflation is contractionary is so entrenched m
the literature that the question asked has typically been n o t / f b u t by how much outpul
would fall in response to an anti-inflationary program. The best-known manifestation
of this approach is the so-called "sacrifice ratio," or cumulative percent output loss
per percentage point reduction in inflation. Okun (1978, p. 348), summarizing the
findings of several papers on the USA, awaes that "the cost of a 1 point reductio~
in the basic inflation rate is 10 percem of a year's GNP, with a range of 6 percent

1542

G.A. Calc~oand C.A. V~gh

to 18 percent." Fischer (1986b) estimates a sacrifice ratio of 5 to 6 - at the lower

end of the Okun range - for the USA for the period 1979-1986. Based on a review
of fourteen episodes in eight countries, Gordon (1982) concludes that, by and large,
contractionary policies - especially "cold turkey" policies - aimed at bringing down
inflation have entailed large output costs. More recently, Ball (1994) examined 28
disinflation episodes in nine OECD countries using quarterly data and found that,
with one exception, disinflation is always costly, with the sacrifice ratio ranging from
2.9 for Germany to 0.8 for France and the United Kingdom.
The conventional view about the output costs of disinflation has also been taken to
apply to open economies, indeed, in traditional open-economy models, disinflation is
expected to cause an initial recession regardless of the nominal anchor which is used
(the exchange rate or the money supply), as argued by Fischer (1986a). Therefore, the
choice of the nominal anchor is based on a comparison of the sacrifice ratio involved
in the two alternative strategies. By examining the sacrifice ratio under different
parameter configurations, Fischer (1986a) concludes that the exchange rate should be
the preferred nominal anchor. A similar conclusion is reached by Chadha, Masson and
Meredith (1992). Based on simulations using MULTIMOD (a large-scale, multi-region
macroeconometric model), they conclude that, for the United Kingdom, the sacrifice
ratio is cut almost in half under an exchange-rate anchor compared to a money anchor.
The intuition behind the view that "disinflation is always and everywhere contractionary" owes much to the unemployment-inflation trade-off, Phillips-curve literature.
Particularly influential has been the staggered-contracting approach pioneered by
Fischer (1977) and Taylor (1979, 1980). In these models, wage contracts are preset
for a number of periods. Hence, credibility of the policy is not enough to generate a
costless disinflation. Only a fully-credible gradual disinflation, which would take into
account the structure of labor contracts, could reduce inflation with no output cost.
For the case of the USA, Taylor (1983) concludes that it would take tbur years to
disinflate from a rate of wage increase of 10 percent per year to 3 percent without
creating unemployment.
The conventional view has not gone unchallenged. In an influential paper, Sargent
(1982) has argued that inflation was stopped virtually overnight with little or no
output costs in the hyperinflations which developed in Austria, Germany, Poland, and
Hungary in the aftermath of World War I. Based on this evidence, he argues that
disinflation need not be contractionary if it is accompanied by a credible change
in regime, which drastically alters the public's perceptions about future government
policies. However, even if Sargent's (1982) conclusions regarding the output costs
of stopping hyperinflation were accepted, such hyperinflations are seen as extreme
episodes whose lessons are not necessarily applicable to much more mundane, garden~
variety inflations 8.

8 Notice that tile averagemonthly rate of inflation in these tbur episodes in the twelvemonths preceding
stabilization ranged fiom a low of 33.3% in Hungary to a high of 455.1% in Gemaany[see V6gh (1992),

Ch. 24: Inflation Stabilization and BOP Crises in Deueloping Countries

1543

Perhaps a more fundamental challenge to the conventional view began to emerge

in the late 1970s when major stabilization plans were implemented in the SouthernCone countries of Latin America (Argentina, Chile, and Uruguay). The cornerstone of
these programs was the announcement of a predetermined path for the exchange rate,
which involved setting a declining rate of devaluation 9. Contrary to Phillips-curve
based predictions, the resulting decline in inflation was accompanied by a boom in
consumption and no signs of higher unemployment. Moreover, the expansion took
place in spite of a sharp appreciation of the real exchange rate. The contractionary
costs associated with disinflation appeared only later in the programs, often before the
programs finally collapsed.
As it turned out, the puzzling phenomenon of an initial expansion followed by a
later recession observed during the Southern-Cone "tablitas" appears to be a common
pattern of exchange-rate-based stabilizations [see Kiguel and Liviatan (1992) and
V6gh (1992)]. In sharp contrast, money-based stabilizations - which are much less
common in chronic-inflation countries - have typically led to an initial recession, as
the conventional view would have it. The remainder of this section takes a detailed
look at some of the empirical evidence on these issues.

3.1. Exchange-rate-based stabilization." empirical regularities

Table 1 lists twelve major exchange-rate-based stabilizations in chronic inflation
countries in the last 35 years. These programs - which took place in Argentina,
Brazil, Chile, Israel, Mexico, and Uruguay - have been studied in great detail and
constitute the main motivation behind much of the literature in the area 10, 11. Based
Table 2]. Garber (1982) and Wicker (1986) have both taken issue wit1 Sargent's (1982) conclusions.
See also V~gh (1992) and Bruno (1993, Chapter 1).
9 In popular parlance, the announced schedule would be referred to as the "tablita" (Spanish for "little
table"). In Chile, the exchange rate was eventually fixed.
10 Case studies include but are certainly not limited to the following. On the Argentine plans, see
De Pablo (1974), Fernandez (1985), Canavese and Di Tdla (t988), Heymann (199l), and Dornbusch
(1995). On the Brazilian plans, see Kafka (1967), Modiano (1988), and Cardoso (1991). On Chile, sec
Corbo (1985) and Edwards and Cox Edwards (1991). On the Israeli plan, see Bruno (1993) and Bufman
and Leiderman (1995). On Mexico, see Dornbuschand Werner(1994) and Santaella and Vela (1996). On
the Uruguayan plans, see Finch (1979), Hanson and de Melo (1985), Viana (1990), and Talvi (1995).
See also Foxlcy (1980), Diaz-Alejandro (1981), Ramos (1986), Corbo, De Melo and Tybout (1986),
Kiguel and Liviatan (1989), Edwards (1991), and Ag6nor and Montiel (1996, Chapter 8).
11 The literature has often distinguished between "orthodox" programs (which do not rely on prices
and/or wages controls) and "heterodox" programs (which do, and thus have "multiple nominal anchors")
Of the programs listed in Table l, five were "orthodox" plans (the three "tablitas", the Argentine 1991
Convertibility plan, and the Uruguayan 1990 plan); the rest were "heterodox" plans. Except tbr tile
behavior of inflation and domestic real interest rates (see below), the response of key macroeconomics
variables to major stabilizationplans has been very similar, regardless of whether the plans were orthodox
or heterodox. Hence, for the purposes of our analysis,not much will be made of this distinction.It should
be noted, however, that the policy debate over the desirabilityof price and wage controls has been intensc:
see, for instance, Dornbusch and Simonsen (1987), Dornbusch, Sturzenegger and Wolf (1990), Bruno
(1993), Leidernlan (1993), and Meltzer (1994).

1544

G.A. C a l v o a n d C.A. V~gh

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Ch. 24." Inflation Stabilization and BOP Crises in Developing Countries

1545

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1546

G.A. Calvo and C.A. V&gh

on these episodes, the literature has identified the following main empirical regularities
associated with exchange-rate-based stabilization 12:
(i) Slow convergence of the inflation rate (measured by the CPI) to the rate of
devaluation. In heterodox programs, inflation has typically fallen faster due to
temporary price controls 13
(ii) Initial increase in real activity -particularly, real GDP and private consumption followed by a later contraction. It is less clear whether the same pattern applies
to investment 14
(iii) Real appreciation of the domestic currency.
(iv) Deterioration of the trade balance and current account balance.
(v) Ambiguous' impact response o f domestic real interest rates. Ex-post domestic
real interest rates have generally decreased in the initial stages of orthodox plans.
However, they appear to have increased substantially in the early stages of the
heterodox programs of the mid- 1980s.
To take a closer look at the main stylized facts, we constructed a panel of annual
observations for four countries (Argentina, Chile, Israel, and Uruguay), which covers
16 years (1978-1993), for a total of 64 observations 15. The panel includes seven of the
twelve exchange-rate-based stabilizations listed in Table 1 (the "tablitas" implemented
in 1978 in Argentina, Chile, and Uruguay, the Israeli 1985 plan, the Argentine 1985
Austral plan, the Uruguayan 1990 plan, and the Argentine 1991 Convertibility plan)
and ten macroeconomic variables (devaluation rate, inflation rate, rates of growth of
GDP, private consumption, durable goods consumption, fixed investment, and public
consumption, all expressed in per capita terms, real exchange rate, current account
deficit as a proportion of GDP, and real lending rate) 16.

~2 See Kiguel and Liviatan (1992), Vdgh (1992), Calvo and V6gh (1994b), Reinhart and V6gh (1994,
1995b), and De Gregorio, Guidotti and V6gh (1998).
13 Although less well-documented,casual empiricism suggests that wholesale price inflation (which
captures the behavior of tradable goods inflation) converges quite rapidly.
t4 Both Kiguel and Liviatan (1992) and Reinhart and V6gh (1995b) report mixed results ~br investment.
Real estate boom-bust cycles also appear to be a hallmark of many of these programs; see Rebelo and
V6gh (1995) and Guerra (1997b). Some spotty data also suggest that output in the non-tradable sector
typically expands more rapidly than in the tradable sector [Rebelo and V~gh (1995)].
~5 The numerous caveats that apply to the empirical exercises which follow are discussed at the end of
the section.
I(~ The sample chosen was dictated by data availability. The sources of data are as tbllows. Data oll
GDP, private consumption, and durable goods consumption were provided by the Central Banks of
Argentina, Israel, Uruguay, and the Chilean Ministry of Finance. For Argentina and Uruguay, durable
goods consumptionis proxied by cat sales. Real exchange rate data for Israel were providedby the Bank
of Israel. All other data are from International Finance Statistics (IMF). Fixed investment corresponds
to gross fixed capital formation adjusted by the GDP deflator. (Ideally, we would have liked to have
private fixed investment, but data are hard to come by.) The real exchange rate is a real effective
exchange rate, as computed by the IMF, defined as a nominal effective exchange rate index adjusted
for relative movements in national price or cost indicators of the home country and its main trading
partners. Following common practice, the index is presented in such a way that an increase rcflects

Ch. 24: Inflation Stabilization and BOP Crises in Developing Countries,

1547

3.1. l. Stabilization time profiles

As a first pass at the data and to illustrate the dynamic response of the different
variables to the implementation of an exchange-rate-based stabilization program,
we constructed profiles in "stabilization" time (as opposed to "calendar" time)17
Stabilization time is denoted by T + j , where T is the year in which the stabilization
program was implemented and j is the number of years preceding or following the
year of stabilization ( j = - 2 , . . . , 4) 18. We then computed the average value of each
variable in stabilization time. The resulting stabilization time profiles, presented in
Figures 1 and 2, thus portray the dynamic behavior of key macroeconomic variables
for a "representative" exchange-rate-based stabilization plan. Vertical bars indicate the
year before stabilization (time T - 1) and, where applicable, dashed lines denote the
mean of the corresponding variable for the entire sample (i.e., for all 64 observations)
Panel A in Figure 1 illustrates the behavior of the rates of devaluation and inflation 19
The U-shaped profile for the rate of devaluation (the nominal anchor) reflects the fact
that, more often than not, policymakers either switch to a more flexible exchange-rate
arrangement (often after a brief period with a fixed exchange rate) or abandon the
program altogether. While inflation is highly responsive to the reduction in the rate
of devaluation, it remains above the rate of devaluation and then lags it as the rate of
devaluation increases. Panel B shows that the real exchange rate (set to 100 in the year
before the stabilization) appreciates for three consecutive years (falling below 80 in
year T + 2) before beginning to depreciate, following the higher rate of devaluation.
The current account deteriorates up to year T + 3 reaching a deficit of 4.8 percent
of GDP - and then reverses course (Panel C).
While the rate of growth of public consumption falls in the year of stabilization presumably reflecting an initial fiscal adjustment it shows no systematic behavior

a real depreciation. Real interest rates were computed by deflating nominal rates by the same year's
inflation rate. Population series from International Finance Statistics (IMF) were used to compute per
capita figttres.
17 Fischer, Sahay and V6gh (1996) have used this approach to analyzing stabilization policies m
transition economies. See also Easterly (1996).
~a If the program began in the last quarter of a given year, the following year is taken as 7'. Thus,
T is 1978 for the Chilean tablita, 1979 for the Argentine and the Uruguayan tablitas, 1985 for the
Austral and Israeli plans, and 1991 for the Convertibilityand the Uruguayan 1990 plans. We should also
note that we did not allow for any overlapping(i.e., any given year in calendar time correspondsto at most
one point in stabilization time). Hence, in the case of Argentina,the fust observation in stabilizationtime
for the Austral plan is 1984 (which corresponds to T 1) and the last one is 1988 (7' + 3). Finally,note
that the nmnber of observations for each year in stabilizationtime may differ, since some stabilizations
episodes do not have observations for all years in stabilizationtime (i.e,, from T - 2 through T + 4). For
instance, there are 7 observations for T - 1, T, and T + 1, but only 4 for T + 4 and 3 for T - 2.
19 Sincethe mean is essentially the same (179.3 percent for the devaluation rate and 177.9 percent fo~
the inflation rate), the panel contains only one horizontal line.

1548

G.A. Caluo and C.A. Vdgh

2000--t500.~\\
I000.~

A. Inflation and devaluation

(percentper year)

500-

B. Real exchange r a t e
(indexnumber,T-1=100)

120~.-

ation
. . . . . . . . . .

m%anjn[at!%n

. . . .

904
804
\

///

\//devaluation
T-2

T-1

T+I

T~-2

T~-3

T+

70a___A_
T-2

C. Current account
(percentof GDP)

0. . . .

-2-3-

T-1

T;1

T;2

T;3

T+4

D. Public consumption growth

(percentperyear)

-4-5T-2

T-1

]~

T+I

T;2

T;3

T+4

E, Real lending rate

(percentperyear)

60---

T-2

T-t

T+I

T+2

T+3

T+4

T+3

T+4

F. Real deposit rate

(percentper year)

10.---5,

4030-5.
20-" ......
-10.

10-

0-

T.2

T-~

T;1

T;2

T;a

"T+4

-15

T-2

]
T-1

T+I

T+2

Fig. 1. Exchange-rate-based stabilization,

afterwards. Panels E and F show the b e h a v i o r o f domestic real interest rates 2o. Real
interest rates fall in the year the plan is i m p l e m e n t e d (with the real lending rate falling
20 Some observations are missing tbr these two variables, The available smnple consisted of
59 observations for the real lending rate and 57 observations for the real deposit rate. Note also the
different scales used in Panels E and E

Ch. 24:

Inflation Stabilization and BOP Crises in Deoeloping Countries

A. Real GDP growth
(percent per year)

1549

B. Private consumption growth

(percent per year)

128.

................

4.

o.~

-2
-4

-4.
-8

T-2

50 - - - - -

T-I

T+I

T+2

T+3

T+4

"i:

T+I

T'+2

32+3

T+4

T+3

T+4

D. Fixed investment growth

(percent per year)

0f I

20

75 . . . .

T-1

C. Durables consumption growth

(percent per year)

40

20
40T-2

T-2

-10
T-1

l"

T+I

T+2

T3

T+4

E. Private consumption to GDP

(in percent)

-15T-2

T-1

18.5 . . . . . . . . . .

74.

18.0. mean

T+I

T+2

F. Fixed investment to GDP

(in percent)

73.
17.5- /

72.
71.

17.0-

70.
16,5-

69.
58.
T-2

T-1

T+I

T+2

T+3

T+4

16.0- - T-2

T-1

r ' ~T+2
- ~ -T+3
+ 4
T+I

Fig. 2. GDP, consumption, and investment in exchange-rate-based stabilization.

for two consecutive years) and increase sharply afterwards. As indicated earlier, tile
accepted wisdom is that real interest rates have increased on impact in heterodox plans.
This does not show up in annual data, suggesting that the initial rise in real interest

1550

G.A. Calvo and C.A. Vdgh

rates in heterodox plans has manifested itself basically as "spikes" immediately after
the implementation of the plans 21.
Figure 2 presents the evidence related to the boom-recession cycle in the growth
of per capita GDP, consumption, and fixed investment. Panel A shows that real GDP
growth increases above the sample mean in the year of stabilization and peaks in T + l.
In T + 2, growth is back to its mean and decreases sharply thereafter. The same pattern
is observed for private consumption (Panel B) and durables consumption (Panel C). In
orders of magnitude, however, the cycle in durables goods is much more pronounced
than the one in private consumption, which is in turn more pronounced than the one in
real GDR At the peak, durable goods consumption is rising at 47.7 percent per year,
private consumption at 8.9 percent, and real GDP at 4.7 percent. Fixed investment
growth follows a similar pattern (Panel D). Finally, Panels E and F show the behavior
of private consumption and fixed investment as a proportion of GDR It can be seen that
the boom in private consumption is also quantitatively important even relative to GDP.
At its peak (in T + 1), the ratio of private consumption to GDP reaches 74.3 percent
(compared to a mean of 68.8 percent). In contrast, Panel F shows that the ratio of fixed
investment to GDP falls in T and surpasses its mean level only in T + 3 before falling
precipitously.
The stabilization time profiles thus point to the presence of a boom-recession cycle
associated with exchange-rate-based stabilization. Although it is empirically difficult
to distinguish a late recession in both successful and unsuccessful programs from
the output collapse that typically accompanies the end of failed programs, Figures
1 and 2 are consistent with the idea that the late recession may take hold before the
programs collapse. Notice that real activity (i.e., GDP and consumption in Figure 2,
Panels A and B) slows down already at T + 2 and falls below the sample mean
at T + 3, which could reflect the effects of rising real interest rates (Figure 1, panels
E and F) and cumulative real exchange appreciation (Figure 1, Panel B). The fact that
this contraction is taking place while the current account deficit continues to grow
(Figure 1, Panel C) suggests that the contraction is not related to the real effects of an
eventual collapse.
3.1.2. Panel regressions

By and large, the profiles in stabilization time presented in Figures 1 and 2 are
consistent with the stylized facts that have been emphasized in the recent literature.
However, while the raw data presented in this manner is clearly suggestive, these
plots cannot answer the key questions of whether the boom-recession cycle in GDR
consumption, and investment has been significant in a statistical sense or whether
it may have been caused by factors other than the exchange-rate-based stabilization
21 This idea is supported by tile quarterly data presented in V6gh (1992) and the evidencem Km,linslg
and Leiderman (1998). These "spikes" are partly related to the sudden drop in inflation when wages and
price controls axe part of the stabilization package.

Ch. 24." Inflation Stabilization and BOP Crises' in Developing Countries

1551

programs themselves. While a definite answer to these questions is far from trivial
and remains a challenge for future research - some simple e c o n o m e t r i c exercises m a y
shed light o n these important issues. Specifically - and following R e i n h a r t and V r g h
(1994, 1995b) - we ran p a n e l regressions o n d u m m y variables i n t e n d e d to capture
the early a n d late stages o f a program, a n d test whether growth in per capita GDP,
consumption, and fixed investment during those periods was significantly different
from trend growth 22. We also test for the significance o f the time pattern o f public
consumption 23. The regressions control for c o m m o n external shocks, as suggested
by Echenique and Forteza (1997) 24. The sample for the panel regressions remains
the same as that used for the stabilization time profiles: four countries (Argentina,
Chile, Israel, and U r u g u a y ) with 16 observations each ( 1 9 7 8 - 1 9 9 3 ) for a total o f
64 observations.
We define the "early" d u m m y as taking a value o f one in the first three years o f
the programs 25. I f the p r o g r a m lasted less than three years (as was the case for the
Argentine "tablita" and the Austral plan), then the "early" d u m m y takes a value o f
one in the first two years o f the program. I n all cases, the "late" d u m m y takes a value
of one in the two years immediately following the "early" stage 26. Notice that the
"late" d u m m y has b e e n defined for all programs, regardless o f whether they actually
failed or not. W h i l e this makes the criterion more stringent (compared to defining the
"late" d u m m y only for those programs that fail), it is m o r e in accordance with the idea
that the late recession takes place in both successful and u n s u c c e s s f u l programs. As
control variables, we chose the Libor rate (adjusted by US inflation), average growth
in OECD countries - both o f which are i n t e n d e d to capture the world business cycle
and terms o f trade 27.

22 See also De Gregorio, Guidotti and Vrgh (1998), Gould (1996), and Echenique and Forteza (1997).
23 As will become clear in Section 5, this evidence is relevant for some theories that have emphasized
the effects of fiscal policy in explaining the real effects of exchange rate-based stabilization.
24 Of course, one would like to control also for the effects of domestic reforms, which have accompanied
several (although certainly not all) of these programs. To that effect, one could construct a "liberalization
index" - which would take into account trade, financial, and structural reforms - along the lines of
work by De Melo, Denizer and Gelb (1995) for transition economies. This remains an issue for future
research.
25 The year in which the program was implemented is included as part of the "early" dmnmy if the
program started in the first three quarters. Otherwise, the following year is taken as the first year of the
"early" dummy.
26 Specifically, the years in which the "early" and "late" dunmaies take a value of one are the following:
Argentine tablita, early = 1 for 1979 and 1980, late = 1 for 1981 and 1982; Austral plan, early- 1 for
1985 and 1986, late-1 for 1987 and 1988; Convertibility plan, early = 1 for 1991, 1992, and 1993;
Chilean tablita, early 1 for 1978, 1979, and 1980, late= 1 for 1981 and 1982; Israel 1985, early= 1 tbr
1985, 1986, and 1987, late = 1 for 1988 and 1989; Uruguayan tablita, early = 1 for 1979, 1980 and 1981,
late= 1 for 1982 and 1983; Uruguay t990, early=l for 1991, 1992, and 1993.
27 All data were obtained from the International Monetary Fund. Both Libor and OECD growth are
expressed in percentage terms. The terms of trade index measttres the relative price of exports in terms
of imports.
TM

1552

G.A. Calvo and C.A. V~gh

Table 2
Exchange-rate-based stabilization: Panel regressionsa
Dependent variables
Growth in
real GDP
(1)
Early dummy
Late dummy
Libor (real)
OECD growth
Terms of trade
No. of obs.

1.84"*
(0.73)
3.49***
(0.82)
-0.31 **
(0,14)
0.71"**
(0.20)
-0.03
(0.02)
64

Growth in
Growthin
real private
real durables
consumption consumption
(2)
(3)
3.33**
(1.57)
-4.60**
( 1.93)
-0.68"*
(0.31)
0.21
(0.47)
0.02
(0.03)
64

14.74"
(7.89)
-29.61 ....
(l 0.01)
--3.3 l**
(1.59)
1.97
(2.44)
-0. l 8
(0.20)
64

Growthin
real fixed
investment
(4)

Growth in
real public
consumption
(5)

0.80
(3.76)
4.46
(4.62)
-2.81"**
(0.77)
0.78
(1.15)
-0.10
(0.10)
64

-3.78
(2.58)
-5.42*
(3.19)
-1.18*"
(0.52)
0.76
(0.78)
0.04
(0.06)
64

a All dependent variables are expressed in per capita terms. The sample includes Argentina, Chile,
Israel, and Mexico for the period 1978-1993. Standard errors are given in parentheses. The method of
estimation was a 2-step GLS procedure which allows for groupwise and cross-group heteroscedasticity
and groupwise autocorrelation. The regressions include fixed effects (not reported). Significance at the
10, 5, and 1 percent level is indicated by one, two, and three asterisks, respectively.

The summary results of the panel regressions are reported in "Iable 2. Let us
first focus on the first three columns (GDP, private consumption, and durables
consumption). The "early" and "late" dummies have the expected signs (positive for
"early" and negative for "late") and are significant (at least at the 10 percent level) in
all three cases. For example, column (2) indicates that growth in private consumption
per capita is 3.33 percent higher (relative to trend growth) during the early stages of
the program and 4.60 lower in the late stages. The size of the coefficients also tends to
support the idea suggested by Figure 2 - that the boom-recession cycle is the most
pronounced for durable goods and the least pronounced for GDP, with consumption
falling somewhere in between. The initial rise in durable goods consumption is more
than four times larger than the rise in private consumption, which is in turn almost
twice as high as the rise in GDP per capita. Increases in Libor (in real terms) negatively
affects all three variables (and are always significant). This result is consistent with the
notion that fluctuations in international interest rates also play a key role in generating
boom-bust cycles in developing countries [see, for example, Calvo, Leiderman and
Reinhart (1993)]. OECD growth matters only for GDP growth, while the effects o f
terms o f trade are never significant.

Ch. 24: Inflation Stabilization and BOP Crises in Developing Countries

1553

In sharp contrast, the cycle in fixed investment is not statistically sigqlificam [Table 2,
column (4)]. Changes in real world interest rates (i.e., real Libor) fully explain the
cycles in fixed investment. In any event, this should perhaps not come as a big
surprise since casual evidence for a majority of programs suggests that the main force
behind the expansionary phase is the sharp increase in private consumption. It is also
consistent with evidence from Bruno and Easterly (1998) and Easterly (1996), who find
that growth following inflation crises is not driven by investment. Finally, column (5)
in Table 2 indicates that the initial fall in public consumption is not statistically
significant.
We may thus conclude that the econometric evidence is consistent with the notion
that exchange-rate-based stabilization leads to boom-recession cycles in real GDP,
private consumption, and consumption of durable goods, even when account is taken
of external factors. The evidence is inconclusive with regard to investment.
3.1.3. Do exchange-rate-based stabilizations sow the seeds' o f their own
destruction?

A notable aspect of exchange-rate-based stabilization programs is that, as noted iu

Table 1, a vast majority have ended in balance-of-payments crises. In fact, of all the
major programs listed in Table 1, the Argemine 1991 Convertibility plan is so far the
only successful plan which has maintained the exchange rate at the level chosen at
the inception of the program 28. Eight of the twelve plans ended in full-blown crises
with large losses of international reserves. Naturally, the stabilization time profiles
in Figures 1 and 2 appear to capture this pattern. In T + 4, the current account
sharply reverses course (Figure 1, Panel C), suggesting that a "crisis" has occurred 2,7
This "crisis" time coincides with a resumption of high inflation, a real exchange rate
depreciation, and a collapse in GDP, consumption, and investment.
As argued by Reinhart and V6gh (1995b), the dynamics unleashed by exchange-rate.
based stabilization plans are likely to be partly responsible for the demise of several
programs. Prolonged periods of real exchange-rate appreciation and growing current
account deficits are seldom sustainable, especially when domestic and external shocks
compound the problems. Corrective devaluations do not always work, particularly in
a world of increasing financial globalization, as the example of Mexico in December
1994 dramatically showed. These regimes are also prone to financial and speculative
attacks which may be unrelated to problems of current account sustainability. The
evidence thus suggests that understanding the links between the dynamics of exchange
rate-based stabilizations and the eventual collapse of most of these programs should

2a The lsraeli 1995 plan was also a successfulplan in terms of obtaining a lasting reduction in inflation.
tlowever, there were severaldevaluations along the way and finally an exchange rate band was adopted.
2,7 Kaminsky and Reinhart (t995) show that BOP crises are associated with a sharp rise in exports.
which shotdd lead to a dramatic improvementin both the trade and current account balances.

1554

G.A. Calvo and C.A. Vdgh

be an integral part o f the research agenda (an analysis of these issues is carried out in
Section 7).

3.2. Money-based stabilization: empirical regularities

Money-based programs in chronic inflation countries have been much less common
than programs based on the exchange rate 3o. Table 3 presents the main features o f five
major money-based programs undertaken in the last 25 years 3l . As the table makes
clear, monetary regimes vary across episodes and pure money-based programs (i.e.,
a clean floating regime) are rare 32 Hence, for the purposes of this chapter, the term
"money-based" stabilization should be broadly understood as including assorted dirty
floating regimes and dual exchange rate systems with a fixed commercial rate (or
equivalent systems). The rationale for lumping these regimes together is that in all
cases the monetary authority has, to a lesser or greater extent, control over the money
supply. This is, o f course, in contrast to an exchange-rate-based regime (under perfect
capital mobility) in which the money supply is fully endogenous. As will be discussed
in detail in Section 5, one should expect regimes in which the monetary authority has
control over the money supply to deliver similar outcomes to those that would obtain
under a pure money-based regime. Hence, to contrast stylized facts with theory, it
makes sense to adopt such a classification.
The following empirical regularities have been identified in money-based programs
[see Calvo and V6gh (1994b)]:
(i) Slow convergence of inflation to the rate of growth of the money supply.
(ii) Real appreciation of the domestic currency.
(iii) No clear-cut response of the trade balance and the current account. I f anything~
there seems to be a short-run improvement in the external accounts.
(iv) Initial contraction in economic activity. A sharp, though short-lived, contraction
in real GDP, consumption, and investment seems to follow the implementation of
money-based programs.
(v) Initial increase in domestic real interest rates.
These empirical regularities are less surprising in that they seem to broadly conform
with available evidence for industrial countries. To illustrate some of these empirica!
regularities, we constructed a panel with five countries (Argentina, Brazil, Chile~

30 As discussed below, there are good reasons to expect the exchange rate to be the preferred anchor
in chronic inflation countries.
31 For case studies, see Harberger (1982), Corbo (1985), Edwards and Cox Edwards (1991), Mcdeiros
(1994), Kiguel and Liviatan (1996), and Favaro (1996).
32 Note that, by definition, a pure money-based program implies a clean floating. The reverse, however,
is not necessarily true: a clean floating might be adopted in conjunction with, say, interest rate or inflatiol~
targeting [see, for instance, Masson, Savastano and Sharma (1997) and V6gh (1997)]. These monetary
regimes, however, have not been observed in any major stabilization effort in high inflation countries.

Ch. 24 .

Inflation Stabilization a n d B O P Crises in D e v e l o p i n g Countries

o~

xs

"
Z

m.

e]

m.

tt.5

,,_z,

~D

4
%
o

r)

~al) ,.s=1 . ~
0

==

~:~

co

,.~
x

"'8

.=

r~

1555

G.A. Calve and C.A. V~gh

1556
A. Inflation and money growth
(percentper year)

30007 - 2500_
20001500-

r/

1000

B. Real GDP growth

(percentper year)

6-~

ation

420-2-

500

/
'

,,,\
m e a n inflation

-4.

~\ ~

2:L2_-2:_L27.2-_L_.~ _~71j . . . .". . . . . . . . . . . .

-6- , ~

~/money growth
-8-

3--2

T-I

T~I

T~-2

T~-3

T+4

'-2

T-I-

C. Real exchange rate

(index number, T-1=100)

110

3--

3~+1

V+2

1'+3

T:

D. Current account
(percentof GDP)
-1.0_ - - ~ ' = T

105

-1.5-

100

~i

-2.0-

95
-2,590
-3.0-

85

-3.5-

80
75
T-2

,,4.0.

T-1

T~I

T+2

T~3

T+4

T-2

T-1

T~-1

T~2

T'+3

T+4

Fig. 3. Money-based stabilization.

D o m i n i c a n Republic, and Peru) with 25 years o f annual data (19'71-1995), for a total
o f 125 observations 33, 34
The stabilization time profiles are illustrated in Figure 3. Panel A shows that the
inflation rate falls dramatically in the first year after stabilization but begins to rise
again s o o n afterwards 3s. A l t h o u g h the inflation rate does r e m a i n above the rate of
m o n e y growth, inflation persistence appears to be m u c h less p r o n o u n c e d that in
exchange-rate-based p r o g r a m s (recall Figure 1, Panel A). R e a l G D P growth falls in
the year o f stabilization f r o m -3.8 to - 7 . 3 percent, but recovers soon after and is
33 Again, data availability dictated the sample size. Since we now focus on a smaller member of variables,
the time series available are longer than before. However, the small nunther of programs and the rather
short duration of some of them calls for c:~ution in the interpretation of the evidence.
34 For these programs, T is 1975 for the Chilean plan and 1990 for the Collor, Bonex, Dominican
Republic, and Peruvian plans. To avoid overlapping with other, exchange-rate-based plans and giving
priority to the actual plan which was in effect the Bonex plan is associated with two dtupanies (1989
and 1990), the Collor plan goes back only until T - 1, and the Chilean 1975 plan goes forward only
until T + 1.
35 The fact that inflation actually rises in the year of stabilization (T) is heavily influenced by the
Peruvian program.

Ch. 24:

lnflation Stabilization and BOP Crises in Deueloping Countries"

155'7

above the sample mean in T + 3 (Panel B). The evidence is thus consistent with a
short-lived but sharp contraction in economic activity. It should be noted, however,
that real GDP growth is already below its mean in the year before the program. The
real exchange rate appreciates throughout the program (Panel C), while the current
account shows no clear pattern (Panel D). Lack of data prevented us from looking at
real interest rates. Quarterly data presented in Calvo and V6gh (1994b), however, are
consistent with the notion of an initial rise in real interest rates.
3.3. R e c e s s i o n n o w v e r s u s r e c e s s i o n later

A comparison of the real activity in money-based and exchange-rate-based stabilizations raises an important issue. The timing of the recessionary effects of
disinflation programs appears to differ across nominal anchors: in money-based plans
the contraction occurs early in the program, while in exchange-rate-based programs
it seems to occur late in the program (compare Figure 2, Panel A with Figure 3,
Panel B). This phenomenon has been dubbed the "recession-now-versus-recessionlater" hypothesis.
To test this hypothesis, we carried out two econometric exercises for the rate
of growth of real per capita GDP for as large a sample as possible. The sample
includes the period 1971-1995 for eight countries (Argentina, Brazil, Chile, Dominican
Republic, Israel, Mexico, Peru, and Uruguay) for a total of 200 observations. The
sample comprises 14 stabilization plans: 9 exchange-rate-based stabilizations (all
of those described in Table 1 except for the first three) and the five money-based
stabilizations listed in Table 3.
Table 4 shows the results of fixed effects regressions on stabilization dummies, controlling for external factors 36. Three regressions are shown: the first two ("individual
regressions") attempt to identify the effects of exchange-rate-based stabilization time
dummies and money-based stabilization time dummies separately (i.e., each regression
includes only the time dummies corresponding to a particular anchor). The third ("joint
regression") includes all stabilization time dummies simultaneously.
Let us first focus on exchange-rate-based stabilization. First, regressions (I) and (3)
indicate that growth in the two years before exchange-rate-based stabilization is not
statistically different from trend growth 37. Hence, exchange-rate-based stabilizations
appear to have been implemented in "normal" times 3s. Growth in the first two years
of stabilization (T and T + 1) is significantly above trend growth in the individual
regression. In the joint regression, growth is significantly above trend in T + 1. In both
cases, growth is significantly below trend four years after stabilization (i.e., in T + 4)~
External factors have the expected signs and are always significant.
36 For the 12 plans analyzedbefore, T remains the same. For the two new plans in the sample (Cruzado
and Mexican plan), T is 1986 for the Cruzado plan and 1988 for the Mexican plan. We do not allow
for overlapping.
37 Of course, since all regressions include fixed effects, trend growth varies across cotmtries.
38 This casts doubts on the idea that the booms associatedwith exchange-rate-basedstabilizations began
prior to the implememationof the programs, as has been argued by Kydland and Zarazaga (1997).

1558

G.A. Calvo and C.A. Vdgh

Table 4
Real GDP per capita growth before and after stabilization a
individual regresssions
Exchange-ratebased
(1)
T- 2
T- 1

-0.46
(1.09)
0.94

(l.08)
7"
T+ 1

2.00*
(1.03)
2.91"**

Moneybased
(2)

Joint regression
Exchange-ratebased

Money
-based
(3)

-6.86***
(1.56)
-4.18 ....

-0.71
(1.18)
0.47

(1.59)

(1.13)

-10.83"**
(1.60)
-3.84**

1.42
(1.11)
2.34**

-6.96***
(1.66)
-4.45 .......
(1.59)
-10.98 ......
(1.59)
-3.87
(1.58)
-2.84
(1.76)
-1.12
(1.77)
0.49
(1.71)

(i .03)

(1.55)

(l. 11)

-0.21
(1.04)
0.49
(1.10)
1.99"
(1.11)
-0.62***
(0.13)

-3.20"
(l.71)
-0.83
(1.71)
0.39
(1.64)
-0.58***
(0.13)

-0.61
(1.11)
-0.26
(1.20)
-2.33**
(1,17)

OECD growth

0.55***
(0.16)

0.57***
(0.17)

0.55***
(0.17)

Terms of trade

0.012"
(0,0069)
200

0.013'
(0.0067)
200

0.013"
(0.0067)

T+2
T+3
T+4
Libor (real)

No. of observations

-0.60 ....
(o.13)

200

Dependent variable is real SDP per capita growth. The sample comprises Argentina, Brazil, Chile,
Dominican Republic, Israel, Mexico, Peru, and Uruguay ~br the period 1971-1995. Standard errors are
given in parentheses. The method of estimation was a 2-step GLS procedm'e, which allows for groupwise
and cross-group heteroscedasticity and groupwise antocorrelation. All regressions include fixed country
effects (not reported). Significance at the 10, 5, and 1 percent level is indicated by one, two, and three
asterisks, respectively.
a

In m o n e y - b a s e d stabilizations, growth in the two years before stabilization is

significantly below trend growth [regressions (2) and (3)]. M o n e y - b a s e d stabilizations
thus appear to have b e e n i m p l e m e n t e d in "bad" times. Growth is sharply below trend
in the year o f stabilization and continues to be significantly below trend in the tirst
year (in both the individual and j o i n t regressions) and second year after stabilization
(in the individual regression). External factors have the expected signs and are always
significant.
These results are thus consistent with the idea o f an early recession in m o n e y - b a s e d
stabilization, and an early b o o m followed by a contraction in exchange-rate-based

Ch. 24: lnflation Stabilization and BOP Crises in Deueloping Countries,

1559

stabilization. A caveat to be noticed is the fact that growth was significantly below
trend before the stabilization in money-based programs. This raises the possibility that
the initial recession might simply be the continuation o f that trend 39.
While the regressions reported in Table 4 are certainly revealing, they may be asking
too much o f the data. The reason is that we are really interested in the behavior
of growth in the "early" and "late" stages o f stabilization programs, rather than in
specific years (i.e., we are interested in "joint significance"). Hence, as before, we
ran panel regressions with early and late dummies, and control variables 4. Table 5
shows the same regression estimated by three different methods: OLS, fixed effects,
and a 2-step GLS with fixed effects. The results do not vary much across different
method of estimations. In all cases, the early and late dummies for exchange-rate-based
stabilization are significant and so is the early dummy for m o n e y - b a s e d stabilization.
In other words, growth in the early stages o f an exchange-rate-based stabilization is
significantly higher than trend growth and significantly below trend growth in the late
stages. In money-based stabilizations, growth is significantly below trend growth in
the early stages and not significantly different from trend growth in the late stages.
Of the control variables, real Libor and OECD growth are always significant. These
results are thus consistent with the recession-now-versus-recession-later hypothesis.
3.4. A word o f caution
A final word o f caution is in order. Research on the empirical regularities o f
stabilization in chronic inflation countries is still very much work in progress. In fact,
we would argue that too little empirical work - relative to theoretical work - has been
done in the area. Needless to say, this type o f analysis faces formidable obstacles,
including small samples (in particular o f money-based programs), the definition o f
inflation stabilization episodes, the classification o f episodes by type o f nominal
anchor, the quality o f the data, and the need to control for other shocks (both domestic
and external). Much work remains to be done and the results presented here should
be taken as suggestive and pointing out directions to follow, rather than as conclusive
evidence.
At a methodological level, we think it is important to distinguish between two
alternative approaches. One approach - the one adopted in this section
might be
t9 In addition, Gould (1996) has argued that the state of the economy be%re stabilization influences the
choice of the nominal anchor, with "bad" times inducing policymakers to choose money as the main
anchor.
40 For tile seven plans which were already part of the previous sample, the danmaies are the same but,
since the sample is now longer, the late dummy takes a value of 1 during 1994 and 1995 for both the
Convertibility plan and the Uruguayan 1990 plan. For the seven new plans, the years in which "early"
and "late" take a value of I are the following: Bonex plan: early = 1 for 1990 (no late dummy); Cruzado
plan: early= 1 for 1986, late= 1 for 1987 and 1988; Chile 1975, early= 1 for 1975 and 1976, late= 1 for
1977; Dominican Republic, early = 1 for 1990, 1991 and 1992, late = 1 for 1993 and 1994; Mexico,
early= 1 for 1988, 1989, and 1990, late 1 for 1991 and 1992; Peru, early 1 for 1990, 199I, and 1992~
late= l for 1993 and 1994.
TM

TM

1560

G.A. Catuo and C.A. V~gh

Table 5
Real GDP per capita growth: Panel estunates a
OLS
(l)
Exchange-rate-based stabilization: Early dummy
Exchange-rate-based stabilization: Late dummy
Money-based: Early dummy
Money-based: Late dmnmy
Libor (real)
OECD growth
Terms of trade
Adjusted R 2
No. of observations

2.31"*
(0.96)
-2.33**
(1.10)
4.90 *0*
(1.40)
1.59
(1.66)
-0.50
(0.13)
0.55***
(0.19)
0.01"
(0.006)
0.18
200

Fixed effects
(2)
2.40**
(1.03)
-2.18*
(1.16)
-5.46***
(1.44)
0.72
(1.69)
-0.61 . . . .
(0.14)
0.45**
(0.19)
-0.005
(0.015)
0.25
200

2-step GLS
(3)
1.73"*
(0.75)
- 1.64"*
(0.80)
-6.29 ....
(1.30)
-1.89
(1.22)
0.62
(0.13)
0.62 ....
(0.16)
0.01
(0.007)
200

a Dependent variable is expressed in per capita terms. The sample includes Argentina, Brazil, Chile,
Dominican Republic, Israel, Mexico, Peru, and Uruguay for the period 1971-1995. Standard errors are
given in parentheses. The 2-step GLS procedure allows for groupwise and cross-group heteroscedasticity
and groupwise autocorrelation. The regressions include fixed effects (not reported). Significance at the
10, 5, and 1 percent level is indicated by one, two, and three asterisks, respectively.

d u b b e d the "episodic" approach. This approach involves selecting the best-kdlown

stabilization episodes, which have received a great deal o f attention. A t the other
extreme, we have a " m e c h a n i c a l " approach, where stabilization episodes are defined
based on the behavior o f inflation. For example, Easterly (1996) defines a stabilization
as an episode characterized by a switch from a period o f two years or more with an
a n n u a l rate o f inflation above 40 percent to a period o f two years or more with an
a n n u a l rate o f inflation below 40 percent.
Both approaches have problems. The "episodic" approach is subjective and will tend
to omit lesser-known episodes 41. The " m e c h a n i c a l " approach defines a stabilization
b y its outcome, which is clearly problematic. Conceptually, an inflation stabilization
p r o g r a m involves a drastic reduction in the rate o f growth o f a policy i n s t r u m e n t
(the exchange rate or the m o n e y supply) and n o t necessarily the attainment o f a
41 It should be noted, though, that omitting smaller programs is not necessarily a bad thing. To isolate
better the effects of a given phenomenon, it makes sense to select episodes in which the phenomenon
in question relative to many other factors which are difficult to control for - was of overriding
importance.

Ch. 24:

Inflation Stabilization and BOP Crises in Developing Countries

t561

policy objective (a fall in the inflation rate). In fact, both theory and evidence provide
numerous examples of stabilizations which involve a rather slow reduction (or even an
initial increase) in inflation. Whatever the merits of both approaches, in the second~
best world of empirical analyses, there is surely something to be learned from both of
them.
Within the episodic approach, Echenique and Forteza (1997) argue that the results
reported in Reinhart and V6gh (1994, 1995b) - in particular, the initial boom under
exchange-rate-based stabilization - are not robust to the inclusion of external factors
(they do not look at either private consumption or durable goods consumption). The
revised estimates reported above do not support such a claim, except for investment.
In any event, controlling for other factors - both domestic and external - is clearly
an important endeavor as it would imply that, quantitatively speaking, models of
exchange-rate-based stabilization should be able to account only for a fraction of the
actual booms observed. Gould (1996) argues that, after adjusting for initial conditions
which make the choice of the nominal anchor endogenous, growth actually improves
in either case.
Using the "mechanical approach" described above, Easterly (1996) argues that
stabilization from high inflation has been expansionary (in terms of GDP and
consumption) regardless of the nominal anchor. In other words, he does not find
evidence of money-based stabilization being contractionary. The difference may
reflect the very different sample - out of 28 episodes, Easterly (1996) classifies
all but 9 as money-based stabilization - and the fact that he considers only successful
programs. In accordance with our findings, however, Easterly (1996) also argues
that higher investment is absent in the early stages of stabilization. The notion that
inflation stabilization may be associated with higher growth also receives support
from the transition economies. Using a 25-country sample, Fischer, Sahay and V6gh
(1996) conclude that inflation stabilization has been expansionary for the transition
economies - regardless of the nominal anchor - but that resorting to a fixed exchange
rate has had an additional positive effect on growth.
A more general critique is that of Kydland and Zarazaga (1997) who argue based on a review of the literature on disinflation in chronic-inflation countries anO
an analysis of business cycles in Argentina - that nominal exchange rate shocks do
not seem to have had any noticeable real effects, even during exchange-rate-based
stabilizations. More specifically, they argue that business cycles in Argentina could be
explained by real shocks. It is worth stressing, however, that the stabilization literature
has certainly not claimed that stabilizations are the main source of business fluctuations
in high-inflation countries; it has only claimed that stabilization programs have reai
effects. The latter is, of course, perfectly consistent with the idea that real shocks
may be the main source of business cycle fluctuations over long periods of time42~
4~ A case in point is Uruguay. Hoflknaisterand Vdgh (t996) find that over tile period 1975--1990nominal
shocks explain only a small fraction of output movements.For the tablita period (1979-1983), however~
a historical decomposition suggests that nominal shocks played a central role.

1562

G.A. Calvo and CA. V~gh

Furthermore, for any given country, major stabilizations are relatively rare events. This
small-sample problem has led researchers in this area to work with panels (i.e., crosscountry analysis). It is thus doubtful whether time-series, business-cycle analysis for a
particular country might be able to pick up the real effects of stabilization. Even if such
effects were there, the "recurrent" sources of business cycle fluctuations - whatever
they may be, and this literature certainly takes no position on this - would probably
dominate.

4. Exchange-rate-based stabilization I: inflation inertia and lack of credibility

Given the main characteristics of chronic inflation processes - decades of high inflation
and a rich history of failed stabilization attempts - it is perhaps not surprising that the
two main explanations advanced for the stylized facts discussed in Section 3 rely on
inflation inertia and lack of credibility.
4. l. Inflation inertia

Rodriguez (1982) was the first to point out that, under conditions of high capital
mobility, a credible decline in the rate o f devaluation may provoke an initial expansion.
The main motivation behind his model was the fall in real interest rates observed in
the initial stages of the Argentine tablita [see also Fernandez (1985)]. In the model,
a reduction in the devaluation rate leads, through the interest parity condition, to
lower domestic nominal interest rates. If inflationary expectations are sticky (i.e.,
adaptive expectations ?t la Cagan), then the real interest rate will fall, stimulating
aggregate demand in the short run. The initial expansion, however, will eventually
be followed by a contraction, as inflation inertia leads to a sustained real exchange
rate appreciation. Rodriguez's (1982) major contribution was thus to show that, even
though Phillips-curve type implications will eventually hold, short-run dynamics may
push the economy in the opposite direction. Notice, incidentally, that the argument
relies on some form of expectational inertia 43.
The above explanation has prima facie high predictive power, as it reproduces quite
well the stylized facts documented in the previous section, including the boom-recession cycle and the U-shaped path of the real exchange rate. It also provides
us with a simple model suggesting the possible traps that one might encounter in a
stabilization effort. For example, if the process is not well understood, policymakers
may reach the conclusion that stabilization has generated a higher sustainable level
of output and economic activity. Since expansion is normally accompanied by higher
4:3 Dornbusch (1982), in contrast, assumes that agents display rational expectations (i.e, are forwardlooking), but that the inflation rate is predetermined and thus exhibits a large degree of inertia. While
Dotvabusch (1982) does not focus on the initial output effects of disinflation, he emphasizes the eventual
recession brought about by the c:maulativereal appreciation of the domestic currency.

1563

Ch. 24." Inflation Stabilization and BOP Crises in Developing Countries

fiscal revenue, policymakers may be induced to slacken their control on government

expenditure, enhancing the economy's overheating and further widening the fiscal
deficit when recession sets in. Further, as emphasized at the time by Dornbusch
(1982) - and more recently by Dornbusch and Werner (1994) - sticky-inflation-based
models call attention to the problem of "overvaluation" and the public's expectations
that a corrective devaluation would have to take place at some point to restore
"equilibrium" relative prices.
Rodriguez's (1982) model postulates reduced-form aggregate demand functions
which depend on the real interest rate and the real exchange rate. In particular,
the model assumes that a higher real interest rate unambiguously lowers aggregate
demand. These appear to be highly plausible assumptions. However, Calvo and V6gh
(1994a) show that such assumptions are rather strong and are not necessarily supported
by models consistent with optimizing behavior. This can be illustrated by a simple
example.
Consider a small open economy perfectly integrated with the rest of the world
in goods and capital markets. The representative household's instantaneous utility
depends (separably) on consumption of tradables, c T, non-tradables (or home goods),
c y, and real monetary balances in terms of tradables, m 44. Thus, lifetime utility as of
time 0 can be written as:
.fo ~ [o(c/) + u(c~) + z(mt)] exp(-/3t) dt,

(4.1)

where/3(> 0) is the rate of time preference, and 0(% u(.) and z(.) are strictly increasing
and strictly concave functions.
The individual has a constant endowment flow of tradable goods, yV, while output
of nontradables, yN, is demand-determined (i.e., in equilibrium, yN = c N for all t). Tile
law of one price holds for the tradable good. The (constant) world real imerest rate is
denoted by r. (It will be assumed that there is no foreign inflation, so that r is also
the world nominal interest rate.) Therefore, the individual's lifetime constraint is given
by:
b0 -I m0 +

T + y_N + rt
Ct

exp(--rt) dt =

c T ~ cN I itmt
,

Ct

e x p ( r t ) dL

(4.2)

where b0 denotes tile individual's initial stock of net foreign assets, et denotes the real
exchange rate (i.e., the relative price of tradable goods in terms of non-tradable goods),
it is the nominal interest rate, and Tt are government lump-sum transfers. Given perfect
capital mobility, the interest parity condition it = r + Et holds, where e~ is the rate of
devaluation.
44 As will become clear below, the other assumptions in the present example make our key ~esuits
invariant with respect to the price deflator in the definition of real money balances.

G.A. Calvo and C.A. V@h

1564

To abstract from fiscal issues, we assume that the government returns back to
the consumer all of its revenues. Hence, the government's lifetime budget constraint
indicates that the present value of transfers must equal the initial stock of governmentheld foreign assets (i.e., international reserves), denoted by Ro, and revenues from
money creation:

/0

rt exp(-rt) dt = Ro +

/0

(tht + etmt) e x p ( r t ) dr.

(4.3)

Combining (4.2) and (4.3), taking into account non-tradable goods market equilibrium,
the interest parity condition, and the transversality condition limt _, 0 mt exp(-rt) -- 0,
yields the economy's resource constraint
ko + yT
L = ~0occ] exp(-rt) dr,
F

(4.4)

where k ( - b + R) is the economy's net stock of foreign assets. Equation (4.4) thus
constrains this small economy's lifetime consumption of tradable goods to be equal to
tradable goods wealth.
Maximization of lifetime utility (4.1) with respect to the budget constraint (4.2)
yields the following first-order conditions 45:
v'(c~) = A,

(4.5)

X
,

(4.6)

z'(mt) = 26,

(4.7)

u'(c~) et

where X is the time-invariant Lagrange multiplier. Equations (4.5) and (4.6) are the
familiar conditions whereby, at an optimum, the household equates the marginal utility
of consumption to the shadow value of wealth, Z, times the relative price of the good
(uaity in the case of tradables and 1/e in the case of non-tradables). Similarly, at an
optimum, the marginal utility of real money balances is set equal to the shadow value of
wealth times the opportunity cost of holding real money balances, i [Equation (4.7)].
Equation (4.5) indicates that optimal consumption of tradable goods is constant
along a perfect fo~resight path. From Equation (4.4), it then follows that cf = rko + y T
a constant, for all t ~> 0. Further, notice that unanticipated changes in the devaluation
rate will not affect consumption of tradable goods. Consequently, from Equation (4.5),
the Lagrange multiplier, ~, is invariant with respect to (unanticipated) changes in the
rate o f devaluation 46. This feature will greatly simplify the ensuing analysis.

Backward-looking indexation is introduced along the lines of Calvo and V6gh

(1994a). The home goods sector operates under sticky prices (i.e., the nominal price
45 As usual, we assume that [3 - r to eliminate inessential dynamics.
46 Of course, the multiplieris always invariantto anticipated changes.

Ch. 24." Inflation Stabilization and BOP Crises in Developing Countries'

1565

of home goods, pN, is a predetermined variable). Let the rate of inflation (of nontradables) be indicated by Jr. We assume that
srt = co, + O(c N _yN),

0 > 0,

(4.8)

where iPN stands for full-employment output ofnon-tradables, and co is a predetermined

variable which satisfies
cbt - X(3rt --cot),

y > 0.

(4.9)

The variable co can be interpreted as the rate o f growth of nominal wages. Hence,
Equation (4.8) says that inflation of home goods is equal to the rate of growth of
nominal wages plus excess aggregate demand 47. In turn, equation (4.9) indicates
that wage inflation increases (decreases) as price inflation (in terms of nontradables)
exceeds (falls short of) wage inflation. This assumption is meant to capture backwardlooking wage indexation mechanisms, whereby the rate o f growth o f nominal wages
is adjusted whenever the inflation rate exceeds the current level of wage growth.
To illustrate the implications of this set-up, integrate backwards Equation (4.9) and
substitute the resulting expression for ~ into Equation (4.8) to obtain
l

Jet

Yq,e x p [ - x ( t - s)] ds + O(cNt --ipN).

(4.10)

0(3

Equation (4.10) shows that current inflation depends on a weighted average of past
inflation rates - with inflation rates in the recent past receiving the greatest weight
and current excess aggregate demand, which is what the notion of "inflation inertia"
is usually taken to mean [see, for instance, Dornbusch and Simonsen (1987)].
We will now study the implications of a once-and-for-all reduction in the rate of
devaluation, which is the central exercise in Rodriguez (1982). Given the invariance
of the Lagrange multiplier with respect to changes in el, it follows from first-order
condition (4.6) that we can safely write c y as an increasing function of the real
exchange rate, et; that is, c N = q)(et), with O~(et) > 0. HencG by Equations (4.8)
and (4.9), we have
&t-~ g0[0(et) - 2N ].

(4.1 1)

Furthermore, by definition, et ~ EtPF*/PtN, where G is the nominal exchange rate (m

units of domestic currency per unit of foreign currency, p T . is the (constant) f o r e i g n

47 Note that, in this specification, )~ is not a predetermined variable (i.e., it could jump on impact if
consumption of home goods does so).

1566

G.A. Calvo and C.A. V~gh

03'
H

~=0

"

!I

...................................\ .....................~ i A

..........................

6-=0

ess

e >

Fig. 4. Inflation inertia: dynamic system.

currency price o f the tradable good and pN is the price o f home goods48. Using this
definition and Equation (4.8), it follows that
- et - cot - 0[~b(e~)_~N].

(4.12)

et

Equations (4.11) and (4.12) constitute a system o f differential equations in cot and
et, which can be shown to be locally stable 49. Since both cot and et are predetermined
variables, this ensures that under perfect foresight - and for a given set o f p a r a m e t e r s all equilibrium paths converge to the steady-state.
Suppose that initially (i.e., for t < 0), the devaluation rate is expected to remain
constant at the value e H. Hence, in the initial steady state (point A in Figure 4), ;r~ = e u
and O(e~) = ~N. At time 0, policymakers announce an unanticipated and permanent
reduction in the devaluation rate from e H to e L. The new steady state is denoted by
point B, where inflation o f home goods is e L, while the real exchange rate remains
unchanged. The dynamics o f the adjustment to the new steady state are illustrated by
the arrowed path in Figure 4.
The time path o f the main variables is illustrated in Figure 5. Nominal wage growth
falls monotonically over time (Panel B). The real exchange rate declines (appreciates)
48 Note that the real exchange rate is a predetermined variable because E is a policy variable and pN is a
predetermined variable.
49 The trace of the matrix associated with the linear approximation around the steady state is
-es~00~(ess) < 0 (where a subscript "ss" denotes steady-state values) and the determinam is
7ess0~b~(ess) > 0, which implies that both roots have negative real parts. For expositional simplicity,
roots will be assumed to be real.

1567

Ch. 24." Inflation Stabilization and BOP Crises in Developing Countries

A. Rate of devaluation

B. Nominal wage growth

co1'
H

gL
I
i

time

e'

C. Real exchange rate

time

D. Consumption of home goods

0N

ess
/- s/"

/I:'

E,

time

t~
Inflation rate

t~

time

F. Domestic real interest rate

at
r

gH
i

/--'---

\\~ ,,

~L ,

"

//

tl

time

t1

time

Fig. 5. Disinflationunder inflation inertia.

in the early stages of the program, and then returns to its initial steady-state value
(Panel C). Given that consumption of tradables remains constant, consumption of
nontradables (Panel D) falls in the early stages (as its relative price, l/e, increases)
and increases later on. Hence, during the initial stages of the stabilization program,
consumption of home goods (and thus output of home goods) falls - i.e., it does not
rise in line with the stylized facts. At some point in time (denoted by fl in Figure 5)~
inflation of home goods must fall below its long-run equilibrium value (Panel E) in
order for the real exchange rate to return to its unchanged steady-state value.
It is this protracted period of deflation needed to restore equilibrium relative prices
which underlies the call for a step devaluation at some point during the adjustment

t568

G.A. Calvo and C.A. V~gh

program [see, for instance, Dornbusch and Werner (1994)]. Indeed, in this model, a
devaluation at time tl in Figure 5 (which corresponds to point C in Figure 4) would
immediately take the economy to its new steady state, provided that workers also
agreed to reduce the rate of nominal wage growth, w, to e L.
It should be noticed that consumption of non-tradables falls in the early stages of the
program in spite of the fact that the domestic real interest rate, rd(~- i--2g), decreases
on impact (Figure 5, Panel F). The reason is that, in utility-maximization models, the
real interest rate determines the slope of the consumption path but not the level of
consumption. Hence, the initial fall in r d implies that, as long as r d < r, consumption
of non-tradable goods will follow a declining path.
Calvo and V6gh (1994a) extend this analysis to the case in which instantaneous
utility is represented by a constant-elasticity-of-substitution utility function. They show
that the results obtained in the context of Dornbusch-Rodriguez models hold true
only if the intertemporal elasticity of substitution exceeds the elasticity of substitution
between tradables and nontradables. In that case, consumption of both tradable and
non-tradables goods increases on impact, which implies that the current account goes
into deficit. The relative magnitude of these parameters is, of course, an empirical
issue. Estimates provided by Ostry and Reinhart (1992), however, cast some doubts
on the relevance of backward-looking models since they show that, for a number of
developing countries, the intertemporal elasticity of substitution is typically smaller
than that between tradables and nontradables 50.
An important feature of Calvo and V6gh's (1994a) formulation is that the
stabilization does not bring about a wealth effect, in the sense that wealth in terms
of tradable goods remains unchanged. This appears as the natural assumption to make
when the purpose of the exercise is to isolate the effects of inflation inertia on the
outcome of an exchange-rate-based stabilization. However, in a more general model
with capital accumulation and endogenous labor supply, the wealth effect associated
with a permanent reduction in the rate of devaluation will cause an increase in
consumption of tradable goods and, given that the real exchange rate cannot change on
impact, a corresponding increase in consumption of non-tradable goods [see Rebelo
and V6gh (1995), Figure 11]. Hence, wealth effects associated with supply-side effects
(analyzed in more detail below) could help explain the initial boom under backwardlooking indexation even under the more plausible parameter configuration in which
the intertemporal ~elasticity of substitution is smaller than the elasticity of substitution
between tradables and non-tradables goods.

5o The more common criticism of Rodriguez (1982) is the assumption of adaptive expectations an
assumption that has fallen out of favor among the profession. This criticism is, however,misplaced since
Rodriguez's (1982) results still hold under rational expectations, as shown in Calvo and V6gh (1994a).
In other words, the key assumption in Rodriguez (t982) is not adaptive expectations but rather that
aggregate demand depends negatively on the real interest rate (provided, of course, that there is some
other source of inflation inertia).

Ch. 24: Inflation Stabilization and BOP Crises in Developing Countries

1569

4.2. Lack o f credibility

A common characteristic o f stabilization plans is imperfect credibility. As pointed out
in Section 2, there are fundamental reasons for stabilization programs to be less than
fully credible. Since stabilization is costly from a political point o f view, why would
anybody expect that, as a general rule, stabilization programs have no chance to fail?
Implementing a program that succeeds in all states of nature is unlikely to be optimal
from the policymaker's point o f view.
Suppose, for the sake o f concreteness, that authorities announce a stabilization plan
in which the exchange rate is set at a lower and constant level forever, but the private
sector believes that the program may eventually be abandoned. To keep matters simple,
let us further assume that everybody believes that the program will be abandoned at
time T > 0 (where time 0 represents "today"), and the rate of devaluation will, once
again, become high after time T (see Figure 6, Panel A). Assuming perfect capital
mobility, the latter implies that the nominal interest rate will be low from time 0 to
time T, and expected to be high afterwards 51. Will this have real effects?
The answer is negative in the money-in-the-utility-function framework used in
subsection 4.1 to illustrate the effects o f backward-looking indexation. In that model,
the nominal interest rate does not affect any goods-markets equilibrium condition.
Thus, the real economy (under flexible prices) would be undisturbed by the monetary
experiment. However, separability between money and goods in the utility function is
a very special, and probably unrealistic, assumption. It implies that the marginal utility
of money is independent o f expenditure, a condition that is likely not to hold if money
is used for transactions 52.
Following Calvo (1986), let us assume that transactions require holding cash in
advance 53. Thus, using the same notation as before, we postulate 54
m, = a(cJ' + CN),

a > 0.

(4.1 3)

et

The consumer's preferences are now given by:

.f~/0 [v(cT) + u(c~)] exp(-fit)dt.

(4.14)

51 Note that, formally, lack of credibility is modeled as a temporary stabilization~ which explains the
label "temporariness hypothesis", often used in the literature.
52 It should be noted, however, that the basic results of Section 4.1 hold true even under non-separability
of real money balances (say, under the cash-in-advance specification explored below). Since we studied
a permanent reduction in the devaluation rate, it would still be the case that consumption of traded
goods remains unchanged under a cash-in-advance specification.
s3 We adopt a cash-in-advance, flexible-prices specification to illustrate the essential mechanisms behind
lack-of-credibility in the simplest possible model. The same results would obtain under a money-in-theo
utility-function specification provided that the cross-derivative between consumption and real money
balances is positive [see Calvo (1986)].
s4 For the derivation of the cash-in-advance constraint in continuous time, see Feenstra (1985)

1570

G.A. Catvo and C.A. V&gh

After substituting Equation (4.13) into (4.2), we obtain a lifetime constraint that
involves only c~ and c~ as choice variables (and whose corresponding Lagrange
multiplier will be denoted by ~). Maximization of Equation (4.14) subject to this
lifetime budget constraint yields

v'(clF) = ~(1 + air),

(4.15)

u'(c~) = ~(1 + air).

(4.16)

el

The term involving the nominal interest rate i, 1 + ai, has a straightforward
interpretation. Under the present assumptions, individuals must hold a stock of cash
before making purchases. This means that, in addition to the market price of the good
(unity for the tradable good and 1/e for the non-tradable good), the cost of the good
is augmented by the opportunity cost of holding the needed real money balances. The
eIfective price of consumption is thus 1 + ai for tradable goods and (1 + ai)/e for
non-tradables.
For the present discussion, we can simplify the supply side even further and
assume that the domestic supplies of tradables and nontradables are fixed at y:r
and yN, respectively. Then, by Equations (4.15) and (4.16), and home goods-market
equilibrium (i.e., c~ = yN), it follows that

et

.'(cy)

u,(yN).

(4.17)

Hence, in equilibrium, the real exchange rate and consumption of tradable goods move
in opposite direction, in other words, any shock that causes consumption of tradable
goods to increase will also entail a real exchange rate appreciation (i.e., a fall in et).
Consider now the effects of a non-credible stabilization program as described above
(Figure 6). Since the representative individual expects a policy reversal at time T,
it implies that he/she will expect the nominal interest rate i to be low from 0 to T,
and high afterwards. Thus, by Equation (4.15), consumption of tradables will be high
between 0 and T and low afterwards. Given that the present discounted value of c'r
must satisfy the resource constraint (4.4), the path of consumption of tradable goods
must look like that in Panel B of Figure 6. Intuitively, since the consumer expects
the good to be cheaper between 0 and T than after T, he/she substitutes consumption
away from the future (when consumption is expected to be relatively expensive) and
towards the present (when consumption is cheaper). The current account deteriorates
on impact and worsens throughout the stabilization as debt service increases (or net
interest income falls), as illustrated in Panel C of Figure 6. Unlike tradable goods whose supply is rendered perfectly elastic by the rest of the world - non-tradable goods
are in fixed supply. Hence, the excess demand for non-tradable goods between 0 and T
will have to be met by a rise in their relative price (i.e., a fall in et), as follows ti-om
Equation (4.17) (Panel D of Figure 6).

1571

Ch. 24." Inflation Stabilization and BOP Crises in Deueloping Countries

B. Consumption of traded goods

A. Rate of devaluation

CT '~

H~
r

Li
~i

rko+y T

time

time

D. Real exchange rate

C. Current account
e

time

time

Fig. 6. Temporary stabilization.

At the beginning of the program there is thus a boom in the consumption of
tradables and a real appreciation, which is eventually followed by a contraction in
the consumption of tradables and a real depreciation 55. Thus, this model displays two
basic stylized facts that have accompanied exchange-rate-based stabilization programs,
as argued in Section 3. It is also noteworthy that, unlike the previous explanation
based on inflation inertia, this model does not rely on an initial fall in real interest
rates. Hence, it could also explain the stylized facts even in programs in which only
nominal, but not necessarily real, interest rates fall in the early stages 56.
By introducing price stickiness into this model, Calvo and V~gh (1993) have shown
that a temporary stabilization may account for other key stylized facts discussed
in Section 3: (i) the joint occurrence of an output boom and a real exchange rate
ss The real effects at time T will occur regardless of whether the program is actually abandonedor not,
provided that if it is not abandoned, the program becomes fully credible at T. Formally,it can be shown
that permanentchanges in the rate of devaluationare everywhere superneuh-al.
56 An interesting extension of the basic model is to assume that T is a stochastic variable, as in Calvo
and Drazen (1998), which leads to richer dynamicpatterns for consumption.In particular, they show thal
in the absence of state-contingentassets, consumptionrises on impact and continues to increase as long
as the policy is in effect. See also Lahiri (1996a,b), Mendoza and Uribe (1996), and Venegas-Martinez
(1997). Fm-thervariations of the basic model include Obstfeld (1985), who studies a gradual, tablita-type
stabilization, and Talvi (1997), who analyzes tile endogenous impact of higher consumption on fiscal
revenues.

1572

G.A. Calvo and C.A. VSgk

appreciation in the early stages of the program; (ii) a recession in the non-tradable
goods sector (i.e., a fall in output below its full-employment level) which may take
place before the program is discontinued; and (iii) inflation remaining above the rate
o f devaluation until the time at which the program is expected to be discontinued 57.
Hence, in this case, inflation persistence is not due to some ad-hoc backward-looking
mechanism but rather to lack of policy credibility. The model thus suggests that the
fact that inflation remains high is not prima-facie evidence o f stickiness in the rate of
inflation 58.
It should be noted that in the exercise illustrated in Figure 6, lack of credibility is
socially costly, because a central planner would set consumption o f tradables constant
and equal to rko + y rr, instead o f setting a path displaying the boom-bust pattern
shown in Panel B of Figure 6. Hence, even though consumption rises as a noncredible exchange-rate-based stabilization program is put into effect, the stabilization
still proves to be a socially costly process. This conclusion, though, depends critically
on the fact that, in cash-in-advance models (with no labor-leisure choice), there
are no benefits associated with a reduction in inflation (i.e., the real equilibriurn is
independent of permanent changes in the inflation rate). In contrast, in transactioncosts models, lower inflation is beneficial because it frees time for productive activities.
In such a set-up, a temporary stabilization may be welfare-improving if the benefits
(in terms of freed resources) o f temporarily lower inflation more than offset the
intertemporal distortion caused by a non-constant path o f the nominal interest rate
[see Reinhart and V6gh (1995a)]. Hence, policymakers may still find it optimal to
implement stabilizations plans that may not be fully credible, provided they command
a "reasonable" level of credibility.
Lack o f credibility thus provides a rich framework to explain the main stylized facts
observed in exchange-rate-based disinflations. The most common criticism o f this type
o f model is that it relies critically on intertemporal consumption substitution, which
is believed to be small or not significantly different from zero. Reinhart and V6gh
(1995a) have examined the empirical relevance o f the "temporariness" hypothesis,
by estimating the intertemporal elasticity o f substitution for five chronic-inflation
countries (Argentina, Brazil, Israel, Mexico, and Uruguay). Using these estimates, they
compute the predicted increases in consumption for seven major stabilization plans

5'7 In this model, the domestic real interest rate falls on impact. As discussed in Section 3, howeve,, real
interest rates have typically increased on impact in heterodox programs. This often reflects tight credit
policy in the early stages of the programs. For instance, the Israeli 1985 plan had an explicit target tbr
bank credit, which was to be achieved by a combination of higher reserves requirements and a higher
discount rate [Barkai (1990)]. The idea is for money to act as an additional nominal anchor in the early
stages of the plan. This could be modeled by assuming that the stock of money is predetermined at
each point in time due to the presence of capital controls [Calvo and V~gh (1993)]. Ag6nor (1994)
incorporates fiscal considerations into a model with imperfect capital mobility to address this issue,
58 Within this fiamework, Ghezzi (1996) has analyzed the important but still little understood
question of when to abandon an initial peg and switch to a more flexible exchange rate regime (a
common occurrence in practice, as argued in Section 3).

Ch. 24." Inflation Stabilization and BOP Crises in Developing Countries

1573

(the three Southern Cone tablitas, the Argentine 1985 Austral plan, the Brazilian 1986
Cruzado plan, the Israeli 1985 plan, and the Mexican 1987 plan) and compare them to
the actual increases. They conclude that, in spite of low (but statistically significant)
elasticities of substitution - ranging from 0.19 to 0.53 - this mechanism has a good
explanatory power in four out of the seven episodes. It is the case, however, that
nominal interest rates must fall substantially for this mechanism to be quantitatively
important, which explains why the model appears to perform poorly for the SouthernCone tablitas 59.
If anything, however, the estimates provided by Reinhart and V6gh (1995a) should
probably be viewed as a lower bound for the importance of the "temporariness"
hypothesis. The reason is that the model does not incorporate durable goods which,
as argued in Section 3, appear to play a central role in the initial consumption boom.
The presence of durable goods is likely to increase the quantitative importance of
intertemporal substitution for two reasons. First, the introduction of durable goods
might yield higher intertemporal elasticities of substitution, as found by Fauvel
and Sampson (1991) for Canada. Second, in addition to intertemporal consumption
substitution, durable goods introduce the possibility of intertemporal p r i c e substitution
because goods can be stored [Calvo (1988)].

5. Exchange-rate-based stabilization lI: durable goods, credit, and wealth

effects
The explanations discussed in the previous section rely on what we view as two
key characteristics of chronic inflation processes: inflation persistence and lack of
credibility. There are other elements, however, which may have played an important
role in stabilization plans in chronic inflation countries. We first discuss the role
of durable goods consumption and credit market segmentation. We then turn to a
discussion of wealth effects, which may result from either supply-side responses or
fiscal policy.
5.1. Durable goods

As shown in Section 3, the consumption boom that characterizes exchange-rate-based

stabilization programs has been particularly evident in the behavior of durable goods.
This pattern of durable goods consumption has inspired an alternative explanation
for the boom-bust cycle put forward by De Gregorio, Guidotti and V6gh (1998)
(henceforth DGV). This hypothesis, which is unrelated to inflation inertia or lack
59 It is worth pointing out that trying to explain all of the observed consumption booms may bc
misleading, as other factors such as lower international interest rates - may account for part of the
boom.

1574

G.A. Calvo and C.A. V~gh

ci
BI

IA!B
]

-4

-3

0,

DAD

-2

-1

time

Fig. 7. Consumption of durable goods.

of credibility, is capable of generating a boom-bust cycle even in a fully credible

program.
Suppose that there are transactions costs associated with the purchase of durable
goods. This implies that individuals buy durable goods only at discrete intervals of
time. in the aggregate, however, sales of durable goods are smooth over time since
different individuals purchase durable goods at different points in time 6. This is
illustrated in Figure 7. There are four consumers (whose purchases of durable goods
are represented by the squares labeled A, B, C, and D) who buy durable goods at
different points in time (i.e., every four periods). Hence, before time 0, aggregate sales
o f durables goods are constant.
Consider now a stabilization plan implemented at time 0. Furthermore, suppose that
there is a wealth effect associated with the stabilization (more on this below). Then,
some consumers will be inclined to anticipate their purchase o f durable goods and
perhaps buy a more expensive durable good. In other words, next year's new Honda
becomes today's new Mercedes. In terms o f Figure 7, consumers B and C (who, in
the absence of the stabilization plan, would have replaced the durable good at time
t = 1 and t = 2, respectively) decide to buy the durable good at t = 0 (the picture
abstracts from "size" effects). Consumer D, who just replaced his/her durable good at
t = -1, also anticipates his/her purchase but to t = 1. In this simple example, there are
no purchases of durables at t = 3 and t = 4, due to the initial bunching o f purchases
at t = 0 and t = 1. The initial boom (in period 0) is thus followed by a bust in periods
2 and 3. Hence, this model is capable of accounting for the boom-bust cycle without
resorting to inflation inertia or lack o f credibility 61.
A key difference between this story and the previous two (inflation inertia and lack
of credibility) lies in the policy implications. Under the temporariness (i.e., lack of
credibility) hypothesis, the boom-bust cycle is a clear indication that policymakers
have not done enough at the outset to convince the public that the program is
6o In the absence of transaction costs and given fliat durable goods depreciate over time consumers
would find it optimal to buy in each period the amount of durable goods that they are planning to
consume during that period. Buying a greater amount would imply a loss for next period. Technically,
it is assumed that consumers follow (S,s) rules and choose optimally the trigger points.
61 Furthemore, if idiosyncratic shocks were introduced into the pictm'e, aggregate purchases of durable
goods would eventually return to the pattern prevailing before the plan was implemelated.

Ch. 24: Inflation Stabilization and BOP Crises in Developing Countries

1575

sustainable over time. Hence, one would expect policymakers to worry when the initial
boom emerges, and perhaps consider measures aimed at enhancing the program's
credibility. In the same vein, inflation inertia (due to backward-looking indexation)
also reflects some unresolved institutional problems which clearly endanger the whole
stabilization strategy [as in the Chilean tablita; see Edwards and Cox Edwards (1991)].
In such a case, policymakers should try to cut the link between current and past
inflation. In sharp contrast, the boom-bust cycle emphasized by DGV (1998) is a direct
consequence of the policymakers' ability to implement a fully credible stabilization
plan. The eventual consumption bust is the natural counterpart of the initial "bunching"
in consumption, and any policy measures aimed at counteracting it are likely to be
suboptimal.
In DGV (1998), the wealth effect formally comes about because the fall in inflation
leads to an increase in real money balances which, in turn, frees time spent in
transacting to be used in productive activities. This channel is consistent with models
(to be examined below) that emphasize supply-side effects of disinflation. The durablegoods consumption cycle described above, however, is independent of how this wealth
effect comes about, and would also hold under alternative scenarios which may not
involve, strictly speaking, a wealth effect. One such scenario, which we find particularly
attractive and examine next, relies on the existence of credit market constraints.
5.2. Credit market segmentation

A boom in domestic absorption, which lies at the heart of the initial expansion and
real exchange rate appreciation, can only happen if domestic residents are able to
borrow from the rest of the world, or lower their holdings of foreign assets (i.e., capital
repatriation). The examples examined so far rely on the fiction of a representative
individual. There is thus no room for some individuals to borrow abroad and lend at
home, while the rest engage in higher domestic borrowing and spending. Developing
countries, however, are typically characterized by large segments of the population
which do not have direct access to international borrowing and lending 62
A relevant scenario with two types of borrowers is one in which type l, say, has
perfect access to international capital markets (like in the above examples), and type lI
can only borrow at home. In addition, type-II individuals borrow in terms of domestic
currency and are constrained to loan contracts displaying a constant nominal interest
rate or a constant string of nominal installments. These are, admittedly, very special
loans but their simplicity may make them cost-effective for medium-ticket durable
consumption loans (i.e., television sets).
In this setup, lower inflation/devaluation may induce a consumption boom, even
though the program is fully credible. To see this, consider the realistic case in which
borrowers pay back their debts in the form of a constant stream of nominal installments.
('~ See, lbr instance, Rojas-Suarez and Weisbrod (1995) who show that domestic bank lending is mote
prevalent ha developingthan in developedcountries.

1576

G.A. Calvo and C.A. VOgh

6050if)

Ill

40-

~ i = 0.50
\
\

30-

\
\
\
\

I1)

\
\

20-

\\

10

\ --.

i = 0.20

"x
l'l-I~ IiTH]

Y~ il i i i ii1~

..........

i illtlt

ii H i H lii

i = 0.03
ii H ii i I i iii

H i j ii i i i i i i i i i i H i i i i H i H i~ i i i i i ii i i Iii

10

i i1'1'1 i"i i

15

20
time

Fig. 8. Real instaUments for various nominal interest rates (percent per year, r = 0.03).

Thus, abstracting from credibility and country-risk problems, and asstmaing that the
real (and nominal) international interest rate is r, the domestic nominal interest rate, i,
will be equal to r + e. We now assume, for simplicity, that loans are given in perpetuity
and that the rate of devaluation is expected to be constant. Hence, an individual who
borrows a sum S will have to pay an installment equal to iS in perpetuity. Furthermore,
normalizing the present price level, P0, to unity, and assuming a constant real exchange
rate, we get that domestic inflation will also be equal to e. The real value of the
installments is then given by
(r-~e) S
P~

(r+e) S
exp(et) '

t~>0,

where t = 0 is the time at which the loan is granted. Consequently, the higher is the
rate of devaluation, the higher will be the nominal interest rate, i, and thus the higher
will be the real value of the first few installments. When inflation is high, the real
value of the first few installments could be exorbitantly large, deterring credit.
Figure 8 illustrates the effects of a lower inflation rate on the time path of real
payments. In the three cases depicted, r = 0.03. The rate of devaluation takes three
different values: 0, 0.17, and 0.47, so that i = 0.03, 0.20, and 0.50, respectively. The
figure shows how the rate of inflation/devaluation can dramatically affect the time path
of real payments. When i - 0.03, the path of real installments is flat. When i = 0.50,
real installments in the early periods are the highest. Naturally, changes in the inflation

Ch. 24: Inflation Stabilization and BOP Crises in Deoeloping Countries

1577

(devaluation) rate do not affect the present discounted value of real installments as o f
time 0, which equals S. Formally, note that

,f0
~

i S exp(-rt) dt = S,
exp(et)

so that changes in e affect real payments, but not the value o f the integral.
Therefore, a substantially lower rate o f devaluation may make credit affordable to
type-II individuals. The ensuing consumption boom puts upward pressure on retailing a highly labor-intensive activity - contributing to further real appreciation of the
currency. Notice that the boom so generated may be socially desirable because it
signifies an improvement in the credit market. Furthermore, if the newly available
credit is directed towards durable goods consumption - as is likely to be the case purchases will fall later on during the program along the lines o f DGV (1998),
contributing to an eventual downturn in economic activity. Hence, this type of scenario
should be quite successful in explaining several stylized facts.
Existence o f credit segmentation may also help to rationalize these phenomena even
in the case in which there are no loan-contract constraints on type-II individuals.
This would be so, for example, if type-I individuals take the implementation of the
stabilization plan as a signal that the government is starting to "get its house in order".
High inflation reflects the existence of tensions among policy objectives. Hence, until
a stabilization program is implemented, foreign investors and type-! individuals may
feel that placing their funds in the country in question exposes them to some kind
of surprise taxation (particularly, if the funds are placed in highly visible domestic
banks) 63. Thus, by assuaging the investors' fears, a stabilization program - which
enjoys some but not necessarily complete credibility - may bring about a lowering
of interest rates for type-II individuals, stimulating expenditure 64.
5.3. Supply-side effects'

All the explanations examined so far are based on demand-side considerations. This
is perhaps only natural considering that much of the literature was inspired by the
Southern-Cone tablitas of the late 1970s where, to most casual observers, the most
striking fact was the increase in consumers' demand for goods (particularly durable
goods). In more recent programs - such as Mexico 1987 and Argentina's 1991
Convertibility plan - it has been argued that monetary stabilization may have played
an important role in unleashing supply-side responses in labor and investment [see
63 Domestic banks play a key role in making funds available to type-iI individuals, because their
comparative advantage stems f?om their better knowledge of the local mmket.
64 Again, if some of the higher consumption falls on durable goods, a boom-bust pattern may emerge
along the lines of DGV (1998). Moreover, there is, in principle, no reason in this example for social
welfare to be negatively affected by the rise in consumption.

1578

G.A. Caluo and C.A. F~gh

Rebelo (1993), Roldos (1995, 1997), Uribe (1997a), and Lahiri (1996a, 1996b)] 6s.
While the evidence presented in Section 3 casts some doubts on the general empirical
relevance o f the investment channel, supply-side effects may well have contributed to
the initial boom in some instances and thus deserve attention 66.
The role o f capital accumulation in generating a steady rise in the relative price of
non-tradables (i.e., a real exchange rate appreciation) is emphasized by Rebelo (1993)
in the Portuguese context. I f reforms increase the economy's steady-state capital stock,
then as the capital-labor ratio rises, the price o f the capital-intensive good (the tradable
good) falls. Roldos (1995) and Uribe (1997a) present models in which domestic money
is needed to buy (or install) capital goods, in the spirit o f Stockman (1981). As a result,
inflation drives a wedge between the real return o f foreign assets and that o f domestic
assets, which implies that the domestic capital stock is a decreasing function of the
inflation rate. A reduction in the inflation rate thus leads to a higher desired capital
stock, and hence to an expansion in aggregate demand and investment. Since the supply
o f non-traded goods is assumed to be relatively inelastic in the short-run, the expansion
in aggregate demand leads to an increase in the relative price o f non-traded goods (i.e.,
a real appreciation) and a trade account deficit.
A somewhat unsatisfactory aspect o f some o f these models is that they rely on some
features - gestation lags, adjustment costs, and particularly the assumption that the
investment good be a "cash good" - which do not have a clear economic interpretation.
In particular, there is no evidence that would seem to tie investment to the level
o f cash transactions. From a qualitative point o f view, however, this assumption is
not necessary for this type o f model to generate the effects just described, as made
clear by Lahiri (1996a). In his model, the nominal interest rate introduces a distortion
between consumption and leisure [as in Roldos (1997)]. When inflation falls, labor
supply increases. This, in turn, leads to a rise in the desired capital stock and, hence,
in investment. Rebelo and V6gh (1995), however, argue that the assumption that
investment be in some way related to cash transactions is critical for the q u a n t i t a t i o e
performance o f a broad class o f models 67.
A more fundamental problem o f supply-side based models is that, given that the
driving force behind such models are wealth effects, they cannot explain the late

o5 It should be noted that these programs were also accompanied by important structural reforms. As
stressed in Section 3, it would be important - though far from trivial - to disentangle the effects of
these reforms from those of the exchange rate-based stabilization per se. Clearly, we would not want to
ascribe to monetary stabilization supply-side effects which may be due to real reforms.
66 There is little systematic evidence on labor supply responses in exchange rate-based stabilization.
For some evidence on Mexico and Argentina, see Roldos (1995).
67 Similar results would obtain if money were used as a factor of production [see Uribe (i 997b)]. This
channel could be rationalized by assuming - following the credit channel literature - that firms do not
have access to capital markets and must resort to bank credit to finance the need for short-term working
capital [see Bernanke and Gertler (1995) and, in the context of stabilization policies, the discussion below
on Edwards and V6gh (1997)]. Bank-intermediated capital has been used to improve the quantitative
predictions of some monetary models; see, for instance, Chaff, Jones and Manuelli (1995).

Ch. 24." Inflation Stabilization and BOP Crises in Developing Countries

1579

contraction observed in many programs. To this end, supply-side considerations must

be supplemented by either lack of credibility or some nominal rigidity 68. To illustrate
how supply-side effects may be combined with temporary stabilization to replicate
some of the stylized facts of exchange-rate-based stabilizations, we proceed to analyze
a simple model which incorporates a consumption-leisure choice in the same cash-inadvance specification presented in Section 4.
Consider a one-good economy in which the representative household maximizes

(5.1)

o~ , ( c~ , gt ) exp(-fit) dt,

where g~ denotes leisure, subject to the lifetime constraint (which already incorporates
the cash-in-advance constraint mt a C Tt ) 69..
( 1 - g t + vt) e x p ( - r t ) d t =

bo+mo+

f0

cT(l +ai~) e x p ( - r t ) d t .

(5.2)

First-order conditions imply that (assuming fi = r):

Ucv(cT, gt) = ~(1 + air),

(5.3)

uc~(cT,g,)
(5.4)

ue(ctr,gt) - 1 + air,

where ~ is the Lagrange multiplier associated with constraint (5.2). Note how
the nominal interest rate introduces a wedge between consumption and leisure, as
Equation (5.4) makes clear. Taking into account the government's intertemporal budget
constraint, it is easy to show that
/co +

(1 - gt) exp(-rt) dt -

f0

cll exp(-rt) dr.

(5.5)

Two important observations, which illustrate some of the points noted above, follow
easily from Equations (5.3), (5.4) and (5.5). First, a permanent reduction in the rate of
devaluation, and thus in i, would cause a once-and-for all increase in consumption
and output. Hence, this would explain the initial expansionary effects, but not the
eventual contraction, observed in exchange-rate-based stabilizations. Second, if the
utility function were separable (i.e., Ucle(') = 0), then a temporary (i.e., non-credible)
stabilization of the type studied in Section 4.2 would lead to a consumption cycle
similar to that illustrated in Panel B of Figure 6, but to a p e r m a n e n t increase in output
6s Sec Rcbeto and V6gh (1995), Lahiri (1996a,b), Mendoza and Uribc (1996), and Edwards and Vdgh
(1997).
(,9 The function u(.) is assumed to be sta-ictlyincreasing and strictly concave, and goods are assumed to
be normal. The household's time endowment is taken to be one. Production is given by 1 - g.

1580

G.A. Calvo and C.A. V~gh

(i.e., a permanent fall in leisure). Hence, the output cycle cannot be rationalized with
a separable utility function.
Suppose now that the cross-derivative is negative; that is, UcTe(.) < 0. Then
it follows from Equations (5.3) and (5.4) that at time T, consumption falls and
leisure increases (i.e., work effort decreases). This piece of information, together
with Equation (5.5), implies that at time 0 both consumption and labor effort rise.
Hence, such a specification of preferences would lead to a boom-bust cycle in both
consumption and output.
An extension of this simple model - which would generate the boom-recession
cycle in output even with separable preferences - is to introduce a costly banking
system and assume that firms need bank credit to pay the wage bill [Edwards and V6gh
(1997)]. In such a framework, a fall in consumption at time T leads to a fall in demand
deposits and, hence, to a reduction in the supply of bank credit. The resulting "credit
crunch" leads to higher lending rates, a lower level of bank credit, and a recession.
More generally, the idea that the banking system may amplify both booms and busts
through changes in bank credit appears quite attractive to explain the issues at hand,
from both a theoretical and a quantitative point of view.
5.4~ Fiscal policy

The elimination of large public sector deficits is clearly a necessary condition for
a lasting reduction in inflation. It is thus not surprising that programs in which the
fiscal adjustment was either absent or short-lived got quickly off track, the best
known examples being the Argentine 1978 tablita and 1985 Austral plan, and the
Brazilian 1986 Cruzado plano In successful plans (like the Israeli 1985 plan and the
Argentine 1991 Convertibility plan), however, the fiscal adjustment has often been
quite important. Such adjustment typically involves some combination of tax increases
and cuts in government spending. While this is consistent with the initial fall in public
consumption shown in the stabilization time profile (Figure 1, Panel D), the panel
regressions reported in column (5) of Table 2 indicate that the coefficient on the "early"
dummy is not significant.
Still, there is an important branch of the literature which has focused on the
expansionary effects of the fiscal policies that often accompany major exchange-ratebased stabilizations. In Helpman and Razin (1987), the reduction in the inflation tax
generates a wealth effect due to the lack of Ricardian equivalence. In Drazen and
Helpman (1988), the wealth effect comes through the expectation of a future reduction
in government spending. Rebelo (1997) considers a scenario in which, in the absence
of reforms, government expenditure increases, thus raising the present value of the
resources needed to finance that spending. By bringing the fiscal situation in order,
a stabilization leads to a wealth effect that may produce a boom even though taxes
increase in the short run 7.
70 See also Giavazzi aald Pagano (1990) and Bertola and Drazen (1993), who analyze the possibly
expansionary role of fiscal policy in the stabilizations of Denmark in 1982 and Ireland in 1987.

Ch. 24:

Inflation Stabilization and BOP Crises in Developing Countries

1581

Rebelo and V6gh (1995) examine the effects of reductions in public consumption
and increases in taxes in a two-sector, general equilibrium model. A fall in government
consumption of tradable goods leads to a consumption boom and a real appreciation,
but investment falls and the current account improves. A reduction in public
consumption of non-tradables leads to a counterthctual real depreciation. Hence, cuts
in fiscal expenditures seem to have limited power in explaining the stylized facts of
exchange-rate-based stabilization. On the other hand, tax increases are recessionary.
Finally, as with supply-side effects, fiscal-based explanations would not be able to
generate an eventual recession, unless of course the policy is reversed.

5.5. A n d the w i n n e r is . . .

In the end, we would want to have a sense of whether a "winner" emerges among all
the competing theories aimed at explaining the empirical regularities associated with
exchange-rate-based stabilization which have been examined in the last two sections.
To focus on essentials, the above models have abstracted from features which, while
"realistic", would have diverted attention away from the key channels. While this is
the logical route to follow, it makes a comparison across models difficult since not all
channels are operating simultaneously. To remedy this, Rebelo and V6gh (1995) have
evaluated, both qualitatively and quantitatively, all the hypotheses examined in the last
two sections (except for the one related to durable goods) in a single, two-sector model
with a labor-leisure choice and capital accumulation. They conclude that, qualitatively,
the only two hypotheses that may explain a boom-recession cycle are lack of credibility
and price or wage stickiness (inflation inertia). (In their model, an initial wealth effect
stemming from supply-side etfects helps the inflation-inertia hypothesis in generating
an initial consumption boom.) This is, of course, consistent with the evaluation that
follows from the simpler models analyzed above.
Quantitatively, however, Rebelo and V6gh (1995) find that supply-side effects seem
critical to account for any sizeable fraction of the observed outcomes. Still, baseline
parametrizations fall short of explaining the observed consumption booms and real
appreciations. While there are configurations of the technology that are consistent
with the data, there is still little information to assess whether these configurations are
empirically plausible. Hence, further work on the structure of the supply-side and on
the differential response of the tradable and non-tradable goods sector - which would
allow us to build more refined quantitative models - would be particularly usefuk
Finally, it is worth stressing the importance of disentangling the effects of
stabilization from other reforms. The reason is that we may be asking models to explain
"too much" in quantitative terms. In other words, the poor quantitative performance
of a broad class of models found by Rebelo and V6gh (1995) may be due not to a
lack of "good" models but rather to the fact that we may be trying to explain all of the
observed consumption booms and real appreciation as a result of exchange-rate-based
stabilizations.

G.A. Calvo and C.A. Vdgh

1582

6. Money-based stabilization
The use of a money anchor to bring down chronic inflation has been much less common
than the use of an exchange-rate anchor. Available evidence, however, suggests that
these stabilizations have led to an initial recession, higher real interest rates, and real
exchange rate appreciation (Section 3). As discussed earlier, the monetary regimes
prevailing in these plans have borne little resemblance to the textbook case of a
"pure" money anchor (i.e., a clean floating exchange rate), and have ranged from dirty
floating to dual exchange rate systems (with a pegged commercial rate). Nonetheless,
a common feature of such regimes is that money has been, albeit to varying degrees,
the predominant nominal anchor. Therefore, to fix ideas, we will focus on the textbook
case of a pure money anchor. We will then argue that, qualitatively, deviations from
this benchmark would not alter the basic results.

6.1. A simple model

From an analytical point of view, the two key elements needed to reproduce the stylized
facts illustrated in Section 3 are (i) an interest-rate elastic money demand and (ii) sticky
prices. We will introduce these two critical elements in the simplest possible way 71.
We generate an interest-rate elastic money demand by introducing money in the
utility function. We will therefore keep the utility function postulated in Equation (4.1),
but assume that it takes a log-specification72:
/o ~ [log(etT) + log(c~) + log(mt)] exp(-/3t) dt.

(6.1)

The household maximizes Equation (6. l) subject to (4.2). The first-order conditions
imply that (again, assuming that fi = r)

c~ = etc~,
1

~.i,,

(6.2)

(6.3)

mt

where 2~ is the Lagrangean multiplier associated with lifetime constraint (4.2).

On the supply side, we follow Calvo's (1983) staggered-prices formulation
a
continuous-time version of the overlapping-contracts models A la Fischer (1977) and
Taylor (1979, 1980) - whereby the price level is sticky (i.e., it is a predetermined
71 In the absence of sticky prices, there would be no difference between money-based and exchange
rate-based stabilization. The reason is that, under money-based stabilization, the real money supply could
change at any point in time fllrough changes in the price level.
72 This model is a simplified version of Calvo and V6gh (1994c). See also Dornbusch (t980) and
Fischer (1986a, 1988).

Ch. 24: Inflation Stabilization and BOP Crises"in Developing Countries

1583

variable at each instant in time), output o f home goods is demand-determined, and the
rate of change in inflation is a negative function of excess aggregate demand:
_

2c, - - i f (

CN

t -Y

-N

),

~ > 0.

(6.4)

Equation (6.4) can be derived by assuming that finns set prices in a non-synchronous
manner taking into account the future path o f aggregate demand and the average price
level prevailing in the economy [see Calvo (1983)]. At any point in time, only a small
subset of firms can change their price. The price level is therefore a predetermined
variable. If excess demand develops at some point in time, a small subset of firms
will change their price and inflation rises. The subset o f firms that will change their
price diminishes over time, which implies that inflation o f home goods falls over time.
Hence, the change in the rate of inflation is negatively related to excess demand in the
non-traded goods sector 73.
As in the previous section, the interest parity condition implies that it = r + ft.
Output of non-tradable goods is demand determined so that c N = yN for all t. The
resource constraint continues to be given by Equation (4.4).
To solve the model, we proceed in two stages, in the first stage, we show that the
path of real money balances, mt (= Mt/EtPT*), is governed by an unstable differential
equation. Note that
- # , - et,

(6.5)

mt

where/~t(--- ~lJMt) denotes the rate of growth of the money supply, which is the policy
instrument in a money-based stabilization. Substituting into Equation (6.5) the interest
parity condition and first-order condition (6.3), we have that
rht

1
- ~t + r - =--.

mt

(6.6)

,~,mt

Around the steady state, Equation (6.6) is an unstable differential equation 74. Hence,
following an unanticipated and permanent reduction in/~t, mt adjusts instantaneously
to its higher steady-state value. Hence, from Equation (6.3), it and thus ~t also adjust
instantaneously to their lower steady-state values.
73 Note that in this formulation, the price level of home goods (,oN) is sticky (i.e., it is a predermined
variable) but the inflation rate of non-tradable goods (~) is fully flexible (i.e., it is a forward-looking
variable). It is also worth stressing that the formulation embedded in Equation (6.4) is not inconsistent
with the one postulated in (4.8), where the level of the inflation rate of home goods depends positively
on excess aggregate demand. The reason is that, in equilibrium, the staggered-prices formulation given
by Equation (6.4) may still generate a Phillips-curve relation in which inflation is above its steady-state
value when excess aggregate demand develops.
74 Notice that, as before, ~ is invariant to changes in ~t~.

t584

G.A. Cairo and C.A. V~gh

fi:=O
!I

I
ii

~H,I

A
/

B/

gL

//

./
fi=O

/C

nss

Fig. 9. Money-based stabilization: dynamic system.

Intuitively, if et fell on impact below ~t~, then mt would be increasing over time,
which necessitates of a lower i (and lower e) to equilibrate the money market, which
further increases mr, and so on. Thus, for mf not to diverge, the rate of depreciation,
and thus the nominal interest rate, must adjust instantaneously.
In the second stage, we form a dynamic system in real money balances in terms of
home goods and the rate of inflation. To that effect, let us define real money balances
in terms o f home goods; that is, nt = M / P N. Then,
ht

- ~t, - st,.

(6.7)

/'/t

The second dynamic equation follows fiom Equation (6.4), taking into account
Equation (6.2) and the fact that, from the definition o f mr and nz, et = nt/mt:
~, = ~@N _ n , c ] ) .
mt

(6.8)

Equations (6.7) and (6.8) constitute a system o f differential equations in n and Jc, for
given c T, m, and the policy variable gt. Around the steady state, the system is saddlepath stable, as it should be since n is the only predetermined variable (Figure 9 depicts
the corresponding phase diagram)75.
J5 Thc deteirninant associated with the linear approximation aroand the steady state is -~nssC~s/mss < O,
which indicates that there is one positive and one negative root.

Ch. 24." Inflation Stabilization and BOP Crises in Developing Countries

1585

Suppose that initially (i.e., for t < 0), the public expects the rate of money growth
to remain constant forever at #H. This initial steady state is characterized by
C~lss = rko +yT,
cN = N,
ess

fiN
rko + yT '

(6.9)
(6.10)
(6.11)

&~ = /~n,

(6.12)

iss = r + #n,
~N
nss
r + #H'

(6.13)

d = F~
rss

(6.15)

(6.14)

where, as before, the domestic real interest rate, r , is defined as i - ar.

In terms of Figure 9, the initial steady state is at point A. Suppose now that, at
time 0, policymakers announce a permanent and unanticipated reduction in the money
growth rate from b~u to #L. The new steady state becomes point B where real money
balances in terms of home goods are higher and inflation is lower. On impact, the
system jumps from point A to point C and then travels along the saddle path towards
its new steady state, point B.
The path of the main variables is illustrated in Figure 10. Real money balances (in
terms of home goods) increase gradually over time (Panel B). On impact, inflation
falls below its new steady-state value and then increases over time (Panel C). The
path of the real exchange rate (Panel E) follows from the fact that ~t/e~ = et - &.
The real exchange rate must fall (i.e., appreciate) on impact to allow for a subsequent
real exchange rate depreciation. The initial fall in the real exchange rate is effected
through a fall in the nominal exchange rate, given that the price level of home goods
is a predetermined variable. The path of consumption of home goods (Panel D) can be
derived from Equation (6.2) and the path of the real exchange rate. Since consumption
of traded goods does not change - and continues to be equal to permanent income of
traded goods - consumption of home goods falls on impact as the relative price of
home goods (i.e., the inverse of the real exchange rate) increases. It then increases
as home goods become cheaper over time. The path of the domestic real interest rate
(Panel F) follows from the definition r d = it - art. The domestic real interest rate
increases on impact - as the inflation rate of home goods falls below the nominal
interest rate - and then falls towards its unchanged steady state.
What is the driving force behind these results? It is best to think about the
equilibrium condition in the money market, which is given by:
nl -

(6.16)
it
We think of the left-hand side of Equation (6.16) as the real money supply in terms
of non-tradable goods and of the right-hand side as real money demand. Upon the

1586

G.A. Caluo and C.A. V@h

B. Real money balances

A. Rate of monetary growth

n

!
/

/-

rlss

/~!

time

time

D. Consumption of home goods

C. Inflation rate
cN~
~N

g H

j_-

//

//

[
0

time

E. Real exchange rate

time

F. Domestic real interest rate

ess'
,

f--

j_--

_-- . . . . .
r

time

- - 4

--

7:~:

time

Fig. 10. Money-basedstabilization: time paths.

announcement of a lower rate of money growth, expected inflation and thus the nominat
interest rate fall. For a given c N this increases real money demand in terms of home
goods. Real money supply, n( = M/PN), however, cannot change on impact because
neither Mt (a policy variable) nor pN (a predetermined variable) change. Hence, the
fall in the nominal interest rate generates an incipient excess demand for real money
balances. To equilibrate the money market, consumption of home goods (and thus
output) needs to fall. For consumption of home goods to fall, home goods must become
more expensive (i.e., the real exchange rate must fall). Since consumption of home
goods must return to its initial steady-state, the domestic real interest rate must increase
to induce a rising path of consumption of home goods.

Ch. 24.. Inflation Stabilization and BOP Crises in Developing Countries'

1587

This simple model thus reproduces the main stylized facts associated with moneybased stabilization illustrated in Section 3: an initial recession, a real exchange rate
appreciation, and higher domestic real interest rates. The model does not exhibit,
however, inflation persistence. To generate that result, we would need to introduce
either inflation inertia or lack of credibility, along the lines of Section 4 [see Calvo
and V6gh (1994c)]. The model also predicts no change in the trade and current account
balances. As a first approximation, unchanged external accounts are not really at odds
with the facts, as argued in Section 3. To generate an alternative prediction, we would
need to get rid of the separability between c N and c T, which would considerably
complicate the solution method because the system would cease to be block-recursive.
6.2. Extensions to other money-based regimes

Would the basic results change if we deviated from the extreme case of a pure
money anchor (i.e., a clean floating)? The answer is no. Consider first a dirty floating,
whereby the monetary authorities intervene in foreign exchange markets to influence
the nominal exchange rate. In the example just analyzed, policymakers might want, on
impact, to buy foreign exchange (i.e., accumulate international reserves) in exchange
for domestic money to prevent the nominal exchange rate from appreciating too much.
In terms of the model, the effects of intervention could be captured in a very simple
way by assuming that, on impact, policymakers increase the nominal money supply
so as to prevent the nominal exchange rate - and thus the real exchange rate - from
appreciating (while still reducing the rate of growth to /~L)76. Since m(= M / E P r*)
jumps immediately to its higher steady-state value, it follows that a higher M0 implies
a higher E0 (relative to the case in which the nominal money supply is not changed
on impact). In other words, the larger the initial increase in the level of the money
supply, the smaller the initial nominal and real appreciation. In terms of Figure 9, this
implies that, depending on how much the money supply increases, the system would
jump on impact to a point along the saddle path between points C and B and then
proceed towards point B. Qualitatively speaking, then, the impact efI~cts would be the
same. Quantitatively, the initial real appreciation and thus the initial recession would
be lessened.
An extreme case of the "intervention" policy just described is a situation in
which the initial level of the money supply is increased as much as needed for tile
nominal exchange rate not to change on impact. In this case, the system would jump
immediately to its new steady state (Point B in Figure 9). Neither the nominal nor the
real exchange rate would change and the initial recession would be avoided altogether.
This case is typically ruled out as implausible on the basis that, in practice, a large
initial increase in the stock of money would likely be interpreted as an increase in
the rate of growth of money, which would severely affect the credibility of the whole
'16 Of course, this is not, strictly speaking, intervention since there is no accmnulation of reserves (I.e..
money is introduced through a "helicopter" drop).

1588

G.A. Caloo and C.A. FOgh

program. Still, it helps rationalizing the monetary authorities' incentives to intervene

in foreign exchange markets. From a theoretical point of view, if policymakers can
manipulate at will the initial money stock, then to generate a recession it would be
necessary to introduce inflation inertia, along the lines analyzed in Section 3.
Consider now the case in which there are capital controls. From a monetary point
o f view, capital controls give policymakers the ability to have further control over the
money supply (if they did not have it to begin with). In the case of a floating rate (or
dirty floating), then it should make little difference. In fact, adding capital controls to
the model above - by, say, assuming that the private sector's stock of net foreign assets
is given and cannot change - would not change anything since the restriction would not
be binding (recall that the current account is zero throughout the adjustment). Mixed
regimes - such as dual exchange rates with a predetermined commercial rate - should
also lead to an initial recession 77. The key is that the initial nominal money supply
will still be a policy instrument (unlike a predetermined exchange rate regime in which
the initial nominal money supply adjusts endogenously to satisfy real money demand).
Hence, any disinflationary policy which leads to a reduction in expected inflation
and thus to an increase in real money demand - will lead to a "liquidity crunch"
and an initial recession. In sum, the effects o f disinflation in any monetary regime
which involves significant capital controls should be qualitatively similar to those of
a textbook money-based stabilization 78.
6.3. Money anchor versus exchange-rate anchor

As noted earlier, a money anchor is much less common than an exchange-rate anchor
in stabilization programs in chronic-inflation countries. Although far from being a
panacea for stopping inflation, policymakers' revealed preference for an exchange-rate
anchor may be rationalized on a number of grounds.
First, the behavior o f money velocity may be quite difficult to predict in the
transition from high to low inflation, especially in chronic-inflation countries where
the distinction between monies and quasi-monies is particularly blurred. Therefore, as
a practical matter, it may be quite difficult to gauge how "tight" a given monetary
rule is likely to be, and whether a "stable" relationship will hold in the aftermath
o f disinflation. In contrast, using the exchange rate has the intrinsic advantage tha~,
given the endogeneity o f the money supply, there is no need in principle to have any
infolmation about money demand and velocity.
77 Models of dual exchange rates using tile samc type of framework emphasized thIoughout this chapter
may be found in Obstfeld (1986a), Guidotti and V6gh (1992), and Calvo, Reinhart and V6gh (1995).
78 As noted in Section 3, there may be regimes with a clean floating which do not necessarily have
a monetary aggregate as the main nominal mlchor [see Masson, Savastano and Sharma (1997) for a
taxonomy of monetary regimes]. These regimes, however, have been rare in major stabilization programs.
Still, V~gh (1997) shows an example in which nominal and real interest rate rules are equivalent to a
money-based reghne.

Ch. 24: Inflation Stabilization and BOP Crises in Developing Countries'

1589

A second, and related, issue is that prolonged periods of high inflation lead to a
high degree of dollarization of the economy 79. In such a situation, the "relevant"
money supply (i.e., the one which affects inflation and real activity) is likely to
include (the domestic-currency value of) foreign currency holdings and deposits. Since
this component cannot be controlled by policymakers, a reduction in the domestic
component of the money supply may have little effect on total liquidity, and, hence,
on inflation. In effect, policy simulations of money-based disinflation for the case
of Uruguay [Hoffmaister and V6gh (1996)] suggest that reducing the rate of growth
of either M1 or M2 (which do not include foreign currency deposits) results in an
extremely slow disinflation compared to using the exchange rate. In sharp contrast,
if policymakers c o u l d (which, of course, they cannot) control M3 (M2 plus foreign
currency deposits), then the speed of disinflation would be roughly the same as that
achieved with an exchange-rate anchor.
A third issue is that, by the simple virtue of being a price rather than a quantity,
the exchange rate provides a much clearer signal to the public of the govermnent's
intentions and actual actions than a money supply target. Thus, if the public's
inflationary expectations are influenced to a large extent by the ability to easily
track and continuously monitor the nominal anchor, the exchange rate has a natural
advantage.
Based on the considerations just discussed, it should not come as a surprise that, by
and far, disinflation programs in chronic-inflation countries have relied on the exchange
rate as the main nominal anchor (with the August 1990 Peruvian program being the
most notable exception). Revealed preferences, therefore, would seem to support the
view - with which we would certainly agree - that the exchange rate should be
viewed as the more suitable nominal anchor in chronic-inflation countries. This is also
consistent with Uribe's (1994) findings on the welfare costs of money-based versus
exchange-rate-based stabilization. By performing different simulations of Calvo and
V6gh's (1994c) model, he argues that exchange-rate-based stabilization is generally
less costly, in terms of welfare, than money-based stabilization.
An important caveat against the use of an exchange-rate anchor is in situations of
very little credibility. For instance, in a countW in which a series of failed exchangerate-based stabilizations has led the public to identify the initial boom and current
account deficit as a signal of an unsustainable stabilization effort, it would probably
be wise to try to switch strategies and opt for a money anchor. The main reason is that
theory suggests [see Calvo and V~gh (1994c)] that the effects of imperfect credibility
differ drastically under each regime: lack of credibility is more disruptive under an
exchange-rate anchor because it reduces the benefits (inflation falls by less) at the same
time that it increases the size of the real dislocations (the boom-bust cycle becomes
more pronounced). In contrast, in money-based stabilization, lack of credibility reduces

"19 See Calvo and V6gh (1992) and Savastano(1996).

1590

G.A. Calvo and C.A. V~gh

both the benefits (in terms of lower inflation) but also the initial recession. Hence, if
the public is perceived as being highly skeptical, a money anchor may be less risky 8.

7. Balance-of-payments crises
As argued in Section 3, most exchange-rate-based stabilization programs end in
balance-of-payments (BOP) crises (recall Table 1). These programs typically unleash
dynamics - consumption booms, sustained real appreciation, current account deficits which call into question their sustainability 81. This, in turn, fuels speculation o f a
possible abandonment o f the exchange-rate anchor. Once the survival of the program
has been called into question, financial factors - such as a large stock o f shortterm debt - often aggravate the situation and may induce self-fulfilling crises.
Whether balance-of-payment crises are ultimately caused by worsening fundamentals
or self-fulfilling elements is a matter o f ongoing debate 82. But even if the ultimate
demise o f the peg responds to some self-fulfilling event, it is still the case that
fundamentals go a long way in determining the potential vulnerability of the system
[Obstfeld and Rogoff (1995)].
Naturally, the potential for balance-of-payments crises is a more general issue and
applies to any pegged exchange rate system, whether the peg is part of an explicit
fifflation stabilization program or not (as most recently exemplified by the South
East Asian crises of the second half o f 1997). However, even when the peg was
not instituted as part o f a program, crises tend to occur as the economy enters a
recession, following a prolonged boom in economic activity, credit expansions, real
exchange rate appreciation, and current account deficits [Kaminsky and Reinhart
(1995)] ~3. These are, of course, essentially the same dynamics as those generated
by exchange-rate-based stabilizations (recall Figures 1 and 2). We suspect this is no
coincidence, since it may be argued that pegged exchange rates keep inflation down
(mainly by linking inflation of tradable goods to world inflation) at the expense o f an
appreciating currency. We would thus suspect that some of the mechanisms discussed
in Sections 4 and 5 may help in explaining the dynamics leading to balance-of-payment
crises in general.
This area has enjoyed a renaissance o f sorts in the aftermath o f the Mexican crisis.
Researchers have gone back to gh'ugman's (1979) seminal paper on the mechanics of
balance-of-payments crises and refined it in several important ways. Hence, after a brief
discussion o f liquidity considerations, we take Krugwnan's (1979) model as the starting
80 Another argLmlent for a money anchor is given in Tornell and Velasco (1995), who ague thai a
money anchor might provide more fiscal discipline.
81 Naturally, a fiscal disequilibrium will only reinforce the sense of tmsustainability.
82 See Krugman (1996) and the comments therein by Kehoe and Obstfeld
83 See also Bordo and Schwartz (1996), Dornbusch, Goldfajn and Valdes (1995), Eichengreen, Rose
and Wyplosz (1995, 1996), Frankel and Rose (1996), Obstfeld (1995), and Sachs, Tornell and Velasco
(1996). For an early analysis of devaluation crises, see Harberger (1981).

Ch. 24: Inflation Stabilization and BOP Crises in Developing Countries'

1591

point o f this section. We then discuss the notion of current account sustainability.
Finally, we examine the role o f financial factors and lack o f credibility in precipitating
balance-of-payment crises.

7.1. Liquidity
Balance-of-payments crises take different forms. A common characteristic is that the
government finds itself unable to comply with financial obligations. A n example is
when the government is committed to keeping a fixed exchange rate (against, say,
the US dollar), and the public wishes to exchange domestic money for dollars in an
amount that exceeds the international reserves available for this operation. As a result,
the government has to abandon its exchange-rate policy. However, the loss of reserves
may occur for other reasons. For instance, reserves may be lost if the country has shortterm liabilities, bonds, that cannot be rolled over in the capital market, and exceed the
level o f available international reserves 84.
A BOP crisis does not necessarily involve insolvency, i.e., the country's inability
to pay. As a general rule, countries undergoing BOP crises have ample resources
to meet their financial obligations. In practice, the problem is that the country does
not have enough financial assets that can be swiftly activated to meet its financial
obligations. Thus, at the core o f a BOP crisis, there is typically a mismatch between
the "liquidity" o f financial obligations and that of government financial assets. This
mismatch is associated with another dominant characteristic of BOP crises, namely,
they take place within a relatively short period of time (normally within a month), a
fact that contributes to dramatize the event 85.
The word "liquidity" in the above paragraph is just a signpost, not a definition. A
good definition o f liquidity is highly elusive. We will discuss the concept in the context
of a special environment. Let p(t, v) be the output price o f a given asset at time t, if the
asset was placed on the market at time v ~< t. We say that the asset is perfectly liquid
ifp(t, t) = p(t, v) for all t and v (and all states o f nature). In other words, an asset is
perfectly liquid if there is no advantage to the seller in announcing his/her intention to
sell in advance o f the actual transaction. Otherwise, ifp(t, t) < p(t, v), we say that the
asset displays some illiquidity. The asset's degree of liquidity could be measured by

~(t, v)

p(t, t)
p(t, v)"

Some simple models assume only two types o f assets, namely (i) perfectly liquid assets,
and (ii) assets for which g(t, v) = 0 for all v < t; that is, assets that would have no
84 This was a key ingredient in the December 1994 balance of payments crisis in Mexico. See, for
instance, Sachs, Tornell and Vetasco (1995) and Calvo and Mendoza (1996).
~5 This should not be interpreted to mean thai the ftmdamental reasons behind a balance of payments
crisis are so short-lived - just the symptoms are.

G.A. Calvo and C.A. V~gh

1592

market value if they had to be liquidated in no time's notice 86. In this case, a BOP crisis
would take place if the liabilities that the government is called upon to service at time t
exceed the stock of liquid assets.
In the models to be discussed here the liquidity properties of an asset are postulated,
not explained.

7.2. The Krugman model

This is an elegant model that captures the essential features mentioned above. We
will present a version along the lines of the utility-based models used in previous
sections of this chapter [see, for example, Calvo (1987) and Obstfeld (1986b)]. For
present purposes, it is enough to assume that all goods are fully tradable, and that the
representative individual is endowed with a constant flow of tradable goods per unit
of time. Hence, using the same notation, lifetime utility is given by
j0 ~ Iv(c/) + z(mt)] exp(-[Jt) dt.

(7.1)

As in Section 4, let the country be fully integrated in goods and capital markets and
thus face a constant international price of the tradable good and a constant world real
interest rate, r, which equals the subjective discount rate. The consumer's intertemporal
budget constraint is thus given by Equation (4.2) (abstracting from the terms that
relate to non-traded goods). The first-order conditions are therefore (4.5) and (4.7).
Therefore, as before, Equation (4.5) implies that, along a perfect foresight equilibrium
path, consumption is constant.
The exchange rate is assumed to be fixed if there are enough reserves to sustain
the value of the domestic currency (i.e., if reserves are above or at their "critical"
level, which we assume to be zero). The exchange rate is sustained by intervening in
the foreign exchange market. Thus, the fixed rate is abandoned once the public wants
to turn domestic into foreign currency in an amount that exceeds the stock of liquid
assets set aside for this operation. In Krugman (1979), these assets are identified with
(international) reserves, R. While the fixed exchange rate regime lasts, perfect capital
mobility implies that the domestic nominal interest rate equals the international one;
that is, it = r. After the fixed rate is abandoned, the exchange rate is allowed to float,
and exchange rate intervention is stopped. Hence, again denoting by et the rate of
devaluation/inflation, perfect capital mobility implies that it = r + et.
We assume that the central bank transfers net profits to the fiscal budget, which
implies that the central bank's capital is constant. Hence, from the central bank's
balance sheet, it follows that

X/It - E t k t + NbA~,
86 Lucas's (1990) cash-in-advancemodel has this characteristic.

(7.2)

Ch. 24: Inflation Stabilization and BOP Crises in Developing Countries

1593

where M is high-powered money, E is the nominal exchange rate (i.e., the price o f
foreign exchange in terms o f domestic currency), R denotes reserves denominated in
foreign exchange, and NDA stands for net domestic assets (i.e., domestic credit)87.
The government's only source of expenditures are lump-sump transfers to households. It finances an exogenously given level of transfers, r, with central bank credit
and proceeds from international reserves (which we assume earn the international
interest rate, r). Thus,
(7.3)

E t T = N b A I + rE~Rt.

Since during the fixed-rate period, it = r and hence, by Equation (4.7), the demand for
money is constant (implying 3)/t = 0), we have:
Rt = - ( r - rRt).

(7.4)

In other words, under fixed exchange rates the loss of international reserves equals
the budget deficit (given by government transfers minus interest revenues from
international reserves) 8s
After fixed rates are abandoned, Rt = Rt - 0, and hence, by Equations (7.2) and
(7.3),
hh + elmt = T.

(7.5)

Assuming, for simplicity, that the individual initially holds no foreign assets or
liabilities, it follows from first-order condition (4.5) and the lifetime constraint that
crt = f r o + yT for all t. Hence, combining first-order conditions (4.5) and (4.7) and
solving for mr, we get the familiar demand-for-money expression:
mi - L(i, rRo +yT),

Li < 0,

Lrt~0+yv> 0.

For simplicity, we will tbcus on steady states (i.e., rh~ (7.5) and (7.6), we have that
eL(r ~ e, f r o + S )

= r.

(7.6)
0). Thus, by Equations

(7,7)

The left-hand side of Equation (7.7) corresponds to revenue from the creation of
money at steady state, while the right-hand side is the amount to be financed by these
means. Clearly, Equation (7.7) will in general display multiple equilibria because the
demand for money is negatively sloped with respect to e. However, since equilibrium
87 Equation (7.2) implicitly assLmaes with no loss of generality that the central bank does not
monetize nominal capital gains on international reserves. Typically the central bank creates a fictitious
non-monetary liability instead.
~8 It is assumed that the initial fiscal deficit is positive; i.e., r -- rRo > O.

G.A. Caluo and C.A. Vdgh

1594
IR
R

AIR

T T* time

Fig. 11. Krugmat~ crisis.

multiplicity is not a key theme in Krugman (1979), we will assume that the economy
settles down on the lowest rate o f devaluation consistent with Equation (7.7), which
will be indicated by e*. Clearly, if r > 0, then after the currency peg is abandoned,
the economy jumps to a higher inflation plateau, and stays there forever. It follows
from expression (7.6) that at "switch point," i.e., the point in time T at which the
currency peg is abandoned, the demandJbr money" collapses. This is a key feature of
the model.
Figure 11 depicts the central characteristics o f an equilibrium path for international
reserves assuming that the government runs a fiscal deficit (i.e., ~ - r R o > 0) and
that the nominal exchange rate is a continuous function o f time (this assumption
will be rationalized later). From 0 to T reserves are driven by Equation (7.4). The
system is abandoned at time T - and not when reserves reach zero
because, as
pointed out above, at switch time the demand for money takes a sudden dip equal to
L(r, rRo + S ) - L ( r + e, fro + S ) = AR. Since the exchange rate is assumed not to
jump at time T, it follows that the government suffers a loss of reserves equal to AR
at time T. Clearly, switch point T is uniquely determined. Thus, the model is able to
capture some of the main characteristics of a BOP crises outlined above.
To close we will now briefly discuss the continuity of the exchange rate path E. In
the first place, we will constrain E to be piece-wise continuous and everywhere righthand differentiable. These are technical assumptions which help to make sure that the
problem is well-defined in a mathematical sense, and that irrelevant nonuniqueness
situations are ruled out. Notice that jumps in E are not ruled out.
Suppose that, contrary to our assumption above, E jumps at t ~> T, and let M[ be
the left liminf of M at t. I f M t > 0, then the representative individual suffers a capital
loss on account of his/her money holdings at time t. Thus, assuming that the demand
for money goes to zero as the nominal interest rate diverges to plus infinity, a plausible
regularity condition, it follows that it will never be optimal to undergo that kind of
capital loss, which implies that M S = 0. Thus, if t > T, there will be an excess supply
o f money at t, which is inconsistent with equilibrium. Suppose now that t = T, and,

Ch. 24:

Inflation Stabilization and BOP Crises in Developing Countries

1595

hence, the jump takes place exactly at switch point. Since M t- = 0, then the BOP crisis
would have occurred before time T, which is a contradiction. This proves that E is
continuous everywhere as assumed above.
Finally, it is worth stressing that, since the interest rate on international reserves is
equal to the international interest rate, the current account will be zero at all times.
Notice, however, that external balance equilibrium does not prevent the occurrence
of a BOP crisis. This is worth keeping in mind when we discuss the current account
approach below.
7.3.

Krugman model: critique and extensions

We now extend the above model in several useful directions.

7.3.1. Bonds

Domestic debt (outside the central bank) may be introduced and thus account for
an element that has played a prominent role recently. Thus, Equation (7.3) would
become:
E~r - N b A t + rEiRt - itD~ + L)t,

(7.8)

where D stands for instant-maturity government debt outside the central bank (in
nominal terms). Actually, bond issuance could completely finance the deficit and, thus,
NDAt = 0. Under those circumstances, no reserves would be lost during the fixed rates
period. However, domestic debt D would increase without bound and, at some point,
no more debt could be placed in the market becanse, otherwise, the government would
not satisfy its intertemporal budget constraint. This is an interesting example because it
is not unusual for governments to try to mask the fiscal disequilibrium in this manner.
International reserves, which are closely watched by the private sector, would in this
fashion be insulated from fiscal disequilibrium (prior to the BOP crisis).
7.3.2. Sterilization

The Krugman model assumes that the mo~etary authority makes no attempt at
sterilizing the effects of reserve accumulation. Money supply is not a target. Thus,
the model assumes that at switch time the monetary authority will not interfere with
the run against domestic money and allow money supply to fall. In practice, money
is not simply cash but includes bank deposits. Therefore, a fall in the money stock
is normally associated with a cut in bank credit. This is a cause of trouble especially
if the event is not fully anticipated 89. Of course, if bank credit is easily substitutable
~9 Under perfect foresight, everybody knows the exact timing of the BOP crisis. However, the model
is easily and realistically extended to the case in which, say, the demand for money has a stochastic
component and hence, there is always an element of surprise in the timing of the crisis [see Flood and
Garber (1984)].

1596

G.A. Caluo and C.A. VOgh

for other type of credit, the bank credit crunch would cause no major disruption. But
in LDCs this is not the case. Consequently, the central bank is induced to intervene
through open market operations to provide the bank credit that would disappear as a
result of the collapse in money demand at switch time.
Flood, Garber and Kramer (1996) argue that there are several important instances in
which central banks have attempted to fully sterilize the collapse in money demand.
Interestingly, they show that this policy, if anticipated, would lead to a BOP crisis
happening immediately, i.e., at time 0. There would be no fixed exchange rate period
like the interval [0, T) in the Krugman model. The proof is straightforward. For money
to remain constant (i.e., full sterilization) at time T, after-crisis inflation should equal
inflation before crisis (which is zero). But this would imply that there is no crisis mid
the exchange rate is constant forever. However, Equation (7.4) implies that sooner or
later international reserves will be driven down to zero, and a crisis will take place, a
contradiction. Thus, the only possibility left is for the crisis to take place at t - 0. In
other words, the fixed-exchange-rate regime collapses upon the announcement.
To have a more vivid picture of this instantaneous crisis, let us assume that at
the time of the announcement real monetary balances fall short of total reserves
(implying that an attack against domestic currency cannot be successful unless it
triggers an expansion of domestic credit). The government's announcement is followed
by an immediate attack on the domestic currency. Since authorities try to stabilize
the stock of money, they intervene increasing domestic credit. Given that the demand
for money has collapsed, the additional liquidity infusion only results in a loss of
international reserves. This will continue until reserves are depleted. At that point
authorities lose control of the exchange rate. Since there are no reserves, the exchange
rate is the adjustment variable. Hence, the currency will devalue (the price level will
rise) until real monetary balances are consistent with the equilibrium expected rate of
devaluation/inflation.
Anticipated sterilization although inconsistent with fixed rates under the above
assumptions could, however, be sustained under other set of plausible assumptions.
F'ood, Garber and Kramer (1996) and Kumhof (1997) show that fixed-rates-cumsterilization is consistent with a situation in which government bonds are imperfect
substitute with international bonds. Calvo (1996b) shows that the same holds if it is
costly to move in and out of money.
7.3.3. Interest rate policy

Another important aspect of reality which is not captured in Krugman's (1979) model
is the possibility of the central bank actively defending the currency by raising shortterm interest rates. Sweden, for instance, raised short-term interest rates to around
500 percent per year in September 1992 to stave off a speculative attack [see, for
instance, l~ugman (1996)]. More recently, both Hong Kong and Brazil sharply raised
interest rates to defend their currencies in the aftermath of the South East Asian
currency crisis. While not always successful, higher interest rates often buy time for

Ch. 24: inflation Stabilization and BOP Crises in Deoeloping Countries

1597

the government to try to uphold the system's credibility by adopting more fundamental
measures. Lahiri and V6gh (1997) model interest rate policy by assuming that the
government controls the interest rate on highly liquid government debt - along the
lines of Calvo and V6gh (1995) - and show that by announcing a policy of higher
interest rates in the event o f a crisis, the crisis may be postponed until international
reserves actually reach zero (i.e., at a point like T* in Figure 11). At that point, the
central bank is forced to float but there is no run (i.e., the money supply remains
constant). This result of "crisis with no run" might also explain situations in which
centTal banks abandon a peg with no dramatic loss of international reserves.
7.4. The current account approach

This approach has become popular after Mexico's 1994 BOP crisis since some
observers have claimed that the crisis originated in the fact that Mexico was spending
"beyond its means". In other words, Mexico's current account deficit was "too large."
(It is worth recalling that in Krugman's model a BOP crisis could take place even
though the current account deficit is nil to the extent that a payments crisis involves a
liquidity shortage, irrespective of the country's overall solvency.) More generally and as shown in Section 3 - exchange-rate-based stabilizations typically lead to
large current account deficits. Whether or not such imbalances are sustainable is thus
a critical question when it comes to evaluate the reasons behind these programs'
collapse.
The sustainability literature is based on the budget-constraint equation for the
conntry as a whole 9o. To illustrate, let us denote b y f and CAD net international debt
and current account deficit (both as a share o f GDP), respectively. Then,
]; : CAm,

- 72;,

(7.9)

where t/is the rate o f growth o f output. Sustainability analysis focuses on steady states.
Thus, settingj; = 0, the steady-state - sustainable - current account deficit satisfies
CADss = r/fs~,

(7.10)

where, as in earlier sections, the subscript "ss" denotes "steady state". This equation
establishes a relationship between steady-state debt and current account deficit. In
the absence of growth (i.e., r/ = 0), then the sustainable current account deficit
is necessarily equal to zero. In contrast, with positive growth a sustainable current
accoum deficit is possible.
This analysis is unable to give us a definite answer on C~4Dss until we pin down
J;s. Recent experience shows that the capital market is reluctant to keep lending to
LDCs exhibiting levels o f indebtedness that exceed 80 percent o f GDP [Williamson
90 For an elaboration, see Milesi-Ferretti and Razin (1996)~

G.A. Calvo and C.A. Vdgh

1598

(1993)]. Hence, this additional piece of information allows us to write the sustainability
condition (7.10) as follows:
CADss <~ 0.8tl.

(7.11)

Thus, a country that can be expected to grow at 4 percent per year cannot sustainably
run a current account deficit exceeding 3.2 percent. Since 4 percent growth was,
if anything, an upper bound for Mexico, this analysis would conclude that its
8 to 9 percent current account deficits were grossly unsustainable.
Notice that CADt = ~ - TSt, where TS denotes the trade surplus (including nonfinancial transfers) as a share of GDR and r f denotes debt service (r is the international
rate of interest). Therefore, by Equation (7.10),

Thus, if we again set the growth rate to 4 percent (i.e., rl = 0.04) and, in addition,
we assume the international interest rate to be 10 percent per annum (i.e., r = 0.10),
then, by Equation (7.12), at the steady state the economy must run a trade balance
surplus of 0.06s as a share of GDR The trade balance surplus increases with the
steady-state debt/GDP ratio, fss. In particular, at the upper bound forJ;s (80 percent of
GDP) the trade balance surplus would be 4.8 percent of GDP.
Presumably, the reason for capital markets to be unwilling to extend credit to LDCs
beyond 80 percent of GDP is that it may become tempting for those countries to
renege on their debt obligations. Temptation, in turn, is likely to be related to the
sacrifice associated with servicing the debt. Gross sacrifice of servicing the debt can be
measured by the associated trade balance surplus. The previous computation suggests
that the capital market becomes nervous about a cotmtry's willingness to repay when
debt service represents only about 5 percent of GDE Notice that the net sacrifice
from servicing the debt could be much less once one takes into account international
penalties from debt delinquency.
Thus, one criticism of current account sustainability computations is that they are
highly sensitive to the definition of sustainable debt/GDP ratios. Besides, the above
example shows that the implied critical sacrifice levels are low when compared to
other capital market transactions. For example, mortgages in the USA are easy for a
household to get if total mortgage payments are less than 25 percent of the household's
income. Thus, if this ratio were also relevant for countries' debt then, using the above
parameters, the critical steady-state debt/GDP ratio would be 4.16 ( = 0 . 2 5 / ( r - r/),
where r - ~/ - 0.06). Therefore, recalling Equation (7.10), a country growing at
4 percent per year could run a sustainable current account deficit of more than
16 percent of GDP! Of course, countries are not mere households because they are
protected by sovereignty clauses. However, prior to the crisis Mexico had given very
clear signals that it wanted to belong to the First World and signed treaties that would
have made it very costly to engage in strategic repudiation of international debt (or
any debt, for that matter).

Ch. 24: Inflation Stabilization and BOP Crises in Developing Countries"

1599

A more fundamental criticism is that steady-state computations could be very

misleading for countries that are undergoing deep economic reforms. The current
account deficit could in those instances be a temporary phenomenon associated with
reform. Once we move away from the steady-state straightjacket, this approach has
precious little to say.
Finally, the current account approach does not address the BOP-crises issue as such.
If the utility function is separable in money and consumption as in expression (7.1),
the demand for money would be impervious to solvency issues. Thus, if we further
assume that the government runs no fiscal deficit and there is no expansion in domestic
credit, then the currency will never be under attack and a BOP crisis will never take
place.
7.5. Financial considerations

Financial factors are likely to play a key role in precipitating balance-of-payment crises.
We now review several such factors, which we deem particularly relevant.
7.5.1. Volatility o f monetary aggregates"

The Krugman model focuses on fiscal deficits as the key determinant o f reserves losses.
However, even in the absence of domestic credit expansion, international reserves
in a fixed-exchange-rate regime may rise or fall as a consequence o f fluctuations
in the demand for money. This is not a minor consideration for LDCs since some
of them exhibit substantially higher fluctuations in their demand for money than
advanced industrial countries. To illustrate the significance of these considerations,
let us examine the case in which the (log) demand for money follows a random walk
and, to abstract from the effects highlighted in Krugman's model, let us assume that
the demand for money is totally inelastic with respect to the nominal interest rate,
and that there is fiscal balance. To simplify the exposition, we will continue making
the assumption that domestic prices equal the nominal exchange rate, which is kept
constant unless there is a BOP crisis.
Letting m denote the demand for real monetary balances, then we postulate (in
discrete time) that
log mt~l = logm~ + Lt,

(7.13)

where m stands for real monetary balances and Lt is an i.i.d, random variable. Under
these circumstances, the demand for money can fall and create a BOP crisis even
though there is no fiscal deficit. If ~t exhibits a mean-zero normal distribution, then the
larger its variance, the larger will be the probability of a BOP crisis given an initial level
of international reserves. Estimates of Equation (7.13) show Mexico, for instance, with
a relatively high standard deviation (about 4 percent per month), while a country like
Austria that has successfully pegged to the Deutsche Mark for about 15 years shows
a standard deviation which is only about 1 percent per month [see Calvo (1996a)].

1600

G.A. Caluo and C.A. Vdgh

In addition, balance-of-payments problems could be exacerbated by external factors.

For example, Calvo and Mendoza (1996) show that there is a significant effect from
US short-term interest rates on Mexico's demand for money (specifically, M2). This
was reflected in a sizable fall in the demand for money during 1994 and, we suspect,
lay at the heart of the Mexican difficulties at the end of the year.
Mexico and other Latin American countries experienced sizable capital inflows in
the first half of the 1990s. As argued by Calvo, Leiderman and Reinhart (1993), about
50 percent of these flows stem from external factors, among which US interest rates
hold a prominent role. Capital inflows gave rise to an expansion in consumption and
investment which, in turn, increased monetary aggregates. Thus, the above-mentioned
link between domestic monetary aggregates and external rates of interest may stem
from direct opportunity-cost or indirect absorption-type considerations. Experience
in several countries, and most notably in Mexico, suggests that the fluctuations in
monetary aggregates provoked by external factors - and more specifically, by capital
flows - could be substantial [see Calvo, Leiderman and Reinhart (1996) and Calvo
and Mendoza (1996)].
An equation like (7.13), enhanced by taking explicit account of external factors,
would be needed to assess the implication of different reserve levels. To illustrate,
consider the simple case in which external factors are fully captured by the random
term in Equation (7.13). We proceed as follows. Let u~ = m S R , where R stands for
international reserves, and m is interpreted as the monetary base. Hence, a BOP crisis
in period t + 1 will take place if ms - mt+l > Rt. Or, equivalently, if
log mt+l = ~t~l < log u/ - _1
mr

ut

(7.14)

Clearly, the probability of a BOP crisis is an increasing function of v. Notice that

this "vulnerability" index is totally independent of the popular index given by the ratio
of reserves to one-month worth of imports. The latter hails back to periods in which
reserves were held to ensure smooth trade, while the index developed here is associated
with the probability of a BOP crisis as a result of financial fluctuations.
In the above example there exists a direct connection between m and R because
we assume m stands for base money (i.e., monetary liabilities of the central bank).
I f instead m stood for M2, the connection is more indirect and depends on how
the central bank reacts to shocks in the larger monetary aggregates. If the central
bank is not responsible for banking problems but defends the exchange rate parity by
intervening and swapping base money for international reserves, then the same analysis
developed above is applicable, except that one would need to derive the demand tbr
base money from Equation (7.13) - which would now apply to M2 - minimum reserve
requirements, and an equation describing the demand for banks' excess liquidity.
In turn, if the central bank is responsible for ensuring adequate banks' liquidity,
then the central bank may be led to expand domestic credit whenever M2 falls, h~
the extreme case in which banks are fully insulated from any liquidity loss as a

Ch. 24: Inflation Stabilization and BOP Crises in Deueloping Countries

1601

consequence of a fall in M2, then M2 is equivalent to base money and the above
example is fully applicable. It is worth noting, however, that in practice M2 is much
larger than money base and, hence, the probability of a BOP crisis, given international
reserves, is likely to be even higher (unless the volatility of M2 is substantially lower
than that of base money).
However, by providing liquidity to offset the fall in M2 the central bank does not
prevent M2 from falling. Thus, if a central bank is keen on not letting monetary
aggregates fall, then it will increase domestic credit even more and provoke a large loss
of reserves after just a small contraction in monetary aggregates. This seems to have
been the case in Mexico during 1994. As noted above, Calvo and Mendoza (1996)
show that the demand for M2 fell in 1994. Since banks held sizable domestic public
debt in their portfolios, rolling back private debt could have been prevented simply
by an open market operation that lowered domestic public debt in banks' portfolios
by an amount equal to the fall in M2. However, the central bank went beyond that
and prior to the crisis succeeded in stabilizing the level of M2. This meant a sizable
expansion of banks' credit to the private sector (more than 40 percent from January to
December 1994). This is quite remarkable given that these measures were undertaken
concurrently with a sizable loss of international reserves. This illustrates how much a
central bank may be willing to risk in order to safeguard the financial system. Similar
behavior was observed in Thailand and Malaysia during the more recent currency
crises in South East Asia.
7.5.2. Short-maturity debt

As pointed om above, the BOP crisis literature has on the whole ignored the role
of domestic debt, and followed Krugman (1979) in assuming that fiscal deficits are
fully monetized. However, the assumption that fiscal deficits are fully monetized
is becoming increasingly unrealistic as governments have started to have access to
international capital markets. It has thus become increasingly possible to finance fiscal
deficits by floating domestic or international public debt. The maturity structure of
this debt varies across countries but it is perhaps fair to say that emerging-markets'
governments are likely to exhibit a debt maturity structure slanted towards the short
end of the spectrum. Mexico again shows an extreme case in this respect: in December
1994 about US$10 billion of domestic debt was due to mature in January, and about
US$30 billion during 1995 (these are large numbers compared to the US$6 billion
stock of international reserves held by Mexico prior to the crisis).
As argued in Calvo (1998) the demand for emerging markets' assets (including
public debt) could be highly volatile for two basic reasons. In the first place, the
effective rate of return on these assets depends on policy - like everywhere else
but with the added complication that policy in emerging markets is itself highly
volatile, reflecting imperfect knowledge of structural parameters and, most importantly~
relatively unstable political equilibria. The instability of the latter has likely increased
after the breakdown of communism. Therefore, assessing the "state of nature" in an

1602

G.A. Cairo and C.A. VOgh

emerging market could be quite costly. It is not enough to know the particulars of
the investment project since, in general, its profitability will depend on govertmaent
regulations. Thus, a project could be very lucrative and yet be unattractive to foreign
investors if, for instance, profits are expected to be subject to high taxes (either directly
or through the imposition of, for example, foreign exchange controls). Consequently,
assessing the state of nature in a given emerging market is likely to entail large "fixed"
costs.
The second basic ingredient for high volatility of demand for emerging markets'
assets is the so-called "globalization" phenomenon, which is characterized by the fact
that investors diversify their portfolios across a large number of emerging markets.
Portfolio diversification, in the absence of Tequila or contagion effects, helps to lower
portfolio risk. Interestingly, however, the benefit from portfolio diversification does not
depend on specific knowledge about the actual state of nature in these economies. For
risk hedging, it is enough that the return on the different assets across countries not be
perfectly correlated. Thus, for instance, by the law of large numbers, risk could become
very low if the different investment projects were stochastically mutually independent.
It is intuitive, and can be rigorously shown in a canonical example [Calvo
(1998)], that under the above circumstances (i.e., high information costs and
globalization), (i) investors will be very sensitive to "news" about expected returns,
and (ii) their incentives to learn about the state of nature in each emerging market
will eventually decrease as the number of emerging markets rises. Consequently, in a
globalized capital market, investment in emerging markets' assets is likely to be highly
sensitive to rumors and relatively unresponsive to "fundamentals."
The above-mentioned phenomenon poses no direct threat of a BOP crisis to the
extent that it only involves fluctuations in stock market prices. However, if a large
share of domestic debt is coming due in the short run, adverse changes in investors'
sentiments about a given emerging market may cause a BOP crisis, particularly if the
exchange rate is held fixed. The only available policy under those circumstances (short
of devaluing) is to raise interest rates on newly-issued domestic debt. Unfortunately,
since investors are ill-infurmed about fundamentals, the interest-rate hike could
possibly be taken as a sign of weakness and not of strength, since they may feel
that higher interest rates are due to the "market" being aware of serious difficulties.
Furthermore, even if investors were better informed, the bonds-attack could lead to
socially costly cr{ses.
As an illustration, consider a simple two-period example in which all public debt has
one-period maturity and the international riskless interest rate is zero. We assume that
debt can be repaid in full, independently of the repayment schedule. However, output
is a function of the debt-repayment schedule. Suppose that the economy is controlled
by a social planner and is subject to the standard intertemporal budget constraint.
Under these circumstances, a social planner will choose the optimal debt-repayment
schedule by maximizing the social utility function subject to the budget constraint~
A social optimum is attained if the country can freely choose the share of total debt
that will be repaid each period. However, if bond-holders insist on getting fully repaid

Ch. 24." Irtflation Stabilization and BOP Crises in Deoeloping Countries'

1603

in the first period, we assume that the effort to comply with the financial obligation
is so counterproductive that output next period would fall to zero. Thus, even though
the country is able to fully repay its outstanding debt in period 1, no rescheduling
would now be possible because potential investors (rationally) expect output to be
zero in period 2. Thus, the existence of large short-term maturity debt may give rise
to multiple equilibria, and make the country vulnerable to socially costly bond-attacks
[see Calvo (1998) and Cole and Kehoe (1996)].
7.5.3. D o m e s t i c debt and credibility

In addition, the existence of domestic-currency denominated public debt can generate

BOP difficulties if the exchange rate policy is not fully credible. Suppose the
government announces a fixed exchange rate but the public believes that the currency
will be devalued next period by e times 100 with probability p. Then, if investors are
risk neutral (in terms of foreign currency) the nominal interest rate satisfies
1

itp + (1 + i,)(1 - p ) = 1 + r,

l+e

(7.15)

where i and r and are the domestic and international one-period interest rates,
respectively. Clearly, if e and p are positive numbers, then the domestic interest rate
will exceed the international one. This phenomenon is called the "peso problem" and
is a common feature of exchange-rate-based stabilization programs.
Suppose the government has a fixed debt level d and that, under full credibility
(i.e., e = 0), the fiscal deficit is zero (i.e., r - rRt + rd = 0). Assuming, for simplicity,
that fiscal deficits are fully monetized, it follows that, if there is an expectation of a
devaluation (but the currency is not devalued), the discrete version of Equation (7.4)
would be given by
Rt+l - Rt = -(72 - rRt + itd),

with the fiscal deficit now being positive since it > r due to the peso problem. Hence,
the peso problem may put into motion Krugman's BOP-crisis machinery 91. Thus,
lack of credibility may result in an unsustainable balance of payments even though
"fundamentals" could be fully in line with a sustainable situation.
7.5.4. Credibility, the d e m a n d f o r money and fiscal deficits

Credibility problems may be reflected through other more subtle, but equally important,
phenomena. As argued in Section 3, there is typically a consumption boom in the
early stages of an exchange-rate-based stabilization. Therefore, the demand for money
~)l A related scenario is discussed by Guidottl and V6gh (1999). In their model, the Krugman machinery
is put into motion by the probability of a devaluation associated with a fiscal consolidation.

1604

G.A. Calvo and C.A. V~gh

will contain a cyclical component associated with tile stabilization program. Higher
monetization at the start of the program may give the impression to policymakers that
the program enjoys a high degree of credibility. An argument one commonly hears
from policymakers is that higher monetization reflects the return of flight capital due
to the higher confidence inspired by the stabilization plan. While this is partially true,
policymakers may wrongly conclude that the higher stock of real monetary balances is
a permanent positive shock. However, if monetization is provoked by the expectation
that the program will be abandoned in the non-too-distant future, then the real stock
of money will eventually collapse, possibly generating a BOP crisis.
In a recent study, Talvi (1997) shows that if tax revenue is an increasing function
of consumption, then prior to crisis the fiscal deficit could shrink, giving the false
impression that the fiscal house is in order. In an example, Talvi (1997) shows that
the fiscal deficit is nil before tile crisis, only to explode afterwards. This pattern of the
fiscal deficit is understandably quite confusing to the average policymaker. It is not
unusual for the initial slackening of the fiscal constraint to be read as an indication
that tax evasion has fallen and, hence, that the higher fiscal revenue has a significant
permanent component. As a result, considerable political pressure is built up for more
government spending. Unfortunately, if imperfect credibility is the key reason for the
initial consumption boom and policymakers give in to pressures to increase government
expenditure, then after-crisis fiscal deficits could reach dangerously high levels - which
will become apparent only after a crisis erupts and policymakers have little room to
manoeuver.

8o Concluding remarks
We have concluded our long journey through the fascinating world of inflation
stabilization and balance-of-payment crises in developing countries. After examining
the possible rationale behind the existence of chronic inflation in many developing
countries, we carried out some simple econometric exercises which support tile
existence of two main puzzles in the area of inflation stabilization. First, exchangerate-based stabilization leads to an initial boom in real GDP, private consumption,
and durable goods consumption. The recession typically associated with disinflation
programs appears only later in the programs. Second, money-based stabilization leads
to an early recession, suggesting that the timing of the contraction depends on the
nominal anchor which is used (the "recession-now-versus-recession-later" hypothesis).
We did not, however, find support for the existence of an investment cycle in exchange-rate-based stabilizations. Nor did we find evidence of a significant fall in public
consumption around the time of stabilization.
We then reviewed the main theories aimed at explaining these puzzles. We first
focused on theories that emphasize expansions in demand: inflation inertia, lack of
credibility (temporary policy), and durable goods. The first, inflation inertia, relies oil
a fall in real interest rates to generate the initial boom. However, within an optimizing

Ch. 24:

Inflation Stabilization and BOP Crises in Deeeloping Countries

1605

framework and in the absence of any wealth effect, this theory would require some
implausible parameter configurations to rationalize the initial boom. Also, it would
have a hard time explaining the boom in programs in which real interest rates rise
on impact. The second, lack of credibility, conforms quite well with the stylized
facts. Quantitatively, however, it faces the problems of low intertemporal elasticities of
substitution. The third, which relies on the timing of purchases of durable goods, may
also reproduce the consumption cycle, lts quantitative relevance has not been evaluated
yet.
We then turned to explanations that rely on wealth effects. The first emphasizes
supply-side responses - both in labor supply and investment - to the removal of
the inflation distortion. While these theories can explain the boom, they cannot
explain the late recession. In addition, the fact that the investment cycle was not
found significant casts some doubts on the relevance of this mechanism. A second
source of wealth effects - cuts in government spending - faces a similar problem
Quantitatively, however, supply-side effects appear to be a critical component of any
story aimed at explaining the empirical regularities associated with exchange-rateo
based stabilization.
To explain the stylized facts of money-based stabilization, we resorted to an
optimizing version of traditional sticky-prices model '~ la Taylor-Fischer. A reduction
in the rate of money growth decreases expected inflation and thus the nominal
interest rate. This induces an incipient excess demand for real money balances. To
restore money-market equilibrium, consumption (and thus output) of home goods
needs to fall. This is effected through a real appreciation of the domestic currency.
It is worth stressing that sticky prices are essential to this type of model. Without this
feature, money-based stabilization would yield the same results as exchange-rate-based
stabilization. Hence, a model designed to explain both the stylized facts of exchangerate-based and money-based stabilization - and, in particular, the recession-nowversus-recession-later hypothesis - requires sticky prices and an interest-rate elastic
money demand [see Calvo and V6gh (1994c)].
Since most exchange-rate-based stabilizations end in thll-blown balance-of-payment
crises - typically accompanied by banking crises - we took a detailed look at both the
mechanics and causes of balance-of-payments crises in the final leg of our journey
(Section 7). While the starting point of this section was Krugman's (1979) seminal
paper on balance-of-payments crises, most of the issues touched upon have come to
light after the December 1994 Mexican crisis, and represent very much research in
progress. It was argued that simple extensions of Krugman's (1979) model may account
for some missing links in the original story: (i) bond-financing may mask the fiscal
problems by preventing reserve losses; (ii) imperfect substitutability between domestic
and foreign assets opens the door for the central bank to sterilize the effects of reserve
losses on money supply; and (iii) an active interest rate policy allows the central bank
to postpone the abandonment of the peg and avoid a run in the final stages.
We then analyzed the current account approach; that is, the view that large currem
account deficits may be unsustainable and lead to balance-of-payments crises. While

1606

G.A. Calvo and CA. VOgh

this channel could provide a concrete link between the dynamics of exchange-ratebased stabilizations and their demise, it still has precious little to say outside the
steady state. In addition, the mechanics through which a BOP crisis would occur are
unclear. Finally, we highlighted the role of financial considerations and credibility as
contributing factors in unleashing balance-of-payments crises. Under high information
costs and globalization, demand for emerging markets' assets is likely to be highly
sensitive to rumors and relatively unresponsive to fundamentals. Changes in investors'
sentiments could make it difficult for the government to roll-over a large stock of shortterm debt, leading to a bond-led attack. A large stock of short-term debt may also result
in self-fulfilling crises. Lack of credibility in the peg - and thus high nominal interest
rates - may also put into motion the Krugman-type machinery in the face of a large
stock of domestic debt.
Where do we go from here'? In the area of inflation stabilization, much work
remains to be done on the empirical regularities of disinflation in chronic inflation
countries. Numerous problems need to be addressed, including sample selection and
small samples for money-based programs. Small samples for successful exchangerate-based programs also pose a problem since the econometric finding of a late
recession is clearly influenced by events in failed programs. A critical aspect in
econometric work is to control for other domestic factors, such as trade and structural
reforms. Disentangling the effects of stabilization from other reforms is important not
only to make sure that the empirical regularities remain such, but also because we
may be asking theoretical models to explain "too much", quantitatively speaking. It
would also be important to document in a systematic way the behavior of the homegoods sector relative to the traded-goods sector. Some available evidence suggests
that the initial boom is much more evident in the home-goods sector. The behavior
of investment should also be looked at in more detail. The goal of this research
agenda would be to establish how much needs to be explained and then build more
refined quantitative models to evaluate the alternative hypotheses, along the lines of
Rebelo and V6gh (1995).
It is clear that we are still far away from a good understanding of the links between
the dynamics of exchange-rate-based stabilizations and their ultimate demise. While
Krugman's (1979) model and variations thereof provide a good description of the
mechanics of BOP crises, they offer in general little insight into the more fundamental
causes of such crises - over and above the obvious implication that a deterioration in
the fiscal balance during a program will put into motion Krugman-type dynamics. We
feet that the notion of current account sustainability needs substantial refinement before
it can offer a consistent and complete account of the facts, but is an area definitely
worth pursuing.
In this respect, a productive area of research would be to focus on the role of
the financial and banking sectors in amplifying the expansionary cycle and possibly
contributing to the downturn and eventual crisis. A particularly relevant channel has to
do with the real estate market. A sizeable fraction of the lending boom goes to finance
real-estate operations [see, for instance, Guerra (1997a)]. These loans are usually made

Ch. 24:

Inflation Stabilization and BOP Crises in Developing Countries

1607

using as collateral temporarily high asset prices. In the context o f the temporariness
hypothesis, G u e r r a (1997b) shows an example in which the fall in asset prices (i.e., land
prices) before the a b a n d o n m e n t o f the p r o g r a m m a y trigger a b a n k i n g crisis. While this
does not explain the end o f the program, it does provide a link b e t w e e n the d y n a m i c s
o f these p r o g r a m s and b a n k i n g crises.

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16t2

G.A. Caluo and C.A. Vdgh

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Ch. 24:

Inflation Stabilization and BOP Crises" in Deueloping Countries

1613

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1614

G.A. Calvo and C.A. VSgk

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Chapter 25

GOVERNMENT DEBT
DOUGLAS W. ELMENDORF
Federal Reserve Board
N. GREGORY MANKIW
Harvard University and NBER

Contents
Abstract
Keywords
1. I n t r o d u c t i o n
2. T h e data
2.1. Debt and dcficits in the USA and other countries
2.2. Measurement issues
2.2.1. Adjusting for economic conditions
2.2.2. Assets and liabilities beyond the official debt
2.2.3. Capital budgeting
2.2.4. Generational accounting
2.3. Future fiscal policy
3. T h e c o n v e n t i o n a l v i e w o f debt
3.1. How does debt affect the economy?
3.1.1. The short run: increased demand for output
3.1.2. The long run." reduced national saving and its consequences
3.1.3. Other effects
3.2. How large is the long-run effect of debt on the economy?
3.2.1. The parable of the debt fairy
3.2.2. A closer look at the effect of debt on private savings
3.2.3. A closer look at international capital flows
3.2.4. A closer look at the marginal product of capital
3.2.5. The deadweight loss of servicing the debt
3.2.6. Summary
4. R i c a r d i a n e q u i v a l e n c e
4.1. The idea and its history
4.1.1. The essence of the Ricardian argument
4. 1.2. A brief history of the Ricardian idea
4.1.3. Why Ricardian equivalence is so important
Handbook of Macroeconomics, Volume 1, Edited by J.B. Taylor and M. Woodfbrd
1999 Elsevier Science B. K All rights reserved
1615

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4.2. The debate over Ricardian equivalence: theoretical issues
4.2.1. Intergenerational redistribution
4.2.2. Capital market imperfections
4.2.3. Permanent postponement of the tax burden
4.2.4. Distortionary taxes
4.2.5. Income uncertainty
4.2.6. Myopia
4.3. The debate over Ricardian equivalence: empirical issues
4.3.1. Testing assumptions about household behavior
4.3.2. Testing the implications for consumption
4.3.3. Testing the implications for interest rates
4.3.4. Testing the implications for international variables
5. Optimal debt policy
5.1. Fiscal policy over the business cycle
5.2. Fiscal policy and national saving
5.2. i. Lifb-cycle saving
5.2.2. lntergenerational saving
5.3. Tax smoothing
6. Conclusion
References

D. W. Elmendorf and N.G. Mankiw

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Abstract

This chapter surveys the literature on the macroeconomic effects of government debt.
It begins by discussing the data on debt aud deficits, including the historical time
series, measurement issues, and projections o f future fiscal policy. The chapter then
presents the conventional theory o f government debt, which emphasizes aggregate
demand in the short run and crowding out in the long run. It next examines the
theoretical and empirical debate over the theory o f debt neutrality called Ricardian
equivalence. Finall); the chapter considers various normative perspectives about how
the government should use its ability to borrow.

Keywords
J E L classification: E6, H6

Ch. 25:

Government Debt

1617

1. Introduction

An important economic issue facing policymakers during the last two decades of the
twentieth century has been the effects of government debt. The reason is a simple one:
the debt of the US federal government rose from 26% of GDP in 1980 to 50% of GDP
in 1997. Many European countries exhibited a similar pattern during this period. In the
past, such large increases in government debt occurred only during wars or depressions.
Recently, however, policymakers have had no ready excuse.
This episode raises a classic question: how does government debt affect the
economy? That is the question that we take up in this paper. It will not surprise
the reader to learn that macroeconomists are divided on the answer. Nonetheless, the
debates over government debt are fascinating and useful to study. They are fascinating
because they raise many fundamental questions about economic behavior. They are
useful to study because learning the sources of disagreement can help an impartial
observer reach a judgment of his own.
Our survey of the effects of government debt is organized as follows. Section 1
considers some of the data on government debt. These data give some sense of the
history of government debt in the USA and elsewhere. This section also discusses
some recent projections for the beginning of the twenty-first century.
Section 2 then examines the conventional view of the effects of government debt.
We call this view "conventional" because it is held by most economists and ahnost
all policymakers. According to this view, the issuance of government debt stimulates
aggregate demand and economic growth in the short run but crowds out capital and
reduces national income in the long run.
Section 3 turns to an alternative view of government debt, called Ricardian
equivalence. According to this view, the choice between debt and tax finance of
government expenditure is irrelevant. This section discusses the basis of this idea, its
history and importance, and the debate over its validity.
Section 4 moves from positive to normative analysis. It considers various perspectives on the question of how the government should use its ability to borrow. The
discussion highlights the potential significance of colmtercyclical fiscal policy, optimal
national saving, and intertemporal tax smoothing.

2. The data
In this section we present some basic facts about government debt and deficits in the
USA and other countries. We give the official data, and then examine a number of
issues regarding the appropriate measurement of fiscal policy. We conclude the section
by considering projections of future fiscal policy in a number of countries.

D. W. Elmendorf and N.G. Mankiw

1618
Panel A
Debt as e Percentage

Percent
120 - -

of GNP

1791 - 1996

100

88

60

40

20

r
1790

~
1810

I,
1830

I
1850

~
1870

~
1890

I
1910

I
1930

i
1950

p
1970

1990

Panel B

Deficit as a P e r c e n t a g e o f G N P
1791 - 1996

Percent
30 - -

I
1790

I
1810

I
1890

I
1858

I
1879

1890

I
1910

I
1930

i
1950

I
1970

I
1980

Fig. I.

2.1. Debt and deficits' in the USA and other countries

We begin with data f r o m the U S A . Panel A o f Figure 1 shows U S federal debt as a
p e r c e n t a g e o f gross national product over the past 200 years 1. It is c o m m o n to exclude
the debt o f state and local governments, as we do, although for many p u r p o s e s it is
m o r e appropriate to consider the consolidated debt o f all levels o f government. M o s t

We take GNP data from Berry (1978, Table IB) tor 1791 to 1868, tiom Romer (1989) for 1869
to 1928, and from the National Income and Product Accotmts since 1929. The end-of-year debt comes
from Bureau of the Census (1975, series Y493) for 1791 to 1939, from Congressional Budget Office
(CBO) (1993, Table A-2) for 1940 to 1961, and from CBO (1997a, Table F-4) since 1962. We splice
the series multiplicatively at the break points and convert dcbt from fiscal-year to calendar-year form.

Ch. 25:

Goeernment Debt

1619

state governments hold positive net assets, because they are prohibited from running
deficits in their operating budgets, and because the assets they accumulate to fund
employee pensions exceed the debt they issue to finance capital projects. The figure
shows federal debt "held by the public", which includes debt held by the Federal
Reserve System but excludes debt held by other parts of the federal government, such
as the Social Security trust fund.
The primary cause of increases in the US debt-output ratio has been wars: the
War of 1812, the Civil War, World War I, and World War II all produced noticeable
upswings in federal indebtedness. The Great Depression and the 1980s are the only
two peacetime intervals when this ratio increased significantly. Between these sharp
increases, the debt-output ratio has generally declined fairly steadily. An important
factor behind the dramatic drop between 1945 and 1975 is that the growth rate of GNP
exceeded the interest rate on government debt for most of that period. Under such
circumstances, the government can collect taxes equal to only its non-interest spending,
finance the interest payments on the outstanding debt by issuing more debt, and still
watch its debt grow more slowly than the economy. This situation has potentially
important implications for the effect of government debt, as we discuss later.
Panel B of Figure 1 shows the US federal budget deficit as a share of GNP over
the past 200 years 2. These deficit numbers are for the so-called "unified budget",
which includes both "on-budget" items like national defense and "off-budget" items
like Social Security, thus capturing essentially all of the fiscal activities of the federal
government. Once again, the effect of wars is quite apparent. The small deficits
between 1955 and 1975 were consistent with a declining debt-output ratio for the
reason just mentioned: although the debt was growing, output was growing faster.
After 1975, larger deficits and a less favorable relationship between the interest rate
and the growth rate caused the debt-output ratio to rise.
Government debt and deficits in other industrialized countries span a wide range, as
shown in Table 1. The first column presents general government net financial liabilities
as a percentage of GDR This measure differs in several respects from that shown in
panel A of Figure 1: it includes all levels of government, nets out financial assets
where the data are available, and normalizes by GDP rather than GNP. Nevertheless,
the US value for 1996 matches the last point shown in the figure. The second and third
columns show the budget surplus and primary budget surplus as percentages of GDP.
The primary surplus equals taxes less all non-interest spending. The highest reported
debt-income ratios are in Italy and Belgium; their high debt service payments induce
substantial budget deficits despite primary budget surpluses.

2 The budget sm~pluscomes from Bureau of the Census (1975, series Y337) for 1791 to 1928, fi~om
Bureau of the Census (1975, series Y341) for 1929 to 1961, and from Congressional Budget Office
(1997a, Table F-4) since 1962. We convert these numbers from a fiscal-year basis to a calendar-year
basis. Note that the deficit does not equal the annum change in federal debt. Roughly speaking, the
change in debt reflects the government'scash outlays and receipts, while the unified deficit involves a
limited amount of capital budgeting. We return to this issue below.

1620

D. Pg Elmendolf and N.G. Mankiw

Table 1
Debt and deficits in industrialized countries in 1996, in percent of GDP a

Country

Net debt

Budget surplus

USA

49

-2

Japan

14

-4

Germany

48

-4

-1

France

39

-4

-l

112

-7

44

-4

-1
4

Italy
United Kingdom

Primary budget surplus

Canada

70

Australia

29

-1

Austria

51

-4

Belgium

127

-3

Denmark

46

-2

Finland

-8

-1
4

Greece

n.a.

-7

Iceland

37

-2

Ireland

n.a.

-1

Korea

-22

Netherlands

48

New Zealand

n.a.

Norway

-28

Portugal

n.a.

53

-5

Spain
Sweden

26

-1

TOTAL of these cotmtries

45

-3

Data are from OECD (1997, pages A33, A35, and A38) and include all levels of government.
"n.a." denotes not available.
a

2.2. Measurement issues'

T h e official US data o n federal g o v e r m n e n t d e b t and deficits o b s c u r e a nu-mbe~ o f
i n t e r e s t i n g and i m p o r t a n t issues ip a s s e s s i n g fiscal policy. We n o w d i s c u s s s o m e o f
t h e s e m e a s u r e m e n t issues.

2.2.1, Adjusting f o r economic conditions

Official data on d e b t and deficits are o f t e n a d j u s t e d to reflect t h r e e e c o n o m i c variables:
the p r i c e level, interest rates, a n d the b u s i n e s s cycle. T h e a d j u s t m e n t for the p r i c e level

1621

Ch. 25." Government Debt

occurs because the real value of the debt is, for many purposes, more important than
the nominal value. For the level of the debt, the price-level adjustment is obvious:
if D is the debt and P is the price level, then the real debt is D/P. For the deficit,
however, the price-level adjustment is somewhat more subtle. It is natural to define
the real deficit to be the change in the real value of the debt. In this case, the real
deficit equals the nominal deficit (deflated by the price level) minus the inflation rate
times the existing debt. That is,
d(D/P) _ d D / d t
dt

dP/dt D
P

P"

The inflation correction, which is represented by the second term on the right-hand
side of this equation, can be large when inflation is high or the outstanding debt is
large. Indeed, it can turn a nominal budget deficit into a real budget surplus.
The second adjustment is for the level of interest rates. The adjustment arises
because the market value of the debt may be more important than the par value. When
interest rates rise, outstanding debt falls in value, and when interest rates fall, the
opposite occurs; of course, a given rate change will cause debt with a longer maturity
to be revalued more than shorter-term debt. The market value of US debt over time
can be calculated using the data and procedures outlined in Seater (1981), Butkiewicz
(1983), and Cox and Hirschhorn (1983). The annual change in the market value can
differ noticeably from the annual change in the par value, but the series follow the
same broad trends.
The third common adjustment to the budget deficit is for business cycle conditions.
Because the deficit rises automatically when economic activity slows, and vice versa,
the budget deficit in a given year may offer a misleading impression of underlying fiscal
policy. The "standardized employment deficit" [Congressional Budget Office (1997a)]
eliminates the effects of the business cycle on the budget. This deficit is based on
estimates of what spending and revenue would be if the economy were operating at
normal levels of unemployment and capacity utilization.
2.2.2. Assets' and liabilities beyond the official debt

Debt held by the public is the largest explicit liability of the federal government, but i~
is not the only liability. Moreover, the federal government also holds significant assets.
As emphasized by Eisner and Pieper (1984) and Eisner (1986), all of these assets and
liabilities should be considered in any overall accounting of the government's financial
situation. Unfortunately, it is quite difficult to assess the value of many government
assets and liabilities.
Some valuation problems are primarily technical. For example, a large share of the
government's physical capital is defense-related, and many of these goods are not sold
in (legal) markets. As another example, federal insurance of bank deposits may prove
to be either very costly to the government or very inexpensive, and it is difficult to
assess the probabilities of the alternative outcomes.

1622

D. ~ Ehnendolf and ~ G. Mankiw

Tabie 2
US federal governmentexplicit assets and liabilitiesa
Category

Estimated value in 1995 ($ billions)

Liabilities

Debt held by the public (excluding the Federal Reserve)

Federal pension liabilities
Insurance liabilities
Other

3219
1513
66
498

Assets

Financial assets
Physical assets
Net liabilities

576
1737
2983

a Data are from Office of Management and Budget (1996).

Other valuation problems are more conceptual. Do the furore Social Security benefits
specified by current law constitute a government liability in the same sense as explicit
debt? The answer to this question depends at least partly on how the liability is
perceived by households. If households believe that these benefits will be paid with
the same probability that the explicit debt will be honored, then it may be sensible
to count the present value of the benefits as government debt. In this specific case,
the additional debt could be roughly three times the explicit debt, as Feldstein (1996a)
estimates the present value of Social Security benefits less taxes for current adults
at roughly $11 trillion in 1995. Similar questions arise for civil service and military
retirement benefits, Medicare, and other entitlement programs. The important general
point is that the appropriate measure of government indebtedness largely depends on
people's behavior. As a result, deciding what measure of fiscal policy is best requires
taking a stand on the correct model of economic behavior.
Attempts to measure a range of explicit government assets and liabilities include the
presentations of historical federal balance sheets by Eisner (1986), Bohn (1992), and
Office of Management and Budget (1996). OMB's estimates for 1995 are summarized
in Table 2. The largest liabilities are debt held by the public (excluding the Federal
Reserve) and expected pension liabilities for federal military and civilian employees.
OMB also includes the expected cost of contingent liabilities that arise from loan
guarantees and insurance programs. The federal government's financial assets include
gold and loans owed to the government; its physical assets include both reproducible
plant and equipment (about three-quarters of which relates to national defense) and
non-reproducible capital such as land and mineral deposits. OMB does not include
in these estimates the cost of future Social Security payments and other "continuing
commitments", arguing that the appropriate way "to examine the balance between

Ch. 25: Government Debt

1623

future Government obligations and resources is by projecting ... total receipts and
outlays" (p. 20).
As it turns out, OMB estimates the government's assets to be worth roughly as much
as its non-debt liabilities in 1995, so net explicit liabilities are close to the value o f debt.
Indeed, net liabilities appear to have followed debt fairly closely in recent decades,
despite sometimes significant differences in their annual changes. Debt increased by
about $2.4 trillion between 1975 and 1995, while OMB estimates that liabilities rose
about $2.6 trillion. Yet, these measures diverged sharply before 1975. Bohn estimates
that the net worth o f the federal government was roughly the same share o f GNP
in 1975 as in 1947, as a dramatic decline in the debt share was offset by a drop in
military assets and a rise in government employee pension obligations.
2.2.3. Capital budgeting

One way to incorporate some government assets into the regular budget process is to
create separate capital and operating budgets. In this way, current outlays would include
not the acquisition o f capital goods, but the depreciation o f previously purchased
capital. One effect o f capital budgeting is that it would allow the government to
spend money on capital assets without running an explicit deficit. Some observers
view this situation as an inducement to profligate spending, particularly because it is
difficult to decide exactly what constitutes capital, and many types o f spending could
acquire that label. For whatever reason, the US federal government (unlike many state
governments) does not rely on a capital budget as a central element o f its budget
process. Nevertheless, the principle o f capital budgeting does affect budget numbers
in two ways.
First, the unified budget includes some specific kinds o f capital budgeting. Since
1992, for example, government credit programs have been counted not in terms o f
their current outlays, but in terms o f the present value o f their expected future outlays.
Thus, the deficit cost o f a direct student loan is not the loan amount itself, but the net
cost o f providing the loan, taking into account the probability o f default. Because the
government's cash outlays reflect the total amount o f the loan, the increase in the debt
exceeds the deficit. A similar pattern is repeated for some other fiscal activities where
the budget amounts differ from the contemporaneous cash outlays or receipts 3.
Second, the federal budget as recorded in the National Income and Product Accounts
does treat government consumption and investment in physical capital differently 4.

3 Formally, the change in debt equals the deficit less so-called "other means of financing". Much of
this category consists of short-term differences between the deficit and borrowing needs, but some other
means of financing (such as direct student loans) involve quite long-term divergences.
4 This treatment in the National Income and Product Accounts was introduced in 1996. There are a
number of other discrepancies between unified budget principles and NIPA budget principles. These
include geographic differences, timing conventions, and some shifting of items between the revenue and
expenditure sides of the budget.

1624

D. W. Elmendorf and N.G. Mankiw

Government consumption includes an estimate of the depreciation of government

capital, and government purchases of new capital are tallied separately. The federal
government's investment in physical capital is fairly modest, with gross investment
less than 15% of consumption expenditures in 1994.

2.2.4. Generational accounting

One prominent alternative to standard debt and deficit accounting is "generational

accounting", proposed by Auerbach et al. (1991) and Kotlikoff (1992). These authors
argue that the conventional deficit and explicit debt "simply reflect economically
arbitrary labeling of government receipts and payments", so that the measured deficit
"need bear no relationship to the underlying intergenerational stance of fiscal policy"
(p. 56). Generational accounts measure fiscal policy by its impact on different
generations, not by the annual flows of spending and taxes.
Generational accounts are constructed by extrapolating current policies through
the lifetimes of all people currently alive, and calculating the net taxes they would
pay under those policies. The net taxes of future generations are then set at a level
which satisfies the government's intertemporal budget constraint. These calculations
provide important information about how fiscal policy redistributes resources across
generations. For example, most of the transfer from young to old during the postwar
period occurred not in the 1980s when measured deficits were high, but between
the 1950s and 1970s when deficits were low but Social Security benefits were being
enhanced.
Nevertheless, generational accounts do suffer from some problems, as explored by
Cutler (1993) and Congressional Budget Office (1995). One set of problems involves
technical issues in constructing the accounts. For example, it is unclear what is the
appropriate discount rate for future taxes, and different discount rates produce very
different quantitative results. A second issue is whether the labelling of government
receipts and payments truly is arbitrary. For instance, the methodology of generational
accounting treats Social Security payments and interest payments on govermnent debt
as essentially equivalent. Yet it is surely easier for the government to reduce future
Social Security benefits than to reduce future coupon payments on existing debt
securities. The label "govenmlent debt" appears to have some true meaning.
A final important problem springs from the fact that generational accounting
is inextricably tied to a specific model of individual behavior. In particular, the
methodology assumes that people are life-cycle consumers without a bequest motive,
so that their behavior and well-being depend on their assessment of government
policies over their entire lifetimes and only over their lifetimes. If individuals are
liquidity-constrained or myopic, however, then their behavior and well-being may be
more sensitive to current taxes than to the present value of the future taxes they expect
to pay. Conversely, if individuals have altruistic bequest motives (a possibility we
discuss extensively later), then their behavior and well-being will be sensitive to future

Ch. 25: Government Debt

1625

taxes that will be paid by their descendants. In either case, generational accounts fail
to provide a good gauge of fiscal policy for either positive or normative purposes.
2.3. Future fiscal policy
Current patterns of taxes and spending are unsustainable in most industrialized
countries over the next twenty-five years. The primary causes of this situation are
the aging of their populations and the rising relative cost of medical care. Table 3
presents the elderly dependency ratio - defined as the population age 65 and over as a
percentage of the population ages 20-64 - for a number of countries. Between 1990
and 2030, longer lifespans and continued low birthrates will sharply increase the ratio
of retirees to working adults. The US population is projected to age less dramatically
than the population of many other industrialized countries, but the increase in retirees
per worker in the USA is still expected to exceed 50%.
In most countries, health care has absorbed an increasing share of national income
over the past several decades. The cost of producing most specific medical services
may not have increased, but the cost of providing medical care that meets the socia!
standard clearly has risen. Predicting future developments in this area is difficult, but
most analysts expect the relative cost of medical care to continue to increase for some
time.
A large share of government outlays involves transfers from working adults to
retirees or the financing of health care. (Of course, these categories overlap heavily.)
Thus, the aging of the population and the increasing cost of health care will put a
significant strain on government finances over the coming decades. Table 4 shows
projections tbr the effect of population aging on various countries' budget surpluses
and debts under the assumption that current tax and spending rules remain unchanged.
The numbers show only the direct effect of aging, and ignore the problem of paying
interest on the accumulating debt. The projections are highly uncertain as well.
Table 3
Elderly dependencyratiosa
Country
Japan
Germany
France
Italy
United Kingdom
Canada
USA

1990

2030

19
24
23
24
27
19
2i

49
54
43
52
43
44
36

a Data are from CongressionalBudget Office (1997b).

1626

D. Pg ElmendoJjand N.G. Mankt'w

Table 4
Projected effect of population aging on fiscal conditions in industrializedcountries, in percent of GDP ~
Country

Primary budget surplus

Change in debt from

2000 to 2030

1995

2030

USA

0.4

-3.8

44

Japan

-3.4

-8.7

190

Germany

-0.6

-6.6

45

1.6

-4.5

62

3.4
-2.8

5.9
1.4

109
27

Canada

1.5

-1.0

39

Australia

0.0

-1.4

37

Austria

2.7

-7.7

171

Belgium

4.3

-0.5

42

Denmark

2.0

2.3

124

Finland

4.3

-8.8

213

Iceland

- I. 1

-3.3

41

France
Italy
United Kingdom

Ireland

1.8

0.0

Netherlands

1.4

-6.0

142

Norway

3.2

4.7

135
110

Portugal
Spain
Sweden

0.6

-5.6

- 1.1

4.4

66

5. l

-2.7

117

a Data are from Roseveare et al. (1996) and refer only to the direct effect of population aging without
incorporating the effect of higher interest payments on the larger outstanding debt. The primary budget
surplus equals taxes less non-interest spending.

Nevertheless, they show a marked deterioration in the fiscal situation of almost every
country.
For the USA, Congressional Budget Office (1997b) (CBO) has performed a careful
analysis of the fiscal outlook. The analysis incorporates the need to pay interest on the
accumulating debt, as well as the feedback between debt and the economy. Table 5
summarizes CBO's results. Without economic feedbacks, government debt more than
doubles as a share of output by 2030; including feedbacks, this share rises three-fold.
A large part of this looming fiscal problem is the expected rise in future payments
for Social Security and Medicare. Dealing with this long-term fiscal imbalance will
likely be one of the most significant challenges facing policymakers during the next
century.

Ch. 25.

1627

Government Debt

Table 5
CBO baseline projections for the US budget, in percent of GDP a
Variable

1995

2030

2050

-1

3
2

6
11

12
18

50

125

267

Primary deficit
Interest payments
Total deficit

-1
3
2

5
12
17

n.a.
n.a.
n.a.

Debt

50

159

n.a.

Without economic feedbacks

Primary deficit
Interest payments
Total deficit
Debt
With economic feedbacks

a Data are from Congressional Budget Office (1997b) and assume that discretionary spending grows
with the economy after 2007. "n.a." signifies that the values were too extreme to be reported by CBO.
3. T h e c o n v e n t i o n a l v i e w o f d e b t

In this section we present what we believe to be the conventional view o f the effects
o f government debt on the economy. We begin with a qualitative description o f those
effects, focusing on the impact o f debt on saving and capital formation, and thereby on
output and income, on factor prices and the distribution o f income, and on the exchange
rate and foreign transactions. We also review some other economic and non-economic
consequences o f government borrowing.
Following our qualitative analysis, we try to quantify some o f the long-run effects
o f debt in a very rough way. Although quantifying these effects precisely is an arduous
task, we think it important to have some quantitative sense o f what is at stake.
Therefore, we present a ballpark estimate o f the impact o f debt, which is interesting in
itself and also illuminates some o f the critical assumptions underlying all quantitative
analyses o f government debt.
Our analysis assumes that government spending on goods and services is not
affected by debt policy. That is, we examine the effects o f issuing a given amount
o f debt and reducing taxes temporarily by an equal amount. Because the government
must satisfy an intertemporal budget constraint, and because debt cannot grow forever
as a share o f income, this temporary tax reduction will generally be accompanied by
a future tax increase. For most o f this section, we simply assume that the present
value o f that tax increase equals the current increase in debt. We defer more careful
consideration o f the budget constraint to the last part o f the section, where we
re-examine the effects o f debt in a world with uncertainty. The analysis also assumes,
except where stated otherwise, that monetary policy is unaffected by debt policy. By

1628

D. W.Elmendorfand N.G. Mankiw

excluding possible monetization of the debt, we can couch our discussion in real, rather
than nominal, terms.
3.1. How does debt affect the economy?

The government's debt policy has important influence over the economy both in the
short run and in the long run. We begin by discussing the short-run effects of budget
deficits. We then turn to the long-run effects, of which the most important is a reduction
in national wealth. In particular, we explain both how deficits affect national saving
and how the change in saving affects many aspects of the economy. We also consider
several other long-run effects of government debt.
3.1.1. The short run: increased demand Jbr output

Suppose that the government creates a budget deficit by holding spending constant
and reducing tax revenue. This policy raises households' current disposable income
and, perhaps, their lifetime wealth as well. Conventional analysis presumes that the
increases in income and wealth boost household spending on consumption goods and,
thus, the aggregate demand for goods and services.
How does this shift in aggregate demand affect the economy? According to
conventional analysis, the economy is Keynesian in the short rim, so the increase in
aggregate demand raises national income. That is, because of sticky wages, sticky
prices, or temporary misperceptions, shifts in aggregate demand affect the utilization
of the economy's factors of production. This Keynesian analysis provides a common
justification for the policy of cutting taxes or increasing government spending (and
thereby running budget deficits) when the economy is faced with a possible recession.
Conventional analysis also posits, however, that the economy is classical in the long
run. The sticky wages, sticky prices, or temporary misperceptions that make aggregate
demand matter in the short run are less important in the long run. As a result, fiscal
policy affects national income only by changing the supply of the factors of production.
Ttm mechanism through which this occurs is our next topic.
3.1.2. The long run." reduced national saving and its consequences

"lb understand the effect of government debt and deficits, it is crucial to keep in
mind several national accounting identities. Let Y denote national income, C private
consumption, S private saving, and T taxes less government transfer payments. The
private sector's budget constraint implies that:
Y-C4S+T.

National income also equals national output, which can be divided imo four types of
spending:
Y=C+I.~G+NX,

Ch. 25." Government Debt

1629

where I is domestic investment, G is government purchases of goods and services,

and N X is net exports of goods and services. Combining these identities yields:
S + ( T - G) = I + N X .

This identity states that the sum of private and public saving must equal the sum of
investment and net exports.
The next important identity is that a nation's current account balance must equal the
negative of its capital account balance. The current account balance is defined as net
exports N X plus net investment income by domestic residents and net transfers; for the
most part, we ignore these last two, smaller pieces. The negative of the capital account
balance is called net foreign investment, or N F I , which is investment by domestic
residents in other countries less domestic investment undertaken by foreign residents.
Thus, the third identity is simply:
NX = NFI,

so that international flows of goods and services must be matched by international

flows of funds. Substituting this identity into the other two identities yields:
S + ( T - G) = I ~ N F I .

The left side of this equation shows national saving as the sum of private and public
saving, and the right side shows the uses of these saved funds for investment at home
and abroad. This identity can be viewed as describing the two sides in the market for
loanable funds.
Now suppose that the govermnent holds spending constant and reduces tax revenue,
thereby creating a budget deficit and decreasing public saving. This identity may
continue to be satisfied in several complementary ways: private saving may rise,
domestic investment may decline, and net foreign investment may decline. We consider
each of these possibilities in turn.
To start, an increase in private saving may ensue for a number of reasons that we
discuss below. In fact, some economists have argued that private saving will rise exactly
as much as public saving falls, and the next section of the paper examines this case at
length. For now, we adopt the conventional view that private saving rises by less than
public saving falls, so that national saving declines. In this case, total investment - at
home and abroad - must decline as well.
Reduced domestic investment over a period of time will result in a smaller domestic
capital stock, which in turn implies lower output and income. With less capital
available, the marginal product of capital will be higher, raising the interest rate and
the return earned by each unit of capital. At the same time, labor productivity would
be lower, thereby reducing the average real wage and total labor income.
Reduced net foreign investment over a period of time means that domestic residents
will own less capital abroad (or that foreign residents will own more domestic capital).

1630

D. W. Elmendorf and N.G. Mankiw

In either case, the capital income o f domestic residents will fall. Moreover, the
decline in net foreign investment must be matched by a decline in net exports, which
constitutes an increase in the trade deficit o f goods and services. As this connection
between the budget deficit and the trade deficit became better known in the U S A during
the 1980s, it led to the popular term "twin deficits". Pushing the trade balance into
deficit generally requires an appreciation o f the currency, which makes domesticallyproduced goods relatively more expensive than foreign-produced goods 5.
3.1.3. Other eJJects

Although increasing aggregate demand in the short run and reducing the capital stock
in the long run are probably the most important effects of government budget deficits,
debt policy also affects the economy in various other ways. We describe several o f
these effects here.
First, government debt can affect monetary policy. A country with a large debt is
likely to face high interest rates, and the monetary authority may be pressured to try to
reduce those rates through expansionary policy. This strategy may reduce interest rates
in the short run, but in the long run will leave real interest rates roughly unchanged
and inflation and nominal interest rates higher. In the USA, at least in recent years,
monetary policy has apparently not responded to fiscal policy in this way. For example,
the US debt-income ratio rose sharply during the 1980s, and the US inflation rate
declined sharply. Nevertheless, successive Chairmen o f the Federal Reserve Board have
warned o f the possible link between the budget deficit and inflation 6.
In extreme cases, a country with a large debt may have difficulty financing an
ongoing deficit through additional borrowing and, as a result, will be tempted to raise
revenue through seigniorage. I f the fiscal authority can force the monetary authority
to finance ongoing deficits with seigniorage, then, as Sargent and Wallace (1981)
argue, inflation is ultimately a fiscal phenomenon rather than a monetary one'7. This

5 For more complete analyses of tile imernational effects of debt, see Frenkel and Razin (1992, chs. 7,
8, 10 and 11) and Obstfeld and Rogoff (1996, ch. 3).
6 Paul Volcker told~Congress in 1985 that "the actual and prospective size of the budget deficit ...
heightens skepticism about our ability to control the money supply and contain inflation" (p. 10). Alan
Greenspan said in 1995 that he expected that "a substantial reduction in the long-term prospective
deficit of the United States will significantly lower very long-term il~lation expectations vis-a-vis other
countries" (p. 141).
7 Woodford (1995) proposes an alternative "fiscal theory of the price level", based on the effect of prices
on the real value of government debt and thus on aggregate demand. Wood~brdconsiders an economy of
infinitely-lived households, and hypothesizes an increase in govermnent debt with no offsetting change
in future taxes or spending. This policy makes households wealthier and increases aggregate demand. If
aggregate supply is unchanged, both goods market equilibrium and the government's budget constraint
require that the price level increases enough to reduce real debt to its initial value. The mechanism is
quite similar to the Pigou Patin!dn (1965) real-balance effect, except that it allows for households thai
appear to be Ricardian, and it involves total government liabilities rather than just outside money. In

Ch. 25:

Government Debt

1631

monetization of the debt is the classic explanation for hyperinflation. For example,
staggering budget deficits as a share of national income were the root cause of
hyperinflations in 1920s Germany and 1980s Bolivia. As Sargent (1983) explains,
inflation can fall sharply in such a country when government borrowing is reduced
and the central bank commits not to finance future deficits. Yet, this line of reasoning
is not very important for most developed countries today, as seigniorage represents a
very small share of total government revenue 8.
A second effect of government debt is the deadweight loss of the taxes needed to
service that debt. The debt-service payments themselves are not a cost to a society as a
whole, but, leaving aside any payments to foreigners, merely a transfer among members
of the society. Yet effecting that transfer in a world without lump-sum taxes will create
some distortion of individual behavior that generates a deadweight loss. Thus, a policy
of reducing taxes and running a budget deficit means smaller deadweight losses as the
debt is being accumulated but larger deadweight losses when the debt is being serviced
with higher taxes.
A third effect of government debt is to alter the political process that determines
fiscal policy. Some economists have argued that the possibility of government
borrowing reduces the discipline of the budget process. When additional government
spending does not need to be matched by additional tax revenue, policymakers and the
public will generally worry less about whether the additional spending is appropriate.
This argument dates back at least to Wicksell (1896), and has been echoed over the
years by Musgrave (1959), Buchanan and Wagner (1977), and Feldstein (1995) among
others. Wicksell claimed that if the benefit of some type of government spending
exceeded its cost, it should be possible to finance that spending in a way that would
receive unanimous support from the voters; he concluded that the government should
only undertake a course of spending and taxes that did receive nearly unanimous
approval. In the case of deficit finance, Wicksell was concerned that "the interests
[of future taxpayers] are not represented at all or are represented inadequately in the
tax-approving assembly" (p. 106). Musgrave noted that when budget balance is altered
for stabilization purposes, "the function of taxes as an index of opportunity cost [of
government spending] is impaired" (p. 522). Buchanan and Wagner asserted that a
balanced-budget rule "will have the effect of bringing the real costs of public outlays
to the awareness of decision makers; it will tend to dispel the illusory 'something
for nothing' aspects of fiscal choice" (p. 178). And Feldstein wrote that "only the
'hard budget constraint' of having to balance the budget" can force politicians to judge
whether spending's "benefits really justify its costs" (p. 405).
It is also possible that the existence of government debt reduces the fiscal flexibility
of the government. If moderate levels of debt have only small negative effects, but
contrast to the Sargent-Wallace analysis, Woodlbrd's point does not depend on any particular response
by the monetary anthority to changes in fiscal policy.
8 For further analysis of the connections between fiscal policy and monetary policy, see Aiyagari and
Gertler (1985), Leeper (1991), McCallum (1984), and Sims (t994).

1632

D. W. Elmendorf and N.G. Mankiw

larger debts are perceived to be quite costly, then a country with a moderate debt
will be constrained from responding to calls for greater spending or lower taxes. This
constraint on future policymakers is, in fact, one of the explanations sometimes given
for why goverlmaents choose to accumulate large debts.
A fourth way in which government debt could affect the economy is by making it
more vulnerable to a crisis of international confidence. The Economist (4/1/95) noted
that international investors have worried about high debt levels "since King Edward
III of England defaulted on his debt to Italian bankers in 1335" (p. 59). During
the early 1980s, the large US budget deficit induced a significant inflow of foreign
capital and greatly increased the value of the dollar. Marris (1985) argued that foreign
investors would soon lose confidence in dollar-denominated assets, and the ensuing
capital flight would sharply depreciate the dollar and produce severe macroeconomic
problems in the USA. As Krugman (1991) described, the dollar did indeed fall sharply
in value in the late 1980s, but the predicted "hard landing" for the US economy did not
result. Krugman emphasized, however, that currency crises of this sort have occurred
in countries with higher debt-output ratios, particularly when much of that debt is held
by foreigners, as in many Latin American countries in the 1980s.
A fifth effect of government debt is the danger of diminished political independence
or international leadership. As with the danger of a hard landing, this problem is more
likely to arise when government borrowing is large relative to private saving and when
the country experiences a large capital inflow from abroad. Friedman (1988) asserted:
"World power and influence have historically accrued to creditor countries. It is not
coincidental that America emerged as a world power simultaneously with our transition
from a debtor nation ... to a creditor supplying investment capital to the rest of the
world" (p. 13).
3.2. How large is the long-run eJJect of debt on the economy?
So far we have described the effects of government debt in qualitative terms. We
now present rough quantitative estimates of some of these effects. We begin with an
extremely simple calculation of the effect on national income of a reduced capital
stock, and we then explore the sensitivity of our results to three key assumptions. Our
ballpark estimate is, in fact, broadly consistent with the few other quantitative analyses
in the literature. We also note the magnitude of the deadweight loss caused by the taxes
needed to finance the debt service. We calibrate our calculations for the US economy,
but the approach is applicable to other countries as well.
3.2.1. The parable o f the debt Jhiry
As we have discussed, a primary effect of govermnent debt is the crowding out of
capital and the consequences that result from this crowding out. How large are these
effects? To answer this question, consider the parable offered by Ball and Mankiw
(1995). hnagine that one night a debt fairy (a cousin of the celebrated tooth fairy)

Ch. 25: GooernmentDebt

1633

were to travel around the economy and replace every government bond with a piece
o f capital o f equivalent value. How different would the economy be the next morning
when everyone woke up?
It is straightforward to calculate the effect o f this addition to the capital stock. I f
factors o f production earn their marginal product, then the marginal product o f capital
equals the capital share o f income ( M P K x K / Y ) divided by the capital-output ratio
(K/Y). In the U S A between 1960 and 1994, the gross return to capital was roughly onethird o f income, and the capital-output ratio averaged a little over three 9. The implied
marginal product o f capital is about 9.5%. More precisely, this figure represents the
gross marginal product; it shows how much an extra dollar o f capital adds to gross
output and income. If the country wants to maintain that dollar o f capital, however, then
it needs to do replacement investment to offset depreciation. Depreciation amounts to
roughly 3.5% o f capital, so the net marginal product o f capital is about 6%. In other
words, each dollar o f capital raises gross national product by 9.5 cents and net national
product by 6 cents.
When the debt fairy magically reverses the effects o f crowding out, the amount
o f capital increases by the amount o f federal government debt, which in the U S A is
about one-half o f gross output. Our estimates o f the marginal product o f capital imply
that gross output would be increased by about 4.75%, and net output by about 3% 10.
In 1997, these increases amount to about $400 billion and $250 billion, respectively.
The story o f the debt fairy is appealing because it offers a simple way to calculate
the effects o f government debt on national income. But is this calculation realistic?
The debt-fairy calculation implicitly makes three assumptions:
(1) Deficits do not affect private saving, so debt crowds out other forms of private
wealth one for one.
(2) The economy is closed, so crowding out takes the form o f a reduced capital stock.
(3) The profit rate measures the marginal product o f capital, so it can be used to gauge
the effects o f a change in the capital stock.

9 These data are drawn fiom the National Income and Product Accotmts of the Colmnerce Department's
Bureau of Economic Analysis (BEA). Net capital income is the sum of corporate profits, rental income,
net interest, and a share of proprietors' income (all with appropriate adjustments for inventory valuation
and capital consumption). Gross capital income equals net income plus depreciation. We use national
income plus depreciation as the measure of total output and income. The capital stock is BEA's net stock
of fixed reproducible tangible wealth excluding consumer durables. Including the value of inventories
and land in the measure of capital would depress the estimated return on capital. On the other hand,
Feldstein et al. (1983) note that "pre-tax" corporate profits in the national income accounts actually
represent profits qfier the payment of state and local property taxes; adding these taxes back into profits
would raise the estimated rates of return. Finally, some authors measure the benefit of additional saving
by the return to nonfinancial corporate capital. Because corporate capital is more heavily taxed than
other capital, it earns a higher pre-tax return. Yet, there is no reason to assume that any addition to the
capital stock would flow disproportionately to corporations.
10 The actual effect of adding tbis much capital would be somewhat smaller, because the marginal
product would decline as the capital stock increased.

1634

D. Igz?Etmendorf and N.G. Mankiw

Let us consider how relaxing each of these assumptions might alter the conclusion that
current US government debt reduces US national income by about 3%.
3.2.2. A closer look at the effect o f debt on private savings'

The debt fairy replaces each dollar of government debt with one dollar of capital. Is
this dollar-for-dollar substitution appropriate? More concretely, if the US government
had run sufficient surpluses during the past twenty years to reduce its debt to zero,
would national wealth now be larger by the amount of the actual current debt?
In actuality, an increased flow of government borrowing will affect the flow of
private saving through several channels. First, private saving will rise because some
households will save part of the tax reduction to consume later in life. Second, forwardlooking consumers will realize that the increasing debt will force higher future interest
payments by the government and, thus, higher future taxes. Third, greater government
borrowing will affect interest rates and wages, and these general-equilibrium effects
in turn will affect private saving. Fourth, the government's debt policy may affect
distortionary capital taxes, which in turn affect private saving. For all of these reasons,
the size of the budget deficit affects tile amount of private saving.
Understanding the long-run effect of debt on capital therefore requires a formal,
general equilibrium model, with particular attention paid to household saving behavior.
Conventional analysis focuses on models with overlapping generations of life-cycle
consumers introduced by Samuelson (1958) and Diamond (1965). Because this model
incorporates people at different stages of their life-cycle who differ in both their level of
wealth and marginal propensity to consume out of wealth, aggregation is often difficult
in realistic models with more than two generations. Blanchard (1985) resolves this
problem by making assumptions about the aging process that simplify aggregation
analytically. Auerbach and Kotlikoff (1987) and other researchers resolve this problem
by simulating a more complicated model numerically.
Before turning to the results from these well-known analyses, however, it is
instructive to examine a simple, stylized example. Consider an economy in which every
person lives for a fixed number of periods. Assume that the interest rate is given (either
because this is a small open economy or because the technology is linear in capital
and labor). Also assume that the consumers choose the same level of consumption in
each period of life (either because their rate of time preference happens to equal the
interest rate or because they have Leontief preferences). Now consider how an increase
in government debt affects the steady state. Higher debt means higher interest payments
and higher taxes. If those taxes are distributed equally across people of different ages,
then each person's after-tax income is reduced by the amount of those interest payments
(per capita) in each period. Because consumers still want to smooth consumption, they
respond to this higher tax burden by reducing consumption in each period by the same
amount. As a result, after-tax income and consumption fall equally, private saving is
unchanged, and private wealth is unchanged. Each dollar of debt crowds out exactly
one dollar of capital, as assumed by the debt fairy parable.

Ch. 25.. Government Debt

1635

To see what happens when various assumptions are relaxed, we turn to the Blanchard
and Auerbach-Kotlikoff analyses. Blanchard develops a continuous-time overlappinggenerations model in which people have log utility and face a fixed probability of
dying in each period. He examines the effect of accumulating additional government
debt and then holding debt at its new level forever. To establish notation, let D denote
debt and W denote national wealth (domestic capital plus net foreign assets), so private
wealth equals D + W. For a small open economy, Blanchard confirms the result from
our simple example: steady-state d W / d D equals -1 if the rate o f time preference equals
the world interest rate. I f the world interest rate and the rate o f time preference differ,
crowding out may be larger or smaller than one for one 11
Matters become more complicated in a closed economy. In this case, as capital
is crowded out, the interest rate rises, and households are encouraged to save. As
a result, the absolute value of d W / d D is smaller in a closed economy than in an
open economy 12. Calculations using the Blanchard model indicate that the difference
between open and closed economies is substantial, but this result appears highly
sensitive to the assumption of log utility, according to which households are very
willing to substitute consumption between periods in response to a higher interest rate.
Most research in the consumption literature suggests a much smaller intertemporal
elasticity o f substitution than unity 13.
Auerbach and Kotlikoff (1987) construct a large-scale general equilibrium model,
and simulate the model to examine the effects o f alternative debt, tax, and Social
Security policies. The numerical simulations reveal not only the steady-state changes
in capital and other variables, but also the transition path to the new steady state.
The model assumes that people have an economic lifetime o f 55 years, have perfect
foresight about future economic conditions, and make rational choices regarding their
consumption and labor supply. The government raises funds through distortionary taxes
and satisfies an intertemporal budget constraint. A production function for net output

11 Let p bc the probability of dying in each period or, as suggested by Blanchard and Summers (1984),
a "myopia coefficient" that reflects mortality or myopia. Let r equal the world interest rate and 0 the
rate of time preference. Then Blanchard reports that
dW
dD

p
p~ 0
p+rp+O
r"

12 Blanchard and Fischer (1989, p. 131) report that, in the steady state,
dK
dD

p(p + O)
(p + r)(p + O - r ) - F H C '

where K is the capital stock, C is consumption, and F is thc aggregate net production fimction.
13 For attempts to use variants of the Blanchard model to estimate the cost of various debt policies, see
Romer (t988) and Evans (1991).

1636

D. 14(Elmendolf and N.G. Mankiw

completes the model, which describes a closed economy. Auerbach and Kotlikoff
choose values for the key parameters based on the empirical literature. Note, in
particular, that they assume that the intertemporal elasticity of substitution is 0.25.
Auerbach and Kotlikoff examine the effect of reducing taxes and accumulating debt
over a certain number of years, and then boosting taxes to hold the debt at its new
per capita level forever. This debt policy reduces saving and capital by transferring
resources from younger and future generations, who have a low or zero marginal
propensity to consume, to older generations, who have a high marginal propensity to
consume. Capital is also diminished by the higher rate of distortionary income taxes in
the long run, although the initial reduction in the tax rate can actually crowd-in capital
in the short run. Auerbach and Kotlikoff analyze deficits equal to 5% of output that
last for one year, 5 years, and 20 years; they do not report the resulting levels of debt,
but these can be calculated approximately based on the size of the deficits and the
interest rate. For all three experiments, the decline in capital appears to be extremely
close to the increase in debt 14.
We conclude this discussion by emphasizing that the short-rml effect of a budget
deficit on consumption and saving is a poor gmide to the long-run effect of debt on
national wealth. In a model with life-cycle consumers, government debt may have
only a small short-run effect, as confirmed by Blanchard (who finds that initial saving
adjusts by only several percent of a change in debt) and Auerbach and Kotlikoff (who
find that at the end of a 20-year tax cut, the capital stock is reduced by only onefifth of its eventual decline). Nonetheless, debt has a much larger effect on life-cycle
consumers in the long run. Auerbach and Kotlikoff's closed-economy model shows
approximately one-for-one crowding out; Blanchard's formulas suggest smaller effects
in a closed economy but roughly one-for-one crowding out in an open economy. On
balance, the debt fairy's one-for-one substitution of capital for debt may be on the high
side of the truth, but it seems a reasonable approximation.
3.2.3. A closer look at international capital flows

When the debt fairy changes government debt into national wealth, the increment to
national wealth is assumed to take the form of domestic capital, witb no change in
net ownership o foreign assets. This is clearly not a realistic description of an opet~
economy. Yet, alternative assumptions about international capital flows would have
little effect on the estimated impact of government debt.
In actuality, net international capital flows are fairly small. Feldstem and Horioka
(1980) examined five-year averages of domestic investment and saving across countries
and found these two variables moved almost exactly one for one with each other. More
recent estimates suggest that the strength of this relationship declined somewhat in

14 'rile increases in debt fiom the tlucc alternative policies are roughly 5, 30 mid 200% of output. The
corresponding declines in the capital stock are 5, 29 and 182% of output.

Ch. 25." Government Debt

1637

the 1980s. Nonetheless, these estimates indicate about 75% of a long-term change
in national saving adds to domestic investment and only 25% goes to investment
abroad 15.
Because many countries allow capital to move freely across their borders, it is
surprising that net international capital flows are not larger in the long run. The
literature has considered many possible explanations 16. For our purposes, though, the
key point is that the existence of international capital flows - or the lack of such flows has little impact on the ultimate cost o f government debt. Suppose that the debt fairy
transformed each dollar o f reduced debt into an extra dollar o f net foreign assets, rather
than an extra dollar of domestic capital. In this case, which is the extreme opposite
o f our original assumption, the debt reduction would not raise domestic output at all
Instead, it would raise foreign output, and some of that output would flow back to this
country as the return on our additional overseas assets. As long as the return to wealth
is the same at home and abroad, the location of the extra wealth does not affect our
income.
Another way to understand this point is to note the distinction between domestic
income and national income. Domestic income is the value o f production occurring
within a nation's borders; this is identically equal to domestic output or GDP.
Tomorrow's domestic output and income depend on today's domestic investment. But
the consumption o f domestic residents depends on t h e i r income, which is the value
o f production accruing to a nation's residents. This is called national income, and it is
identically equal to national output or GNR Tomorrow's national output and income
depend on today's national saving, wherever this saving is ultimately invested.
Naturally, this strong statement requires several caveats. First, the statement ignores
the tax implications of the location of capital. Governments receive a higher effective
tax rate on capital located in their countries than on capital owned by their residents
but located abroad. Thus, the social return to domestic investment is higher than the
social return to foreign investment, even if the private (after-tax) returns are the same.
Second, additional capital accunmlation does not reduce the marginal product of
capital as quickly if the capital can flow abroad. As we saw in our earlier discussion
of the Blanchard model, the effect of debt on the capital stock is reduced if changes
in the capital stock affect the interest rate and thereby private saving.
Third, the location of nationally-owned capital does affect the distribution of income.
If the domestic capital stock increases, so does the wage, while the return to capital
and the interest rate fall; domestic workers benefit and owners o f domestic capital are

15 See Feldstein and Bacchetta (1991) and Dornbusch (1991).

~0 Frankel (1991), Mussa and Goldstein (1993), and Gordon and Bovenberg (1996) review the evidence
regarding international capital mobility and discuss a number of explanations for the observed immobility.
For a recent attempt to explain the Feldstein-Horioka puzzle within the context of neoclassical growth
theory, see Barro et al. (1995).

1638

D. W. Elmendorfand N.G. Mankiw

hurt 17. An increase in the ownership of capital located abroad does not have these
effects.
Fourth, international capital flows change the composition of domestic production.
If a smaller deficit raises net foreign investment, then net exports will rise, while
if it increases only domestic investment, then of course investment spending will
rise. Moreover, the budget deficit affects the exchange rate if there are significant
international capital flows, but not otherwise.
On balance, it seems that the issuance of government debt has only a small effect on
international capital flows in the long run and that those flows have only a small effect
on the return to extra saving. Acknowledging the openness of the economy, therefore,
does not substantially alter the estimated impact of government debt.
3.2.4. A closer look at the marginal product oJcapital

In describing the impact of the debt fairy, we calculated the marginal product of
capital using the capital share of national income and the capital-output ratio. This
calculation was based on the standard premise that the factors of production, including
capital, are paid their marginal product. Now we reconsider whether that calculation
was appropriate.
In recent years, there has been a wave of research that proposes a new view of
capital. As Mankiw (1995) discusses, a variety of empirical problems with the basic
neoclassical growth model would be resolved if the true capital share in the production
function is much larger than the one-third measured from the national income accounts.
One reason that the true capital share might be larger than the raw data suggest is that
capital may have significant externalities, as argued by Romer (1986, 1987). If the
social marginal product of capital is well above the private marginal product that we
observe, then reducing government debt and raising the capital stock would have much
larger effects than the debt fairy parable suggests.
Another possible reason for a large capital share is that the correct measure of capital
includes human capital, such as education and training, as well as tangible physical
capital, like plant and equipment. Mankiw et al. (1992) propose an extension of the
basic Solow (1956) model in which there are fixed saving rates for both physical capital
and human capital. They show that cross-country data are consistent with this model
and an aggregate production function of the tbrm Y=K1/3HI/3L 1/3. If the share of
income devoted to human-capital accumulation is unchanged by debt policy, then the
reduction in income caused by the crowding out of physical capital will also reduce
the stock of human capital; in this case, government debt reduces income substantially
more than our earlier calculation indicated. By contrast, if the stock of human capital
remained fixed, then our earlier calculation would be correct.

17 Bccausc some owners of domestic capital are foreigners, this shill actually raises national income
slightly.

Ch. 25: GovernmentDebt

1639

3.2.5. The deadweight loss of servicing the debt

When discussing the qualitative effects of debt, we reviewed a number of issues beyond
the impact of debt on the capital stock. The only one of those effects that is readily
quantifiable is the deadweight loss of the additional taxes needed to meet the debt
service burden 18. Of course, the deadweight loss of taxation was reduced during the
period when taxes were lower and the debt was accumulated, and optimal debt policy
requires balancing these effects. Our concern here, however, is just with the cost of
an ongoing debt.
If the government builds up a certain debt, and then decides to hold that debt
constant in real terms, the additional debt service per dollar of accumulated debt is r,
the real interest rate on debt. If 3. is the deadweight loss per dollar of tax revenue,
then the loss per dollar of debt is ~r. The total real return on intermediate-maturity
government debt averaged about 2% between 1926 and 1994 (Stocks, Bonds', Bills'
and Inflation, 1995). A standard choice for ;. is Ballard, Shoven and Whalley's (1985)
estimate of one-third, although Feldstein (1996b) argues that incorporating distortions
to the form of compensation and the demand for deductions - in addition to the usual
distortions to labor and capital supply - makes the true 3, much larger. If )~ equals onehalf, then 2r=0.01, and with the US debt-income ratio at one-half, the deadweight
loss from servicing the debt is about half a percent of output.

3.2.6. Summary
As concern about current and prospective US budget deficits has grown, quantitative
estimates of the effect of debt have begun to appear in official US government
documents. For example, in the 1994 Economic Report of the President (pp. 85
87), tile Council of Economic Advisers assumed that the President's deficit-reduction
plan would boost national saving by 1% of output each year for 50 years. Then the
Report used a simple Solow growth model to show the effect of that extra saving on
the economy. It concluded that the additional saving would eventually raise output
by 3.75%. More recently, the Congressional Budget Office (1997b) constructed a
complex model of the economy and the federal budget and simulated the model
through the year 2050. Because current law would produce an explosive rise in the
national debt over that period, CBO's results do not reflect steady-state effects. In the
simulation that includes the economic effects of increasing debt, debt rises by 30%
of output by 2020, resulting in output that is 2% smaller than it otherwise would be.
Over the following decade, debt increases by another 80% of output, and output is
diminished by more than 8% relative to the same baseline. Thus, these calculations
are similar in spirit to those found in the academic literature.

is Auerbaeh and Kotlikoff's (1987) estimates of the weffare effects of debt policy include this cost, but
isolating its significance from their published results is not possible.

1640

D. W. Elmendorf and N.G. Mankiw

We have now quantified, in a very rough way, some long-run effects of government
debt on the economy. The debt fairy parable implied that each dollar of debt reduces net
output by about 6 cents each year. More careful consideration of the strong assmnptions
embodied in that parable suggested that this estimated cost is at least in the right
ballpark. The deadweight loss from the taxes needed to service the debt adds about
another one cent per dollar of debt. Thus, the US debt of the late 1990s, which
equals about half of annual output, is reducing net output by about 3.5%. In 1997,
this amounts to around $300 billion per year.
Is this cost large? Labor productivity has increased by about one percent per year in
the USA since 1975, so reducing output by three to four percent is like giving up three
to four years of productivity growth. That is a significant loss, but it does not qualify
as a disaster. One final comparison of the cost of the current debt is with the effect
of the upcoming demographic transition in the USA. Congressional Budget Office
(1997b) projects that, under current law, population aging and rising health care costs
will boost non-interest spending of the federal government by five percent of output
between 1996 and 2025. if tile current debt were maintained in real terms, it would
represent about one-third of real output in 2025 (because of economic growth). Thus,
eliminating that debt would add about two percent to national income, or almost half
of the extra income needed to cover the additional government spending.

4. Ricardian equivalence
So far our discussion has focused on the conventional analysis of government debt. By
"conventional", we mean that this analysis describes the views held by most economists
and almost all policymakers. There is, however, another view of government debt that
has been influential in the academic debate, even if endorsed by only a minority of
economists. That view is called Ricardian equivalence after the great 19th century
economist David Ricardo, who first noted the theoretical argument. In recent years,
the Ricardian view has been closely associated with Robert Barro, whose work has
given the view renewed vigor and prominence.
4.1. The idea and its' history

Ricardian equivalence is a type of neutrality proposition: it states that a certain type

of government policy does not have any important effects. In this section we discuss
the general idea, its history, and its importance as a theoretical benchmark. In the
following sections we examine the various dimensions of the debate over the validity
of Ricardian equivalence as a description of the real world.
4.1.1. The essence o f the Ricardian argument

Suppose that the government cuts taxes today without any plans to reduce gover~ur~ent
purchases today or in the future. As we have seen, conventional analysis concludes

Ch. 25.

Government Debt

1641

that this policy will stimulate consumption, reduce national saving and capital
accumulation, and thereby depress long-term economic growth. By contrast, the theory
of Ricardian equivalence asserts that this policy will not alter consumption, capital
accumulation, or growth. The situation with the tax cut and budget deficit is e q u i v a l e n t
to the situation without it.
The Ricardian argument is based on the insight that lower taxes and a budget deficit
today require (in the absence of any change in government purchases) higher taxes
in the future. Thus, the issuing of government debt to finance a tax cut represents
not a reduction in the tax burden but merely a postponement of it. If consumers
are sufficiently forward looking, they will look ahead to the future taxes implied by
government debt. Understanding that their total tax burden is unchanged, they will not
respond to the tax cut by increasing consumption. Instead, they will save the entire tax
cut to meet the upcoming tax liability; as a result, the decrease in public saving (the
budget deficit) will coincide with an increase in private saving of precisely the same
size. National saving will stay the same, as will all other macroeconomic variables.
In essence, the Ricardian argument combines two fundamental ideas: the government budget constraint and the permanent income hypothesis. The government budget
constraint says that lower taxes today imply higher taxes in the future if government
purchases are unchanged; the present value of the tax burden is invariant to the path
of the tax burden. The permanent income hypothesis says that households base their
consumption decisions on permanent income, which depends on the present value of
after-tax earnings. Because a debt-financed tax cut alters the path of the tax burden
but not its present value, it does not alter permanent income or consumption. Thus, all
of the predictions of the conventional analysis of government debt no longer hold.
Another way to view the Ricardian argument is suggested by the title of Robert
Barro's classic 1974 paper "Are Government Bonds Net Wealth?" To the owners of
government bonds, the bond represents an asset. But to taxpayers, government bonds
represents a liability. A debt-financed tax cut is like a gift of government bonds to
those getting the tax cut. This gift makes the holder of the bond wealthier, but it makes
taxpayers poorer. On net, no wealth has been created. Because households in total are
no richer than they were, they should not alter their consumption in response to the
tax cut.
It is important to emphasize that the Ricardian argument does not render all fiscal
policy irrelevant. If the government cuts taxes today and households expect this tax
cut to be met with future cuts in government purchases, then households' permanent
income does rise, which stimulates consumption and reduces national saving. But
note that it is the expected cut in government purchases, rather than the tax cut, that
stimulates consumption. The reduction in expected future government purchases would
alter permanent income and consumption because they imply lower taxes at some time,
even if current taxes are unchanged.
Because the Ricardian view renders some fiscal policies irrelevant but allows other
fiscal policies to matter, providing a convincing test of this view has proven difficult.
For example, in the early 1980s, a debt-financed tax cut advocated by President Reagan

D. W.Elmendorfand N.G. Mankiw

1642

in his first administration was followed by a substantial rise in government debt and a
fall in national saving. Some observers, such as Benjamin Friedman (1992), see this
episode as a natural experiment that decisively rejects Ricardian equivalence. Yet it
is possible that consumers expected this tax cut to mean smaller government in the
future; smaller government was, in fact, President Reagan's intention, and to some
extent it has been the result. Moreover, other developments, such as a booming stock
market, occurred at the same time and surely had some effect on household decisions.
In this case, higher consumption and lower national saving could coincide with a
tax cut without contradicting Ricardian equivalence. Because neither interpretation of
history can be ruled out, both the conventional and Ricardian views of government
debt continue to have adherents within the economics profession.

4.1.2. A brief history o f the Ricardian idea

The modern literature on Ricardian equivalence began with Robert Barro's 1974 paper.
Not only did this paper clearly set out the Ricardian argument but it also anticipated
much of the subsequent literature by discussing many of the reasons why Ricardian
equivalence might not hold. What the paper did not do, however, was credit Ricardo
with the idea. It was not until James Buchanan's 1976 comment on Barro's paper that
the term Ricardian equiualence was coined.
Ricardo was interested in the question of how a war might be funded. In an
1820 article, he considered an example of a war that cost 20 million pounds. He noted
that if the interest rate were 5%, this expense could be financed with a one-time tax of
20 million pounds, a perpetual tax of 1 million pounds, or a tax of 1.2 million pounds
for 45 years. He wrote,
in point of economy, there is no real difference in either of the modes; for twenty millions in
one payment, one million per annum for ever, or 1,200,0000 pounds for 45 years, are precisely
of the same value ...
Ricardo also was aware that the question raises the issue of intergenerational linkages
(which we discuss more fully in a later section):
It would be difficult to convince a man possessed of 20,000 pounds, or any other sum, thai
a perpetual payment of 50 pounds per annum was equally burdensome with a single tax of
1000 pounds. He would have some vague notion that the 50 pounds per annum would be paid
by posterity, and would not be paid by him; but if he leaves his fortune to his son, and leaves
it charged with this perpetual tax, where is the difference whether he leaves him 20,000 pounds
with the tax, or 19,000 pounds without it?
Although Ricardo viewed these different methods of government finance as equivalent,
he doubted whether other people in fact had the foresight to act in so rational a
manner:
The people who pay taxes ... do not manage their private affairs accordingly.We are apt to think
that the war is burdensome only in proportion to what we are at the moment called to pay for il
in taxes, without reflecting on the probable duration of such taxes.

Ch. 25." Gouernment Debt

1643

And, indeed, Ricardo did not dismiss g o v e r n m e n t debt as an insignificant p o l i c y

concern. B e f o r e the British parliament, he once declared,
This would be the happiest country in the world, and its progress in prosperity would go beyond
the powers of imagination to conceive, if we got rid of two great evils - the national debt and
the corn laws 19.
B e c a u s e R i c a r d o doubted the practical validity o f R i c a r d i a n equivalence, O ' D r i s c o l l
(1977) suggested the t e r m Ricardian non-equiualence, although this phrase has never
caught on. W h e t h e r or not Ricardo was a Ricardian, he n o w gets credit for first noting
the possible irrelevance o f g o v e r n m e n t debt.
M o r e recently, several sources have suggested the possibility o f debt neutrality, as
Barro in fact noted in his 1974 paper. In 1952, Tobin p o s e d the Ricardian question:
How is it possible that society merely by the device of incurring a debt to itself can deceive itself
into believing that it is wealthier? Do not the additional taxes which are necessary to carry the
interest charges reduce the value of other components of private wealth?
Tobin v i e w e d this R i c a r d i a n logic as raising an intriguing theoretical question, but he
never suggested that it m i g h t actually h o l d in practice.
The R i c a r d i a n a r g u m e n t also appears in Patinkin's (1965, p. 289) classic treatise,
Money, Interest, and Prices, which was based on a 1947 dissertation at the U n i v e r s i t y
o f Chicago. In c o n s i d e r i n g whether g o v e r n m e n t b o n d s should be treated as part o f
h o u s e h o l d wealth, Patinkin wrote,
The difficulty with this approach is that tile interest burden on these bonds must presumably be
financed by future taxes. Hence if the private sector discounts its future tax liabilities in the same
way that it discounts future interest receipts, the existence of government bonds will not generate
any net wealth effect.
Patinkin does not c l a i m originality for this idea. In a footnote, he says, "This p o i n t is
due to Carl Christ, w h o cites in turn discussions w i t h M i l t o n Friedman".
In 1962, M a r t i n Bailey's textbook explained clearly (p. 75) the possibility "that
households regard deficit financing as equivalent to taxes". B a i l e y explains:
[Govermnent debt] implies future taxes that would not be necessary if the expenditures were
financed with current taxation. If a typical household were to save the entire amount that was
made available to it by a switch from current taxation to deficit financing, the interest on the
saving would meet the future tax charges to pay interest on the government bonds, while the
principal saved would be available to meet possible future taxes imposed to repay the principal
on the govermnent bonds. If the household has a definite idea of how it wants to allocate its total
present and future resources among consumption at different points of time, and if it recognizes
that the shift from current taxation to deficit financing does not change its total resources at all
l~om a long-run point of view, then it will indeed put entirely into saving any 'income' made
available to it by a government decision to finance by bond issue rather than current taxation.

19 Quoted m Buchholz (1989, p. 73). Ricardo's opposition to the corn laws (which restricted the imporl
of grain from abroad) suggests that he took his theory of comparative advantage more seriously than he
did his theory of debt neutrality.

D. ~ Elmendo~f and N.G Mankiw

1644

That is, the household will consume exactly the same amount, whichever form of financing is
used.
Bailey even points out in a footnote that "the same argument applies if no repayment
[of the debt's principal] is expected, if the typical household plans to leave an estate".
Bailey does not cite Ricardo, but in the text's preface he refers to this section and
notes, "a claim to original authorship must be shared with at least two other persons,
Gary Becker and Reuben Kessel, who independently developed the same material for
their respective courses".
The idea of Ricardian equivalence, therefore, has had a long and distinguished
history. Yet there is no doubt that Robert Barro's 1974 paper was a turning point
in the literature on government debt. Barro stated the conditions for Ricardian
equivalence more clearly than the previous literature had, and he laid out explicitly
the intergenerational model needed to establish the result. (We discuss this model
below.) Perhaps the greater thoroughness in Barro's treatment of the issue is founded
in his apparent belief in debt neutrality. Previous authors, including Ricardo, raised
the theoretical possibility of neutrality but often doubted its practical applicability.
In a way, Barro can be viewed as the Christopher Columbus of Ricardian
equivalence. Columbus was not the first European to discover America, for Leif
Ericsson and others had come before. Instead, Columbus' great confidence in the
importance of his mission ensured that he was the last European to discover America:
after Columbus, America stayed discovered. Similarly, Robert Barro was not the first
economist to discover Ricardian eqnivalence, but he was surely the last. Since Barro's
work, Ricardian equivalence has maintained its place at the center of the debate over
government debt, and no one will be able to discover it again.
4.1.3. Why Ricardian equioalence is so important

Although most economists today agree with David Ricardo and doubt that Ricardian
equivalence describes actual consumer behavior, the idea of Ricardian equivalence
has been extraordinarily important within the academic debate over government debt.
There are two reasons for this.
The first reason is that a small but prominent minority of economists, including
Robert Barro, have argued that Ricardian equivalence does in fact describe the
world, at least as a first approximation. This small group has provided a usefut
reminder to the rest of the profession that the conventional view of government debt
is far from a scientific certitude. The inability of macroeconomists to perform true
experiments makes macroeconomic knowledge open to debate. Although we believe
that policymakers are best advised to rely on the conventional view of government
debt, we admit that there is room for reasonable disagreement.
The second and more significant reason that Ricardian equivalence is important
is that it offers a theoretical benchmark for much further analysis. There are many
parallels both inside and outside of economics. Mathematicians study Euclidean
geometry (even though we now kalow that we live in a non-Euclidean world);

Ch. 25: GovernmentDebt

1645

physicists study frictionless planes (even though all real planes exhibit some friction);
and economists study Arrow-Debreu general-equilibrium models with complete and
perfectly competitive markets (even though markets in actual economies are neither
complete nor perfectly competitive).
The theoretical benchmark in economics that is most similar to Ricardian equivalence is the Modigliani-Miller theorem. Modigliani and Miller established conditions
under which a firm's choice between debt and equity finance is irrelevant. Similarly,
Ricardian equivalence is the claim that the govermnent's choice between debt and
tax finance is irrelevant. Few finance economists believe that the Modigliani-Miller
theorem describes actual fix'ms' financing decisions. Nonetheless, the theorem provides
a starting point for many discussions in corporate finance. Similarly, even if Ricardian
equivalence does not describe the world, it can be viewed as one natural starting
point in the theoretical analysis of government debt. As the next section should make
clear, trying to explain why Ricardian equivalence is not true can yield a deeper
understanding about the effects of government debt on the economy.
4.2. The debate ouer Ricardian equivalence: theoretical issues

Although most economists today are skeptical of the Ricardian proposition that
government debt is irrelevant, there is less consensus about why government debt
matters. The conventional view (which we discussed earlier) begins with the premise
that a debt-financed tax cut stimulates consumption. There are various reasons why
this might be the case.
4.2.1. Intergenerational redistribution

One reason governrnent debt might matter is that it represents a redistribution of

resources across different generations of taxpayers. When the government cuts taxes
and issues government debt today, the government budget constraint requires a tax
increase in the future, but that tax increase might fall on taxpayers who are not yet
living. This redistribution of resources from future to current taxpayers enriches those
who are now living; current taxpayers respond to the increase in their resources by
consuming more. This intergenerational redistribution is tbe mechanism that makes
government debt matter in basic overlapping-generations models, such as those of
Diamond (1965) and Blanchard (1985).
Barro's 1974 paper built on Becker's (1974) theory of the family to provide a
clever rejoinder to this argument. Barro argued that because future generations are the
children and grandchildren of the current generation, it is a mistake to view them as
independent economic actors. Instead, Barro suggested that current generations might
behave altruistically toward future generations. In the presence of this intergenerational
altruism, it is no longer natural to presume that current generations will take advantage
of the opportunity to consume at the expense of future generations.

D. W, Elmendorf and N.G. Mankiw

1646

Barro proposed the following model of the family. Suppose that the total utility of
generation t, denoted Vt, depends on consumption during its lifetime Ct and on the
utility of its children Vt+l, discounted by some factor/3:
vt = u ( G ) +/3vt+L.
Recursive substitution establishes that

Vt = U(Ct) -}-/3U(CI+I) +/32U(Ct+2 ) q_/33U(Ct+3 ) + . . .

That is, the utility of generation t depends on its own consumption and the consumption
of all future generations. In essence, the relevant decisionmaldng unit is not the
individual, who lives only a finite number of years, but the family, which continues
forever. As a result, the family member alive today decides how much to consume
based not only on his own income but also on the income of future members of
his family. Ricardian equivalence is, therefore, preserved: a debt-financed tax cut
may raise the income an individual receives in his lifetime, but it does not raise his
family's permanent income. Instead of consuming the extra income from the tax cut,
the individual saves it and leaves it as a bequest to his descendants, who will bear the
future tax liability.
The debate over Ricardian equivalence is, therefore, in part a debate over how
different generations are linked to one another. This issue has broad significance for
macroeconomics. As Kotlikoff and Summers (1981) established, a large fraction of
wealth in the US economy is eventually bequeathed rather than consumed by its current
owner 2. It is possible that many bequests are accidental rather than intentional; that
is, people might leave bequests because they die unexpectedly before consuming their
entire wealth. Yet the fact that annuity markets (even if imperfect) are used so rarely
suggests that consumers must have some desire to leave bequests.
The altruism model proposed by Barro is one possible model of the bequest motive,
but there are others. Another popular model is the "joy of giving" or "warm glow"
model, according to which a person's utility depends on the size of his bequest rather
than on the utility of his children. That is,

V, = U(Ct) + G(B~),
where G(Bt) represents the utility from giving a bequest of size B , Closely related
to this model is the "strategic bequest motive" proposed by Bernheim et al. (1985);
according to this model, parents use bequests to induce certain types of behavior from
their children, such as visiting home more frequently. These alternative models of the
bequest motive do not give individuals any reason to look ahead to their children's

20 For oilier discussions of the role of intergenerational transt~rs in wealth accumulation, see Gate and
Scholz (1994), Kesslerand Masson (1989), Kotlikoff (1988), and Modigliani (1988).

Ch. 25." Government Debt

1647

tax liabilities and, therefore, do not yield Ricardian equivalence in the presence of
policy-induced intergenerational redistributions.
It is sometimes mistakenly claimed that the effects of government debt depend on
whether people have finite lives (as is the case in the Diamond overlapping-generations
model) or infinite lives (as is effectively the case in the Barro intergenerational-altruism
model). The key issue, however, is not the finiteness of life but the introduction over
time of new taxpayers without links to the past. [This point was established by Philippe
Weil (1989).] To see this, imagine an economy in which consumers die (according to
some Poisson process) but no new consumers are ever born. In this economy, all future
tax liabilities must fall on people who are currently living, so Ricardian equivalence
would hold, despite the finiteness of life. By contrast, consider an economy in which
new consumers are born over time but, once born, live forever. In this economy, some
of the future tax liabilities implied by government debt would fall on future arrivals,
and Ricardian equivalence would fail to hold.
The Barro model of intergenerational altruism, which links all future arrivals to
those currently living, has attracted a variety of theoretical criticisms. One of the
more entertaining is that offered by Bernheim and Bagwell (1988), who build on
the well established tenet that human reproduction is sexual and that, as a result,
people share common descendants. Indeed, if one looks back and forth among
everyone's future family trees, one quickly concludes that the entire world population
is connected through a web of familial relationships. This observation, together with
intergenerational altruism, yields profound predictions. According to the Barro model,
a transfer of a dollar (in present value) between Doug Elmendorf and one of his
descendants does not affect anyone's consumption. Similarly, a transfer between Greg
Mankiw and one of his descendants does not affect anyone's consumption. But if
Elmendorf and Mankiw have common descendants, as surely they must, then a
transfer between Elmendorf and Mankiw does not affect anyone's consumption. Indeed,
because everyone is connected through common descendants, the entire distribution of
income is irrelevant - a prediction that is surely false. Bernheim and Bagwell use this
argument as a reductio ad absurdum to conclude that the Barro model cannot describe
the relationships among generations.
A less intriguing, but ultimately more persuasive, critique of the Barro model of
intergenerational altruism arises from the work of Evans (1991), Daniel (1993), and
Smetters (1996). Suppose that we consider a standard model of intergenerational
altruism but add the seemingly innocuous wrinkle that the degree of altruism (as
measured above by the parameter fi) differs across families. Even if all consumers
have some degree of altruism, it is likely in the presence of heterogeneity that many
consumers will not have operative bequest motives. In the steady state of such a model,
the interest rate is determined by the time preference of the most patient family (that
is, the family with the highest fi). At this interest rate, other families will choose to hit
the corner solution of zero bequests and, therefore, will act like a series of overlapping
generations: they will save for life-cycle reasons but will leave no bequests. For these
zero-bequest families, transfers of resources across generations will have real effects.

1648

D. ~ Elmendorf and N.G. Mankiw

Despite the failure o f Ricardian equivalence in this model, the level o f government
debt does not matter for aggregate variables in the economy's steady state. Because
the time preference of the most patient family pins down the steady-state interest rate,
it also pins down the capital stock and the level o f output. A debt-financed tax cut,
for instance, will stimulate consumption, crowd out capital, and raise the real interest
rate for a period o f time, but the most patient family will respond by increasing saving
until, eventually, the capital stock and real interest rate return to their former levels.
This result suggests that Ricardian equivalence may work better as a long-run theory
than as a short-run theory.
Finally, it is worth noting that, for some purposes, the importance o f these
intergenerational issues may be overstated. Poterba and Summers (1987) claim that,
even without intergenerational altruism, people may have long enough time horizons
to make Ricardian equivalence approximately true in the short run for some policy
interventions. For example, imagine that the government cuts taxes today, issues
government debt with an interest rate of 5%, and then services the interest payments
with higher taxes over the infinite futm'e. In this case, about 77% of the future taxes
occur within 30 years, indicating that the redistribution o f the tax burden toward
future generations, though not zero, is relatively small. Moreover, because the marginal
propensity to consume out of wealth for life-cycle consumers is relatively small, the
redistribution that does occur has only a small effect on consumption. Thus, the
immediate result may be an increase in private saving approximately equal to the
budget deficit. Poterba and Smnmers argue that if Ricardian eqnivalence fails in a
substantial way in the short run, the explanation must lie not in the intergenerational
redistribution caused by government debt but in some other mechanism 21.
4.2.2. Capital market imperfections

The simplest, and perhaps most compelling, explanation for the failure o f Ricardian
equivalence is the existence of capital market imperfections. For households thal
discount future utility highly or that expect rapidly rising income, the optimal
consumption path may require consuming more than their income when young (and
less when old) by borrowing in financial markets. The possibility of default and
bankruptcy, however, may prevent these households from borrowing for the purposes
o f current consumption. In this case, the optimal strategy is to consume all o f current
income and hold exactly zero assets.

2I Even if private saving does rise approximately one-tbl~one with the budget deficit in thc short run,
there could be substantial crowding out of capital in the long run. The Auerbac~Kotlikoff simulations
discussed earlier suggest that the full effects of government debt take a long time to appeal in life-cycle
models. Thus, the Poterba-Summers argument raises the possibility -- in contrast to the model with
heterogeneous altruism just discussed - that Ricardian equivalence may work well as a short-run theory
but not as a long-run theory.

Ch. 25: GovernmentDebt

1649

In the presence of such a binding borrowing constraint, Ricardian equivalence will

no longer hold. A debt-financed tax cut effectively gives the constrained household
the loan that it wanted but could not obtain from private lenders. The household will
respond by increasing consumption, even with the knowledge that the result is higher
taxes and lower consumption in the future.
The potential importance of capital market imperfections is highlighted by the small
amount of wealth that many people hold compared to the level of government debt
in our economy. In recent years, the federal government debt has been about half
of national income. If Ricardian equivalence held, the typical household should be
holding additional wealth equal to half of annual income. Yet many households have
wealth far below that level. To reconcile Ricardian equivalence with these facts, one
would need to believe that in the absence of government debt, most households in
the economy would have substantially negative net wealth. This seems implausible:
few consumers are able to obtain substantial loans without tangible collateral. Thus,
it seems that government debt has allowed many households to consume more than
they otherwise would.
The literature contains some debate over whether capital market imperfections
should cause a failure of Ricardian equivalence. Hayashi (1987) and Yotsuzuka (1987)
present examples of endogenous capital market imperfections based on asymmetric information that preserve Ricardian equivalence. In these models, asymmetric
information about future income, together with the possibility of default, prevents
households from borrowing against future income. Yet because taxes are assumed to
be lump sum, there is no information problem about the stream of tax payments;
as a result, the borrowing constraint does not affect the ability of households to
trade off taxes today and taxes in the future. In this case, a debt-financed tax cut
causes the borrowing constraint to adjust in such a way as to leave consumption
opportunities unchanged. As Bernheim (1987) points out, however, this result is
crucially dependent on the assumption that taxes are lump sum. I f taxes rise with
income, then the asymmetry in information about future income causes a similar
asymmetry in information about future tax liabilities, in this more realistic case, these
models yield the more conventional result that a debt-financed tax cut relaxes the
borrowing constraint, allowing households to consume more.
4.2.3. Permanent postponement o f the tax burden

When a person first hears the case tbr Ricardian equivalence, a natural response is,
"Yes, that theory might apply if a budget deficit today required higher taxation in the
future. But, in fact, the government never has to pay offits debts. When the government
cuts taxes and runs a budget deficit, it can postpone the tax burden indefinitely". This
simple argument, it turns out, raises a number of complex questions for economic
theory.
The first point to make is that Ricardian equivalence does not require that the
government ever pay off its debts in the sense of reaching zero indebtedness. Imagine

1650

D. W. Elmendo~and N. G. Mankiw

that the government cuts taxes for one year by dD, increases the government debt
by that amount, and then leaves government debt at the new higher level forever.
To service this additional government debt would require additional taxes of r d D
every year, where r is the interest rate on the debt. The present discounted value of
these higher taxes is dD, which exactly offsets the value of the tax cut. Hence, if
consumers look ahead to all future taxes, Ricardian equivalence holds, even though
the government never retires the additional debt it has issued.
Matters become more complicated if the government does not raise taxes to finance
the interest on this additional debt but, instead, finances these interest payments by
issuing even more debt. This policy is sometimes called a "Ponzi scheme" because it
resembles investment scams in which old investors are paid off with money from new
investors. If the government pursues such a Ponzi scheme, the government debt will
grow at rate r, and the initial tax cut and budget deficit do not imply higher taxes in
the future.
But can the government actually get away with this Ponzi scheme? The literature
has explored this question extensively 22. An important issue is the comparison between
the interest rate on government debt r and the growth rate of the economy g. If r is
greater than g, then government debt will increase faster than the economy, and the
Ponzi scheme will eventually be rendered infeasible: the debt will grow so large that
the government will be unable to find buyers for all of it, forcing either default or a
tax increase. By contrast, if r is less than g, then government debt will increase more
slowly than the economy, and there is nothing to prevent the government from rolling
over the debt forever.
The comparison between r and g has broader generaPequilibrium implications,
however, and these implications help explain the effects of government debt. In
standard neoclassical growth theory, r reflects the marginal product of capital, and
g reflects population growth and technological change. These two variables can be used
to gauge whether the economy has reached a dynamically efficient equilibrium. If r is
greater than g, then the economy is efficient in the sense of having less capital than at
the "Golden Rule" steady state. By contrast, if r is less than g, then the economy is
inefficient in the sense of having accumulated too much capital. In this case, a reduction
in capital accumulation can potentially increase consumption in all periods of time. A
govermnent Ponzi scheme, like the "asset bubbles" studied by Tirole (1985), is both
feasible and desirable in such an economy because it helps ameliorate the problem of
oversaving.
Dynamic inefficiency and successful, Pareto-improving Ponzi schemes offer an
intriguing theoretical possibility, but they are not of great practical relevance for the
US economy or other economies around the world. Economists today do not believe
that households are saving too much, driving the return to capital below the economy's

22 See, for instance, Ball et al. (1998), Blanchard and Weil (t992), Bohn (1993), and O'Connell and
Zeldes (1988).

Ch. 25: GovernmentDebt

1651

growth rate. And, indeed, Abel et al. (1989) present evidence for dynamic efficiency.
Hence, Ricardian equivalence cannot be refuted by asserting that the government can
roll over the debt forever.
Yet one nagging fact remains: in the US economy, the interest rate on government
debt has on average been less than the growth rate of the economy. Abel et al. reconcile
this fact with their finding of dynamic efficiency by noting that government debt and
economic growth have different risk characteristics. They present an example o f a
dynamically efficient economy in which uncertainty about economic growth drives
down the return on risk-free assets, such as government debt, below the average growth
rate. Thus, one cannot judge dynamic efficiency (and the feasibility of government
Ponzi schemes) simply by comparing the average return on risk-free assets with the
average growth rate 23.

4.2.4. Distortionary taxes

The Ricardian equivalence proposition is based on the assumption that taxes are
lump sum. If instead taxes are distortionary, then a postponement o f the tax burden
affects incentives and thereby behavior. These microeconomic distortions could have
a large macroeconomic impact, making Ricardian equivalence a poor approximation
to reality.
To see the potential importance o f distortionary taxation, imagine an economy
described by the standard Ramsey growth model except that taxes, rather than being
lump-sum, are raised with a proportional income tax with rate r. The following
equations describe the steady state:

y=f(k),

Ty-rD+g,

r-if(k),

(1

r)r =p.

The first equation is the production function. The second equation states that tax
revenue ry equals the interest on the debt rD plus government spending g. The third
equation states that the interest rate r equals the marginal product of capital. (Both
interest income and capital income are assumed to be taxed at the same rate, so the
tax does not affect this equation.) The fourth equation states that the after-tax interest
rate equals the rate of subjective time preference p; this is the steady-state condition for
the Ramsey model. Given these equations, it is straightforward to see how an increase
in government debt affects the economy. Higher debt leads to higher debt service; a

23 Ball et al. (1998) build on these ideas and consider policies in dynamically efficient economies
called "Ponzi gambles" in which the government cuts taxes and rolls over the resulting debt for as
long as is possible. In their model, debt can raise the welfare of all generations in those realizations of
history in which taxes do not need to be increased. Yet the policy is a gamble because the government
is sometimes forced to raise taxes. Moreover, those tax increases are especially undesirable because
they occur in realizations of history in which future generations are already burdened by low economic
growth.

D. W. Elmendorf and N.G. Mankiw

1652

higher debt service requires a higher tax rate; a higher tax rate implies a higher beforetax interest rate; and a higher interest rate requires a smaller steady-state capital stock.
As in the traditional analysis, government debt crowds out capital, even though the
mechanism here is quite different.
We can easily calibrate the magnitude of this effect for this model. By fully
differentiating this system we obtain an expression to show how much debt crowds
out capital:

dDdk - { r -~D Jf "l + -l - r ' )~/ f "~}

'

If we specialize the production function to Cobb-Douglas y - U ~, then this expression

becomes:
dk
{
D
r+(1
-(1dD
- a) ~

r ) l - ce~-I
~}

For the US economy, taxes take about one-third of income ( T - 1/3), capital earns about
one third of income (a = 1/3), and the debt equals about one-seventh of the capital
stock (D/k = 1/7). For these paranaeter values, dk/dD =-1.11. That is, an extra dollar of
government debt reduces the steady-state capital stock by slightly over one dollar. This
example shows that substantial crowding out can occur simply because of distortionary
taxation 24.
Although this example is sufficient to show the potential importance of distortionary
taxation, more realistic analyses of debt policy go beyond this special case. In the
steady state of the Ramsey model, national saving is infinitely elastic at the rate of
time preference. Other models, such as the life-cycle model of Auerbach and Kotlikoff
(1987), would predict a more limited saving response to a change in the after-tax rate
of return. In addition, it is important to consider the dynamic effects of tax changes,
as in Judd (1987) and Dotsey (1994), and the effects of taxes on labor supply, as in
Trostel (1993) and Ludvigson (1996). Perhaps the only certain conclusion is that in a
world with distortionary taxation, Ricardian equivalence is unlikely to provide a good
first approximation to the true effects of debt policy.

4.2.5. Income uncertainty

Another possible reason tbr the failure of Ricardian equivalence is that government
debt may alter consumers' perception of the risks they face. This possibility was

24 The numerical results presented here are, of course, sensitive to a variety of detailed asstm~ptions. If
we introduce depreciation, so that the production function is.f (k) - k c*- 6k, then the degree of crowding
as measured by dk/dD falls. If we take a broad view of capital, so that a is larger than t/3, then the
degree of crowding rises.

Ch. 25: GovernmentDebt

1653

explored by Chan (1983), Barsky et al. (1986), Kimball and Mankiw (1989) and
Croushore (1996). These authors begin with the axioms that taxes are levied as
a function of income and that furore income is uncertain. Therefore, when the
government cuts taxes today, issues government debt, and raises income taxes in
the future to pay off the debt, consumers' expected lifetime income is unchanged,
but the uncertainty they face is reduced. If consumers have a precautionary saving
motive, this reduction in uncertainty stimulates current consumption. Put differently,
consumers discount risky uncertain income and uncertain future taxes at a higher
rate than the interest rate on government bonds; a postponement of the tax burden,
therefore, encourages current spending.
The potential importance of this mechanism is highlighted by the recent interest in
buffer-stock theories of saving. [See, for instance, Carroll (1997).] In these models,
consumers are impatient (in the sense of having a high subjective discount rate) but are
nonetheless prudent (in the sense of having a precautionary saving motive). As a result,
consumers maintain a small amount of saving in order to protect themselves against
unlikely but very adverse shocks to their income. If consumers do not pay significant
taxes when these unlikely, adverse outcomes are realized, then a postponement of the
tax burden will stimulate current consumption.
4.2.6. Myopia

When non-economists are explained the idea of Ricardian equivalence, they often have
trouble taking the idea seriously. The reason for this response goes to the heart of
how economists view human behavior. Rational, optimizing, forward-looking homo
economicus is a creature of the economist's imagination. Economists are trained in
the power of this model, but non-economists are often more skeptical. In particulai,
non-economists are doubtful about whether people have the foresight to look ahead to
the future taxes implied by government debt, as is required for Ricardian equivalence
to hold.
It is hard to incorporate this sort of myopia into economic theory. Yet there have
been some attempts to model short-sightedness. Strotz (1956) and Laibson (1997), for
instance, consider preferences according to which consumers give excessive weight
to current utility (compared to the benchmark case of exponential discounting). As
a result, consumers exhibit time-inconsistent behavior and can be made better off
through a binding commitment to increased saving. This model can explain the
popular notion that people save too little, but it cannot by itself explain a failure of
Ricardian equivalence. In this model, the time-inconsistent consumer faces a standard
intertemporal budget constraint, so a postponement of the tax burden does not alter
the consumer's opportunities. This consumer saves too little but, without a binding
borrowing constraint or other imperfection, is fully Ricardian in response to fiscal
policy.
Although the ILicardian behavior of Strotz-Laibson consumers shows that myopia
by itself need not undermine Ricardian equivalence, this result does not necessarily

1654

D. 14(,Elmendolf and N. G. Mankiw

render myopia irrelevant in this debate. The impatience implicit in the Strotz-Laibson
preferences can explain the prevalence of liquidity constraints and buffer-stock saving,
which in turn highlights the deviations from Ricardian equivalence emphasized earlier.
In addition, it is possible that the Strotz-Laibson approach to modelling myopia is not
the best one. Developing better models of myopic behavior remains a challenge for
future research.
4.3. The debate over Ricardian equivalence. empirical issues'

The theoretical literature just discussed offers various reasons why government debt
may affect consumption and capital accumulation. Yet these deviations from Ricardian
equivalence do not prove that the proposition is a bad first approximation of the actual
economy. To reach such a judgment, one must assess the quantitative importance of
these theoretical deviations from the Ricardian benchmark.
Some of the research discussed earlier bears on this issue. As noted above,
calculations using the Blanchard model of finite lifetimes imply that debt can crowd out
a significant amount of capital, and Auerbach and Kotlikoff's simulations show that the
combination of finite lifetimes and distortionary taxes can generate roughly one-for-one
crowding out. Moreover, many of the theoretical analyses cited in the previous section
include calibrations that illustrate the potential importance of the channels through
which debt may affect the economy.
Simulations, however, are no substitute for evidence. In this section we review the
empirical evidence on the validity of Ricardian equivalence. We begin with tests of
the assumptions underlying the proposition and conclude that a substantial fraction of
households probably do not behave as the proposition assumes. We next turn to tests of
the proposition's implications for various macroeconomic variables. Despite substantial
research in this area, we believe that the results are ultimately inconclusive 25.
4.3.1. Testing assumptions about household behaoior

When testing theories, economists typically focus on the theories' implications rather
than their assumptions. Yet, because testing the implications of Ricardian equivalence
raises substantialdifficulties, examining the underlying assumptions is also worthwhile.
The key assumption is consumption smoothing both within lifetimes and across
generations. That is, households are assumed to choose consumption and saving based
on a rational evaluation of an intertemporal budget constraint that includes both current:
and future generations.
One piece of evidence that many households do not behave in this way is the small
amount of wealth that they hold. This situation may arise from a combination of

25 Our review of this litcrattue is necessarily brieE For more thorough discussions with additional
citations, see Bernheim (1987) and Seater (1993).

Ch. 25: GovernmentDebt

1655

impatience and borrowing constraints, as described earlier, or because some people

are not very forward-looking. In either case, a deficit-financed tax cut would spur
consumption.
Numerous papers also present evidence that people do not smooth consumption
fully over time. Campbell and Mankiw (1989) use aggregate data to show that
consumption is more sensitive to current income than the basic consumptionsmoothing model predicts. Hall and Mishkin (1982), Zeldes (1989), and Carroll and
Summers (1991) make the same point using household data. Further confirmation
comes from households' responses to changes in taxes and government benefits; for
example, see Poterba (1988), Wilcox (1989), and Shapiro and Slemrod (1995). In these
studies, deviations from the life-cycle model are economically as well as statistically
significant. Some studies, such as Runkle (1991), Attanasio and Browning (1995), and
Attanasio and Weber (1995), have argued that income and consumption data are in fact
consistent with the consumption-smoothing model. But the weight of the evidence from
the consumption literature is that consumption smoothing is far from complete. In our
view, this conclusion casts serious doubt on the empirical plausibility of Ricardian
equivalence.
4.3.2. Testing the implications Jbr consumption
A large and contentious literature has focused on the implication of Ricardian
equivalence that a reduction in current taxes with no change in current or future
government spending should not affect household consumption. The standard approach
is to estimate a traditional aggregate consumption function, with consumer spending
as the dependent variable and income, wealth, fiscal policy, and various other controls
as independent variables. Ricardian equivalence is rejected if the coefficients on taxes
and debt are significantly different from zero.
Although this approach seems to offer a direct test of the Ricardian view, there are
a number of problems with its implementation. The fit'st problem is the treatment of
expectations. The behavior of forward-looking households depends on expectations of
fiscal policy, not just the measures of current fiscal policy that are included in these
regressions. Suppose that the current level of taxation reflects expectations of fitture
government spending. (This is in fact implied by the theory of tax smoothing, which
we discuss later.) In this case, a significant negative coefficient on current taxes in the
consumption function does not necessarily violate Ricardian equivalence.
A second problem is simultaneity. Some of this literature estimates the consumption
function with ordinary least squares. This approach is valid only if the shocks to the
consumption function do not affect fiscal policy or other right-hand side variables.
Other papers attempt to address this problem using instrumental variables, but finding
persuasive instruments is close to impossible 26.
~' For a discussion of tile identification problem in the context of tests of Ricardian equivaJcncc, see
Cardia (1997).

1656

D. lie Elmendorf and N.G. Mankiw

A third problem in this literature is that the number of observations is small

compared with the number of highly correlated explanatory variables, h~ addition to
the basic fiscal variables, some authors include measures of the marginal tax rate, while
others separate taxes and spending by the level of government. Still others decompose
the income and fiscal variables into permanent and transitory components as a way of
capturing expectations. Although there may be good reasons to include these variables
as a matter of theory, their addition compounds the problem of multicollinearity. One
way to increase the independent variation in the explanatory variables is to use a longer
estimation period, but this procedure can introduce spans in which consumption is
clearly distorted, such as during wars.
A final problem is that these specifications may have little power to distinguish
between the Ricardian and conventional views of fiscal policy. As discussed earlier,
life-cycle consumers' marginal propensity to consume out of a temporary tax cut may
be only a few cents on the dollar. This value may be statistically indistinguishable
from the Ricardian benchmark of zero effect. Nonetheless, the difference between a
small and a zero marginal propensity to consume is economically important, for a
small short-run drop in saving can cumulate to a large long-run decline in the capital
stock.
Various recent papers have tried to avoid some of these problems by building
on the Euler equation approach pioneered by Hall (1978). By looking at the firstorder condition for a representative consumer, rather than an aggregate consumption
function, some of the problems in measuring expectations are avoided. Yet the problem
of power remains. The first-order condition for a finite-horizon consumer in the
Blanchard model is not very different from the first-order condition for an infinitehorizon consumer. Nonetheless, policy can have substantially different effects in the
two cases, especially in the long run.
With these problems in mind, it is perhaps not surprising that this literature has
failed to reach a consensus on the validity of Ricardian equivalence. Some researchers
have concluded that equivalence is a reasonable description of the world; for example,
see Kormendi (1983), Aschauer (1985), Seater and Mariano (1985), Evans (1988)
and Kormendi and Meguire (1986, 1990, 1995). Other researchers have reached the
opposite conclusion; for example, see Feldstein (1982), Modigliani and Sterling (1986,
1990), Feldstein and Elmendorf (1990), Evans (1993), and Graham and Himarios
(1991, 1996).
Our view is that this literature considered as a whole is simply inconclusive. Many
studies that fail to reject Ricardian equivalence are also unable to reject the life-cycle
model, as their standard errors are large relative to the difference in coefficient values
implied by the alternative hypotheses 27. Further, some studies that find insignificant

2"1 For example, see Evans (1988), Kormendi and Meguire (1990), and Seater and Mariano (1985). The
latter paper presents an extreme example of lack of power: the authors cannot reject the hypothesis that
the coefficienton taxes equals zero, but neither can they reject that it equals minus one.

Ch. 25: Government Debt

1657

effects o f taxes on consumption also find insignificant effects o f government spending,

which is inconsistent with both Ricardian and life-cycle models and suggests that this
framework does not reflect the true effects o f fiscal policy %. More generally, most
results in this literature appear very sensitive to small differences in specification 29.
4.3.3. Testing the implications f o r interest rates

Ricardian equivalence implies that a debt-financed reduction in government revenue

should not affect interest rates. The conventional view o f debt generally implies the
opposite. A n important set o f papers tests this implication by examining the effect o f
the budget deficit on interest rates after controlling for government spending and other
influences.
As with the literature concerning the consumption effects of fiscal policy, research
into interest-rate effects appears straightforward, but numerous problems quickly arise.
Indeed, some o f the problems in the two literatures are quite similar.
One problem is that interest rates depend on expectations o f fiscal policy and other
variables and those expectations are hard to measure. A number of studies use forecasts
from vector autoregressions as a proxy for expectations, but the quality of those proxies
is unclear. Vector autoregressions assume that variables follow a stable time-series
process, and they do not incorporate non-quantitative information. Both of these points
are likely to be important, especially for fiscal policy variables, which are the outcome
o f a political process. Measurement error in the proxies for expectations biases the
estimated coefficients toward zero and, thus, toward the null hypothesis of Ricardian
equivalence.
A second problem with this approach as a test o f Ricardian equivalence is thai
there is no natural metric for gauging the size of interest-rate effects. For the effect
o f taxes on consumption, there are natural Keynesian and life-cycle benchmarks as
well as the Ricardian benchmark. Indeed, this feature was critical in assessing whether
tests of Ricardian equivalence had any power against alternative descriptions o f the
world. But no such alternative benchmarks exist for interest rates, because the size of
the movements expected under non-Ricardian views depends on a host of elasticities.
In particular, if international capital flows have an important effect on the domestic

28 For example, see Seater and Mariano (1985).

29 For example, some of the strongest evidence in favor of Ricardian equivalence comes from the
especially thorough investigation conducted by Kormendi (1983) and Kormendi and Meguire (1986,
1990, 1995). Yet, Kormendi and Meguire (1990) show that although theh results are robust to a variety
of changes in specification (Table 1), they are not robust to the seemingly innocuous choice of deflator
(Table 2). For further discussion of Kormendi and Meguire's specification, see the exchanges between
them and Barth et al. (1986), Modigliani and Sterling (1986, 1990), and Graham (1995). As another
example of the sensitivity of results, Graham and Himarios (1991, 1996) show that the estimates of
Aschauer (1985) and Evans (1988) are not robust to alternative formulations of the Euler equation or
measures of consumption.

1658

D. W. Elmendorf and N.G. Mankiw

financial market, interest rates may not respond much to fiscal policy even if Ricardian
equivalence is invalid.
With these caveats in mind, it is worth noting that this literature has typically
supported the Ricardian view that budget deficits have no effect on interest rates.
Plosser (1982) pioneered the approach of measuring expected policy using vector
autoregressions. Further work in this vein by Plosser (1987), Evans (1987a, 1987b)
and Boothe and Reid (1989) has confirmed Plosser's original conclusion that a zero
effect o f deficits cannot be rejected 3.
Our view is that this literature, like tile literature regarding the effect o f fiscal
policy on consumption, is ultimately not very informative. Examined carefully, the
results are simply too hard to swallow, for three reasons. First, the estimated effects o f
policy variables are often not robust to changes in sample period or specification 31.
Second, the measures of expectations included in the regressions generally explain
only a small part of the total variation in interest rates. For example, the average
R-squared of Plosser's basic monthly regressions [Plosser (1987), Tables 6 and 7]
is 0.06, and the corresponding value of Evans' basic quarterly regressions [Evans
(1987b), Table 1] is 0.09. This poor fit suggests some combination of measurement
error in expectations and the omission o f other relevant (and possibly correlated)
variables. Under either explanation, the estimated coefficients on the policy variables
must be viewed with skepticism. Third, Plosser (1987) and Evans (1987b) generally
cannot reject the hypothesis that government spending, budget deficits, and monetary
policy each have no effect on interest rates. Plosser (1987) also reports that expected
inflation has no significant effect on nominal interest rates. These findings suggest that
this framework has little power to measure the true effects o f policy.
4.3.4. Testing the implications Jor international variables

Ricardian equivalence implies that a debt-financed reduction in government revenue

should not affect the exchange rate or the current account. In contrast, the conventional
view o f debt implies that the exchange rate should appreciate in these circumstances
and the trade deficit should increase. Several researchers have tested these implications
and reached conflicting conclusions.
Evans (1986) applies to exchange rates the methodology used by Plosser and Evans
to study the effect of budget deficits on interest rates. He concludes that US budget

30 Dii-Ierentsorts of analyses by Evans (1985), Hoelscher (1986), and Wachtel and Yomlg (1987) have
reached mixed conclusions.
31 For example, Plosser (1987, Table 10) reports sharply different coefficient estimates during the 1968
1976 and 1977-1985 sample periods and using monthly data as opposed to quarterly data. As another
example, Evans (1987a, Tables 1 and 2) estimates that budget deficits had a small and statistically
insignificant effect on nominal interest rates during the 1950s, 1960s and 1970s, but an effect that was
large, statistically significant, and surprisingly negative between 1979 and 1984. Of course, the effect of
budget deficits may well have changed over time, but an estimated shift of this magnitude signals some
problem with specification.

Ch. 25." GouernmentDebt

1659

deficits tend to cause a depreciation o f the dollar, in contrast to both the Ricardian
and conventional views. Evans' analysis is subject to the same problems that plague
the interest-rate literature discussed above 32. Moreover, a decline in the dollar should
cause a strengthening o f tbe trade balance. Yet Bernheim (1988) and Rosensweig and
Tallman (1993) conclude that US trade deficits worsen when the US budget deficit
increases.
In the end, the empirical literature examining the effects o f fiscal policy on
consumption, interest rates, and international variables fails to offer clear evidence
either for or against the Ricardian hypothesis. If the evidence is so weak, why then
do most economists feel confident in rejecting Ricardian equivalence as a description
o f the world? The answer, we believe, is that most economists are incredulous about
the assumptions that are needed to support the Ricardian view o f government debt. In
this case, the debate over theory is more persuasive than the debate over evidence.

5. Optimal debt

policy

Disagreement about the appropriate amount o f government debt in the USA is as old as
the country itself. Alexander Hamilton (1781) believed that "a national debt, if it is not
excessive, will be to us a national blessing", while James Madison (1790) argued that
"a public debt is a public curse". Indeed, the location o f the nation's capital was chosen
as part o f a deal in which the federal government assumed the Revolutionary War debts
o f the states: because the Northern states had larger outstanding debts, the capital was
located in the South. Attention to the national debt has waxed and waned over the
years, but has been intense during the past two decades. Similarly, government debt
and deficits have been a focus of recent public debate in many European countries.
The appropriate use o f government debt depends on how debt affects the economy.
As we have seen in the theoretical debate over Ricardian equivalence, debt could
potentially have many different effects. As a result, the literature on optimal debt policy
is broad in scope, ttere we focus on the three effects that are most often viewed as
important: the use of debt policy to reduce the magnitude o f economic fluctuations,
the use o f debt policy to increase national saving, and the use o f debt policy to reduce
tax distortions by smoothing taxes over time.
5.1. Fiscal polioT over the business cycle

Although some economists argue that fluctuations in aggregate output represent an

optimal response to shifts in preferences or technology, most economists believe that
some output variability arises from rigidities or coordination failures. These changes

32 For example, fewer than half of the estimated coefficientsreported by Evans (1986, Tables 1 and 7)
are statistically distinguishable fi'om zero.

1660

D. FEElmendorf and N.G. Mankiw

in output, and especially shortfalls of output relative to the potential determined

by the available factors of production, are socially costly. In this case, timely
adjustments to the government deficit and debt may raise social welfare. This notion of
"countercyclical fiscal policy" dates at least to Keynes, and Blinder and Solow (1973)
present one of the classic analyses.
Countercyclical fiscal policy arises automatically from the design of tax and transfer
programs. When output and income are high, tax liabilities rise and eligibility for
government benefits falls, reducing the budget deficit; when output and income are
low, these effects reverse and the deficit widens. These "automatic stabilizers" are
important quantitatively. The Congressional Budget Office (1997a) estimates that when
real output falls by 1%, tax revenue declines by about 1%.
Countercyclical fiscal policy may also be implemented on a discretionary basis.
For example, during the 1975 recession, Gerald Ford and Congress agreed to a small
cut in personal income taxes. Over time, however, this sort of policy has fallen into
disfavor. During the 1990 recession, for instance, taxpayers received a reduction in tax
withholding but not tax liability. Part of this shift in views comes from a realization that
an explicitly temporary change in taxes has only a small effect on the consumption of
even moderately forward-looking consumers. Moreover, there are generally long lags in
enacting discretionary changes in fiscal policy, so any effect on aggregate demand may
be poorly timed. Finally, and perhaps most important, there is an increased appreciation
for the ability of the Federal Reserve to conduct effective countercyclical monetary
policy.
5.2. Fiscal policy and national saving

The most important long-run effect of government debt under tile conventional viewis to reduce national wealth. Thus, optimal debt policy in the long run depends
primarily on optimal national saving. Current public debate often takes as given the
netion that saving should be increased. Proving this point, however, is by no means
straightforward. Bernheim (1994), Lazear (1994) and Hubbard and Skinner (1996)
provide recent discussions of why more saving might be desirable. Examining this
topic in detail is beyond the scope of this paper, but we consider briefly the issues that
relate to government debt. We consider first whether debt policy should be used to
make people save more for their own retirement, and then whether debt policy should
be used to make current generations leave more wealth to future ones.
5.2.1. LiJe-cycle saving

Feldstein (1985) argues that people should do more saving within their lifetimes
because the marginal product of capital exceeds their marginal rate of substitution
between present and furore consumption. This wedge arises, he argues, because of the
taxation of capital income. He is surely right that capital taxation distorts households'

Ch. 25: GooernmentDebt

1661

consumption decisions. But does this imply that debt policy should be used to increase
national saving? The answer is not obvious.
Suppose that people are life-cycle consumers whose consumption is distorted by
capital taxation. Eliminating the distortion would be desirable, but this goal cannot
be achieved simply through debt policy. For instance, if the govertmaent raises lumpsum taxation today, reduces government debt, and thereby reduces lump-sum taxation
later within these consumers' lifetimes, Ricardian equivalence obtains, and national
saving does not change. By contrast, Ricardian equivalence fails to hold if the future
tax reductions benefit future generations. In this case, national saving rises because
the income effect of current taxation reduces current generations' consumption.
Nonetheless, the distortion between current and future consumption of any given
generation is unchanged. That is, the increase in national saving induced by debt policy
does not mitigate the distortionary effects of capital taxation.
When considering how policy affects national saving, it is important to distinguish
between the allocation of constmaption across a person's lifetime and the allocation of
consumption across generations. Capital taxation inefficiently encourages consumption
when a person is young compared to consumption when the same person is old. In a
life-cycle model, however, debt policy does not affect this comparison. Instead, debt
policy affects the consumption of current generations compared to the consumption
of future generations. Thus, in a life-cycle model with rational consumers and
distortionary capital taxes, life-cycle saving is inefficiently low, but debt policy cannot
remedy the problem.
5.2.2. Intergenerational saoing

Debt policy can affect national saving by transferring resources among generations
of life-cycle consumers. One approach to intergenerational equity in the context of
debt policy is to focus on the appropriate distribution of paying for government
services. The "benefit principle" implies that current spending should be financed
out of current taxes, but capital spending should be financed over the life of the
capital. Musgrave (1959) advocated this approach, terming it "pay-as-you-use finance"
(p. 558)33. This principle provides one justification for the practice of financing wars which are expected to benefit future as well as current generations - largely through
debt issuance.
Another approach to intergenerational concerns about government debt is to consider
the overall welfare of different generations using an explicit social welfare function.
As Romer (1988) notes, a utilitarian social planner discounts income at the rate
6 = O + g / o , where 0 is the intergenerational discount rate for utility, g is the growth
rate of income, and a is the intertemporal elasticity of substitution (which equals

33 Musgrave also argued that the budget deficit should vary over the business cycle for stabilization
purposes.

1662

D. W. EImendorf and N. G. Mankiw

the inverse of the elasticity of marginal utility with respect to consumption), income
growth matters here because it reduces the utility gained from an extra dollar of
income. If the net marginal product of capital r exceeds 6, then deferring consumption
to future generations is socially optimal.
Applying this criterion is by no means straightforward. Obviously, one must
determine how much to discount the utility of future generations. One might argue
that zero is the most consistent with people choosing a social welfare function "behind
a veil of ignorance" [Rawls (1971)] about the generation to which they belong. If
0 = 0 , g=0.01, and 0=0.33, the social discount rate 6 is 0.03. If r=0.06, which is
the value we used earlier, the net gain from deferring consumption ( r - 6 ) is 0.03.
One is thus led to conclude that increased national saving would be desirable. Yet the
opposite conclusion arises if o--0.1, so that 6 is 0.1. In this case, economic growth
together with sharply diminishing marginal utility ensures that the marginal utility of
future generations is low, so there is little benefit to saving on their behalf. In the
end, therefore, the utilitarian approach to intergenerational saving illuminates the key
parameters that determine optimal national saving, but it does not allow us to reach
an easy conclusion on whether national saving is in fact too low or too high.

5.3. Tax smoothing

Another approach to analyzing optimal debt policy, advocated by Barro (1979),

emphasizes the distortionary nature of taxation. The deadweight loss from a tax
depends roughly on the square of the tax rate. Thus, the distortion-minimizing way to
finance a given stream of government spending is to maintain a smooth tax rate over
time. If future government spending were known with certainty, the optimal tax rate
would be constant. Because future government spending is uncertain, the optimal tax
rate sets the present value of revenue equal to the present value of expected spending.
As information about spending becomes available, the optimal tax rate changes. Under
this view, the budget deficit is simply the difference between government spending
and the amount of revenue generated by this tax rate, and the debt will rise and fall
accordingly over time.
Barro's tax-smoothing model is follnally parallel to Friedman's permanent-income
hypothesis. According to the permanent-income hypothesis, households smooth
consumption by basing it on their expected permanent income; they save and borrow
in response to transitory changes in income. According to the tax-smoothing model,
governments smooth tax rates by basing tax rates on expected permanent government
spending; they increase or decrease government debt in response to transitory changes
in spending or revenue.
Barro (1979) finds that the tax-smoothing theory of debt explains fairly well the
behavior of US debt since 1920, and Barro (1987) reaches a similar conclusion for
British debt from 1700 through World War I. Much of the variation in spending
that Barro studies is related to wars. Thus, the tax-smoothing logic provides another

Ch. 25:

Government Debt

1663

justification (in addition to intergenerational equity) for a c c u m u l a t i n g government debt

during wars and paying off the debt during peacetime.

6. Conclusion
This essay has touched o n some o f the major issues in the debates over the effects
o f g o v e r n m e n t debt. Because o f the broad scope o f this topic, we have had to be
selective. We have i g n o r e d m a n y important related subjects, such as the m a n a g e m e n t
o f g o v e r n m e n t debt with instruments o f varying maturities, the debate over inflationindexed debt, the pros a n d cons o f alternative rules for setting fiscal policy, and the
theories o f political e c o n o m y that attempt to explain w h y and w h e n governments issue
debt. We trust that readers who have m a d e it to this c o n c l u s i o n will understand why
we avoided these additional fascinating but extensive topics.

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Ch. 25:

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Chapter 26

OPTIMAL FISCAL AND MONETARY POLICY*

V.V. CHARI

University o f Minnesota and Federal Reserve Bank of Minneapolis

PATRICK J. KEHOE

University o f Pennsylvania, Federal Reserve Bank of Minneapolis, and National Bureau of Economic
Research

Contents

Abstract
Keywords
Introduction
1. The primal approach to optimal taxation
1.1. The Ramsey allocation problem
1.2. Elasticities and commodity taxation

1672
1672
1673
1676
1676
1680

1.3. Uniform commodity taxation

1682

1.4. Intermediate goods

1684
1686

2. Fiscal policy
2.1. General framework

1686

2.2. Capital income taxation

1693
1693
1697
1699
1699
1705
1708

2.2.1. In a steady state

2.2.2. In a non-steady state
2.3. Cyclical properties
2.3.1. Debt taxation as a shock absorber
2.3.2. Tax-smoothing and incomplete markets
2.3.3. A quantitative illustration
2.4. Other environments

11711

2.4.1. Endogenous growth models

17 i 1

2.4.2. Open economy models

2.4.3. Overlapping generations models

1714
1718
1720
1721
1721

3. Monetary policy
3.1. Three standard monetaty models
3.1.1. Cash~redit

* The views expressed herein are those of the authors and not necessarily those of the Federal Rescrvc
Bank of Minneapolis or the Federal Reserve System.

Handbook o f Macroeconomics, Volume I, Edited by .lB. 'laylor and M~ WbodJord

1999 Elsevier Science B.V. All rights reserved
1671

1672
3.1.2. Money-in-the-utility-function
3.1.3. Shopping-time
3.2. From monetary to real
3.3. Cyclicalproperties
4. Conclusion
References

v..v.Chari and P.J. Kehoe

1728
1732
1733
1736
1742
1743

Abstract
We provide an introduction to optimal fiscal and monetary policy using the primal
approach to optimal taxation. We use this approach to address how fiscal and monetary
policy should be set over the long run and over the business cycle.
We find four substantive lessons for policymaking: Capital income taxes should be
high initially and then roughly zero; tax rates on labor and consumption should be
roughly constant; state-contingent taxes on assets should be used to provide insurance
against adverse shocks; and monetary policy should be conducted so as to keep
nominal interest rates close to zero.
We begin by studying optimal taxation in a static context. We then develop a general
framework to analyze optimal fiscal policy. Finally, we analyze optimal monetary
policy in three commonly used models of money: a cash--credit economy, a moneyin-the-utility-function economy, and a shopping-time economy.

Keywords
primal approach, Ramsey problems, capital income taxation, Friedman rule, tax
smoothing
J E L classification: E5, E6, E52, E62, H3, H21

Ch. 26: OptimalFiscal and MonetaryPolicy

1673

Introduction

A fundamental question in macroeconomics is, How should fiscal and monetary policy
be set over the long run and over the business cycle? Answering this question requires
integrating tools from public finance into macroeconomics. The purpose of this chapter
is to lay out and extend recent developments in the attempts to do that within a
framework which combines two distinguished traditions in economics: the public
finance tradition and the general equilibrium tradition in macroeconomics. The public
finance tradition we follow in this chapter stems from the work of Ramsey (1927),
who considers the problem of choosing an optimal tax structure in an economy with a
representative agent when only distorting taxes are available. The general equilibrium
tradition stems from the work of Cass (1965), Koopmans (1965), Kydland and Prescott
(1982), and Lucas and Stokey (1983).
Within the public finance tradition, our framework builds on the primal approach to
optimal taxation. [See, for example, Atkinson and Stiglitz (1980), Lucas and Stokey
(1983), and Chari et al. (1991).] This approach characterizes the set of allocations
that can be implemented as a competitive equilibrium with distorting taxes by two
simple conditions: a resource constraint and an implementability constraint. The
implementability constraint is the consumer budget constraint in which the consumer
and the firm first-order conditions are used to substitute out for prices and policies.
Thus both constraints depend only on allocations. This characterization implies that
optimal allocations are solutions to a simple programming problem. We refer to this
optimal tax problem as the Ramsey problem and to the solutions and the associated
policies as the Ramsey allocations and the Ramsey plan.
We study optimal fiscal and monetary policy in variants of neoclassical growth
models. This analysis leads to four substantive lessons for policymaking:
Capital income taxes should be high initially and then roughly zero.
Tax rates on labor and consumption should be roughly constant.
State-contingent taxes on assets should be used to provide insurance against adverse
shocks.
Monetary policy should be conducted so as to keep nominal interest rates close to
zero.
The basic logic behind these policymaking lessons is that Ramsey policies smooth
distortions over time and states of nature. Smoothing tax distortions over time implies
that capital tax rates should be roughly zero and labor and consumption taxes should be
roughly constant [Lucas and Stokey (1983) and Chari et al. (1994)]. Ramsey policies
also imply that heavily taxing inelastically supplied inputs is optimal. Thus Ramsey
policies involve taxing capital income at initially high rates, but then dropping these
rates, to zero in the long run. [See Judd (1985) and Chamley (1986).]
Since keeping capital, labor, and consumption taxes roughly constant is optimal, the
government needs some source of revenue to ensure that taxes need not be sharply
changed when the economy is hit by shocks. One way to provide such revenue
insurance is to have explicitly state-contingent debt, in the sense that the rate of return

1674

EE Chari and P.J. Kehoe

on the debt varies with the shocks. Another way is to have non-state-contingent debt
with taxes on interest income which vary with the shocks. Revenue insurance can also
be provided by having taxes on capital income that vary with the shocks while still
being roughly zero on average.
In terms of monetary policy, Friedman (1969) advocates a simple rule: set nominal
interest rates to zero. In the models we consider, the Friedman rule is optimal if the
consumption elasticity of money demand is one. We think that this rule deserves
attention because the weight of the empirical evidence is that the consumption elasticity
of money demand is indeed one. [See Stock and Watson (1993).]
Throughout the chaptm, we emphasize that the primal approach, in essence, involves
finding optimal wedges between marginal rates of substitution and marginal rates of
transformation. Typically, many tax systems can decentralize the Ramsey allocations.
Thus optimal tax theory yields results on optimal wedges, and thus the prescriptions
for optimal taxes depend on the details of the particular tax system. For example, in the
one-sector growth model, a tax system which includes any two of consumption, labor,
and capital income taxes can decentralize the Ramsey allocations, in such a model,
it is optimal to set intertemporal marginal rates of substitution equal to intertemporal
marginal rates of transformation in the long run. With a tax system that consists of
capital and labor taxes, this is accomplished by setting capital income taxes equal
to zero. With a tax system that consists of consumption and labor taxes, this is
accomplished by making consumption taxes constant. Thus the Ramsey allocations can
be implemented either with zero capital income taxes or with constant consumption
taxes.
Throughout this chapter, we focus on economies in which the government effectively
has access to a commitment technology. As is well known, without such a technology,
there are time inconsistency problems, so the equilibrium outcomes with commitment
are not necessarily sustainable without commitment. Economies with commitment
technologies can be interpreted in two ways. One is that the government can simply
commit to its future actions by, say, restrictions in its constitution. The other, and the
way we prefer, is that the government has no access to a commitment technology,
but the commitment outcomes are sustained by reputational mechanisms. [See, for
example, Chari et al. (1989), Chari and Kehoe (1990, 1993), and Stokey (199l) for
analyses of optimal policy in environments without commitment.] Throughout this
chapter we also restrict attention to proportional tax systems.
The results we develop all come from environments with an infinite number of
periods and include some combination of uncertainty, capital, debt, and money.
Many of the basic principles, however, can be developed in a simple static context
in which the ideas are easiest to digest. In Section l, in a static context, we
develop two of the three main results in public finance which show up repeatedly
in macroeconomic models. First, under appropriate separability and homotheticity
conditions on preferences, it is optimal to tax goods at a uniform_ rate. Second, if
all consumption goods, types of labor income, and pure profits can be taxed, then it
is optimal not to tax intermediate goods. The uniform commodity tax result shows up

Ch. 26:

Optimal Fiscal and Monetary Policy

1675

repeatedly in analyses of fiscal policy, and this result and the intermediate-goods result
show up repeatedly in analyses of monetary policy. We defer to the next section the
development of the third main result, that it is optimal to set taxes on capital income
equal to zero in the long run.
In Section 2, we lay out a stochastic neoclassical growth model to analyze fiscal
policy. We begin with a deterministic version of this model to highlight the long-run
properties of optimal fiscal policy. In this version, we develop the results of Chamley
(1980, 1986) on the optimality of zero capital-income taxation in a steady state, the
generalizations by Judd (1985) to environments with heterogeneous agents, and some
qualifications by Stiglitz (1987) when there are restrictions on the tax system. Next,
we show that for a commonly used class of utility functions, optimal capital taxes are
zero not only in a steady state, but also after the first period.
Next, we consider a stochastic model without capital to highlight how optimal fiscal
policy should respond to shocks. We illustrate how, by using debt as a shock absorber,
taxes on labor income are optimally smoothed in response to shocks to government
consumption and technology [as in Lucas and Stokey (1983) and Chari et al. (1991)].
We then contrast these results with the assertions in Barro (1979) about tax-smoothing
in a reduced-form model. We argue that the work of Marcet et al. (1996) on taxation
with incomplete markets partially affimas Barro's assertions. We also consider the
quantitative features of optimal fiscal policy in a standard real business cycle model
[as in Chari et al. (1994)].
We go on to discuss how the results developed in a closed economy with infinitely
lived agents and only exogenous growth extend to other environments. We first show
that in an endogenous growth framework along a balanced growth path, all taxes are
zero. [See Bull (1992) and Jones et al. (1997).] Essentially, in this framework, capital
income taxes distort physical capital accumulation, and labor income taxes distort
human capital accumulation. Hence it is optimal to front-load both taxes. We then
consider an open economy and show that under both source-based and residencebased taxation, optimal capital income taxation is identically zero. The intuition for
these results is that with capital mobility, each country faces a perfectly elastic supply
of capital and therefore optimally chooses to set capital income tax rates to zero.
[See Atkeson et al. (1999) and Garriga (1999).] Finally, we consider an overlapping
generations model and show that only under special conditions is the tax rate on
capital income zero in a steady state. The conditions are that certain homotheticity
and separability conditions hold. [See Atkeson et al. (1999) and Garriga (1999).]
In Section 3, we lay out a general framework for the analysis of monetary policy.
We consider three commonly used models of money: a cash-credit monetary economy,
a money-in-the-utility-function monetary economy, and a shopping-time monetary
economy. For each model, we provide sufficient conditions for the optimality of the
Friedman rule. These conditions for the cash-credit economy and the money-in-theutility-function economy are analyzed by Chari et al. (1996), while conditions for the
shopping-time economy are analyzed by Kimbrough (1986), Faig (1988), Woodford
(1990), Guidotti and V6gh (1993), and Correia and Teles (1996), as well as by

V.V. Chari and RJ. Kehoe

1676

Chaff et al. (1996). The common features of the requirements for optimality are
simple homotheticity and separability conditions similar to those in the public finance
literature on optimal uniform commodity taxation.
There have been conjectures in the literature - by Kimbrough (1986) and Woodford
(1990), among others - about the connection between the optimality of the Friedman
rule and the intermediate-goods results. For all three monetary economies, we show
that when the homotheticity and separability conditions hold, the optimality of the
Friedman rule follows from the intermediate-goods result.
Finally, we report results for a quantitative monetary business cycle model. We
find that if debt has nominal non-state-contingent returns, so that asset markets are
incomplete, inflation can be used to make real returns contingent, so that debt can
serve as a shock absorber.

1. The primal approach to optimal taxation

The general approach to characterizing competitive equilibria with distorting taxes
described in this section is known in the public finance literature as the primal
approach to taxation. [See Atkinson and Stiglitz (1980).] The basic idea is to recast
the problem of choosing optimal taxes as a problem of choosing allocations subject
to constraints which capture the restrictions on the type of allocations that can be
supported as a competitive equilibrium for some choice of taxes. In this section, we
lay out the primal approach and use it to establish some basic principles of optimal
taxation, together with the results on uniform commodity taxation and intermediategoods taxation.
The rest of this chapter applies these basic principles of optimal taxation to a
variety of environments of interest to macroeconomists. These environments all have
an infinite number of periods and include some combination of uncertainty, capital,
debt, and money. As such, the derivations of the results look more complicated than
the derivations here, but the basic ideas are quite similar.
1.1. The Ramsey allocation problem

Consider a model economy in which n types of consumption goods are produced with
labor. The resource constraint is given by
F ( c l + gl . . . . , c,, + g~, l) = 0,

(1.1)

where ci and gi denote private and government consumption of good i, I denotes

labor, and F denotes a production process that satisfies constant returns to scale. The
consumer's problem is to maximize utility:
max U(cl . . . . , c,,, l)
subject to Z p i ( l
i

(1.2)
+ r,.)ci = 1,

(1.3)

Ch. 26:

Optimal Fiscal and Monetat T Policy

1677

where p~ is the price of good i and vi is the ad valorem tax rate on good i. Thus there
are n linear commodity taxes. We normalize the wage to 1.
A representative firm operates the constant returns technology F and solves

(1.4)

subject to F(xl .... ,x,, l) = 0,

(1.5)

Zpixi

max

(x,/)

where xi denotes output of good i. The government budget constraint is

fff2pigi

(1.6)

Z p i ~ . C i.
i

Market clearing requires that

ci+gi

=Xi

for

i =

1,... ,n.

(1.7)

Throughout this chapter, we take government expenditures as given. A competitive

equilibrium is a policy Jr = (r/)7=l; allocations c, l, and x; and a price system p
that satisfy the following: (i) tile allocations c and l maximize Equation (1.2) subject
to (1.3), (ii) the allocations x and l solve Equation (1.4), (iii) the government budget
constraint (1.6) holds, and (iv) the allocations c and x satisfy condition (1.7).
Throughout this chapter, we assume that first-order conditions are necessary and
sufficient and that all allocations are interior. The sufficiency of the first-order
conditions for firms and consumers holds under appropriate concavity assumptions,
and interiority can be assured with appropriate monotonicity and Inada conditions.
Proposition 1. The allocations in a competitive equilibrium satisfy

F(cl + gt . . . . . cn + g~,, l) -- 0

(1.s)

and the implementability constraint

Z

Uici + U/1 = O.

(1.9)

Furthermore, given allocations which satisfy Equations (1.8) and (1.9), we can
construct policies and prices which, together with the given allocations, constitute
a competitive equilibrium.
R e m a r k : The literature usually refers to Equation (1.9) as the implemenlability
constraint because it is a constraint on the set of allocations that can be implemented
as a competitive equilibrium with distorting taxes. This constraint can be thought of
as the consumer budget constraint with both the taxes and the prices substituted out
by using first-order conditions.

Ell,, Chari and P.J Kehoe

1678

Proof: We first prove that the allocations in a competitive equilibrium must satisfy
Equations (1.8) and (1.9). Condition (1.8) follows from substituting the market-clearing
condition (1.7) into (1.5). To derive Equation (1.9), notice that the consumer's firstorder conditions are

Ui = api(1 + zi)
-gl

for

i= 1,...,n,

= 0~

Zpi(1 + Ti)ci -- [,

(1.10)
(1.11)
(1.12)

where a is the Lagrange nmltiplier on the budget constraint. Substituting Equations

(1.10) and (1.11) into (1.12) gives (1.9). Next, we prove that i f c and l satisfy (1.8) and
(1.9), then a price systemp, a policy Jr, and an allocation x, together with the given
allocations, constitute a competitive equilibrium. We use the first-order conditions for
the firm, which are

Pi =--Fi/Ft

for

i = 1,...,n.

(1.13)

We construct x, p, and zc as follows: xi - ci + gi, Pi is from (1.13), and s~- is from

l+ri-

UiFI
UIFi"

Given our assumptions on the utility function, the first-order conditions are necessary
and sufficient for consumer and firm maximization. With x, p, and c so defined,
(c, l,x,p, zc) clearly satisfies firm maximization. When a = -Ul, conditions (1.10) and
(1.11) clearly are also satisfied. Substituting for Ui and Ul in Equation (1.9), we have
Z

ciaPi(1 + ri)

al

O.

Dividing by a and rearranging gives Equation (1.12). The government budget

constraint is satisfied by Walras' law. D
We can now define a type of optimal tax equilibrium in which the government
objective is to maximize the utility of consumers. We think of the government as first
choosing policies and of private agents as then choosing their actions. Let H denote
the set of policies for which a competitive equilibrium exists. A Ramsey equilibrium
is a policy Jr = (ri)i~_l i n / / ; allocation rules c(.), l(.), and x(.); and a price function
p(.) that satisfy the following: (i) the policy Jr solves
max g(c(sr'), l(jr'))
subject to Z p i ( j r ' ) g i
i

Zpi(~') r~ci(jr')

(1.14)

and (ii) for every Jr', the allocations c(jr'), l ( S ) , x(jr'), the price system p ( S ) , and
the policy Jr' constitute a competitive equilibrium.

Ch. 26: Optimal Fiscal and Monetary Policy

1679

Notice that we require optimality by consumers and firms for all policies that
the government might choose. This requirement is analogous to the requirement of
subgame perfection in a game. To see why this requirement is important, suppose we
had not imposed it. That is, suppose we required optimality by consumers and firms
only at the equilibrium policies, but allowed allocation and price rules to be arbitrary
elsewhere. Then the set of equilibria is much larger. For example, allocation rules that
prescribe zero labor supply for all policies other than some particular policy would
satisfy all the equilibrium conditions. Since the government's budget constraint is then
satisfied only at the particular policy, the government optimally chooses that policy.
We think that such equilibria do not make sense. That is, we think the requirement
that consumers and firms behave optimally for all policies is the sensible way to solve
the government's problem of forecasting private behavior.
If the competitive equilibrium associated with each policy is unique, clearly the
Ramsey equilibrium is also unique. If there are multiple competitive equilibria
associated with some policies, our definition of a Ramsey equilibrium requires that
a selection be made from the set of competitive equilibria. In this case, there may be
many Ramsey equilibria, depending on the particular selection made. In this chapter,
we focus on the Ramsey equilibrium that yields the highest utility for the government.
In such a Ramsey equilibrium, a particular allocation and price system are realized,
namely, c, l, and p. We call these the Ramsey allocations and prices'. We then have
the following proposition as an immediate corollary of Proposition 1.
Proposition 2. The Ramsey allocations solve the Ramsey problem, which is to choose
c and 1 to maximize U(c,l) subject to conditions (1.8) and (1.9).
We have studied an economy in which the government uses consumption-goods
taxes to raise revenues and have shown how the problem of solving for the Ramsey
equilibrium reduces to the simpler problem of solving for the Ramsey allocations.
Other tax systems lead to the same Ramsey problem. For example, consider a tax
system that includes taxes on the n consumption goods as well as taxes on labor
income. It can be shown that the Ramsey allocations can be supported by a tax system
that uses any n of the n + 1 instruments. For example, the Ramsey allocations can be
supported by taxes on consumption goods 2 through n and labor income or by taxes on
consumption goods alone. The fact that the Ramsey allocations can be decentralized
in many ways implies that it is more useful to think about optimal taxation in terms
of the implied wedges between marginal rates of substitution and marginal rates of
transformation rather than in terms of the particular tax system used to decentralize
the Ramsey allocations.
The form of the Ramsey allocation problem depends on the assumption that the
tax system contains at least n independent instruments. We call such a tax system
complete. An example of an incomplete tax system is one in which taxes on the first
consumption good and labor are constrained to be zero. For such an incomplete tax

1680

V..I(Chari and P.J. Kehoe

system, the analog of Proposition 1 is that a set of allocations is part of a competitive

equilibrium if and only if the set satisfies conditions (1.8) and (1.9), together with

U~
U/

F1
Ft

Intuitively, this constraint captures the fact that the government has no tax instruments
that drive a wedge between the marginal rate of substitution of the first consumption
good and labor and the marginal rate of transformation of the same commodities. The
reader will find proving this analog useful in part, because the proof illustrates that
condition (1.9) must hold regardless of the nature of the tax system. That is, when the
tax system is incomplete, the implementability constraint is unchanged, and the new
constraints that reflect this incompleteness must be added to the Ramsey problem.
1.2. Elasticities and commodity taxation
We can use the Ramsey allocation problem to derive some simple results on optimal
commodity taxes. We show that with additively separable preferences, tax rates depend
on income elasticities, with necessities being taxed more than luxuries. The discussion
here closely follows Atkinson and Stiglitz (1980, chap. 12).
Consider the first-order conditions for the Ramsey problem:
(1 + ~) Ui - 3.UiHi = y~.,

(1.15)

(1 + 3.) U~ - ~UzHt = -yFz,

(1.16)

where ~ and 7 are the Lagrange multipliers on the implementability constraint

and the resource constraint, respectively; Hi =-- - ( ~ i Uj.icj + UiiI)/Ui; and Hi
- ( ~ j Uiicj + Uid)/Uz. Using Equations (1.10), (1.ll), and (1.13) in (1.15) and (1.16)
and simplifying gives
T,1+~

,~(~. - H I )
1 +)L-,~H~'

Rearranging shows that the relative tax rates for two goods i andj are determined by

r#(1 + Ti)
~/(1 + Tj)

Hi - H t
~ - Hi

(1.17)

Now, Equation (1.17) is not an explicit formula for optimal tax rates, since tile //i,
Hi, and Hr terms depend on endogenous variables. Nevertheless, (1.17) shows that if
Hi > Hi, then vi > rj. Suppose next that the utility function is additively separable.
Then

Uii ci

ui

(1.18)

Let c(p, m), l(p, m) denote the solution to the problem of rnaximizing utility subject
to ~ p i c i = l + m, where m is nonlabor income, so that ci(p, m) is the demand function

Ch. 26." Optimal Fiscal and Monetary Policy

1681

for good i. Letting a denote the Lagrange multiplier on the budget constraint, we can
differentiate the first-order condition Ui(c(p, m)) = a ( p , m ) p i with respect to nonlabor
income m to obtain
Oc~

Oa

Ui Oa

U"om = P * ~ -

a Om

or

H,

10ci
Ci 017/1

10a

17 (31"tl

(1.19)

so that
Hi _ t b

/qj

(1.20)

t/i'

where t/i is the income elasticity of demand for good i. Thus necessities should be
taxed more than luxuries.
The standard partial equilibrium result is that goods with low price elasticities
of demand should be taxed more heavily than goods with high price elasticities. In
general equilibrium, this result does not necessarily hold. It does hold if preferences
are additively separable and there are no income effects. That is, utility is quasi-linear
and is given by
Vi(ci)

- 1.

(1.21)

For such a utility function, Equation (1.20) is not helpful because the income
elasticities for all the consumption goods are zero. It is easy to show that for a utility
function of the form (1.21), Hi = 1/ei, where e/= -(Oci/Opi)Pi/C i is the price elasticity
of demand. To see this, differentiate the first-order condition with respect to Pi,

U,.(c(p, m), lq_,, m)) = api,

(1.22)

to obtain
OCi
Uii ,~-- = a,
opi

(1.23)

where a is constant because of quasi-linearity. Substituting Equations (1.22) and (1.23)

into (1.18) gives Hi - 1/ei. Since ri > r/ when Hi >/-/.1, consumption goods which
are relatively more price inelastic (have low e,.) should be taxed relatively heavily.
To summarize, with additive separability, the general result is that tax rates depend
on income elasticities, with necessities taxed more than luxuries. Moreover, the familiar

EV.. Chari and P..J. Kehoe

1682

intuition from partial equilibrium that goods with low price elasticities should be taxed
heavily does not necessarily apply in a general equilibrium setting.

1.3. Uniform commodity taxation

Here we set up and prove the classic result on uniform commodity taxation. This result
specifies a set of conditions under which taxing all goods at the same rate is optimal.
[See Atkinson and Stiglitz (1972).]
Consider a utility function of the form

U(c, l) - W(G(c), l)

(1.24)

where c = ( c i , . . . , cn) and G is homothetic.

Proposition 3. I f utility satisfies' condition (1.24) that is', utility is weakly separable
across consumption goods and is homothetic in consumption
then Ui/Uj = Fi/Fj
for i = 1.... , n. That is, optimal commodity taxation is uniform in the sense that the
Ramsey taxes satisfy "ci = ~- for i = 1 , . . . , n.
Proof: Substituting the firm's first-order conditions (1.13) into the consumer's first-

order condition, we have that

u~
l+ri-

U1Fi

Thus ~ - rj if and only if ~ / F / - Uj/~.

Note that a utility function which satisfies condition (1.24) satisfies

cj

cj

'~

-'~

for all

i, k.

(1.25)

To see this, notice that from homotheticity, it follows that

Ui(ac, l)
Uk(ac, l)

Ui(c, l)
gk(c, l)

or

[ Ui(c, 1) ]
Ui(ac, l) = [ Uk(c,l)J Ul,(ac, l).
Differentiating Equation (1.26) with respect to c~ and evaluating it at a
gives (1.25).

(1.26)
=

Ch. 26." Optimal Fiscal and Monetary Policy

1683

Consider next the first-order condition for ci from the Ramsey problem, namely,

where, again, ~ is the multiplier on the implementability constraint and 7 is the

multiplier on the resource constraint. From Equation (1.25), we have that there is some
constant A such that ~ / c / U / j = A ~ for all i. Using this fact and the form of utility
function, we can rewrite Equation (1.27) as
(1 + 3") WLGi + ,~ [AWl Gi + lW12Gi] ~ ~Fi.

(1.28)

Since Equation (1.28) holds for all i and j, Gi/Fi ~ Gj/Fj for all i a n d j and
Ui _ WLG i _ W1Gi _ Uj

[]
Note that the Ramsey allocations can be decentralized in many ways. For example,
taxes on goods can all be set to an arbitrary constant, including zero, and remaining
revenues raised by taxing labor income.
Consider some generalizations of this proposition. Suppose that the utility function
is homothetic and separable over a subgroup of goods, in the sense that the utility
function can be written as

U ( c l , . . . , c,,~(ck+l . . . . . c,),l)
with ~b homothetic. Then it is easy to show that the Ramsey taxes Tk+L = ... - r~.
Next, if there is some untaxed income, then we need to modify Proposition 3. Suppose
that we add to the model an endowment of good 1, Yl, which is not taxed. Then the
implementability constraint becomes

Uici + U1l = Ulyl.

Z
i

Then even if U satisfies U(0(Cl .... , c,0, l) with 0 homothetic, it is not true that optimal
taxes are uniform (because of the extra terms Uljyl from the derivatives of Utyl). If we
add the assumption that U is additively separable across c l , . . . , co, then the Ramsey
taxes for goods 2 through n will be uniform, but not equal to the tax on good 1.
Next, suppose that the tax system is incomplete in the sense that the government is
restricted to setting the tax on good 1 to some fixed number, say, TI = 0. Then the
Ramsey problem now must include the constraint
U~ _ F1
in addition to the resource constraint and the implementability constraint. Then even
if U satisfies condition (1.24), optimal commodity taxes on goods 2 through n are not

EE Chari and PJ. Kehoe

1684

necessarily uniform. Finally, in order to connect this result on uniform commodity

taxation to some of the later results, suppose that the utility function is defined
over an infinite sequence of consumption and labor goods as U(cl, c2 . . . . ,11,12,...).
The assumption that the utility is of the form V(q~(Cl. . . . . ct .... ),11,12,...) with
homothetic and separable between consumption and all labor goods 11,/2.... ,
together with the assumption that the utility function is additively separable across
time with constant discount factor/3, restricts the utility function to the form
~ C 1 c7

1.4. Intermediate goods'

Here we establish the classic intermediate-goods result for a simple example. (This
example turns out to be useful when we study monetary economies.) Recall the
standard result in public finance that under a wide variety of circumstances, an optimal
tax system maintains aggregate production efficiency. [See Diamond and Mirrlees
(1971).] In the context of an economy with multiple production sectors, transactions
between firms can be taxed. Taxing such transactions distorts the relations between the
marginal rate of transformation in one sector and the marginal rate of transformation
in another sector and yields aggregate production inefficiency. In such a setup, the
standard result on aggregate production efficiency immediately implies that taxing
intermediate goods is not optimal.
Consider an economy with three final goods .... private consumption x, government
consumption g, and labor l - and an intermediate good z. The utility function is U(x, l)~
The technology set for producing the final consumption good using labor ll and the
intermediate good is described by

f ( x , z , ll) <~ O,

(1.29)

w h e r e f is a constant returns to scale production function. There is a technology set for

producing the intermediate good and government consumption using labor/2 described
by

h(z,g, 12) <~ O,

(1.30)

where h also is a constant returns to scale production function. The consumer's problem
is to maximize

U(x, l~ + 12)
subject to p(1 4 r ) x ~. w(l~ + h)~

Ch. 26:

Optimal Fiscal and Monetary Policy

1685

where p and w are the prices of the consumption good and labor and T is the tax on
the consumption good. The firm that produces private consumption goods maximizes
profits
px - wll - q(1 + t})z

subject to condition (1.29); q is the price of intermediate goods, and ~7 is the tax
on intermediate goods. The firm that produces intermediate goods and government
consumption goods maximizes profits
qz + rg - wI2,

where r is the price of government consumption, subject to condition (1.30).

We can easily show that the Ramsey allocation problem is given by
max U(x, Ii + 12)
subject to conditions (1.29), (1.30), and
xUx + (ll +/2) Ut = 0.

(1.3l)

We then have
Proposition 4. The solution to the Ramsey allocation problem satisfies production
efficiency; namely, the marginal rates o f transformation are equated across
technologies. Equioalently, setting the tax on intermediate goods tl = 0 is optimal.
Proof: For this economy, production efficiency is equivalent to

f~

h~

(1.32)

Solving the Ramsey allocation problem, we obtain the following first-order conditions
for z, ll, and 12, respectively:
vf~ = -#hz,

(1.33)

Ut + 3,(xUix + UI + lUa) + of - O,

(1.34)

UI + 2(xUtx + Uz + 1UH) +/zh/= O,

(1.35)

where v, /~, and )L are the multipliers on (1.29), (l.30), and (1.31). Combining
Equations (1.34) and (1.35) gives of =/~hl, which, combined with (1.33), establishes
Equation (1.32).
The first-order conditions for profit maximization for the firms imply that
,fi_ q(l+t])_
f
w

hz( l

h,

~/).

Thus, if condition (l.32) holds, Equation (1.36) implies that r/-- 0. [2

(1 .36)

1686

V.V.Chari and PJ. Kehoe

The intermediate-goods result holds in general settings in which there are (possibly
infinitely) many goods and many production technologies. We have assumed that
the production technologies satisfy constant returns to scale. If there are increasing
returns to scale, then there are standard problems with the existence of a competitive
equilibrium. If there are decreasing returns to scale, then the intermediate-goods result
continues to hold, provided that pure profits can be fully taxed away.
It turns out that the result for uniform commodity taxation follows from the intermediate-goods result. To see this, consider a utility function o f the form
U ( c , l) - W ( G ( c ) , l),

(1.37)

where c = ( c l , . . . , c n ) and G is homogeneous o f degree 1. We can reinterpret

this economy as an economy with a single consumption good x, which is produced
using n intermediate-goods inputs ( c l , . . . ,c,~) with the constant returns to scale
technology x = G(c). The intermediate-goods result requires that in an optimal tax
system, the taxes on the intermediate-goods inputs be zero, so that there are taxes only
on final goods x and 1. This is clearly equivalent to a uniform tax on (cl . . . . , cn).

2. Fiscal policy
In this section, we begin by setting out a general framework for analyzing optimal fiscal
policy in a stochastic one-sector growth model. We use a deterministic version o f this
model to develop results on the taxation of capital income, in both the short and long
run. We first show that the optimal capital income taxes are zero in a steady state, even
if there are heterogeneous consumers. We then show that for a class of utility functions,
there is only one period with nonzero capital income taxes, following which capital
income taxes are zero along a transition to the steady state. We then turn to the cyclical
properties of optimal fiscal policy. In a stochastic model without capital, we illustrate
how debt can act as a shock absorber. We briefly discuss how incomplete markets
can alter these results. We then illustrate the main features o f optimal fiscal policy
over a business cycle using a calibrated version of the model with capital. Finally,
we discuss how these results are altered in three other environments: an endogenous
growth model, an open economy model, and an overlapping generations model.
2.1. G e n e r a l f r a m e w o r k

Consider a production economy populated by a large number of identical, infinitely

lived consumers. In each period t = 0, 1.... , the economy experiences one o f finitely
many events st. We denote by s t = ( s o , . . . , st) the history o f events up to and including
period t. The probability, as of period 0, o f any particular history s t is t~t(st). The initial
realization so is given. This suggests a natural commodity space in which goods are
differentiated by histories.

Ch. 26." Optimal Fiscal and Monetary Policy

1687

In each period t, the economy has two goods: a consumption-capital good and labor.
A constant returns to scale technology which satisfies the standard Inada conditions is
available to transform capital k(s t-l) and labor l(s t) into output via F(k(st-X), l(st), st).
Notice that the production function incorporates a stochastic shock st. The output
can be used for private consumption c(st), government consumption g(sX), and new
capital k(st). Throughout, we will take government consumption to be exogenously
specified. Feasibility requires that

c(s ~) + g(s t) + k(s ~) = F(k(s ~-1), l(sl), st) + (1 - 6) k(s I-I ),

(2.1)

where 6 is the depreciation rate on capital. The preferences of each consumer are given
by

[3~lz(s ~) U(c(s~), l(s~)),

(2.2)

t,S t

where 0 < [2 < 1 and U is strictly increasing in consumption, is strictly decreasing in

labor, is strictly concave, and satisfies the Inada conditions.
Government consumption is financed by proportional taxes on the income from labor
and capital and by debt. Let T(s t) and O(s t) denote the tax rates on the income from
labor and capital. Government debt has a one-period maturity and a state-contingent
return. Let b(s ~) denote the number o f units of debt issued at state s t and Rb(S t+l) denote the return at any state s L+I = (s ~, st+l). The consumer's budget constraint is

c(st)+k(st)+b(s t) <~ [1

T(st)] w(st) l(st)+Rk(st)k(st-l)+Rb(sl)b(sl-1),

(2.3)
where Rk(s t) = 1 + [1 - O(st)][r(s ~) - 6] is the gross return on capital after taxes and
depreciation and r(s t) and w(s t) are the before-tax returns on capital and labor. Consumers' debt holdings are bounded by b(s ~) >~ - M for some large constant M. Competitive pricing ensures that these returns equal their marginal products, namely, that

r(s t) = Fk(k(s t l), l(st), st),

w(s') = Fl(k(s t 1), l(st), s,).

(2.4)
(2.5)

Consumers' purchases o f capital are constrained to be nonnegative, and the purchases

of government debt are bounded above and below by some arbitrarily large constants.
We let x(s t) = (c(sl), l(st),k(st), b(st)) denote an allocation for consumers at s t and
let x = (x(st)) denote an allocation for all s t. We let (w, r,R~,) = (w(st), r(st),Rh(s~))
denote a price system.
The government sets tax rates on labor and capital income and returns tbr
government debt to finance the exogenous sequence o f government consumption. The
government's budget constraint is

b ( s t ) _ Rb(st)b(st-I)+g(s t)

r(st)w(s,)l(s,)__O(s,j[r(st)_6]k(s

l 1).

(2.6)

We let 3"c(st) = (T(st), O(st)) denote the government policy at s t and let zc - (~(st))
denote the infinite sequence of policies. The initial stock of debt, b 1, and the initial
stock o f capital, k-l, are given.

gg Chari and P.J Kehoe

1688

Notice that for notational simplicity, we have not explicitly included markets in
private claims, so all borrowing and lending is between consumers and the government.
Since all consumers are identical, such claims will not be traded in equilibrium; hence
their absence will not affect the equilibrium. Thus we can always interpret the current
model as having complete contingent private claims markets.
A competitive equilibrium for this economy is a policy a~, an allocation x, and
a price system (w,r, Rb) such that given the policy and the price system, the
resulting allocation maximizes the representative consumer's utility (2.2) subject to the
sequence of budget constraints (2.3), the price system satisfies (2.4) and (2.5), and the
government's budget constraint (2.6) is satisfied. Notice that we do not need to impose
the feasibility condition (2.1) in our definition of equilibrium. Given our assumptions
on the utility function, constraint (2.3) is satisfied with equality in an equilibrium, and
this feature, together with (2.6), implies (2.1).
Consider now the policy problem faced by the govenunent. We suppose that there is
an institution or a commitment technology through which the government, in period 0,
can bind itself to a particular sequence of policies once and for all. We model this
by having the government choose a policy g at the beginning of time and then
having consumers choose their allocations. Formally, allocation rules are sequences
of functions x(gc) = (x(s t [ at)) that map policies ~ into allocations x(ar). Price rules
are sequences of functions w(a~) ~- (w(s t [ a~)) and r(av) = (r(s t I a~)) that map
policies av into price systems. Since the government needs to predict how consumer
allocations and prices will respond to its policies, consumer allocations and prices
must be described by rules that associate government policies with allocations. We
will impose a restriction on the set of policies that the government can choose. Since
the capital stock in period 0 is inelastically supplied, the government has an incentive
to set the initial capital tax rate as high as possible. To make the problem interesting,
we will require that the initial capital tax rate, O(so), be fixed at some rate.
A Ramsey equilibrium is a policy av, an allocation rule x(.), and price rules w(.) and
r(.) that satisfy the following: (i) the policy zc maximizes

~13t~(s ') U(c(s' I aO, l(s' l =))

I~S t

subject to constraint (2.6), with allocations and prices given by x(ag), w(g), and r(gr);
and (ii) for every gl, the allocation x(~1), the price system w(avl), r(ar'), and Rb(~'),
and the policy ~' constitute a competitive equilibrium.
We now turn to characterizing the equilibrium policies and allocations. In terms of
notation, it will be convenient here and throughout the chapter to let Uc(s t) and U1(s ~)
denote the marginal utilities of consumption and leisure at state s t and let Fk(s t) and
Fl(s t) denote the marginal products of capital and labor at state s t. We will show that a
competitive equilibrium is characterized by two fairly simple conditions: the resource
constraint

c(s') -~ g(s*) + k(s ~) = f'(k(s'-t), l(st), s,) + (1 - 6) k(s t q)

(2.7)

Ch. 26: OptimalFiscal and Monetary Policy

1689

and the implementability constraint

~y~(s

t) [Uc(s')c(s~) + U~(st) l(st)] = Uc(so)[R~(so)k-~ +Rb(so)b-1],

(2.8)

l,s t

where Rk(so) = I + [1 - O(so)][Fk(so) - b]. The implementability constraint should be

thought of as an infinite-horizon version of the budget constraint of either the consumer
or the government, where the consumer and firm first-order conditions have been used
to substitute out the prices and policies. We have

Proposition 5, The consumption, labor, and capital allocations and the capital tax
rate and return on debt in period 0 in a competitive equilibrium satisfi2 conditions
(2.7) and (2.8). Furthermore, given allocations and period Opolicies that satisfy (2. 7)
and (2.8), we can construct policies, prices, and debt holdings that, together with the
given allocations and period-O policies, constitute a competitive equilibrium.
Proof: We first show that a competitive equilibrium must satisfy (2.7) and (2.8). ] b see
this, note that we can add (2.3) and (2.6) to get (2.7), and thus feasibility is satisfied
in equilibrium. Next, consider the allocation rule x(c). The necessary and sufficient
conditions for c, 1, b, and k to solve the consumer's problem are given as follows. Let
p(s ~) denote the Lagrange multiplier on constraint (2.3). Then by Weitzman's (1973)
and Ekeland and Scheinkman's (1986) theorems, these conditions are constraint (2.3),
together with first-order conditions for consumption and labor:

[3tg(s t) Ue(s t) <<p(st), with equality if c(s t) > 0,

[3tl~(st) Ul(s t) <~-p(st)(1 - r(st))w(st), with equality if l(s t) > 0;

(2.9)
(2.10)

first-order conditions for capital and government debt:

[p(st)--~+p(st+l)Rb(st+l)l b(st)=O~

(2.11)

[p(st)--~-~p(st~')Rk(s"')
] ~+1 s

(2.12)

k(st) = O;

and the two transversality conditions

~ p ( s ~ ) b(s~) .... o,

(2.13~

s t

t lim ~-2p(s ~) k(s ~) - O.

(2.14)

S /

We claim that any allocation which satisfies (2.3) and (2.9)-(2.14) must also satisfy
(2.8). To see this, multiply (2.3) byp(st), sum over t and s t, and use (2.11)-(2.14) to
obtain

}~p(s~)~c(s')-[1
t,s t

~(sl)] w(s~)l(s')} =p(so)[Rk(so)k ~+Rb(so)b

~].

(2.15)

V.V.Chari and P.J Kehoe

1690

Using (2.9) and (2.10) and noting that interiority follows from the Inada conditions,
we can rewrite Equation (2.15) as

V~(s') [G.(s') c(s ~) + Ut(s') l(s')] = G ( s 0 ) [R~(s0) k ~ + Rb(s0) b l].

t,s t
(2.16)
Thus (2.7) and (2.8) are necessary conditions that any competitive equilibrium must
satisfy.
Next, suppose that we are given allocations and period-0 policies that satisfy (2.7)
and (2.8). We construct the competitive equilibrium as follows. First, note that for
an allocation to be part of a competitive equilibrium, it must satisfy conditions (2.3)
and (2.9)-(2.14). Multiplying (2.3) by p(s t) and summing over all periods and states
following s" and using (2.9)-(2.14), we get

V~(s~)

t=~+l s,

(2.17)

Thus any competitive equilibrium debt allocation must satisfy (2.17), and hence (2.17)
defines the unique debt allocations given consumption, labor, and capital allocations.
The wage rate and the rental rate on capital are determined by (2.4) and (2.5) from
the capital and labor allocations. The labor tax rate is determined from (2.5), (2.9),
and (2.10) and is given by

V~(s9

[1 - "v(s~)]/~)(s~).

(2.18)

We can use Equations (2.3), (2.9), (2.11), and (2.12) to construct the capital tax rate
and the return on debt. From these conditions, it is clear that given the allocations, the
tax rate on capital and the return on debt satisfy

~(st) Uc(s t) = ~ [3~(stl) Uc(stl) Rk(gtl

sttllst

#(s t) U~(s t) .... ~

fitt(s t F1 ) U~.(s t+l )Rb(S

1),

t+l

),

(2.19)

(2.20)

s/+1 ]st

c(s '+~) + k(s "~1) + b(s '~1)

= [1 - r(s'+l)] w(s '+1) l(s ~+~)+/~(s ~+j)/c(s') + gb(s '+1) O(s'),

(2.21)

where Rl,(s ~+~) - 1 + [1 - O(st~l)][r(s t+l) - 6]. It turns out that these conditions do
not uniquely determine the tax rate on capital and the return on debt. To see this,
suppose that st+l can take on one of N values. Then counting equations and unknowns
in Equations (2.19)-(2.21) gives N + 2 equations and 2N unknowns in each period and
state. Actually, however, there is one linear dependency across these equations. To see

Ch. 26: OptimalFiscal and Monetary Policy

1691

this, multiply (2.21) by [3#(s t*l) Uc(s ~+1) and sum across states in period t + 1. Use
(2.17), (2.19), and (2.20) to obtain an equation that does not depend on Rb and 0.
Since we can replace any of the N equations from (2.21) with this equation, there are
only N + 1 equations left to determine Rb and 0. Thus there are N - 1 degrees of
indeterminacy in setting the tax rate on capital and determining the return on debt.
One particular set of policies supporting a competitive equilibrium has the capital tax
rate not contingent on the current state. That is, suppose for each s ~,
0(st,&+l) = 0(s l)

for all

st+~.

(2.22)

We can then use (2.19) to define O(s t) and use the period-t + 1 version of (2.21)
to define Rb(st+l), It is straightforward to check that the constructed return on debt
satisfies (2.20). Another set of policies supporting the same competitive equilibrium
has the return on debt not contingent on the current state. [For details, see Chari et
al. (1994), and for a more general discussion of this kind of indeterminacy, see Bohn
(1994).] []
If the competitive equilibrium associated with each policy is unique, clearly the
Ramsey equilibrium is also unique. If there are multiple competitive equilibria
associated with some policies, our definition of a Ramsey equilibrium requires
that a selection be made from the set of competitive equilibria. We focus on the
Ramsey equilibrium that yields the highest utility for the government. Given our
characterization of a competitive equilibrium, the characterization of this Ramsey
equilibrium is immediate. We have

Proposition 6. The allocations in a Ramsey equilibrium solve the Jbllowing

programming problem."
f3' #(s t) U(c(s t), l(sr ))

max ~_~ Z
S t

(2.23)

subject to (2.7) and (2.8).

For convenience, write the Ramsey allocation problem in Lagrangian form:

max ~_~[3tl~(st) { W(c(s'),l(s'),)~)- XU~.(so)[Rk(so)k_~ + Rb(so)b-~]}

(2.24)

t~S t

subject to (2.7). The function W simply incorporates the implementability constraint

into the maximand and is given by

W(c(s'), l(st), J.) - U(c(s'), l(s')) + [U~(s t) c(s') + Ul(s') l(s')],

(2.25)

where 3. is the Lagrange multiplier on the implementability constraint, (2.8). ]'he firstorder conditions for this problem imply that, for t ) 1,
Wz(s')

We(s9

Fl(st)

(2.26)

v.v. Chari and P..J.Kehoe

1692
and

Wc(st)=Zfilz(s~+l Is*)W~(s t+l) [ 1 - 6 + F k ( s t + l ) ]

for

t=0,1,2 .....

S t+l

(2.27)
A property of the Ramsey allocations which is useful in our analysis of the cyclical
properties of optimal fiscal policy is the following. If the stochastic process on s follows
a Markov process, then from Equations (2.26) and (2.27) it is clear that the allocations
from period 1 onward can be described by time-invariant allocation rules c(k, s; ~),
l(k,s; )0, k'(k,s; )0, and b(k, s; 3.). The period-0 first-order conditions include terms
related to the initial stocks of capital and debt and are therefore different from the
other first-order conditions. The period-0 allocation rules are thus different from the
stationary allocation rules, which govern behavior from period 1 onward.
Thus far, we have considered a tax system with capital income taxes and labor
income taxes. A wide variety of other tax systems lead to the same Ramsey
allocation problem. For example, consider a tax system that includes consumption
taxes, denoted r~(st), as well as labor and capital income taxes. For such a system,
the implementability constraint is given by

~ [ 3 ~ ( s t) [Uc(s ~) c(s t) + Ul(s')/(st)] -- (1go(s)

+ v~0) [Rk(So)k-i +Rb(S0) b-l]
[,S t

(2.28)
where Re(so) = 1 + [1 - O(so)][Fk(so) - 6] and r~0 is the tax rate on consumption in
period 0. The first-order conditions of the competitive equilibrium with such a tax
system are given by
c/~(s')

Uc(st)

T(s')

~ + ~rlts

,~

,.

(2.29)

and

Uc(sf) -Uc(st+l) Rk(sZ+l),

l+r,:(s t) ~-~ /3/~(s" l I St)l + ~(st+,)

(2.30)

S I+l ]S t

where Rg(s t+l) - 1 + [1 - O(st+l)][Fk(s t'l) - 6]. Inspection of these first-order

conditions shows that if an allocation satisfies the implementability constraint (2.28)
and the resource constraint (2.1), it can be decentralized as a competitive equilibrium
under a variety of tax systems. Examples of such tax systems include those with only
consumption taxes and labor income taxes and those with only consumption taxes and
capital income taxes. More complicated examples include those in which tax rates on
capital and labor income are required to be the same, but are allowed to be different
from tax rates on consumption. The message of this analysis is that optimal tax theory
implies optimal wedges between marginal rates of substitution and marginal rates of

Ch. 26." Optimal Fiscal and Monetary Policy

1693

transformation and is typically silent on the detailed taxes used to implement these
wedges.
Recall that with a capital and labor income tax system, we ruled out lump-sum taxes
by imposing a constraint on period-0 capital income taxes. In a consumption and labor
tax system, an analogous constraint is necessary. Notice that if consumption taxes are
constant so that Tc(s t) = re0 for all s t and that if labor is subsidized appropriately so that
r(s t) = -re0, then (2.29) and (2.30) become the undistorted first-order conditions. By
setting r~0 arbitrarily high, it is possible to satisfy (2.28) at the lump-sum tax allocations
and thus to achieve the undistorted optimum. One way to rule this out is to impose
an upper bound on T~.0. (There seems to be some confusion about this point in the
literature.)
2.2. C a p i t a l i n c o m e taxation
2.2.1. In a steady state

Here we develop the results on the optimality of zero capital income taxes in a steady
state, and we consider various generalizations and qualifications for that result.
For simplicity, we consider a nonstochastic version o f the model in which the
stochastic shock in the production function is constant and government consumption
is also constant, so g ( s t) = g. Suppose that under the Ramsey plan, the allocations
converge to a steady state. In such a steady state, We. is constant. Thus, from
Equation (2.27),
1 =/3(1 - 6 + Fk).

(2.31)

The consumer's intertemporal first-order condition (2.19) in a steady state reduces to

1 =/311 + (1 - O)(Fk - 6)].

(2.32)

Comparing (2.31) and (2.32), we can see that in a steady state, the optimal tax rate
on capital income, 0, is zero. This result is due to Chamley (1980, 1986).
A natural conjecture is that with heterogeneous consumers, a nonzero tax on capital
income is optimal to redistribute income from one type of consumer to another. We
examine this conjecture in an economy with two types o f consumers, indexed i = 1,2,
whose preferences are given by
OG

V " [jtUi( c. lit),

(2.33)

t-O

where cit and [it denote the consumption and labor supply o f a consumer o f type i.
Notice that the discount factors are assumed to be the same for both types of
consumers. The resource constraint for this economy is given by
c~t + c2t + g + kt~ l = F ( k t , 11~, lzt) + (1 - 6) kt,

(2.34)

where the production function F has constant returns to scale. Notice that the
production function allows for imperfect substitutability between the two types o f labor

V.V. Chari and P.J. Kehoe

1694

and capital. For this economy, the implementability constraints for the two types of
consumers i = 1,2 are given by

fit (V~tci t + U/,lit) = Uico(Rkok'o + Rbobio),

(2.35)

t
where k~ and bi~ denote the initial ownership o f capital and debt by consumers o f
type i 1. If the tax system allows tax rates on capital income and labor income
to differ across consumer types, then it is straightforward to establish that the
resource constraint and the two implementability constraints completely characterize
a competitive equilibrium.
For the Ramsey equilibrium, we suppose that the government maximizes a weighted
sum of consumers' utilities of the form
oo

o(3

601 ~-~fi t U 1(Clt, llt)+co2 Z / 3 t U 2 (cat, 12t),

t 0
tO

(2.36)

where the welfare weights coi C [0, 1] satisfy cot + (92 = 1. The Ramsey problem
is to maximize Equation (2.36) subject to the resource constraint (2.34) and the
implementability constraints (2.35). Let us define

W(c,t, c2f, ILt, 12t, )~1, ;-2) = ~

[coiUi(ci,, li,) + ,~i(U{,cit + U];l,,) 1

(2.37)

i-1,2

for t ~> 1; and for t = 0, W equals the right-hand side o f Equation (2.37) evaluated
at t = 0 minus ~ ~ U~o(Rkok
i
i Here 3,i is the Lagrange multiplier on the
~i + Rbobo).
implementability constraint for the consumer o f type i. The Ramsey problem is, then,
to maximize
O(3

~_~ fit W(CII, CZt, 11;, lat, "~'1,/~2)

t-O
subject to the resource constraint (2.34). The first-order conditions for this problem
imply that

W~f--fiW~.~+l(1-6+Fkt~l)

for

i=1,2

and

t=0,1,2 .....

(2.38)

In a steady state, W , is a constant, and thus

1 = [3(1 - 6 + F~),

(2.39)

which as before implies that the steady-state tax on capital income is zero. This resait
is due to Judd (1985).
I Notice in (2.35) tile initial assets arc denoted k~ and b~, while in (2.8) they are denoted k I and b i.
Throughout the chapter hi deterministic environments initial assets have a subscript 0, while in stochastic
environments initial assets have a subscript -1. This unfortunate inconsistency stems from the traditiov,
of using kt ~t to denote the capital choise in period t.

1695

Ch. 26." Optimal Fiscal and Monetary Policy

This result also holds when type-1 consumers are workers who supply labor, cannot
save or borrow, and hold no initial capital, while type-2 consumers are capitalists who
own all the capital but supply no labor. Then we replace Equation (2.35) for type-1
consumers with

U~tclt + Ul~llt = 0

for all t.

(2.40)

Notice that in the solution to the Ramsey problem, Equation (2.38) continues to hold
for the capitalists, and thus the steady-state tax on capital income is zero. Notice
also that this result shows that even if the Ramsey planner puts zero weight on the
capitalists, taxing capital in the long run is still not optimal. The reason is that the
cumulative distortion o f the capital taxes on intertemporal margins makes even the
workers prefer the static distortion o f marginal rates that comes from labor income
taxes.
Now suppose that the tax system does not allow tax rates on either capital income
or labor income to differ across consumer types. These restrictions on the tax system
imply extra constraints on the allocations that can be achieved in a competitive
equilibrium. Consider first the restriction that tax rates on capital income do not differ
across consumers. To derive the restrictions that this adds to the Ramsey problem,
consider the consumers' intertemporal first-order conditions, which can be written as
U~t - fi [1 + (1 Uc(t+ 1

Ot+l)(Fktq

1 -

6)].

(2.41)

Since the right-hand side of Equation (2.41) does not vary with i, the restriction
U]t =-U2'2t
Uct+l

(2.42)

holds in any competitive equilibrium. Thus Equation (2.42) is an extra restriction that
must be added to the Ramsey problem. Let/~ denote the Lagrange multiplier on (2.42).
Defining

ui + J'
where xt - (cmczt,ll~,12t,Zi,Z2),
we can use the same argument as before, with
V replacing W, to conclude that the steady-state tax on capital income is zero.
Consider next the restriction that tax rates on labor income do not vary across
consumers. Consider the consumers' first-order conditions for labor supply, which can
be written as
-

Uict Flit

1 -

Tt.

(2.43)

V.V. Chari and P..J Kehoe

L696

Since the right-hand side of Equation (2.43) does not vary with i, the restriction
v,',

_ e,,,

Uclt U~t

(2.44)

F/2I

holds in any competitive equilibrium and thus must be added to the Ramsey problem.
We proceed as before and, with no confusion, define

{ U/~U;2

Fm ~

(2.45)

where vt is the Lagrange multiplier on (2.44). A first-order condition lbr the Ramsey
problem is

-~V/,+t + V+t, - / 3 G t , + l

[Fk,+~ + (l

O)].

In a steady state, this reduces to

vc!
Clearly, unless Vk - 0, the steady-state tax on capital income is not zero. Inspection
of Equation (2.45) shows that Vk = 0 if and only if Filt/F12t does not depend
on k. Recall that the production function is separable between k and (11,I2) if
Fm/F12t does not depend on k. Such separable production functions can be written
in the form F(k, ll,/2) = F(k, H(ll,/2)) for some function H. [For some related
discussion, see Stiglitz (1987).]
This analysis of fiscal policy with restrictions suggests that other restrictions on
tax rates may lead to nonzero taxation of capital income in a steady state even in
a representative agent model. Consider an economy with identical consumers, and
consider another restriction on the tax system, namely, that tax rates are equal for
all periods. Suppose, for example, that taxes on capital income are restricted to being
equal for all periods l?om period 1 onward, while labor tax rates are unrestricted. Using
the consumer's first-order conditions, we see that
G/

G,+I

-- /3 [1 q- (1 -- 0t+l)(~'kt+l

(2.46)

- ~)]

together with the restriction that 0t~ 1 = 01 for all t > 1, implies the following restriction
across allocations:
fiU~.f+~

1 F~-1,t+i~L-~5- L~-~c i - 1 F~,j--~

for all

t > 1.

(2.47)

The appropriate Ramsey problem, then, has constraints of the torm (2.47), as well as
the imptementability constraint and the resource constraint. We leave it to the reader

Ch. 26:

Optimal Fiscal and Monetary Policy

1697

(as a difficult exercise) to show that, under suitable conditions, the optimal tax on
capital income is positive, even in the steady state. The intuition is that with no such
restrictions, it is optimal to front-load the capital income taxes by initially making them
large and positive and eventually setting them to zero. When taxes are constant, it is
optimal to try to balance these two opposing forces and make them somewhat positive
tiu'oughout.
The discussion of the extra constraints on the Ramsey problem implied by
restrictions on the tax system suggests the following observation. Zero capital income
taxation in the steady state is optimal if the extra constraints do not depend on the
capital stock and is not optimal if these constraints depend on the capital stock (and,
of course, are binding).
Another possible restriction is that there is some upper bound on tax rates. Suppose,
for example, that capital tax rates are at most 100 percent. Then in addition to satisfying
the analogs of conditions (2.7) and (2.8), an allocation must satisl} an extra condition
to be part of a competitive equilibrium. Rewrite the analog of Equation (2.19) as
Ucz - - ~ U c t ~ l ( ] .@ ( l - Ot.l l )(Fkl+l - c~)).

(2.48)

Then if an allocation satisfies

Fk~+~ >~ 6
and

0t+ 1

(2.49)

~ 1, Equation (2.48) implies that

U~ >~ fiU~t+L.

(2.50)

Thus we can simply impose (2.50) as an extra constraint. With this constraint, for
suitable restrictions on the utility function, the optimal policy is to set the tax rate to its
upper bound for a finite number of periods. After that, the tax takes on an intermediate
value for one period and is zero thereafter.
2.2.2. In a non-steady state

in the preceding subsection, we showed that in a variety of circumstances, in a steady

state, the optimal tax on capital income is zero. Sometimes one can establish a much
stronger result, namely, that optimal capital income taxes are close to zero after only
a few periods. [See Chamley (1986), for example.] In this subsection, we show that
for a commonly used class of utility functions, it is not optimal to distort the capital
accumulation decision in period 1 or thereafter.
The class of utility functions we consider are of ~/he fbrm
cl-O
U(c, l) = l-.S a + V(l).

(2.5l)

One might conjecture that if utility functions of this fbrm have the property that optimal
capital income taxes are exactly zero after period 1, then for utility functions that are in

1698

V..g Chari a n d P.. K e h o e

some sense close to these, keeping capital income tax rates close to zero after period 1
is also optimal.
To motivate our result, we write the consumer's first-order condition for capital as
qt+ 1 ( 1 -- 6 + F k t + 1 ) -- 1 = qt+ 10t v 1 ( F k t + 1 -- (~),

(2.52)

where qz+l - flUct+/Uc: is the Arrow-Debreu price of a unit of consumption in

period t + 1 in units of consumption in period t. Now, in an undistorted equilibrium,
the consumer's first-order condition has the same left-hand side as (2.52), but the righthand side equals zero. Thus the right-hand side of (2.52) measures the size of the wedge
between the distorted and undistorted first-order conditions for capital accumulation
in period t. We then have
Proposition 7. For utility functions o f the form (2.51), it is not optimal to distort the
capital accumulation decision at period 1 or thereafter. Namely, the optimal tax rate
on capital income received in period t is zero f o r t ~ 2. Equivalently,
qt+lOt+l(F~t+l-6) = 0 Jbr all

t ~> 1.

(2.53)

Proof: For t >~ 1, the first-order conditions for the Ramsey problem imply that
Wct+ l . .

1 =/3~O

- 6 + Fk~+i),

(2.54)

where W is given in Equation (2.25). For t ~> 1, the consumer's first-order conditions
for capital imply that
Uct+l

1 =/3~

[1 + (1 - O,-,q)(Fk~+l - 6)1.

(2.55)

Now, for any utility function of the tbrm (2.51), we can easily show that

W.+l Uct+l
We,
U.

(2.56)

Substituting Equation (2.56) into (2.54) and subtracting the resulting equation from
(2.55) gives the result. E]
Proposition 7 implies that the tax rate on capital income received in period t is zero
for t ~> 2 and is typically different from zero in period 1. In period 0, of course, the
tax rate is fixed by assumption.
This result is much stronger than the standard Chamley result, which refers to steady
states, and the logic behind this result is actually more connected to the uniform tax
results than to the rest of the Chamley-type results. To see this, suppose that the tax

Ch. 26." Optimal Fiscal and Monetary Policy

1699

system allows the government to levy only proportional taxes on consumption and
labor income. For this tax system, the analog of the restriction o f the initial tax on
capital income is that the initial consumption tax is given. Then with a utility function
of the form (2.51), consumption taxes are constant in all periods except period 0.
In a continuous-time version o f the deterministic model with instantaneous
preferences given by Equation (2.51), Chamley (1986) shows that the tax rate on capital
income is constant for a finite length o f time and is zero thereafter. The reason for
Chamley's different result is that he imposes an exogenous upper bound on the tax
rate on capital income. If we impose such an upper bound, the Ramsey problem must
be amended to include an extra constraint to capture the restrictions imposed by this
upper bound. (See the example in Subsection 2.2.1.) In the deterministic version of
the model, with preferences given by Equation (2.51), the tax rate is constant at this
upper bound for a finite number of periods, there is one period o f transition, and the
tax rate is zero thereafter.
In the stochastic version of the model, constraints o f this kind can also be imposed.
One can derive an upper bound endogenously. Consider the following scenario. At the
end of each period t, consumers can rent capital to firms for use in period t + 1 and
pay taxes on the rental income from capital in period t + 1. Or consumers can choose
to hide the capital, say, in their basements. If they hide it, the capital depreciates and
is not available for use in t + 1. Thus, if they hide it, there is no capital income, and
consumers pay zero capital taxes.
2.3. Cyclical properties
2.3.1. D e b t taxation as a shock absorber

In this subsection, we illustrate how state-contingent returns on debt can be used

as a shock absorber in implementing optimal fiscal policy. One interpretation of
state-contingent returns on debt is that the government issues debt with a non-statecontingent return and uses taxes or partial defaults to make the return state-contingent.
We show that under reasonable assumptions, during periods o f high government
expenditures such as wartime, the government partially defaults on debt, and during
periods o f low government expenditures such as peacetime, it does not. Many o f the
insights here are developed in Lucas and Stokey (1983) and Chaff et al. (1991).
We illustrate this shock-absorber role in a version o f our model o f fiscal policy with
no capital. Specifically, we assume that F ( k , 1,z) = zl, where z is a technology shock.
The resource constraint is
c(s t) + g ( s t ) ~" z ( s ' ) l(s')

and the consumer's first-order condition for labor supply is

ul(st) - I1 r(s')] z(~)

gc(s t)

(2.57)

V.E Chari and P.J Kehoe

1700

The first-order condition tbr debt is

(2.58)

Uc(s t) = ~ [3~(St+l) Vc(st+l)Rb(xt+l)/[A(st).

st+~

For convenience, let H(s t) - Uc(s t) c(s ~) + Ul(s t) l(st). Notice that the resource constraint and the consumer's first-order condition imply H(s t) = Uc(st)[v(st)z(s t) l(s t) g(st)]. Thus H(s t) is the value of the (primary) government surplus at s t in units of
current marginal utility. The implementability constraint reduces to

~_~ fig(st) H(st) = U~(so) R0 b t.

(2.59)

t,S t

Expression (2.17) reduces to

(2.60)
t=r+l

s t

Now imagine that the government promises a non-state-contingent (gross) rate of

return on government debt R(s t 1) and then levies a state-contingent tax v(s t) on the
gross return on government debt. That is, R and v satisfy

Rh(s ~) = [1 - V(s~)]/~(s~<).
Consider next determining the tax rate and the return on debt. The after-tax return on
debt [1 - v(sr)] R(s r-l) in some period r and state s" is obtained as follows. Multiplying
the consumer budget constraint by fit p(s ~) U~:(st) and summing from period r and over
all periods and states from period r + 1 onward, we obtain the familiar requirement
that the value of the government's after-tax debt obligation must equal the expecteC
present value of government surpluses:

t=r+l

,v t

(2.61)
While the after-tax returns are determined by Equation (2.61), the gross returns and file
tax rates on debt are not separately determined. The reason is that both consumers and
the govermnent care only about the after-tax return on debt. Obviously, there are many
ways of combining (before-tax) gross returns and tax rates to give the same after-tax

Ch. 26:

Optimal Fiscal and Monetary Policy

1701

returns. More formally, if v and R support a particular set o f Ramsey allocations, so

do any v and R' that satisfy
[1 - v(s~)]R'(s ~ 1) : [1 - v(s")]R(s r 1)

for all

r and s '~.

(2.62)

We resolve this indeterminacy by normalizing gross returns R to satisfy

k(s' 1)= ~(st+L)U~(s'-l)

(2.63)

where s t - (s t-l, st). Notice that the normalization in Equation (2.63), together with
(2.62), implies that tax rates on debt satisfy

#(s t [ s I L) U,.(Sl)V(S t)

for all

tands t 1

(2.64)

S t

where/~(s t [ s t 1) = l~(st+l)/t~(st).
Next, we derive the first-order conditions fbr the Ramsey problem. Let 3. denote the
Lagrange multiplier on the implementability constraint. The first-order conditions for
t ~> 1 imply that

z(s t) u,.(s') + U;(s') + Z [z(s')H~(s') + H;(s')] = 0,

(2.65)

where H,.(s t) and Hl(s t) denote the derivatives o f H ( s t ) . For t - 0, the first-order
condition is the same as (2.65), except that the right-hand side is replaced by

,~ [z(so) G c ( s o ) + Gl(so)] [1 - V(So)] R_lb_l.

These first-order conditions can be used to prove the following proposition:
Proposition 8. For t >~ 1, there exist .functions ~, 7, and ~ such that the Ramsey
consumption allocations, labor allocations, and labor tax rates can be written as

c(s') ' C'(gt,zD,

l(s') = 7(g,z,),

c(s') = ~(gt,z,).

Moreover, if b ~ = O, then c(so), l(so), and ~C(so) are given by these same functions.
Proof: For t /> 1, substituting from the resource constraint for l(s t) into (2.65)
gives one equation o f the form F ( c , g , z ; ) O = 0. Solving this gives the Ramsey
consumption allocation as a function o f the current levels o f government consumption,
the technology shock, and the multiplier. From the resource constraint and from
Equation (2.57), we know that the labor allocation and the labor tax rate are a function
of these same variables. For t = 0, the same procedure gives allocations and the labor
tax rate in period 0 as a function of go, z0, and 5~. We can solve for )~ by substituting

V.V Chari and P.J. Kehoe

1702

the allocations into the implementability constraint (2.59). Clearly, for b-1 = 0, the
first-order conditions for t = 0 are the same as the first-order conditions for t ~> 1. []
Proposition 8 says that the allocations and the labor tax rate depend only on
the current realizations of the shocks and not separately on the entire history
o f realizations. This proposition implies that labor tax rates inherit the stochastic
properties of the underlying shocks. For example, if government consumption is i.i.d.
and the technology shock is constant, then tax rates are i.i.d. (This result does not hold
in general with capital.)
If government consumption is persistent, then so are the tax rates. This result of
standard neoclassical theory sharply contrasts with claims in the literature that optimal
taxation requires labor tax rates to follow a random walk. [See Barro (1979), Mankiw
(1987), and our discussion in the following subsection, 2.3.2.]
To understand the nature of the Ramsey outcomes, we consider several examples.
In all o f them, we let technology shocks be constant, so z(st) = 1 for all s t. We begin
with a deterministic example that illustrates how Ramsey policies smooth distortions
over time.
E x a m p l e 1. Consider an economy that alternates between wartime and peacetime.
Specifically, let gt = G for t even and gt = 0 for t odd. Let the initial indebtedness
R l b 1 = 0. We will show that the government runs a deficit in wartime and then
pays off the debt in the ensuing peacetime. Consider the first-order condition for the
Ramsey problem in peacetime. Using the resource constraint, we have that
(1 + )L)[U,.(O) + Ul(O)] + ,~c[U~.,..(O) + 2 U~.I(O)+ Ua(O)] - 0,
where the partial derivatives are evaluated at gr = 0. By strict concavity, the second
bracketed term is negative. Since the multiplier ~ is positive, the first term is positive.
From Equation (2.57), we have that U~. + Uz -- rUc. Thus r(0) > 0. When we use
Proposition 8, Equation (2.59) implies that H ( G ) +/3H(0) = 0, which can be rewrittetJ
as

Uc( G)[ T( G) l(g ) - G] + [3U,,( O)['~( O) l(O)] - O.

That is, the discoumed value of the government surplus is zero over the two-period
cycle o f government consumption. Since the government runs a surplus in peacetime,
it must run a deficit in wartime. Here the government sells debt b(G) - G -- r(G) l(G)
in wartime and retires debt in the next peacetime. The gross return on the debt from
wartime to peacetime is R ( G ) = Uc(G)/[3U~(O), and with our normalization, the tax
rate on debt is always zero.
E x a m p l e 2. Consider an economy that has recurrent wars with long periods of peace
in between. Specifically let gt = G for t = 0, T, 2T, ..., and let gt - 0 otherwise. Let

1703

Ch. 26." Optimal Fiscal and Monetary Policy

the initial indebtedness R-lb-x =

over each T-period cycle, that is,

0.

Again, by Proposition 8, the budget is balanced

G ( G ) [ T ( G ) l(G) - G] + fiU~(O)[v(O) l(O)] + . . . +/3 ~ 1U~(O)[r(O) l(O)] = O.

Here, as in Example 1, the government runs a deficit in wartime and a constant surplus
in peacetime. The war debt is slowly retired during the following T - 1 periods of
peace. The government enters the next wartime with zero debt and restarts the cycle.
Specifically, the government issues debt of level G - v(G) l(G) in wartime. In the first
period of peacetime, the government sells

G(G)
fiu.(o)
---

[G

r(G) I(G)].- r(0) l(0)

units of debt. In the second period, it sells

G(G)_ [G - (G) I(G)]- -rS-~l--(-) r(0), l(0),

fi2 Uc(O)

and so on. Clearly, the debt is decreasing during peacetime.

E x a m p l e 3. Here we will illustrate the shock-absorbing nature of optimal debt
taxes. Let government spending follow a two-state Markov process with a symmetric
transition matrix with positive persistence. The two states are g: = G and gt = 0. Let
Jr=Prob{gt~l=GIg,-G}=Prob{g,+l=01g:

0} > 31

Therefbre, the probability of staying at the same state is greater than the probability
of switching states. Let go =- G, and let the initial indebtedness R 1b 1 be positive.
The government's period t budget constraint is

b(s t) = [1 - v(st)] R(s t-l) b(s: 1) + g ( s ' ) - T(s') l(s').

(2.66)

From Proposition 8, the allocations and the labor tax rates depend only on the current
realization gt for t ~> 1. Under the Markov assumption, Equations (2.60) and (2.63)
imply that the end-of-period debt b(s t) and the interest rate R(s t) depend only on the
current realization gt. From Equation (2.66), we know that the tax rate on debt depends
on the current and the previous realizations. Let b(g:), R(g:), and v(g~-i ,g~) denote the
end-of-period debt, the gross interest rate, and the tax rate on debt, For a large class
of economies, we can prove the following proposition:
Proposition 9. Suppose that in the solution to the Ramsey problem, tt(0) > H(G) > O;
that is, the value of government surpluses is larger in peacetime than in wartime, the

1704

V.Y Chari and P..Z Kehoe

government's debt is always positive, the marginal utility of consumption is greater in

wartime U~(G) than in peacetime Uc(O), and both b(G) and b(O) are positive. Then
v(0, G) > v(G, G) > 0 > v(O, 0) > v(G, 0).

(2.67)

That is, the debt tax rates' are most extreme in periods of' transition: they are highest
in transitions from peacetime to wartime and lowest in transitions from wartime to
peacetime. Furthermore, debt is taxed in wartime and subsidized in peacetime.
R e m a r k : It is possible to show that the assumptions in this proposition are satisfied
for a large class of economies if the initial debt is sufficiently large.
Proof: Let V(G) and V(0) denote the expected present value of govermnent surpluses

when the economy is in state G and state 0, respectively. These surpluses are given by
the left-hand side of Equation (2.61) multiplied by the marginal utility of consumption
in that state, which can be written recursively as
V(G) = H(G) + fi[jr V(G) + (1 - Jr) V(0)],

(2.68)

V(0) = H(0) +/3[cV(0) + (1 - Jr) V(G)].

(2.69)

Solving these, we obtain

Jr)H(O)+(I-/3Jr)H(G)
~
D
/3(1 - v)H(G) + (1 -/3jr)H(O)
V(0) =
,
D
V(G) -

fi(1

(2.70)
(2.71)

where D = (1 -/3go) 2 -/32(1 -Jr)2 > 0. From Equation (2.60), we obtain

/3[:rV(G) + (1 - Jr) V(0)]

,
U~.(G)
/3[jrV(O) + (1 sD V(G)]
b(0) =
,
uc(0)
b(G) =

(2.72)
(2.73)

and from Equation (2.63), we obtain

gc(c)
R(G) . . . . . . . . . . . . . . . . . . .
,
/3[~Uc(G) + (1 - :r) Uc(O)] ~

uc(o)
R(0) =/3[jrUe(0) + (1 --Jr) U~.(G)]"

(2.74)
(2.75)

Combining these, we obtain expressions for the befbre-tax obligations of the

government:
JrV(G) + (1 - aT) V(0)
R(G) b(G) = JrUc(G) + (1 - :v) Uc(O)'
R(O) b(O) --

Jr V(0) + (1 - Jr) V(G)

Jr U~:(0) + (1 -- Jr) Uc(G)

(2.*76)
(2./7)

Ch. 26.. OptimalFiscal and Monetary Policy

1705

Since H(G) < H(0), Equations (2.70) and (2.71) imply that V(G) < V(0). Using this
result, :w > , and U~(0) < U~(G), we can see that Equations (2.76) and (2.77) imply
that

R(G) b(G) < R(O) b(O).

(2.78)

We can rewrite Equation (2.61) as

V(&)

[1 - v(gt-a,gt)] R(&-I) b(&-l) - Uc(gt)"

(2.79)

The right-hand side of Equation (2.79) depends only on the cm'rent state; thus (2.78)
implies that v(0, G) > v(G, G) and v(0, 0) > v(G, 0). To establish Equation (2.67), we
need only show that v(G, G) > 0 > v(0, 0). But this follows from (2.64) and (2.'79),
using V(G) < V(0) and Uc(0) < Uc(G). []
The intuition for these results is as follows. The Ramsey policy smooths labor tax
rates across states. This smoothing implies that the government runs a smaller surplus
in wartime than in peacetime. With persistence in the shocks, the expected present
value of surpluses starting from tile next period is smaller if the economy is currently
in wartime than if it is in peacetime. The end-of-period debt is, of course, just the
expected present value of these surpluses. [See Equation (2.60).] Thus the end-of'period debt is smaller if tile economy is in wartime than if it is in peacetime, so

D(G) < b(O).

As was shown in (2.78), R(G)b(G) < R(O)b(O). Thai is, the obligations of the
government if there was war in the preceding period are smaller than if there was
peace. Suppose the economy is currently in wartime, so gt = G. The current deficit
and end-of-period debt are the same regardless of the history. Thus, if the inherited debt
obligations are larger, the only way to meet the government budget constraint is to tax
debt at a higher rate. So a transition from peacetime to wartime results in higher debt
taxes than does a continuation of wartime. Similar intuition applies for the comparisons
of transitions from wartime to peacetime with continuations of peacetime.
2.3.2. Tax-smoothing and incomplete markets
Here we develop Barro's (1979) result on tax-smoothing and compare it to the work
of Marcet et al. (1996) on optimal taxation with incomplete markets. In a wellknown paper, Barro (1979) analyzes a reduced-form model of optimal taxation. Ithis theoretical development, there is no uncertainty and the government chooses a
sequence of tax rates ~t on income to maximize

t=Z-~o(1 + r ) "

1706

EV. Chari and P.J. Kehoe

where Yt is income in period t and r is an exogenously given interest rate, subject to

budget constraints of the form
bt = (1 + r ) b t

I + g t - "6Yt,

where g~ is government spending, b-t is given, and an appropriate boundedness

condition on debt is imposed. These constraints are equivalent to the present value
budget constraint
Z
"rty: _
gt
t=0 (1 +r)t
l=0 ( l + r ) t + b

(2.80)

Barro shows that in this deterministic setup, optimal tax rates are constant.
Barro goes on to assert that the analog of this result with uncertainty is that optimal
taxes are a random walk. In an environment with uncertainty, the properties of optimal
policy depend on the structure of asset markets. If asset markets are complete, the
analogous present value budget constraint is

r(sgy(s')
t~S t

1 +.(s,)

g(s')
-

l,s t

i-+r( -Z +b

With this asset structure, optimal tax rates are clearly constant across both time
and states of nature. If asset markets are incomplete, then the analysis is much
more complicated and depends on precise details of the incompleteness. Suppose, for
example, that the only asset available to the government is non-state-contingent debt.
The sequence of budget constraints for the government can be written as

b(s') = (l + ,) b(s' t) + g(s ~) _ r(~)y(s,)

together with appropriate boundedness conditions on debt. Substituting the first-order
conditions to the government's problem into the budget constraints and doing some
manipulations yields

~ [ 3 ' '~(~' t s )
f--F

S t

U r ( s I ) y ( s t)

T(St)y(st)]

.... (1 +~)b(: ~).

U~(s")y(s9

(2.82)

The restriction that debt is not state-contingent is equivalent to the requirement that
the left-hand side of Equation (2.82) is the same for any two states in period r in the
sense that for all s r l,

t--r

u~(s~)y(s') [g(s~) - ~(s')y(~')l

U~(s")y(s")

St

U~(s')y(s')
I = r

s'

(2.83)

[g(,,)

Ur(s ~'/ ) y ( s

r(st)y(st)j
F/

>

where s ~ = (s: ~,s.) and s"' - (s" 1,s~,) tbr all s,.,s.,. Analyzing an economy with
incomplete markets requires imposing, in addition to (2.81), an infinite number of

Ch. 26:

Optimal Fiscal and Monetary Policy

1707

constraints of the form (2.83). This problem has not yet been solved. An open question
is whether optimal tax rates in such an environment follow a random walk.
In our general equilibrium setup, restrictions on government policy also impose
extra constraints. Suppose that neither capital tax rates nor the return on debt can be
made state-contingent. Then the additional restrictions that the allocation must satisfy
so that we can construct a competitive equilibrium are given as follows. Substituting
Equations (2.17) and (2.18) into the consumer's budget constraint yields, after some
simplification,

t=v

(2.84)

xr

- {1 + [1 - O(s ~ l)][Fl~(s")- c5]} k(s '-1)

:Ro(s r l)b(s'

1),

where 0(s r 1) satisfies

(2.85)
Sr

The requirement that the debt be non-state-contingent is, then, simply the requirement
that the left-hand side of Equation (2.84) with O(s ~ -l) substituted from (2.85) be the
same for all st. Furthermore, we need to impose bounds on the absolute value of the
debt to ensure that the problem is well posed. We then have that if an allocation satisfies
these requirements, together with the resource constraint (2.7) and the implementability
constraint (2.8), a competitive equilibrium can be constructed which satisfies the
restriction that neither the capital tax rate nor the return on debt be state-contingent.
Clearly, computing equilibria with non-state-contingent capital taxes and return on debt
is a difficult exercise.
Marcet et al. (1996) analyze an economy with incomplete markets but without
capital. When government consumption is serially uncorrelated,, they find that the
persistence properties of tax rates are a weighted average of a random walk and
a serially uncorrelated process. They also find that the allocations are close to the
complete markets allocations. They argue that their results partially affirm Barro's
(1979) assertion.
In Section 3, we consider a model in which debt is nominal and non-state-contingent.
There we show that inflation can be used to make the real returns state.-contingent
and that the Ramsey allocations are identical to those in an economy with real statecontingent debt. This result is reminiscent of our result that even if debt returns are
not state-contingent, as long as capital tax rates are state-contingent, the Ramsey
allocations are identical to those in an economy in which all instruments are statecontingent. This feature suggests that for actual economies, judging the extent of
market incompleteness can be tricky.

1708

EV. Chari and P.J. Kehoe

2.3.3. A quantitative illustration

Here we consider a standard real business cycle model and use it to develop the
quantitative features of optimal fiscal policy. We follow the development in Chari et
al. (1994). In quantitative stochastic growth models, preferences are usually specified
to be of the form
el(c, l) -

[c 1 ~(L - l)y]v'
~p

where L is the endowment of labor. This class of preferences has been widely used
in the literature [Kydland and Prescott (1982), Christiano and Eichenbaum (1992),
Backus et al. (1992)]. The production technology is usually given by
F ( k , l,z, t) = UZ(ePt+~l) 1 a.

Notice that the production technology has two kinds of labor-augmenting technological
change. The variable p captures deterministic growth in this change. The variable z
is a technology shock that follows a symmetric two-state Markov chain with states zt
and zh and transition probabilities Prob(zt~l = zi I zt = zi) = ~ for i = l, h. Government
consumption is given by gt = ge pt, where again p is the deterministic growth rate
and g follows a symmetric two-state Markov chain with states gf and gh and transition
probabilities Prob(gt+t = gi i gt = gi) = ~ for i = l,h. Notice that without shocks
to technology or government consumption, the economy has a balanced growth path
along which private consumption, capital, and government consumption grow at rate p
and labor is constant. Zhu (1992) shows that in economies of this form, setting capital
income tax rates to be identically zero is not optimal. We ask whether capital tax rates
are quantitatively quite different from zero.
Recall from the proof of Proposition 5 that certain policies are uniquely determined
by the theory, while others are not. Specifically, the labor tax rate is determined, while
the state-by-state capital tax rate and return on debt are not. From Equation (2.19),
however, we know that the value of revenues fi'om capital income taxation in
period t + 1 in terms of the period-t good is uniquely determined. To turn this variabie
into a tax rate, consider the ratio of the value of these revenues to the value of capital
income, namely;

O~(s ,) = )2 q(s~'t) O(s~l)[F/,(s~)

6]
q(s'+l)[Fk(s t+l) - 6]
~

(2.86)

where q(s t*l ) = [3[.1(stt i ] s t) U~.(st~l)/Uc(s i) is the price of a unit of consumption at

state s t+l in units of consumption at s t. We refer to Oe(s ~) as the ex ante tax rate on
capital income.

Ch. 26:

Optimal Fiscal and Monetary Policy

1709

Table 1
Parameter values for two models"
Model

Parameters and values

Baseline model

Preferences

y - 0.80

Technology

a = 0.34

~p- 0
6 = 0.08

fi - 0.97
p = 0.016

Gover,tment consumption

g/= 350

g h - 402

= 0.95

Technology shock

z l - 0.04

z h = 0.04

~ = 0.91

L = 5475

Markov chains for

High risk aversion model

Preferences

q~= -8

a Source: Chari et al. (1994).

Next, in defining the last variable that is uniquely determined by the theory, it
is useful to proceed as follows. Imagine that the government promises a non-statecontingent rate of return on government debt ?(s t ~) and levies a state-contingent tax
v(s ~) on interest payments from government debt. That is, ? and v satisfy

Rh(s t) = 1 + ?(s ~ L)[1 - v(st)],

(2.87)

and ~ q ( s t ) v ( s t) = 0, where q(s t) is the price of a unit of consumption at state s in

units of consumption at state s t-l. Thus ?(s t 1 ) is the equilibrium rate of return on a unit
purchased in period t - 1 at s t 1, which yields a non-state-contingentreturn ?(s t` l) at all
states s t. It is clear from (2.21) that the theory pins down Rl,(s t) k(s f 1) ~ Rb(S t) b(s t 1).
Given our definition of v, it is also clear that the theory pins down the sum of the tax
revenues from capital income and the interest on debt, which is given by

O(s t) [Ft(s t) - 6]/~(s ~ 1)+ v(s')~(s' ')b(s'-l).

(2.88)

We transform these revenues into a rate by dividing by the income from capital and
debt to obtain the tax rate on private assets, given by

rl(st)= O(s')[l~'k(st)

6]k(st ~)+ v(st)~(s t L)b(s' ~)

[Fk(s t) - 6] k(s t 1) + ?(s t l)b(s, 1)

(2.89)

We consider two parametrizations of this model. (See Table 1.) Our baseline model
has ~p = 0 and thus has logarithmic preferences. Our high risk aversion model has
~p = - 8 . The remaining parameters of preferences and the parameters tbr technology
are those used by Chari et al. (1994). We choose the three parameters of the Markov
chain for government consumption to match three statistics of the postwar US data:

ggChari and R J K e h o e

1710
Table 2
Properties of the fiscal policy modelsa

Percentage in models

Income tax rates

Labor
Mean

Baseline

High risk aversion

23.87

20.69

Standard deviation

0.10

0.04

Autocorrelation

0.80

0.85

Capital

Mean

0.00

0.06

Standard deviation

0.00

4.06

Autocorrelation

0.83

Private assets

Mean

1.10

0.88

Standard deviation

53.86

78.56

Autocorrelation

-0.01

0.02

a All statistics are based on 400 simulated observations. The means and standard deviations are in
percentage terms. For the US economy,the tax rates are constructed as described by Chari et al. (1994).
For the baseline model, the capital tax rate is zero; thus, its autocorrelationis not defined.
the average value of the ratio of government consumption to output, the variance of
the detrended log of government consumption, and the serial autocorrelation of the
detrended log of government consumption. We construct the Markov chain tbr the
technology parameters by setting the mean of the technology shock equal to zero,
and we use Prescott's (1986) statistics on the variance and serial correlation of the
technology shock to determine the other two parameters.
For each setting of the parameter values, we simulate the Ramsey equilibrium for our
economy, starting from the steady state of the deterministic versions of our models.
In Table 2, we report some of the resulting properties of the fiscal variables in our
models.
In the baseline model, the tax rate on labor income fluctuates very little. For example,
i f the labor tax rate were approximately normally distributed, then 95 percent of the
time, the tax rate would fluctuate between 23.67 percent and 24.07 percent. The tax on
capital income is zero. This is to be expected because with ~p = 0, the utility function
is separable between consumption and leisure and is homothetic in consumption, and
the utility function thus satisfies the conditions discussed in Subsection 2.2.2. In the
baseline model, the tax on private assets has a large standard deviation. Intuitively, we
know that the tax on private asset income acts as a shock absorber. The optimal tax rate
on labor does not respond much to shocks to the economy. The government smooths

Ch. 26:

Optimal Fiscal and Monetary Policy

1711

labor tax rates by appropriately adjusting the tax on private assets in response to shocks.
This variability of the tax on private assets does not distort capital accumulation,
since what matters for the capital accumulation decision is the ex ante tax rate on
capital income. This can be seen by manipulating the first-order condition for capital
accumulation.
In Table 2, we also report some properties of the fiscal policy variables for the high
risk aversion model. Here, too, the tax rate on labor income fluctuates very little. The
tax rate on capital income has a mean o f - 0 . 0 6 percent and a standard deviation of
4.06 percent so that the tax rate is close to zero. We find this feature interesting because
it suggests that, for the class of utility functions commonly used in the literature, not
taxing capital income is optimal. Here, as in the baseline model, we find that the
standard deviation of the tax rate on the income from private assets is large.
2.4. Other environments'
2.4.1. Endogenous growth models'
Thus far, we have considered fiscal policy in models in which the growth rate of the
economy is exogenously given. We turn now to models in which this growth rate is
determined by the decisions of agents. Our discussion is restricted to a version of the
model described in Lucas (1990). Analysis of optimal policy in this model leads to a
remarkable result: Along a balanced growth path, all taxes are zero. Bull (1992) and
Jones et al. (1997) discuss extensions to a larger class of models.
Consider a deterministic, infinite-horizon model in which the technology for
producing goods is given by a constant returns to scale production function F(kl, h~lj~),
where kt denotes the physical capital stock in period t, ht denotes the human capital
stock in period t, and lli denotes labor input to goods production in period t. Human
capital investment in period t is given by htG(12t), where 12t denotes labor input into
human capital accumulation and G is an increasing concave function. The resource
constraints for this economy are
ct + g + kt+l = F(kl, htllt) + (1 - Ok) kt

(2.90)

hx+L = htG(lzt) + (1 - 6h) h,~

(2.91)

and

where et is private consumption, g is exogenously given government consumption, and

6/, and Oh are depreciation rates on physical and human capital, respectively.
The consumer's preferences are given by
oo

[3' c'] v(lt, + let)~(1 - a),

t-O

where v is a decreasing convex function. Government consumption is financed by

proportional taxes on the income from labor and capital in the goods production sector

1712

EV. Chari and RJ Kehoe

and by debt. Let rt and 0t denote the tax rates on the income from labor and capital.
Government debt has a one-period maturity. Let bt+l denote the number of units of
debt issued in period t and Rbtbt denote the payoff in period t. The consumer's budget
constraint is
ct + k~+j + bt+l ~< (1 - rt) wthtllt + Rekt + Rbtbt,

(2.92)

Rkt - 1 + ( 1 - Ot)(rt - c5) is the gross return on capital after taxes and depreciation and 1"1 and wt are the before-tax returns on capital and labor. Note that human
capital accumulation is a nonmarket activity. The consumer's problem is to choose
sequences of consumption, labor, physical and human capital, and debt holdings to
maximize utility subject to (2.91) and (2.92). We assume that consumer debt holdings
are bounded above and below by some arbitrarily large constants. Competitive pricir~
ensures that the returns to factor inputs equal thei,~ marginal pre~ducts, nameIy, tha~
where

rl = f k ( k . h~l~),

(2.93)

wt = Ft(kt, hfllt).

(2,94)

We let xt = (ct, lit, 12t, kt, kt, bt) denote an allocation for consumers in period t and let
x = (st) denote an allocation for all t. The government's budget constraint is
b,+ l = Rbtb~ + g - rtwthtll~ - Ot(r~ - (3)k,

(2.95)

We let zct = (rt, 0t) denote the goverrmaent policy at period t and let s~ ~- (zc~) denote
the infinite sequence of policies. '1"he initial stock of debt, b 1, and the initial stock of
capital, k-l, are given. A competitive equilibrimn is defined in the usual way. We have
the following proposition.
Proposition lO. The consumption allocation, the labor allocation, the physical and
human capital allocations, the capital tax rate, and the return on debt in period 0 in
a competitive equilibrium satisfy (2.90), (2.91), and
O(3
"~ [3 [ ct

Uct = Ao,

(2.96)

t-0

where

A0 -- C:~.0{[I + (1 -00)(~0 - 6)1 l,o +R~0b0}

U~o [l~0 + 1 - 6h + (~(l~0)]

G'(12o)

Furthermore, given any allocations and period-O policies' that satisfy (2.90), (2.91Z
(2.96), and

Ul,

[3U/~.!

hLG'(12~) - ht+l G'(lzt+l) [ 1 -

C~h -I-

G(12, l )] +

[3U~z+l ll~+l
ht+~
'

(2.97)

we can construct policies, prices, and debt holdings whick, together wztk the given
allocations and period-O policies, constitute a competitive equilibrium.

Ch. 26:

Optimal tqscal and Monetary Policy

1713

Proof: The procedure we use to derive the implementability constraint is to express

the consumer budget constraint in period-0 form with the prices substituted out. Recall
that in the model with exogenous growth, this procedul"e implied that the capital
stock from period 1 onward did not appear in the implementability constraint. It turns
out that when human capital is accumulable, human capital does not appear in the
implementability constraint from period 1 onward either.
The consumer's first-order conditions imply that
(2.98)
(2.99)

-[YU1, = )~t(1 - rt)wtht,

-ill U# -= ~tthtG' (12,),

(2.100)

-ktt + ktt ~1 [1 - Oh + G(121+l)] + )~t+l (1

(2./01)

t)+O wt+lllt+l - O.

Multiplying Equation (2.101) by ht~l, substituting for /tt~ and gt+~ from (2.99) and
(2.100), and using Equation (2.91), we obtain
--

2t(1 ---Tt)wlhl+L '~t+l(1-- Tt+l)w~+lht+2

+
G'(lzt)
G'(12,+1)

+ "~t+l (1 -- Z)+I ) W t + 1 l t t . l l h t t

1 - O.

(2.102)
From Equation (2.102) and a standard transversality condition, we know that
~,o
)to(1 - Z'O)Wohl
Z )~t+l(l - "gt~i) wt+tllt+lht, 1 =
t =o
G'(12o)

(2.103)

Similarly, we can show that

~l+lRk,.+lk~+l = 2okt + Z
t-o

,~tkt.

(2.104)

t=l

Next, we multiply the consumer budget constraint (2.92) by ~.t and sum from period
0 onward. When we use (2.103) and (2.104), (2.96) follows. To derive (2.97), we
substitute (2.99) into (2.102). We leave it to the reader to prove the converse. []
The Ramsey problem is to maximize consumer utility subject to conditions (2.90),
(2.91), (2.96), and (2.97). Recall that human capital accumulation occurs outside
the market and cannot be taxed. In any competitive equilibrium, the Euler equation
for human capital accumulation is undistorted. Therefore, there is no tax instrument
that can be used to make the Euler equation for human capital accumulation hold
for arbitrary allocations. In contrast, for arbitrary allocations, the Euler equation
for physical capital can be made to hold by choosing the tax on capital income
appropriately. This incompleteness of the tax system implies that the undistorted Euler
equation for human capital accumulation is a constraint on the set of competitive
allocations. We have the following proposition.

1714

V.V. Chari and P..J Kekoe

Proposition 11. Suppose that the Ramsey allocations converge to a balanced growth
path. In such a balanced growth path, all taxes are zero.
Proof." We prove that along a balanced growth path, the first-order conditions for the
Ramsey problem are the same as those for a planner who has access to lump-sum
taxes. (This, of course, does not mean that the government can achieve the lump-sum
tax allocations, because there are distortions along the transition path.)
Let W(ct, lit + 12t; )0 = U ( c , lit + 12t) + ~ctUct, where ~ is the Lagrange multiplier
on (2.96). For our specified utility function,
W(ct, lit + 12t; ~) = [1 + ~(1 - o')] U(ct, lit + [2t).
The Ramsey problem is to maximize
t

[3 W(cf, lit + [2t; ~.) - )~Ao

subject to (2.90), (2.91), and (2.97). Consider a relaxed problem in which we
drop condition (2.97). Since the objective function in this rewritten problem from
period 1 onward is proportional to that of a social planner who has access to lump-sum
taxes, the solutions to the two problems are the same along a balanced growth path.
This solution also satisfies condition (2.97). Thus, along a balanced growth path, the
Ramsey problem has the same solution as the lump-sum tax problem. The solutions to
these last two problems differ along the transition paths only because the two problems
imply different allocations for period 0 and therefore for the capital stocks for the
beginning of period 1. []
The reader may be concerned that this result depends on the ratio of government
consumption to output going to zero. To see that this concern is not warranted,
consider an extension of the model described above. Consider an environment in
which the government chooses the path of government consumption optimally. To
see this, suppose that the period utility function is given by U(cl, li + 12) + V(g),
where V is some increasing function of government consumption. The government
problem in this setup is to choose both tax rates and government consumption to
maximize the consumer utility. We can solve this problem in two parts. In the first part,
government consumption is taken as exogenous and tax rates are chosen optimally. In
the second part, government consumption is chosen optimally. The proof described
above obviously goes through for extensions of this kind. For V(g) - a g I /(1 -(f)~
it is easy to show that along a balanced growth path, govermnent consumption is a
constant fraction of output.
2.4.2. Open economy models'
So far, we have considered models of a closed economy. We turn now to considering
issues that arise in an open economy. The elasticity of capital supply is likely to be

Ch. 26." Optimal Fiscal and Monetary Policy

1715

much greater in an open economy than in a closed economy because in the open
economy capital is mobile and can flow to the country with the highest rate o f return.
We consider a small open economy that takes the rates o f return on saving in the rest
o f the world as given. In so doing, we abstract from the interesting strategic issues that
arise when more than one authority sets taxes, and we abstract from general equilibrium
linkages between an economy's fiscal policy and world prices.
In an open economy, in addition to the standard taxes a government can levy on
its citizens, a government can tax foreign owners o f factors that are located in its
country. To allow this possibility, we allow there to be source-based taxes as well as
residence-based taxes. Source-based taxes are taxes that governments levy on income
generated in their country at the income's source, regardless o f ownership. Residencebased taxes are taxes that governments levy on the income o f their residents regardless
o f the income's source. We show that source-based taxes on capital income are zero in
all periods and that, with a restriction that ensures that the economy has a steady state,
residence-based taxes on capital income are zero in all periods as well. This result is
much stronger than the corresponding result for closed economies. [See Razin and
Sadka (1995) for some closely related work.]
Consider a model with both source-based and residence-based taxation. We model
source-based taxes as those levied on a firm and residence-based taxes as those levied
on consumers. Let r[ denote the world rental rate on capital absent any domestically
levied taxes. The firm's problem is to solve

m a x f ( k t , l t ) - (1 + 02~)r[lq- (1 + rj~)writ,
where 0fi and Tji are the source-based tax rates on capital and labor. The first-order
conditions are
Ot~r,*

Fk, - r ,*,

(2.105)

"Cj~wt = Fit - wt.

(2.106)

Consumers solve
O<3

max ~

[3' U(ct, lt)

(2.107)

t-0

subject to
o~

oG

p,c, =
t~O

--

(2.

o8)

t-O

where pt = 1T~= i(1/&), R~.- 1 v ( l -O~.~,)(r~--6), P0 = 1, 0~. and ~2 are the residence
based tax rates on capital and labor, and initial assets are set to zero for convenience.
The consumer first-order conditions are summarized by
U#

- w t ( 1 - ~>t),

fiU~. 1
1
U~.,
Rt+~"

(2.109)
(2.110)

V.g Chari and P.J Kehoe

1716

The economy-wide budget constraint (which is simply the sum of the consumer and
government budget constraints) is given by
oo

oQ

Zqt[ct+g+kt+l--(1
t=0

6)kt] = ~-~qtF(kt,

lt),

(2.111)

t=0

where qt = l T s = 1(1/R2) and R2 = r* + 1 - 6 . Notice that the economy as a whole

borrows and lends at the before-tax rate R2, while consumers borrow and lend at the
after-tax rate R~.. Intuitively, we know that any taxes on borrowing or lending levied
on consumers are receipts of the government and cancel out in their combined budget
constraint.
Notice also that in the closed economy models studied in earlier sections, the
competitive equilibrium has consumer budget constraints, a government budget
constraint, and a resource constraint. In this small open economy, there is no resource
constraint, and it is convenient to replace the govermnent budget constraint by the
economy-wide budget constraint.
To derive the constraints for the Ramsey problem, substitute the consumer first-order
conditions into Equation (2.108) to get the implementability constraint
c'/d

~l~'[Gtc,

+ U~,l,] = o,

(2.112)

t=0

where we have used the fact that Equation (2.110) implies that pt = fit U~./Uco. Next,
notice that the first-order conditions of the firm and the consumer can be summarized
by Equations (2.105), (2.110), and
UI, _ F)a ( 1 - Tj_).

U,

(2.113)

(1 + rj~)

Thus, tbr each marginal condition, there is at least one tax rate so that the tax system
is complete and there are no additional constraints on the Ramsey problem. Thus, with
both source- and residence-based taxes available, the Ramsey problem is to maximize
Equation (2.107) subject to (2.111) and (2.112).
With purely source-based taxation, rct= Oct --- O, so from Equation (2.110) it is clea~
that for such a tax system, the Ramsey problem has the additional constraint
fiUcg+l

Ucl

R/+1"

With purely residence-based taxation, r# = 0/* = 0, so from Equation (2.105) it is clear

that the Ramsey problem has the additional constraint

Yt,, = r;.

Ch. 26:

1717

Optimal Fiscal and Monetary Policy

Consider the Ramsey problem when both source- and residence-based taxes are
available. For convenience, write the problem as
oo

max Z

[3' W(ct, lt, 3.)

l-O

subject to (2.111), where W(c,, It, 3,) condition for capital implies that

U(ct, lt) + )~ [Uact + U#lt]. The first-order

F~t = rt*,

(2.114)

while the first-order condition for consumption implies that

fiWd+l

We,

Rt+ I

(2.115)

From Equation (2.114) it is clear that setting @ = 0 for all t is optimal. Next, note
that this small economy will have a steady state only if
flR[ - 1

(2.116)

for all t. Under this parameter restriction, Equation (2.115) implies that Wet = Wc, l,
and thus the Ramsey allocations are constant, so in particular, Uct = Uct)l. Equations
(2.110) and (2.116) imply that Oct = 0 for all t.
Under a system with only source-based taxes, the Ramsey problem is to maximize
~--,t = o [3 W ( c , It, )~) subject to conditions (2.111) and (2.115). If we consider a relaxed
version of this problem with the constraint (2.115) dropped, the above analysis
makes clear that the solution to this relaxed problem satisfies this dropped constraint
and hence solves the original problem. The first-order condition for capital then
implies (2.114); hence, 0j~ = 0 tbr all t.
Similarly, under a system with only residence-based taxes, the Ramsey problem
is to maximize ~ - o fit W ( c , lt, )0 subject to conditions (2.111) and (2. 114). If we
consider a relaxed version of this problem with the constraint (2.114) dropped, the
above analysis makes clear that the solution to this relaxed problem satisfies this
dropped constraint and hence solves the original problem The first-order condition for
consumption in the relaxed problem is (2.115). Under the parameter restriction (2.116),
Wct = We, l, so Uc, = Ua+l. Hence, equations (2.110) and (2.116) imply that Oct = 0
for all t.
In sum:
Proposition 12. Under a system with both source- and residence-based taxes,
0/~ = O~.t = O.for all t. Under a system with only source-based taxes, O/t = O.fi~r all t.
Under a system with only residence-based taxes, with the additional restriction (2.116),
Oct = 0 f o r all t.

1'718

V.E Chari and t~J Kehoe

Notice that the Ramsey allocations from the problem with both source- and
residence-based taxes can be achieved with residence-based taxes alone. With the
additional restriction (2.116), the allocations from the problem with both types of
taxes can be achieved with source-based taxes alone. The intuition for why sourcebased taxes are zero is that with capital mobility, each country faces a perfectly elastic
supply of capital as a factor input and therefore optimally chooses to set capital income
taxes on firms to zero. The intuition for why residence-based taxes are zero is that
under (2.116) the small economy instantly jumps to a steady state, and so the Chamleytype logic applies for all t.
2.4.3. Ot;erlapping generations models'
The discussion thus far has focused on models with infinitely lived agents. There
is also an extensive literature on optimal policy in overlapping generations models.
[See, for example, Atkinson (197l), Diamond (1973), Pestieau (1974), and Atkinson
and Sandmo (1980); the surveys by Auerbach (1985) and Stiglitz (1987); and the
applied work of Auerbach and Kotlikoff (1987) and Escolano (1992).] The results in
this literature are much weaker than those in standard models with infinitely lived
agents. One reason is that in a life cycle model, agents have very heterogeneous
preferences over the infinite stream of consumption goods. For example, in a twoperiod overlapping generations model, an agent of generation t values consumption
goods only in periods t and t + 1.
In this subsection, we show that tax rates on capital income in a steady state are
zero if certain homotheticity and separability conditions are satisfied. This result is
well known. For an exposition using the dual approach, see, for example, Atkinson
and Stiglitz (1980). Here we follow the primal approach used by Atkeson et al. (1999)
and Garriga (1999). In this sense, the proposition we prove is more closely connected
to the results on uniform commodity taxation than to the results on zero capital taxation
in infinitely lived agent economies.
We briefly develop a formulation of optimal fiscal policy in an overlapping
generations model. Consider a two-period overlapping generations model with a
constant population normalized to 1. The resource constraint is
clt + c2t + kt+l + g = F(kt, lit, 12t) + (1 - (3) I/~

(2.117)

where clt and c2L denote the consumption of a representative young agent mad a
representative old agent in period t, IjL and 12t denote the corresponding labor inputs,
k1 denotes the capital stock in t, and g denotes government consumption. Each young
agent in t solves the problem
max U (cm lit) + fiU (c2t L~I,12i+t)
subject to
Clt + kt+| + bt+t - (1 --- Tit) W l t l l t

and
c2,+j - (1

~:2t~l) Wzt+ll2t+l "4:-[1 + (1 - Ot+l)(rt+ 1 -- 6)] kt+l + e t + l b t + l ,

Ch. 26:

Optimal Fiscal and Monetary Policy

t719

where rl: and T2/ are the tax rates on the two types o f labor inputs and O: is the tax
rate on capital income. The government budget constraint is
TltWltllt + T2tw2tl2t + Otrtk/ + bt+l = g + R t b .

To define an optimal policy, we need to assign weights to the utility of agents in

each generation. We assume that the government assigns weight )~t to generation t with
)~ < 1. Then the Ramsey problem can be written as
O(3

max U(c2o,/20)/X + ~

Xt [U(cl:, ll/)+

[~U(c2t+l, 12/+1)]

t-0

subject to the resource constraint for each t and

R(Clf,llt)+[3R(c21~-l,12,~-l) = 0

for each t,

(2.118)

where R(c, l) =-- cU:(c, l) + 1U:(c, l) and U(C20,/20) is the utility of the initial
old. There is also an implementability constraint for the initial old, which plays
no role in our steady-state analysis. Constraints (2.118) are the implementability
constraints associated with each generation. It is straightforward to show that if the
solution to the Ramsey problem converges to a steady state with constant allocations
(cl,, lit, C2t+l, 12t+l, kt~ 1) = (Cl, 11, c 2 , / 2 , k), then the Ramsey allocations satisfy

1
2

F/, + 1 - 6.

(2.119)

In a steady state, the first-order condition for capital accumulation is

Uc(cl,ll)
~g~.(c2,~)

1 +(1 - O ) ( F x - 6 ) .

(2.120)

Inspecting these equations, we see that unless

U~(c~, ll)

,~

[~Uc(c2,/2)

(2.121)

the tax rate on capital income is not zero. In general, we would not expect this condition
to hold. Notice the contrast with infinitely lived representative consumer models in
which, in a steady state, the marginal utility of the representative consumer U,(c, l:)
is constant. In an overlapping generations model, we would not expect the marginal
utility o f a consumer to be constant over the consumer's lifetime.
If the utility function is of the form
C1 o

U(c, l) = - 1 - ~ + V(1)
then we can show the following:

(2.122)

1720

EV.. Chari and P.J. Kehoe

Proposition 13. I f the utility Jimction is o f the Jbrm (2.122), then in a steady state,
the optimal tax on capital income is zero.

Proof: To prove this, consider the first-order conditions for the Ramsey problem for
consumption evaluated at a steady state:
U~.l + atR~.l - ~tt,

(2.123)

/3[Ue2 + atRc2] = ;t,~,,

(2.124)

where )~t~tt and )~tat are the multipliers on (2.117) and (2.118), respectively. We can
easily see that at and b~t are constant in a steady state. With a utility function of the
form (2.122), &. is proportional to Uc so that (2.123) and (2.124) imply (2.121). []
The key properties used in proving this result are homotheticity of the utility function
over consumption and the separability of consumption and leisure. In this sense, this
proposition is more closely connected to the results on unitbrm commodity taxation
than to the results on zero capital taxation in infinitely lived agent economies.
When )~ = fl and F ( k , 11,12) = F ( k , 11 + 12) then one can show that for all strictly
concave utility functions the optimal tax on capital income is zero in a steady state.
[See Atkeson et al. (1999).]

3. Monetary policy
In this section, we study the properties of monetary policy in three monetary
economies. Friedman (1969) argues that to be optimal, monetary policy should follow
a rule: set nominal interest rates to zero. For a deterministic version of our economy,
this would imply deflating at the rate of time preference. Phelps (1973) argues that
Friedman's rule is unlikely to be optimal in an economy with no lump-sum taxes.
Phelps' argument is that optimal taxation generally requires using all available taxes,
including the inflation tax. Thus Phelps argues that the optimal inflation rate is higher
than the Friedman rule implies. In this section, we set up a general framework that
allows us to analyze Phelps' arguments.
We analyze them in three standard monetary economies with distorting taxes: a
cash--credit model, a money-in-the-utility-function model, and a shopping-time model.
The conditions for the optimality of the Friedman rule in the first two economies
are analyzed by Chari et al. (1996), while those for the shopping-time model are
extensively analyzed in the literature. [See Kimbrough (1986), Faig (1988), Woodford
(1990), Guidotti and V6gh (1993), and Correia and Teles (1996), as well as Chariet
al. (t996).] In this section, we show that the Friedman rule is optimal when simple
homotheticity and separability conditions are satisfied. These conditions are similar to
the ones developed in the uniform taxation results in Section 1.
We explore the cmmection between tile optimality of the Friedman rule and the
intermediate-goods result. For all three monetary economies, when the homotheticity

Ch. 26." Optimal Fiscal and Monetary Policy

1721

and separability conditions hold, the optimality of the Friedman role follows from the
intermediate-goods result. To prove this, we show that under such conditions, all three
monetary economies can be reinterpreted as real intermediate-goods economies, and
the optimality o f the Friedman rule in the monetary economies follows directly from
the intermediate-goods result in the reinterpreted real economies. In contrast, when
these conditions do not hold, there is no such connection. To prove this, we show
that when these conditions do not hold, there are two possibilities. First, there are
monetary economies in which the Friedman rule holds which cannot be reinterpreted
as real intermediate-goods economies. Second, there are monetary economies which
can be reinterpreted as real intermediate-goods economies but in which the Friedman
result does not hold.
Finally, we conduct some numerical exercises designed to develop quantitative
features o f optimal monetary policy. We find that if debt has nominal non-statecontingent returns, inflation can be used to make real returns state-contingent so that
debt can serve as a shock absorber.

3.1. Three standard monetary models

3.1.1. Cash-credit
Consider a simple production economy populated by a large number of identical,
infinitely lived consumers. In each period t = 0, 1. . . . , the economy experiences one
o f finitely many events st. We denote by s t = (so . . . . . st) the history of events up to
and including period t. The probability, as o f period 0, of any particular history s t is
#(st). The initial realization so is given.
In each period t, the economy has three goods: labor and two consumption
goods, a cash good and a credit good. A constant returns to scale technology is
available to transform labor l(s t) imo output. The out-put can be used for private
consumption o f either the cash good c l(s t) or the credit good c2(s t) or for government
consumption g(s t).
The resource constraint in this economy is thus

c~ (s') + c2(s t) + g(st) = l(st).

(3.~)

The preferences of each consumer are given by

Z [~t[~(st) U(CI(St)' C2(SI)' [(SI))'

st

(3.2)

where the utility function U is strictly concave and satisfies the Inada conditions.
In period t, consumers trade money, assets, and goods in particular ways. At the start
of period t, after observing the current state st, consumers trade money and assets in a
centralized securities market. The assets are one-period, non-state-contingent nominal

v.v. Chari and RJ Kehoe

1722

claims. Let M(s t) and B(s t) denote the money and the nominal bonds held at the end
o f the securities market trading. Let R(s t) denote the gross nominal return on these
bonds payable in period t + 1 in all states S t+x = ( s t , s t l 1). Notice that the nominal
return on debt is not state-contingent. After this trading, each consumer splits into
a shopper and a worker. The shopper must use the money to purchase cash goods.
To purchase credit goods, the shopper issues nominal claims, which are settled in the
securities market in the next period. The worker is paid in cash at the end o f each
period.
This environment leads to the following constraint for the securities market:

M(s,)+ B(st)= R(s t 1)B(s,-l)+ M(s,-l) p(s t 1)cl(st 1)

_p(s t 1)c2(s,-1 ) + p ( s t u)[1 __ r(s t l)] l(s,-I),

(3.3)

where p is the price o f the consumption goods and T is the tax rate on labor income.
The real wage rate is 1 in this economy given our specification of technology. The lefthand side of Equation (3.3) is the nominal value o f assets held at the end of securities
market trading. The first term on the right-hand side is the value of nominal debt
bought in the preceding period. The next two terms are the shopper's unspent cash.
The fourth term is the payments for credit goods, and the last term is the after-tax
receipts from labor services. We will assume that the holdings of real debt B(st)/p(s t)
are bounded above and below by some arbitrarily large constants. Purchases o f cash
goods must satisfy the following cash-in-advance constraint:

p(s t) cl (s t) <~M(st).

(3.4)

We assume throughout that the cash-in-advance constraint holds with equality. We let

x(s t) = (cl(st), c2(st), l(st),M(st),B(sl)) denote an allocation for consumers at s t, and

we let x = (x(st)) denote an allocation for all s ~. We let q = (p(st),R(st)) denote a
price system for this economy. The initial stock o f money M 1 and the initial stock o f
nominal debt B-I are given.
Money is introduced into and withdrawn from the economy through open market
operations in the securities market. The constraint facing the government in this market
is

M ( s ' ) - M ( s l - I ) + B(s t) = R(s I 1)B(st-l)~ p(st-l)g(s t 1)-p(st-I) r(SL-l) l(st-1).

(3.5)
The terms on the left-hand side o f this equation are the assets sold by the government.
The first term on the right is the payments on debt incurred in the preceding period,
the second term is the payment for government consumption, and the third term is tax
receipts from labor income. Notice that government consumption is bought on credit.
We let Jr = (r(st)) denote a policy for all s t.
Given this description of an economy, we now define a competitive equilibrium.
A competitive equilibrium is a policy ~, an allocation x, and a price system q such

Ch. 26: OptimalFiscal and Monetary Policy

1723

that given the policy and the price system, the resulting allocation maximizes the
representative consumer's utility and satisfies the government's budget constraint.
In this equilibrium, the consumer maximizes Equation (3.2) subject to (3.3), (3.4),
and the bounds on debt. Money earns a gross nominal return of 1. I f bonds earn a gross
nominal return of less than 1, then the consumer can make profits by buying money
and selling bonds. Thus, in any equilibrium, R(s 0 ~> 1. The consumer's first-order
conditions imply that U~(st)/U2(s t) = R(st); thus in any equilibrium, the following
constraint must hold:

gl(s t) >~ g2(st).

(3.6)

This feature of the competitive equilibrium constrains the set of Ramsey allocations.
Consider now the policy problem faced by the government. As before, we assume
that there is an institution or a commitment technology through which the government
can bind itself to a particular sequence of policies once and for all in period 0, and
we model this technology by having the government choose a policy ~ = (r(s0)
at the beginning of time and then having consumers choose their allocations. Since
the government needs to predict how consumer allocations and prices will respond
to its policies, consumer allocations and prices are described by rules that associate
allocations with government policies. Formally, allocation rules and price functions are
sequences of functions x(jr) = (x(s t t :r)) and q(jr) = (/)(s t ] ~ ) , R ( s t [ ~)) that map
policies Jr into allocations and prices.
A Ramsey equilibrium is a policy Jr, an allocation rule x(.), and a price system q(.)
that satisfy the following: (i) the policy Jr maximizes

}-~'[Y~(s9 g(cx(st l m, c2(s' l m, l(st l jr))

I~S r

subject to (3.5), with allocations given by x(jr), and (ii) ~br every Jr', the allocation x ( ~ ' ) and the price system q(~t), together with the policy Jr', constitute a
competitive equilibrium.
As is well known, if the initial stock of nominal assets held by consumers is positive,
then welfare is maximized in the Ramsey problem by increasing the initial price level
to infinity. If the initial stock is negative, then welfare is maximized by setting the
initial price level so low that the government raises all the revenue it needs without
levying any distorting taxes. To make the problem interesting, we set the initial sum
of nominal assets of consumers M 1 + R I B 1 to zero. For convenience, let Ui(sO
for i = 1,2, 3 denote the marginal utilities at state s t. Using standard techniques [for
example, from Lucas and Stokey (1983), Chari et al. (1991), and Section 1], we can
establish the implementability constraint:
Proposition 14. The consumption and labor allocations in a competitive equilibrium
satisfy conditions (3.1), (3.6), and the implementability constraint

Z/{tg(st) [c,(s~) U~ (s~)+ c2(s~)U~(st)+/(s t)U3(st)] = O,

l

S t

(3.7)

1724

V.V. Chari and P.J. Kehoe

Furthermore, allocations that satisfy (3.1), (3, 6), and (3.7) can be decentralized as a
competitive equilibrium.
The Ramsey problem is to maximize consumer utility subject to conditions (3.1),
(3.6), and (3.7). Consider utility functions of the form
(3.8)

U(cI, c2, l) ~- V(w(c1, c2), [),

where w is homothetic. We then have

Proposition 15. For utility functions of the .]'brm (3.8), the Ramsey equilibrium has
R(s t) = 1 .for all st.
Proof: Consider for a moment the Ramsey allocation problem with constraint (3.6)
dropped. We will show that under (3.8), constraint (3.6) is satisfied. Let Z denote the
Lagrange multiplier on (3.7) and fitkt(s t) y(s t) denote the Lagrange multiplier on (3.1).
The first-order conditions for ci(s t) :for i - 1,2 in this problem are
(l +Z) Ui(s ~) +Z

cj(s t) Uji(s t) + l(s t) U3i(s t) = y(st).

(3.9)

U =

Recall from Section ] that a utility function which satisfies (3.8) also satisfies

v'2 c:(s') ~l(s') @, C:(s9 ~2(s t)

Z_.,
j=l

V 1(S t)

Z_,

j=l

(3.10)

U2(s t)

Next, dividing Equation (3.9) by Ui and noting that U3i/Ui

have that

+ ,ts r v-7~f ~

= VI2/VI

for i

=- 1 , 2 ,

we

(3.1 l)

Using Equation (3.10), we have that the left-hand side of (3.11) has the same value
for i - 1 and for i = 2. Therefore, Ul(st)/U2(s t) = 1. Since the solution to the
less-constrained problem satisfies (3.6), it is also a solution to the Ramsey allocation
problem. From the consumer's first-order condition, we have that UI (st)/U2 (s t) = R(st)
and thus that R(s t) = 1. []
Now let us relate our results to Phelps' (1973) arguments for taxing liquidity
services. Phelps (1973, p. 82) argues that "if, as is often maintained, the demand for
money is highly interest-inelastic, then liquidity is an attractive candidate for heavy
taxation at least from the standpoint of monetary and fiscal efficiency". Our results
suggest that the commction between the interest elasticity of money demand and the
desirability of taxing liquidity services is, at best, tenuous.

Ch. 26: Optimal Fiscal and Monetary Policy

1725

To see this, suppose that the utility function is of the form

clj ~

U ( c l , c2, l)

c~ ~

+~

+ V(1).

(3.12)

Then the consumer's first-order condition UE/U2 = R becomes

m o
-

(c - m) a

- R,

(3.13)

where m is real money balances and c - cl + c2. The implied interest elasticity of
money demand r/is given by
1

R 1/

r/= ~ - R ~ / - r

1"

(3.14)

Evaluating this elasticity at R = 1 gives r/ = 1/2a, and thus the elasticity of money
demand can range from zero to infinity. Nevertheless, all preferences in this class
satisfy our homotheticity and separability conditions; hence the Friedman rule is
optimal. Phelps' partial equilibrium intuition does not hold up for reasons we saw
in Section 1. As we noted there, in general equilibrium, it is not necessarily true that
inelastically demanded commodities should be taxed heavily.
The homotheticity and separability conditions are equivalent to the requirement that
the consumption elasticity of money demand is unity. To see this, consider a standard
money demand specification:
log m = a0 + ai log c + f ( R ) ,
w h e r e f ( R ) is some invertible function of the interest rate. If al - 1, so the consumption
elasticity of money demand is unity, this formulation implies that m/c = e a+jO~),
or that there is some function h such that h(m/c) = R. The consumer's first-order
condition is U1/U2 = R. Thus UI/U2 must be homogeneous of degree 0 in m and c if
the consumption elasticity of money demand is unity. This formulation immediately
implies the homotheticity and separability conditions.
Note two points about the generality of the result. First, restricting w to be
homogeneous of degree 1 does not reduce the generality of the result, since we can
write w(.) = g ( f ( . ) ) , where g is monotone and f is homogeneous of degree 1,
and simply reinterpret V accordingly. Second, the proof can be easily extended to
economies with more general prodnction technologies, including those with capital
accumulation. To see how, consider modifying the resource constraint (3.1) to
f (Cl(Sl), C2(St),g(xt), l(st), k(s'), k(sl-l)) = O,

(3.15)

where k is the capital stock a n d f is a constant returns to scale function, and modifying
the consumer's and the government's budget constraints appropriately. Let capital

1726

Vii

Chari and PJ. Kehoe

income net of depreciation be taxed at rate O(s~), and let capital be a credit good,
although the result holds if capital is a cash good. For this economy, combining the
consumer's and the firm's first-order conditions gives

U1 (s ~) _ R(s,fl(s').
Thus the optimality of the Friedman rule requires that Ul(st)/U2(s
The constraint requiring that R(s t)/> 1 now implies that

~) = ft(st)/J2(st).

g~(s')
./i(s')
u2(s,--5 >~ A(s'~'

(3.16)

and the implementability constraint (3.7) now reads

t

s,

(3.17)

= vc(s0) {[l - 0(s0)] [./i(s0) - 6)]} k

~,

where k_ 1 is the initial capital stock. Since the tax on initial capital O(so) acts like a
lump-sum tax, setting it as high as possible is optimal. To make the problem interesting,
we follow the standard procedure of fixing it exogenously. The Ramsey allocation
problem is to choose allocations to maximize utility subject to conditions (3.15),
(3.16), and (3.17). For preferences of the form (3.8), the analog of Equation (3.11)
has the right-hand side multiplied by f(s') for i = 1,2. This analog implies that
U1(st)/U2 (s t) = fl (st)/f2 (st), and thus the Friedman rule holds.
We now develop the connection between the optimality of the Friedman rule and
the uniform taxation result, in this economy, the tax on labor income implicitly taxes
consumption of the cash good and the credit good at the same rate. In Section l, we
showed that if the utility function is separable in leisure and the subutility function over
consumption goods is homothetic, then the optimal policy is to tax all consumption
goods at the same rate. If R(s t) > 1, the cash good is effectively taxed at a higher
rate than the credit good, since cash goods must be paid for immediately, but credit
goods are paid for with a one-period lag. Thus, with such preferences, efficiency
requires that R(s t) = 1 and therefore that monetary policy follow the Friedman rule.
To make this intuition precise, consider a real barter economy with the same
preferences (3.2) and resource constraint (3.1) as the monetary economy and with
commodity taxes on the two consumption goods. Consider a period-0 representation
of the budget constraints. The consumer's budget constraint is

~ q(s t) {[1 + rl(s~)] ci (s t) + [1 + T2(st)] C2(st)} ~ ~ q(s ~) l(st),

t

(3.18)

St

and the government's budget constraint is

~ q(st)g(st)= ~ Z q(s~)[ T'(st)c''(s~) + T2(st)c2(s~)] '

t

St

(3.19)

St

where q(s t) is the price of goods in period t and at state sq A Ramsey equilibrium for
this economy is defined in the obvious fashion. The Ramsey allocation problem for

Ch. 26." Optimal Fiscal and Monetary Policy

1727

this barter economy is similar to that in the monetary economy, except that the barter
economy has no constraint (3.6).
The consumer's first-order conditions imply that
Ul(s t)

1 -b Tl(S t)

U2(s9

1 + r2(sg

Thus Ramsey taxes satisfy Tt(s t) = r2(s ~) if and only if in the Ramsey allocation
problem of maximizing Equation (3.2) subject to (3.1) and (3.7), the solution has
Ui(sZ)/Uz(s t) = 1. Recall from Proposition 3 in Section 1 that for utility functions
of the form (3.8), the Ramsey equilibrium has ~q(s t) = r2(s t) for all s t.
Thus, with homotheticity and separability in the period utility function, the optimal
taxes on the two consumption goods are equal at each state. Notice that this proposition
does not imply that commodity taxes are equal across states. [That is, Ti(s t) may not
equal Tj(sr) for t ~ r and for i,j = 1,2.]
We have shown that if the conditions for uniform commodity taxation are satisfied
in the barter economy, then in the associated monetary economy, the Friedman rule
is optimal. Of course, since the allocations in the monetary economy must satisfy
condition (3.6) while those in the barter economy need not, there are situations in which
uniform commodity taxation is not optimal in the barter economy but in which the
Friedman rule is optimal in the monetary economy. To see this, consider the following.
Example. Let preferences have the form
1 oi

1 o2

U(Cl, c2, l) - icl~ al + ~_-U~

c2
+ V(l).

(3.20)

The first-order conditions for the Ramsey problem in the barter economy imply that

Ul(s t)
U2(s t)

cl(s t) a~
-

c2(st)-~

1 +).(1
-

a2)

1 + )~(1 - 01)"

(3.21)

Clearly, Ul(s t) >~ U2(s ~) if and only if CVl ~ o 2. For cases in which al = 02,
these preferences satisfy condition (3.6), and both uniform commodity taxation and
the Friedman rule are optimal. If as > a2, then neither uniform commodity taxation
nor the Friedman rule is optimal. What is optimal is to tax good 1 at a higher rate
than good 2. In the barter economy, this higher taxation is accomplished by setting
rl (s t) > r2 (s t), while in the monetary economy, it is accomplished by setting R(st) > 1.
More interestingly, when a~ < a2, uniform commodity taxation is not optimal, but the
Friedman rule is. To see this, note that when a~ < {72, the solution in the monetary
economy that ignores the constraint Ul(s t) >~ U2(s t) violates this constraint. Thus this
constraint must bind at the optimum, and in the monetary economy, U1 (s t) = Ue(st).
Thus, in the barter economy, taxing good 1 at a lower rate than good 2 is optimal,
and this is accomplished by setting rl (st) < r2(s~). In the monetary economy, taxing

v.v. Chari and P..L Kehoe

1728

good 1 at a lower rate than good 2 is not feasible, since R(s t) ~> 1, and the best feasible
solution is to set R(s t) = 1.
in this subsection, we have focused on the Lucas and Stokey (1983) cash-credit
version of the cash-in-advance model. It turns out that in the simpler cash-in-advance
model without credit goods, the inflation rate and the labor tax rate are indeterminate.
The first-order conditions for a deterministic version of that model are the cash-in=
advance constraint, the budget constraint, and

Ult _ Rt
U2i
1 - Tt'

1 Ult _ R~p:
[3 U2t Pt+l

where the period utility function is U(ct, lt) and Rt is the nominal interest rate from
period t to period t + 1. Here, only the products R / ( 1 - vt) and Rtp/pt+~ are pinned
down by the allocations. Thus the nominal interest rate, the tax rate, and the inflation
rate are not separately determined. The Ramsey allocation can be decentralized in a
variety of ways. In particular, trivially, both the Friedman rule and arbitrarily high rates
of inflation are optimal.

3.1.2. Money-in-the-utility-fimction
In this section, we prove that the Friedman rule is optimal for a money-in-the-ntilityfunction economy under homotheticity and separability conditions similar to those
above.
Consider the tbllowing monetary economy. In this economy, labor is transformed
into consumption goods according to
c(s ) + g(s t) = l(st).

(3.22)

(We use the same notation here as in the last subsection.) The pretbrences of the
representative consumer are given by

Z ~_~ffl~(st) U(M(st)/P(St)' c(st)' l(st))'

t

(3.23)

S t

where the utility function has the usual monotonicity and concavity properties and
satisfies the Inada conditions. In period t, the consumer's budget constraint is

p(s t) c(s,)+ M ( s t ) + B(s ~) = M(st-l) + R(s t a) B(s ~ 1) +p(s~)[ 1 _ T(st)] l(st).

(3.24)
The holdings of real debt B(s~)/p(s ~) are bounded below by some arbitrarily large
constant, and the holdings of money are bounded below by zero. Let M l and

Ch. 26: OptimalFiscal and Monetary Policy

1729

R_IB 1 denote the initial asset holdings of the consumer. The budget constraint of
the government is given by
B(s t) = R(s t 1)B(st 1)+p(st)g(st ) _ [M(s t) _ M ( s t

1)] _p(st)[1

_ r(st)ll(sZ).
(3.25)
A Ramsey equilibrium for this economy is defined in the obvious fashion. We set
the initial stock of assets to zero for reasons similar to those given in the preceding
section. Let m(s t) = M(st)/p(s t) denote the real balances in the Ramsey equilibrium.
Using logic similar to that in Proposition 14, we can show that the consumption and
labor allocations and the real money balances in the Ramsey equilibrium solve the
Ramsey allocation problem
max

Z Z
f

(3.26)

ff t~(s~) U (m(s~)' c(st)' l(s~) )

S t

subject to the resource constraint (3.22) and the implementability constraint

~ [Y [m(s~) U~(s') + c(s') U2(s~)+ l(s ~) U3(s ~)]

- o.

(3.27)

These two constraints, (3.22) and (3.27), completely characterize the set of competitive
equilibrium allocations.
We are interested in finding conditions under which the Friedman rule is optimal.
Now the consumer's first-order conditions imply that
Ut(s')

U2(s9

_ 1

R(st)

(3.28)

Thus, for the Friedman rule to hold, namely, for R(s f) = 1, it must be true that
Ui (s t) _ O.

U2(s t)

(3.29)

Since the marginal utility of consumption goods is finite, condition (3.29) will hold
only if Ul(s t) = 0, that is, if the marginal utility of real money balances is zero.
Intuitively, we can say that under the Friedman rule, satiating the economy with real
money balances is optimal.
We are interested in economies for which preferences are not satiated with any finite
level of money balances and for which the marginal utility of real money balances
converges to zero as the level of real money balances converges to infinity. That is,
for each c and l, l i m m ~ Ul(m,c,l) = 0 and l i m m ~ U2(m,c,l) > 0. Intuitively,
in such economies, the Friedman rule holds exactly only if the value of real money
balances is infinite, and for such economies, the Ramsey allocation problem has no
solution. To get around this technicality, we consider an economy in which the level
of real money balances is exogenously bounded by a constant. We will say that the

V.V.Chari and P..J Kehoe

1730

Friedman rule is optimal if, as this bound on real money balances increases, the
associated nominal interest rates in the Ramsey equilibrium converge to one.
With this in mind, we modify the Ramsey allocation problem to include the
constraint

m(s t) <~ Fn,

(3.30)

where ffz is a finite bound. Consider preferences of the form

U(m, c, l) = V(w(m, c), l),

(3.31)

where w is homothetic. We then have

Proposition 16. l f the utility Jimction is' of the form (3.31), then the Friedman rule is"

optimal.
Proof: The Ramsey allocation problem is to maximize Equation (3.23) subject to
(3.22), (3.27), and (3.30). Consider a less-constrained version of this problem in which
constraint (3.30) is dropped. Let/3t/~(st)y(s t) and 3, denote the Lagrange multipliers
on constraints (3.22) and (3.27). The first-order conditions for real money balances
and consumption are

(l+Z) Ul(St)+~[m(st)Ull(St)+c(st)U21(st)+l(st)U31(xt)]

=0

(3.32)

and
(1 + )~) U2(s l) +,I, [m(s ~) U12(s t ) + c(s t) U22(s t) + l(s t) U32(st)] = ]/(st).

(3.33)

Since the utility function satisfies condition (3.31), it follows (as in Section 1) that

m(s~) gll(s~) + c(s~) g21(s ~) m(s~) Ui2 + c(s~) U22(s ')

=
gl (s ~)
g2(s ~)

(3.34)

Using the form of Equation (3.31), we can rewrite conditions (3.32) and (3.33) as

(1 + ~) +.,~

[m(s t) Ull(S l) + c(s') U21(st)

Ul (s')

+ l(~t) V21(st) ] = 0

(3.35)

"~ " Vl(s') I

and
(1 -I- ~) -l-,~ [ re(St) Ul2(St)u2(st)
+ C(St) U22(st)

. ~. v:l(s')] _ y(s ~)

+ ,ts ~

cl2(s~)

(3.36)

From Equation (3.34), we know that

]/(s~)
g2(sO

(3.37)

m the less-constrained problem. Hence the associated m(s t) is arbitrarily large, and
thus for any finite bound N, the constraint (3.30) binds in the original problem. The
result then follows from (3.28). []

Ch. 26." Optimal Fiscal and Monetary Policy

1731

Again, restricting w to be homogeneous does not reduce the generality of the result.
Clearly, the Friedman rule is optimal for some preferences which do not satisfy
condition (3.31). Consider
m [ ~l

U(m,c,l)- 1-al

c I o~
+

+ V(I).

(3.38)

Note that for cases in which (Yl ~ 02, Equation (3.38) does not satisfy condition (3.31).
The first-order condition for the Ramsey problem for money balances m ( s t ) , when the
upper bound on money balances is ignored, is
[1 +)~(1

O~)]m ( s l ) -~ - O.

(3.39)

Unless the endogenous Lagrange multiplier ,~ just happens to equal (oi - 1) 1,

Equation (3.38) implies that the Friedman rule is optimal.
In related work, Woodford (1990) considers the optimality of the Friedman rule
within the restricted class of competitive equilibria with constant allocations and
policies. Woodford shows that if consumption and real balances are gross substitutes,
then the Friedman rule is not optimal. Of course, there are functions that satisfy our
homotheticity and separability assumptions which are gross substitutes, for example,
m I (y

g ( m , c, l) = ~

c 1 (r

+~

+ v(1).

The reason for the difference in the results arises from the difference in the
implementability constraints. Woodford's problem is
max U ( m , c, l)

(3.40)

subject to
c+g

<~ l,

U t m + U2c + U3l - (1 - [ 3 ) U l ,

(3.41)
(3.42)

where (3.42) is the implementability constraint associated with a competitive equilibrium with constant allocations. The first-order conditions for our problem are similar to
those fbr Woodford's problem, except that his include derivatives of the right-hand side
of condition (3.42). Notice that in Woodford's problem, iffi = 1 and preferences satisfy
our homotheticity and separability conditions, then the Friedman rule is optimal.
Notice, too, that if the model had state variables, such as capital, then constant
policies would not typically imply constant allocations. To analyze the optimal constant
monetary policy for such an economy, we would analyze a problem similar to that in
Equation (3.26) with extra constraints on allocations that capture these restrictions.
[These restrictions would be similar in spirit to those in (2.47).]

v.v Chari and P..J.Kehoe

1732

3.1.3. Shopping-time
In this subsection, we prove the optimality o f the Friedman rule in a shopping-time
monetary economy under appropriate homotheticity and separability conditions.
Consider a monetary economy along the lines of Kimbrough (1986). Labor is
transformed into consumption goods according to

c(st)+ g(s t) <~l(st).

(3.43)

The preferences of the representative consumer are given by

~ [3~l~(s~) U (c(s~), l(s t) + O(c(st), M(st)/p(st))),

t

(3.44)

St

where U is concave, U1 > 0, U2 < 0, 01 > 0, and q~2 < 0. The function ~(Cl, M/p)
describes the amount o f time needed to obtain c units of the consumption good when
the consumer has M/p units of real money balances. We assume that q~l > 0 so that with
the same amount of money, more time is needed to obtain more consumption goods.
We also assume that q~2 < 0 so that with more money, less time is needed to obtain
the same amount of consumption goods. The budget constraints of the consumer and
the government are the same as (3.24) and (3.25).
The Ramsey equilibrium is defined in the obvious fashion. Let m(s t) -M(st)/p(s t)
and set the initial nominal assets to zero; we can then show that the consumption and
labor allocations and the real money balances in the Ramsey equilibrium solve the
problem
max Z

Z / 3 ~ #(s~)
St

U( c(st)' l(st) + O(c(s~)' m(st) ))

subject to condition (3.43) and

Z
t

~ [~t~(St) {c(st)
st

I ~71(st) + 01(st)

g2(st)]

-t-

[(S t) g2(s t)

-~

m(st)O2(s t) U2(s')} - 0.
(3.45)

From the consumer's first-order conditions, we know that

02 = 0. We then have
Proposition 17.

R(s s) - 1 if and only if

[[ ~ is homogeneous of degree k and k >~ 1, then the Friedman rule

is optimal.
Proof: The first-order conditions for the Ramsey problem with respect to
l(s ~) are given by

m(s t) and

U202+,~[cU1202+U2202(Olc+~2m+l)+U202+u2(O12c+O22m)]=O

(3.46)

U2 + [cUI2

(3.47)

and
+

U22(~1C -I- ~2m + I) + U2] + 7 - 0,

where 7 is the multiplier on the resource constraint and we have dropped reference to s t

Ch. 26." Optimal Fiscal and Monetary Policy

1733

Suppose first that 02 ;e 0 SO that the optimal policy does not follow the Friedman
rule. Then, from Equations (3.46) and (3.47), we have that
~U2(012c Jr 022 m)

02

+ y = O.

(3.48)

Now, under the condition that 0(c, m) is homogeneous of degree k and k >~ 1, we
have that 02(ac, ]tm) = ak-102(C , m). Differentiating with respect to a and evaluating at
a = 1, we have that c012 + m022 = (k - 1)02, and thus
CO12 q- toO22

02

~> 0.

(3.49)

Since 3. ~> 0, U2 < 0, and y > 0, conditions (3.48) and (3.49) contradict each other. []
Note that this proof does not go through if q~(c, m) is homogeneous of degree less
than 1. Using the dual approach, however, Correia and Teles (1996) prove that the
Friedman rule is optimal for this shopping-time economy when 0(c, m) is homogeneous
of any degree.
3.2. From monetary to real

In this subsection, we examine the relationship between the optimality of the Friedman
rule and the intermediate-goods result developed in Section 1. The relationship is the
following. First, if the homotheticity and separability conditions hold, then in the three
monetary models we have studied, the optimality of the Friedman rule follows from
the intermediate-goods result. Second, if these conditions do not hold, then in all three
economies, the optimality of the Friedman rule and the intermediate-goods result are
not connected.
To establish these results, we proceed as follows. We begin by setting up the
notation for a simple real intermediate-goods economy and review the intermediategoods result for that economy. We then show that when our homotheticity and
separability conditions hold, the cash-credit goods and the money-in-the-utilityfunction economies can be reinterpreted as real economies with intermediate goods.
For these two monetary economies, we establish that the optimality of the Friedman
rule in the monetary economy follows from the intermediate-goods result in the
reinterpreted real economy. It is easy to establish a similar result for the shoppingtime economy. This proves the first result.
Next, we consider monetary economies which do not satisfy our conditions. We
establish our second result with a couple of examples. We start with an example
in which the monetary economy can be reinterpreted as a real intermediate-goods
economy but in which the Friedman rule does not hold in the monetary economy.
We then give an example of a monetary economy in which the Friedman rule does
hold, but this economy cannot be reinterpreted as a real intermediate-goods economy.

t734

EV. Chari and P.J. Kehoe

The cash-credit economy can be reinterpreted as a real production economy with

intermediate goods. Under our homotheticity and separability assumptions, the period
utility is U(w(cl~, c2t), 4) and the resource constraint is
cll + c2l +gt = 4.

(3.50)

Since the gross nominal interest rate cannot be less than unity, the allocations in the
monetary economy must satisfy

wl(cl,, c2~) >>.w2(c1~, c2~).

(3.51)

The reinterpreted economy is an infinite sequence of real static economies. In each

period, the economy has two intermediate goods zlt and z2t, a final private consumption
good xt, labor 4, and government consumption gt. The intermediate goods zlt and z2t in
the real economy correspond to the final consumption goods c~t and c2t in the monetary
economy. The period utility function is U(xt, 4). The technology set for producing the
final good xt is given by
f l ( x , , z l , , z z t , 4) = x , - - w ( z l , , z 2 , ) <<.O,
f2(xt,zlt,Z2t,4)

= w2(zlt,Z2t)-Wl(Zlt,z2t)

~ O,

(3.52)
(3.53)

while the technology for producing the intermediate goods and government consumption is given by
h(zlt, z2t, gt, 4) = zl~ + z2t + gt - It <<.O.

(3.54)

The real econon'ly and the monetary economy are obviously equivalent. The intermediate-goods result for the real economy is that the Ramsey allocations satisfy
production efficiency. For this economy, because the marginal rate of transformation
between zl and z2 is 1 in the intermediate-goods technology, production efficiency
requires that
WI
W2

1.

(3.55)

Recall that in the monetary economy, the Friedman rule is optimal when Equation (3.55) holds. Thus the intermediate-goods result in the real economy implies the
optimality of the Friedman rule in the monetary economy.
Does this implication hold more generally? Whenever the monetary economy can
be reinterpreted as an intermediate-goods economy, is the Friedman rule optimal in
the monetary economy? No. Suppose that the utility function U(cl, c2, l) is of the
separable form V(w(cl, c2), 1), but that it does not have a representation in which
w exhibits constant returns to scale. Suppose that w instead exhibits decreasing returns.
For example, suppose that w(cl, c2) = (Cl + k)~c 21-~, where k is a constant. In the

Ch. 26:

Optimal Fiscal and Monetary Policy

1735

intermediate-goods reinterpretation, the constant k can be thought of as a scarce factor

inelastically supplied by the consumer. The intermediate-goods result holds, provided
that the returns to the scarce factor are fully taxed away. I f the returns to the scarce
factor cannot be taxed, then the intermediate-goods result does not hold. It is easy to
show that the Friedman rule is not optimal in the monetary economy. In a sense, the
Friedman rule is not optimal because in the monetary economy, there is no sensible
interpretation under which the parameter k can be taxed.
Next, one might ask, Is it true that whenever the Friedman rule is optimal in the
monetary economy, there exists an analogous intermediate-goods economy? Again, no.
Consider, for example, Ramsey allocation problems in which the constraint U1 >~ U2
binds, but in which the utility function is not separable in consumption and leisure.
The Friedman rule is optimal, but the monetary economy cannot be reinterpreted as
an intermediate-goods economy.
In this subsection, we have shown that under our homotheticity and separability
assumptions, the optimality of the Friedman rule follows from the optimality of
uniform commodity taxation. We have also shown that the optimality of the Friedman
rule follows from the intermediate-goods result. These findings are not inconsistent
because the uniform taxation result actually follows from the intermediate-goods result.
(See Section 1.)
The construction of the intermediate-goods economy for the money-in-the-utilityfunction economy is straightforward. Recall that in the monetary economy, under our
homotheticity and separability conditions, the period utility function is U ( w ( m t , ct), lt)
and the resource constraint is ct + gt = l~. The reinterpreted economy is again an infinite
sequence of real static economies. In each period, the economy has two intermediate
goods zl~ and z2t, a final private consumption good xt, labor lt, and government
consumption gt. The intermediate goods zit and z2t correspond to money mt and the
consumption good ct in the monetary economy, respectively. The technology set for
producing the final good xt is given by
f ( x t , Z l t , Z 2 t , lt) = Xt - W(Zlt,Z2t) <~ O.

The technology set for producing intermediate goods and consumption is given by
k ( x t , z l t , z 2 t , lt) - z2t + g t -It <~ O.

The real and monetary economies are obviously equivalem. Production efficiency in the
intermediate-goods economy requires that the marginal rates of transformation between
zl and z2 in the two technologies be equated. Since the marginal rate of transformation
between zl and z2 in the intermediate-goods technology is z e r o (h2/h3 = 0), we have
wl/w2 = 0. Thus production efficiency in the intermediate-goods economy implies
optimality of the Friedman rule in the monetary economy.

1736

EV. Chari and P..~ Kehoe

3.3. Cyclical properties

We turn now to some quantitative exercises which examine the cyclical properties of
optimal monetary policy in our cash-credit goods model. For some related work, see
Cooley and Hansen (1989, 1992).
In these exercises, we consider preferences of the form
U(c,

l)

= {[C 1 Y ( L - l)Y] qJ -

1}/%

where L is the endowment of labor and

c = [(1 - or) c'[ + ac#] i/v.

The technology shock z and government consumption both follow the same symmetric
two-state Markov chains as in the model in Section 2.
In the baseline model, for preferences, we set the discount factor/3 = 0.97; we
set ~p = 0, which implies logarithmic preferences between the composite consumption
good and leisure; and we set 7 = 0.80. These values are the same as those in Christiano
and Eichenbaum (1992). The parameters cr and v are not available in the literature,
so we estimate them using the consumer's first-order conditions. These conditions
imply that Ult/U2t = Rt. For our specification of preferences, this condition can be
manipulated to be

( (7 ]u(E-V)RI/O
k T2~ )
'

C2t

cl,

v)

(3.56)

With a binding cash-in-advance constraint, ci is real money balances and c2 is

aggregate consumption less real money balances. We measure all the variables with
US data: real money balances by the monetary base, Rt by the return on threemonth Treasury bills, and consumption by consumption expenditures. Taking logs in
Equation (3.56) and running a regression using quarterly data for the period 1959-1989
gives a = 0.57 and v = 0.83.
Our regression turns out to be similar to those used in the money demand literature.
To see this, note that Equation (3.56) implies that
Clt
Clt + C2t

- [1 + (

kT-

,~1/(1 V)R,/(1_v) ] 1

'

(3.57)

Taking logs in Equation (3.57) and then taking a Taylor's expansion yields a money
demand equation with consumption in the place of output and with the restriction that
the coefficient on consumption is 1. Our estimates imply that the interest elasticity
of money demand is 4.94. This estimate is somewhat smaller than estimates obtained
when money balances are measured by MI instead of the base.

Ch. 26.

Optimal Fiscal and Monetary Policy

1737

Table 3
Properties of the cash-credit goods monetary models
Rates

Percentage in models
Baseline

High risk aversion

I.I.D.

Labor income tax

Mean

20.05

20.18

20.05

Standard deviation

0.11

0.06

0.11

Autocorrelation

0.89

0.89

0.00

Correlation with shocks

Government consumption
Technology
Output

0.93

-0.93

0.93

-0.36

0.35

-0.36

0.03

-0.06

0.02

Inflation

Mean

-0.44

4.78

-2.39

Standard deviation

19.93

60.37

9.83

0.02

0.06

-0.41

0.37

0.26

0.43

Technology

-0.21

-0.21

-0.70

Output

-0.05

-0.08

-0.48

-2.78

Autocorrelation
Correlation with shocks
Government consumption

Money growth

Mean

-0.70

4.03

Standard deviation

18.00

54.43

3.74

0.04

0.07

0.00

Autocorrelation
Correlation with shocks
Government consumption
Technology
Output

0.40

0.28

0.92

-0.17

-0.20

0.36

0.00

-0.07

0.02

We set the initial real claims on the government so that, in the resulting stationary
equilibrium, the ratio of debt to output is 44 percent. This is approximately the ratio
of US federal government debt to GNP in 1989.
For the second parametrization, we set ~[~ = - 8 , which implies a relatively high
degree o f risk aversion. For the third, we set ~p = 0 and make both technology shocks
and government consumption i.i.d.
In Table 3, we report the properties of the labor tax rate, the inflation rate, and the
money growth rate for these three parametrizations of our cash-credit goods model. In

v.g Chari and l~J Kehoe

1738

all three, the labor tax rate inherits the persistence properties of the underlying shocks
(as it did in Subsection 2.3.1).
Consider the inflation rate and the money growth rate. Recall that for these cashcredit goods monetary models, the nominal interest rate is identically zero. Table 3
shows that the average inflation rate and the money growth rate are roughly zero.
This result may, at first glance, be puzzling to readers familiar with the implications
of the Friedman rule in deterministic economies. If government consumption and the
technology shock were constant, then the price level and the money stock would fall
at the rate of time preference, which is 3 percent per year. In a stochastic economy, the
inflation rate and the money growth rate vary with consumption. Therefore, the mean
inflation rate depends not only on the rate of time preference, but also on the covariance
of the inflation rate and the intertemporal marginal rate of substitution. Specifically,
the consumer's first-order conditions imply that

] =/3Et[UI(StM)/U 1(st)] R(sg)p(St)/p(sl+l),

(3.58)

where Et is the expectation conditional on s t.

Under the Friedman rule, R(s t) = 1. Using the familiar relationship that the
expectation of a product of two random variables is the sum of the product of the
expectations of these variables and their covariance in Equation (3.58) and rearranging,
we obtain

Et [p(sf)/p(st~l)] = 1//3

covt(p(st)/p(s t*l), Ui (st+l)/Uj (st))

Et [ U1 (s t+~)/U~ (s 9]

(3.59)

In a stationary deterministic economy, Equation (3.59) reduces to Pt/Pt+l = 1//3 so that

following the Friedman rule is equivalent to deflating at the rate of time preference. In
our stochastic economy, periods of higher-than-average consumption (and hence lowerthan-average marginal utility) are also periods of lower-than-average inflation (and
hence higher-than-average p(s t)/p(st+l)). Thus the covariance term in Equation (3.59)
is negative. Taking unconditional expectations on both sides of Equation (3.59), we
have that following the Friedman rule implies that E[p(st)/p(s t+l)] > 1//3.
For all three parametrizations, the autocorrelation of the inflation rate is small or
negative. Thus, in each, the inflation rate is far from a random walk. The correlations
of inflation with government consumption and with the technology shock have the
expected signs. Notice that these correlations have opposite signs, and in the baseline
and high risk aversion models, this leads to inflation having essentially no correlation
with output. The most striking feature of the inflation rates is their volatility. In the
baseline model, for example, if the inflation rate were normally distributed, it would
be higher than 20 percent or lower than - 2 0 percent approximately a third of the time.
The inflation rates for the high risk aversion model are even more volatile. The money
growth rate has essentially the same properties as the inflation rate. The inflation rates
in these economies serve to make the real return on debt state-contingent. In this sense,

Ch. 26:

1739

Optimal Fiscal and Monetary Policy

A: Government Consumption Shock

0,75.

B: Technology Shock

Labortax rate

0.75

0.5.

0,5

o
o
0.

0.25

0
Inflation rate

-025 .

-0.25

-0.5
0

0.2

0.4

0.5

0.8

Autocorrelation of government consumption shock

0.2

0,4

0.6

08

Autocorrelation of technology shock

Fig. I. Persistence plots of inflation rates and labor tax rates versus shocks to government consumption
and technology: (a) govermnent consumption shock; (b) technology shock.

debt, together with appropriately chosen monetary policy, acts as a shock absorber.
The inflation rates are volatile in these economies because we have not allowed for
any other shock absorbers.
The results for the high risk aversion model are basically similar to those for the
baseline model, with two exceptions. First, the correlation o f the labor tax rate with
the shocks has opposite signs from the baseline model. Changing the risk aversion
changes the response o f the marginal rate of substitution o f consumption and leisure
to the shocks. This change in the response alters the sign o f the correlation. Second,
and more significantly, the inflation rate in the high risk aversion model is substantially
more variable and has a higher mean than the inflation rate in the baseline model. The
reason for the difference is that the higher variability in the inflation rate increases the
covariance term in Equation (3.59) and thus increases the average inflation rate.
The results for the i.i.d, model are similar to those for the baseline model, with
two exceptions. In the i.i.d, model, the autocorrelation o f the labor tax rate and
the autocorrelation o f the inflation rate are quite different from their values in the
baseline model. The labor tax rate has basically the same persistence properties as the
underlying shocks - and so does the price level. A standard result is that if a random
variable is i.i.d., its first difference has an autocorrelation o f - 0 . 5 . The inflation rate
is approximately the first difference o f the log o f the price level. Thus, in our i.i.d.
model, the autocorrelation of the inflation rate is close to -0.5.
We investigated the autocorrelation properties o f the labor tax rate and the inflation
rate as we varied the autocorrelation (or persistence) o f the underlying shocks. We
found that the autocorrelation of both the labor tax rate and the inflation rate increased
as we increased the persistence of the underlying shocks. Specifically, we set one shock
at its mean value and varied the persistence of the other shock. In Figure 1A, we
plot the autocorrelations o f the labor tax rate and the inflation rate as functions of the
autocorrelation of government consumption. In Figure 1B, we plot the autocorrelations

V.V. Chari and P.J. Kehoe

1740
A: S h o c k to G o v e r n m e n t C o n s u m p t i o n
12

E~

oco
o ~
7>-

/
0

15

1'0

20

period

B: Labor Tax Rate

8
20

19.
5

10

15

period

C: inflation Rate
60--40o~
200-20 ~rO
10

period

15

F~ig. 2. Responses to government consumption

shock: (a) the shock to governmentconsumption;
(b) labor tax rate; (c) inflation rate.

o f these rates as functions of the autocorrelation o f the technology shock. In both o f

these figures, the autocorrelations o f the rates increase as the autocorrelations o f the
shocks increase.
The inflation rate and money growth rate are close to i.i.d. These rates are positively
correlated with government consumption and negatively correlated with the technology
shock. As with the labor tax rate, these shocks have opposing effects on inflation and
similar effects on output, implying that the correlation of inflation and money growth
with output is roughly zero.
To gain some intuition for the labor tax rates and the inflation rates, we simulated
a version o f the baseline model in which technology shocks were set equal to their
mean levels so that the only source of uncertainty is government consumption. In
Figure 2, we report a 20-period segment o f our realizations. In Figure 2A, we see
the shock to government consumption: this variable is constant at a low level from

Ch. 26." Optimal Fiscal and Monetary Policy

1741

period 0 to period 5, is then high from period 6 to period 12, and returns to its low
level from period 13 to period 20. In Figure 2B, we plot the optimal labor tax rates.
These tax rates follow the same pattern: they are constant between periods 0 and 5,
when government consumption is low; are slightly higher between periods 6 and 12,
when government consumption is higher; and return to their low level between periods
13 and 20, when government consumption returns to its low level. The striking feature
is that labor tax rates hardly fluctuate in response to the shocks. In Figure 2C, we plot
the optimal inflation rate. There is a large inflation rate from period 5 to period 6,
when government consumption rises to its higher level, and a large deflation rate from
period 12 to period 13, when government consumption falls. In periods without a
change in government consumption, the inflation rate is roughly zero.
To gain an appreciation of the magnitude of the shock absorber role of inflation,
it is useful to trace through the effects of shocks on govenmlent debt, revenues, and
expenditures. Using the analog of Proposition 7 for this economy, we can show that
the allocations c(st), l(st), real money balances re(st), and real debt B(st)/p(s t) depend
only on the current state st, while the change in the price level p(s~)/p(s ~ 1) depends
on st 1 and st. We write these functions as c(st), l(st), m(st), b(st), and ~(st-1, st).
Consider now the government's budget constraint under the assumption that the
economy in period t - 1 is at the mean level of government consumption and the mean
level of the technology shock. Denote this state by ~. Consider two scenarios. Suppose
first that the economy in period t stays at ~. We can rearrange the government's budget
constraint to obtain

b(S)-

, ~,~

[g(~)- r(~)z(S)l(~)]-

m(S)

(3.60)

Suppose next that the economy in period t switches to state s', where g is higher and
the technology shock is at its average level. The government budget constraint can
then be written as

b(s') -

R(s)
b
~(~,s')

+~

[ g ( s ) - T(~)z(~)/(~)]- m(s')

0r(S,s')J '

(3.61)

In both (3.60) and (3.61), the term on the left is the new debt. The first term on the right
is the inberited debt obligations net of the inflation tax. The second term on the right
is the inflation-adjusted government deficit from period t 1. The inflation adjustment
reflects that both government consumption and tax revenues are credit goods that are
paid for with a one-period lag. The last term on the right is the seigniorage. Subtracting
Equation (3.60) from (3.61) gives the accounting identity
A New debt -= A Value of old debt + A Tanzi effect- A Seigniorage,
(-23)

(19)

(+1)

(3.62)

(+5)

where the Tanzi effect is the difference in the inflation-adjusted deficit. [See Tanzi
(1977).] (The numbers in parentheses are discussed below.)

1742

v.v Chari and t~J Kehoe

We can use our simulation to calculate the terms in Equation (3.62). We normalize
the economy so that mean output is 100 units of the consumption good. We consider
an innovation in government consumption of 1 unit of this consumption good. This
innovation leads to an increase in the present value of government consumption of
28 units of the consumption good. The numbers in parentheses below the terms in
Equation (3.62) are the changes in the relevant terms in units of the consumption good.
The value of the old debt falls by 19 units because the sharp rise in inflation acts as a
tax on inherited nominal debt. In our economy, the government debt is positive when
the shocks are at their mean values. The government runs a surplus to pay the interest
on the debt. A rise in the inflation rate erodes the value of the nominal surplus, leading
to a Tanzi effect of 1 unit. The large inflation rate is, of course, due to a sharp rise
in the money growth rate. The government collects 5 units of additional seigniorage
by printing this money. Thus the new debt falls by 23 units. Since the present value
of govenmaent consumption rises by 28 units, the present value of labor tax revenues
needs to rise by only 5 units. This result implies that labor tax rates need to change
by only a small amount.
In this economy, the volatile inflation rate acts as a shock absorber, allowing the
labor tax rate to be smooth. In essence, the government pays for 82 percent (23/28)
of the increase in the present value of government spending by increasing the price
level sharply, which taxes inherited nominal claims, and for only 18 percent (5/28) by
increasing the present value of labor taxes.
Note that our autocorrelation results are quite different from those of Mankiw
(1987). Using a partial equilibrium model, he argues that optimal policy implies
that both labor taxes and inflation should follow a random walk. It might be
worth investigating whether there are any general equilibrium settings that rationalize
Manldw's argument.
In the models considered in this subsection, nominal asset markets are incomplete
because returns on nominal debt are not state-contingent. The government, however,
can insure itself against adverse shocks by varying the ex post inflation rate
appropriately. These variations impose no welfare costs because private agents care
only about the expected inflation rate and not about the ex post inflation rate. A useful
extension might be to consider models in which ex post inflation imposes welfare costs.
An open question is whether optimal inflation rates will be roughly a random walk if
the welfare costs are high enough.

4. Conclusion

In this chapter we have analyzed how the primal approach can be used to answer
a fundamental question in macroeconomics: How should fiscal and monetary policy
be set over the long run and over the business cycle? We use this approach to draw
a number of substantive lessons for policymaking. Obviously, these lessons depend
on the details of the specific models considered. By and large we have considered

Ch. 26:

OptimalFiscal and Monetary Policy

1743

environments without imperfections in private markets, such as externalities and

missing markets. In m o d e l s with such imperfections, optimal p o l i c y not only m u s t be
responsive to the efficiency considerations we have emphasized, but also must attempt
to cure the private m a r k e t imperfections.

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AUTHOR INDEX

Alrmlan, H.M. 368, 535

Anderson, E. 564
Anderson, E.W. 368, 369
Ando, A., s e e Modigliani, F 762
Andolfatto, D. 994, 1158, 1173, 1203, 1207,
1221
Andres, J., s e e Blanchard, O.,I. 1214
Araujo, A. 323
Arellano, M. 787
Arifovic, J. 455,465, 472, 521-523, 525-52'7,
531
An'ow, K. 664, 1033, 1042
Arrow, K.J. 1218
Arthur, W.B. 454, 476, 534
Ascari, G. 1041
Aschauer, D.A. I656, I657
Asea, R, s e e Mendoza, E. 1439
Ashenfelter, O. 618, 11038, 1039
Askildsen, J.E. 1074
Atkeson, A. 575, 610, 786, 847, 1298, 1675,
1718, 1720
Atkinson, A.B. 1673, 1676, 1680, 1682, 1718
Attanasio, O.P 564, 607, 608, 610-613, 752,
753, 756, 759, 769, 777, 779, 781,783, 784,
787, 789 794, 796, 797, 802, t264, 1655
Auerbach, A.J. 380, 549, 576, 588, 590, 591,
593, 616, 82I, I624, 1634, t635, 1639,
1652, 1718
Auerbach, A.J., s e e Feldstein, M.S. 904, 906
Auernheimer, L. 1449
Auster, R. 474
Autor, D. 57'7
Axilrod, S.H. t493
Azariadis, C. 262, 264, 271, 289, 389, 395,
516, 527, 658, 660, 661, 1035

Abel, A.B. 818, 831, 834, 835, 994, 1069,

1237, t251, 1253, 1265, t266, 1268, 127I,
1272, 1284, 1285, 1651
Abowd, J. 567, 568, 570, 571,616, 759
Abraham, J. 1039
Abraham, K.G. 1058
Abraham, KJ. 1183, 1221
Abramovitz, M. 208
Abramowitz, M. 865, 887
Acemoglu, D. 852, 1215
Adam, M. 500
Adams, C. 1538
Adelman, EL., s e e Adehnan, 1. 9
Adelman, I. 9
Ag&nor, RR. 1543, 1572
Aghion, P. 264, 665, 672, 715, 719, t 157, 1208,
1210, 1213, 1377, 1450, 1454, 1465
Aiyagari, S.R. 442, 547, 552, 566, 567, 983,
1140, 1293, 1631
Aizenman, J. 1497, 1538, 1540
Akaike, H. 217
Akerlot, G. 1344
Akerlof, G.A. 198, 397, 1034, 1035, 1039,
1157, 1200
al Nowaihi, A. 1415, 1422, 1437
Alesina, A. 162, 277-279, 692, 1404, 1416,
1422-1426, 1430, I432, 1438, 1439, 1446,
1449, 1450, 1454, 1460, 1461, 1464--1466,
1469, t471, 1518, 1522, 1540
Alesina, A., s e e Tabellini, G. 1456, 1465
Alessie, R. 774, 775
Allais, M. 661, 1309
Allen, D.S. 871
Allen, E 576
Ahneida, A. 1432, 1495
Alegoskoufis, G.S. 166, 214, 215
Altonji, J. 615
Alto@, J., s e e Hayashi, E 796
Alto@, J.G. 789
Altug, S. 584, 595,611,612, 785, 786, 792
Alvarez, E 575,996
Ambler, S. 944, t062, 1067
Americml Psychiatric Association t325

Bacchetta, E 1344
Bacchetta, E, s e e Feldstein, M 1637
Bachelier, L. 1316
Backus, C.K. 549
Backus, D. 1017, 1031, 1270, 1405, 1414,
1415
Backus, D.K. 9, 42, 45, 938, 1316, 1708
i-1

I-2
Bade, R. 1432, 1438
Bagehot, W. 155, 1485, 1515
Bagwell, K. 1125
Bagwell, K., s e e Bemheim, B.D. 1647
Bailey, M.J. 1643
Bairoch, P 719, 724
Baker, J.B. 1125
Balasko, Y. 427, 506
Balassa, B.A. 705
Balke, N.S. 6, 61, 114, 204, 205, 221
Ball, L. 42, 72, 199, 1023, t037, 1039, 1041,
1127, 1415, 1499, 1504, 1542, 1632, 1650,
1651
Ball, R. 1321
Ballard, C. 1639
Banerjee, A., s e e Aghion, P 1377
Bange, M.M., s e e De Bondt, W.E 1321
Banks, J. 751, 758, 759, 770, 783, 788,
790--792
Banks, J., s e e Attanasio, O.R 756, 759, 793,
794
Bannerjee, A.'~ 1332
Bansal, R. 1255
Barberis, N. 1294, 1322
Barclays de Zoete Wedd Securities 1238
Barkai, H. 1572
Barnett, S. 831
Barnett, W. 538, 540
Barone, E. 702
Barro, R.L 101, 157, t58, 173, 237, 245, 246,
252, 269, 271,272, 277-281,284, 643,651,
657, 659, 671, 675, 681, 683-685, 688,
689, 6 9 1 - 6 9 4 , 696, 943, 974, 1023, 1055,
1155, 1404, 1405, 1411, 1412, 1414, 1415,
1425, 1438, 1439, 1466, 1485-1489, 1637,
1641, 1642, 1645, 1662, 1675, 1702, 1705,
1707
Barsky, R. 43,558, 564, 565
Barsky, R., s e e Solon, G. 579, 1058, 1102,
1106
Barsky, R., s e e Warnel, E.J. 1019
Barsky, R.B. 182, 215, 216, 1149, 1237, t277,
1294-1296, 1653
Barth, J.R. 1657
Bartle, R.G. 76
Barucci, E. 525
Basar, T. 1449
Basu, S. 399, 402, 433, 983, 992, 994, 1069,
1080-1082, 1096, 1097, t117, 1142
Bates, D.S. 1310, 1324
Batmaol, W.J. 252, 269

Author

Index

Baxter, M. 9, 11, 12, 45, 203, 380, 430, 934,

938, 974, 980, 992, 1296, 1404
Bayoumi, T. 161,211,216, 217, 219
Bayoumi, T., s e e Mussa, M. 208
Bazaraa, M.S. 331
Bean, C., s e e Blanchard, O.J. 1214
Bean, C.R. 785, 1497
Beaudry, R 99, 395, 413, 592, 1264
Beaulieu, J.J. 801,802, 876
Becker, G. 592, 653
Becker, G.S. 317, 1645
Becker, G.S., s e e Ghez, G 615, 752, 759
Becker, R. 369
Beetsma, R. 1411, 1436, 1438
Bekaert, G. 1281
Bell, D.E. 1313
Bellman, R. 336, 340
Belsley, D. 882, 887, 888, 892
Beltratti, A. 524, 525
Ben-David, D. 265, 278
Ben Porath, Y. 577, 582
Benabou, R. 1017, 1018, t031, 1128, 1129,
1469, 1472, 1473
B~nabou, R. 268
Benartzi, S. 1290, 1312, 1313
B6nassy, J. 507
Benassy, J.-R 1506
Benhabib, J. 283, 395, 399-405, 408, 412-414,
417, 419, 421,423-427, 431,433-435,437,
442, 505, 550, 847, 1145, 1449, 1465, 1467,
1472
Benigno, R, s e e Missale, A. 1450
Benjamin, D. 161
Bennett, R. 395
Bensaid, B. 1446, 1449
Benveniste, A. 476, 531
Benveniste, L.M. 321
Bergen, M., s e e Dutta, S. 1019, 1020
Bergen, M., s e e Levy, D. 1014, 1015, 1019
Bergen, RR. 1041
Berger, L.A. 1330
Bergstr6m, V. 538
Bernanke, B.S. 68, 72, 76, 83, 89, 91-93, 114,
144, 178, 182-184, 800, 856, 857, 1036,
1343, 1345, 1346, 1352, 1357, 1361, 1363,
1365, 1369, 1371, 1373, 1376 1378, 1495,
1578
Bernard, A.B. 254, 271,287, 288
Bernard, V.L. 1321
Bernheim, B.D. 1646, 1647, 1649, 1654, 1659,
1660

Author

Index

Berry, M., s e e Dreman, D. 1320

Berry, T.S. 1618
Bertocchi, G. 474
Bertola, G. 643, 708, 801,821, 834, 835, 840,
843, 1187, 1222, 1472, 1580
Bertsekas, D.E 326
Besley, T. 856
Betts, C.M. 217
Beveridge, S. 1062, 1143
Bewley, T. 566, 1155
Bhaskar, V. 1037
Bianchi, M. 290, 292
Bikhchandani, S. 1332
Bils, M. 694, 910, 912, 983, 1053, 1059, 1069,
1070, 1072, 1075, 1076, 1078 1081, 1085,
1087, 1102, t104, 1119, 1120, 1130
Bils, M.J. 579
Binder, M. 271, 1092
Binmore, K. 462
Binmore, K.G. 1188
Bisin, A. 427
Bismut, C., s e e Benaboa, R. 1017, 1018,
1031
Bizer, D. 380
Bjorck, A., s e e Dahlquist, G. 337
Black, E 417, 1280, 1310, 1331, 1507
Blackwell, D. 320
Blad, M., s e e BSnassy, J. 507
Blanchard, O.J. 40-42, 211, 216, 21'7, 391,
416, 471,504, 643, 660, 818, 852, 877, 887,
888, 890, 892, 906, 912, 1013, 1030, 1033,
1034, 1036, 1041, 1112, 1130, 1162, 1173,
1176, 1183, 1184, 1194, 1202, 1214, 1221,
1266, 1491, 1634, 1635, 1645, 1650
Blanchard, O.J., s e e Missale, A. 1450
Blank, R. 579
Blinder, A. 587, 750, 1018-1020, 1038
Blinder, A.S. 41,876, 881,887, 893, 903, 904,
907, 908, 910, 1018, 1085, 1118, 1344,
1485, 1499, 1660
Blinde~, A.S., s e e Bernanke, B.S. 83, 91, 93
Bliss, C. 1461, 1465
Bliss, R., s e e Fama, E.E 1280
Blomstrom, M. 277, 279, 280
Bloomfield, A. 156
Blume, L.E. 321,322, 4 7 4
Blume, L.E., s e e Bray, M. 474
Blundell, R. 572, 602, 611,612, 620, 764, 770,
779, 781,783,788, 790-792, 797
Blundell, R., s e e Banks, J. 758, 759, 770, 783,
788, 79~792

I-3
Boadway, R. t463
Bodnar, G. 1318
B6hm, V. 475, 646
Bohn, H. 1465, 1622, 1650, 1691
Boldrin, M. 362, 399, 400, 506, 962, 1062,
1284, 1297, 1465
Bolen, D.W. 1325
Bollerslev, T. 1236, 1280
BoRon, R, s e e Aghion, R 1377, 1450, 1454,
1465
Bona, J.L. 313
Boothe, EM. 1658
Bordo, M.D. 152, 155-160, 162, 164-167, 182,
184, 185, 194, 202-204, 207-209, 211,215,
217-221, 1404, 1438, 1590
Bordo, M.D., s e e Bayoumi, T. 161
Bordo, M.D., s e e Betts, C.M. 217
Borenstein, S. 1124
Boschan, C., s e e Bry, G. 8
Boschen, J.E 139
Boskin, M.J. 618
Bossaerts, P. 454
Bosworth, B., s e e Collins, S. 653
Bourguignon, E, s e e Levy-Leboyer, M. 222
Bovenberg, A i . , s e e Gordon, R.H. 1637
Bovenberg, L . , s e e Beetsma, R. 1411
Bowen, W. 619
Bowman, D. 1313
Boyd, W.H., s e e Bolen, D.W. 1325
Boyle, M., s e e Paulin, G. 751
Boyle, R 380
Boyle, RR, s e e Tan, K.S. 334
Brainard, WC. 817
Brauch, R., s e e Paulin, G. 751
Braun, R.A. 974
Bratm, S.N., s e e gxane, S.D. 876, 877
Bray, A. 1290
Bray, M. 454, 463,465, 466, 473-475, 527
Brayton, F. 1043, 1344, 1485
Brayton, E, s e e Itess, G.D. 1485, 1509
Breeden, D. 1246
Breiman, L. 289
Bresnahan, T.F. 911,912
Bretton Woods Commission 208
Broadbent, B. 1412
Broadbent, B., s e e Barro, R.J. 1412
Broadie, M., s e e Boyle, R 380
Brock, W.A. 319, 407, 455, 528, 532, 547, 552,
556, 942, 951, 1507
Brown, C. 585
Brown, R, s e e Ball, R. 1321

I-4
Brown, S. 1242
Browning, E. 1463
Browning, M. 598, 606, 607, 610 612, 750,
752, 771,778, 787, 792, 798, 803
Browning, M., s e e Attanasio, O.R 607, 608,
610, 611,613, 779, 789, 791, 1655
Browning, M., s e e Blundell, R. 611,612, 779,
781,783, 790, 791
Broze, L. 487, 488
Brugiavini, A. 775
Brugiavini, A., s e e Banks, J. 770, 788
Brmnberg, R., s e e Modigliani, E 761
Brumelle, S.L., s e e Puterman, M.L. 336, 338
Brunner, A.D. 104
Brmmer, K. 1"79, 183, 191, 1025, 14911
Bruno, M. 471, 1090, 1496, 1538, 1539, 1543,
1553
Bry, G. 8
Bryant, R.C. 1043, 1491, 1497, 1516-15t8
Bryant, R.R. 1313
Buchanan, J.M. 1631, 1642
Buchholz, T.G. 1643
Buckle, R.A. 1019
Bufman, G. 1543
Buiter, W. 1030, 1521
Bulirsch, R., s e e Stoer, J. 334
Bull, N. 1675, 1711
Bullard, J. 466, 507, 509, 515, 526
Bullard, J., s e e Arifovic, J. 527
Bulow, J. 1448, I449
Burdett, K. 1173, 1196
Bureau of the Census 1618, 1619
Burns, A.E 5, 8, 931,934
Burns, A.E, s e e Mitchell, W.C. 8, 44
Burnside, C. 399, 930, 980-985, 994, 1078,
1142, 1162
Burtless, G. 618, 620
Butkiewicz, J.L. 1621

Caballe, J. 578
Caballero, R.J. 399, 749, 771,794, 801, 802,
821-823, 828, 830, 832, 834-838, 840-842,
844, 846, 847, 852, 855, 856, 994, 1032,
1157, 1158, 1160, 1187, 1210, 1211, 1213,
1472
Caballero, R.J., s e e Bertola, G. 801, 821, 834,
840, 843, 1187
Cagan, R 157, 161,203, 1534
Cage, R., s e e Paulin, G. 751
Calmfors, L. 1214

Author

Index

Calomiris, C.W. 169, 181, 183, 187, 191,

1376
Calvo, G.A. 389, 397, 408, 419, 422, 1030,
I032, 1034, 1114, t346, 1360, 1363, 1389,
1400, 1415, 1428, 1445 1447, 1449, 1450,
1535, 1538, 1539, 1546, 1552, 1554, 1557,
1563, 1564, 1568, 1569, 1571-1573, 1582,
1583, 1587-t589, 1591, 1592, 1596, 1597,
1599-1603, 1605
Cameron, S. 589
Campbell, J. 92
Campbell, JR. 846, 847, 994
Campbell, J.Y. 763, 764, 769, 784, 930, 961,
1120, 1140, 1141, 1145, 1150, 1235-1238,
1251, 1255, 1257, 1258, i26t, 1264-1266,
1268, 1270, 1272, 1274, 1275, 1280, 1284,
1286, 1290, 1320, 1655
Canavese, A.J. 1543
Canetti, E.D., s e e Blinder, A.S. 1018, 1118
Canjels, E. 55
Canova, E 283,376, 377, 379
Cantor, R. 1344
Canzoneri, M.B. 159, 160, 1405, t414, 1415,
1507, 1508
Capie, E 154, 163,222, 1438
Caplin, A. 849, 850
Caplin, A.S. 801,910, 1031, 1032
Card, D. 580, 1016, 1148
Card, D., s e e Abowd, J. 567, 568, 570, 571,
616, 759
Card, D., s e e Ashenfelter, O. 1038, 1039
Cardia, E. 1655
Cardia, E., s e e Ambler, S. 1062, 1067
Cardoso, E. 1543
Carey, K., s e e Bernanke, B.S. 178, 182
Carlson, J. 473
Carlson, J.A. 904
Carlson, J.A., s e e BucMe, R.A. 1019
Carlson, J.B. 104
Carlstrom, C. 1348, 1357, 1368, 1378, 1379
Carlton, D. 1129
Carlton, D.W. 1018 1020
Carmichael, H.L. 1155
Carpenter, R.E. 876, 881,912, 1344
Carroll, CD. 567, 572, 573, 593, 759, 762,
769, 771,785, 788, 793, 1264, 1344, 1653,
1655
Case, K.E. 1323
Casella, A. 1463, 1465
Caselli, E 277-279, 283, 284, 286

Author Index

Cass, D. 244, 246, 247, 295, 389, 516, 643,

649, 662, 942, 948, 1673
Cass, D., s e e Balasko, Y. 427
Castafieda, A. 380
Cazzavilan, G. 426
Cecchetti, S.G. 182, 217, 876, 1015, 1016,
1018, 1019, 1251, 1265, 1270, 1272, 1294,
1296
Cecchetti, S.G., s e e Ball, L. 1037
Chadha, B. 1031, 1542
Chah, E.Y. 775
Chamberlain, G. 283, 286, 785
Chamberlain, T.W. 1334
Chamley, C. 400, 851, 1439, 1673, 1675, t693,
t 697, 1699
Champsaur,, R 538, 463
Chan, L. 1321
Chan, L.K.C. 1653
Chandler, L.V 176
Chang, C . C , Y . , s e e Chamberlain, T.W. 1334
Chari, V.V. 72, 124, 397, 422, 672, 697, 698,
700, 701, 709, 715, 720, 722, 723, 974,
1036, 1037, 1040-1042, 1371, 1448, 1449,
1459, 1488, 1489, 1578, 1673--1676, 1691,
1699, 1708-1710, 1720, 1723
Chari, V . V . , s e e A t k e s o n , A .
1675, 1718, 1720
Chattetjee, S. 996, 1126
Chatterji, S. 475, 507
Chattopadhyay, S.K., s e e Chatte~ji, S. 475,
507
Chen, N. 1281
Chen, X. 476, 532
Cheung, C.S., s e e Chamberlain, q~W. 1334
Chevalier, J.A. 1122, 1123
Chiappori, RA. 391,395, 516
Childs, G.D. 882
Chinn, M., s e e Frankel, J. 1497
Chirinko, R.S. 815, 817, 1058, t066, 1086,
t344, 1367
Chiswick, B., s e e Beckcr, G. 592
Cho, D. 278
Cho, I.-K. 455, 465, 524, 525
Cho, J.O. 974, 976, 1025, 1036
Cho, J.O., s e e Bils, M. 983, 1075, 1079, 1104
Chou, R.Y. 1236, 1280
Chou, R,Y., s e e Bollerslev, T 1236, 1280
Choudhri, E.U., s e e Bordo, M.D. 184, 194
Chow, C.-S. 326, 334
Chow, G.C. 1294
Christensen, L.R. 673, 688

I-5
Christiano, LJ. 43, 67 70, 83, 84, 89, 91-94,
99, 108, 109, 114, 115, 124, 137, 143, 144,
314, 329, 330, 339, 347, 349, 350, 355,
362, 364, 367, 369, 370, 376, 377, 379,
426, 504, 547, 764, 881, 888, 909, 952,
962, 974, 1011, 1017, 1018, 1021, 1030,
1038, 1089, 1100, 1296, 1365, 1369, 1708,
1736
Christiano, L.J., s e e Aiyagari, S.R. 1140
Christiano, L.J., s e e Boldrin, M. 962, 1284,
1297
Christiano, L.J., s e e Chari, V.M 72, 1449, 1673,
1675, 1676, 169I, 1699, 1708 1710, 1720,
1723
Chtmg, K.L. 299
Clarida, R. 95, 96, 136, 422, 1364, 1368,
1486
Clark, D., s e e Kushner, H. 476
Clark, J.M. 816
Clark, K.B. 602, i173
Clark, EB., s e e Mussa, M. 208
Clark, T.A. 173
Clark, T.E. 1091, 1485
Cochrane, J. 1120
Cochrane, J.tt. 101, 211, 796, 1234, 1246,
1249, 1296
Cochrane, J.H., s e e Campbell, J.Y. 1237, t251,
1284, 1286
Coe, D.T. 265
Cogley, T. 211,395, 547, 967, 1142, 1503
Cohen, D. 271
Cohen, D., s e e Greenspan, A. 798, 844, 847
Cohn, R., s e e Modigliani, E i321
Cole, H.L. 576, 1163, 1194, 1201-1203, 1207,
1446, 1449, 1603
Cole, H.L., s e e Chari, V.V. 1459
Coleman, T. 601
Coleman, W.J. 367, 380
Coleman II, W.J. 114
Coleman II, WJ., s e e Bansal, R. 1255
Collins, S. 653
Conference Board 43
Congressional Budget Office 1618, 1619, 1621,
1624-1627, 1639, 1640, 1660
Conley, J.M., s e e O'Ban; W.M. 1332
Conlon, J.R. 1032
Constantinides, G.M. 559, 567, 781,803, 1237,
1284, 1291, 1293
Constantinides, G.M., s e e Ferson, W.E. 1284
Contini, B. 1177, 1178, i180, 1200, 1222
Cook, T. 194, 195, 1493

I-6
Cooley, T.E 42, 69, 97, 101, 115, 124, 137,
376, 380, 408, 411, 549, 847, 954, 962,
974, 1376, 1463, 1736
Cooley, T.E, s e e Cho, J.O. 974, 976, 1025,
1036
Cooper, R. 204, 398, 824
Cooper, R., s e e Azariadis, C. 395
Cooper, R., s e e Chatterjee, S. 996, 1126
Cootncr, EH. 1316
Corbo, V 1543, 1554
Correia, I. 974, 1537, 1675, 1720, 1733
Cossa, R. 584
Council of Economic Advisers 1639
Cox, D. 705
Cox, W.M. 1621
Cox Edwards, A., s e e Edwards, S. I543, 1554,
1555, 1575
Crawford, V.P. 475
Crossley, 32, s e e Browning, M. 610, 798
Croushore, D. 1485, 1653
Crucini, M.J. 178, 705
Crucini, M.J., s e e Baxter, M. 1296
Cukiennan, A. 1404, 1414, 1415, 1432, 1437,
1438, 1450, 1456, 1463, 1465
Cukierman, A., s e e Alesina, A. 1424, 1426
Cukierman, A., s e e Brunner, K. 1025
Cummings, D., s e e Christensen, L.R. 673,
688
Cmmnins, J.G. 822, 856, 1344
Cunliffe Report 161
Currie, D. 454, 504
Cushman, D.O. 95, 96
Cutler, D.M. 797, 1290, 1320, 1321, 1624
Cyrus, T., s e e Frankel, J.A. 280
Dahlquist, G. 337
Daniel, B.C. 1647
Daniel, K. 1322
Dantbine, J.-R 329, 370, 952, 962, 1002,
1157
Darby, M.R. 166
Dasgupta, R 655,656
d'Autume, A. 487
DaVanzo, J. 618
Daveri, E 1220
Davidson, J. 750
Davies, J.B. 766
Davis, D. 1033
Davis, RJ. 333
Davis, S,J. 1151, 1152, 1160, 1161, 1176,
1178, 1180, 1194, 1199

Author

Index

Davis, S.J., s e e Attanasio, O.P. 796, 797

Davutyan, N. 156
Dawid, H. 523, 527
De Bondt, W.E 1307, 1320, 1321, 1323
de Fontnouvelle, R, s e e Brock, W.A. 528
De Fraja, G. 1037
De Gregorio, J. 1546, 1551, 1573, 1575, 1577
de Itaan, J., s e e Eijffmger, S. 1404, 1438
de la Torre, M. 41
De Melo, J., s e e Corbo, V 1543
de Melo, J., s e e Hanson, J. 1543
De Melo, M. 1535, 1551
De Pablo, J.C. 1543
de Soto, H. 695
Deaton, A. 752, 756, 764, 771,775, 776, 783,
785, 787, 794, 798, 1344
Deaton, A., s e e Blinder, A. 750
Deaton, A., s e e Browning, M. 611, 612, 752,
787, 792
Deaton, A.S. 1264
Deaton, A.S., s e e Campbell, J.Y. 764
Debelle, G. 1489, 1518, 1522
DeCanio, S. 454, 463
DeCecco, M. 155
Degeorge, E 1321
DeKock, G. 158
DeLong, J.B. 252, 279, 695, 1042, 1290,
1324

DeLong, J.B., s e e Barsky, R.B. 1237, 1277,

1294-1296
den Haan, W.J. 271,347, 354, 369, 994, 1166,
1194, 1203, 1204, 1206, 1207
Denardo, E.V 320
Denison, E.E 237, 653
Denizer, C., s e e De Melo, M. 1535, 1551
Denson, EM. 40
Desdoigts, A. 290
DeTray, D.N., s e e DaVanzo, J. 618
Devereux, M. 952, 1466, 1471
Devereux, M., s e e Alcssie, R. 775
Deverettx, M., s e e Beaudry, P. 395, 413
Devereux, M.B. 1126
Devereux, M.B., s e e Beaudry, P. 99
Devine, T.J. 1166
Dewatripont, M., s e e Aghion, E 1157
Dezhbakhsh, H. 1039
Di Tella, G., s e e Canavesc, A.J. 1543
Diamond, E 796
Diamond, P., s e e Shafir, E. 1316
Diamond, P.A. 661, 1157, 1161, 1162, 1t73,
1188, 1634, 1645, 1684, 1718

Author

Index

Diamond, RA., s e e Blanchard, O.J. 41, 42,

1162, 1173, 1183, 1184, 1194, 1202, 1221
Diaz-Alejandro, C.E 1543
Diaz-Gimenez, J., s e e Castafieda, A. 380
Dickens, WT., s e e Akerlof, G.A. 198
Dickey, D.A. 53, 54, 212
Dickinson, J. 618
Dicks-Mireaux, L., s e e Feldstein, M. 1633
Diebold, EX. 6, 11
Dielman, T., s e e Kallick, M. 1325
Dixit, A. 824, 829, 844, 1115, 1121, 1126
Dixit, A.K., s e e Abel, A.B. 835
Dixon, H. 537
Dodd, D.L., s e e Graham, B. 1323
Dolado, J. 1437
Dolado, J.J. 1214
Dolde, W. 1318
Dolde, W.C., s e e Tobin, J. 773
Domar, E. 640
Dombergel, S. 1019
Dominguez, K. 164, 182
Domowitz, I. 1020, 1083, 1093
Doms, M. 823, 838
Donaldson, J.B., s e e Constantinides, G.M.
1293
Donaldson, J.B., s e e Danthine, J.-R 329, 370,
952, 962, 1002, 1157
Doob, J.L. 299
Dornbusch, R. 198, 1043, 1543, 1562, 1563,
1565, 1568, 1582, 1590, 1637
Dotsey, M. 370, 952, 974, 1032, 1043, 1 5 2 2 ,
1652
Drazen, A. 1463, 1465, 1541, 1580
Drazen, A., s e e Alesina, A. 162, 1450, 1 4 6 1 ,
1465, 1540
Drazen, A., s e e Azariadis, C. 262, 264, 2 ' 7 1 ,
289, 527, 658, 660
Drazen, A., s e e Bertola, G. 1580
Drazen, A., s e e Calvo, G.A. 1571
Drcman, D. 1320, 1323
Dreze, J. 770
Drifflll, J., s e e Backus, D. 1405, 1414, 1 4 1 5
Driskill, R.A. 1042
Drudi, E 1450
Drugeon, J.R 426
Dueker, M.J. 1485
Duffle, D. 380
Duffle, D., s e e Constantinides, G.M. 567, 781,
1237, 1291
Duffy, J. 257, 439, 473, 500
Duffy, J., s e e Arifovic, J. 527

I-7
Duffy, J., s e e Bullard, J. 526
Duguay, R 215
Dumas, B. 561,564
Dunlop, J.T. 939, 1059
Dunn, K.B. 800, 1284
Dunne, T., s e e Donas, M. 823, 838
Dupor, B. 994
Durkheim, 1~. 1331
Durlauf, S.N. 254, 262 264, 268, 270, 271,
287, 289, 303,550, 905407
Dtalauf, S.N., s e e Bernard, A.B. 254, 271,287,
288
Dutta, RK 380
Dutta, S. 1019, 1020
Dutta, S., s e e Levy, D. 1014, 1015, 1019
Dutton, J. 156
Dyl, E.A. 1334
Dynan, K.E. 770

Easley, D., s e e Blume, L.E. 321,322, 474

Easley, D., s e e Bray, M. 474
Easterly, W. 277~79, 281, 675, 703, 1538,
1547, 1553, 1560, 1561
Easterly, W., s e e Bruno, M. 1553
Eaton, J. 719
Eberly, J.C. 801,802, 1344
Eberly, J.C., s e e Abel, A.B. 831, 834, 835,
994
Echenique, E 1551, 1561
Eckstein, O. 1344
Eden, B. 1019, 1023
Edin, D.A. 1457
Edwards, S. 1538, 1543, 1554, 1555, 1575,
1578-1580
Edwards, S., s e e Cukierman, A. 1456, 1465
Edwards, W. 1322
Eichenbaum, M. 83, 94, 96, 99, 100, 137, 184,
549, 550, 785, 799, 800, 803, 885, 888,
905407, 912, 957, 1084
Eichenbatun, M., s e e Aiyagafi, S.R. 1t40
Eichenbaum, M., s e e Burnside, C. 399, 930,
980-985, 994, 1078, 1142, 1162
Eichenbaum, M., s e e Chari, VV 72, 1449
Eichenbaum, M., s e e Christiano, L.J. 43, 6?70, 83, 84, 89, 91 94, 99, 108, 115, 124,
137, 143, 144, 376, 377, 379, 764, 974,
1011, 1021, 1038, 1089, 1100, 1365, 1369,
1708, 1736
Eichenbamn, M.S., s e e Christiano, L.J~ 881,
888

I-8
Eichengreen, B. 152, 154-157, 160, 162-164,
168, 178, 185, 187, 189, 204, 208, 209,
211,219, 1449, 1465, 1590
Eichengreen, B., s e e Bayomni, T. 211, 216,
217, 219
Eichengreen, B., s e e Bordo, M.D. 162
Eichengreen, B., s e e Casella, A. 1463, 1465
Eijffinger, S. 1404, 1432, 1438
Eisner, R. 817, 1310, 1621, 1622
Ekeland, I. 1689
E1 Karoui, N. 835
Elias, VJ. 673
Ellison, G. 475, 1124
Ellson, R.E., s e e Bordo, M.D. 157
Elmendorf, D.W. 1439
Elmendorf, D.W., s e e Ball, L. 1650, 1651
Elmendorf, D.W., s e e Feldstein, M. I656
Emery, K.M. 215
Emery, K.M., s e e Balke, N.S. 114
Engel, E., s e e Caballero, R.J. 801, 802, 821,
835-838, 840-842, 994, 1032, 1158
Engelhardt, G. 1344
Engle, R., s e e Bollerslev; T. 1280
Engle, R.E 50
Engle, R.E, s e e Chou, R.Y. 1236, 1280
Engkmd, R 9
Epstein, L.G. 556, 558, 564, 565, 744, 769,
1250, 1256
Erceg, C. 1041
Erceg, C.J., s e e Bordo, M.D. ]82
Eriksson, C. 1208
Erlich, D. t314
Ermoliev, Y.M., s e e Arthur, W.B. 476
Escolano, J. 1718
Esquivel, G., s e e Caselli, E 277-279, 283,284,
286
Esteban, J.-M. 264
Estrella, A. 43, 1281, 1485
Evans, C. 982
Evans, C.L. 105
Evans, C.L., s e e Bordo, M.D. 182
Evans, C . L . , s e e Christiano, L.J. 67, 68, 70, 83,
84, 89, 91-94, 99, 108, 137, 143, 144, 1011,
1021, 1038, 1089, 1100, 1365, 1369
Evans, C.L., s e e Eichenbaum, M. 83, 9 4 , 96,
137
Evans, G.W. 425, 426, 453-455, 461-465,468,
470, 472.478, 480, 481, 483, 484, 487,
489-492, 495-497, 500, 502, 504-507,
509-513,516, 518-521,526-528, 530 532,
1025, 1125

Author

Index

Evans, M. 182
Evans, E 283, 1635, 1647, 1656 1659
Faig, M. 1675, 1720
Fair, R. 1416, 1425
Fair, R.C. 876, 1077, 1491
Fair, R.C., s e e Dominguez, K. 182
Falcone, M. 326
Fallick, B.C. 855
Fama, E.E 1235, 1280, 1281, 1307, 13t6,
1320-1323
Farber, H. 1200
Farmer, R. 662, 1002
Farmer, R.E. 391,395, 396, 411-414, 427-430,
434, 437, 500, 505
Farmer, R.E., s e e Benhabib, J. 395, 399-402,
408, 412-414, 417, 425,427,431,433-435,
442, 505
Farrell, J. 1121
Faust, J. 69, 217, 1416, 1425, 1437
Fauvel, Y. 1573
Favaro, E. 1554, 1555
Fay, J.A. 1077, 1103
Fazzari, S.M. 818, 1344
Fazzari, S.M., s e e Carpenter, R.E. 881, 912,
1344
Fazzari, S.M., s e e Chifinko, R.S. 1066, 1086
Featherstone, M. 1332
Federal Reserve Board 176
Feenberg, D. 60
Feenstra, R. 1569
Feenstra, R.C., s e e Bergen, ER. 1041
Feiwel, G.R. 535
Feldman, M. 474
Feldstein, M. 44, 197, 1485, 1497, 1498, 1622,
1631, 1633, 1636, 1637, 1639, 1656, 1660
Feldsteh~, M.S. 904, 906
Felli, E. 1083, 1122
Fellner, W. 641,657
Ferejohn, J. 1425
Fernald, J.G., s e e Basu, S. 399, 402, 433, 994,
1117, 1142
Fernandez, R. 1543, 1562
Ferris, S.E 1314
Ferson, W.E. 1284
Festinger, L. 1314
Fethke, G. 1037
Fiebig, D.G., s e e Domberger, S. 1019
Filippi, M., s e e Contini, B. 1177, 1178, 1180,
1222
Fillion, J.E 1498

Author

Index

Finch, M.H.J. 1543

Finegan, T.A., s e e Bowen, W. 619
Finn, M. 981, 1091
Fiorina, M. 1425
Fischer, A.M., s e e Dueker, M.J. 1485
Fischer, S. 182, 197, 202, 215, 216, 1025,
1026, 1155, 1404, 1405, 1438, t449, 1489,
1496, 1498, 1538, 1542, 1547, 1561, 1582
Fischer, S., s e e Blanchard, O.J. 471,643, 660,
1013, 1033, 1034, 1036, 1491, 1635
Fischer, S., s e e Bruno, M. 1538
Fischer, S., s e e Debelle, G. 1489, 1518, 1522
Fischhoff, B. 1319, 1326
Fischhoff, B., s e e Lichtenstein, S. 1318
Fishe, R.RH. 173
Fisher, I. 154, 157, 203, 1316, 1321, 1343,
1372, 1377, 1485
Fisher, J. 92
Fishel, J., s e e Boldrin, M. 962, 1284, 1297
Fisher, J., s e e Christiano, L.J. 314, 347, 349,
350, 355, 362, 364, 962, 1296
Fishe~; J.D.M. 910, 1368, 1375, 1376, 1378
Fisher, /.D.M., s e e Campbell, J.R. 846
Fishlow, A. 155
Flandreau, M. 154
Flannery, B . E , s e e Press, W.H. 329-334, 343,
348, 356, 365
Flavin, M. 572, 749, 763, 784
Flenmfing, J.S. 773
Flood, R.P 152, 158, 202, 408, 1428, 1429,
1438, 1507, 1595, 1596
Flood, R.R, s e e Garber, EM. 165
Florovsky, G. 1326
Forbes, K. 277, 278
Ford, A.G. 155
Fore, D., s e e Roseveare, D. 1626
Foresi, S., s e e Backus, D.K. 1316
Forteza, A., s e e Echenique, E 1551, 1561
Fortune, R 1310
Foufoula-Georgiou, E., s e e Kitanidis, EK.
326
Fourgeaud, C. 454, 465, 473, 475
Fox, B.L. 326
Foxley, A. t543
Fral~kel, J. 1497
Frankel, J.A. 280, 281, 1590, 1637
Franses, RH. 289
Fratianni, M. 143t
Freeman, R. 577
Fregert, K. 1016
French, K. 1280

I-9
French, K.R., s e e Fama, E.E 1235, 1281, 1320,
1323
Frenkel, J.A. 203, 1630
Frenkel, J.A., s e e Aizenman, J. 1497
frennberg, R 1238
Friedman, B.M. 43, 44, 1632, 1642
Friedman, D. 475
Friedman, J.H., s e e Breiman, L. 289
Friedman, M. 46, 48, 61, 137, 154, 160, 162,
168, 172, 176, 179, 180, 185, 189, 195, 203,
222, 275, 376, 572, 761, 762, 943, 1011,
1173, 1325, 1485, 1488, 1496, 1537, 1674,
1720
Froot, K. 1266, t316
Frydman, R. 453, 454, 474, 528, 536, 539
Fuchs, G. 464, 474
Fudenberg, D. 455,475, 1155
Fudenberg, D., s e e Ellison, G. 475
Fuerst, T. 99, 974, 1378
Fuerst, T., s e e Carlstrom, C. 1348, 1357, 1368,
1378, 1379
Fuhrer, J.C. 454, 905, 908, 1039, 1040, 1491,
1518
Fuhrer, J.C., s e e Carroll, C.D. 769, 785
Fuk~da, S.-i. 875
Fuller, W.A., s e e Dickey, D.A. 53, 54, 212
Fullerton, D. 576, 588, 616
Funkhouser, R. 699
Futia, C. 299
Galbraith, J.K. 1182
Gale, D. 389, 475, 849, 851, 1376
Gale, D., s e e Chamley, C. 851
Gale, W.G. 1646
Galeotti, M. 909, 1086, 1124
Gali, J. 395,405-407, 426, 429, 434, 993, 994,
1117, 1119, 1120, 1129
Gall, J. 67, 69, 217
Gall, J., s e e Benhabib, J. 424
Gall, J., s e e Clarida, R. 96, 136, 422, 1364,
1368, 1486
Gallarotfi, G.M. 154
Gallego, A.M. 321,322
Galor, O. 262, 263, 272, 660
Gandolfi, A.E., s e e Darby, M.R. 166
Garber, RM. 165, 1323, 1543
Garber, RM., s e e Eichengreen, B. 187, 189
Garber, EM., s e e Flood, R.E 408, 1595, 1596
Garcia, R. 790
Garibaldi, E 1180, 1222
Garratt, A. 504

1-10
Garratt, A., s e e Currie, D. 454, 504
Garriga, C. 1675, 1718
Gaspar, J. 324, 369
Gastil, R.D. 689
Gatti, R., s e e Alesina, A. 1432
Gavin, W. 1485
Geanakoplos, J.D. 395, 458, 1322
Gear, C.W. 346
Geczy, C.C., s e e Brav, A. t290
Gelb, A., s e e De Melo, M. 1535, 1551
Genberg, H. 165, t428
Geoffard, EY., s e e Chiappori, EA. 391
Gerlach, S., s e e Bacchetta, R 1344
Gersbach, H. 1376
Gertler, M. 83, 92 94, 1040, 1343, 1348, 1366,
1373, 1374, 1376-1378
Gertler, M., s e e Aiyagari, S.R. 1293, 1631
Gertler, M., s e e Bernanke, B.S. 92, 144, 183,
856, 857, 1036, 1345, 1346, 1352, 1357,
1365, 1369, 1371, 1373, 1376 1378, 1578
Gertler, M., s e e Clarida, R. 95, 96, 136, 422,
1364, 1368, 1486
Geweke, J. 34, 334
Geweke, J., s e e Barnett, W. 540
Geweke, J.E 89
Ghali, M., s e e Surekha, K. 908
Ghez, G. 615, 752, 759
Ghezzi, R 1572
Ghosh, A.R. 202, 207, 208
Giavazzi, E 167, 203, 1438, 1446, 1449, 1580
Giavazzi, E, s e e Missale, A. 1450
Gibson, G.R. 1307
Gigerenzer, G. 1308, 1318
Gilbert, R.A. 195
Gilchrist, S. 847, 1344
Gilchrist, S., s e e Bernanke, B.S. 856, 1036,
1345, 1373, 1376
Gilchrist, S., s e e Gertler, M. 83, 92 94, 1366,
t373, 1374, 1376
Gill, RE. 329
Gilles, C., s e e Coleman II, W.J. 114
Gilson, R.J. 1154
Giovannini, A. 156, 158, 160, 166, t69, 380
Giovannini, A., s e e Giavazzi, E 167
Gizycki, M.C., s e e Gruen, D.K. 1316
Glasserman, R, s e e Boyle, R 380
Glazer, A. 1456, 1465
Glomm, G. 712, 1472
Glosten, L. 1280
Goetzmann, W., s e e Brown, S. 1242

Author

Index

Goetzmaml, W.N. 1242, 1252, 1314, 1320,

1333
Goff, B.L. 159
Gokhale, J. 750
Gokhale, J., s e e Auerbach, A.J. 1624
Goldberg, EK., s e e Attanasio, O.R 777
Goldfajn, I., s e e Dornbusch, R. 1590
Goldstein, M., s e e Mussa, M. 208, 1637
Gomes, J. 994, 1159
Gomme, R 962, 1062
Gomme, R, s e e Andolfatto, D. 1173
Gomme, R, s e e MacLeod, W.B. 1157
Goodfriend, M. 88, 120, 121, 156, 173, 191,
194~196, 764, 1013, 1117, 1346, 1509,
1514, 1515
Goodhart, C . , s e e Capie, E 154
Goodhart, C.A.E. 193
Goodhart, C.A.E., s e e Almeida, A. 1432,
1495
Goodharl, C.E.A. 1438, 1495, 1507, 1508,
1514
Goodman, A. 797
Goolsbee, A. 839, 843, 848
Gordon, D.B. 128, 134
Gordon, D.B., s e e Barro, R.J. 158, 1155, 1405,
1411, 1415, 1438, 1485-1489
Gordon, D.B., s e e Leeper, E.M. 69
Gordon, R. 1030
Gordon, R.H. 1637
Gordon, R.J. 40, 46, 48, 49, 181, 1542
Gordon, R.J., s e e Balke, N.S. 6, 61,204, 205,
221
Gorman, W.M. 553, 556, 782, 803
Gorton, G., s e e Calomiris, C.W. 181
Gottfries, N. 463, 1121, I122
Gould, D.M. 1551, 1559, 1561
Gourieroux, C. 487
Gourieroux, C., s e e Broze, L. 487, 488
Gourieromx, C., s e e Fourgeaud, C. 454, 465,
473, 475
Gourinchas, E-O. 609, 1344
Graham, B. 1323
Graham, F.C. 1656, 1657
Grandmont, J.-M. 439, 454, 460, 464, 474.,
475, 48t, 507, 514, 526, 661
Granger, C. 34
Granger, C.W.J. 88l, 903
Granger, C.WJ., s e e Engle, R.E 50
Gray, J.A. 1025, 1026, 1038
Green, D., s e e MaCurdy, T.E. 619, 620
Green, E. 575

Author

Index

Green, H., s e e Beaudry, R 592

Greenberg, D., s e e Burtless, G. 618
Greenberg, D.H., s e e DaVanzo, J. 618
Greenspan, A. 199, 798, 844, 847, 1630
Greenwald, B. 857, 1122, 1377
Greenwood, J. 380, 550, 576, 664, 692, 962,
980, 995
Greenwood, J., s e e Cooley, T.E 847
Greenwood, J., s e e Gomes, J. 994, 1159
Greenwood, J., s e e Gomme, E 962, 1062
Gregory, A.W. 376, 377
Gregory, A.W., s e e Devereux, M. 952
Grier, K.B. 253
Griffiths, M., s e e Dolado, J. 1437
Griliches, Z. 54l
Grilli, V. 95, 1404, 1432, 1438, 1439, 1465
Grilli, V, s e e Alesina, A. 1430
Grilli, V, s e e DeKock, G. 158
Grilli, V., s e e Drazen, A. 1463, 1465, 1541
Grilli, V.U. 169
Gros, D., s e e Adams, C. 1538
Gross, D. 857, 1344
Gross, D.B., s e e Goolsbee, A. 839
Grossman, G.M. 264, 639, 672, 715, 1210,
1464
Grossman, H.J. 158, 1415, 1449
Grossman, S.J. 801, 1237, 1242, 1246, 1268,
1291, 1293
Grout, P.A. 852
Gruen, D.K. 1316
Guerra, A. 1546, 1606, 1607
Guesnerie, R. 439, 454, 460, 464, 465, 474,
475, 506, 511,516, 526
Guesnerie, R., s e e Chiappori, RA. 391, 395,
516
Guesnerie, R., s e e Evans, G.W. 464
Guidotti, RE. 1537, 1588, 1603, 1675, 1720
Guidotti, RE., s e e Cairo, G.A. 1447, 1450
Guidotti, RE., s e e De Gregorio, J. 1546, 1551,
1573, 1575, 1577
Guiso, L. 772
Guiso, L., s e e Galeotti, M. 909
Guide, A.M., s e e Ghosh, A.R. 202, 207, 208
Gultekin, M. 1317
Gultekin, N.B., s e e Gultekin, M. 1317
Guo, J.-T., s e e Farmer, R.E. 395,427-430, 434,
505
Guo, J.-12 416, 427
Gurley, J.G. I507
Gust, C. 1041
Guttman, E, s e e Erlich, D. t314

1-11
Haberler, G. 185
Hahn, E 661
H a h n , T . , s e e Cook, T.
194, 1493
Hahn, W. 479
Hairault, J.-O. 1036
Haldane, A.G. 1432, 1438, 1485, 1495, 1497
Haley, W.J. 585
Hall, G. 911
Hall, R.E. 399, 556, 573, 595, 607, 608, 673,
679, 680, 683 686, 702, 765, 767-769,
784, 789, 791, 794, 817, 856, 930, 982,
1068, 1070, 1079, 1089, 1092, 1095, 1096,
1141-1143, 1145, 1151-1153, 1157, 116~
1164, t200, 1261, 1485, 1493, 1498, 1655,
1656
Hall, S., s e e Currie, D. 454, 504
Hall, S., s e e Garratt, A. 504
Hallerberg, M. 1460, 1465
Haltiwanger, J., s e e Caballero, R.J. 821, 837,
838, 840-842, 1158
Haltiwanger, J., s e e Cooper, R. 824
Haltiwanger, J.C. 881
Haltiwanger, J.C., s e e Abraham, K.G. 1058
Haltiwanger, J.C., s e e Davis, S.J. 1151, 1152,
1160, 1161, 1176, 1178, 1180, 1194, 1199
Hamermesh, D. 577
Hamilton, A. 1659
Hamilton, J. 963
Hamilton, J.D. 12, 72, 80, 182, 1118, 1265
Hammerlin, G. 344
Hammour, M.L., s e e Caballero, R.J. 846, 847,
852, 855, 856, 1157, 1158, 1160, 1187,
1210, 1211, 1213, 1472
Hannerz, U. 1332
Hansen, B. 1194
Hansen, B.E. 38, 39
Hansen, G.D. 547, 551,602, 976, 977, 1200
Hansen, G.D., s e e Cooley, T.E 69, 97, 101,
115, 124, t37, 380, 408, 411,974, 1736
Hansen, L.E 547, 555, 556, 558, 57~574, 768~
769, 784, 882, 915, 1234, 1246, 1249, 1250,
1261, 1294, 1295
Hansen, L.R, s e e Anderson, E.W. 368, 369
tlansen, L.R, s e e Cochrane, J.H. 1234, 1246,
1249
Hansen, L.E, s e e Eichenbaum, M. 549, 550,
785, 799, 800, 803
Hanson, J. 1543
Hansson, B., s e e Frennberg, R 1238
Harberger, A.C. 1554, 1590

1-12
Harden, 1., s e e yon Hagen, J. 1439, 1460,
1465
Hardouvelis, G.A. 1281
Hardouvelis, G.A., s e e Estrella, A. 43, 1281
Harris, R., s e e Cox, D. 705
Harrison, A. 277, 279, 280
Harrison, S.G., s e e Christiano, L.J. 426
Harrison, S.H. 402
Harrod, R. 640
Hart, O. 852,1154
Hartwick, J. 656
Harvey, A.C. 9
Harvey, C.R. 1236, 1280
Hashimoto, M. 1152
Hassett, K.A. 815, 818, 843, 1344
Hassett, K.A., s e e Auerbach, A.J. 821
Hassett, K.A., s e e Cummins, J.G. 822, 856,
1344
Hassett, K.A., s e e Fallick, B.C. 855
Hassler, J. 9, 1238
Haug, A.A., s e e Dezhbakhsh, I-I. 1039
Haugen, R.A., s e e Ferris, S.R 1314
Hause, J.C. 569
Hausman, J. 620
Hausman, J., s e e Burtless, G. 620
Hawley, C.B., s e e O'Brien, A.M. 776
Hayashi, E 773,775, 776, 785, 788, 790, 796,
800, 818, 1649
Head, A., s e e Devereux, M.B. 1126
Heal, G., s e e Dasgupta, E 655, 656
Heal, G.M., s e e Ryder Jr, H.E. 1284
Heaton, J. 380, 547, 569, 803, 1242, 1255,
1284, 1293
Heckman, J.J. 576, 578, 579, 582, 584-587,
590, 592, 593, 595, 601-603,605, 615 617,
620-624, 752, 759, 1166
Heckman, J.J., s e e Ashenfelter, O. 618
Heckman, J.J., s e e Cameron, S. 589
Heckman, J.J., s e e Cossa, R. 584
tteckman, J.J., s e e Killingsworth, M.R. 550,
601, 1148
Heijdra, B.J. 1119, 1120, 1126
Heinemann, M. 495, 525
Hellwig, M., s e e Gale, D. 13']6
Helpman, E. 203, 1580
Helpman, E., s e e Coe, D.T. 265
Helpman, E., s e e Drazen, A. 1580
Helpman, E., s e e Grossman, G.M. 264, 639,
672, 715, 1210, 1464
Hendershott, RH. 1333
Henderson, D.W. 1497

Author

Index

Henderson, D.\, s e e Bryant, R.C. 1491, 1497,

1516
Henderson, D.W., s e e Canzoneri, M.B. 160,
1507, 1508
Hendry, D., s e e Davidson, J. 750
Hercowitz, Z. 664
Hercowitz, Z., s e e Barro, R.J. 1023
Hercowitz, Z., s e e Greenwood, J. 550, 664,
962, 980
Herrendorf, B. 1415, 1436, 1438
Hess, G.D. 9, 1485, 1509
Hester, D.A. 871
Heston, A., s e e Summers, R. 238, 301, 640,
673-675, 677, 680, 681,689, 720
Hetzel, R.L. 180
Heymann, D. 506, 1539, 1540, 1543
Hibbs, D. 1400, 1425
Hildenbrand, W. 535, 537
Himarios, D., s e e Graham, EC. 1656, 1657
Himmelberg, C.R, s e e Gilchrist, S. 1344
Hiriart-Urruti, LB. 331
Hh'schhorn, E., s e e Cox, W.M. 1621
Hirschman, A. 1540
Hirshleifet, D., s e e Bikhchandani, S. 1332
Hirshleifer, D., s e e Daniel, K. 1322
Hobijn, B., s e e Franses, RH. 289
Hodrick, R. 9, 12, 34, 428, 931,932
Ho&'ick, R.J., s e e Bekaert, G. 1281
Hodrick, R.J., s e e Flood, R.R 1507
Hoelscher, G. 1658
Hoffmaister, A. 1561, 1589
Hoffman, D.L. 51,412
Hoffmann, K.-H., s e e Hanmaerlin, G. 344
Holbrook, R. 569
Holmstrom, B. 1376, 1417, 1418, 1425
Holt, C.A., s e e Davis, D. 1033
Holt, C.C. 882, 885, 888, 909, 910, 912
Holtham, G., s e e Bryant, R.C. 1491, 1497,
1516
Holtz-Eakin, D., s e e Blinder, A.S. 41
Hommes, C.H. 529, 532
Hommes, C.H., s e e Brock, W.A. 455, 528,
532
Honkapohja, S. 464, 481,507, 535
Honkapohja, S., s e e Evans, G.W 425, 426,
454, 455, 461,464, 465,468, 470, 472-478,
480, 481,483,484, 487, 489492, 495~497,
502, 504-507, 509--513, 516, 518-521,
526 528, 530-532, 1025
Hooker, M.A., s e e Fuhrer, J.C. 454

Author

Index

[-looper, E, s e e Bryant, R.C. 1043, 1491, 1497,

1516-1518
Hopenhayn, H. 672, 708, 994
Hopenhayn, H.A. 844
Horioka, C., s e e Feldstein, M. 1636
Horn, H. 1415
Hornstein, A. 549, 996
Hornstein, A., s e e Fisher, J.D.M. 910
Horvath, M. 994
Horvath, M., s e e Boldrin, M. 962, 1062
Hoshi, T. 1344
Hosios, A.J. 1193, 1224
Hotz, VJ. 792, 803
Houthakker, H.S. 803
Howard, R. 336
Howitt, R 389, 399, 455, 506, 507, 514, 515,
517, 521,527, 1174, 1508
Howitt, R, s e e Agbion, R 264, 665, 672, 715,
719, 1208, 1210, 1213
Howrey, E.R, s e e Fair, R.C. 1491
Hoynes, H.W., s e e Attanasio, O.P. 753
Hsieh, C.-T. 673, 687
Hubbard, R.G. 567, 569, 572, 573, 593, 771,
776, 794, 797, 856, 1344, 1376, 1660
Hubbard, R.G., s e e Cummins, J.G. 822, 1344
Hubbard, R.G., s e e Domowitz, I. 1020, 1083,
1093
Hubbard, R.G, s e e Fazzari, S.M. 818, 1344
Hubbard, R.G., s e e Gertler, M. 1376
Hubbard, R.G., s e e Hassett, K.A. 815, 818,
843, 1344
Huberman, G., s e e Kahn, C. 1154
Huffman, G.W. 437
Huffman, G.W., s e e Greenwood, J. 380, 962,
980
HuggeR, M. 380, 576, 593
Halten, C. 664
Flultgren, "12 1100
Humphrey, T.M. 1485
tttmlphreys, B.R. 909
Hurd, M.D. 780
Hybels, J., s e e Kallick, M. 1325
Hyslop, D., s e e Card, D. 1016
Ibbotson, R. 1321
lden, G., s e e Barth, J.R. 1657
Ikenberry, G.J. 163
Im, K. 283
lmrohoroglu, A. 797
Ingberg, M., s e e Honkapohja, S. 535
lngram, B. 984

1-13
Inman, R., s e e Bohn, H. 1465
Intriligator, M., s e e Griliches, Z. 541
Ireland, RN. 129, 194, 1036, 1492, 1494,
1497
Irish, M., s e e Browning, M. 611, 612, 752,
787, 792
Irons, J.,see Faust, J. 1416, 1425
Irwin, D.A. 178
lsard, E, s e e Flood, R.E 158, 1429, 1438
Islam, N. 283-285, 287, 653
Ito, T. 1425
Iwata, S., s e e Hess, G.D. 9
Jackman, R. 1221
Jackman, R . , s e e L a y a r d ,
R. 1098, lt76, 1177,
1221
Jackwerth, J.C. 1310
Jaeger, A., s e e Harvey, A.C. 9
Jaffee, D.M. 1376
Jagannathan, R., s e e Glosten, L. 1280
Jagannathan, R., s e e Hansen, L.E 547, 1234,
1246, 1249
James, H., s e e Bernanke, B . S . 183, 184
James, W. 1330
Janis, I. 1332
Jappelli, 32 776, 780, 790, 1344
Jappelli, T., s e e Guiso, L. 772
Jeanne, O. 156, 1041
Jeanne, O., s e e Bensaid, B. 1446, 1449
Jefferson, P.N. 1485, 1509
Jegadeesh, N. 1321
Jegadeesh, N., s e e Chan, L. 1321
Jensen, H. 1415, 1427
Jensen, H., s e e Beetsma, R. 1436, 1438
Jensen, M. 1344
Jeon, B.N., s e e yon Furstenberg, G.M. 1333
Jermann, U.J. 1296
Jennann, U.J., s e e Alvarez, E 575
Jermann, U.J., s e e Baxter, M. 980, 992
Jewitt, I., s e e Buiter, W. 1030
Jimeno, J.E, s e e Blanchard, O.J. 1214
Jimeno, J.E, s e e Dolado, J.J. 1214
John, A., s e e Cooper, R. 398
Johnson, H.G. 702, 704, 705
Johnson, P, s e e Goodman, A. 797
Johnson, RA., s e e Durlauf, S.N. 254, 263,264,
270, 271,289, 303
Johnson, RG., s e e Banks, J. 751
Johnson, S.A. 345, 381
Jones, C.I. 237, 264, 290, 292, 672, 696,
714-716, 718, 719

1-14
Jones, C.I., s e e Hall, R.E. 673, 679, 680,
683-686, 702, 856
Jones, L.E. 245, 257, 261, 380, 672, 709,
711-713, 720, 1675, 1711
Jones, L.E., s e e Chaff, V.V. 715, 1578
Jones, M. 1540
Jonsson, G. 1404, 1411, 1415, 1426, 1438
Jonung, L. 159, 1485
Jonung, L., s e e Bordo, M.D. 152, 215, 217,
220, 221
Jonung, L., s e e Fregert, K. 1016
Jorda, O. 881
Jorgenson, D. 664
Jorgenson, D.W. 817
Jorgenson, D.W., s e e Christensen, L.R. 673,
688
Jorgenson, D., s e e Hall, R.E. 817
Jorion, E, s e e Goetzmann, W.N. 1242, 1252,
1320
Jovanovic, B. 702, 848, 1200
Jovanovic, B., s e e Greenwood, J. 664, 692
Judd, J.R 1485, 1487, 1512, 1516
Judd, K. 590, 1652
Judd, K., s e e Bizer, D. 380
Judd, KJ., s e e Gaspar, .I. 324, 369
Judd, K.L. 314, 324, 340, 343, 347, 348, 350,
354, 1673, 1675, 1694
Judson, R. 663
Judson, R., s e e Porter, R. 1509
Juhn, C. 569, 619
Jun, B. 474
Juster, E32 777
Juster, 32, s e e Barsky, R. 558, 564, 565
Kaas, L . , s e e B6hm, V. 646
Kafka, A. 1543
Kahaner, D. 329, 333
Kahn, C. 1154
Kahn, C.M., s e e Blanchard, O.J. 391,504
Kahn, J., s e e Crucini,,M.J. 178, 705
Kahn, J.A. 897, 910
Kalm, J.A., s e e Bils, M. 910, 912, 1053, 1078,
1079, 1085
Kahneman, D. 1308, 1309, 1311
Kahneman, D., s e e Thaler, R.H. 1313
Kahneman, D., s e e Tversky, A. 1308, 1315,
1319, 1330
Kalaba, R., s e e Belhnan, R. 340
Kaldol; N. 237, 238, 240, 640, 941
Kalecki, M. 1054
Kallick, M. 1325

Author

Index

Kamihigashi, 32 428
Kaminsky, G.L. 1550, 1553, 1590
Kandel, S. 1235, 1252, 1253, 1265, 1270,
1272
Kandori, M. 475
Kane, A., s e e Chou, R.Y. 1236, 1280
Kaniovski, Y.M., s e e Arthur, W.B. 476
Kaplan, S.N. 856, 1344
Karatzas, L, s e e El Karoui, N. 835
Karras, G., s e e Cecchetti, S.G. 217
Kashyap, A.K. 137, 877, 881,886, 903,906,
912, 1018, 1344, 1374, 1376
Kashyap, A.K., s e e Cecchetti, S.G. 876
Kashyap, A.K., s e e Hoshi, 32 1344
Kashyap, A.K., s e e Hubbard, R.G. 1344
Katz, L. 577, 578
Katz, L., s e e Autor, D. 577
Katz, L.E, s e e Abraham, K.J. 1183, 1221
Katz, L.E, s e e Cutler, D.M. 797
Katz, L.W., s e e Blanchard, O.J. 1176
Kaufman, H. 1344
Keane, M.P. 608, 609, 786, 790
Keefer, E, s e e Knack, S. t466, 1471
Kehoe, RJ., s e e Atkeson, A. 847, 1675, 17t8,
1720
Kehoe, PJ., s e e Backus, C.K 549
Kehoe, RJ., s e e Backus, D.K. 9, 42, 45, 938,
1708
Kehoe, EJi, s e e Chari, V.V. 124, 397, 422, 672,
697, 698, 700, 701, 709, 720, 722, 723,
974, 1036, 1037, t040-1042, 1371, 1448,
1449, 1488, 1489, 1673-1676, 1691, 1699,
1708 1710, 1720, 1723
Kehoe, RJ., s e e Cole, H.L. 1449
Kehoe, T.J. 314, 380, 389, 391,574, 575
Kehoe, T.J., s e e Cole, H.L. 1446, 1449, 1603
Kehrei, K.C., s e e Moffitt, R.A. 618
Kelly, M. 271
Kemmerer, E.W. 173
Kendlick, D.A., s e e Armnan, H.M. 535
Kenen, RB. 165, 1496
Kennan, J. 803
Kessler, D. 1646
Keynes, J.M. 158, 161, 1055, 1059, 1537
Kiefer, J. 476
Kiefcr, N.M., s e e Burdett, K. l t 73
Kiefer, N.M., s e e Devine, T.J. 1166
Kiguel, M. 1535, 1543, 1546, 1554, 1555
Kihlstrom, R.E. 563
Kiley, M.T. 422, 423, 1041, 1117, 1129
Killian, L. 87

Author

Index

Killingsworth, M.R. 550, 601, 1148

Kim, J. 129, 1036
Kim, K. 377, 379
Kim, M., s e e Nelson, C.R. 1320
Kim, S. 95
Kim, S.-J. 672, 711-714
Kimball, M., s e e Barsky, R. 558, 564, 565
Kimball, M., s e e Carroll, C.D. 762, 771
Kimball, M.S. 556, 770, 1036, 1041, 1056,
1114, 1117, 1127, 1653
Kimball, M.S., s e e Basu, S. 983, 992, 994,
1069, 1080, 1081, 1117
Kimbrough, K.R 1537, I675, 1676, 1720,
1732
Kindahl, J., s e e Stigler, G. t018
Kindleberger, C.R 162
King, M. 199, 1333, 1485, 1489
King, R.G. 9, 46, 54, 69, 101,278, 369, 391,
429, 435, 545, 549, 649, 672, 689, 692,
7ll-713,929, 931,932, 939, 941,945,953,
954, 971, 995, 1036, 1041, 1043, 1062,
1140, 1364, 1367, 1491
King, R.G., s e e Barro, R.J. 974
King, R.G., s e e Baxtel, M. 9, 11, 12, 430, 934,
974
King, R.G., s e e Dotsey, M. 974, 1032, 1043
King, R.G., s e e Goodfriend, M. 1013, 1117,
1346, 1515
King, S. 101
Kirby, C. 1320
Kirman, A.R 475, 528, 536, 539-541
Kitanidis, RK. 326
Kiyotaki, N. 524, 852, 857, 1353, 1356, 1376,
1378, t379
Kiyotald, N., s e e Blanchard, 03. 1033, 1034
Kiyotaki, N., s e e Boldrin, M. 399
Kleidon, A.W. 1320
Klein, B. 202, 215, 216
Klein, L. 94t
Klemperer, RD. / 121
Klenow, PJ. 663,673, 679, 680, 683 686, 694,
702, 705,707
Klenow, RJ., s e e Bils, M. 694
Klenow, EJ., s e e Heckman, J.J. 578
Klock, M., s e e Silbennan, J. 1316
Knack, S. 1466, 1471
Kneese, A. 656
Knowles, S. 277, 278
Kocherlakota, N. 574, 954, 985, 1234, 1251,
1253
Kocherlakota, N., s e e Cole, H.L. 576

1-15
Kocherlakota, N., s e e Ingram, B. 984
Kocberlakota, N.R. 271,673,694
Kochin, L., s e e Benjamin, D. 161
Kollintzas, T. 904-907
Kollman, R. 1085
Kon-Ya, E, s e e Shiller, R.J. 1316
Konings, J., s e e Garibaldi, P 1180, 1222
Koopmans, T. 931,942, 948
Koopmans, T.C. 244, 246, 247, 295, 643, 649,
1673
Koopmans, TJ. 9
Kormendi, R.C. 278-281,671, 1656, 1657
Kornai, J. 703
Kortum, S., s e e Eaton, J. 719
Kosobud, R., s e e Klein, L. 941
Kosters, M.H. 618
Kotkin, B., s e e Bellman, R. 340
Kotlikoff, L. 1448, 1449, 1465
Kotlikoff, L., s e e Hayashi, E 796
Kotlikoff, L.J. 780, 1624, 1646
Kotlikoff, L.J., s e e Auerbach, A.J. 380, 549,
576, 588, 590, 591, 593, 616, 1624, 1634,
1635, 1639, 1652, 1718
Kotlikoff, L.J., s e e Gokhale, J. 750
Koyck, L.M. 816
Kramer, C., s e e Flood, R.R 1596
Krane, S.D. 876, 877
Kremer, M., s e e Blanchard, O.J. 852
Kremer, M., s e e Easterly, W. 277, 278, 281,
675
Kreps, D.M. 540, 557, 1256
Kreps, D.M., s e e Bray, M. 474
Kreps, D.M., s e e Fudenberg, D. 475
K~%ger, S. 380, 843, 847
Krishnamurthy, A. 1376, 1378
Kroner, K.E, s e e Bollerslev, T. 1236, 1280
Krueger, A., s e e Autor, D. 577
Kateger, A.O. 673, 679, 699
Krueger, J.T. 104, 105
Krugman, R 1215, 1536, 1590, 1592, 1594,
1596, 1601, 1605, 1606, 1632
Krusell, R 380, 547, 566, 567, 994, 1293,
1445, 1473
Krusell, P, s e e Greenwood, J. 664
Kuan, C.-M. 476
Kugler, P. 1281
Kuh, E., s e e Meyel, J.R. 8t7
Kumhof, M. 1596
Kurz, M. 474
Kushner, H. 476
Kushner, H.J. 476

1-16
Kusko, A.L. 1327
Kuttner, K., s e e Evans, C.L. 105
Kutmer, K.N., s e e Friedman, B.M. 43, 44
Kuttner, K.N., s e e Kruegm; J.T. 104, 105
Kuznets, S. 941
Kuznets, S., s e e Friedman, M. 572
Kwiatkowski, D. 2t2
Kydland, EE. 9, 42, 158, 428, 547, 549, 578,
929, 953, 956, 957, 962, 980, 98t, 1058,
1059, 1140, 1141, 1145, t167, 1195, 1400,
1405, 1415, 1449, 1485, 1486, 1488, 1557,
1561, 1673, 1708
Kydland, EE., s e e Backus, C.K. 549
Kydland, EE., s e e Backus, D.K. 1708
Kydtand, EE., s e e Bordo, M.D. 158, t60, 185,
215, 1438
Kydland, EE., s e e Hotz, V.J. 792, 803
Kyle, A.S,, s e e Campbcll, J.Y. 1290
La Porta, R. 1240, 1320
Labadie, R, s e e Giovamaini, A. 380
Labadie, RA., s e e Coleman II, W.J. 114
Lach, S. 1019
Ladron de Guevara, A. 317
Laffont, J., s e e Gourieroux, C. 487
Laffont, JJ., s e e Kihlstrom, R.E. 563
Laffont, J.-J. 538
Lahiri, A. 1539, 1571, 1578, 1579, 1597
Lai, K.S. 876
Laibson, D. 1653
Laidler, D. 1485
Lakonishok, J. 1323
Lakonishok, J., s e e Chan, L. 1321
Lain, R-S., s e e Cecchetti, S.G. 1251, 1265,
1270, 1272, 1294, 1296
Lam, ES. 802
Lambert, J.D. 346
Lambertini, L. 1457, 1465
Lamo, A.R. 290
Lamont, O.A., s e e Kashyap, A.K. 881, 912,
1344, 1374
Landi, L., s e e Barucci, E. 525
Lane, R 1472
Langer, E.J. 1329
Lansing, K., s e e Guo, J.-T. 416
Lapham, B.J., s e e Devereux, M.B. 1126
Laroque, G., s e e Fuchs, G. 464, 474
Laroque, G., s e e Grandmont, J.-M. 464, 474,
475, 481,507
Laroque, G., s e e Grossman, S.J. 801
Lau, L. 664

Author

Index

Lau, S.H.E 1037

Lawrance, E. 607 609
Layard, R. 1098, t176, 1177, 1221
Layard, R., s e e Jackman, R. 1221
Layne-Farrar, A., s e e Heckman, J.J. 578
Lazaretou, S. 159
Lazear, E.R 1660
Lazear, E.R, s e e Hall, R.E. 1152
LeaNte of Nations 162
Leahy, J. 844, 1332
Leahy, J., s e e Caballero, R.J. 823, 828, 830
Leahy, J., s e e Caplin, A. 849, 850
Learner, E.E. 282
Lebow, D.E. 215, 1016
Lebow, D.E., s e e Blinder, A.S. 1018, 1t18
Lee, C. 1324
Lee, J.-W., s e e Barro, R.J. 277-281,671, 68I,
683-685, 688, 689, 691-694
Lee, J.-W. 703
Lee, J.Y. 395
Lee, K. 284
Lee, T.H., s e e Granger, C.W.J. 881,903
Leeper, E.M. 69, 74, 83, 93, 101, 128, 132,
134, 137, 418, 420, 1036, 1089, 1369, 1518,
1520, 1631
Leeper, E.M., s e e Faust, J. 69, 217
Leeper, E.M., s e e Gordon, D.B. 128, 134
Lefort, E, s e e Caselli, E 277-279, 283, 284,
286
Lehmann, B.N. 1321
Leibfritz, W., s e e Roseveare, D. 1626
Leiderman, L. 1432, 1438, 1495, 1543
Leiderman, L., s e e Bufman, G. 1543
Leiderman, L., s e e Calvo, G.A. 1552, 1600
Leiderman, L., s e e Kamhlsky, G.L. 1550
Leijonhufvud, A. 152, 202, 215
Leijonhufvud, A., s e e Heymann, D. 1539,
1540
Lemarechal, C . , s e e Hiriart-Urruti, LB. 331
LeRoy, S.F. 1235, 1319
Lettau, M. 470, 472, 524, 527, 1293, 1297
Leung, C. 271
Levhari, D. 1450, 1465
Levin, A. 283, 1017, 1031, 1035, 1036, 1038
Levin, A., s e e Brayton, E 1043, 1344, 1485
Levine, D.K., s e e Fudenberg, D. 455, 475
Levine, D.K., s e e Kehoe, T.J. 380, 389, 391,
574, 575
Levine, J. 1332
Levine, P., s e e al Nowaihi, A. 1415, 1422,
1437

Author

Index

Levine, R. 269, 277-282, 390, 423, 671, 694,

1376
Levine, R., s e e King, R.G. 278, 689, 692
Levy, D. 1014, 1015, 1019
Levy, D., s e e Carpenter, R.E. 876
Levy, D., s e e Dutta, S. 1019, 1020
Levy-Leboyer, M. 222
L~vy-Strauss, C. 1331
Lewis-Beck, M. 1425
Li, J.X. 326
Li, Y., s e e Jolmson, S.A. 345, 381
Lichtenstein, S. 13 l 8
Lichtenstein, S., s e e Fischhoff, B. 1319
Lilien, D.M. 1160, 1183, 1221
Lilien, D.M., s e e Hall, R.E 1153
Lillard, L. 569, 572
Limongi, E, s e e Przeworski, A. 1466
Lin, C., s e e Levin, A. 283
Lindbeck, A. 1098, 1425, 1465
Lindert, R 156
Lioni, G., s e e Contini, B. 1177, 1178, 1180,
1222
Lippi, F. 1432
Lippi, E, s e e Cukierman, A. 1438
Lippi, M. 217
Lipsey, R.E., s e e Blomstrom, M. 277, 279,
280
Lia, C.Y., s e e CoLflon, J.R. 1032
Liviatan, N., s e e Cukierman, A. 1437
Liviatan, N., s e e Kiguel, M. 1535, 1543, 1546,
1554, 1555
Lizondo, J.S. 1538
Lizzeri, A. 1459
Ljung, L. 474, 476, 481,482
Ljungqvist, L. 1214
Lo, A.W. 132i
Lo, A.W., s e e Campbell, J.Y. 1255, 1257, 1258,
1261, 1266, 1270, 1320
Loayza, N.V. 708
Lochner, L., s e e Cossa, R. 584
Lochner, L., s e e Heckman, J.J. 576, 578, 582,
584, 586, 587, 590, 592, 593
Lockwood, B. 1411, 1415
Lockwood, B., s e e Herrendorf, B. 1436, 1438
Lohman, S. 1416-1418, 1425, 1431, I438
Londregan, J., s e e Alesina, A. 1425
Long, J. 929, 952, 953, 994
Loomes, G. 1313
Lopez-de-Silanes, E, s e e La Porta, R. 1240
Lorentz, A.L. 344
Lothian, J.R., s e e Darby, M.R. 166

1-17
Loury, G.C. 299
Lovell, M.C. 881, 893, 908, 910
Lown, C., s e e Bernanke, B.S. 1343
Lucas, D.J. 1035, 1036, 1042
Lucas, D.J., s e e Heaton, J. 380, 547, 569, 1255,
1293
Lucas, R. 398, 424, 425, 641, 651, 929, 932,
953
Lucas, R.E. 46, 50, 380, 1158, 1446, 1449
Lucas, R.E., s e e Stokey, N.L. 314, 318021,
346, 951,998, 999
Lucas Jr, R.E. 67, 88, 158, 238, 245, 264, 265,
293, 454, 457, 463, 474, 545, 547, 554,
559, 561, 575, 578, 582, 583, 615, 616,
672, 710-715, 720, 797, 1022 1024, 1043,
1195, 1268, 1489, 1490, 1495, 1500, 1592,
1673, 1675, 1699, 1711, 1723, 1728
Lucas Jr, R.E., s e e Atkeson, A. 575
Lucas Jr, R.E., s e e Stokey, N.L. 271,299
Ludvigson, S. 785, 788, 1344, 1652
Lundvik, E, s e e Hassler, J. 9, 1238
Lusardi, A. 608, 790, 791
Lusardi, A., s e e Browning, M. 606, 771
Lusardi, A., s e e Garcia, R. 790
Lutmaer, E.G.J. 575
Lyons, R.K., s e e Caballero, R.J. 399

Maberly, E.D., s e e Dyl, E.A. 1334

Macaulay, ER. 173
MacAvoy, RW., s e e Funkhouser, R. 699
Maccini, L.J. 881,893, 894, 903, 907
Maccini, L.J., s e e Blinder, A.S. 887, 904, 910,
1344
Maccini, L.J., s e e Durlauf, S.N. 905 907
Maccini, L.J., s e e Haltiwanger, J.C. 881
Maccini, L.J., s e e Humphreys, B.R. 909
MacDonald, R., s e e Bordo, M.D. 156
Mace, B.J. 796
Mackay, D. 1307
MacKinlay, A.C., s e e Campbell, J.Y. 1255,
1257, 1258, 1261, 1266, 1270, 1320
MacKinlay, A.C., s e e Lo, A.W. 1321
MacLeod, W.B. 1157, 1186
MaCurdy, T.E. 551, 567-569, 5'72, 592, 595,
615, 616, 619-62t, 752, 759, 767, 792, 975,
1148, 1149
MaCurdy, T.E., s e e Attanasio, O.R 792
MaCurdy, T.E., s e e Blundell, R. 602, 620
MaCurdy, T.E., s e e Heckman, J.J. 615
Maddala, G.S. 275

1-18
Maddison, A. 288, 673~i75, 677, 678, 720,
721
Madison, J. 1659
Mailath, G.J., s e e Kandori, M. 475
Makhija, A.K., s e e Ferris, S.R t314
Malcomson, J.M., s e e MacLeod, W.B. 1157,
1186
Malinvaud, E., s e e Blanchard, O.J. 1214
Malkiel, B. t316
Mankiw, N.G. 135, 158, 159, 173, 216, 244246, 252-255, 269-271,277~79, 289, 397,
567, 653, 655, 660, 673, 679--686, 694,
749, 785, 790, 800, 961, 1281, 1290, 1292,
1638, 1702, 1742
Mankiw, N.G., s e e Abel, A.B. 1266, 1651
Mankiw, N.G., s e e Ball, L. 42, 1023, 1632,
1650, 1651
Mankiw, N.G., s e e Barro, R.J. /637
Mankiw, N.G., s e e Barsky, R.B. 1653
Mankiw, N.G., s e e Campbell, J.Y. 769, 784,
1261, 1264, 1290, 1655
Mankiw, N.G., s e e Elmendorf, D.W. 1439
Mankiw, N.G., s e e Hall, R.E. 1485, 1493,
1498
Mankiw, N.G., s e e Kimball, M.S. 1653
Mann, C.L., s e e Bryant, R.C. 1043, 1491,
1497, 1516-1518
ManueUi, R.E, s e e Chaff, VV 715, 1578
Manuelli, R.E., s e e Jones, L.E. 245, 257, 261,
380, 672, 709, 711 713,720, i675, 1711
Mao, C.S., s e e Dotsey, M. 370, 952
Marcet, A. 314, 326, 348, 351,454, 455, 464,
465, 468, 473476, 480, 494, 499, 525,
528-530, 532, 1675, 1705, 1707
Marcet, A., s e e Canova, E 283
Marcet, A . , s e e den Haan, W.J. 347, 354, 369
Margarita, S., s e e Beltratti, A. 524, 525
Margaritis, D. 474
Mariano, R.S., s e e Seatel; J.J. 1656, 1657
Maffger, R.R 1344 "
Marimon, R. 455, 464, 472, 475, 523, 53l,
1214
Marmlon, R., s e e Evans, G.W. 483, 509, 527,
528, 531
Marion, N., s e e Flood, R.R 1429, 1438
Mark, N.C., s e e Cecchetti, S.G. 1251, 1265,
1270, 1272, 1294, 1296
Marris, S. 1632
Marschak, J. 582, 1043
Marshall, A. 203
Marshall, D.A., s e e Bekaert, G. 1281

Author

Index

Marshall, D.A., s e e Marcet, A. 326, 348, 351,

455
Marston, R., s e e Bodnar, G. 1318
Marston, R.C. 164
Martin, J.R 1181
Mas-Colell, A., s e e Kehoe, T.J. 380
Masciandaro, D., s e e Grilli, V 1404, 1432,
1438, 1439, 1465
Masson, A., s e e Kessler; D. 1646
Masson, E, s e e Chadha, B. 1542
Masson, ER. 1554, 1588
Matheny, K.J. 395, 441
Matsukawa, S. 1037
Matsuyama, K. 395, 399
Matthieson, D., see Mussa, M. 208
Mauro, R 277
Mauro, E, s e e Easterly, W. 1538
Maussner, A. 528
Mayhew, S. 1310
McAfee, R.R, s e e Howitt, R 389, 399, 506,
517, 521
McCallum, B.T. 83, 173, 184, 198, 203, 408,
487, 488, 496, 503, 1022, 1026, 1043,
1411, 1426, 1432, 1437, 1438, 1485, 1487,
1488, 1490, 1491, 1493, 1495, 1500, 1502,
1506-1510, 1512, 1515-1519, 1631
McCulloch, J.H., s e e Dezhbakhsh, H. /039
McElroy, M. 619
McFadden, D. 1314, 1316, 1328
McGrattan, E.R. 348, 974
McGrattan, E.R., s e e Anderson, E.W. 368,
369
McGrattan, E.R., s e e Chari, V.V. 124, 397, 422,
672, 697, 698, 700, 701, 709, 720, 722,
723, 974, 1036, 1037, 1040-1042, 1371
McGrattan, E.R., s e e Marimon, R. 455, 475,
523
McGuire, W.J. 1332
Mclntire, J.M., s e e Carlson, J.B. 104
McKelvey, R.D. 380
McKibbin, WJ., s e e Henderson, D.W. 1497
McKinnon, R. 1496
McKinnon, R.I. 166, 207
McLaughlin, K.J. 1016, 1152
McLean, I., s e e Eichengreen, B. t57
McLennan, A. 474
McLennan, A., s e e McKelvey, R.D. 380
McManus, D.A. 908
Means, G.C. 1082
Meckling, W., s e e Jcnsen, M. 1344
Medeiros, C. 1554, 1555

Author

Index

Medoff, J.L., s e e Fay, J.A. 1077, 1103

Meehl, P. 1319
Meghir, C. 611, 613, 775, 804
Meghir, C., s e e Arellano, M. 787
Meghir, C., s e e Attanasio, O.R 793,794
Meghir, C., s e e Blundell, R. 611, 612, 779,
781,783,790-792
Meghir, C., s e e Browning, M. 607, 611,778
Meguire, R, s e e Konnendi, R.C. 278-281,671,
1656, 1657
Mehra, R. 547, 961, 1234, 1236, 1249, 1251,
1264, 1268, 1270, 1272, 1289, 1312
Mehra, R., s e e Constantinides, G.M. 1293
Mehra, R., s e e Danthine, J.-R 329, 370, 952
Meigs, A.J. 191
Melenberg, B., see Alessie, R. 774
Melino, A., s e e Blanchard, O.J. 912
Melino, A., s e e Epstein, L.G. 558, 565
Melino, A., s e e Grossman, S.J. 1242
Melnick, R., s e e Bruno, M. 1539
Meltzer, A.H. 162, 169, 174-176, 178, 179,
185, 204, 215-217, 222, 1466, 1485, 1543
Meltzer, A.H., s e e Brunner, K. 179, 183, 191,
1025
Meltzer, A.H., s e e Cukierman, A. 1414, 1450,
1463
Mendoza, E. 1439, 1571, 1579
Mendoza, E., s e e Calvo, G.A. 1591, 1600,
1601
Meredith, G., s e e Chadha, B. 1542
Melton, R. 1275
Merton, R.K. 389, 1333
Merz, M. 994, 1158, 1173, 1203, 1207
Metivier, M., s e e Benveniste, A. 476, 531
Metzler, L.A. 867
Meyer, J.R. 817
Mihov, I., s e e Bernanke, B.S. 72, 76, 83, 89,
114, 1365, 1369
Milesi-Ferretti, G.-M., s e e Mendoza, E. 1439
Milesi-Ferretti, G.-M. 1425, 1 4 2 6 , 1597
Milgrom, R 475, 1322
Millard, S.R 1217, 1220
Miller, B.L. 566
Miller, M., s e e Lockwood, B. 1411, 1415
Miller, M., s e e Modigliani, E 1343
Miller, R.A., s e e Altug, S. 584, 595, 611, 612,
785, 786, 792
Mills, E 1082
Mills, J., s e e Erlich, D. 13t4
Mills, L.O., s e e Boschcn, J.E 139
Mills, T.C. 204

1-19
Mills, T.C., s e e Capie, E 163, 1438
Mincer, J. 581,592, 684
Minehart, D., s e e Bowman, D. 1313
Mirman, L., s e e Levhari, D. 1450, 1465
Mirman, L.J., s e e Brock, W.A. 319, 547, 552,
556, 942, 951
Miron, J.A. 173, 216, 876, 907, 1242
Miron, J.A., s e e Barsky, R.B. 1149
Miron, J.A., s e e Beaulieu, J.J. 876
Miron, J.A., see Feenberg, D. 60
Miron, J.A., s e e Mankiw, N.G. 173, 216,
1281
Mirrlees, J.A. 1154
Mirrlees, J.A., s e e Diamond, RA. 1684
Mishkin, ES. 101, 183, 216, 1023, 1380, 1432,
1438
Mishkin, ES., s e e Bernanke, B.S. 1495
Misl~dn, ES., s e e Estrella, A. 1485
Mishkin, ES., s e e Hall, R.E. 607, 608, 789,
1655
Mishra, D. 1416, 1425
Missale, A. 1450
Mitchell, B.R. 222
Mitchell, W.C. 8, 44, 1053
Mitchell, W.C., s e e Burns, A.E 5, 8, 931,934
Mitra, K. 530, 532
Mnookin, R.H., s e e Gilson, R.J. 1154
Modiano, E.M. 1543
Modigliani, E 761,762, 780, 1321, 1343, 1646,
1656, 1657
Modigliani, E, s e e Dreze, J. 770
Modigliani, E, s e e Holt, C.C. 882, 885, 888,
909, 910, 912
Modigliani, E, s e e Jappelli, T. 780
Modigliani, E, s e e Samuelson, P.A. 643
Moffitt, R. 752, 787
Moffitt, R.A. 618
Moler, C., s e e Kahaner, D. 329, 333
Mondino, G. 1540
Monfort, A., s e e Gourieroux, C. 48"]
Monfo, S., s e e Robbins, H. 4'76,478
Montgomery, E. 1017, 1018
Montiel, E 1539
Montiel, E, s e e Agdnor, RR. 1543
Monta'ucchio, L. 330
Montrucchio, L., s e e Boldfin, M. 362
Moore, B.J. 455, 475, 496
Moore, G.H. 1059
Moore, G.H., s e e Zarnowitz, V. 40
Moore, G.R., s e e Fuhrer, J.C. 905, 908, 1039,
1040, 1518

1-20

Author

Moore, J., s e e Kiyotaki, N. 852, 857, 1353,

1356, 1376, 1378, 1379
Moreno, D. 481
Morgan, D. 1374
Morrison, C,J. 1086
Mortensen, D.T. 1157, 1158, 1162, 1163, 1173,
1182, 1183, 1187, 1188, 1194, 1198, 1203,
1208, 1217, 1220, 1222
Mortensen, D.T., s e e Burdett, K. 1173, 1196
Mortensen, D.T., s e e Millard, S.R 1217, 1220
Morton, T.E, 338
Mosser, EC. 910
Motley, B., s e e Judd, J.E 1485, 1487, 1512,
1516
Mroz, T.A. 618
Maoz, T.A., s e e MaCurdy, T.E. 592, 752
Muellbauer, J., s e e Deaton, A. 783
Mueller, D. 1464
Mulligan, C.B. 346, 1150
Mundell, R.A. 1496
Murphy, K. 581
Murphy, K., s e e Juhn, C. 569, 619
Murphy, K., s e e Katz, L. 577, 578
Murphy, K.M. 262, 278, 1082
Mmxay, C.J., s e e Nelson, C.R. 11
Murray, W., s e e Gill, RE. 329
Musgrave, R.A. 1631, 1661
Mussa, M. 208, 1404, 1637
Mussa, M., s e e Flood, R.P. 152, 202, 1428
Mussa, M.L., s e e Frenkel, J.A. 203
Muth, J.E 457, 473,484
Muth, J.E, s e e Holt, C.C. 882, 885, 888, 909,
910, 912
Myerson, R. 1459
Nakanmra, A. 618
Nakamura, M., s e e Nakamura, A. 618
Nalebuff, B., s e e Bliss, C. 1461, 1465
Nance, D.R. 1318
NaI~kervis, J.C., s e e McManus, D.A. 908
Nash, S., s e e Kahaner, D. 329, 333
Nason, J.M., s e e Cogley, T. 395, 547, 967,
1142, 1503
Natanson, I.R 342
NBER

Neale, M.A., s e e Northcrafl, G.B. 1315

Negishi, T. 559
Nelson, C.R. 11, 211, 213, 264, 969, 1264,
1320
Nelson, C.R., s e e Beveridge, S. 1062, 1143
Nelson, D.B. 182

Index

Nelson, E, 1035
Nerlove, M. 283,284
Neumann, G.R., s e e Burdett, K. 1173
Neusser, K. 941
Neves, J., s e e Correia, I. 974
Neves, R, s e e Blundell, R. 792
Ng, S., s e e Garcia, R. 790
Nickell, S., s e e Layard, R. 1098, 1176, 1177,
1221
Nickell, S.J. 823
Nicolini, J.E, s e e Marcet, A. 455,530, 532
Niederreiter, H. 334
Nilsen, O.A., s e e Askildsen, J.E. 1074
Nishimura, K., s e e Benhabib, J. 403~405, 425,
435
Nordhaus, W. 1400, 1425
North, D. 1449
Northcrafl, G.B. 1315
Novales, A. 803
Nurkse, R. 163,203
Nyarko, Y. 465, 474
O'Barr, W.M. t332
O'Brien, A.M. 776
O'Brien, A.P. 181
Obstfeld, M. 159, 164, 165, 407, 1411, 1415,
1429, 1438, 1449, 1507, 1571, 1588, 1590,
1592, 1630
Obstfeld, M., s e e Froot, K. 1266
O'Connell, S.A. 1650
Odean, T. 1314, 1323
O'Driscoll, G.P. t643
OECD 1181, 1182, 1215, 1620
Office of Management and Budget 1622
Officer, L. 155
Ogaki, M., s e e Atkeson, A. 610, 786
Ohanian, L.E. 1036
Ohanian, L.E., s e e Cooley, T.E 42, 962, 974
O'Hara, M., s e e Blume, L.E. 321,322
Ohlsson, H., s e e Edin, D.A. 1457
Okina, K. 1508
Okun, A.M. 1014, 1541
Oliner, S . D . 137, 820, 1374, 1376
Oliner, S.D., s e e Cummins, J.G. 856
Olsder, G., s e e Basar, T. 1449
Olshen, R.A., s e e Breiman, L. 289
Oppers, S. 154
Orphanides, A. 198, 1485
Ortega, E., s e e Canova, E 376, 377, 379
Ortigueira, S., s e e Lads'on de Guevara, A. 3 t 7
Ostry, J. 1568

Author

Index

Ostry, J., s e e Montiel, P 1539

Ostry, J.D., s e e Ghosh, A.R. 202, 207, 208
Owen, ED., s e e Knowles, S. 277, 278
Ozlel; S. 1457, 1465
Ozler, S., s e e Alesina, A. 277 279, 1460, 1466,
1471
Paarsch, H., s e e MaCurdy, T.E. 619, 620
Pacelli, L., s e e Contini, B. 1177, 1178, 1180,
1222
Packal6n, M. 525
Padilla, J., s e e Dolado, J. 1437
Pagan, A., s e e Kim, K. 377, 379
Pagan, A.R. 9, 69, 108
Pagano, M., s e e Giavazzi, E 203, 1438, 1446,
1449, 1580
Pagano, M., s e e Jappelli, T. 776
Papageorgiou, A. 334
Papageorgiou, C., s e e Duffy, J. 257
Paquet, A., s e e Ambler, S. 944
Parekh, G. 87, 109
Parente, S.L. 672, 674, 702, 708
Parke, W.R., s e e Davutyan, N. 156
Parker, J., s e e Barsky, R. 43
Parker, J., s e e Gourinchas, P-O. 609, 1344
Parker, J.A. 1120
Parker, J.A., s e e Solon, G. 579, 1058, 1102,
1106
Parkin, M. 1037, 1412, 1415, 1506
Parkin, M., s e e Bade, R. 1432, 1438
Pashardes, R, s e e Blundell, R. 781
Paskov, S.H. 334
Patel, J., s e e Degeorge, E 1321
Patinkin, D. 407, 1506, t507, 1630, 1643
Paulin, G. 751
Paxson, C., s e e Deaton, A. 798
Paxson, C., s e e Ludvigson, S. 788
Pazos, E 1534
Peles, N., s e e Goetzmann, W.N. 1314
Pencavel, J. 550, 601,605, 975, 1148
Peralta-Alva, A. 374
Perli, R. 402, 431,435
Perli, R., s e e Benhabib, J. 425, 426, 437
Perotti, R. 1466, 1469, 1472
Perotti, R., s e e Alesina, A. 1439, 1464, 1465
Perron, R 264
Perry, G.L., s e e Akerlof, G.A. 198
Persson, M. 1447, 1449
Persson, T. 278, 692, 1400, 1403, 1413,
1415-1418, 1420, 1421, 1425, 1433, 1435,
1437 1440, 1442, 1445, 1448-1450, 1454,

1-21
1456, 1459, 1460, 1465, 1466, 1469, 1470,
1490
Persson, T., s e e Engkmd, R 9
Persson, T., s e e Hassler, J. 9, 1238
Persson, T., s e e Horn, H. 1415
Persson, T., s e e Kotlikoff, L. 1448, 1449,
1465
Persson, T., s e e Persson, M. 1447, 1449
Pesaran, H. 487
Pesaran, M.H., s e e Binder, M. 271
Pesaran, M.H., s e e lm, K. 283
Pesaran, M.H., s e e Lee, K. 284
Pestieau, RM. 1718
Petersen, B.C., s e e Carpenter, R.E. 881, 912,
1344
Petersen, B.C., s e e Domowitz, I. 1020, 1083,
1093
Petersen, B.C., s e e Fazzari, S.M. 818, 1344
Petterson, R 1457
Pflug, G., s e e Ljung, L. 476
Phaneuf, L. 1028, 1039, 1041
Phelan, C. 380, 575, 796
Phelan, C., s e e Atkeson, A. 1298
Phelps, E. 944, 1025, 1026, 1039
Phelps, E.E., s e e Frydman, R. 453, 454, 474,
528, 536, 539
Phelps, E.S. 46, 168, 1059, 1098, 1121, 1122,
1157, 1173, 1176, 1192, 1220, 1537, 1538,
1720, 1724
Philippopoulus, A., s e e Lockwood, B. 1415
Phillips, A.W. 1510
Phillips, A.W.H. 46
Phillips, L.D., s e e Lichtenstein, S. 1318
Phillips, PC.B., s e e Kwialkowski, D. 212
Picard, P 1157
Pieper, RJ., s e e Eisner, R. 1621
Pierce, J.L. 195
Piketty, T., s e e Aghion, P. 1377
Pindyck, R. 1072
Pindyck, R.S. 835, 910, 912
Pindyck, R.S., s e e Abel, A.B. 835
Pindyck, R.S., s e e Caballero, R.J. 844
Pippenger, J. 156
Pischke, J.-S., s e e Jappelli, T. 790
Pischke, J.-S. 764
Pissarides, C.A. 774, 1163, 1173, 1183, 1184,
1188, 1193, 1194, 1200, 1203, 1207, 1209,
1220
Pissarides, C.A., s e e Garibaldi, E 1180, 1222
Pissarides, C.A., s e e Jackman, R. 1221

1-22
Pissarides, C.A., s e e Mortensen, D.T. t158,
1182, 1183, 1194, 1198, 1203, 1208
Plosser, C.I. 952, 954, 958, 961, 963, 1094,
1658
Plosser, C.I., s e e King, R.G. 9, 54, 369, 391,
429, 435, 549, 929, 931, 941, 945, 954,
995
Plosser, C.I., s e e Long, J. 929, 952, 953, 994
Plossel, C.I., s e e Nelson, C.R. 11,211, 213,
264, 969
Plutarchos, S., s e e Benhabib, J. 437
Polemarchakis, H.M., s e e Geanakoplos, J.D
395, 458
Policano, A., s e e Fethke, G. 1037
Pollak, R.A. 803
Pollard, S. 161
Poole, W. 192, 1514, 1515
Poonia, G.S., s e e Dezhbakhsh, H. 1039
Popper, K. 376
Porter, R. 1509
Porter, R.D., s e e LeRoy, S.F. 1235, 1319
Porteus, E.L., s e e Kreps, D.M. 557, 1256
Porfier, E 1068, 1126
Portier, E, s e e Hairault, J.-O. 1036
Posen, A. 1404, 1426, 1432, 1438
Posen, A., s e e Mishkin, ES. 1432, 1438
Poterba, J.M. 159, 1235, 1320, 1465, 1648,
1655
Poterba, J.M., s e e Cutler, D.M. 1290, 1320,
1321
Poterba, J.M., s e e Feldstein, M. 1633
Poterba, J.M., s e e Kusko, A.L. 1327
Power, L., s e e Cooper, R. 824
Pradel, J., s e e Fourgeaud, C. 454, 465, 4'73,
475
Praschnik, J., s e e Hornstein, A. 549
Prati, A. 162
Prati, A., s e e Alesina, A. 1446, 1449
Prati, A., s e e Drudi, E 1450
Prescott, E.C. 178, 365, 545, 675, 700, 702,
930, 934, 952, 954, 956, 957, 961, 963,
982, 1033, 1296, 1488, 1489, 1710
Prescott, E.C., s e e Chaxi, V.V. 1488, 1489,
1674
Prescott, E.C., s e e Cooley, T.E 376, 549, 954
Prescott, E.C., s e e Hansen, G.D. 602
Prescott, E.C., s e e Hodrick, R. 9, 12, 34, 428,
931,932
Prescott, E.C., s e e Kydland, EE. 9, 42, 158,
428, 547, 549, 929, 953, 956, 957, 962,
980, 981, 1058, 1059, 1140, 114t, 1145,

Author

Index

1167, 1195, 1400, 1405, 1415, 1449, 1485,

1486, 1488, 1673, 1708
Prescott, E.C., s e e Lucas Jr, R.E. 547, 554
Prescott, E.C., s e e Mehra, R. 547, 961, 1234,
1236, 1249, 1251, 1264, 1268, 1270, 1272,
1289, 1312
Prescott, E.C., s e e Parente, S.L. 672, 674,
708
Prescott, E.C., s e e Stokey, N.L. 951,998, 999
Prescott, E.S. 380
Press, W.H. 329-334, 343, 348, 356, 365
Preston, I., s e e Banks, J. 759, 783, 790, 791
Preston, 1., s e e Blundell, R. 572, 764, 797
Priouret, R, s e e Benveniste, A. 476, 531
Pritchett, L. 237
Pritchett, L., s e e Easterly, W 277, 278, 281,
675
Przeworski, A. 1466
Psacharopoulos, G. 685
Puterman, M.L. 336, 338, 339
Quadrini, V., s e e Cooley, T.E 1376
Quadrini, V, s e e Krusell, E 1445, 1473
Quah, D. 254, 263, 268, 272, 275, 283, 287,
288, 290-292, 294, 299
Quah, D., s e e Leung, C. 271
Quah, D.T., s e e Blanchard, O.J. 211, 216, 217
Quah, D.T., s e e Durlauf, S.N. 550
Quandt, R.E. 34
Quattrone, G.A. 1329
Rabin, M. 1319
Rabin, M., s e e Bowman, D. 1313
Rabinowitz, P., s e e Davis, EJ. 333
Radner, R. 952
Radner, R., s e e Benhabib, J. 1465
Ramey, G. 281,852, 1157, 1159
Ramey, G., s e e den Haan, W.J. 994, 1166,
1194, 1203, 1204, 1206, t207
Ramey, G., s e e Evans, G.W. 455, 461,462
Ramey, V.A. 67, 876, 885, 897, 902, 905-907,
909, 911,914, 1084, 1089
Ramey, V.A., s e e Bresnahan, T.E 911,912
Ramey, VA., s e e Chah, E.Y. 775
Ramey, V.A., s e e Ramey, G. 281
Ramos, J. 1543
Ramsey, E 643, 649
Ramsey, ER 1673
Rankin, N. 1025
Rankin, N., s e e Dixon, H. 537
Rapping, L., s e e Lucas Jr, R.E. 615, 616

Author

Index

Rasche, R.H., s e e Hoffman, D.L. 51,412

Ratti, R.A. 1497
Ravikttmar, B., s e e Chatterjee, S. 1126
Ravikumar, B., s e e Glomm, G. 712, 1472
RaMs, J. 1662
Ray, D., s e e Esteban, J.-M. 264
Rayack, V~ 579
Razin, A. 1715
Razin, A., s e e Frenkel, J.A. 1630
Razin, A., s e e Helpman, E. 203, 1580
Razin, A., s e e Mendoza, E. 1439
Razin, A., s e e Milesi-Ferretti, G.-M. 1597
Rebelo, S.T. 245, 260, 261, 709, 952, 1546,
1568, 1578-1581, 1606
Rebelo, S.T., s e e Burnside, C. 399, 930, 980,
982 985, 994, 1078, 1142
Rebelo, S.T., s e e Correia, I. 974
Rebelo, S.T., s e e Easterly, W. 703
Rebelo, S.T., s e e Gomes, J. 994, 1159
Rebelo, S.T., s e e King, R.G. 9, 54, 369, 391,
429, 435, 545, 549, 649, 672, 711-713, 929,
932, 945,954, 995, 1062, 1140
Rebelo, S.T., s e e Stokey, N.L. 578, 583, 672,
709, 711,714, 954
Redish, A. 154, 155, 166
Redish, A., s e e Betts, C.M. 217
Redmond, J. 161
Reichenstein, W. 101
Reichlin, L., s e e Evans, G.W. 1125
Reichlin, L., s e e Lippi, M. 217
Reid, B.G., s e e Boothe, PM. 1658
Reinbart, C.M. 1545, 1546, 1551, 1553, 1561,
1572, 1573
Reinhart, C.M., s e e Calvo, G.A. 1538, 1539,
1552, 1588, 1600
Reinhart, C.M., s e e Kaminsky, G.L. 1553,
1590
Reinhart, C.M., s e e Ostry, J. 1568
Renelt, D., s e e Levine, R. 269, 277-282, 390,
423, 671,694
Reserve Bank of New Zealand 1500
Resnick, L.B., s e e Levine, J. 1332
Restoy, F. 1272
Revelli, R., s e e Contini, B. 1177, 1178, 1180,
1200, 1222
Revenga, A., s e e Blanchard, O.J. 1214
Rey, R, s e e Aghion, R 1157
Ricardo, D. 1642
Rich, G. 1514
Richard, S.E, s e e ttansen, L.P 556
Richards, S., s e e Meltzer, A.H. 1466

1-23
Rietz, T. 1252, 1272, 1296
Riley, J. 1461, 1465
Rios-Rull, J. 943
Rios-Rull, J.-V., s e e Castafieda, A. 380
Rios-Rull, J.-V. 380
Rios-Rull, V., s e e Krusell, P. 1445, 1473
Ritter, J.R. 1321
Ritter, J.R., s e e Ibbotson, R. 1321
Rivers, D. 840
Rivlin, T.J. 343
Rob, R., s e e Jovanovic, B. 702
Rob, R., s e e Kandori, M. 475
Robb, R., s e e Heckman, J.J. 752
Robbins, H. 476, 478
Roberds, V~, s e e Hansen, L.E 573,574
Roberts, H.V. 1307
Roberts, J., s e e Milgrom, P 475
Roberts, J.M. 1013, 1033, 1040, 1116, 1118,
1505
Roberts, J.O., s e e Lebow, D.E. 215
Roberts, K. 1466
Robertson, J.C., s e e Pagan, A.R. 69, 108
Robinson, D. 217
Robinson, J. 1054, 1120
Robinson, S., s e e Meltzer, A.H. 204, 216, 217,
222
Rockafellar, R.T. 325
Rockoft, H. 155, 157
Rockoff, H., s e e Bordo, M.D. 160
Rodriguez, C.A. 1562, 1563, 1565, 1568
Rodr~guez-Clare, A., s e e Klenow, RJ. 663,673,
679, 680, 683-686, 694, 702, 705, 707
Rodrik, D., s e e Alesina, A. 278, 692, 1466,
i469
Rogers, C. 1449, 1450
Rogers, D., s e e Fullerton, D. 576, 588, 616
Rogerson, R. 551,602, 97~978, 1145
Rogerson, R., s e e Benhabib, J. 402, 550, 1145
Rogerson, R., s e e Bertola, G. 1222
Rogerson, R., s e e Cho, J.O. 976
Rogerson, R., s e e Cole, H.L. 1163, 1194,
1201 1203, 1207
Rogerson, R., s e e Greenwood, J. 550, 995
Rogerson, R., s e e Hopenhayn~ H. 672, 708,
994
Rogerson, R., s e e Parente, S.L. 702
Rogoff, K. 961, 1415- 1418, 1420, 1422, 1425,
1429, 1432, 1434, 1438
Rogoff, K., s e e Bulow, J. 1448, 1449
Rogoff, K., s e e Canzoneri, M.B. 1507, 1508

1-24
Rogoff, K., s e e Obstfeld, M. 407, 1507, 1590,
1630
Rojas-Snarez, L. 1575
Roland, G., s e e Persson, T. I460
Roldos, J. 1578
Roll, R. 1328
Romer, C.D. 6, 69, 92, 137, 183, 187, 204,
205, 1618
Romer, D. 237, 643, 649, 651, 661,930, 1013,
I034, 1140, 1157, 1163, 1635, i661
Romer, D., s e e Ball, L. 1023, 1037, 1041,
1127
Romcr, D., s e e Franket, J.A. 280, 281
Romer, D., s e e Mankiw, N.G. 244-246, 252255, 269-271,277--279, 289, 653, 655, 660,
673,679-683, 685, 686, 1638
Romer, D.H., s e e Romer, C.D. 69, 92, 137
Romer, RM. 238, 245, 260, 261,264, 265, 271,
278, 280, 398, 424, 425, 641, 651, 665,
672, 705-707, 715-717, 719, 1638
Romer, P.M., s e e Evans, G.W. 425, 426, 506,
521
Rose, A., s e e Akerlol, G.A. 1200
Rose, A.K, s e e Eichengreen, B. 1590
Rose, A.K., s e e Frankel, J.A. 1590
Rosen, A., s e e Meehl, R 1319
Rosen, S. 584, 585, 976
Rosensweig, J.A. 1659
Rosenthal, H., s e e Alesina, A. 1425, 1426
Roseveare, D. 1626
Ross, L. 1319
Ross, S., s e e Brown, S. 1242
Ross, S.A. 1331
Rossana, R.J. 879, 881, 886, 907
Rossana, R.J., s e e Maccini, L.J. 881, 893, 894,
903, 907
Rossi, RE., s e e Jones, L.E. 380, 672, 711--713,
1675, 1711
Rotemberg, J.J. 67, 68, 395, 397, 406, 407,
423, 429, 434, 838, 910, 974, 996, 1020,
1033, 1034, I036, 1040, 1041, 1043, 1044,
1055, 1056, 1058, 1062, 1063, 1067-1069,
1074, 1081, 1082, 1088--1090, 1092, 1093,
1106, 1107, 1114, 1116, 1118, 1123q125,
1129, 1143, 1144, 1365, 1464, 1492, 1494,
1497
Rotemberg, J.J., s e e Mankiw, N.G. 785
Rotemberg, J.J., s e e Pindyck, R. 1072
Rotemberg, J.J., s e e Poterba, J.M. 159
Rothschild, M. 823
Rotwein, E. t011

Author

index

Roubini, N. 1439, 1465

Roubini, N., s e e Alesina, A. 277~79, 1404,
1423, 1425, 1460, 1466, 1471
Roubini, N., s e e Grilli, V 95
Roubini, N., s e e Kim, S. 95
Rouwenhorst, K.G. 1296
Royer, D., s e e Balasko, Y 506
Rubinstein, A. 1188
Rubinstein, A., s e e Bilmlore, K.G. 1188
Rubinstein, M. 554-556
Rubinstein, M., see Jackwerth, J.C. 1310
Rudd, J.B., s e e Blinder, A,S. 1018, 1 t 18
Rudebusch, G.D. 69, t04, 196, 1493
Rudebusch, G.D., s e e Diebold, EX. 6
Rudebusch, G.D., s e e Oliner, S.D. 137, 820,
1374, 1376
Rudebusch, R.G. 11
Rudin, J. 1040
Ruhm, C. 1152
Runlde, D., s e e Glosten, L. 1280
Run!de, D., s e e Keane, M.R 608, 609, 786,
790
Runkle, D.E. 789, 790, 1 6 5 5
Rtmkle, D.E., s e e Geweke, J.E 89
Runkle, D.E., s e e Mankiw, N.G. 135
Russek, ES., s e e Barth, J.R. 1657
Rust, J. 314, 317, 336
Rust, J., see Amman, H.M. 535
Rustichini, A., s e e Benhabib, J. 400, 847, 1449,
1467, 1472
Rustichini, A., s e e Boldrin, M. 400, 1465
Ryder, H. 587
Ryder k; H.E. 1284

Sabelhaus, J., s e e Gokhale, J. 750

Sachs, J. 1590, 1591
Sachs, J., s e e Bruno, M. 1090
Sachs, J., s e e Roubini, N. 1439, 1465
Sachs, J.D. 252, 703
Sack, B., s e e Galeotti, M. 909
Sadka, E., s e e Razin, A. 1715
Sahay, R. 1535
Sahay, R., s e e Fischer, S. 1538, 1547, 1561
Saint Marc, M. 222, 223
Saint-Paul, G. 1162, 1472
Saint-Paul, G., s e e Blanchard, O.J. 1214
Sakellaris, R, s e e Barnett, S. 831
Salad-Martin, X. 269, 277, 279--282, 659,
694

Author

1-25

Index

Salad-Martin, X., s e e Barro, R.J. 237, 245,

246, 252, 269, 271, 272, 278, 284, 643,
651,657, 659, 671,675, 1637
Salge, M. 499
Sahnon, C.K., s e e Haldane, A.G. 1485, 1497
Salmon, M. 525
Salmon, R, s e e Kirman, A.R 536, 539-541
Saloner, G., s e e Rotemberg, J.J. 910, 1058,
1093
Salter, W.E.G. 848
Sampson, L., s e e Fauvel, Y. 1573
Samuelson, RA. 46, 643, 661, 1311, 1634
Samwick, A. 609
Samwick, A.A., s e e Carroll, C.D. 567
Sandmo, A., s e e Atkinson, A.B. 1718
Sandroni, A. t293
Sanguinetti, E 1540
Sanguinetti, R, s e e Heymann, D. 506
Sanguinetti, R, s e e Jones, M. 1540
Santaella, J. 1543
Santos, M., s e e Caballe, J. 578
Santos, M.S. 321-323, 326, 327, 335, 353,
354, 382, 590, 1266
Santos, M.S., s e e Bona, J.L. 313
Santos, M.S., s e e Ladron de Guevara, A. 317
Santos, M.S., s e e Peralta-Alva, A. 374
Sargent, T. 162, 198, 929
Sargent, T., s e e Ljungqvist, L. 1214
Sargent, T., s e e Lucas Jr, R.E. 582
Sargent, T., s e e Marimon, R. 455, 523
Sargent, T.J. 73, 121, 135, 417, 418, 453, 455,
457, 458, 464, 465, 489, 504, 523, 524,
529-531,763,888, 1023, 1024, 1145, 1506,
1507, 1519, 1542, 1543, 1630, 1631
Sargent, T.J., s e e Anderson, E.V~ 368, 369
Sargent, T.J., s e e Cho, I.-K. 455, 465, 524,
525
Sargent, T.J., s e e Evans, G.W. 530
Sargent, T.J., s e e Hansen, E.P 558, 573, 574,
882, 915, 1294, 1295
Sargent, rl:J., s e e Marcet, A. 454, 464, 465,
468, 473-476, 480, 494, 499, 525, 528, 529,
532, 1675, 1705, 1707
Sattinger, M. 577, 578
Saunders, A. 181
Sauvy, A. 222
Savage, L.J. 1308, 1324
Savage, L.J., s e e Friedman, M. 1325
Savastano, M.A. 1589
Savastano, M.A., s e e Masson, RR. 1554,
1588

Savin, N., s e e Bray, M. 454, 465, 466, 473,

475, 527
Savin, N., s e e Ingrain, B. 984
Savin, N.E., s e e McManus, D.A. 908
Savouri, S., s e e Jackman, R. 1221
Sayers, R.S. 156
Sbordone, A. 983
Sbordone, A., s e e Cochrane, J. 1120
Sbordone, A.M. 1078, 1099, 1108, 1118,
1128
Scammell, W.M. 156
Scarpetta, S. 1214
Schaling, E. 1437
Schaling, E., s e e Eijffinger, S. 1432, 1438
Schaller, H., s e e Moore, B.J. 455
Scharfstein, D., s e e Chevalier, J.A. 1122,
1123
Scharfstein, D., s e e Hoshi, T. 1344
Scheinkman, J., s e e Ekeland, L 1689
Scheinkman, J., s e e He&man, J.J. 579
Scheinkman, J.A. 566
Scheinkman, J.A., s e e Benveniste, L.M. 321
Schiantarelli, E, s e e Galeotti, M. 909, 1086,
1124

Schmidt, R, s e e Kwiatkowski, D. 212

Schmidt-Hebbel, K., s e e Easterly, W. 1538
Schmitt-Groh6, S. 406, 407, 416, 418, 429,
431,435
Schmitt-Groh6, S., s e e Benhabib, J. 419, 421,
423
Schmitz Jr, J.A. 672, 695 697, 699
Schnadt, N., s e e Capie, E 154
Scholes, M., s e e Black, E 1310, 1331
Scholz, J.K., s e e Gale, W.G. 1646
SchSnhofer, M. 515
Schopenback, R, s e e Erlich, D. 1314
Schotter, A. 1415
Schuh, S. 877, 881,912
Schuh, S., s e e Davis, S.J. 1151, 1152, 1160,
1161, 1178, 1194, 1199
Schuh, S., s e e Fuhrer, J.C. 905, 908
Schuh, S., s e e Humphreys, B.R. 909
Schultz, T.V~ 653
Schmnaker, L.L. 344, 345
Schwartz, A., s e e Thaler, R.H. 1313
Schwartz, A.J. 156, 161, 173, 180, 204, 1515
Schwartz, A.J., s e e Bordo, M.D. 159, 165, 184,
194, 203,204, 208, 217, 1404, 1590
Schwartz, A.J., s e e Darby, M.R. 166
Schwartz, A . . I . , s e e Friedman, M. 6l, 137, 154,
162, 172, 176, 179, 180, 185, 189, 222

1-26
Schwert, G.W. 1236, 1280
Schwert, G.W., s e e French, K. 1280
Seater, J.J. 162!, 1654, 1656, 1657
Sedlacek, G., s e e Heckman, J.J. 578, 579
Sedlacek, G.J., s e e Hotz, V.J. 792, 803
Segal, I.B. 1157
Senhadji, A.S., s e e Diebold, EX. 11
Sentana, E., s e e King, M. 1333
Seppala, J., s e e Marcet, A. 1675, 1705, 1707
Seslnick, D. 746, 751
Shafir, E. 1316, 1324, 1329
Shafir, E., s e e Tversky, A. 1324
Shapiro, C. 1157
Shapiro, C., s e e Farrell, J. 1121
Shapiro, M. 938, 980
Shapiro, M., s e e Barsky, R. 558, 564, 565
Shapiro, M.D. 138, 818, 1069, 1075, 1655
Shapiro, M.D., s e e Dominguez, K. 182
Shapiro, M.D., s e e Mankiw, N.G. 135
Shapiro, M.D., s e e Ramey, V.A. 67, 1089
Sharma, S., s e e Masson, RR. 1554, 1588
Sharpe, S. 1344
Shaw, E.S., s e e Gurley, J.G. 1507
Shaw, K. 584
Shay, R.R, s e e Juster, ET. 777
Shea, J. 402, 608, 790, 983, 1117
Sheffrin, S.M., s e e Driskill, R.A. 1042
Shefrin, H. 1313, 1317, 1321, 1330
Shell, K. 389, 391,516
Shell, K., s e e Balasko, Y. 427
Shell, K., s e e Barnett, W. 540
Shell, K., s e e Cass, D. 389, 516, 662
Shepard, A., s e e Borenstein, S. 1124
Sherali, D.H., s e e Bazaraa, M.S. 331
Sheshinski, E. 1031, 1037
Sherry, C.M., s e e Bazaraa, M.S. 331
Shiller, R.J. 173, 1234, 1235, 1238, 1249, 1290,
1316, 1317, 13t9, /320, 1323, 1324, 1327,
133~1332
Shiller, R.J., s e e Campbell, J.. t235, 1265,
1280, 1320
Shiller, R.J., s e e Case, K.E. 1323
Shiller, R.J., s e e Grossman, S.J. 1242, 1246,
1268, 1291
Shin, M.C., s e e Puterman, M.L. 339
Shin, Y., s e e Im, K. 283
Shin, Y., s e e Kwiatkowski, D. 212
Shleifer, A. 1317, 1324
Shleifer, A., s e e Barberis, N. 1294, 1322
Sh!eifer, A., s e e Bei~nheim,B.D. 1646
Shleifer, A., s e e DeLong, J.B. 1290, 1324

Author

Index

Shleifer, A., s e e La Porta, R. 1240

Shleifer, A., s e e Lakonishok, J. 1323
Shleifer, A., s e e Lee, C. 1324
Shleifer, A., s e e Murphy, K.M. 262, 278,
1082
Shoemaker, C.A., s e e Johnson, S.A. 345, 381
Shor, N.Z. 331
Shoven, J.B. 705, 708
Shoven, J.B., s e e Ballard, C. 1639
Sibert, A., s e e Rogoff, K. 1416, 1417, 1420,
1425
Sichel, D., see 0liner, S.D. 820
Siegel, J.J. 1312, 1313
Silberman, J. 1316
Simkins, S. 931
Simmons, B. 163
Simon, H.A., s e e Holt, C.C. 882, 885, 888,
909, 910, 912
Simons, H.C. 852, 1485
Simonsen, M.H., s e e Dornbusch, R. 1543,
1565
Sims, C.A. 34, 44, 69, 83, 93, 95, 99, I05, 121,
128, 129, 131, 132, 134, 144, 397, 418,
539, 673, 694, 1509, 1518, 1520, 1631
Sims, C.A., s e e Hayashi, E 788
Sims, C.A., s e e Leeper, E.M. 69, 74, 83, 93,
101, 128, 132, 134, 1036, 1089, 1369
Sinai, A., s e e Eckstein, O. 1344
Singer, B. 292
Singer, B., s e e Heckman, J.J. 1166
Singleton, K. 1270
Singleton, K.J., s e e Dural, K.B. 800, 1284
Singleton, K.J., s e e Hansen, L.E 547, 555,
556, 768, 769, 784, 882, 1234, 1246, 1250,
1261
Siow, A., s e e Altonji, J.G. 789
Skinner, B.E 1328
Skinner, J.S. 771,772
Skinner, J.S., s e e Hubbard, R.G. 567, 569, 572,
573, 593, 771,776, 794, 797, 1660
Slade, M.E. 1015
Slemrod, J,, s e e Shapiro, M.D. 1655
Slovic, P., s e e Fischhoff, B. 1319
Small, D.H., s e e Hess, G.D. 1485, 1509
Small, D.H., s e e Orphanides, A. 1485
Smetters, K.A. 1647
Smith, A.A., s e e Krusell, E 380, 547, 566, 567~
994
Smith Jr, A.A., s e e Krusell, E 1293
Smith, C.W., s e e Nance, D.R. 1318
Smith, E.L. 1312

Author

1-27

Index

Smith, G.W., s e e Devereux, M. 952

Smith, G.W., s e e Gregory, A.W. 376, 377
Smith, R., s e e Alogoskoufis, G.S. 166, 214
Smith, R.R, s e e Lee, K. 284
Smithson, C.W., s e e Nance, D.R. 1318
Shower, D., s e e Blanchard, O.J. 1214
Soares, J., s e e Cooley, T.E 1463
S6derlind, R, s e e Hassle1; J. 9, 1238
S6derstr6m, T., s e e Ljung, L. 476
Soerensen, J.R 528
Solnick, A., s e e Judd, K.L. 340
Solon, G. 579, 1058, 1102, 1106
Solon, G., s e e Barsky, R. 43
Solow, R.M. 237, 244, 246, 257, 643, 656, 664,
681,929, 930, 942, 950-952, 1140, 1207,
1638
Solow, R.M., s e e Blanchard, O.J. 1214
Solow, R.M., s e e Blinder, A.S. 1660
Solow, R.M., s e e Hahn, F. 661
Solow, R.M., s e e Samuelson, RA. 46
Sommariva, A. 222
Sonnenschcin, H., s e e Hildenbrand, W. 535,
537
Sorger, G., s e e Honmles, C.H. 529, 532
Souleles, N., s e e Jappelli, T. 790
Spear, S.E. 465
Spear, S.E., s e e Marimon, R. 455, 531
Spiegel, M.M., s e e Benhabib, J. 283
Spilerman, S., s e e Singer, B. 292
Spulber, D., s e e Caplin, A.S. 801, 1031, 1032
Spynnewin, E 803
Srba, E, s e e Davidson, J. 750
Srinivasan, T.N. 705
Stacchetti, E., s e e Jones, L.E. 720
Stafford, E, s e e Holbrook, R. 569
Stafford, E, s e e Ryder, H. 587
Staiger, D. 49, 50
Staiger, R. i415
Staiger, R.W., s e e Bagwell, K 1125
Stambaugh, R.F., s e e French, K. 1280
Stambaugh, R.E, s e e Kandel, S. 1235, 1252,
1253, 1265, 1270, 1272
Stark, T., s e e Croushore, D. 1485
Starr, R.M., s e e Chah, E.Sq 775
Startz, R., s e e Nelson, C.R, 1264
Statman, M., s e e Shefrin, H. 1313, t317,
1330
Stedinger, J.R, s e e Johnson, S.A. 345, 38I
Stein, J.C., s e e Kashyap, A.K. 137, 881,912~
1344, 1374, 1376
Stengel, R.E 904

Stephen, E, s e e Ryder, H. 587

Sterling, A., s e e Modigliani, E 1656, 1657
Stigler, G. 1018
Stigler, G.J. 1173
Sfigler, S.M. 275
Stiglitz, J., s e e Dixit, A. 1115, 1121, 1126
Sfiglitz, J., see Greenwald, B. 857, 1122,
1377

Stiglitz, J., s e e Jaffee, D.M. 1376

Stiglitz, J.E. 1675, 1696, 1718
Stiglitz, J.E., s e e Atkinson, A.B. 1673, 1676,
1680, 1682, 1718
Stiglitz, J.E., s e e Shapiro, C. 1157
Stock, J.H. 9, 11, 39, 43, 45, 50-54, 821,
878, 919, 934, 938, 939, 1011, 1021, 1404,
1674
Stock, J.H., s e e Feldstein, M. 44, 1485, 1497,
1498
Stock, J.H., s e e King, R.G. 54, 941
Stock, J.H., s e e Staiger, D. 49, 50
Stockman, A. 1578
Stockman, A.C. 549
Stoclcman, A.C., s e e Baxter, M. 203, 938,
1404
Stockman, A.C., s e e Darby, M.R. 166
Stockman, A.C., s e e Gavin, V~ 1485
Stockman, A.C., s e e Ohanian, L.E. 1036
Stocks, Bonds, Bills arid Inflation 1639
Stockton, D.J., s e e Lebow, D.E. 215, 1016
Stoer, J. 334
Stoker, Z, s e e Blundell, R. 770, 788
Stokey, N., s e e Alvarez, E 996
Stokey, N., s e e Lucas Jr, R.E. 559, 561
Stokey, N., s e e Milgrom, R 1322
Stokey, N.L. 271,299, 314, 318-321,346, 578,
583, 672, 705, 709, 711, 714, 951, 954,
998, 999, 1674
Stokey, N.L., s e e Lucas, R.E. 380, 1446, 1449
Stokey, N.L., s e e Lucas Jr, R.E. 158, 1673,
1675, 1699, 1723, 1728
Stone, C.J., s e e Breiman, L. 289
Sh'ang, G. 82
Strongin, S. 83.-85, 87, 114
Strotz, R.H. 1653
Strotz, R.H., s e e Eisner, R. 1310
Stroud, A.H. 334
Stuart, A. 1485
Stulz, R.M. 1317
Sturzeneggcr, E, s e e Dornbusch, R. t543
Sturzenegge~; F., s e e Guo, J.-T. 427
Sturzenegger, E, s e e Mondino, G. 1540

1-28

Author

Suarez, J. 1378
Subrahmanyam, A., s e e Daniel, K. 1322
Sugden, R., s e e Loomes, G. 1313
Suits, D., s e e Kallick, M. 1325
Stmmlers, L.H. 961
Summers, L.H., s e e Abel, A.B. 1266, 1651
Summers, L.H., s e e Alesina, A. 1432
Surmaaers, L.H., s e e Bemheim, B.D. 1646
Summers, L.H., s e e Blanchard, O.J. 416,
1635
Summers, L.H., s e e Carroll, C.D. 759, 793,
1655
Summers, L.H, s e e Clark, K.B. 602, 1173
Summers, L.H., s e e Cutler, D.M. 1290, 1320,
1321
Summers, L.H., s e e DeLong, J.B. 279, 695,
1042, 1290, 1324
Summers, L.H., s e e Easterly, W. 277, 278, 281,
675
Summers, L.H., s e e Kotlikoff, L.J. 780, 1646
Summers, L.H., s e e Mankiw, N.G. 785
Summers, L.H., s e e Poterba, J.M. 1235, 1320,
1648

Summers, R. 238, 301, 640, 673 675, 677,

680, 681,689, 720
Sun, T. 1270
Sundaram, R.K., s e e Dutta, RK. 380
Sundaresan, S.M. 1284
Sundel, S., s e e Marimon, R. 455, 472, 531
Surekha, K. 908
Sussman, O., s e e Suarez, J. 1378
Svensson, J. 1466, 1471, 1472
Svensson, L.E.O. 156, 197, 417, 1033, 1034,
1273, 1411, 1432, 1434, 1489, 1493, 1494,
1498, 1504
Svensson, L.E.O., s e e Englund, R 9
Svensson, L.E.O., s e e Kotlikoff, L. 1448, 1449,
1465
Svensson, L.E.O., s e e Leiderman, L. 1432,
1438, 1495
Svensson, L.E.O., s e e Persson, M. 1447, 1449
Svensson, L.E.O., s e e Persson, T. 1449, 1450,
1454, 1456, 1465
Swagel, R, s e e Alesina, A. 277~79, 1460,
1466, 1471
Swan, T.W 244, 246, 247, 643
Sweeney, J., s e e Kneese, A. 656
Swoboda, A., s e e Genberg, H. 165
Symansky, S.A., s e e Bryant, R.C. 1491, t497,
1516
Szafarz, A., s e e Adam, M. 500

Szafarz, A.,

see

Index

Broze, L. 487, 488

Tabellini, G. 1414, 1415, 1450, 1456, 1464,

1465
Tabellini, G., s e e Alesina, A. 1446, 1449, 1450,
1454, 1465, 1518, 1522
Tabellini, G., s e e Cu!derman, A. 1456, 1465
Tabetlini, G., s e e Daveri, E 1220
Tabellini, G., s e e Edwards, S. 1538
Tabellini, G., s e e Grilli, V. 1404, 1432, 1438,
1439, 1465
Tabeltini, G., s e e Ozler, S. 1457, 1465
Tabellini, G., s e e Persson, T. 278, 692, 1400,
1403, 1413, 1415 1418, 1420, 1421, 1425,
1433, 1435, 1437-1440, 1442, 1445, i448,
1449, 1459, 1460, 1466, 1469, 1470, 1490
Taber, C., s e e Heckman, J.J. 576, 578, 582,
584, 586, 587, 590, 592, 593
Taguas, D., s e e Blanchard, 03. 1214
Tallarini Jr, T.D., s e e Hansen, L.E 558, 1294,
1295
Tallman, E.W, s e e Rosensweig, J.A. 1659
Talvi, E. 1543, 1571, 1604
Tan, K.S. 334
Tanner, S., s e e Banks, J. 758, 792
Tanzi, V. 1741
Tarshis, L. 939, 1059
Tauchen, G. 367
Taylol, A., s e e Obstfeld, M. 164, 165
Taylor, C. 1330
Taylor, J.B. 46, 182, 314, 397, 408, 417, 422,
454, 474, 487, 489, 495, 545, 1011, 1013,
1015, 1017, 1025, 1027 1031, 1037 1039,
1042, 1043, 1113, 1364, 1411, I485, 1487,
1488, 1490, 1497, 1505, 1507, t512, 1513,
1516, t518, 1542, 1582
Taylor, J.B., s e e Phelps, E. 1025, 1026
Taylor, L.D, s e e Houthakker, H.S. 803
Taylor, S.E. 1330
Tejada-Guibert, J.A., s e e Johnson, S.A. 345,
381
Teles, R, s e e Correia, I. 1537, 1675, 1720,
1733
l'elmer, C.I., s e e Backus, D.K. 1316
Temin, R 162, 179, 180, 183, 184
Temple, J. 276
Terlizzese, D., s e e Guiso, L. 772
Terna, R, s e e Beltratti, A. 524, 525
Terrones, M. 1425
Teruyama, H., s e e Fukuda, S.-i. 875
Tesar, L., s e e Mendoza, E. 1439

Author

Index

Tesar, L., s e e Stockanan, A.C. 549

Tetlow, R., s e e Fillion, J.E 1498
Teukolsky, S.A., s e e Press, W.H. 329-334, 343,
348, 356, 365
Thaler, R., s e e Froot, K. 1316
Thaler, R., s e e Lee, C. 1324
Thaler, R.It. 1313, 1317
Thaler, R.H., s e e Benartzi, S. 1290, 1312,
1313
Thaler, R.H., s e e De Bondt, W.E 1307, 1320,
1323
Thaler, R.H., s e e Shefrin, H. 1317
Thaler, R.H., s e e Siegel, J.J. 1312
The Economist 1238, 1632
Theunissen, A.J., s e e Whittaker, J. 1508
Thomas, J. 994
Thomas, J.K., s e e Bernard, V.L. 1321
Thomas, T.J. 161
Thompson, S.C., s e e Taylor, S.E. 1330
Thomson, J.B., s e e Carlson, J.B. 104
Thornton, H. 1485
Thurow, L. 759
Tieslau, M.A., s e e Hoftinan, D.L. 412
Tillmann, G. 474
Timberlake, R.H. 169, 174
Timmermann, A.G. 454, 455, 500, 530
Tinbergen, J. 817
Tirole, J. 1266, 1650
Tirole, J., s e e Fudenbelg, D. 1155
Tirole, J., s e e Holmstrom, B. 1376
Titman, S., s e e Jegadeesh, N. 1321
Tobin, J. 773, 817, 818, 1643
Tobin, J., s e e Brainard, W.C. 817
Tobin, J., s e e Eichengreen, B. 168
Todd, R, s e e Heckman, J.J. 578, 582
Todd, R., s e e CNistiano, L.J. 1365
Toharia, D., s e e Blanchard, O.J. 1214
Toma, M. 174, 177, 187, 190
Toma, M., s e e Goff, B.L. 159
Tommasi, M. 1540
Torrmlasi, M., s e e Jones, M. 1540
Tommasi, M., see Mondino, G. 1540
Topel, R. 578
Topel, R., s e e Juhn, C. 619
Topel, R., s e e Murphy, K. 581
Tornell, A. 1466, 1472, 1590
Tornell, A., s e e Lanc, R 1472
Tornell, A., s e e Sachs, J. 1590, 1591
Townsend, R.M. 453,461,474, 529, 795, 796,
1350, 1376

1-29
Townsend, R.M., s e e Phelan, C. 380, 575,
796
Traub, J.E 338
Traub, J.E, s e e Papageorgiou, A. 334
Trehan, B. 159
Tria, G., s e e Felli, E. 1083, 1122
Triffin, R. 157, 165
Trostel, PA. 1652
Tryon, R., s e e Brayton, E 1043, 1344, 1485
Tsiddon, D. 1031
Tsiddon, D., s e e Lach, S. 1019
Ysitsiklis, J.N., s e e Chow, C.-S. 326, 334
Tsutsui, Y., s e e Shiller, R.J. 1316
Tullio, G. 156
Tullio, G., s e e Sommariva, A. 222
Tullock, G., s e e Grief, K.B. 253
Tuncer, B., s e e Krueger, A.O. 699
Turnovsky, S. 474
Tversky, A. 1308, 1315, 1319, 1324, 1330
Tversky, A., s e e Kahnelnan, D. 1308, 1309,
1311
Tversky, A., s e e Quattrone, G.A. 1329
Yversky, A., s e e Shafir, E. 1316, 1324, t329
Tversky, A., s e e Thaler, R.H. 1313
Tybout, J., s e e Corbo, V. 1543
Tylor, E.B. 1331
Uldig, H. 70
Uhlig, It., s e e Lettau, M. 524, 1297
Uhlig, H., s e e Taylor, J.B. 314
United Nations 681
Uppal, R., s e e Dumas, B. 564
Uribe, M. 1539, 1578, 1589
Uribe, M., s e e Benhabib, J. 419, 421,423
Uribe, M., s e e Mendoza, E. 1571, 1579
Uribe, M., s e e Schmitt-Groh~, S. 416, 418,
431
US Bureau of the Census 585
Uzawa, H. 578, 651,710
Valdes, R., s e e Dornbusch, R. 1590
Valdivia, V, s e e Cln'istiano, I,.J. 504
Van Huyck, J.B., s e e Orossman, H.J. 158, 1415,
1449
van Wincoop, E., s e e Beau&y, P 1264
Van Zandt, T., s e e Lettau, M. 470, 472
Vasicek, O. 1270
V6gh, C . , s e e Guidotti, RE. 1675, 1720
V6gh, C.A. 1535, 1538, 1542, 1543, 1546,
1550, 1554, t588
V6gh, C.A., s e e Bordo, M.D. 158

1-30
V6gh, C.A, s e e Calvo, G.A~ 1428, 1535, 1538,
1539, 1546, 1554, 1557, 1563, 1564, 1568,
1571, 1572, 1582, 1587-1589, 1597, 1605
V+gh, C.A., s e e De Gregorio, J. 1546, 1551,
1573, 1575, I577
V~gh, C.A., s e e Edwards, S. 1578-1580
V~gh, C.A., s e e Fischer, S. 1538, 1547, 1561
V~gh, C.A., s e e Guidotti, RE. 1537, I588,
1603
V6gh, C.A., s e e Hoffmaister, A. 1561, 1589
V~gb, C.A., s e e Lahiri, A. 1597
V~gh, C.A., s e e Rebelo, S.T. 1546, 1568, 1578,
1579, 1581, 1606
V+gh, C.A., s e e Reinhart, C.M. 1545, 1546,
1551, 1553, 1561, 1572, 1573
V~gh, C.A., s e e Sahay, R. 1535
Vela, A., s e e Santaella, J. 1543
Velasco, A. 416, 1446, 1449, 1450, 1459, 1465,
1540
Velasco, A, s e e Sachs, J. 1590, 1591
Velasco, A., s e e Tommasi, M, 1540
Velasco, A., s e e Tornell, A. 1466, 1472, 1590
Venable, R., s e e Levy, D. 1014, 1015, 1019
Venegas-Martinez, E 1571
Ventura, G., s e e Huggett, M. 380
Veracierto, M. 994
Verdict, 3,., s e e Saint-Paul, G. 1472
Vetterling, WT., see Press, W.H. 329 334, 343,
348, 356, 365
Viana, L. 1543
Vickers, J. 1414, 1415
Vigo, J,, s e e Santos, M.S. 321,322, 326, 327,
335
Vinals, J., s e e Goodhart, C.E.A. 1438, 1495
Vishny, R.W, s e e Barberis, N. 1294, 1322
Vishny, R.W, s e e La Porta, R. 1240
Vishny, R.W., s e e Lakonishok, J. 1323
Vishny, R.W., s e e Murphy, K.M. 262, 278,
1082
Vishny, R.W., s e e Shleifer, A. 1324
Visscher, M., s e e Prescott, E.C. 700
Vires, X. 474, 532
Vires, X., s e e Jun, B. 474
Volcker, P.A. 1630
yon Furstenberg, G.M. 1333
yon Hagen, J. 1439, 1460, 1465
yon Hagen, J., s e e Eichengreen, B. 1465
yon Hagen, J., s e e FratiaImi, M. 1431
yon Hagen, J., s e e Hallerberg, M. 1460, 1465
yon Weizs~icker,C. 641,650, 657
Vredin, A.E., s e e Bergstr6m, V. 538

Author

Index

Vuong, Q.H., s e e Rivers, D. 840

Wacbtel, R 1658
Wachtel, P., s e e Evans, M. 182
Wachter, S.M., s e e Goetzmann, WN. 1333
Wadhwani, S., s e e King, M. 1333
Wagner, R.E., s e e Buchanan, J.M. 1631
Waldmann, R.J., s e e DeLong, J.B. 1290, i324
Walk, H., s e e Ljtmg, L. 476
Walker, M., s e e Moreno, D. 481
Wallace, N., s e e Sargent, ZJ. 417, 418, 489,
1024, 1506, 1507, 1519, 1630
Waller, C. 1431
Walle~, C., s e e Fratianni, M. 1431
Wallis, K., s e e Kreps, D.M. 540
Walsh, C.E. 1433, 1434, I437, 1438, 1490
Walsh, C.E., s e e Trehan, B. 159
Walsh, C.E., s e e Waller, C. 1431
Wang, EA. 1322
Wang, J. 1237, 1293
Wm~g, L.-T., s e e Dezhbakhsh, H. I039
Wang, T., s e e Dumas, B. 564
Warner, A.M., s e e Sachs, J.D. 252, 703
Warner, E.J. 1019
Wascher, W., s e e Lebow, D.E. 1016
Watson, J., s e e den Haan, W.J. 994, 1166, 1194,
1203, 1204, 1206, 1207
Watson, J., s e e Ramey, G. 852, 1157, 1159
Watson, M,W. 6, 50, 547, 931
Watson, M.W, s e e Bernanke, B.S. 144
Watson, M,W, s e e Blanchard, O.J. 1266
Watson, M.W., s e e Canjels, E. 55
Watson, M.W., s e e King, R.G. 46, 54, 939,
941
Watson, M.W., s e e Staiger, D. 49, 50
Watson, M.W, s e e Stock, J.H. 9, 43, 45, 50--52,
821, 878, 919, 934, 938, 939, 1011, 1021,
1404, 1674
Webb, S., s e e Goo&nan, A. 797
Webber, A., s e e Capie, E 222
Weber, G. 774
Weber, G., s e e Alessie, R. 774, 775
Weber, G., s e e Attanasio, O.E 611-613, 756,
769, 781, 783, 784, 787, 790, 791, 793,
794, 1264, 1655
Weber, G., s e e Bhmdell, R. 781
Weber, G., s e e Brugiavini, A. 775
Weber, G., s e e Meghir, C. 61t, 613, 775, 804
Weber, M. 133t
Weder, M. 403,437
Wehrs, W., s e e Carlson, J.A. 904

Author

Index

Weibull, J., s e e Lindbeck, A. 1465

Weil, D.N., s e e Mankiw, N.G. 173, 216, 244246, 252-255, 269-271,277-279, 289, 653,
655, 660, 673,679q583, 685, 686, 1638
Weil, P. 547, 1235, 1250, 1253, 1256, 1647
Weil, R, s e e Blanchard, O.J. 1650
Weil, R, s e e Restoy, E 1272
Weingast, B., s e e North, D. 1449
Weinstein, M.M. 182
Weisbrod, S.R., s e e Rojas-Suarez, L. 1575
Weiss, A., s e e Greenwald, B. 1122
Weiss, L., s e e Scheinkman, J.A. 566
Weiss, Y. 583
Weiss, Y., s e e Blinder, A. 587
Weiss, Y., s e e Lillard, L. 569, 572
Weiss, Y., s e e Sheshinski, E. 1031, 1037
Weitzman, M.L. 1689
Welch, E 579
Welch, I., s e e Bikhchandani, S. 1332
Wen, LE, s e e Devereux, M. 1466, 1471
Wen, L. 427, 431
Wenzelburgm, J., s e e B6hm, V. 475
Werner, A., s e e Dornbusch, R. 1543, 1563,
1568
West, K.D. 871,876, 880, 882, 885, 887, 888,
894, 896, 897, 900, 902, 905 908, 913, 919,
1028, 1041, 1320, 1497
Whalley, J. 705
Whalley, J., s e e Ballard, C. 1639
Whalley, J., s e e Shoven, J.B. 705, 708
Whalley, J., s e e Srittivasan, T.N. 705
Wheatley, S. 1242, 1261
Wheelock, D.C. 177, 179
Wheelock, D.C., s e e Calomiris, C.W 187,
191
Whinston, M.D., s e e Segal, I.B. 1157
White, E., s e e Bordo, M.D. 159
White, E.N. 180
White, H. 524
White, H., s e e Chen, X. 476, 532
White, H., s e e Kuan, C.-M. 476
Whited, T. 1344
Whited, T., s e e Hubbard, R.G. 1344
Whiteman, C. 487
Whitt, W. 326
Whittaker, J. 1508
Wickens, M.R., s e e Robinson, D. 217
Wicker, E. 162, 176, 177, 179 181, 1543
Wicksell, K. 203, 1485, 1631
Wieland, V, s e e Orphanides, A. 1485
Wigmore, B.A. 163, 183

1-31
Wilcox, D. 1242
Wilcox, D., s e e Kusko, A.L. 1327
Wilcox, D.W. 1655
Wilcox, D.W, s e e Carroll, C.D. 769, 785
Wilcox, D.W, s e e Cecchetti, S.G. 876
Wilcox, D.W., s e e Kashyap, A.K. 137, 877,
886, 903, 906, 912
Wilcox, D.W., s e e Orphanides, A. 198, 1485
Wilcox, D.W., s e e West, K.D. 908
Wildasin, D., s e e Boadway, R. 1463
Wilkinson, M. 881
Williams, J.C., s e e Brayton, E 1043, 1344,
1485
Williams, J.C., s e e Gilchrist, S. 847
Williams, J.C., s e e Wright, B.D. 347, 348
Williamson, J. 1597
Williamson, O.E. 852
Williamson, S. 1376
Willis, R., s e e Heckman, J.J. 602, 623
Wilson, B., s e e Saunders, A. 181
Wilson, C.A. 408
Wilson, R. 5 5 4 , 796
Winter, S.G., s e e Phelps, E.S. 1121
Woglom, G. 1127
Wohar, M.E., s e e Fishe, R.P.H. 173
Wojnilower, A. 1344
Wolf, H., see Dornbusch, R. 1543
Wolf, H., s e e Ghosh, A.R. 202, 207, 208
Wolff, E. 664
Wolfowitz, J., s e e Kiefer, J. 476
Wolinsky, A. 1188
Wolinsky, A., s e e Binmore, K.G. 1188
Wolinsky, A., s e e Rubinstein, A. 1188
Wolman, A.L., s e e Dotsey, M. 974, 1032,
1043
Wohnan, A.L., s e e King, R.G. 1036, 1041,
1043, 1364, 1367
Wolters, J., s e e Tullio, G. 156
Wong, K.-E 108
Wood, G.E., s e e Capie, E 163, 1438
Wood, G.E., s e e Mills, T.C. 204
Woodford, M. 389, 395, 406, 407, 409, 418,
421-423, 439, 454, 473~476, 481,483, 507,
516, 518, 521,662, 1036, 1157, 1507, 1509,
1518-1520, 1537, 1630, 1675, 1676, 1720,
1731
Woodford, M., s e e Bernanke, B.S. t361, 1363
Woodford, M., s e e Boldrin, M. 506
Woodford, M., s e e Farmer, R.E. 395, 396
Woodford, M., s e e Guesnerie, R. 439, 454,
460, 465, 474, 475, 506, 511,516, 526

1-32
Woodford, M., s e e Kehoe, T.J. 380
Woodford, M., s e e Lucas Jr, R.E. 1023
Woodford, M., s e e Rotemberg, J.J. 67, 68,
395, 406, 407, 429, 434, 974, 996, 1020,
1041, 1043, 1044, 1055, 1056, 1062, 1063,
1067 1069, 1074, 1081, 1082, 1088 1090,
1092, 1093, 1106, 1107, 1118, 1123-1125,
1129, 1143, 1144, i365, 1492, 1494, 1497
Woodford, M., s e e Santos, M.S. 1266
Woodward, EA., s e e Baker, J.B. 1125
Wooldridge, J., s e e Bollerslev, Z 1280
Wozniakowski, H., s e e Traub, J.E 338
Wright, B.D. 347, 348
Wright, M.H., s e e Gill, RE. 329
Wright, R. 1158
Wright, R., s e e Benhabib, J. 402, 550, 1145
Wright, R., s e e Boldrin, M. 399
Wright, R., s e e Burdett, K. 1196
Wright, R., s e e Greenwood, J. 550, 995
Wright, R., s e e Hansen, G.D. 976
Wright, R., s e e Kiyotaki, N. 524
Wright, R., s e e Parente, S.L. 702
Wright, R., s e e Rogerson, R. 978
Wurzel, E., s e e Roseveare, D. 1626
Wynne, M. 974
Wynne, M.A., s e e Huffman, G.W 437
Wyplosz, C . , s e e Eichengreen, B. 168, 1590
Xie, D. 425
Xie, D., s e e Benhabib, J. 425
Xie, D., s e e Rebelo, S.T. 952
Xu, "L 344
Pashiv, E. 1200
Yellen, J.L., s e e Akerlof, G.A. 397, 1034, 1035,
1039, 1157, 1200
Yeo, S., s e e Davidson, J. 750
Yi, K.-M., s e e Kocherlakota, N.R. 271
Yin, G.G., s e e Kushner, H.J. 476
Yong, W., s e e Bertocchi, G. 474
Yorukoglu, M., s e e Cooley, T.F. 847

Author

Index

Yorukoglu, M., s e e Greenwood, J. 576

Yotsuzuka, T. 1649
Young, A. 664, 672, 673,687, 716
Young, J., s e e Wachtel, E 1658
Yu, B., s e e Hashimoto, M. 1152
Yun, T. 1026, 1036

Zarazaga, C.E. 1540

Zarazaga, C.E., s e e Kydland, EE. 1557, 1561
Zarnowitz, V 9, 40
Zeckhauser, R., s e e Degeorge, E 1321
Zeckhauser, R.J., s e e Abel, A.B. 1266, 1651
Zeira, J., s e e Galor, O. 262, 263
Zejan, M., s e e Blomstrom, M. 277, 279, 280
Zeldes, S.R 566, 607-609, 771,789, 790, 802,
1344, 1655
Zeldes, S.E, s e e Barsky, R.B. 1653
Zeldes, S.R, s e e Hubbard, R.G. 567, 569, 572,
573, 593, 771,776, 794, 797
Zeldes, S.E, s e e Mankiw, N.G. 790, 1290
Zeldes, S.R, s e e Miron, J.A. 876, 907
Zeldes, S.R, s e e O'Connell, S.A. 1650
Zellner, A. 34
Zenner, M. 497
Zha, T., s e e Cushman, D.O. 95, 96
Zha, T., s e e Leeper, E.M. 69, 74, 83, 93, 101,
128, 132, 134, 1089, 1369
Zha, T., s e e Sims, C.A. 69, 83, 93, 99, 128,
129, 131, 132, 134, 144
Zhang, L., s e e Lockwood, B. 1411, 1415
Zhou, Z., s e e Grossman, S.J. 1237, 1293
Zhu, X. 1708
Zilcha, I., s e e Becker, R. 369
Zilibotti, E, s e e Gali, J. 405, 426
Zilibotti, F., s e e Marimon, R. 1214
Zin, S.E., s e e Epstein, L.G. 556, 558, 564, 744,
769, 1250, 1256
Zingales, L., s e e Kaplan, S.N. 856, 1344

SUBJECT INDEX

accelerator 884, 890, 896, 909

accelerator model 816, 817
accelerator motive 867, 902
activist vs. non-activist policies 1485
actual Jaw of motion (ALM) 466, 472, 490,
511
adaptive expectations 453,465
adaptive learning 464, 472, 493, 510
stability under 471
adaptively rational expectations equilibrium
532
adjustment
costs 800, 1072
employment 1075
hours 1075
in investment 1296
non-convex 821, 839
production 867, 892, 893,900
hazard 835, 836, 840
speed of 881,889, 908
age distribution 753, 848
aggregate convexity 843
aggregate demand 1617, 1628, 1630
aggregate httman capital 583, 590 593
aggregate productivity 1195
aggregate productivity shock 1204
heterogeneous 1214
aggregate shocks 578, 582, 865
aggregation 548-594, 604, 605, 614, 615, 745,
781,804, 836, 849, 910
across commodities 782
AK model 672, 673, 709-715, 720, 733
allocation rules 1688, 1723
alternative dating 499
amplification 841, 1145, 1158, 1159, 1161
anchoring 1314-1317, 1322
animal spirits 395, 5t7, 521,941
anomalies 1307, t308, 1316, 1317, 1321, 1322,
1333, 1334
approximation error 326 345, 351-382
arbitrage 1246
ARMA models 489, 496, 501
Arrow-Debrcu equilibrium 795

asset-price chaunel 1378

asset prices, variable 1356
asset pricing models with t~edback 500
asset pricing with risk neutrality 498
associated differential equation 519
asymmetric fixed costs 825
asymmetry in adjustmen! of employment
1158
asymptotic stability 479, 639
autarky 853
automatic stabilizers 1660
average cohort techniques 787

backlog costs 884

backstop technology 656
balance-of-payments (BOP) crises 1534, 1535,
1553
balanced-budget rule 1631
balanced growth path 50, 392, 393, 424, 425,
427
band-pass filter, s e e BP filter
bank lending channel 1376
Barro, R. 1640, 1642 1646
Bayesian learning 474
Bayesian updating 461,465
Belgium 1619
Bellman's Principle of Optimality 9 9 8
bequest motive 745, 780, 1624, 1646,
1647
strategic 1646
best practice 848
/3-convergence 659
Beveridge curve 1194, 1196, 1221, 1222
bilateral bargaining problem 1157
black market premium 671,688, 689, 691 694,
703
Blanchard Kahn technique 505
Bolivia 1631
boom recession cycle 1550, 1552, 1581
bootstrap methodology 79
BOP crises, s e e balance-of-payments crises
borrowers' net worth 1345
1-33

1-34
borrowing constraint 566, 575, 593, 595, 597,
598, 772, 775, 1293
s e e also capital market inaperfections;
credit market imperfections; liquidity
constraints
Boschen-Mills index 139 142
bottlenecks 842, 843
bounded rationality 454, 464
BP (band-pass) filter 12, 933, 934
Bretton Woods 152, 153, 163-168, 188, 190,
192, 199, 202-204, 206-209, 211,213, 215,
218-220
Brownian motion 825, 845
regulated 845
bubble-free solution 1524
bubble solutions 1522
bubbles 499
explosive 499
budget deficit 1619
budget surplus 16t9
buffer-stock saving 771, 1653, 1654
building permits 45
Burns Mitchell business cycle measurement
932
business cycles 865, 927 1002, 1620, 1621,
1659
s e e also cycles; fluctuations in aggregate
activity
facts about 934, 938, 939, 956
general equilibrium models 67
in RBC model 968
measuring 932
persistence of 939
table of stumnary statistics 956, 957
US facts 934
USA 935--938, 956
Cagan model of inflation 497
calculation equilibrium 462
calibration 545, 550, 567, 601,614, 6t6
Canada 45
capacity utilization 41,427, 431,930
modeling of 980
rate of 981
steady-state rate of 984
capital 1617, 1687
broad measure 701
desired 816, 842
frictionless 832, 838
human 673, 678, 679, 681--687, 701, 7t0,
713, 714, 716--718, 720, 732, 734

Subject lndex
s e e also human capital
organizational 700, 701
physical 678-683, 701, 710, 713, 714, 721,
732
specific 1154
stockof 1629, 1630, 1632, 1633, 1636-1638,
1648, 1652, 1656
target 820
unmeasured 701,702
vintage 702
capital accumulation 942, 1203
general equilibrium nature of 946
optimal 946
perpetual inventory method 944
capital budgeting 1623
capital controls 1588
capital imbalances, establishments' 837
capital hltensities 641,644, 679, 680, 682, 685,
686
capital investment decision 1349
capital/labor substitution 856
capital market imperfections 1648, 1649
see also borrowing constraint; credit market
imperfections
capital taxation 166i, 1708
optimality of zero 1693
capital utilization 848
CARA utility 794
cash-in-advance constraint 397, 1722
cash-credit model 1720, 1721
"catching up with the Joneses" 1284
certainty equivalence 762
Chamley result 1698
characteristics model 578, 579, 582, 602
characterization of equilibria 487, 489
Chotesky factor 80
classification 262, 289, 303
classifier systems 465, 523
closed economy 1714
closed-form solution 769
club-convergence 660
Cobb-Douglas production function in RBC
model 944, 950
"cobweb" model 456
coefficient of relative risk aversion 1249
cohort data 781
cohort effects 576, 577, 590-592, 617, 753,
754
cointegration 50, 750, 820, 838, 877-881,
885 887, 903, 1266
collateral 857

Subject Index

commitment 574, 575, 1488, 1523

technology 1688, 1723
vs. flexibility 1489
commodity space 1686
comparative advantage 547, 548, 577-579,
584, 587
comparative dynamics measured by impulse
response 967, 968, 970
competitive equilibrium 844, 845, 1677, 1688,
1722
competitive trajectory 650
complementarity 1161
complements 599, 601,611-613, 855
complete markets 553, 558, 563, 595, 602,
786, 1688
computation of (approximate) solutions 525
computational general equilibrium (CGE) 705,
708
computational intelligence 465
computational tool 455
conditionally linear dynamics 475,481
conditioning 556, 594, 597-599, 601,605, 612,
613
consistent expectations equilibria 529
constant returns to scale 639, 83l, 1687
in RBC model production function 995
consmner expectations 45
consumer theory 603
consumer's budget constraint 1264, 1712,
1728
consumption 40, 545, 546, 548-558, 560-564,
566, 567, 572-576, 587, 590, 594-603,
605 614, 616, 621, 1276
behavior in US business cycles 938
empirical 1344
estimates 605-6t4
'excess' sensitivity 524
growth 1233, 1242, 1276
inequality in 797
pemlanent-income hypothesis 943
private 1687
procyclical 433 M35
smoothing 805
in RBC model 967
fime-averaged data 1242
consumption-based asset pricing 1249
consumption expenditare 745
Consumption Expenditure Survey (CEX) 750
consumption per capita 643
consumption taxes 1692
contract multiplier 1028

1-35
contractual problems 849
control rights 852
control variables 688, 689
convergence 240, 245-2'76, 284-288, 290, 295,
296, 659
global 486
local 519
probability of 480
speed of 531,659
convergence analysis 454, 477M79
convertibility 153, 160
convertibility rules 209, 213
convex adjustment costs 818, 823
coordination failures 461
coordination of beliefs 391
corner solutions 804
cost of capital 817, 1344
cost shifters 906, 912
cost shock 867, 884, 899, 907, 908, 912
Costa Rican tariff reform 707
costly state verification 1349
creative destruction 848, 1210, 1213
credibility 1536, 1603
credit chains 1378
credit constraints 856
credit market 847
imperfections 1343
see also borrowing constraint; capital
market imperfections
segmentation 1575, 1577
cross-country regression 276, 281
cross-section least-squares regression 269
cross-sectional density 840
of establishments' capital imbalances 837
cross-sectional growth regression 252, 269
273, 275, 276, 284~289, 671,675, 694
literature 688
crossover 522
crowding out 1632, 1633, 1636, 1638, 1648,
1652, 1654
currency crises 1534
current account deficit 1598
Cmxent Population Survey 796
curse of dimensionality 843, 847
customer markets 1120
cycles 460, 507, 509, 526, 865
deadweight loss 1631, 1632, 1639, 1640,
1662
debt contract 1350
debt-deflation 1372

1-36
debt neutrality 1644
deb~income ratio 1630
debt-output ratio 1619
decentralized economy 547, 575, 576, 602
decision rule 888-890
deficits 1617
nominal 1621
real 1621
demand shocks 865, 884, 889-892, 895, 898,
1055
demographic transition 658
demographic variables 793
demographics 547, 551 615, 744
and retirement behavior 758
depreciation 642, 1633
detrending and business cycle measurement
932
difference models of habit 1284
difference-stationary models 764
difference-stationary process 211,215, 1497
differential equation 472
diminishing returns 639
separately to capital and augmented labor
653
dirty floating 1587
discount factor 548, 555-557, 561, 567, 588,
595, 606, 607, 609, 610, 616
disinflation, output costs of 1542
disiunction effect 1324
disparity in GDP 675
disparity in incomes 674
distribution dynamics 263,290-295, 299
distribution of country incomes 674
distribution of relative GDP 674
dividend growth 1233, 1242, 1276
dollarization t589
domestic debt 1595, 1601
domestic policy regime 153, 202
Dornbusch-type model 502
DSGE, see dynamic stochastic general
equilibrium models
durability 798, 1242
durable goods 549, 746, 799, 1550, 1552, 1573,
1575
dynamic economic models 312, 313
Dynamic New Keynesian (DNK) framework
1346
dynamic programming 834
dynamic stochastic general equilibrium (DSGE)
models 930, 1139, 1145, 1150, 1157,
1166

S u b j e c t Index

models with job search

1158

earnings 546, 567-573, 577-588, 592, 593,

598, 605, 615, 623
s e e also wages
structural equation 582
variance 569-572, 578, 586
econometric approaches 237
economic growth 1617, 1641, 1651
economic relationship 852
education 577, 578, 580, 584, 602, 607, 609,
613,615, 622, 623,653
eductive approaches 462, 464
effective labor 650
efficiency of termh~ations 1152
efficiency units 566, 658
s e e also labor in efficiency units
efficiency wages 577, 578, 1098, 1157, 1159,
t 160
efficient equilibrium 854
efficient markets 1307, 1308, 1316, 1319 1322,
1333
elastic labor supply 1145
elasticity 545, 546, 550-552, 563, 579, 580,
592-594, 596-601,605, 607, 610, 614-617,
620
of capital supply 1714
long run 838
of demand, varying 1119
of intertemporal substitution 552, 557, 561,
564, 597, 600, 601,614, 615, 769, 791,
1148, 1250
of investment 857
of labor supply schedule 1147
of substitution 645
election 522
embodied technology 1207
embodiment-effect 664
employment 39
employment contract 1153
employment fluctuations 1173, 1194
enaployment protection t215, t217
employment relationship 1157
endogenous fluctuations 506, 531
endogenous growth models 238, 241,243,245,
257, 259, 261, 264, 265, 269, 271, 297,
506, 651,653, 1711
entry 1067
variable 1125
entry and exit 551,602, 615,616, 824, 844
envelope theorem in RBC model 998

1-37

Subject Index

"episodic" approach 1560

e-SSE 520
Epstein-Zin-Weil model 1259
equipment 840
equity premium puzzle 1234, 1245, 1249,
1250
error correction model 750
E-stability 463, 466, 468, 471~473,488, 490,
491,504, 511
iterative 463
strong 473, 483, 491,512
weak 473,483, 512
Euler equation 314, 345~47, 349-352, 354,
355, 364, 368, 371, 373, 374, 381, 382,
555-558, 566, 567, 575, 597, 598, 606, 607,
609, 611,621,650, 765, 767, 794, 805
undistorted 1713
Euler equations 745, 791
excess bond returns 1276, 1277, 1280
excess sensitivity 772, 784, 785, 790
excess smoothness puzzle 747
excess stock returns 1249, 1276, 1277
excess volatility 1319, 1320
excessive destruction 856
exchange rate 527, 531, 1658
anchor 1588
and markups 1122
arrangements 167, 203
exchange-rate-based stabilization 1535, 1543,
1553, 1559
empirical regularities 1546
existence of competitive equilibrium in RBC
model 1002
exit, delayed 850
see also entry and exit
exogenous growth models 261
exogenous technological progress 650
expectation functions 453, 461,464
expectational stability, s e e E-stability
expectations, average 528
expectations hypothesis of term structure
1281
experience 582, 584, 590, 602
experimental evidence 530
exports 41
extensive margins 843
external effects 390, 399M01, 403--405,
424-427, 43l, 433435, 437
external finance premimn 1345
external habit models 1284
externalities in RBC model 1002

factor-saving bias 641

factors of production 909
Family Expenditure Survey (FES) 746, 750
family income 564, 569, 589
Federal Reserve I53, 168, 169, 172-182,
184-202, 219
feedback
derivative 1510
proportional 1510
feedback rule 68, 71
feedforward networks 524
financial accelerator t 345
financial development 671,688, 692
financial markets, role in economic growth
1376
firing cost 1186, t214, 1222
fiscal authorities 1524
fiscal deficits 1538, 1594, 1604
fiscal increasing returns 416
fiscal policy 672, 692, 694, 712, 715, 1580,
1617, 1624
countercyclical 1617, 1660
fiscal theory of price-level determination 1520,
1524
fixed costs 390, 426, 435, 828, 848, 911
flow-fixed costs 831
fixed effect 787
flexible accelerator 816, 865, 893, 903
flexible cyclical elasticity 842
flexible neoclassical model 817
floating exchange rate 1582
fluctuations in aggregate activity 547, 549, 552,
556, 569, 1053
see also business cycles
induced by markup variation 1055, 1104
France 45
free entry condition 844, 845
fYictionless neoclassical model 817
Friedman rule 1720
Frisch demands 595 597, 603
Frisch labor supply 1146
full-order equilibrium 530
functional forms 550, 583,584, 588, 598, 601,
607, 611,623
fundamental solution 498
fundamental transformation 852
gain sequence 469, 475
decreasing 469
fixed 469
small 470

1-38
general equilibrium 543-625, 888
generational accounting 1624
genetic algorithms 465, 521,525
Germany 45, 1631
global culture 1332, 1333
GLS 788
gold standard 153-190, 199-220
Golden Rule 1650
Gorman-Laneaster technology 800
government
budget constraint 1687, 1719
consumption 671, 69l, 694, 1687, 1736
rate to GDP 688, 689
debt 16t7, 1687
production 672, 695, 701
production of investment 699
purchases 41
purchases and markups 1120
share 692
in GDP 671,689
in investment 695, 696
in manufacturing output 696
in output 693
gradual adjustments 823
gradualism 849
Granger causality 34
Great Depression 153, 163, 175, 178, 180-184,
199, 200, 213, 1343
Great Inflation of the 1970s 153
great ratios of macroeconomics 939, 940
gross domestic product (GDP)
per capita 674
per worker 671
gross substitutes 1731
growth
cycles 9
growth accounting 678, 687, 688
growth miracles in East Asia 709
growth-rate targets 1524
maximum growth rate 677, 726, 728, 732
habit formation 798, 802, 1237, 1284
habits 564, 802
Harro4-Domar models 640
hazard rate
constant 839
effective 836
increasing 840
hedging demand 1275
Iterfindaht index 824
heterogeneity 546, 547, 552, 553

Subject Index

in firms 1366
in learning 527
in values of job matches 1152
of preferences 545, 558, 563
unobserved 779, 831
heterogeneous agents 843, 1237, 1290
heterogeneous consumers 1686
Hicks composite commodity 766
Hicksian demand decomposition in RBC model
971
hiring rate 1161
histogram 840
historical counterfactual simulations 1523
history-dependent aggregate elasticity 841
Hodrick-Prescott filter, see HP filter
hold-up problems 852
home production 402, 417, 431,702
home sector 435
homotheticity 1725, 1728, 1733
Hotelling's rule 657
HP (Hodrick-Prescott) filter 12, 932, 933
human capital 527, 546, 547, 576, 577,
583-592, 594, 639, 653, I638, 1712
hump-shaped impulse responses 405, 436,
1374
hump-shaped profiles 755
hyperinflation (seignorage) 509, 520, 531,
1631
hysteresis and threshold effects 455, 530
i.i.d, model 1739
identification problem 75-78
global identification 76, 77
local identification 76
undefidentification 76, 77
idiosyncratic risk 795, 1290
idiosyncratic shocks 840
in productivity 1183
imbalances 826
imperfect competition 665
implementability constraint 1677, 1689, 1719,
1729
implicit collusion 1123
imports 41
impulse 1140
impulse response
measure of comparative dynamics 967
to productivity in RBC model 967
impulse response functions 74, 81, 85, 86, 90,
98, 100, 102, 107, 110, 112, 133, 140, 397,
41t, 430, 431,880, 894

Subject Index
inaction range 832
Inada conditions 645
income distribution, cross-country 671
income elasticity 1681
income inequality 797
income processes 569, 574, 610
income tax 672
income uncertainty 1652
incomplete contracts 853, 854, 856
incomplete markets 566-576, 1742
indeterminacy 491, 494, 506, 1161, 1506,
1691
nominal 418, 1506, 1524
of price level 215, 216, 415, 4t7, 419, 423
real 413, 415, 416, 418, 419, 423
indicator, cyclical 1062
indivisible labor model, role in RBC model
977
industry equilibrium 888,889
inequality 745, 795
infinite-horizon consumption program 647
inflation 42, 1534, 1536, 1630
and business cycles 939
and markups 1128
inertia 1562
level 198
persistence 166, 211,213-215
rate 1738
autocorrelation 1738, 1739
variability 207
inflation correction 1621
inflation forecast targeting 1504
inflation-indexed bonds 127t
inflation-indexed consol 1269
inflation targeting 1499, 1505
vs. price-level targeting 1497
inflation tax 1538, 1720
inflationary expectations 1281
intbrmation externality 849
information pooling 849
information set 455
informational problems 849-85 i, 858
infrequent actions 825
instability 481,519
of interest rate pegging 514
of REE 507
institutional faetors 852
instrument feasibility 1507
instrument instability 1517
instrument variable 1492, 1524
instrm~ental variables (IV) estin~ator 787

1-39
instrumental variables (IV) regression 1261
insurance 745, 795
integrated world capital market 1297
interest rate 43, 1620, 1621, 1629, 1630,
1634, 1635, 1637, 1639, 1648, 1652, 1653,
1657 1659
nominal 1524
interest rate instrument t514
interest rate policy 1596
interest rate smoothing 1509
intermediate-goods result 1684, 1720, 1733
intermediate-goods taxation 1676
intermediate input use 1081
internal habit models 1284
international capital flows 1636 1638
International Financial Statistics (IFS) 1238
international reserves 1594
intertemporal allocation 761
intertemporal budget 555, 561,647, 661
intertemporal budget constraint 1259, 1268
intertemporal CAPM 1275
intertemporal channel 1142
intertemporal elasticity
of labor supply 1149
of substitution in leisme 1147
intertemporal marginal rate of substitution
1245
intertemporal non-separabilities 775
intertemporal optimization 745
intcrtemporal substitution 1055, 1150
"intervention" policy 1587
intradistribution dynamics 274, 292
intratemporal first-order conditions 775
inventories, target 894
inventodcs of finished goods 887
inventory fluctuations 1084
procyclical 872-882, 898, 900, 909
inventory investment 865
inventory-sales ratio 871
inventory-sales relationship 867
investment 40, 641
collapse 851
competitive equilibrium 844
delays 1365
distortions 672, 695-698
empirical 1344
expected 839
frictionless 832
lumpy 822, 823
share in output 693,699
spike 823, 824, 857

1-40
investment (eont'd)
tax incentives 843
US manufacturing 840
investment episode 823
investment output ratio 714
irrational expectations 1237, 1293
irregular models 490, 493, 505
irreversibility constraint 832
irreversible investment 822, 828, 832
iso-elastic utility function 606, 607, 610
Italy 1619
Ito's lenmla 825
Japan 45
Jensen's inequality 1247
job-finding rate, cyclical behavior of 1162
job loss 1151
job search t143, 1150, 1158, 1162
job-specific capital I152
job to job flows 1198, 1200
job-worker separations 1184
jobs
creation 846, 1150, 1158, 1161, 1173, 1176,
1178, 1185, 1201, 1219
cost 1187, 1193, 1215, 1222
creation and destruction, international
comparison 1178
destruction 846, 1150, t 158, 1160, 1166,
1173, 1176, 1178, 1185, 1197, 1201,
12t9
rate 1151, 1152
flow 1197
international comparison 1180
reallocation 1222
termination 1152
cost 1193
joint production 853
joint surplus 1157
just-in-time 871
Kaldor facts about economic growth 941
Keynes, J.M. 1660
Keynesian analysis [ 628
Keynesian consumption function 761
Kreps-Porteus axiomatization 744
Krugman model 1592
Kuhn Tucker multiplier 774
labor 1687
bargaining strength 1219
labor-augmentation 651

Subject Index

labor contract 1154

labor force 1174
labor force status 602, 603, 607, 611, 614,
623
labor hoarding 1076, 1078, 1097
labor in efficiency units 650
see also efficiency units
labor income 1237, 1275, 1290
labor market 855
policy 1214
restrictions 672, 695
labor power 1220
labor productivity 42
labor regulations 852
labor share 1059
labor supply 546-553, 562, 577, 585, 587, 592,
594, 596, 598, 599, 601,602, 605, 606, 608,
610 62l, 623, 744, 777, 792, 1150, 1296
elasticity 975, t371
in RBC model 975
empirical 1148
endogenous in RBC model 945
extensive margin 976
female 6 t 1
fixed costs of working 976
indivisible labor model 976
male 611
substitution effect 975
unobserved effort of 930
labor tax rate, autocorrelation 1739
lack of credibility 1569, 1572, 1581
Latin America 1543
laws of large numbers 837
leading example 488, 493
learning 453,488
by doing 664
in games 475
in misspecified models 528
least squares learning 465,467, 526
social 849
stability under 496
statistical 493
lean~ing dynamics, persistent 455
learning equilibria 515
learning rules 439, 454
econometric 472
finite-memory 474
fixed-gain 51 I
statistical 465
learning sunspot solutions 494
learning transition 531

Subject Index

Legendre--Clebsch condition 904

levels accounting 678-687
leverage 1280
life cycle 583, 586-588, 593, 595, 601, 603,
604, 609, 615, 620, 621, 744, 749, 752,
754, 760, 792, 793
life cycle-permanent income model 760
life expectancy 691-693
lifetime budget constraint 647
see also intertemporal budget
likelihood function 840
linear allocation rules 554, 563, 564
linear commodity taxes 1677
linear filter l 1
linear model 467, 487, 842
with two forward leads 501
linear-quadratic model 457, 865, 876, 882, 903,
904
liquidity 1255, 1591
liquidity constraints 745,772, 773, 789, 1654
see also borrowing constraint
liquidity variables 817
log-linearization 788
long-term bonds 1255, 1280
low-equilibrium trap 646
Lucas aggregate supply model 457
Lucas critique 1491
Lucas program 67
lumpy project 823
Lyapunov theorems 479
M2 44
M1 velocity 50
machinery, price of 696
macroeconomics 639
magical thinking 1328, 1329
maintenance 823
maintenance investment 839
major and infrequent adjustments 823
managed float 152, 153, 167, 202, 204, 207
manufacturers 870
marginal cost schedule 1054
declining 1066
marginal production costs 867, 890, 892, 896,
899, 902, 905, 907
marginal profitability of capital 830
marginal rate of substitution 549, 551,554-557,
559, 560, 598, 622, 765
heterogeneity 620-623
marginal utility 767
market capitalization 1239

1-41
market clearing 1021 I024, 1026, 1035
expected 1021, 1024-1027
market imperfection 390, 405, 424, 426, 433
market structure 546, 553, 558, 575, 598
market tightness i 185
market work 550, 594, 601
Markov chain 1708, 1736
Markov process 1264
markup 399, 400, 406, 407, 426, 429, 431,
1053
average 1068
countercyclical 406, 1113
for France 1068
cyclical 1092
desired 1056
measurement 1058
models of variation 1055, 1112
procyclical 1113, 1128
variable 406, 407
variation in desired 1129
Marshallian demands 597
martingale 767
martingale difference sequence 487
match capital 1152
matching function 1183
matching model 1163
Maximum Principle 650
measure of financial development 691
measurement error 518, 546, 56I, 572 574,
609, 616, 1242
"mechanical" approach 1560
mechanism design 1154
Medicare 1622, 1626
men 550, 552, 607, 615, 620
mental compartments 1317
menu costs 397
microeconomic data 543 625, 745
microeconomic lumpiness 824
microfoundations 761
military purchases 1088
Mincer model 568, 569, 581,582, 584, 592
minimal state variable solutions, see MSV
solutions
mismatch 1221
mismeasarement of average inflation 1254
Modigliani-Miller theorem t343
monetary accormnodation 1539
monetary base 44, 1507, 1524
monetary economies 1720
monetary model with mixed datings 500

1-42

Subject & d e x

monetary policy 692, 695, 715, 1012, 102~

1037, 1281, 1630, 1660, 1720
optimal, cyclical properties of t736
monetary policy rule 1364
monetary policy shocks 65-145
effect 69
on exchange rates 94-96
on US domestic aggregates 91-94
on volatility 123-127
identification schemes 68 70, 1369
Bernanke-Mihov critique 115-123
Bernanke Mihov test 11%121
empirical results 121 123
Coleman, Gilles and Labadie 114, 115
narrative approach 13(>141
see also Romer and Romer shock
pitfalls 134 136
plausibility 100-104
assessment strategies 114-123
problems t43-145
interpretations 71-73
non-recursive approaches 127-134
output effects 1129
recm'siveness assumption 78-127
see also recursiveness assumption
responses to 1368
monetary regimes 153, 168, 178, 202, 204,
211,216, 220
nmney 44, 1011 1013, 1020-1029, 1031-1033,
1035, 1036, 1040, 1041
money anchor 1588
money-based stabilization 1535, 1543, 1554,
1558, 1582
money demand 50, 598, 1603, 1736
consumption elasticity of 1725
interest elasticity of 1736
money growth rate 1738
money-in-the-utility-function model 1720,
1728

money supply 1536

money velocity 1588
see also M1 velocity
monopolies 695
monopolistic competition 1033-1036, 1041,
1042
monotonicity 830
Morgan Stanley Capital International (MSCI)
1238
MSV (minimal state variable) solutions 488,
493, 502
and learning 503

locally (in)deternfinate 490

non-MSV solutions 493
multiple competitive equilibria 1679
multiple equilibria 1539, 1603
multiple REE, see under R E E
multiple solutions 487, 1506, 1524
multiple steady states 460
multiple strongly E-stable solutions 501
multiplicity of steady states 658, 662
multivariate models 502
with time t dating 505
mutation 522
Muth model 465, 484, 525
myopia 1653, 1654
Nash bargain, generalized 1189
National Account 751,752
national accounting identities 1628
National Bureau of Economic Research (NBER)
6,8
national income 1617
national saving 1628, 1629, 1637, 1639, 1641,
I652, 1659-1662
natural experiments 822
natural rate 1176
nalnral resources 639
negative income tax experiments 1148
neoclassical exogenous growth model 243,261,
673
neoclassical growth model 245, 246, 252, 259,
269, 272, 276, 639, 695, 697, 701, 1140
basis for RBC model 942
neoclassical theory of investment 817
net convergence effect 692, 693
net present value rule 835
net worth and the demand for capital 1352
neural networks 465, 524
neurons 524
noise
case of small 513
intrinsic 507
noise traders 1290
noisy k-cycle 5/3
noisy steady states 483, 509
nominal anchor 207, 211, 215, 216, 1535,
1542, 1557
nominal income targeting 1505
non-durables 746
non-nested models 840
non-random attrition 787
non-Ricardian policy 418

1-43

Subject Index

non-Ricardian regime 418

non-separability of consumption and leisure
759
non-state-contingent nominal claims 1722
Non-Accelerating Inflation Rate of Unemployment (NAIRU) 46
nonlinear models 468
nonlinearity 828, 839
nonparametric techniques 532
numerical algorithms 320, 324, 326, 328, 348,
358, 378
numerical solutions 318, 326, 352, 805
obsolescence 848
OECD 685, 718, 719, 1174
OECD adult equivalence scale 757
oil prices, effects of 1089
one-sector model 639
one-step-ahead forward-looking reduced form
506
open economy 1714
open market operations 1722
openness 703
operationality 1486, 1523
opportunism 851,858
opportunity costs 854
optimal control 1490
optimal debt policy 1639, 1659, 1660, 1662
optimal fiscal policy 1686
optimal investment path 834
optimal national saving 1617
optimal tax theory 1692
optimal trajectory 650
optimal wedges 1692
optimum quantity of money rule 1537
option to wait 832, 834
ordinary differential equation (ODE)
approximation 468, 478
orthogonality conditions 785
out-of-sanrple forecasting 840
out-of-steady-state behavior 649
output 1687
output levels 206
output variability 208, 211
overconfidence 1319-1323, 1325, 1326, 1328
overhead labor 1065
overidenfifying restrictions 768
overlapping contracts models 495, 1582
overlapping generations model 390, 395, 397,
398, 427, 458, 546, 549, 576-594, 660,
1634, 1635, 1645 1647

overparanletrization 473
overreaction 1319 1322
overtaking 650
overvaluation 1563

panel data 275, 283-287, 295, 781

Pareto weights 55%564, 796
partial adjustment model 821,838
participation 574, 601, 1218
path dependence of adaptive learning dynamics
455
peacetime 1699
Penn World Table 674, 680
pent-up demand 841
perceived law of motion (PLM) 466, 472, 490,
511
perceptron 524
perfect competition 831
perfect foresight 650
perfect insulation 846
perfect-insurance hypothesis 796
periodic or chaotic dynamics 646
see also cycles
permanent-income hypothesis 749, 1641,
1662
permanent shocks 216-219
perpetual inventory method 680
persistence 870 882, 891, 893, 900, 902, 904,
1142, 1162, I166, 1739
of business cycles, see persistence under
business cycles
of fluctuations 527
of inflation 1537
peso problem 1252
pessimism 1295
Phillips cm've 46, 1056, 1363, 1542
planner's problem in RBC model 997, 1002
policy 455
affecting labor markets 672
distorting investment 695
impeding efficient production 672
policy accommodation 1538
policy ftmction 320-381
political rights 671,689
political stability 671,688, 692
Ponzi scheme 1650
population aging 1625, 1640
population growth 941
endogenous 639
power utility 1249

1-44
precautionary saving 744, 770, 1253, 1288,
1653
preference parameters 550, 555, 556, 558, 567,
601, 605
preferences 546-550, 552, 553, 556-558, 564,
565, 567, 572, 582, 593, 601, 604, 605,
607, 608, 610, 614, 616, 617, 623
additive 594
conditional 778
fimctional forms 550
Gorman polar 766, 783
heterogeneity 545, 552, 558-565, 567, 593,
594, 609, 621,623
homogeneity 553 556, 577
of representative agent in RBC model 942
quadratic 762, 770
present-value model of stock prices 1264
log-linear approximation 1265
present-value neutrality 573
price elasticity 1681
price functions 1723
price puzzle 97-100
price rules 1688
price-cost margin 1053
s e e also markup
price-dividend ratio 1265, 1266, 1276
prices 42
of maclfinery 696
of raw materials 1082
pricing, equilibrium 555, 602, 845
primal approach 1676
primary budget 1619
principal-agent problems 1345
principles of optimal taxation 1676
private and public saving 1629
private information 574-576, 849
production costs, non-convex 897, 911
production economy 1686
production efficiency 1684, 1735
production function 548-550, 578, 579, 581,
583-586, 588, 590, 591,594
non-Cobb-Douglas 1064
production possibilities surface 401
production smoothing 876, 877, 884, 895,
1085
production to order 887
production to stock 887
productivity 552, 553, 566, 583, 602, 1057
cyclical 938, 1094
deterministic growth of 943
general 1192, 1193

Subject I n d e x

growth of 942
shocks 930, 943, 965, 972
amplification of 963
modeled as first-order autoregressive process
963
persistence of (serial correlation) 952,
963
RBC model's response to 964
remeasurement of 982
slowdown 664
profit function 830
profits 1057
cyclical 1100
projection facility (PF) 480
propagation of business cycles 865
propensity to constune 762
property rights 852, 856
proportional costs 825
proportional taxes 1687
prospect theol2 1308 1313
protection of specific investments 1154
"provinces" effect 1540
proxies for capital utilization 1080
prudence 771
PSID 783
public consumption 1581
public debt 1601, 1603
public finance 1676
public saving 1629, 1641
putty-clay models 847, 848
q-theory

817
Tobin's q
averageq 817,818
"flexible q" 818
marginal q 818
fragility of 828
quadratic adjustment cost model 823, 838
Quandt Likelihood Ratio (QLR) 34
quantitative perfunnance 1578, 1581
quantitative theory 671-673, 695-719
see also dynamic stochastic general
equilibrinm models
quasi-magical thinking 1329, 1330
see also

Ramsey allocation problem 649, 1679, 1691,

1692, 1713, 1719, 1723, 1729
Ramsey equilibrium 1678, 1688, 1723, 1'729,
1732
Ramsey growth model 1651, 1652
Ramsey prices 1679

1-45

Subject Index

random walk 767, 1316, 1319, 1702, 1706,

1738, 1742
geometric 825
range of inaction 826
rate of arrival of shocks 1193
rate of discount 1193
rate of return 566, 577, 582, 595, 606, 610
ratio models of habit 1284
rational bubbles 499, 1266
rational expectations 453
transition to 454
rational learning 461
rationalizability 464
rationing 857
RBC models, see real business cycle
Reagan, R, 1641
rea~ balance model 489, 496
real business cycle (RBC) 394, 402, 413,427,
428, 437, 442, 505, 843, 928, 1296
amplification of productivity shocks in 958,
967
as basic neoclassical model 942
baseline model 1143, 1709, 1736
failures 1144
calibration 953-955,959
competitive equilibrium 999
concave planning problem 1002
contingent rules 1000
criticisms 961
depreciation rate of capital 944
discount factor 942
modified 945
endowments in 943
cxtensions 994
firm's problem 1001
government spending and taxes in 974
high risk aversion model 1709
high-substitution version
calibration 985, 987
decision rules for 985
ingredients of 984
probability of technical regress 989, 990
role of capacity utilization in 985
role of indivisible labor in 985
sensitivity to measurement of output 992
sensitivity to parameters 990, 991
simulation of 986
household's problem 1000
importance of consumption smoothing in
967

Inada conditions on production function

996
interest rate effects 973
internal propagation in 967
labor
demand for 956
supply of 956
Lagrangian for 946
lifetime utility 996
market clearing 1001
production function in 943
RBC model as basic neoclassical model
942
simulations of 957
solution
certainty equivalence 952
dynamic programming 951
linear approximations 949
loglinear approximations 952
rational expectations 951
steady state of 947
transtbrmation to eliminate growth 944
transitional dynamics of 948
transversality condition for 946
wage effect in 973
wealth effects in 971
with nominal rigidities 974
real exchange rate 1547
real interest rate 1220, 1233, 1276, 1286
measurement of 939
real marginal cost 1053
real shocks 1174
real wage 1296
reallocation of workers 1160, 1183, 1199
recession now versus recession later 1535,
1557
recursive algorithm 468, 475, 479, 486
recursive least squares 467
recursive least squares learning 494
recursive utility 557
recursiveness assumption 68, 73, 78 127
benchmark identification schemes 83 -85
F F policy shock 87, 88
influence of federal funds futmes data
104--108
NBR policy shock 88
NBR/TR policy shock 89
problems 97
results 85
robustness 96, 97
sample period sensitivity 108 1i4

1-46
recursiveness assumption (cont'd)
relation with VARs 78-83
REE (rational expectations equilibria) 452
cycles 458
multiple 454, 467
reduced order lhnited information 529
unique 484
reflecting barriers 828
regime switching 426
regression tree 289
regular models 490
regulation barrier 832
relative price of inves~lent to consumption
696 698, 700, 701
reluctance to invest 828, 832
renegotiation 1153, 1t55
renewable/nonrenewable resources 655,656
rental prices 588, 590, 592
of capital 1000
reorganization 1160, 1161
representative agent 556, 557, 560, 561, 563,
587, 601, 838, 1249, 1259, 1268
in RBC model
altered preferences in indivisivle labor
977
altruistic links 943
preferences of 942
representative household 643
representativeness heuristic 1319, 1322, 1327
reproduction 522
research and development (R&D) 664, 672,
692, 695, 708, 709, 715-7!9
residence-based taxation 1715
restricted perceptions equilibrium 529
restrictions in job separation 1222
restrictions on government policy t707
retailers 869
retirements 839
returns to scale 639
decreasing 656
increasing 652, 653,664, 828, 830, 1066
social 460, 509, 521
Ricardian equivalence 418, 1617, 1640 1659,
1661
Ricardian regime 418
Ricardo, D. 1640
risk 546, 547, 552, 554-558, 563 567, 569,
572, 575,593,606
risk adjustment 555, 557, 558
risk aversion 547, 552, 556 -558, 564-566, 606,
771

Subject Ndex
risk premium 1246, 1247, 1250
risk price 1236, 1280
risk-sharing in indivisible labor version of RBC
model 977
riskfree rate puzzle 1235, 1252
robustness approach 1491, 1523
Romer and Romer shock 137-142
rnte-like behavior i487, 1522
rule-of-thumb decision procedure 524
rules I52-154, 156, 158, 160, 166, 168, 184,
200, 208, 219, 220
rules vs. discretion 1485
Rybczinski theorem 404
(S, s) model 801,802, 831,910, 911
sacrifice ratio 1541
saddle point 405, 649
saddle point stability 490
Sargent and Wallace model 489
saving 641
private 1628, 1629, 1632--1634, 1637, 1641,
1648
'saving lot a rainy day' equation 764
scale effects 672, 715, 716, 718, 719
school attainment 691
school enrolhnent 681,684
post-secondary 683
primary 683
secondary 68l.-683
schooling 576 578, 581 592
sclerosis 856
scrapping 844, 847, 855, 856
endogenous 844
search and matching approach 1173, 1183
search efficiency 1162
search equilibrium 1186
search externalities 506
seasonal adjustment 1242
seasonal variations in work volulne 1149
second-best solutions 849
secondary job loss 1163
sector-specific external effects 402
sectoral shifts hypothesis 1221
securities market 1722
seignorage model 460, 471, 509, 525, 530,
1741
selection criterion 468
selection device 454
self-fulfilling fluctuations 506
separability 556, 602, 603, 607, 608, 612, 613,
617, 1725, 1728, 1733

Subject lndex

tests 611
separation rate 1151
Sharpe ratio 1249
shock absorber 1699, 1710, 1739
shock propagation 1203
shocks and accommodation 1539
shopping-time model 1720, 1732
shopping-time monetary economy 1732
short-term bonds 1280
shurt-tenn maturity debt 1603
o-convergence 659
Sims Zba model 128-134
empirical results 131-134
skill-biased technology shock 1215, 1216,
1218
skills 546, 547, 569, 576-579, 581,582, 584,
586-588, 590-594, 623
slow adaption 480
slow speed of adjustment 8"77,894
small durables 798
small open economy 1715
small sample 820
small versus large finns t373
smooth pasting conditions 827
Social Security 1619, 1622, 1624, 1626, 1635
Solow residual 930, 1140, 1141
as productivity measure 962
in growth accounting 962
mismeasurement 962
solvency conditions 575
specificity 851,852, 856
spectral analysis 11
SSE, see stationary sunspot equilibria
stability conditions 454
stabilization 1534, 1562
stabilization goals 153
stabilization time profiles 1547
stable equilibrium point 481
stable roots 393
staggered contracts model 1012, 1013, 1024,
1027, 1030, 1032, 1039
staggered price and wage setting 1012, 1013,
1027, 1030, 103t, 1033, 1035-1037, 1040
staggered price setting 397, 422, 423, 1129,
t363
staggered-prices formulation t582
standardized employment deficit 1621
state-contingent claims 555, 602
state-contingent returns on debt 1687, 1699
state-dependent pricing 1031, 1032
state dynamics 477

1-47
state prices 1294
stationary distribution of RBC model 999
stationary sunspot equilibria (SSE) 408, 517
e-SSE 517
near deterministic solutions 520
steady states 468, 507, 525, 549-551,576, 592,
598, 639
of RBC model 944
sterilization 1595
sticky price models 503, 1113
stochastic approximation 468, 475, 476
stochastic discount factor 1234, 1245
log-normal 1246
stochastic growth model 546 577, 592
stochastic simulations 1516, 1523
stock market 1310, 1312, 1313, 1315, 1316,
1320-1328, 1331, 1333
stock market volatility puzzle 1235, 1236,
1268, 1276, 1280
stock prices 43
stock return 1233, 1240
stockout costs 884, 885
Stolper-Samuelson theorem 404
Stone price index 783
storage technologies 574, 575
strategic complementarity 1129
strategic delays 858
strong rationality 464
structural model 462
structural shifts 530
structalres 840
subgame perfection 1679
subjective discount factor 548, 552, 561, 593,
595, 609, 616
subsistence wage 657
substitutes 577, 590, 591,613,616
sm~ costs 858
sunspot equilibria 454, 515
sunspot paths 662
sunspot solutions 495
see also learning sunspot solutions
sunspots 489, 515
supply of capital 846
supply price of labor 1192, 1193
supply shocks 1129
supply-side responses 1577
surplus 853
surplus consumption ratio 1286
survivorship bias 1242
sustainability 1597

1-48
T-mapping 467, 471,512
Tanzi effect 1741
target points 826
target variables 1492, 1523
tariff 672, 695, 703-707
taste shift 778
tax
see also labor tax rate; capital taxation
distortionary 165l, 1652, 1654
on capital income 1686
on employment 1220
on international trade 703
policy 672, 708
rate 1441
on private assets 1709
reforms 822
smoothing 1655, 1659, 1662, 1705
intertelnporal 1617
source-based 1715
system 1679
Taylor expansion 1265
Taylor rule 1364
technological change 1708
technological embodiment 848
technological progress 641, 1207, 1213
disembodied 1207, 1208
endogenous 639
Harrod-neutral, Hicks-neutral 944
labor-augmenting 944
purely labor-augmenting 650
techimlogical regress, probability of in RBC
models 930
technology adoption 672, 708
technology shocks 1141, 1142, 1736
temporariness hypothesis 1569, 1572
temporary shocks 216
temporary work 1165
term premimn 1255
term structure of interest rates 1270
termination costs 708
thick-market externality 1161
threshold externalities 527
thresholds 258-262, 276, 289
time-additive utility function 661
time aggregation 881
time-consistent behavior 1488
time dependency 799
time-dependent pricing 1031, 1032
time-inconsistent behavior 1653
time preference 547, 588
time preference rate 1253

Subject Index

time series 264, 272, 287, 288

time series volatility 756
time to build 832, 850
time-vary/ng aggregate elasticity 841
timing assumption 469
Tobin's q 817, 1296
see also q-theory
total factor productivity (TFP) 42, 673, 678,
687, 688, 702
trade deficit 1630, 1658, 1659
trade policy 672, 692, 694, 702
training 577, 582-584, 586-592, 653
transition rates 1166
transversality conditions 392, 393,400, 650
Treasury bills 1233
trend-stationary models 764
trend-stationary process 10, 211, 1497
trigger points 830
tuition costs 583, 588, 590
twin deficits 1630
two-stage least squares estimation 1261
tmcertainty 545-547, 556, 558, 564, 566, 567,
569, 572, 574, 575, 593, 605, 606, 620,
621,623,744, 1627, 1653
underinvestment 852, 854
underreaction 1319-1322
unemployment 546, 569-571, 578, 579, 1143,
1150, 1158, 1161, I162, 1173, 1174, 1194,
1214
experiences of OECD countries 1213
natural level 1157
rise in 1182
serial correlation 1163
unemployment compensation 1217
unemployment income 1214
unemployment inflow and outflow rates 1181
unemployment rates 1176
unemployment spell duration hazard 1184
tmemployment-skill profile 1216
unified budget 1619
uniform commodity taxation 1676, 1726
union bargaining 1098
uniqueness of equilibrium in RBC model
1002
unit root 11
United Kingdom 45
tmivariate models 488, 497
unstable equilibrium point 481
utility function 548-550, 556-558, 560, 594,
596, 597, 599-601,606, 607, 610

1-49

Subject Index

momentary in RBC model 944

offsetting income and substitution effects
944
utility recursion 557
utilization of capital 1079
vacancies 41, 1194
vacancy chain 1200
vacancy dmation hazard 1184
value function 319-327, 329, 335, 336, 340,
345, 351-355, 357-359, 365,368, 378
value matching 827
variable costs 828
variety, taste for 705
vector autorcgression (VAR) 73,438
definition 73
vintage capital models 847, 848
volatility
employment 1157
inventories 869, 870
monetary aggregates 1599
vote share 1455
wage bargaining 1130
wage contract 1173, 1186
wage inequality 1182, 1214, 1218, 1219

wages 42, 547, 550-553, 556, 566-569, 572,

577-579, 581,587, 593, 595-601,603-607,
611, 612, 616, 617, 619, 621, 623, 1181,
1629, 1637
see also earnings
cyclical 939
equilibrium 556
fixed 1157
marginal 1069
rigidity 1055
war of attrition 1540
wars 1619, 1642, 1656, 1661-1663, 1699
wealth distribution 556, 561,567, 572, 593
wealth-output ratios 1240
wealth shock 1372
welfare costs of macroeconomic fluctuations
1297
welfare theorems, role in RBC analysis 1001
wholesalers 869
within-period responscs 599
women 550, 552, 607, 615, 620, 623
worker flows 1180
into unemployment 1164
worker turnover 1176
works in progress inventories 887
yield spread

1256, 1280