Abstract: This paper investigates exchange rate dynamics and its forecast errors by incorporating bounded rationality in a small open-economy New Keynesian model. Decision-makers possess limited foresight, capable of planning only up to a finite distance into the future. This yields dynamic overshooting of forecast errors in the real exchange rate across different time horizons. It also distinguishes between short- and long-term expectation formations, where the Law of Iterated Expectations breaks. This framework provides a micro-foundation for understanding time- and forecast-horizon variability in uncovered interest parity (UIP) puzzles. Our model predictions on these UIP violations align both qualitatively and quantitatively with empirical estimates.

Abstract: While two strands of the literature suggest that producer price index (PPI) inflation, in addition to or instead of consumer price index (CPI) inflation, should be a targeting variable in a monetary policy rule, the distinction between the two is only important when they do not co-move strongly. Our first contribution is to document that their correlation has indeed fallen substantially since the start of this century. Our second contribution is to propose a model to understand this divergence based on expanding global supply chains. Our theory also produces additional predictions that are confirmed in the data. As such changes are structural rather than temporary, and so does the co-movement between CPI-PPI inflation, it implies that central banks need to take the change in the production structure of the economy into account when deciding their inflation target.

Abstract: This paper studies the impact of government expenditure on inflation through the lens of an augmented Phillips curve implied from a structural New Keynesian model. Our estimation results, based on external instruments, show that the augmented Phillips curve has a flatter slope than the canonical specification, and government expenditure has a negative coefficient. Changes in government expenditure account for a substantial portion of inflation variations and provide new insights into the “missing disinflation” puzzle. We also find that inflation and inflation expectations respond negatively to fiscal spending shocks, reaffirming the supply-side channel through which inflation responds to fiscal expansions.

Abstract: We present new facts on how convenience yields fluctuate with macroeconomic variables and fiscal policy. We find the convenience yield of long-term Treasuries is negatively correlated with inflation expectations, and inflation expectations predict future debt-to-GDP growth at different horizons. To rationalize these findings, we incorporate the convenience yield into a staggered-price model with a non-Ricardian fiscal policy. The government finances deficit shocks partially through higher inflation and partially through more borrowing in the future, which reduces the convenience yield today. The feedback loop between the convenience yield and future debt supply amplifies the effect of fiscal shocks on the cost of government borrowing and its debt balances. We further verify this channel in the data using empirically constructed exogenous deficit shocks.

Abstract: We build a tractable New Keynesian model to jointly study four types of monetary and fiscal policy. We find quantitative easing (QE), lump-sum fiscal transfers, and government spending have the same effects on the aggregate economy when fiscal policy is fully tax financed. Compared with these three policies, conventional monetary policy is more inflationary for the same amount of stimulus. QE and transfers have redistribution consequences, whereas government spending and conventional monetary policy do not. Ricardian equivalence breaks: tax-financed fiscal policy is more stimulative than debt-financed policy. Finally, we study optimal policy coordination and find that adjusting two types of policy instruments, the policy rate together with QE or fiscal transfers, can stabilize three targets simultaneously: inflation, the aggregate output gap, and cross-sectional consumption dispersion.

Abstract: Analyses of the interaction between monetary and fiscal policy often turn crucially on assumptions that are made about outcomes far in the future, sometimes infinitely far. This is a problematic feature of rational-expectations analyses, given the limited basis for assumptions about the distant future. This paper instead considers both short-term effects and long-run consequences of alternative monetary and fiscal policies under an assumption of bounded rationality. In particular, it assumes that explicit forward planning extends only a finite distance into the future, with anticipated situations at that horizon evaluated using a value function learned from past experience. Such an approach makes announcements of future policies relevant, but avoids the debates about equilibrium selection that plague rational-expectations analyses. The combined monetary-fiscal regimes that result in stable long-run dynamics are characterized, and the effectiveness of temporary changes in either type of policy as a source of short-run demand stimulus is analyzed. The effectiveness of a coordinated change in monetary and fiscal policy is shown to be greatest when decision makers' degree of foresight is intermediate in range (average planning horizons on the order of ten years), rather than shorter or longer.