ESSAYS ON ISSUES THE FEDERAL RESERVE BANK DECEMBER 2006 OF CHICAGO NUMBER 233a

Chicago Fed Letter

2005 Conference on Price Stability: A summary by Jonas D. M. Fisher, senior economist, economic advisor, and macroeconomic policy team leader, and Spencer D. Krane, vice president and economic advisor On November 3 and 4, 2005, the Federal Reserve Bank of Chicago’s Inflation Research Center hosted the “2005 Conference on Price Stability.” This conference brought together leading academic economists and policymakers to discuss the latest research on the determinants of inflation and their implications for questions facing monetary policymakers.

Six research papers were presented and and fall of inflation. The authors test their discussed during the conference. In ad- story by estimating their model on U.S. dition, two panels addressed key ques- data. Specifically, they estimate the pa- tions facing policymakers: “How low rameters of the Fed’s model as well as should inflation be?” and “Does fiscal the parameters of the economy, and they policy threaten price stability?” In this find their model performs well relative Chicago Fed Letter, we summarize the pro- to purely statistical benchmark models ceedings of the conference.1 We begin of inflation. with the sessions devoted to research pa- In his comments, Christopher Sims, Materials presented at the pers and then discuss the policy panels. Princeton University, expressed skepti- conference are available at In “Shocks and government beliefs: The cism. The estimated parameters of the www.chicagofed.org/ rise and fall of American inflation,” Tom Fed’s model would ascribe to the Fed im- news_and_conferences/ Sargent, New York University; Noah plausible beliefs about the economy and conferences_and_events/ Williams, Princeton University; and Tao the costs of stabilizing inflation, particu- Zha, Federal Reserve Bank of Atlanta, larly in the critical period of 1973–74. 2005_inflation.cfm. tried to understand the pattern of infla- The reason, he argued, is that the Fed is tion in the U.S. after World War II (low allowed to mistrust the data too much; in the 1950s and early 1960s, high in the that is, to think that its model of the econ- late 1960s and 1970s, low again since the omy is unstable. Sims’ preferred story is 1980s) by asking the question: What was one in which the magnitude of shocks the Fed thinking? Sargent, Williams, and to the economy changed over time, and Zha suppose that the Fed does not know he argued that such a model performs how the economy works, but bases its in- just as well compared with the bench- flation policy on regressions (a technique marks of Sargent–Williams–Zha. of fitting a simple equation to real data In “Redistribution of nominal wealth and points) of unemployment on lagged in- the welfare cost of inflation,” Matthias flation and unemployment. When run- Doepke, University of California, Los ning these regressions, the Fed thinks Angeles, and Martin Schneider, Federal that the regression coefficients might be Reserve Bank of Minneapolis, explored changing over time in certain ways. Fur- the role of unanticipated inflation in re- thermore, the Fed does not perfectly con- distributing wealth from borrowers to trol inflation because inflation is subject lenders. Since most financial contracts to random shocks. It is the interaction are not indexed to inflation, an unexpect- between the Fed’s changing beliefs and ed rise in the price level erodes the real the inflation shocks that explains the rise value of debt, benefiting borrowers at the expense of lenders. They ask the ques- net worth (relative to total income) fell overpriced station to another is very low. tion, “If we experienced an inflationary in the 1970s and rose afterward; stock Knowing this, gasoline retailers adjust episode today that would be comparable holdings by households moved similarly; their prices almost continuously to match to the one that happened in the U.S. in real estate holdings moved in the oppo- their rivals’. Konieczny and Skrzypacz the 1970s, who would gain, who would site direction; and after the 1970s, house- formalize this story within a model where lose, and by how much?” The authors holds lent more to each other but less to each price change has an associated cost, find that richer and older households, other sectors of the economy. Piazzesi and and they test it using observations of re- which tend to be net lenders, lose be- Schneider argued that demographics tailers’ prices from Poland and the United tween 1% and 3% of their total lifetime can explain the movements in net worth, States. They conclude that the differences consumption. Middle-class and middle- but inflation expectations are crucial to in search intensity explain a substantial aged households, which tend to be net understanding the behavior of the com- portion of the differences across goods borrowers, gain up to 5% of their total ponents, both in terms of quantities in the frequency of price adjustment. lifetime consumption. Poor young house- and prices. John Leahy, New York University, clarified holds also gain slightly—this is not because In his comments, Per Krusell, Princeton how Konieczny and Skrzypacz built on they borrow large sums but because the University, pointed out that the most previous theories of product–market redistribution of wealth leads to a net fall important factor in the portfolio changes search, and cast a skeptical light on some in labor supply and increases real wages. is the expectation of low stock returns of their empirical conclusions. He ques- Although some of the gain of young and tioned whether some of the empirical findings might not be caused by factors omitted from the model. For example, One policy panel discussed what inflation rates monetary policy the authors’ model has no formal role ought to aim to deliver; a second panel explored the connection for differences in producers’ costs of between fiscal policy and inflation in advanced economies. production. Such cost heterogeneity increases the dispersion of prices, there- by increasing the incentive to search low-income households, as well as middle- in the 1970s. Although some have ar- and the frequency of price adjustment. aged and middle-income households, in- gued that they were linked to inflation, Other omitted factors that could influ- volves redistribution from older, wealthier the link is not explicit in Piazzesi and ence both search and pricing are the households, a fair amount comes at the Schneider’s analysis. One of the key product’s perishability, the frequency expense of foreigners, who are major contributions of the paper, in his view, of purchases, and the share of income holders of nominal debt in the U.S. was showing the importance of housing spent on a particular purchase. for understanding other asset markets. In discussing the paper, John Cochrane, Marco Del Negro, Federal Reserve University of Chicago, said he was initial- Jerzy Konieczny, Wilfrid Laurier Univer- Bank of Atlanta, presented “On the fit ly surprised that the effects are so large sity, presented “Search, costly price ad- and forecasting performance of new- and commented on which feature of the justment, and the frequency of price Keynesian models,” joint work with Frank model might be responsible for these re- changes—Theory and evidence,” which Schorfheide, University of Pennsylvania; sults. Cochrane noted two caveats. First, is joint work with Andrzej Skrzypacz, Frank Smets, European Central Bank; and one of the main beneficiaries of unantici- Stanford University. The paper addresses Raf Wouters, National Bank of Belgium. pated inflation today would be the gov- the remarkable similarity across coun- He showed that a superior macroeco- ernment (given its large outstanding tries in the relative frequency of price nomic forecasting performance can be debt), and these benefits might be squan- adjustments across goods: Service prices attained by combining some recent gen- dered if the government failed to put its adjust very infrequently, the prices of eral equilibrium models—which incor- gains to good use. Second, foreigners processed manufactured goods adjust porate many explicit assumptions about who are hurt by inflation may be reluc- somewhat more, and the prices of rela- the economy’s structure—with purely tant to hold U.S. debt in the future, and tively unprocessed goods, such as gaso- statistical models based on vector autore- it is important to balance this possibility line and tomatoes, change almost daily. gressions. The technique also allows the against the gains from this one-time One hypothesis is that this ordering re- researcher to check which aspects of the profit at their expense. flects how intensively customers search data seem most at odds with the implica- for the lowest available price. For instance, In “Inflation and the price of real assets,” tions of the general equilibrium models the likelihood of finding a barber well Monika Piazzesi, University of Chicago, that are used for policy evaluation. matched to your style at a better price and Martin Schneider, Federal Reserve is low, so your demand for haircuts re- In his discussion of this paper, James Bank of Minneapolis, studied the impact sponds very little to the barber’s price. Hamilton, University of California, San of inflation on households’ allocation of Knowing this, the barber delays chang- Diego, argued that the relative weight wealth across stocks, houses, and other ing his price to keep up with inflation. given to models and statistical representa- nominal assets over the past 50 years. In contrast, all gasoline is the same, so tions of the data should vary in favor of They are interested in explaining the fol- the cost of switching from a temporarily the latter as more and more data become lowing features of the data: Household available. Accordingly, more sophisticated structures that better capture the evolu- firms will not pass through changes in into the decisions of households and tion of the economy will be necessary cost one-for-one into prices. This ap- firms.”4 Furthermore, he cited data to keep the general equilibrium mod- proach also creates the possibility of pric- suggesting that at such inflation rates, els relevant for forecasting purposes. ing to market. Atkeson and Burstein find relative prices seemed to move enough that a plausibly parameterized version to allocate resources, yet the variability The last research paper of the confer- of the model can reproduce the two of inflation remained low. ence was “Trade costs, pricing to market, facts about international relative prices and international relative prices” by Finally, Chari discussed how the structure described previously. Andrew Atkeson and Ariel Burstein, of the monetary policy decision-making both of the University of California, Los There is a general consensus that mone- process influences the achievement of Angeles. The paper is motivated by two tary policy ought to be aimed at deliv- low inflation. For example, game theo- facts. The first is that manufacturing ering low and stable inflation. Yet there retic strategies become important when terms of trade (defined as the ratio of is no consensus on what inflation rate policy is decided by a committee whose the price index for imported goods to or rates are optimal policy outcomes. members may have differing prefer- the price index for exported goods) are This issue was discussed by Martin ences over inflation and when current significantly less volatile than the inter- Eichenbaum, Northwestern University; decision-makers cannot bind the actions national relative price of manufactured Richard Clarida, Columbia University; of future policymakers. Accordingly, it goods (the ratio of the Producer Price and V. V. Chari, University of Minnesota, is important to have institutions that give Index for manufactured goods to a trade- in the first policy forum, “How low should rise to robust policy rules that ensure weighted average of the manufactured inflation be?” The panel opened by re- low inflation. goods price indexes for the country’s viewing the costs of inflation: foregone The basic proposition that governments trading partners). This represents evi- interest on nominal balances, shoe leather with large deficits may resort to printing dence of pricing to market, the practice costs associated with holding money,2 money to pay for spending suggests there by producers of charging different prices allocative distortions due to the nomi- is a connection between fiscal policy and domestically and abroad. The second nal structure of the tax code, and the price stability. Given the large deficits fact is that fluctuations in real exchange heightened uncertainty over the future that have been run in recent years by rates for tradeable goods (the ratio of price level that is associated with high the federal government, it is natural to the component of the Consumer Price and variable inflation. As a result of these be concerned that price stability is at Index, CPI, covering tradable goods in costs, it may be optimal for policy to aim risk. Still, there remains much contro- one country to the comparable com- for zero inflation or even modest defla- versy among academic economists and ponent of the CPI in a second country, tion (the so-called Friedman rule). None- policymakers regarding the connection with both indexes measured in a com- theless, the panelists did not suggest that between fiscal policy and inflation in mon currency) are nearly as large as deflation was an optimal prescription advanced economies, such as that of fluctuations in overall real exchange for the U.S. economy. rates (the ratio of the two overall CPIs in the countries, again measured in a Eichenbaum argued that the costs of common currency). inflation are likely to be small in a low- Michael H. Moskow, President; Charles L. Evans, inflation economy and that there is little Senior Vice President and Director of Research; Douglas The purpose of the paper is to develop Evanoff, Vice President, financial studies; Jonas Fisher, social value in reducing inflation sub- Economic Advisor and Team Leader, macroeconomic a theory that can explain these empirical stantially below 1% to 2%. He also noted policy research; Richard Porter, Vice President, payment facts. The paper constructs a model of a potential benefit from unexpectedly studies; Daniel Sullivan, Vice President, microeconomic policy research; William Testa, Vice President, regional two symmetric countries that produce higher inflation—because the U.S. is a programs and Economics Editor; Helen O’D. Koshy, and trade a large number of goods net debtor internationally, unexpected Kathryn Moran, and Han Y. Choi, Editors; Rita subject to frictions in the international inflation would transfer wealth to the U.S. Molloy and Julia Baker, Production Editors. goods market. The structure of produc- from the rest of the world. He warned, Chicago Fed Letter is published monthly by the Research Department of the Federal Reserve tion in the model resembles the kind of however, that the reputational costs of Bank of Chicago. The views expressed are the aggregation used in constructing price such an implicit default far outweigh authors’ and are not necessarily those of the indexes. Goods are imperfect substitutes the benefits. Federal Reserve Bank of Chicago or the Federal Reserve System. within a sector, but goods within a sector are more substitutable than goods across Clarida noted that measurement error © 2006 Federal Reserve Bank of Chicago and Phelps’s optimal tax3 suggest that the Chicago Fed Letter articles may be reproduced in sectors. Production costs vary both across whole or in part, provided the articles are not sectors and across firms within a sector. optimal inflation rate is positive. He did reproduced or distributed for commercial gain and provided the source is appropriately credited. In addition to the production costs, not suggest that these alone necessarily justified a positive inflation target. Rather, Prior written permission must be obtained for there are costs of international trade. any other reproduction, distribution, republica- Monopoly power and the assumption the 1% to 3% inflation rates that have tion, or creation of derivative works of Chicago Fed been achieved by most central banks Letter articles. To request permission, please contact that goods within a sector are more sub- Helen Koshy, senior editor, at 312-322-5830 or stitutable than goods across sectors break appear to satisfy the optimality laid out email [email protected]. Chicago Fed in Alan Greenspan’s definition of price Letter and other Bank publications are available the link between prices and costs in the on the Bank’s website at www.chicagofed.org. model, allowing for the possibility that stability being an environment in which “inflation ... does not materially enter ISSN 0895-0164 the U.S. These issues were discussed to raise revenues via seigniorage (profit conditions (the “state”) into policy ac- by Alice Rivlin, Brookings Institution; from the difference between the cost of tions. Furthermore, standard economic Marco Bassetto, Federal Reserve Bank printing money and its face value). models assume that while there may be of Chicago; and Thomas Sargent, New Furthermore, high deficits can provide uncertainty about future policy actions York University, in the second policy incentives to devalue the stock of nomi- (because the future state is uncertain), forum, “Does fiscal policy threaten nal debt. Bassetto offered, as an illus- all agents in the economy understand the price stability?” tration, developments in Italy from the rule itself. Sargent questioned the em- autumn of 1992 to mid-1995. During pirical relevance of this assumption. Rivlin focused on the fiscal challenges this period, market interest rates were Specifically, he asked whether the U.S. facing the U.S. She noted that more extremely high and extremely volatile, government has historically set policy than about 8% of U.S. gross domestic and appeared to be largely detached according to clearly defined policy rules product (GDP) is currently devoted to from monetary policy. When it be- and offered some examples of policy funding Social Security, Medicare, and came likely that Italy would join the ambiguity from U.S. history. Medicaid. But increased longevity, the European Monetary Union (with the baby boom retirement wave, and rap- The Chicago Fed’s Inflation Research associated likelihood of fiscal disci- idly increasing medical costs are likely Center is hosting another conference, pline), market interest rates fell and be- to drive spending on these programs titled “Firms’ Price Choices: Exchanging came much more stable. Bassetto took much higher. She projected that, ab- Insights between Industrial Organiza- this as evidence that profligate and un- sent changes in the structure and/or tion, Marketing Science, and Macro- certain fiscal policy can threaten price financing of these programs, they will economics,” on December 15, 2006. The stability. Having said this, he noted that account for over 25% of GDP by 2050. conference’s goal is to foster mutually the fiscal deficit currently experienced The current trends imply growing fis- beneficial exchange between economists in the U.S. is still rather small, both by cal deficits. Currently, our deficits are from these three fields studying firms’ historical standards and relative to financed largely through massive capi- pricing decisions. other OECD (Organization for Eco- tal flows from abroad. But this only post- nomic Cooperation and Development) 1 We thank François Velde, David Marshall, pones the inevitable adjustments, since countries. Deficits of this magnitude are Gadi Barlevy, Jeff Campbell, Marco Bassetto, the accumulation of U.S. foreign debt unlikely to trigger the sorts of effects and Marcelo Veracierto for their assistance will have to be serviced, and foreign illustrated by Italian fiscal policy in the in preparing this article. borrowing makes us vulnerable to 2 early 1990s. However, Bassetto concluded To minimize the negative effect of inflation changing policies of foreign investors. on the purchasing power of money, people by reiterating Rivlin’s point that in the Rivlin noted that the bipartisan coop- have to spend more time and effort protect- absence of entitlement reform, the U.S. eration it would take to implement ing the value of their nominal assets— debt/GDP ratio could grow large wearing out their shoes on the way back the necessary reforms was not likely in enough to induce inflation instability. and forth to the bank. the current political environment. 3 See Edmund S. Phelps, 1973, “Inflation in Finally, Sargent took a step back and con- But do these sorts of fiscal deficits threat- the theory of public finance,” Scandinavian sidered how fiscal policy is traditionally en price stability? Bassetto noted that, as Journal of Economics, Vol. 75, No. 1, March, treated in economic theory. Economic pp. 67–82. a matter of theory, high deficits can theory typically defines a policy as a 4 increase incentives of a central bank See www.federalreserve.gov/boarddocs/ state-contingent rule that maps economic speeches/2001/20011011/default.htm.