Essays in Monetary and Fiscal Policy by MASSACHUSETTS INSTITUTE Adrien Auclert OF TECHNOLOLGY B.S., Ecole Centrale Paris (2007) JUN 09 2015 MASt, University of Cambridge (2007) M.S., ENSAE (2009) LIBRARIES M.S., London School of Economics (2009) Submitted to the Department of Economics in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy at the MASSACHUSETTS INSTITUTE OF TECHNOLOGY June 2015 @ 2015 Adrien Auclert. All rights reserved. The author hereby grants to MIT permission to reproduce and to distribute publicly paper and electronic copies of this thesis document in whole or in part in any medium now known or hereafter created. Signature redacted- Signature of Author .. ...................... Department of Economics, MIT May 8, 2015 Signature redacted C ertified by .............. I...... ....................................... ....................... IvAn Werning Robert M. Solow Professor of Economics Thesis Supervisor Signature redacted Certified by ........ ................ :........r.. ............................... ....................... Robert M. Townsend Elizabeth & James Killian Professor of Economics Thesis Supervisor Signature redacted A ccepted b y ..... ................ .... ............. ....................................... Ricardo Caballero Ford International Professor of Economics Chairman, Department Committee on Graduate Studies Essays in Monetary and Fiscal Policy by Adrien Auclert Submitted to the Department of Economics on May 8, 2015 in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy in Economics Abstract This thesis consists of three chapters on monetary and fiscal policy. The first chapter explores the importance of redistribution in explaining why monetary policy has aggregate effects on household consumption. I argue that traditional representative agent models focusing on substitution effects ignore a key component of the monetary policy transmission mechanism, which exists because those who gain from accommodative monetary policy have higher marginal propensities to consume (MPCs) than those who lose. I use a sufficient statistic approach to show that, provided households' elasticities of intertemporal substitution are reasonably small, redistributive effects can be as important as substitution effects in explaining the response of aggregate consumption to real interest rate changes in the U.S. My calibrated general equilibrium model predicts that, if U.S. mortgages all had adjustable rates, the effect of interest-rate changes on consumer spending would more than double and would be asymmetric, with rate increases reducing spending by more than cuts would increase it. The second chapter, joint with Matthew Rognlie, explains why a monetary union between countries (such as the Eurozone today) may lead to a stronger fiscal union. Since exchange rates can no longer adjust to offset shocks, the presence of nominal rigidities implies that fiscal risk-sharing becomes more valuable in a monetary union. As a result, countries in such a union are capable of overcoming their lack of commitment to fiscal transfers. However, inefficient equilibria without fiscal transfers remain possible. We derive implications for the optimal policy of the central bank when the fiscal union is under stress. The third chapter, also joint with Matthew Rognlie, studies the possibility that feedbacks between sovereign bond spreads and governments' desire to default may lead to multiple equilibria in sovereign debt markets. We show that such multiplicity does not exist in the infinite-horizon model of Eaton and Gersovitz (1981), a widely adopted benchmark for quantitative analyses of these markets. Our proof may be important to understand Euro government bond markets, and calls for renewed attention on the theoretical conditions that are needed for sovereign debt models to generate multiple equilibria. Thesis Supervisor: Ivdn Werning Title: Robert M. Solow Professor of Economics Thesis Supervisor: Robert M. Townsend Title: Elizabeth & James Killian Professor of Economics 3 This page is intentionally left blank 4 Acknowledgements I am indebted to a great many people for their help, advice and support during the writing of this thesis. I cannot find enough words to thank IvAn Werning. Ivdn has always managed to be incredibly supportive, while at the same time pushing me to reach far beyond my limits. He spent uncountable hours helping me take my research to the next level-his feedback was exhaustive, from framing the big picture to working out the small details on the board. He was an incredible teacher, always came up with new ways of looking at problems, and his astonishing intuition anticipated many of the findings in this thesis. He taught me never to settle for incomplete results, always to shoot for the highest quality in everything I did, but he also always had my general well-being at heart. In short he was the ideal advisor: inspiring, dedicated, and caring. I am also incredibly grateful to Robert Townsend for his help and support throughout this thesis. Rob appears to have an infinite amount of time to spend with his students-our meetings always had a starting time, but never an end time. But he was generous with me in many other ways, supporting my development as an economist by inviting me to present my early work at a conference in Chicago, by fostering connections with researchers from Brazil, and by putting me in charge of preparing several of his lectures which helped me develop my research as well as my teaching skills. I learned a lot from Rob, about theory, data, and economics in general. Jonathan Parker gave me a fresh perspective on many ideas I was taking for granted. He was the most organized person on my thesis committee, and I thank him for pushing me to get things done in time- in particular, for getting me to start writing my job market paper before it was too late. I was blessed with the chance of learning from fantastic teachers and amazing researchers throughout the five years of my dissertation at MIT. My knowledge and understanding of macro has been greatly influenced by Daron Acemoglu, Marios Angeletos, Ricardo Caballero, Alp Simsek, and particularly Guido Lorenzoni whose deep insights and elegant modeling style I continued to benefit from, many years after he left Cambridge for Chicago. I learned a lot from my TAs at MIT, in particular from Gabriel Carroll, Amir Kermani and Michael Peters. And I learned a lot from my students, who are too numerous to cite here. They were a big part of what made my PhD experience so enjoyable. I also had the chance of benefiting from the wonderful staff of the economics department. Thanks in particular to Beata Shuster for her endless enthusiasm and many fun conversations, to John Arditi for his not-so-grumpy greetings every morning, to Linda Woodbury for helping me organize lunches with seminar speakers at the eleventh hour, and to Gary King for patiently sorting out every problem I ever presented him with. I was lucky to embark on this MIT adventure with an incredible group of classmates, from whom I learned a great deal and many of whom have become great friends, notably Steve Murphy, Luu Nguyen, Daan Struyven and Nils Wernerfelt. This list extends beyond my classmates to Jean-No8l Barrot, Frangois Geerolf, and my first-year roommate Vincent Pons. As my officemate for three years, Matthew Rognlie may well be the economist from whom I have learned the most during this PhD. Our long daily conversations, interrupted only by the indispensable take-out dinner from Chipotle, spanned virtually every topic of economics and 5 much beyond. I have tremendously enjoyed working with Matt on two of the chapters in this thesis, and I hope that our collaboration will continue far beyond this. Outside of MIT, I was unbelievably lucky to count on the continuous support of my family and friends. My parents Laurent and Elisabeth have always encouraged me to pursue my dreams. This PhD was a big one; they made it possible. My long-time friends Alix, Anne-Claire, Benoit, Carolin, C61ine, Chris, Claire, Fabio, Geoffroy, FM, JB, JS, Matthieu, Maxime, Paskal, Pierre, Pierre, Thibaut, Samuel, S6bastien, Stephane, Sophie, Val6rie, my brother Nicolas, my sister H6loYse, and my inlaws Barbara, Guillaume, Isabelle, Brigitte and Ah Hem all looked with some amusement-sometimes mixed with concern-at the long hours I put into bringing this thesis to completion. They helped me put things in perspective and stay sane during insane times. This thesis would never have been possible without the unconditional support, energy and determination of my wife, Evelyne Kong. Evelyne's love carried me through these five years. I owe it to her to have managed to finish this thesis at all, and what is more, on time and according to plan. 6 Contents 1 Monetary Policy and the Redistribution Channel 11 1.1 Household balance sheets and wealth effects .. ... .. ... ... .. .. 18 1.1.1 Perfect-foresight model . ... ... .. ... .. ... ... .. .... 19 1.1.2 Adjustment after a shock .. .. ... ... .. ... ... ... .. 20 1.1.3 The consumption response to shocks under incomplete markets . 25 1.2 Aggregation and the redistribution channel .. .. ... .. ... .. .. 27 1.2.1 Fixed balance sheets in response to shocks . ... .. .. ... .. 27 1.2.2 Aggregation result .. ... .. .. ... .. ... .. .. ... .. 28 1.2.3 Three general equilibrium applications . .. .. .. .. .. .. ... 29 ... 1.2.4 Extensions . .. .. .. ... .. .. .. .. .. .. ... .. 32 1.2.4.1 Elastic labor supply