An Economical Business-Cycle Model

16 September 2015
12:30  - 13:30

Pascal Michaillat, London School of Economics and Political Science



This paper develops simple formulas for optimal monetary and debt policy—formulas expressed with observable variables and estimable statistics—in a macroeconomic model of unemployment. To maximize welfare, policy should stabilize the unemployment rate at its efficient level, which is unaffected by aggregate demand or supply shocks and therefore constant over the business cycle. Monetary policy can stabilize unemployment because inflation is fixed so the nominal interest rate controls the aggregate demand. The gap between the optimal rate and the current rate of interest is proportional to the gap between the efficient rate and the current rate of unemployment and inversely proportional to the interest semielasticity of output. The unemployment gap and semielasticity are the key statistics in the formula. If households are not perfectly Ricardian and partly consider government bonds as net wealth, debt policy also achieves stabilization because households derive utility from real wealth so the debt level controls the aggregate demand—even at the zero lower bound on nominal interest rate. The gap between the optimal level and the current level of debt is proportional to the unemployment gap and inversely proportional to the deficit-financed tax multiplier. The core of the analysis is conducted with constant inflation, but the results carry over when inflation sluggishly responds to aggregate shocks.

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