On the Time Inconsistency of International Borrowing in an Optimal Growth Model

This paper analyzes international borrowing and lending in an optimal growth model with adjustment costs for investment. We study the relation between optimal savings and investment, and the current account, in the transition towards the balanced growth path, and derive the implications of financial openness for both the transition path and the balanced growth path. A comparison with financial autarky reveals that, to the extent that countries start from different initial conditions, and there is pre-commitment to debt repayment, financial openness is beneficial for both “poor” and “rich” countries, as it allows them to engage in mutually beneficial inter-temporal trade. During the adjustment process, relatively “poor” countries experience higher consumption and investment compared to autarky, and thus cumulate current account deficits. There is an inter-temporal tradeoff, in that they experience lower steady state consumption, due to the need to service their accumulated foreign debt. The opposite happens in relatively “rich” countries. The inter-temporal tradeoffs implied by financial openness result in a time inconsistency problem. “Poor” countries reach a point in the adjustment process at which it is welfare improving to renege on their commitment to repay their foreign debt. In the absence of sufficient pre-commitment mechanisms, international lenders anticipate these incentives, and international borrowing and lending are driven to zero. This time inconsistency problem can thus explain both the Feldstein-Horioka puzzle and the Lucas paradox that capital does not flow from “rich” to “poor” countries. Credible sanctions in the case of default and ceilings on international borrowing are analyzed as partial solutions to the time inconsistency problem of international borrowing.

Keywords: time inconsistency, international borrowing, optimal growth, financial openness, debt default
JEL Classification: F43 F34 O11 D91 D92

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The Clash of Central Bankers with Labor Market Insiders, and the Persistence of Unemployment and Inflation in the Main Industrial Economies

This paper analyzes the implications of optimal monetary policy for the dynamic behavior of inflation in a “natural rate” model characterized by endogenous unemployment persistence. We analyze a dynamic “insider outsider” model of the “Phillips Curve”, that accounts for the persistence of unemployment following nominal and real shocks. We derive optimal monetary policy under both discretion and commitment to an inflation target. We demonstrate that under discretion, because of the endogenous persistence of deviations of unemployment from its “natural” rate, deviations of inflation from target display the same degree of persistence as unemployment. Under full commitment to an inflation target there is no inflation persistence. An empirical investigation for the main industrial economies suggests that the persistence of deviations of inflation from a constant inflation target is of the same order of magnitude as the persistence of deviations of unemployment from its “natural” rate. This finding is consistent with the hypothesis put forward in this paper, of a clash between central bankers and labor market insiders, that cause both unemployment and inflation to persist.

Keywords: unemployment persistence, inflation, monetary policy, insiders outsiders, central banks

JEL Classification: E3, E4, E5

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Unemployment Persistence, Inflation and Monetary Policy in A Dynamic Stochastic Model of the Phillips Curve

This paper puts forward an alternative “new Keynesian” dynamic stochastic general equilibrium model of aggregate fluctuations. The model is characterized by one period nominal wage contracts and endogenous persistence of deviations of unemployment from its natural rate. Aggregate fluctuations are analyzed under both a Taylor nominal interest rate rule and under the assumption of optimal discretionary monetary policy. Under both types of monetary policy, the persistence of unemployment results in persistent inflation as the central bank responds to deviations of unemployment from its natural rate. Econometric evidence from the United States since the 1890s cannot reject the main predictions of the model.

Keywords: aggregate fluctuations, unemployment persistence, inflation, monetary policy, insiders outsiders, natural rate
JEL Classification: E3, E4, E5

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On the Taylor Rule and Optimal Monetary Policy in a “Natural Rate” Model

This paper investigates the stabilizing role of monetary policy in a dynamic, stochastic general equilibrium model of the “natural rate”, in which non indexed nominal wages are periodically set by labor market “insiders”. This nominal distortion allows for nominal shocks to have temporary real effects, and thus, for monetary policy to be able to affect short run fluctuations in both inflation and real output. We derive and analyze optimal monetary policy in the presence of real and nominal shocks, and highlight the properties of the optimal monetary policy rule. The optimal policy rule is second best, as it cannot completely neutralize productivity shocks, and is associated with a tradeoff between the stabilization of inflation and output. We also demonstrate that the optimal policy can be replicated by a set of appropriately parametrized Taylor rules, according to which deviations of the current nominal interest rate from its “natural” rate, depend on deviations of inflation from target and output from its “natural” level. We prove that the optimal Taylor rule is not unique, as multiple sets of parameters are consistent with optimality. Provided that the monetary authorities attach a sufficiently low weight to deviations of output from its “natural” level, the optimal policy could also be replicated through a unique, appropriately parametrized Wicksell rule, according to which deviations of the nominal interest rate from its “natural” rate depend only on deviations of inflation from target. The optimal set of Taylor rules is a set of simple, but not too simple rules, as, the nominal interest rate must react to changes in the “natural” rate of interest, in addition to deviations of inflation from target, and output from its “natural”level.

Discussion Paper no. 5-2015, Department of Economics, Athens University of Economics and Business

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Financial Openness versus Autarky in a Neoclassical Growth Model

This paper compares financial openness with autarky in a neoclassical growth model, with adjustment costs for investment. We analyse the relation between growth and the current account in the transition towards the balanced growth path, and derive the implications of the two financial regimes for the balanced growth path. For an economy with an initial capital stock which is lower than the rest of the world, output (GDP) per capita on the balanced growth path is the same under financial openness and autarky. However, Gross National Product (GNP) and consumption per capita are lower under financial openness than under autarky. The reason is that the economy has to pay interest on the foreign debt it has accumulated during the transition. During the transition, the economy runs current account deficits and accumulates net foreign debt. The opposite applies to an economy, whose initial capital stock is higher than the rest of the world. There are benefits from financial openness and inter-temporal trade for either type of economy, as, during the transition, the path of the world real interest rate differs from the path of autarky real interest rates for either type of economy.


Macroeconomics and Politics in the Accumulation of Greece’s Debt: An Econometric Investigation, 1975-2009

This paper focuses on an econometric investigation of the macroeconomic and political factors that contributed to Greece’s excessive debt accumulation and its failure to adequately address its fiscal imbalances, from the restoration of democracy in 1974 till the crisis of 2009. The econometric investigation is based on a model in which two political parties alternate in power, and in which governments choose primary expenditure and taxes to minimize deviations from politically determined expenditure and tax targets, subject to a debt accumulation equation. The model predicts a political equilibrium in which primary expenditure and taxes follow feedback rules which go in the direction of stabilizing the debt to GDP ratio. However, this stabilization incentive is weaker in election years. The model also predicts potential partisan differences in the evolution of primary expenditure and taxes, due to the different preferences of political parties. Estimates of government reaction functions to public debt for the period 1975-2009 suggest a rather weak stabilizing reaction of primary deficits to public debt. This stabilizing reaction disappears in election years, which are characterized by strong fiscal expansions. We find no evidence of partisan differences in the reaction of primary deficits to inherited debt, but we do find evidence of lower primary deficits in the post-1992 Maastricht treaty period. Overall the model accounts for the accumulation of Greece’s government debt in terms of the trend increase in primary expenditure, the positive shocks to primary expenditure in election years and the weak stabilizing reaction of government revenue, due to tax smoothing.

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GreeSE Paper no. 68, Hellenic Observatory, London School of Economics

Discussion Paper no. 10-13, Department of Economics, Athens University of Economics and Business

Assessing Deviations from Ricardian Equivalence in an Endogenous Growth Model

This paper proposes a method for assessing the quantitative significance of deviations from the Ricardian equivalence hypothesis. The model proposed for this purpose belongs to a class of endogenous growth theories with investment adjustment costs, in which savings and investment are co-determined through adjustments in the real interest rate. The equilibrium investment rate determines the long-run growth rate, because of constant returns to capital accumulation due to externalities of the “learning by doing” type. We set up and compare two versions of the model, one with a representative household, in which Ricardian equivalence holds, and one with overlapping generations, in which it does not. We calibrate the two versions of the model using common parameter values and assess the significance of deviations from Ricardian equivalence in the overlapping generations model. For plausible parameter values, the differences in growth rates are of the order of 0.2 to 0.3 of a percentage point per annum, which accumulated over twenty five years are between 5.1%-7.8% of aggregate output. Neither growth rates nor interest rates appear to be particularly sensitive to the aggregate debt to output ratio. A rise of the debt to output ratio from 60% to 200% of aggregate output results in a decrease in the growth rate of about 0.03 of a percentage point, which accumulated over twenty five years is less than 1% of aggregate output. The differences for real interest rates are even smaller. Overall the results suggest that Ricardian equivalence is a relatively good approximation to reality, and the relative simplicity of the representative household model does not lead to predictions that would be too far off quantitatively, even if the world is characterized by overlapping generations.

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