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Monetary Economics and Policy A Foundation for Modern Currency Systems.pdf
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The ongoing refinement of this project has transformed it into a more ambitious undertaking. It now delves into current theoretical and policy controversies, drawing connections with similar issues that have permeated the
history of monetary economics. The overarching goal is to provide a comprehensive and unifying framework to understand monetary economics and policy, shedding light on these controversies or, at the very least, offering
a thorough perspective on them. At the core of this framework are microfounded monetary models, where currency is deemed intrinsically worthless.
A currency devoid of intrinsic value, such as today’s government currencyor cryptocurrencies, is a relatively new concept in history, quite mysterious,prominently emerging since the abandonment of the Bretton Woods systemin 1973. However, it has a precise definition: a claim that makes a promise topay in units of itself. This definition empowers the currency issuer to print
those claims at will, free from ties to a tangible commodity.Monetary activities during the last fifteen years, marked by extraordinaryevents such as the 2007–2008 financial crisis, the global COVID-19 lockdown, and the recent inflationary surge, are testaments to the power that
central banks wield in the economy. We have witnessed how creatively theyhave deployed their unseen tools and “weapons.”
Part I of this book addresses a compelling issue within monetary economics essential for advancing our understanding of the effectiveness of monetary policy. The central theme revolves around the control of the price leveland explores whether the central bank can anchor the currency’s value on adesired path. A currency devoid of intrinsic value is in search of real backing,but the definition of currency, giving special properties to the central bank’sliabilities, can empower onlythe central bank asthe agentthat can fully controlits value. This part showcases the diverse array of tools available to the central
bank for this purpose. Within a proposed general framework for price determination, controversial theories like “the fiscal theory of the price level” are
incorporated, particularly as a special case when the central bank extends the
unique properties of its liabilitiestothetreasury by backingthetreasury’s debt.
Part I also explores the concept of money, particularly relevant in a papercurrency system. It extends beyond the currency (base money) issued by
the central bank to encompass private financial claims, known as safe assets.These assets share similar properties with currency, serving as a store of valueand a medium of exchange. This expanded perspective prompts an analysis
of past controversies regarding the supply of liquidity, questioning whetherit should be provided by the private sector or the government and in whatmanner. Furthermore, it explores whether private money creation can disrupt
the central bank’s control over the currency’s value. Within this framework,Part I also addresses currency competition involving cryptocurrencies andtheimplications of a central bank digital currency framework.Part II is concerned with the role of monetary policy in stabilizing theeconomy, presenting the New Keynesian monetary model and discussing the
optimality of an inflation targeting policy. This part shares similarities withthe renowned two books on the topics, by Jordi Galí and Michael Woodford.However, it also proposes a simple graphical analysis that, despite some simplification, can be helpful for understanding some of the main implications.It also includes an interesting departure from the benchmark framework, in
which the central bank’s only policy tool is the policy rate, adding the quantity
of central bank’s reserves as relevant for the control of inflation and economic
activity.
Part III focuses on “crisis” models, which naturally emerge by enhancing
the main framework with relevant variations. It addresses economic conditions observed over the last fifteen years, including liquidity traps, debt
p r e fa ce xvii
deleveraging, credit crunches, and liquidity squeezes resultingfromthe underperformance of private money. Within this context, this part aims to provide
insights into the various policies implemented to counteract these events and
stabilize economic activity. Topics covered include forward guidance, general unconventional policies like quantitative and credit easing, and the more
unorthodox concept of helicopter money. Addressing the liquidity crunch
reopens the debate on how central bank liquidity should substitute for the
failure of private liquidity during a crisis and questions whether the supply
of money should be left solely to the private sector or to the government, and
in what manner.
Part IV focuses on inflation and high inflation episodes, centering on
the most controversial theme in macroeconomics—the Phillips curve. The
Phillips curve is explored through different theories that have attempted to
support or disprove its evidence. The concept of the natural rate of unemployment is presented alongside theories of short-run neutralities. Alternative
theories, more aligned with the Keynesian view of unemployment due to the
inflexibility of wages and the seldomly reached maximum capacity of output, are also compared to recount the observed inflation experiences in the
United States over the last sixty-five years. High inflation episodes or hyperinflations are presented, rooted in the failures of providing a real anchor to
the value of currency, aligning with the theoretical findings of Part I. The
disanchoring might result as a consequence of subtle connections between
monetary and fiscal policies, often made very explicit through monetary
financing of deficits, or because of a deteriorated quality of the assets held by
the central bank.
Part V draws conclusions, while Part VI contains appendices.
This book’s readership ranges from Master’s to Ph.D. students. Some
sections, such as the graphical analysis in Part II, can also be covered in
advanced undergraduate classes. The material of this book is more than what
can be taught in a one-semester course. In the Monetary Economics course
from the Master in International and Monetary Economics at the University of Bern, I taught Chapters 1 and 2, Chapters 5–7, and some topics in
Chapters 9 and 12. Chapters 4, 8, 10, and 11, which connect banking models to monetary economics, can also be taught in more advanced graduate
classes.
Becoming a monetary economist was a logical step after my completing a
Ph.D. in economics at Princeton University between 1996 and 2000. During
that period, the Princeton Department of Economics boasted an impressive
xviii p r e fa ce
faculty engaged in monetary theories and analyses, including notable figures
such as Ben Bernanke, Alan Blinder, Paolo Pesenti, Kenneth Rogoff, Argia
Sbordone, Chris Sims, Mark Watson, Michael Woodford, and Lars Svensson
(who joined the department later). This stimulating environment nurtured
a community of students and friends who have made significant contributions to the field over the years, including scholars with whom I interacted,
such as Kosuke Aoki, Brian Doyle, Rochelle Edge, Gauti Eggertsson, Marc
Giannoni, Gita Gopinath, Refet Gurkaynak, Alejandro Justiniano, Thomas
Laubach, Eduardo Loyo, Giovanni Olivei, Bruce Preston, Giorgio Primiceri,
Barbara Rossi, Andrea Tambalotti, and Cedric Tille.
Despite its seemingly natural progression, my academic journey began
more as an international economist with a focus on open-macro topics, with
my maintaining an interest in monetary policy issues. I wrote my thesis, titled
“Optimal Monetary Policy for Open Economies,” under the joint supervision
of Ken Rogoff and Mike Woodford.1 In collaboration with Mike, who served
not only as an incredible mentor and friend, but also as a crucial source of
inspiration for my understanding of monetary economics through our conversations and his writings, I had the privilege of producing early works in
my career while at New York University. These works focused on performing
welfare-based analyses of policies in dynamic stochastic general equilibrium
models through a linear-quadratic approach, offering clear applications for
thinking about optimal monetary policy in various contexts.
Nevertheless, it was only just before my departure from New York University in 2006 to join LUISS in Rome that I began working more intensively on
issues in monetary economics. Collaborating with Luca Ricci, we explored
the implementation of Tobin’s (1972) idea of using inflation to “grease the
wheels” of the labor market, resulting in the derivation of a nonlinear Phillips
curve based on downward wage inflexibility. The watershed moments, however, occurred during the 2007–2008 financial crisis and the 2011 European
sovereign debt crisis. In those periods, we witnessed new approaches to conducting monetary policy that extended beyond merely setting the policy rate.
These crises, in my view, unveiled the inherent power of central banks in
monetary systems with intrinsically worthless currencies. While contributing columns to Italian newspapers on the observed policies, I began to form
1. Ben Bernanke was also on mythesis committee, while Chris Sims kindly wrote a reference
letter for my job market, and Lars Svensson participated in my thesis defense committee.
p reface xix
intuitions aboutthe authority central banks wielded. Nevertheless, I struggled
to find a solid theoretical foundation for that power.
I began exploring these uncharted territories by initially considering the
importance of substituting central bank liquidity for private liquidity to avert
a liquidity crunch. This represented an additional tool for monetary policy,
critical alongside the interest rate policy, to mitigate the ensuing contraction in economic activity. This exploration took shape in a joint project with
Salvatore Nisticò.
With Roberto Robatto, we delved further into investigating the endogeneity of private liquidity creation and its inefficiencies, aiming to explore the
effectiveness and limits of government intervention. Collaborating with Gauti
Eggertsson and Federica Romei, we extended the original work of Eggertsson and Krugman (2012) on debt deleveraging. In that context, we explored
optimal monetary policy when the zero lower bound becomes a constraint,
accounting for the distributional consequences of monetary policy among
heterogeneous agents.
I was also interested in dissecting the alternative compositions of the central bank’s balance sheet, studying the relevance or irrelevance of various
open-market operations based on the interaction between monetary and fiscal policies. This included the study of helicopter money experiments in joint
works with Salvatore Nisticò. With these foundations, I began to envision and
theorize that the central bank could anchor the value of currency through
appropriately specifying an array of tools. I further explored the importance
of the size of the central bank’s balance sheet in reference to recent operations
of quantitative tightening in collaboration with Gianluca Benigno.
Works with Luca Benati on one side, and Linda Schilling and Harald Uhlig
on the other, have also enriched my understanding of the functioning of other
types of monetary systems, such as commodity money and cryptocurrencies. To close the circle, Gauti Eggertsson has brought me back to rethink the
Phillips curve with his idea that its steep part could be helpful in explaining
the current inflation we have been experiencing. I am very grateful to all the
aforementioned coauthors, without whom it would not be possible for me
to understand enough about monetary economics and for this book to come
to life.
Introduction 3
1 The Value of Currency 7
1.1 Introduction 7
1.2 Outline of the Results 12
1.3 Model 13
1.3.1 Consumers 13
1.3.2 Government 17
1.3.3 Equilibrium 20
1.4 Determining the Value of the Currency 22
1.4.1 The Fiscal Theory of the Price Level 24
1.4.2 Central Bank Theory of the Price Level 28
1.5 Holding Gold 32
1.6 References 38
2 Cash as a Medium of Exchange 40
2.1 Introduction 40
2.2 Outline of the Results 44
2.3 Model 44
2.3.1 Consumers 44
2.3.2 Government 48
vii
viii c o nt e nt s
2.3.3 Equilibrium 48
2.3.4 Seigniorage 50
2.4 Price Determination through the Interest Rate Policy 52
2.5 Price Determination through Money Aggregates 55
2.6 The Gold Standard 58
2.7 Optimal Policy 61
2.8 Cryptocurrency Competition 62
2.8.1 Only Government Money Is Used 67
2.8.2 Both Types of Money Are Used 68
2.8.3 Only Private Money Is Used 70
2.8.4 Launching a Fully Backed Cryptocurrency 72
2.9 References 74
3 Central Bank Digital Currency 76
3.1 Introduction 76
3.2 Outline of the Results 79
3.3 Model 79
3.3.1 Consumers 79
3.3.2 Government 83
3.3.3 Equilibrium 84
3.4 Price Determination 85
3.5 Optimal Liquidity Policy 87
3.6 References 90
4 Private Money 92
4.1 Introduction 92
4.2 Outline of the Results 94
4.3 Model 95
4.3.1 Consumers 96
4.3.2 Government 98
4.3.3 Intermediaries 98
4.3.4 Equilibrium 99
4.4 The Supply of Public and Private Liquidity 101
content s ix
4.5 Dominant Currency 104
4.6 References 110
part ii. stabilization policies 111
Introduction 113
5 The Benchmark New Keynesian Model 118
5.1 Introduction 118
5.2 Outline of the Results 120
5.3 Model 120
5.3.1 Households 120
5.3.2 Firms 125
5.3.3 Government 126
5.4 Equilibrium with Flexible Prices 126
5.5 Price Rigidities 128
5.5.1 Equilibrium with Price Rigidities 131
5.5.2 Log-linear Approximation 132
5.6 References 135
6 An AS-AD Graphical Analysis 137
6.1 Introduction 137
6.2 Outline of the Results 140
6.3 Productivity Shock 140
6.3.1 A Temporary Productivity Shock 140
6.3.2 A Permanent Productivity Shock 142
6.3.3 Optimism or Pessimism on Future Productivity 143
6.4 Markup Shock 144
6.5 Public Spending Shock 146
6.6 Preference Shock 147
6.7 Disanchoring of Price Expectations 148
6.8 References 149
x contents
7 Inflation Targeting as an Optimal Policy 150
7.1 Introduction 150
7.2 Outline of the Results 152
7.3 Optimal Policy under Commitment 152
7.4 Optimal Policy under Discretion 163
7.5 Interest Rate Rules 164
7.6 Optimal Inflation Target 168
7.7 References 171
8 NK Model with a Banking Sector 174
8.1 Introduction 174
8.2 Outline of the Results 175
8.3 Model 176
8.3.1 Banking Model 176
8.3.2 Households 179
8.3.3 Firms 181
8.3.4 Government 182
8.4 Equilibrium 182
8.5 Log-linear Approximation 184
8.6 Optimal Policy 190
8.7 References 193
part iii. crisis models 197
Introduction 199
9 Liquidity Trap 202
9.1 Introduction 202
9.2 Outline of the Results 206
9.3 Helicopter Money 207
9.3.1 Helicopter Money Coordinated by Monetary
and Fiscal Policy 212
9.3.2 Helicopter Money by Central Bank Only 214
contents xi
9.4 Unconventional Monetary Policy 215
9.4.1 Irrelevance of Unconventional Open
Market Operations 218
9.4.2 Relevance of Unconventional Open
Market Operations 223
9.5 Forward Guidance 225
9.6 Managing the Central Bank’s Reserves 230
9.7 Other Channels for Unconventional Monetary Policies 236
9.8 References 239
10 Deleveraging and Credit Crunch 242
10.1 Introduction 242
10.2 Outline of the Results 244
10.3 Debt Deleveraging 245
10.4 The Credit Crunch 253
10.5 A General Framework 256
10.6 References 263
11 Shortage of “Safe Assets” 266
11.1 Introduction 266
11.2 Outline of the Results 269
11.3 Model 269
11.3.1 Consumers 270
11.3.2 Financial Intermediaries 272
11.3.3 Government 274
11.4 Equilibrium with the Government Satiating
Liquidity 275
11.5 Equilibrium with No Frictions in the Supply
of Private Safe Assets 276
11.6 Equilibrium with Frictions in the Supply of Private
Safe Assets 278
11.7 Government Intervention 281
11.7.1 Government Policy with a Limit on Taxes 282
xii c o nt e nt s
11.7.2 Regulation of Intermediaries’ Investments 286
11.7.3 General Discussion 287
11.8 References 289
part iv. inflation 291
Introduction 293
12 The Inflation-Unemployment Trade-Off 299
12.1 Introduction 299
12.2 Outline of the Results 302
12.3 Natural Rate of Unemployment 303
12.4 Keynesian Unemployment 308
12.5 Short-Run Non-neutralities 311
12.6 Persistent Monetary Non-neutralities 316
12.7 An L-Shaped New Keynesian Phillips Curve 320
12.8 References 326
13 Hyperinflation 329
13.1 Introduction 329
13.2 Outline of Results 333
13.3 Deficit Financing and Inflation 333
13.3.1 Money-Financed Real Fiscal Deficit 335
13.3.2 Money-Financed Nominal Fiscal Deficit 338
13.3.3 ... with Interest Rate Policies 340
13.4 Some Unpleasant Monetarist Arithmetic 342
13.4.1 Tight Money Paradox 345
13.5 Central Bank’s Balance Sheet and Inflation 348
13.6 References 351
part v. conclusion 353
The Future of Monetary Policy 355
c o nt e nt s xiii
part vi. appendix 363
Appendix to Chapter 1 365
A Derivation of Equation (1.5) 365
Appendix to Chapter 2 367
B Derivation of Equation (2.4) 367
Appendix to Chapter 3 368
C Derivation of Equation (3.4) 368
Appendix to Chapter 5 369
D Derivation of Equations (5.3) and (5.4) 369
E Derivation of the Log-linear Approximations
of Section 5.5.2 of Chapter 5 370
Appendix to Chapter 7 373
F Derivations of the Loss Function (7.1) 373
G Conditions for Determinacy 378
Appendix to Chapter 8 379
H Derivations of Approximations (8.22)
and (8.23) 379
I Derivations of the Loss Function (8.27) 380
Bibliography 383
Index 399
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