Working Papers

"Secular Drivers of the Natural Rate of Interest in the U.S." (with Marcel Peruffo) (Job Market Paper) [pdf]

Abstract: We develop a heterogeneous agent, overlapping generations model with non-homothetic preferences that nests several explanations for the decline in the natural rate of interest (Rn) suggested in the literature: demographic change, a slowdown in productivity growth, a rise in income inequality, and public policy. We add out-of-pocket health expenditures to the analysis. The model can account for a 2.2 percentage point (pp) decline in Rn between 1975 and 2015, within the range of empirical estimates. Rising income inequality is an important driver (-0.70 pp), and together with demographic change (-0.71 pp) and the slowdown in productivity growth (-1.0 pp) explains most of the decline. Growing public debt is the major counteracting force (+0.31 pp). Permanent income inequality is of greater importance than inequality due to uninsurable income risk, and matching the degree of non-homotheticity in consumption and savings behavior to empirical estimates is essential for this result. We find a moderate role for out-of-pocket health expenditures (-0.14 pp). We predict that Rn reaches a low of 0.38% by 2030, after which a slow reversal begins. The natural rate stabilizes at 1% over the long run, a low level when compared to the postwar path of Rn implied by the model. This remains true even if we take into account soaring public debt levels due to the COVID-19 pandemic. Fiscal policy can have considerable impact on the level of Rn, and we propose to treat the level of the natural rate as a public policy choice.

"A Toolkit for Solving Models with a Lower Bound on Interest Rates of Stochastic Duration" (with Gauti B. Eggertsson, Sergey K. Egiev, Alessandro Lin, Luca Riva) [NBER working paper], [code], [VoxEU column]
Forthcoming, Review of Economic Dynamics

Abstract: This paper presents a toolkit to solve for equilibrium in economies with the effective lower bound (ELB) on the nominal interest rate in a computationally efficient way under a special assumption about the underlying shock process, a two-state Markov process with an absorbing state. We illustrate the algorithm in the canonical New Keynesian model, replicating the optimal monetary policy in Eggertsson and Woodford (2003), as well as showing how the toolkit can be used to analyse the medium-scale DSGE model developed by the Federal Reserve Bank of New York. As an application, we show how various policy rules perform relative to the optimal commitment equilibrium. A key conclusion is that previously suggested policy rules – such as price level targeting and nominal GDP targeting – do not perform well when there is a small drop in the price level, as observed during the Great Recession, because they do not imply sufficiently strong commitment to low future interest rates (“make-up strategy”). We propose two new policy rules, Cumulative Nominal GDP Targeting Rule and Symmetric Dual-Objective Targeting Rule that are more robust. Had these policies been in place in 2008, they would have reduced the output contraction by approximately 80 percent. If the Federal Reserve had followed Average Inflation Targeting – which can arguably approximate the new policy framework announced in August 2020 – the output contraction would have been roughly 25 percent smaller.

"Demographic Change and Debt Dynamics in the U.S." [draft coming soon]

The decline in fertility rates and the retirement of the baby boom generation is expected to put a strain on U.S. public finances: more people claiming benefits and less people paying into the system. However, demographic change can affect the budget through other channels as well, like output growth and the real interest rate. In this paper we take a comprehensive look at the trajectory of public debt over the next decades through the lens of a quantitative life-cycle model. The model allows for an endogenous response of growth, the real interest rate, social security spending and the level of debt itself to the oncoming demographic transition. Our model predicts a 35 percentage points lower debt to output ratio by the year 2048 compared to recent Congressional Budget Office estimates, mainly because of low real interest rates. Population aging is putting downward pressure on the real rate, which is only partially undone by the counteracting effect of higher public debt levels on interest rates. We also show that the impact of social security reform on public debt can be mitigated or magnified by the endogenous response of growth and the real interest rate.

Research in Progress:

"The Decline of the U.S. Labor Share: A Decomposition by Institutional Sectors" (Draft available upon request)