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Working Papers

The Optimal Design of a Fiscal Union, with Mikhail Dmitriev (under review)

We study cooperative and non-cooperative fiscal policy in an open economy model where cross-country risk sharing is imperfect and countries face terms of trade externalities. We show that the optimal form of fiscal cooperation, or fiscal union, is defined by one parameter: the Armington elasticity of substitution between goods from different countries. We prove that members of a fiscal union should: (1) harmonize steady state income tax rates when the Armington elasticity is low in order to ameliorate terms of trade externalities; and (2) send fiscal transfers across countries when the Armington elasticity is high in order to improve risk sharing. Our analytical predictions hold both outside of and within currency unions. For standard calibrations, we find that the welfare gain from the optimal fiscal union is as high as 5% of permanent consumption when countries are able to trade safe government bonds, and can approach 20% when countries lose access to international financial markets. We also find that labor mobility significantly improves welfare and alleviates the need for a transfer union entirely.

The Financial Accelerator and the Optimal Lending Contract, with Mikhail Dmitriev (under review) -- Bank of Canada Paper Prize, 2014 Canadian Economic Association Conference

In the financial accelerator literature pioneered by Bernanke, Gertler and Gilchrist (1999) entrepreneurs are myopic and lenders suboptimally choose a safe rate of return on their loans. We derive the optimal lending contract for forward looking entrepreneurs and provide three main results. First, under the optimal contract we find that financial frictions actually stabilize business cycle fluctuations relative to a frictionless benchmark. Second, we show that shocks to the variance of unobserved idiosyncratic productivity --- so-called "risk shocks" --- have little effect on the real economy under the optimal contract. Third, we find that amplification under the suboptimal contract depends on loose monetary policy: when interest rate setting follows a standard Taylor rule, the financial accelerator is significantly dampened or even reversed.

Collateral Constraints and State-Contingent Contracts, with Mikhail Dmitriev

It is commonly assumed that binding collateral constraints amplify the impact of aggregate shocks on the economy. However, we show that when firms can hedge against aggregate risk with state-contingent lending contracts, binding collateral constraints no longer amplify shocks relative to the basic New Keynesian model. We embed state-contingent lending contracts in a quantitative business cycle model in the spirit of Kiyotaki and Moore (1997) and Iacoviello (2005) and find that in general equilibrium unconstrained lenders sell insurance against aggregate risk to constrained borrowers. The provision of insurance against aggregate risk prevents the usual tightening of collateral constraints during downturns and leads to relatively mild recessions.

Price Stability in Small Open Economies, with Mikhail Dmitriev (under review)

We study the conduct of monetary policy in a continuum of small open economies and obtain a novel closed-form solution that does not restrict the elasticity of substitution between home and foreign goods to one. We give an exact characterization of optimal monetary policy and welfare with and without international policy cooperation, under internationally complete asset markets and financial autarky, for producer currency pricing and local currency pricing. The tractability of our model allows us to parse out the effect of each individual ingredient on optimal policy. Under producer currency pricing we prove that price stability is optimal, while under local currency pricing policy should fix the exchange rate. In the absence of consumption home bias we find that non-unitary elasticity, imperfect risk-sharing, and non-cooperative monetary policy in and of themselves do not lead to deviations from these benchmark policies.

Work In Progress

Exchange Rate Policy, Competitiveness and Welfare

Time-Varying Risk, Sticky Information and the UIP Puzzle