Fiscal Origins of Monetary Paradoxes

Dejanir Silva, Nicolas Caramp

Research output: Working paper

Abstract

We revisit the monetary paradoxes of standard monetary models in a liquidity trap and study the channels through which they occur. We focus on two paradoxes: the Forward Guidance Puzzle and the Paradox of Flexibility. First, we propose a decomposition of consumption into substitution and wealth effects, both of which take into account the general equilibrium effects on output and inflation, and we show that the substitution effect cannot account for the puzzles. Instead, monetary paradoxes are the result of strong wealth effects which, generically, are solely determined by the expected fiscal response to the monetary shocks. We estimate the fiscal response to monetary policy shocks and find responses with the opposite sign to the ones implied by the standard equilibrium. Finally, we introduce the estimated fiscal responses into a medium-size DSGE model. We find that the impulse-response of consumption and inflation do not match the data, suggesting that wealth effects induced by fiscal policy are important even outside of the liquidity trap.
Original languageEnglish (US)
Number of pages62
StatePublished - Mar 19 2018

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Paradox
Fiscal
Wealth effect
Substitution effect
Liquidity trap
Inflation
General equilibrium
Decomposition
Monetary shocks
DSGE models
Guidance
Fiscal policy
Impulse response
Monetary policy shocks

Cite this

Fiscal Origins of Monetary Paradoxes. / Silva, Dejanir; Caramp, Nicolas.

2018.

Research output: Working paper

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