Sanjay K. Chugh

Macroeconomic Dynamics, 2009.  Vol. 3, p. 133-150.

Abstract:

We quantitatively demonstrate that the precise timing of financial markets and goods markets in a flexible-price cash good/credit good model does not matter for the baseline results in the Ramsey literature on optimal fiscal and monetary policy.  This result is reassuring because Ramsey analysis, in the tradition begun by Lucas and Stokey (1983) and Chari, Christiano, and Kehoe (1991), has been applied to a quickly-expanding rich class of DGSE models recently, making it important to know whether models based on these original structures have been pursuing a mirage.  In the original models, the timing is such that nominal money holdings are freely-adjustable in response to shocks in the period in which they will be used to purchase consumption.  We alter this timing convention so that nominal balances cannot be adjusted in the period they will be used --- the timing assumption of Svensson (1985) --- to study how sensitive the baseline results are to this slight, and ultimately ad-hoc, modification.  We find that Ramsey-optimal inflation continues to display very high variability just as in the original models. The basic intuition for the result is that, no matter the timing of markets, inflation variability creates no relative price distortions.  Thus, interpretation of results from the recent spate of Ramsey studies, which have had as a primary motivation the determination of the optimal degree of inflation stabilization in the presence of various features and frictions in the economy, is not blurred by the choice of cash/credit timing.

PDF file, May 2007 version

Journal of Monetary Economics, 2008.  Vol. 55, p. 1401-1414.

Abstract:

Costly nominal wage adjustment has received renewed attention in the design of optimal policy.  In this paper, we embed costly nominal wage adjustment into the modern theory of frictional labor markets to study optimal fiscal and monetary policy.  The main result is that the optimal rate of price inflation is quite volatile despite the presence of nominal wage rigidities.  This finding contrasts with results obtained in standard sticky-wage models, which employ neoclassical labor markets at their core.  In addition, the tax-smoothing result that lies at the heart of optimal policy prescriptions in standard Ramsey models does not carry over to a search and bargaining environment. Both results stem from a common source in our model.  Shared rents associated with the formation of long-term employment relationships imply that the optimal policy entails fluctuations in after-tax real wages much larger than in models with neoclassical labor markets, in which no such rent-sharing margin exists. The results demonstrate that the level at which nominal wage rigidity is modeled --- whether simply layered on top of a neoclassical market or articulated in the context of an explicit relationship between workers and firms --- can matter a great deal for policy recommendations.

PDF file, August 2008 version
PDF file, Expanded version, February 2007

Economics Letters, 2008.  Vol. 100, p. 204-207.

This short paper generalizes the consumption externalities model of Dupor and Liu (AER, 2003) to allow for externalities of different magnitudes and directions (positive and negative) in different goods.

Journal of Monetary Economics, 2007.  Vol. 54, p. 1809-1836.

Abstract:

Ramsey models of fiscal and monetary policy featuring time-separable preferences and a fixed supply of capital predict highly volatile inflation with no serial correlation.  In this paper, we show that an otherwise-standard Ramsey model that incorporates capital accumulation and habit persistence predicts highly persistent inflation.  The result depends on increases in either the ability to smooth consumption or the preference for doing so.  The effect operates through the Fisher relationship:  a smoother profile of consumption implies a more persistent real interest rate, which in turn implies persistent optimal inflation.   Our work complements a recent strand of the Ramsey literature based on models with nominal rigidities.  In these latter models, inflation volatility is lower than in the baseline model but continues to exhibit little persistence. We quantify the effects of habit and capital on inflation persistence and also relate our findings to recent work on optimal fiscal policy with incomplete markets.

PDF file, May 2006 version

Review of Economic Dynamics, 2006.  Vol. 9, p. 683-714.

Abstract:

I exploit evidence on cyclical fluctuations in the cross-sectional dispersion of firm-level productivity to quantify how much volatility in borrowers' leverage ratios and how large a business cycle can be explained by "second-moment shocks."  In a standard financial accelerator model, second-moment shocks lead to fluctuations in leverage an order of magnitude larger than due to standard "first-moment" TFP shocks.  While this result represents substantial improvement over baseline analyses of accelerator models, it is still five times lower than the volatility of borrowers' (firms') leverage ratios I document using Compustat data.  In terms of macroeconomic aggregate quantities, pure dispersion shocks account for a small share of GDP fluctuations in the model, less than five percent.  Depending on whether or not second-moment fluctuations are independent from or intertwined with shocks to the mean level of productivity, the model also performs well in explaining either (but not both) the observed acyclicality of leverage or the observed countercyclicality of firm-level dispersion.  Overall, the mechanism the model articulates is conceptually clear and seems quantitatively promising.

PDF file,  November 2009 version

Abstract:

We study the role of agency frictions and costly external finance in cyclical labor market dynamics, with a focus on how credit-market frictions may amplify aggregate TFP shocks.  The main result is that aggregate TFP shocks lead to large fluctuations of labor market quantities if the model is calibrated to the empirically-observed countercyclicality of the finance premium.  A financial accelerator mechanism thus amplifies labor market fluctuations.  In contrast, if the finance premium is procyclical, which the model can be parameterized to accomodate, amplification is absent, and labor-market fluctuations display the Shimer (2005) puzzle.  The cyclicality of the finance premium in the model is governed by the degree of "technology spillover" from aggregate TFP to firms' idiosyncratic productivity.  If positive shocks to aggregate TFP on average improve firms' idiosyncratic productivity, a correlation that has support in firm-level studies of productivity, equilibrium labor-market fluctuations are amplified through two channels.  One channel is a direct productivity channel --- firms are on average more productive for a given size positive aggregate shock than if there were no productivity correlation.  The second channel is a financial conditions channel, through which improved firm-level productivity reduces the risk of bankruptcy, which dampens the external finance premium and lowers firms' financing costs.  Both channels induce firms to expand activity, including hiring, more sharply than if there were no productivity correlation.  Sixty percent of the model's amplification comes through the financing channel, and 40 percent of the model's amplification comes through the productivity channel.

PDF file, June 2009 version

Abstract:

We study optimal fiscal policy in an economy in which the number of product varieties is endogenous and in which sunk costs of development make products long-lived assets for the firms that sell them.  Two main results emerge.  First, depending on the particular form of variety aggregation, new product development may be either subsidized or taxed in the long run.  This subsidization or taxation occurs on the dividends that firms pay out to their owners.  In the most empirically relevant and intuitively appealing form of variety aggregation, however, the model delivers a clear prediction:  dividend income should be taxed quite heavily.  Because dividend income is a form of capital income, the result can be regarded as one of positive capital taxation, and the basic reason is the long-lived nature of product varieties.  Second, regardless of the form of variety aggregation, in the short-run --- i.e., in the face of business-cycle shocks --- maintaining low volatility of labor income tax rates is not optimal.  The standard deviation of the optimal labor income tax rate is over 2 percentage points, over an order of magnitude larger than benchmark tax-smoothing results in the Ramsey literature.  Like long-run dividend taxation, the lack of tax smoothing is due to the long-lived nature of products in the economy.  The higher is the rate of product turnover, the lower is the degree of optimal tax volatility.  In the limiting case of purely static product creation decisions, tax smoothing is optimal.

PDF file  April 2009 version

Abstract:

We provide a characterization of general-equilibrium efficiency in the standard labor search and matching framework.  The efficiency condition builds on the well-known Hosios condition for labor-market efficiency, which is derived in partial-equilibrium models of the labor market.  What makes our analysis general equilibrium is that we consider a labor force participation decision, a margin absent in many models of the labor market.  The efficiency condition we develop has a simple interpretation in terms of marginal rates of substitution and marginal rates of transformation; it also provides a criterion by which general equilibrium search models can measure the attainment of efficiency, as well as provides a new basis for empirical tests of labor-market efficiency.

PDF file  March 2009 version

Abstract:

We study optimal capital-income taxation in an economy in which search frictions in physical capital markets give rise to flows of economic profit.  These profit flows are necessary compensation for sunk search costs of entry into the capital market.  Viewed in this way, profits are quasi-rents.   At any point in time, however, profit flows from existing matches can also be viewed as pure rents.  Whether a Ramsey government considers profit flows as pure rents or as quasi-rents is crucial for whether and to what extent capital-income taxation should be used to tax profits.  We prove that if the government treats profits as quasi-rents, the canonical long-run zero-capital-tax prescription arises.  If profits are instead treated as pure rents, the long-run optimal capital-income tax is non-zero, with a calibrated version of this economy featuring a capital-income tax rate of over 30 percent.  The sharply contrasting results are not due to any lack of commitment.  Rather, because profit flows are explicitly linked to free-entry conditions, a Ramsey government has an economic basis for adopting either the pure-rent view or the quasi-rent view.  In the long run, however, the quasi-rent equilibrium is welfare-superior.

PDF file  September 2008 version

Abstract:

In existing models of jointly-optimal fiscal and monetary policy, the monetary aspects of the economic environment have little to do with capital taxation prescriptions.  Instead, the capital-taxation prescriptions of the underlying purely real economy in such models carry over unchanged, qualitatively and very nearly quantitatively, to the monetary economy.  In this paper, we employ a micro-founded model of money in order to more meaningfully connect optimal fiscal and monetary policy, with a particular focus on optimal capital taxation.  Our main result is that deep-rooted frictions underlying monetary trade in and of themselves provide a rationale for nonzero capital taxation --- specifically, for capital subsidies.  Optimal capital subsidies arise in versions of our model where monetary trades lead to capital holdup problems --- in which case the prescription to subsidize capital follows readily --- as well as versions of our model where holdup problems are absent.  The latter result especially highlights the unique connection between fiscal and monetary policy our model articulates because the underlying purely real economy in our model features zero capital taxation.  Connecting our results with some other recent advances in optimal capital taxation, we prove that for some versions of our environment, capital-income subsidies are consistent with zero intertemporal distortions.  Our main conclusion is that capital-tax policy can fundamentally be driven by monetary issues.

PDF file  August 2008 version

Abstract:

We re-examine the optimality of tax smoothing from the point of view of frictional labor markets.  Our central result is that whether or not this cornerstone optimal fiscal policy prescription carries over to an environment with labor market frictions depends crucially on the cyclical nature of labor force participation.   If the participation rate is exogenous at business-cycle frequencies --- as is typically assumed in search and matching models --- we show it is not optimal to smooth tax rates on labor income in the face of business-cycle shocks.  However, if households do optimize at the participation margin, then tax-smoothing is optimal despite the presence of matching frictions.  To understand these results, we develop a concept of general-equilibrium efficiency in search-based environments, which builds on existing (partial-equilibrium) search-efficiency conditions.  Using this concept, we develop a notion of search-based labor-market wedges that allows us to trace the source of the sharply-contrasting fiscal policy prescriptions to the value of adjusting participation rates.  Our results demonstrate that policy prescriptions can be very sensitive to the cyclical nature of labor-force participation in search-based environments.

PDF file, November 2008 version

Abstract:

We show how to implement the concept of competitive search equilibrium in a fully-specified DSGE environment.  Competitive search equilibrium, an equilibrium concept well-understood in labor market theory, offers an alternative to the commonly-used Nash bargaining in search-based macro models.  Our simulation-based results show that business cycle fluctuations under competitive search equilibrium are virtually identical to those under Nash bargaining for a broad range of calibrations of Nash bargaining power.  We also prove that business cycle fluctuations under competitive search equilibrium are identical to those under Nash bargaining restricted to the popularly-used Hosios condition for search efficiency. This latter result extends the efficiency properties of competitive search equilibrium to a DSGE environment.  Our results thus provide a foundation for researchers interested in studying business cycle fluctuations using search-based environments to claim that the sometimes-awkward assumption of bargaining per se does not obscure interpretation of results.

PDF file, February 2008 version

Abstract:

A growing body of evidence suggests that ongoing relationships between consumers and firms may be important for understanding price dynamics.  We investigate whether the existence of such customer relationships has important consequences for the conduct of both long-run and short-run policy. We explore this question using the Ramsey framework of optimal fiscal and monetary policy, in the tradition of Lucas and Stokey (1983) and Chari, Christiano, and Kehoe (1991), because it is a powerful laboratory for uncovering properties of optimal policy.  The framework is particularly effective at uncovering the welfare consequences of stabilizing inflation over the business cycle, an issue about which central bankers have strong priors.  Our central result is that when consumers and firms are engaged in long-term relationships, the optimal rate of price inflation volatility is very low even though all prices are completely flexible.  This finding is in contrast to first-generation Ramsey models of optimal fiscal and monetary policy, which are based on Walrasian markets.  Echoing the basic intuition of models based on sticky prices, unanticipated inflation in our environment causes a type of relative price distortion across markets.  Such distortions stem from fundamental trading frictions that give rise to long-lived customer relationships and makes pursuing inflation stability optimal.

PDF file, October 2007 version

Abstract:

A growing body of evidence suggests that an important reason why firms do not change prices nearly as much as standard theory predicts is out of concern for disrupting ongoing customer relationships because price changes may be viewed as "unfair."  Existing models that try to capture this concern regarding price-setting are all based on goods markets that are fundamentally Walrasian.  In Walrasian goods markets, transactions are spot, making the idea of ongoing customer relationships somewhat difficult to understand. We develop a simple dynamic general equilibrium model of a search-based goods market to make precise the notion of a customer as a repeat buyer at a particular location.  In this environment, the transactions price plays a distributive role as well as an allocative role.  We exploit this distributive role of prices to explore how concerns for fairness influence price dynamics. Using pricing schemes with bargaining-theoretic foundations, we show that the particular way in which a "fair" outcome is determined matters for price dynamics. The most stark result we find is that complete price stability can arise endogenously.  These are issues about which models based on standard Walrasian goods markets are silent.

PDF file, June 2007 version

Abstract:

We study optimal fiscal and monetary policy in an environment where explicit frictions give rise to valued money, making money essential in the sense that it expands the set of feasible trades. Our main results are in stark contrast to the prescriptions of earlier flexible-price Ramsey models.  The two most important findings that emerge from our work are that the Friedman Rule is typically not optimal and inflation volatility is very low in the face of business-cycle shocks.  A departure from the Friedman Rule does not arise because of any incompleteness of the tax system, as can sometimes occur in standard Ramsey models. Rather, by developing precise notions of MRS and MRT, we show that the tax system in our model is complete. Regarding the optimal dynamic policy, realized (ex-post) inflation is quite stable over the business cycle, in contrast to the very volatile ex-post inflation rates that arise in standard flexible-price Ramsey models. Taken together, these findings turn conventional wisdom from traditional Ramsey monetary models on its head.

Abstract:

Heterogeneity between unemployed and employed individuals matters for optimal fiscal policy. This paper considers the consequences of welfare heterogeneity between these two groups for the determination of optimal capital and labor income taxes in a model with matching frictions in the labor market. In line with a recent finding in the literature, we find that the optimal capital tax is typically non-zero because it is used to indirectly mitigate an externality along the extensive labor margin that arises from search and matching frictions. However, the consideration of heterogeneity makes our result differ in an important way: even for a well-known parameter configuration (the Hosios condition) that typically eliminates this externality, we show that the optimal capital income tax is still positive.  We also show that labor adjustment along the hours margin has an important effect on efficiency at the extensive margin, and hence on the optimal capital tax, independent of welfare heterogeneity.  In terms of specific findings, we highlight three. First, with neither welfare heterogeneity between unemployed and employed individuals nor an intensive margin, Ramsey allocations are Pareto optimal despite a non-zero proportional labor tax. Second, the quantitative effects of welfare heterogeneity and intensive labor adjustment on the optimal capital income tax rate are essentially additive. Third, the steady-state welfare loss of following a zero capital tax, a standard prescription in much of the optimal capital taxation literature, rather than the positive capital taxes we find is about 0.7 percent of steady-state consumption.

PDF file, February 2007 version

Abstract:

Changes in government spending may serve as a coordination mechanism in at least some labor markets, helping to more easily bring together individuals looking for jobs with firms looking for workers.  If government spending increases matching efficiency in this way, using Walrasian labor markets to study how innovations in government purchases affect the economy may miss an important transmission channel.  We construct a simple dynamic model with labor search frictions that captures this idea. Our main result is that a positive government spending shock increases employment at both the extensive and intensive margins and leads to a countercyclical movement in the markup of price over the real wage.  Our results, particularly the countercylical response of the markup following a demand shock, bridges a gap in the existing literature studying the effects of fiscal policy shocks.  The important link in the dynamic response of the model is a shift in the job creation schedule, which is our model's analog of the Walrasian labor demand schedule.

PDF file, January 2007 version

Abstract:

Large and frequent changes in prices are an evident feature of micro-level data.  We construct a simple DSGE model that is consistent with several of the newly-emerging stylized facts about high-frequency price movements, and we use it to assess some of its macroeconomic predictions.  The most striking macro implication of the model is its ability to reproduce quite well the countercyclical markups observed in aggregate data, even though our model is calibrated only to match high-frequency price dynamics.  The key building blocks of our model are consumers who are heterogenous in their needs to purchase various goods, heterogenous with respect to each other over these preferences, and heterogenous with respect to each other about "when" they shop for goods.  These features imply a high-frequency intertemporal price discrimination aspect of firm pricing behavior because different groups of consumers purchase goods at different times; a rich mix of extensive margin effects (which consumers purchase goods) and intensive margin effects (the quantities of goods various consumers purchase) is at the heart of our model's ability to replicate both micro- and macro-price dynamics.  Our model and results are a first step in providing unified frameworks in which to think about both micro- and macro-price phenomena.