Kenneth Rogoff | Macro Paper Warehouse

Monetary Policy without Commitment

Thu, 01 Jan 2026 00:00:00 +0000

Research question and motivation: Post-pandemic inflation across advanced economies rose to levels not seen since the early 1980s, reviving interest in central bank credibility. The standard quantitative macro models used to interpret this episode assume exogenous central bank reaction functions and inflation targets, which limits their usefulness. This paper instead makes monetary policy endogenous: a welfare-maximizing central bank that lacks the ability to commit re-optimizes every period. The goal is to characterize how lack of commitment shapes long-run inflation and transition dynamics, questions that prior credibility work (Barro-Gordon 1983; Rogoff 1985) could not address because it used static or log-linearized settings.

Chapter 34 The intertemporal approach to the current account

The intertemporal approach treats the current-account balance as the outcome of forward-looking saving and investment decisions rather than as a residual determined by relative prices, and this chapter surveys the theory and the evidence for it as developed since the early 1980s. The authors trace its origins to two pressures: Lucas’s critique, which suggested that open-economy models “might yield more reliable policy conclusions if demand and supply functions were derived from the optimization problems of households and firms rather than specified to match reduced-form estimates,” and the large, divergent current-account adjustments that followed the oil shocks of 1973-74 and 1979-80, on which “[n]either the classical monetary models nor the Keynesian models in vogue at the time offered reliable guidance.” Before any theory they flag a measurement problem that “plague[s] all of the empirical literature”: reported current accounts omit net capital gains on foreign assets and are not corrected for inflationary erosion of their real value, so that for the United States in 1991 the economically meaningful deficit is “probably much closer to” minus 108.7 billion dollars than to the national-accounts figure. The theory is then built up in stages. From time-separable isoelastic preferences and the economy’s intertemporal budget constraint comes a characterisation in which the current account responds to deviations of interest income, output, government consumption and investment from their permanent levels, plus a consumption-tilting term reflecting any gap between world real interest rates and domestic impatience – each prediction stated with an explicit ceteris paribus clause. The model’s quantitative failure is displayed rather than hidden: with a world real interest rate of 8 percent, growth of 4 percent and an intertemporal elasticity of 0.4, the implied steady-state net foreign asset position is minus twenty times annual output and “the economy’s trade balance surplus each period must be 80 percent of GDP” – levels “never observed in practice.” Successive sections add comparative advantage, investment with adjustment costs, nontradables, consumer durables, terms-of-trade and transfer effects, demographic structure and fiscal policy, then uncertainty under complete markets, bonds only, partially complete markets and endogenous incompleteness. On the evidence, the authors first take on Feldstein and Horioka, reproducing the original 16-country OECD regression for 1960-74 (a saving coefficient of 0.887 with a standard error of 0.074, R-squared 0.91) and reporting a weakened but still highly significant coefficient of 0.622 for 1982-91; they also note that the average OECD time-series correlation between saving and investment rates over 1974-90 is 0.495 after linear detrending and 0.512 in first differences. Their conclusion is that these correlations “provide[] no basis at all for dismissing the basic premises of the intertemporal approach,” offering four reconciling mechanisms – current-account targeting by governments, OECD countries sitting near stochastic steady states for external debt, retained earnings raising investment through the Gertler-Rogoff channel, and demographic structure – while conceding that “no single one fully explains the behavior of all countries.” Formal structural tests are treated much more sceptically. Constructing permanent values is “perhaps the most problematic issue of all”: with a real rate of 3 percent, moving the persistence parameter from 1 to 0.97, “an amount generally too small to detect empirically,” halves permanent output, and the discount rates that would remove this sensitivity “appear implausible.” The Campbell-Shiller present-value tests reject the model’s exact restriction for most countries – Sheffrin and Woo reject for Canada, Denmark and the UK but not Belgium; Ghosh does not reject for the US but rejects for Canada, Germany, Japan and the UK; and even the weaker Granger-causality implication is passed only by the US in Ghosh’s full sample – while the actual current account is generally more volatile than the predicted one, six times more so for Canada on Otto’s estimate, which Ghosh reads as evidence of “’too much’ capital mobility, in contrast to the Feldstein-Horioka claim of too little.” Extending Britain’s sample back to 1870 improves the visual fit “dramatically” yet still fails the formal restriction. Distinguishing global from country-specific shocks helps substantially: global shocks are about half of G-7 productivity shocks, and once separated “the coefficients on the global shocks are invariably much smaller than those on the country-specific shocks, and are usually insignificant.” The chapter’s closing claim is comparative rather than triumphal: the models “provide only a starting point,” but the complete-markets alternative makes the current account “little more than an accounting convention” in a world the authors judge far from complete, while Mundell-Fleming “offers no valid benchmark for evaluating external balance” and “has no clear, much less testable, predictions about current-account dynamics.”

Empirical exchange rate models of the seventies: Do they fit out of sample?

This study compares the out-of-sample forecasting accuracy of the structural exchange rate models that had come to dominate the 1970s literature against simple time series alternatives, and finds that a random walk does at least as well as any of them. The competitors are three “asset” models – the flexible-price monetary (Frenkel-Bilson) model, the sticky-price monetary (Dornbusch-Frankel) model, and the Hooper-Morton model, which extends the latter to let the long-run real exchange rate move with unanticipated trade balance shocks – all nested in a single quasi-reduced form in relative money supplies, relative real income, the short-term interest differential, the expected long-run inflation differential and cumulated home and foreign trade balances. Against them stand six univariate time series techniques applied to raw and prefiltered data, a random walk with an estimated drift, an unconstrained vector autoregression in the same variables, the forward rate, and the spot rate itself. Estimation uses monthly, seasonally unadjusted data from March 1973, the start of the floating-rate period, through June 1981; forecasting begins in November 1976, and every model’s parameters – including its seasonal parameters – are re-estimated each period by rolling regression so that only information available at the time of each forecast is used. Horizons are one, three, six and twelve months, chosen to match the available forward rate maturities. The critical design choice is that the structural models are given the benefit of the doubt: their forecasts are built from the actual realized future values of their own explanatory variables, which “directly addresses one possible defense of these models: structural exchange rate models have explanatory power, but predict badly because their explanatory variables are themselves difficult to predict.” Even so, “none of the models achieves lower, much less significantly lower, RMSE than the random walk model at any horizon” for the dollar/mark, dollar/pound, dollar/yen or trade-weighted dollar. The result survives estimating the structural models by ordinary least squares, generalized least squares and Fair’s instrumental variables method, allowing lagged adjustment, freeing the domestic and foreign coefficients, swapping M1-B for M2 or the reserve-adjusted base, trying alternative inflation-expectations proxies, substituting price levels for monetary variables, running the models on cross-rates to sidestep unstable US money demand, starting the forecast period in November 1978, and ending it in November 1980. The authors are careful about what they can and cannot claim statistically: because formal tests of forecast-accuracy differences require restrictive assumptions, they assert only that “the other models do not perform significantly better than the random walk model,” not that the random walk is significantly better. They are equally careful that their result is not good news: “while the random walk model may be as good a predictor as any of major-country exchange rates, it does not predict well,” with root mean square errors of 1.99 percent at one month and 8.65 percent at twelve months even for the more predictable trade-weighted dollar, and 3.70 and 18.3 percent for the dollar/yen rate. Companion constrained-coefficient experiments lead them to conclude that “neither sampling error nor simultaneous equations bias can fully explain the results,” and they canvass – without settling among – structural instability from the oil shocks and policy-regime changes, inadequate modelling of expectations, failure to capture real disturbances, and misspecified money demand, describing the ranking of these explanations as “at this point speculative.”

Sovereign Debt: Is to Forgive to Forget?

The paper is a single theorem and its consequences. The question is what enforces a sovereign loan when, unlike a domestic loan backed by collateral, “the assets that can be appropriated in the event of a foreign sovereign’s default are generally negligible.” The dominant answer at the time, from Eaton and Gersovitz (1981) onward, was reputation: a country borrows because default would tarnish its name and cut it off from world capital markets in future, an answer whose appeal the authors grant is that it “seem[s] robust to institutional detail” – you need not speculate about creditors’ legal rights in their own courts or their ability to get their governments to retaliate. The authors set out “to query reputation-for-repayment theories, not to praise them,” and they do it with an arbitrage argument that needs almost no structure: a small country facing competitive, risk-neutral foreign investors, one infinitely-lived representative agent whose utility is restricted only by preferring more to less, and the assumption that the market value of a claim on the country’s entire future gross income is finite (which rules out Ponzi-type reputational contracts). The decisive observation is that a country which defaults on a purely reputational contract is not actually excluded from world capital markets: it may lose the ability to borrow, but it can still buy state-contingent insurance by paying cash in advance, because the investor’s side of such a contract is enforced by the legal system in the investor’s own country. Theorem 1 then shows that from any node at which reputational debt has positive market value, the country can stop paying and instead fund a sequence of cash-in-advance contracts out of exactly the payments it withholds, satisfying the investors’ break-even condition and the requirement that the country never owe anything ex post, while contributing strictly less than it would have paid – so reputational debt must be non-positive in any sequential equilibrium. Theorem 2 generalises this to the case where creditors can impose direct penalties: lending becomes possible, but the amount is bounded by the expected present value of those penalties alone, and “a good reputation for repaying loans will not in any way enhance a country’s ability to borrow” beyond that bound – which may itself be too generous, “since countries can typically bargain with their creditors.” The only assumption that would save reputational lending is that the country be barred from holding assets abroad, which the authors argue contradicts the premise of the very models they are attacking. They then work through six limitations of the result – reputation spillovers outside the lending relationship, non-competitive lenders, observable-but-not-verifiable shocks, private information, unobservable preferences, and restrictions on the use of reserves – conceding that the private-information case is genuinely unresolved and only conjecturing that the intuition carries over. The conclusions are correspondingly framed as a redirection of research rather than a closed case: enforcement rests on lenders’ legal and political rights, an area the authors call “a gray area of Western law” that “must be studied further,” while “reputation for repayment considerations are at most a secondary factor” – and, answering the title, “debts which are forgiven will be forgotten.”

The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?

International macroeconomics, the authors observe, “is a field replete with truly perplexing puzzles, and we generally have five to ten (or more) alternative answers to each of them. These answers are typically very clever but far from thoroughly convincing, and so the puzzles remain.” This paper proposes a single culprit for six of them: significant but plausible costs of trading goods across borders, modelled as Samuelsonian iceberg costs, interacting with the high elasticity of substitution between home and foreign goods. The strategy is deliberately restrictive. Rather than selecting, puzzle by puzzle, from the menu of possible capital market imperfections, the authors ask “how far one can go in elucidating major empirical riddles without appealing to intrinsically international capital-market imperfections” – and find that “once one allows for trade costs in goods markets, many of the main empirical objections to the canonical models of international macroeconomics disappear.” The mechanism is always the same interaction. With an elasticity of substitution of 6 and trade costs of 25 percent applied to all of output, home expenditure on home goods exceeds home expenditure on imports by a factor of 4.2, a ratio “consistent with those we observe for many OECD countries.” The same two parameters, in a two-period small-country endowment model, generate a five-segment step function linking the current account to the domestic real interest rate: for small imbalances trade costs have no effect at all, but once a deficit is large enough to reverse the direction of trade in the home good, its price rises today relative to tomorrow and the effective real borrowing rate jumps. With a world rate of 5 percent, trade costs of 10 percent and an elasticity of 6, the country’s real interest rate can range from 20 percent to −8 percent. The observed range is far narrower, which is exactly the point – “incipient real interest differentials put a sharp check on a country’s incentives to run large current-account deficits or surpluses” – and is consistent with the Feldstein-Horioka slope having fallen from 0.89 in the original 1960s-70s data to 0.60 for OECD countries over 1990-1997 while remaining far above zero. The prediction that deficit countries face higher real rates is tested on annual OECD data for 1975-1998 and confirmed: with country fixed effects and time dummies, a one-percent-of-GDP rise in the current account surplus is associated with roughly a 20 to 30 basis point fall in the real interest rate. In a stochastic version with complete Arrow-Debreu markets, the same parameter pair – an elasticity of 6 and trade costs of 25 percent – delivers a home equity share of 81 percent, against the 80-90 percent observed and the roughly 50-plus percent the traded/nontraded dichotomy can explain; with an elasticity of 10, trade costs of just 10 percent yield 72 percent. The consumption correlations puzzle then follows largely as a corollary, and the authors add a reframing: the right benchmark for consumption correlations is output net of investment and government spending, whose average G7 correlation is 0.17, well below the 0.40 average consumption correlation. For the last two puzzles – the three-to-four-year half-life of real exchange rate deviations, and the broad disconnect between exchange rates and macroeconomic aggregates – the authors are explicit that trade costs alone are not enough: “to explain adequately the various pricing puzzles, we would need to develop a much richer framework featuring imperfect competition plus sticky prices and/or wages,” and they do not build one here. What they argue instead is that trade costs “must constitute an essential element, implicitly if not explicitly,” because with pervasive retail-level segmentation and prices preset in local currency, exchange rate movements have minimal short-run real effects “and therefore must be huge to clear financial markets.” The closing section confronts the obvious objection – transport technology has improved and tariffs have fallen – and reports that the quantity puzzles have indeed become less acute while net transport costs may not have fallen much, since shipping costs rose for manufactures even as they fell for bulk commodities.