NBER Macroeconomics Annual | Macro Paper Warehouse

[What Ends Recessions?]: Comment

Commenting on Christina and David Romer’s claim that active Federal Reserve policy ended postwar recessions, Cochrane argues that their historical narrative cannot distinguish a Fed that reacts to output from a Fed that causes it, that their regression-based policy multipliers are not separately identified from the Fed’s own feedback rule without an explicit, defended monetary theory, and that the size, permanence, and delay of their estimated multipliers do not match any known account of how money affects output. Cochrane places the Romers’ project squarely in the line of Friedman-Schwartz-style historical monetary analysis and revives the identification critiques Tobin and Kareken-Solow raised against that method thirty years earlier: a history of Fed officials perceiving recessions and lowering rates documents that the Fed reacted systematically to output and inflation, but says nothing about whether output reacted to the Fed, since predictable (“systematic”) policy actions are exactly the kind of correlation with dubious causal content that VAR methodology was built to sidestep. Working through the underlying regression algebra, Cochrane shows the Romers’ OLS and instrumental-variables “policy multiplier” estimates are observationally equivalent to the negative of the Fed’s own feedback rule unless one assumes, as they implicitly do, that anticipated and unanticipated monetary policy have identical real effects – an assumption he argues is hard to reconcile with the apparent neutrality of announced disinflations and the ends of hyperinflations. He further argues the estimated multipliers are implausibly large (requiring investment responses far outside what the investment literature supports), permanent, and delayed in a way no theory of monetary transmission predicts, and that a simple look at how little nondurables-and-services consumption moves across four recessions suggests households already expect recessions to be short-lived on their own, undercutting the premise that policy-induced “ending” is even needed. Cochrane closes by faulting the paper for engaging none of the intervening thirty years of VAR and monetary-theory literature that grew directly out of the very identification problems it re-encounters, while praising the Romers’ FOMC-minutes evidence as a potentially valuable input to resolving the Fed’s own reaction function.

A Frictionless View of U.S. Inflation

Cochrane asks whether U.S. postwar inflation can be understood using a “frictionless” fiscal theory of the price level – in which the price level is pinned down by the government’s intertemporal budget constraint rather than by a transactions demand for money – and argues that once the primary surplus is modeled as reacting to recessions by promising higher future surpluses, the fiscal theory can rationalize otherwise puzzling correlations, such as high government debt coinciding with low inflation, even though the theory has no testable implications of its own for the joint behavior of debt, surpluses, and prices. Motivated by financial innovation’s erosion of any well-defined transactions-facilitating monetary aggregate, and by the quantity theory’s poor track record explaining postwar U.S. inflation, Cochrane exposits the fiscal theory in a frictionless setting: the identity that nominal debt divided by the price level equals the present value of real primary surpluses can, under a “non-Ricardian” fiscal policy, determine the price level exactly as the quantity equation does in monetary theory, and this fiscal determination is immune to financial innovation since it depends on total government debt rather than on any liquid, transaction-facilitating asset. Cochrane clarifies the definition of “Ricardian” regimes (policies under which the government’s budget identity holds for any conceivable price level, rendering the constraint powerless to pin one down) using a wheat-standard thought experiment, and is candid that the fiscal theory per se has no testable implications distinguishing it from a monetary story, since the same accounting identity linking debt, surpluses, and returns holds regardless of which variable is doing the adjusting. Building a new dataset on the maturity structure of U.S. federal debt, Cochrane documents correlations that look backward for a naive fiscal story – the largest primary deficit occurred in 1975 alongside the onset of serious inflation, while the 1980s saw dramatically rising debt with falling inflation – and resolves the apparent puzzle by showing that once the surplus is modeled as a higher-order process in which today’s low surplus (extra debt sold in a recession) signals higher future surpluses, the fiscal theory can rationalize why debt-financed deficits smooth rather than destabilize inflation. He closes by noting that fiscal policy already accounts for much of the observed price-level smoothing in the postwar data, and that both larger debt-financed smoothing and a naive money-growth rule would have performed worse.

Excess Savings and Twin Deficits: The Transmission of Fiscal Stimulus in Open Economies

This paper studies the effects of debt-financed fiscal transfers in a general-equilibrium, heterogeneous-agent model of the world economy, merging a closed-economy HANK fiscal model (Auclert, Rognlie and Straub 2018) with an open-economy HANK model (Auclert, Rognlie, Souchier and Straub 2021) and, going beyond a small-open-economy assumption, letting fiscal deficits move the world interest rate as in Frenkel and Razin (1986). Its central analytical result is that fiscal deficits are eventually financed entirely by foreigners – in the long run, a country’s public debt increase leaves its private wealth unchanged and is absorbed one-for-one abroad (Proposition 1) – but that this happens only gradually. In the short run, because households have high, realistic marginal propensities to consume (MPCs) and spend mostly on home-biased domestic goods, almost all of a fiscal deficit shows up as a rise in the deficit country’s own private saving (“excess savings”), while the current account deteriorates only slowly (a “slow-motion twin deficit”), with a transition speed set jointly by the matrix of intertemporal MPCs and the degree of home bias. The paper shows analytically that the world economy decomposes into an aggregate, closed-economy-like response to the world-average fiscal shock and a small-open-economy-like response of each country’s deviation from that average, and it tests this prediction against cross-country data on private savings, current accounts and fiscal deficits since the start of the Covid pandemic, finding that a simple cross-sectional regression coefficient closely matches the model’s calibrated prediction after five quarters. A quantitative extension with 26 asymmetric countries and an explicitly estimated Covid demand shock replicates these patterns and finds that fiscal deficits, not the pandemic shock itself, account for the large majority of observed excess savings.

Heterogeneity and Aggregate Fluctuations: Insights from TANK Models

By building three nested HANK economies and then constructing a deliberately simple two-agent counterpart for each, this paper argues that what household heterogeneity does to aggregate output can be read off the differential behaviour of just two household types, hand-to-mouth and unconstrained, and that idiosyncratic income risk itself contributes little. The nesting isolates three ingredients in turn: idiosyncratic income risk alone (HANK-I, with a natural debt limit so no constraint binds), an occasionally binding borrowing constraint (HANK-II), and a portfolio choice between liquid bonds and partly illiquid equity subject to an adjustment cost and a short-sale constraint (HANK-III). In HANK-I the whole gap from the representative-agent model runs through a single “risk shifter” term in the aggregate Euler equation, and that term barely moves: output volatility under HANK-I exceeds RANK’s by a factor of only 1.22 with a correlation of 0.97, because the squared elasticity of individual consumption to idiosyncratic income is strongly convex in consumption, so the households whose risk actually responds carry a small weight in the aggregate. The paper is blunt that the standard two-agent model is not a good approximation: in TANK-I the output response to an expansionary monetary shock is “highly amplified… almost trebling the effect on impact,” and the response to a technology shock has the wrong sign, because TANK-I misses the interest rate exposure channel entirely and reverses the sign of the income distribution channel. Three changes repair it — hand-to-mouth households are held permanently against the borrowing limit and so service interest on a constant debt, they are given productivity below the unconstrained (0.56 against a normalized mean of one), and they receive dividends on the same rule as in HANK — and the resulting TANK-II tracks HANK-II closely, with a volatility ratio of 1.10 for monetary shocks and near-unit correlation, while also reproducing the effect of tightening the borrowing limit from 30% to 50% constrained. Adding portfolio choice changes the answer again: because wealthy hand-to-mouth households can smooth cash-on-hand by liquidating equity at a cost, dividends no longer pass one-for-one into their consumption, the income distribution channel weakens, monetary shocks are amplified, and a positive technology shock now lowers output — a prediction the authors immediately flag as contrary to existing evidence and as hinging on their counterfactual constant-real-rate assumption. Splitting the hand-to-mouth into poor (weight 0.05) and wealthy (0.25) restores the approximation in TANK-III. Section 6 relaxes the constant real rate for a Taylor rule with φ_π = 1.5 and φ_y = 0.125, and the models converge dramatically; the mechanism is stated as a proposition, since the natural level of output is invariant to idiosyncratic risk and the shared Phillips curve displays divine coincidence, so under strict inflation targeting every model delivers the identical output path. The caveats are the authors’ own and are load-bearing: the result applies to environments where precautionary saving responds little to aggregate shocks, countercyclical income risk is absent from the analysis, only monetary and technology shocks are studied, heterogeneity is not allowed to touch the supply side, and nothing normative is claimed — the irrelevance proposition concerns output, not the real interest rate, and not welfare.

The Cost Channel of Monetary Transmission

This 2001 NBER Macroeconomics Annual paper by Marvin Barth and Valerie Ramey tests whether monetary policy operates through a supply-side “cost channel” – in which a monetary contraction raises firms’ working-capital financing costs and thereby raises production costs and prices – in addition to the conventional demand channel, using two separate empirical frameworks. The first is an aggregate six-variable quarterly VAR (1959:Q1-2000:Q3) that uses long-run restrictions following Gali (1999) to identify a technology shock (the only shock permitted a permanent effect on labor productivity) and a monetary policy shock (the federal-funds-rate innovation orthogonal to it); the authors show that the estimated responses to a contractionary monetary shock – falling labor productivity, falling hours, procyclically falling real wages, and a temporary price-level increase – resemble the responses to a negative technology shock far more than the responses to an identified demand shock (a defense-spending increase), which instead raises output and lowers real wages countercyclically. The second framework is a seven-equation industry-level pseudo-panel VAR (monthly, 1959-2000, 7 lags, with a macro block of industrial production, the PCE deflator, commodity prices, M2, and the federal funds rate, and an industry block of output and the price-to-wage ratio for 21 two- and three-digit manufacturing industries) that tests whether a contractionary funds-rate shock raises the industry price-to-wage ratio (P/W) – the signature of a supply-side cost shock – even as output falls. Over the full sample, 10 of 21 industries show P/W rising for more than half of the first 24 months, 6 significantly at the 10% level; the effect is far stronger before 1979 (15 of 21 industries significant) than during 1983-2000 (only 3 of 21 significant), a period split the authors attribute to financial deregulation, the end of Federal Reserve “credit actions” that had directly restricted bank lending, and the shift to floating exchange rates. Consistent with this timing, in a standardized 25-basis-point funds-rate shock the pre-Volcker output trough is almost four times as deep and the “price puzzle” (prices rising after a contractionary shock) persists for over two years, versus a roughly nine-month funds-rate reversion and largely flat prices after 1983. The authors motivate the mechanism with a working-capital calculation (Federal Reserve Flow of Funds and BEA data, averaged 1959-2000): gross working capital equals about 17 months of final sales and net working capital about 11 months, and a simple labor-demand equation implies that, holding real wages fixed, a 100-basis-point rate rise lowers labor demand by about 3% when the capital cost share is 0.3 – or by about 15% once a credit-channel-style widening of external financing spreads is layered onto the roughly 400-basis-point average funds-rate increase seen over a Romer tightening episode. Cross-industry heterogeneity in the price-to-wage response correlates positively with industries’ interest-expense burden relative to sales (correlation of about 0.53 in an early-1970s cross-section, about 0.43 in a 1990 cross-section), which the authors read as further evidence linking the price response to financing costs specifically. They test and argue against sticky-price/flexible-wage and misspecified-Fed-reaction-function explanations for the same facts, but explicitly acknowledge that countercyclical-markup theories are observationally equivalent to their cost-channel story without direct marginal-cost data, and they frame the cost channel as a short-run phenomenon layered on top of the standard demand channel rather than a challenge to long-run monetary neutrality.

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.

When inequality matters for macro and macro matters for inequality

This paper argues that two standard excuses for relying on representative-agent macro models – that heterogeneous-agent models with aggregate shocks are computationally intractable, and that realistic household heterogeneity does not matter much for aggregate dynamics anyway – are both weaker than commonly believed. To address the first, the authors extend Michael Reiter’s discrete-time linearization approach to continuous time: they solve a model’s stationary equilibrium fully nonlinearly using the finite-difference methods of Achdou et al. (2015), take a first-order Taylor expansion of the full discretized equilibrium system around that steady state using automatic differentiation, and solve the resulting large linear system of stochastic differential equations by standard techniques, exploiting continuous time’s tendency to generate sparse transition matrices; a companion model-free dimensionality-reduction method, adapted from the engineering “model reduction” literature, lets the computer – rather than the researcher – identify the low-dimensional information in the cross-sectional distribution needed to forecast prices accurately, generalizing the “approximate aggregation” logic of Krusell and Smith (1998) beyond cases where a hand-picked set of moments happens to work. On the standard Krusell-Smith (1998) business-cycle model, the method is roughly 1,500 times faster and about three times more accurate (by Den Haan’s 2010 error metric) than the best-performing algorithm in the JEDC comparison project, though its accuracy – being a local, linear approximation – degrades as the size of aggregate shocks grows. To address the second excuse, the authors apply their (open-sourced) toolbox to a two-asset incomplete-markets model, calibrated to match the U.S. joint distribution of income, wealth, and marginal propensities to consume, in which “wealthy hand-to-mouth” households arise endogenously from a costly-to-access illiquid asset. This richer model jointly reproduces two features of aggregate consumption dynamics – sensitivity to predictable income changes and relative smoothness – that have long challenged representative-agent and simple spender-saver benchmarks, and, in an extension with capital-skill complementarity, shows that aggregate productivity shocks can generate substantial, shock-specific swings in income and consumption inequality, providing what the authors call “a striking counterexample to the main result of Krusell and Smith (1998).”