We augment a standard monetary dynamic general equilibrium model to include a Bernanke-Gertler-Gilchrist financial accelerator mechanism. We fit the model to US data, allowing the volatility of cross-sectional idiosyncratic uncertainty to fluctuate over time. We refer to this measure of volatility as risk. We find that fluctuations in risk are the most important shock driving the business cycle. (JEL D81, D82, E32, E44, L26)

We present a model embodying moderate amounts of nominal rigidities that accounts for the observed inertia in inflation and persistence in output. The key features of our model are those that prevent a sharp rise in marginal costs after an expansionary shock to monetary policy. Of these features, the most important are staggered wage contracts that have an average duration of three quarters and variable capital utilization.

Why is inflation persistently high in some periods and low in others? The reason may be the absence of commitment in monetary policy. In a standard model, absence of commitment leads to multiple equilibria, or expectation traps, even without trigger strategies. In these traps, expectations of high or low inflation lead the public to take defensive actions, which then make accommodating those expectations the optimal monetary policy. Under commitment, the equilibrium is unique and the inflation rate is low on average. This analysis suggests that institutions which promote commitment can prevent high inflation episodes from recurring.

This paper develops the quantitative implications of optimal fiscal policy in a business cycle model. In a stationary equilibrium, the ex ante tax rate on capital income is approximately zero. The tax rate on labor income fluctuates very little and inherits the persistence properties of the exogenous shocks; thus there is no presumption that optimal labor tax rates follow a random walk. Most of the welfare gains realized by switching from a tax system like that of the United States to the Ramsey system come from an initial period of high taxation on capital income. Copyright 1994 by University of Chicago Press.