One usually identifies bubble solutions to linear rational expectations models by extra components (irrelevant lags) arising in addition to market fundamentals. Although there are still many solutions relying on a minimal set of state variables, i.e., relating in equilibrium the current state of the economic system to as many lags as initial conditions, there is a conventional wisdom that the bubble-free (fundamentals) solution should be unique. This paper examines the existence of endogenous stochastic sunspot fluctuations close to solutions relying on a minimal set of state variables, which provides a natural test for identifying bubble and bubble-free solutions. It turns out that only one solution is locally immune to sunspots, independently of the stability properties of the perfect-foresight dynamics. In the standard saddle-point configuration for these dynamics, this solution corresponds to the so-called saddle stable path.

This paper provides an explanation for the supervisory role of the central bank in a monetary general equilibrium model of bank liquidity provision. Under incomplete information on the individual banks' liquidity needs, individual banks find it optimal to invest solely in bank loans holding no cash reserves, and rely on the interbank market for their withdrawal demands. Using the costly state verification approach under uncertainty in aggregate liquidity demands, the supervisory role of the central bank as a large intermediary arises as an incentive-compatible arrangement by which banks hold the correct level of cash reserves. First, it takes up a delegated monitoring role for the banking system. Second, it engages in discount-window lending at a penalty rate, where the discount margin covers exactly the monitoring cost incurred. Finally, under the central banking mechanism, currency premium no longer exists in the sense that currency is worth the same as deposits having an equal face value.

This paper provides estimates of the welfare cost of volatility attributable to monetary and fiscal policy shocks. It uses a continuous-time stochastic dynamic general equilibrium model based on a recursive utility function that disentangles risk aversion from intertemporal substitution. We find that monetary and fiscal policy shocks may lead to opposite welfare effects: negative for monetary growth shocks, but positive for government expenditure shocks. Furthermore, we find that welfare costs are sensitive to the parameter values chosen for risk aversion and intertemporal substitution, and we conclude that welfare costs are potentially much larger than that found by Lucas, forcing some modification of the policy conclusions associated with Lucas's pioneering work.

A long-standing area of research and policy interest is the construction of a measure of monetary policy stance. One measure that has been proposed, as an alternative to indices that employ monetary aggregates or exchange rates, is the spread between the actual real interest rate and its flexible-price, or natural-rate, counterpart. We examine the properties of the natural real interest rate and real-interest-rate gap using a dynamic stochastic general equilibrium model. Issues we investigate include the response of the gap and its components to fundamental economic shocks and the indicator and forecasting properties of the real-interest-rate gap for inflation, both in the model and in the data. Our results suggest that the real-interest-rate gap has value as an inflation indicator, supporting a neo-Wicksellian framework.

This paper examines the dynamic implications of different preference formulations in open-economy business-cycle models with incomplete asset markets. In particular, we study two preference formulations: a time-separable preference formulation with a fixed discount factor, and a time-nonseparable preference structure with an endogenous discount factor. We analyze the moment implications of two versions of an otherwise identical open-economy model—one with a fixed discount factor and the other with an endogenous discount factor—and study impulse responses to productivity and world real-interest-rate shocks. Our results suggest that business-cycle implications of the two models are quite similar under conventional parameter values. We also find that the approximation errors associated with the solutions of these two models are of the same magnitude.

Martin Feldstein is one of the most influential empirical economists of the late twentieth century. In the 1960's, as a research fellow at Oxford University, where he earned a D.Phil. in Economics, he pioneered the empirical analysis of production functions for hospitals and for other health care providers. In the process, he helped to launch the modern field of health economics. In the 1970's, shortly after moving from Oxford to Harvard, his research expanded from health economics to a broader range of social insurance programs, particularly Social Security and unemployment insurance. He developed theoretical models for analyzing how these programs affected the incentives facing households and firms, and then marshaled empirical evidence to document the substantive importance of these program-induced distortions. Feldstein's work sparked an active public policy debate on the economic effects of these programs, and this debate continues to the present day.

Feldstein was one of the first to use household-level data from surveys and administrative records to analyze how taxes and government transfer programs affect household behavior. His research contributions, and his pedagogical role in training dozens of graduate students, accelerated the diffusion of new empirical strategies in the field of applied economics. Researchers in public finance still make widespread use of the TAXSIM computer model, a household-level program for computing tax liabilities, which Feldstein began to build during the 1970's.

In the early 1980's, Feldstein spent two years as the Chairman of the Council of Economic Advisers. During that time, he warned frequently of the long-term economic costs of large budget deficits, even though this was a very unpopular view on political grounds. Feldstein's time in Washington expanded his interests still further, to encompass international economic policy issues as well as domestic questions. When he returned to Harvard and the NBER in the mid-1980's, Feldstein directed several projects on the sources of, and policy responses to, international economic crises.

Throughout the late 1980's and early 1990's, Feldstein continued to make central contributions to his primary field of public finance. In a series of papers on how taxable income responds to changes in marginal tax rates, Feldstein developed a new framework for evaluating the efficiency cost of income taxation. These papers also contributed in a very significant way to the debate on how congressional tax analysts should compute the revenue effects of tax reforms. He also continued his long-standing interest in social insurance policy. His 1995 Ely Lecture to the American Economic Association was a clarion call drawing economic researchers to the analysis of Social Security reform proposals, and it anticipated the very active policy debate of the last half decade.

Feldstein has been actively involved in both undergraduate and graduate teaching during his 35 years on the Harvard faculty. He has served on the dissertation committees of more than 60 graduate students, and he has trained many of the current leaders in the field of public economics. He currently directs and lectures in Harvard's Principles of Economics course, which is the largest undergraduate course at Harvard.

Martin Feldstein has made landmark contributions in many subfields of applied economics. He has also played a critical role in shaping the direction of economic research more generally in his position as President of the National Bureau of Economic Research, a post he has held since 1977. Feldstein has made the NBER a clearinghouse for a wide range of current policy-relevant economic research, and he has directed numerous research projects that have generated important new economic insights. During Feldstein's tenure as NBER president, yellow-covered NBER working papers and, increasingly, the NBER internet site, www.nber.org, have become standard starting points for researchers investigating many topics in applied economics.

In 1977, Martin Feldstein received the John Bates Clark Medal from the American Economic Association, recognizing him as the outstanding economist under the age of 40. Twenty-five years later, in 2002, he was elected president of that association.

This interview was conducted at Martin Feldstein's office at the NBER. One wall of the small conference room in which we worked is decorated with original drawings of some of the political cartoons that lampooned Feldstein's deficit worries during his time at the Council of Economic Advisers. Outside the conference room, a glass case contains literally hundreds of books that are the results of NBER research studies dating back to 1920. The interview follows a loose chronological pattern.

This book has an ambitious objective: “the discussion and the practical illustration of techniques used in applied macroeconometrics” (p. v). At less than 300 pages, the text is relatively small, which implies that it will have problems competing with many of the heavyweight general econometric texts in terms of scope. On the other hand, there is the potential for it to address issues that these sorts of texts typically do not. Several come to mind: At a “high” level, the importance of interdependence in systems and the ongoing issue of identification; and at a practical level, problems with short samples, data revisions, and unobserved variables.