Dynamic Stochastic General Equilibrium Model Research Articles

Macroeconomic Impact of Environmental Policy Uncertainty and Monetary Policy Implications

This paper evaluates the macroeconomic implications of uncertainty arising from delays or unpredictability regarding the timing and extent of environmental policy implementation. An environmental dynamic stochastic general equilibrium (E-DSGE) model shows that increasing uncertainty about environmental policies is associated with a subsequent decline in investment, as firms prefer to postpone investment decisions. The decline in physical investment within polluting sectors subsequently induces a fall in employment, consumption and output. Using a novel climate policy uncertainty index developed by Gavriilidis (2021), alongside Google Trend data index, the paper shows that uncertainty about climate regulations has both recessionary and inflationary effects, corroborating the theoretical findings. Further analysis suggests that appropriate monetary policy tools could moderate the welfare cost arising from the environmental policy uncertainty, emphasizing the need for Central Banks to adopt a more aggressive stance in stabilizing GDP and inflation in the face of environmental policy uncertainty shocks.

Imperfect coordination in DSGE models: The resurgence of Keynes in mainstream macroeconomics

The imperfect coordination of expectations and actions is a central theme running through Keynes’s General Theory. Incorporating this theme into mainstream macroeconomics, however, has proved to be a difficult endeavour. In particular, attempts to accommodate coordination failures within Dynamic Stochastic General Equilibrium (DSGE) models through multiple equilibria and “dynamic” indeterminacy, while promising in the 1990s, were gradually abandoned in the 2000s. Since then, the “New Keynesian” framework has come to dominate macroeconomic modelling. And since the coordination of agents is not at issue in this latter framework, mainstream macroeconomics has seemed to leave the coordination theme out of its focus, if not its scope. In this paper, we challenge this perception and argue that the coordination theme is actually alive and well. We especially present two recent research programmes which, while belonging to the DSGE paradigm, give pride of place to coordination failures and share a common objective: providing, within the class of DSGE models, an alternative to the New Keynesian framework that would involve the most important ideas emerging from Keynes’s General Theory.

Green Fiscal and Tax Policies in China: An Environmental Dynamic Stochastic General Equilibrium Approach

Implementing green fiscal and tax policies for reducing emissions and pollution without negatively impacting economic growth remains a challenge. We aimed to determine whether environmental protection and economic growth can both be attained under a green fiscal and tax policy. Specifically, we created a dynamic stochastic general equilibrium (DSGE) model to explore the environmental, economic, and welfare impacts of green fiscal and tax policies. Additionally, a welfare analysis based on an environmental DSGE (E-DSGE) model was performed. We found that (1) raising the environmental or energy tax rate was beneficial for reducing emissions and environmental pollution. However, this approach inhibited economic growth, an outcome not conducive to improving welfare. (2) Increasing the subsidy rate for emission reduction not only incentivized businesses to reduce emissions but also improved economic growth and welfare. (3) The emission reduction mechanisms of environmental tax policies, energy tax policies, and subsidy policies are different. Among them, the environmental tax policy and the energy tax policy both reduce pollution by forcing businesses to increase their emission reduction efforts, but the former is a tax on pollution emissions, while the latter is a tax on energy consumption. However, emission reduction subsidy policies incentivize companies to increase their emission reduction efforts and reduce pollution emissions by alleviating their financial burden. (4) Increasing government spending on environmental remediation could promote economic growth. However, considering that this does not motivate companies to reduce emissions, increasing their share will lead to a reduction in emission reduction subsidies, ultimately negatively impacting social welfare. (5) An environmental tax would cause greater losses in welfare than an energy tax. These findings will enable policymakers to optimize expenditures and tax systems.

The coevolution effect of central bank digital currency and green bonds on the net-zero economy

Directed by the net-zero emission goal, the green bond has become an essential financial tool to promote the development of the green economy. However, the greenwashing risk makes it doubtful whether the green bond can play a positive role. Therefore, this study constructs a six-sector dynamic stochastic general equilibrium (DSGE) model to analyze whether the coevolution of central bank digital currency (CBDC) and green bonds can fully play a positive role in promoting the net-zero economy. The results indicate that: (i) Increased CBDC supply has a positive effect on the economy, and also promotes green bond financing and net-zero emissions. (ii) Compared with non-interest-bearing CBDC, the coevolution of interest-bearing CBDC and green bonds is more likely to promote the net-zero economy and enhance the effectiveness of monetary policy. (iii) When the economy is overheating or in recession, the central bank can regulate green bond financing by adjusting the CBDC interest rate to promote a net-zero economy. (iv) The coevolution of interest-bearing CBDC and green bonds will achieve a higher welfare level than non-interest-bearing CBDC. This study provides guidance for the coevolution of CBDC technology innovation and green bond financial innovation.

Dividend Taxation and Financial Business Cycles

We examine the interactions between different dividend tax systems and financial shocks in a dynamic stochastic general equilibrium (DSGE) model with an occasionally-binding investment credit limit. We show that dividend taxes largely determine the collateral value of assets, thereby occasionally distorting investment decisions and altering the propagation of financial shocks. Permanently lower dividend taxes dampen financially-driven business cycles in a state-contingent fashion. They also help explain substantial macroeconomic asymmetries following equally-sized expansionary and contractionary financial shocks.

Fiscal Policy for Inclusive Growth. A Case Study of Myanmar

Following decades of isolation under military rule, Myanmar initiated historic political reforms since 2011, but faces challenges translating liberalization into broad-based advancement. A dynamic stochastic general equilibrium modelling approach estimated on Myanmar data is used, with simulations quantifying potential growth and distributional impacts of strategic government expenditure reallocations towards infrastructure upgrading, agricultural investments, expanded social transfers and progressive tax reforms. Results indicate sustained infrastructure and rural productivity spending have high output multipliers while well-targeted transfers reduce income inequality. However, institutional absorptive capacities condition realization of social returns. Complementary governance enhancements like project oversight and competitiveness in public investment allocation prove vital. Regional peer benchmarking provides comparative lessons. Altogether, evidence-based fiscal reorientation towards addressing pressing human capital, rural-urban and firm competitiveness constraints can accelerate inclusive growth in Myanmar if pursued prudently. Sustainable expansion requires strengthening public financial management (PFM) systems and results monitoring.

The problems of macroeconomics as institutional problems: complementing the ‘what went wrong’ story with a social epistemology perspective

Abstract After the financial crisis of 2008, many economists expressed dissatisfaction with the state of macroeconomics. They criticised deficiencies in the dominant dynamic stochastic general equilibrium modelling approach and conceptions of good macroeconomic research behind that dominance. This paper argues that there is a deeper problem in macroeconomics, which remains unaddressed. I connect existing literature critical of the institutions of macroeconomics and of economics in general to the institutional preconditions of effective criticism outlined by the philosopher Helen Longino. I find that as an epistemic community, macroeconomics does not function in a way that adequately supports critical evaluation of established beliefs, norms and practices. This failure may partly explain why many views on macroeconomic modelling, the tenability of which economists questioned after the crisis, were able to persist for so long. My analysis gives additional support to several recent proposals for institutional reforms in economics.

A DSGE Model with Government-owned Banks

Abstract How relevant are government-owned banks in the economy, especially during recessions? We study the role of government-owned banks in a dynamic stochastic general equilibrium (DSGE) model with heterogeneous financial intermediaries, heterogeneous households, and minimum capital requirement constraints. We show that the capitalization of government-owned banks during recessions smooths the effects of a negative shock and helps the economy recover more quickly. However, these stabilizing effects could be partially offset by banks’ inefficiency in transforming one unit of capital into loans. Therefore, ignoring the heterogeneity between private and government-owned banks may lead to misleading assessments and conclusions regarding the effects of economic policies on the macroeconomic and banking variables. This is particularly important for evaluating the effectiveness of macroprudential policies.

The Response of Macroeconomic Variables to Government Spending Shocks in the Sudanese Economy 1989-2019: Comparing the Structural Shocks (DSGE Approach) and Impulse Response (SVAR Model)

The importance that different (approaches and models) to modeling the macroeconomy place on theoretical coherence compared to their capacity to match the data and the quality of the econometric model description varies. Dynamic stochastic general equilibrium (DSGE) models are more theoretical, whereas vector autoregression (SVAR) models provide a better match to the data. For developed economies, there are well-established publications on measuring the response of economic indicators to government spending shocks and aggregate macroeconomic activity. In addition, such empirical studies in emerging nations are scarce. This research seeks to fill this void by utilizing the DSGE model and the SVAR approach to investigate the influence of the response of macroeconomic variables to government spending shocks in the Sudanese economy from 1989 to 2019. The findings indicate that the influence of government expenditure shocks on the Sudanese economy is inconsistent with Keynesian principles, as some selected macroeconomic indicators do not respond positively to government expenditure shocks. The non-responsiveness of the inflation rate and exchange rate to government expenditure shocks is demonstrated; this finding may indicate the monetary authority’s weakness in managing monetary variables in the Sudanese economy. In most situations, fiscal and monetary policies were in sync, and “double expansionary” and “double contractionary” policy coordination may be the proper approach; and also create tools that fit the Sudanese economy’s structure.

Modeling the impact of COVID-19 on the tourism sector in Mauritius: A dynamic stochastic general equilibrium analysis

This paper develops a Dynamic Stochastic General Equilibrium model to gauge on the detrimental effects of COVID-19 on the tourism sector and consequently on the macroeconomy of Mauritius. Findings demonstrate COVID-19-induced tourism export shock triggering subdued exports, imports, investments and tax revenues while government debt, inflation rate, transfer income experienced bullish momentum. Overall, results from the model bode well with the real macroeconomic conditions which prevailed post the pandemic. Policywise, findings advocate the development of a new sector to diversify the exporting arm of the Mauritian economy. Our model can be used not only by local authorities but also by foreign economies which exhibit similar features to those of the Mauritian economy in view of shaping out optimal policies.

Effect of Financial Frictions on Monetary Policy Conduct: A Comparative Analysis of DSGE Models with and without Financial Frictions

In this study, we explored the impact of bank leverage and financial frictions on the transmission of real and financial shocks. Two new Keynesian dynamic stochastic general equilibrium (DSGE) models, with and without financial frictions, were employed in the context of the Tunisian economy. In the analysis, we considered three types of shocks—productivity, monetary, and adverse bank capital shocks. The findings reveal that, in the model with financial frictions, the response of macroeconomic and financial variables to demand and supply shocks was more pronounced than in the baseline model, where frictions primarily exist at the borrower level. In this study, we underscored the significance of financial shocks, particularly negative bank capital shocks, in triggering substantial macroeconomic and financial fluctuations, especially when banks operate with higher leverage ratios. Additionally, the inclusion of financial frictions in the DSGE model enhanced its ability to capture the empirical features of real and financial shocks, providing valuable insights for effective monetary policymaking. The results provide foundational insights for Tunisian policymakers to assess the impact of financial frictions in the context of the Tunisian economy. This is significant for the Central Bank of Tunisia, which has not yet adopted a specific DSGE model. Therefore, through our analysis, we determined the amplificatory role of financial frictions in the dynamics of macroeconomic and financial variables in Tunisia and examined the main transmission channels of shock propagation.

Inefficient shocks and optimal monetary policy

Real disturbances that lead to trade-offs between inflation and output gap stabilization have not been studied much in the context of monetary policy settings in emerging markets and developing economies (EMDEs). We identify market price support present in the agriculture sectors of the EMDEs as inefficient shocks that lead to such trade-offs. Using a three-sector new Keynesian dynamic stochastic general equilibrium model, we show trade-offs between core-inflation and output gap stabilization under discretionary and commitment policies. This result departs from the popular viewpoint, stating that the strict core-inflation targeting is an optimal monetary policy for EMDEs susceptible to relative price changes.

Currency Flowback and Opening Up Bond Markets

The internationalization of the Renminbi (RMB) has become a practical reality in global financial markets and economic dynamics. Understanding the mechanism of currency flowback, the movement of the RMB back to China’s domestic financial system after being utilized abroad, is crucial in comprehending the evolving landscape of global finance and China’s position within it. This article investigates the relationship between currency flowback and RMB internationalization through theoretical frameworks, empirical evidence, and model simulations. The opening of bond markets plays a pivotal role in facilitating currency flowback and promoting RMB internationalization by attracting foreign investors and increasing the liquidity of domestic bond markets. A Dynamic Stochastic General Equilibrium (DSGE) model incorporating bond market opening-up illustrates the potential for improved financial stability and economic resilience. However, the conclusions drawn from simulations are contingent on maintaining a moderate foreign holding ratio of domestic bonds to mitigate risks associated with excessive foreign ownership.

Impact of fiscal policies on the labor market with search friction: An estimated DSGE model for Japan

This study investigates the effects of heterogenous fiscal policies on Japan's labor market amidst increasing national debt and economic downturns. We develop a Dynamic Stochastic General Equilibrium model incorporating labor market search friction, staggered wage negotiation, price stickiness and productive government employment. This model is used to compare the impacts of multiple fiscal policies—including government employment spendings, direct government expenditures, and tax cuts—on employment. The model, estimated with macroeconomic data of Japan spanning 1985 to 2019, offers a detailed look at how fiscal policies influence employment dynamics.Our analysis shows that increasing employment within the government sector significantly lowers unemployment rates, with a long-term unemployment reduction effect (multiplier) of −0.4. Collectively, all fiscal policies contribute to 23.96 % of the employment rate fluctuations, with government employment policies playing a dominant role, accounting for 8.55 % of these variations. This underscores the significant stabilizing effect of government employment policies in the labor market and their capacity to boost private sector employment through enhanced household income and increased private sector productivity. This research not only sheds light on the critical role of public sector interventions during economic downturns but also enhances our understanding of the effectiveness of Japan's fiscal policies.

Green transition and financial stability: The role of green monetary and macroprudential policies and vouchers

This paper analyzes a mix of alternative policies in supporting the green transition and the phase-out of fossil fuels, without compromising financial stability. An environmental dynamic stochastic general equilibrium (E-DSGE) model with two sectors (green and brown) and endogenous default is developed to assess potential climate-induced financial stability threats that can be mainly generated through physical and transition risks mechanism. Those risks are evaluated through a compound capital depreciation shock and a carbon tax shock. The paper offers several findings. First of all, a too stringent carbon tax would increase the medium-term default rate in both sectors, harming financial stability due to potentially detrimental effects on banks’ balance sheet. Second, there exists a trade-off in implementing green monetary or macroprudential policies: if a policy can encourage the green transition, financial stability is compromised due to a rise in default rates. In contrast, if a policy aims to reduce vulnerabilities and financial stability risks, then the phase-out of the polluting sector to foster the green sector would be hard to achieve. The model finds that under certain physical and transition risks, a dual interest rate policy, coupled with a fiscal policy in which carbon tax revenues are redistributed to households as vouchers to encourage the consumption of green goods, is able to support the green transition and safeguard financial stability. Therefore, top-down and bottom-up approaches are the keys for sustainability in the whole economy and financial system.

A DSGE model approach to examining the impact of the Russian–Ukrainian War and oil shocks on the Moroccan economy

AbstractThis study explores the impact of oil shocks on the Moroccan economy using a dynamic stochastic general equilibrium (DSGE) model. The DSGE simulations reveal that these shocks, exacerbated by the war in Ukraine, led to a contraction in the output gap, consumption, investment, and savings, as well as increased inflation. These results highlight the vulnerability of the Moroccan economy to external shocks, particularly those linked to energy prices. They underline the need for Morocco to diversify its energy sources and reduce its dependence on oil imports. Furthermore, our results suggest that economic policies should focus on mitigating the effects of these shocks. Future research could seek to refine this model by incorporating other factors likely to influence the Moroccan economy, such as changes in global demand or specific government policies.

Macroprudential policies and Brexit: A welfare analysis

AbstractBrexit will have implications on financial stability and the implementation of macroprudential policies. The United Kingdom (UK) will no longer be subject to the jurisdiction of the European Systemic Risk Board. This paper studies the welfare implications of this change of regime. By means of a dynamic stochastic general equilibrium model, I compare the pre‐Brexit scenario with the new one, in which the UK sets macroprudential policy independently. I find that, after Brexit, the UK is better off by setting its own macroprudential policy without taking into account Europe's welfare as a whole.

The impact of COVID‐19 pandemic on the Thai economy and the effectiveness of monetary policy: A Bayesian DSGE model approach

AbstractThis study estimates a medium‐scale dynamic stochastic general equilibrium model for the Thai economy to evaluate the impact of the COVID‐19 pandemic containment policy on key macroeconomic aggregates. The shock to labor supply is considered as the main transmission channel. The paper discussed the role of monetary policy in regard to economic recovery and also identified the dominant shocks driving the business cycle. Thai quarterly series from 2011Q1 to 2021Q2 is used for the Bayesian estimation of the model. Though the pandemic shock caused a sharp decline in output, consumption and investment, the results suggest a fast recovery in the growth rates of the variables in about 2.5 years. At the same time, the dominant shocks that account for output variation in the medium to long term are investment, labor supply and productivity shocks. Monetary policy is effective in shortening the recovery due to its impact on private investment. The key drivers of Thai household consumption in the long run are investment, labor supply and productivity shocks. On average, the investment shock appears to be the key driver of the business cycle at all horizons.

Debt-financed fiscal stimulus in South Africa

Levels of government debt-to-GDP have been rising substantially for over a decade in emerging market economies such as South Africa, which has led to much debate around the implementation of large-scale debt-financed fiscal stimulus programs in response to the economic fallout of the global covid-19 pandemic. Debt-financed fiscal policies directly stimulate aggregate demand through government expenditure or tax cuts, but their effectiveness is highly dependent on direct crowding-out of private sector expenditure, spill-over effects to the private sector through a higher risk premium on interest rates, and the interaction between fiscal policy and monetary policy. Using an open-economy dynamic stochastic general equilibrium model for South Africa, we identify the effect of six different fiscal policy instruments on short-term and long-term interest rates. These disaggregated expenditure and revenue shocks raise long-term real yields between 18 and 29 basis points, but there are non-negligible differences in the dynamic responses to each fiscal instrument. Our main findings suggest that, in the context of fiscal sustainability, an investment-driven debt-financed fiscal stimulus programme would reduce the government debt-to-GDP ratio, especially in periods of economic slack when monetary policy would typically be more accommodative. In fact, since the global financial crisis, monetary policy has reduced the burden of fiscal adjustment in response to rising debt and a rising risk premium. But further shocks to the risk premium could offset any gains from the current stance of monetary policy (for example, a credit rating shock raises the long-term government bond rate 155 basis points).

Would the Euro Area Benefit from Greater Labor Mobility?

We assess how within euro area labor mobility impacts economic dynamics in response to shocks. In the analysis we use an estimated two-region monetary union dynamic stochastic general equilibrium model that allows for a varying degree of labor mobility across regions. We find that, in contrast with traditional optimal currency area predictions, enhanced labor mobility can either mitigate or exacerbate the extent to which the two regions respond differently to shocks. The effects depend crucially on the nature of shocks and variable of interest. In some circumstances, even when it contributes to aligning the responses of the two regions, labor mobility may complicate monetary policy tradeoffs. Moreover, the presence and strength of financial frictions have important implications for the effects of labor mobility. If the periphery’s risk premium is more responsive to its indebtedness than our estimates, there are various shocks for which labor mobility may help stabilize the economy. Finally, the euro area’s economic performance following the Global Financial Crisis would not have been necessarily smoother with enhanced labor mobility.