Dynamic Stochastic General Equilibrium Model Research Articles

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.

Empirical evidence on the Euler equation for investment in the US

SummaryIs the typical specification of the Euler equation for investment employed in dynamic stochastic general equilibrium (DSGE) models consistent with aggregate macro data? The answer is yes using state‐of‐the‐art econometric methods that are robust to weak instruments and exploit information in possible structural changes. Unfortunately, however, there is very little information about the values of the parameters in aggregate data because investment is unresponsive to changes in capital utilization and the real interest rate. Bayesian estimation using fully specified DSGE models is more accurate due to both informative priors and cross‐equation restrictions.

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.

Inter-industry trade and business cycle dynamics

Abstract Motivated by the increased importance of trade between industrialized and less-developed countries, we build a two-sector dynamic stochastic general equilibrium model featuring inter-industry trade as well as intra-industry trade to analyze the business cycle dynamics of industrialized countries. We find that import-competing sectors are more sensitive to domestic productivity shocks than exporting sectors, due to their stronger reliance on domestic demand. This generates pressure to adjust relative prices and to reallocate factors of production. It also propagates the international spillover effects of productivity shocks leading to stronger business cycle comovement across countries, relative to a traditional business cycle model that does not feature inter-industry trade.

The financialization of local government debt in China and its risk transmission to commercial banks

China's local government debt has risen sharply due to fiscal stimulus and decentralized financing. This debt expansion increases systemic risk as default risk is transmitted to banks, the primary holders of local debt. Using a Dynamic Stochastic General Equilibrium model incorporating local governments and banks, we show that local debt expansion increases banks' nonperforming loans and crowds out private credit, increasing bank risk-taking. We empirically examine 2010–2019 data on 350 Chinese banks and find that the level of local debt positively impacts bank risk-taking, especially low-capital, nonstate, and unlisted banks. The mechanisms operate through an increase in nonperforming loans due to default risk and a reduced regional repayment capacity due to crowded-out private credit. Our study reveals the impact of local debt on bank risk and financial stability in China. Policy implications include strengthening bank regulation and pursuing diversified government financing.

From parameters to policies: sensitivity analysis and fiscal and monetary reactions

PurposeThis paper seeks to explore the sensitivity of these parameters and their impact on fiscal policy outcomes. We use the existing literature to establish possible ranges for each parameter, and we examine how changes within these ranges can alter the outcomes of fiscal policy. In this way, we aim to highlight the importance of these parameters in the formulation and evaluation of fiscal policy.Design/methodology/approachThe role of fiscal policy, its effects and multipliers continues to be a subject of intense debate in macroeconomics. Despite adopting a New Keynesian approach within a macroeconomic model, the reactions of macroeconomic variables to fiscal shocks can vary across different contexts and theoretical frameworks. This paper aims to investigate these diverse reactions by conducting a sensitivity analysis of parameters. Specifically, the study examines how key variables respond to fiscal shocks under different parameter settings. By analyzing the behavioral dynamics of these variables, this research contributes to the ongoing discussion on fiscal policy. The findings offer valuable insights to enrich the understanding of the complex relationship between fiscal shocks and macroeconomic outcomes, thus facilitating informed policy debates.FindingsThis paper aims to investigate key elements of New Keynesian Dynamic Stochastic General Equilibrium (DSGE) models. The focus is on the calibration of parameters and their impact on macroeconomic variables, such as output and inflation. The study also examines how different parameter settings affect the response of monetary policy to fiscal measures. In conclusion, this study has relied on theoretical exploration and a comprehensive review of existing literature. The parameters and their relationships have been analyzed within a robust theoretical framework, offering valuable insights for further research on how these factors influence model forecasts and inform policy recommendations derived from New Keynesian DSGE models. Moving forward, it is recommended that future work includes empirical analyses to test the reliability and effectiveness of parameter calibrations in real-world conditions. This will contribute to enhancing the accuracy and relevance of DSGE models for economic policy decision-making.Originality/valueThis study is motivated by the aim to provide a deeper understanding of the roles macroeconomic model parameters play concerning responses to expansionary fiscal policies and the subsequent reactions of monetary authorities. Comprehensive reviews that encompass this breadth of relationships within a single text are rare in the literature, making this work a valuable contribution to stimulating discussions on macroeconomic policies.

Analysing the response of CO2 emissions to business cycle in a developing economy: evidence for South Africa post-apartheid era

Introduction: This research addresses the response of CO2 emissions to economic fluctuations in South Africa post-Apartheid, covering the period 1990–2018. While previous studies focused on developed countries, limited attention has been given to sub-Saharan developing nations. The study challenges the assumption of constant emissions elasticity in current forecasts.Methods: The study employs a two-step strategy. Firstly, the rolling window regression with Hodrick-Prescott filtering was used to investigate whether the CO2 emissions elasticity varies over time. Secondly, a Markov-switching approach was used to examine the regime-switching behavior in GDP.Results and Discussion: Results suggest that CO2 emisssions elasticity varies over time. This was confirmed through alternative filtering techniques (Christiano-Fitzgerald, Baxter King, and the Butterworth filter). Markov-switching analysis revealed a regime-switching behavior in GDP, indicating negative CO2 emissions elasticity during recessions and positive elasticity during expansions. These findings persist even when accounting for monetary policy shocks and productivity shocks in the Environmental Dynamic Stochastic General Equilibrium (E-DSGE) model. Noteworthy is that South Africa is among the top 20 greenhouse gas emitters globally.Conclusion and recommendations: The study recommends tailored carbon-pricing policies that are conscious to the countercyclical nature of business cycles. Pricing emissions higher during economic upswings aligns with periods of growth. Additionally, the government is advised to invest in research and development for energy conservation, efficiency, and renewable technologies to counterbalance emissions growth. Implementing emission caps and tax incentives can further enforce pollution abatement measures. Policymakers should consider these asymmetrical responses when addressing global warming challenges in South Africa.

Inflation response in a New Keynesian model with money illusion

AbstractThis study investigates the role of money illusion (MI) in a dynamic stochastic general equilibrium model. We introduce MI such that households, in their intertemporal optimization, erroneously recognize nominal variables as real ones. We find that first, our model could exhibit money nonneutrality in the long run; second, the Taylor principle is a sufficient condition for determinacy but not a necessary condition; third, the response to output in monetary policy rule matters for the model not to exhibit money nonneutrality in the long run; and finally, MI could flatten the slope that represents the output‐inflation trade‐off.

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).

A Critical Analysis of the Financial Frictions Approach in a Minskyan Perspective

The concept of financial frictions is at the core of the Financial Frictions Approach (FFA) which underlines that to explain the financial crisis of 2007–2008 it is sufficient to add the financial system to the New Keynesian Dynamic Stochastic General Equilibrium (NK-DSGE) model. Many economists have cited Hyman Minsky among those who “emphasized the importance of financial frictions.” The aim of this work is: 1) to show that Minsky cannot be considered the precursor of the FFA and that FFA does not allow for a solid explanation of financial crises; and 2) to present a sound explanation of the financial instability affecting capitalist economies based on two teachings characterizing Minsky’s work. The first consists in Minsky’s interpretation of John Maynard Keynes’s General Theory, which recovers the revolutionary elements of Keynes’s thought neglected by the Neoclassical Synthesis. The second teaching consists in underlining the need to integrate Keynes’s and Joseph Schumpeter’s theoretical frameworks.

Fiscal Policy in a DSGE Model of a Resource-Rich Emerging Economy: The Nigerian Experience

This paper examines the role of fiscal policy in driving macroeconomic dynamics in a resource-rich emerging economy like Nigeria. Specifically, the paper investigates the macroeconomic implications of fiscal policy using a small open economy dynamic stochastic general equilibrium model that features oil in the fiscal rule. The model is estimated via Bayesian methods using data covering the period 2010Q1- 2021Q1. The results show that the feedback coefficient of output in the fiscal rules is mainly negative, indicating a counter-cyclical fiscal stance. Also, increased oil revenue leads to a rise in government consumption, investment and transfer payments. Further evidence indicates that government spending and transfer payments rose in response to increased debt. We also show that fiscal shocks are highly persistent and that government spending on consumption and investment, tax instruments and transfer are expansionary.

James Tobin on Overlapping Generations Models and the Microeconomic Foundations of Macroeconomics Reconsidered

The American Keynesian economist and Nobel laureate James Tobin entitled his contribution to the inaugural issue of Journal of Money, Credit and Banking “A General Equilibrium Approach to Monetary Theory” (1969) yet he was sharply critical of the version of general equilibrium analysis used in the now-prevalent dynamic stochastic general equilibrium (DSGE) approach to macroeconomic modeling. He also rejected claims that overlapping generation (OLG) models provided a choice-theoretic foundation for the holding of fiat money, denying that the assumption that people held fiat money because no other asset existed was less arbitrary than allowing costs of transactions between assets to be non-zero. Yet, while not accepting OLG as the explanation of why people hold fiat money, Tobin, in a series of articles from 1967 to 1983 (some joint with Walter Dolde), placed the life-cycle model of consumption and saving (whose origins he attributed to an earlier Yale economist, Irving Fisher) into an OLG setting. This article examines Tobin’s critiques of DSGE and OLG modelling in macroeconomics, what he meant by “a general equilibrium approach to monetary theory,” and his contribution placing the life-cycle model in an OLG setting.

The economic and environmental effects of China's environmental expenditure under financing constraints.

Sound ecological and environmental governance systems are critical for promoting green and low-carbon economic transformation and high-quality development. However, financing constraints are major obstacle to the revitalization and transformation of China's real economy. In this study, we constructed an environmental dynamic stochastic general equilibrium (E-DSGE) model that incorporates two types of environmental expenditure and financing constraints, and discussed their economic and environmental effects. Based on this, we further considered the impacts of financing constraints on policy effects. Firstly, we found that increases in carbon emission reduction subsidies in government expenditure (1) increase total economic output and (2) motivate enterprises to increase emission reduction efforts and reduce pollution intensity and emissions, thereby reducing the inventory of environmental pollutants while balancing economic benefits and emission reduction. Secondly, increasing the proportion of government special expenditure on environmental protection promote output growth and directly reduces the pollution stock in the environment. However, such policies may also reduce the emission reduction efforts of enterprises, leading to increases in their pollution emissions and intensity. Lastly, the existence of financing constraints is not conducive to the growth of total output but increases the pollution control effect of emission reduction subsidies and pollution prevention expenditure. Application of the E-DSGE model offers new theoretical insight into environmental economics and macroeconomics. Moreover, the results of this study provide a reference for optimizing the structure of fiscal expenditure.

A Study of the Challenges of Digital Currencies to the Traditional Financial System and Their Implications for Economic Policy

Abstract Digital currencies, as an emerging monetary form, have profoundly transformed the landscape of financial transactions and redefined the structure of economic ecosystems, exerting an unprecedented influence on traditional financial systems. This study scrutinizes the ramifications of digital currencies on conventional financial systems, utilizing a theoretical framework as the foundation. It specifically employs Vector Autoregression (VAR) and Dynamic Stochastic General Equilibrium (DSGE) models to construct an impact model that examines the influence of digital currencies on monetary policies. The analysis utilizes empirical data to assess the efficacy of digital currencies in shaping economic policy, focusing particularly on their effect on monetary intermediation targets. The findings reveal that digital currencies significantly affect monetary policy, primarily through mechanisms of interest rate and exchange rate transmission. Moreover, the advent of digital currencies is associated with reductions in the money supply, exchange rates, and credit volumes of commercial banks. The analysis establishes a long-term stable equilibrium among the money supply, digital currency volume, cash leakage rate, fixed-to-floating rate ratio, and excess reserve ratio. Notably, the scale of digital currency exerts the most substantial impact on the money supply, contributing 10.89% to its variance. This study underscores the intricate relationships between digital currencies and economic policies, highlighting their critical role in contemporary financial systems.

External Shocks and Business Cycles in Nigeria: Accounting for the Roles of Domestic Oil-Refining Alternative and Oil Price Fiscal Rule

The paper investigates the role of oil price fiscal rule (OPFR), and functional domestic oil refineries in curtailing the effects of external shocks on the Nigerian economy. A dynamic stochastic general equilibrium (DSGE) model is developed, calibrated and estimated using Random Walk Metropolis sampling method. The model is estimated under the benchmark, OPFR-only, and refinery-only scenarios. The results reveal that building or revamping domestic oil refineries may help the economy to withstand long term shock, but in the short run, the OPFR clearly emerges as the most potent. The non-oil external shocks are not significant under the three scenarios. However, oil-related external shocks have significant implications for business cycles in Nigeria, reinforcing the demand- and supply-side shocks. Furthermore, it is found that there is a need for functional domestic oil refineries in insulating the economy against external shocks, however, there is a huge welfare loss associated with refinery development alone. Thus, policymakers should consider instituting the OPFR to stem external shocks in the short run, while building oil refineries to tackle external shocks in the long run.

Public sector employment rigidity and macroeconomic fluctuation: A DSGE simulation for China.

Public sector employment in China has exhibited pronounced non-cyclical characteristics, with a recruiting scale and wage level showing limited responsiveness to economic fluctuations. The allure of civil service jobs in China has seen a significant resurgence post-COVID-19, with an observable increase in demand among educated job seekers for stable government positions amid growing economic uncertainties. This study investigates the implications of public sector employment rigidity on macroeconomic stability using a dynamic stochastic general equilibrium (DSGE) model integrated with search and matching (S&M) theory. Simulations incorporating alternative government job policies reveal that non-cyclical public employment exacerbates macroeconomic cyclical fluctuations. The low elasticity of public sector wages with respect to corporate wages fosters stable expectations among workers regarding the future value of government jobs, increasing the perceived value of the current state of unemployment. This leads job seekers to voluntarily remain unemployed, reducing labor supply to firms. Meantime, it preserves workers' bargaining power with firms, reinforcing wage stickiness and undermining the stabilizing role of price adjustments in employment. Hypothetical scenario analyses indicate that adopting a pro-cyclical wage policy for the public sector can mitigate the obstacles of wage cuts for firms, stimulate the creation of new jobs during economic downturns, and consequently reduce the magnitude and duration of rising unemployment rates. In contrast, maintaining a non-cyclical public sector wage may not prevent a continuous rise in unemployment or a worsening economic situation, even with expanded sector recruitment. This finding holds significant relevance in the context of the post-COVID era characterized by an economic slump and employment tension, providing theoretical support for establishing a transparent and flexible wage adjustment mechanism in the public sector that is linked to market conditions.

Optimal monetary policy responses to carbon and green bubbles:A two-sector DSGE analysis

This paper investigates the emergence of carbon and green bubbles and their impacts on macroeconomic performance and the environment, with a particular focus on identifying the optimal monetary policy responses. We construct a two-sector dynamic stochastic general equilibrium (DSGE) model that incorporates monetary policy and allows carbon and green rational bubbles to emerge. We find that while supply-side shocks drive bubble formation in both sectors, demand-side shocks have a disproportionate impact on these sectors. The paper also shows that contractionary monetary policies are effective in reducing both carbon emissions and asset bubbles. Optimal monetary policy response to the emergence of asset bubbles is calculated, emphasizing the crucial role of central banks in designing monetary policy rules that account for the emergence of bubbles. Social welfare can be optimized by reducing annual interest rates by 0.0612% and 0.0512% when green and brown bubble sizes increase by 1%, respectively. Furthermore, the most effective strategy to achieve a significant improvement in social welfare in both the short-run and the long-run is to implement policies where nominal interest rates react negatively to both types of asset bubbles simultaneously. The impacts of carbon taxation and green credit policies on asset bubbles are also studied.

Monetary policy in practice: do central banks respond to movements in exchange rate and credit growth?

PurposeThis study examines the importance of exchange rate and credit growth fluctuations when designing monetary policy in Thailand. To this end, the authors construct a small open economy New Keynesian dynamic stochastic general equilibrium (DSGE) model. The model encompasses several essential characteristics, including incomplete financial markets, incomplete exchange rate pass-through, deviations from the law of one price and a banking sector. The authors consider generalized Taylor rules, in which policymakers adjust policy rates in response to output, inflation, credit growth and exchange rate fluctuations. The marginal likelihoods are then employed to investigate whether the central bank responds to fluctuations in the exchange rate and credit growth.Design/methodology/approach This study constructs a small open economy DSGE model and then estimates the model using Bayesian methods.Findings The authors demonstrate that the monetary authority does target exchange rates, whereas there is no evidence in favor of incorporating credit growth into the policy rules. These findings survive various robustness checks. Furthermore, the authors demonstrate that domestic shocks contribute significantly to domestic business cycles. Although the terms of trade shock plays a minor role in business cycles, it explains the most significant proportion of exchange rate fluctuations, followed by the country risk premium shock.Originality/value This study is the first attempt at exploring the relevance of exchange rate and credit growth fluctuations when designing monetary policy in Thailand.