Medium-scale DSGE Model Research Articles

The empirical performance of the financial accelerator since 2008

We evaluate the empirical performance of financial frictions à la Bernanke et al. (1999) during and after the Global Financial Crisis. We document that in an ex-post analysis based on nonlinear Bayesian methods, these frictions do not improve the standard medium-scale DSGE model's ability to explain the macroeconomic dynamics during the Great Recession. The reason is that in the estimated model with financial frictions, the drastic post-2008 collapse of investment causes firms' leverage to decline. Taking the model at face value, this would trigger a narrowing of the credit spread, contradicting the observed persistently large credit spread throughout the post-2008 period. Additionally, the estimated model attributes only a minor role to risk shocks à la Christiano et al. (2014). These findings are confirmed independently for US and euro area data.

Merging Structural and Reduced-Form Models for Forecasting

Abstract Recent economic crises have posed important challenges for forecasting. Models estimated pre-crisis may perform badly when normal economic relationships have been disrupted. Meanwhile, forecasting, especially in central banks, is increasingly based on a suite of models, following two main approaches: structural (DSGE) and reduced form. The challenge remains to identify which model – or combination of models – is likely to make better forecasts in a changing environment. We explore this issue by assessing the forecasting performance of combinations of a medium-scale DSGE model with standard reduced-form methods applied to the Spanish economy and a reference period that includes both the great recession and the sovereign debt crisis. Our findings suggest that: (i) the mean reverting properties of the DSGE model cause it to underestimate the growth of real variables following the inclusion of crisis episodes in the estimation period; (ii) despite this, reduced-form VARs benefit from the imposition of an economic prior from the structural model; but (iii) pooling information in the form of variables extracted from the structural model with (B)VAR methods does not improve forecast accuracy. By analysing the quantiles of the predictive distributions, we also provide evidence that merging models can help improve the forecast in a context including crisis episodes.

The Origins of Monetary Policy Disagreement: The Role of Supply and Demand Shocks

Abstract We investigate how dissent in the FOMC is affected by structural macroeconomic shocks obtained using a medium-scale DSGE model. We find that dissent is less (more) frequent when demand (supply) shocks are the predominant source of inflation fluctuations. In addition, supply shocks are found to raise private sector forecasting uncertainty about the path of interest rates. Since supply shocks impose a trade-off between inflation and output stabilization while demand shocks do not, our findings are consistent with heterogeneous preferences over the dual mandate among FOMC members as a driver of policy disagreement.

Technology diffusion and international business cycles

This paper shows that the cross-country diffusion of innovations forms a critical channel through which macroeconomic shocks are transmitted across economies. This inference is obtained from a two country, medium scale DSGE model that includes an endogenous growth mechanism. R&D activity and innovation are the main components of this mechanism and they are introduced through a labor-augmenting technology. The model features international diffusion of technologies as the innovations by a firm are not only adopted by other firms within a country but also by those in the other country. Estimating the model with US and Euro Area data, I observe that foreign shocks contribute a high share to the macroeconomic volatility in each economy. By contrast, foreign shocks make a negligible contribution when the model is estimated after shutting down technology diffusion. The results, more generally, show that it is not technology shocks, nor any other shock, but the transmission of shocks through the diffusion of new technologies that is the key driver of international business cycles.

Trade Policies and Fiscal Devaluations

Fiscal devaluations—an increase in import tariffs and export subsidies (IX) or an increase in value-added taxes and payroll subsidies (VP)—have been shown to provide as much stimulus under fixed exchange rates as a currency devaluation. We find that if agents expect policies to be reversed and the tax pass-through is large, VP is contractionary and IX provides a modest boost. In our medium-scale DSGE model, both features are crucial in accounting for Germany’s underperformance in response to VP in 2007. These findings cast doubt on fiscal devaluations as a cyclical stabilization tool when monetary policy is constrained. (JEL E32, E52, E62, F13, F33, H20)

Unconventional monetary policy and the bond market in Japan: A new Keynesian perspective

Using the lens of a medium scale DSGE model, we analyze macroeconomic effects of Japan’s unconventional monetary policy which is known as Qualitative and Quantitative Easing (QQE). Our focus is on the bond market. The model features: (i) commercial bank’s demand for excess reserve in response to liquidity risk and (ii) linkage among central bank, commercial banks and the government via government bonds and bank reserve. We simulate the policy effects of a quantitative easing (QE) shock and a negative shock to the interest rate on excess reserve (IOER). The QE multiplier for real GDP is 1.94 and it has substantial effect on lowering the bond yield in line with the policy target of QQE. On the other hand, an IOER cut has qualitatively similar effects on the real and financial sectors but quantitatively its effect is of second order importance. In light of these policy simulations, we evaluate Japan’s recent yield curve control policy.

Macroeconomic stabilisation properties of a euro area unemployment insurance scheme

In this paper we use a medium-scale DSGE model to quantitatively assess the macroeconomic stabilisation properties of a supranational unemployment insurance scheme. The model is calibrated to the euro area’s core and periphery and features a rich fiscal sector, sovereign risk premia and labour market frictions. Adopting both simple policy rules and optimal policies for the centralised insurance scheme, our simulations point to enhanced business cycle synchronisation and inter-regional consumption smoothing. The results suggest a sizeable reduction in the volatility of macroeconomic aggregates at the region-level, while the cross-regional correlation of unemployment and inflation increases significantly, compared to the decentralised setting. The higher degree of inter-regional risk-sharing comes at the cost of sizable fiscal transfers. Limiting such transfers via claw-back mechanisms reduces the degree of stabilisation across countries.

Behavioral New Keynesian Models: An empirical assessment

This paper uncovers the fact that cognitive discounting modeled à la Gabaix (2020) is highly generalizable to alternative models and expectational assumptions by offering a mathematically tractable way of introducing behavioral elements in linearized models. This is not the case for other models of bounded rationality, as most derivations, if not all among those proposed up to today, are algebraically too cumbersome to be of general applicability.This finding is used to introduce cognitive discounting into the Smets and Wouters (2007) model, hence building and estimating the first micro-founded behavioral medium scale DSGE model, to my knowledge. The empirical estimation shows that the data prefers a substantial degree of bounded rationality even in a model with as many frictions as the Smets and Wouters model.

Data Cloning Estimation and Identification of a Medium-Scale DSGE Model

We apply the data cloning method to estimate a medium-scale dynamic stochastic general equilibrium model. The data cloning algorithm is a numerical method that employs replicas of the original sample to approximate the maximum likelihood estimator as the limit of Bayesian simulation-based estimators. We also analyze the identification properties of the model. We measure the individual identification strength of each parameter by observing the posterior volatility of data cloning estimates and access the identification problem globally through the maximum eigenvalue of the posterior data cloning covariance matrix. Our results corroborate existing evidence suggesting that the DSGE model of Smeets and Wouters is only poorly identified. The model displays weak global identification properties, and many of its parameters seem locally ill-identified.

Yield curve and the macroeconomy: Evidence from a DSGE model with housing

The slope of the yield curve has long been found to be a useful predictor of future economic activities, but the relationship is unstable. One change we have identified in this paper is that, between the early 1990s and the collapse of the housing market in 2007, movements at the long end of the yield curve have an increase in predictive power. We use a medium-scale DSGE model with a housing sector and a yield curve as a guide to find out the sources of such change. The model implies that an increase in the short-term interest rate and a decrease in the long-term interest rate have different impacts on the economy, and to use the slope as a predictor one needs to distinguish movements at the two ends of the yield curve. Based on simulated data from the model, we find that nominal wage rigidities and the capital adjustment costs are closely related to the predictive power of the yield curve. This result is further confirmed with actual data.

Trade policies and fiscal devaluations

Fiscal devaluations—an increase in import tariffs and export subsidies (IX) or an increase in value-added taxes and payroll subsidies (VP)—have been shown to provide as much stimulus under fixed exchange rates as a currency devaluation. We find that if agents expect policies to be reversed and the tax pass-through is large, VP is contractionary and IX provides a modest boost. In our medium-scale DSGE model, both features are crucial in accounting for Germany’s underperformance in response to VP in 2007. These findings cast doubt on fiscal devaluations as a cyclical stabilization tool when monetary policy is constrained.

Interpreting Structural Shocks and Assessing Their Historical Importance

Abstract We revisit three major US recessions through the lens of a standard medium-scale DSGE model (Smets, F., and R. Wouters. 2007. “Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach.” The American Economic Review 97: 586–606) augmented with financial frictions. We first estimate the DSGE model using a Bayesian approach for three alternative periods, each containing a major US recession: the Great Depression, the Stagflation and the Great Recession. Then, we assess the stability of structural parameters, and analyze what frictions were particularly important and what shocks were the main drivers of aggregate fluctuations in each historical period. This exercise can be understood as a test of the standard New-Keynesian DSGE model with financial accelerator in closed economies. We find that the estimated DSGE model is able to provide a sound explanation of all three recessions by closely relating both estimated structural shocks and frictions with well known economic events.

Monetary policy uncertainty and firm dynamics

This paper uses a FAVAR model with external instruments to show that monetary policy uncertainty shocks are recessionary and are associated with an increase in firms' exit and a decrease in firms' entry. At the same time, the stock price declines, while the TFP increases in the medium run. To explain this result, we build up and estimate a medium-scale DSGE model featuring firm heterogeneity and endogenous firm entry and exit. These features are crucial in matching the empirical responses. The baseline model outperforms an alternative model without firm dynamics in reproducing the FAVAR responses and implies a larger effect of monetary policy uncertainty shock on the real economic activity.

A Medium-Scale DSGE Model for the Integrated Policy Framework

A Medium-Scale DSGE Model for the Integrated Policy Framework

Phase-Dependent Monetary and Fiscal Policy

This paper studies how the effects of monetary and fiscal policy vary depending on the business cycle phase. It shows that in a medium-scale DSGE model, estimated on US data, monetary policy has a stronger impact on the economy in downturns and booms. Labor and capital income taxes display similar patterns. Government expenditure shocks and consumption tax shocks, on the contrary, have a stronger impact on output in depressions and recoveries. The paper also shows that accounting for the source of business cycle fluctuations is potentially important when assessing state-dependence in policy transmission.

A Medium-Scale Bayesian DSGE Model for Kazakhstan with Incomplete Exchange Rate Pass-Through

This paper analyzes the sources of business cycle fluctuations in Kazakhstan and the relevance of various frictions in the economy using a medium-scale DSGE model with imperfect exchange rate pass-through. We estimate the model via Bayesian methods and present estimates of structural parameters of the model and highlight the role of various shocks in explaining the actual dynamics of observed variables. In the absence of quality and deseasonalized data, we show that the DSGE model with time-varying markups possesses a reasonable level of accuracy as the one-sided Kalman filter predictions match the dynamics of the observable variables. Posterior estimates of the model show that the long-run growth rate of output is 4.5% per annum and the exchange rate pass-through to domestic prices is between 21% and 35% within a quarter. We also find that risk premium shocks have played an important role in determining the inflation rate, the interest rate and the real exchange rate in the economy since 2015.

Monetary Policy Under Imperfect Information and Consumer Confidence

Although it is generally accepted that consumer confidence measures are informative signals about the state of the economy, theoretical macroeconomic models designed for the analysis of monetary policy typically do not provide a role for them. I develop a framework with asymmetric information in which the efficacy of monetary policy can be improved, when the imperfectly informed central banks include confidence measures in their information set. The beneficial welfare effects are quantitatively substantial in both a stylized New Keynesian model with optimal monetary policy and an estimated medium-scale DSGE model.

The Effects of Investor Confidence Shocks on Business Cycles

This paper extends a quantitative medium-scale New-Keynesian DSGE model with financial intermediaries to account for shocks to investor confidence. Shocks of this nature manifest themselves as per period changes to financial intermediaries' leverage ratios. A Bayesian MCMC approach is utilized to estimate the base and extended model, including shock process parameters, for the U.S. economy using five macroeconomic time series from 1984 through 2019. The estimation results suggest that confidence shocks have a large and sustained effect on the real economy. Overconfidence initially provides a boost to the economy but this effect subsides and then triggers a prolonged recession. In the base model, a decomposition of U.S. output growth into its constituent shocks shows that the effect of negative shocks to capital quality contributed significantly to the financial crisis of 2008. However, this effect is muted in the extended model suggesting that shocks to confidence were important contributors to the output gap during the Great Recession.

Evaluating the Unconventional Monetary Policy of the Bank of Japan: A DSGE Approach

When the nominal interest rate reaches the zero lower bound (ZLB), a conventional monetary policy, namely, the adjustment of short-term interest rate, may become impractical and ineffective for central banks. Therefore, quantitative easing (QE) is one of the few available policy options of central banks for stimulating the economy and dealing with deflationary pressure. Since February 1999, the Bank of Japan (BoJ) has conducted several unconventional monetary policy programs. Considering the scarce research in this field from a structural macroeconomic model approach, a medium-scale New Keynesian DSGE model with government bonds of different maturities was developed to check the portfolio rebalancing channel of quantitative qualitative easing (QQE) conducted by the BoJ from April 2013 on the basis of the assumption of imperfect asset substitutability. The model was calibrated on the basis of the structure of the Japanese economy in April 2013. The main conclusion is that the BoJ’s asset purchase has a real effect on pushing output and inflation higher, and long-term interest rates lower. Sensitivity simulation analysis shows that, given the same size of asset purchase, the persistence of asset purchase determines the peak effect in the short run. A long-lasting asset purchase can push up inflation higher, and long-term interest rates lower for a relatively longer period, but the long-run effect on output and investment does not have much difference. The policy implication for BoJ is just to announce a long-lasting QE program and make it credible to the market.

Deep recessions, slowing productivity and missing (dis-)inflation in the euro area

This paper analyses the role of endogenous total factor productivity dynamics in explaining business cycle persistence as well as the missing (dis-)inflation and productivity puzzles in the euro area. We show by means of an estimated medium-scale DSGE model in which TFP evolves endogenously as the result of costly investment in R&D and technology adoption that the endogenous slowdown in total factor productivity can explain the depth and persistence of the output drop and the weak recovery following the double-dip recession in the euro area. Our results suggest that a decrease in R&D efficiency and innovation is key in explaining the pre-crisis euro area productivity slowdown, while as of 2008 a crises-induced drop in technology adoption constitutes the most important factor. We document a flattening of the Phillips curve relationship under the endogenous TFP mechanism, resulting from the interaction between inflation and productivity dynamics. The endogenous reaction in TFP dampens the inflation response over the business cycle and can thus help explain both the moderate fall in euro area inflation during its crises and its sluggish increase in the subsequent recovery.