Medium-scale DSGE Model Research Articles

On the welfare and cyclical implications of moderate trend inflation

The welfare and cyclical implications of moderate trend inflation are addressed in an augmented medium-scale DSGE model. Increasing trend inflation from 2 to 4 percent generates a consumption-equivalent welfare loss of about 4 percent. Welfare costs of this magnitude are driven by: staggered wage contracts, trend growth, extended borrowing, a roundabout production structure, and the interaction between trend inflation and shocks to the marginal efficiency of investment (MEI). A sticky-price model abstracting from these features generates much smaller losses. Moderate trend inflation also has important business-cycle implications, interacting much more strongly with MEI shocks than with productivity or monetary shocks.

The state-dependent effects of tax shocks

This paper studies the state-dependent effects of shocks to tax rates. We begin with a stylized model in which clean analytical expressions are available. The model predicts that a tax rate cut is most stimulative for output in periods in which output is relatively high. The model is also used to discuss some conceptual issues related to the construction of tax multipliers. We then consider a medium-scale DSGE model with tax rates on labor and capital income and on consumption. The model is solved via a third order perturbation. Consonant with the intuition from the analytical model, tax multipliers for all three types of tax rates vary significantly across states, and are most stimulative for output in states in which output is high. To evaluate the normative desirability of tax cuts as a tool to combat recessions, we also study the properties of the tax cut welfare multiplier, which measures the change in aggregate welfare conditional on a tax rate change. In contrast to output multipliers, welfare multipliers are found to be countercyclical. A number of extensions and modifications are considered and our conclusions are generally robust.

Uncertainty-dependent effects of monetary policy shocks: A new-Keynesian interpretation

We estimate a nonlinear VAR model to study the real effects of monetary policy shocks in regimes characterized by high vs. low macroeconomic uncertainty. We find unexpected monetary policy moves to exert a substantially milder impact in presence of high uncertainty. We then exploit the set of impulse responses coming from the nonlinear VAR framework to estimate a medium-scale new-Keynesian DSGE model with a minimum-distance approach. The DSGE model is shown to be able to replicate the VAR evidence in both regimes thanks to different estimates of some crucial structural parameters. In particular, we identify a steeper new-Keynesian Phillips curve as the key factor behind the DSGE model’s ability to replicate the milder macroeconomic responses to a monetary policy shock estimated with our VAR in presence of high uncertainty. A version of the model featuring firm-specific capital is shown to be associated to estimates of the price frequency which are in line with some recent evidence based on micro data.This article is part of a Special Issue entitled “Fiscal and Monetary Policies”.

The macroeconomics of the minimum wage

This paper studies the macroeconomic impact of a statutory minimum wage. I demonstrate by means of a medium-scale DSGE model, which I estimate with US data, how the minimum wage impacts aggregate variables. The model framework enables me to take into account various general-equilibrium effects that the minimum wage can potentially trigger. Under the estimated stance of monetary policy, the model predicts that the minimum wage has a negligible effect on the macroeconomy. However, if the Federal Reserve conducted highly dovish monetary policy, the federal minimum wage would substantially affect the macroeconomy. A minimum-wage hike would even cause an economic expansion. The paper also examines the possibility of indexing the minimum wage to an inflation measure. It compares the indexation to price inflation with the indexation to wage inflation. By considering an alternative estimated model, I present evidence that performance standards are an important adjustment channel through which firms react to changes in the minimum wage.

Why Are Fiscal Multipliers Asymmetric? The Role of Credit Constraints

Recent empirical evidence strongly points to the state-dependence of fiscal multipliers which are larger in recessions than in expansions. Yet, standard business cycle models face great difficulty in producing such asymmetric fiscal policy effects. By incorporating endogenously binding collateral constraints into a medium scale DSGE model, we find that fiscal effectiveness can vary substantially across the business cycle. The key to our framework is the state-dependent nature of collateral constraints; binding in bad times while slack in good times, amplifying the effectiveness of fiscal policy and hence generating fiscal multipliers that are larger during recessions.

Term Structure and Real-Time Learning

This paper introduces the term structure of interest rates into a medium-scale DSGE model. This extension results in a multi-period forecasting model that is estimated under both adaptive learning and rational expectations. Term structure information enables us to characterize agents’ expectations in real time, which addresses an imperfect information issue mostly neglected in the adaptive learning literature. Relative to the rational expectations version, our estimated DSGE model under adaptive learning largely improves the model fit to the data, which include not just macroeconomic data but also the yield curve and the consumption growth and inflation forecasts reported in the Survey of Professional Forecasters. Moreover, the estimation results show that most endogenous sources of aggregate persistence are dramatically undercut when adaptive learning based on multi-period forecasting is incorporated through the term structure of interest rates.

Uncertainty-Dependent Effects of Monetary Policy Shocks: A New Keynesian Interpretation

We estimate a nonlinear VAR model to study the real effects of monetary policy shocks in regimes characterized by high vs. low macroeconomic uncertainty. We Â…find unexpected monetary policy moves to exert a substantially milder impact in presence of high uncertainty. We then exploit the set of impulse responses coming from the nonlinear VAR framework to estimate a medium-scale new-Keynesian DSGE model with a minimum-distance approach. The DSGE model is shown to be able to replicate the VAR evidence in both regimes thanks to different estimates of some crucial structural parameters. In particular, we identify a steeper new-Keynesian Phillips curve as the key factor behind the DSGE modelÂ’s ability to replicate the milder macroeconomic responses to a monetary policy shock estimated with our VAR in presence of high uncertainty. A version of the model featuring fiÂ…rm-speciÂ…c capital is shown to be associated to estimates of the price frequency which are in line with some recent evidence based on micro data.

Uncertainty-Dependent Effects of Monetary Policy Shocks: A New Keynesian Interpretation

We estimate a nonlinear VAR model to study the real effects of monetary policy shocks in regimes characterized by high vs. low macroeconomic uncertainty. We find unexpected monetary policy moves to exert a substantially milder impact in presence of high uncertainty. We then exploit the set of impulse responses coming from the nonlinear VAR framework to estimate a medium-scale new-Keynesian DSGE model with a minimum-distance approach. The DSGE model is shown to be able to replicate the VAR evidence in both regimes thanks to different estimates of some crucial structural parameters. In particular, we identify a steeper new-Keynesian Phillips curve as the key factor behind the DSGE model’s ability to replicate the milder macroeconomic responses to a monetary policy shock estimated with our VAR in presence of high uncertainty. A version of the model featuring firm-specific capital is shown to be associated to estimates of the price frequency which are in line with some recent evidence based on micro data.

Limited Asset Market Participation and the Euro Area Crisis. An Empirical DSGE Model

We estimate a medium scale DSGE model for the Euro area with Limited Asset Market Participation (LAMP). Our results suggest that in the recent EMU years LAMP is particularly sizeable (393 during 1993-2012) and important to understand business cycle features. The Bayes factor and the forecasting performance show that the LAMP model is preferred to its representative household counterpart. In the RA model the risk premium shock is the main driver of output volatility in order to match consumption correlation with output. In the LAMP model this role is played by the investment-specific shock, because Non-Ricardian households introduce a Keynesian multiplier effect and raise the correlation between consumption and investments. We also detect contractionary role of monetary policy shocks during the post-2007 years. In this period consumption of Non-Ricardian households fell dramatically, but this outcome might have been avoided by a more aggressive policy stance.

Sentiment and the U.S. business cycle

Psychological factors are commonly believed to play a role on cyclical economic fluctuations, but they are typically omitted from state-of-the-art macroeconomic models.This paper introduces “sentiment” in a medium-scale DSGE model of the U.S. economy and tests the empirical contribution of sentiment shocks to business cycle fluctuations.The assumption of rational expectations is relaxed. The paper exploits, instead, observed data on expectations in the estimation. The observed expectations are assumed to be formed from a near-rational learning model. Agents are endowed with a perceived law of motion that resembles the model solution under rational expectations, but they lack knowledge about the solution’s reduced-form coefficients. They attempt to learn those coefficients over time using available time series at each point in the sample and updating their beliefs through constant-gain learning. In each period, however, they may form expectations that fall above or below those implied by the learning model. These deviations capture excesses of optimism and pessimism, which can be quite persistent and which are defined as sentiment in the model. Different sentiment shocks are identified in the empirical analysis: waves of undue optimism and pessimism may refer to expected future consumption, future investment, or future inflationary pressures.The results show that exogenous variations in sentiment are responsible for a sizable (above forty percent) portion of historical U.S. business cycle fluctuations. Sentiment shocks related to investment decisions, which evoke Keynes’ animal spirits, play the largest role. When the model is estimated imposing the rational expectations hypothesis, instead, the role of structural investment-specific and neutral technology shocks significantly expands to capture the omitted contribution of sentiment.

THE REGIME-SWITCHING VOLATILITY OF EURO AREA BUSINESS CYCLES

We document the strong evidence of time variation in the volatility of Euro Area business cycles since 1970. Then we provide the quantitative sources of these changes using a medium-scale DSGE model allowing time variation in structural disturbance variances. We show that (1) the size of different types of shock oscillates, in a synchronized manner, between two regimes over time, with the high-volatility regime prevailing predominantly in the 1970s, sporadically in the 1980s and 1990s, and during the Great Recession; (2) their relative importance remains, however, unchanged across regimes, where neutral technology shocks and marginal efficiency of investment shocks are the dominant sources of business cycle fluctuations; and 3) these investment shocks, which affect the transformation of savings into productive capital, can be interpreted as an indicator of credit conditions.

What Cycles? Data Detrending in DSGE Models

It is widely-known that different methods of detrending data yield different business cycle features. The choice of the detrending method, however, is usually arbitrarily made. This paper aims at revealing potential pitfalls of different detrending methods for the estimation of a standard medium-scale DSGE model. By comparing nine popular detrending methods, we find that model parameter estimates, variance decompositions, optimal monetary policies, and out-of-sample forecasting performances of the model are all sensitive to how the data are detrended. We also discuss some possible criteria to choose among different methods.

Estimation of Dynamic Models with Occasionally Binding Constraints.

We present an algorithm for estimating non-linear dynamic models, including those featuring occasionally binding constraints. The algorithm extends the Cubature Kalman Filter of Arasaratnam and Haykin (2009) with dynamic state space reduction, to give adequate speed in the presence of occasionally binding constraints, and to ensure that it can handle the large state spaces generated by pruned perturbation solutions to medium-scale DSGE models. We further extend the base algorithm to allow for alternative cubature procedures to improve the tracking of non-linearities. The algorithm relies on the solution method for models with occasionally binding constraints of Holden (2016b). We illustrate that the method can solve some of the identification problems that plague linearized DSGE models.

Macroeconomic Dynamics in Korea during and after the Global Financial Crisis: A Bayesian DSGE Approach

We estimate a medium-scale DSGE model, including a financial accelerator and the search and matching framework in labor markets, for the Korean economy, using the Bayesian technique. The estimated model shows that the recent sluggishness in GDP growth can be explained by slow technology growth, and the decline in CPI inflation is affected by a falling markup in domestic homogeneous goods production and a negative intertemporal consumption preference. Although wages, unemployment, and total labor hours are influenced by various factors, households' weak bargaining power causes a slow recovery in wages, while pushing the unemployment rate down. There was also a spillover from non-big-5 to big-5 firms during the global financial crisis, while monetary and fiscal policy has been mostly conservative in the post-crisis period.

Interest-Rate Pegs, Central Bank Asset Purchases and the Reversal Puzzle

We analyze the macroeconomic implications of a transient interest-rate peg in combination with a QE program in a non-linear medium-scale DSGE model. In this context, we re-examine what has become known as the reversal puzzle (Carlstrom, Fuerst and Paustian, 2015) and provide an analytical explanation for its appearance. We show that the puzzle is intimately related with agents' expectations. If, for instance, agents do not anticipate the peg, the reversal does not appear. The same is true if agents' inflation expectations are influenced by a monetary authority which follows a price-level-targeting rule instead of a standard Taylor rule. In this case, sign reversals do not occur even for very long durations of pegged nominal interest rates.

Fiscal Foundations of Inflation: Imperfect Knowledge

This paper proposes a theory of the fiscal foundations of inflation based on imperfect knowledge and learning. Because imperfect knowledge breaks Ricardian equivalence the scale and composition of the public debt matter for inflation. High moderate-duration debt generates wealth effects on consumption demand that impairs the intertemporal substitution channel of monetary policy: aggressive monetary policy is required to anchor inflation expectations. Counterfactual experiments, in an estimated medium-scale DSGE model, reveal the US economy would have been substantially more volatile over the Great Inflation and Great Moderation periods, had average debt been consistent with levels currently observed in Italy or Japan.

DSGE pileups

The sampling distribution of estimators for DSGE structural parameters tends to be non-normal and/or pile up on the boundary of the theoretically admissible parameter space. This calls into question both the reliability of asymptotic approximations and the presumption of correct specification. This paper seeks to develop a conceptual framework for understanding how these phenomena arise, and to provide pragmatic methods for dealing with them in practice. The results are presented in three examples and a medium scale DSGE model.

Monetary policy shocks: We got news!

We assess the role of monetary policy news shocks in the context of a medium scale DSGE model estimated on US data. We estimate several versions of the model and find decisive evidence in favour of the inclusion of monetary policy news shocks over a two-quarter horizon. According to our results, monetary policy news shocks account for a non-negligible fraction of the variance of real variables, especially at shorter forecast horizons. Further, we document that the importance of monetary policy news shocks goes beyond what was observed in recent years. The historical importance of monetary policy news shocks dates back to the 1999–2006 period when the official FOMC statements provided information about both the current policy setting and the expected future policy path. We also show that adding monetary policy news shocks to the model does not lead to identification problems.

How the capital utilization adjustment cost should be implemented in DSGE model

Variable capital utilization is an important element in recent DSGE models. To allow capital utilization to respond to shocks, the cost of varying utilization is modelled in terms of either accelerated depreciation of capital (Greenwood et al., 1988) or foregone consumption (Christiano et al., 2005). We perform a Bayesian estimation of the standard medium-scale DSGE model augmented with news shocks to examine which specification is supported by the data. The former exhibits a superior fit with the data relative to the latter. We show that it is attributable to the fact that the former explains better the properties of nominal variables, such as inflation and nominal interest rates.

Term Premium Variability and Monetary Policy

Two traditional explanations for the mean and variability of the term premium are: (i) time-varying risk premia on long bonds, and (ii) segmented markets between long- and short-term bonds. This paper integrates these two approaches into a medium-scale DSGE model. We consider two sources of business cycle variability: shocks to total factor productivity (TFP), and shocks to the marginal efficiency of investment (MEI). The ability of the risk approach to match the first moment of the term premium depends upon the relative importance of these two shocks. If MEI shocks are an important driver of the business cycle, then long bonds are a hedge against the business cycle so that the average term premium is negative. The opposite is the case for the TFP shocks. But for either source of shocks, the risk approach to the term premium predicts a trivial amount of variability in the term premium. In contrast, the segmented markets model can easily match both moments. The market segmentation reflects a real distortion, so that smoothing the term premium is typically welfare-improving. There are two difficulties with such a policy. First, the mean level of the term premium will not properly reflect the segmentation distortion because of the risk adjustment. Second, if the term premium is measured with error, the welfare gain of a term premium peg is naturally reduced. The paper demonstrates that both of these effects are quantitatively modest so that the welfare advantage to a term premium peg survives.