Practical tools for policy analysis in DSGE models with missing channels

October 31, 2012

By Dario Caldara, Richard Harrison and Anna Lipinska

In this paper we analyze the propagation of shocks originating in sectors that are not present in a baseline dynamic stochastic general equilibrium (DSGE) model. Specifically, we proxy the missing sector through a small set of factors, that feed into the structural shocks of the DSGE model to create correlated disturbances. We estimate the factor structure by matching impulse responses of the augmented DSGE model to those generated by an auxiliary model. We apply this methodology to track the effects of oil shocks and housing demand shocks in models without energy and housing sectors.

I have selected this paper because I very it very intriguing, in a too-good-to-be-true way. Suppose you have estimated a New-Keynesian model that comes down to three equations. You want to add shocks that have not been considered in the estimation. This paper suggest a way to add these shocks without touching the initial estimates, which you cannot re-estimate anyway for identification reasons. In other words, this is a procedure that would allow to bypass idenfication issues and add many more shocks. As I said, I am intrigued.

Data Revisions in the Estimation of DSGE Models

October 28, 2012

By Miguel Casares and Jesús Vázquez Pérez

Revisions of US macroeconomic data are not white-noise. They are persistent, correlated with real-time data, and with high variability (around 80% of volatility observed in US real-time data). Their business cycle effects are examined in an estimated DSGE model extended with both real-time and final data. After implementing a Bayesian estimation approach, the role of both habit formation and price indexation fall significantly in the extended model. The results show how revision shocks of both output and inflation are expansionary because they occur when real-time published data are too low and the Fed reacts by cutting interest rates. Consumption revisions, by contrast, are countercyclical as consumption habits mirror the observed reduction in real-time consumption. In turn, revisions of the three variables explain 9.3% of changes of output in its long-run variance decomposition.

In a typical DSGE model, all agents take decisions given the current state of the economy. The estimate of that state is subject to revision, whose amplitude is in the same order of magnitude as the business cycle. So these revisions got to have an impact and they do as this paper shows.

Note that it makes use of the real-time dataset at the Federal Reserve Bank of Philadelphia. The Federal Reserve Bank of St. Louis also has one, ALFRED, which is derived from the popular FRED.

Trading Volume in General Equilibrium with Complete Markets

October 23, 2012

By Eric Aldrich

This paper investigates asset trade in a general-equilibrium complete-markets endowment economy with heterogeneous agents. It shows that standard no-trade results cease to hold when agents have heterogeneous beliefs and that substantial trade volume is generated, even in the presence of a spanning set of assets. Further, trade volume and price movements have a positive relationship in the model, as is well documented in the empirical literature. This paper also develops a computational algorithm for solving finite-period heterogeneous-beliefs economies and demonstrates how the problem is well suited for large-scale parallel computing methods, such as GPU computing.

This paper shows two important things: first, it is possible to generate economies where agents trade with each other in assets, and do this a lot. This has been a big issue in the previous literature. Second, it makes methodological advances in computing equilibria for heterogeneous agent models with finite horizons. That is quite a bog deal as the literature is more and more moving into economies that feature heterogeneity within life-cycles.

Monetary policy in a DSGE model with “Chinese Characteristics”

October 7, 2012

By Chun Chang, Zheng Liu and Mark M. Spiegel

We examine optimal monetary policy under prevailing Chinese policy – including capital controls and nominal exchange rate targets – in a DSGE model calibrated to Chinese and global data. Under the closed capital account, domestic citizens are prohibited from holding foreign assets. Foreign currency revenues are sold to the central bank, which then sterilizes these purchases by issuing domestic debt. Uncovered interest parity conditions do not hold, so sterilization results in transfers between the private sector and the government. Given a negative shock to relative foreign interest rates, similar to that which occurred during the global financial crisis, sterilization costs increase and optimal policy calls for a reduction in sterilization activity, resulting in an easing of monetary policy and an increase in Chinese inflation. We then compare these dynamics to three alternative liberalizations: A partial opening of the capital account, removing the exchange rate peg, or doing both simultaneously. The regime with liberalized capital accounts and floating exchange rate yields the lowest losses to the central bank under the foreign interest rate shock. However, intermediate reforms do less well. In particular, letting the exchange rate float without opening the capital account results in higher losses following the interest rate shock than the benchmark case of no liberalization.

Many have been clamoring for the People’s Bank of China to relax its policies, and this interesting paper looks at how the Chinese economy would react to foreign interest rate shocks under various scenarios. Relaxed policies seem to lead to better outcones, but one has to wonder how costly a transition to these new policies would be. Simulating such exit strategies (there is not much economic history to draw from) would be particularly interesting with this model.

Monetary policy with heterogeneous agents

October 5, 2012

By Nils Gornemann, Keith Kuester and Makoto Nakajima

We build a New Keynesian model in which heterogeneous workers differ with regard to their employment status due to search and matching frictions in the labor market, their potential labor income, and their amount of savings. We use this laboratory to quantitatively assess who stands to win or lose from unanticipated monetary accommodation and who benefits most from systematic monetary stabilization policy. We find substantial redistribution effects of monetary policy shocks; a contractionary monetary policy shock increases income and welfare of the wealthiest 5 percent, while the remaining 95 percent experience lower income and welfare. Consequently, the negative effect of a contractionary monetary policy shock to social welfare is larger if heterogeneity is taken into account.

A fine example of how the recent literature analyzing monetary policy in a heterogeneous agent context can lead to interesting results. In particular, it goes against the generally held idea that monetary expansion benefits only the rich (through money injection in the banks).


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