Monetary policy for a bubbly world

October 21, 2016

By Vladimir Asriyan, Luca Fornaro, Alberto Martin and Jaume Ventura

We propose a model of money, credit and bubbles, and use it to study the role of monetary policy in managing asset bubbles. In this model, bubbles pop up and burst, generating fluctuations in credit, investment and output. Two key insights emerge from the analysis. First, the growth rate of bubbles, which is driven by agents’ expectations, can be set in real or in nominal terms. This gives rise to a novel channel of monetary policy, as changes in the inflation rate affect the real growth rate of bubbles and their effect on economic activity. Crucially, this channel does not rely on contract incompleteness or price rigidities. Second, there is a natural limit on monetary policy’s ability to control bubbles: the zero-lower bound. When a bubble crashes, the economy may enter into a liquidity trap, a regime in which agents shift their portfolios away from bubbles – and the credit that they sustain – to money, reducing intermediation, investment and growth. We explore the implications of the model for the conduct of “conventional” and “unconventional” monetary policy, and we use the model to provide a broad interpretation of salient macroeconomic facts of the last two decades.

Intriguing paper. Of course, modeling bubbles is tricky business, and the policy prescription will depend on how you generate bubbles. But the message is clear, the monetary authority should receive a clearer mandate to care about financial stability beyond its worries about inflation, and the existence of bubbles adds more fuel to this idea.

What order? Perturbation methods for stochastic volatility asset pricing and business cycle models

October 19, 2016

By Oliver de Groot

When a DSGE model features stochastic volatility, is a third-order perturbation approximation sufficient? The answer is often no. A key parameter – the standard deviation of stochastic volatility innovations – does not appear in the coefficients of the decision rules of endogenous variables until a fourth- or sixth-order perturbation approximation (depending on the functional form of the stochastic volatility process). This paper shows analytically this general result and demonstrates, using three models, that important model moments can be imprecisely measured when the order of approximation is too low. i) In the Bansal-Yaron long-run risk model, the equity risk premium rises from 4.5% to 10% by going to sixth-order. ii) In a workhorse real business cycle model, the welfare cost of business cycles also rise when a fourth-order approximation properly accounts for the presence of stochastic volatility. iii) In a canonical New-Keynesian model, the risk-aversion parameter can be lowered while matching the term premium when a fourth-order approximation is used.

It is important to choose an approximation methods that reflects well for the exercise you are trying to perform. That said, there can also be other avenues, in particular with piecewise-linear and/or grid methods that can work better at potentially a lower cost. This paper highlights hat these are important considerations.

Bootstrapping DSGE models

October 17, 2016

By Giovanni Angelini, Giuseppe Cavaliere and Luca Fanelli

This paper explores the potential of bootstrap methods in the empirical evaluation of dynamic stochastic general equilibrium (DSGE) models and, more generally, in linear rational expectations models featuring unobservable (latent) components. We consider two dimensions. First, we provide mild regularity conditions that suffice for the bootstrap Quasi-Maximum Likelihood (QML) estimator of the structural parameters to mimic the asymptotic distribution of the QML estimator. Consistency of the bootstrap allows to keep the probability of false rejections of the cross-equation restrictions under control. Second, we show that the realizations of the bootstrap estimator of the structural parameters can be constructively used to build novel, computationally straightforward tests for model misspecification, including the case of weak identification. In particular, we show that under strong identification and bootstrap consistency, a test statistic based on a set of realizations of the bootstrap QML estimator approximates the Gaussian distribution. Instead, when the regularity conditions for inference do not hold as e.g. it happens when (part of) the structural parameters are weakly identified, the above result is no longer valid. Therefore, we can evaluate how close or distant is the estimated model from the case of strong identification. Our Monte Carlo experimentations suggest that the bootstrap plays an important role along both dimensions and represents a promising evaluation tool of the cross-equation restrictions and, under certain conditions, of the strength of identification. An empirical illustration based on a small-scale DSGE model estimated on U.S. quarterly observations shows the practical usefulness of our approach.

Nice discussions on ways to improve the assessment of estimated DSGE models. However, this applies only to linear models, which are a subset of DSGE models, not the other way around like the abstract seems to imply.

Foreign Official Holdings of U.S Treasuries, Stock Effect and the Economy: A DSGE Approach

October 15, 2016

John Nana Francois

Previous studies focus on quantifying the effect of foreign official holdings of long-term U.S Treasuries (FOHL) on the long-term interest rate. The consensus is that FOHL has a large and negative effect on the long-term interest rate. The long-term interest rate matters in determining aggregate demand, (Andres et al., 2004). However, these studies discount the macroeconomic implications of FOHL on the U.S economy. This paper extends the literature and studies the macroeconomic implications of FOHL shocks through their impact on the long-term interest rate in a dynamic stochastic general equilibrium (DSGE) model. The model treats short and long-term government bonds as imperfect substitutes through endogenous portfolio adjustment frictions(costs). Three main findings emerge from the baseline model: (1) A positive shock to FOHL impacts the long-term interest rate negatively through a stock effect channel-defined as persistent changes in interest rate as a result of movement along the Treasury demand curve. This result is consistent with the empirical literature; (2) The decline in the long-term interest rate creates favorable economic conditions that feed back into the economy and increases consumption, output and inflation through an endogenous term structure implied by the model and; (3) Monetary authority responds to the increase in inflation and output by raising the short-term interest rate. The simultaneous increase in the short-term interest rate and fall in the long-term interest rate causes the term spread to fall. This last result sheds light on the decoupling of interest rates observed between 2004-2006, a phenomenon known as the “Greenspan Conundrum”. The findings from the DSGE model are supported by impulse response functions obtained from a structural near-Vector Auto-regression(near-VAR) model.

Some people worry about foreign holdings of government debt, in particular by countries deemed not-that-friendly. I never thought this mattered much, and I was not aware of a literature on the topic. This paper make a neat attempt at sorting this out.

The Earned Income Tax Credit: Targeting the Poor but Crowding Out Wealth

October 13, 2016

By Maren Froemel and Charles Gottlieb

In this paper, we quantify the effects of the Earned Income Tax Credit (EITC) from a macroeconomic perspective. We use an incomplete markets model to analyze jointly the labor supply and saving responses to changes in tax credit generosity and their aggregate and distributional implications. In line with existing literature, our results show that the EITC is an effective policy instrument to raise labor force participation and provide insurance to working poor households. However, we show that the EITC also disincentivizes private savings for a large part of the population, except for the poorest transfer recipients. Furthermore, since unskilled labor supply reacts more strongly than skilled workers’ labor supply, wages for low skilled workers fall relative to high skilled workers. Whilst reducing post-tax earnings inequality, the EITC contributes to both a higher skill premium and wealth inequality. Finally, our welfare analysis suggests that EITC expansions are welfare improving for the majority of the population, both ex ante and when accounting for transitional dynamics.

Basic income guarantees are much discussed these days, but with few quantitative analyses performed. As these show that basic income is likely a bad idea, interest should focus on better policies, such as the earned income tax credit applied in the United States. This paper is a nice exercise that demonstrated its advantages and pitfalls from a macroeconomic perspective.

The Fiscal Multiplier in Small Open Economy: The Role of Liquidity Frictions

October 11, 2016

By Jasmin Sin

This paper studies the fiscal multiplier using a small-open-economy DSGE model enriched with financial frictions. It shows that the multiplier is large when frictions are present in domestic and international financial markets. The reason is that in the model government bonds are more liquid than private financial assets and that entrepreneurs face liquidity constraints. A bond-financed fiscal expansion eases these constraints and stimulates investment and hence growth. This mechanism, however, breaks down under the assumption of perfect international capital mobility, suggesting that conventional models which ignore the presence of frictions in international capital markets tend to underestimate the fiscal multiplier.

Interesting point. This could explain why multiplier estimates differ so widely depending on period, regime, country, or model.

Household Borrowing Constraints and Residential Investment Dynamics

September 14, 2016

By Hashmat Khan and Jean-François Rouillard

Why does residential investment lead output in the US and Canada but it is coincident in eurozone countries? In this paper we explore the role of home-equity loans used to boost consumption as a channel that affects residential investment. We consider a multi-agent model where some home-owning households face borrowing constraints that reflect home-equity loans or refinancing constraints. The main contribution of our paper is to highlight that the severity of the households’ borrowing constraints in an economy can generate both stylized facts of residential investment dynamics. In US and Canada, a greater proportion of households rely on home-equity loans relative to eurozone countries. This difference matters for the distinct residential investment dynamics observed across countries.

This paper puts an additional twist to the long-standing puzzle about residential investment leading the cycle in the US while non-residential investment is lagging in the US. The paper also reinforces that financial institutions do matter.