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What is new? | Recent Work | Conferences and Workshops | Research Links | Economic
Data and News
What is new?
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- New Paper
(May 2009):
Welfare-based optimal
monetary policy with unemployment and sticky prices: A linear-quadratic
framework
- New Paper
(December 2008):
The Welfare
Consequences of Monetary Policy and the Role of the Labor Market: a Tax
Interpretation
- Revised Paper: (April 2009):
Optimal Policy
Restrictions on Observable Outcomes
- Invited
Papers and Conference Discussions
- Conferences
and Workshops
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Research
organized by topics
- Optimal
monetary policy
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European Monetary
Union and
Open economy monetary policy
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Inflation dynamics and DSGE
modeling |
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- Financial and currency crises |
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- Invited papers, Comments
and Conference discussions
Optimal
monetary policy
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| In the standard new Keynesian framework, an
optimizing policy maker does not face a trade-off between stabilizing
the inflation rate and stabilizing the gap between actual output and
output under flexible prices. An ad hoc, exogenous cost-push shock is
typically added to the inflation equation to generate a meaningful
policy problem. In this paper, we show that a cost-push shock arises
endogenously when a cost channel for monetary policy is introduced into
the new Keynesian model. A cost channel arises when firms' marginal
cost depends directly on the nominal rate of interest. Besides
providing additional empirical evidence for a cost channel, we explore
its implications for monetary policy trade-offs, the objectives of
monetary policy, and the effects of shocks on the economy under optimal
discretionary and optimal commitment policies. We show that the
presence of a cost channel alters the optimal policy problem in
important ways. For example, both the output gap and inflation are
allowed to fluctuate in response to productivity and fiscal shocks
under optimal monetary policy.
Technical Appendix
Extended Working Paper version: The Cost Channel in a New Keynesian
Model: Evidence and Implications
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| When central banks set monetary policy they do so
without knowing either the economy's true structure or its
parameterization. As a consequence, to set policy efficiently central
banks must infer, or learn, the relevant structural relationships from
available data. But, because a central bank's policy changes economic
outcomes, the chosen policy may help or hinder its efforts to learn.
This paper considers a variety of economic environments, examining
whether real-time learning allows a central bank to learn the economy's
underlying structure. When monetary policy is formulated as an optimal
discretionary targeting rule we find that the rational expectations
equilibrium and the optimal policy are real-time learnable. This result
is robust to a variety of assumptions concerning the private sector
learning behaviour. Learning happens slowly by the very nature of the
econometric problem faced by the central bank, and in general it is not
affected by real-time optimal policy making. When policy is set with
discretion learning can lead to better outcomes. We also find that
learning occurs more quickly and is less costly if the central bank
smooths interest rates.
Earlier working paper version: Learning to Set Policy Optimally, Ente Luigi
Einaudi - Temi di Ricerca 43, August 2005
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| We
explore the distortions in business cycle models with inefficiencies in
price setting and in the search process matching firms to unemployed
workers, and the implications for monetary policy. To this end, we
characterize the trade-offs faced by the policymaker in terms of the
missing tax instruments that would implement the first best. Our
findings are that the cost of search inefficiency is large, but the
incentive for policy to deviate from the inefficient flexible-price
allocation is in general small. Sizable welfare gains are available if
the steady state of the economy is inefficient, and these gains do not
depend on the existence of an inefficient dispersion of wages. Finally,
the gains from deviating from price stability are larger in economies
with more volatile labor flows, as in the U.S. |
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IIn this paper, we
derive a linear-quadratic model for monetary policy analysis that is
consistent with sticky prices and search and matching frictions in the
labor market. We show that the second-order approximation to the
welfare of the representative agent depends on inflation and "gaps"
that involve current and lagged unemployment. Our approximation makes
explicit how the costs of fluctuations are generated by the presence of
search frictions. These costs are distinct from the costs associated
with relative price dispersion and fluctuations in consumption that
appear in standard new Keynesian models. We use the model to analyze
optimal monetary policy under commitment and discretion and to show
that the structural characteristics of the labor market have important
implications for optimal policy.
Technical
Appendix
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We study the
restrictions implied by optimal policy DSGE models for the volatility
of observable endogenous variables. Our approach uses a parametric
family of singular models to discriminate which volatility sample
outcomes have zero probability of being generated by an optimal policy.
Thus the set of volatility outcomes generated by the model is not of
measure zero even if there are no random deviations from optimal
policymaking. This methodology is applied to a new Keynesian business
cycle model widely used in the optimal monetary policy literature, and
its implications for the assessment of US monetary policy performance
over the 1984-2005 period are discussed.
(Earlier
drafts of this paper were titled "How to
distinguish bad policies from
bad luck")
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Policy decisions
affect economic outcomes, and the likelihood of observing a given state
of the world. We investigate how policy choices affect learning of the
true model of the economy when the policymaker's model is
mis-specified. We ask under what conditions can the central bank learn
the correct specification of the model describing the economy, and what
is the impact of exogenous shocks and of adopting an optimal monetary
policy on the speed of learning. Slow learning can occur simply because
identifying the correct model at standard confidence levels requires a
long data sample. We show that optimal monetary policy does not impair
or slow down learning when compared to simple Taylor rules.
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European
Monetary Union and Open Economy Monetary Policy
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| We develop a general equilibrium model of an
emerging market economy where productivity growth differentials between
tradable and non-tradable sectors result in an equilibrium appreciation
of the real exchange rate---the so-called Balassa-Samuelson effect. The
paper explores the dynamic properties of this economy and the welfare
implications of alternative policy rules. We show that the real
exchange rate appreciation limits the range of policy rules that, with
a given probability, keep inflation and exchange rate within
predetermined numerical targets. We also find that the
Balassa-Samuelson effect raises significantly the welfare loss
associated with policy rules that prescribe active exchange rate
management. |
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| We argue a fixed exchange rate can be an optimal
choice even if a policymaker could commit to the first-best monetary
policy whenever the private sector's beliefs reflect incomplete
information about the policymaker's dependability. This model implies
that new EU member states have an incentive to join the Euro area not
for its impact on the behaviour of the policymaker, but on the beliefs
of the private sector. Monetary policies are evaluated using a new
Keynesian model of a small open economy solved under imperfect policy
credibility. We quantify the minimum distance between announced policy
and private sector's beliefs necessary for a peg to perform better than
an independent monetary policy when the policymaker can commit to the
first best policy. Exposure to foreign and financial shocks make
joining the Euro area relatively more attractive for a given level of
credibility. |
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| Trade
and Optimal Monetary Policy joint with Giovanni Lombardo (work
in progress) |
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Using a stochastic business cycle model of a
small open economy we ask how the problem of the optimizing
policy-maker changes endogenously as the international trade structure
is altered. We
document that differences in trade across countries (especially EME and
OECD countries) are substantial, and that the composition of trade
varies as much as openness to trade. The trade and production
structures examined in our theoretical model easily map into measurable
macroeconomic characteristics of countries. Our results are as follows.
First, the traditional imports to GDP ratio turns out to be close to
irrelevant for the ranking of monetary policies. Second, the
composition of imports has a very substantial impact on welfare. Given
the same degree of openness, the exchange rate peg is more inefficient
if the bias towards non-tradable goods is high, and less inefficient if
the share of imported intermediates is low. That is, open countries
engaging in much vertical trade find it more costly to peg the exchange
rate. Third, while a stylized regularity of emerging market economies
is the very high share of imported capital goods, compared with
industrial countries, this turns out to have no impact on the welfare
result. Fourth, local currency pricing has a muted impact . This is the
consequence of two assumptions: the existence of a long chain of
substitutability in demanded goods, and the mobility of labor across
sectors, so that imported inputs affect factor prices in all sectors
directly, rather than through general equilibrium effects.
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Inflation
dynamics and DSGE modeling |
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The canonical new
Keynesian Phillips Curve has become a standard component of models
designed for monetary policy analysis. However, in the basic new
Keynesian model, there is no unemployment, all variation in labor input
occurs along the intensive hours margin, and the driving variable for
inflation depends on workers' marginal rates of substitution between
leisure and consumption. In this paper, we incorporate a theory of
unemployment into the new Keynesian theory of inflation and empirically
test its implications for inflation dynamics. We show how a traditional
Phillips curve linking inflation and unemployment can be derived and
how the elasticity of inflation with respect to unemployment depends on
structural characteristics of the labor market such as the matching
technology that pairs vacancies with unemployed workers. We estimate on
US data the Phillips curve generated by the model. While we can reject
the baseline new Keynesian Phillips curve in favor of the
search-frictions specification, we show it is still too stylized to
fully describe the dynamics of firms' marginal costs.
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| Restaurant prices in the Euro area saw an
unprecedented increase after the introduction of the Euro. We argue
that this increase can be explained by an extension of commonly used
models of sticky prices due to menu costs. This extension involves the
state-dependent decision of firms on when to adopt the Euro. Two main
mechanisms drive the result. First, our model concentrates otherwise
staggered price increases around the introduction of the Euro. Second,
before the adoption of the Euro, prices do not reflect marginal cost
increases expected to occur after the changeover. This ``horizon
effect'' disappears as soon as the new currency is adopted,
contributing to a jump in prices at that time. Calibration of the model
shows that it generates a blip in inflation of the same magnitude
observed in the data.
Mathematical
Appendix
Comments on the
Italian Press: La Stampa,
Il Messaggero, Italia Oggi, Il
Mattino, La Sicilia, La Gazzetta Del Sud, Wall Street Italia, Il Denaro, Greenplanet
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| The performance of Dynamic Stochastic General
Equilibrium models is often tested against estimated VARs. This
requires that the data-generating process consistent with the DSGE
theoretical model has a finite-order VAR representation. This paper
discusses the assumptions needed for a finite-order VAR(p)
representation of a DSGE model to exist. When a VAR(p) is only an
approximation to the true VAR, the truncated VAR(p) may return largely
incorrect estimates of the impulse response function. The results do
not hinge on small sample bias or on incorrect identification
assumptions. But the bias introduced by truncation can lead to bias in
the identification of the structural shocks. Identification strategies
that are equivalent in the true VAR representation perform differently
in the approximating VAR.
Expanded Working Paper Version: Banco De
Espana Working Paper, Forthcoming, Vector Autoregressions and Reduced
Form Representations of DSGE models
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| We
study the rejection of the expectations
hypothesis within a New Keynesian business cycle model. According to
Backus, Gregory, and Zin (1989), the Lucas general equilibrium asset
pricing model can account for neither sign nor magnitude of average
risk premia in forward prices, and is unable to explain rejection of
the expectations hypothesis. We show that a New Keynesian model with
habit-formation preferences and a monetary policy feedback rule
produces an upward-sloping average term structure of interest rates,
procyclical interest rates, and countercyclical term spreads. In the
model, as in U.S. data, inverted term structure predicts recessions.
Most importantly, a New Keynesian model is able to account for
rejections of the expectations hypothesis. Contrary to Buraschi and
Jiltsov (2005), we identify systematic monetary policy as a key factor
behind this result. Rejection of the expectation hypothesis can be
entirely explained by the volatility of just two real shocks which
affect technology and preferences. |
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| We
study variables
that are normally unobservable, but very important for the conduct of
monetary policy, expected inflation and inflation risk premia, within a
New Keynesian business cycle model. We solve the model using a
third-order approximation which allows us to study time-varying risk
premia. Our model is consistent with rejection of the expectations
hypothesis and the business-cycle behavior of nominal interest rates in
the U.S. data. We find that inflation risk premia are very small and
display little volatility. Hence, monetary policy authorities can use
the difference between nominal and real interest rates from
index-linked bonds as a proxy for inflation expectations. Moreover, for
short maturities current inflation is a good predictor of inflation
risk premia. We also find that short-term real interest rates and
expected inflation are significantly negatively correlated and that
short-term real interest rates display greater volatility than expected
inflation. These results are consistent with empirical studies that use
survey data and index-linked bonds to obtain measures of expected
inflation and real interest rates. Finally, we show that our economy is
consistent with the Mundell-Tobin effect, that is, increases in
inflation are associated with higher nominal interest rates, but lower
real interest rates. |
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The Impact of Inflation
Targeting: Testing the Good Luck Hypothesis (updated June 2008) |
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Over the last twenty years the level and
volatility of inflation decreased across industrial countries. The
inflation behaviour can be explained by a shift in monetary policy or
by a lucky period of low volatility in business cycle shocks. To test
the 'luck hypothesis' we examine the inflation experience of Canada,
one of the earliest and most successful adopter of an inflation
targeting monetary policy. We Kalman-filter the historical structural
shocks consistent with an estimated DSGE model, but allow for part of
the variance in the data to be explained by a vector of non-structural
random innovations. The estimated DSGE model shocks are used to build
counterfactual histories. Ex-ante the estimated model predicts
inflation volatility to more than halve under inflation targeting. But
conditional on the shocks, we show that the luck hypothesis can explain
with a high probability Canada's low inflation volatility since the
early 1990s. Any inflation stabilization induced by the shift in policy
is accounted for the most part by the impact on expectations.
Counterfactuals built neglecting expectations would prove the inflation
targeting policy irrelevant.
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Financial
and currency crises
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Financial
Crises and Market Crashes: Herds or Coordination Failures? |
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| Which equilibrium should be selected in a game
with multiple Nash equilibria ? This paper proves under what conditions
the strategy of a large population of randomly coupled players engaging
in a one-stage game converges in time to a Nash equilibrium, and if so,
to which of the different ones. Extending Kandori, Mailath and Rob
(1993) results, I introduce a flexible setup where the individual
strategy choice is explicitly modeled, where the population dynamics is
derived from the aggregation of the individual behaviour, and where a
variety of selection and learning mechanisms can be easily introduced.
This setup can be used for a novel explanation of market crashes. The
model generates herding among agents choice, with the same
observational features of similar phenomena produced by social
learning, information-driven models. |
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When
do Financial Crises Happen?
Dynamic Externality as a Source of Global Instability (work
in progress) |
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This paper explains equilibrium selection in
repeated plays of a coordination game in the presence of small
stochastic shocks, and uses this mechanism to model currency and
financial crises. It provides a novel explanation for market crashes.
In the model the economy will spend most of its time fluctuating about
the stable state, but spontaneous transitions will occur to a different
stable state, without any aggregate shock affecting the economy. Due to
the presence of nonlinear interactions the effects of many small
independent shocks affecting all agents, usually inconsequential, need
not cancel out: they can instead produce large fluctuations in the
economy. Agents interact by considering the utility of their investment
decreasing in the number of investors who have already abandoned
investments in the same currency. A small negative random shock will
make them switch investment currency if many others have already
switched. This behaviour may determine a currency crisis, depending on
the sensitivity of the single investors to the actions of all the
others.
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Invited
Papers, Comments and Conference
discussions
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"A Macroeconomic
Perspective on Reserve Accumulation" by Avner Bar-Ilan and Nancy
Marion, Review of International Economics - Santa Cruz Center for
International Economics Conference on "Global Liquidity", 11-12 April
2008, Santa Cruz, CA.
"The Recessionary
Impact of Stabilizing Inflation" in Recessions: Prospects and Developments,
Nerea M. Pérez and June A. Ortega, eds., Nova Science
Publishers, October 2008 (invited paper)
"Asset
Prices
and Economic Activity in an Era of Credible Monetary Policy (and
Bubbles)", India Economy
Review 4, September 2007 (invited paper)
"Pegged
Exchange Rate Regimes: a Trap?" by Joshua Aizenman and Reuven
Glick, SCCIE Conference on Applied International Finance, 5 December
2005, Santa Cruz, CA.
"Optimal
Sticky Prices under Rational Inattention" by Bartosz Mackowiak and
Mirko Wiederholt, Third ECB-IMOP Workshop on Dynamic Macroeconomics,
10-11 June 2005, Hydra, Greece.
"Robust
Monetary Policies in a Small Open Economy" by Kai Leitemo and Ulf
Soderstrom, UCSC-SCCIE Conference on 'The Implications of Uncertainty
and Learning for Monetary Policy', 1 April 2005, Santa Cruz, CA.
"Optimal Monetary Policy in
Two Basic Sticky-Price Models" by Robert King, Optimal Monetary
Policy session, 2004 AEA Annual Meeting, January 2-5, San Diego, CA.
"Currency Boards,
Dollarized Liabilities and Monetary Policy Credibility" by Mark
Spiegel and Diego Valderrama, Journal of International Money and
Finance/Institute on Global Conflict and Cooperation/Santa Cruz Center
for International Economics/Deutsche Bank 2003 Conference on 'Regional
and International Implications of the Financial Instability in Latin
America', April 11-12, University of California-Santa Cruz, CA
"Discerning What is
too Tight" by Kenneth Kuttner and Adam Posen, North American
Journal of Economics and Finance 2003 CMC Workshop on 'The
Macroeconomics of Low Inflation and the Prospects for Global
Deflation', April 25-26, McKenna College, Claremont, CA
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Conferences and Workshops
| The Euro and the Dollar in a
Globalized Economy
May 27, 2006
University of California - Santa Cruz
Jointly presented by the Santa Cruz Center
for International Economics at UCSC, the San Francisco Federal
Reserve Bank, the Center for European Integration Studies at Bonn
University
Sponsored by the Delegation of the European
Commission in Washington, DC
Program and
papers available at the website of the:
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The
Implications of Uncertainty and Learning for Monetary Policy
April
1, 2005
University Center, UC Santa Cruz
Organized by
Federico Ravenna and Carl Walsh , UCSC
Sponsored by
Santa Cruz Center for International Economics
Program
and papers available at the website of the:
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Research
Links
The
European Monetary Union Home Page by Giancarlo Corsetti
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Global
Macroeconomics and Financial Policy Site by Nouriel Roubini |
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Reference:
Lars Svensson's homepage links |
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Reference: AEAweb Resources
for Economists on the Internet |
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