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Nominal Price versus Asset Price Stabilization
Abstract
This paper studies the optimal monetary policy response to a distortionary shock to firms' investment demand. We consider a sticky price model with investment ad- justment costs. We document the desirability of and the trade-off between nominal price and asset price stabilization in response to this shock. Optimal policy is con- tractionary in response to an ineffi cient boom in investment and asset prices. Relative to the optimal policy, nominal price stabilization generates short-run overinvestment and asset price inflation. In this and other sticky price models, nominal price inflation measures labor market distortion. The market price of the capital stock, through mar- ginal q, usefully summarizes capital market distortion. We calculate significant relative welfare gains from following the optimal policy instead of nominal price stabilization in response to the shock. Then, we limit the central bank's ability to distinguish non-fundamental asset price changes by adding productivity shocks. We utilize new techniques, developed by Svensson and Woodford (2002), to compute optimal policy under asymmetric information and show that there remains a significant role for asset prices in formulating monetary policy.
... 2 Iacoviello (2004) analyzes monetary policy in a model with credit cycles a la Kyotaki and Moore (1997) and housing, and concludes that reacting to asset prices does not improve macroeconomic stability. 3 See also Dupor (2003). ...
... This is necessary exactly to take into account of transitional e¤ects from the deterministic to the di¤erent stochastic steady states respectively implied by each alternative policy rule. 16 Finally, it is important to recall that our framework features heterogeneity of consumers. ...
... where g G Y and C e K is given by (16). With preferences U (C; N ) = log(C) + log(1 + N ) one can use (4), (73) and (77) to compute steady state labor hours as: ...
We study optimal Taylor-type interest rate rules in an economy with credit market imperfections. Our analysis builds on the agency cost framework of Carlstrom and Fuerst [1997. Agency costs, net worth and business fluctuations: a computable general equilibrium analysis. American Economic Review 87, 893–910], which we extend in two directions. First, we embed monopolistic competition and sticky prices. Second, we modify the stochastic structure of the model in order to generate a countercyclical premium on external finance. This is achieved by linking the mean distribution of investment opportunities faced by entrepreneurs to aggregate total factor productivity. We model monetary policy in terms of simple welfare-maximizing interest rate rules. We find that monetary policy should respond to increases in asset prices by lowering interest rates. However, when monetary policy responds strongly to inflation, the marginal welfare gain of responding to asset prices vanishes. Within the class of linear interest rate rules that we analyze, a strong anti-inflationary stance always attains the highest level of welfare.
... The early work of Gertler (1999, 2001) and Cechetti et al (2000) focused on whether it was useful to include a response to asset prices in addition to the response to an inflation forecast. Dupor (2001Dupor ( , 2002a analyses the trade-off that may arise between price stability and asset price stabilisation when there are frictions in the credit market and nonfundamental shocks in asset markets. Borio and Lowe (2002) and Bordo and Jeanne (2002b) focus on the implications of the non-linearities that may arise as financial imbalances increase the probability of a self-fulfilling bust in collateral values and credit, possibly leading to financial fragility. ...
... Given the uncertainty surrounding estimates of equilibrium values of asset prices, such an assessment of the sources of the shocks will in general not be an easy task. As discussed in Dupor (2001) and illustrated in this paper with the model of Smets and Wouters (2003), non-fundamental asset price shocks may introduce a trade off between inflation stabilisation and asset price stabilisation. However, compared to cost-push shocks, the time inconsistency problem would appear to be much less as such shocks will typically tend to move the output gap and inflation in the same direction. ...
... In the first subsection we discuss the role of non-fundamental asset price shocks in creating a trade-off between inflation and output gap and asset price stabilisation. This follows work by Dupor (2001Dupor ( , 2002. In the second section, we discuss the implications of the asymmetric effects of an asset price collapse as highlighted by Kiyotaki and Moore (1997) and Kocherlakota (2000). ...
The paper aims at deriving some stylised facts for financial, real, and monetary policy developments during asset price booms. We observe various macroeconomic variables in a pre-boom, boom and post-boom phase. Not all booms lead to large output losses. We analyse the differences between highcost and low-cost booms. High-cost booms are clearly those in which real estate prices and investment crash in the post-boom periods. In general it is difficult to distinguish a high-cost from a low-cost boom at an early stage. However, high-cost booms seem to follow very rapid growth in the real money and real credit stocks just before the boom and at the early stages of a boom. There is also evidence that high-cost booms are associated with significantly looser monetary policy conditions over the boom period, especially towards the late stage of a boom. We finally discuss the results with regard to the theoretical literature.
... The contrasting results of the latter authors regarding Gertler (2000, 2001) within a similar model framework is due to the different assumption about what exactly can be observed by the policymaker (Cecchetti et al. 2002). Dupor (2002Dupor ( , 2005 finds similar results. He suggests that in response to inefficient shocks to investment demand, optimal policy reduces both price fluctuations and non-fundamental asset price movements. ...
... The contrasting results within similar model frameworks are due to different assumptions about what exactly can be observed by the policymaker (Cecchetti et al. 2002). Dupor (2002Dupor ( , 2005 finds similar results and he suggests that in response to inefficient shocks to investment demand, optimal policy reduces both price fluctuations as well as non-fundamental asset price movements. This raises the importance of both as targets of the monetary authority. ...
Diese Dissertation beinhaltet drei eigenständige Aufsätze, die die Interaktionen von Bewertungsmodellen für Wertpapiere, Finanzmärkten und der Volkswirtschaft untersuchen. Alle drei Papiere tragen zu einem besseren Verständnis von Verknüpfungen zwischen Finanzmärkten und Realwirtschaft. Im Mittelpunkt dieser Arbeit stehen Gewohnheitspräferenzen und Bayesianische Schätzmethoden, um sowohl theoretische als auch empirische Erkenntnisse zu liefern, die helfen, die makroökonomische und die Finanzliteratur stärker zu verbinden. Das erste Essay beschäftigt sich mit Gewohnheitspräferenzen und deren Fähigkeit, verschiedene Aktienrenditen in einem Portfolio zu erklären. Die zugrunde gelegten konsumbasierten Bewertungsmodelle basieren auf mikrofundierten Präferenzen und implizieren somit individuelles und aggregiertes Verhalten von Individuen. Aus diesem Grund werden Bayesianische Methoden genutzt, um diese a priori Information in die Schätzung einfließen zu lassen. Im zweiten Essay, einer gemeinsamen Arbeit mit Harald Uhlig, schätzen wir ein DSGE-Modell. Hervorzuheben ist, dass wir sowohl die Momente zweiter Ordnung für Wertpapierrenditen berücksichtigen als auch die a priori Wahrscheinlichkeiten für stilisierte Fakten wie Frisch-Elastizität und Sharpe ratio. Dieses Vorgehen liefert eine Modellschätzung, die gleichzeitig Fakten der Konjunkturzyklen, Momente zweiter Ordnung von Wertpapierrenditen sowie Finanzmarktfakten besser erklären kann. Das dritte Essay präsentiert ein DSGE-Modell, das die Interaktionen der Aktienmarktbooms zum Ende der 1980er und 1990er Jahre mit der Realwirtschaft erklären kann. Mit Hilfe nichtseparabler Präferenzen und nominaler Rigiditäten lässt sich der simultane Anstieg von BIP, Konsum, Investitionen, geleisteten Arbeitsstunden und Löhnen in dieser Zeit erklären. Abschließend wird die Rolle der Geldpolitik während Aktienmarktbooms diskutiert, und es werden optimale geldpolitische Regeln hergeleitet.
... However, the authors warn policy makers that this policy requires an accurate identification of asset price bubbles and also the costs and benefits associated with the monetary strategy. Dupor (2002) develops a perspective for studying optimal response of monetary policy to distortionary shocks to firms' investment demand which is assumed to be based on irrational expectations. He introduces a model with nominal price rigidity, investment adjustment cots and endogenous capital accumulation. ...
... In this case, inflation targeting policy is assumed to induce over accumulation of capital since it fails to respond adequately to distortionary shocks to firms' investment demand. Therefore, as also implied by Bordo and Jeanne (2002), Dupor (2002) concludes that monetary policy should be designed to respond to asset price movements when these come from non-fundamental sources no matter how this policy leads to nominal price deflation introducing a trade-off between inflation and asset price stabilization. Filardo (2000Filardo ( , 2001 focuses on the role of monetary policy on asset price bubbles within the context of a small-scale macroeconomic model and several simulations. ...
In recent years the issue of the role of asset prices in monetary setting has become increasingly topical since booms and busts in asset market are associated with the fluctuations in overall economic activity through its impacts on aggregate spending. In this study, we use Smooth Transition Regression (STR) models to explore whether stock prices may have a major role on the phase of the short-term interest rates in Eastern European countries implementing inflation targeting regime, namely Czech Republic, Poland, Russian Federation and Turkey. Empirical results point out that stock prices have an impact on short term interest rates in Czech Republic, Poland, Russian Federation and Turkey but the effect is statistically significant only for the case of Turkey. The result implies that Central Bank of the Republic of Turkey (CBRT) may respond to the changes in stock prices as long as the response does not generate any disturbance in the other areas of the overall economic activity.
... e different. Parameters are estimated imprecisely. We cannot reject the hypothesis that policy does not respond to inflation; however, we do find that the central bank responds to stock-market activity. Understanding the empirical role of asset prices in influencing monetary policy is crucial given recent theoretical developments along these lines. Dupor (2002 Dupor ( , 2003) studies a model where a non-fundamental increase in equity prices leads to inefficient physical investment. Optimal policy responds to these asset price fluctuations by raising the real interest rate to offset investment. In this model, simply targeting nominal price inflation will not realize the benefits of responding ...
... Understanding the empirical role of asset prices in influencing monetary policy is crucial given recent theoretical developments along these lines. Dupor (2002 Dupor ( , 2003) studies a model where a non-fundamental increase in equity prices leads to inefficient physical investment. Optimal policy responds to these asset price fluctuations by raising the real interest rate to offset investment. ...
... The experience of the last twenty years shows that the adverse consequences of the burst of a bubble hit not only weak economies, but also strong economies such as the US and Japan. Monetary policy should, therefore, target asset prices in addition to inflation (Dupor, 2002;. Goodhart's (2001) suggestion, based on Alchian and Klein (1973), and in contrast to Bernanke and Getler, 2000), that central banks should consider housing prices and, to a lesser extent, stock market prices in their policy decisions, is very pertinent. ...
A number of countries have adopted Inflation Targeting (IT) since the early 1990s in an attempt to reduce inflation to low levels. Since then, IT has been praised by most literature as a superior framework of monetary policy. We suggest that IT is a major policy prescription closely associated with the New Consensus Macroeconomics (NCM). This paper concentrates mainly on the IT aspects of the NCM. We address the theoretical foundations of IT. This is followed by an assessment of its theoretical foundations, where a number of aspects are discussed. We then turn our attention to an assessment of the empirical work on IT, where we distinguish the work that has been done utilising structural macroeconomic models, and work based in single equation techniques. The IT theoretical framework and the available empirical evidence do not appear to support the views of the proponents.
... VejaBernanke e Gertler (1995) e (2000. Para uma visão dissidente, vejaDupor (2002).18 Veja Gagnon e Ihring (2002) e também Devereux e outros (2003B). ...
... We do this by allowing investment decisions to respond to observed stock market values rather than the "fundamental q". This takes on board the observation of Dupor (2002) who argues that inefficient shocks to firms' investment schedules may render a case for activist monetary policy responses to bubbles. The evidence shown in Figure 1, would also suggest that there is a case on empirical grounds for this extension. ...
... This is based on the strong assumptions that indexation habits will adjust immediately to the new inflation objective. With For alternative interpretations of this equity premium shock and an analysis of optimal monetary policy in the presence of such shocks, see Dupor (2001 ...
... This chapter's results challenge this conclusion, and argue for a more proactive policy response aimed at preventing the development of assetprice bubbles, and giving policy more "room to maneuver" in offsetting the impact of its eventual collapse. It is not alone in that regard: recent papers by Jeanne (2002a, 2002b) and Dupor (2002Dupor ( , 2003 also contain similar prescriptions. ...
... In addition , political and moral hazard considerations are likely to make central banks reluctant to intervene in financial markets . These issues are controversial and several authors , including Borio and Lowe ( 2002 ) , Bordo and Jeanne ( 2002 ) , Dupor ( 2002 ) and Cecchetti et al . ( 2000 ) , have argued that central banks should ' ' lean against the wind ' ' by raising interest rates in the face of emergent asset booms . ...
The introduction of risk sensitive bank capital charges into currency dependent economies exasperates the inherent procyclicality of banking regulations and frustrates the conduct of monetary policy. The authors argue that, by requiring capital charges resulting from foreign currency lending to be denominated in the same foreign currency, the capital charge becomes countercyclical.
... Recent examples include Bernanke and Gertler (2000), Smets (1997), Kent and Lowe (1997), Chiarella et al. (2001), Mehra (1998), Vickers (1999), Filardo (2000), Okina, Shirakawa and Shirats (2000) and Dupor (2001). ...
A dynamic model is set up to explore monetary policy in the presence of asset price volatility. If the probability for the asset price to increase or decrease in the next period is taken as an exogenous variable, the monetary policy rule turns out to be a linear function of state variables. We also explore a monetary policy rule assuming that the probability for the asset price to decrease or increase can be affected by monetary policy and asset price bubbles, and find that a state-dependent monetary policy rule might arise. We further consider monetary policy with asset prices in the presence of a zero-interest-rate bound. Our study shows that a financial market depression can make a deflation and an economic recession worse, implying that policy actions aiming at escaping a liquidity trap should not ignore asset prices.
... An early study of this type can be found in Blanchard (1981) who has analyzed the relationship between the stock value and output in " good news " and " bad news " cases. Recent papers on this topic include Bernanke and Gertler (2000), Smets (1997), Kent and Lowe (1997), Chiarella et al. (2001), Mehra (1998), Vickers (1999), Filardo (2000, Okina, Shirakawa and Shirats (2000), and Dupor (2001). Among these papers, the work by Bernanke and Gertler (2000) has attracted much attention. ...
Bielefeld, University, Diss., 2004. Computerdatei im Fernzugriff.
... We do this by allowing investment decisions to respond to observed stock market values rather than the "fundamental q". This takes on board the observation of Dupor (2002) who argues that inefficient shocks to firms' investment schedules may render a case for activist monetary policy responses to bubbles. The evidence shown in Figure 1, would also suggest that there is a case on empirical grounds for this extension. ...
... This shock can also take up exogenous distortions or non-rational bubbles in asset prices. For such alternative interpretations of this equity premium shock and an analysis of optimal monetary policy in the presence of such shocks, seeDupor (2001). ...
This paper develops and estimates a dynamic stochastic general equilibrium (DSGE) model with sticky prices and wages for the euro area. The model incorporates various other features such as habit formation, costs of adjustment in capital accumulation and variable capacity utilization. It is estimated with Bayesian techniques using seven key macroeconomic vari-ables: GDP, consumption, investment, prices, real wages, employment, and the nominal interest rate. The introduction of ten orthogonal structural shocks (including productivity, labor supply, investment, preference, cost-push, and monetary policy shocks) allows for an empirical investigation of the effects of such shocks and of their contribution to business cycle fluctuations in the euro area. Using the estimated model, we also analyze the output (real interest rate) gap, defined as the difference between the actual and model-based potential output (real interest rate). (JEL: E4, E5) Copyright (c) 2003 The European Economic Association.
... This is based on the strong assumptions that indexation habits will adjust immediately to the new inflation objective. With For alternative interpretations of this equity premium shock and an analysis of optimal monetary policy in the presence of such shocks, see Dupor (2001 ...
We present a new approach to study empirically the effect of the introduction of the euro on currency invoicing. Our approach uses a compositional multinomial logit model, in which currency choice depends on the characteristics of both the currency and the country. We use unique quarterly panel data of Norwegian imports from OECD countries for the 1996-2006 period. One of the key findings is that the eurozone countries in trade with Norway have substantially increased their share of home currency invoicing after the introduction of the euro. In addition, the euro as a vehicle currency has overtaken the role of the US dollar in Norwegian imports. The econometric analysis shows a significant effect of euro introduction above and beyond the determinants of currency invoicing (i.e., inflation rate, inflation volatility, foreign exchange market size, and product composition). However, the rise in producer currency invoicing by eurozone countries is primarily caused by a drop in inflation volatility.
... s occasionally depart from rational expectations. Our model is 'reduced form' behavioral. These short-term deviations from rationality are assumed rather than modeled. In this sense, the strategy follows Cecchetti, Lam and Mark (2002), who also assume but do not model, deviations from rationality in order to explain certain asset pricing anomalies. Dupor (2002) studies how a central bank with full information and commitment, which we refer to as case (a), responds to shocks to expectations. In this environment, he establishes that a central bank optimally responds to both nominal price and non-fundamental asset price fluctuations. Each measures a distinct distortion on the economy. Why is this ...
Inflation, output and interest rate stabilization are all potential central bank objectives. We explore whether monetary policy should respond to asset price fluctuations when they are driven by irrational expectational shocks to the future returns to capital. In our model, an optimistic shock to future returns generates both an increase in equity prices and physical investment. The increased investment is inefficient and, thus, a central bank optimally responds to this expectations shocks. This induces a trade-off between stabilizing nominal prices and non-fundamental asset price movements. We compare the optimal policy under different assumptions: full versus limited information and commitment versus discretion. If the central bank has limited information about whether an asset price movement has a fundamental or non-fundamental origin, then the central bank responds less aggressively to the non-fundamental exuberance shocks than under full information. Without commitment, a central bank responds more aggressively to non-fundamental exuberance shocks.
... This is the only shock that is not directly related to the structure of the economy.13 For alternative interpretations of this equity premium shock and an analysis of optimal monetary policy in the presence of such shocks, seeDupor (2001). ...
Using a Bayesian likelihood approach, we estimate a dynamic stochastic general equilibrium model for the US economy using seven macroeconomic time series. The model incorporates many types of real and nominal frictions and seven types of structural shocks. We show that this model is able to compete with Bayesian Vector Autoregression models in out-of-sample prediction. We investigate the relative empirical importance of the various frictions. Finally, using the estimated model, we address a number of key issues in business cycle analysis: What are the sources of business cycle fluctuations? Can the model explain the cross correlation between output and inflation? What are the effects of productivity on hours worked? What are the sources of the "Great Moderation"? (JEL D58, E23, E31, E32)
... The list is growing fast; a selected set of references includes Kent and Lowe (1998), Bernanke andGertler (1999, 2001), Cecchetti et al (2000,2003), Filardo (2001Filardo ( , 2003, Dupor (2002), Gilchrist and Leahy (2002), Gruen et al (2003) and Smets and Wouters (2003). ...
Monetary policies of the ECB and US Fed can be characterised by Taylor rules, that is both central banks seem to be setting rates by taking into account the output gap and inflation. We also set up and tested Taylor rules which incorporate money growth and the euro-dollar exchange rate, thereby improving the fit between actual and Taylor rule based rates. In general, Taylor rules appear to be a much better way of describing Fed policy than ECB policy. Simulations suggest that the ECB's short-term interest rates have been at a much lower level in the last two years compared with what a Taylor rule would suggest.
... Woodford himself, of course, recognises that other " rigidities " or frictions could play a role, violating this " divine coincidence " , as termed by Blanchard (2005). Wage rigidities are one such example, which would imply seeking to stabilise wages too (eg Blanchard and Gali (2005)). Dupor (2002) argues that financial rigidities could provide a rationale for stabilising asset prices. tolerance of economic agents is unimportant. And rational expectations are standard, so that agents and policymakers are assumed to know the model of the economy and to use this information optimally. The " unorthodox " paradigm is quite different. ...
Monetary policies of the ECB and US Fed can be characterised by Taylor rules, that is both central banks seem to be setting rates by taking into account the output gap and inflation. We also set up and tested Taylor rules which incorporate money growth and the euro-dollar exchange rate, thereby improving the fit between actual and Taylor rule based rates. In general, Taylor rules appear to be a much better way of describing Fed policy than ECB policy. Simulations suggest that the ECB's short-term interest rates have been at a much lower level in the last two years compared with what a Taylor rule would suggest.
A conference was held under the aegis of the UK’s ‘Government Economic Service’, 30 November 2005, under the title ‘Is There a New Consensus in Macroeconomics?’, and a book emerged from that conference (Arestis, 2007a). The conference concluded that there is now a new macroeconomic consensus in the sense that there is today a level of agreement among economists on macro issues not seen since the late 1960s/early 1970s.2 This does not imply, of course, that there is complete agreement, with no detractors and opponents, or that the consensus will be permanent. Neither does it mean that the new consensus is above board without much criticism in place. On the contrary, one of the aims of this chapter is to do just that, namely to appraise it critically.
We study optimal monetary policy in two prototype economies with sticky prices and credit market frictions. In the first economy, credit frictions apply to the financing of the capital stock, generate acceleration in response to shocks and the "financial markup" (i.e., the premium on external funds) is countercyclical and negatively correlated with the asset price. In the second economy, credit frictions apply to the flow of investment, generate persistence, and the financial markup is procyclical and positively correlated with the asset price. We model monetary policy in terms of welfare-maximizing interest rate rules. The main finding of our analysis is that strict inflation stabilization is a robust optimal monetary policy prescription. The intuition is that, in both models, credit frictions work in the direction of dampening the cyclical behavior of inflation relative to its credit-frictionless level. Thus neither economy, despite yielding different inflation and investment dynamics, generates a trade-off between price and financial markup stabilization. A corollary of this result is that reacting to asset prices does not bear any independent welfare role in the conduct of monetary policy
I modify the uniform-price auction rules in allowing the seller to ration bidders. This allows me to provide a strategic foundation for underpricing when the seller has an interest in ownership dispersion. Moreover, many of the so-called "collusive-seeming" equilibria disappear.
This paper estimates a DSGE model with many types of shocks and frictions for both the US and the euro area economy over a common sample period (1974-2002). The structural estimation methodology allows us to investigate whether differences in business cycle behaviour are due to differences in the type of shocks that affect the two economies, differences in the propagation mechanism of those shocks, or differences in the way the central bank responds to those economic developments. Our main conclusion is that each of these characteristics is remarkably similar across both currency areas. Copyright © 2005 John Wiley & Sons, Ltd.
This paper reviews the challenges faced by central banks in recent years in order to evaluate their policy implications going forward. To highlight the genuine uncertainty surrounding the lessons to be drawn, the paper examines recent experience through two intentionally polarised perspectives, viz. the "continuity" and "new-environment" views. These perspectives lead to somewhat different conclusions regarding the nature of the challenges central banks are likely to face in the current economic landscape and the policy responses that may be appropriate. While the continuity view stresses the reliability of traditional policy benchmarks, the newenvironment view suggests that it may be worth considering assigning greater weight to the build-up of financial imbalances when calibrating policy. Such an approach could be consistent with current policy frameworks, but it would point to a somewhat longer horizon for evaluating policy alternatives as well as greater attention to the balance of risks to the outlook.
Business cycles in different regions of the United States tend to synchronize. This study investigates the reasons behind this synchronization of business cycles and the consequent formation of a national business cycle. Trade between regions may not be strong enough for one region to "drive" business cycle fluctuations in another region. This study suggests that regional business cycles synchronize due to a nonlinear "mode-locking" process in which weakly coupled oscillating systems (regions) tend to synchronize. There is no definitive test for mode-lock. However, simulations, correlations, Granger causality tests, tests for nonlinearities, vector autoregressions, and spectral analysis reveal modest econometric support for the regional mode-locking hypothesis of business cycle synchronization. Copyright Blackwell Publishers, 2005
In this paper we first explore the impact of nominal and real persistence on the transmission process of various shocks in an estimated DSGE model of euro area. We then analyse its impact on optimal monetary policy and investigate the performance of various monetary policies when the policy maker is uncertain about the degree of nominal and real persistence. JEL Classification: E4; E5.
At the dawn of the 21st century, property and equity ownership are spread more broadly across the population than they once were. One consequence of this is that asset price booms and crashes now have a direct impact on general welfare. The fact that bubbles distort nearly all economic decisions gives policymakers a stronger interest in asset price stability. In this essay I examine the theoretical and empirical case for the existence of equity and property bubbles, and then summarize the economic distortions that they create. The evidence suggests increasing our attention on property prices. I go on to discuss the possible policy responses, including examining the consequences of changing the way in which housing is included in standard aggregate price measures.
This paper develops and estimates a stochastic dynamic general equilibrium (SDGE)model with sticky prices and wages for the euro area. The model incorporates various other features such as habit formation, costs of adjustment in capital accumulation and variable capacity utilisation. It is estimated with Bayesian techniques using seven key macro-economic variables: GDP, consumption, investment, prices, real wages, employment and the nominal interest rate. The introduction of ten orthogonal structural shocks (including productivity, labour supply, investment, preference, cost-push and monetary policy shocks) allows for an empirical investigation of the effects of such shocks and of their contribution to business cycle fluctuations in the euro area. Using the estimated model, the paper also analyses the output (real interest rate) gap, defined as the difference between the actual and model-based potential output (real interest rate). JEL Classification: E4; E5.
Central banks should not be in the business of trying to prick asset price bubbles. Bubbles generally arise out of some combination of irrational exuberance, technological jumps, and financial deregulation (with more of the second in equity price bubbles and more of the third in real estate booms). Accordingly, the connection between monetary conditions and the rise of bubbles is rather tenuous, and anything short of inducing a recession by tightening credit conditions prohibitively is unlikely to stem their rise. Even if a central bank were willing to take that one-in-three or less shot at cutting off a bubble, the cost-benefit analysis hardly justifies such preemptive action. The macroeconomic harm from a bubble bursting is generally a function of the financial system's structure and stability—in modern economies with satisfactory bank supervision, the transmission of a negative shock from an asset price bust is relatively limited, as was seen in the United States in 2002. However, where financial fragility does exist, as in Japan in the 1990s, the costs of inducing a recession go up significantly, so the relative disadvantages of monetary preemption over letting the bubble run its course mount. In the end, there is no monetary substitute for financial stability, and no market substitute for monetary ease during severe credit crunch. These two realities imply that the central bank should not take asset prices directly into account in monetary policymaking but should be anything but laissez-faire in responding to sharp movements in inflation and output, even if asset price swings are their source.
The paper focuses on satisfaction with income and proposes a utility model built on two value systems, the `Ego' system - described as one own income assessment relatively to one own past and future income - and the `Alter' system - described as one own income assessment relatively to a reference group. We show how the union of these two value systems and the use of relative deprivation measures can lead to a model able to accommodate a wide range of theories on income and happiness. The model is then tested using the Consortium of Household Panels for European Socio-economic Research (CHER), a collection of 19 panel surveys including over 1.2 m. individual observations. We find absolute income to sit at the intersection between the `Ego' and the `Alter' systems and to play the most prominent role in explaining satisfaction with income. Relative deprivation is also found to be important for understanding the income-happiness nexus while we find income expectations to be less relevant once we control for absolute income. Overall, the `Alter' system (the cross-section comparison with others) seems to be more relevant in valuing income than the `Ego' system (the longitudinal self-comparison of income).
Business cycles in different regions of the United States tend to synchronize. This study investigates the reasons behind this synchronization of business cycles and the consequent formation of a national business cycle. Trade between regions may not be strong enough for one region to "drive" business cycle fluctuations in another region. This study suggests that regional business cycles synchronize due to a nonlinear "mode-locking" process in which weakly coupled oscillating systems (regions) tend to synchronize. There is no definitive test for mode-lock. However, simulations, correlations, Granger causality tests, tests for nonlinearities, vector autoregressions, and spectral analysis reveal modest econometric support for the regional mode-locking hypothesis of business cycle synchronization. Copyright Blackwell Publishers, 2005