No full-text available
To read the full-text of this research,
you can request a copy directly from the authors.
An Estimated DSGE Open Economy Model of the Indian Economy with Financial Frictions
Abstract
We develop an open economy DSGE model of the Indian economy and estimate it by Bayesian Maximum Likelihood methods. We build up in stages to a model with a number of features important for emerging economies in general and the Indian economy in particular: a large proportion of credit-constrained consumers, a financial accelerator facing domestic firms seeking to finance their investment, “liability dollarization” and incomplete exchange rate pass-through. Our estimation results support the inclusion of financial frictions in an otherwise standard small open economy model. The simulation properties of the estimated model are examined under a generalized inflation targeting Taylor-type interest rate rule with forward- and backward-looking components.
... In India, 'rule of thumb' consumers constitute a significant proportion of households and this category of consumers comprises those who are unable to smooth consumption overtime due to the lack of access to financial services. The presence of a significant fraction of households being non-Ricardian, coupled with their inaccessibility to formal financial services should amplify the propagation of shocks in a relatively more volatile output environment of India (see Gabriel et al., 2012 andGabriel et al., 2016). The main objective of this paper, along with these features, is to uncover and evaluate the interconnections and spillover effects in the two-country setting. ...
... This applies to the preference and technology parameters (for which we do not impose a symmetry condition between the US and India). Using trade data for shares, the domestic import share parameter, a, is calibrated to be 0.38 as set out in Gabriel et al. (2016) ...
... The estimation results are plausible and are generally similar to those of Lubik and Schorfheide (2005) for the US and of Gabriel et al. (2016) for the Indian SOE. The estimated parameters capturing the policy response to both inflation and output, w à 1 and w à 2 , suggest that the RBI appears to be quite aggressive in preempting inflationary pressures and responding to output stabilisation. ...
Advanced and emerging economies are becoming more interdependent with rapid pace of globalization of capital markets and technological innovations in recent years. We examine whether technology and monetary policy shocks get transmitted between advanced and emerging market economies and to what extent they generate complementary or competitive effects. Given the globally integrated nature of capital markets, we uncover a transmission mechanism by which technology and policy shocks in advanced and emerging countries spill over between them through the capital flow channel. We mainly investigate whether analysis from a SVAR model by econometricians provides empirically similar conclusions to those from a macroeconomic theory-based DSGE model in measuring the impact of demand-side policy and technology shocks. We fit our VAR models to the same time series data used to calibrate and estimate the DSGE model. We conclude that monetary and fiscal policy shocks are competitive between the US (advanced economy) and India (emerging market), while domestic and global technology shocks or the exchange rate shocks have complementary effects. Intuitively, technology enhances productivity in both countries, while policy shocks tend to drive capital to a country with higher rate of return. Thus policy shocks in advanced countries could have unintended effects in terms of capital inflows to emerging economies and hence greater coordination of policies can help limit adverse cross-border spillovers.
... Third, there are frictions in the financial markets facing households as in Gabriel et al. (2023) and in the form of non-Ricardian consumers to capture credit constraints, 10 and an inefficient financial sector as in Smets and Wouters (2007). Furthermore, we allow for the law of one price (LOP) gap in imports and by implication assume incomplete exchange rate pass-through into import 10 The presence of rule of thumb consumers who have no access to formal financial services and credit to smooth out consumption should improve the model fit for an emerging economy in the type of volatile economic environment that has been described so far (see Gabriel et al., 2016 andGabriel et al., 2023, among others). prices as in Monacelli (2005) and Senbeta (2011). ...
This paper examines the implications of fuel subsidy removal in an oil-producing economy, focusing on the central bank’s response to volatile oil prices. Using a Markov-switching dynamic stochastic general equilibrium model, we analyze the welfare effects of this policy change under different regimes of oil price volatility and monetary policy. Our empirical findings, based on data from Nigeria (2000:2 - 2021:4), reveal time-varying switches in oil price fluctuations and monetary policy adjustments that synchronize with states of high oil price volatility. We also find that subsidy removal has welfare-reducing and heterogenous effects on households, especially when implemented in an environment of heightened volatility. The efficacy of monetary policy in mitigating the impacts of subsidy removal depends on the ability of the central bank to design a flexible framework capable of adapting
to economic shifts, while balancing its stabilization objectives. Furthermore, the observed monetary policy switching endogenous to different states of oil price shocks suggests a need for the central banks of oil-producing emerging economies to consider the prospects of a dual-mandate regime.
... The share of capital in the production function (α) is fixed at 0.33 (see Ginn & Pourroy, 2019). The paper follows Gabriel et al. (2011) and Gabriel et al. (2016) and fix price and wage markups (η p t , η w t ) to 0.14. The calvo parameters (ω P , ω w ) in line with existing literature, have been set to to 0.75. ...
This paper employs the DSGE model with rich fiscal block to examine the asymmetries in the transmission and effectiveness of the government expenditure shock across the active fiscal and passive monetary policy (AFPM) regime and the active monetary and passive fiscal policy (AMPF) regime in the Indian economy. In the AMPF regime, the central bank actively targets inflation, and the fiscal authority ensures public debt sustainability. On the other hand, in the AFPM regime, the central bank weakly targets inflation and stabilizes public debt in the economy. With higher multipliers and debt rollover, the government expenditure stimulus has been more beneficial in the AFPM regime than in the AMPF regime. In the AMPF regime, the central bank has effectively neutralized the inflationary effects of the government expenditure shock. However, this neutralization has weakened the effect of the government expenditure shock on consumption, investment, and output. Based on the findings, the paper suggests the monetary authority to keep its stance accommodative when the fiscal authority injects government expenditure stimulus into the economy.
... Following Galí (2015), we calibrated the model parameters from the available literature as reported in Table 2 based on India and China. Certain calibrated parameters that are unavailable in the case of both these economies are taken from the advanced economy counterparts as done in the empirical study among others by Gabriel et al. (2016). ...
We examine the influence of demand shock, supply shock and the monetary policy shock on macroeconomic variables using the New Keynesian Dynamic Stochastic General Equilibrium framework. Our study tries to identify the efficient monetary policy mix as an antidote to the prevailing economic fragilities that originated due to the COVID-19 pandemic and geopolitical conflict in case of India and China. Under both simulated and Bayesian analysis, our findings revealed the inflationary effect of demand and supply shock with a target-oriented monetary policy under sticky prices as the efficient policy tool to counter these effects. The macroeconomic projections depicted the favourable influence of output due to active intervention of target-oriented monetary policy in both these economies.
... Then, we estimate impulse response functions based on the simulated shocks. The existing empirical literature on DSGE models does not provide adequate calibrated parameter values for developing economies (Gabriel et al., 2016). Hence, some of the calibrated values are taken from those estimated in the context of developed economies. ...
We examine the effectiveness of fiscal and monetary policy in mitigating the impact of COVID-19 in India using the NK-DSGE framework. In terms of policy effectiveness, our findings imply that expansionary monetary policy is effective in reviving economic growth both from the demand side and supply side. In contrast, expansionary fiscal policy is effective only from the supply side. Our findings recommend the implementation of optimal policy mix in a coordinated and staggered framework for effective mitigation of ill-effects of the COVID-19, such as reviving employment and capacity utilization to its pre-pandemic level with minimal inflationary effects.
... The model is based on eight observable variables (see Table 1). . We take the three month treasury bill rate as a proxy of the nominal interest rate (e.g., Patnaik et al., 2011, Anand et al., 2014and Gabriel et al., 2016. ...
Food price volatility is a major threat for welfare, economic prosperity and political stability. The monetary authority is generally viewed in the literature as the only institution responsible for price stability, however this approach overlooks the importance of food price stabilization policies using fiscal instruments. We develop and estimate a Bayesian DSGE model that incorporates monetary and fiscal policy tailored to India, replicating food demand and food supply subsidies. We find that following a world food price shock, CPI and therefore interest rate volatility would be 21% higher in the absence of food subsidies. Putting this effect aside would lead to overestimating the effectiveness of inflation targeting by the central bank. Accordingly, we find that the subsidy policy has large heterogeneous distributional welfare effects: while farmers benefit from all subsidies, the inclusion of urban households into the demand subsidy program is required to offset supply subsidy welfare cost.
... The discount factor (β), which represents how the agents assess future utility versus present utility, is set to 0.99 as per the standard practice for quarterly models. The elasticity of substitution among different varieties of intermediate goods is taken as 7.02 following (Gabriel, Levine, & Yang, 2016). ...
In order to build a strong and sustainable recovery post the COVID-19 pandemic, we need to draw important observations from the growth experience of the past. In this context, this paper uses a dynamic stochastic general equilibrium (DSGE) model that takes into account persistent growth rate shocks to decompose the Indian GDP into potential output and output gap. Apart from analysing the trajectory of potential output-output gap, it also examines their underlying drivers. The results suggest that a combined deceleration in neutral and investment-specific technology growth post 2016, brought down the potential growth to around 6 per cent in 2020Q1. The output gap also witnessed a persistent decline since 2018Q1, primarily due to weak demand and a rise in investment adjustment costs reflecting heightened stress in the investment and financial sectors. A forecasting exercise is also undertaken which shows that the estimates of output gap from the model possess competing inflation forecasting ability compared to HP filtered output gap.
How do financial frictions affect macroeconomic volatility and monetary policy in emerging market economies? This article assesses the empirical relevance of such frictions by estimating a two‐bloc emerging market/rest‐of‐the‐world model containing two key features of emerging economies: partial transaction and liability dollarization, and financial frictions where capital financing is partially or totally in foreign currency. Our estimation employs the “one‐step approach” which allows us to be “agnostic” regarding nonstationarity in the data and simultaneously estimate structural and trend parameters. Using data for Peru and the US, we find substantial empirical support for both the financial accelerator and partial dollarization mechanisms. The data fit of the baseline model improves with the addition of each of these frictions, exogenous shocks are significantly amplified in their presence and our preferred model captures several important stylized facts of a small emerging open economy.
Purpose
The primary purpose of this paper is to investigate the sources of the business cycle fluctuations in Vietnam. To this end, the author develops a small open economy New Keynesian dynamic stochastic general equilibrium (SOE-NK-DSGE) model. Accordingly, this model includes various features, such as habit consumption, staggered price, price indexation, incomplete exchange-rate pass-through (ERPT), the failures of the law of one price (LOOP) and the uncovered interest rate parity. It is then estimated by using the Bayesian technique and Vietnamese data 1999Q1–2017Q1. Based on the estimated model, this paper analyzes the sources of the business cycle fluctuations in this emerging economy. Indeed, this research paper is the first attempt at developing and estimating the SOE-NK-DSGE model with the Bayesian technique for Vietnam.
Design/methodology/approach
A SOE-NK-DSGE model—Bayesian estimation.
Findings
This paper analyzes the sources of the business cycle fluctuations in Vietnam.
Originality/value
This research paper is the first attempt at developing and estimating the SOE-NK-DSGE model with the Bayesian technique for Vietnam.
The question facing many emerging economies is the extent to which a workhorse advanced economy model can yield important insights for monetary policymaking. We note that the standard sticky price, monopolistically competitive model does not allow analysis of money and credit dynamics and led to a concentration of research on simple interest rate reaction functions. Time-varying financial frictions tend to act as a tax on intermediation activities and so can vary output in a significant manner. In this paper, we consider the implications of financial frictions for baseline monetary policy using a model calibrated on Indian data and find that a simple interest rate reaction function may not be welfare maximizing.
Over the past decade there has been remarkable progress in developing empirical micro-founded macroeconomic models for monetary policy analysis that feature coherence both to economic theory and to the data. In this paper, we estimate using Bayesian methods a second-generation micro founded model of the U.S. economy. We examine the characteristics of optimal monetary policies in the model, where we consider two types of policy objectives: general stabilization of macroeconomic fluctuations associated with "flexible inflation targeting," and maximization of consumer welfare. We find that, for either type of objective, optimized versions of the Taylor Rule are able to deliver outcomes that are only a few percent below the first-best policy. We then explore optimal policy taking account of parameter and specification uncertainty and identify the parameters and specification issues that are critical for the conduct of monetary policy and hence have the highest value in terms of research
We develop a closed-economy DSGE model of the Indian economy and estimate it by Bayesian Maximum Likelihood methods using Dynare. We build up in stages to a model with a number of features important for emerging economies in general and the Indian economy in particular: a large proportion of credit-constrained consumers, a financial accelerator facing domestic firms seeking to finance their investment, and an informal sector. The simulation properties of the estimated model are examined under a generalized inflation targeting Taylor-type interest rate rule with forward and backward-looking components. We find that, in terms of model posterior probabilities and standard moments criteria, inclusion of the above financial frictions and an infor- mal sector significantly improves the model fit.
We generalize the method proposed by Gelman and Rubin (1992a) for monitoring the convergence of iterative simulations by comparing between and within variances of multiple chains, in order to obtain a family of tests for convergence. We review methods of inference from simulations in order to develop convergence-monitoring summaries that are relevant for the purposes for which the simulations are used. We recommend applying a battery of tests for mixing based on the comparison of inferences from individual sequences and from the mixture of sequences. Finally, we discuss multivariate analogues, for assessing convergence of several parameters simultaneously.
We first develop a two-bloc model of an emerging open economy interacting with the rest of the world calibrated using Indian and US data. The model features a financial accelerator and is suitable for examining the effects of financial stress on the real economy. Three variants of the model are highlighted with increasing degrees of financial frictions. The model is used to compare two monetary interest rate regimes: domestic Inflation targeting with a floating exchange rate (FLEX(D)) and a managed exchange rate (MEX). Both rules are characterized as a Taylor-type interest rate rules. MEX involves a nominal exchange rate target in the rule and a constraint on its volatility. We find that the imposition of a low exchange rate volatility is only achieved at a significant welfare loss if the policymaker is restricted to a simple domestic inflation plus exchange rate targeting rule. If on the other hand the policymaker can implement a complex optimal rule then an almost fixed exchange rate can be achieved at a relatively small welfare cost. This finding suggests that future research should examine alternative simple rules that mimic the fully optimal rule more closely.
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).
This article documents the main stylized features of macroeconomic fluctuations for 12 developing countries. It presents cross-correlations between domestic industrial output and a large group of macroeconomic variables, including fiscal variables, wages, inflation, money, credit, trade, and exchange rates. Also analyzed are the effects of economic conditions in industrial countries on output fluctuations in the sample developing countries. The results point to many similarities between macroeconomic fluctuations in developing and industrial countries (procyclical real wages, countercyclical variation in government expenditures) and some important differences (countercyclical variation in the velocity of monetary aggregates). Their robustness is examined using different detrending procedures. Copyright 2000 by Oxford University Press.
We examine an interesting puzzle in monetary economics between what monetary authorities claim (namely, to be forward looking and preemptive) and the poor stabilization properties routinely reported for forecast-based rules. Our resolution is that central banks should be viewed as following 'Calvo-type' inflation-forecast-based (IFB) interest rate rules that depend on a discounted sum of current and future rates of inflation. Such rules might be regarded as both within the legal frameworks and potentially mimicking central bankers' practice. We find that Calvo-type IFB interest rate rules are, first, less prone to indeterminacy than standard rules with a finite forward horizon. Second, in difference form, the indeterminacy problem disappears altogether. Third, optimized forms have good stabilization properties as they become more forward looking, a property that sharply contrasts that of standard IFB rules. Fourth, they appear data coherent when incorporated into a well-known estimated dynamic stochastic general equilibrium (DSGE) model of the euro area.
This paper develops and estimates a dynamic stochastic general equilibrium New Keynesian model of a small open economy with partial dollarization. We use Bayesian techniques and Peruvian data to evaluate two forms of dollarization: currency substitution (CS) and price dollarization (PD). Our empirical results are as follows. First, we find that the two forms of partial dollarization are important to explain the Peruvian data. Second, models with both forms of dollarization dominate models without dollarization. Third, a counter-factual exercise shows that by eliminating both forms of partial dollarization the response of both output and consumption to a monetary policy shock doubles, making the interest rate channel of monetary policy more effective. Forth, based on the variance decomposition of the preferred model (with CS and PD), we find that demand type shocks explain almost all the fluctuation in CPI inflation, being the monetary shock the most important (39 percent). Remarkably, foreign disturbances account for 34 percent of output fluctuations.
This 20th edition of the NBER Macroeconomics Annual treats many questions at the cutting edge of macroeconomics that are central to current policy debates. The papers and discussions include an analysis of the differential between American and European unemployment rates, with the authors of the paper taking issue with Edward Prescott's view that higher European tax rates are responsible; a provocative account of the relationship between fluctuations in the hiring rate of new workers and the U.S. unemployment rate; an analysis of the 20-year decline in aggregate volatility (and the rise in firm volatility); a model that compares the effectiveness of monetary policy that targets inflation rates to one that targets simple wage inflation; a roadmap to using Bayesian approaches in solving empirical puzzles; and a microeconomic model that shows the desirability of maintaining a stable inflation rate even in isolated situations that would seem to call for a more flexible policy toward inflation.
DSGE models are currently estimated with a two-step approach: the data is first transformed and then DSGE structural parameters are estimated. Two-step procedures have problems, ranging from component misspecification to incorrect assumptions about the correlation between cyclical and non-cyclical components. In this paper, I present a one-step method, where DSGE structural parameters are jointly estimated with filtering parameters. First, I illustrate the properties of the one-step procedures using simulated data. Then, I show that different data transformations imply different structural estimates and that two-step approaches lack a statistical-based criterion to select amongst them. The one-step approach allows to choose the most likely specification of the non-cyclical component for individual series and/or to construct robust estimates by Bayesian averaging. The role of the investment specific shock as source of GDP volatility is reconsidered.
This article uses a simple New Keynesian dynamic stochastic general equilibrium model as a prior for a vector autoregression, and shows that the resulting model is competitive with standard benchmarks in terms of forecasting, and can be used for policy analysis.
Many prominent critics regard the international financial system as the dark side of globalization, threatening disadvantaged nations near and far. But in The Next Great Globalization, eminent economist Frederic Mishkin argues the opposite: that financial globalization today is essential for poor nations to become rich. Mishkin argues that an effectively managed financial globalization promises benefits on the scale of the hugely successful trade and information globalizations of the nineteenth and twentieth centuries. This financial revolution can lift developing nations out of squalor and increase the wealth and stability of emerging and industrialized nations alike. By presenting an unprecedented picture of the potential benefits of financial globalization, and by showing in clear and hard-headed terms how these gains can be realized, Mishkin provides a hopeful vision of the next phase of globalization.Mishkin draws on historical examples to caution that mismanagement of financial globalization, often aided and abetted by rich elites, can wreak havoc in developing countries, but he uses these examples to demonstrate how better policies can help poor nations to open up their economies to the benefits of global investment. According to Mishkin, the international community must provide incentives for developing countries to establish effective property rights, banking regulations, accounting practices, and corporate governance--the institutions necessary to attract and manage global investment. And the West must be a partner in integrating the financial systems of rich and poor countries--to the benefit of both.The Next Great Globalizationmakes the case that finance will be a driving force in the twenty-first-century economy, and demonstrates how this force can and should be shaped to the benefit of all, especially the disadvantaged nations most in need of growth and prosperity.
This article describes a technique for distributing quarterly time series across monthly values. The method generalizes an approach described by Fernandez (1981). The article also presents results of a test of the accuracy of these two approaches and of the accuracy of two standard procedures suggested by Chow and Lin (1971).
We develop a variation of the macroeconomic model of banking in Gertler and Kiyotaki (GK2011) that allows for household liquidity risks and bank runs as in Diamond and Dybvig (DD1983). As in GK, endogenous procyclical movements in bank balance sheets lead to countercyclical fluctuations in the cost of bank credit. However, due to maturity mismatch in banking, bank runs are possible as in DD. Whether a bank run equilibrium exists depends on the condition of bank balance sheets and an endogenously determined liquidation price for bank assets. Thus in normal times a bank run equilibrium may not exist, but the possibility can arise in a severe recession. Overall, the goal is to present a framework that synthesizes the macroeconomic and microeconomic approaches to banking and banking instability. * Thanks to Francesco Ferrante and Andrea Prespitino for outstanding research assis-tance, well above the call of duty.
This chapter develops a dynamic general equilibrium model that is intended to help clarify the role of credit market frictions in business fluctuations, from both a qualitative and a quantitative standpoint. The model is a synthesis of the leading approaches in the literature. In particular, the framework exhibits a “financial accelerator”, in that endogenous developments in credit markets work to amplify and propagate shocks to the macroeconomy. In addition, we add several features to the model that are designed to enhance the empirical relevance. First, we incorporate money and price stickiness, which allows us to study how credit market frictions may influence the transmission of monetary policy. In addition, we allow for lags in investment which enables the model to generate both hump-shaped output dynamics and a lead-lag relation between asset prices and investment, as is consistent with the data. Finally, we allow for heterogeneity among firms to capture the fact that borrowers have differential access to capital markets. Under reasonable parametrizations of the model, the financial accelerator has a significant influence on business cycle dynamics.
We generalize the method proposed by Gelman and Rubin (1992a) for monitoring the convergence of iterative simulations by comparing between and within variances of multiple chains, in order to obtain a family of tests for convergence. We review methods of inference from simulations in older to develop convergence-monitoring summaries that are relevant for the purposes for which the simulations are used. We recommend applying a battery of tests for mixing based on the comparison of inferences from individual sequences and from the mixture of sequences. Finally, we discuss multivariate analogues, for assessing convergence of several parameters simultaneously.
The current …nancial crisis has made it abundantly clear that business cycle model-ing no longer can abstract from …nancial factors. It is also becoming increasingly clear that the stylized modeling of labor markets without explicit unemployment that is the current standard approach has its limitations. Some questions which the dominating extant business cycle models are mute on, but that we would like to answer are: How important are …nancial and labor market frictions for the business cycle dynamics of a small open economy? In particular, what are the quantitative e¤ects of …nancial factors on output and ination, and how do they interact with monetary policy? What drives the variation in the intensive and extensive margin of labor supply respectively? What is the estimated Frisch elasticity in a model that allows for both an intensive and an extensive margin of labor supply? In order to address these questions we extend what is becoming the standard new Keynesian model in three important dimensions. First, we incorporate …nancial frictions in the accumulation and management of capital. Second, we model the labor market using a search and matching framework. Third, we extend the model into a small open economy setting. We make a theoretical contribution by incorporating endogenous job separation in this rich framework. Finally, we estimate the full model using Bayesian techniques and illustrate the importance of the various frictions. seminar participants at various presentations. The views expressed in this paper are solely the responsibility of the authors and should not be interpreted as reecting the views of the Executive Board of Sveriges Riksbank or of the European Central Bank.
We introduce rule-of-thumb consumers in an otherwise standard dynamic sticky price model, and show how their presence can change dramatically the properties of widely used interest rate rules. In particular, the existence of a unique equilibrium is no longer guaranteed by an interest rate rule that satisfies the so-called Taylor principle. Our findings call for caution when using estimates of interest rate rules in order to assess the merits of monetary policy in specific historical periods. The study of the properties of alternative monetary policy rules, and the assessment of their relative merits, has been one of the central themes of the recent literature on monetary policy. Many useful insights have emerged from that research, with implications for the practical conduct of monetary policy, and for our understanding of its role in different macroeconomic episodes. Among some of the recurrent themes, much attention has been drawn to the potential benefits and dangers associated with simple interest rate rules. Thus, while it We have benefited from comments by Bill Dupor, Ken West (the editor), an anonymous referee, and participants at the JMCB–Chicago Fed Tobin's Conference and the NBER Summer Institute, as well as seminars at the Federal Reserve Board, BIS, CREI-UPF, George Washington University and the Bank of Spain. All remaining errors are our own. Galí acknowledges financial support from DURSI (Generalitat de Catalunya), MCYT (Grant SEC2002-03816), and the Bank of Spain. The views expressed in this paper do not necessarily represent those of the Bank of Spain.
In this paper we compare two standard extensions to the New Keynesian model featuring financial frictions. The first model, originating from Kiyotaki and Moore (1997), is based on collateral constraints. The second, developed by Carlstrom and Fuerst (1997) and Bernanke et al. (1999), accentuates the role of external finance premia. Our goal is to compare the workings of the two setups. Towards this end, we tweak the models and calibrate them in a way that allows for both qualitative and quantitative comparisons. Next, we make a thorough analysis of the two frameworks using moment matching, impulse response analysis and business cycle accounting. Overall, we find that the business cycle properties of the external finance premium framework are more in line with empirical evidence. In particular, the collateral constraint model fails to generate hump-shaped impulse responses and, for some important variables, shows moments that are inconsistent with the data by a large margin.
This paper documents the empirical relation between the interest rates that emerging economies face in international capital markets and their business cycles. The dataset used in the study includes quarterly data for Argentina during 1983-2000 and for Brazil, Mexico, Korea, and Philippines,during 1994-2000. In this sample, interest rates are very volatile, strongly countercyclical, and strongly positively correlated with net exports. Output is very volatile and consumption is more volatile than output. These regularities are common to all emerging economies in the sample, butare not observed in a developed economy such as Canada. The paper presents a dynamic general equilibrium model of a small open economy, in which (i) firms have to pay for a fraction of the input bill before production takes place, and in which (ii) the labor supply is independent of consumption.Using a version of the model calibrated to Argentina s economy, we find that interest rate shocks alone can explain 50% of output fluctuations and can generate business cycle patterns consistent with the regularities described above and with the major booms and recessions in Argentina in the last two decades. We conclude that interest rates are an important factor for explaining businesscycles in emerging economies and further research should be devoted to fully understand their determination.
We consider the desirability of modifying a standard Taylor rule for interest rate policy to incorporate adjustments for measures of financial conditions. We consider the consequences of such adjustments for the way policy would respond to a variety of disturbances, using the dynamic stochastic general equilibrium model with credit frictions developed in Cúrdia and Woodford (2009a). According to our model, an adjustment for variations in credit spreads can improve upon the standard Taylor rule, but the optimal size of adjustment depends on the source of the variation in credit spreads. A response to the quantity of credit is less likely to be helpful. Copyright (c) 2010 The Ohio State University.
We develop a quantitative monetary DSGE model with financial intermediaries that face endogenously determined balance sheet constraints. We then use the model to evaluate the effects of the central bank using unconventional monetary policy to combat a simulated financial crisis. We interpret unconventional monetary policy as expanding central bank credit intermediation to offset a disruption of private financial intermediation. Within our framework the central bank is less efficient than private intermediaries at making loans but it has the advantage of being able to elastically obtain funds by issuing riskless government debt. Unlike private intermediaries, it is not balance sheet constrained. During a crisis, the balance sheet constraints on private intermediaries tighten, raising the net benefits from central bank intermediation. These benefits may be substantial even if the zero lower bound constraint on the nominal interest rate is not binding. In the event this constraint is binding, though, these net benefits may be significantly enhanced.
In emerging markets, external debt is denominated almost entirely in large, developed country currencies such as the U.S. dollar. This liability dollarization offers a channel through which exchange rate variation can lead to business cycle instability. When firms' assets are denominated in domestic currency and liabilities are denominated in foreign currency, an exchange rate depreciation worsens firms' balance sheets, which leads to higher capital costs and contractions in capital spending. To illustrate this, I construct a quantitative, sticky price, small open economy model in which a monetary policy induced devaluation leads to a persistent contraction in output. In this model, fixed exchange rates offer greater stability than an interest rule that targets inflation.
We find that in a sample of emerging economies business cycles are more volatile than in developed ones, real interest rates are countercyclical and lead the cycle, consumption is more volatile than output and net exports are strongly countercyclical. We present a model of a small open economy, where the real interest rate is decomposed in an international rate and a country risk component. Country risk is affected by fundamental shocks but, through the presence of working capital, also amplifies the effects of those shocks. The model generates business cycles consistent with Argentine data. Eliminating country risk lowers Argentine output volatility by 27% while stabilizing international rates lowers it by less than 3%.
This paper studies the properties of the Bayesian approach to estimation and comparison of dynamic equilibrium economies. Both tasks can be performed even if the models are nonnested, misspecified, and nonlinear. First, we show that Bayesian methods have a classical interpretation: asymptotically, the parameter point estimates converge to their pseudotrue values, and the best model under the Kullback–Leibler distance will have the highest posterior probability. Second, we illustrate the strong small sample behavior of the approach using a well-known application: the U.S. cattle cycle. Bayesian estimates outperform maximum likelihood results, and the proposed model is easily compared with a set of BVARs.
We discuss prior elicitation for the parameters of dynamic stochastic general equilibrium (DSGE) models, and provide a method for constructing prior distributions for a subset of these parameters from beliefs about steady-state relationships and second moments of the endogenous variables. The empirical application documents how the specification of the prior distribution affects our assessment of the relative importance of price and wage rigidities in a New Keynesian DSGE model.
This paper estimates and tests a new Keynesian small open economy model in the tradition of Christiano et al. [2005. Nominal rigidities and the dynamic effects of a shock to monetary policy. Journal of Political Economy 113(1), 1–45] and Smets and Wouters [2003. An estimated stochastic dynamic general equilibrium model of the Euro area. Journal of the European Economic Association 1(5), 1123–1175] using Bayesian estimation techniques on Swedish data. To account for the switch to an inflation targeting regime in 1993 we allow for a discrete break in the central bank's instrument rule. A key equation in the model – the uncovered interest rate parity (UIP) condition – is well known to be rejected empirically. Therefore we explore the consequences of modifying the UIP condition to allow for a negative correlation between the risk premium and the expected change in the nominal exchange rate. The results show that the modification increases the persistence in the real exchange rate and that this model has an empirical advantage compared with the standard UIP specification.
We consider a general equilibrium model with frictions in credit markets used by households. In our economy, houses provide housing services to consumers and serve as collateral to lower borrowing cost. We show that this amplifies and propagates the effect of monetary policy shocks on housing investment, house prices and consumption. We also consider the effect of a structural change in credit markets that lowers the transaction costs of additional borrowing against housing equity. We show that such a change would increase the effect of monetary policy shocks on consumption, but would decrease the effect on house prices and housing investment.
This paper investigates the effects of exchange rate regimes and alternative monetary policy rules for an emerging market economy that is subject to a volatile external environment in the form of shocks to world interest rates and the terms of trade. In particular, we highlight the impact of financial frictions and the degree of exchange rate pass through in determining the relative performance of alternative regimes in stablizing the economy in the face of external shocks. Our results are quite sharp. When exchange rate pass-through is high, a policy of non-traded goods inflation targeting does best in stablizing the economy, and is better in welfare terms. When exchange rate pass-through is low, however, a policy of strict CPI inflation targeting is better. In all cases, a fixed exchange rate is undesirable. In addition, financial frictions have no implications for the ranking of alternative policy rules.
Emerging market business cycles exhibit strongly countercyclical current accounts, consumption volatility that exceeds income volatility, and “sudden stops†in capital inflows. These features contrast with developed small open economies. Nevertheless, we show that a standard model characterizes both types of markets. Motivated by the frequent policy regime switches observed in emerging markets, our premise is that these economies are subject to substantial volatility in trend growth. Our methodology exploits the information in consumption and net exports to identify the persistence of productivity. We find that shocks to trend growth—rather than transitory fluctuations around a stable trend—are the primary source of fluctuations in emerging markets. The key features of emerging market business cycles are then shown to be consistent with this underlying income process in an otherwise standard equilibrium model.
The authors construct a model of a dynamic economy in which lenders cannot force borrowers to repay their debts unless the debts are secured. In such an economy, durable assets play a dual role: not only are they factors of production but they also serve as collateral for loans. The dynamic interaction between credit limits and asset prices turns out to be a powerful transmission mechanism by which the effects of shocks persist, amplify, and spill over to other sectors. The authors show that small, temporary shocks to technology or income distribution can generate large, persistent fluctuations in output and asset prices. Copyright 1997 by the University of Chicago.
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.
Although the spectral analysis of stationary stochastic processes has solid mathematical foundations, this is not the case for non-stationary stochastic processes. In this paper, the algebraic foundations of the spectral analysis of non-stationary ARMA processes are established. For this purpose the Fourier Transform is extended to the field of fractions of polynomials. Then, the Extended Fourier Transform pair pseudo-covariance generating function / pseudo-spectrum, analogous to the Fourier Transform pair covariance generating function / spectrum,is defined. The new transform pair is well defined for stationary and non-stationary ARMA processes. This new approach can be viewed as an extension of the classical spectral analysis. It is shown that the frequency domain has some additional algebraic advantages over the time domain.
In this paper, I review the literature on the formulation and estimation of dynamic stochastic general equilibrium (DSGE) models with a special emphasis on Bayesian methods. First, I discuss the evolution of DSGE models over the last couple of decades. Second, I explain why the profession has decided to estimate these models using Bayesian methods. Third, I briefly introduce some of the techniques required to compute and estimate these models. Fourth, I illustrate the techniques under consideration by estimating a benchmark DSGE model with real and nominal rigidities. I conclude by offering some pointers for future research.
This paper studies whether the international monetary system can be affected by asymmetries in the cross-country positions in the international financial markets, i.e., the fact that some countries are large debtors while others are creditors. An important channel that is explored is the interaction between international risk sharing and the stabilization role of monetary policy in each country. The main finding is that the welfare costs of incomplete markets and the gains of deviating from a policy of price stability are increasing with the cross-country asymmetries in the initial net international positions and in particular they become nonnegligible when the persistence of the shocks increases (1% of a permanent shift in steady-state consumption, for the welfare costs of incomplete markets, and 0.2%, for the gains of deviating from a policy of price stability). When global imbalances become larger, optimal monetary policy requires an increase in the volatilities of the real returns on assets and in particular of the nominal interest rates, which should happen to be more correlated across countries. Copyright (c) 2009 The Ohio State University.
In a market-based financial system, banking and capital market developments are inseparable, and funding conditions are closely tied to fluctuations in the leverage of market-based financial intermediaries. Offering a window on liquidity, the balance sheet growth of broker-dealers provides a sense of the availability of credit. Contractions of broker-dealer balance sheets have tended to precede declines in real economic growth, even before the current turmoil. For this reason, balance sheet quantities of market-based financial intermediaries are important macroeconomic state variables for the conduct of monetary policy.
We estimate an alternative type of monetary policy rule, termed Calvo rule, according to which the central bank is assumed to target a discounted infinite sum of future expected inflation. Compared to conventional inflation forecast-based rules, which are typically of the Taylor-type with discrete forward looking horizons, this class of rule is less prone to the problem of indeterminacy. Parameter estimates obtained from GMM estimation provide support for Calvo-type rules, suggesting that the Federal Reserve targeted a mean forward horizon of between 4 and 8 quarters.
This paper develops a small open economy model where entrepreneurs partially finance investment using foreign currency denominated debt subject to a risk premium above and beyond international interest rates. We use Bayesian estimation techniques to evaluate the importance of balance sheet vulnerabilities combined with the presence of the financial accelerator for emerging market countries. Using Korean data, we obtain an estimate for the external risk premium, indicating the importance of the financial accelerator and potential balance sheet vulnerabilities for macroeconomic fluctuations. Furthermore, our estimates of the Taylor rule imply a strong preference to smooth both exchange rate and interest rate fluctuations.
This paper calculates indices of central bank autonomy (CBA) for 163 central banks as of end-2003, and comparable indices for a subgroup of 68 central banks as of the end of the 1980s. The results confirm strong improvements in both economic and political CBA over the past couple of decades, although more progress is needed to boost political autonomy of the central banks in emerging market and developing countries. Our analysis confirms that greater CBA has on average helped to maintain low inflation levels. The paper identifies four broad principles of CBA that have been shared by the majority of countries. Significant differences exist in the area of banking supervision where many central banks have retained a key role. Finally, we discuss the sequencing of reforms to separate the conduct of monetary and fiscal policies. IMF Staff Papers (2009) 56, 263–296. doi:10.1057/imfsp.2008.25; published online 23 September 2008
This paper incorporates a financial accelerator mechanism in a small open economy macro model with money and nominal price rigidities. Our goal is to explore the connection between financial distress that feeds into the real economy and the exchange rate regime. Our principle finding is that financial accelerator effects are much stronger under fixed rates than under flexible rates (with a suitably managed monetary policy). Roughly speaking, an exchange rate peg forces the central bank to adjust the interest rate in a manner that enhances the financial distress. This occurs even when debt is denominated in units of foreign currency. Finally, unexpectedly delaying the abandonment of an exchange rate peg several quarters after a shock can produce distress nearly as bad as occurs under a permanent peg, due to the unanticipated contractions in asset prices.
We use a micro-founded macroeconometric modeling framework to investigate the design of monetary policy when the central bank faces uncertainty about the true structure of the economy. We apply Bayesian methods to estimate the parameters of the baseline specification using postwar U.S. data and then determine the policy under commitment that maximizes household welfare. We find that the performance of the optimal policy is closely matched by a simple operational rule that focuses solely on stabilizing nominal wage inflation. Furthermore, this simple wage stabilization rule is remarkably robust to uncertainty about the model parameters and to various assumptions regarding the nature and incidence of the innovations. However, the characteristics of optimal policy are very sensitive to the specification of the wage contracting mechanism, thereby highlighting the importance of additional research regarding the structure of labor markets and wage determination.