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Modeling Time-Variation Over the Business Cycle (1960-2017): An International Perspective
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In this paper, I explore the changes in international business cycles with quarterly data for the eight largest advanced economies (U.S.) since the 1960s. Using a time-varying parameter model with stochastic volatility for real GDP growth and inflation allows their dynamics to change over time, approximating nonlinearities in the data that otherwise would not be adequately accounted for with linear models (Granger et al. (1991), Granger (2008)). With that empirical model, I document a period of declining macro volatility since the 1980s, followed by increasing (and diverging) inflation volatility since the mid-1990s. I also find significant shifts in inflation persistence and cyclicality, as well as in macro synchronization and even forecastability. The 2008 global recession appears to have had an impact on some of this. I ground my empirical strategy on the reduced-form solution of the workhorse New Keynesian model and, motivated by theory, explore the relationship between greater trade openness (globalization) and the reported shifts in international business cycle. I show that globalization has sizeable (yet nonlinear) effects in the data consistent with the implications of the model-yet globalization's contribution is not a foregone conclusion, depending crucially on more than the degree of openness of the international economy.
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Prevailing explanations of the decline in real interest rates since the early 1980s are premised on the notion that real interest rates are driven by variations in desired saving and investment. But based on data stretching back to 1870 for 19 countries, our systematic analysis casts doubt on this view. The link between real interest rates and saving-investment determinants appears tenuous. While it is possible to find some relationships consistent with the theory in some periods, particularly over the last 30 years, they do not survive over the extended sample. This holds both at the national and global level. By contrast, we find evidence that persistent shifts in real interest rates coincide with changes in monetary regimes. Moreover, external influences on countries’ real interest rates appear to reflect idiosyncratic variations in interest rates of countries that dominate global monetary and financial conditions rather than common movements in global saving and investment. All this points to an underrated role of monetary policy in determining real interest rates over long horizons.
We use a broad-range set of inflation models and pseudo out-of-sample forecasts to assess their predictive ability among 14 emerging market economies (EMEs) at different horizons (1 to 12 quarters ahead) with quarterly data over the period 1980Q1-2016Q4. We find, in general, that a simple arithmetic average of the current and three previous observations (the RW-AO model) consistently outperforms its standard competitors—based on the root mean squared prediction error (RMSPE) and on the accuracy in predicting the direction of change. These include conventional models based on domestic factors, existing open-economy Phillips curve-based specifications, factor-augmented models, and time-varying parameter models. Often, the RMSPE and directional accuracy gains of the RW-AO model are shown to be statistically significant. Our results are robust to forecast combinations, intercept corrections, alternative transformations of the target variable, different lag structures, and additional tests of (conditional) predictability. We argue that the RW-AO model is successful among EMEs because it is a straightforward method to downweight later data, which is a useful strategy when there are unknown structural breaks and model misspecification.
We model local inflation dynamics using global inflation and domestic slack motivated by a novel interpretation of the implications of the workhorse open-economy New Keynesian model. We evaluate the performance of inflation forecasts based on the single-equation forecasting specification implied by the model, exploiting the spatial pattern of international linkages underpinning global inflation. We find that incorporating cross-country interactions yields significantly more accurate forecasts of local inflation for a diverse group of 14 advanced countries (including the U.S.) than either a simple autoregressive model or a standard closed-economy Phillips curve-based forecasting model. We argue that modeling the temporal dimension—but not the cross-country spillovers—of inflation does limit a model's explanatory power in-sample and its (pseudo) out-of-sample forecasting performance. Moreover, we also show that global inflation (without domestic slack) often contributes the most to achieve the gains on forecasting accuracy observed during our sample period (1984:Q1-2015:Q1)—this observation, according to theory, is crucially related to the flattening of the Phillips curve during this time period of increased globalization.
The open-economy dimension is central to the discussion of the trade-offs that monetary policy faces in an increasingly integrated world. I investigate the monetary policy transmission mechanism in a two-country workhorse New Keynesian model where policy is set according to Taylor (in: Carnegie-Rochester conference series on public policy, vol 39, pp. 195–214, 1993) rules. I find that a common monetary policy isolates the effects of trade linkages on the cross-country dispersion alone, and that the establishment of a currency union as a means of deepening policy integration may lead to indeterminacy. I argue that the common (coordinated) monetary policy equilibrium is the relevant benchmark for policy analysis showing that open economies tend to experience lower macro volatility, a flatter Phillips curve, and more accentuated trade-offs between inflation and slack. Moreover, the trade elasticity often magnifies the effects of trade integration (globalization) beyond what conventional measures of trade openness would imply. I also discuss how other features such as the strength of a common anti-inflation bias in policymaking, technological diffusion across countries, and the sensitivity of labor supply to real wages influence the quantitative effects of policy and openness in this context. Finally, I conclude that these theoretical predictions are largely consistent with the stylized facts of the Great Moderation.
The importance of international considerations in the US Federal Reserve System's deliberations has become more and more important over time as global financial crises and events create ever stronger repercussions in the US economy. This book critically evaluates the role of the Federal Reserve System as a player in the international monetary system over the past one hundred years, starting with its initial responsibility under the gold standard and looking ahead to the challenges it will face in the twenty-first century under the fiat standard. The book is based on a conference of the same name held at the Federal Reserve Bank of Dallas in September 2014, as part of the Federal Reserve System's centennial, and contributors include many of the most highly regarded financial historians and policymakers.
Since the early 1980s, the United States economy has changed in some important ways: Inflation now rises considerably less when unemployment falls and the volatility of output and inflation have fallen sharply. This paper examines whether changes in monetary policy can account for these phenomena. The results suggest that changes in the parameters and shock volatility of monetary policy reaction functions can account for most or all of the change in the inflation-unemployment relationship. As in other work, monetary-policy changes can explain only a small portion of the output growth volatility decline. However, changes in policy can explain a large proportion of the reduction in the volatility of the output gap. In addition, a broader concept of monetary-policy changes--one that includes improvements in the central bank's ability to measure potential output--enhances the ability of monetary policy to account for the changes in the economy.
In this paper we use both New Keynesian and Classical monetary models to explain why volatility transfers from high to low frequency cycles occur, causing the business cycle to elongate, and how they could reverse. Our results show that an increase in inflation aversion or a reduction in the commitment to output stabilization would create volatility transfers sufficient to give rise to a great moderation, while a reversal of those commitments would take it away again. In short, the lower frequency cycles become more volatile at the expense of traditional business cycle frequencies, even though there are no reversals in the parameters that govern the economy’s underlying economic behaviour, dynamics or volatility. This implies we should expect less frequent but more severe recessions, with smoother business cycle expansion phases in between. We identify moderate expectations for output or earnings growth to be the key element that under-pins these results.