Assessing DSGE model nonlinearities

We develop a new class of time series models to identify nonlinearities in the data and to evaluate DSGE models. U.S. output growth and the federal funds rate display nonlinear conditional mean dynamics, while inflation and nominal wage growth feature conditional heteroskedasticity. We estimate a DSGE model with asymmetric wage and price adjustment costs and use predictive checks to assess its ability to account for these nonlinearities. While it is able to match the nonlinear inflation and wage dynamics, thanks to the estimated downward wage and price rigidities, these do not spill over to output growth or the interest rate.     

Inflation Uncertainty, Output Growth Uncertainty and Macroeconomic Performance

We use a bivariate generalized autoregressive conditionally heteroskedastic (GARCH) model of inflation and output growth to examine the causality relationship among nominal uncertainty, real uncertainty and macroeconomic performance measured by the inflation and output growth rates. The application of the constant conditional correlation GARCH(1,1) model leads to a number of interesting conclusions. First, inflation does cause negative welfare effects, both directly and indirectly, i.e. via the inflation uncertainty channel. Secondly, in some countries, more inflation uncertainty provides an incentive to Central Banks to surprise the public by raising inflation unexpectedly. Thirdly, in contrast to the assumptions of some macroeconomic models, business cycle variability and the rate of economic growth are related. More variability in the business cycle leads to more output growth.     

Evaluating Point and Density Forecasts of DSGE Models

This paper investigates the accuracy of forecasts from four dynamic stochastic general equilibrium (DSGE) models for inflation, output growth and the federal funds rate using a real‐time dataset synchronized with the Fed's Greenbook projections. Conditioning the model forecasts on the Greenbook nowcasts leads to forecasts that are as accurate as the Greenbook projections for output growth and the federal funds rate. Only for inflation are the model forecasts dominated by the Greenbook projections. A comparison with forecasts from Bayesian vector autoregressions shows that the economic structure of the DSGE models which is useful for the interpretation of forecasts does not lower the accuracy of forecasts. Combining forecasts of several DSGE models increases precision in comparison to individual model forecasts. Comparing density forecasts with the actual distribution of observations shows that DSGE models overestimate uncertainty around point forecasts. Copyright © 2013 John Wiley & Sons, Ltd.     

The effect of nominal exchange rate volatility on real macroeconomic performance in the CEE countries

This paper analyzes the relation between nominal exchange rate volatility and several macroeconomic variables, namely real output growth, excess credit, foreign direct investment (FDI) and the current account balance, in the Central and Eastern European EU member states. Using panel estimations for the period between 1995 and 2008, we find that lower exchange rate volatility is associated with higher growth, higher stocks of FDI, higher current account deficits, and higher excess credit. At the same time, the recent evidence seems to suggest that following the global financial crisis, “hard peg” countries may have experienced a more severe adjustment process than “floaters”. The results are economically and statistically significant and robust.     

Macroeconomic Adjustment and the Poor: Analytical Issues and Cross‐Country Evidence

Abstract.  This paper studies the links between macroeconomic adjustment and poverty. The first part summarizes some of the recent evidence on poverty in the developing world. The second reviews the various channels through which macroeconomic policies affect the poor, whereas the third is devoted to the specific role of the labor market. It presents an analytical framework that captures some of the main features of the urban labor market in developing countries and studies the effects of fiscal adjustment on wages, employment, and poverty. The fourth part presents cross‐country regressions linking various macroeconomic and structural variables to poverty. Higher levels and growth rates of per capita income, higher rates of real exchange rate depreciation, better health conditions, and a greater degree of commercial openness lower poverty, whereas inflation, greater income inequality, and macroeconomic volatility tend to increase it. Moreover, the impact of growth on poverty appears to be asymmetric; it seems to result from a significant relationship between episodes of increasing poverty and negative growth rates.     

Trend growth and learning about monetary policy rules

The paper examines the effect of trend productivity growth on the determinacy and learnability of equilibria under alternative monetary policy rules. Under zero trend inflation we show that the economic structure is isomorphic to that of Bullard and Mitra (2002) and show that under a policy rule that responds to current period inflation and output a higher trend growth rate relaxes the conditions for determinacy and learnability. Results are mixed for other policy rules. Under the expectations-based rule, trend growth tightens the conditions for determinacy but it relaxes the conditions for learnability. Under the lagged-data-based rule, trend growth tightens the conditions for determinacy and learnability. Our analysis shows that lower (higher) trend growth has similar effects as higher (lower) trend inflation in the sense of making inflation more (less) forward-looking. Thus, our results complement previous studies on the role of high trend inflation as a cause of macroeconomic volatility in the U.S. in the 1970s, as this period was also characterized by productivity growth slowdown.     

Estimating and accounting for the output gap with large Bayesian vector autoregressions

We consider how to estimate the trend and cycle of a time series, such as real gross domestic product, given a large information set. Our approach makes use of the Beveridge–Nelson decomposition based on a vector autoregression, but with two practical considerations. First, we show how to determine which conditioning variables span the relevant information by directly accounting for the Beveridge–Nelson trend and cycle in terms of contributions from different forecast errors. Second, we employ Bayesian shrinkage to avoid overfitting in finite samples when estimating models that are large enough to include many possible sources of information. An empirical application with up to 138 variables covering various aspects of the US economy reveals that the unemployment rate, inflation, and, to a lesser extent, housing starts, aggregate consumption, stock prices, real money balances, and the federal funds rate contain relevant information beyond that in output growth for estimating the output gap, with estimates largely robust to substituting some of these variables or incorporating additional variables.     

Catch-up inflation and nominal convergence: The balancing act for new EU entrants

The paper addresses some of the macroeconomic implications of the simultaneous pursuit of the goals of nominal and real convergence in the presence of a fast and sustained catch-up process. It is argued that when pursued simultaneously, nominal and real convergence may give rise to conflicting policy targets for the new EU members and acceding countries. The reason is that a fast catch-up process within a rigid macroeconomic framework is very likely to be accompanied by catch-up inflation, which is an equilibrium feature of this process. The paper proposes a simple accounting framework which is used to simulate the likely range of the expected catch-up inflation in the new EU members and acceding countries and discusses some of the related policy implications.     

How should monetary policy respond to changes in the relative price of oil? Considering supply and demand shocks

This paper examines optimal monetary policy in a New Keynesian model where supply and demand shocks affect the price of oil. Optimal policy fully stabilizes core inflation when wages are flexible. The nominal rate rises (falls) in response to the demand (supply) shock. With sticky wages core inflation falls (rises) in response to the demand (supply) shock. Impulse response functions from a VAR estimated with post-1986 U.S. data show minimal movement in core inflation in response to both shocks. The federal funds rate rises (falls) in response to the demand (supply) shock, consistent with the predictions from the theoretical model for policy that stabilizes core inflation.     

LONG‐RUN RISKS IN THE TERM STRUCTURE OF INTEREST RATES: ESTIMATION

This paper estimates a model in which persistent fluctuations in expected consumption growth, expected inflation, and their time‐varying volatility determine asset price variation. The model features Epstein–Zin recursive preferences, which determine the market price of macro risk factors. Analysis of the US nominal term structure data from 1953 to 2006 shows that agents dislike high uncertainty and demand compensation for volatility risks. Also, the time variation of the term premium is driven by the compensation for inflation volatility risk, which is distinct from consumption volatility risk. The central role of inflation volatility risk in explaining the time‐varying term premium is consistent with other empirical evidence including survey data. In contrast, the existing long‐run risks literature emphasizes consumption volatility risk and ignores inflation‐specific time‐varying volatility. The estimation results of this paper suggest that inflation‐specific volatility risk is essential for fitting the time series of the US nominal term structure data. Copyright © 2012 John Wiley & Sons, Ltd.     

The effects of real and nominal uncertainty on inflation and output growth: some garch‐m evidence

In this paper we use GARCH‐M methods to test four hypotheses about the effects of real and nominal uncertainty on average inflation and output growth in the United States from 1948 to 1996. We find no evidence that higher inflation uncertainty or higher output growth uncertainty raises the average inflation rate. We also find no support for the idea that more risky output growth is associated with a higher average real growth rate. Our key result is that in a variety of models and sample periods, inflation uncertainty significantly lowers real output growth. Copyright © 2000 John Wiley & Sons, Ltd.     

The Impact of the 2008 Crisis on UK Prices: What We Can Learn from the CPI Microdata1

This paper takes the locally collected price quotes used to construct the CPI index in the UK for the period 1996–2013 and explores the impact of the Great Recession (2008‐9) on the pricing behaviour of firms. We develop a time series framework which captures the link between macroeconomic variables and the behaviour of prices in terms of the frequency of price change, the dispersion of price levels and the size, dispersion and kurtosis of price‐growth. We find strong evidence for inflation having an effect, but not output. The change in the behaviour of prices during the Great Recession is largely explained by the changes in inflation and VAT. Nevertheless, the magnitude of the inflation effect is sufficiently small that it need not influence monetary policy.     

Estimating the Bank of Mexico’s reaction function in the last three decades: A Bayesian DSGE approach with rolling-windows

This paper uses a small open economy Dynamic Stochastic General Equilibrium (DSGE) model to investigate how Mexico’s central bank has conducted its monetary policy in the period 1995–2019. The main objective of the paper is to document the systematic changes in the Bank of Mexico’s reaction function by analyzing possible shifts in the parameters of the policy rule. The central bank’s policy is modeled using a Taylor rule that relates the nominal interest rate to output, inflation, and the exchange rate. I employ Bayesian computational techniques and conduct rolling-window estimations to explicitly show the transition of the policy coefficients over the sample period. Furthermore, the paper examines the macroeconomic implications of these changes through rolling-window impulse–response functions. The results suggest that the Bank of Mexico’s response to inflation has been steady since 1995, while the response to output and the exchange rate has decreased and stabilized after 2002.     

UK Macroeconomic Volatility and the Term Structure of Interest Rates*

This study uses a macro‐finance model to examine the ability of the gilt market to predict fluctuations in macroeconomic volatility. The econometric model is a development of the standard ‘square root’ volatility model, but unlike the conventional term structure specification it allows for separate volatility and inflation trends. It finds that although volatility and inflation trends move independently in the short run, they are cointegrated. Bond yields provide useful information about macroeconomic volatility, but a better indicator can be developed by combining this with macroeconomic information.     

The asymmetric effects of uncertainty on inflation and output growth

We study the effects of growth volatility and inflation volatility on average rates of output growth and inflation for post‐war US data. Our results suggest that increased growth uncertainty is associated with significantly lower average growth, while higher inflation uncertainty is significantly negatively correlated with lower output growth and lower average inflation. Both inflation and growth display evidence of significant asymmetric response to positive and negative shocks of equal magnitude. Copyright © 2004 John Wiley & Sons, Ltd.     

Measuring Real and Nominal Macroeconomic Shocks and their International Transmission under Different Monetary Systems

A fundamental distinction can be drawn between real and nominal macroeconomic shocks. The aim of this paper is to identify and measure these two types of shocks, and to estimate the response of output growth and inflation to them. A VAR methodology that incorporates long-run identifying restrictions is used. The analysis is carried out for the US and the UK using annual data since 1869 and quarterly post-war data. The transmission of these shocks between the two countries under different international monetary systems is compared.     

How does interest rate policy affect inflation? A simple general equilibrium model with the interest rate as the policy instrument

This paper analyses the connection between the assumptions often made on the utility functions of economic agents when general equilibrium is considered. Concretely, we analyse the effect of certain assumptions regarding the elasticity of marginal utility for both the existence of equilibrium and, assuming equilibrium exists, for the effect that raising the nominal interest rate has on the equilibrium inflation rate. Typical macroeconomic wisdom states that an increase in the interest rate will decrease inflation, and this seems to have been the basis for real-life macroeconomic policy in several countries. However, this wisdom is based on models in which the money supply, and not the interest rate, is the policy instrument. Using a very simple general equilibrium model of intertemporal consumption, this paper finds sufficient conditions for the negative relationship to hold (and for it not to hold) in the short run, when monetary policy is characterised by a given nominal interest rate. Above all, it is shown how the relative risk aversion characteristics that are assumed of the economic agents are important.     

Bank competition,financial development and macroeconomic stability: Empirical evidence from emerging economies

In this study, we investigate the potential contribution of bank competition to macroeconomic stability, and the interactive role of financial development. We classify macroeconomic stability into economic and financial stability. Economic stability is represented by the volatility of actual and unexpected output growth, whereas financial stability is assessed by the aggregate Z-score and volatility of the private credit-to-gross domestic product ratio. We employ two structural and two non-structural measures of bank competition in our analysis. Applying a two-step dynamic panel system (GMM) to macroeconomic data from 48 developing nations from 1999 to 2018, we find a bell-shaped relationship between bank competition and macroeconomic stability. The findings imply that a higher level of bank competition promotes macroeconomic stability by reducing output growth volatility, fluctuations in private credit, and the probability of bank default. There is an optimal level of bank competition beyond which it may foster economic and financial instability. Moreover, financial development enhances bank competition’s positive impact on macroeconomic stability.     

A large factor model for forecasting macroeconomic variables in South Africa

This paper uses large Factor Models (FMs), which accommodate a large cross-section of macroeconomic time series for forecasting the per capita growth rate, inflation, and the nominal short-term interest rate for the South African economy. The FMs used in this study contain 267 quarterly series observed over the period 1980Q1-2006Q4. The results, based on the RMSEs of one- to four-quarter-ahead out-of-sample forecasts from 2001Q1 to 2006Q4, indicate that the FMs tend to outperform alternative models such as an unrestricted VAR, Bayesian VARs (BVARs) and a typical New Keynesian Dynamic Stochastic General Equilibrium (NKDSGE) model in forecasting the three variables under consideration, hence indicating the blessings of dimensionality.     

Macroeconomic forecasting and structural change

The aim of this paper is to assess whether modeling structural change can help improving the accuracy of macroeconomic forecasts. We conduct a simulated real‐time out‐of‐sample exercise using a time‐varying coefficients vector autoregression (VAR) with stochastic volatility to predict the inflation rate, unemployment rate and interest rate in the USA. The model generates accurate predictions for the three variables. In particular, the forecasts of inflation are much more accurate than those obtained with any other competing model, including fixed coefficients VARs, time‐varying autoregressions and the naïve random walk model. The results hold true also after the mid 1980s, a period in which forecasting inflation was particularly hard. Copyright © 2011 John Wiley & Sons, Ltd.