Should monetary policy lean against the wind? Simulations based on a DSGE model with an occasionally binding credit constraint

In this research paper, we extend the model constructed by Gambacorta and Signoretti (2014) by introducing an occasionally binding credit constraint based on a penalty function approach in line with Brzoza-Brzezina, Kolasa, and Makarski (2015) to study the performance of the Taylor rule augmented with asset prices. First, we compare the properties of the baseline model and its modified version. Then, we use both models to study the performance of the basic and extended Taylor rule. The performance of Taylor rules is examined under the optimisation of a central bank's loss function and the welfare maximisation of economic agents. The analysis delivers the following results. The model with an occasionally binding credit constraint has more favourable properties regarding the hump-shaped and asymmetric impulse responses compared to an eternally binding credit constraint model. The best rule regarding the lowest value of the central banks' loss function proves to be the rule augmented with asset prices. The optimal reactions are, however, shock- and model-dependent, and therefore, any rule-like behaviour does not seem to be appropriate. The welfare maximisation under the occasionally binding credit constraint model reveals that reacting to asset prices might not be welfare-improving for both types of economic agents – households and entrepreneurs. This result is in contradiction with the implications achieved under the eternally binding credit constraint model.     

A realistic model for official interest rate movements and their consequences

This article extends the Vector Autoregression (VAR) methodology to examine the consequences of monetary policy decisions by considering two types of nonlinearities in the determination of official interest rates: (1) the asymmetry related to the different nature of the discrete and infrequent positive and negative interest rate movements determined by central bankers and (2) the convexity in the transmission of policy shocks induced by the nonnegativity constraint in interest rates. For the UK, we find some evidence of both types of asymmetries. In the US, responses to unexpected interest rate shocks are far more symmetric. Results highlight the importance of considering all types of asymmetries when studying monetary transmission.     

Is the relationship between monetary policy and house prices asymmetric across bull and bear markets in South Africa? Evidence from a Markov-switching vector autoregressive model

This paper examines asymmetries in the impact of monetary policy on the middle segment of the South African housing market from 1966:M2 to 2011:M12. We use Markov-switching vector autoregressive (MS-VAR) model in which parameters change according to the phase of the housing cycle. The results suggest that monetary policy is not neutral as house price growth decreases substantially with a contractionary monetary policy. We find that the impact of monetary policy is larger in bear regime than in bull regime; indicating the role of information asymmetry in reinforcing the financial constraint of economic agents. As expected, monetary policy reaction to a positive house price shock is found to be stronger in the bull regime. This suggests that the central bank reacts more in bull regime in order to prevent potential crisis related to the subsequent bust in house prices bubbles which are more prominent in bull markets. These results substantiate important asymmetries in the dynamics of house prices in relation to monetary policy, vindicating the advantages of generating regime dependent impulse response functions.     

Temporary bubbles

This article studies the dynamics of an overlapping generations model with capital, money and cash-in-advance constraints. The economy can exhibit two different regimes. In the first one, the cash-in-advance constraint is binding and money is a dominated asset. In the second one, the constraint is strictly satisfied and money has the same return as capital. When the second regime holds on a finite number of periods, we say that the economy experiences a temporary bubble. We prove that temporary bubbles can exist in an economy, which would experience under-accumulation without money. We also show that cyclical bubbles may occur.     

Asymmetry and Duration Dependence in Australian GDP and Unemployment

The periodic structure of business cycles suggests that significant asymmetries are present over different phases of the cycle. This paper uses markov regime-switching models with fixed and duration dependent trasition probabilities to directly model expansions, contractions and durations in Australian GDP growth and unemployment growth. Evidence is found of significant asymmetry in growth rates across expansions and contractions for both series. GDP contractions exhibit duration dependence implying that as output recessions age the likelihood of switching into an expansion phase increases. Unemployment growth does not exhibit duration dependence in either phase. Evidence is also presented that non-linearities in unemployment growth are well explained by the asymmetries in the GDP growth cycle. The analysis suggests that recessions are periods of rapid and intense job destruction, that Australian unemployment tends to ratchet up in recessionary periods and, in contrast to US and UK studies, that shocks to Australian unemployment growth are more persistent in recessions than expansions.     

Unemployment insurance design: Inducing moving and retraining

Evidence suggests that unemployed individuals can affect their job prospects by undertaking a costly action like deciding to move or retrain. Realistically, such an opportunity only arises for some individuals and the identity of those may be unobservable ex ante. The problem of characterizing constrained optimal unemployment insurance in this case has been neglected in previous literature. We construct a model of optimal unemployment insurance where multiple incentive constraints are easily handled. The model is used to analyze the case when an incentive constraint involving moving costs must be respected in addition to the standard constraint involving costly unobservable job-search. Absent wealth effects on behavior, we derive closed-form solutions showing that when the moving/retraining incentive constraint binds, unemployment benefits should increase over the unemployment spell, with an initial period with low benefits and an increase after this period has expired.     

Precautionary saving or denied dissaving

Precautionary saving in response to uninsurable income risk can in principle explain the stylized fact that aggregate saving increases with the variance of income, but it is controversial how much of the observed variation in incomes is, in fact, unpredictable. Borrowing constraints offer an alternative explanation that does not require consumers to be uncertain about their future income. This paper employs a three-cohort, overlapping generations model with quadratic utility and no capital to show that, if agents are patient enough, heterogeneity alone can account for more than half the decrease in the equilibrium interest rate caused by a borrowing constraint. The possibility of facing a binding borrowing constraint in the future induces saving, and this saving increases with the cross-sectional variation in income. Another channel that pushes down the interest rate is the direct effect caused by currently constrained agents not being allowed to dissave. For patient agents, the two channels have roughly the same impact on the interest rate.     

Investment-specific technological changes: The source of long-run TFP fluctuations

Technological innovations originating in the capital–producing sector may spillover to the rest of the economy and enhance aggregate TFP in the long-run. This paper assesses the quantitative importance of investment-specific technological changes in long-run movements in aggregate TFP. To this end, we construct a two-sector business cycle model where an IST diffusion process influences long-run movements in aggregate TFP via spillover. We then establish the linkage between the primitive shocks of the model and two shocks that can be identified from a VAR approach: one shock accounting for the long-run movement in aggregate TFP and the other accounting for the long-run movement in the inverse of the relative price of investment. We show analytically that the correlation of these two long-run shocks can be fruitful in distinguishing the quantitative importance of IST innovations in long-run movements in aggregate TFP. Using post-war U.S. data, we find that these two long-run shocks identified by the MFEV approach are almost perfectly collinear. Moreover, these two shocks can explain a significant, and surprisingly similar, fraction of the business-cycle fluctuations in other important macro variables. Our findings suggest that embodied technological changes are an important driver of long-run movements in aggregate TFP.     

Heterogeneous producers facing common shocks: An overlapping-generations example

An analytically tractable model of a competitive, full-information economy is provided in which, for some parameter values, entry and exit over the course of the business cycle is concentrated among small firms. This model is intended to make the logical point that the relatively high sensitivity of small firms to business-cycle fluctuations does not necessarily indicate the presence of informational or incentive constraints in financial markets.     

Efficient propagation of shocks and the optimal return on money

We study optimal allocations in an environment in which money is essential due to lack of commitment and anonymity of individuals. Because the economy features aggregate preference shocks, we apply a notion of implementability that allows for allocations with non-trivial business-cycle dynamics for the propagation of shocks. We show that history dependence is predicted by the theory of second best and becomes necessary for optimality when the degree of patience is neither too low nor too high. Our analysis concludes with a discussion of whether there is a role for the propagation of shocks in alternative economic environments.     

Optimal long-run inflation with occasionally binding financial constraints

This paper studies the optimal long-run inflation rate in a simple New Keynesian model with occasionally binding collateral constraints that intermediate-good firms face on hiring labor. The paper finds that the optimal long-run annual inflation rate is around 1.5% if the economy is hit by a total factor productivity (TFP) shock and nearly 2.5% if the economy is subject to a markup shock. The shadow value of the collateral constraint is akin to an endogenous cost-push shock. Differently from usual cost-push shocks, however, this shock is asymmetric as it takes non-negative values only. Since the mean of this asymmetric endogenous cost-push shock is positive, inflation is also positive on average. In addition, a binding collateral constraint resembles a time-varying tax on labor, which the monetary authority can smooth by setting a positive inflation rate. More generally, the basic result is related to standard Ramsey theory in that optimal policy smoothes distortions over time.     

Can the Mortensen-Pissarides Matching Model Match the Business-Cycle Facts?

We examine whether the Mortensen-Pissarides matching model can account for the business-cycle facts on employment, job creation, and job destruction. A novel feature of our analysis is its emphasis on the reduced-form implications of the matching model. Our main finding is that the model can account for the business-cycle facts, but only if the average duration of a nonemployment spell is relatively high—about 9 months or longer.     

European economic integration and (a)symmetry of macroeconomic fluctuations

This paper empirically investigates output and consumption asymmetries in the Eurozone and enlarged EU over the period 1992–2007, and their consequences for monetary policy. Our results reveal that in the Eurozone output asymmetry has remained practically unaltered; however, there is some indication of greater consumption smoothing. The UK, Denmark and Sweden are no less asymmetric than the average Eurozone member state and could probably enter the EMU without significant macroeconomic costs. New EU member states are diverse but display higher output and, in particular, consumption asymmetries. This warrants some caution against too quick expansion of the EMU.     

POLITICAL ASYMMETRY AND COMMON EXTERNAL TARIFFS IN A CUSTOMS UNION

This paper examines the effect of political and economic asymmetries in the formation of common external tariffs (CETs) in a customs union (CU). We do so by introducing possible cross‐border lobbying and by endogenizing tariff formation in a political economic model for the determination of CETs. The latter allows us to consider asymmetries among the member nations in their susceptibilities to lobbying. We also consider asymmetries in the influence of the member nations in CU‐wide decision‐making. A central finding of this paper is that, in the absence of economic asymmetry, the CET rises monotonically with the degree of asymmetry in country influences if the two countries are equally susceptible to lobbying. If influences are the same, the CET also rises monotonically with the degree of asymmetry in susceptibilities. These results hold irrespective of whether the lobby groups in the two member countries cooperate or work non‐cooperatively.     

A Pearson's test for symmetry with an application to the Spanish business cycle

In this paper, we look for asymmetries in the Spanish business cycle. To that end, we firstly propose an easy nonparametric testing procedure to test for symmetry based on a Pearson's chi-squared statistic, which we call P-test. Then, we test for two popular forms of asymmetry, deepness and steepness, using a battery of nonparametric tests. In addition, we analyse possible complementarities between the tests used in this paper, and we compute p-value adjustments for multiple tests.     

Average-cost pricing: Some evidence and implications

We present new survey evidence on pricing behavior for more than 14,000 European firms, and study its macroeconomic implications. Among firms that are price setters, roughly 75% respond that their prices are set as a markup on total costs, a business practice termed “full cost pricing”. Only 25% set prices as markups over variable or marginal costs. Moreover, using industry data for the U.S., we find that the correlation between changes in output prices and changes in variable input prices is significantly lower when fixed costs are likely to be more important.Since our results are similar to the findings in the classic and controversial paper of Hall and Hitch (1939) and subsequent survey evidence, we believe it worth studying the implications of full cost pricing for macroeconomics. We first propose a problem for the firm where full cost pricing can arise as optimizing behavior. We embed this problem, featuring an occasionally binding constraint, into a simple general equilibrium model. We show that when the model is hit by a shock that makes the constraint binding, the response of endogenous variables is amplified significantly more than it would be under the unconstrained regime.     

Can asymmetric conditional volatility imply asymmetric tail dependence?

In this article, we investigate two types of asymmetries, that is, the asymmetry of conditional volatility and the asymmetry of tail dependence in the crude oil markets. We employ the two different sample datasets in which each dataset covers the time period of stable and unstable oil prices, individually. A variety of different copulas and three asymmetric GARCH regression models are used in order to capture the two types of asymmetries. In particular, we extend the TBL-GARCH model proposed by Choi et al. (2012) to the asymmetric GARCH regression type model. The findings from the two different approaches are congruent, in that there is no asymmetry of tail dependence and no asymmetric conditional volatility in crude oil returns over the two different sample periods. Our study reconfirms the findings of Aboura and Wagner (2016) by showing that asymmetric conditional volatility relates to asymmetric tail dependence.     

Capacity constraints, asymmetries, and the business cycle

We study how an occasionally binding capacity constraint affects the properties of business cycles. A real business cycle model is constructed where production takes place at individual plants and the number of plants operated varies over the cycle. The capacity constraint binds in states where all plants are operated. We derive the aggregate production function for this economy, which turns out to differ from the standard Cobb–Douglas function while retaining its desirable properties. The business cycle features of this one-sector growth model are similar to those of a standard real business cycle model in most respects. Our model does, however, display some properties of actual economies that standard models do not. In particular, business cycles in our model are asymmetric—troughs are deeper on average than peaks are tall. Also, labor's share of income is counter-cyclical, as it is in US data.     

Nonlinear interest rate reaction functions for the UK

We empirically analyze Taylor-type equations for short-term interest rates in the United Kingdom using quarterly data from 1970Q1 to 2006Q2. Starting from strong evidence against a simple linear Taylor rule, we model nonlinearities using logistic smooth transition regression (LSTR) models. The LSTR models with time-varying parameters consistently track actual interest rate movements better than a linear model with constant parameters. Our preferred LSTR model uses lagged interest rates as a transition variable and suggests that in times of recessions the Bank of England puts more weight on the output gap and less so on inflation. A reverse pattern is observed in non-recession periods. Parameters of the model change less frequently after 1992, when an inflation target range was announced. We conclude that for the analysis of historical monetary policy, the LSTR approach is a viable alternative to linear reaction functions.     

Macroeconomic dynamics in Macedonia and Slovakia: Structural estimation and comparison

This paper estimates a structural macroeconomic model using data for Macedonia and Slovakia to characterize possible challenges Macedonia can face concerning macroeconomic stabilization during its transition process. A comparison of the estimated model parameters suggests that, in Slovakia, the output gap is less sensitive to real interest rate movements and prices experience greater inertia. The estimated monetary policy reaction functions show Macedonia and Slovakia as inflation targeters, with Macedonia as the more conservative one, despite its officially applied exchange rate targeting regime. The differences in the estimated parameters imply differing transmission mechanisms for Macedonia and Slovakia. Consequently, the variance of domestic variables in Slovakia is most influenced by monetary policy shocks, while there is no single dominating shock explaining the volatility of Macedonia's macroeconomic variables. The exchange rate shock, the monetary policy shock and the demand shock are jointly important in determining the volatility of Macedonia's variables. The model simulations indicate that Macedonia experiences lower output gap and inflation volatility than Slovakia. This comes, nevertheless, at the cost of higher interest rate and real exchange rate volatility in Macedonia, which could be an indication of more volatile financial markets with possible negative implications for financial stability.