Monetary policy, taxes, and the business cycle

This paper analyzes the interaction of inflation with the tax code and its contribution to aggregate fluctuations. We find significant effects operating through the tax on realized nominal capital gains. A tax on nominal bond income magnifies these effects. Our innovation is to combine monetary policy shocks with non-indexed taxes in a model where the central bank implements policy using an interest rate rule. Monetary policy had important effects on the behavior of the business cycle before 1980 because policymakers did not exert effective control over inflation. Monetary policy reform around 1980 led to better control, and with more stable inflation, the effect of the interaction between monetary policy and the nominal capital gains tax has become negligible.     

New Keynesian Macroeconomics and the Term Structure

This article complements the structural New Keynesian macro framework with a no-arbitrage affine term structure model. Whereas our methodology is general, we focus on an extended macro model with unobservable processes for the inflation target and the natural rate of output that are filtered from macro and term structure data. We find that term structure information helps generate large and significant parameters governing the monetary policy transmission mechanism. Our model also delivers strong contemporaneous responses of the entire term structure to various macroeconomic shocks. The inflation target shock dominates the variation in the "level factor" whereas monetary policy shocks dominate the variation in the "slope and curvature factors."     

New measures of the output gap based on the forward-looking new Keynesian Phillips curve

Forward-looking versions of the New Keynesian Phillips curve imply that the output gap, the deviation of the actual output from its natural level due to nominal rigidities, drives the dynamics of inflation relative to expected inflation. We exploit this to set up a bivariate unobserved component model for extracting new estimates of the output gap in the US. The gap estimates are large and persistent even after allowing for correlated trend and cycle shock. We then augment our model to use the information in the unemployment rate. The estimates confirm the presence of a large and persistent cyclical component.     

Pricing Models: A Bayesian DSGE Approach for the U.S. Economy

This paper compares and estimates three pricing mechanisms in the context of a small DSGE model of the U.S. economy. We interpret our results as favoring the pricing mechanism presented in Wolman (1999 Wolman model) over the New Keynesian model with indexation ( Gali and Gertler 1999 , Smets and Wouters 2004a ) and the sticky information model of Mankiw and Reis (2002) . The key factor that explains the performance of the Wolman model is that the data reject the key assumption of the New Keynesian model that the firm's probability of price change is constant over time and independent of the contract's vintage. Our results also show that incorporating indexation in the New Keynesian model represents a poor expedient in matching the autocorrelation function of the inflation process over the last 20 years.     

Intrinsic Persistence of Wage Inflation in New Keynesian Models of the Business Cycles

We derive and estimate a New Keynesian wage Phillips curve that accounts for intrinsic inertia. In line with microevidence on wage setting, we consider a wage‐setting model featuring an upward‐sloping hazard function, based on the notion that the probability of resetting a wage depends on the time elapsed since the last reset. Our wage Phillips curve embeds also backward terms. We test the hazard function slope using generalized method of moment estimation. Then, placing our equation in a small‐scale New Keynesian model, we investigate its dynamic properties using Bayesian estimation. Model comparison shows that our model outperforms commonly used alternative methods to introduce persistence.     

Estimation of the equilibrium exchange rate: The CHEER approach

The paper presents the results of an investigation where the concept of a steady-state level of the exchange rate is equated with the capital market equilibrium based on the CHEER approach. The empirical analysis concentrates on Poland, because in this case the assessment of the equilibrium exchange rate is of vital importance. The prospect of the Polish currency joining the ERM2 provokes controversies and requires research into the economic consequences of accession to the EMU. The international transmission mechanisms affecting the Polish economy are identified within the VEqCM framework. The calculations indicate that in the last years of the analyzed sample (i.e. up to December 2006) the zloty/euro exchange rate was slightly overvalued, and the steady-state level was found to have been adjusting to the value of 4.1 zlotys.     

Deep Habits in the New Keynesian Phillips Curve

We derive and estimate a New Keynesian Phillips Curve (NKPC) in a model with deep habits. Habits are deep in that they apply to individual consumption goods instead of aggregate consumption. This alters the NKPC in a fundamental manner since it introduces consumption growth and future demand terms into the NKPC equation. We construct the driving process in the deep habits NKPC by using the model's optimality conditions to impute time series for unobservable variables. The resulting series is considerably more volatile than unit labor cost. Generalized methods of moments estimation shows an improved fit and a much lower degree of indexation compared to the standard NKPC.     

Quantifying the uncertainty about the fit of a new Keynesian pricing model

Recent studies by Gali and Gertler [1999. Inflation dynamics: a structural econometric analysis, Journal of Monetary Economics 44, 195-222] and Sbordone [2002. Prices and unit labor costs: testing models of pricing, Journal of Monetary Economics 49, 265-292] conclude that a theoretical inflation series implied by a forward-looking New Keynesian pricing equation fits post-1960 U.S. inflation closely. Their theoretical inflation series is conditional on (i) a reduced-form forecasting process for real marginal cost; and (ii) the calibration of the pricing equation. The present paper shows that both of these determinants are surrounded by considerable uncertainty. When quantifying the impact of this uncertainty on theoretical inflation, we can no longer say whether the forward-looking pricing equation explains observed inflation dynamics very well or very poorly.     

Firm dynamics, markup variations, and the business cycle

We present a model in which net business formation is endogenously procyclical. Variations in the number of operating firms lead to countercyclical variations in markups that give rise to endogenous procyclical movements in measured total factor productivity (TFP). Based on this result, the paper suggests a simple structural decomposition of variations in TFP into those originating from exogenous shocks and those originating endogenously from the interaction between firms’ entry and exit decisions and the degree of competition. The decomposition suggests that around 40% of the movements in measured TFP can be attributed to this interaction. Moreover, the paper analyzes the effects on (i) the measurement of the volatility of exogenous shocks in the U.S. economy and (ii) the magnification of shocks over the business cycle.     

Instability of sunspot equilibria in real business cycle models under adaptive learning

We provide conditions under which a general, reduced-form class of real business cycle (RBC) models has rational expectations equilibria that are both indeterminate and stable under adaptive learning. Indeterminacy of equilibrium allows for the possibility that non-fundamental “sunspot” variable realizations can be used to drive the model, and several researchers have offered calibrated structural models where sunspot shocks play such a role. However, we show that the structural restrictions researchers have adopted lead to reduced-form systems that are always unstable under adaptive learning dynamics, thus calling into question the plausibility of these sunspot-driven RBC models.     

Portfolio optimization in the presence of dependent financial returns with long memory: A copula based approach

In this paper, we seek to examine the effect of the presence of long memory on the dependence structure between financial returns and on portfolio optimization. First, we focus on the dependence structure using copulas. To select the best copula, in addition to the goodness of fit tests, we employ a graphical method based on visual comparison of the fitted copula density and the smoothed copula density estimated by wavelets. Moreover, we check the stability of the copula parameter. The empirical results show that the long memory affects the dependence structure. Second, we analyze the impact of this dependence structure on the optimal portfolio. We propose a new approach based on minimizing the Conditional Value at Risk and assuming that the dependence structure is modeled by the copula parameter. The empirical results show that our approach outperforms the traditional minimizing variance approach, where the dependence structure is represented by the linear correlation coefficient.     

How Sticky Is Sticky Enough? A Distributional and Impulse Response Analysis of New Keynesian DSGE Models

In this paper, we add to the literature on the assessment of how well data simulated from new-Keynesian dynamic stochastic general equilibrium (DSGE) models reproduce the dynamic features of historical data. In particular, we evaluate sticky price, sticky price with dynamic indexation, and sticky information models using impulse response and correlation measures and via implementation of a distribution based approach for comparing (possibly) misspecified DSGE models using simulated and historical inflation and output gap data. One of our main findings is that for a standard level of stickiness (i.e., annual price or information adjustment), the sticky price model with indexation dominates other models. We also find that when a lower level of information and price stickiness is used (i.e., bi-annual adjustment), there is much less to choose between the models (see Bils and Klenow 2004 , for evidence in favor of lower levels of stickiness). This finding is due to the fact that simulated and historical densities are "much" closer under bi-annual adjustment.     

99 Luftballons: Monetary policy and the house price boom across U.S. states

We use a dynamic factor model estimated on quarterly state-level data from 1986 to 2005 via Bayesian methods to disentangle the relative importance of the common component in OFHEO house price movements from local (state- or region-specific) shocks. We find that historically movements in house prices were mainly driven by the local component. The recent period (2001-2005) has been different: the increase in house prices is a national phenomenon. We use a VAR to investigate the extent to which expansionary monetary policy is responsible for this phenomenon. We find the impact of policy shocks on house prices to be small in comparison with the magnitude of recent fluctuations.     

A stochastic dominance analysis of yen carry trades

Yen carry trades have made headline news for over a decade. We examine the profitability of such trades for the period 2001–2009. Yen carry trades generated high mean returns and Sharpe ratios prior to the recent financial crisis. They continued to outperform major stock markets for the full sample period. Given the non-normality of carry trade returns, we apply non-parametric tests based on stochastic dominance (SD) to evaluate whether the high returns of yen carry trades are compatible with risk as reflected in returns on US and global stock market indices. We apply a general test for SD developed recently by Linton, Maasoumi and Whang (2005) to six currencies as well as portfolios of these currencies. For a large class of risk-averse investors, profits from yen carry trades cannot be attributed to risks.     

Real Wage Rigidities and the New Keynesian Model

Most central banks perceive a trade-off between stabilizing inflation and stabilizing the gap between output and desired output. However, the standard new Keynesian framework implies no such trade-off. In that framework, stabilizing inflation is equivalent to stabilizing the welfare-relevant output gap. In this paper, we argue that this property of the new Keynesian framework, which we call the divine coincidence , is due to a special feature of the model: the absence of nontrivial real imperfections. We focus on one such real imperfection, namely, real wage rigidities. When the baseline new Keynesian model is extended to allow for real wage rigidities, the divine coincidence disappears, and central banks indeed face a trade-off between stabilizing inflation and stabilizing the welfare-relevant output gap. We show that not only does the extended model have more realistic normative implications, but it also has appealing positive properties. In particular, it provides a natural interpretation for the dynamic inflation–unemployment relation found in the data.     

Unemployment and the business cycle

This paper presents a dynamic general equilibrium model where labor effort is imperfectly observable and there is unemployment in equilibrium. In contrast to shirking models in the efficiency wage literature, detected shirkers are not dismissed. Instead, they face a monetary punishment because they forgo an increase in their compensation. Estimated versions of the model can generate the high variation in employment and low variation of real wages observed over the business cycle, and are consistent with existing qualitative evidence about the responses of the economy to fiscal policy shocks.     

Forming priors for DSGE models (and how it affects the assessment of nominal rigidities)

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.     

Reconsidering the natural rate hypothesis in a New Keynesian framework

This paper formulates a stylized New Keynesian model in which each individual firm can select the frequency of its price adjustments. The endogeneity of contract duration has a dramatic impact on the magnitude of the aggregate effects of steady-state inflation. With a plausible calibration of the magnitude of menu costs and other structural parameters, this model predicts a relationship between steady-state inflation and the frequency of price adjustment that is reasonably close to the empirical findings of cross-country studies. Furthermore, at moderate inflation rates, steady-state inflation generates relative price distortions that have a non-trivial impact on aggregate output, but this impact wanes and eventually disappears at much higher annual inflation rates because the frequency of price adjustment approaches that of the flexible-price economy.     

Do long swings in the business cycle lead to strong persistence in output?

This paper investigates how the occasional long swing in the business cycle can produce long-memory behavior in US output. To prove this theoretical relationship, we extend the Hamilton Markov chain regime switching model of real aggregate output to include the occasional long regime. We do this by modeling the duration length of the expansion and recession regimes as draws from a fat-tailed distribution with realized durations that are high in variability and occasionally extreme in value. Empirically, we find that the tail indices for the length of US economic booms and busts correspond with the long-memory parameter estimates of Diebold and Rudebusch [1989. Long memory and persistence in aggregate output. Journal of Monetary Economics 24, 189-209] and Sowell [1992a. Modeling long-run behavior with the fractional ARIMA model. Journal of Monetary Economics 29, 277-302] for real US output. Estimates of our extended regime switching model produce better short- and long-run forecasts of output in comparison to forecasts with a fractionally integrated model. Furthermore, our estimated regime-switching model finds US expansions to be fragile during their infancy, but become more and more likely to continue after surviving the first seven quarters.     

Trend Inflation and the Nature of Structural Breaks in the New Keynesian Phillips Curve

We show that with a unit root in inflation, the new Keynesian Phillips curve (NKPC) implies an unobserved components model with a stochastic trend component and an inflation gap. Our empirical results suggest that with an increase in trend inflation during the Great Inflation, the response of inflation to real economic activity decreases and the persistence of the inflation gap increases due to an increase in the persistence of the unobserved stationary component. These results are in line with the predictions of Cogley and Sbordone ( 2008 ), who show that the coefficients of the NKPC are functions of time‐varying trend inflation.