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THE CONSENSUS MACROECONOMIC MODEL

A PRESENTATION BY;KHURRUM S. MUGHAL

FARAZ A. KHAN XIN MIAO

FOR THE SEMINAR COURSE;

INTERNATIONALE WIRTSCHAFT, FINANZMÄRKTE UND MAKROÖKONOMETRIE

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MACRO MODELS

• Why Macro Models are needed– Monetary policy– Interest rate & Inflation

• Three basic equations– IS Curve– Philips curve– Monetary Rule

• Consensus Macro Models:– New Noeclassical Synthesis (NNS) Models– New Keynisian Models

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)(1 eyy )( T

e byy

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MACRO MODELS

• Macroeconomic Modelling for Monetary Policy Evaluation by Gali and Gertler (2007)– Theoratical paper– New vintage of macroeconomic modelling

• Shocks and Frictions in US Business Cycles: a Bayesian DSGE Approach by Frank Smets and Rafael Wouters (2007)– Theoratical and Empirical– Business cycle analysis and flucuations– Data set of US economy 1966-2004

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MACROECONOMIC MODELLING FOR MONETARY

POLICY EVALUATION

By Gali and Gertler*

*Galí, Jordi, and Mark Gertler. 2007. "Macroeconomic Modeling for Monetary Policy Evaluation." Journal of

Economic Perspectives, 21(4): 25–46.

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INTRODUCTION • Background

– that monetary policy can cause economic activities deviate from their natural levels;

• Key implications of the new vintage macro models:• Monetary transmission depends on private sector

expectations of the future path of the central bank’s policy instrument.– short-term interest rate as instrument– individuals and firms are forward-looking

• The natural values of both output and the real interest rate provide important reference point for monetary policy. – natural values are explicit. natural level of economic activity is defined as the

equilibrium, where prices are flexible and all other cyclical distortions are absent.

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THE BASELINE MODEL

• The Baseline Model consists of Aggregate Demand/Supply and Monetary Rule

• Two key ingredients:

– Monopolistic competition:• firms are price setters in this model, so there must be imperfect

competition. Firms face downward-sloping demand curves.

– Nominal rigidities:• nominal prices adjust sluggishly, responding to central banks’ short

run nominal/ real interest rate adjustment.

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AGGREGATE DEMANDAssumptions:

– is built up from the spending decisions of representative households and representative firms.

– both capital and insurance markets are perfect. Households are satisfied at their optimizing consumption/saving decisions, and firms are satisfied at their optimizing investment decisions.

– investment changes proportionally with Tobin’s q.

(q=market value of installed capital / replacement cost of capital)

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(Output gap is negatively related with long run real interest rate gap, and positively related with gap in “q”)

• Defining Short run real interest rate

– long run real interest rate gap depends positively on both current and expected future short run real interest rate gap.

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AGGREGATE DEMAND

1( ) nt t t t trr r E rr

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AGGREGATE DEMAND• Monetary policy influences aggregate demand:

– Given the sluggish adjustment of prices, central bank may vary short run real interest rate by changing short run nominal interest rate.

• Exogenous fluctuations (e.g. Govt. spending) influence both natural level of output and interest rate but do not affect the form of equation of aggregate demand, because the model estimates gap variables

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AGGREGATE SUPPLY

• Aggregate Supply evolves from price-setting decisions of individual firms.

• Assumption: – “firms set prices on a staggered basis, saying that each period a

subset of firms set their respective prices for multiple periods”.

• What is staggered price setting?– In a given period, firms set prices equal to a weighted average of the

current and expected future nominal marginal costs.

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AGGREGATE SUPPLY

• Forward looking Phillips curve:– Inflation depends not only on current value of excess

output and cost push shock, but also expected future values.

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AGGREGATE SUPPLY

• Inflation depends not only on current value of excess output and cost push shock, but also expected future values.

• In the absence of cost push shock “ut”, inflation depends only on current and future value of output gap. Central bank maintains prices by adjusting short run interest rate.

• If cost push shock exists, inflation depends on current and expected movements in cost push shock and output gap. And the only way to offset this cost push pressure on inflation is to contract economic activity.

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HOW MONETARY POLICY IS CONDUCTED

• Each period central bank chooses a target for the short run interest rate. This is done through adjusting money supply to meet the quantity of money, demanded at the target interest rate.

• Without inflation and excess demand real interest rate is the same as target nominal interest rate

• If economy is “overheating” with a positive output gap and positive inflation, central bank would increase nominal interest rate more than one-for-one with inflation according to the coefficient. (in order to contract demand sufficiently)

nt t t y tr rr y

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MONETARY POLICY EVALUATION

• We can use this model to evaluate different scenarios of monetary policy:– Importance of managing expectations of future policy– The need to track movements in the economy‘s general

equilibrium

• Assumptions:– Central Bank Aims to:

• Maintain price stability• Maintain output at its natural level• Natural level of output is close to the socially efficient value

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SIMULATIONSEXPERIMENT 1: Managing Expectations

• Central bank follows an aggressive policy to fight inflation:– Central bank signals its intentions to private sector– Central bank does not signal its intentions to private sector

(the private sector believes that central bank is likely to accomodate inflation)

• Result: Managing expectations improves the short run trade-off between output and inflation stabilization.

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SIMULATIONSEXPERIMENT 2: Tracking Natural Equilibrium

• Assuming that the economy is hit with a productivity shock influencing the natural values of output and real interest rate.– Central bank adjusts the nominal interest rate according to

natural rate of interest and inflation.– Does not.

• Result: Managing expectations improves the short run trade-off between output and inflation stabilization.

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EXTENSIONS

• Applying the model with data shows persistance of results whereas the model itself shows instantaneous jumps.

• We can counteract if we;– Introduce adjustment costs– Introduce wage rigidity

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NEW DIRECTIONS

The model lacks in the following aspects:

• Labor market frictions

• Financial market imperfections

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SHOCKS AND FRICTIONS IN US BUSINESS CYCLES: A

BAYESIAN DSGE APPROACH

By FRANK SMETS AND RAFAEL WOUTERS*

*Smets, Frank, and Rafael Wouters. 2007. "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach." American Economic

Review, 97(3): 586–606.

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INTRODUCTION• New Neoclassical Synthesis (NNS) models

– small-scale monetary business cycle models with sticky prices and wages for monetary policy analysis.

• This paper: An extended version of these models (on US data), largely based on:– Lawrence J. Christiano, Martin Eichenbaum, & Charles L. Evans

(CEE, 2005)

• Covering the period 1966:1- 2004:4, and using a Bayesian estimation methodology.

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INTRODUCTION• Model features sticky nominal price and wage

settings that allow for– backward inflation indexation, – habit formation in consumption and investment adjustment costs

that create hump-shaped responses of aggregate demand, – and variable capital utilization – and fixed costs in production.

• The stochastic dynamics is driven by seven orthogonal structural shocks:– total factor productivity shocks, – two shocks that affect the inter-temporal margin (risk premium

shocks and investment-specific technology shocks), – two shocks that affect the intra-temporal margin (wage and price

mark-up shocks), – two policy shocks (exogenous spending and monetary policy

shocks).

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OBJECTIVES OF THE PAPER

• NNS models have become the standard workhorse for monetary policy analysis, it is important to verify whether they can explain the main features of the US macro data

• Using the estimated NNS model to address a number of key issues:

– what are the main driving forces of output developments in the United States?

– productivity shocks

– inflation developments.

– to investigate the stability of the results

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THE LINEARIZED DSGE MODEL• Households rent capital services to firms and decide how

much capital to accumulate given the capital adjustment costs they face. As the rental price of capital changes, the utilization of the capital stock can be adjusted at increasing cost.

• Firms produce differentiated goods, decide on labor and capital inputs, and set prices.

– Prices are therefore set in function of current and expected marginal costs, but are also determined by the past inflation rate

– marginal costs depend on wages and the rental rate of capital.

– wages depend on past and expected future wages and inflation.

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POLICY IMPLICATIONS

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APPLICATIONS• What Are the Main Driving Forces of Output?

• Determinants of Inflation and the Output- Inflation Cross Correlation

• The Effect of a Productivity Shock on Hours Worked

• Why have output and inflation become volatile?

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A) What Are the Main Driving Forces of Output?

• SHORT RUN: (Demand Shocks)– Exogenous Spending Shock– Risk premium Shock – Investment specific technology shock

• MED - LONG RUN: (Supply Shocks)– Productivity Shock– Wage markup Shock

Note: A demand (supply) shock is a sudden event that increases or decreases demand (supply) for goods or services temporarily. A positive demand (supply) shock increases demand (supply) and a negative demand shock decreases demand (supply).

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B) Determinants of Inflation and the Output-Inflation Cross Correlation

• Price markups in short run

• Wage markups in long run

– are mostly driven by the price mark-up shocks in the short run and the wage mark-up shocks in the long run.

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C) The Effect of a Productivity Shock on Hours Worked:

• Positive productivity shocks result in fall of hours worked.

• Productivity shocks have a significant short-run negative impact on hours worked.

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CONCLUSION

• The microfounded NNS model fits US data.

• However it needs further development in terms of understanding nominal and real frictions.

• Some questions about the structural shocks.

• Quantitative macroeconomic modelling is necessary for policy evaluation however the models may evolve further with data application and future shock experiences.

Thanks

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Sources

• Galí, Jordi, and Mark Gertler. 2007. "Macroeconomic Modeling for Monetary Policy Evaluation." Journal of Economic Perspectives, 21(4): 25–46.

• Smets, Frank, and Rafael Wouters. 2007. "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach." American Economic Review, 97(3): 586–606.