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154
On the accuracy of linear DSGE solution methods and the consequences for log-normal asset pricing
(2021)
This paper demonstrates a failure of standard, generalized Schur (or QZ) decomposition based solutions methods for linear dynamic stochastic general equilibrium (DSGE) models when there is insufficient eigenvalue separation about the unit circle. The significance of this is demonstrated in a simple production-based asset pricing model with external habit formation. While the exact solution afforded by the simplicity of the model matches post-war US consumption growth and the equity premium, QZ-based numerical solutions miss the later by many annualized percentage points.
153
The recently observed disconnect between inflation and economic activity can be explained by the interplay between the zero lower bound (ZLB) and the costs of external financing. In normal times, credit spreads and the nominal interest rate balance out; factor costs dominate firms' marginal costs. When nominal rates are constrained, larger spreads can more than offset the effect of lower factor costs and induce only moderate inflation responses. The Phillips curve is hence flat at the ZLB, but features a positive slope in normal times and thus a hockey stick shape. Via this mechanism, forward guidance may induce deflationary effects.
152
The authors examine the effectiveness of labor cost reductions as a means to stimulate economic activity and assesses the differences which may occur with the prevailing exchange rate regime. They develop a medium-scale three-region DSGE model and show that the impact of a cut in the employers’ social security contributions rate does not vary significantly under different exchange rate regimes. They find that both the interest rate and the exchange rate channel matters. Furthermore, the measure appears to be effective even if it comes along with a consumption tax increase to preserve long-term fiscal sustainability.
Finally, they assess whether obtained theoretical results hold up empirically by applying the local projection method. Regression results suggest that changes in employers’ social security contributions rates have statistically significant real effects – a one percentage point reduction leads to an average cumulative rise in output of around 1.3 percent in the medium term. Moreover, the outcome does not differ significantly across the different exchange rate regimes.
151
The so-called Troika, consisting of the EU-Commission, the European Central Bank (ECB) and the International Monetary Fund (IMF), was supposed to support the member states of the euro area which had been hit hard by a sovereign debt crisis. For that purpose, economic adjustment programs were drafted and monitored in order to prevent the break-up of the euro area and sovereign defaults. The cooperation of these institutions, which was born out of necessity, has been partly successful, but has also created persistent problems. With the further increase of public debt, especially in France and Italy, the danger of a renewed crisis in the euro area was growing. The European Stability Mechanism (ESM) together with the European Commission will replace the Troika in the future, following decisions of the EU Summit of December 2018. It shall play the role of a European Monetary Fund in the event of a crisis. The IMF, on the other side, will no longer play an active role in solving sovereign debt crises in the euro area. The current course is, however, inadequate to tackle the core problems of the euro zone and to avoid future crises, which are mainly structural in nature and due to escalating public debt and lack of international competitiveness of some member countries. The current Corona crisis will aggravate the institutional problems. It has led to a common European fiscal response ("Next Generation EU"). This rescue and recovery program will not be financed by ESM resources and will not be monitored by the ESM. One important novelty of this package is that it involves the issuance of substantial common European debt.
150
Despite the increasing use of cashless payment instruments, the notion that cash loses importance over time can be unambiguously refuted. In contrast, the authors show that cash demand increased steeply over the past 30 years. This is not only true on a global scale, but also for the most important currencies in advanced countries (USD, EUR, CHF, GBP and JPY). In this paper, they focus especially on the role of different crises (technological crises, financial market crises, natural disasters) and analyse the demand for small and large banknote denominations since the 1990s in an international perspective. It is evident that cash demand always increases in times of crises, independent of the nature of the crisis itself. However, largely unaffected from crises we observe a trend increase in global cash aligned with a shift from transaction balances towards more hoarding, especially in the form of large denomination banknotes.
149
The authors embed human capital-based endogenous growth into a New-Keynesian model with search and matching frictions in the labor market and skill obsolescence from long-term unemployment. The model can account for key features of the Great Recession: a decline in productivity growth, the relative stability of inflation despite a pronounced fall in output (the "missing disinflation puzzle"), and a permanent gap between output and the pre-crisis trend output.
In the model, lower aggregate demand raises unemployment and the training costs associated with skill obsolescence. Lower employment hinders learning-by-doing, which slows down human capital accumulation, feeding back into even fewer vacancies than justified by the demand shock alone. These feedback channels mitigate the disinflationary effect of the demand shock while amplifying its contractionary effect on output. The temporary growth slowdown translates into output hysteresis (permanently lower output and labor productivity).
148
Occasionally binding constraints have become an important part of economic modelling, especially since western central banks see themselves (again) constraint by the so-called zero lower bound (ZLB) of the nominal interest rate. A binding ZLB constraint poses a major problem for a quantitative-structural analysis: Linear solution methods do no work in the presence of a non-linearity such as the ZLB and existing alternatives tend to be computationally demanding. The urge to study macroeconomic questions related to the Great Recession and the Covid-19 crisis in a quantitative-structural framework requires algorithms that are not only accurate, but that are also robust, fast, and computationally efficient.
A particularly important application where efficient and fast methods for occasionally binding constraints (OBCs) are needed is the Bayesian estimation of macroeconomic models. This paper shows that a linear dynamic rational expectations system with OBCs, depending on the expected duration of the constraint, can be represented in closed form. Combined with a set of simple equilibrium conditions, this can be exploited to avoid matrix inversions and simulations at runtime for signifcant gains in computational speed.
147
Central banks sometimes evaluate their own policies. To assess the inherent conflict of interest, the authors compare the research findings of central bank researchers and academic economists regarding the macroeconomic effects of quantitative easing (QE). They find that central bank papers report larger effects of QE on output and inflation. Central bankers are also more likely to report significant effects of QE on output and to use more positive language in the abstract. Central bankers who report larger QE effects on output experience more favorable career outcomes. A survey of central banks reveals substantial involvement of bank management in research production.
146
Empirical estimates of equilibrium real interest rates are so far mostly limited to advanced economies, since no statistical procedure suitable for a large set of countries is available. This is surprising, as equilibrium rates have strong policy implications in emerging markets and developing economies as well; current estimates of the global equilibrium rate rely on only a few countries; and estimates for a more diverse set of countries can improve understanding of the drivers. The authors propose a model and estimation strategy that decompose ex ante real interest rates into a permanent and transitory component even with short samples and high volatility. This is done with an unobserved component local level stochastic volatility model, which is used to estimate equilibrium rates for 50 countries with Bayesian methods.
Equilibrium rates were lower in emerging markets and developing economies than in advanced economies in the 1980s, similar in the 1990s, and have been higher since 2000. In line with economic integration and rising global capital markets, synchronization has been rising over time and is higher among advanced economies. Equilibrium rates of countries with stronger trade linkages and similar demographic and economic trends are more synchronized.
145
The ruling of the German Federal Constitutional Court and its call for conducting and communicating proportionality assessments regarding monetary policy have been the subject of some controversy. However, it can also be understood as a way to strengthen the de-facto independence of the European Central Bank. The authors shows how a regular proportionality check could be integrated in the ECB’s strategy that is currently undergoing a systematic review. In particular, they propose to include quantitative benchmarks for policy rates and the central bank balance sheet. Deviations from such benchmarks can have benefits in terms of the intended path for inflation while involving costs in terms of risks and side effects that need to be balanced. Practical applications to the euro area are provided