Money and DSGE models – a few good papers

In this very good recent interview with the always extremely insightful David Laidler on Russ Robert’s Econtalk David rightly highlights the problem that money disappeared from macroeconomics during the 1990s with the development of DSGE models.

I share David’s worry that many macroeconomists – particular central bank economists – use models where there is no money. However, over the last couple of years some economists have tried to bring money into DSGE models. This research deserves a lot more attention.

I have complied a small sample of papers on money in DSGE models:

Monetary Transmission in the New Keynesian Framework: Is the Interest Rate Enough?

- Josh Hendrickson

The baseline New Keynesian model consists of a dynamic IS equation, a Phillips curve, and an interest rate rule that describes monetary policy. In recent years, this framework has become standard for monetary policy and monetary business cycle analysis. One charac- teristic of this model, and extensions thereof, is that the path of the short term interest rate fully captures the monetary transmission mechanism. This proposition is contrary to both theory and evidence presented by monetarists and advocates of the credit channel. As a result of these differences, this paper presents a model that includes agency costs, a richer specification of money demand, and nests the baseline New Keynesian model as a special case to evaluate the dynamics implied by each assumption. The results show that the New Keynesian model does a poor job of replicating empirical properties observed in the data. On the other hand, the model employed in this paper that includes elements from both the credit channel and monetarist literature is able to perform quite well. These results suggest that the representation of the monetary transmission process in the New Keynesian model is incomplete.

Money’s Role in the Monetary Business Cycle

- Peter Ireland

A small, structural model of the monetary business cycle implies that real money balances enter into a correctly-specified, forward-looking IS curve if and only if they enter into a correctly-specified, forward-looking Phillips curve. The model also implies that empirical measures of real balances must be adjusted for shifts in money demand to accurately isolate and quantify the dynamic effects of money on output and inflation. Maximum likelihood estimates of the model’s parameters take both these considerations into account, but still suggest that money plays a minimal role in the monetary business cycle.

The role of money and monetary policy in crisis periods: the Euro area case
– Jonathan Benchimol and Andre Fourcans

In this paper, we test two models of the Eurozone, with a special emphasis on the role of money and monetary policy during crises. The role of separability between money and consumption is investigated further and we analyse the Euro area economy during three different crises: 1992, 2001 and 2007. We find that money has a rather significant role to play in explaining output variations during crises whereas, at the same time, the role of monetary policy on output decreases significantly. Moreover, we find that a model with non-separability between consumption and money has better forecasting performance than a baseline separable model over crisis periods.

Risk Aversion in the Euro area

- Jonathan Benchimol

We propose a New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model where a risk aversion shock enters a separable utility function. We analyze five periods, each one lasting twenty years, to follow over time the dynamics of several parameters (such as the risk aversion parameter), the Taylor rule coefficients and the role of this risk aversion shock on output and real money balances in the Eurozone. Our analysis suggests that risk aversion was a more important component of output and real money balance dynamics between 2006 and 2011 than it had been between 1971 and 2006, at least in the short run.

This is a of course a very incomplete list of papers, but overall there are still very few papers on money in DSGE models. I hope I with this post can inspire others to look into this interesting topic and hopefully one day even central bankers will come to the conclusion that we need to bring money back into the game.

If you are interested in DSGE models in general there is a sub-group in the Global Monetary Policy Network at Linkedin on the topic. Join GMPN here and the DSGE sub-group here.

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The Hetzel-Ireland Synthesis

I am writing this while I am flying with Delta Airlines over the Atlantic. I will be speaking about the European crisis at a seminar on Friday at Brigham Young University in Provo, Utah.

I must admit that it has been a bit of a challenge to blog in recent weeks. Mostly because both my professional and my private life have been demanding. After all blogging is something I do in my spare time. So even though I wanted to blog a lot about the latest FOMC decision and the world in general I have simply not been able to get out the message. Furthermore – and this will interest many of my readers – Robert Hetzel and his wonderful wife Mary visited Denmark last week. Bob had a very busy schedule – and so did I as I attended all of Bob’s presentations in Copenhagen that week. Bob told me before his presentations that I would not be disappointed and that none of the presentations would be a “rerun”. Bob is incredible – all of this presentations covered different countries and topics. Obviously there was a main theme: The central banks failed.

I must admit after three days of following Bob and having the privilege to hear him talk about the University of Chicago in 1970s and his stories about Milton Friedman I simply had an mental “overload”. I had a very hard time expressing my monetary policy views – and the major policy turnaround at the Fed didn’t make it easier.

Anyway I feel that I have to share some of Bob’s incredible insight after his visit to Copenhagen, but I also feel that whatever I write will not do justice to his views.

So I have chosen a different way of doing it. Instead of telling you what Bob said in Copenhagen I will try to tell the story about how (a clever version of) New Keynesian economics and Monetarism could come to similar conclusions – and that merger is really Market Monetarism.

Why is that? I have for some time wanted to write something about a couple of new and very interesting, but slightly technical paper by Mike Belongia and Peter Ireland. Both Mike and Peter have a monetarist background, but Peter has done a lot work in the more technical New Keynesian tradition. And that is what I will focus on here, but I promise to return to Mike’s and Peter’s other papers.

The other day my colleague and good friend Jens Pedersen sent me a paper Peter wrote in 2010 – “A New Keynesian Perspective on the Great Recession”. When I read the paper I realised how I was going to write the story about Bob’s visit to Copenhagen.

Bob’s and Peter’s explanations of the Great Recession are exactly the same – just told within slightly different frameworks. Bob first wrote a piece on the Great Recession it in 2009 and Peter wrote his piece in 2010.

Peter and Bob are friends and both have been at the Richmond fed so it is not totally surprising that their stories of what happened in 2008-9 are rather similar, but I nonetheless think that we can learn quite a bit from how these two great intellects think about the crisis.

So what is the common story?

In think we have to go back to Milton Friedman’s Permanent Income Hypothesis (PIH). While at the Richmond Peter while at the Richmond fed in 1995 actually wrote about PIH and how it could be used for forecasting purposes. And one thing I noticed at all of Bob’s presentations in Copenhagen was how he returned to Irving Fisher and the determination of interests as a trade off between consumption today and in the future. Friedman and Fisher in my view are at the core of Bob’s and Peter’s thinking of the Great Recession.

So here is the Peter and Bob story: In 2007-8 the global economy was hit by a large negative supply shock in the form of higher oil prices. That pushed up US inflation and as a consequence US consumers reduced their expectations for their future income – or rather their Permanent Income. With the outlook for Permanent Income worsening interest rates should drop. However, as interest rates hit zero the Federal Reserve failed to ease monetary policy because it was unprepared for a world of zero interest rates. The Fed should of course more aggressively moved to a policy of monetary easing through an increase in the money base. The fed moved in that direction, but it was too late and too little and as a result monetary conditions tightened sharply particularly in late 2008 and during 2009. That can be described within a traditional monetarist framework as Bob do his excellent book “The Great Recession – policy failure or market failure” (on in his 2009 paper on the same topic) or within an intelligent New Keynesian framework as Peter do in his 2010 paper.

Peter uses the term a “New Keyensian Perspective” in his 2010. However, he does not make the mistakes many New Keynesians do. First, for all he realizes that low nominal interest rates is not easy monetary policy. Second, he do not assume that the central bank is always making the right decisions and finally he realizes that monetary policy is not out of ammunition when interest rates hit zero. Therefore, he might as well have called his paper a “New Friedmanite-Fisherian Perspective on the Great Recession”.

Anyway, try read Bob’s book (and his 2009 paper) and Peter’s paper(s). Then you will realize that Milton Friedman and Irving Fisher is all you need to understand this crisis and the way out of is.

I am finalizing this post after having arrived to my hotel in Provo, Utah and have had a night of sleeping – damn time difference. I look forward to some very interesting days at BYU, but I am not sure that I will have much time for blogging.

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