Guest post: Reflections on Fama (By Otto Brøns-Petersen)

If I ever had a real mentor I would have to say it was Otto Brøns-Petersen. Otto was my boss when I started working at the Danish Ministry of Economic Affairs in the Mid-1990s. Otto taught me a lot about economics, but he particularly taught me to understand the politics of economic policy making. Something that made me tremendously skeptical about the ability of policy makers to do the “right thing”.

While I left government work long-time ago Otto kept working for the Danish government until recently. However, he is now Head of Research at the Danish free market think tank CEPOS.

Recently Otto wrote a piece for the Danish business Daily Børsen on some policy implications to draw from Nobel Prize winner Eugene Fama’s work. I asked Otto whether he would be interested in writing a similar piece for my blog . I am happy he accepted the challenge.

– Lars Christensen

PS After knowing Otto for nearly 25 years I just realized I would describe his economic thinking as Coasian more than anything else.

Reflections on Fama

– By Otto Brøns-Petersen

This year marks the 50th anniversary of Eugene Fama’s demonstration of “random walk” in stock prices. The price today does not predict the price tomorrow. Rather, stock prices absorb the information available to the market at any given time. As financial markets do not systematically omit information, there are no systematic price movements. The market is “efficient”.

In the longer term, however, patterns in price movements do emerge. Fama has been leading the research into how such patterns can be explained and what they mean. A couple of weeks ago, he and two other American economists, Lars Peter Hansen and Robert Shiller, were awarded the Nobel Prize in Economics for their empirical work on pricing in financial markets.

Does this mean that we have now cracked the code of what drives prices in the long term? Far from it! Fama’s research continues, and his colleague, John Cochrane, even believes that he has his best work ahead of him. Futhermore, with its choice of laureates, the Nobel Committee choose to highlight that there are two very different and competing approaches to understanding financial markets. Fama’s approach is to look for rational investor motives. In particular, it appears that changes in investors’ risk aversion can explain movements in prices over time. Shiller’s approach, on the other hand, is based on behavioral economics, which looks for psychological motives that are not necessarily rational.

Can we learn something from this research, something about good policy? In my opinion, we can indeed.

Firstly, bubbles in the financial markets are very difficult to predict. Disagreement about how empirical price movements should be interpreted theoretically is in itself an element of unpredictability. But although consensus on the interpretation of historical data might increase, predictability about the future will not necessarily do so too. Researchers are watchingers are not alone in looking over their shoulders for/at investors, but investors are also watching also looking over their shoulders for/at scientists and their research.. There is money to be made from learning how to avoid historical errors in the future. In particular, theories of systematic errors will tend to undercut themselves because of learning by agents. So, we should not expect to be able to predict bubbles.

Secondly, cognitive and psychological limitations on rationality not only apply to investors but also to politicians and officials. If investors have exaggerated beliefs about being able to get out of a market before it falls, one should be concerned about a similarly exaggerated belief of authorities that they can trace an unsustainable market development before it is too late.

Thirdly, it is crucial to realize whether incentives support appropriate behavior in financial markets. Basically, there are very strong incentives to avoid errors for investors who have their fortunes at stake. And the financial markets even support rational behavior by selecting good investors at the expense of bad ones. Markets, so to speak, entail what we could call “systemic rationality”. If incentives, on the other hand, reward inappropriate behavior – eg. in the form of moral hazard, where the bill for mistakes ends up with someone else than the decision-makers – one should indeed expect more inappropriate behavior. Finally, it is important to be clear about the incentives not just for agents in the financial markets, but also for political and bureaucrat decision-makers.

In my opinion, there is reason to worry whether policy makers are drawing the wrong lessons from the financial crisis in their policy response. Financial Supervisory Authorities, central banks and central government officials have been asked to step up surveillance of the macro economy, financial markets and financial institutions. Regulation is on the rise. Actual improvements in incentives are, however, still missing.

One might ask: Doesn’t increased monitoring just add extra security and isn’t it in the worst case harmless? Unfortunately, it also has costs.

Firstly, it may give the agents in financial markets and customers in financial firms a false sense of security, giving authorities greater moral responsibility for financial crises and thus increase the likelihood of government bailouts. Thus, it increases the moral hazard problem and distorts incentives.

Secondly, the increased monitoring to avoid one type of error increases the frequency of another type of error. We may (but not very likely) discover more bubbles early on, but at the expense of more false alarms and misguided political interventions. At the same time, the incentive structure of authorities seems unsound. It will attract attention if a crisis is overlooked, whereas it is harder to tell if an intervention was based on a wrong diagnosis. There is thus a built-in propensity for political action, and the ever-changing political winds add a further element of instability in regulation and legislation.

Interestingly enough, the recent Danish Government Committee on the Financial Crisis noted that liberalization of financial markets has been a net economic advantage, both advantages and disadvantages taken into account. There is a need for a similar assessment of financial regulation and supervision in general.

It is perhaps understandable that many after the financial crisis instinctively conclude that “someone ought to watch out and make sure we will not see another crisis.” But it may well be a little like hoping for someone to come up with a “sure thing” stock advice. Neither is founded in reality. The effective tools in the toolbox of economists are called: Incentives, incentives and incentives.


I am pretty bad at playing pool (there is no economics in this story)

A couple of days ago I was playing pool with Mathias my 3-year old son (we are still on vacation). Or rather I was playing and he was telling me what balls to hit and where to pocket them.

That led to the following conversation:

Mathias: “Dad are you are professor?” (he meant to ask me whether I was a professional)

My reply: “No unfortunately not” (I really would love to call myself professor – never mind the professional part)

Mathias looked around the room looking for somebody who could listen to him and said “Can somebody please help my dad?”

I guess he was not too impressed with his dad’s skills at the pool table…I think I will stick to economics for now.

But sorry for not blogging too much these days – I am working on improving my pool skills and spending time in the pool.

More silliness from the tin foil hat Austrians

I love reading the normally good blog posts on written by clever economists such as George Selgin and Kurt Schuler. However, the Facebook page of very often fails to live up to the same good standards as the blog. In fact most updates are what I consider to be internet-Austrian nonsense.

Here is the latest example:

“If the dollar were suddenly to lose reserve status, the United States of America would face catastrophic inflation.”

The freebanking facebook page is quoting an article by Lawrence J. Fedewa. I have never heard about him before, but his article is a pretty good example of the kind of “the-world-is-coming-to-an-end” nonsense, which is floating around in cyberspace mostly written by tin foil hat Austrians.

But let me address the quote above.

First of all there are no signs that the dollar in any way is loosing its reserve status. In fact the dollar is more popular than ever. Hence, since the onset of the crisis in 2008 we have seen a massive increase in dollar demand – in fact that was what caused the crisis.

Or just ask yourself what currency is about to replace the dollar as the reserve currency of the world? The euro? I think not? Or the yuan? Think again you silly people.

I am presently vacationing in Thailand and I am pretty sure that if I wanted to pay any local street vendor here with dollars they would be very happy to accept it. But would they accept euros? Probably – there is a lot of German tourists in the area where we are vacationing so the locals are probably familiar with the euro.

But what if I tried to pay with yuan? I doubt the street vendors would accept that. So no the verdict is pretty clear from the Thai street vendors – the US greenback is what they prefer to any other currency (I nonetheless pays in Thai baht).

But lets get back to some more silliness. This is again from Fedewa’s article:

If the dollar were suddenly to lose reserve status, the United States of America would face catastrophic inflation. All the dollars that the Federal Reserve has been creating, at about $85 billion each month, would begin to be dumped right on our heads, and the dollar would become virtually worthless. A loaf of bread could cost $50, a basket of groceries could cost $500. Hyperinflation has happened to many nations, including post WWI Germany, France and Russia, and modern day Greece and Spain.

Note here this is the trick used by the internet-Austrians – “It might be that we do not have hyperinflation yet but it will comes once dollar demand collapses”. Fine, first of all there is unfortunately no real sign that dollar demand is declining and money-velocity in the US is still quite elevated.

Second, if dollar demand where to start declining it would be good news as it would mean that the world would becoming “normal” again. That the excessive demand for dollars driven by deflation fears were easing. That obviously would increase inflationary pressures. And that should be welcomed – after all there is still significant slack in the US economy and inflation continues to be way below the Federal Reserve’s semi-official inflation inflation of 2% and the reason the fed has had to massively expand its balance sheet is exactly the massive demand for dollars.

But ok lets say that out of the blue everybody suddenly did not want to hold US dollars – I still fail to see why that would be the case, but lets for the sake of the argument assume that to be the case. A collapse in dollar demand would of course effectively be massive US monetary easing. The impact of this would likely be a sharp increase in both real and nominal GDP – and inflation.

Would the Fed be helpless in this situation? No not at all. The Fed of course could just tighten monetary policy. It could of course easily shift quantitative easing into reverse by for example announcing that if would cut the money base by 100 or 200bn dollars per months until inflation expectations returned to (just) below 2% and given the fact that the Fed’s balance sheet has never been bigger it could cut the money base a lot. There is not limits to how easing or tightening a central bank can do. Only paleo Keynesians and tin foil Austrians fail to understand this.

It is too bad that there is so much nonsense about monetary policy floating around in cyberspace, but it is unfortunately only getting worse and worse. I don’t know why this is and these views have probably always been around, but I for one is sick and tired of listening to all is nonsense!

And finally, the US government is not about to default. The crackpots on the left are wrong when the claim that the US government would have to default had the debt ceiling not been raised (the US government could just have cut spending) and the crackpots on the right are wrong when they claim that the US government debt is out of control (the budget deficit is declining strongly and public debt levels have stabilized).

But of course that financial markets know that all this is just political hype in Washington. Just look at the S&P500 – it has gone up all though this show of US political dysfunctionality. Why? Because monetary policy dominates fiscal policy. It is the Sumner Critique stupid!

And now back to my vacation…

PS I have no clue whether Fedewa considers himself to be an Austrian. I use the term tin foil hat Austrian to describe a tendency or type of argument used by so many commentators rather than by people who actually read von Mises and Hayek. By the way I bet most of the people in cyberspace making what they believe to be “Austrian” arguments actually found these arguments on Youtube rather than by reading “Human Action” and other must-read Austrian classics. What I don’t understand is why Austrian scholars who actually did study von Mises and Hayek are not coming out much more aggressively and tell people like Peter Schiff that his arguments are nonsense. I would love to see a debate between for example Steve Horwitz and Peter Schiff.

PPS I just came to think of the Austrian version of Godwin’s law. Godwin’s law states that “As an online discussion grows longer, the probability of a comparison involving Nazis or Hitler approaches 1.” The Austrian version of this should read: “As an online discussion about monetary policy grows longer, the probability that an Austrian will mention Zimbabwe or the Weimar Republic approaches 1.”

Fama, Shiller and Billy Beane – A Nobel Prize in Baseball

A couple of days ago it was announced that Eugene Fama, Lars Peter Hansen and Robert Shiller had been awarded the Nobel Prize in economic for their contribution to the understanding of asset prices.

The interesting thing of course is that Fama’s main contribution is the Efficient Market Hypothesis (EMH), while Shiller’s main contribution has been to try to empirically prove that EMH is wrong.

I think most of my readers know that I am mostly in the EMH camp, but also that I in my day-job is in the business of trying to beat the market. So I am a bit split – even though I after years of trying to beat the markets and having obsermtved others trying to do the same thing has come to the conclusion that people do get lucky – sometimes more than once (just look at Shiller!) – but that it is very hard to find anybody who consistently beat the markets. That in my view is the real-world version of EMH. Or said in another way it might be possible to find indicators that will make it possible for you to beat the market in shorter or longer periods, but these indicators eventually breaks down.

Anyway, the Nobel Prize news reminded me of an old post I did on the Oakland A’s. So let me quote a bit from that post. I think it shows why both Fama and Shiller are right.

I have been watching Moneyball. It is a great movie… economics play a huge role in this movie. So that surely made me interested. It is of course very different from Michael Lewis’ excellent book Moneyball, but it is close enough to be an interesting movie even to nerdy economists like myself.

… why bring Moneyball into a discussion about money and markets? Well, because the story of the Oakland A’s is a pretty good illustration that Scott Sumner is right about the Efficient Market Hypothesis (EMH) – even when it comes to the market of baseball players. So bare with me…

And here I should of course also have said that Fama is right.

Back to my old post:

The story about the Oakland A’s is the story about the A’s’ general manager Billy Beane who had the view that the market was under-pricing certain skills among baseball players. By investing in players with these under-priced skills he could get a team, which would be more “productivity” than if he had not acknowledged this under-pricing. Furthermore as other teams did not acknowledge this he would increase his chances of winning even against teams with more resources. It’s a beautiful story – especially because theory worked. At least that is how it looked. In the early 2000s the Oakland A’s had much better results than should have been expected given the fact that the A’s was one the teams in the with the lowest budgets in the league. The thesis in Moneyball is that that was possible exactly because Billy Beane consistently used of Sabermetrics – the economics of Baseball.

Whether Lewis’ thesis correct or not is of course debatable, but it is a fact that the Oakland A’s clearly outperformed in this period. However, after Moneyball was published in 2003 the fortune of the Oakland A’s has changed. The A’s has not since then been a consistent “outperformer”. So what happened? Well, Billy Beane was been beaten by his own success and EMH!

So Billy Beane was the Robert Shiller of baseball. He found a way to beat the market! But success was, however, not forever – again back to my old post:

Basically Billy Beane was a speculator. He saw a mis-pricing in the market and he speculated by selling overvalued players and buying undervalued players. However, as his success became known – among other things through Lewis’ book – other teams realised that they also could increase their winning chances by applying similar methods. That pushed up the price of undervalued players and the price of overvalued player was pushed down. The market for baseball players simply became (more?) efficient. At least that is the empirical result demonstrated in a 2005-paper An Economic Evaluation of the Moneyball Hypothesis“ by Jahn K. Hakes and Raymond D. Sauer. Here is the abstract:

Michael Lewis’s book, Moneyball, is the story of an innovative manager who exploits an inefficiency in baseball’s labor market over a prolonged period of time. We evaluate this claim by applying standard econometric procedures to data on player productivity and compensation from 1999 to 2004. These methods support Lewis’s argument that the valuation of different skills was inefficient in the early part of this period, and that this was profitably exploited by managers with the ability to generate and interpret statistical knowledge. This knowledge became increasingly dispersed across baseball teams during this period. Consistent with Lewis’s story and economic reasoning, the spread of this knowledge is associated with the market correcting the original mis-pricing.”

Isn’t it beautiful? The market is not efficient to beginning with, but a speculator comes in and via the price system ensures that the market becomes efficient. This is EMH applied to the baseball market. Hence, if a market like the baseball market, which surely is about a lot more than making money can be described just remotely as efficient why should we not think that the financial markets are efficient? In the financial markets there is not one Billy Beane, but millions of Billy Beanes.

Every bank, every hedgefund and every pension fund in the world employ Billy Beane-types – I am one of them myself – to try to find mis-pricing in the financial markets. We (all the Billy Beanes in the financial markets) are using all kind of different methods – some of them very colourful like technical analysis – but the aggregated result is that the markets are becoming more efficient.

Like Billy Bean the speculators in the financial markets are constantly scanning the markets for mis-priced assets and they are constantly looking for new methods to forecast the market prices. So why should the financial markets be less efficient than the baseball market? I think Scott is right – EMH is a pretty good description of the financial markets or rather I haven’t seen any other general theory that works better across asset classes.

So yes Fama and Shiller both deserve the Nobel Prize (as do Lars Peter Hansen), but I don’t believe that Robert Shiller is better at forecasting than the markets in general and I would certainly not think that regulators are better at forecasting than the market!

The mother of all sudden stops – lessons from the 1930s

I really never understood why most economists study so little economic history as they tend to do, but it is a fact that most professional economists are quite uneducated when it comes to economic history.

My contribution to changing that is sharing research on economic history with my readers. So take a look at this new paper by Olivier Accominotti and Barry Eichengreen on The Mother of All Sudden Stops: Capital Flows and Reversals in Europe, 1919-1932″.

Here is the abstract:

We present new data documenting European capital issues in major financial centers from 1919 to 1932. Push factors (conditions in international capital markets) perform better than pull factors (conditions in the borrowing countries) in explaining the surge and reversal in capital flows. In particular, the sharp increase in stock market volatility in the major financial centers at the end of the 1920s figured importantly in the decline in foreign lending. We draw parallels with Europe today.

A couple of days ago I argued that David Laidler should be awarded the Nobel Prize in economics, but if it is award to Barry Eichengreen for his contribution to “the understanding of economic history” I think it would be well-deserved!

Laos is facing an old-fashioned balance-of-payment crisis

I am writing this while I am vacationing with the family in Thailand. However, in a couple of weeks we will be heading to Laos where my wife has worked for a number of years.

So I thought it would be interesting to write a small post on the economic situation in Laos and “luckily” for me – or at least for the relevance of what I am going to write – we are at the moment at challenging times for the Lao economy. I am of course no implying this in anyway is good – it is bad – but just saying that it is easier to write a blog post if there is some interesting to write about and for some reason crisis is more interesting than no-crisis.

This story is a couple of days old:

Debt-ridden Laos has been told by the International Monetary Fund to tighten its policies to avoid a major economic crisis.

An IMF mission held annual consultations recently with the government in the country’s capital Vientiane, raising concerns about its rising inflation, the banking system, public spending, deteriorating current account deficit and falling international reserves, according to the Washington-based Fund’s officials.

“A tightening of macroeconomic policies is urgently needed to reduce vulnerabilities, replenish international reserves and engineer a soft landing,” Ashvin Ahuja, who led the IMF mission from Aug. 28 to Sept. 12, said on his return to the U.S. capital.

The IMF warning came amid a persistent shortfall in revenue, which led Prime Minister Thongsing Thammavong to order ministries and government agencies last month to closely control expenditures for Laos to pay its debts and avoid a financial crisis.

“In general, Laos is running a high level of debt and is at risk of a financial crisis,” Thongsing said, according to the state-controlled Vientiane Times newspaper. “This means we should closely control all aspects of investment and sharpen our focus during the upcoming 2013-14 fiscal year.”

Finance Minister Phouphet Khamphounvong told the national Assembly, the country’s parliament, in July that the government debt is 29.8 percent of Gross Domestic Product (GDP), or the country national output. The debt to GDP ratio is one of the indicators of the health of an economy.

This sounds like the most classic of classic Emerging Markets crises – a balance-of-payment crisis caused by excessive easy monetary and fiscal policy under a pegged or quasi-pegged exchange rate regime.

This story is really simple and very much a textbook crisis. The fiscal situation is unsustainable – the debt to GDP ratio continues to increase. As a result sooner or later the government will have to monetize the budget deficit (this is the old story of some unpleasant monetarist arithmetics). Obviously the central bank will not be able to maintain a pegged or a quasi-pegged exchange rate if it also have to fund an ever larger government budget deficit. Therefore, devaluation fears will be escalating leading to currency outflow. This is what we are seeing in Laos – the currency reserve continues to drop.

Furthermore, if fiscal policy is eased via the banking system – as it is partly the case in Laos (and other quasi-reformed communist countries like China and Vietnam) then you are also going to get a banking problem sooner or later. Furthermore, there are some clear reminders of earlier Emerging Markets crises where government controlled, sponsored or government owned banks are subject to special interests – such as the business ventures of top government or ruling party officials. This obviously is the ultimate form of moral hazard. I don’t know the Lao story well-enough, but my suspicion would clearly be that we could be facing this kind of problems with crony-government-banking in Laos as well.

Hence, in the stylized textbook balance-of-payment crisis you have a situation where the currency is facing a major correction due to a cocktail of overly easing fiscal, monetary and credit policies (add some cronyism). This also seems to be the case of Laos today.

Ensure nominal stability through fiscal consolidation and banking reform 

The policy prescription in such a scenario is quite clear. If you want to maintain a pegged or quasi-pegged exchange rate you will have to significantly reduce the devaluation expectations and the only way to do that is to reduce the public budget deficit so nobody will fear that the public debt will be monetized. The cost of this of course would be a major slump in domestic demand or said in another way you cannot both ensure currency stability and economic stability.

A more prudent alternative to a sharp drop in domestic demand would be to allow the currency to weaken significantly – in the case of Laos a sharp devaluation of the kip. Obviously that would not solve the fundamental fiscal and banking problems. You would still need massive fiscal consolidation and banking reform (a total de-politicization and privatization of the Lao banking sector). However, a devaluation (and a shift to some kind of rule based monetary policy regime) could significantly reduce the possible negative economic and financial implications of the needed fiscal and financial adjustments.

I am no expert on the Laotian economy, but it certainly looks like we are here dealing with a very classic balance-of-payment crisis. This is something we rarely see these days and most countries are not really maintaining pegged exchange rates (the euro countries is a horrible outlier here). It will be very interesting to see how this plays out in the coming quarters. It could unfortunately end very badly if the situation is mis-managed, but I also think that crisis can be avoided if the right step are taking by Laotian policy makers – devaluation and the introduction of a new monetary policy regime with a more freely floating kip, fiscal consolidation and banking reform.  This obviously is much easier said than done in a only partly reformed communist country.

One thing I hope that the IMF is not recommending to the policy makers in Laos is to “fight to the end” to defend an unsustainable level for the kip. That could potentially lead to an extreme tightening of monetary policy which would send the economy into a free fall and a banking crisis would be nearly impossible to avoid. This is the kind of mistakes countries like Thailand and South Korea made in 1997. I hope Laos will not repeat these mistakes.

PS I did not mention China here, but it is obviously important. About one third of Laos’ exports goes to China so it is very easing to argue that Laos is hugely affected by Chinese monetary tightening. This is the China as a monetary superpower story. That said the recent slowdown in the Thai is likely somewhat more important.

David Laidler should be awarded the Nobel Prize in Economics

My biggest wish for the Autumn is that David Laidler will win the Nobel Prize in Economics next week for …

“…his contribution to monetary economics and the history of economic thought”

There is unfortunately little chance that that will happen, but it is about time that a historian of economic thought is awarded the Nobel Prize.

While we are awaiting for the good news (fingers crossed) you should read David’s latest paper – Reassessing the Thesis of the Monetary HistoryThis is the abstract:

The economic crisis that began in 2007 and still lingers has invited comparison with the Great Depression of the 1930s. It has also generated renewed interest in Milton Friedman and Anna Schwartz’s explanation of the latter as mainly the consequence of the Fed’s failure as a lender of last resort at its onset, and the ineptitude of its policies thereafter. This explanation is reassessed in the light of events since 2007, and it is argued that its plausibility emerges enhanced, even though policy debates in recent years have paid more attention to interest rates and credit markets than to Friedman and Schwartz’s key variable, the quantity of money.

David of course was the research assistant for Friedman and Schwartz when they wrote Monetary History.

HT Mike Belongia

PS don’t tell me that the Nobel Prize in Economics is not a real Nobel Prize – I don’t care.

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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