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.


Thinking about monetary policy in Russia – a useful DSGE model?

I am going to Moscow in a couple of weeks. Going to Russia always inspires me to think about monetary policy in commodity exporting countries. I recently found what looks to be an interesting paper on monetary policy in commodity exporting countries – Monetary Policy in an Economy Sick with Dutch Disease”. The paper is from 2007.

I have started reading the paper, but as usual I want to share my joy of having found the paper with my readers before actually having read the entire paper. Here is the abstract:

“The paper studies monetary policy in an economy, in which the manufacturing sector is ousted completely by the presence of a large natural resource industry. Thus, the economy produces only non-tradable goods, which can complement or substitute imported goods, and the primary shock to the economy comes from the fluctuations in the world price of the exported commodity. A model of such an economy is calibrated using parameters relevant for Russia, which is an example of an economy sick with Dutch Disease, and several conventional policy rules are considered. It is shown that in absence of a well-functioning fiscal stabilization fund, it may be optimal for monetary authorities to respond to the real exchange rate, as the Bank of Russia allegedly does, using purchases of foreign reserves as the policy instrument. The logic of these actions is to replace the absent fiscal stabilization policy. In case monetary policy is conducted using an interest rate instrument, there should be no reaction to the real exchange rate and only slight one – to inflation.”

In the paper the authors Kirill Sosunov and Oleg Zamulin present a DSGE model for the Russian economy. The model in many ways is similar to my own thinking of the Russian economy and I therefore think it would be interesting to update Zamulin and Sosunov’s work. It would for example be extremely interesting to simulate the 2008-9 shock in the model under different monetary policy rules and what rules would have done the least harm to the Russian economy. Would my suggestion that Russia should have followed an Export Price Norm for example have prevented the crisis?

I have earlier claimed the sharp contraction in the Russian economy in 2008-9 was due to monetary policy failure. My feeling is that Zamulin and Sosunov’s model would yield a similar result, but I am not sure.

Anyway, I hope to be able to do some work on that model myself – with the help of my colleague Jens Pedersen – in the coming weeks. Then we will see what we manage to get out of the model and I would of course encourage others out there with interest in DGSE model and particularly with interest in monetary policy in commodity exporting countries to have a look at the model for yourself (please drop me a mail if you are doing work on monetary policy in commodity exporting countries as well –

Now back to reading the paper…

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