Did monetary policy kill the Phillips Curve? Some simple arithmetics

An apparent disconnect has taken place between inflation and economic activity in the US over the last 25 years, with price inflation remaining remarkably stable in spite of large fluctuations in the output gap and other measures of economic slack. This observation has led some to believe that the Phillips curve–a summary measure of aggregate supply–has flattened. We argue that this view may be premature and put forward a few, simple arithmetics which give rise to testable implications for demand and supply curve slopes. Equipped with New Keynesian theory and estimated SVAR models, we decompose the unconditional variation in US macro data into the components driven by demand and supply disturbances, and confront the inflation disconnect with our simple arithmetics. This exercise reveals a relatively stable supply curve slope once shocks to supply have been properly accounted for. The demand curve, instead, has flattened substantially in recent decades. Our results are at odds with a decline in the Phillips curve slope, but fully consistent with a shift towards a more firm monetary policy commitment to inflation stability.publishedVersio

Monetary policy when export revenues drop

We study how monetary policy should respond to shocks which permanently alter the steady state structure of the economy. In such a case monetary policy affects not only the short run misallocations due to nominal rigidities, but also relative prices which stimulate reallocation of capital. We consider a permanent and negative shock to export revenues that requires a larger traded sector and a smaller non-traded sector in the new steady state. This reallocation calls for a change in relative prices during the transition, but may also lead to a period of high unemployment. We show how an appropriate monetary policy could mitigate the welfare costs of the transition by allowing the exchange rate to depreciate, and thereby allowing inflation to increase in the short run. Traditional monetary policy regimes, such as inflation targeting or a fixed exchange rate, would imply high unemployment and inefficiently slow transition. Stabilizing nominal wage growth, in contrast, would be close to the welfare-optimal monetary policy.publishedVersio

Monetary Policy in Oil Exporting Economies

How should monetary policy be constructed when national income depends on oil exports? I set up a general equilibrium model for an oil exporting small open economy to analyze this question. Fundamentals include an oil sector and domestic non-oil firms – some of which are linked to oil markets via supply chains. In the model, the intermediate production network implies transmission of international oil shocks to all domestic industries. The presence of wage and price rigidities at the sector level leads to non-trivial trade-offs between different stabilization targets. I characterize Ramsey-optimal monetary policy in this environment, and use the framework to shed light on i) welfare implications of the supply chain channel, and ii) costs of alternative policy rules. Three results emerge: First, optimal policy puts high weight on nominal wage stability. In contrast, attempts to target impulses from the oil sector can be disastrous for welfare. Second, while oil sector activities contribute to macroeconomic fluctuations, they do not change the nature of optimal policy. Third, operational Taylor rules with high interest rate inertia can approximate the Ramsey equilibrium reasonably well

Foreign Shocks

How and to what extent are small open economies affected by international shocks? I develop and estimate a medium scale DSGE model that addresses both questions. The model incorporates i) international markets for firm-to-firm trade in production inputs, and ii) producer heterogeneity where technology and price setting constraints vary across industries. Using Bayesian techniques on Canadian and US data, I document several macroeconomic regularities in the small open economy, all attributed to international disturbances. First, foreign shocks are crucial for domestic fluctuations at all forecasting horizons. Second, productivity is the most important driver of business cycles. Investment efficiency shocks on the other hand have counterfactual implications for international spillover. Third, the relevance of foreign shocks accumulates over time. Fourth, business cycles display strong co-movement across countries, even though shocks are uncorrelated and the trade balance is countercyclical. Fifth, exchange rate pass-through to aggregate CPI inflation is moderate, while pass-through at the sector level is positively linked to the frequency of price changes. Few of these features have been accounted for by existing open economy DSGE literature, but all are consistent with reduced form evidence. The model presented here offers a structural interpretation of the results.publishedVersio

Sectoral Interdependence and Business Cycle Synchronization in Small Open Economies

Existing DSGE models are not able to reproduce the observed influence of international business cycles on small open economies. We construct a two-sector New Keynesian model to address this puzzle. The set-up takes into account intermediate trade and producer heterogeneity, where goods and service industries differ in terms of i) price flexibility, ii) trade intensity, iii) technology, iv) I-O structure, and v) the volatility of productivity innovations. The combination of intermediate markets and heterogeneous producers makes international business cycles highly important for the small economy, even if it has a large service sector. Exploiting I-O matrices of Canadian and US industries, the model is able to reproduce the role of international disturbances typically found in empirical studies. Model simulations deliver cross-country correlations in macroeconomic variables of about 0:7, with half of the variation in domestic variables attributed to foreign shocks.publishedVersio

Foreign Shocks in an Estimated Multi-Sector Model

How are macroeconomic fluctuations in open economies affected by international business cycles? To shed some light on this question, I develop and estimate a medium scale DSGE model for a small open economy. The model incorporates i) international markets for firm-to-firm trade in production inputs, and ii) producer heterogeneity where technology and price setting constraints vary across industries. Using Bayesian techniques on Canadian and US data, I document several macroeconomic regularities in the small open economy, all attributed to international disturbances. First, foreign shocks are crucial for domestic fluctuations at all forecasting horizons. Second, productivity is the most important driver of business cycles. Investment efficiency shocks on the other hand have counterfactual implications for international spillover. Third, the relevance of foreign shocks accumulates over time. Fourth, business cycles display strong co-movement across countries, even though shocks are uncorrelated and the trade balance is countercyclical. Fifth, exchange rate pass-through to aggregate CPI inflation is moderate, while pass-through at the sector level is positively linked to the frequency of price changes. Few of these features have been accounted for in existing open economy DSGE literature, but all are consistent with reduced form evidence. The model presented here offers a structural interpretation of the results

Natural Disasters, Economic Growth and Armed Civil Conflict

Catastrophes such as floods, droughts and earthquakes have caused significant human and infrastructural losses throughout history. Nevertheless, researchers struggle to quantify macroeconomic impacts, and the existing literature is ambiguous in its findings. In this study I use econometric methods on panel data from Centre for Research on the Epidemiology of Disasters (CRED), and find that hydrometeorological, climatological and geophysical events all affect economic growth negatively in the short run. Second, while events typically linked to climate change tend to cause negative growth shocks the same year they occur, geophysical disasters do not alter overall economic performance before the next year. With respect to future global warming, these dynamic differences give important insights for the understanding of how economies might be affected by climate change. However, by means of two stage least square methods, I do not find that negative economic shocks caused by weather related disasters increase the likelihood of armed civil conflicts. This latter result is in contrast to conclusions in much of the seminal conflict literature, but similar to findings in other recent cross-country studies that use the instrument variable approach

Business Cycles in an Oil Economy: Lessons from Norway

The recent oil price fall has created concern among policy makers regarding the consequences of terms of trade shocks for resource-rich countries. This concern is not a minor one – the world's commodity exporters combined are responsible for 15–20% of global value added. We estimate a two-country New Keynesian model in order to quantify the importance of oil price shocks for Norway – a large, prototype petroleum exporter. Domestic supply chains link mainland (non-oil) Norway to the off-shore oil industry, while fiscal authorities accumulate income in a sovereign wealth fund. Oil prices and the international business cycle are jointly determined abroad. These features allow us to disentangle the structural sources of oil price fluctuations, and how they affect mainland Norway. The estimated model provides three important results: First, pass-through from oil prices to the oil exporter implies up to 20% higher business cycle volatility. Second, the majority of spillover effects stem from non-oil disturbances such as innovations in international investment efficiency. Conventional oil market shocks, in contrast, explain at most 10% of the Norwegian business cycle. Third, the prevailing fiscal regime provides substantial protection against external shocks while domestic supply linkages make the oil exporter more exposed.publishedVersio

Foreign Shocks

How and to what extent are small open economies affected by international shocks? I develop and estimate a medium scale DSGE model that addresses both questions. The model incorporates i) international markets for firm-to-firm trade in production inputs, and ii) producer heterogeneity where technology and price setting constraints vary across industries. Using Bayesian techniques on Canadian and US data, I document several macroeconomic regularities in the small open economy, all attributed to international disturbances. First, foreign shocks are crucial for domestic fluctuations at all forecasting horizons. Second, productivity is the most important driver of business cycles. Investment efficiency shocks on the other hand have counterfactual implications for international spillover. Third, the relevance of foreign shocks accumulates over time. Fourth, business cycles display strong co-movement across countries, even though shocks are uncorrelated and the trade balance is countercyclical. Fifth, exchange rate pass-through to aggregate CPI inflation is moderate, while pass-through at the sector level is positively linked to the frequency of price changes. Few of these features have been accounted for by existing open economy DSGE literature, but all are consistent with reduced form evidence. The model presented here offers a structural interpretation of the results

Foreign Shocks in an Estimated Multi-Sector Model

How are macroeconomic fluctuations in open economies affected by international business cycles? To shed some light on this question, I develop and estimate a medium scale DSGE model for a small open economy. The model incorporates i) international markets for firm-to-firm trade in production inputs, and ii) producer heterogeneity where technology and price setting constraints vary across industries. Using Bayesian techniques on Canadian and US data, I document several macroeconomic regularities in the small open economy, all attributed to international disturbances. First, foreign shocks are crucial for domestic fluctuations at all forecasting horizons. Second, productivity is the most important driver of business cycles. Investment efficiency shocks on the other hand have counterfactual implications for international spillover. Third, the relevance of foreign shocks accumulates over time. Fourth, business cycles display strong co-movement across countries, even though shocks are uncorrelated and the trade balance is countercyclical. Fifth, exchange rate pass-through to aggregate CPI inflation is moderate, while pass-through at the sector level is positively linked to the frequency of price changes. Few of these features have been accounted for in existing open economy DSGE literature, but all are consistent with reduced form evidence. The model presented here offers a structural interpretation of the results