Production Stages and the Transmission of Technological Progress

We develop and estimate a DSGE model which realistically assumes that many goods in the economy are produced through more than one stage of production. Firms produce differentiated goods at an intermediate stage and a final stage, post different prices at both stages, and face stage-specific technological change. Wage-setting households are imperfectly competitive with respect to labor skills. Intermediate-stage technology shocks explain most of short-run output fluctuations, whereas final-stage technology shocks only have a small impact. Despite the dominance of technology shocks, the model predicts a near-zero correlation between hours worked and the return to work and mildly procyclical real wages. The factors mainly responsible for these findings are an input-output linkage between firms operating at the different stages and movements in the relative price of goods. We show that, depending the source, a technology improvement may either have a contractionary or expansionary impact on employment.Business Cycles, Production Stages, Technological Change, Nominal Rigidities

The Welfare Implications of Inflation versus Price-Level Targeting in a Two-Sector, Small Open Economy

The authors analyze the welfare implications of simple monetary policy rules in the context of an estimated model of a small open economy for Canada with traded and non-traded goods, and with sticky prices and wages. They find statistically significant heterogeneity in the degree of price rigidity across sectors. They also find welfare gains in targeting only the non-traded-goods inflation, since prices are found to be more sticky in this production sector, but those gains come at the cost of substantially increased aggregate volatility. The authors look for the welfare-maximizing specification of an interest rate reaction function that allows for a specific price-level target. They find, however, that, overall, the higher welfare is achieved, given the estimated model for the Canadian economy, with a strict inflation-targeting rule where the central bank reacts to the next period's expected deviation from the inflation target and does not target the output gap.Economic models; Exchange rates; Inflation targets

Has Exchange Rate Pass-Through Really Declined in Canada?

Several empirical studies suggest that exchange rate pass-through has declined in recent years in industrialized countries. Results for Canada also indicate that, in the 1990s, import and consumer prices became less responsive to exchange rate movements. These findings are based on reducedform regressions that are typically motivated by partial-equilibrium models of pricing. Bouakez and Rebei instead use a structural, general-equilibrium approach to test the premise that exchange rate pass-through has decreased in Canada. Their approach consists in estimating a dynamic stochastic general-equilibrium model for Canada over two subsamples, which cover the periods before and after the Bank's adoption of inflation targeting. The authors then use impulse-response analysis to assess the stability of exchange rate pass-through across the two subsamples. Their results indicate that pass-through to Canadian import prices has been rather stable, while passthrough to Canadian consumer prices has declined in recent years. Counterfactual experiments reveal that the change in monetary policy regime is largely responsible for this decline.Business fluctuations and cycles; Economic models; Exchange rates; Inflation and prices; International topics

The Welfare Implications of Fiscal Dominance

This paper studies the interdependence between fiscal and monetary policy in a DSGE model with sticky prices and non-zero trend inflation. We characterize the fiscal and monetary policies by a rule whereby a given fraction k of the government debt must be backed by the discounted value of current and future primary surpluses. The remaining fraction of debt is backed by seigniorage revenues. When k = 1, there is no fiscal dominance, since the fiscal authority backs all debt and accommodates (independent) monetary policy, by adjusting current or future primary surpluses to satisfy the government’s intertemporal budget constraint. If k = 0, all debt is backed by the monetary authority and there is complete fiscal dominance. A continuum of possibilities lies between these two polar cases. We numerically show that: 1) the degree of fiscal dominance, as measured by (1 - k), is positively related to trend inflation, and 2) when prices are sticky, k has significant effects on the business cycle dynamics. The model is estimated using Bayesian techniques. Estimates of k imply a high degree of fiscal dominance in both Mexico and South Korea, but almost no fiscal dominance in Canada and the U.S. The country-specific estimates of the structural parameters are used in a second-order approximation of the equilibrium around the deterministic steady-state to evaluate the welfare costs of fiscal dominance. Results suggest significant welfare losses for countries with high degrees of fiscal dominance.Economic models; Fiscal policy; Inflation: costs and benefits; Monetary policy framework

Optimal Taylor Rules in an Estimated Model of a Small Open Economy

We develop a model of a small open economy with three types of nominal rigidities (domestic goods prices, imported goods prices and wages) and eight different structural shocks. We estimate the model's structural parameters using a maximum likelihood procedure and use it to compute welfare-maximizing Taylor rules for setting domestic short-term interest rates. For these computations, we use a second-order approximation around the model's deterministic steady state, which allows the Taylor rule coefficients to affect the means of consumption, leisure and real balances as well as their variances. Welfare gains from moving to the optimal Taylor rule are substantial, but require a very precise knowledge of the values of the model's structural parametersEconomic models; Open economy; Optimal monetary policy; Taylor rules

The Macroeconomic Effects of Military Buildups in a New Neoclassical Synthesis Framework

The authors study the macroeconomic consequences of large military buildups using a New Neoclassical Synthesis (NNS) approach that combines nominal rigidities within imperfectly competitive goods and labour markets. They show that the predictions of the NNS framework generally are consistent with the sign, timing, and magnitude of how hours worked, after-tax real wages, and output actually respond to an upsurge in military purchases. The key factors leading to these findings are: (i) variations in the ratio of price to marginal cost resulting from nominal-price inflexibilities, (ii) staggered nominal-wage setting, and (iii) time-varying marginal tax rates. Unlike the standard neoclassical model, the NNS framework successfully explains the macroeconomic effects of military buildups when taxes are distortionary.Fiscal policy; Economic models; Business fluctuations and cycles

Nominal Rigidities and Exchange Rate Pass-Through in a Structural Model of a Small Open Economy

The authors analyze exchange rate pass-through in an estimated structural model of a small open economy that incorporates three types of nominal rigidity (wages and the prices of domestically produced and imported goods) and eight different structural shocks. The model is estimated using quarterly data from Canada and the United States. It predicts a remarkably similar dynamic relationship between the nominal exchange rate and prices in response to the different structural shocks: the nominal exchange rate overshoots its long-run level, and changes in the nominal exchange rate are passed through slowly to the domestic price level. The authors show that, although pricing to market (the slow adjustment of the domestic-currency prices of imported goods) is necessary to generate slow pass-through to the prices of imported goods, it is not necessary to generate slow pass-through to the overall price level. Sticky domestic wages also generate slow exchange rate pass-through, even when the prices of imported goods adjust instantaneously to changes in the exchange rate.Business fluctuations and cycles; Economic models; Exchange rates; Inflation and prices; International topics

Optimal Taylor Rules in an Estimated Model of a Small Open Economy

The authors compute welfare-maximizing Taylor rules in a dynamic general-equilibrium model of a small open economy. The model includes three types of nominal rigidities (domestic-goods prices, imported-goods prices, and wages) and eight different structural shocks. The authors estimate the model's structural parameters by maximum likelihood using Canadian and U.S. data, and use a second-order approximation of the model to measure the welfare effects of different Taylor rules. By estimating the model, the authors can compare welfare levels with that attainable under the Taylor rule estimated for their sample period. They find that the welfare gains from moving to the optimal Taylor rule are larger than those obtained by previous researchers.Economic models; Exchange rates; Inflation targets

Optimal Taylor Rules in an Estimated Model of a Small Open Economy

We develop a model of a small open economy with three types of nominal rigidities (domestic goods prices, imported goods prices and wages) and eight different structural shocks. We estimate the model's structural parameters using a maximum likelihood procedure and use it to compute welfare-maximizing Taylor rules for setting domestic short-term interest rates. For these computations, we use a second-order approximation around the model's deterministic steady state, which allows the Taylor rule coefficients to affect the means of consumption, leisure and real balances as well as their variances. Welfare gains from moving to the optimal Taylor rule are substantial, but require a very precise knowledge of the values of the model's structural parameters.Economic models; Open economy; Optimal monetary policy; Taylor rules

The Macroeconomic Effects of Non-Zero Trend Inflation

The authors study the macroeconomic effects of non-zero trend inflation in a simple dynamic stochastic general-equilibrium model with sticky prices. They show that trend inflation leads to a substantial reduction in the stochastic means of output, consumption, and employment. It also leads to an increase in the variability and persistence of most aggregates. Price dispersion across firms unambiguously increases the welfare costs of inflation. The effects hold qualitatively no matter how sticky prices are modelled, but they are quantitatively much stronger under Calvo pricing.Business fluctuations and cycles; Economic models; Inflation and prices; Inflation targets