Three Essays on Monetary Economics

The title of my dissertation is "Three Essays on Monetary Economics". If another title would have been appropriate, that is "A Monetary Analysis of the Euro Area". This clearly summarizes what I have done in my three contributions. In fact, all the empirical parts of the thesis have been done using aggregate data of the Euro Area, implying that the monetary policy suggestions derived may be helpful for the European Central Bank (ECB). In this introduction I would like just to briefly explain what I did, but in particular I would guide the reader through the structure of the thesis, highlighting the differences and the relationships among the different chapters. Hence I will not report in detail the results of my analysis. They may be easily found reading the introduction and the concluding remarks of each chapter, bearing in mind the following description. Nevertheless, I will try to emphasize which is the original contribution of each single chapter. In the first chapter, I derived the optimal monetary policy rule indeed for European Central Bank. I set a maximization problem where the central bank has to maximize an objective (loss) function with respect to some variable of interests (namely inflation, output and interest rate smoothing) subject to a constraint represented by a series of equation (a model) synthesizing the economy. In this first chapter the model is given by just two equations, one for the demand side and the other for the supply side. Solving the maximization problem, it is possible to compute the optimal state contingent rule, i.e. a rule which indicated the central bank how to set the interest rate in order to minimize the loss function, given some preferences about the different objectives. The aim in deriving such a rule is threefold. First, I could derive policy suggestions for the ECB in terms of the optimal rule to follow. Second, I could evaluate the desirability to follow a rule such the optimal one rather than a Taylor rule, which is quite popular given the fact that it is a quite easy guide for a central bank. Third, and this is the original contribution, focusing on a sample period in which the ECB was effectively at work, differently from the previous articles where the authors considered period far in the past, I obtain different results. The goal of the second chapter is to investigate the relevance of the credit channel for the transmission of the monetary policy in the Euro Area, basing my analysis on a New Keynesian Dynamic Stochastic General Equilibrium model. The relevance of the credit channel is well known in the literature, and many good surveys exist and discuss the empirical work in the area. There are many recent works which incorporate such a channel in the DSGE models. Nevertheless, the empirical analysis of the so called financial accelerator mechanism is still scant in this context. I know just five papers dealing with such a topic, and just one of them focuses on the Euro area. The author analyzes how important are the financial frictions in the U.S. and Euro Area, finding that they are particularly relevant in the latter area, both for the standard BGG model and for the other modified models augmented with different source of frictions she proposes. My work is different in two respects. On one hand, I use a larger sample. I consider the period from the first quarter of 1980 to the last quarter of 2006 (instead of 1980q1-2002q4). The results are not surprising: financial frictions play a relevant role in the Euro Area. Nevertheless, given some differences in the specifications of the model, I obtained different, and in some cases better, results in terms of estimation. On the other hand, I have a different aim in implementing this paper. In fact, given that the financial frictions are relevant, I want to highlight which are the consequences for the monetary policy, and this leads me to the third chapter. In the third chapter I implemented the same exercise developed in the first one. Nevertheless, having a different model representing the constraint for the monetary authority, I could rely on the strength of the modern macroeconomic models and on their usefulness for the monetary analysis. It is also important to stress that I used data far in the past, before the existence of the ECB, because of the complexity of the estimated model. As a consequence, given the arguments brought in the first chapter, I will not interpret the results obtained as policy suggestion for the ECB. Those results are related to the presence of the asset prices and of the financial premium among endogenous variables, which allowed me to focus on the one hand on a quite discussed issue in the literature, i.e. the desirability to target the asset prices, and on the other hand, and finally this is the main contribution, to analyze the convenience for the central bank to target some measure of the financial friction, such for instance the financial premium

The external finance premium in the euro area A useful indicator for monetary policy?

In this paper I estimate a New Keynesian Dynamic Stochastic General Equilibrium model for the Euro Area, which closely follows the structure of the model developed by Smets and Wouters (2003, 2005, 2007), with the addition of the so-called financial accelerator mechanism developed in Bernanke, Gertler and Gilchrist (1999). The main aim is to obtain a time series for the unobserved external finance premium that entrepreneurs pay on their loans, with the further aim of providing a dynamic analysis of it. Results confirm in general what was recently found for the US by De Graeve (2008), namely that (1) the model incorporating financial frictions can generate a series for the premium, without using any financial macroeconomic aggregates, that is highly correlated with available proxies for it, (2) the estimated premium is not necessarily counter-cyclical (this depends on the shock considered). Nevertheless, although in addition the model with financial frictions better describes Euro Area data than the model without them, the former is not satisfactory in many other respects. For instance, the accelerator effect turns out to be statistically not significant. However, this does not impede financial frictions from remaining a key ingredient to model. In fact, I found that the estimated premium is a very powerful predictor of inflation. It overcomes, in terms of the Mean Squared Forecast Error, the traditional output gap measure in a Phillips curve specification. JEL Classification: E4, E5, E37Bayesian estimation, Euro Area External Finance Premium, financial accelerator, inflation, NK DSGE

A demand-driven search model with self-fulfilling expectations: The new `Farmerian' framework under scrutiny

In this paper, we implement Bayesian econometric techniques to analyze a theoretical framework built along the lines of Farmer's micro-foundation of the General Theory. Specifically, we test the ability of a demand-driven search model with self-fulfilling expectations to match the behaviour of the US economy over the last thirty years. The main findings of our empirical investigation are the following. First, all over the period, our model fits data very well. Second, demand shocks are the most relevant in explaining the variability of concerned variables. In addition, our estimates reveal that a large negative demand shock caused the Great Recession via a sudden drop of confidence. Overall, those results are consistent with the main features of the New 'Farmerian' Economics as well as to latest demand-side explanations of the finance-induced recession

Financial Factors and the Macroeconomy - a Policy Model

This paper documents the theoretical structure of an extension of the Norges Bank policy model NEMO. New features include an explicit treatment of the credit market, including a separate banking sector, a role for housing services and house prices, and the option of using macro-prudential instruments as the LTV-ratio and capital requirements as policy instruments. The model rely on building blocks from the recent literature on the interaction between the financial sector and the real economy

Structural Factors, Unemployment and Monetary Policy: The Useful Role of the Natural Rate of Interest

We study the role of monetary policy in response to variations in unemployment due to structural factors, modeled as exogenous changes in matching efficiency and in the size of the labor force. We find that monetary policy should play a role in such a scenario. Both negative shocks to the matching efficiency and negative shocks to the labor force increase inflation, thus calling for an increase in the interest rate when policy is conducted following Taylor-type rules. However, the natural rate of interest declines in response to both shocks. The optimal Ramsey policy prescribes small deviations from price stability and lowers the interest rate, thus tracking the natural rate of interest in response to both shocks. Structural factors in the labor market may have contributed to the recent decline in the natural rate of interest in the US.publishedVersio

House Prices, Expectations, and Time-Varying Fundamentals

We investigate the behavior of the equilibrium price-rent ratio for housing in a simple Lucas-type asset pricing model. We allow for time-varying risk aversion (via external habit formation) and time-varying persistence and volatility in the stochastic process for rent growth, consistent with U.S. data for the period 1960 to 2011. Under fully-rational expectations, the model significantly underpredicts the volatility of the U.S. price-rent ratio for reasonable levels of risk aversion. We demonstrate that the model can approximately match the volatility of the price-rent ratio in the data if near-rational agents continually update their estimates for the mean, persistence and volatility of fundamental rent growth using only recent data (i.e., the past 4 years), or if agents employ a simple moving-average forecast rule that places a large weight on the most recent observation. These two versions of the model can be distinguished by their predictions for the correlation between expected future returns on housing and the price-rent ratio. Only the moving-average model predicts a positive correlation such that agents tend to expect higher future returns when house prices are high relative to fundamentals–a feature that is consistent with survey evidence on the expectations of real-world housing investors.publishedVersio

Output Gap, Monetary Policy Trade-Offs and Financial Frictions

This paper investigates how the presence of financial frictions and financial shocks changes the definition and the estimated dynamics of the output gap in a New Keynesian model. Financial shocks absorb explanatory power from efficient labor supply shocks, thus changing radically the dynamics of the economy's efficient frontier. Despite their large impact on the output gap, financial factors affect the monetary policy trade-offs only to some extent. Nominal stabilization can be achieved at the cost of limited (but non-negligible) fluctuations in real economic activity. Finally, we discuss an alternative measure of the output gap (in deviation from the optimal equilibrium) that is a better measure of imbalances in the economy than the conventional output gap.publishedVersio

House Prices, Credit Growth, and Excess Volatility: Implications for Monetary and Macroprudential Policy

Progress on the question of whether policymakers should respond directly to financial variables requires a realistic economic model that captures the links between asset prices, credit expansion, and real economic activity. Standard DSGE models with fully-rational expectations have difficulty producing large swings in house prices and household debt that resemble the patterns observed in many developed countries over the past decade. We introduce excess volatility into an otherwise standard DSGE model by allowing a fraction of households to depart from fully-rational expectations. Specifically, we show that the introduction of simple moving-average forecast rules for a subset of households can significantly magnify the volatility and persistence of house prices and household debt relative to otherwise similar model with fully-rational expectations. We evaluate various policy actions that might be used to dampen the resulting excess volatility, including a direct response to house price growth or credit growth in the central bank's interest rate rule, the imposition of more restrictive loan-to-value ratios, and the use of a modified collateral constraint that takes into account the borrower's loan-to-income ratio. Of these, we find that a loan-to-income constraint is the most effective tool for dampening overall excess volatility in the model economy. We find that while an interest-rate response to house price growth or credit growth can stabilize some economic variables, it can significantly magnify the volatility of others, particularly inflation.publishedVersio

Monetary and Macroprudential Policy with Multi-Period Loans

We study the implications of multi-period loans for monetary and macroprudential policy, considering several realistic modifications - variable vs. fixed loan rates, non-negativity constraint on newly granted loans, and possibility for the collateral constraint to become slack - to an otherwise standard DSGE model with housing and financial intermediaries. Our general finding is that multiperiodicity affects the working of both policies, though in substantially different ways. We show that multiperiod contracts make the monetary policy less effective, but only under fixed rate mortgages, and do not generate significant asymmetry to its transmission. In contrast, the effects of macroprudential policy do not depend much on the type of interest payments, but exhibit strong asymmetries, with tightening having stronger effects than easening, especially for short and medium maturities.publishedVersio