The ‘Puzzles’ Methodology: En Route to Indirect Inference?

We review the methods used in many papers to evaluate DSGE models by comparing their simulated moments with data moments. We compare these with the method of Indirect Inference to which they are closely related. We illustrate the comparison with contrasting assessments of a two-country model in two recent papers. We conclude that Indirect Inference is the proper end point of the puzzles methodology.Bootstrap, US-EU Model, DSGE, VAR, Indirect Inference, Wald Statistic, Anomaly, Puzzle.

Modelling nominal rigidities in general dynamic equilibrium framework

The widely-used "New Keynesian' model assumes that there is no price flexibility, but prices and wages are extremely "sticky'. In such a model, it is also usual to assume some scheme of lagged indexation which increases the stickiness of inflation. Theoretically, however, we have found that indexation not to lagged actual inflation but to lagged expected inflation (rational indexation) turns out to be the best way to carry out indexation. One major implication of applying this as the indexation formula is that the New Keynesian model behaves in a more 'classical' manner, with very little price stickiness, though still stickiness in real wages and in price mark-ups. Also, given the rational indexation scheme, the optimal monetary policy turns out to be price-level targeting, because such a rule would ensure price stability and minimise the distortions to relative prices due to price shocks. However, whether this socially optimal indexation scheme is feasible in practice is determined by a new empirical testing method suggested by Minford, Theodoridis and Meenagh (2007). From this test, we find that all models with a Calvo contracts framework with different indexation schemes are comprehensively rejected, including the case with theoretically optimal indexation, and so is a 'New Classical' model version, with flexible prices and wages and a one quarter information lag. There is no evidence that indexation of any sort existed. However, the New Classical model does not perform worse than the simple Calvo contract model, suggesting that when the model is improved sufficiently to pass this test, price rigidity will not necessarily feature in the specification

Monetarism rides again? US monetary policy in a world of quantitative easing

In a model of banking we give money a role in providing cheap collateral; i.e. besides the Taylor Rule, monetary policy can affect the risk-premium by varying the supply of M0 in open market operations, so that even at the zero bound monetary policy is still effective, and fiscal policy still crowds out investment. A simple rule for making M0 respond to credit conditions can substantially enhance the economy's stability. This, in combination with Price-level or nominal GDP targeting rules for interest rates, stabilises the economy further, making aggressive and distortionary regulation of banks' balance sheets redundant

Product differentiation, the volume of trade and profits under Cournot and Bertrand duopoly

This paper analyses how product differentiation affects the volume of trade under duopoly using Shubik-Levitan demand functions rather than the Bowley demand functions used by Bernhofen (2001). The Shubik-Levitan demand functions have the advantage that an increase in product differentiation does not increase the size of the market as happens with the Bowley demand functions. It is shown that the volume of trade in terms of quantities is decreasing in the degree of product differentiation when the trade cost is relatively low, but increasing in the degree of product differentiation when the trade cost is relatively high

Some problems in the testing of DSGE models

We review the methods used in many papers to evaluate DSGE models by comparing their simulated moments and other features with data equivalents. We note that they select, scale and characterise the shocks without reference to the data; crucially they fail to use the joint distribution of the features under comparison. We illustrate this point by recomputing an assessment of a two-country model in a recent paper; we find that the paper's conclusions are essentially reversed

The ‘Puzzles’ methodology: en route to Indirect Inference?

We review the methods used in many papers to evaluate DSGE models by comparing their simulated moments with data moments. We compare these with the method of Indirect Inference to which they are closely related. We illustrate the comparison with contrasting assessments of a two-country model in two recent papers. We conclude that Indirect Inference is the proper end point of the puzzles methodology

Monetary policy in a model with commodity and financial markets

This paper builds a small open economy model for a net commodity exporter to consider financial frictions and monetary policies in order to investigate the main determinants of business cycles. Since we make a distinction to the access of financial markets between the commodity and non-commodity sectors, we notice that as usual, a commodity price shock benefits the competitiveness of the economy and its borrowing terms. We outline a novel effect in this paper which we dub the 'financial market effect' following a positive commodity price shock that decreases the credit premium and hence exacerbate the commodity price boom. However the negative sectoral downturn affects entrepreneur credit together with disinflationary pressures of a real exchange rate appreciation. This opens the role for stabilization policies which we analyse comparing three types of monetary regimes. Estimating the model on South Africa, a major commodity exporting economy with inflation targeting regime, we find as conventional wisdom suggests that a hypothetical Taylor rule targeting the price-level allows for adjustment in inflation expectations that can dampen disinflationary pressures. Furthermore, due to smoother change in nominal rate of interest, there is lesser variability in financial markets

A long-commodity-cycle model of the world economy over a century and a half — making bricks with little straw

This paper explores the world business cycle using unfiltered data from 1870 and looks for a theory that could account for the long wave commodity cycle in the world economy. We build a simple DSGE model that includes a long time-to-build constraint in the commodity sector. We find that this model can produce long cycles in output and commodity prices as introduced by Kontradieff (1925) and Schumpeter (1935). Our findings show that these long business cycles are produced by the long gestation of commodity capacity which causes very large swings in commodity prices

Testing and estimating models using Indirect Inference

In this short article we explain how to test an economic model using Indirect Inference. We then go on to show how you can use this test to estimate the model