Robust expectations and uncertain models – A robust control approach with application to the New Keynesian economy

This paper extends Svensson and Woodford’s (2003) partial information framework by allowing the private agents to achieve robustness against incomplete information about the structure of the economy by distorting their expectations in a particular direction. It shows how a linear rational expectations equilibrium under concern for robustness can be solved by exploiting the recursive structure of the problem and appropriately modifying the Bellman equations in their framework. The standard Kalman filter is then used for information updating under imperfect measurement of the state variables. The standard New Keynesian model is used for illustrating how concern for modelling errors interacts with imperfect information. Agents achieve robustness by simultaneously over-estimating the persistence of exogenous shocks, but under-estimating the policy response to the output gap. This under- estimation, combined with imperfect measurement, leads to larger and more persistent responses of private consumption to government expenditure shocks under robust expectations.expectations, robust control, model uncertainty, monetary policy, imperfect information

A positive theory of monetary policy and robust control

This paper applies the robust control approach to a simple positive theory of monetary policy, when the central bank’s model of the economy is subject to misspecifications. It is shown that a central bank should react more aggressively to supply shocks when the model misspecifications grow larger. Moreover, the model misspecifications aggravate the inflation bias and a trade-off between output stabilisation and inflation worsens when the uncertainty surrounding the central bank’s model increases. This implies that the larger the model misspecifications are, the more inflation-averse the central bank should be.risk-sensitivity, robust control theory, monetary policy, Brainard conservatism, model uncertainty

A positive theory of monetary policy and robust control

This paper applies the robust control approach to a simple positive theory of monetary policy, when the central bank’s model of the economy is subject to misspecifications. It is shown that a central bank should react more aggressively to supply shocks when the model misspecifications grow larger. Moreover, the model misspecifications aggravate the inflation bias and a trade-off between output stabilisation and inflation worsens when the uncertainty surrounding the central bank’s model increases. This implies that the larger the model misspecifications are, the more inflation-averse the central bank should be.risk-sensitivity, robust control theory, monetary policy, Brainard conservatism, model uncertainty

Central Bank Independence and Wage Bargaining Structure - Empirical Evidence

This paper studies the relationship between central bank independence, wage bargaining structure and macroeconomic performance in OECD countries. A cross-sectional time-series (TSCS) model for inflation, nominal wage growth and unemployment for the period 1973–1996 is estimated using different and updated measures of central bank independence. The importance of the price stability objective in the central bank statute is used as a proxy for the degree of conservativeness of the central bank. A recently published data set on wage bargaining structure is used, and a distinction is made between coordination of wage bargaining and formal centralization. A new measure of union power is constructed, which combines formal centralization and union density. The implications of the large differences that can be seen between coverage and unionization rates in some countries are briefly discussed. Two important results emerge. First, the central bank's political independence and personnel independence contribute most importantly to a successful inflation policy. Second, a high level of coordination contributes to moderate inflation rates and unemployment, while union monopoly power tends to increase inflation.central bank independence; wage bargaining; monetary policy

Robust expectations and uncertain models – A robust control approach with application to the New Keynesian economy

This paper extends Svensson and Woodford’s (2003) partial information framework by allowing the private agents to achieve robustness against incomplete information about the structure of the economy by distorting their expectations in a particular direction. It shows how a linear rational expectations equilibrium under concern for robustness can be solved by exploiting the recursive structure of the problem and appropriately modifying the Bellman equations in their framework. The standard Kalman filter is then used for information updating under imperfect measurement of the state variables. The standard New Keynesian model is used for illustrating how concern for modelling errors interacts with imperfect information. Agents achieve robustness by simultaneously over-estimating the persistence of exogenous shocks, but under-estimating the policy response to the output gap. This under-estimation, combined with imperfect measurement, leads to larger and more persistent responses of private consumption to government expenditure shocks under robust expectations.expectations; robust control; model uncertainty; monetary policy; imperfect information

Does Centralised Wage Setting Lead into Higher Taxation

This paper studies implications of centralised wage setting for the level of taxation and public expenditure in an analytical model with unionised labour markets. We extend the previous studies by allowing for both demand and supply effects of labour. Also, in addition to the standard social planner approach, we consider a political economy set up, where the tax rate is chosen to maximise the welfare of a median voter. Our results suggest that when working hours are endogenous, the relationship between the degree of centralisation and the labour tax rate is ambiguous. In particular, if the marginal utility from public provision is sufficiently low, centralised wage setting implies lower optimal tax rate on labour. This is due to a 'budgetary discipline effect', which reduces the optimal tax rate preferred by the median voter under centralised wage setting.Taxation, wage setting, public expenditure, median voter

Euler consumption equation with non-separable preferences over consumption and leisure and collateral constraints

This paper derives and estimates an aggregate Euler consumption equation which allows one to compare the importance of collateral constraints and non-separability of consumption and leisure as alternative sources of excess sensitivity of consumption to current income. Estimation results suggest that during a severe financial distress both non-separability and collateral constraints are needed to capture excess sensitivity of consumption to current economic conditions. During more tranquil times, evidence on collateral effects is more limited and non-separability is sufficient to make the Euler consumption equation agree well with the data.housing; financial distress; excess sensitivity of consumption

Testing the structural interpretation of the price puzzle with a cost channel model

We estimate a new-Keynesian DSGE model with the cost channel to assess its ability to replicate the price puzzle ie the inflationary impact of a monetary policy shock typically arising in VAR analysis. In order to correctly identify the monetary policy shock, we distinguish between a standard policy rate shifter and a shock to trend inflation ie the time-varying inflation target set by the Fed. While offering some statistical support to the cost channel, our estimated model clearly implies a negative inflation reaction to a tightening of monetary policy. We offer a discussion of the possible sources of mismatch between the VAR evidence and our own.cost channel; inflation dynamics; price puzzle; trend inflation

Competition and Innovation - Microeconometric Evidence Using Finnish Data

In this study we provide a theoretical prediction of a complementary relationship between the incentive effects of product market competition and R&D subsidies using the theory of Aghion et. al (1997, 2001). The complementarity relationship and that of an inverted U-relationship is then tested using a large Finnish firm level data set combined with patent and patent citations of the firms. Econometric analysis shows that the inverted U-relationship is fairly robust to different innovation measures derived from patent data. We also find that the inverted-U relationship tends to be steeper when also R&D subsidies are considered. This result suggests that there exists a complementarity between competition and R&D subsidies.Product market competition, Innovations, R&D subsidies

Productivity and job flows: heterogeneity of new hires and continuing jobs in the business cycle

This paper focuses on tenure driven productivity dynamics of a firm-worker match as a potential explanation of "unemployment volatility puzzle". We let new matches and continuing jobs differ by their productivity levels and by their sensitivity to aggregate productivity shocks. As a result, new matches have a higher destruction rate and lower, but more volatile, wages than old matches, as new hires receive technology associated with the latest vintage. Our contribution is to produce model driven stickiness of old jobs’ wages which does not rely on ad hoc assumptions on wage rigidity. In our model, an aggregate productivity shock generates a persistent productivity difference between the two types of matches, creating an incentive to open new productive vacancies and to destroy old matches that are temporarily less productive. The model produces a well behaving Beveridge curve, despite endogenous job destruction, and more volatile vacancies and unemployment, without a need to rely on differing wage setting mechanisms of new and continuing jobs. Price rigidities do not alter the basic mechanism and the transmission of monetary policy shock is very similar to the standard New Keynesian model with search frictions. JEL Classification: E24, E32, J64Beveridge curve, job flows, Matching, monetary policy shock, nominal rigidities, productivity shocks, tenure, vintage structure