The role of financial frictions in the 2007-2008 crisis : an estimated DSGE model

After the banking crises experienced by many countries in the 1990s and in 2008, financial market conditions have turned out to be a relevant factor for economic fluctuations. The purpose of this paper is to determine whether frictions in financial markets are important for business cycles, and whether the recent 2007-2008 crisis has enhanced (or reduced) the size of some shocks and the role played by financial factors in driving economic fluctuations. The analysis is based on both versions of the Smets and Wouters DSGE model (2003, 2007), which are estimated using Bayesian techniques. The two versions differ because the Smets and Wouters (2007) version entails a risk premium shock, which captures that interest rate faced by firms and households might be different from the policy rate because of some unmodelled frictions. Both versions are augmented to include an endogenous financial accelerator mechanism as in Bernanke, Gertler and Gilchrist (1999), which arises from information asymmetries between lenders and borrowers that create inefficiencies in financial markets. The analysis is based on the same data-set as in the Smets and Wouters model, but extended to 2010. One first set of results suggests that the recent crisis has amplified the relevance of financial factors, as well as unmodelled frictions. Overall, this paper proves that the Smets and Wouters model augmented with a financial accelerator mechanism is suitable to capture much of the historical developments in U.S. financial markets that led to the financial crisis in 2007-2008. In particular, the concomitance of a peak in leverage ratio and the deepening of the recession supports the argument that leverage and credit have an important role to play in shaping the business cycle, in particular the intensity of recessions

Financial frictions and the zero lower bound on interest rates: a DSGE analysis

Recent developments in Canada, the United Kingdom, the euro area, Japan, Sweden, Switzerland and the United States have triggered a debate on whether monetary policy is effective when the nominal interest rate is close to zero. In this context, the monetary authority is no longer in a position to pursue a policy of monetary easing by lowering nominal interest rates further. However, some economists have down-played the risk of hitting the zero lower bound, at least for the US economy. In this paper, I assess the implications of the zero lower bound in a DSGE model with financial frictions. The financial accelerator mechanism is formalized as in Bernanke, Gertler and Gilchrist (1995). The paper attempts to address three main issues. First, I evaluate whether the zero lower bound -- by limiting the use of the nominal interest rate as a policy instrument -- might hamper the monetary authority from offsetting the negative effects of an adverse shock. Second, I analyze whether price-level targeting, through the stabilization of private sector expectations, might be a better monetary rule than inflation targeting in order to avoid the "liquidity trap". Third, I investigate the effectiveness of fiscal stimulus (namely, an increase in government expenditure) when financial markets are imperfect and the nominal interest rate is close to its zero lower bound. In this context, two questions will be addressed: first, do financial frictions weaken the effect of a fiscal expansion? Second, how are results affected when the zero lower bound is binding? To address these questions, I introduce a negative demand shock and an adverse financial shock. I find that by adopting a price-level targeting rule, the monetary authority might alleviate the recession generated by the interaction of financial frictions and lower-bounded nominal interest rates. Alternatively, an increase in government expenditure has a positive impact on output, but fiscal multipliers are below one, due to a strong crowding-out effect of private consumption. This effect is muted when the nominal interest rate is lower bounded. In analyzing discretionary fiscal policy, this paper does also focus on two crucial aspects: the duration of the fiscal stimulus and the presence of implementation lags.Optimal monetary policy, financial accelerator, lower bound on nominal interest rates, price-level targeting, fiscal stimulus.

Fiscal Consolidation and Implications of Social Spending for Long-Term Fiscal Sustainability. ESRI Research Bulletin 2014/1/2

During the economic and financial crisis fiscal positions across OECD countries deteriorated sharply. Many countries have already started fiscal consolidations but additional consolidation will be required. Moreover, additional challenges to the sustainability of fiscal balances are posed by population ageing and additional spending requirements on health and pensions, which by European Commission and the OECD projections will drive up public spending in almost all OECD countries over the horizon 2012-2050

Consumption and credit constraints: A model and evidence for Ireland

Since the onset of the financial crisis, consumption has fallen in many economies. This paper presents a small-scale DSGE model with occasionally binding credit constraints. Indebted households start facing credit constraints when the value of their main asset, which we assume to be housing, declines. As a response, they stop smoothing consumption and deleverage. We show that even households that only expect to face a credit constraint in the future deleverage. In an Irish dataset collected during the crisis, we reject the permanent income hypothesis for highly leveraged households and thus find evidence for a disruption in consumption smoothing. This effect suggests the presence of credit constraints

Fiscal Forecast Errors: Governments Versus Independent Agencies? ESRI Research Bulletin 2014/1/1

Should the role of preparing budgetary projections be delegated to an independent agency? A debate around this issue has arisen in Europe, given the deterioration of governments’ budget balances in many European countries and the lack of accuracy in fiscal projections. Of particular concern is that planned government deficits turned out to consistently exceed budgetary plans by a significant magnitude in recent years. Explanatory factors for these misalignments include unexpected or unplanned large GDP shocks or fiscal stimulus packages. However beyond this, a lack of both transparency and a realistic account of facts may be at fault

Financial frictions and the zero lower bound on interest rates: a DSGE analysis

Recent developments in Canada, the United Kingdom, the euro area, Japan, Sweden, Switzerland and the United States have triggered a debate on whether monetary policy is effective when the nominal interest rate is close to zero. In this context, the monetary authority is no longer in a position to pursue a policy of monetary easing by lowering nominal interest rates further. However, some economists have down-played the risk of hitting the zero lower bound, at least for the US economy. In this paper, I assess the implications of the zero lower bound in a DSGE model with financial frictions. The financial accelerator mechanism is formalized as in Bernanke, Gertler and Gilchrist (1995). The paper attempts to address three main issues. First, I evaluate whether the zero lower bound -- by limiting the use of the nominal interest rate as a policy instrument -- might hamper the monetary authority from offsetting the negative effects of an adverse shock. Second, I analyze whether price-level targeting, through the stabilization of private sector expectations, might be a better monetary rule than inflation targeting in order to avoid the "liquidity trap". Third, I investigate the effectiveness of fiscal stimulus (namely, an increase in government expenditure) when financial markets are imperfect and the nominal interest rate is close to its zero lower bound. In this context, two questions will be addressed: first, do financial frictions weaken the effect of a fiscal expansion? Second, how are results affected when the zero lower bound is binding? To address these questions, I introduce a negative demand shock and an adverse financial shock. I find that by adopting a price-level targeting rule, the monetary authority might alleviate the recession generated by the interaction of financial frictions and lower-bounded nominal interest rates. Alternatively, an increase in government expenditure has a positive impact on output, but fiscal multipliers are below one, due to a strong crowding-out effect of private consumption. This effect is muted when the nominal interest rate is lower bounded. In analyzing discretionary fiscal policy, this paper does also focus on two crucial aspects: the duration of the fiscal stimulus and the presence of implementation lags

Labour market policies for inclusiveness. A literature review with a gap analysis

The COVID-19 pandemic triggered renewed interest in the use of different fiscal spending and transfer programmes to address the worsening conditions and deepening inequalities within the labour markets. This paper reviews the role of specific fiscal spending and transfer programmes in shaping labour market dynamics by disentangling different macroeconomic and microeconomic mechanisms. The paper pre- sents the recent empirical evidence on the topic in an attempt to abstract several empirical regularities and identify research gaps. The analysis also highlights gaps in the literature and suggests how future research could fill these gaps

Financial frictions and the zero lower bound on interest rates: a DSGE analysis

Recent developments in Canada, the United Kingdom, the euro area, Japan, Sweden, Switzerland and the United States have triggered a debate on whether monetary policy is effective when the nominal interest rate is close to zero. In this context, the monetary authority is no longer in a position to pursue a policy of monetary easing by lowering nominal interest rates further. However, some economists have down-played the risk of hitting the zero lower bound, at least for the US economy. In this paper, I assess the implications of the zero lower bound in a DSGE model with financial frictions. The financial accelerator mechanism is formalized as in Bernanke, Gertler and Gilchrist (1995). The paper attempts to address three main issues. First, I evaluate whether the zero lower bound -- by limiting the use of the nominal interest rate as a policy instrument -- might hamper the monetary authority from offsetting the negative effects of an adverse shock. Second, I analyze whether price-level targeting, through the stabilization of private sector expectations, might be a better monetary rule than inflation targeting in order to avoid the "liquidity trap". Third, I investigate the effectiveness of fiscal stimulus (namely, an increase in government expenditure) when financial markets are imperfect and the nominal interest rate is close to its zero lower bound. In this context, two questions will be addressed: first, do financial frictions weaken the effect of a fiscal expansion? Second, how are results affected when the zero lower bound is binding? To address these questions, I introduce a negative demand shock and an adverse financial shock. I find that by adopting a price-level targeting rule, the monetary authority might alleviate the recession generated by the interaction of financial frictions and lower-bounded nominal interest rates. Alternatively, an increase in government expenditure has a positive impact on output, but fiscal multipliers are below one, due to a strong crowding-out effect of private consumption. This effect is muted when the nominal interest rate is lower bounded. In analyzing discretionary fiscal policy, this paper does also focus on two crucial aspects: the duration of the fiscal stimulus and the presence of implementation lags

Fiscal forecast errors

The fact that the literature tends to find optimistic biases in national fiscal projections has led to a growing recognition in the academic and policy arenas of the need for independent forecasts in the fiscal domain, prepared by independent agencies, such as the European Commission in the case of Europe. Against this background the aim of this paper is to test: (i) whether the forecasting performance of governments is indeed worse than that of international organizations, and (ii) whether fiscal projections prepared by international organizations are free from political economy distortions. The answer to these both questions is no: our results, based on real-time data for 15 European countries over the period 1999- 2007, point to the rejection of the two hypotheses under scrutiny. We motivate the empirical analysis on the basis of a model in which an independent agency tries to minimize the distance to the government forecast. Starting from the assumption that the government’s information set includes private information not available to outside forecasters, we show how such a framework can help in understanding the observed empirical evidence.Las previsiones presupuestarias que preparan las autoridades nacionales tienden a presentar, en promedio, una visión optimista de la senda futura de las finanzas públicas. Este hecho ha sido probado en numerosos trabajos en particular, en el caso de Europa, en la última década. Por ello, se escuchan voces que piden que otras instituciones, independientes de los Gobiernos nacionales, asuman un papel más relevante en el proceso de planificación presupuestaria. En particular, en el caso de Europa, se menciona a la Comisión Europea. En este marco, el objetivo del presente documento es contrastar dos cuestiones muy concretas con respecto a las previsiones presupuestarias preparadas por las instituciones internacionales: i) ¿es la exactitud de dichas proyecciones mucho mejor que la de las preparadas por las autoridades nacionales?, y ii) ¿están libres dichas previsiones de distorsiones derivadas de factores tales como los ciclos electorales? Nuestros resultados, basados en una muestra de datos (previsiones) obtenidos de informes publicados en tiempo real para 15 países europeos en el período 1999-2007, señalan que la respuesta a las dos preguntas es negativa. Además de la evidencia empírica, en el documento se desarrolla un modelo teórico muy estilizado con el que se proporciona una posible explicación de los resultados empíricos. Dicha explicación se basa en la idea de que las autoridades nacionales disponen de más información que los analistas externos en todas las etapas de elaboración y seguimiento de los planes presupuestarios. Así pues, la institución independiente, al tratar de aproximarse lo más posible a la previsión del Gobierno (para reducir el déficit de acceso a la información), puede acabar incorporando en su propia previsión parte del sesgo político habitual en las proyecciones oficiales

The role of financial frictions during the crisis: An estimated DSGE model

After the recent banking crisis in 2008, financial market conditions have turned out to be a relevant factor for economic fluctuations. This paper provides a quantitative assessment of the impact of financial frictions on the U.S. business cycle. The analysis compares the original Smets and Wouters model (2003, 2007) with an alternative version augmented with the financial accelerator mechanism à la Bernanke, Gertler and Gilchrist (1996,1999). Both versions are estimated using Bayesian techniques over a sample extended to 2012. The analysis supports the role of financial channels, namely the financial accelerator mechanism, in transmitting dysfunctions from financial markets to the real economy. The Smets and Wouters model, augmented with the financial accelerator mechanism, is suitable to capture much of the historical developments in U.S. financial markets that led to the financial crisis. The model can account for the output contraction in 2008, as well as the widening in corporate spreads and supports the argument that financial conditions have amplified the U.S. business cycle and the intensity of the recession