Detecting recessions in the Great Moderation: a real-time analysis

The nature of the business cycle, particularly in the United States, has changed dramatically over the past several decades. In the 1970s and early 1980s, the U.S. economy often whipsawed up and down. Since then, real economic activity stabilized considerably, entering a period economists call the “Great Moderation.” With the ups and downs of the economy becoming less dramatic, it has become harder to determine in real-time when the economy dips into recession. ; Economists have a variety of methods to determine when the economy is entering a recession. These methods range from directly analyzing a broad spectrum of data to the formal use of recession prediction models. The National Bureau of Economic Research (NBER) uses the first approach, relying on several data series to make a determination of when the economy enters or exits a recession. Their decisions are intended to be accurate, not timely. More formal recession prediction models are designed to send a timely signal, but often do not take account of how the Great Moderation has altered the business cycle. ; Davig uses a framework that efficiently uses a large set of data in a “business cycle tracking” model. The model accounts for shifts in overall economic volatility – to capture the Great Moderation – and sends a signal when the economy is shifting between periods of low and high economic activity. The model can be used in different ways to extract a signal regarding whether the economy is likely heading for an NBER recession.

Phillips curve instability and optimal monetary policy

This paper assesses the implications for optimal discretionary monetary policy if the slope of the Phillips curve changes. The paper first derives a ‘switching’ Phillips curve from the optimal pricing decision of a monopolistic firm that faces a changing cost of price adjustment. Two states exists, a state with a high cost of price adjustment that generates a ‘flat’ Phillips curve and a low-cost state that generates a relatively ‘steep’ curve. The second aspect of the paper constructs a utility-based welfare criterion. A novel feature of this criterion is that it has a relative weight on output gap deviations that is state dependent, so it changes with the cost of price adjustment. Optimal monetary policy is computed subject to the switching-Phillips curve under both ad-hoc and utility-based welfare criteria. The utility-based criterion instructs monetary policy to disregard the slope of the Phillips curve and keep its systematic actions constant across different states. This stands in contrast to the prescription coming under the ad-hoc criterion, which advises monetary policy to change its systematic behavior according to the slope of the Phillips curve.Phillips curve ; Monetary policy

An Interpretation of Fluctuating Macro Policies

This paper estimates simple regime-switching rules for monetary policy and tax policy over the post-war period in the United States and imposes the estimated policy process on a standard dynamic stochastic general equilibrium model with nominal rigidities. The estimated joint policy process produces a unique stationary rational expectations equilibrium in a simple New Keynesian model. We characterize policy impacts across regimesPolicy rules, Markov-switching, DSGE models

MONETARY-FISCAL POLICY INTERACTIONS AND FISCAL STIMULUS

Increases in government spending trigger substitution effects—both inter- and intra-temporal—and a wealth effect. The ultimate impacts on the econ- omy hinge on current and expected monetary and fiscal policy behavior. Studies that impose active monetary policy and passive fiscal policy typically find that government consumption crowds out private consumption: higher future taxes cre- ate a strong negative wealth effect, while the active monetary response increases the real interest rate. This paper estimates Markov-switching policy rules for the United States and finds that monetary and fiscal policies fluctuate between ac- tive and passive behavior. When the estimated joint policy process is imposed on a conventional new Keynesian model, government spending generates positive consumption multipliers in some policy regimes and in simulated data in which all policy regimes are realized. The paper reports the model’s predictions of the macroeconomic impacts of the American Recovery and Reinvestment Act’s implied path for government spending under alternative monetary-fiscal policy combina- tions.

Monetary policy regime shifts and inflation persistence

This paper reports the results of estimating a Markov-Switching New Keynesian (MSNK) model using Bayesian methods. The broadest and best fitting MSNK model is a four-regime model allowing independent changes in the regimes governing monetary policy and the volatility of the shocks. We use the estimates to investigate the mechanisms that lead to a decline in the persistence of inflation. We show that the population moment describing the serial correlation of inflation is a weighted average of the autocorrelation parameters of the exogenous shocks. Changes in the monetary or shock volatility regimes shift weight over these serial correlation parameters and affect the serial correlation properties of inflation. Estimation results indicate that a shift to a monetary regime that reacts more aggressively to inflation reduces the weight on the more persistent shocks, so lowers inflation persistence. Similarly, a shift to the low-volatility regime reduces the weight on the more persistent shocks and also contributes to reducing inflation persistence. Estimates of model-implied inflation persistence indicate that it began rising in the late 1960s and peaked around the Volcker disinflation. The subsequent decline in persistence is due to both a more aggressive monetary policy regime and less volatile shocks.

EXPECTATIONS AND FISCAL STIMULUS

Increases in government spending trigger substitution effects—both inter- and intra-temporal—and a wealth effect. The ultimate impacts on the econ- omy hinge on current and expected monetary and fiscal policy behavior. Studies that impose active monetary policy and passive fiscal policy typically find that government consumption crowds out private consumption: higher future taxes cre- ate a strong negative wealth effect, while the active monetary response increases the real interest rate. This paper estimates Markov-switching policy rules for the United States and finds that monetary and fiscal policies fluctuate between ac- tive and passive behavior. When the estimated joint policy process is imposed on a conventional new Keynesian model, government spending generates positive consumption multipliers in some policy regimes and in simulated data in which all policy regimes are realized. The paper reports the model’s predictions of the macroeconomic impacts of the American Recovery and Reinvestment Act’s implied path for government spending under alternative monetary-fiscal policy combina- tions.

Reply to "Generalizing the Taylor principle": a comment

Farmer, Waggoner, and Zha (2009) show that a new Keynesian model with a regime-switching monetary policy rule can support multiple solutions that depend only on the fundamental shocks in the model. Their note appears to find solutions in regions of the parameter space where there should be no bounded solutions, according to conditions in Davig and Leeper (2007). This puzzling finding is straightforward to explain: Farmer, Waggoner, and Zha (FWZ) derive solutions using a model that differs from the one to which the Davig and Leeper (DL) conditions apply. In addition, FWZ impose cross-equation restrictions between behavioral relations and the exogenous driving process. This rather special assumption undermines the traditional sharp distinction in micro-founded general equilibrium models between 'deep' parameters and the parameters governing the exogenous processes.

What is the effect of financial stress on economic activity

Despite the apparent risk that financial stress poses to the real economy, the relationship between financial stress and economic activity is complex and not well understood. The experience of the United States and other countries has shown that businesses and households often pull back on new investments and purchases in response to the tighter credit conditions and greater uncertainty caused by financial stress. Yet important gaps remain in our understanding of this critical relationship. ; One potential complication is that the relationship may change when financial stress is elevated and the economy is in a recession. Over the last 20 years, the U.S. economy has shown a tendency to switch between two very distinct states—a normal state in which economic activity is high and financial stress is low, and a distressed state in which economic activity is low and financial stress is high. Does the impact of financial stress on economic activity depend on which of these two states currently prevails? And how do changes in financial stress and economic activity affect the likelihood of switching from one state to the other? ; Davig and Hakkio examine these questions. A key finding is that, over the last two decades, increases in financial stress have had a much stronger effect on the real economy when the economy is in a distressed state. In addition, rising financial stress plays a role in eventually tipping a strong economy into a distressed state. As a result, policymakers should monitor financial conditions closely, both in good as well as bad times.

Endogenous monetary policy regime change

This paper makes changes in monetary policy rules (or regimes) endogenous. Changes are triggered when certain endogenous variables cross specified thresholds. Rational expectations equilibria are examined in three models of threshold switching to illustrate that (i) expectations formation effects generated by the possibility of regime change can be quantitatively important; (ii) symmetric shocks can have asymmetric effects; (iii) endogenous switching is a natural way to formally model preemptive policy actions. In a conventional calibrated model, preemptive policy shifts agents’ expectations, enhancing the ability of policy to offset demand shocks; this yields a quantitatively significant “preemption dividend.”Monetary policy ; Taylor's rule

Monetary-fiscal policy interactions and fiscal stimulus

Increases in government spending trigger substitution effects both inter- and intra-temporal and a wealth effect. The ultimate impacts on the economy hinge on current and expected monetary and fiscal policy behavior. Studies that impose active monetary policy and passive fiscal policy typically find that government consumption crowds out private consumption: higher future taxes create a strong negative wealth effect, while the active monetary response increases the real interest rate. This paper estimates Markov-switching policy rules for the United States and finds that monetary and fiscal policies fluctuate between active and passive behavior. When the estimated joint policy process is imposed on a conventional new Keynesian model, government spending generates positive consumption multipliers in some policy regimes and in simulated data in which all policy regimes are realized. The paper reports the model's predictions of the macroeconomic impacts of the American Recovery and Reinvestment Act's implied path for government spending under alternative monetary-fiscal policy combinations.