1. 7/13/2015The Consensus Macro Model1 THE CONSENSUS MACROECONOMIC MODEL A PRESENTATION BY; KHURRUM S. MUGHAL FARAZ A. KHAN XIN MIAO FOR THE SEMINAR COURSE; INTERNATIONALE WIRTSCHAFT, FINANZMÄRKTE UND MAKROÖKONOMETRIE

2. 7/13/2015The Consensus Macro Model2 MACRO MODELS Why Macro Models are needed –Monetary policy –Interest rate & Inflation Three basic equations –IS Curve –Philips curve –Monetary Rule Consensus Macro Models: –New Noeclassical Synthesis (NNS) Models –New Keynisian Models

3. 7/13/2015The Consensus Macro Model3 MACRO MODELS Macroeconomic Modelling for Monetary Policy Evaluation by Gali and Gertler (2007) –Theoratical paper –New vintage of macroeconomic modelling Shocks and Frictions in US Business Cycles: a Bayesian DSGE Approach by Frank Smets and Rafael Wouters (2007) –Theoratical and Empirical –Business cycle analysis and flucuations –Data set of US economy 1966-2004

4. 7/13/2015The Consensus Macro Model4 MACROECONOMIC MODELLING FOR MONETARY POLICY EVALUATION By Gali and Gertler* *Galí, Jordi, and Mark Gertler. 2007. "Macroeconomic Modeling for Monetary Policy Evaluation." Journal of Economic Perspectives, 21(4): 25–46.

5. 7/13/2015The Consensus Macro Model5 INTRODUCTION Background –that monetary policy can cause economic activities deviate from their natural levels; Key implications of the new vintage macro models: Monetary transmission depends on private sector expectations of the future path of the central bank’s policy instrument. – short-term interest rate as instrument – individuals and firms are forward-looking The natural values of both output and the real interest rate provide important reference point for monetary policy. –natural values are explicit. natural level of economic activity is defined as the equilibrium, where prices are flexible and all other cyclical distortions are absent.

6. 7/13/2015The Consensus Macro Model6 THE BASELINE MODEL The Baseline Model consists of Aggregate Demand/Supply and Monetary Rule Two key ingredients: –Monopolistic competition: firms are price setters in this model, so there must be imperfect competition. Firms face downward-sloping demand curves. –Nominal rigidities: nominal prices adjust sluggishly, responding to central banks’ short run nominal/ real interest rate adjustment.

7. 7/13/2015The Consensus Macro Model7 AGGREGATE DEMAND Assumptions: –is built up from the spending decisions of representative households and representative firms. –both capital and insurance markets are perfect. Households are satisfied at their optimizing consumption/saving decisions, and firms are satisfied at their optimizing investment decisions. –investment changes proportionally with Tobin’s q. (q=market value of installed capital / replacement cost of capital)

8. 7/13/2015The Consensus Macro Model8 (Output gap is negatively related with long run real interest rate gap, and positively related with gap in “q”) Defining Short run real interest rate –long run real interest rate gap depends positively on both current and expected future short run real interest rate gap. AGGREGATE DEMAND

9. 7/13/2015The Consensus Macro Model9 AGGREGATE DEMAND M onetary policy influences aggregate demand: –Given the sluggish adjustment of prices, central bank may vary short run real interest rate by changing short run nominal interest rate. Exogenous fluctuations (e.g. Govt. spending) influence both natural level of output and interest rate but do not affect the form of equation of aggregate demand, because the model estimates gap variables

10. 7/13/2015The Consensus Macro Model10 AGGREGATE SUPPLY Aggregate Supply evolves from price-setting decisions of individual firms. Assumption: –“firms set prices on a staggered basis, saying that each period a subset of firms set their respective prices for multiple periods”. What is staggered price setting? – In a given period, firms set prices equal to a weighted average of the current and expected future nominal marginal costs.

11. 7/13/2015The Consensus Macro Model11 AGGREGATE SUPPLY Forward looking Phillips curve: –Inflation depends not only on current value of excess output and cost push shock, but also expected future values.

12. 7/13/2015The Consensus Macro Model12 AGGREGATE SUPPLY Inflation depends not only on current value of excess output and cost push shock, but also expected future values. In the absence of cost push shock “u t ”, inflation depends only on current and future value of output gap. Central bank maintains prices by adjusting short run interest rate. If cost push shock exists, inflation depends on current and expected movements in cost push shock and output gap. And the only way to offset this cost push pressure on inflation is to contract economic activity.

13. 7/13/2015The Consensus Macro Model13 HOW MONETARY POLICY IS CONDUCTED Each period central bank chooses a target for the short run interest rate. This is done through adjusting money supply to meet the quantity of money, demanded at the target interest rate. Without inflation and excess demand real interest rate is the same as target nominal interest rate If economy is “overheating” with a positive output gap and positive inflation, central bank would increase nominal interest rate more than one-for-one with inflation according to the coefficient. (in order to contract demand sufficiently)

14. 7/13/2015The Consensus Macro Model14 MONETARY POLICY EVALUATION We can use this model to evaluate different scenarios of monetary policy: –Importance of managing expectations of future policy –The need to track movements in the economy‘s general equilibrium Assumptions: –Central Bank Aims to: Maintain price stability Maintain output at its natural level Natural level of output is close to the socially efficient value

15. 7/13/2015The Consensus Macro Model15 SIMULATIONS EXPERIMENT 1: Managing Expectations Central bank follows an aggressive policy to fight inflation: –Central bank signals its intentions to private sector –Central bank does not signal its intentions to private sector (the private sector believes that central bank is likely to accomodate inflation) Result:Managing expectations improves the short run trade-off between output and inflation stabilization.

16. 7/13/2015The Consensus Macro Model16 SIMULATIONS EXPERIMENT 2: Tracking Natural Equilibrium Assuming that the economy is hit with a productivity shock influencing the natural values of output and real interest rate. –Central bank adjusts the nominal interest rate according to natural rate of interest and inflation. –Does not. Result:Managing expectations improves the short run trade-off between output and inflation stabilization.

17. 7/13/2015The Consensus Macro Model17 EXTENSIONS Applying the model with data shows persistance of results whereas the model itself shows instantaneous jumps. We can counteract if we; –Introduce adjustment costs –Introduce wage rigidity

18. 7/13/2015The Consensus Macro Model18 NEW DIRECTIONS The model lacks in the following aspects: Labor market frictions Financial market imperfections

19. 7/13/2015The Consensus Macro Model19 SHOCKS AND FRICTIONS IN US BUSINESS CYCLES: A BAYESIAN DSGE APPROACH By FRANK SMETS AND RAFAEL WOUTERS* * Smets, Frank, and Rafael Wouters. 2007. "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach." American Economic Review, 97(3): 586–606.

20. 7/13/2015The Consensus Macro Model20 INTRODUCTION New Neoclassical Synthesis (NNS) models –small-scale monetary business cycle models with sticky prices and wages for monetary policy analysis. This paper: An extended version of these models (on US data), largely based on: –Lawrence J. Christiano, Martin Eichenbaum, & Charles L. Evans (CEE, 2005) Covering the period 1966:1- 2004:4, and using a Bayesian estimation methodology.

21. 7/13/2015The Consensus Macro Model21 INTRODUCTION Model features sticky nominal price and wage settings that allow for –backward inflation indexation, –habit formation in consumption and investment adjustment costs that create hump-shaped responses of aggregate demand, –and variable capital utilization –and fixed costs in production. The stochastic dynamics is driven by seven orthogonal structural shocks: –total factor productivity shocks, –two shocks that affect the inter-temporal margin (risk premium shocks and investment-specific technology shocks), –two shocks that affect the intra-temporal margin (wage and price mark-up shocks), –two policy shocks (exogenous spending and monetary policy shocks).

22. 7/13/2015The Consensus Macro Model22 OBJECTIVES OF THE PAPER NNS models have become the standard workhorse for monetary policy analysis, it is important to verify whether they can explain the main features of the US macro data Using the estimated NNS model to address a number of key issues: –what are the main driving forces of output developments in the United States? –productivity shocks –inflation developments. –to investigate the stability of the results

23. 7/13/2015The Consensus Macro Model23 THE LINEARIZED DSGE MODEL Households rent capital services to firms and decide how much capital to accumulate given the capital adjustment costs they face. As the rental price of capital changes, the utilization of the capital stock can be adjusted at increasing cost. Firms produce differentiated goods, decide on labor and capital inputs, and set prices. –Prices are therefore set in function of current and expected marginal costs, but are also determined by the past inflation rate –marginal costs depend on wages and the rental rate of capital. –wages depend on past and expected future wages and inflation.

24. 7/13/2015The Consensus Macro Model24 POLICY IMPLICATIONS

25. 7/13/2015The Consensus Macro Model25 APPLICATIONS What Are the Main Driving Forces of Output? Determinants of Inflation and the Output- Inflation Cross Correlation The Effect of a Productivity Shock on Hours Worked Why have output and inflation become volatile?

26. 7/13/2015The Consensus Macro Model26 A) What Are the Main Driving Forces of Output? SHORT RUN: (Demand Shocks) –Exogenous Spending Shock –Risk premium Shock –Investment specific technology shock MED - LONG RUN: (Supply Shocks) –Productivity Shock –Wage markup Shock Note: A demand (supply) shock is a sudden event that increases or decreases demand (supply) for goods or services temporarily. A positive demand (supply) shock increases demand (supply) and a negative demand shock decreases demand (supply).

27. 7/13/2015The Consensus Macro Model27 B) Determinants of Inflation and the Output- Inflation Cross Correlation Price markups in short run Wage markups in long run –are mostly driven by the price mark-up shocks in the short run and the wage mark-up shocks in the long run.

28. 7/13/2015The Consensus Macro Model28 C) The Effect of a Productivity Shock on Hours Worked: Positive productivity shocks result in fall of hours worked. Productivity shocks have a significant short-run negative impact on hours worked.

29. 7/13/2015The Consensus Macro Model29 CONCLUSION The microfounded NNS model fits US data. However it needs further development in terms of understanding nominal and real frictions. Some questions about the structural shocks. Quantitative macroeconomic modelling is necessary for policy evaluation however the models may evolve further with data application and future shock experiences.

30. Thanks 7/13/2015The Consensus Macro Model30

31. Sources Galí, Jordi, and Mark Gertler. 2007. "Macroeconomic Modeling for Monetary Policy Evaluation." Journal of Economic Perspectives, 21(4): 25–46. Smets, Frank, and Rafael Wouters. 2007. "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach." American Economic Review, 97(3): 586–606.