nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2020‒03‒02
23 papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Rational Bubbles in Non-Linear Business Cycle Models: Closed and Open Economies By Robert Kollmann
  2. The Vietnamese business cycle in an estimated small open economy New Keynesian DSGE model By Van Nguyen, Phuong
  3. The Optimal Inflation Target and the Natural Rate of Interest By Philippe Andrade; Jordi Gali; Hervé Le Bihan; Julien Matheron
  4. More Gray, More Volatile? Aging and (Optimal) Monetary Policy By Baksa, Dániel; Munkácsi, Zsuzsa
  5. Evaluating the forecasting accuracy of the closed- and open economy New Keynesian DSGE models By Van Nguyen, Phuong
  6. State Dependence in Labor Market Fluctuations By Francesco Zanetti; Carlo Pizzinelli; Konstantinos Theodoridis
  7. Unemployment Fluctuations and Nominal GDP Targeting By Billi, Roberto
  8. A Simple Algorithm for Solving Ramsey Optimal Policy with Exogenous Forcing Variables By Chatelain, Jean-Bernard; Ralf, Kirsten
  9. Opportunity and Inequality across Generations By Koeniger, Winfried; Zanella, Carlo
  10. Quest for Robust Optimal Macroprudential Policy By Aguilar, Pablo; Fahr, Stephan; Gerba, Eddie; Hurtado, Samuel
  11. To seed, or not to seed. By David DESMARCHELIER; Alexandre MAYOL
  12. Digital Adoption, Automation, and Labor Markets in Developing and Emerging Economies By Alan Finkelstein Shapiro; Federico S. Mandelman
  13. Hours Risk and Wage Risk: Repercussions over the Life-Cycle By Robin Jessen; Johannes König
  14. Understanding Heterogeneous Agent New Keynesian Models: Insights from a PRANK By Keshav Dogra; Sushant Acharya
  15. Output Hysteresis and Optimal Monetary Policy By Vaishali Garga; Sanjay R. Singh
  16. Micro Jumps, Macro Humps: Monetary Policy and Business Cycles in an Estimated HANK Model By Adrien Auclert; Matthew Rognlie; Ludwig Straub
  17. Crime and Output: Theory and Application to the Northern Triangle of Central America By Dmitry Plotnikov
  18. Density forecast combinations: the real-time dimension By McAdam, Peter; Warne, Anders
  19. Monetary Policy, Rational Confidence and Neo-Fisherian Depressions By Lucio Gobbi; Ronny Mazzocchi; Roberto Tamborini
  20. 4GM: A New Model for the Monetary Policy Analysis in Colombia By Andres Gonzalez; Alexander Guarin; Diego A. Rodriguez-Guzman; Hernando Vargas-Herrera
  21. Intrinsic persistence of wage inflation in New Keynesian models of the business cycles By Di Bartolomeo, Giovanni; Di Pietro, Marco
  22. Optimal monetary policy in a New Keynesian model with heterogeneous expectations By Di Bartolomeo, Giovanni; Di Pietro, Marco; Giannini, Bianca
  23. Monetary Policy, Redistribution, and Risk Premia By Rohan Kekre; Moritz Lenel

  1. By: Robert Kollmann (University of California San Diego)
    Abstract: This paper studies rational bubbles in non-linear dynamic general equilibrium models of the macroeconomy. The term ‘rational bubble’ refers to multiple equilibria due to the absence of a transversality condition (TVC) for capital. The lack of TVC can be due to an OLG population structure. If a TVC is imposed, the macro models considered here have a unique solution. Bubbles reflect self-fulfilling fluctuations in agents’ expectations about future investment. In contrast to explosive rational bubbles in linearized models (Blanchard (1979)), the rational bubbles in non-linear models here are bounded. Bounded rational bubbles provide a novel perspective on the drivers and mechanisms of business cycles. I construct bubbles (in non-linear models) that feature recurrent boom-bust cycles characterized by persistent investment and output expansions which are followed by abrupt contractions in real activity. Both closed and open economies are analyzed. In a non-linear two-country model with integrated financial markets, bubbles must be perfectly correlated across countries. Global bubbles may, thus, help to explain the synchronization of international business cycles.
    Keywords: Long-Plosser model; rational bubbles; non-linear DSGE models; business cycles in closed and open economies; boom-bust cycles; Dellas model
    JEL: E3 C6 E1 F3 F4
    Date: 2020–02–11
  2. By: Van Nguyen, Phuong
    Abstract: The primary purpose of this paper is to investigate the sources of the business cycle fluctuations in Vietnam. To this end, we develop a small open economy New Keynesian Dynamic Stochastic General Equilibrium (SOE-NK-DSGE) model. Accordingly, this model includes various features, such as habit consumption, staggered price, price indexation, incomplete exchange-rate pass-through, the failures of the law of one price and the uncovered interest rate parity. It is then estimated by using the Bayesian technique and Vietnamese data 1999Q1 − 2017Q1. Based on the estimated model, this paper analyzes the sources of the business cycle fluctuations in this emerging economy. Indeed, this research paper is the first attempt on developing and estimating the SOE-NK-DSGE model with the Bayesian technique for Vietnam.
    Keywords: International macroeconomics; international spillover; Vietnamese economy; New Keynesian DSGE model; Bayesian estimation
    JEL: E12 E31 E32 E47 E52 F41 F43
    Date: 2020–02
  3. By: Philippe Andrade; Jordi Gali; Hervé Le Bihan (Banque de France); Julien Matheron (Banque de France)
    Abstract: We study how changes in the steady-state real interest rate affect the optimal inflation target in a New Keynesian DSGE model with trend inflation and a lower bound on the nominal interest rate. In this setup, a lower steady-state real interest rate increases the probability of hitting the lower bound. That effect can be counteracted by an increase in the inflation target, but the resulting higher steady-state inflation has a welfare cost in and of itself. We use an estimated DSGE model to quantify that tradeoff and determine the implied optimal inflation target, conditional on the monetary policy rule in place before the financial crisis. The relation between the steady-state real interest rate and the optimal inflation target is downward sloping. While the increase in the optimal inflation rate is in general smaller than the decline in the steady-state real interest rate, in the currently empirically relevant region the slope of the relation is found to be close to –1. That slope is robust to allowing for parameter uncertainty. Under “make-up” strategies such as price level targeting, the required increase in the optimal inflation target under a lower steady-state real interest rate is, however, much smaller.
    Keywords: inflation target; effective lower bound; natural interest rate; steady-state real interest rate
    JEL: E31 E52 E58
    Date: 2019–10–01
  4. By: Baksa, Dániel; Munkácsi, Zsuzsa
    Abstract: The empirical and theoretical evidence on the impact of population aging on inflation is mixed, and there is no evidence regarding the volatility of inflation. Using advanced economies’ data and a DSGE-OLG model - a multi-period general equilibrium framework with overlapping generations - we find that aging leads to downward pressure on inflation and higher inflation volatility. Our paper shows how aging affects the short-term cyclical behavior of the economy and the transmission channels of monetary policy. We also examine the interplay between aging and optimal central bank policies. As aging redistributes wealth among generations, generations behave differently, and the labor force becomes more scarce. Our model suggests that aging makes monetary policy less effective, and aggregate demand less elastic to changes in the interest rate. Moreover, in grayer societies, central banks should react more strongly to nominal variables to compensate for higher inflation volatility.
    Keywords: aging; monetary policy transmission; optimal monetary policy; inflation targeting
    JEL: E31 E52 J11
    Date: 2020–02
  5. By: Van Nguyen, Phuong
    Abstract: The primary purpose of this paper is to compare the forecasting performance of a small open economy New Keynesian Dynamic Stochastic General Equilibrium (SOE-NK-DSGE) model with its closed-economy counterpart. Based on the quarterly Australian data, these two competing models are recursively estimated, and point forecasts for seven domestic variables are compared. Since Australia is a small open economy, global economic integration and financial linkage play an essential role in this country. However, the empirical findings indicate that the open economy model yields predictions that are less accurate than those from its closed economy counterpart. Two possible reasons could cause this failure of the SOE-NK-DSGE model: (1) misspecification of the foreign sector, and (2) a higher degree of estimation uncertainty. Thus, this research paper examines further how these two issues are associated with this practical problem. To this end, we perform two additional exercises in a new variant of the SOE-NK-DSGE and Bayesian VAR models. Consequently, the findings from these two exercises reveal that a combination of misspecification of the foreign sector and a higher degree of estimation uncertainty causes the failure of the open economy DSGE model in forecasting. Thus, one uses the SOE-NK-DSGE model for prediction with caution.
    Keywords: Small open economy New Keynesian DSGE model; Bayesian estimation; forecasting accuracy; RMSEs
    JEL: B22 C11 E37 E47
    Date: 2020–02
  6. By: Francesco Zanetti; Carlo Pizzinelli; Konstantinos Theodoridis
    Abstract: This paper documents state dependence in labor market fluctuations. Using a Threshold Vector Autoregression model (TVAR), we establish that the unemployment rate, the job separation rate, and the job finding rate exhibit a larger response to productivity shocks during periods with low aggregate productivity. A Diamond-Mortensen-Pissarides model with endogenous job separation and on-the-job search replicates these empirical regularities well. We calibrate the model to match the standard deviation of the job-transition rates explained by productivity shocks in the TVAR, and show that the model explains 88 percent of the state dependence in the unemployment rate, 76 percent for the separation rate and 36 percent for the job finding rate. The key channel underpinning state dependence in both job separation and job finding rates is the interaction of the firm’s reservation productivity level and the distribution of match-specific idiosyncratic productivity. Results are robust across several variations to the baseline model.
    Keywords: Search and Matching Models, State Dependence in Business Cycles, Threshold Vector Autoregression
    JEL: E24 E32 J64 C11
    Date: 2020–02–26
  7. By: Billi, Roberto (Research Department, Central Bank of Sweden)
    Abstract: I evaluate the welfare performance of a target for the level of nominal GDP in a New Keynesian model with unemployment, accounting for a zero lower bound (ZLB) constraint on the nominal interest rate. Nominal GDP targeting is compared to employment targeting, a conventional Taylor rule, and the optimal monetary policy with commitment. I find that employment targeting is optimal when supply shocks are the source of fluctuations; however, facing demand shocks and the ZLB constraint, nominal GDP targeting can outperform substantially employment targeting.
    Keywords: employment targeting; optimal monetary policy; Taylor rule; ZLB
    JEL: E24 E32 E52
    Date: 2020–01–01
  8. By: Chatelain, Jean-Bernard; Ralf, Kirsten
    Abstract: This article presents an algorithm that extends Ljungqvist and Sargent's (2012) dynamic Stackelberg game to the case of dynamic stochastic general equilibrium models including forcing variables. Its first step is the solution of the discounted augmented linear quadratic regulator as in Hansen and Sargent (2007). It then computes the optimal initial anchor of "jump" variables such as inflation. We demonstrate that it is of no use to compute non-observable Lagrange multipliers for all periods in order to obtain impulse response functions and welfare. The algorithm presented, however, enables the computation of a history-dependent representation of a Ramsey policy rule that can be implemented by policy makers and estimated within a vector auto-regressive model. The policy instruments depend on the lagged values of the policy instruments and of the private sector's predetermined and "jump" variables. The algorithm is applied on the new-Keynesian Phillips curve as a monetary policy transmission mechanism.
    Keywords: Ramsey optimal policy, Stackelberg dynamic game, algorithm, forcing variables, augmented linear quadratic regulator, new-Keynesian Phillips curve.
    JEL: C61 C62 C73 E47 E52 E61 E63
    Date: 2019–10–25
  9. By: Koeniger, Winfried; Zanella, Carlo
    Abstract: We analyze inequality and mobility across generations in a dynastic economy. Nurture, in terms of bequests and the schooling investment into the next generation, is observable but the draw of nature in terms of ability is hidden, stochastic and persistent across generations. We calibrate the model to U.S. data to illustrate mechanisms through which nurture and nature affect mobility and the transmission of income inequality across generations, thus complementing the vast empirical literature. To provide a benchmark for the observed status quo, we solve for the social optimum in which the planner weighs dynasties equally and chooses optimal tax schedules subject to incentive compatibility. Analyzing the transition from the calibrated steady state to this social optimum, we find that insurance against intergenerational ability risk increases on the transition path by making welfare of family dynasties more dependent on nurture relative to nature. The insurance comes at the cost of less social mobility. We compare welfare in the social optimum and economies with a simple history-independent tax and subsidy system.
    Keywords: Human capital, schooling, bequests, asymmetric information, intergenerational mobility, inequality
    JEL: E24 H21 I24 J24 J62
    Date: 2020–02
  10. By: Aguilar, Pablo; Fahr, Stephan; Gerba, Eddie; Hurtado, Samuel
    Abstract: This paper contributes by providing a new approach to study optimal macroprudential policies based on economy wide welfare. Following Gerba (2017), we pin down a welfare function based on a first-and second order approximation of the aggregate utility in the economy and use it to determine the merits of different macroprudential rules for the Euro Area. With the aim to test this framework, we apply it to the model of Clerc et al (2015). In this model, we find that the optimal level of capital is 15.6 percent, or 2.4 percentage points higher than the 2001-2015 value. Optimal capital reduces significantly the volatility of the economy while increasing somewhat the total level of welfare in steady state, even with a time-invariant instrument. Expressed differently, bank default rates would have been 3.5 percentage points lower while credit (GDP) 5% (0.8%) higher had optimal capital level been in place during the 2011-13 crisis. Further, we find that the optimal Countercyclical Capital Buffer rule depends on whether observed or optimal capital levels are already in place. Conditional on optimal capital level, optimal CCyB rule should respond to movements in total credit and mortgage lending spreads. Gains in welfare from an optimal combination of instruments is higher than the sum of their individual effects due to synergies and spillovers.
    Keywords: Financial stability; global welfare analysis; financial DSGE model
    JEL: G21 G28 G17 E58 E61
    Date: 2020–02
  11. By: David DESMARCHELIER; Alexandre MAYOL
    Abstract: Within this paper, we develop a simple overlapping generations model (OLG) with a renewable resource (forest) in the spirit of Koskela et al. (2002). Seeding activities (more broadly, forestry) are introduced in the form of a domestic production as well as a joy-of-giving bequest motive regarding the resource. In this simple framework, we show that altruism always guarantee a positive resource level at the steady state. However, studying the dynamics, we point out that the stability of the steady state crucial depends upon both altruism and forestry productivity: under a low forestry productivity, the steady state is always stable while, under a high forestry productivity, two period-cycles (flip bifurcation) can emerge near the steady state if and only if altruism is sufficiently high which rises the question of resource preservation and leads to the conclusion that the road to hell is paved with good intentions.
    Keywords: Renewable resource, OLG model, altruism, flip bifurcation.
    JEL: E32 O44
    Date: 2019
  12. By: Alan Finkelstein Shapiro (Universidad de los Andes; Tufts University); Federico S. Mandelman (Federal Reserve Bank of Atlanta)
    Abstract: We document a strong negative link between self-employment and the rate of digital adoption by firms in developing and emerging economies. No link between digital adoption and the unemployment rate is found, however. To explain this evidence, we build a general equilibrium search-and-matching model with endogenous labor force participation, self-employment, endogenous firm entry, and information-and-communications technology adoption. The main finding is that changes in the cost of technology adoption per se cannot rationalize the evidence. Instead, changes in firms' barriers to entry directly linked to the cost of technology adoption are key to explain the data.
    Keywords: automation; self-employment; digital adoption; Information-and-telecommunications-technology capital (ICT); labor search frictions; endogenous firm entry; developing and emerging economies; unemployment
    JEL: E24 J23 J24 J64 O14
    Date: 2019–12–02
  13. By: Robin Jessen; Johannes König
    Abstract: We decompose permanent earnings risk into contributions from hours and wage shocks. To distinguish between hours shocks, modeled as innovations to the marginal disutility of work, and labor supply reactions to wage shocks we formulate a life-cycle model of consumption and labor supply. Both permanent wage and hours shocks are important to explain earnings risk, but wage shocks have greater relevance. Progressive taxation strongly attenuates cross-sectional earnings risk, its life-cycle insurance impact is much smaller. At the mean, a positive hours shock of one standard deviation raises life-time income by 10%, while a similar wage shock raises it by 12%.
    Keywords: Earnings Risk, Wage Risk, Labor Supply, Progressive Taxation, Consumption Insurance
    JEL: D31 J22 J31
    Date: 2020
  14. By: Keshav Dogra; Sushant Acharya
    Abstract: In recent years there has been a lot of interest in the effect of income inequality (heterogeneity) on the economy, from both academics and policymakers. Researchers have developed Heterogeneous Agent New Keynesian (HANK) models that incorporate heterogeneity and uninsurable idiosyncratic risk into the New Keynesian models that have become a cornerstone of monetary policy analysis. This research has argued that heterogeneity and idiosyncratic risk change many features of New Keynesian models – the transmission of conventional monetary policy, the forward guidance puzzle, fiscal multipliers, the efficacy of targeted transfers and automatic stabilizers, among others. However, the source of the difference between HANK and representative agent New Keynesian (RANK) models remains unclear. This is because HANK models are typically not analytically tractable, leaving it unclear what exactly is driving the results. To shed light on the macroeconomic consequences of heterogeneity, we develop a stylized HANK model that contains key features present in more complicated HANK models.
    Keywords: incomplete markets; fiscal multipliers; forward guidance; New Keynesian; monetary and fiscal policy
    JEL: E52 E2
    Date: 2020–02–24
  15. By: Vaishali Garga; Sanjay R. Singh
    Abstract: We analyze the implications for monetary policy when deficient aggregate demand can cause a permanent loss in potential output, a phenomenon we term output hysteresis. In the model, the incomplete stabilization of a temporary shortfall in demand reduces the return to innovation, thus reducing total factor productivity growth and generating a permanent loss in output. Using a purely quadratic approximation to welfare under endogenous growth, we derive normative implications for monetary policy. Away from the zero lower bound (ZLB), optimal commitment policy sets interest rates to eliminate output hysteresis. A strict inflation targeting rule implements the optimal policy. However, when the nominal interest rate is constrained at the ZLB, strict inflation targeting is suboptimal and admits output hysteresis. A new policy rule that targets output hysteresis returns output to its pre-shock trend and approximates the welfare gains under optimal commitment policy. A central bank that is unable to commit to future policy actions suffers from hysteresis bias, as the bank’s inconsistent policy does not offset past losses in potential output.
    Keywords: endogenous growth; zero lower bound; output hysteresis; optimal monetary policy
    JEL: E52 E61 O41
    Date: 2019–12–01
  16. By: Adrien Auclert; Matthew Rognlie; Ludwig Straub
    Abstract: We estimate a Heterogeneous-Agent New Keynesian model with sticky household expectations that matches existing microeconomic evidence on marginal propensities to consume and macroeconomic evidence on the impulse response to a monetary policy shock. Our estimated model uncovers a central role for investment in the transmission mechanism of monetary policy, as high MPCs amplify the investment response in the data. This force also generates a procyclical response of consumption to investment shocks, leading our model to infer a central role for these shocks as a source of business cycles.
    Keywords: HANK, estimation, investment
    JEL: E21 E22 E32 E43 E52
    Date: 2020
  17. By: Dmitry Plotnikov
    Abstract: This paper presents a structural model of crime and output. Individuals make an occupational choice between criminal and legal activities. The return to becoming a criminal is endogenously determined in a general equilibrium together with the level of crime and economic activity. I calibrate the model to the Northern Triangle countries and conduct several policy experiments. I find that for a country like Honduras crime reduces GDP by about 3 percent through its negative effect on employment indirectly, in addition to direct costs of crime associated with material losses, which are in line with literature estimates. Also, the model generates a non-linear effect of crime on output and vice versa. On average I find that a one percent increase in output per capita implies about ½ percent decline in crime, while a decrease of about 5 percent in crime leads to about one percent increase in output per capita. These positive effects are larger if the initial level of crime is larger.
    Keywords: Economic conditions;Supply and demand;Economic growth;Labor market policy;Unemployment;Crime,Employment,Growth,WP,crime level,indirect cost,criminal activity,homicide rate,tightness
    Date: 2020–01–16
  18. By: McAdam, Peter; Warne, Anders
    Abstract: Density forecast combinations are examined in real-time using the log score to compare five methods: fixed weights, static and dynamic prediction pools, as well as Bayesian and dynamic model averaging. Since real-time data involves one vintage per time period and are subject to revisions, the chosen actuals for such comparisons typically differ from the information that can be used to compute model weights. The terms observation lag and information lag are introduced to clarify the different time shifts involved for these computations and we discuss how they influence the combination methods. We also introduce upper and lower bounds for the density forecasts, allowing us to benchmark the combination methods. The empirical study employs three DSGE models and two BVARs, where the former are variants of the Smets and Wouters model and the latter are benchmarks. The models are estimated on real-time euro area data and the forecasts cover 2001–2014, focusing on inflation and output growth. We find that some combinations are superior to the individual models for the joint and the output forecasts, mainly due to over-confident forecasts of the BVARs during the Great Recession. Combinations with limited weight variation over time and with positive weights on all models provide better forecasts than those with greater weight variation. For the inflation forecasts, the DSGE models are better overall than the BVARs and the combination methods. JEL Classification: C11, C32, C52, C53, E37
    Keywords: Bayesian inference, euro area, forecast comparisons, model averaging, prediction pools, predictive likelihood
    Date: 2020–02
  19. By: Lucio Gobbi; Ronny Mazzocchi; Roberto Tamborini
    Abstract: We examine the so-called "Neo-Fisherian" claim that, at the zero lower bound (ZLB) of the monetary policy interest rate, and the economy in a depression equilibrium, in order to restore the desired inflation rate the policy rate should be raised consistently with the Fisher equation. This claim has been questioned on the ground that the Fisher equation cannot be used mechanically to peg the long-run inflation expectations. It is necessary to examine how inflation expectations are formed in response to, and interact with, policy actions and the evolution of the economy. Hence we study a New Keynesian economy where agents' inflation expectations are based on their correct understanding of the data generations process, and on their probabilistic confidence in the central bank's ability to keep inflation on target, driven by the observed state of the economy. We find that the Neo-Fisherian claim is a theoretical possibility depending on the interplay of a set of parameters and very low levels of agents' confidence. Yet, on the basis of simulations of the model, we may say that this possibility is remote for most commonly found empirical values of the relevant parameters. Moreover, the Neo-Fisherian policy-rate peg is not sustained by the expectations formation process.
    Date: 2019
  20. By: Andres Gonzalez; Alexander Guarin (Banco de la República de Colombia); Diego A. Rodriguez-Guzman; Hernando Vargas-Herrera (Banco de la República de Colombia)
    Abstract: This paper introduces 4GM, a semi-structural model for monetary policy analysis and macroeconomic forecasting in Colombia. This model is based on a New-Keynesian rational expectation framework for an oil-exporting small open economy. In this paper, we present the model structure and examine the response of its variables to domestic, foreign and oil-price shocks. Further, we assess 4GM in terms of its historical shock decomposition and its out-of-sample forecasting. **** RESUMEN: En este documento se presenta el 4GM, un modelo semi-estructural para el análisis de política monetaria y el pronóstico macroeconómico en Colombia. El modelo sigue un enfoque NeoKeynesiano con expectativas racionales para una economía pequeña y abierta exportadora de petróleo. En el artículo, presentamos la estructura del modelo, y examinamos la respuesta de sus variables a choques domésticos, externos y al precio del petróleo. Además, evaluamos el 4GM en términos de su descomposición histórica de choques y su pronóstico fuera de muestra.
    Keywords: Semi-structural model, monetary policy, macroeconomic forecasting, modelo semi-estructural, política monetaria, pronóstico macroeconómico
    JEL: E17 E37 E47 E52 E58
    Date: 2020–02
  21. By: Di Bartolomeo, Giovanni; Di Pietro, Marco
    Abstract: Our paper derives and estimates a New Keynesian wage Phillips curve that accounts for intrinsic inertia. Our approach considers a wage-setting model featuring an upward-sloping hazard function, that is based on the notion that the probability of resetting a wage depends on the time elapsed since the last reset. According to our specification, we obtain a wage Phillips curve that also includes backward-looking terms, which account for persistence. We test the slope of the hazard function using GMM estimation. Then, placing our equation in a small-scale New Keynesian model, we investigate its dynamic properties using Bayesian estimation. Model comparison shows that our model outperforms commonly used alternative methods to introduce persistence.
    Keywords: duration-dependent wage adjustments; intrinsic inflation persistence; DSGE models; hybrid Phillips curves; model comparison
    JEL: E24 E31 E32 C11
    Date: 2020–02
  22. By: Di Bartolomeo, Giovanni; Di Pietro, Marco; Giannini, Bianca
    Abstract: In a world where expectations are heterogeneous, what is the design of the optimal policy? Are canonical policies robust when heterogeneous expectations are considered or would they be associated with large welfare losses? We aim to answer these questions in a stylized simple New Keynesian model where agents’beliefs are not homogeneous. Assuming that a fraction of agents can form their expectations by some adaptive or extrapolative schemes, we focus on an optimal monetary policy by second-order approximation of the policy objective from the consumers’utility function. We find that the introduction of bounded rationality in the New Keynesian framework matters. The presence of heterogeneous agents adds a new dimension to the central bank’s optimization problem— consumption inequality. Optimal policies must be designed to stabilize the cross-variability of heterogeneous expectations. In fact, as long as different individual consumption plans depend on different expectation paths, a central bank aiming to reduce consumption inequality should minimize the cross-sectional variability of expectations. Moreover, the traditional trade-off between the price dispersion and aggregate consumption variability is also quantitatively affected by heterogeneity.
    Keywords: monetary policy; bounded rationality; heterogeneous expectations
    JEL: E52 E58 J51 E24
    Date: 2020–02
  23. By: Rohan Kekre (University of Chicago - Booth School of Business); Moritz Lenel (Princeton University - Bendheim Center for Finance)
    Abstract: We study the transmission of monetary policy through risk premia in a heterogeneous agent New Keynesian environment. Heterogeneity in households' marginal propensity to take risk (MPR) summarizes differences in portfolio choice on the margin. An unexpected reduction in the nominal interest rate redistributes to households with high MPRs, lowering risk premia and amplifying the stimulus to the real economy. Quantitatively, this mechanism rationalizes the role of news about future excess returns in driving the stock market response to monetary policy shocks.
    Keywords: monetary policy, risk premia, heterogeneous agents
    JEL: E44 E63 G12
    Date: 2020

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