THE CONSENSUS MACROECONOMIC MODEL

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

2. 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 The Consensus Macro Model

3. 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 The Consensus Macro Model

4. 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. The Consensus Macro Model

5. 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. The Consensus Macro Model

6. 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. The Consensus Macro Model

7. 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) The Consensus Macro Model

8. AGGREGATE DEMAND (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. The Consensus Macro Model

9. AGGREGATE DEMAND • Monetary 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 The Consensus Macro Model

10. 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. The Consensus Macro Model

11. 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. The Consensus Macro Model

12. 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 “ut”, 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. The Consensus Macro Model

13. 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) The Consensus Macro Model

14. 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 The Consensus Macro Model

15. 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. The Consensus Macro Model

16. 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. The Consensus Macro Model

17. 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 The Consensus Macro Model

18. NEW DIRECTIONS The model lacks in the following aspects: • Labor market frictions • Financial market imperfections The Consensus Macro Model

19. 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. The Consensus Macro Model

20. 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. The Consensus Macro Model

21. 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). The Consensus Macro Model

22. 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 The Consensus Macro Model

23. 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. The Consensus Macro Model

24. POLICY IMPLICATIONS The Consensus Macro Model

25. 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? The Consensus Macro Model

26. 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). The Consensus Macro Model

27. 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. The Consensus Macro Model

28. 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. The Consensus Macro Model

29. 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. The Consensus Macro Model

30. Thanks The Consensus Macro Model

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.