RICERCA ITALIANA     

Financial, credit and labour markets in business cycle models for policy evaluation. Theory and empirics.

Abstract

Quantitative DSGE models rooted in microeconomic foundations have become the workhorse tool for the analysis of monetary policy in the current macroeconomic literature (Gali and Gertler (2007)).

At the theoretical level, the baseline DSGE framework, however, suffers of a number of shortcomings:
i) It is incapable of generating fluctuations in unemployment (all variations in the labor input take place only at the intensive margin, i.e. in hours per worker).
ii) It usually assumes perfect capital markets, and therefore cannot provide any assessment of the likely role of financial factors in shaping households’ consumption and saving decisions. As a consequence, the role of financial intermediation is very little studied in this specification.
iii) It is unable to match some important features of asset price dynamics, in particular stock price dynamics.
iv) It studies monetary and fiscal policies assuming either the existence of a benevolent social planner or of an exogenously given fiscal policy, and it therefore neglects both the possibility of having separate monetary and fiscal decisions and the one of endogenizing the conduct of fiscal policy.
v) It neglects the existence of uncertainty concerning model specification and parameters and the possibility of learning by agents.
vi) It is linear or linearized around the steady state.

At the empirical level the effort on model evaluation has been limited to >>>

Principal Investigator

Carlo Ambrogio Favero Università Commerciale "Luigi Bocconi" MILANO

Research Objectives

The objective of our research programme is to extend the baseline DSGE framework to explore the importance of the omitted theoretical dimensions and to provide a thorough empirical evaluation for a better use of DSGE models for (monetary and fiscal) policy evaluation.
The final objective of the project is to deliver inputs and research results useful to the construction of models of the business cycle for policy simulation capable of handling the main puzzles and the unresolved issues for the standard DSGE models.

First Results

The explicit inclusion in DSGE model of labour and credit markets frictions, the intractions between monetary and fiscal policy, non-linearities and learning should enhance the potential of this type of models for policy simulation analysis.
Furthermore, better model evaluation practice should allow us to assess more precisely the degree of confidence to be put in the results of simulation of different policies.

Timescale

24 months

National and international background

DSGE models and labor market imperfections

In recent years, monetary business cycle models with monopolistic competition and staggered price setting have been widely used to study the implications of alternative specifications of monetary policy (see Woodford, 2003, and Gali, 2007, for textbook treatments). One shortcoming of these models, however, is that they do not include a very detailed description of the labor market, and are therefore not suited to discuss the relationship between monetary policy and unemployment, a relationship that lies at the heart of practical monetary policy discussions. In the labor market literature, on the other hand, search and matching models with equilibrium unemployment have been fairly successful in explaining aggregate labor market fluctuations (see, for instance, Mortensen and Pissarides, 1994, Pissarides, 2000, or Shimer, 2005). Such labor market specifications have recently been extended to monetary business cycle models by Trigari (2004, 2006) and Walsh (2005) and thus present a natural alternative to the standard monetary framework.

Using traditional business cycle models with staggered price and wage setting, but without search and matching frictions on the labor market, Christiano, Eichenbaum, and Evans (2005) and Smets and Wouters (2003, 2006) have demonstrated that nominal wage rigidities are a crucial ingredient when explaining business cycle fluctuations in the U.S. and in Europe. Similarly >>>