Monetary Economics Program Meeting

November 6, 2009
Nicholas Bloom and James H. Stock, Organizers

Francois Gourio, Boston University and NBER
Disaster Risk and Business Cycles

To construct a business cycle model consistent with the observed behavior of asset prices, and study the effect of shocks to aggregate uncertainty, Gourio introduces a small, time-varying risk of economic disaster in a standard real business cycle model. He establishes two simple theoretical results: first, when the probability of disaster is constant, the risk of disaster does not affect the path of macroeconomic aggregates - a "separation theore"" between macroeconomic quantities and asset prices in the spirit of Tallarini (2000). Second, shocks to the probability of disaster, which generate variation in risk premia over time, are observationally equivalent to preference shocks. An increase in the perceived probability of disaster leads to a collapse of investment and a recession, an increase in risk spreads, and a decrease in the yield on safe assets. To assess the empirical validity of the model, Gourio infers the probability of disaster from observed asset prices and feeds it into the model. The variation over time in this probability appears to account for a significant fraction of business cycle dynamics, especially sharp downturns in investment and output such as 2008-IV.

John C. Driscoll and Ruth Judson, Federal Reserve Board
Sticky Deposit Rates: Data and Implications for Models of Price Adjustment

Driscoll and Judson use a panel dataset of over 2,500 branches of about 900 depository institutions (DIs) observed weekly over ten years to examine the dynamics of changes in interest rates on interest checking accounts, money market deposit accounts (MMDAs), and six different maturities of CDs, replicating and extending previous work on the topic. They have six key findings. First, CD rates are quite flexible, with the median institution changing such rates every 5 weeks on average, while rates on MMDAs and interest checking accounts show much more inertia, changing every 12 weeks and 18 weeks on average, respectively. By comparison, the target federal funds rate - an important determinant of DIs' cost of funds, and thus a good proxy for DI marginal cost - changed about every 12.5 weeks over the sample. Second, the frequency of rate changes exhibits considerable dispersion for some types of deposits, with about a quarter of branches changing interest checking rates twice a year or less frequently. Third, deposit rate changes are asymmetric: rates adjust about twice as frequently during periods of falling target federal funds rate than rising ones. Fourth, rates are uniformly quite sticky during periods when the federal funds rate is flat, with median durations between price changes ranging from 8 weeks to 39 weeks. Fifth, the median size of rate changes is 20 basis points, comparable to the typical 25 basis point change in the target federal funds rate; the distribution of average decreases and increases is about the same, and is relatively dispersed, with many small changes of a few basis points. Sixth, there is a greater degree of upward stickiness in rates on interest checking and money market accounts for branches of large DIs than for branches of smaller ones. Although these results are broadly consistent with panel data studies of goods and services prices, deposit rates display more asymmetry in adjustment, and there are other deposit rate facts for which there is not yet comparable evidence on prices. The authors compare their facts to the predictions of eight models of price adjustment, and find that although such models can match about half the facts about deposit rates, none predicts the asymmetric response, and none attempts to model the cross-firm dispersion in rate-setting behavior.

Scott Borger, Office of Immigration Statistics;James D. Hamilton, UC, San Diego and NBER; and Seth Pruitt, Federal Reserve Board of Governors
The Market-Perceived Monetary Policy Rule

Borger, Hamilton, and Pruitt introduce a novel method for estimating a monetary policy rule using macroeconomic news. Market forecasts of both economic conditions and monetary policy are affected by news, and their estimation links the two effects. This enables them to estimate directly the policy rule that agents use to form their expectations, and in so doing to flexibly capture the particular dynamics of policy response. They find that between 1994 and 2007 the market-perceived Federal Reserve policy rule changed: the output response vanished, and the inflation response path became more gradual but larger in long-run magnitude. In a standard model, they show that output smoothing caused by a larger inflation response magnitude is offset by the more measured pace of response. Their response coefficient estimates are robust to measurement and theoretical issues with both potential output and the inflation target.

Glenn Rudebusch and Eric T. Swanson, Federal Reserve Bank of San Francisco
The Bond Premium in a DSGE Model with Long-Run Real and Nominal Risks

The term premium on nominal long-term bonds in the standard dynamic stochastic general equilibrium (DSGE) model used in macroeconomics is far too small and stable relative to empirical measures obtained from the data - an example of the "bond premium puzzle." However, in models of endowment economies, researchers have been able to generate reasonable term premiums by assuming that investors have recursive Epstein-Zin preferences and face long-run economic risks. Rudebusch and Swanson show that introducing Epstein-Zin preferences into a canonical DSGE model can also produce a large and variable term premium without compromising the model' ability to fit key macroeconomic variables. Long-run real and nominal risks further improve the model' ability to fit the data with a lower level of household risk aversion.

Manuel Adelino, MIT; Kristopher Gerardi, Federal Reserve Bank of Atlanta; Paul Willen, Federal Reserve Bank of Boston and NBER
Why Don't Lenders Renegotiate More Home Mortgages? Redefaults, Self-Cures and Securitization

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