Monetary Economics

November 1, 2013
Frederick Mishkin and Michael Woodford, Columbia University, Organizers

Alan Moreira, Yale University, and Alexi Savov, New York University

The Macroeconomics of Shadow Banking

Moreira and Savov propose a dynamic macroeconomic model of financial intermediation in an environment where households demand liquid assets. In contrast to the literature, intermediaries can issue equity without any friction. In normal times, intermediaries maximize liquidity creation by levering up the collateral value of their assets, a process the authors call shadow banking. A rise in uncertainty causes investors to demand liquidity in bad states. Intermediaries respond by simultaneously deleveraging and substituting toward safe liabilities; shadow banking effectively shuts down, prices fall and investment plummets. The model generates amplification via endogenous collateral runs, as well as flight to quality effects. The model's macroeconomic effects are consistent with a slow economic recovery even when - and especially when - intermediary capital is high. The authors analyze the impact of several policy interventions in the areas of unconventional monetary policy and regulatory reform.

Emmanuel Farhi, Harvard University and NBER, and Ivan Werning, MIT and NBER

A Theory of Macroprudential Policies in the Presence of Nominal Rigidities (NBER Working Paper 19313)

Farhi and Werning provide a unifying foundation for macroprudential policies in financial markets for economies with nominal rigidities in goods and labor markets. Interventions are beneficial because of an aggregate demand externality. Ex post, the distribution of wealth across agents affects aggregate demand and the efficiency of equilibrium through Keynesian channels. However, ex ante, these effects are not privately internalized in the financial decisions agents make. The authors obtain a formula that characterizes the size and direction for optimal financial market interventions. They provide a number of applications of their general theory, including macroprudential policies guarding against deleveraging and liquidity traps, capital controls attributable to fixed exchange rates or liquidity traps and fiscal transfers within a currency union. Finally, the authors show how their results are also relevant for redistributive or social insurance policies, such as income taxes or unemployment benefits, allowing one to incorporate the macroeconomic benefits associated with these policies.

Varadarajan Chari, University of Minnesota and NBER; Alessandro Dovis, Princeton University; and Patrick Kehoe, Federal Reserve Bank of Minneapolis and NBER

Rethinking Optimal Currency Areas

The classic optimal currency area criterion is that countries with more correlated shocks are better candidates for forming a union. Chari, Dovis, and Kehoe show that when countries have credibility problems this simple criterion must be changed: symmetric countries gain credibility when joining the union only when the shocks affecting credibility are not highly correlated. The authors' analysis provides an amended optimal currency area criterion that they argue is more relevant than the classic one. They illustrate their argument both for a reduced form model and for a relatively standard sticky-price general equilibrium model. They argue that their new criterion should lead to a rethinking of the massive amount of empirical work on optimal currency areas.

Emi Nakamura and Jón Steinsson, Columbia University and NBER

High Frequency Identification of Monetary Non-Neutrality (NBER Working Paper 19260)

Nakamura and Steinsson provide new evidence on the responsiveness of real interest rates and inflation to monetary shocks. Their identifying assumption is that the increase in the volatility of interest rate news in a 30-minute window surrounding scheduled Federal Reserve announcements arises from news about monetary policy. Real and nominal yields and forward rates at horizons out to three years move close to one-for-one at these times, implying that changes in expected inflation are small. At longer horizons, the response of expected inflation grows. Accounting for "background noise" in interest rates on Federal Open Market Committee (FOMC) days is crucial in identifying the effects of monetary policy on interest rates, particularly at longer horizons. The authors show that in conventional business cycle models with nominal rigidities their estimates imply that monetary non-neutrality is large. The authors’ estimates also imply substantial inflation inertia.

Simon Gilchrist, Boston University and NBER; Raphael Schoenle, Brandeis University; and Jae Sim and Egon Zakrajsek, Federal Reserve Board

Inflation Dynamics during the Financial Crisis

Using confidential product-level price data underlying the U.S. Producer Price Index (PPI), Gilchrist, Schoenle, Sim, and Zakrajsek analyze the effect of changes in firms' financial conditions on their price setting behavior during the Great Recession. The evidence indicates that during the height of the crisis in late 2008, firms with "weak" balance sheets increased prices significantly, whereas firms with "strong" balance sheets lowered prices, a response consistent with an adverse demand shock. These stark differences in price setting behavior are consistent with the notion that financial frictions may significantly influence the response of aggregate inflation to macroeconomic shocks. The authors explore the implications of these empirical findings within the New Keynesian general equilibrium framework that allows for customer markets and departures from the frictionless financial markets. In the model, firms have an incentive to set a low price to invest in market share, though when financial distortions are severe, firms forgo these investment opportunities and maintain high prices in an effort to preserve their balance sheet capacity. Consistent with the authors' empirical findings, the model with financial distortions, relative to the baseline model without such distortions, implies a substantial attenuation of price dynamics in response to contractionary demand shocks.

Marco Del Negro and Marc Giannoni, Federal Reserve Bank of New York, and Frank Schorfheide, University of Pennsylvania and NBER

Inflation in the Great Recession and New Keynesian Models

It has been argued that existing dynamic stochastic general equilibrium (DSGE) models cannot properly account for the evolution of key macroeconomic variables during and following the recent Great Recession, and that models in which inflation depends on economic slack cannot explain the recent muted behavior of inflation, given the sharp drop in output that occurred in 2008–2009. Del Negro, Giannoni, and Schorfheide use a standard DSGE model available prior to the recent crisis and estimated with data up to the third quarter of 2008 to explain the behavior of key macroeconomic variables since the crisis. They show that as soon as the financial stress jumped in the fourth quarter of 2008, the model successfully predicts a sharp contraction in economic activity along with a modest and more protracted decline in inflation. The model does so even though inflation remains very dependent on the evolution of economic activity and of monetary policy. The authors conclude that while the model considered does not capture all short-term fluctuations in key macroeconomic variables, it has proved to be surprisingly accurate during the recent crisis and the subsequent recovery.

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