Ebook Monetary Policy In An Estimated Stochastic Dynamic General Equilibrium Model Of The Euro Area
In this paper we present and estimate a stochastic dynamic general equilibrium (SDGE) model for the euro area. Following Christiano, Eichenbaum and Evans (CEE, 2001) it features a relatively large number of frictions that appear to be necessary to capture the empirical persistence in the main euro area macroeconomic data. Many of these frictions have become quite standard in the SDGE literature. Following Kollman (1997) and Erceg, Henderson and Levin (2000), the model exhibits both sticky nominal prices and wages that adjust following a Calvo mechanism. However, the introduction of partial indexation of the prices and wages that can not be re-optimised results in a more general dynamic inflation and wage specification that will also depend on past inflation. Following Greenwood, Hercowitz, and Huffmann (1988) and King and Rebelo (2000) the model incorporates a variable capital utilisation rate. This tends to smooth the adjustment of the rental rate of capital in response to changes in output. As in CEE (2001), the cost of adjusting the utilisation rate is expressed in terms of consumption goods. We also follow CEE (2001) by modelling the cost of adjusting the capital stock as a function of the change in investment, rather than the level of investment as is commonly done. Finally, external habit formation in consumption is used to introduce the necessary empirical persistence in the consumption process (See Fuhrer (2000) and McCallum and Nelson (1999)).
While the model used in this paper has many elements in common with that used in CEE (2001), the analysis differs in two main respects. First, we introduce a full set of structural shocks to the various structural equations. Next to two “supply” shocks, a productivity and a labour supply shock, we add two “demand” shocks, a preference shock and a cost-of-capital (or investment) shock, a “cost-push” shock (modelled as a shock to the mark-up equation) and two monetary policy shocks. We estimate the parameters of the model and the stochastic processes governing the structural shocks using seven key macroeconomic time series in the euro area: real GDP, consumption, investment, the GDP deflator, the real wage, employment and the nominal short-term interest rate. The estimation methodology can be viewed as a constrained maximum likelihood procedure, whereby the usual likelihood criterion is augmented by a condition that the model-based cross-covariances can not be too different from their empirical counterparts estimated using an unrestricted VAR.
Overall, our estimation procedure yields a plausible set of estimates for the structural parameters of the sticky price and wage SDGE model. In contrast to the results of CEE (2001) for the US, we find that there is a considerable degree of price stickiness in the euro area. This feature appears to be important to account for the empirical persistence of euro area inflation in spite of the presence of sticky wages and variable capacity utilisation which tend to introduce stickiness in marginal costs. At this point it is not clear whether this difference is a result of structural differences between the US and the euro area, small differences in the underlying structural model or differences in the estimation methodology.
The introduction and estimation of a set of orthogonal structural shocks also allows us to examine the relative contribution of the various shocks to the empirical dynamics of the macro economic time series in the euro area. One of our findings is that in spite of the fact that we estimate the productivity parameter to be the most persistent structural shock, it accounts for only about 10 percent of the long run variance in output. In contrast to some of the results in the identified VAR literature, the “demand” shocks dominate the “supply” shocks in explaining output at all frequencies. A dominant factor in explaining the variance of inflation are the so-called “cost-push” shocks. However, the medium-term component of inflation is mostly driven by monetary policy shocks.
Our estimates of the effects of a temporary monetary policy shock are very much in line with the existing evidence on the euro area (e.g. Peersman and Smets (2000)). However, the important difference with the estimated effects of a persistent policy shock underlines the crucial importance of the combination of forward-looking pricing behaviour and the persistence of the shocks for assessing the effects of monetary policy.
Our second contribution in this paper is to analyse optimal monetary policy within this model. As a benchmark, we, first, analyse the response of the observable variables to the various shocks in a flexible price and wage economy. We find that due to the sluggish response of the two demand components in the estimated model, the natural real interest rate typically rises very significantly in response to positive “demand” shocks, while it falls in response to the “supply” shocks. In contrast to Neiss and Nelson (2000), we find that the natural rate is much more volatile than the observed one. The natural output level on the other hand does not respond very much to “demand” shocks.
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