Interest and Prices

This paper develops and estimates a dynamic stochastic general equilibrium (DSGE) model with sticky prices and wages for the euro area. The model incorporates various other features such as habit formation, costs of adjustment in capital accumulation and variable capacity utilization. It is estimated with Bayesian techniques using seven key macroeconomic variables: GDP, consumption, investment, prices, real wages, employment, and the nominal interest rate. The introduction of ten orthogonal structural shocks (including productivity, labor supply, investment, preference, cost-push, and monetary policy shocks) allows for an empirical investigation of the effects of such shocks and of their contribution to business cycle e uctuations in the euro area. Using the estimated model, we also analyze the output (real interest rate) gap, dee ned as the difference between the actual and model-based potential output (real interest rate). (JEL: E4, E5)

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An estimated dynamic stochastic general equilibrium model of the euro area

This paper develops and estimates a dynamic stochastic general equilibrium (DSGE) model with sticky prices and wages for the euro area. The model incorporates various other features such as habit formation, costs of adjustment in capital accumulation and variable capacity utilisation. It is estimated with Bayesian techniques using seven key macro-economic variables: GDP, consumption, investment, prices, real wages, employment and the nominal interest rate. The introduction of ten orthogonal structural shocks (including productivity, labour supply, investment, preference, cost-push and monetary policy shocks) allows for an empirical investigation of the effects of such shocks and of their contribution to business cycle fluctuations in the euro area. Using the estimated model, the paper also analyses the output (real interest rate) gap, defined as the difference between the actual and model-based potential output (real interest rate).

An estimated dynamic stochastic general equilibrium model of the euro area. NBB Working Paper Nr. 35

where it denotes the Fed’s operating target for the federal funds rate, pt is the inflation rate (measured by the GDP deflator), yt is the log of real GDP, and y# t is the log of potential output (identified empirically with a linear trend). The rule has since been subject to considerable attention, both as an account of actual policy in the United States and elsewhere, and as a prescription for desirable policy. Taylor argues for the rule’s normative significance both on the basis of simulations and on the ground that it describes U.S. policy in a period in which monetary policy is widely judged to have been unusually successful (Taylor, 1999), suggesting that the rule is worth adopting as a principle of behavior. Here I wish to consider to what extent this prescription resembles the sort of policy that economic theory would recommend. I consider the question in the context of a simple, but widely used, optimizing model of the monetary transmission mechanism, which allows one to reach clear conclusions about economic welfare. The model is highly stylized but incorporates important features of more realistic models and allows me to make several points that are of more general validity. Out of concern for the robustness of the conclusions reached, the analysis here addresses only broad, qualitative features of the Taylor rule and attempts to identify features of a desirable policy rule that are likely to hold under a variety of model specifications.

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The Taylor Rule and Optimal Monetary Policy

The natural rate of interest—the real interest rate consistent with output equaling its natural rate and stable inflation—plays a central role in macroeconomic theory and monetary policy. Estimation of the natural rate of interest, however, has received little attention. We apply the Kalman filter to estimate jointly time-varying natural rates of interest and output and trend growth. We find a close link between the natural rate of interest and the trend growth rate, as predicted by theory. Estimates of the natural rate of interest, however, are very imprecise and subject to considerable real-time measurement error.

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Measuring the Natural Rate of Interest

A long-standing area of research and policy interest has been the construction of a measure of monetary policy stance. One measure that has been proposed—as an alternative to indices that employ monetary aggregates or exchange rates—is the spread between the actual real interest rate and its flexible-price, or natural-rate, counterpart. We examine the properties of the natural real interest rate and ‘real interest rate gap’ using a dynamic stochastic general equilibrium model. Issues we investigate include: (1) the response of the gap and its components to fundamental economic shocks; and (2) the indicator and forecasting properties of the real interest rate gap for inflation, both in the model and in the data. Our results suggest that the real interest rate gap has value as an inflation indicator, supporting the ‘neo-Wicksellian framework’ advocated by Woodford (2000).

The real interest rate gap as an inflation indicator

Recent studies have argued that the New Keynesian Phillips curve (Calvo pricing model) is empirically valid, provided that real marginal cost rather than detrended output is used as the variable driving inflation. One interpretation of this result is that real marginal cost is not closely related to the output gap, and so models for monetary policy need to include labormarket rigidities. An alternative interpretation is that marginal cost and the output gap are closely related, but that the latter needs to be measured in a manner consistent with dynamic general equilibrium models. To date, there has been little econometric investigation of this alternative interpretation. This paper provides estimates of the New Keynesian Phillips curve for the U.S., the U.K., and Australia using theory-consistent estimates of the output gap. Using this theory to measure the output gap leads to a considerable improvement in the empirical performance of output-gapbased Phillips curves.

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Inflation Dynamics, Marginal Cost, and the Output Gap: Evidence from Three Countries

A long-standing area of research and policy interest is the construction of a measure of monetary policy stance. One measure that has been proposed, as an alternative to indices that employ monetary aggregates or exchange rates, is the spread between the actual real interest rate and its flexible-price, or natural-rate, counterpart. We examine the properties of the natural real interest rate and real-interest-rate gap using a dynamic stochastic general equilibrium model. Issues we investigate include the response of the gap and its components to fundamental economic shocks and the indicator and forecasting properties of the real-interest-rate gap for inflation, both in the model and in the data. Our results suggest that the real-interest-rate gap has value as an inflation indicator, supporting a neo-Wicksellian framework.

In this paper we evaluate the dynamic inconsistency argument put forth by Kydland and Prescott (1977) and Barro and Gordon (1983) as an explanation for differences in the average inflation experience across OECD countries. The focus is on the empirical evidence relating the overall degree of competition among firms, as measured by the markup of price over marginal cost, and inflation over the 1973–88 period. The prediction is that higher markups raise the monetary authority's incentive to increase output, leading to higher equilibrium rates of inflation. We find that the markup does well in explaining cross-country differences in average inflation. JEL Classification: E31, E58, D43



L'ecart du prix par rapport au cout marginal et l'inflation: resultats pour les pays de l'OCDE. Ce memoire examine l'argument mis de l'avant par Kydland et Prescott (1977) et Barro et Gordon (1983) pour expliquer les differences dans le taux moyen d'inflation entre les pays de l'OCDE. On porte une attention speciale aux resultats empiriques qui relient le degre general de concurrence entre les entreprises, mesure par l'ecart du prix par rapport au cout marginal, et le niveau d'inflation entre 1973 et 1988. La prediction est que des ecarts prix/cout marginal plus eleves augmentent l'incitation des autorites monetaires a accroitre le niveau de production, ce qui entraine des taux d'inflation d'equilibre plus eleves. Il s'avere que l'ecart du prix par rapport au cout marginal tend a expliquer bien les differences dans le niveau moyen d'inflation entre pays.

The markup and inflation: evidence in OECD countries

http://apps.eui.eu/Personal/Pappa/Papers/kathypaper.pdf

Katharine S. Neiss

Papers

The real interest rate gap as an inflation indicator

Inflation Dynamics, Marginal Cost, and the Output Gap: Evidence from Three Countries

The real interest rate gap as an inflation indicator

The markup and inflation: evidence in OECD countries

Persistence without too much price stickiness: the role of variable factor utilization