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Florin Bilbiie is Research Fellow at the University of Oxford, Nuffield College, and Roland Straub is an Economist at the International Monetary Fund. We thank Roberto Perotti, Giancarlo Corsetti, Jordi Galí, Andrew Scott, Mike Woodford, Roger Farmer, Kosuke Aoki, Mike Artis, Gianluca Benigno, Paul Bergin, Giuseppe Bertola, Fabrice Collard, Marco DelNegro, Mike Haliassos, Stephanie Schmitt-Grohe, Fabio Ghironi, Nobu Kiyotaki, David Lopez-Salido, Albert Marcet, Alex Michaelides, Tommaso Monacelli, John Muellbauer, Gernot Mueller, Kris Nimark, Fabrizio Perri, Paolo Pesenti, Pau Rabanal, Thomas Sargent, Frank Schorfheide, Jon Skinner, and Jaume Ventura for comments. Participants at the CEPR’s 2004 European Summer Symposium in Macroeconomics in Tarragona, and seminars at London School of Economics, CREI-Universitat Pompeu Fabra, Nuffield College, Oxford, European University Institute, Birkbeck, IGIERBocconi, IMF; and DOFIN provided valuable comments. All remaining errors are ours.
Some theories rely on “bad luck,” taken to come from either: (i) larger shocks that generated greater overall variability and a more difficult policy environment (e.g. Blinder (1982), and Sargent (2002)); or (ii) an “honest mistake”: the Fed was overestimating the natural rate throughout the 1970s (Orphanides, 2002; Collard and Dellas, 2004). This theory does not explain, howver, why the good performance occured in the 1950s and first half of 1960s, nor why policy response changed in 1980. Others blame policymakers directly: DeLong (1997) and Romer and Romer (2002) argue that the Fed was too averse towards recessions because of the Great Depression leaving its mark − if this is so, it is hard to explain why the United States did not have high inflation earlier. Chari, Christiano, and Eichenbaum (1999) emphasize “expectations traps”: inflationary policy, they argue, was pursued because it is a self-fulfilling equilibrium feature of discretionary policy.
Bilbiie and Straub (2006) run single-equation, reduced-form Generalized Method of Moments (GMM) estimations of an Euler equation for output and find that the coefficient on the interest rate has changed sign in the early 1980s.
Christiano and Gust (1999) address point (i) and show that in a limited participation model a sunspot shock to inflationary expectations can decrease output. But the other problems still remain.
Our model shares with Alvarez, Lucas, and Weber (2001) only the structure of asset markets. Their paper focuses on a completely different question, in particular on the presence of a liquidity effect under market segmentation. In their framework, all agents hold currency, whereas our model is cashless. Finally, our model incorporates a Philips curve relationship.
GLV (2003b) are the first to study determinacy properties of interest rate rules when some agents do not hold capital, but their analysis relies on numerical simulations and is further complicated by the presence of capital and non-separable utility, which change determinacy properties dramatically.
Notably, we abstract from fundamental shocks (such as technology) that move the “natural” levels of output and interest rates, although we do introduce these shocks when estimating the model, allowing for an arbitrary stochastic structure.
In the background of nonparticipation in asset markets, there could be many reasons (constraints or preferences); but as long as all reasons have the same observational consequence, their relative importance is immaterial for our purposes. Our preffered explanation consists of constraints such as transactions costs; recent theoretical and empirical research shows that such market frictions alone could account for the observed participation shares (see for example Vissing-Jorgensen (2002)).
This approximation only holds if steady-state consumption shares of the two types are equal, that is asset income is zero in steady-state. This is insured by assuming a fixed cost of production whose share in steady-state output is equal to net markup and makes steady-state profits zero.
We thank Jordi Galí for having suggested the Keynesian cross interpretation.
In the standard model, all agents hold assets, so this mechanism is completely irrelevant. Any increase in wage exactly compensates the decrease in dividends, since all output is consumed by asset holders.
However, it is important to note that this negative income effect does not mean that for a given increase in output, the consumption of asset holders will necessarily decrease in equilibrium. Moreover, precisely due to the negative income effect making asset holders willing to work more, actual profits may not fall, since hours will increase by more and marginal cost by less. In fact, for certain configurations of shocks and parameters, the equilibrium of our model implies more procyclical profits than the standard New Keynesian model with countercyclical markups. See Bilbiie (2003) for further discussion.
These can represent variations in the price markups coming from time-varying elasticity of substitution between intermediate goods, variations in the degree of market power in the labor market, distortionary taxation or other time-varying inefficiency wedges - see Woodford (2003, Chapter 6) for details.
The New Keynesian Phillips curve is not influenced by the presence of non-asset holders only because steady-state profit income is zero. This is not the case in the more general set-up, but the differences are not crucial for the mesage of our paper.
Formally, one puts together equations (4) and (5), having replaced (6) and looks at the eigenvalues of this dynamic system. Since both inflation and output are forward-looking variables, both eigenvalues need to be larger than one for equilibrium to be determinate. When this is not the case, equilibrium is indeterminate, and sunspot shocks have real effects.
This condition is necessary and sufficient if the Philips curve reads merely: πt = yt. With the forward-looking Philips curve, this condition is sufficient under somehwat more restrictive conditions on λ. For a full-fledged determinacy discussion, see Bilbiie (2003), where sufficient conditions are also provided. He shows that this result holds generically, that is for rules responding to current inflation, as well as for rules responding to output gap under more restrictive conditions.
Note, however, that since steady-state consumption shares are equal we do not need to assume increasing returns. Under these assumptions, the reduced-form coefficients simply modifiy as follows: χo = 1 + φ and δo = 1 − φλ/(1 − λ).
This is consistent with our view that limited participation to asset markets comes from constraints and not preferences, since in the latter case maximizing intertemporally the utility of non-asset holders would be hard to justify on welfare grounds. However, note that for the discretionary Markov equilibrium studied here, this choice makes no difference since terms from time t + 1 onwards are treated parametrically in the maximization and the time-t objective function is identical.
Note that since we abstract from shocks other than cost-push, the efficient level of output is zero, and output is equal to the output gap defined with reference to this efficient level.
To keep things simple, we focus on the discretionary, and not fully optimal (commitment) solution to the central banker’s problem. This case can be argued to be more realistic in practice, as do CGG (1999).
Bayesian estimation has several advantages compared to classical Maximum Likelihood (ML) methods. In particular, estimating DSGE models with classical ML generate in many cases very flat likelihood functions. This makes the identification of the global optimum difficult.
Consumer Expenditure Survey data on asset holdings starts only in 1984, while the Survey of Consumer Finances over-samples high-wealth households (making it inappropriate for our exercise). The Panel Study of Income Dynamics (PSID) contains wealth data with a five-year frequency only starting in 1984. Some wealth information is contained in the family files previous to 1984.
Among them: (i) consumer assets (saver certificates, Money Market (MM) mutual funds, ceiling-free MM certificates, Negotiable Order of Withdrawal (NOW) and super-NOW accounts, MM deposit accounts, tax-exempt All-Savers certificates); (ii) consumer credit and mortgages (equity access accoutns, secondary mortgage market, floating-rate loans, leasing and flexible credits, variable rate mortgages and consumption installment loans); (iii) Treasury securities (variable rate bonds, adjustable-rate Fannie MAE, etc.); (iv) Tax-exempt securities; e. corporate bonds (deep-discound bonds, zero coupon and variable-rate bonds, bonds with warrants and interest rate swaps); (v) futures and options on cash market instruments, stock market indices, etc.
The basic purpose of the DIDMCA is stated clearly in the first paragraph: “(a) The Congress hereby finds that: (i) limitations on the interest rates which are payable on deposits and accounts discourage persons from saving money, create inequities for depositors, impede the ability of depository institutions to compete for funds, and have not achieved their purpose of providing an even flow of funds for home mortgage lending; and (ii) all depositors, and particularly those with modest savings, are entitled to receive a market rate of return on their savings as soon as it is economically feasible for depository institutions to pay such rate.”
The data on real GDP (GDPC1) is from the Bureau of Economic Analysis (BEA), while inflation is the quarterly annualized percentage change of CPI-U from the Bureau of Labor Statistics (BLS), and the nominal interest rate is the average Federal Funds Rate (FYFF) in percentage points.
The beginning of the estimation period is dictated by the behavior of monetary policy, as only after 1965 did the federal funds rate act as a primary instrument of monetary policy - see Meulendyke (1989).
The absence of endogenous persistence from the model generally biases estimates towards parameter constellations which imply indeterminacy, since ceteris paribus indeterminacy implies more endogenous persistence (see LS, 2004 for a discussion of indeterminacy and endogenous persistence in DSGE models). The main results of our paper are confirmed, however, even in a simpler version of the model without habit formation, price indexation, and interest rate smoothing (results are available upon request).
For γ = 0, this reduces to the economy without habits in the first section since Γ2 = 0 and Γ1 = δ. If λ = 0, this boils down to a standard economy with habits: Γ1 = 1, Γ2 = γ.
This is true for studies using the same data as ours, but not for studies such as Orphanides (2002), which use data that were available at the time to policymakers. Our choice of prior is in line with our use of historical data.
Although the estimated share of liquidity constrained consumers for the pre-Volcker period are in line with the results by Campbell and Mankiw (1989), there are, however, differences in the interpretation of the results as discussed in Bilbiie and Straub (2005).
The change in the sign of the IS clope was found independently by Bilbiie and Straub (2006) using single-equation, reduced-form GMM estimation.
As the same authors show, sunspot shocks drive up both inflation and output, which is contrary to the stagflation observed in the pre-Volcker sample. Fundamental shocks, on the other hand, cannot be studied in an indeterminate equilibrium: they can have virtually any effects. CGG (2000) argue that even variability as explained by cost-push shocks is increased in a ‘near-determinate’ equilibrium, whereby the coefficient on inflation is slightly above one. But this merely explains why in a determinate equilibrium with an active rule responding less to inflation results in higher variability of the latter; dynamics in the indeterminate equilibrium are not pinned down.
Notice that we present the moments of the HP-filtered output.
The latter result is surprising, since one would expect that the high degree of interest rate smoothing in the Volcker-Greenspan sample would be enough to make the “structure scenario” far better in this respect.
Arthur Burns emphasized the cost-push nature of inflation in the 1970s time and again in various speeches and statements as documented, for example, in Hetzel (1999) and Mayer (1999). Alan Blinder (1982) gives a careful account of the nature of the shocks and their impact on inflation. Both Ireland (2004) and LS (2004) argue that cost-push shocks have been the main cause of fluctuations in the pre-Volcker era, based on variance decompositions from a “new synthesis” model estimated by maximum likelihood and Bayesian methods, respectively.
That is, an eg shock, taking into account that it also has an impact on the Phillips curve due to the triangular decomposition of the shock processes’ VAR.
Our framework is slightly different from LS, since in their set up habit persistence in consumption is multiplicative. More importantly, they have inelastic labor supply, so lagged output does not enter the Phillips curve since habits have no effect on the intratemporal optimality condition.
Note that this holds because price dispersion in steady state is 1.