JULY/AUGUST 2007 Vol. 89, No. 4
Frontiers in Monetary Policy Research
Proceedings of the Thirty-First Annual Economic Policy Conference of the Federal Reserve Bank of St. Louis
The July/August issue of Review includes the proceedings from the 31st economic policy conference of the Federal Reserve Bank of St. Louis, "Frontiers in Monetary Policy Research." Economists working at this frontier bring forward new ideas from research in general equilibrium modeling and highlight both the promise and the limitations of recent advances.
An Estimated DSGE Model for the United Kingdom
The authors estimate the dynamic stochastic general equilibrium model of Christiano, Eichenbaum, and Evans (2005) on U.K. data. Their estimates suggest that price stickiness is a more important source of nominal rigidity in the United Kingdom than wage stickiness. Their estimates of parameters governing investment behavior are only well behaved when post-1979 observations are included, which reflects government policies until the late 1970s that obstructed the influence of market forces on investment.
Commentary on "An Estimated DSGE Model for the United Kingdom"
Macroeconomic Implications of Changes in the Term Premium
Linearized New Keynesian models and empirical no-arbitrage macro-finance models offer little insight regarding the implications of changes in bond term premiums for economic activity. This paper investigates these implications using both a structural model and a reduced-form framework. The authors show that there is no structural relationship running from the term premium to economic activity, but a reduced-form empirical analysis does suggest that a decline in the term premium has typically been associated with stimulus to real economic activity, which contradicts earlier results in the literature.
Commentary on "Macroeconomic Implications of Changes in the Term Premium"
Long-Run Risks and Financial Markets
The recently developed long-run risks asset pricing model shows that concerns about long-run expected growth and time-varying uncertainty (i.e., volatility) about future economic prospects drive asset prices. These two channels of economic risks can account for the risk premia and asset price fluctuations. In addition, the model can empirically account for the cross-sectional differences in asset returns. Hence, the long-run risks model provides a coherent and systematic framework for analyzing financial markets.
Commentary on "Long-Run Risks and Financial Markets"
Arbitrage-Free Bond Pricing with Dynamic Macroeconomic Models
The authors examine the relationship between changes in short-term interest rates induced by monetary policy and the yields on long-maturity default-free bonds. The volatility of the long end of the term structure and its relationship with monetary policy are puzzling from the perspective of simple structural macroeconomic models. The authors explore whether richer models of risk premiums, specifically stochastic volatility models combined with Epstein-Zin recursive utility, can account for such patterns. They study the properties of the yield curve when inflation is an exogenous process and compare this with the yield curve when inflation is endogenous and determined through an interest rate (Taylor) rule. When inflation is exogenous, it is difficult to match the shape of the historical average yield curve. Capturing its upward slope is especially difficult because the nominal pricing kernel with exogenous inflation does not exhibit any negative autocorrelation—a necessary condition for an upward-sloping yield curve, as shown in Backus and Zin. Endogenizing inflation provides a substantially better fit of the historical yield curve because the Taylor rule provides additional flexibility in introducing negative autocorrelation into the nominal pricing kernel. Additionally, endogenous inflation provides for a flatter term structure of yield volatilities, which better fits historical bond data.
Commentary on "Arbitrage-Free Bond Pricing with Dynamic Macroeconomic Models"
Monetary Policy as Equilibrium Selection
Can monetary policy guide expectations toward desirable outcomes when equilibrium and welfare are sensitive to alternative, commonly held rational beliefs? This paper studies this question in an exchange economy with endogenous debt limits in which dynamic complementarities between dated debt limits support two Pareto-ranked steady states: a suboptimal, locally stable autarkic state and a constrained optimal, locally unstable trading state. The authors identify feedback policies that reverse the stability properties of the two steady states and ensure rapid convergence to the constrained optimal state.
Commentary on "Monetary Policy as Equilibrium Selection"
Model Fit and Model Selection
This paper uses an example to show that a model that fits the available data perfectly may provide worse answers to policy questions than an alternative, imperfectly fitting model. The author argues that, in the context of Bayesian estimation, this result can be interpreted as being due to the use of an inappropriate prior over the parameters of shock processes. He urges the use of priors that are obtained from explicit auxiliary information, not from the desire to obtain identification.
Commentary on "Model Fit and Model Selection"