monetary policy and a stock market boom-bust cycle lawrence christiano, roberto motto and massimo...
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Monetary Policy and a Stock Market Boom-Bust Cycle
Lawrence Christiano, Roberto Motto and Massimo Rostagno
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• Inflation has been relatively stable for a while
• Attention has shifted to other issues: stock market volatility
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Stock market has been volatile:
1. Is it ‘excessively’ volatile in the welfare sense?
2. What role (if any) does (should) monetary policy play?
3. Conventional wisdom – Bernanke-Gertler: ‘leave it alone’ In any case, inflation targeting will automatically stabilize
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Inflation appears to be fallingduring the start-up of boom-bustepisodes in US.
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‘Stock Market Boom-Bust Cycle’• Episode in which:
– Stock prices, consumption, investment, output, employment rise sharply and then fall
– Inflation low during boom
• US examples:– Interwar period– Mid 1950s - mid 1970s– Mid 1990s - present
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Rational Theory of Boom-Bust
• Follow Beaudry-Portier (see also more recently Jaimovich-Rebelo)
– Boom-bust cycle triggered by:• Expectation that technology will be strong in future• Expectation ultimately not realized
• Examples:
– Fiber-optic cable– Motorola satellites
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Key Findings• Start by trying to build a non-monetary theory of boom-
bust cycle
– With investment adjustment costs, habit persistence, can almost get successful theory
– However, miss on several key dimensions• Stock market goes wrong way, highly volatile real rate, no
persistence
• When we integrate sticky (allocative) wages and an inflation-targeting central bank, we obtain a more successful theory.
– perhaps boom-bust cycles reflect interaction of sticky wages and inflation targeting monetary policy
– an example of Levin, et al point that inflation targeting not optimal when wages are sticky
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Outline
• Boom-bust in non-monetary economy
• Bring in sticky wages/prices and monetary policy as simply as possible
• Redo analysis in model with additional financial frictions– banking system (CCE), agency costs (BGG)– permits addressing role of credit and
monetary aggregates
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Parameterization of RBC Model• Model is specialized version of model with
many frictions estimated for US by Christiano-Motto-Rostagno (2006)
• Parameters:
• Steady state:
1.01358 0.25, z 1.01360.25, b 0.63, a 15.1,
0.40, 0.025, L 109.82, L 1, 0.83, p 4.
CY 0.64, K
Y 12.59, l 0.092
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Results for RBC Model
• Habit persistence in preference and adjustment costs on change in investment crucial for getting ‘close’ to stock-market boom-bust…
• However,– Stock market wrong– Real interest rate highly volatile– No persistence
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All wrong!
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Adding habit persistence and investment adjustment costs.
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Using Static Adjustment Costs Doesn’t Help
• Static (‘standard’ adjustment costs)
Kt 1 1 Kt I t ItK t
Kt
ItK t
c2
ItK t
2
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Static adjustment costsdon’t help.
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Conclusions so far:• Need:
– habit persistence
– need adjustment costs in changing the flow of investment (for economic interpretation of this formulation, see Matsuyama and Lucca).
• Still, not good enough…..not great on persistence
• Increase lead time in signal (p) from 4 to 12
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What do Agents Expect After Seeing a Signal?
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Why Does Price of Capital Fall?• Standard Present Value Formula:
• Real rate spikes up – not surprising PV falls
Pk,t dCtdKt 1
, R t 1k Kt 1 1zt 1ht 1 1
11 rt 1
t 1 t, t ~ marginal utility of Ct
Pk,t i 1
j 1
i1
1 rt j1 i 1R t ik
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Why Does Price of Capital Fall?...• Price of capital from implication that price
equals marginal cost:
PK,t
Static part ofmarginal cost
1
1 S ItIt 1
S ItIt 1
ItIt 1
1 PK,t 1
1 rt 1 S It 1
It
It 1It
2
High anticipated investment implies that investmenttoday reduces future adjustment costs
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‘Monetizing the Model’• We add:
– Calvo sticky price setup (‘Phillips curve’)
– Calvo sticky wage equations
– Intertemporal Euler equation for bonds
– Take limit where money demand goes to zero
– Monetary policy rule
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Goods Production• Final goods:
• Intermediate goods:
• firms reoptimize and instead set price as follows:
Yt 0
1Yjt
1 t dj
f, 1 f
Yjt tKjt ztl jt
1 zt if tKjt ztl jt 1 zt
0, otherwise, 0 1
1 p p
Pit t 1 1 Pi,t 1
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Sticky Wages (Erceg, Henderson, Levin)
• Homogeneous labor assembled from specialized household labor services:
• households reoptimize wage in given period and set their wage as follows:
l t 0
1ht,i
1 w di
w, 1 w
Wj,t t 1 w 1 w zWj,t 1
1 w w
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Demand for Money• Money in the utility function:
• We drive coefficient on money balances to zero in equilibrium conditions.
E tj
l 0 l t uCt l bCt l 1 L
h t,j1 L
1 L
Pt lCt lMt ld
1 q
1 q
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Monetary Policy• ‘Target interest rate’
• Actual interest rate:
• Parameters of monetary model
R t E t t 1 y log Y tY t
R t iR t 1 1 i R t
f 1.20, w 1.05, p 0.63, w 0.81, 0.84,
w 0.13, i 0.81, 1.95, y 0.18, 0.
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Findings• Now have a (sort of) reasonable model of boom-bust
– highly persistent
– ex post real interest rate moves only a very small amount
– Stock price moves in ‘right’ way (though a little anemic).
• Quantity movements in monetary model swamp movements in RBC model
– Boom-bust (though triggered by real event) is primarily a monetary policy phenomenon
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Basic Diagnosis• Application of logic in
– Erceg, Christopher, Dale Henderson, and Andrew Levin, 2000, `Optimal Monetary Policy with Staggered Wage and Price Contracts,' Journal of Monetary Economics, 46, 281-313.
– Levin, A., Onatski, A., Williams, J., Williams, N., 2005. "Monetary Policy under Uncertainty in Microfounded Macroeconometric Models." In: NBER Macroeconomics Annual 2005, Gertler, M., Rogoff, K., eds. Cambridge, MA: MIT Press.
• Sticky wages are the key, sticky prices unimportant
• Inflation targeting important
• Real wage ‘should’ rise in boom, but is prevented:– wage is sticky– price is sticky downward, because of monetary policy
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Sticky pricesdon’t matter!
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Sticky wages matter!
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Wage indexationmatters
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Inflation targeting important!
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‘Full’ Model has Credit, Monetary Aggregates
• Model incorporates banking sector, as in Chari, Christiano and Eichenbaum.
– M1, M3, demand deposits, currency, bank reserves.
• Financial frictions as in Bernanke, Gertler and Gilchrist.
• Total credit (borrowing of working capital by banks, plus loans to entrepreneurs).
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M1 ~ currency + demand deposis
M2/M3 ~ M1 + savings deposits
Credit ~ total borrowing (includes time deposits, but not currency)
Entrepreneurs: own and rent out capital
Firms: need working capital to pay factors
Banks(hold reserves)
Households
Demand deposits,Savings deposits,Time deposits
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Findings• BGG financial frictions attenuate
somewhat the effects of boom-bust
• Rationalizes monetary policy of looking at credit.
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Conclusion
• With habit persistence and cost-of-change adjustment costs, can make progress on generating stock market boom-bust.– But, problems…
• Bring in sticky wages and inflation targeting, and can generate boom-bust
• Perhaps monetary policy should react to other variables, such as credit growth.