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The Use of DSGE Models for
Monetary Policy Analysis at Sveriges Riksbank
with a discussion of Optimal Policy Projections
BANK INDONESIA and BANK FOR INTERNATIONAL SETTLEMENTS WORKSHOP
“STRUCTURAL DYNAMIC MACROECONOMIC MODELSIN ASIA-PACIFIC ECONOMIES”
Bali, Indonesia, June 3 - 4, 2008
Stefan Laséen
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Purpose of Presentation
Brief description of the DSGE model that has been developed at the Riksbank during the last yearsDescribe how the model is used in the forecasting process and for policy analysisRamses = Riksbank Aggregate Macromodel for Studies of the Economy in Sweden
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Agenda
Models used for forecasting at the Riksbank1. Ramses: model overview2. Forecasting
Forecasting performanceRamses role in the forecasting processRamses forecasting impact
3. Policy analysis with RamsesOptimal Policy Projections
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Models used at the RiksbankDSGE = RamsesBVARs & DSGE-VARLarge data set models (nowcasting)
Forecast combinations (classic + Bayesian model averaging)Static factor (principal components) routinesEarly information/forward looking information models
Other partial information models and judgements (sector experts)
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Ramses Model Overview I
Small open economy version of the CEE (JPE 2005)-modelAdding more shocks (Smets & Wouters)Model estimated on Swedish data 1986Q1-2007Q4
Allow for break in policy to account for monetary policy regime shift
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Ramses Model Overview II
Model we use in practice is very similar to the one presented in Adolfson et al. (JEDC 2008, forthcoming)Modified version of the UIP condition to improve on fitting exchange rate dynamicsMonetary policy described by simple rule
Not loss function based approach for the moment – work in progress
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Closed Economy AspectsHouseholds
Utility from consumption, leisureCapital accumulation
Domestic intermediate goods firmsCobb-Douglas (capital and labour)Imperfect competition
Competitive final goods firmsCentral bank
Taylor-type rule, interest rate ‘smoothing’
Government: distortionary fiscal policyexogenous VAR for taxes and government expenditures
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Open Economy AspectsConsumption and investment baskets of foreign and domestic goodsImporting (consumption, investment) firms and exporting firms
Imperfect competitionBrand naming technologyLocal currency price setting
⇒ Incomplete exchange rate pass-through (sticky prices)
Trade in foreign bonds with endogenous risk-premiumForeign economy exogenous
(SVAR for inflation, GDP, nominal interest rate)
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FrictionsNominal
Domestic prices, import and export prices (Calvo)Wage stickiness (Calvo)Working capital channel
RealCapital adjustment costs (investment)Habit persistence in consumptionImperfect competitionDistortionary taxes
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Estimated Shocks
Technology (stationary and permanent), investment specific, asymmetric (domestic vs foreign)Markup shocks (4)Preference shocks (2)Risk premium shockMonetary policy shocks (2)
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Forecasting Performance IBayesian estimation of key model parameters (pertaining to dynamics)
Steady state parameters typically calibrated
Forecasting properties in line with BVARsForecasting properties in line with Riksbank’s own forecasts
Pseudo out-of-sample comparison (no real time data)Riksbank forecasts conditional on constant interest rate assumption
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Forecasting Performance IIRiksbank BVAR DSGE
Infla
tion
Inte
rest
Rat
e
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Forecasting Performance III
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Forecasting and Communication6 forecast rounds and interest rate decisions per year
3 forecasts published in “Monetary Policy Report” (February, June, October)3 internal forecastsPress conference after every interest rate decision (previously only when interest rate had been changed)Names of Executive Board Members appear in the minutes
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Ramses’ Role in the Forecasting Process I
Meeting 1 : International developments & world economy forecast (TCW)Meeting 2 : Financial markets (repo rate expectations, exchange rate…) Meeting 3: Assessment of initial conditionsAlternative Macro Scenarios MeetingMeeting 4: Macro forecast
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Ramses’ Role in the Forecasting Process II
Meeting 5: Disaggregated macro forecastMonetary Policy Meeting (Executive Board & Monetary Policy Dep. (MPD), Financial Stability Dep.)Meeting 6: The Executive Board Main Scenario
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Ramses’ Role in the Forecasting Process III
Initial conditions (Meeting 3)Unconditional forecasts
Focus on starting conditions e.g. what shocks have hit the economy?
Implications for the unconditional forecast (e.g. interest rate setting according to Ramses estimated policy rule)
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Ramses’ Role in the Forecasting Process III Example: How Ramses is used to analyze initial conditions
GDP forecast high initially?Why?
Positive imported consumption markup shock
Higher prices on imported goodsRelatively cheap domestic goodsNet-export and production increase
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Q1−05 Q3−05 Q1−06 Q3−06 Q1−07 Q3−07 Q1−08 Q3−08 Q1−09 Q3−09 Q1−10 Q3−10
−3
−2
−1
0
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BNP
RP MP CP RestTN FO IT WM PM Rest. TN
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Ramses’ Role in the Forecasting Process IV
Macro forecast (Meeting 4)Conditional forecast, conditioned on
MPD assessment of initial conditions (current quarter) -monitoring rather than conditioningMPD view on world (TCW) economy forecast MPD initial repo rate assessment
Conditional forecasts using Waggoner-Zha (mix of shocks, historically relevant)Ramses & BVAR forecasts used to update previous forecast (e.g. in MPR or Update)DSGE-VAR (Del Negro & Schorfheide)Optimal Policy Projections
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Ramses’ Role in the Forecasting Process V
Disaggregated macro forecast (Meeting 5)”Consistency check” of forecast
Ramses forecast conditioned on major domestic real variables (Y, C, I, X, M, H) and ROW (Y*, PI*, R*) in forecastImplications for inflation, repo rate?WZ – what are the driving forces (shocks)?
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Ramses’ Forecasting Impact I
Ramses has been used as a forecasting and policy tool since 2005.One way to assess Ramses forecasting impact is to examine how the final forecasts for key variables relate to Ramses conditional forecasts
Ramses forecasts are conditional on sector experts’ assessment of the current stance in the economy (current quarter)
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Ramses’ Forecasting Impact IICan assess this by running the following regression:
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Ramses’ Forecasting Impact III
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Ramses’ Forecasting Impact IV:GDP
R2
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Ramses’ Forecasting Impact V: Inflation
R2
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Ramses’ Forecasting Impact VI: Worked Hours
R2
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Policy Analysis with Ramses I Effects of monetary policy I
Impulse response functions in the DSGE and the BVAR (Minnesota prior, recursiveness assumption)BVAR with Minnesota prior not a very useful tool to get precise effects of policy shocks => use DSGE model when assessing the effects of alternative interest rate paths
Choice supported by DSGE-VAR analysisDSGE-VAR an interesting alternative to Minnesota BVAR and DSGE in forecasting
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Policy Analysis with Ramses I Effects of monetary policy II
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Policy Analysis with Ramses IIMacro risks (Alternative macro scenarios meeting)
Alternative macro development (risks to world economy forecast, domestic risks – higher wages scenario, effects of labour market reforms, productivity)
Example from Monetary Policy Report2007:1: Higher nominal wage growth
Study effects on GDP, inflation, nominal interest rate
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Policy Analysis with Ramses IIScenario: Higher Wages y/y
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04 05 06 07 08 09 10
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Nominal wage, Main scenario
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Policy Analysis with Ramses IIScenario: Higher Wages -> GDP y/y
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04 05 06 07 08 09 10
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GDP, Main scenario
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Policy Analysis with Ramses IIScen.: Higher Wages -> Inflation y/y
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Inflation, Higher Wages
Inflation, Main scenario
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Policy Analysis with Ramses IIScen.: Higher Wages -> Interest Rate
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Repo rate, Main scenario
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Policy Analysis with Ramses III
Monetary Policy MeetingHow should the repo rate path change relative to initial assumption to achieve inflation projections in line with target while taking real considerationsAlternative repo rate projections generated with monetary policy shocks
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Policy Analysis with Ramses IVInterest Rate Scenarios
Repo rate meeting – MPR 07:1
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Low er interest rate scenario
M ain scenario
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Policy Analysis with Ramses IVInterest Rate Scenarios: Inflation y/y
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Policy Analysis with Ramses IVInterest Rate Scenarios: GDP y/y
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Positive Vs. Normative aspectsThe analysis described above has stong positive flavor
Policy response to various shocks according to historical behavior(Instrument rule)
Ongoing work: More normative analysis (ALLS)Operational loss function: Stabilize yearly CPI inflation rate, somegap measure + policy interest rate
This is a difficult issue:Theory: Central bank ”loss function” n.e. to household welfare, how handle model misspecification, RE-ass.Practical: How agree on a gap variable (used in internal and external communication)
Optimal Policy Projections at the Riksbank
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1.Introduction
Flexible inflation targeting: “Stabilize inflation around theinflation target, with some weight on stabilility of the realeconomy (output gap)”Construct optimal policy projections (OPPs) for Ramses,the Riksbank’s open-economy medium-sized DSGE modelfor forecasting and policy analysisThe Riksbank Aggregate Model for Studies of theEconomy of Sweden (Adolfson, Laséen, Lindé, and Villani)(ALLV)OPP: Find instrument-rate path that minimizes quadraticloss function under commitment in a timeless perspective:Alternative to historical empirical or ad hoc instrumentrule (Taylor-type rule)
2 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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1.Introduction
Flexible inflation targeting: “Stabilize inflation around theinflation target, with some weight on stabilility of the realeconomy (output gap)”Construct optimal policy projections (OPPs) for Ramses,the Riksbank’s open-economy medium-sized DSGE modelfor forecasting and policy analysisThe Riksbank Aggregate Model for Studies of theEconomy of Sweden (Adolfson, Laséen, Lindé, and Villani)(ALLV)OPP: Find instrument-rate path that minimizes quadraticloss function under commitment in a timeless perspective:Alternative to historical empirical or ad hoc instrumentrule (Taylor-type rule)
2 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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1.Introduction
Flexible inflation targeting: “Stabilize inflation around theinflation target, with some weight on stabilility of the realeconomy (output gap)”Construct optimal policy projections (OPPs) for Ramses,the Riksbank’s open-economy medium-sized DSGE modelfor forecasting and policy analysisThe Riksbank Aggregate Model for Studies of theEconomy of Sweden (Adolfson, Laséen, Lindé, and Villani)(ALLV)OPP: Find instrument-rate path that minimizes quadraticloss function under commitment in a timeless perspective:Alternative to historical empirical or ad hoc instrumentrule (Taylor-type rule)
2 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
![Page 43: The Use of DSGE Models for Monetary Policy Analysis at ... · PDF fileDSGE Models for Monetary Policy Analysis at Sveriges Riksbank with a discussion of Optimal Policy Projections](https://reader031.vdocument.in/reader031/viewer/2022030405/5a7ad0397f8b9a72118b649d/html5/thumbnails/43.jpg)
1.Introduction
Flexible inflation targeting: “Stabilize inflation around theinflation target, with some weight on stabilility of the realeconomy (output gap)”Construct optimal policy projections (OPPs) for Ramses,the Riksbank’s open-economy medium-sized DSGE modelfor forecasting and policy analysisThe Riksbank Aggregate Model for Studies of theEconomy of Sweden (Adolfson, Laséen, Lindé, and Villani)(ALLV)OPP: Find instrument-rate path that minimizes quadraticloss function under commitment in a timeless perspective:Alternative to historical empirical or ad hoc instrumentrule (Taylor-type rule)
2 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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1. Introduction: New
OPPs in DSGE model of this sizeEstimation requires combination of Klein and AIMalgorithms for speedTest of whether past policy was optimal or notAlternative definitions of the output gap (potential output:trend output, conditional flexprice output, orunconditional flexprice output)Commitment in a timeless perspective: Alternative waysof computing initial Lagrange multipliers (past policy:optimal or just systematic)
3 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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1. Introduction: New
OPPs in DSGE model of this sizeEstimation requires combination of Klein and AIMalgorithms for speedTest of whether past policy was optimal or notAlternative definitions of the output gap (potential output:trend output, conditional flexprice output, orunconditional flexprice output)Commitment in a timeless perspective: Alternative waysof computing initial Lagrange multipliers (past policy:optimal or just systematic)
3 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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1. Introduction: New
OPPs in DSGE model of this sizeEstimation requires combination of Klein and AIMalgorithms for speedTest of whether past policy was optimal or notAlternative definitions of the output gap (potential output:trend output, conditional flexprice output, orunconditional flexprice output)Commitment in a timeless perspective: Alternative waysof computing initial Lagrange multipliers (past policy:optimal or just systematic)
3 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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1. Introduction: New
OPPs in DSGE model of this sizeEstimation requires combination of Klein and AIMalgorithms for speedTest of whether past policy was optimal or notAlternative definitions of the output gap (potential output:trend output, conditional flexprice output, orunconditional flexprice output)Commitment in a timeless perspective: Alternative waysof computing initial Lagrange multipliers (past policy:optimal or just systematic)
3 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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1. Introduction: New
OPPs in DSGE model of this sizeEstimation requires combination of Klein and AIMalgorithms for speedTest of whether past policy was optimal or notAlternative definitions of the output gap (potential output:trend output, conditional flexprice output, orunconditional flexprice output)Commitment in a timeless perspective: Alternative waysof computing initial Lagrange multipliers (past policy:optimal or just systematic)
3 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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1. Introduction: Conclusions
OPPs feasible in RamsesParameter estimates relatively stablePast policy not optimalEstimated loss-function paramaters: λy = 1.1, λ∆i = 0.39Output-gap (potential-output) definition mattersInitial Lagrange multiplers matter (somewhat)
4 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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1. Introduction: Conclusions
OPPs feasible in RamsesParameter estimates relatively stablePast policy not optimalEstimated loss-function paramaters: λy = 1.1, λ∆i = 0.39Output-gap (potential-output) definition mattersInitial Lagrange multiplers matter (somewhat)
4 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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1. Introduction: Conclusions
OPPs feasible in RamsesParameter estimates relatively stablePast policy not optimalEstimated loss-function paramaters: λy = 1.1, λ∆i = 0.39Output-gap (potential-output) definition mattersInitial Lagrange multiplers matter (somewhat)
4 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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1. Introduction: Conclusions
OPPs feasible in RamsesParameter estimates relatively stablePast policy not optimalEstimated loss-function paramaters: λy = 1.1, λ∆i = 0.39Output-gap (potential-output) definition mattersInitial Lagrange multiplers matter (somewhat)
4 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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1. Introduction: Conclusions
OPPs feasible in RamsesParameter estimates relatively stablePast policy not optimalEstimated loss-function paramaters: λy = 1.1, λ∆i = 0.39Output-gap (potential-output) definition mattersInitial Lagrange multiplers matter (somewhat)
4 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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1. Introduction: Conclusions
OPPs feasible in RamsesParameter estimates relatively stablePast policy not optimalEstimated loss-function paramaters: λy = 1.1, λ∆i = 0.39Output-gap (potential-output) definition mattersInitial Lagrange multiplers matter (somewhat)
4 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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2. The model
State space form:�Xt+1
Hxt+1jt
�= A
�Xtxt
�+ Bit +
�C0
�εt+1
Xt predetermined variables in quarter t (nX = 71),xt forward-looking variables (nx = 23),it instrument rate, εt+1 i.i.d. shock (nε = 23),xt+1jt � Etxt+1
A, B, C, H estimated with Bayesian methods, consideredfixed and known for the optimal projections(certainty equivalence)
6 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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2. The model
Target variables
Yt = D
24 Xtxtit
35 ,
Period loss function
Lt � Y0tWYt = (pct � pc
t�4�π�)2+λy (yt � yt)2+λ∆i(it� it�1)
2,
Yt � (pct � pc
t�4 � π�, yt � yt, it � it�1)0
Flexible inflation targeting: 4-qtr CPIX inflation,alternative definitions of potential output ytIntertemporal loss function (0 < δ < 1)
Et
∞
∑τ=0
δτLt+τ.
7 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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2. The model: Optimal policy
Minimize intertemporaral loss function undercommitment in a timeless perspective. Solution:�
xtit
�=
�FxFi
� �Xt
Ξt�1
�,�
Xt+1Ξt
�= M
�Xt
Ξt�1
�+
�C0
�εt+1.
Fi policy function: depends on A, B, C, H, D, W, δ, but noton Σεε (certainty equivalence)Ξt�1 Lagrange multiplers for equations forforward-looking variables in period t� 1 (nΞ � nx = 23)Klein (2000) algorithm returns Fx, Fi, M
8 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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2. The model: Simple instrument rule
it = ρRit�1 + (1� ρR) [ bπct + rπ(π
ct�1 � bπc
t) + ryyt�1 + rxbxt�1
+r∆π(πct � πc
t�1) + r∆y(yt � yt�1) + εRt
“Implicit” instrument rule
it = fXXt + fxxt
Klein algorithm returns Fx, Fi, M
9 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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4. Optimal policy projections
yt � fyt+τ,tg∞τ=0 projection in period t for any variable yt:
mean forecast conditional on information in period tProjection model for projections (Xt, xt, it, Yt) in quarter t is
�Xt+τ+1,t
Hxt+τ+1,t
�= A
�Xt+τ,txt+τ,t
�+Bit+τ,t, Yt+τ,t = D
24 Xt+τ,txt+τ,tit+τ,t
35for τ � 0.
12 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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4. Optimal policy projections
Optimal projection (Xt, xt, it, Yt), minimizes theintertemporal loss function under commitment in atimeless perspective
∞
∑τ=0
δτLt+τ,t,
Lt+τ,t = Yt+τ,t0WYt+τ,t.
0 < δ � 1 OK
13 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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4. Optimal policy projections
Solve with Klein or AIM (Anderson-Moore) algorithms:Solution �
xt+τ,t
it+τ,t
�= F
�Xt+τ,t
Ξt+τ�1,t
�,�
Xt+τ+1,tΞt+τ,t
�= M
�Xt+τ,t
Ξt+τ�1,t
�,
for τ � 0, where Xt,t = Xtjt, Ξt�1,t givenDecision in quarter tInformation in quarter t includes data up to t� 1, Xtjtestimated from Xt�1jt under the assumption of simpleinstrument rule in quarter t� 1
14 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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5. Results: Projections in 2006:3Optimal policy for different output gaps, instrument rule
0 2 0 4 04
2
0
2
1qtr CPIX inflation%
, %/y
r
0 2 0 4 0
2
1 .5
1
0 .5
0
0 .54qtr CPIX inflation
0 2 0 4 0
2
1 .5
1
0 .5
0
0 .5
4qtr domestic infl.
0 2 0 4 00 .5
0
0 .5
1
1 .5
Output gap
0 2 0 4 0
2 .5
2
1 .5
1
0 .5
0
Instrument rate
%, %
/yr
0 2 0 4 00 .4
0 .2
0
0 .2
0 .4
0 .6
0 .8
Instrumentrate change
0 2 0 4 0
3
2
1
0
1
2
Real exchange rate
0 2 0 4 0
4
2
0
Real in terest rate
0 2 0 4 0
4
3
2
1
0
1
Natural interest rate
%, %
/yr
Quarters0 2 0 4 0
4
2
0
2
4
Interestrate gap
Quarters0 2 0 4 0
0 .5
0
0 .5
1
1 .5
Output
Quarters0 2 0 4 0
1
0
1
2
Potential output
QuartersCo n d itio n al Un co n d itio n al Tren d In stru men t ru le
20 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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5. Results: Projections in 2006:3Optimal policy for different output gaps, Ξt�1,t = 0
0 2 0 4 04
2
0
2
1qtr CPIX inflation%
, %/y
r
0 2 0 4 0
2
1 .5
1
0 .5
0
4qtr CPIX inflation
0 2 0 4 0
2
1 .5
1
0 .5
0
0 .5
4qtr domestic infl.
0 2 0 4 00 .5
0
0 .5
1
1 .5
Output gap
0 2 0 4 0
2 .5
2
1 .5
1
0 .5
0
Instrument rate
%, %
/yr
0 2 0 4 00 .4
0 .2
0
0 .2
0 .4
Instrumentrate change
0 2 0 4 0
2
1
0
1
2
Real exchange rate
0 2 0 4 0
4
2
0
Real in terest rate
0 2 0 4 0
3
2
1
0
1
Natural interest rate
%, %
/yr
Quarters0 2 0 4 0
4
2
0
2
Interestrate gap
Quarters0 2 0 4 0
0 .5
0
0 .5
1
1 .5
Output
Quarters0 2 0 4 0
1
0
1
Potential output
QuartersCo n d itio n al,Ξ
1=0 Un co n d itio n al,Ξ
1=0 Tren d ,Ξ
1=0 In stru men t ru le
21 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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5. Results: Projections in 2007:4Optimal policy for different output gaps, instrument rule
0 20 40
1
0
1
2
1qtr CPIX inflation%
, %/y
r
0 20 40
1
0 .5
0
0 .5
4qtr CPIX inflation
0 20 401
0 .5
0
0 .5
4qtr domestic infl.
0 20 40
0
0 .5
1
Output gap
0 20 40
2
1
0
1
2
Instrument rate
%, %
/yr
0 20 40
0 .5
0
0 .5
1
1 .5
Instrumentrate change
0 20 40
4
2
0
2
Real exchange rate
0 20 40
2
1
0
1
2
Real interest rate
0 20 40
2
0
2
4
Natural interest rate
%, %
/yr
Quarters0 20 40
4
2
0
2
4Interestrate gap
Quarters0 20 40
0
0 .5
1
Output
Quarters0 20 40
0 .5
0
0 .5
Potential output
QuartersCo n d itio n al Uncond itional Trend Instru men t ru le
22 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy
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5. Results: Projections in 2006:3Optimal policy, different loss functions (cond. output gap)
0 2 0 4 04
2
0
2
1 q tr CPIX in f latio n%
, %/y
r
0 2 0 4 0
2
1
0
4 q tr CPIX in f latio n
0 2 0 4 0
2
1
0
4 q tr d o mestic in f l.
0 2 0 4 0
0 .5
0
0 .5
1
O u tp u t g ap
0 2 0 4 06
4
2
0
In stru men t r ate
%, %
/yr
0 2 0 4 0
2
0
2
In stru men trate ch an g e
0 2 0 4 042
0246
Real ex ch an g e rate
0 2 0 4 06
4
2
0
Real in terest r ate
0 2 0 4 05
0
5
N atu ral in terest r ate
%, %
/yr
Q u ar ter s0 2 0 4 0
1 0
5
0
5
In terest r ate g ap
Q u ar ter s0 2 0 4 0
0 .5
0
0 .5
1
1 .5
O u tp u t
Q u ar ter s0 2 0 4 0
1
0
1
2
Po ten tial o u tp u t
Q u ar ter s(a) λ
y=1.1, λ
∆i=0.37 (b) λ
y=0, λ
∆i=0.01 (c) λ
y=1.1, λ
∆i=0.01 (d) λ
y=0, λ
∆i=0.37
23 Adolfson, Laséen, Lindé, and Svensson Optimal Monetary Policy