We propose a consumption-based model that allows for an inverted term structure of real and nominal risk-free rates. In our framework the agent is subject to time-varying macroeconomic risk and interest rates at all maturities depend on her risk perception which shape saving propensities over time. In bad times, when risk is perceived to be higher in the short- than the long-term, the agent would prefer to hedge against low realizations of consumption in the near future by investing in long-term securities. This determines, in equilibrium, the inversion of the yield curve. Pricing time-varying consumption volatility risk is essential for obtaining the inversion of the real curve and allows to price the average level and slope of the nominal one.
Economists, observers and policy-makers often emphasize the role of sentiment as a potential driver of the business cycle. In this paper we provide three contributions to this debate. First, we critically survey the existing literature on sentiment (considering both confidence and uncertainty) and economic activity. Second, we review existing empirical measures of sentiment, in particular consumer confidence, stock market volatility (SMV) and Economic Policy Uncertainty (EPU), on monthly data for 27 countries, 1985-2016. Third, we identify some new stylized facts based on international evidence. While different measures are surprisingly lowly correlated on average in each country, they are typically highly positively correlated across countries, suggesting the existence of a global factor. Consumer confidence has the closest co-movement with economic and financial variables, and most of the correlations are contemporaneous or forward-looking, consistent with the view that economic sentiment is indeed a driver of activity.
The Great Recession has been characterised by the two stylized facts: the buildup of leverage in the household sector in the period preceding the recession and a protracted economic recovery that followed. We attempt to explain these two facts as an information friction, whereby agents are uncertain about a new state of the economy following a financial innovation. To this end, we extend Boz and Mendoza (2014) by explicitly modelling the credit markets and by modifying the learning to an adaptive set-up. In our model the build-up of leverage and the collateral price cycles takes longer than in a stylized DSGE model with financial frictions. The boom-bust cycles occur as rare events, with two systemic crises per century. Financial stability is achieved with an LTV-cap regulation which smooths the leverage cycles through quantity (higher equity participation requirement) and price (lower collateral value) effects, as well as by providing an anchor in the learning process of agents.
This paper explores how changes in macroeconomic uncertainty have affected the decision to participate in the European Central Bank’s Survey of Professional Forecasters. Two different approaches are employed in order to address this question. First, a time-series analysis explores if changes in measures of uncertainty over time have led to changes in aggregate response rates. And second, a discrete-choice model for panel data is estimated to test if changes in uncertainty measures have had effects on the likelihood to participate by SPF forecasters. The main result of the paper is that higher (lower) uncertainty reduces (increases) participation in the survey. This effect is statistically and economically significant. As participation and uncertainty are found to be negatively correlated, measures of uncertainty from the ECB’s SPF could be biased downwards.
This paper uses a two-step approach to characterize the evolution of US macroeconomic and financial variables during episodes of very high uncertainty. First, we identify episodes of very high uncertainty using a regime-switching model. Second, we assess the behaviour of macroeconomic and financial variables during these episodes of very high uncertainty. This methodology is analogous to the approach followed by Baele et al. (2013), who study episodes of flights to safety in financial markets. We find that very high uncertainty episodes are associated with a weaker growth performance and sharp declines in stock prices. However, we find that this relation is non-linear in that uncertainty does not seem to matter during periods characterized by medium or low uncertainty.
The VIX, the stock market option-based implied volatility, strongly co-moves with measures of the monetary policy stance. When decomposing the VIX into two components, a proxy for risk aversion and expected stock market volatility (“uncertainty”), we find that a lax monetary policy decreases both risk aversion and uncertainty, with the former effect being stronger. The result holds in a structural vector autoregressive framework, controlling for business cycle movements and using a variety of identification schemes for the vector autoregression in general and monetary policy shocks in particular. The effect of monetary policy on risk aversion is also apparent in regressions using high frequency data.
This paper evaluates whether macroeconomic uncertainty changes the impact of oil shocks on the oil price. Using a structural threshold VAR model, we endogenously identify different regimes of uncertainty in which we estimate the effects of oil demand and supply shocks. The results show that higher macroeconomic uncertainty, as measured by higher world industrial production volatility, significantly increases the responsiveness of oil prices to oil shocks. This implies a lower price elasticity of oil demand and supply in the uncertain regime, or in other words, that both oil curves become steeper when uncertainty is high. The difference in oil demand elasticities is both statistically and economically meaningful. Accordingly, varying uncertainty about the macroeconomy can explain time variation in the oil price elasticity and hence in oil price volatility. Also the impact of oil shocks on economic activity appears to be significantly stronger in uncertain times.
We argue that the U.S. personal saving rate's long stability (from the 1960s through the early 1980s), subsequent steady decline (1980s-2007), and recent substantial increase (2008-2011) can all be interpreted using a parsimonious `buffer stock' model of optimal consumption in the presence of labor income uncertainty and credit constraints. Saving in the model is affected by the gap between `target' and actual wealth, with the target wealth determined by credit conditions and uncertainty. An estimated structural version of the model suggests that increased credit availability accounts for most of the saving rate's long-term decline, while fluctuations in net wealth and uncertainty capture the bulk of the business-cycle variation.
This paper studies optimal discretionary monetary policy in the presence of uncertainty about the degree of financial frictions. Changes in the degree of financial frictions are modelled as changes in parameters of a hybrid New-Keynesian model calibrated for the UK, following Bean, Larsen and Nikolov (2002). Uncertainty about the degree of financial frictions is modelled as Markov switching between regimes without and with strong financial frictions. Optimal monetary policy is determined for different scenarios of permanent and temporary regime shifts in financial frictions, as well as for variations in financial frictions over the business cycle. Optimal monetary policy is found to be state-dependent. In each state, optimal monetary policy depends on the transition probabilities between the different regimes.
We study 30 vintages of FRB/US, the principal macro model used by the Federal Reserve Board staff for forecasting and policy analysis. To do this, we exploit archives of the model code, coefficients, baseline databases and stochastic shock sets stored after each FOMC meeting from the model’s inception in July 1996 until November 2003. The period of study was one of important changes in the U.S. economy with a productivity boom, a stock market boom and bust, a recession, the Asia crisis, the Russian debt default, and an abrupt change in fiscal policy. We document the surprisingly large and consequential changes in model properties that occurred during this period and compute optimal Taylor-type rules for each vintage. We compare these optimal rules against plausible alternatives. Model uncertainty is shown to be a substantial problem; the efficacy of purportedly optimal policy rules should not be taken on faith.
This paper studies optimal discretionary policy with parameter uncertainty about inflation inertia. Optimal policy rules and impulse responses are presented within a hybrid New-Keynesian model estimated for the euro area by Smets (2003). We find that it may be optimal for policy to respond more aggressively to cost-push shocks and real interest rate shocks in the presence of uncertainty about inflation inertia, depending on the form of the central bank’s objective function. Moreover, in the cases where optimal policy is not certainty equivalent, we find that inflation returns slightly more gradually to equilibrium following a shock when the degree of inflation inertia is uncertain.
How monetary policy should be set optimally when the structure of the economy exhibits inflation persistence is an important question for policy makers. This paper provides an overview of the implications of inflation persistence for the design of monetary policy.
We estimate the effect of demand and price uncertainty on firms’ investment decisions from a panel of manufacturing firms. Uncertainty measures are derived from firms’ subjective qualitative expectations. They are close to their theoretical counterparts, the variances of future demand and price shocks. We find that demand uncertainty depresses planned and realized investment, while price uncertainty is insignificant. This is consistent with the behavior of monopolistic firms with irreversible capital (Caballero, 1991). Further, firms revise their investment plans very little. They may do so in response to new information on sales growth, but not as a result of reduced uncertainty.
The academic literature has so far little to say about the underlying causes of the large structural asset and liability imbalances of emerging markets that frequently contributed to financial crises. The aim of the paper is to contribute to filling this gap by proposing a theoretical model that links currency and maturity mismatches with real volatility in the economy. We show that if (i) a significant share of the debt is denominated in foreign currency-creating a currency mismatch- and (ii) borrowing is constrained by solvency, then currency mismatch can create and exacerbate a maturity mismatch. An important feature of the model is that higher economic or political uncertainty tightens solvency constraints and tilts the debt profile towards short term debt, thereby increasing the volatility of output. Taking the model implications to the data, we find empirical support for the model’s predictions using data for 28 emerging market economies.
This paper uses a small, calibrated forward-looking model of the euro-area economy to investigate the implications of incomplete information about potential output for the conduct and the design of monetary policy. Three sets of issues are examined. First, the certainty-equivalent optimal policy under both commitment and discretion is characterised. In both cases, incomplete information about potential output leads to very persistent deviations between the actual and the perceived output gap in response to supply and cost-push shocks. The costs of imperfect information are quite large. Second, the implications for simple policy rules such as Taylor or inflation-forecast rule are examined. In first-difference form, both rules continue to perform relatively well with imperfect information as long as the output gap and the inflation forecast are optimally estimated. Third, the implications of potential output uncertainty for the optimal delegation to an independent central bank are examined. Incomplete information implies that it is optimal to appoint a more 'hawkish' central bank.
