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Real Rigidities, Firm Dynamics and Monetary Non-Neutrality: Role of Demand Shocks

(with Eugene Oue, Felipe Saffie and Jon Willis)

We propose a parsimonious framework for real rigidities, in the form of strategic complementarities, that can generate real and nominal dynamics and match key features of the data across several literatures. Existing menu-cost models featuring strategic complementarities require unrealistically volatile shocks to idiosyncratic productivity to be consistent with pricing moments. We develop a simple menu-cost model with strategic complementarities along with idiosyncratic productivity and demand shocks that are disciplined by the data. This approach allows us to overcome previous criticism from analysis of models that employ only an idiosyncratic productivity shock and calibrate solely using data from the price-adjustment literature. Despite its simplicity, the model can generate sizable monetary non-neutrality along with the magnitude of cost pass-through documented in previous studies, while also remaining consistent with micro pricing and markup evidence.

First Draft : December 2022

Paper

Most Recent Working Paper [April 2023]

Identifying Monetary Policy Shocks: A Natural Language Approach

(with Thomas Drechsel)

Aruoba_DrechselWe develop a novel method for the identification of monetary policy shocks. By applying natural language processing techniques to documents that Federal Reserve staff prepare in advance of policy decisions, we capture the Fed’s information set. Using machine learning techniques, we then predict changes in the target interest rate conditional on this information set and obtain a measure of monetary policy shocks as the residual. We show that the documents’ text contains essential information about the economy which is not captured by numerical forecasts that the staff include in the same documents. The dynamic responses of macro variables to our monetary policy shocks are consistent with the theoretical consensus. Shocks constructed by only controlling for the staff forecasts imply responses of macro variables at odds with theory. We directly link these differences to the information that our procedure extracts from the text over and above information captured by the forecasts.

First Draft : March 2022

Paper

Most Recent Working Paper [December 2023]

Data Produced in the Paper (Monetary Policy Shock, Sentiments, Greenbook Forecast Errors and FOMC Composition)

Pricing Under Distress

 (with Andres Fernandez, Daniel Guzman, Ernesto Pasten, and Felipe Saffie)

The nature of uncertainty is key to determining the effectiveness of monetary policy. Pricing_Under_Distress
When uncertainty increases, it creates two confounding effects: a realization effect and an anticipation effect. In a menu cost model, while the realization effect increases the frequency of price changes, the anticipation effect reduces it. By using the 2019 riots in Chile as a quasi-natural experiment, we show that the pricing behavior of supermarkets is consistent with a pure anticipation effect: during the 31-day period following the start of the Riots, supermarkets reduce the frequency of price changes by about 50% and, conditional on a price change, the absolute magnitude of price changes is about 20% larger. A quantitative menu cost model with news about a future increase in idiosyncratic demand dispersion calibrated to Chilean product-level data can deliver the pricing dynamics observed during the Riots. We show that the
effectiveness of monetary policy interventions crucially depends on the timing of the intervention relative to the arrival of the news and whether or not the anticipated
change materializes.

First Draft : December 2021

Paper

Most Recent Working Paper [October 2023]

SVARs With Occasionally-Binding Constraints

(with Frank Schorfheide, Marko Mlikota, and Sergio Villalvazo)

Forthcoming in Journal of Econometrics.

We develop a structural VAR in which an occasionally-binding constraint generates censoring of one of the dependent variables. Once the censoring mechanism is triggered, we allow some of the coefficients for the remaining variables to change. We show
that a necessary condition for a unique reduced form is that regression functions for the non-censored variables are continuous at the censoring point and that parameters satisfy some mild restrictions. In our application the censored variable is a nominal interest rate constrained by an effective lower bound (ELB). According to our estimates based on U.S. data, once the ELB becomes binding, the coefficients in the inflation equation change significantly, which translates into a change of the inflation responses to (unconventional) monetary policy and demand shocks. Our results suggest that the presence of the ELB is indeed empirically relevant for the propagation of shocks. We also obtain a shadow interest rate that shows a significant accommodation in the early parts of the Great Recession, followed by a mild and steady accommodation until liftoff
in 2016.

First draft : May 2020

 

Paper

Most Recent Working Paper [June 2021]

NBER Working Paper 28571 [March 2021]

Additional Materials

Codes

Piecewise Linear Approximations and Filtering for DSGE Models with Occasionally-Binding Constraints

(with Pablo Cuba-Borda, Kenji Higa-Flores, Frank Schorfheide, Sergio Villalvazo)

Published in Review of Economic Dynamics, July 2021, 41, 96-120.

We develop an algorithm to construct approximate decision rules that are piecewise-


linear and continuous for DSGE models with an occasionally binding constraint. The functional form of the decision rules allows us to derive a conditionally optimal particle filter (COPF) for the evaluation of the likelihood function that exploits the structure of the solution. We document the accuracy of the likelihood approximation and embed it into a particle Markov chain Monte Carlo algorithm to conduct Bayesian estimation. Compared with a standard bootstrap particle filter, the COPF significantly reduces the persistence of the Markov chain, improves the accuracy of Monte Carlo approximations of posterior moments, and drastically speeds up computations. We use the techniques to estimate a small-scale DSGE model to assess the effects of the government spending portion of the American Recovery and Reinvestment Act in 2009 when interest rates reached the zero lower bound.

First Draft : January 2019

Paper

Most Recent Working Paper [January 2021]

NBER Working Paper 27991 [October 2020]

Published Version (requires subscription)

Additional Materials

Replication Files: NK DSGE Model

Replication Files: Consumption-Savings Model

Macroeconomic Dynamics Near the ZLB: A Tale of Two Countries

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(with Pablo Cuba-Borda and Frank Schorfheide)

Published in Review of Economic Studies, 2018, 85, 87-118.

Previously circulated under the title “Macroeconomic Dynamics Near the ZLB: A Tale of Two Equilibria”.

We compute a sunspot equilibrium in an estimated small-scale New Keynesian model with a zero lower bound (ZLB) constraint on nominal interest rates and a full set of stochastic fundamental shocks. In this equilibrium a sunspot shock can move the economy from a regime in which inflation is close to the central bank’s target to a regime in which the central bank misses its target, inflation rates are negative, and interest rates are close to zero with high probability. A nonlinear filter is used to examine whether the U.S. in the aftermath of the Great Recession and Japan in the late 1990s transitioned to a deflation regime. The results are somewhat sensitive to the model specification, but on balance, the answer is affirmative for Japan and negative for the U.S.

First draft  : September 2012

Paper

NBER Working Paper (old version) [June 2014]

Federal Reserve Bank of Philadelphia Working Paper (old version) [July 2013]

Federal Reserve Bank of Philadelphia Working Paper [May 2016]

Most Recent Working Paper  [December 2016]

Additional Material

Maryland Center for Economics and Policy (MCEP) Summary

Improving GDP Measurement: A Measurement Error Perspective

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(with Francis X. Diebold, Jeremy J. Nalewaik, Frank Schorfheide and Dongho Song)

Published in Journal of Econometrics, April 2016, 191(2), 384-397.

We provide a new measure of historical U.S. GDP growth, obtained by applying optimal signal-extraction techniques to the noisy expenditure-side and income-side GDP estimates. The quarter-by-quarter values of our new measure often differ noticeably from those of the traditional measures. Its dynamic properties differ as well, indicating that the persistence of aggregate output dynamics is stronger than previously thought.

First draft : January 2013

Implemented by the Federal Reserve Bank of Philadelphia as GDPplus

Paper

NBER Working Paper 18954 [April 2013]

Federal Reserve Bank of Philadelphia Working Paper [April 2013]

Most Recent Working Paper (may not be identical to the published version)

Published Paper (requires subscription)

Additional Materials

Maryland Center for Economics and Policy (MCEP) Summary

Assessing DSGE Model Nonlinearities

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(with Luigi Bocola and Frank Schorfheide)

Published in Journal of Economic Dynamics and Control, 2017, 83, 34-54.

We develop a new class of time series models to identify nonlinearities in the data and to evaluate DSGE models. U.S. output growth and the federal funds rate display nonlinear conditional mean dynamics, while inflation and nominal wage growth feature conditional heteroskedasticity. We estimate a DSGE model with asymmetric wage and price adjustment costs and use predictive checks to assess its ability to account for nonlinearities. While it is able to match the nonlinear inflation and wage dynamics, thanks to the estimated downward wage and price rigidities, these do not spill over to output growth or the interest rate.

First draft : October 2011

Paper

Most Recent Working Paper [July 2017]

Online Appendix

Published Version (requires subscription)

Federal Reserve Bank of Philadelphia Working Paper [November 2013]

NBER Working Paper 19693 [December 2013]

Improving GDP Measurement: A Forecast Combination Perspective

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(with Francis X. Diebold, Jeremy J. Nalewaik, Frank Schorfheide and Dongho Song)

Published in Causality, Prediction, and Specification Analysis: Recent Advances and Future Directions: Essays in Honor of Halbert L. White Jr (X. Chen and N. Swanson eds.), 2013, Springer, 1-26.

Two often-divergent U.S. GDP estimates are available, a widely-used expenditure-side version GDPE, and a much less widely-used income-side version GDPI . We propose and explore a “forecast combination” approach to combining them. We then put the theory to work, producing a superior combined estimate of GDP growth for the U.S., GDPC. We compare GDPC to GDPE and GDPI , with particular attention to behavior over the business cycle. We discuss several variations and extensions.

First draft : August 2011

Paper

NBER Working Paper 17421 [September 2011]

Federal Reserve Bank of Philadelphia Working Paper [September 2011]

Most Recent Working Paper (may not be identical to the published version)

Homework in Monetary Economics: Inflation, Home Production and Production of Homes

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(with Morris A. Davis and Randall Wright)

Published in Review of Economic Dynamics, July 2016, 21, 105-124.

We introduce household production and the production of houses (construction) into a monetary model. Theory predicts infl‡ation, as a tax on market activity, encourages substitution into household production and hence investment in housing. In the model, the stock and appropriately-de‡flated price of housing increase with infl‡ation or nominal interest rates. We document this in data for the U.S. and other countries. A calibrated model accounts for up to 52% (87%) of the relationship between interest rates and housing wealth defl‡ated by nominal output (by the money supply). It also implies the cost of infl‡ation is higher than in models without home production.

First draft : March 2011

Paper

NBER Working Paper 18276 [August 2012]

Most Recent Working Paper (may not be identical to the published version)

Published Version (requires subscription)

Globalization, the Business Cycle, and Macroeconomic Monitoring

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(with Francis X. Diebold, Ayhan Kose and Marco Terrones)

Published in NBER International Seminar on Macroeconomics 2010, 2011, 245-286

We propose and implement a framework for characterizing and monitoring the global business cycle. Our framework utilizes high-frequency data, allows us to account for a potentially large amount of missing observations, and is designed to facilitate the updating of global activity estimates as data are released and revisions become available. We apply the framework to the G-7 countries and study various aspects of national and global business cycles, obtaining three main results. First, our measure of the global business cycle — the G-7 real activity factor — captures a significant amount of common variation across countries and displays the major global cyclical events of the past forty years. Second, the G-7 and idiosyncratic country factors appear to play different roles at different times in shaping national economic activity. Finally, the degree of G-7 business cycle synchronization among country factors has changed over time.

First draft : May 2010

Paper

NBER Working Paper [August 2010]

Most Recent Working Paper (may not be identical to the published version)

Published Version

Additional Materials

Extracted country factors (business-cycle indices) and the G-7 factor.

An Estimated Search-Based Monetary DSGE Model with Liquid Capital

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(with Frank Schorfheide)

We have no current plans of revising or publishing this paper. It is meant to be an extension of Aruoba and Schorfheide (2011).

In this note we extend the search-based monetary DSGE model studied in Aruoba and Schorfheide (2010) and introduce liquid capital claims. More specifically, buyers in the decentralized market can use a fraction of their capital stock holdings in addition to money to acquire goods from sellers. We show that if liquid capital is a small fraction of the overall capital then money and capital claims can co-exist as a medium of exchange in the decentralized market. Our analysis extends earlier work by Lagos and Rochetau to an environment in which capital is used as a factor of production in the decentralized market. We then estimate our model using Bayesian methods. We find that the estimated fraction of capital that is liquid is close to zero, which means that the data favor the specification without liquid capital, studied in Aruoba and Schorfheide (2010).

First draft : January 2010

Paper

Working Paper [January 2010]

Real-Time Macroeconomic Monitoring: Real Activity, Inflation, and Interactions

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(with Francis X. Diebold)

Prepared for the American Economic Association 2010 Annual Meeting Session “Revisiting and Rethinking the Business Cycle”.

Published in American Economic Review Papers and Proceedings, May 2010, 100(2), 20-24

We sketch a framework for monitoring macroeconomic activity in real-time and push it in new directions. In particular, we focus not only on real activity, which has received most attention to date, but also on inflation and its interaction with real activity. As for the recent recession, we find that (1) it likely ended around July 2009; (2) its most extreme aspects concern a real activity decline that was unusually long but less unusually deep, and an inflation decline that was unusually deep but brief; and (3) its real activity and inflation interactions were strongly positive, consistent with an adverse demand shock.

First Draft : December 2009

Paper

NBER Working Paper 15657 [January 2010]

Most Recent Working Paper (may not be identical to the published version)

Published Version (Requires Subscription)

Institutions, Tax Evasion and Optimal Policy

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Previously circulated under the title “Informal Sector, Government Policy and Institutions”

Published in Journal of Monetary Economics, 2021, 118, 212-229.

The mix of inflation and income taxation that governments adopt vary considerably across countries. We take a Ramsey optimal-policy approach to explain these differences, focusing on the institutions of the country, modeled as the difficulty of tax evasion, as the key variation across countries. In our model households optimally choose the extent of informal activity and a benevolent government optimally chooses policies, both taking as given the institutions of the economy. The model matches qualitatively the observed relationships between institutions and inflation, taxes and tax evasion. In a cross-country quantitative exercise with 125 countries, the model delivers a good fit: the correlation of data and model-generated values for inflation and taxes are 0.42 and 0.78, respectively.

First Draft : September 2009

Paper

Most Recent Working Paper [July 2018]

Published Version (requires subscription)

Press Mentions

Econ Browser (James Hamilton’s Blog) [May 16, 2010]

Wall Street Journal Website [May 17, 2010]

Money, Search and Business Cycles

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Published in International Economic Review, August 2011, 52(3), 935-959.

Monetary models that specify explicit frictions to generate money demand have been developed over the last 20 years and have been used to address many questions. In this article, I investigate the short-run properties of a particular model considering a number of versions based on some modeling choices. All versions feature flexible prices. I find that in many aspects, both real and nominal, the model resembles other, more reduced-form models. Some variations of the model come closer to matching some key nominal facts than a reduced-form model. The model also generates counter cyclical markups, in line with the data.

First Draft : November 2009

Most Recent Working Paper (may not be identical to the published version)

Online Appendix

Published Version (requires subscription)

Sticky Prices versus Monetary Frictions: An Estimation of Policy Trade-offs

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(with Frank Schorfheide)

Also circulated as “Insights from an Estimated Search Model of Money with Nominal Rigidities”.

Published in American Economic Journal: Macroeconomics, January 2011, 3, 60-90.

We develop a two-sector monetary model with a centralized and decentralized market. Activities in the centralized market resemble those in a standard New Keynesian economy with price rigidities. In the decentralized market agents engage in bilateral exchanges for which money is essential. This paper is the first to formally estimate such a model, evaluate its fit based on postwar U.S. data, and assess its money demand properties. Steady state welfare calculations reveal that the distortions created by the monetary friction may be of similar magnitude as the distortions created by the New Keynesian friction.

First draft : October 2007

Paper

NBER Working Paper 14870 [April 2009]

Most Recent Working Paper (may not be identical to the published version)

Online Appendix

Published Version (requires subscription)

Additional Materials

Data and Gauss Programs

Optimal Fiscal and Monetary Policy when Money is Essential

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(with Sanjay K. Chugh)

Published in Journal of Economic Theory, September 2010, 145(5), 1618-1647.

Contains parts of the now-defunct working paper titled “Money and Optimal Capital Taxation”.

We study optimal fiscal and monetary policy in an environment where explicit frictions give rise to valued money, making money essential in the sense that it expands the set of feasible trades. The two main results are that the Friedman Rule is typically not optimal, and the long-run capital income tax is not zero. Neither of these results is due to any incompleteness of the tax system, as can sometimes occur in standard Ramsey analysis. Rather, by developing a precise notion of margins of adjustment using standard concepts of MRS and MRT, we show that the tax system in our model is complete. The need to distort cash-intensive activity in some sense causes a nonzero capital tax in our model. This deep connection between monetary issues and fiscal policy is in contrast to existing models of jointly-optimal fiscal and monetary policy, in which the monetary aspects of the economic environment have little to do with capital taxation prescriptions. Taken together, these findings reframe some conventional wisdom from baseline Ramsey models.

First Draft : August 2006

Paper

Most Recent Working Paper (may not be identical to the published version)

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Bargaining and the Value of Money

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(with Guillaume Rocheteau and Christopher J. Waller)

Published in Journal of Monetary Economics, November 2007, 54, 2636-2655.

Search models of monetary exchange have typically relied on Nash (1950) bargaining, or strategic games that yield an equivalent outcome, to determine the terms of trade. By considering alternative axiomatic bargaining solutions in a simple search model with divisible money, we show that the properties of the bargaining solutions do matter both qualitatively and quantitatively for questions of first importance in monetary economics such as: (i) the efficiency of monetary equilibrium; (ii) the optimality of the Friedman rule; (iii) the welfare cost of inflation.

Paper

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Money and Capital

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(with Christopher J. Waller and Randall D. Wright)

Published in Journal of Monetary Economics, March 2011, 58, 98-116

Also circulated as “Money and Capital: A Quantitative Analysis”.

The effects of money (anticipated inflation) on capital formation is a classic issue in macroeconomics. Previous papers adopt reduced-form approaches, putting money in the utility function, or imposing cash in advance, but using otherwise frictionless models. We follow instead a literature that tries to be explicit about the frictions making money essential. This introduces new elements, including a two-sector structure with centralized and decentralized markets, stochastic trading opportunities, and bargaining. These elements matter quantitatively and numerical results differ from findings in the reduced-form literature. The analysis also reduces a gap between microfounded monetary economics and mainstream macro.

First Draft : 2005

Paper

Most Recent Working Paper (may not be identical to the published version)

Online Appendix

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Real-Time Measurement of Business Conditions

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(with Francis X. Diebold and Chiara Scotti)

Published in Journal of Business and Economic Statistics, 2009, 27(4), 417-427 (lead article).

We construct a framework for measuring economic activity at high frequency, potentially in real time. We use a variety of stock and flow data observed at mixed frequencies (including very high frequencies), and we use a dynamic factor model that permits exact filtering. We illustrate the framework in a prototype empirical example and a simulation study calibrated to the example.

First Draft : March 2007

As of January 9, 2009, the Federal Reserve Bank of Philadelphia started producing the Aruoba-Diebold-Scotti Business Conditions Index based on the methods developed in this paper.

Paper

NBER Working Paper 14349 [September 2008]

Most Recent Working Paper (may not be identical to the published version)

Published Version (requires subscription)

Additional Materials

Simple Example (uses Eviews)

RATS code that replicates the results of the paper (also includes our data) (Written by Tom Doan from Estima — offered here with no warranties)

Press Mentions

Dow Jones Newswires [January 9, 2009]

The Press of Atlantic City [January 11, 2009]

Philadelphia Inquirer [January 15, 2009]

Econ Browser (James Hamilton’s Blog) [April 15, 2009]

Capital Spectator [November 20, 2009]

Philadelphia Inquirer [January 29, 2010]

Data Revisions are not Well-Behaved

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Published in Journal of Money, Credit and Banking, March/April 2008, 40(2-3), 319-340.

We document the empirical properties of revisions to major macroeconomic variables in the United States. Our findings suggest that they do not satisfy simple desirable statistical properties. In particular, we find that these revisions do not have a zero mean, which indicates that the initial announcements by statistical agencies are biased. We also find that the revisions are quite large compared to the original variables and they are predictable using the information set at the time of the initial announcement, which means that the initial announcements of statistical agencies are not rational forecasts.

First Draft : 2003

Paper

Most Recent Working Paper (may not be identical to the published version)

Appendix

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Additional Materials

More Results

The Macroeconomy and the Yield Curve: A Dynamic Latent Factor Approach  

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(with Francis X. Diebold and Glenn D. Rudebusch)

Published in Journal of Econometrics, March-April 2006, 131(1-2), 309-338.

We estimate a model that summarizes the yield curve using latent factors (specifically, level, slope, and curvature) and also includes observable macroeconomic variables (specifically, real activity, inflation, and the monetary policy instrument). Our goal is to provide a characterization of the dynamic interactions between the macroeconomy and the yield curve. We find strong evidence of the effects of macro variables on future movements in the yield curve and evidence for a reverse influence as well. We also relate our results to the expectations hypothesis.

Paper

NBER Working Paper 10616 [July 2004]

Most Recent Working Paper (may not be identical to the published version)

Published Version (requires subscription)

Additional Materials

Data Used in the Paper (text file)

RATS code that replicates the results of the paper (Written by Tom Doan from Estima — offered here with no warranties)

Comparing Solution Methods for Dynamic Equilibrium Economies

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(with Jesus Fernandez-Villaverde and Juan F. Rubio-Ramirez)

Published in Journal of Economic Dynamics and Control, December 2006, 30(12), 2477-2508.

This paper compares solution methods for dynamic equilibrium economies. We compute and simulate the stochastic neoclassical growth model with leisure choice using first, second, and fifth order perturbations in levels and in logs, the finite elements method, Chebyshev polynomials, and value function iteration for several calibrations. We document the performance of the methods in terms of computing time, implementation complexity, and accuracy, and we present some conclusions based on the reported evidence.

Paper

Most Recent Working Paper (may not be identical to the published version)

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Additional Materials

Companion Webpage (includes codes and an extended working paper)

Search, Money and Capital: A Neoclassical Dichotomy

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(with Randall D. Wright)

Published in Journal of Money Credit and Banking, December 2003, 35(6), 1085-1105.

Recent work has reduced the gap between search-based monetary theory and mainstream macroeconomics by incorporating into the search model some centralized markets as well as some decentralized markets where money is essential. This paper takes a further step toward this integration by introducing labor, capital, and neoclassical firms. The resulting framework nests a search-theoretic monetary model and a standard neoclassical growth model as special cases. Perhaps surprisingly, it also exhibits a dichotomy: one can determine the equilibrium path for the value of money independent of the paths of consumption, investment, and employment in the centralized market.

Most Recent Working Paper  (may not be identical to the published version)

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Discussion by Christopher J. Waller (requires subscription)

Discussion by Peter Howitt (requires subscription)

Moving Holidays and Seasonal Adjustment: The Case of Turkey

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(with C. Emre Alper)

Published in Review of Middle East Economics and Finance, December 2004, Vol. 2 : No 3, Article 3.

 

When holiday variation is present so that the dates of certain holidays change from year to year, the relatively automatic seasonal adjustment procedures may fail to extract the seasonal component from a series since the holiday effects are not confined to that component. Turkey, a predominantly Muslim country, constitutes a good example of moving holidays since the official calendar is Gregorian, based on the cycles of the Earth around the sun, while significant Islamic holidays are tied to the Hegirian calendar, based on the lunar cycles. One finds significant deterministic seasonality remains in the conventionally de-seasonalized time series and removing the effects of religious seasonality using a very simple method improves the qualities of the de-seasonalized component.
Paper

Extended Working Paper

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Deseasonalizing Turkish Macroeconomic Data: A Caveat to Applied Researchers in Turkey

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(with C. Emre Alper)

Published in Istanbul Stock Exchange Review, Volume: 5(18), April/May/June 2001, pp. 33-52.

This paper analyzes the effects of regular seasonal fluctuations of macroeconomic variables in Turkey due to the religious events (religious holidays and Ramadan)[1] in monthly frequency. Conventional deterministic deseasonalization techniques are applied to the detrended and linearized major macroeconomic series. Investigation of the seasonally filtered series reveals residual seasonal regularities vis-à-vis the religious holidays and Ramadan  for some of the series. Consequences of ignoring this type of seasonality are also scrutinized.

[1] According to the Hegirian Calendar.

Paper

Most Recent Working Paper (in English / in Turkish) [may not be identical to the published version]

Extended Working Paper

Published Version