Macroeconomics II: Monetary policy in New-Keynesian

Models

Dániel Baksa

ELTEcon

ELTEcon
 Macroeconomics II
Model so far
Dániel Baksa

Model so far

Reaction functions
Basic setting: IS-curve, NKPC and Taylor rule Exogenous rule
Reaction to inflation
Replicate the core behavior, but still not perfect Reaction to expected
inflation
Consumption habit, Tobin-Q, indexation and wage Reaction to output
gap
inflation could help (Smets-Wouters model) Interest rate
smoothing
Core equation is Taylor rule that is ad-hoc Optimal monetary
policy
Understanding the inflationary reaction Optimal simple rules
Natural rate Ramsey optimum

Optimal rule

2
 Macroeconomics II
Monetary policy in NK-model
Dániel Baksa

Monetary policy wants to stabilize the inflation and Model so far

economic fluctuations: Reaction functions

Exogenous rule
Reaction to inflation
1 How? Reaction to expected
inflation
2 Instrument? Instution? Policy desig? Reaction to output
gap
Interest rate
smoothing
Define output gap (xbt ) as the deviation of total output from Optimal monetary
natural level: policy
Optimal simple rules
Ramsey optimum

ctn
ct − Y
xbt = Y

3
 Macroeconomics II
Natural level of output
Dániel Baksa

Model so far

Reaction functions
Consistent with flexible price equilibrium, in the basic model: Exogenous rule
Reaction to inflation
Reaction to expected
inflation

ctn = Et Y n 1 bn Reaction to output

t+1 − rt
Y [ gap
σ Interest rate
smoothing

ctn = 1 + η A
Y ct Optimal monetary
policy
η+σ Optimal simple rules
Ramsey optimum

4
 Macroeconomics II
So output gap and natural level:
Dániel Baksa

Model so far

Reaction functions
1 C C
 1  Exogenous rule
xbt = Et xd
t+1 + ξt − Et ξt+1 − ibt − Et πt+1 − rbtn Reaction to inflation
σ σ Reaction to expected
inflation

(1 − ωβ)(1 − ω)  L  Reaction to output

gap
πt = ξt + (η + σ)xbt + βEt πt+1 Interest rate
ω smoothing

ctn = n 1 bn Optimal monetary

t+1 − rt
Y [
Et Y policy
σ Optimal simple rules
Ramsey optimum

ctn = 1+ηc
Y At
η+σ

5
 Macroeconomics II

Dániel Baksa

Model so far

Reaction functions
Exogenous rule
Reaction to inflation
If the policy closed the output gap, the Reaction to expected
inflation

inflation would be zero. Reaction to output

gap
Interest rate
smoothing

Optimal monetary
policy
Optimal simple rules
Ramsey optimum

6
 Macroeconomics II
Exogenous interest rate
Dániel Baksa

Model so far

Reaction functions
Exogenous rule
Good idea: Reaction to inflation
Reaction to expected
inflation
Reaction to output
gap
Interest rate
it = rtn smoothing

Optimal monetary
policy
If it always holds, the output gap may be closed. Optimal simple rules
Ramsey optimum

7
 Macroeconomics II

Dániel Baksa

Model so far

Reaction functions
Exogenous rule
Reaction to inflation

But it does not work... Reaction to expected

inflation
Reaction to output
gap
Interest rate
smoothing

Optimal monetary
policy
Optimal simple rules
Ramsey optimum

8
 Macroeconomics II
Problems
Dániel Baksa

Mathematical reason - Blanchard-Kahn conditions are Model so far

not satisfied Reaction functions
2 forward looking variable (inflation, output gap) Exogenous rule
Reaction to inflation
But only one eigenvalue larger than 1 Reaction to expected
inflation
Multiple equilibrium Reaction to output
gap
Interest rate
Economic interpretation smoothing

Optimal monetary
No nominal anchor in the economy, and monetary policy
policy does not care about inflation and output gap Optimal simple rules
Ramsey optimum
combinations
Any output gap and inflation is possible
Otherwise this natural level rate can be calculated only
ex-post

9
 Macroeconomics II

Dániel Baksa

Model so far

Reaction functions
Exogenous rule
Reaction to inflation

We need an obvious rule Reaction to expected

inflation
Reaction to output
gap
Interest rate
smoothing

Optimal monetary
policy
Optimal simple rules
Ramsey optimum

10
 Macroeconomics II
Reaction to inflation
Dániel Baksa

Model so far

Reaction functions
Exogenous rule
Reaction to inflation
Reaction to expected
inflation
Reaction to output
gap

it = rtn + φπ πt + ξti
Interest rate
smoothing

Optimal monetary
policy
Optimal simple rules
Ramsey optimum

11
 Macroeconomics II

Dániel Baksa

Model so far

Reaction functions
Exogenous rule
Reaction to inflation

Reaction size? Reaction to expected

inflation
Reaction to output
gap
Interest rate
smoothing

Optimal monetary
policy
Optimal simple rules
Ramsey optimum

12
 Macroeconomics II
Reaction
Dániel Baksa

Model so far

Reaction functions
Exogenous rule
Mathematical approach - Blanchard-Kahn conditions Reaction to inflation
Reaction to expected
2 forward-looking variables inflation
Reaction to output
And we need 2 eigenvalues larger than 1 gap
Interest rate
smoothing
Economic interpretation Optimal monetary
Monetary policy reacts on inflation that influence the policy
Optimal simple rules
domestic demand Ramsey optimum

13
 Macroeconomics II
Output gap and interest rate
Dániel Baksa

In IS curve the following should be satisfied

Model so far
it − Et πt+1 − rtn > 0 Reaction functions
Exogenous rule
Reaction to inflation
Combining with Taylor-rule: Reaction to expected
inflation
Reaction to output
gap

rtn + φπ πt − Et πt+1 − rtn > 0 Interest rate

smoothing

Optimal monetary
φπ π t > Et πt+1 policy
Optimal simple rules
Ramsey optimum
Assuming the Et πt+1 = πt + ∆t where ∆t is the expected
change that particulary zero:

φπ > 1

14
 Macroeconomics II

Dániel Baksa

Model so far

Reaction functions
Exogenous rule

The monetary policy wants to influence Reaction to inflation

Reaction to expected
inflation

the output gap... Reaction to output

gap
Interest rate
smoothing

Optimal monetary
policy
Optimal simple rules
Ramsey optimum

15
 Macroeconomics II

Dániel Baksa

Model so far

Reaction functions
Exogenous rule

... then the inflation reaction should be Reaction to inflation

Reaction to expected
inflation

φπ > 1 !!! Reaction to output

gap
Interest rate
smoothing

Optimal monetary
policy
Optimal simple rules
Ramsey optimum

16
 Macroeconomics II
Nice, but easy to challenge it
Dániel Baksa

Model so far

Reaction functions
Exogenous rule
Reaction to inflation
Central bank needs to react to all inflationary shocks... Reaction to expected
inflation
Reaction to output
E.g.: oil price push up, the policy increase like crazy gap
Interest rate
smoothing
It means that the central bank intensifies the volatility Optimal monetary
of real variables (but the agents are risk averse) policy
Optimal simple rules
Ramsey optimum

17
 Macroeconomics II

Dániel Baksa

Model so far

Reaction functions
Exogenous rule
Reaction to inflation

Reacts to expected inflation Reaction to expected

inflation
Reaction to output
gap
Interest rate
smoothing

Optimal monetary
policy
Optimal simple rules
Ramsey optimum

18
 Macroeconomics II
Forward-looking rule
Dániel Baksa

Model so far

Reaction functions
Exogenous rule
Reaction to inflation
Reaction to expected
inflation
Reaction to output
gap

it = rtn + φπ πt+1 + ξti

Interest rate
smoothing

Optimal monetary
policy
Optimal simple rules
Ramsey optimum

19
 Macroeconomics II
Várt inflációra való reakció
Dániel Baksa

Model so far

Reaction functions
Self-fulfilling policy: Exogenous rule
Reaction to inflation
Reaction to expected
Central bank threatens: if the inflation deviates from its inflation
Reaction to output
target, interest rate will change. gap
Interest rate
Agents looks forward and believe in possible policy smoothing

measure, so they accommodate to new equilibrium Optimal monetary

policy
Since the inflation starts stabilizing the interest rate Optimal simple rules
hike is not as large as in original model Ramsey optimum

20
 Macroeconomics II
IRF: Cost-push shock
Dániel Baksa

Nominal interest rate Inflation

0.2 0.25

0.2 Model so far

0.15

0.15 Reaction functions

0.1 Exogenous rule
0.1 Reaction to inflation
Reaction to expected
0.05 inflation
0.05
Reaction to output
gap
0 0
5 10 15 5 10 15 Interest rate
smoothing

GDP Output gap Optimal monetary

0 0 policy
Contemp. Optimal simple rules
Forward looking Ramsey optimum
-0.05 -0.05

-0.1 -0.1

-0.15 -0.15
5 10 15 5 10 15

21
 Macroeconomics II
IRF: Demand shock
Dániel Baksa

Nominal interest rate Inflation

0.5 0.5

0.4 0.4 Model so far

0.3 0.3 Reaction functions

Exogenous rule
0.2 0.2 Reaction to inflation
Reaction to expected
0.1 0.1 inflation
Reaction to output
gap
0 0
5 10 15 5 10 15 Interest rate
smoothing

GDP Output gap Optimal monetary

0.25 0.25 policy
Contemp. Optimal simple rules
0.2 0.2
Forward looking Ramsey optimum

0.15 0.15

0.1 0.1

0.05 0.05

0 0
5 10 15 5 10 15

22
 Macroeconomics II
Reaction to output gap
Dániel Baksa

Model so far

Reaction functions
Exogenous rule
Monetary policy has secondary objective ... Reaction to inflation
Reaction to expected
inflation
and reacts to output gap Reaction to output
gap
Interest rate
smoothing

Optimal monetary
policy
it = rtn + φπ πt+1 + φx xt + ξti Optimal simple rules
Ramsey optimum

23
 Macroeconomics II
Reaction to output gap
Dániel Baksa

Model so far

Reaction functions
Exogenous rule
Cost-push shock: central bank should increase the rate Reaction to inflation
Reaction to expected
but not as much because of output gap inflation
Reaction to output
Stability conditions: overall reaction to inflation should gap
Interest rate
results an anchor smoothing

Optimal monetary
How to measure output gap? After 10 years ex-post it policy
Optimal simple rules
is trivial, but not in real-time... Ramsey optimum

24
 Macroeconomics II
IRF: Cost-push shock
Dániel Baksa

Nominal interest rate Inflation

0.2 0.25

0.2 Model so far

0.15

0.15 Reaction functions

0.1 Exogenous rule
0.1 Reaction to inflation
Reaction to expected
0.05 inflation
0.05
Reaction to output
gap
0 0
5 10 15 5 10 15 Interest rate
smoothing

GDP Output gap Optimal monetary

0 0 policy
-0.01 -0.01
wo Gap react Optimal simple rules
Gap react Ramsey optimum
-0.02 -0.02

-0.03 -0.03

-0.04 -0.04

-0.05 -0.05

-0.06 -0.06
5 10 15 5 10 15

25
 Macroeconomics II
IRF: Demand shock
Dániel Baksa

Nominal interest rate Inflation

0.5 0.5

0.4 0.4 Model so far

0.3 0.3 Reaction functions

Exogenous rule
0.2 0.2 Reaction to inflation
Reaction to expected
0.1 0.1 inflation
Reaction to output
gap
0 0
5 10 15 5 10 15 Interest rate
smoothing

GDP Output gap Optimal monetary

0.25 0.25 policy
wo Gap react Optimal simple rules
0.2 0.2
Gap react Ramsey optimum

0.15 0.15

0.1 0.1

0.05 0.05

0 0
5 10 15 5 10 15

26
 Macroeconomics II

Dániel Baksa

Model so far

Central bank needs to react to
Reaction functions
Exogenous rule
Reaction to inflation
Reaction to expected
inflation

unobserved variable... Reaction to output

gap
Interest rate
smoothing

Optimal monetary
policy
Optimal simple rules
Ramsey optimum

27
 Macroeconomics II

Dániel Baksa

Model so far

Reaction functions
Exogenous rule

... reaction to expected inflation is good Reaction to inflation

Reaction to expected
inflation

compromise. Reaction to output

gap
Interest rate
smoothing

Optimal monetary
policy
Optimal simple rules
Ramsey optimum

28
 Macroeconomics II
Smoothing in Taylor-rule
Dániel Baksa

Model so far

Avoiding volatile reaction in real variables Reaction functions

Exogenous rule
Reaction to inflation
Reaction to expected
inflation
Reaction to output
gap
it = ρi it−1 + (1 − ρi )(rtn + φπ Et πt+1 + φx xt ) + it Interest rate
smoothing

Optimal monetary
Practical reasons: policy
Optimal simple rules
Ramsey optimum
Forecasts are often updated
Smoothing avoid constant reactions to new information

29
 Macroeconomics II
IRF: Keresleti sokk
Dániel Baksa

Nominal interest rate Inflation

0.4 0.25

0.2 Model so far

0.3

0.15 Reaction functions

0.2 Exogenous rule
0.1 Reaction to inflation
Reaction to expected
0.1 inflation
0.05
Reaction to output
gap
0 0
5 10 15 5 10 15 Interest rate
smoothing

GDP Output gap Optimal monetary

0.25 0.25 policy
wo Smoothing Optimal simple rules
0.2 0.2
Smoothing Ramsey optimum

0.15 0.15

0.1 0.1

0.05 0.05

0 0
5 10 15 5 10 15

30
 Macroeconomics II
IRF: Költség sokk
Dániel Baksa

Nominal interest rate Inflation

0.15 0.25

0.2 Model so far

0.1 0.15
Reaction functions
0.1 Exogenous rule
Reaction to inflation
0.05 0.05 Reaction to expected
inflation
0
Reaction to output
gap
0 -0.05
5 10 15 5 10 15 Interest rate
smoothing

GDP Output gap Optimal monetary

0.01 0.01 policy
wo Smoothing Optimal simple rules
0 0 Smoothing Ramsey optimum

-0.01 -0.01

-0.02 -0.02

-0.03 -0.03
5 10 15 5 10 15

31
 Macroeconomics II

Dániel Baksa

Model so far

Reaction functions
Exogenous rule

Ok, but how can we set the Reaction to inflation

Reaction to expected
inflation

parameters??? Reaction to output

gap
Interest rate
smoothing

Optimal monetary
policy
Optimal simple rules
Ramsey optimum

32
 Macroeconomics II
Looking for optimal parameters
Dániel Baksa

Model so far

Reaction functions
Two approaches Exogenous rule
Reaction to inflation
Take a welfare loss function: weighted average of Reaction to expected
inflation
variance of output gap and variance of inflation Reaction to output
gap
Interest rate
1 Choose parameters for Taylor rule to minimize the smoothing

welfare loss Optimal monetary

policy
2 Or looking for Ramsey optimum: minimizing welfare Optimal simple rules
loss by constraints (NKPC and IS curve) Ramsey optimum

33
 Macroeconomics II
Welfare loss function
Dániel Baksa

Model so far

Reaction functions
Exogenous rule
Reaction to inflation
Reaction to expected
∞ inflation
1 X tn 2 o
β πt + αx xt2
Reaction to output
Wt = − gap
2 Interest rate
smoothing
t=0
Optimal monetary
policy
We can derive it from the second order approximation of the Optimal simple rules
Ramsey optimum
utility function.

34
 Macroeconomics II
Optimal simple rule
Dániel Baksa

Structural assumptions:
1 C C
 1 
xbt = Et xd
t+1 + ξt − Et ξt+1 − ibt − Et πt+1 − rbtn Model so far
σ σ
Reaction functions
(1 − ωβ)(1 − ω)  L 
Exogenous rule
πt = ξt + (η + σ)xbt + βEt πt+1 Reaction to inflation
ω Reaction to expected
inflation
ctn n 1 bn Reaction to output
t+1 − rt
Y [
= Et Y gap
σ Interest rate
smoothing

ctn 1+ηc
Y = At Optimal monetary
policy
η+σ Optimal simple rules
Ramsey optimum

Objectives

it = ρi it−1 + (1 − ρi )(rtn + φπ Et πt+1 + φx xt ) + it

∞
1 X tn 2 o
Wt = − β πt + αx xbt 2 −→ max
2 ρi ,φπ ,φx
t=0

35
 Macroeconomics II
Ramsey optimum
Dániel Baksa

Another approach Model so far

Reaction functions
Exogenous rule
∞ Reaction to inflation
1 X n o Reaction to expected
Wt = − β t πt2 + αx xbt 2 −→ max inflation
2 πt ,xt ,it Reaction to output
gap
t=0 Interest rate
smoothing

Where the constraints are IS-curve and NKPC. Possible Optimal monetary
policy
optimization Optimal simple rules
Ramsey optimum
Discretional policy: reacting to the contemporaneous
variables
Full-commitment: consider the whole lifetime

36
 Macroeconomics II
Discretional policy
Dániel Baksa

Model so far

Reaction functions
Exogenous rule
Reaction to inflation
1n 2 o
πt + αx xbt 2 Reaction to expected
inflation
2   Reaction to output
gap
1 C  1 
+ λxt Et xdt+1 +
C
ξt − Et ξt+1 − ibt − Et πt+1 − rbtn − xbt Interest rate
smoothing
σ σ
  Optimal monetary
π (1 − ωβ)(1 − ω) 
L

policy
+ λt ξt + (η + σ)xbt + βEt πt+1 − πt −→ max
ω πt ,xt ,it Optimal simple rules
Ramsey optimum

37
 Macroeconomics II
Discretional policy
Dániel Baksa

FOCs:
Model so far
1
it : −λxt =0 Reaction functions
σ Exogenous rule
Reaction to inflation
(1 − ωβ)(1 − ω) Reaction to expected
xt : αx xt − λxt + λπt (η + σ) = 0 inflation
Reaction to output
ω gap

: πt − λπt = 0
Interest rate
πt smoothing

Optimal monetary
policy
It becomes the following Optimal simple rules
Ramsey optimum

(1 − ωβ)(1 − ω) η + σ
xt = − πt
ω αx

38
 Macroeconomics II
Full-commitment
Dániel Baksa

Model so far

Reaction functions
Exogenous rule
∞ Reaction to inflation
1 X n o
β t πt2 + αx xbt 2 Reaction to expected
inflation
2 t=0 Reaction to output
  gap
1 C  1 b  Interest rate
+ β t λxt
Et xd
t+1 +
C
ξt − Et ξt+1 − it − Et πt+1 − rbtn − xbt smoothing
σ σ
  Optimal monetary
t π (1 − ωβ)(1 − ω)  L  policy
+ β λt ξt + (η + σ)xbt + βEt πt+1 − πt −→ max Optimal simple rules
ω πt ,xt ,it
Ramsey optimum

39
 Macroeconomics II
Full-commitment
Dániel Baksa

FOCs:
1
it : −β t λxt =0 Model so far
σ Reaction functions
(1 − ωβ)(1 − ω)
β t αx xt − β t λxt + β t−1 λxt−1 + β t λπt
Exogenous rule
xt : (η + σ) = 0 Reaction to inflation
ω Reaction to expected
1 inflation
πt : β t πt + β t−1 λxt−1 + β t−1 βλπt−1 − β t λπt = 0 Reaction to output
σ gap
Interest rate
smoothing

Optimal monetary
It becomes the following policy
Optimal simple rules
Ramsey optimum

(1 − ωβ)(1 − ω)
αx xt + λπt (η + σ) = 0
ω
πt + λπt−1 − λπt = 0

40
 Macroeconomics II
Full-commitment
Dániel Baksa

Model so far

Reaction functions
Exogenous rule
After some simplification Reaction to inflation
Reaction to expected
inflation
Reaction to output
gap
Interest rate
(1 − ωβ)(1 − ω) η + σ smoothing
xt = xt−1 − πt Optimal monetary
ω αx policy
Optimal simple rules
Ramsey optimum

41
 Macroeconomics II
IRF: Demand shock
Dániel Baksa

Nominal interest rate #10

-18 Inflation #10
-18 GDP
0.3 3 5

0.25 2.5 4 Model so far

0.2 2 3
Reaction functions
0.15 1.5 2 Exogenous rule
Reaction to inflation
0.1 1 1 Reaction to expected
inflation
0.05 0.5 0
Reaction to output
gap
0 0 -1
5 10 15 5 10 15 5 10 15 Interest rate
smoothing

Output gap
-17 Welfare
-35 loss Optimal monetary
#10 #10
4 3 policy
Discretional
2.5
Optimal simple rules
Commitment
3 Ramsey optimum
2

2 1.5

1
1
0.5

0 0
5 10 15 5 10 15

42
 Macroeconomics II
IRF: Cost-push shock
Dániel Baksa

Nominal interest rate Inflation GDP

0.25 0.03 0

0.2 -0.05 Model so far

0.02

0.15 -0.1 Reaction functions

0.01 Exogenous rule
0.1 -0.15 Reaction to inflation
Reaction to expected
0 inflation
0.05 -0.2
Reaction to output
gap
0 -0.01 -0.25
5 10 15 5 10 15 5 10 15 Interest rate
smoothing

Output gap Welfare

-3 loss Optimal monetary
#10
0 2 policy
Discretional Optimal simple rules
-0.05
1.5 Commitment Ramsey optimum

-0.1
1
-0.15

0.5
-0.2

-0.25 0
5 10 15 5 10 15

43
 Macroeconomics II
IRF: Technology shock
Dániel Baksa

Nominal interest rate #10

-18 Inflation GDP
0 4 0.8

-0.1 Model so far

2 0.6

-0.2 Reaction functions

0 0.4 Exogenous rule
-0.3 Reaction to inflation
Reaction to expected
-2 0.2 inflation
-0.4
Reaction to output
gap
-0.5 -4 0
5 10 15 5 10 15 5 10 15 Interest rate
smoothing

Output gap
-17 Welfare
-34 loss Optimal monetary
#10 #10
5 5 policy
Discretional Optimal simple rules
4
0 Commitment Ramsey optimum

3
-5
2

-10
1

-15 0
5 10 15 5 10 15

44
 Macroeconomics II

Dániel Baksa

Model so far

Reaction functions
Exogenous rule
Reaction to inflation

Thank you for your attention! Reaction to expected

inflation
Reaction to output
gap
Interest rate
smoothing

Optimal monetary
policy
Optimal simple rules
Ramsey optimum

45