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Working Paper
The Transmission of Financial Shocks and Leverage of Financial Institutions: An Endogenous Regime-Switching Framework
We conduct a novel empirical analysis of the role of leverage of financial institutions for the transmission of financial shocks to the macroeconomy. For that purpose, we develop an endogenous regime-switching structural vector autoregressive model with time-varying transition probabilities that depend on the state of the economy. We propose new identification techniques for regime switching models.Recently developed theoretical models emphasize the role of bank balance sheets for the build-up of financial instabilities and the amplification of financial shocks. We build a market-based ...
Working Paper
When does the cost channel pose a challenge to inflation targeting central banks?
In a sticky-price model where firms finance their production inputs, there is both a lower and an upper bound on the central bank's inflation response necessary to rule out the possibility of self-fulfilling inflation expectations. This paper shows that real wage rigidities decrease this upper bound, but coefficients in the range of those on the Taylor rule place the economy well within the determinacy region. However, when there is time-variation in the share of firms who finance their inputs (i.e. Markov-Switching) then inflation targeting interest rate rules are often found to result in ...
Working Paper
Optimal monetary policy regime switches
Given regime switches in the economy?s growth rate, optimal monetary policy rules may respond by switching policy parameters. These optimized parameters differ across regimes and from the optimal choice under fixed regimes, particularly in the inflation target and interest rate inertia. Optimal switching rules produce welfare gains relative to constant rules, with switches in the implicit real interest rate used for policy and the degree of interest rate inertia producing the largest gains. However, gains from switching rules decrease if the monetary authority trades-off the probability of ...
Working Paper
Optimal Monetary Policy Regime Switches
An economy that switches between high and low growth regimes creates incentives for the monetary authority to change its rule. As lower growth tends to produce lower real interest rates, the monetary authority has an incentive to increase the inflation target and increase the degree of inertia in setting rates in an attempt to keep the nominal rate away from the zero lower bound. An optimizing monetary authority therefore responds to permanently lower growth by slightly increasing both the inflation target and inertia; focusing solely on the inflation target ignores a key margin of ...
Working Paper
Assessing the Effects of the Zero-Interest-Rate Policy through the Lens of a Regime-Switching DSGE Model
Standard dynamic stochastic general equilibrium (DSGE) models assume a Taylor rule and forecast an increase in interest rates immediately after the 2007-2009 economic recession given the predicted output and inflation, contradictory to the extended period of near-zero interest rate policy (ZIRP) conducted by the Federal Reserve. In this paper, I study two methods of modeling the ZIRP in DSGE models: the perfect foresight rational expectations model and the Markov regime-switching model, which I develop in this paper. In this regime-switching model, I assume that, in one regime, the policy ...
Working Paper
Learning about Regime Change
Total factor productivity (TFP) and investment specific technology (IST) growth both exhibit regime-switching behavior, but the regime at any given time is difficult to infer. We build a rational expectations real business cycle model where the underlying TFP and IST regimes are unobserved. We then develop a general perturbation solution algorithm for a wide class of models with unobserved regime-switching. Using our method, we show that learning about regime-switching alters the responses to regime shifts and intra-regime shocks, increases asymmetries in the responses, generates forecast ...
Working Paper
A Time-Varying Threshold STAR Model with Applications
Smooth-transition autoregressive (STAR) models, competitors of Markov-switching models, are limited by an assumed time-invariant threshold level. We augment the STAR model with a time-varying threshold that can be interpreted as a "tipping level" where the mean and dynamics of the VAR shift. Thus, the time-varying latent threshold level serves as a demarcation between regimes. We show how to estimate the model in a Bayesian framework using a Metropolis step and an unscented Kalman filter proposal. To show how allowing time variation in the threshold can affect the results, we present two ...