Discussion of

Endogenous volatility at the zero lower bound: implications for stabilization policy By Susanto Basu and Brent Bundick

Sebastian Schmidt (ECB) 9th Conference of the International Research Forum on Monetary Policy

March 2016 Disclaimer: The views expressed on the slides are my own and do not necessarily represent those of the ECB.

1 / 26

This paper

Inspects the mechanisms by which an increase in uncertainty about future shocks can give rise to non-negligible declines in aggregate demand in states where the effective lower bound (ELB) is binding

Studies the role of the monetary (and fiscal) policy configuration

2 / 26

Framework Small non-linear business cycle model with price adjustment costs and rational expectations, calibrated to the U.S. economy Preference shock with stochastic volatility Baseline policy configuration consists of a Taylor rule, no fiscal stabilization policy Implicit focus on ’intended equilibrium’ where inflation fluctuates around target 3 / 26

Equilibrium responses to the preference shock Output gap / Consumption 2

Inflation 2

0

0

−2 −2

−4 −6

0.95

1

1.05

Real wage rate

−4

1

1.05

Nominal and real interest rate

2

8

0

6

−2

4

−4

2

−6

0.95

0 0.95

1

1.05

Preference shock (at)

0.95

1

1.05

Preference shock (at)

Note: The chart depicts equilibrium responses to the preference shock when the uncertainty shock is at steady state. 4 / 26

Implications of an increase in uncertainty for equilibrium responses Output gap / Consumption

Inflation

0 −0.1

−0.2

−0.2 −0.4

−0.3 −0.4

−0.6 0.95

1

1.05

Real wage rate 0

−0.5

0.95

1

1.05

Nominal and real interest rate 0.5

−0.2 −0.4

0

−0.6 −0.8

0.95

1

1.05

Preference shock (at)

−0.5

0.95

1

1.05

Preference shock (at)

Note: The chart depicts the effects of an uncertainty shock equal to one unconditional standard deviation (+50bp) for equilibrium responses to the preference shock.

5 / 26

Uncertainty and the ELB At the ELB, central bank cannot lower current policy rate to counteract precautionary saving motive associated with an exogenous increase in uncertainty

6 / 26

Uncertainty and the ELB At the ELB, central bank cannot lower current policy rate to counteract precautionary saving motive associated with an exogenous increase in uncertainty Asymmetric response of baseline policy rule to shocks gives rise to downward bias in expected inflation, thereby raising ex-ante real interest rate

6 / 26

Uncertainty and the ELB At the ELB, central bank cannot lower current policy rate to counteract precautionary saving motive associated with an exogenous increase in uncertainty Asymmetric response of baseline policy rule to shocks gives rise to downward bias in expected inflation, thereby raising ex-ante real interest rate This so-called deflationary/contractionary bias increases with the degree of uncertainty 6 / 26

Related literature on the role of uncertainty at the ELB

Semi-loglinear sticky price models: Adam and Billi (2007), Nakov (2008)

Fully non-linear sticky price models: Nakata (2013a), Johannsen (2014), Plante, Richter and Throckmorton (2014)

7 / 26

The role of the monetary and fiscal policy configuration What type of policy configuration can mitigate the adverse effects of an exogenous increase in uncertainty at the ELB?

8 / 26

The role of the monetary and fiscal policy configuration What type of policy configuration can mitigate the adverse effects of an exogenous increase in uncertainty at the ELB? History-dependent monetary policies that make up for past deviations of inflation from target, e.g. optimal commitment policy

8 / 26

The role of the monetary and fiscal policy configuration What type of policy configuration can mitigate the adverse effects of an exogenous increase in uncertainty at the ELB? History-dependent monetary policies that make up for past deviations of inflation from target, e.g. optimal commitment policy Fiscal stabilization policy, e.g. optimal government spending

8 / 26

The role of the monetary and fiscal policy configuration What type of policy configuration can mitigate the adverse effects of an exogenous increase in uncertainty at the ELB? History-dependent monetary policies that make up for past deviations of inflation from target, e.g. optimal commitment policy Fiscal stabilization policy, e.g. optimal government spending More generally, those policies that are effective in mitigating the adverse effects of first-moment shocks [Adam and Billi (2006), Nakov (2008), Schmidt (2013), Nakata (2013b)] 8 / 26

Comments

9 / 26

Question I

How do the effects of the uncertainty shock (at the ELB) depend on private sector characteristics?

10 / 26

Question I

How do the effects of the uncertainty shock (at the ELB) depend on private sector characteristics?

Two considerations: i. Labor market ii. Preferences

10 / 26

i. Labor market

Model features competitive labor market, hence firms’ marginal costs are quite volatile

Are the adverse effects of uncertainty shocks at the ELB smaller when nominal wages are sticky? Here, I consider downward nominal wage rigidities (DNWR)1

1

For empirical evidence, see, for instance, Fallick, Lettau and Wascher (2016). 11 / 26

Augmenting the baseline model with DNWR Household j faces asymmetric adjustment costs Φt,j when posting its nominal wage. Linex function specification of Varian (1974)2 Φt,j = φW

exp [−ψ (Wt,j /Wt−1,j − 1)] + ψ (Wt,j /Wt−1,j − 1) − 1 ψ2

Adj. costs are proportional to aggregate labor income Wt Nt . Wage Phillips curve

2

See also Kim and Ruge-Murcia (2009); and Fahr and Smets (2010). 12 / 26

Nominal wage adjustment cost function for ψ > 0 Φ t,j

0.03

0.025

0.02

0.015

0.01

0.005

0 0.99

0.992 0.994 0.996 0.998

1

1.002 1.004 1.006 1.008

1.01

W t,j /Wt-1,j

13 / 26

Calibration of model with DNWR

β

0.99

φP

192

σa

0.015

φW

96

σ

2

φπ

1.5

ρσ a

0.85

ψ

400

η

0.24

φx

0.25

σσ

θ

6

ρa

0.85

θW

a

0.005 6

Higher standard deviation of at than in the baseline model (+0.005) New parameters related to nominal wage adjustment costs

14 / 26

Impulse responses to a negative preference shock: Baseline model vs DNWR

Output gap / Consumption 0

0

-1

Inflation

0 -0.5

-1

-2

-1

-3

-2

-4

Baseline -3 DNWR

-2

-4

-2.5

-1.5

-5 5

0

Wage inflation

10

15

20

Real wage rate

5

10

15

20

Nominal interest rate

5

4

10

15

20

Natural real rate

3 2

-2

2 0

-4

1 -2

0

-6 5

10

15

Quarter

20

5

10

15

Quarter

20

5

10

15

20

Quarter

Note: The chart depicts impulse responses to a negative preference shock for the baseline model and the model with DNWR. The size of the shock in the two models is chosen such that the initial drop of the output gap is similar. 15 / 26

Implications of an increase in uncertainty for impulse responses: Baseline vs DNWR

Output gap / Consumption

0

Price inflation

0 -0.05

-0.1 -0.1 -0.15

-0.2

-0.2 -0.3 -0.25 -0.3

-0.4

-0.35 -0.5

-0.4

Baseline DNWR

-0.45

-0.6

-0.5 2

4

6

8

Quarter

10

12

2

4

6

8

10

12

Quarter

Note: The chart depicts the implications of an uncertainty shock equal to one unconditional standard deviation (+50bp) for impulse responses to a negative preference shock in the baseline model and in the model with DNWR. 16 / 26

Alternative degrees of asymmetry in nominal wage adjustment costs

Output gap / Consumption

0

Price inflation

0 -0.05

-0.1 -0.1 -0.15

-0.2

-0.2 -0.3 -0.25 -0.3

-0.4

-0.35 -0.5

Baseline DNWR (ψ=400) DNWR (ψ=50)

-0.4 -0.45

-0.6

-0.5 2

4

6

8

Quarter

10

12

2

4

6

8

10

12

Quarter

Note: The chart depicts the implications of an uncertainty shock equal to one unconditional standard deviation (+50bp) for impulse responses to a negative preference shock in the baseline model and in the model with DNWR. 17 / 26

ii. Preferences and precautionary motive Assumed preferences are non-separable in consumption and leisure Ctη (1 − Nt )1−η U (Ct , Nt , at ) = at 1−σ

1−σ (1)

with η ∈ (0, 1), σ > 1 → UC,N > 0 A reduction in consumption raises the marginal utility of leisure Hence, substitutability between consumption and leisure weakens precautionary labor supply motive (the more so the larger σ)

18 / 26

Implications of an increase in uncertainty for equilibrium responses Output gap / Consumption

Inflation

0 −0.1

−0.2

−0.2 −0.4

σ=2 σ=4

−0.6 0.95

1

1.05

−0.3 −0.4 −0.5

Real wage rate

0.95

1

1.05

Nominal interest rate

0 0

−0.2 −0.4

−0.2

−0.6 −0.8

−0.4 0.95

1

1.05

Preference shock (at)

0.95

1

1.05

Preference shock (at)

Note: The chart depicts the effects of an uncertainty shock equal to one unconditional standard deviation (+50bp) for equilibrium responses to the preference shock.

19 / 26

Question II Authors suggest to focus analysis on monetary policy configurations that arguably remove the contractionary bias channel on account of non-existence of equilibrium under baseline policy rule for realistic calibration of exogenous shock volatility the baseline policy rule not being a realistic description of recent U.S. monetary policy → ”Should we remove the contractionary bias?”

20 / 26

I am a bit skeptical:

1. A more realistic model would allow for higher exogenous shock volatility without necessarily contesting equilibrium existence, as exemplified by the model with DNWR

21 / 26

2. A rule that responds to the price level - like the one proposed by the authors - allows for a transitory overshooting of the central bank’s inflation objective after a period of too-low inflation.

22 / 26

2. A rule that responds to the price level - like the one proposed by the authors - allows for a transitory overshooting of the central bank’s inflation objective after a period of too-low inflation. This does not seem to reflect well U.S. central bankers’ perceptions of their strategy during the crisis: To be sure, we have not followed the theoretical prescription of promising to keep rates low enough for long enough to create a period of above-normal inflation. Donald L. Kohn, then Vice Chairman of the Board of Governors (October 9, 2009) 22 / 26

Summary of economic projections, December 2015 U.S. policymakers do not seem to anticipate a temporary overshooting of the inflation objective under their individual assessments of projected appropriate monetary policy

Table: PCE inflation

2015

2016

2017

2018

Longer run

Median

0.4

1.6

1.9

2.0

2.0

Central tendency

0.4

1.2-1.7

1.8-2.0

1.9-2.0

2.0

23 / 26

Conclusion

Basu and Bundick provide a very concise analysis of the mechanisms by which an exogenous increase in uncertainty about future shocks gets amplified when the ELB is binding Relevant when thinking about how to design policies in the current low-interest-rate environment Would be interesting to verify quantitative implications from the stylized baseline model in a more complex model

24 / 26

References Adam, K., and R. Billi (2007). Discretionary Monetary Policy and the Zero Lower Bound on Nominal Interest Rates. Journal of Monetary Economics, 54, 728-752. Fahr, S., and F. Smets. (2010). Donward Wage Rigidities and Optimal Monetary Policy in a Monetary Union. Scandinavian Journal of Economics, 112(4), 812-840. Fallick, B., M. Lettau, and W. Wascher. (2016). Downward Nominal Wage Rigidity in the United States During and After the Great Recession. FEDS Working Paper 2016-001. Johannsen, B. (2014). When are the effects of fiscal policy uncertainty large? FEDS Working Paper 2014-040. Kim, J., and F.J. Ruge-Murcia. (2009). How much inflation is necessary to grease the wheels? Journal of Monetary Economics, 56(3), 365-377. Kohn, D. (2009). Monetary Policy Research and the Financial Crisis: Strengths and Shortcomings. Speech at the Federal Reserve Conference on Key Developments in Monetary Policy, Washington D.C., October 9, 2009. Nakata, T. (2013a). Uncertainty at the Zero Lower Bound. FEDS Working Paper 2013-009. 25 / 26

Nakata, T. (2013b). Optimal Fiscal and Monetary Policy with Occasionally Binding Zero Bound Constraints. FEDS Working Paper 2013-040. Nakov, A. (2008). Optimal and Simple Monetary Policy Rules with Zero Floor on the Nominal Interest Rate. International Journal of Central Banking, 4(2), 73127. Plante, M., A. Richter, and N. Throckmorton (2014). The Zero Lower Bound and Endogenous Uncertainty. Working Paper. Schmidt, S. (2013). Optimal Monetary and Fiscal Policy with a Zero Bound on Nominal Interest Rates. Journal of Money, Credit and Banking, 45(7), 1335-1350. Varian, H. (1974). A Bayesian Approach to Real Estate Assessment. In: Feinberg, S.E., Zellner, A. (Eds.), Studies in Bayesian Economics in Honour of L.J. Savage.

26 / 26

Background slides

27 / 26

Wage Phillips curve in model with DNWR

  φW 1 − η Ct − wt = − W πtW wt exp(−ψ(πtW − 1)) − 1 η 1 − Nt θ ψ   at+1 λt+1 Nt+1 W −βEt wt+1 exp(−ψ(πt+1 − 1)) − 1 at λt Nt 1−σ

where λt = η

(Ctη (1−Nt )1−η ) Ct

.

Parameter ψ represents the degree of asymmetry in nominal wage adjustment costs. back 28 / 26

Endogenous volatility at the zero lower bound

Framework. Small non-linear business cycle model with price adjustment costs and ..... Speech at the Federal Reserve Conference on Key Developments in.

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