Nominal and real rigidities in monetary stochastic dynamic general equilibrium models of the business cycle

Abstract

The purpose of the present study is to explore the specific contributions of various nominal and real rigidities in monetary DGE models in a systematic way and in a common framework. I will concentrate on a quite simple model setup in order to find out the important transmission mechanisms at work. The focus will be on exogenous money growth shocks as the driving force of the business cycle and not on interest rate shocks. The book contains five main chapters. All these chapters are presented in a way that allows the reader to study them separately. Therefore the building blocks of the models will be repeated in every chapter. The first four chapters are concerned with the question which rigidities are essential to explain actual business cycles while Chapter 6 analyzes optimal monetary policy in a stochastic DGE model. In Chapter 2 the basic model is presented. Prices are set in a staggered way as in Taylor (1980). The chapter addresses two questions that have not yet been answered in the literature. First: Is there a difference between money introduced via a CIA-constraint or via a MIU-specification? Second: Does it matter how the household’s preferences look like? The answers are yes in both cases. It turns out that the CIA-model with a standard CRRA utility function can better account for the business cycle. Thus in Chapter 3 the MIU-setup as well as GHH preferences will be discarded. But the model will be augmented by capital accumulation considerations. The chapter considers instead the implications of the price setting scheme: Taylor pricing is compared to Calvo pricing. It turns out that the failure of the basic model to generate persistent output responses is due to Taylor type price staggering. The model version with Calvo pricing can account quite well for the empirical impulse responses, confirming the results of Kiley (2002) in a more general setup. Chapter 4 considers the role of habits in consumption. While this feature has already been analyzed by others, e.g. Christiano, Eichenbaum and Evans (2003), there is no study that tries to figure out the specific effects of habit formation in isolation. In addition, related studies use Calvo pricing. Here the MIU-model with Taylor price staggering will again be considered in order to examine whether this can improve the model with respect to its ability to create persistence in output. Unfortunately only the response of consumption to a money growth shock can be improved. For a high enough value of the habit persistence parameter consumption can even be hump-shaped, as it is empirically (see Figure 1.4). Chapter 5 presents a model with Taylor wage staggering and adjustment costs of price changes as in Rotemberg (1982). It turns out that this specific combination is important to get persistent output responses to a money growth shock. When using also Taylor price staggering the result breaks down and output and prices will not be persistent. Sticky prices through adjustment costs of prices operate similar as sticky prices under Calvo pricing. When they interact with adjustment costs of capital they can even strengthen the persistence in output. In the absence of the costs for adjusting the capital stock there are only very moderate effects on output. Chapter 6 goes a step further. Here the question is not whether a monetary stochastic DGE model can generate persistence but whether a central bank can stabilize the price level as claimed by King and Wolman (1999). The analysis builds upon the framework used before: the household maximizes life-time utility and firms maximize profits. The central bank acts as a social planner that takes into account the optimizing behavior of the household and the firms. Maximizing welfare is then equivalent to maximizing utility of the representative household. It is shown that the result of King and Wolman does not hold under a different specification of the preference function so that in general the monetary authority will not be successful in completely stabilizing the price level, as is also observed empirically. Chapter 7 summarizes the main findings and gives some suggestions for future research while Chapter 1 discusses briefly important advances in macroeconomic theory as well as in empirical methods to characterize the business cycle.