Federico Ravenna

Vector autoregressions and reduced form representations of DSGE models

Dynamic Stochastic General Equilibrium models are often tested against empirical VARs or estimated by minimizing the distance between the models and the VAR impulse response functions. These methodologies require that the data-generating process consistent with the DSGE theoretical model has a VAR representation. This paper discusses the assumptions needed for a finite-order VAR(p) representation of any subset of a DSGE model variables to exist. When a VAR(p) is only an approximation to the true VAR, the paper shows that the truncated VAR(p) may return largely incorrect estimates of the impulse response function. The results do not hinge on an incorrect identification strategy or on small sample bias. But the bias introduced by truncation can lead to bias in the identification of the structural shocks. Identification strategies that are equivalent in the true VAR representation perform differently in the approximating VAR. (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.)

The Road to Adopting the Euro: Monetary Policy and Exchange Rate Regimes in EU Candidate Countries

This paper examines the choice of exchange rate regime in EU candidate countries during the process of accession to the European Monetary Union (EMU). In the presence of real exchange rate appreciation due to the Balassa-Samuelson effect, candidate countries face a trade-off between trend appreciation of the nominal exchange rate and high inflation rates. In a general equilibrium model of an emerging market economy, we show that under a fixed or heavily managed exchange rate the Balassa-Samuelson effect might prevent compliance with the Maastricht inflation criterion, unless a contractionary policy is adopted. We then discuss how the real exchange rate appreciation shifts the output gap/inflation variance trade-off, increasing the cost of managing or fixing the exchange rate. As a consequence, the requirement of membership in the Exchange Rate Mechanism (ERM-II) and the Maastricht inflation criterion constrain the policy choice while providing no additional benefit to countries credibly committed to joining the Euro. Finally, we show that relaxing either the exchange rate requirement or the inflation criterion has sharply different business cycle implications for the accession countries.

Monetary Policy and Rejections of the Expectations Hypothesis

We study the rejection of the expectations hypothesis within a New Keynesian business cycle model.Earlier research has shown that the Lucas general equilibrium asset pricing model can account for neither sign nor magnitude of average risk premia in forward prices, and is unable to explain rejection of the expectations hypothesis.We show that a New Keynesian model with habitformation preferences and a monetary policy feedback rule produces an upwardsloping average term structure of interest rates, procyclical interest rates, and countercyclical term spreads.In the model, as in U.S. data, inverted term structure predicts recessions.Most importantly, a New Keynesian model is able to account for rejections of the expectations hypothesis.Contrary to earlier work, we identify systematic monetary policy as a key factor behind this result.Rejection of the expectation hypothesis can be entirely explained by the volatility of just two real shocks which affect technology and preferences. Keywords: term structure of interest rates, monetary policy, sticky prices, habit formation, expectations hypothesis JEL classification numbers: E43, E44, E5, G12

Monetary Policy, Expected Inflation, and Inflation Risk Premia

Within a New Keynesian business cycle model, we study variables that are normally unobservable but are very important for the conduct of monetary policy, namely expected inflation and inflation risk premia. We solve the model using a third-order approximation that allows us to study time-varying risk premia. Our model is consistent with rejection of the expectations hypothesis and the business-cycle behaviour of nominal interest rates in US data. We find that inflation risk premia are very small and display little volatility. Hence, monetary policy authorities can use the difference between nominal and real interest rates from index-linked bonds as a proxy for inflation expectations. Moreover, for short maturities current inflation is a good predictor of inflation risk premia. We also find that short-term real interest rates and expected inflation are significantly negatively correlated and that short-term real interest rates display greater volatility than expected inflation. These results are consistent with empirical studies that use survey data and index-linked bonds to obtain measures of expected inflation and real interest rates. Finally, we show that our economy is consistent with the Mundell-Tobin effect: increases in inflation are associated with higher nominal interest rates, but lower real interest rates. Keywords: term structure of interest rates, monetary policy, expected inflation, inflation risk premia, Mundell-Tobin effect JEL classification numbers: E5, E43, E44, G12

Why Join A Currency Union? A Note On The Impact Of Beliefs On The Choice Of Monetary Policy

We argue that a fixed exchange rate can be an optimal choice even if a policy maker could commit to the first-best monetary policy whenever the private sectors beliefs reflect incomplete information about the policy makers dependability. This model implies that joining a currency area may be optimal for its impact not on the behavior of the policy maker, but on the beliefs of the private sector. Monetary policies are evaluated using a new Keynesian model of a small open economy solved under imperfect policy credibility. We quantify the minimum distance between announced policy and the private sectors beliefs that is necessary for a peg to perform better than an independent monetary policy when the policy maker can commit to the first-best policy.