Frank Smets

An Estimated Dynamic Stochastic General Equilibrium Model of the Euro Area

This paper develops and estimates a dynamic stochastic general equilibrium (DSGE) model with sticky prices and wages for the euro area. The model incorporates various other features such as habit formation, costs of adjustment in capital accumulation and variable capacity utilisation. It is estimated with Bayesian techniques using seven key macro-economic variables: GDP, consumption, investment, prices, real wages, employment and the nominal interest rate. The introduction of ten orthogonal structural shocks (including productivity, labour supply, investment, preference, cost-push and monetary policy shocks) allows for an empirical investigation of the effects of such shocks and of their contribution to business cycle fluctuations in the euro area. Using the estimated model, the paper also analyses the output (real interest rate) gap, defined as the difference between the actual and model-based potential output (real interest rate).

On the Fit of New Keynesian Models

This article provides new tools for the evaluation of dynamic stochastic general equilibrium (DSGE) models and applies them to a large-scale new Keynesian model. We approximate the DSGE model by a vector autoregression, and then systematically relax the implied cross-equation restrictions and document how the model fit changes. We also compare the DSGE models impulse responses to structural shocks with those obtained after relaxing its restrictions. We find that the degree of misspecification in this large-scale DSGE model is no longer so large as to prevent its use in day-to-day policy analysis, yet is not small enough to be ignored.

The Taylor Rule: A Useful Monetary Policy Benchmark for the Euro Area?

This paper explores the Taylor rule--defined as an instrument rule linking the central banks policy rate to the current inflation rate and the output gap--as a benchmark for analysing monetary policy in the euro area. First, it analyses the stabilization properties of the Taylor rule in a closed economy model of the euro area, estimated using aggregate data from five EU countries. An optimized Taylor rule performs quite well compared to the unconstrained optimal feedback rule. Second, the robustness of these results to estimation error in the output gap and model uncertainty is examined. Copyright 1999 by Blackwell Publishers Ltd.

Output gaps and monetary policy in the EMU area

Abstract Several considerations suggest that the ECB may respond to EMU-wide output gaps in setting policy: estimated reaction functions indicate that central banks respond to output gaps; a Taylor rule in which the central bank responds to inflation and the gap accounts for recent movements in interest rates in the EMU-area; and optimal control exercises conducted in estimated econometric models suggest that reacting to the gap may be optimal, even if the central bank cares solely about inflation. In this paper, we obtain point estimates with associated confidence bands of the EMU-wide output gap using UC models.

The Monetary Transmission Mechanism: Evidence from the G-7 Countries

In this paper we compare the effects of monetary policy on output and prices in the G-7 countries using a parsimonious macroeconometric model comprising, output, prices and a short-term interest rate. We identify monetary policy shocks by assuming that they do not affect real output instantaneously (within the quarter) or in the long run and implement these restrictions using a sequential instrumental variables technique. We show that the so-called pricepuzzle which has been noticed in the large VAR-literature in which only shortrun restrictions are used, disappears. This suggests that the puzzle is due to the fact that the use of only short-run identifying restrictions does not properly discriminate between contractionary aggregate supply shocks and monetary policy shocks. We conclude that the effects of a standardised monetary policy action are very similar across countries.

The term structure of Euro-rates: some evidence in support of the expectations hypothesis

This paper studies 1, 3, 6 and 12-month Euro-rates for 17 countries using between 10 and 30 years of data. Term spreads contain information about future short-term rates in all 51 regressions that we estimate. Furthermore, in 35 cases we accept the expectations hypothesis. Using cross-sectional regressions, we estimate the variance of the term premium and the correlation of the term premium and the expected change in short rates. The estimates are compatible with existing informal estimates. We conclude that, despite the presence of a timevarying term premium, for many countries the expectations hypothesis is broadly compatible with the data.

Financial Asset Prices and Monetary Policy: Theory and Evidence

The work presented in this paper falls into two parts. First, using a simple model and within the context of the central banks objective of price stability, it is shown that the optimal monetary response to unexpected changes in asset prices depends on how these changes affect the central banks inflation forecast, which in turn depends on two factors: the role of the asset price in the transmission mechanism and the typical information content of innovations in the asset price. In this context, the advantages and disadvantages of setting monetary policy in terms of a weighted average of a short-term interest rate and an asset price such as the exchange rate - a Monetary Conditions Index (MCI) - are discussed. The second, more empirical, part of the paper documents, using an estimated policy reaction function, the short-term response to financial asset prices, including the exchange rate, in two countries with inflation targets (Australia and Canada) and suggests that the different response to exchange rate changes in these countries can in part be explained by differences in their underlying sources.

Maintaining price stability: how long is the medium term?

Using a small estimated forward looking model of the euro area economy, this paper analyses the determinants of the optimal monetary policy horizon for maintaining price stability. First, the optimal policy horizon for a price level objective is generally longer than that for an inflation objective. Second, the policy horizon becomes longer, the greater the weight on other objectives like minimising output gap and interest rate variability. Third, the optimal policy horizon is shorter, the higher the degree of “forward-lookingness” in the economy and the greater the slope of the Phillips curve. Finally, even if society cares only about inflation stabilisation, it often pays to give the central bank a price level objective, provided the horizon is optimally chosen to be somewhat longer.

MCIs and monetary policy

Abstract Several central banks have recently adopted a Monetary Conditions Index (MCI) to guide monetary policy under floating exchange rates. This paper discusses some analytical and practical questions raised by MCIs. Furthermore, using data for Australia, Canada and New Zealand, which all operate monetary policy under floating rates and with an inflation target, it estimates the responses of the central banks to exchange rate changes. The results reveal clear differences between central banks: while the Reserve Bank of Australia does not appear to respond, the Bank of Canada and the Reserve Bank of New Zealand, who use the MCI as an operating target, do respond quite strongly to movements in the exchange rate.

Are the Effects of Monetary Policy in the Euro Area Greater in Recessions than in Booms

This paper investigates whether monetary policy impulses have asymmetric effects on output growth in seven countries of the euro area (Germany, France, Italy, Spain, Austria, Belgium and the Netherlands). First, it is shown that these seven countries share the same business cycle. Next, strong evidence is presented that area-wide monetary policy impulses, measured as the contribution of monetary policy shocks to the short-term interest rate in a simple VAR for the euro area economy, have significantly larger effects on output growth in recessions than in booms. These differences are most pronounced in Germany, France, Italy, Spain, and Belgium, while they are much smaller in Austria and the Netherlands JEL Classification: E4, E5