Ruxandra Prodan

Additional Evidence of Long-Run Purchasing Power Parity with Restricted Structural Change

We investigate two alternative versions of Purchasing Power Parity (PPP): reversion to a constant mean in the spirit of Cassel and reversion to a constant trend in the spirit of Balassa and Samuelson, using long-span real exchange rate data for industrialized countries. We develop unit root tests that both account for structural change and maintain a long-run mean or trend. With conventional tests, previous research finds evidence of some variant of PPP for 9 of the 16 countries. With the unit root tests in the presence of restricted structural change, we find evidence of PPP for five additional countries.

Potential Pitfalls in Determining Multiple Structural Changes With an Application to Purchasing Power Parity

We investigate the empirical performance of the Bai and Perron multiple structural change tests and show that the use of their critical values may cause severe size distortions in persistent series. To correct these size distortions while maintaining a good power, we implement the Bai structural change test and extend it in two directions, developing a new procedure to choose the number of breaks and a restricted version that specifically models breaks that imply mean or trend reversion. Using our new methodologies, we reconcile the results of unit root tests with those of tests for structural change when testing for long-run purchasing power parity.

The Statistical Behavior of GDP after Financial Crises and Severe Recessions

Do severe recessions associated with financial crises cause permanent reductions in potential GDP? If the economy eventually returns to its trend, does the return take longer than the return following recessions not associated with financial crises? We develop a statistical methodology appropriate for identifying and analyzing slumps, episodes that combine a contraction and an expansion and end when the economy returns to its trend growth rate. We analyze the Great Depression for the United States, severe and milder financial crises for advanced economies, severe financial crises for emerging markets, and postwar recessions for the United States and other advanced economies. The preponderance of evidence for episodes comparable with the current U.S. slump is that, while potential GDP is eventually restored, the slumps last an average of nine years. If this historical pattern holds, the Great Recession that started in 2007:Q4 will not ultimately affect potential GDP, but the Great Slump is not yet half over.

Deviations from Rules-Based Policy and Their Effects

Rules-based monetary policy evaluation has long been central to macroeconomics. Using the original Taylor rule, a modified Taylor rule with a higher output gap coefficient, and an estimated Taylor rule, we define rules-based and discretionary eras by smaller and larger policy rule deviations, the absolute value of the difference between the actual federal funds rate and the federal funds rate prescribed by the three rules. We use tests for multiple structural changes to identify the eras so that knowledge of subsequent economic outcomes cannot influence the choice of the dates. With the original Taylor rule, monetary policy in the U.S. is characterized by a rules-based era until 1974, a discretionary era from 1974 to 1985, a rules-based era from 1985 to 2000, and a discretionary era from 2001 to 2013. With the modified Taylor rule, the rules-based era extends further into the 1970s and there is an additional rules-based period starting in 2006. We calculate various loss functions and find that economic performance is uniformly better during rules-based eras than during discretionary eras, and that the original Taylor rule provides the largest loss during discretionary periods relative to loss during rules-based periods.

FORECASTING SERIES CONTAINING OFFSETTING BREAKS: OLD SCHOOL AND NEW SCHOOL METHODS OF FORECASTING TRANSNATIONAL TERRORISM

Transnational terrorism data are difficult to forecast because they contain an unknown number of structural breaks of unknown functional form. The rise of religious fundamentalism, the demise of the Soviet Union, and the rise of al Qaeda have changed the nature of transnational terrorism. ‘Old School’ forecasting methods simply smooth or difference the data. ‘New School’ methods use estimated break dates to control for regime shifts when forecasting. We compare the various forecasting methods using a Monte Carlo study with data containing different types of breaks. The studys results are used to forecast various types of transnational terrorist incidents.

Taylor) Rules versus Discretion in U.S. Monetary Policy

The Taylor rule has been the dominant metric for monetary policy evaluation over the past 20 years, and it has become common practice to identify periods where policy either adheres closely to or deviates from the Taylor rule benchmark. The purpose of this paper is to identify (Taylor) rules-based and discretionary eras solely from the data so that knowledge of subsequent economic outcomes cannot influence the choice of the dates. We define Taylor rules-based and discretionary eras by smaller and larger Taylor rule deviations, the absolute value of the difference between the actual federal funds rate and the federal funds rate prescribed by the original Taylor rule, and use tests for multiple structural changes and Markov switching models to identify the eras. Monetary policy in the U.S. is characterized by a Taylor rules-based (low deviations) era until 1974, a discretionary (high deviations) era from 1974 to about 1985, a rules-based era from about 1985 to 2000, and a discretionary era from 2001 to 2008. The Taylor rule deviations are about three times as large in the discretionary eras than in the rules-based eras and are almost four times larger in the most discretionary era (1974 to 1984) than in the least discretionary era (1985 to 2000). With the Markov switching models, which allow for regime changes at the beginning and end of the sample, we also identify a discretionary era from 1965 to 1968 and a rules-based era in 2006 and 2007. The discretionary and rules-based eras closely correspond to periods where the Taylor rule deviations are above and below two percent.

Chapter 6 Forecasting Persistent Data with Possible Structural Breaks: Old School and New School Lessons Using OECD Unemployment Rates

In contrast to recent forecasting developments, “Old School” forecasting techniques, such as exponential smoothing and the Box–Jenkins methodology, do not attempt to explicitly model or estimate breaks in a time series. Adherents of the “New School” methodology argue that once breaks are well estimated, it is possible to control for regime shifts when forecasting. We compare the forecasts of monthly unemployment rates in 10 OECD countries using various Old School and New School methods. Although each method seems to have drawbacks and no one method dominates the others, the Old School methods often outperform the New School methods for forecasting the unemployment rates.

The Taylor Principles

We use tests for structural change to identify periods of low, positive, and negative Taylor rule deviations, the difference between the federal funds rate and the rate prescribed by the original Taylor rule. The tests define four monetary policy eras: a negative deviations era during the Great Inflation from 1965 to 1979, a positive deviations era during the Volcker disinflation from 1979 to 1987, a low deviations era during the Great Moderation from 1987 to 2000, and another negative deviations era from 2001 to 2014. We then estimate Taylor rules for the different eras. The most important violations of the Taylor principles, the four elements that comprise the Taylor rule, are that the coefficient on inflation was too low during the Great Inflation and that the coefficient on the output gap was too low during the Volcker disinflation. We then analyze deviations from several alterations of the original Taylor rule, which identify a negative deviations era from 2000 to 2007 and a low deviations era from 2007 to 2014. Between 2000 and 2007, Fed policy cannot be explained by any variant of the Taylor rule while, between 2007 and 2014, Fed policy is consistent with a rule where the federal funds rate does not respond at all to inflation and either responds very strongly to the output gap or incorporates a time-varying equilibrium real interest rate.

Policy Rules and Economic Performance

Monetary policy evaluation has evolved over time from fixed rules versus discretion to policy rules versus constrained discretion. We propose a metric to evaluate monetary policy rules by calculating quadratic loss ratios, the (inflation plus unemployment) loss in high deviations periods divided by the loss in low deviations periods, with policy rules with higher loss ratios preferred to rules with lower loss ratios. The central result of the paper is that rules with larger coefficients on inflation than on the output gap have higher loss ratios (and are therefore preferred to) rules with equal coefficients or rules with higher coefficients on the output gap. This result is robust to policy lags between one and two years, different weights on inflation loss than on unemployment loss, various definitions of high and low deviations periods, and time varying equilibrium real interest rates. We conclude that the Fed should “constrain” constrained direction by responding more strongly to inflation gaps than to output gaps.

Policy Rule Legislation in Practice

The legislated policy rules proposed by the Federal Reserve Accountability and Transparency Act of 2014 and the Financial Regulatory Improvement Act of 2015 have the potential to transform the conduct of monetary policy. If enacted, the Fed would have the obligation to explicitly state a benchmark for how the federal funds rate would respond to variables such as inflation and the output gap that enter into different variants of Taylor rules. While the Fed would choose its own legislated policy rule, it would be required to explain deviations from the rule and/or changes to the rule. Suppose that policy rule legislation had been in place for the past 60 years. When would the Fed have been in compliance, and when would there have been deviations from or changes to the rule? The central result of the paper is that, among the class of rules we consider, there is no single legislated policy rule that would have avoided large deviations over extended periods of time. Rules that produce low deviations during most of the 1950s and early 1960s produce high deviations during the late 1960s and between 1975 and 1985. More recently, rules that produce low deviations during the first half of the 2000s produce high deviations during the first half of the 2010s, and vice versa. If the legislation was adopted and the Fed wanted to avoid deviations from and/or changes to the rule, this would increase the predictability of monetary policy. Based on historical and statistical research showing that economic performance is better in rules-based than in discretionary eras, we believe this would be a desirable outcome.