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Monetary Policy in New Keynesian DSGE Models
Bhatnagar, Aryaman
Bhatnagar, Aryaman
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Abstract
Modern macroeconomics relies heavily on the use of New Keynesian Dynamic Stochastic General Equilibrium (NK-DSGE) models. These models have the dual advantage of combining the rigorous micro-foundations based approach of Real Business Cycle models with Keynesian elements such as monopolistic competition and nominal rigidities. Incorporating nominal price and wage rigidities creates a role for monetary policy in the economy. This feature makes New Keynesian models the ideal choice for analyzing monetary policy dynamics. However, while these models have been widely adopted by economists and are extremely useful for policy analysis, they often ignore or are not designed to accommodate key components, which could play a major role in driving economic dynamics.In that context, the goal of this dissertation is two-fold. First, we examine how monetary policy and the broader economy would be affected once we relax certain common assumptions seen in the standard New Keynesian model. Second, we analyze the choice and design of monetary policy rules. In particular, we explore the welfare implications of adopting alternative monetary policy rules such as labor income targeting and flexible money growth targeting.The dissertation consists of four chapters. In the first chapter, we drop the assumption of a single representative agent and analyze the impact of including non-Ricardian households. We focus on two key areas. The first is the link between monetary policy and consumption inequality in the presence of non-Ricardian households. We find that a contractionary monetary policy shock increases consumption inequality. Part of this increase is due to a novel government transfer channel. This channel becomes significantly stronger when steady state debt is positive. We also find that because of this link, the presence of non-Ricardian households amplifies the impact of monetary policy on output and inflation. The second area relates to the choice of monetary policy rule. We compare six monetary policy rules, including a new labor income targeting rule in which the central bank targets the growth rate of gross nominal labor income. We find that this new monetary policy regime produces the lowest welfare loss.In chapter two, we extend the non-Ricardian household framework to an open economy model with several empirically relevant features such as capital formation, cost of investment adjustment, and risk premium on foreign borrowing. The model is calibrated using data for a developed economy (USA) and a developing economy (India). We find that our earlier results regarding monetary policy, inequality, and the transfer channel hold in this modified framework. In addition to that, we also find that a government consumption shock can increase consumption inequality and that the presence of non-Ricardian households blunts the effects of fiscal policy. Finally, labor income targeting continues to be the superior rule in this model as well. Its performance improves even further if we assume that the central bank places a positive weight on consumption inequality.In chapter three we evaluate the performance of labor income targeting in two standard models. The first model is a small New Keynesian model in which we compare it with the Taylor Rule, Inflation Targeting, Nominal GDP Targeting, and Output Gap Targeting. We find that labor income targeting is the second-best rule after output gap targeting. It works well by reducing the volatility in output gap and wage inflation. Additionally, in contrast to gap targeting, labor income targeting does not suffer from determinacy issues and does not rely upon unobservable variables, thus making it a desirable policy choice. These results are robust to changes in parameter values. Next, we estimate a medium scale model using Bayesian techniques for the US economy and compare the performance of labor income targeting with the estimated Taylor rule. We find that LIT works better in the full sample as well in all the sub samples by generating lower variance for output gap, price inflation, and wage inflation. Our findings suggest that labor income targeting possesses desirable properties and could be a viable monetary policy alternative.Finally, in chapter four we move away from the standard “cashless” models and add money and monetary shocks. We answer two questions: 1) Do money rules increase welfare as opposed to using the conventional Taylor rule? and 2) If so, when do these rules increase welfare? In an economy calibrated to match US data, we find that money rules do outperform the Taylor rule in terms of welfare. Among money rules, we see that a flexible money growth rule generates the highest welfare. This is followed by a modified Taylor rule which incorporates monetary aggregates and then the constant money growth rule. These results are robust to changes in model parameters. Next, we look at the impact of key monetary parameters on the welfare gains. We find that a low currency to deposit ratio, elasticity of substitution, reserves to money supply ratio, ratio of banking activities, and money supply to nominal consumption ratio are associated with higher welfare gains. Furthermore, the gains of using money rules are higher under monetary shocks as opposed to real shocks.
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Date
2023-05-31
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University of Kansas
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Keywords
Economics, DSGE Models, Inflation Targeting, Labor Income Targeting, Monetary Policy, New Keynesian, Taylor Rule