NBER macroeconomics annual 1997 ben s bernanke and julio rotemberg

NBER Macroeconom Annual 1997 NationalBureauof EconomicResearch NBER Macroeconomics Annual 1997 Editors and BenS Bernanke JulioJ Rotemberg THE MIT PRESS Cambridge,Massachusetts London, England Send ordersand business informationto: The MIT Press Five Cambridge Center Cambridge, MA 02142 In the United Kingdom, continental Europe, and the Middle East and Africa, send ordersand business correspondenceto: The MIT Press Ltd Fitzroy House, 11 Chenies Street London WC1E 7ET England ISSN: 0889-3365 ISBN: hardcover 0-262-02435-7 paperback 0-262-52242-X CopyrightInformation Permission to photocopy articles for internal or personal use, or the internal or personal use of specific clients, is granted by the copyright owner for users registered with the Copyright Clearance Center (CCC) Transactional Reporting Service, provided that the fee of $10.00 per copy is paid directly to CCC, 222 Rosewood Drive, Danvers, MA 01923 The fee code for users of the Transactional Reporting Service is: 0889-3365/97 $10.00 For those organizations that have been granted a photocopy license with CCC, a separate system of payment has been arranged ? 1997 by The National Bureau of Economic Research and the Massachusetts Institute of Technology BYAFFILIATION NBERBOARDOF DIRECTORS OFFICERS John H Biggs, Chairman Carl F Christ, Vice Chairman Martin Feldstein, Presidentand ChiefExecutiveOfficer Gerald A Polansky, Treasurer Sam Parker, Directorof Financeand Administration Susan Colligan, Assistant CorporateSecretary Deborah Mankiw, Assistant CorporateSecretary DIRECTORS AT LARGE Peter C Aldrich Elizabeth E Bailey John H Biggs Andrew Brimmer Carl F Christ Don R Conlan Kathleen B Cooper Jean A Crockett George C Eads Martin Feldstein George Hatsopoulos Karen N Horn Lawrence R Klein Leo Melamed Merton H Miller Michael H Moskow Robert T Parry Peter G Peterson Richard N Rosett Bert Seidman Kathleen P Utgoff Donald S Wasserman Marina v N Whitman John O Wilson DIRECTORS BY UNIVERSITY APPOINTMENT George Akerlof, California, Berkeley Jagdish Bhagwati, Columbia William C Brainard, Yale Glen G Cain, Wisconsin Franklin Fisher, MassachusettsInstitute of Technology Saul H Hymans, Michigan Marjorie B McElroy, Duke Joel Mokyr, Northwestern Andrew Postlewaite, Pennsylvania Nathan Rosenberg, Stanford Harold T Shapiro, Princeton Craig Swan, Minnesota David B Yoffie, Harvard Arnold Zellner, Chicago DIRECTORS BY APPOINTMENT OF OTHER ORGANIZATIONS Marcel Boyer, Canadian Economics Association Mark Drabenstott, American Agricultural EconomicsAssociation William C Dunkelberg, National Association of Business Economists Richard A Easterlin, EconomicHistory Association Gail D Foster, The ConferenceBoard A Ronald Gallant, American Statistical Association Robert S Hamada, AmericanFinance Association John J Siegfried, AmericanEconomics Association Rudolph A Oswald, American Federationof Laborand Congressof Industrial Organizations Gerald A Polansky, American Institute of CertifiedPublic Accountants Josh S Weston, Committeefor EconomicDevelopment DIRECTORS EMERITI Moses Abramovitz Franklin A Lindsay James J O'Leary Paul W McCracken George T Conklin, Jr George B Roberts Thomas D Flynn Eli Shapiro Geoffrey H Moore Because this volume is a record of conference proceedings, it has been exempted from the rules governing critical review of manuscripts by the Board of Directors of the National Bureau (resolution adopted June 1948, as revised 21 November 1949 and 20 April 1968) Contents Editorial: Ben Bernankeand Julio Rotemberg Abstracts FISCALPOLICYIN LATINAMERICA 11 Michael Gavin and RobertoPerotti COMMENTS:Torsten Persson 61 Aaron Tomell 67 DISCUSSION 70 THE NEOCLASSICALREVIVALIN GROWTHECONOMICS:HAS IT GONE TOO FAR? 73 Peter Klenow and Andres Rodriguez-Clare COMMENTS:Greg Mankiw 103 Charles Jones 107 DISCUSSION 113 THE ECONOMICSOF PREFUNDINGSOCIALSECURITY AND MEDICAREBENEFITS 115 Martin Feldstein and Andrew Samwick COMMENTS:Rao Aiyagari 148 Lawrence Kotlikoff 158 DISCUSSION 162 UNEMPLOYMENT AND EXPECTATIONS, JUMPING(S,s) TRIGGERS, HOUSEHOLDBALANCESHEETS 165 Chris Carrolland Wendy Dunn vi *CONTENTS COMMENTS:Angus Deaton 217 Simon Gilchrist 220 DISCUSSION 227 THENEW NEOCLASSICALSYNTHESISAND THEROLEOF MONETARYPOLICY 231 Marvin Goodfriendand RobertKing COMMENTS:Ellen McGrattan 283 Olivier Blanchard 289 DISCUSSION 294 FORTHE FRAMEWORK AN OPTIMIZATION-BASED ECONOMETRIC EVALUATIONOF MONETARYPOLICY 297 Julio Rotembergand Michael Woodford COMMENTS:Jeffrey Fuhrer 346 Bennett McCallum 355 DISCUSSION 360 NBER Editorial, Annual Macroeconomics 1997 The 1997 edition of the NBER MacroeconomicsAnnual contains, as usual, a mixture of policy-focused research and studies of broader positive issues within macroeconomics Two of the papers are concerned with fiscal policy: Michael Gavin and Roberto Perotti provide a comprehensive new data set on fiscal policy in Latin America, which they use both to characterize the cyclical behavior of government budgets in that region and to develop some hypotheses about the determinants of that behavior On the domestic fiscal front, Martin Feldstein and Andrew Samwick propose an approach for changing the U.S social security system from its current "pay-as-you-go" format to a fully funded program, and they discuss the likely effects of this change on the U.S economy The volume also includes two papers on monetary policy: Marvin Goodfriend and Robert King draw some lessons for monetary policy from what they perceive to be a new consensus among research-oriented macroeconomists, which they dub the "new neoclassical synthesis"; and Julio Rotemberg and Michael Woodford compute the properties of optimal monetary policies for a dynamic sticky-price model of the U.S economy Finally, this issue of the MacroAnnual includes two papers on big issues of positive economics, as Peter Klenow and Andres Rodriguez revisit the question of why rates of economic growth differ across countries, and Christopher Carroll and Wendy Dunn seek to understand how consumer debt and asset holdings help determine the evolution of aggregate consumption Gavin and Perotti have painstakingly assembled data on consolidated government receipts and expenditures for thirteen Latin American countries Based on these data, the authors demonstrate that there are large differences between the typical cyclical behavior of fiscal variables in Latin America and that found in the major industrial countries The most *BERNANKE& ROTEMBERG dramatic difference is that fiscal policy tends to be procyclical in Latin America, with government spending in particular falling during recessions, in contrast to the more familiar pattern of countercyclical fiscal policy found in most OECD countries While they cannot completely rule out other explanations, the authors argue that this procyclical behavior is due primarily to the inability of Latin American governments to borrow in bad times Since these are also times in which revenue falls (revenue is procyclical both in industrial countries and in Latin America, but somewhat more so in the latter), Latin American governments are forced to curtail their expenditures at the very time that (from a Keynesian perspective, at least) they may be most needed Another interesting set of findings in Gavin and Perotti's paper concerns the connection between the exchange-rate regime and fiscal policy It is often alleged that fixed exchange rates induce greater fiscal discipline The paper shows that this conventional wisdom is not borne out empirically, at least in Latin America Periods of fixed exchange rates, it turns out, are actually associated with larger, rather than smaller, government budget deficits Moreover, periods of fixed exchange rates often end in exchange-rate crises, following which, as part of a stabilization package, deficits are cut While a sophisticated version of the theory that fixed exchange rates promote fiscal discipline may still prove correct, the authors have shown that crude versions of this story not fit the facts for Latin America This finding provoked a lively discussion, with the formal discussants proving several alternative interpretations of Gavin and Perotti's results In their paper, Klenow and Rodriguez return to the question of whether one can explain differences in output per capita across countries by differences in physical and human capital alone, assuming that all countries have identical production possibilities An important contribution of their work is the construction of new estimates of human capital that take into account differences across countries in the return to schooling at the primary and secondary levels These data allow the authors to estimate the extent to which countries' total incomes ought to vary as a result of differences in schooling (as well as in physical capital) Klenow and Rodriguez find that these implied differences in income not go far in explaining the actual disparity in incomes across countries, and so conclude that variations in national income levels are mostly due to differences in productivity, as opposed to differences in inputs Since they regard much recent work on growth (the "neoclassical revival") as having emphasized the latter instead of the former, they call for a change in the direction of growth research A particularly challenging fact emerging from this work, as Charles Jones emphasizes in his comments, is that Editorial countries which are very productive also tend to have high levels of human and physical capital, i.e., productivity and the level of inputs are positively correlated The burning question then becomes whether factor accumulation causes productivity improvements, because the social returns to human and physical capital are higher than the private return; or whether differences in productivity that stem from other sources lead factors to be accumulated Feldstein and Samwick's paper suggests that there may be a surprisingly easy solution to the problems of the social security program in the United States, one that will make essentially everybody better off They argue that by slightly increasing taxes on people who are currently working it would be possible to phase out the existing pay-as-you-go system, under which benefits are paid largely from current worker contributions, in favor of a system in which retirement benefits received by an individual are financed by that person's own past contributions The authors' calculations show that the contributions needed to fund one's own retirement appear to be quite small relative to the taxes that would have to be paid under a pay-as-you-go system with the same retirement benefits The reason for this difference is that the rate of return on capital (which is what people would earn on their social security contributions under the proposed, fully funded system) far exceeds the "rate of return" on contributions to the pay-as-you-go system (which roughly equals the growth rate of the economy) A critical issue, which received much attention at the conference, is why there should be such a big difference between the two rates of return, particularly since the riskfree rate of return in the United States is not much above the economy's growth rate As stressed by Rao Aiyagari in his comments, if one takes the view that the difference between the average return on capital and the risk-free rate stems from people's aversion to the risks inherent in holding claims on capital, then the prefunding approach proposed by Feldstein and Samwick is less attractive; people would not feel that the higher expected return available under prefunding fully compensates them for the additional risk they would bear On the other hand, Feldstein and Samwick's proposal is more attractive if one believes that the difference in returns arises from limited participation in equity markets, since in this case prefunding would provide less well-off people an opportunity to earn much more on their contributions than they have been able to in the past Another important, and related, issue pertinent to Feldstein and Samwick's proposal is the extent to which it would increase national saving The authors suggest a positive saving effect, arising because a mandatory increase in contributions, by reducing current resources, should act to *BERNANKE& ROTEMBERG depress consumption In his comments, Lawrence Kotlikoff expressed some skepticism about the empirical importance of this channel, suggesting that in reality people would simply offset increased social security contributions by reducing other forms of saving (although whether the majority of the population has sufficient liquid assets to this is debatable) Kotlikoff thought that the proposal might indeed increase saving, but rather through a second potential channel: He argued that the elimination of future transfers from the young to the old would effectively reduce the wealth of those people currently working, thereby inducing them to consume less Carroll and Dunn develop the idea, which has been advanced by policymakers such as Alan Greenspan, that increased borrowing by consumers during the 1980s has made aggregate consumption more vulnerable to changes in consumer sentiment In the first part of their paper they provide some evidence on the determinants of consumption, the strongest finding being that consumption appears to be particularly sensitive to people's beliefs about the risks of becoming unemployed; however, the reduced-form relationships between consumption and measures of indebtedness are generally found to be weak The greatest portion of Carroll and Dunn's paper is devoted to the development of a theoretical model which attempts to rationalize Greenspan's hypothesis by studying the behavior of individuals who (1) must choose whether to rent or own their home and (2) are motivated to keep a buffer stock of liquid assets that can be used for unforeseen contingencies It is assumed that homeownership is cheaper in the long run than renting but involves the commitment of both a down payment and a future stream of mortgage payments, which can be changed only by bearing the heavy transaction costs of selling the home Thus in deciding to purchase a house the consumer faces a tradeoff between lower expected living costs on the one hand, and greater financial flexibility in the face of possibly adverse income shocks on the other The model is difficult to solve, even numerically, because of the large number of state variables However, simulations of the model suggest that when consumers become more pessimistic about their future employment prospects, they attempt to increase their buffer stocks of liquid assets and are thus less willing to make a down payment on a house Further, the model can reproduce the stylized facts about the 1980s, in that a credit-market liberalization (e.g., a reduction in the required down payment) is shown to lead to a runup in consumer debt, and the higher debt burden in turn increases the sensitivity of consumer spending to labor-market uncertainty Much of the discussion of the paper concerned how a complex simulation model of the sort used in this paper should be tested and evaluated, given that (because of compu- Comment*347 micro foundations But it has a hope of being robust to the critique Second, the welfare function for policy analysis arises naturally from the agents' objective function Many pervious studies have used ad hoc objective functions, such as weighted combinations of the variances of output around potential and inflation around its target It is not obvious that such metrics appropriately reflect the loss of welfare associated with employment and price fluctuations A second goal of the paper is to estimate the model, seriously confronting the structure with the important dynamic properties of output, inflation, and nominal interest rates as summarized in a vector autoregression This impulse is essential if one's ultimate goal is to use the model to deliver advice to monetary policymakers It is too easy to write an elegant theoretical model, and too difficult to write a model that also replicates key dynamic elements found in the data Policymakers will rightly be leery of the former, and at least somewhat more comfortable with the latter The paper then uses the model to perform counterfactual policy exercises (how would a different policy have altered the outcome?) and to compute an "optimal" monetary policy Both of these model exercises are of inherent interest to practical policymakers and to researchers In my discussion of the paper, I want to focus on a few fundamental issues Is the Rotemberg-Woodford model still subject to the Lucas critique? How efficiently are the behavioral parameters estimated, and how generalizable is their estimation technique? How does monetary policy work in the model? How important are the innovations (the disturbance terms) to the empirical success of the model? To anticipate, I will suggest that the model is still subject to the Lucas critique in two important ways, that the behavioral parameters could be estimated with a more efficient use of information, that monetary policy works in a nonstandard way in the model, and that the dynamics in the disturbance terms are crucial to the empirical performance of the model TheLucasCritique The paper claims that its modeling strategy adequately addresses the Lucas critique I think it has only partially done so The Lucas critique is, after all, a theoretical assertion that ultimately rests on empirical testing Much of the critique is deflected when we include rational expectations 348 *FUHRER in our models, so that agents alter their view of the future when policymakers and other alter the systematic component of their behavior Some more of the critique may be deflected-although we cannot know this a priori-when we use optimizing foundations for our models The logic is, of course, that an individuals' taste parameters may be assumed to be fairly stable in response to the behavior of policymakers (or others), whereas the reduced-form consumption rule that arises from the interaction of taste parameters, budget constraints, and expectations of future resources should not be assumed to be stable When a model represents aggregate consumer choice with a single parameter for the intertemporal elasticity of substitution, a single parameter reflecting the time rate of preference, and so on, we must admit the possibility that these aggregated concepts may not be time-invariant The effects of the changing demographic composition of the population and the introduction of new products and technologies may render aggregate "micro" parameters unstable In any event, we can and must test whether such models are in fact stable across time and regimes Such testing would be easy to in this paper The authors have already taken a stand on when a break in monetary regime occurred (1979) They can easily allow for a separate reaction function before 1980 and test for the stability of the other structural parameters before and after 1980 Such a test would go a long way towards empirically establishing the robustness of the model specification to the Lucas critique I will return to a second Lucas-critique concern in a moment The thrust of the argument is that the disturbance terms identified in the paper are at least as likely to be subject to the Lucas critique as are the behavioral parameters Estimatingthe StructuralParameters The behavioral parameters are chosen so as to match the structural model's and the VAR's response to a federal-funds-rate shock However, as Rotemberg and Woodford document in their framework, the fundsrate shock accounts for no more than 5% of the variation in the endogenous variables While this estimator should deliver consistent estimates of the behavioral parameters, it is certainly inefficient with respect to the full set of information in the vector autocovariance function used as a metric by Rotemberg and Woodford later in the paper The funds-rate impulse responses contain some of the second-moment information in the data, weighted in a particular way The autocovariance function has all the second-moment information in the VAR An alternative to the impulse-response estimator is to fit the model to the autocovariance Comment 349 function by maximizing the model's likelihood This method is both computationally feasible and econometrically efficient.1 Of more concern is the extent to which Rotemberg and Woodford's estimation strategy can be generalized It is well known that it is not possible to map reduced-form responses to (orthogonalized) VAR innovations into structural model responses to model innovations The mapping is one-to-one in the case studied in this paper: the VAR-derived reaction function is common to both the VAR and the structural model But as Rotemberg and Woodford show in Section of their paper, the correspondence is nontrivial for the other disturbances in their model In general, such a mapping will not be possible, and thus the estimator cannot be used for most cases MonetaryPolicyin theModel Monetary policy behaves differently in this model than in conventional descriptions The reason is that there are essentially no lags in this model other than those in the reaction function The one exception is consumption, which is assumed to be predetermined two periods ahead I don't know what economic behavior motivates this assumption, although it certainly helps the model to fit the delayed response of output to a federal-funds-rate shock in the VAR Without this assumption, if monetary policy did not respond with a lag, then the model would have literally no dynamics (other than the dynamics in the disturbance terms) Everything would jump immediately to its equilibrium (even with sticky prices) This sounds very different from standard depictions of monetary policy Many have cited Friedman's "long and variable lags" of the effects of policy The Fed needs to look ahead because it is steering a huge, inertial tanker that responds very gradually to its actions That sense is totally absent in Rotemberg and Woodford's model In fact, in their model, the Fed is driving an extremely responsive Lamborghini, but for no particular reason it moves the steering wheel very gradually, as if it were at the wheel of a 1972 Ford Pinto This logical disconnect between the Fed's inertial behavior and the economy it attempts to influence allows the structural model to exhibit some persistent dynamics, but one has to wonder why the Fed would act in that way if the economy really behaved as depicted here Estimating the structural parameters in this way took less than one minute on a Sun workstation 350 *FUHRER TheRoleof theDisturbance Terms Rotemberg and Woodford identify disturbance terms that embody complex dynamics, which, when added to the behavioral equations in the model, capture almost all of the covariance information in the VAR What does this exercise tell us? In short, I think it tells us that they should wave the white flag It seems fair to ask economists to surrender when they are forced to conclude that the dynamics present in the data can only be explained by things whose dynamics arise for reasons that we can't explain However, the extent to which the disturbance terms account for the dynamics is not as clear as it could be in the paper Therefore, I propose a model diagnostic to determine the contribution made by the disturbances: I exclude the disturbances from the model, and compute the resulting "error-free" autocovariance function.2 As Figure of this comment shows, the resulting autocovariance functions don't look at all like those in Figure of the paper For Rotemberg and Woodford's model, this diagnostic tells us that the disturbance terms are responsible for explaining virtually all of the dynamics evident in the VAR.3 Put in a more positive light, Rotemberg and Woodford's paper raises a fundamental question about where to draw the line between a model's ability to generate dynamics based on its behavioral equations and based on its error processes Microeconomic shocks to taste and technology might well be serially correlated, so one should not by default assume that they are i.i.d The question is how much the model should rely on its disturbances for its dynamics Finally, it is not clear why the authors use VAR-based expectations to solve for the disturbance terms This procedure implies a mixed-bag model with structural parameters derived from the impulse response assuming rational expectations, and disturbances that are computed taking those parameters as given and using VAR expectations Below, I sketch a method that retrieves the disturbance terms jointly with the structural parameters, assuming rational expectations throughout To estimate the autocovariance function, I compute the disturbance terms implied by Rotemberg and Woodford's model and parameters, using methods documented in Fuhrer and Moore (1995) I then "whiten" the disturbances, regressing each on its own lags and the lags of other disturbances, and calculate the residual covariance matrix from these residuals This residual covariance matrix, together with the structural parameters, uniquely determines the autocovariance function implied by the model I checked the sensitivity of the autocovariance function to the estimation of the residual covariance matrix; the qualitative results presented here in Figure are completely unaffected by modest changes in the estimated covariance matrix An autocovariance function computed using alternative parameters estimated via FIML produce a nearly identical plot Figure COMPARISON OF AUTOCOVARIANCE FUNCTIONS: VAR VS ROTEMBERG-WOODFORD MODEL Pi, pi(-k) x10-4 ~~~~~2 23->>>>> 0- - - x10 10 ? -2 10 15 20 - - - - - - - - - 0 Pi, y(-k) x10-5 20 4- 10 15 0o20 R, y(-k) x10-4 3- 15 2- 10 [...]... important role in the weakness of consumption during and after the 1990 recession TheNew Neoclassical SynthesisandtheRoleof Monetary Policy MARVIN GOODFRIEND AND ROBERTG KING Macroeconomics is moving toward a New Neoclassical Synthesis, which like the synthesis of the 196 0s melds classical with Keynesian ideas This paper describes the key features of the new synthesis and its implications for the role of monetary... explaining the causes of productivity differences across countries TheEconomics SocialSecurityandMedicare of Prefunding Benefits MARTIN FELDSTEIN AND ANDREW SAMWICK This paper presents a detailed analysis of the economics of prefunding benefits for the aged, focusing on social security but indicating some of the analogous magnitudes for prefunding Medicare benefits We use detailed census and social security... Neoclassical Synthesis rationalizes an activist monetary policy, which is a simple system of inflation targets Under this "neutral" monetary policy, real quantities evolve as suggested in the literature on real business cycles Going beyond broad principles, we use the new synthesis to address several operational aspects of inflation targeting These include its practicality, the response to oil shocks,... policy has been under-studied, perhaps with adverse implications for policy, and certainly with lost opportunities to confront theories, Prepared for the NBER MacroeconomicsAnnual, 1997 The authors thank Ben Beranke, Ricardo Hausmann, Philip Lane, Torsten Persson, Julio Rotemberg, Emesto Talvi, Vito Tanzi, Aaron Tornell, and Andres Velasco for useful comments and discussions Construction of the database... tational considerations) it is possible to conduct simulations for only a small number of parameter values Goodfriend and King see macroeconomics evolving towards a new consensus, which combines new Keynesian theories of price stickiness and imperfect competition with the real business cycle (RBC) assumption that the behavior of consumption, investment, and labor supply can be rationalized as choices of optimizing... includes transfers of profits from fiscal monopolies and state-owned enterprises, royalties from oil extraction, etc A comparison of the structure of tax revenue is possible only for the central government, because the numbers of observations on the individual revenue items of local governments drop substantially in Latin America This table illustrates some familiar results, and some less familiar ones... GDP This asymmetry is statistically significant at very high confidence levels It is consistent with the idea that recessions are economically and/ or politically more costly than output booms, and that the fiscal policy response to them is accordingly stronger It is also consistent with the idea that some elements of the fiscal structure, such as unemployment compensation, are relatively insensitive... booms, at least permit the appearance of surpluses that emerge from the automatic stabilizers that are built into the fiscal structure, and should perhaps go further with discretionary tax increases or spending cuts Either approach suggests that surpluses should increase 30 *GAVIN& PEROTTI Table8 CYCLICALPROPERTIES OF THEFISCALBALANCE OLS coefficients Goodand bad times distinguished Overall Industrial... Generalgovernment.Dependentvariableis the changein the overallfiscalsurplus,measuredas a share of GDP t-statisticsare given in parentheses.Countrydummyvariablesare includedin all regressions in good times and decline in bad We begin in Section 4.1 with the facts, and turn to interpretations in Section 4.2 4.1 SYLIZEDFACTS The first column of Table 8 shows that the presumption of procyclical surpluses is borne out by the industrial-country... practically useful policy implications, and they consider a variety of issues, such as the optimal policy response to an oil price shock A main result is that monetary policy ought to stabilize prices, so that the effects of aggregate demand shocks are minimized and allocations mimic as closely as possible those implied by the RBC theory The authors also point out the difficulties inherent in using interest