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Monetary Policy and a Stock Market Boom-Bust Cycle. Lawrence Christiano, Roberto Motto and Massimo Rostagno. Inflation has been relatively stable for a while Attention has shifted to other issues: stock market volatility. Stock market has been volatile:

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monetary policy and a stock market boom bust cycle

Monetary Policy and a Stock Market Boom-Bust Cycle

Lawrence Christiano, Roberto Motto and Massimo Rostagno

Inflation has been relatively stable for a while
  • Attention has shifted to other issues: stock market volatility

Stock market has been volatile:

  • Is it ‘excessively’ volatile in the welfare sense?
  • What role (if any) does (should) monetary policy play?
  • Conventional wisdom –
  • Bernanke-Gertler: ‘leave it alone’
  • In any case, inflation targeting will automatically stabilize

Inflation appears to be falling

during the start-up of boom-bust

episodes in US.

stock market boom bust cycle
‘Stock Market Boom-Bust Cycle’
  • Episode in which:
    • Stock prices, consumption, investment, output, employment rise sharply and then fall
    • Inflation low during boom
  • US examples:
    • Interwar period
    • Mid 1950s - mid 1970s
    • Mid 1990s - present
rational theory of boom bust
Rational Theory of Boom-Bust
  • Follow Beaudry-Portier (see also more recently Jaimovich-Rebelo)
    • Boom-bust cycle triggered by:
      • Expectation that technology will be strong in future
      • Expectation ultimately not realized
  • Examples:
    • Fiber-optic cable
    • Motorola satellites
key findings
Key Findings
  • Start by trying to build a non-monetary theory of boom-bust cycle
    • With investment adjustment costs, habit persistence, can almost get successful theory
    • However, miss on several key dimensions
      • Stock market goes wrong way, highly volatile real rate, no persistence
  • When we integrate sticky (allocative) wages and an inflation-targeting central bank, we obtain a more successful theory.
    • perhaps boom-bust cycles reflect interaction of sticky wages and inflation targeting monetary policy
    • an example of Levin, et al point that inflation targeting not optimal when wages are sticky
  • Boom-bust in non-monetary economy
  • Bring in sticky wages/prices and monetary policy as simply as possible
  • Redo analysis in model with additional financial frictions
    • banking system (CCE), agency costs (BGG)
    • permits addressing role of credit and monetary aggregates
parameterization of rbc model
Parameterization of RBC Model
  • Model is specialized version of model with many frictions estimated for US by Christiano-Motto-Rostagno (2006)
  • Parameters:
  • Steady state:
results for rbc model
Results for RBC Model
  • Habit persistence in preference and adjustment costs on change in investment crucial for getting ‘close’ to stock-market boom-bust…
  • However,
    • Stock market wrong
    • Real interest rate highly volatile
    • No persistence
using static adjustment costs doesn t help
Using Static Adjustment Costs Doesn’t Help
  • Static (‘standard’ adjustment costs)
conclusions so far
Conclusions so far:
  • Need:
    • habit persistence
    • need adjustment costs in changing the flow of investment (for economic interpretation of this formulation, see Matsuyama and Lucca).
  • Still, not good enough…..not great on persistence
  • Increase lead time in signal (p) from 4 to 12
why does price of capital fall
Why Does Price of Capital Fall?
  • Standard Present Value Formula:
  • Real rate spikes up – not surprising PV falls
why does price of capital fall1
Why Does Price of Capital Fall?...
  • Price of capital from implication that price equals marginal cost:

High anticipated investment implies that investment

today reduces future adjustment costs

monetizing the model
‘Monetizing the Model’
  • We add:
    • Calvo sticky price setup (‘Phillips curve’)
    • Calvo sticky wage equations
    • Intertemporal Euler equation for bonds
    • Take limit where money demand goes to zero
    • Monetary policy rule
goods production
Goods Production
  • Final goods:
  • Intermediate goods:
  • firms reoptimize and instead set price as follows:
sticky wages erceg henderson levin
Sticky Wages (Erceg, Henderson, Levin)
  • Homogeneous labor assembled from specialized household labor services:
  • households reoptimize wage in given period and set their wage as follows:
demand for money
Demand for Money
  • Money in the utility function:
  • We drive coefficient on money balances to zero in equilibrium conditions.
monetary policy
Monetary Policy
  • ‘Target interest rate’
  • Actual interest rate:
  • Parameters of monetary model
  • Now have a (sort of) reasonable model of boom-bust
    • highly persistent
    • ex post real interest rate moves only a very small amount
    • Stock price moves in ‘right’ way (though a little anemic).
  • Quantity movements in monetary model swamp movements in RBC model
    • Boom-bust (though triggered by real event) is primarily a monetary policy phenomenon
basic diagnosis
Basic Diagnosis
  • Application of logic in
    • Erceg, Christopher, Dale Henderson, and Andrew Levin, 2000, `Optimal Monetary Policy with Staggered Wage and Price Contracts,' Journal of Monetary Economics, 46, 281-313.
    • Levin, A., Onatski, A., Williams, J., Williams, N., 2005. "Monetary Policy under Uncertainty in Microfounded Macroeconometric Models." In: NBER Macroeconomics Annual 2005, Gertler, M., Rogoff, K., eds. Cambridge, MA: MIT Press.
  • Sticky wages are the key, sticky prices unimportant
  • Inflation targeting important
  • Real wage ‘should’ rise in boom, but is prevented:
    • wage is sticky
    • price is sticky downward, because of monetary policy

Sticky prices

don’t matter!



targeting important!

full model has credit monetary aggregates
‘Full’ Model has Credit, Monetary Aggregates
  • Model incorporates banking sector, as in Chari, Christiano and Eichenbaum.
    • M1, M3, demand deposits, currency, bank reserves.
  • Financial frictions as in Bernanke, Gertler and Gilchrist.
  • Total credit (borrowing of working capital by banks, plus loans to entrepreneurs).


own and rent out



need working

capital to pay factors

M1 ~ currency + demand deposis

M2/M3 ~ M1 + savings deposits

Credit ~ total borrowing (includes time deposits, but not currency)


(hold reserves)

Demand deposits,

Savings deposits,

Time deposits


  • BGG financial frictions attenuate somewhat the effects of boom-bust
  • Rationalizes monetary policy of looking at credit.
  • With habit persistence and cost-of-change adjustment costs, can make progress on generating stock market boom-bust.
    • But, problems…
  • Bring in sticky wages and inflation targeting, and can generate boom-bust
  • Perhaps monetary policy should react to other variables, such as credit growth.