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:

1. Is it ‘excessively’ volatile in the welfare sense?

2. What role (if any) does (should) monetary policy play?

3. Conventional wisdom – Bernanke-Gertler: ‘leave it alone’ In any case, inflation targeting will automatically stabilize

Inflation appears to be fallingduring the start-up of boom-bustepisodes in US.

‘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

• 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• 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

Outline

• 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• Model is specialized version of model with

many frictions estimated for US by Christiano-Motto-Rostagno (2006)

• Parameters:

• Steady state:

1.01358 0.25, z 1.01360.25, b 0.63, a 15.1,

0.40, 0.025, L 109.82, L 1, 0.83, p 4.

CY 0.64, K

Y 12.59, l 0.092

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

All wrong!

Adding habit persistence and investment adjustment costs.

Using Static Adjustment Costs Doesn’t Help

• Static (‘standard’ adjustment costs)

Kt 1 1 Kt I t ItK t

Kt

ItK t

c2

ItK t

2

Static adjustment costsdon’t help.

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

What do Agents Expect After Seeing a Signal?

Why Does Price of Capital Fall?• Standard Present Value Formula:

• Real rate spikes up – not surprising PV falls

Pk,t dCtdKt 1

, R t 1k Kt 1 1zt 1ht 1 1

11 rt 1

t 1 t, t ~ marginal utility of Ct

Pk,t i 1

j 1

i1

1 rt j1 i 1R t ik

Why Does Price of Capital Fall?...• Price of capital from implication that price

equals marginal cost:

PK,t

Static part ofmarginal cost

1

1 S ItIt 1

S ItIt 1

ItIt 1

1 PK,t 1

1 rt 1 S It 1

It

It 1It

2

High anticipated investment implies that investmenttoday reduces future adjustment costs

‘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• Final goods:

• Intermediate goods:

• firms reoptimize and instead set price as follows:

Yt 0

1Yjt

1 t dj

f, 1 f

Yjt tKjt ztl jt

1 zt if tKjt ztl jt 1 zt

0, otherwise, 0 1

1 p p

Pit t 1 1 Pi,t 1

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:

l t 0

1ht,i

1 w di

w, 1 w

Wj,t t 1 w 1 w zWj,t 1

1 w w

Demand for Money• Money in the utility function:

• We drive coefficient on money balances to zero in equilibrium conditions.

E tj

l 0 l t uCt l bCt l 1 L

h t,j1 L

1 L

Pt lCt lMt ld

1 q

1 q

Monetary Policy• ‘Target interest rate’

• Actual interest rate:

• Parameters of monetary model

R t E t t 1 y log Y tY t

R t iR t 1 1 i R t

f 1.20, w 1.05, p 0.63, w 0.81, 0.84,

w 0.13, i 0.81, 1.95, y 0.18, 0.

Findings• 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• 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 pricesdon’t matter!

Sticky wages matter!

Wage indexationmatters

Inflation targeting important!

‘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).

M1 ~ currency + demand deposis

M2/M3 ~ M1 + savings deposits

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

Entrepreneurs: own and rent out capital

Firms: need working capital to pay factors

Banks(hold reserves)

Households

Demand deposits,Savings deposits,Time deposits

Findings• BGG financial frictions attenuate

somewhat the effects of boom-bust

• Rationalizes monetary policy of looking at credit.

Conclusion

• 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.