Monetary Policy and a Stock Market Boom-Bust Cycle

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Monetary Policy and a Stock Market Boom-Bust Cycle

• Lawrence Christiano, Roberto Motto and Massimo
  Rostagno

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

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• 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

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Inflation appears to be falling during the
start-up of boom-bust episodes in US.
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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

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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

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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

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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

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Parameterization of RBC Model

• Model is specialized version of model with many
  frictions estimated for US by Christiano-Motto-Ros
  tagno (2006)
• Parameters
• Steady state

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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

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All wrong!
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Adding habit persistence and investment
adjustment costs.
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Using Static Adjustment Costs Doesnt Help

• Static (standard adjustment costs)

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Static adjustment costs dont help.
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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

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What do Agents Expect After Seeing a Signal?
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Why Does Price of Capital Fall?

• Standard Present Value Formula
• Real rate spikes up not surprising PV falls

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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
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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

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Goods Production

• Final goods
• Intermediate goods
• firms reoptimize and instead set price
  as follows

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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

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Demand for Money

• Money in the utility function
• We drive coefficient on money balances to zero in
  equilibrium conditions.

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Monetary Policy

• Target interest rate
• Actual interest rate
• Parameters of monetary model

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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

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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

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Sticky prices dont matter!
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Sticky wages matter!
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Wage indexation matters
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Inflation targeting important!
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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).

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• 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)
Demand deposits, Savings deposits, Time deposits
Households
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Findings

• BGG financial frictions attenuate somewhat the
  effects of boom-bust
• Rationalizes monetary policy of looking at credit.

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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.