Model Switching and Model Averaging in Time- Varying Parameter Regression Models

This paper investigates the usefulness of switching Gaussian state space models as a tool for implementing dynamic model selecting (DMS) or averaging (DMA) in time-varying parameter regression models. DMS methods allow for model switching, where a different model can be chosen at each point in time. Thus, they allow for the explanatory variables in the time-varying parameter regression model to change over time. DMA will carry out model averaging in a time-varying manner. We compare our exact approach to DMA/DMS to a popular existing procedure which relies on the use of forgetting factor approximations. In an application, we use DMS to select different predictors in an in ation forecasting application. We also compare different ways of implementing DMA/DMS and investigate whether they lead to similar results.

IInflation and Globalisation: A Dynamic Factor Model with Stochastic Volatility

National inflation rates reflect domestic and international (regional and global) influences. The relative importance of these components remains a controversial empirical issue. We extend the literature on inflation co-movement by utilising a dynamic factor model with stochastic volatility to account for shifts in the variance of inflation and endogenously determined regional groupings. We find that most of inflation variability is explained by the country specific disturbance term. Nevertheless, the contribution of the global component in explaining industrialised countries’ inflation rates has increased over time.

Optimal progressive taxation in a model with endogenous skill supply.

This paper examines whether efficiency considerations require that optimal labour income taxation is progressive or regressive in a model with skill heterogeneity, endogenous skill acquisition and a production sector with capital-skill complementarity. We find that wage inequality driven by the resource requirements of skill-creation implies progressive labour income taxation in the steady-state as well as along the transition path from the exogenous to optimal policy steady-state. We find that these results are explained by a lower labour supply elasticity for skilled versus unskilled labour which results from the introduction of the skill acquisition technology.

The Optimal Degree of Monetary-Discretion in a New Keynesian Model with Private Information

This paper considers the optimal degree of discretion in monetary policy when the central bank conducts policy based on its private information about the state of the economy and is unable to commit. Society seeks to maximize social welfare by imposing restrictions on the central bank's actions over time, and the central bank takes these restrictions and the New Keynesian Phillips curve as constraints. By solving a dynamic mechanism design problem we find that it is optimal to grant "constrained discretion" to the central bank by imposing both upper and lower bounds on permissible inflation, and that these bounds must be set in a history-dependent way. The optimal degree of discretion varies over time with the severity of the time-inconsistency problem, and, although no discretion is optimal when the time-inconsistency problem is very severe, our numerical experiment suggests that no-discretion is a transient phenomenon, and that some discretion is granted eventually.

Can a Lucas model with habit generate realistic conditional volatility in exchange rate returns?

In this paper, we attempt to give a theoretical underpinning to the well established empirical stylized fact that asset returns in general and the spot FOREX returns in particular display predictable volatility characteristics. Adopting Moore and Roche s habit persistence version of Lucas model we nd that both the innovation in the spot FOREX return and the FOREX return itself follow "ARCH" style processes. Using the impulse response functions (IRFs) we show that the baseline simulated FOREX series has "ARCH" properties in the quarterly frequency that match well the "ARCH" properties of the empirical monthly estimations in that when we scale the x-axis to synchronize the monthly and quarterly responses we find similar impulse responses to one unit shock in variance. The IRFs for the ARCH processes we estimate "look the same" with an approximately monotonic decreasing fashion. The Lucas two-country monetary model with habit can generate realistic conditional volatility in spot FOREX return.

Optimal Monetary Policy in a New Keynesian Model with Habits in Consumption

While consumption habits have been utilised as a means of generating a humpshaped output response to monetary policy shocks in sticky-price New Keynesian economies, there is relatively little analysis of the impact of habits (particularly,external habits) on optimal policy. In this paper we consider the implications of external habits for optimal monetary policy, when those habits either exist at the level of the aggregate basket of consumption goods (‘superficial’ habits) or at the level of individual goods (‘deep’ habits: see Ravn, Schmitt-Grohe, and Uribe (2006)). External habits generate an additional distortion in the economy, which implies that the flex-price equilibrium will no longer be efficient and that policy faces interesting new trade-offs and potential stabilisation biases. Furthermore, the endogenous mark-up behaviour, which emerges when habits are deep, can also significantly affect the optimal policy response to shocks, as well as dramatically affecting the stabilising properties of standard simple rules.

The Taylor Principle and (In-) Determinacy in a New Keynesian Model with hiring Frictions and Skill Loss

We introduce duration dependent skill decay among the unemployed into a New-Keynesian model with hiring frictions developed by Blanchard/Gali (2008). If the central bank responds only to (current, lagged or expected future) inflation and quarterly skill decay is above a threshold level, determinacy requires a coefficient on inflation smaller than one. The threshold level is plausible with little steady-state hiring and firing ("Continental European Calibration") but implausibly high in the opposite case ("American calibration"). Neither interest rate smoothing nor responding to the output gap helps to restore determinacy if skill decay exceeds the threshold level. However, a modest response to unemployment guarantees determinacy. Moreover, under indeterminacy, both an adverse sunspot shock and an adverse technology shock increase unemployment extremely persistently.

The Export Base Model with a Supply-Side Stimulus to the Export Sector

Paper delivered at the Western Regional Science Association Annual Conference, Sedona, Arizona, February, 2010.

Productivity shocks and aggregate fluctuations in an estimated endogenous growth model with human capital

Employing an endogenous growth model with human capital, this paper explores how productivity shocks in the goods and human capital producing sectors contribute to explaining aggregate fluctuations in output, consumption, investment and hours. Given the importance of accounting for both the dynamics and the trends in the data not captured by the theoretical growth model, we introduce a vector error correction model (VECM) of the measurement errors and estimate the model’s posterior density function using Bayesian methods. To contextualize our findings with those in the literature, we also assess whether the endogenous growth model or the standard real business cycle model better explains the observed variation in these aggregates. In addressing these issues we contribute to both the methods of analysis and the ongoing debate regarding the effects of innovations to productivity on macroeconomic activity.

Tax smoothing in a business cycle model with capital-skill complementarity

This paper undertakes a normative investigation of the quantitative properties of optimal tax smoothing in a business cycle model with state contingent debt, capital-skill complementarity, endogenous skill formation and stochastic shocks to public consumption as well as total factor and capital equipment productivity. Our main finding is that an empirically relevant restriction which does not allow the relative supply of skilled labour to adjust in response to aggregate shocks, signi cantly changes the cyclical properties of optimal labour taxes. Under a restricted relative skill supply, the government fi nds it optimal to adjust labour income tax rates so that the average net returns to skilled and unskilled labour hours exhibit the same dynamic behaviour as under fl exible skill supply.

A two-sector growth model with institutional saving and investment

This paper develops a two-sector growth model in which institutional investors play a significant role. A necessary and sufficient condition is established under which these investors own the entire capital stock in the long run. The dependence of the long-run growth rate on the behaviour of such investors, and the effects of a productivity increase are analysed.

Analysing the impact of public capital stock using the NEG wage equation: a panel data approach

This paper examines the relationship between the level of public infrastructure and the level of productivity using panel data for the Spanish provinces over the period 1984-2004, a period which is particularly relevant due to the substantial changes occurring in the Spanish economy at that time. The underlying model used for the data analysis is based on the wage equation, which is one of a handful of simultaneous equations which when satisfied correspond to the short-run equilibrium of New Economic Geography theory. This is estimated using a spatial panel model with fixed time and province effects, so that unmodelled space and time constant sources of heterogeneity are eliminated. The model assumes that productivity depends on the level of educational attainment and the public capital stock endowment of each province. The results show that although changes in productivity are positively associated with changes in public investment within the same province, there is a negative relationship between productivity changes and changes in public investment in other regions.

Learning about Risk and Return: A Simple Model of Bubbles and Crashes

This paper demonstrates that an asset pricing model with least-squares learning can lead to bubbles and crashes as endogenous responses to the fundamentals driving asset prices. When agents are risk-averse they need to make forecasts of the conditional variance of a stock’s return. Recursive updating of both the conditional variance and the expected return implies several mechanisms through which learning impacts stock prices. Extended periods of excess volatility, bubbles and crashes arise with a frequency that depends on the extent to which past data is discounted. A central role is played by changes over time in agents’ estimates of risk.

Fear of model misspecifcation and the robustness premium

Robust decision making implies welfare costs or robustness premia when the approximating model is the true data generating process. To examine the importance of these premia at the aggregate level we employ a simple two-sector dynamic general equilibrium model with human capital and introduce an additional form of precautionary behavior. The latter arises from the robust decision maker s ability to reduce the effects of model misspecification through allocating time and existing human capital to this end. We find that the extent of the robustness premia critically depends on the productivity of time relative to that of human capital. When the relative efficiency of time is low, despite transitory welfare costs, there are gains from following robust policies in the long-run. In contrast, high relative productivity of time implies misallocation costs that remain even in the long-run. Finally, depending on the technology used to reduce model uncertainty, we fi nd that while increasing the fear of model misspecfi cation leads to a net increase in precautionary behavior, investment and output can fall.

Time-consistent fiscal policy under heterogeneity: Conflicting or common interests?

This paper studies the aggregate and distributional implications of Markov-perfect tax-spending policy in a neoclassical growth model with capitalists and workers. Focusing on the long run, our main fi ndings are: (i) it is optimal for a benevolent government, which cares equally about its citizens, to tax capital heavily and to subsidise labour; (ii) a Pareto improving means to reduce ine¢ ciently high capital taxation under discretion is for the government to place greater weight on the welfare of capitalists; (iii) capitalists and workers preferences, regarding the optimal amount of "capitalist bias", are not aligned implying a conflict of interests.