Bayesian estimation of monetary DSGE models and testing for indeterminacy

Abstract

This thesis consists of three self-contained papers on U.S. monetary policy. The first paper examines monetary policy in the early 2000s, a prolonged period of low interest rates for which the efficacy of policy is intensely debated. Through the lens of an estimated simple New Keynesian (NK) model, the paper finds that when measuring inflation using headline CPI, the Federal Reserve's response to inflation turns out to be passive, therefore implying indeterminacy. Only when measuring inflation using core PCE does monetary policy appear to have been sufficiently active to rule out indeterminacy. Faced with this dilemma, the paper finally estimates an extended model that distinguishes between core and headline inflation. Estimation results from this model decisively rule out indeterminacy and suggest that indeed the Fed has put more weight on core PCE. The second paper contrasts interest rate rules featuring fixed versus time-varying inflation target. It finds that the rule embedding time variation in inflation target empirically fits better and that the Fed has been responding strongly to the inflation gap not only in the Great Moderation period but also in the Great Inflation era. Therefore, this finding rules out self-fulfilling inflation expectations as an explanation of the high inflation episode in the 1970s. The paper also documents that changes in monetary policy have dampened most of the fluctuations in the inflation gap and contributed to the decline in its persistence and predictability. The third paper investigates the impact of commodity price fluctuations on monetary policy and estimates a NK model with an explicit role for commodity price fluctuations. It finds that the pre-Volcker period is characterized by a determinate version of the model featuring high degree of real wage rigidity In this environment, the commodity price shocks of the 1970s created a severe trade-off between inflation and output gap stabilization. Faced with this puzzle, the central bank chose to react aggressively to both inflation and output growth, but not to the output gap, thereby ruling out indeterminacy. The paper further documents that oil price shocks are no longer as inflationary as they used to be due to a decline in real wage rigidity, thereby explaining the resilience of the economy to sustained oil price hikes in the 2000s.