jump diffusion processes and the term structure of interest rates the authors investigate the term structure of interest rates when the underlying state variables and production technologies follow the jump diffusion processes even in some cases where the traditional expectations theory about the term structure is consistent with general equilibrium under diffusion processes the traditional theory is not consistent under jump diffusion processes it is shown that bond prices are strictly higher under jump risks than otherwise and that consumers with logarithmic utility functions will develop hedge portfolios in the presence of jump diffusion a number of continuous time asset pricing models have been derived under stochastic diffusion processes with continuous sample paths see e g black and scholes 2 merton 21 breeden 3 and cox ingersoll and ross 8 however recent empirical studies see e g brown and dybvig 4 feinstone 10 and jarrow and rosenfeld 17 suggest that the underlying processes may follow

how much do rights matter summary do better political rights yield more economic development by addressing the econometric challenges plaguing this question we find support for a positive impact of rights on development for a significant grouping of countries the association is nonlinear the positive impact of rights is particularly strong at low rights levels it is either absent or negative in an intermediate rights range and returns to a moderate positive impact at high levels of rights there is also evidence to suggest that transitions from autocratic political dispensations are associated with significant negative output shocks

technology shocks and labor market dynamics some evidence and theory a positive technology shock may lead to a rise or a fall in per capita hours depending on how hours enter the empirical var model we provide evidence that independent of how hours enter the var a positive technology shock leads to a weak response in nominal wage inflation a modest decline in price inflation and a modest rise in the real wage in the short run and a permanent rise in the long run we then examine the ability of several competing theories to account for this var evidence our preferred model features sticky prices sticky nominal wages and habit formation the same model also does well in accounting for the labor market evidence in the post volcker period

interest rates inflation and federal reserve policy since 1980 this paper characterizes federal reserve policy since 1980 as one that actively manages short term nominal interest rates in order to control inflation and evaluates this policy using a dynamic stochastic sticky price model of the united states economy the results show that the fed s policy insulates aggregate output from the effects of exogenous demand side disturbances and by calling for a modest but persistent reduction in short term interest rates following a positive technology shock helps the economy to respond to supply side disturbances as it would in the absence of nominal rigidities

when do long run identifying restrictions give reliable results many recent articles have identified behavioral disturbances in vector autoregressions by imposing restrictions on the long run effects of shocks this article demonstrates that this approach will be unreliable unless the underlying economy satisfies three types of strong restrictions although many aspects of these issues have been raised before this article draws out and illustrates the implications for inferences under the long run scheme furthermore it provides strategies for dealing with the problems

inflation risk and international asset returns abstract we show that inflation risk is priced in international asset returns we analyze inflation risk in a framework that encompasses the international capital asset pricing model icapm of adler and dumas 1983 in contrast to the extant empirical literature on the icapm we relax the assumption that inflation rates are constant we estimate and test a conditional version of the model for the g5 countries france germany japan the uk and the us over the period 1975 1998 and find evidence of statistically and economically significant prices of inflation risk in addition to priced nominal exchange rate risk our results imply a rejection of the restrictions imposed by the icapm in an extension of our analysis to 2003 we show that even after the termination of nominal exchange rate fluctuations in the euro area in 1999 differences in inflation rates across countries entail non trivial real exchange rate risk premia

the eects of fiscal policy and its interactions with monetary policy in brazil this paper analyzes the eects of fiscal policy shocks on the dynamics of the economy and the interaction between fiscal and monetary policy using structural vector autoregressions svars we test the fiscal theory of the price level for brazil analyzing the response of public sector liabilities to primary surplus shocks for the hybrid identification we find that it is not possible to distinguish empirically between ricardian monetary dominance and non ricardian fiscal dominance regimes however using sign restrictions there is some evidence that the government followed a ricardian monetary dominance regime from january 2000 to june 2008

a method for taking models to the data abstract this paper develops a method for combining the power of a dynamic stochastic general equilibrium model with the flexibility of a vector autoregressive time series model to obtain a hybrid that can be taken directly to the data it estimates this hybrid model via maximum likelihood and uses the results to address a number of issues concerning the ability of a prototypical real business cycle model to explain movements in aggregate output and employment in the postwar us economy the stability of the real business cycle model s structural parameters and the performance of the hybrid model s out of sample forecasts

the cyclicality of separation and job finding rates this paper uses cps gross flow data to analyze the business cycle dynamics of separation and job finding rates and to quantify their contributions to overall unemployment variability cyclical changes in the separation rate are negatively correlated with changes in productivity and move contemporaneously with them while the job finding rate is positively correlated with and tends to lag productivity contemporaneous fluctuations in the separation rate explain between 40 and 50 percent of fluctuations in unemployment depending on how the data are detrended this figure becomes larger when dynamic interactions between the separation and job finding rates are considered

aid policies and growth reply in burnside and dollar 2000 we used standard regression techniques from the growth literature to measure the effect of foreign aid on growth the main finding in our paper was that the effect of foreign aid on growth depended on the macroeconomic policies of recipient countries in this issue william easterly et al 2004 challenge the robustness of our result to new data before commenting on their findings it is useful to review the basis of our original findings our paper focused on three versions of a panel growth regression estimated using data for 51 countries and six four year periods from 1970 to 1993 these regressions may be summarized as

vector autoregressions and reduced form representations of dsge models abstract the performance of dynamic stochastic general equilibrium models is often tested against estimated vars this requires that the data generating process consistent with the dsge theoretical model has a finite order var representation this paper discusses the assumptions needed for a finite order var p representation of a dsge model to exist when a var p is only an approximation to the exact infinite order var the truncated var p may return largely incorrect estimates of the impulse response function the results do not hinge on small sample bias or on incorrect identification assumptions but the bias introduced by truncation can lead to bias in the identification of the structural shocks identification strategies that work in the exact var representation perform poorly in the truncated var

regime switching approach to monetary policy effects even though monetary policy has kept interest rates at historically low levels the japanese economy has experienced long lasting recessions since the 1990s in this paper japanese data are employed to conduct an empirical analysis of changes in the effects of monetary policy on the real economy it is found that monetary policy effects vary depending on the phase of the business cycle and the lending attitudes diffusion indices more precisely policy effects are larger in recession but diminish in extreme recession and monetary policy is more effective when lenders attitudes are severe but less effective when they are excessively severe

gdp nowcasting application and constraints in a small open developing economy despite data limitations an attempt is made to find out if a gdp nowcasting model can provide reliable forecasts for a small open economy two competing bayesian vector autoregressive models are tested rigorously to obtain the optimal model by minimizing in sample forecasting errors the main finding of this study is that gdp nowcasting can produce reliable results for a small open economy despite the unavailability of sufficient data sets and the lack of high frequency indicators

external shocks u s monetary policy and macroeconomic fluctuations in emerging markets estimated structural vars show that external shocks are an important source of macroeconomic fluctuations in emerging markets furthermore u s monetary policy shocks affect interest rates and the exchange rate in a typical emerging market quickly and strongly the price level and real output in a typical emerging market respond to u s monetary policy shocks by more than the price level and real output in the u s itself these findings are consistent with the idea that when the u s sneezes emerging markets catch a cold at the same time u s monetary policy shocks are not important for emerging markets relative to other kinds of external shocks

income and democracy evidence from system gmm estimates abstract does higher income cause democracy accounting for the dynamic nature and high persistence of income and democracy we find a statistically significant positive relation between income and democracy for a postwar period sample of up to 150 countries our results are robust across different measures of democracy and instrumentation strategies

what does the bank of japan do to east asia abstract in recent policy debates some have argued that expansionary monetary policy in japan can increase real output in japan and in japan s neighbors while others have warned that it is a beggar thy neighbor policy in this paper we estimate structural vector autoregressions to assess the effects of japanese monetary policy shocks we find that the effects of japanese monetary policy shocks on macroeconomic variation in east asia have been modest and difficult to reconcile with the beggar thy neighbor view we estimate that the asian crisis was preceded by expansionary monetary policy shocks in japan but we fail to find support for the view that these shocks contributed to the crisis

the dynamic effects of aggregate demand and supply disturbances we interpret fluctuations in gnp and unemployment as due to two types of disturbances disturbances that have a permanent effect on output and disturbances that do not we interpret the first as supply disturbances the second as demand disturbances demand disturbances have a hump shaped mirror image effect on output and unemployment the effect of supply disturbances on output increases steadily over time peaking after two years and reaching a plateau after five years

labor and investment frictions in a real business cycle model abstract this paper develops a prototype real business cycle model in which labor and investment frictions may compete directly with technology shocks in accounting for fluctuations in the postwar us economy using ireland s 2004a a method for taking models to the data journal of economic dynamics and control 28 1205 1226 methodology we establish that both types of friction are quantitatively important technology shocks still explain a substantial fraction of the fluctuations in aggregate output as the baseline real business cycle model predicts formal hypothesis tests suggest that changes in the recurrence of shocks frictions and structural parameters all play a role in accounting for the shift in the time series properties of the data between the periods before and after 1980

the tips treasury bond puzzle we show that the price of a treasury bond and an inflation swapped treasury inflation protected securities tips issue exactly replicating the cash flows of the treasury bond can differ by more than 20 per 100 notional treasury bonds are almost always overvalued relative to tips total tips treasury mispricing has exceeded 56 billion representing nearly 8 of the total amount of tips outstanding we find direct evidence that the mispricing narrows as additional capital flows into the markets this provides strong support for the slow moving capital explanation of arbitrage persistence

comparing dsge var forecasting models how big are the differences abstract i generate priors for a vector autoregression var from a standard real business cycle rbc model an rbc model with capital adjustment costs and habit formation and a sticky price model with an unaccommodating monetary authority the response of hours worked to a tfp shock differs sharply across these models i compare the accuracy of forecasts made from each of the resulting dynamic stochastic general equilibrium vector autoregression dsge var models despite having different structural characteristics the dsge vars are comparable in terms of forecasting performance as in previous work dsge vars compare favorably with atheoretical vars

factor adjustment costs a structural investigation abstract this paper assesses various capital and labor adjustment costs functions estimating a general equilibrium framework with bayesian methods using us aggregate data the estimation finds that the adjustment costs are convex in both capital and labor and allowing for their joint interaction is important the structural model enables us to identify the response of factor adjustment costs to exogenous disturbances and to establish that shocks to technology and the job separation rate are key drivers of adjustment costs the analysis shows that factor adjustment costs enable the model to explain fluctuations in the firm s market value in the data

financial and fiscal interaction in the euro area crisis this time was different abstract this paper highlights the anomalous characteristics of the euro area twin crises by contrasting the aggregate macroecosnomic dynamics in the period 2009 2013 with the business cycle fluctuations of the previous decades we report three novel stylised facts first the contraction in output was marked by an anomalous downfall in private investment and an increase in households savings while consumption and unemployment followed their historical relation with gdp second households and financial corporations debts and house prices deviated from their pre crisis trends while non financial corporations debt followed historical regularities third the jumps in the public deficit gdp and debt gdp ratios in 2008 2009 were unprecedented and so was the fiscal consolidation that followed our analysis points to the financial nature of the crisis as a likely explanation for these facts importantly the anomalous increase in public debt is in large part explained by extraordinary measures in support of the financial sector which show up in the stock flow adjustments and reveal a keyinteraction between the fiscal and the financial sectors

causality cointegration and control abstract the first sections of the paper show that causality tests can be relevant when considering the effectiveness of a control mechanism rejecting some results in earlier papers the relevance comes from a more careful consideration of what information is available to whom and when compared to previous work the final section of the paper extends this analysis to cointegrated variables when causality is a necessary consequence

interconnections between eurozone and us booms and busts using a bayesian panel markov switching var model summary the proposed panel markov switching var model accommodates changes in low and high data frequencies and incorporates endogenous time varying transition matrices of country specific markov chains allowing for interconnections an efficient multi move sampling algorithm draws time varying markov switching chains using industrial production growth and credit spread data several important data features are obtained three regimes appear with slow growth becoming persistent in the eurozone turning point analysis indicates the usa leading the eurozone cycle amplification effects influence recession probabilities for eurozone countries a credit shock results in temporary negative industrial production growth in germany spain and the usa core and peripheral countries exist in the eurozone copyright 2016 john wiley sons ltd

can long run restrictions identify technology shocks gali s innovative approach of imposing long run restrictions on a vector autoregression var to identify the effects of a technology shock has become widely utilized in this paper we investigate its reliability through monte carlo simulations using calibrated business cycle models overall gali s methodology appears to be fruitful the impulse responses derived from the artificial data generally have the same sign and qualitative pattern as the true responses and the approach can be informative in discriminating between alternative models however our results reveal some important quantitative shortcomings including considerable estimation uncertainty about the impact of technology shocks on macroeconomic variables more generally the conditions under which the methodology performs well appear considerably more restrictive than implied by the key identifying assumption this underscores the importance of using economic models to guide in the implementation of the approach in interpreting the results and in assessing its limitations jel c32 e32 o33

technology shocks and monetary policy assessing the fed s performance abstract the purpose of the present paper is twofold first we characterize the fed s systematic response to technology shocks and its implications for u s output hours and inflation second we evaluate the extent to which those responses can be accounted for by a simple monetary policy rule including the optimal one in the context of a standard business cycle model with sticky prices our main results can be described as follows first we detect significant differences across periods in the response of the economy as well as the fed s to a technology shock second the fed s response to a technology shock in the volcker greenspan period is consistent with an optimal monetary policy rule third in the pre volcker period the fed s policy tended to overstabilize output at the cost of generating excessive inflation volatility our evidence reinforces recent results in the literature suggesting an improvement in the fed s performance

political accountability and the room to maneuver a search for a causal chain many studies of the room to maneuver make no provision for popular evaluation of policy they assert rather than demonstrate popular satisfaction with policy choices and macroeconomic outcomes the authors present a framework that explicitly models channels for popular preferences to influence policies and outcomes results for economic policy making in britain do not support the room to maneuver thesis in the authors sample 1981 to 1997 the british government was responsive to changes in political evaluations and its policy choices effectively fed back into popular evaluations of government policy however this accountability mechanism worked outside the real economy shifts in popular evaluations induced changes in policy but had no impact on inflation and economic growth government capacity to shape macroeconomic outcomes was limited and popular influence over economic policy was ineffectual this form of accountability probably existed because british citizens had difficulty gauging the real impacts of their government s policies

pricing foreign currency options under stochastic interest rates abstract in this paper we build a general framework to price contingent claims on foreign currencies using the heath et al 1987 model of the term structure closed form solutions are obtained for european options on currencies and currency futures assuming that the volatility functions determining the term structure are deterministic as such this paper provides an example of a bond price process for both the domestic and foreign economies consistent with grabbe s 1983 formulation of the same problem

aid policies and growth the authors of this paper use a new database on foreign aid to examine the relationships among foreign aid economic policies and growth of per capita gdp in panel growth regressions for 56 developing countries and 6 four year periods 1970 93 they find that the policies that have a great effect on growth are those related to fiscal surplus inflation and trade openness they construct an index for those three policies and have that index interact with foreign aid they have instruments for both aid and aid interacting with policies they find that aid has a positive impact on growth in developing countries with good fiscal monetary and trade policies in the presence of poor policies aid has no positive effect on growth this result is robust in a variety of specifications which include or exclude middle income countries include or exclude outliers and treat policies as exogenous or endogenous they examine the determinants of policy and find no evidence that aid has systematically affected policies either for good or for ill they estimate an aid allocation equation and show that any tendency for aid to reward good policies has been overwhelmed by donors pursuit of their own strategic interests in a counterfactual they reallocate aid reduce the role of donor interests and increasing the importance of policy such a reallocation would have a large positive effect on developing countries growth rates

identifying the role of risk shocks in the business cycle using stock price data i introduction the finance literature on the forecastibility of stock returns has concluded that stock market movements are by and large not because of changes in the expected future cash flow of firms but are primarily because of changes in the risk premium that is how the expected cash flows are discounted by stock market participants cochrane 2011 1 these changes in risk premia also have important implications for real variables in the economy especially for consumption and investment an increase in the risk premium prompts households to reduce current consumption as they start to discount expected future income more heavily more importantly changes in the required return on equity alter the cost of capital of corporations when they finance new investment for firms that rely on external debt to finance marginal investment a lower stock price translates into lower net worth and therefore a higher cost of borrowing bernanke gertler and gilchrist 1999 similarly firms that rely on new equity issues are able to raise less funds from each new share when their stock price is lower even for firms that finance investment exclusively through internal funds i e retained earnings plus depreciation allowance the required return on existing shares reveals the opportunity cost of internally financed investment tobin 1969 tobin and brainard 1977 this is because at least in principle these funds can be returned to existing shareholders as dividends and new funds can then be raised from the markets through new equity shares for which investors would demand a risk premium figure 1 omitted in the aggregate u s corporations are predominantly financed through equity the dotted line in figure 1 plots the credit market liabilities of u s non financial corporations as a percent of the sum of equity and credit market liabilities in their balance sheets 2 by this measure debt financing accounts for about a third of total financing averaged over the whole sample and equity financing accounts for about two thirds the solid line in figure 1 provides an alternative measure which takes into account all financial liabilities including items such as trade payables but nets out financial assets to obtain a measure of net debt mcgrattan and prescott 2005 now debt financing accounts for only 15 of total financing in the post war period and its importance has declined in the last two decades note that both of these series are stock measures as opposed to flow measures that is they refer to financing of all past investments and do not necessarily reflect how corporations are financing investment at the margin these measures can also be biased against debt financing because most debt items are recorded on a book value basis in the flow of funds but equity is recorded on a market value basis to overcome these caveats i consider the flow components of sources of funds i e internal funds net new equity and net new debt as a share of corporate tangible investment in figure 2 several patterns emerge first the ratio of internal funds to gross capital expenditures has been close to 1 throughout the post war period in other words at least in the aggregate u s corporate investment has been by and large financed internally second new equity issuance has not been an important source of financing in fact net new stock issues have been mostly negative in the latter part of the sample this mainly reflects the preference of corporations to distribute resources to shareholders through stock buybacks rather than ordinary dividend payments because of the preferential tax treatment of long term capital gains third net new debt has contributed to about a third of aggregate financing assuming that the discrepancy in the flow account is distributed proportionally to each financing component as internal funds and net new stock issues are fairly reliable data series we can reasonably lump the rather large discrepancy item in the ffa data with net debt

the dynamic impacts of monetary policy an exercise in tentative identification it is currently popular to identify monetary policy shocks with innovations in some measure of reserves or in the federal funds rate these assumptions about the interest elasticity of the supply of or demand for reserves imply monetary policy shocks that produce dynamic responses of macroeconomic variables that are anomalous relative to traditional monetary analyses this paper tentatively identifies supply and demand shocks in the markets for reserves and m2 for the 1980s and contrasts them with results for the 1970s in the later period identified monetary policy shocks have dynamic impacts that are fully consistent with traditional analyses

the effects of fiscal shocks on employment and the real wage we study the transmission of fiscal shocks in the labor market we employ a structural var and base identification on the restrictions that shocks to government consumption investment and employment must raise output and deficits these restrictions hold in both prototype real business cycle rbc and new keynesian models shocks to government consumption and investment increase real wages and employment contemporaneously both at state level and in the aggregate the dynamics in response to employment shocks are mixed increases in government employment raise the real wage and total employment in the aggregate however in one third of the states they reduce total employment

drawing conclusions from structural vector autoregressions identified on the basis of sign restrictions abstract this paper discusses the problems associated with using information about the signs of certain magnitudes as a basis for drawing structural conclusions in vector autoregressions we also review available tools to solve these problems for illustration we use dahlhaus and vasishtha s 2019 study of the effects of a u s monetary contraction on capital flows to emerging markets we explain why sign restrictions alone are not enough to allow us to answer the question and suggest alternative approaches that could be used

on the short term predictability of exchange rates a bvar time varying parameters approach abstract in this paper we propose a bayesian vector autoregressive model with time varying parameters bvar tvp to examine the short term predictability of exchange rates an important contribution of the paper is the application of the bvar tvp model for the first time to daily data using information from financial markets another contribution is the production of forecasts in real time at the very short horizon of one trading day ahead typically used by traders and investors in financial markets we employ financial criteria and recently developed statistical tests to assess the exchange rate predictability we find that the bvar tvp model outperforms the random walk for all exchange rates these forecast gains are due primarily to the time variation of coefficients and secondly to information from other financial markets it is shown that international investors could have made statistically significant excess profits if they had followed an inter day trading strategy based on the buy sell signals generated by the model s one day ahead exchange rate forecasts even after allowing for transaction costs and risk factors

the colonial origins of comparative development an empirical investigation comment abstract acemoglu johnson and robinson s 2001 seminal article argues property rights institutions powerfully affect national income using estimated mortality rates of early european settlers t

investment shocks and business cycles abstract the origins of business cycles are still controversial among macroeconomists this paper contributes to this debate by studying the driving forces of fluctuations in an estimated new neoclassical synthesis model of the u s economy in this model most of the variability of output and hours at business cycle frequencies is due to shocks to the marginal efficiency of investment imperfect competition and to a lesser extent technological frictions are the key to their transmission although labor supply shocks explain a large fraction of the fluctuations in hours at very low frequencies they are irrelevant over the business cycle this finding is important because the microfoundations of these disturbances are widely regarded as unappealing

trend breaks long run restrictions and contractionary technology improvements abstract structural vector autoregressions with long run restrictions are extraordinarily sensitive to low frequency correlations recent literature finds that the estimated effects of technology shocks are sensitive to how one treats hours per capita however after allowing for statistically and economically significant trend breaks in productivity results are much less sensitive hours fall when technology improves the issue is that the common high low high pattern of productivity growth and hours i e the low frequency correlation inevitably leads to a positive estimated response the trend breaks control for this correlation this example suggests a practical need for care in using long run restrictions

common drifting volatility in large bayesian vars the general pattern of estimated volatilities of macroeconomic and financial variables is often broadly similar we propose two models in which conditional volatilities feature comovement and study them using u s macroeconomic data the first model specifies the conditional volatilities as driven by a single common unobserved factor plus an idiosyncratic component we label this model bvar with general factor stochastic volatility bvar gfsv and we show that the loss in terms of marginal likelihood from assuming a common factor for volatility is moderate the second model which we label bvar with common stochastic volatility bvar csv is a special case of the bvar gfsv in which the idiosyncratic component is eliminated and the loadings to the factor are set to 1 for all the conditional volatilities such restrictions permit a convenient kronecker structure for the posterior variance of the var coefficients which in turn permits estimating the model even with large datasets while perhaps misspecifi

what does a technology shock do a var analysis with model based sign restrictions abstract this paper estimates the effects of technology shocks in var models of the u s identified by imposing restrictions on the sign of impulse responses these restrictions are consistent with the implications of a popular class of dsge models with both real and nominal frictions and with sufficiently wide ranges for their parameters this identification strategy thus substitutes theoretically motivated restrictions for the atheoretical assumptions on the time series properties of the data that are key to long run restrictions stochastic technology improvements persistently increase real wages consumption investment and output in the data hours worked are very likely to increase displaying a hump shaped pattern contrary to most of the related var evidence results are not sensitive to a number of specification assumptions including those on the stationarity properties of variables

news shocks and labour market dynamics in matching models we enrich a baseline real business cycle rbc model with search and matching frictions on the labour market and real frictions that are helpful in accounting for the response of macroeconomic aggregates to shocks the analysis allows shocks to have an unanticipated and a news i e anticipated component the bayesian estimation of the model reveals that the model that includes news shocks on macroeconomic aggregates produces a remarkable fit of the data news shocks in stationary and non stationary tfp investment specific productivity and preference shocks significantly affect labour market variables and explain a sizeable fraction of macroeconomic fluctuations at medium and long run horizons historically news shocks have played a relevant role for output but they have had a limited influence on unemployment

the statistical and economic role of jumps in continuous time interest rate models this paper analyzes the role of jumps in continuous time short rate models i first develop a test to detect jump induced misspecification and using treasury bill rates find evidence for the presence of jumps second i specify and estimate a nonparametric jump diffusion model results indicate that jumps play an important statistical role estimates of jump times and sizes indicate that unexpected news about the macroeconomy generates the jumps finally i investigate the pricing implications of jumps jumps generally have a minor impact on yields but they are important for pricing interest rate options

the transmission of international shocks a factor augmented var approach the empirical literature on the transmission of international shocks is based on small scale vars in this paper we use a large panel of data for 17 industrialized countries to investigate the international transmission mechanism and revisit the anomalies that arise in the empirical literature we propose a factor augmented var favar that extends the model in bernanke boivin and eliasz 2003 to the open economy the main results can be summarized as follows first the dynamic effects on the uk economy of an unanticipated fall of short term interest rates in the rest of the world are real house price inflation investment gdp and consumption growth peak after one year wages peak after two years cpi and gdp deflator inflation peak during the third year second a positive international supply shock makes the distribution of the components of the uk consumption deflator negatively skewed third in response to a domestic monetary shock we find no evidence of the exchange rate and liquidity puzzles and little evidence of the forward discount and price anomalies

the sources of financial crises pre and post fed evidence this paper investigates the generation and the propagation mechanism of currency demand and supply shocks before and after world war i the structural determinants of the variability of stock prices and interest rates and the changes introduced by the creation of the fed on the dynamics of the system it is shown that in the pre 1914 era external monetary shocks interacted with a seasonal demand for money to produce financial crises the fed helped to prevent crises by insulating the u s economy from external shocks a structural vector autoregressive model provides evidence for these claims copyright 1991 by economics department of the university of pennsylvania and the osaka university institute of social and economic research association

measuring the effects of dollar appreciation on asia a favar approach abstract exchange rate shocks have mixed effects on economic activity in both theory and empirical var models in this paper we extend the empirical literature by considering the implications of a positive shock to the u s dollar in a factor augmented vector autoregression favar model for the u s and three large asian economies korea japan and china the favar framework allows us to represent a country s aggregate economic activity by a latent factor generated from a broad set of underlying observable economic indicators to control for global conditions we also include in the favar a global conditions index which is another latent factor generated from the economic indicators of major trading partners we find that a dollar appreciation shock reduces economic activity and inflation not only for the u s economy but also for all three asian economies this result which is robust to a number of alternative specifications suggests that in spite of their disparate economic structures and policy regimes the dollar appreciation shock affects the asian economies primarily through its impact on u s aggregate demand and this demand channel dominates the expenditure switching channel that affects a country s export competitiveness

signalling effects of monetary policy we develop a dynamic general equilibrium model in which the policy rate signals the central bank s view about macroeconomic developments to price setters the model is estimated with likelihood methods on a u s data set that includes the survey of professional forecasters as a measure of price setters inflation expectations this model improves upon existing perfect information models in explaining why in the data inflation expectations respond with delays to monetary impulses and remain disanchored for years in the 1970s u s monetary policy is found to signal persistent inflationary shocks explaining why inflation and inflation expectations were so persistently heightened the signalling effects of monetary policy also explain why inflation expectations adjusted more sluggishly than inflation after the robust monetary tightening of the 1980s

affine model of inflation indexed derivatives and inflation risk premium abstract this paper proposes an affine based approach which jointly captures the nominal interest rate the real interest rate and the inflation risk premium to price inflation indexed derivatives including zero coupon inflation indexed swaps year on year inflation indexed swaps inflation indexed swaptions and inflation indexed caps and floors we provide an example and explain how to use traded zero coupon inflation indexed swap rates to estimate inflation risk premiums

inflation indexed swaps and swaptions this article considers the pricing and hedging of inflation indexed swaps and the pricing of inflation indexed swaptions and options on inflation indexed bonds to price the inflation indexed swaps we suggest an extended hjm model the model allows both the forward rates and the consumer price index to be driven not only by a standard multidimensional wiener process but also by a general marked point process our model is an extension of the hjm approach proposed by jarrow and yildirim jarrow r yildirim y 2003 pricing treasury inflation protected securities and related derivatives using an hjm model journal of financial and quantitative analysis 38 409 430 and later also used by mercurio mercurio f 2005 pricing inflation indexed derivatives quantitative finance 5 3 289 302 to price inflation indexed swaps furthermore we price options on so called tips bonds assuming the model is purely wiener driven we then introduce an inflation swap market model to price inflation indexed swaptions all prices derived have explicit closed form solutions furthermore we formally prove the validity of the so called foreign currency analogy

fragility and the effect of international uncertainty shocks abstract when economic systems are fragile even modest shocks for example a shock to international capital movements can have strong negative effects on key macroeconomic fundamentals this paper proposes a large scale bayesian vector autoregression with factor stochastic volatility to investigate the macroeconomic consequences of international uncertainty shocks in g7 countries and shows that uncertainty increases fragility the factor structure enables us to identify an international uncertainty shock by assuming that it is the joint volatility process that determines the dynamics of the variance covariance matrix of the common factors to allow for first and second moment shocks we moreover assume that the uncertainty factor enters the var equation as an additional regressor our findings suggest that an international uncertainty shock has negative effects across all economies and variables under consideration leading to strong declines in output prices exports interest rates and equity prices the precise degree of fragility varies across countries a simple correlation exercise suggests that structural differences may be partially responsible for the observed differences

financial intermediaries instability and euro area macroeconomic dynamics abstract fitting a markov switching structural vector autoregression to euro area data we show that after taking into account heteroskedasticity the differences in the behavior of the economy between tranquil and financial distress periods e g great recession and sovereign debt crisis reflect variations in the transmission mechanism when and only when a period of financial distress occurs disruptions in financial intermediation trigger adverse effects for the real economy and turn out to be the primary source of business cycle fluctuations finally we provide strong evidence that ecb interventions in the financial sector had beneficial effects on the real economy during the sovereign debt crisis

endogenous money or sticky prices abstract what explains the correlations between nominal and real variables in the postwar us data are these correlations indicative of significant nominal rigidity or do they simply reflect the particular way that monetary policymakers react to developments in the real economy to answer these questions this paper uses maximum likelihood to estimate a model of endogenous money this model allows but does not require nominal prices to be sticky the results show that nominal price rigidity over and above endogenous money plays a role in accounting for key features of the data

technology shocks and robust sign restrictions in a euro area svar we use a model based identification strategy to estimate the impact of technology shocks on hours worked and employment in the euro area the sign restrictions applied in the vector autoregression var analysis are consistent with a large class of dynamic stochastic general equilibrium dsge models and are robust to parameter uncertainty the results are in line with the conventional real business cycle rbc interpretation that hours worked rise as a result of a positive technology shock by comparing the sign restrictions method to the long run restriction approach of gali quaterly journal of economics 1992 709 38 we show that the results do not depend on the stochastic specification of the hours worked series or the data sample but only on the identification scheme

do technology shocks lead to a fall in total hours worked this paper contributes to the debate initiated by gali in 1999 i provide a theory with capital income taxation labor hoarding as well as long run shifts in the social attitudes to the workplace modelled as leisure at the workplace to argue that there are other shocks that may influence labor productivity in the long run i introduce medium run identification and show it to be superior to long run identification or standard short run identification when applied to artificial data with u s data and medium run identification i find the robust result that technology shocks lead to a hump shaped response of total hours worked which is mildly positive following a near zero initial response jel e32 e24 c32 c15 copyright c 2004 the european economic association

state dependence in labor market fluctuations this paper documents state dependence in labor market uctuations using a threshold vector autoregression model tvar we establish that the unemployment rate the job separation rate and the job finding rate exhibit a larger response to productivity shocks during periods with low aggregate productivity a diamond mortensen pissarides model with endogenous job separation and on the job search replicates these empirical regularities well we calibrate the model to match the standard deviation of the job transition rates explained by productivity shocks in the tvar and show that the model explains 88 percent of the state dependence in the unemployment rate 76 percent for the separation rate and 36 percent for the job finding rate the key channel underpinning state dependence in both job separation and job finding rates is the interaction of the firm s reservation productivity level and the distribution of match specific idiosyncratic productivity results are robust across several variations to the baseline model

unconventional economic policies and sentiment an international assessment this paper estimates using bayesian and global vars the spillover effects of unconventional fiscal and monetary policies implemented in the united states and in the eurozone during the last decade consumer confidence and investor sentiment indicators are introduced in the models in order to highlight the signalling channel in the responses to economic policy innovations in times of crisis our results reveal that consumer and investor perceptions of innovative economic measures are relevant to study the pass through of economic policies to the real sector in times of crisis and zero lower bound interest rates in particular the signalling channel plays an important role in successful unconventional economic policies moreover if unconventional economic policies have an impact abroad the effects are similar to those measured in the domestic country region consequently coordination and transparency are a prerequisite for ensuring short term growth after a global financial crisis

monetary policy shocks and foreign investment income evidence from a large bayesian var abstract this paper assesses the transmission of monetary policy in a large bayesian vector autoregression based on the approach proposed by banbura et al 2010 the paper analyzes the impact of monetary policy shocks in the united states and canada not only on a range of domestic aggregates trade flows and exchange rates but also foreign investment income the analysis provides three main results first a surprise monetary policy contraction has a statistically important impact on both gross and net foreign investment income flows in both countries against the background of growing foreign wealth and investment income this result provides preliminary evidence that foreign balance sheet channels might play an increasingly significant role for monetary transmission second the impact of monetary policy on foreign investment income flows differs considerably across asset categories and over time suggesting that the investment instruments and the currency denomination of a country s foreign assets and liabilities are potentially relevant for the way in which monetary policy affects the domestic economy finally the results support existing evidence on the effectiveness of large vector autoregressions and the bayesian shrinkage approach in eliminating price and exchange rate puzzles

bayesian methods for dynamic multivariate models if dynamic multivariate models are to be used to guide decisionmaking it is important that probability assessments of forecasts or policy projections be provided when identified bayesian vector autoregression var models are presented with error bands in the existing literature both conceptual and numerical problems have not been dealt with in an internally consistent way in this paper the authors develop methods to introduce prior information in both reduced form and structural var models without introducing substantial new computational burdens their approach makes it feasible to use a single large dynamic framework for example twenty variable models for tasks of policy projections copyright 1998 by economics department of the university of pennsylvania and the osaka university institute of social and economic research association

aid policies and growth comment in an extraordinarily influential paper craig burnside and david dollar 2000 p 847 find that aid has a positive impact on growth in developing countries with good fiscal monetary and trade policies but has little effect in the presence of poor policies this finding has enormous policy implications the burnside and dollar 2000 henceforth bd result provides a role and strategy for foreign aid if aid stimulates growth only in countries with good policies this suggests that 1 aid can promote economic growth and 2 it is crucial that foreign aid be distributed selectively to countries that have adopted sound policies international aid agencies public policy makers and the press quickly recognized the importance of the bd findings this paper reassesses the links between aid policy and growth using more data the bd data end in 1993 we reconstruct the bd database from original sources and thus 1 add additional countries and observations to the bd data set because new information has become available since they conducted their analyses and 2 extend the data through 1997 thus using the bd methodology we reexamine whether aid influences growth in the presence of good policies given our focus on retesting bd we do not summarize the vast pre bd literature on aid and growth we just note that there was a long and inconclusive literature that was hampered by limited data availability debates about the mechanisms through which aid would affect growth and disagreements over econometric specification see gustav f papanek 1972 robert cassen 1986 paul mosley et al 1987 peter boone 1994 1996 and henrik hansen and finn tarp s 2000 review since bd found that aid boosts growth in good policy environments there have been a number of other papers reacting to their results including paul collier and jan dehn 2001 carljohan dalgaard and hansen 2001 patrick guillaumont and lisa chauvet 2001 hansen and tarp 2001 robert lensink and howard white 2001 and collier and dollar 2002 these papers conduct useful variations and extensions some of which had already figured in the pre bd literature such as introducing additional control variables using nonlinear specifications etc some of these papers confirm the message that aid only works in a good policy environment while others drive out the aid policy interaction term with other variables this literature has the usual limitations of choosing a specification without clear guidance from theory which often means there are more plausible specifications than there are data points in the sample we differentiate our paper from these others by not deviating from the bd specification thus we do not test the robustness of the results to an unlimited number of variations but instead maintain the bd methodology this paper conducts a very simple robustness check by adding new data that were unavailable to bd thus we expand the sample used over their time period and extend the data from 1993 to 1997 easterly department of economics new york university 269 mercer street new york ny 10003 center for global development and national bureau of economic research e mail william easterly nyu edu levine department of finance carlson school of management university of minnesota 321 19th avenue south minneapolis mn 55455 and national bureau of economic research e mail rlevine csom umn edu roodman center for global development 1776 massachusetts avenue nw washington dc 20036 e mail droodman cgdev org we are grateful to craig burnside for supplying data and assisting in the reconstruction of previous results without holding him responsible in any way for the work in this paper thanks also to francis ng and prarthna dayal for generous assistance with updating the sachs warner openness variable and to three anonymous referees craig burnside and henrik hansen for helpful comments 1 see for instance the world bank 1994 2001 2002 the u k department for international development 2000 president george w bush s speech march 16 2002 the announcement by the white house on creating the millennium challenge corporation white house 2002 as well as a washington post editorial february 9 2002 a financial times column by alan beattie march 11 2002 and the economist march 16 2002

changing macroeconomic dynamics at the zero lower bound this article develops a change point var model that isolates four major macroeconomic regimes in the us since the 1960s the model identifies shocks to demand supply monetary policy and spread yield using restrictions from a general equilibrium model the analysis discloses important changes to the statistical properties of key macroeconomic variables and their responses to the identified shocks during the crisis period spread shocks became more important for movements in unemployment and inflation a counterfactual exercise evaluates the importance of lower bond yield spread during the crises and suggests that the fed s large scale asset purchases helped lower the unemployment rate by about 0 6 percentage points while boosting inflation by about 1 percentage point

closed form solutions for term structure derivatives with log normal interest rates we derive a unified model that gives closed form solutions for caps and floors written on interest rates as well as puts and calls written on zero coupon bonds the crucial assumption is that simple interest rates over a fixed finite period that matches the contract which we want to price are log normally distributed moreover this assumption is shown to be consistent with the heath jarrow morton model for a specific choice of volatility closed form solutions for interest rate derivatives in particular caps floors and bond options have been obtained by a number of authors for markovian term structure models with normally distributed interest rates or alternatively log normally distributed bond prices see for example jamshidian 1989 1991a heath jarrow and morton 1992 brace and musiela 1994 geman el karoui and rochet 1995 these models support black scholes type formulas most frequently used by practitioners for pricing bond options and swaptions unfortunately these models imply negative interest rates with positive probabilities and hence they are not arbitrage free in an economy with opportunities for riskless and costless storage of money briys crouhy and schobel 1991 apply the gaussian framework to derive closed form solutions for caps floors and european zero coupon bond options to exclude the influence of negative forward rates on the pricing of zero coupon bond options they introduce an additional boundary condition as shown by rady and sandmann 1994 these pricing formulas are only supported by a term structure model with an absorbing boundary for the forward rate at zero where the absorbing probability is not negligible which for a term structure model is a quite problematic assumption

real time forecasting with a mixed frequency var this article develops a vector autoregression var for time series which are observed at mixed frequencies quarterly and monthly the model is cast in state space form and estimated with bayesian methods under a minnesota style prior we show how to evaluate the marginal data density to implement a data driven hyperparameter selection using a real time dataset we evaluate forecasts from the mixed frequency var and compare them to standard quarterly frequency var and to forecasts from midas regressions we document the extent to which information that becomes available within the quarter improves the forecasts in real time this article has online supplementary materials

were there regime switches in u s monetary policy working paper 2004 14 june 2004 abstract a multivariate model identifying monetary policy and allowing for simultaneity and regime switching in coefficients and variances is confronted with u s data since 1959 the best fit is with a model that allows time variation in structural disturbance variances only among models that also allow for changes in equation coefficients the best fit is for a model that allows coefficients to change only in the monetary policy rule that model allows switching among three main regimes and one rarely and briefly occurring regime the three main regimes correspond roughly to periods when most observers believe that monetary policy actually differed and the differences in policy behavior are substantively interesting though statistically ill determined the estimates imply monetary targeting was central in the early 80s but was also important sporadically in the 70s the changes in regime were essential neither to the rise in inflation in the 70s nor to its decline in the 80s jel classification e52 e47 c53 key words counterfactuals lucas critique policy rule monetary targeting simultaneity volatility model comparison i the debate over monetary policy change in an influential paper clarida gali and gertler 2000 cgg presented evidence that us monetary policy changed between the 1970 s and the 1980 s indeed that in the 70 s it was drastically worse they found that the policy rule apparently followed in the 70 s was one that when embedded in most stochastic general equilibrium models would imply non uniqueness of the equilibrium and hence vulnerability of the economy to sunspot fluctuations of arbitrarily large size their estimated policy rule for the later period on the other hand eliminated this indeterminacy these results are a possible explanation of the volatile and rising inflation of the 70 s and of its subsequent decline the cgg analysis has two important weaknesses one is that it fails to account for stochastic volatility us macroeconomic variables and particularly the federal funds rate have gone through periods of tranquility and of agitation with forecast error variances varying greatly from period to period ignoring such variation does not lead to inconsistent estimates of model parameters when the forecasting equations themselves are constant but it strongly biases toward a finding of changed parameters tests of the stability of the forecasting equations the other weakness is that the cgg analysis rests on powerful and implausible identifying assumptions they require that we accept that the response of the monetary authority to expected future inflation and output does not depend on the recent history of inflation money growth or output it is hard to understand why this should be so especially in the 70 s when monetarism was a prominent theme in policy debates congress was requiring reports from the fed of projected time paths of monetary aggregates and financial markets were reacting sensitively to weekly money supply numbers the requirement for existence and uniqueness of equilibrium in dynamic models is that the monetary policy rule show a more than unit response of interest rates to the sum of the logs of all nominal variables that appear on the right hand side of the reaction function if we force a particular measure of expected future inflation to proxy for all the nominal variables that actually appear independently in the reaction function we are bound to get distorted conclusions on the one hand because expected future inflation will be a noisy measure of the full set of nominal influences on policy we might get downward bias in our estimates from the usual errorsin variables effect on the other hand to the extent that expected future inflation like most expected future values shows less variation than current nominal variables we could find a mistaken scaling up of coefficients

labor supply factors and economic fluctuations we propose a new v ar identication scheme that enables us to disentangle labor supply shocks from wage bargaining shocks identication is achieved by imposing robust sign restrictions that are derived from a new keynesian model with endogenous labor force par ticipation according to our analysis on us data over the period 1985 2014 labor supply shocks and wage bargaining shocks are important drivers of output and unemployment both in the short run and in the long run these results suggest that identication strategies used in estimated new keynesian models to disentangle labor market shocks may be misguided we also analyze the behavior of the labor force participation rate through the lenses of our model wend that labor supply shocks are the main drivers of the participation rate and account for about half of its decline in the aftermath of the great recession

efficient estimation with panel data when instruments are predetermined an empirical comparison of moment condition estimators i examine the empirical performance of instrumental variables estimators with predetermined instruments in an application to life cycle labor supply under uncertainty the estimators studied are two stage least squares generalized method of moments gmm forward filter independently weighted gmm and split sample instrumental variables i compare the bias efficiency trade off for the estimators using bootstrap algorithms suggested by freedman and by brown and newey results indicate that the downward bias in gmm is quite severe as the number of moment conditions expands outweighing the gains in efficiency the forward filter estimator however has lower bias and is more efficient than two stage least squares

long run implications of investment specific technological change an attempt is made to disentangle its effects from the more traditional hicksneutral form of technological progress the balanced growth path for the model is characterized and calibrated to u s national income and product account nipa data the quantitative analysis suggests that investment specific technological change accounts for the major part of growth jel e13 030 041 047

neutral technology shocks and the dynamics of labor input results from an agnostic identification this article studies the dynamic response of labor input to neutral technology shocks it uses benchmark dynamic stochastic general equilibrium models enriched with labor market search and matching frictions and investment specific technological progress that enables a new agnostic identification scheme based on sign restrictions on a structural vector autoregression svar the estimation supports an increase of labor input in response to neutral technology shocks this finding is robust across different perturbations of the svar model

commodity price shocks and the business cycle structural evidence for the u s this paper evaluates the relative importance of commodity price shocks in the u s business cycle therefore we extend the standard set of business cycle shocks to include unexpected changes in commodity prices the resulting svar shows that commodity price shocks are a very important driving force of macroeconomic fluctuations second only to investment specific technology shocks particularly with respect to inflation neutral technology shocks and monetary policy shocks on the other hand seem less relevant at business cycle frequencies neutral technology shocks rather play an important role at low frequencies

bond yields and the federal reserve bond yields respond to policy decisions by the federal reserve and vice versa to learn about these responses i model a high frequency policy rule based on yield curve information and an arbitrage free bond market in continuous time the fed s target is a pure jump process jump intensities depend on the state of the economy and the meeting calendar of the federal open market committee the model has closed form solutions for yields as functions of a few state variables introducing monetary policy helps to match the whole yield curve because the target is an observable state variable that pins down its short end and introduces important seasonalities around fomc meetings the volatility of yields is snake shaped which the model explains with policy inertia the policy rule crucially depends on the two year yield and describes fed policy better than taylor rules

energy consumption and projected growth in selected caribbean countries this paper examines two issues that are central to the understanding of the need to increase efficiency in the use distribution and production of energy in the caribbean region the empirical results of this paper suggest the following first the three caribbean countries provide evidence of short run bi directional granger causality from energy consumption to real gross domestic product per capita second the forecasts with a bvar model indicate that significant growth in energy demand could be expected in haiti jamaica and trinidad and tobago until at least 2010 third the increased growth in energy consumption suggests the need for long term commitments from caribbean countries to undertake a series of policy economic market and research and development measures to advance the adoption and deployment of new energy technologies

income and democracy existing studies establish a strong cross country correlation between income and democracy but do not control for factors that simultaneously affect both variables we show that controlling for such factors by including country fixed effects removes the statistical association between income per capita and vari ous measures of democracy we present instrumental variables estimates that also show no causal effect of income on democracy the cross country corre lation between income and democracy reflects a positive correlation between changes in income and democracy over the past 500 years this pattern is con sistent with the idea that societies embarked on divergent political economic development paths at certain critical junctures jel d7 e 1

the dynamic effects of neutral and investment specific technology shocks the neoclassical growth model is used to identify the short run effects of neutral technology shocks which affect the production of all goods homogeneously and investment specific shocks which affect only investment goods the real equipment price crucial for identifying the investment shocks experiences an abrupt increase in its average rate of decline in 1982 so the analysis is based on a split sample on the basis of the preferred specification the two technology shocks account for 73 percent of hours and 44 percent of output s business cycle variation before 1982 and 38 percent and 80 percent afterward the shocks also account for more than 40 percent of hours and 58 percent of output s forecast errors over a three to eight year horizon in both samples the majority of these effects are driven by the investment shocks

pricing interest rate derivatives a general approach the relationship between affine stochastic processes and bond pricing equations in exponential term structure models has been well established we connect this result to the pricing of interest rate derivatives if the term structure model is exponential affine then there is a linkage between the bond pricing solution and the prices of many widely traded interest rate derivative securities our results apply to m factor processes with n diffusions and l jump processes the pricing solutions require at most a single numerical integral making the model easy to implement we discuss many options that yield solutions using the methods of the article

debt and stabilization policy evidence from a euro area favar abstract the euro area poses a unique problem in evaluating policy a currency union with a shared monetary policy and country specific fiscal policy analysis can be further complicated if high levels of public debt affect the performance of stabilization policy we construct a framework capable of handling these issues with an application to euro area data in order to incorporate multiple macroeconomic series from each country but simultaneously treat country specific fiscal policy we develop a hierarchical factor augmented var with zero restrictions on the loadings that yield country level factors monetary policy then responds to area wide conditions but fiscal policy responds only to its country level conditions we find that there is broad quantitative variation in different countries responses to area wide monetary policy and both qualitative and quantitative variation in responses to country specific fiscal policy moreover we find that debt conditions do not diminish the effectiveness of policy in a significant manner suggesting that any negative effects must come through other channels

the effects of technology shocks on hours and output a robustness analysis we analyze the effects of neutral and investment specific technology shocks on hours and output long cycles in hours are removed in a variety of ways hours robustly fall in response to neutral shocks and robustly increase in response to investment specific shocks the percentage of the variance of hours output explained by neutral shocks is small large the opposite is true for investment specific shocks news shocks are uncorrelated with the estimated technology shocks copyright 2009 john wiley sons ltd

shocks and government beliefs the rise and fall of american inflation working paper 2004 22 september 2004 abstract the authors use a bayesian markov chain monte carlo algorithm to estimate a model that allows temporary gaps between a true expectational phillips curve and the monetary authority s approximating nonexpectational phillips curve a dynamic programming problem implies that the monetary authority s inflation target evolves as its estimated phillips curve moves the authors estimates attribute the rise and fall of post world war ii inflation in the united states to an intricate interaction between the monetary authority s beliefs and economic shocks shocks in the 1970s altered the monetary authority s estimates and made it misperceive the tradeoff between inflation and unemployment that misperception caused sharp rise in inflation in the 1970s the authors estimates indicate that policy makers updated their beliefs continuously by the 1980s policy makers beliefs about the phillips curve had changed enough to account for fed chairman paul volcker s conquest of u s inflation in the early 1980s jel classification e3 e5 key words updating beliefs policy evaluation self confirming equilibrium nash inflation ramsey outcomes i introduction today many statesmen and macroeconomists believe that inflation can largely be determined by a government monetary authority then why did the federal reserve board preside over high us inflation during the late 1960s and the 1970s and why under paul volcker did it rapidly bring inflation down during the early 1980s this paper answers these questions by estimating a model that features a particular process that makes a procession of economic shocks induce the monetary authority to alter its model of inflation unemployment dynamics the phillips curve at each date t the monetary authority updates its beliefs about the phillips curve and then recomputes a first period action recommended by a phelps problem a discounted dynamic programming problem that minimizes the expected value of a discounted quadratic loss function of inflation and unemployment 1 the monetary authority pursues the same objectives at each date using the same structural model with only its estimates of that model changing over time 2 this model of the systematic part of inflation puts the monetary authority s beliefs about the phillips curve front and center 3 we assume that the monetary authority s model of the phillips curve deviates in two subtle but important ways from what it would be in a rational expectations model e g kydland and prescott 1977 the first deviation is that while the true phillips curve is like kydland and prescott s we assume that the monetary authority omits the public s expected rate of inflation from its phillips curve by itself this omission need not prevent the outcomes of our model from coinciding with those of kydland and prescott s nor need it imply that the government s model is wrong in a way that could be detected from even an infinite sample whether the monetary authority s model is wrong in a statistically detectable way depends on how we allow the monetary authority to reestimate the parameters of its model in particular if the monetary authority were to believe that the coefficients of its phillips curve are constant over time then its estimates would converge to ones that support a self confirming equilibrium sce after convergence its estimated phillips curve would correctly describe occurrences along the sce path for inflation and unemployment such an after convergence version of our model has little hope of explaining the rise and fall of us inflation that model would have inflation fluctuating randomly around a constant sce level that coincides with kydland and prescott s time consistent suboptimal i e excessive level 4 this outcome motivates our second subtle deviation from a rational expectations equilibrium