IMES DISCUSSION PAPER SERIES

Post-Crisis Slow Recovery and Monetary Policy

Daisuke Ikeda and Takushi Kurozumi
Discussion Paper No. 2014-E-16

INSTITUTE FOR MONETARY AND ECONOMIC STUDIESBANK OF JAPAN
2-1-1 NIHONBASHI-HONGOKUCHOCHUO-KU, TOKYO 103-8660
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IMES Discussion Paper Series 2014-E-16
December 2014

Post-Crisis Slow Recovery and Monetary Policy
Daisuke Ikeda* and Takushi Kurozumi**
Abstract
In the aftermath of the recent financial crisis and subsequent recession, slow
recoveries have been observed and slowdowns in total factor productivity (TFP)
growth have been measured in many economies. This paper develops a model thatcan describe a slow recovery resulting from an adverse financial shock in thepresence of an endogenous mechanism of TFP growth, and examines howmonetary policy should react to the financial shock in terms of social welfare. It isshown that in the face of the financial shocks, a welfare-maximizing monetary
policy rule features a strong response to output, and the welfare gain from output
stabilization is much more substantial than in the model where TFP growth isexogenously given. Moreover, compared with the welfare-maximizing rule, a strict
inflation or price-level targeting rule induces a sizable welfare loss because it has
no response to output, whereas a nominal GDP growth or level targeting rule
performs well, although it causes high interest-rate volatility. In the presence of theendogenous TFP growth mechanism, it is crucial to take into account a welfare loss
from a permanent decline in consumption caused by a slowdown in TFP growth.
Keywords: Financial shock; Endogenous TFP growth; Slow recovery; Monetary
policy; Welfare cost of business cycle
JEL classification: E52, O33*Director and Senior Economist, Institute for Monetary and Economic Studies, Bank of Japan(E-mail: daisuke.ikeda@boj.or.jp)**Director and Senior Economist, Institute for Monetary and Economic Studies, Bank of Japan(E-mail: takushi.kurozumi@boj.or.jp)
The authors appreciate comments from and discussions with Tobias Adrian, Andrea Ajello,
Kosuke Aoki, Gadi Barlevy, R. Anton Braun, Brent Bundick, Jeffrey Campbell, Lawrence
Christiano, Diego Comin, Michael Devereux, Taeyoung Doh, Martin Eichenbaum, Andrew
Filardo, Marvin Goodfriend, Christopher Gust, Andreas Hornstein, Yasuo Hirose, Matteo
Iacoviello, Alejandro Justiniano, Enisse Kharroubi, Jinill Kim, Jun Il Kim, Nobuhiro Kiyotaki,
Narayana Kocherlakota, Andrew Lee Smith, Giovanni Lombardo, Thomas Lubik, Christian
Matthes, José Mustre-del-Río, Jun Nie, Matthias Paustian, Edward S. Prescott, Albert Queraltó,
Jordan Rappaport, Pierre-Daniel Sarte, Stephanie Schmitt-Grohé, Mototsugu Shintani, Jae Sim,
Yuta Takahashi, Yuki Teranishi, Mathias Trabandt, Nicholas Trachter, Kozo Ueda, Martín
Uribe, Willem Van Zandweghe, Jonathan Willis, Alexander Wolman, Mark Wynne, Kei-Mu Yi,
Tack Yun, colleagues at the Bank of Japan, and participants at the 2014 BOJ-IMES Conference“Monetary Policy in a Post-Financial Crisis Era,” 22nd SJE International Symposium “Recent
Issues in Macroeconomics: Post Financial Crisis,” 10th Dynare Conference, Fall 2014
Midwest Macro Meeting, 16th Macro Conference, SWET 2014, and seminars at the BIS, FRB,
Chicago Fed, Kansas City Fed, and Richmond Fed. The views expressed in this paper are thoseof the authors and do not necessarily reflect the official views of the Bank of Japan.

1Introduction

In the aftermath of the recent …nancial crisis and subsequent recession, slow recoveries
have been observed in many economies. GDP has not recovered to its pre-crisis growthtrend in the U.S., while it has not returned to even its pre-crisis level in the Euro
area. As indicated by recent studies, such as Cerra and Saxena (2008) and Reinhart
and Rogo¤ (2009), …nancial crises tend to be followed by slow recoveries in which GDP
scarcely returns to its pre-crisis growth trend and involves a considerable economic loss.
Indeed, since the …nancial crisis in the 1990s, Japan’s GDP has never recovered to its
pre-crisis growth trend, and Japan’s economy has experienced a massive loss in GDP.
The post-crisis slow recoveries therefore cast doubt on the validity of the argument in
the literature starting from Lucas (1987) that the welfare costs of business cycles are
small enough that they do not justify stabilization policy.1 Thus our paper addresses thequestion of whether and to what extent monetary policy can ameliorate social welfare
in the face of a severe recession that is caused by a …nancial factor and is followed bya slow recovery. Particularly, in that situation, should monetary policy focus mainly
on in‡ation stabilization and make no response to output, as advocated in the existing
monetary policy literature including Schmitt-Grohé and Uribe (2006, 2007a, b)?2
This paper develops a model that can describe a slow recovery resulting from anadverse …nancial shock, and examines how monetary policy should react to the …nancial
shock in terms of social welfare. According to the International Monetary Fund (2009),
slowdowns in total factor productivity (TFP) growth were a signi…cant cause of slow
recoveries following banking crises around the globe over the past 40 years.3 Indeed,
1

Lucas (1987) argues that U.S. business cycles in the postwar period— of course, prior to 1987—
involve at most negligible welfare costs. See also Lucas (2003).
2

Schmitt-Grohé and Uribe (2006, 2007a, b) show that a welfare-maximizing monetary policy rulefeatures a muted response to output in a dynamic stochastic general equilibrium model (without …nancial
frictions or endogenous mechanisms of TFP growth).
3

IMF (2009) also indicates that long-lasting reductions in the employment rate and the capital-laborratio contribute to the post-crisis slow recoveries as well.

2

as a main source of Japan’s prolonged stagnation, Hayashi and Prescott (2002) pointout a slowdown in TFP growth subsequent to the collapse of asset price bubbles inthe early 1990s. Such slowdowns have also been measured after the recent …nancial
crisis, particularly in Europe. Our paper thus introduces a …nancial friction and an
endogenous mechanism of TFP growth in an otherwise canonical dynamic stochastic
general equilibrium (DSGE) model.4 TFP grows endogenously by expanding the varietyof goods through technology innovation and adoption as in Comin and Gertler (2006),
who extend the framework of endogenous technological change developed by Romer(1990). The …nancial friction constrains …rms’ borrowing capacity as in Jermann andQuadrini (2012). Then, an adverse shock to the borrowing capacity— which is referred toas an adverse “…nancial shock”following Jermann and Quadrini— induces a slow recovery
through the endogenous mechanism of TFP growth. Speci…cally, the adverse …nancial
shock tightens …rms’ …nancing and thereby reduces their activity, which in turn has asigni…cant negative impact on the economy as a whole by decreasing activity not only
on the demand side but also on the supply side of the economy. In particular, the e¤ect
on the supply side induces a permanent decline in output relative to a balanced growth
path through a permanent decline in TFP. The possibility of such permanent declines in
output and other real variables distinguishes our model from those used in the existing
literature on monetary policy. This distinctive feature yields a novel implication formonetary policy in terms of welfare costs of business cycles.
This paper analyzes a class of simple monetary policy rules that adjust the current
policy rate in response to the past policy rates and the current rates of in‡ation andoutput growth. The paper shows that in the face of the …nancial shocks, a welfare4

Queraltó (2013) builds a small open-economy real business cycle (RBC) model with the Gertler
and Karadi (2011) …nancial friction and the Comin and Gertler (2006) endogenous mechanism of TFP
growth to describe post-crisis slow recoveries observed in emerging market economies. Guerron-Quintana
and Jinnai (2014) use U.S. time series, including their measured intangible capital, to estimate (mainly
shocks in) an RBC model with the Kiyotaki and Moore (2012) …nancial friction and the Kung andSchmid (2013) endogenous technological change. They show that around the time of Lehman Brothers’
demise, liquidity declined signi…cantly, inducing the U.S. Great Recession.

3

maximizing monetary policy rule features a strong response to output. This …nding contrasts starkly with Schmitt-Grohé and Uribe (2006, 2007a, b). This contrast arises fromtwo factors. First, the type of the shock considered in deriving a welfare-maximizing ruledi¤ers: our paper focuses only on the …nancial shock, while their papers consider mainly
a TFP shock. Second, Schmitt-Grohé and Uribe (2006, 2007a) include a policy response
to wage in‡ation in their policy rules, and Schmitt-Grohé and Uribe (2007b) assume
no nominal wage rigidity in their model. Our paper also demonstrates that the welfare
gain from output stabilization is much more substantial than in the model where TFP
growth is exogenously given. In the presence of the endogenous TFP growth mechanism,
it is crucial to take into account a welfare loss from a permanent decline in consumption
caused by a slowdown in TFP growth.5 Moreover, compared with the welfare-maximizing
rule, a strict in‡ation or price-level targeting rule induces a sizable welfare loss, because
it has no response to output. By contrast, a nominal GDP growth or level targeting rule
performs well, although it causes relatively high interest-rate volatility.
The paper also conducts a …nancial crisis scenario simulation under the monetary
policy rules analyzed above. In this simulation, a slowdown in TFP growth is much lesspronounced under the welfare-maximizing monetary policy rule than under the strict
price-level targeting rule. Consequently, output recovers to its pre-crisis growth trend
faster under the welfare-maximizing rule, implying that the welfare gain from adopting
this rule relative to the strict price-level targeting rule is sizable, as noted above. Under
the nominal GDP level targeting rule, the achieved levels of TFP and output are almost
the same as those under the welfare-maximizing rule, implying that the welfare gain fromadopting the latter rule relative to the former is small, as indicated above. Yet a smaller
decline in …rms’loans than that in the value of their collateral tightens their borrowing
constraint and raises the marginal cost of funds and hence in‡ation. Under the nominal
5

Similarly, Barlevy (2004) argues that business cycle ‡uctuations can a¤ect social welfare by in‡uencing the growth rate of consumption, in contrast to Lucas (1987, 2003).

4

GDP level targeting rule, this rise in in‡ation induces an initial increase in the interest
rate even in the …nancial crisis scenario, and then the interest rate is lowered to hit arate of zero, causing relatively high interest-rate volatility, as noted above.
A closely related and complementary study has been done by Reifschneider, Wascher,and Wilcox (2013). These authors conduct optimal-control exercises using a version of
the FRB/US model with an ad hoc loss function that re‡ects the Federal Reserve’s dual
mandate. They argue plausibly that a signi…cant portion of the recent damage to the
supply side of the U.S. economy is endogenous to the weakness in aggregate demand,6
and such endogeneity provides a strong motivation for a vigorous policy response to a
weakening in aggregate demand. Our paper has demonstrated a similar argument totheirs, but has examined a welfare-maximizing monetary policy rule using a fully ‡edged
DSGE model augmented with the Jermann and Quadrini (2012) …nancial friction andshock and the Comin and Gertler (2006) endogenous mechanism of TFP growth.
The remainder of the paper proceeds as follows. Section 2 brie‡y reviews recent
post-crisis recoveries. Section 3 presents a DSGE model with a …nancial friction and an
endogenous mechanism of TFP growth. Section 4 con…rms that this model can describea slow recovery resulting from an adverse …nancial shock. Section 5 conducts monetary
policy analysis using the model. Section 6 concludes.

2

A Brief Review of Post-Crisis RecoveriesThis section brie‡y reviews the economic developments around recent …nancial crises toshow key features of post-crisis recoveries.7 The crises focused on here are the 2007–08
crises in the Euro area, the U.K., and the U.S. and the 1997 crisis in Japan.8
6Summers (2014) argues— in contrast to Say’s law— that “Lack of Demand creates Lack of Supply.”7

For comprehensive studies on post-crisis recoveries, see, e.g., Cerra and Saxena (2008), Reinhart
and Rogo¤ (2009), IMF (2009), and Reinhart and Reinhart (2010).
8

In 1997, Yamaichi Securities— one of the top four securities companies in Japan at that time—
failed, and Hokkaido Takushoku Bank failed, which was the …rst failure of a city bank in Japan’s
postwar history.

5For these …nancial crises, Fig. 1 plots the developments of four key variables: real
GDP per capita, TFP (Solow residual), bank lending, and the CPI in‡ation rate. Notethat in each panel of the …gure, the scale of years at the top is for Japan only, whilethat at the bottom is for the other three economies. In Panels (a) and (b), the pre-crisis
trend grows at a rate that is average over the four economies during the …ve years before
each crisis. In each panel, the following key feature of post-crisis recoveries is detected.
First, and most importantly, the post-crisis recoveries were quite slow, as shown inPanel (a). Since the onset of the recent crises, GDP has not recovered to the pre-crisis
growth trend in the U.S., while it has not returned to even its pre-crisis level in theEuro area and the U.K. Japan’s GDP has never recovered to the pre-crisis growth trend
since the 1997 crisis, and Japan’s economy has experienced a massive loss in GDP. This
con…rms the empirical evidence of Cerra and Saxena (2008), Reinhart and Rogo¤ (2009),
IMF (2009), and Reinhart and Reinhart (2010): …nancial crises tend to be followed byslow recoveries in which economic activity scarcely returns to its pre-crisis growth trend,
inducing a considerable loss in GDP.
As a main source of Japan’s prolonged stagnation, Hayashi and Prescott (2002) indicate a slowdown in TFP growth following the collapse of asset price bubbles in theearly 1990s. This slowdown continued in the post-1997 crisis period, as can be seen in
Panel (b). Moreover, after the 2007–08 crises, slowdowns in TFP growth have also beenmeasured, particularly in Europe. This is the second key feature of post-crisis recoveries.9
The third key feature is that a reduction in the degree of …nancial intermediation
was observed during and after the …nancial crises, as shown in Panel (c). Bank lending
in the Euro area, the U.K., and the U.S. all dropped sharply in 2009 and then remained
stagnant. Japan’s bank lending was already stagnant because of non-performing-loan
problems subsequent to the collapse of asset price bubbles in the early 1990s, and it
9

IMF (2009) also indicates the importance of slowdowns in TFP growth for slow recoveries that
followed banking crises around the globe over the past 40 years.

6dropped further in 1999.
Last, the in‡ation rate was less stable after the …nancial crises, as shown in Panel (d).
In the Euro area, the U.K., and the U.S., the in‡ation rate measured by CPI dropped
after the 2007–08 crises and then continued to ‡uctuate.10 In Japan, the CPI in‡ation
rate was already low after the collapse of asset price bubbles in the early 1990s, and it
dropped further after the 1997 crisis, falling into de‡ation.
Based on these features of post-crisis recoveries, the next section develops a modelthat can describe a slow recovery resulting from an adverse …nancial shock.

3

A DSGE Model for Slow Recoveries

To describe a post-crisis slow recovery like those reported in the preceding section, ourpaper introduces a …nancial friction and an endogenous mechanism of TFP growth inan otherwise canonical DSGE model.11 TFP grows endogenously by expanding thevariety of goods through technology innovation and adoption, as in Comin and Gertler(2006). The …nancial friction constrains the borrowing capacity of intermediate-good…rms, as in Jermann and Quadrini (2012). The combination of the …nancial friction andendogenous TFP growth then generates a powerful ampli…cation mechanism of a shock tothe borrowing capacity, which is called a “…nancial shock”as in Jermann and Quadrini.
An adverse …nancial shock tightens …nancing of intermediate-good …rms and thereby
reduces their activity. This in turn has a signi…cant negative impact on the economy asa whole by decreasing activity not only on the demand side but also on the supply sideof the economy. In particular, the e¤ect on the supply side, such as technology adoptersand innovators, induces a permanent decline in TFP relative to its growth trend and thus
10

Although the sharp drop in the CPI in‡ation rate in the Euro area and the U.S. partly re‡ected adecline in energy prices, the in‡ation rate measured by CPI excluding energy decreased as well.
11

Apart from the …nancial friction and endogenous TFP growth, our model is fairly canonical. Indeed,
the model has no habit formation in consumption preferences, no cost in investment adjustment, and no
dynamic indexation in price and wage setting. This allows us to focus on a new mechanism generated
by the …nancial friction and endogenous TFP growth in monetary policy analysis.

7causes a permanent decline in output relative to a balanced growth path. The possibilityof such permanent declines in output and other real variables distinguishes our modelfrom those used in the existing literature on monetary policy. This distinctive featureof our model yields a novel implication for monetary policy in terms of welfare costs ofbusiness cycles.
In the model economy, there are …nal-good …rms, intermediate-good …rms, retailers,
wholesalers, technology adopters, technology innovators, households, employment agencies, and a central bank.12 The behavior of these agents is described in what follows.

3.1

Final-good …rms

There is a continuum of …nal-good …rms f 2 [0; At 1 ]. Each …rm f produces …nal good
Xf;t by combining intermediate goods fXf;t (h)gh2[0;1] according to the CES production
R1
function Xf;t = [ 0 (Xf;t (h))( x 1)= x dh] x =( x 1) with the elasticity of substitution x > 1.
The …rm sells the …nal good to wholesalers under perfect competition so as to maximize
R1 xxx
pro…t Pf;tXf;tPf;t (h)Xf;t (h)dh, given the …nal good’s price Pf;tand intermediate0x
goods’prices fPf;t(h)gh2[0;1] . The …rst-order condition for pro…t maximization yields …rm

f ’s demand curve for each intermediate good Xf;t (h)
! x
x
Pf;t
(h)
Xf;t (h) = Xf;t
:
x
Pf;t

(1)

Substituting this demand curve in the production function leads to the price equation
R1 x
x
for …nal good Xf;t , Pf;t
= [ 0 (Pf;t(h))1 x dh]1=(1 x ) .

3.2

Intermediate-good …rms

Intermediate-good …rms play a central role in the model. They engage in various typesof activity: borrowing, hiring, capital investment, purchase of newly adopted ideas,
production, price setting, and dividend payment.
12

Wholesalers, retailers, and employment agencies are added to the model, only for introducing priceand wage rigidities.

8

There is a continuum of intermediate-good …rms h 2 [0; 1]. Each …rm h owns capital
Kt 1 (h) and a continuum of adopted ideas (e.g., patents) f 2 [0; At 1 (h)], and adjusts
the capital utilization rate ut (h). For each adopted idea f , the …rm uses e¤ective capital ut (h)Kf;t 1 (h) and labor nf;t (h) to produce intermediate good Xf;t (h) according to
the Cobb-Douglas production function Xf;t (h) = (nf;t (h))1
capital elasticity of output(ut (h)Kf;t 1 (h)) with the

2 (0; 1). The symmetry among adopted ideas f implies anidentical e¤ective capital-labor ratio in …rm h’s production for each intermediate good
Xf;t (h), f 2 [0; At 1 (h)]. Then, aggregating …rm h’s production functions— along with…nal-good …rms’demand curves (1)— yields! x
Z At 1 (h)
x
Pf;t
(h)
Xf;t
df = (nt (h))1xPf;t0where nt (h) =R At 1 (h)0nf;t (h)df and Kt (h) =R At (h)0(ut (h)Kt 1 (h)) ;(2)

Kf;t (h)df .

Each …rm h accumulates capital Kt (h) and adopted ideas At (h) according to
Kt (h) = (1k;t (h)) Kt 1 (h) + It (h);(3)

At (h) = (1a ) At 1 (h) +(4)a;t (h);where It (h) is …rm h’s capital investment,a;t (h) is the number of newly adopted ideas…rm h purchases from technology adopters,k;t (h) 2 (0; 1) is the (time-varying) depreci-

ation rate of capital, anda 2 (0; 1) is the obsolescence rate of ideas. As in Greenwood,

Hercowitz, and Hu¤man (1988) and Comin and Gertler (2006), it is assumed that a higher
utilization rate of capital leads to a higher depreciation rate of capital. Speci…cally, thedepreciation rate function takes the formwithk 2 (0; 1),

1 > 0, andk;t (h) =k + 1 (ut (h)1)+( 2 =2)(ut (h)1)2

2 > 0, as in Schmitt-Grohé and Uribe (2012).

Following Jermann and Quadrini (2012), each …rm h uses debt and equity. Debt ispreferred to equity because of its tax advantage. Given the gross risk-free (nominal)
interest rate rt , the e¤ective gross (nominal) interest rate for each …rm h is rt = 1 + (1)(rt 1), where2 (0; 1) denotes the tax bene…t. This bene…t is …nanced by a lump-sum
9tax on households. Each …rm h starts the period with intertemporal debt Pt 1 Bt 1 (h),where Pt is the price of retail goods. It is assumed that the …rm must pay for labornt (h), capital investment It (h), and newly adopted ideasa;t (h) before its production

takes place. To …nance this payment, the …rm raises funds with an intratemporal loan
Pt Lt (h) = Pt Wt nt (h) + Pt It (h) + Pt Vt(5)a;t (h);where Wt is the real wage and Vt is the real value of an adopted idea.13 The intratemporalloan is repaid with no interest at the end of the period. The capacity of the intratemporalloan Pt Lt (h) and intertemporal debt Pt Bt (h) is constrained by the value of capital andadopted ideas held by the …rm because of a lack of enforcement. In particular, the…rm can default on its debt (both Pt Lt (h) and Pt Bt (h)) before the payment for the
intratemporal loan is made at the end of the period. In case of default, the capital andadopted ideas held by the …rm are seized with probabilityt 2 (0; 1).

Then, it follows

from the argument of Jermann and Quadrini (2012) that the intratemporal loan Pt Lt (h)is limited by the borrowing constraint
Pt Lt (h)t

Pt Bt (h)rt

Pt Kt (h) + Pt Vt At (h):(6)

It is assumed throughout the paper that this borrowing constraint is always binding
and that the log-deviation of the foreclosure probabilityt from its steady-state value

follows the stationary …rst-order autoregressive processlog
where 0

< 1 and

t

=

log

t 1

+

;t ;

;t is white noise and is called a “…nancial shock.”

After the intratemporal loan arrangement is made, each …rm h produces and sells
intermediate goods to …nal-good …rms and then pays back the loan. Moreover, the …rm
13

With several speci…cations of intratemporal loans, Jermann and Quadrini (2012) conduct robustness
exercises. Their baseline speci…cation supposes that …rms use an intratemporal loan to …nance total
payment made in the period, including payments for dividends and intertemporal debt. Their alternative
speci…cation assumes that only the wage bill is …nanced by an intratemporal loan. Apart from …rms’
purchase of newly adopted ideas, our speci…cation is an intermediate between these two.

10

renews intertemporal debt and pays dividends Pt Dt (h) to households. Let the sum of thedividends and associated payment costs in terms of retail goods be denoted by 't (h)At 1 ,where 't (h) = Dt (h)=At 1 +d (Dt (h)=At 1

in the whole economy (de…ned later),d)2 , At represents the level of technologyd > 0 is the elasticity of dividend payment costs,

and d is the steady-state value of detrended dividends dt (h) = Dt (h)=At 1 . The presenceof At 1 in the costs ensures a balanced growth path in the model. The …rm’s budget
constraint— along with …nal-good …rms’demand curves (1)— can then be written as
Pt Wt nt (h) + Pt It (h) + Pt Vt a;t (h) + Pt 't (h)At 1 + Pt 1 Bt 1 (h)! x
Z At 1 (h)x(h)
PPt Bt (h)
f;t
x
Pf;t
=
(h)Xf;t
df +
:
x
Pf;t
rt
0

(7)

Each …rm h chooses dividends Dt (h), capital Kt (h), intertemporal debt Bt (h), laborxnt (h), the utilization rate ut (h), its products’ prices fPf;t(h)gf 2[0;At 1 (h)] , and adopted

ideas At (h) to maximize the expected discounted value of the present and future diviP
dends E0 1
t=0 m0;t Dt (h) subject to (2)–(7), where m0;t is the real stochastic discountfactor between period 0 and period t. Because intermediate-good …rms are symmetric,

the …rm index h can be deleted from the …rst-order conditions for dividend maximization. Then, substituting the …rst-order condition for dividends in those for capital andintertemporal debt yields"
1 = Et mt;t+1
1 = Et mt;t+1

0
St+1 ut+1 n1t+1 =Kt1 + (1k;t+1 ) 1='t+1 +1='0t + t (1
t)

'0t
+
0
t+1 't+1

rt

t+1

0 rt
;
t t 'trt

where mt;t+1 = m0;t+1 =m0;t , '0t = @'t =@(Dt =At 1 ) = 1 + 2 d (Dt =At 1
t =Pt

#

;

(8)
(9)

d), St andare the Lagrange multipliers on the aggregate production function (2) and theborrowing constraint (6), andt = Pt =Pt 1 is the gross in‡ation rate of retail goods’

price. Combining the …rst-order conditions for dividends, labor, and the utilization rate11

leads to
1

where

0
k;t

=

Wt nt
;
0
k;t ut Kt 1

(10)
1

0
k;t

St =

1
+
'0t

t

1 +

2 (ut

1). Substituting the …rst-order condition for= @ k;t =@ut =

Wt
1

;

(11)

dividends in those for the prices yields
xPf;t= Pt x St '0t ;

where

x =

x =( x(12)1).14 Moreover, the aggregate production function (2), the budget

constraint (7), and the …rst-order condition for adopted ideas can be rewritten as
Z At 1
Xf;t df = n1t (ut Kt 1 ) ;(13)
0

Wt nt + It + Vt
Vt = Et mt;t+1

( x

Bt 1

Bt
;
rt
t
0
1)St+1 Xf;t+1 + (1a )Vt+1 (1='t+1 + t+1 ):1='0t + t (1t)

a;t + 't At 1 +=0 1
x St ' t n t(ut Kt 1 ) +

(14)
(15)

In the ampli…cation mechanism generated by the …nancial friction and endogenous
TFP growth, intermediate-good …rms’ demand curve for adopted ideas (15) plays animportant role. Through this demand curve, an adverse …nancial shock decreases thevalue of an adopted idea Vt , because it not only lowers the foreclosure probability

t but

also tightens the borrowing constraint (6) and thus increases the associated Lagrange
multipliert.

As shown later, such a decrease in the value of an adopted idea causes

technology adopters to become less willing to adopt developed but not yet adopted ideas.
The resulting decline in newly adopted ideas has a persistent e¤ect because of theiraccumulation process (4). Therefore, an adverse …nancial shock induces a permanent
decline in output relative to a balanced growth path through the persistent decline inadopted ideas (or equivalently TFP). This mechanism is further strengthened when an
adverse …nancial shock is persistent or is expected to continue occurring.
14

The symmetry among intermediate-good …rms
an identical price for each intermediate goodR 1 impliesxx
x
Xf;t (h), h 2 [0; 1]. Thus it follows that Pf;t
= [ 0 (Pf;t(h))1 x dh]1=(1 x ) = Pf;t(h) for all h.

12

3.3

Retailers

There is a representative retailer. It produces retail goods Yt by combining wholesale
R 1 ( 1)= ygoods fYh;t gh2[0;1] according to the CES production function Yt = ( 0 Yh;tydh) y =( y 1)
with the elasticity of substitutiony > 1. It sells retail goods to households, intermediate-

good …rms, and technology adopters and innovators so as to maximize pro…t Pt Yt
R1
Ph;t Yh;t dh, given Pt and wholesale goods’prices fPh;t gh2[0;1] . The …rst-order condition
0
for pro…t maximization yields the retailer’s demand curve for each wholesale good Yh;t
Yh;t = Yt

Ph;t
Pt

y

(16)

:

Substituting this demand curve in the production function leads to retail goods’ priceequation
Pt =

Z 1

1

1
Ph;t

1
y

y

:

dh

(17)

0

3.4

Wholesalers

There is a continuum of wholesalers h 2 [0; 1]. Each wholesaler h produces its good Yh;tby combining …nal goods fXf;t gf 2[0;At 1 ] according to the CES production function Yh;t =
RA
(
1)= a
( 0 t 1 Xf;tadf ) a =( a 1) with the elasticity of substitution a > 1 to minimize cost
R At 1 x
x
Pf;t Xf;t df , given fPf;t
gf 2[0;At 1 ] . The …rst-order condition for cost minimization
0
yields wholesaler h’s demand curve for each …nal good Xf;t
Xf;t = Yh;tx
Pf;tM Ch;ta;(18)

where M Ch;t is the Lagrange multiplier on wholesaler h’s production function and represents its marginal cost. Substituting this demand curve in the production function leadsRA
x 1 a
to M Ch;t = [ 0 t 1 (Pf;t)
df ]1=(1 a ) . This shows that the marginal cost is identicalamong wholesalers. Using the price equations (12), the marginal cost can be reduced to
M Ct = Pt x St '0t A1t
13

a

;

(19)

wherea =a =( a1). Then, from this equation and equations (12), (13), and (18),the output of wholesale good Yh;t is given by
Yh;t = At a 1 1 n1t(20)(ut Kt 1 ) :Using this equation, two more key equations can be derived. First, substituting equations (12), (19), and (20) in wholesalers’demand curve (18) leads to Xf;t = n1t(ut Kt 1 ) =At 1 .

Combining this equation and intermediate-good …rms’demand curve for adopted ideas(15) yields
Vt = Et mt;t+1( x1)St+1 n1t+1 (ut+1 Kt ) =At + (11='0t + t (10a )Vt+1 (1='t+1 +

t+1 )

t)

:

(21)

Second, aggregating wholesale goods’ output equations (20)— along with retailers’ demand curves (16)— leads toYt =At a 1 1

n1t(ut Kt 1 ) =

1

At 1

p;t

n1t

(22)

(ut Kt 1 ) ;

p;t

where
p;t =

Z 1
0

Ph;t
Pt

y

(23)

dh

represents dispersion of wholesale goods’prices and wherea1

At = At1(24)

represents the level of technology in the whole economy and its growth ratet = At =At 1

shows the gross rate of technological change. Equation (22) shows a standard CobbDouglas production function, except that TFP is endogenously determined by
T F Pt =

At 1

1

(25)

:

p;t

Under monopolistic competition, each wholesaler h sets its product’s price on a staggered basis as in Calvo (1983) and Yun (1996). In each period, a fractionp 2 (0; 1) of

wholesalers sets prices according to the indexation rule Ph;t = Ph;t 1 , where14

is thesteady-state value of the in‡ation ratet , while the remaining fraction 1

p chooses

the price P~h;t that maximizes the associated pro…t
Et

1
X

f
p Mt;t+f

f ~Ph;tM Ct+f Yh;t+f jt ;f =0given the marginal cost M Ct+f and retailers’demand curve Yh;t+f jt = Yt+f ( f P~h;t =Pt+f )where Mt;t+f is the nominal stochastic discount factor between period t and period t + f .
The …rst-order condition for the optimal staggered price P~h;t yields
P~h;t
=
Pt
where

y =

y =( y

p1;t
y

(26)

;

p2;t

1) and the auxiliary variables

p1;t and

p2;t are de…ned recursivelyby
M Ct Yt+
p1;t =
Pt Ct
Yt+
p2;t =
Ct

p Et

p Et

"

"

y

p1;t+1t+1
1

yp2;t+1
t+1

#

#

;

;

(27)
(28)

where the equilibrium condition Mt;t+h = ( h Ct =Ct+h )= t+h — which is derived later— isused,

2 (0; 1) is the subjective discount factor, and Ct is consumption. Moreover, under

the staggered price setting, retail goods’ price equation (17) and the price dispersion
equation (23) can be reduced respectively to
1 = (1p;t = (1

3.5

P~h;t
p)
Pt
P~h;t
)
p
Pt

!1

! y

y

1

+ p

y

;

(29)

p;t 1 :

(30)

t
y

+ p

t

Technology adopters

There is a continuum of technology adopters. Each adopter owns a developed but not
yet adopted idea that is in the interval between At 1 and Zt 1 . This adopter makes an

15

y

,

investment Ia;t for technology adoption in terms of retail goods. The adopter successfully
adopts the idea with probabilityt 2 (0; 1). This probability takes the form
t =

with

At 1
Ia;t
At 1

0

!

(31)

;

0 > 0 and ! 2 (0; 1), as in Comin and Gertler (2006).

Thus, the probabilitytincreases with investment Ia;t , and there is a spillover e¤ect from already adopted ideas
At 1 to individual adoption. The presence of At 1 keeps the probability(2

Because At 1 =At 1 = At 1a )=(1)t stationary.

, the spillover e¤ect is positive as long as+ a < 2,

which holds under our parameterization of the model presented later.
After the adoption, a fraction a of adopted ideas becomes obsolete. Thus, the amountof newly adopted ideas sold to intermediate-good …rms is given bya;t = (1a)

t (Zt 1

At 1 ) :(32)

The value of a developed but not yet adopted idea is given by
Jt = max
I~a;t

n

I~a;t + (1

o
)
E
m
J
]
:
t
t t;t+1 t+1a ) [ t Vt + (1(33)

A developed idea, if successfully adopted, is sold to intermediate-good …rms at the real
price Vt . Otherwise, the value of the idea is given by its expected discounted value
Et mt;t+1 Jt+1 .
The …rst-order condition for investment Ia;t yields
Ia;t = ! (1

a)

t (Vt

Et mt;t+1 Jt+1 ) :(34)

Thus, a decline in the value of an adopted idea Vt directly decreases technology adoption
investment Ia;t , which in turn lowers the probability of technology adoptiont and thus

further decreases the investment Ia;t . This spiral slows the rate of technology adoption
and hence the growth rates of At and TFP. Moreover, substituting equation (34) inequation (33) leads to
Jt = (1a ) f(1!) t Vt + [116(1!) t ] Et mt;t+1 Jt+1 g ;(35)

which shows that a decline in the value of an adopted idea Vt decreases the value of adeveloped but not yet adopted idea Jt .

3.6

Technology innovators

There is a representative technology innovator. This innovator transforms one unit ofretail goods intot units of developed ideas. Given the obsolescence ratea , the frontierof developed ideas, Zt , follows the law of motion
Zt = (1a ) Zt 1 +t Id;t ;(36)

where Id;t is R&D investment. As in Comin and Gertler (2006), the R&D productivity
t takes the form
t =

with

z > 0 and

z

Zt 1
;
1
At 1 Id;t(37)

2 (0; 1). The zero-pro…t condition under perfect competition can be

reduced to
1=

t (1

a ) Et mt;t+1 Jt+1 :(38)

Combining this condition and the law of motion of developed ideas (36) yields
Id;t = (1a ) [Zt(1a ) Zt 1 ] Et mt;t+1 Jt+1 :(39)

Thus, a decline in the expected discounted value of a developed but not yet adopted
idea Et mt;t+1 Jt+1 — which arises from a decline in the expected discounted value of an
adopted idea Et mt;t+1 Vt+1 because a lower value of Vt decreases Jt as in (35)— decreases
R&D investment Id;t . This then slows the growth rate of Zt and constrains TFP growth.

3.7

Households and employment agencies

Households are standard as in the literature on DSGE models. There is a continuumof households with measure unity, each of which is endowed with one type of specialized labor f 2 [0; 1]. Households have monopolistic power over wages for specialized17

labor, and the wages are set in a staggered manner.15 A representative employment
agency transforms specialized labor into homogeneous labor and provides the latter tointermediate-good …rms.
The problem of households consists of three parts: a consumption-saving problem,the employment agency’s problem, and a wage-setting problem. In the consumptionsaving problem, each household chooses consumption Ct and savings Bt to maximize theutility function
E0

1
X

t

log(Ct )t=0n

1 + 1=

1+1=

nf;t

;

(40)

subject to the budget constraint
Pt Ct +
where

Pt Bt
= Pt Wf;t nf;t + Pt 1 Bt 1 + Tf;t ;rt> 0 is the elasticity of labor supply,(41)

n > 0 is the coe¢ cient on labor disutility

relative to contemporaneous consumption utility, Wf;t and nf;t are the real wage and the
supply of specialized labor f , and Tf;t is the sum of intermediate-good …rms’dividend
payout Pt Dt , the other …rms’pro…ts, a lump-sum public transfer, and a net ‡ow fromcontingent claims on the opportunity of wage changes. The presence of the contingent
claims allows the model to keep a representative-household framework.
Combining the …rst-order conditions for the consumption-saving problem yields
1 = EtCt rt;
Ct+1 t+1(42)

which leads to Mt;t+h = mt;t+h = t+h = ( h Ct =Ct+h )= t+h .
The retail-good market clearing condition is now given by
Yt = Ct + It + 't At 1

Dt + Ia;t (Zt 1

At 1 ) + Id;t :(43)

The output Yt equals households’consumption Ct , intermediate-good …rms’capital investment It , their dividend payment costs ('t At 1 Dt ), technology adopters’investment
Ia;t (Zt 1

At 1 ), and technology innovators’R&D investment Id;t .

15Nominal wage rigidity is an important factor to describe a slow recovery resulting from an adverse…nancial shock in the model, as shown later.

18

The employment agency transforms specialized labor fnf;t gf 2[0;1] into homogeneous
R 1 ( 1)= ndf ) n =( n 1) withlabor nt according to the CES aggregation function nt = ( 0 nf;tn
the elasticity of substitutionn > 1. The agency then chooses the amount of all types of

R1

specialized labor fnf;t gf 2[0;1] to maximize pro…t Pt Wt nt

0

Pt Wf;t nf;t df , given homo-

geneous labor’s wage Pt Wt and specialized labor’s wages fPt Wf;t gf 2[0;1] . The …rst-ordercondition for pro…t maximization yields the employment agency’s demand curve for eachtype of specialized labor
Pt Wf;tPt W tnf;t = nt

n

(44)

:

Substituting this demand curve in the aggregation function leads to homogeneous labor’s
wage equation
Pt W t =Z 1

1(Pt Wf;t )1

1

n

df

n

(45)

:

0

The wage of each type of specialized labor is set on a staggered basis as in Erceg,
Henderson, and Levin (2000). In each period, a fraction
according to the indexation rule Pt Wf;t =steady-state wage in‡ation rate and2 (0; 1) of wages is set

w Pt 1 Wf;t 1 , wherew =is the grossis the steady-state value of the gross rate of~t , while the remaining fraction 1

technological changew

w is set at the wage Pt Wf;tthat maximizes
Et

1
X

(

h
w)

h
~
t+h w Pt Wf;t nf;t+hjt

n

1 + 1=

h=0

1+ 1

nf;t+hjt ;~ f;t =(Pt+h Wt+h )]given the employment agency’s demand curve nf;t+hjt = nt+h [ hw Pt W
where

t

n

,

is the Lagrange multiplier on the budget constraint (41). The …rst-order~ f;t yields
condition for the optimal staggered wage Pt W
~ f;t
Pt W
Pt W twheren =n =( n

!1+ n

=

w1;t
n n

1) and the auxiliary variables

19

;

(46)

w2;t

w1;t andw2;t are de…ned recursively

by
1+ 1
+
w1;t = nt

Wt nt+
w2;t =
Ct

w Et

"

w Et

Wt

n

(1+ 1 )
w1;t+1t+1 Wt+1

"

Wt

1

n

w2;t+1t+1 Wt+1

#

#

(47)

;

(48)

:

Under the staggered wage setting, homogeneous labor’s wage equation (45) can be reduced to
1 = (1

3.8

w)

~ f;t
Pt W
Pt W t

!1

n

+ w

t

Wt 1
Wt

1

n

(49)

:

The central bank

The central bank follows a Taylor (1993)-type rule that adjusts the current policy rate
in response to the past policy rate and the current rates of price in‡ation and output
growth of retail goods
log rt =r log rt 1 + (1r)

log r +

where r is the steady-state policy rate,smoothing, and

and

(log

t

log ) +

dy

log

Yt
Yt 1

log

; (50)

r 2 [0; 1) represents the degree of policy rate

16
dy are the policy responses to in‡ation and output growth.

The equilibrium conditions consist of equations (3)–(6) (without the index h and withthe equality holding in (6)), (8)–(11), (14), (19), (21), (22), (24)–(32), (34)–(38), (42),(43), (46)–(49), and (50). Appendix A presents equilibrium conditions and the steadystate in terms of stationary variables.

4

A Slow Recovery from an Adverse Financial ShockThis section con…rms that the model presented in the preceding section possesses thecapability to describe a slow recovery resulting from an adverse …nancial shock. To this16

No output gap is included in the monetary policy rules considered in the paper. This is because in themodel, where monetary policy can a¤ect TFP, it is not clear which output gap monetary policymakers
ought to stabilize. The gap between actual output and potential output that could be obtained in theabsence of nominal rigidities— which has been considered as a theoretically appropriate output gap formonetary policymakers in models where TFP is exogenously given— seems to be inappropriate, because
welfare losses arise not only from nominal rigidities but also from the endogenous TFP mechanism.

20

end, the model is parameterized, linearized around the steady state, and solved for the rational expectations equilibrium. Then, impulse responses show how an adverse …nancial
shock induces a slow recovery. Last, two key factors to describe the slow recovery— theendogenous mechanism of TFP growth and nominal wage rigidity— are explained.

4.1

Parameterization of the modelThis section begins by parameterizing the model. The model parameters are divided into
three sets. The …rst set contains parameters that are standard in DSGE models. The
second set pertains to the technology innovation and adoption. The values of parametersin this set are chosen on the basis of Comin and Gertler (2006). The third set pertains
to the …nancial friction. For this set, the parameter values calibrated by Jermann andQuadrini (2012) are employed. Table 1 lists the parameterization of the quarterly model.
Regarding the parameters in the …rst set, this paper chooses the subjective discountfactor at= 0:9975 and the steady-state gross rate of technological change at=

1:0025, implying an annualized steady-state real interest rate of 2 percent. Steady-statelabor is normalized to unity, i.e., n = 1. The paper also sets the elasticity of labor supply
at= 1, the capital elasticity of output at= 0:36, the steady-state capital utilization

rate at u = 1, the steady-state capital depreciation rate at

k = 0:025 (i.e., an annualized

rate of 10 percent), the steady-state elasticity of capital depreciation atdegrees of price and wage rigidities at

2 = 1 = 0:5, thep =w= 0:75, the elasticities of substitution

among wholesale goods and among labor at

y

=

n

= 11 (i.e.,

y

=

n

= 1:1), thesteady-state gross in‡ation rate at= 1:005 (i.e., an annualized rate of 2 percent), thedegree of policy rate smoothing at

r = 0:7, and the policy responses to in‡ation andoutput growth at= 0:25. These parameter values are more or less

= 1:5 anddy

within the values calibrated or estimated in previous studies with DSGE models.
Next, the values of the parameters that pertain to the technology innovation andadoption are explained. This paper follows Comin and Gertler (2006) to set the elastici-

21ties of substitution among intermediate goods and among …nal goods at(i.e.,x =x =a = 2:67

a = 1:6), the steady-state probability of technology adoption at= 0:025(i.e., an average duration of technology adoption of 10 years), the elasticity of the probability of technology adoption at ! = 0:95, and the elasticity of R&D productivity at= 0:8. The steady-state ratio of R&D investment to output is chosen at id =y = 0:025.17
Last, the values of the parameters that pertain to the …nancial friction are presented.
This paper follows Table 2 of Jermann and Quadrini (2012) to set the steady-state
probability of foreclosure at
d = 0:146, the tax bene…t at

4.2= 0:1634, the elasticity of the dividend payment costs at= 0:35, and the …nancial shock persistence at= 0:9703.

Impulse responses to an adverse …nancial shock

Using the model parameterization presented above, this subsection analyzes impulse
responses to an adverse …nancial shock.18
Fig. 2 presents impulse responses of intratemporal loans Lt , labor nt , capital investment It , output Yt , consumption Ct , the in‡ation rate
T F Pt to the adverse …nancial shock;1 =t , the interest rate rt , and TFP

0:01. This …gure expresses labor in terms ofpercentage deviations from its steady-state value and the rates of in‡ation and interestin terms of percentage di¤erences from their steady-state values, while the others are
expressed in terms of percentage deviations from their steady-state growth paths starting from period 0. The solid line, called the “benchmark,” represents the case of themodel presented in the preceding section. When the adverse …nancial shock
economy in period 1, it lowers the foreclosure probability;1 hits thet and tightens the borrowing

constraint (6), so that intratemporal loans to intermediate-good …rms, Lt , drop. The
17

The values of the obsolescence rate of ideas a and the scaling parameter of R&D productivity
are calculated from steady-state conditions, as shown in Appendix A.2.
18

zRegarding impulse responses to a monetary policy shock (i.e., a shock added to the monetary policy
rule (50)), we con…rm that the model possesses standard properties for monetary policy analysis. Thatis, in response to a contractionary monetary policy shock, the interest rate rises, and then output, labor,
consumption, and investment all decline. In‡ation decreases as well. Overall, these impulse responses
are consistent with those in canonical DSGE models.

22

…rms then reduce labor nt , capital investment It , and purchase of newly adopted ideasa;t .

This in turn has a negative impact on the economy as a whole. The declines inlabor and capital investment decrease output Yt and consumption Ct , as well as in‡ation
19
t , inducing a recession.

In reaction to the declines in in‡ation and output growth, themonetary policy rule (50) lowers the interest rate rt . On the other hand, the decline in
the purchase of newly adopted ideas lowers technology adoption and innovation, so that
TFP falls permanently relative to its steady-state growth path through the endogenous
mechanism embedded in the model. As noted above, an adverse …nancial shock decreases the value of an adopted idea Vt through intermediate-good …rms’demand curve
for adopted ideas (21). This decline in the value of an adopted idea reduces technology
adopters’investment Ia;t through equation (34) and lowers the adoption probabilitytthrough equation (31), thereby slowing the growth rates of At and TFP. Moreover, because the adverse …nancial shock is persistent, it lowers the expected discounted valueof an adopted idea, Et mt;t+1 Vt+1 , and decreases the expected discounted value of a developed but not yet adopted idea, Et mt;t+1 Jt+1 , through equation (35). This decreasein the latter expected discounted value reduces R&D investment Id;t through equation(39) and slows the growth rate of Zt , which constrains TFP growth and causes TFP tofall permanently (relative to the steady-state growth path). As a consequence of thismechanism, neither output, consumption, nor capital investment returns to the steadystate balanced growth path after the adverse …nancial shock hits the economy. Indeed,
output drops below the steady-state balanced growth path by about 0:9 percentage point
and then recovers by less than half of the drop, remaining below the path by about 0:6
percentage point even after 40 quarters (10 years). From these observations, we con…rm
19

In response to the adverse …nancial shock, in‡ation declines because of a decrease in wholesalers’real marginal cost M Ct =Pt . Equation (19) shows that M Ct =Pt = x (St =At a 1 1 )'0t . As can be seen in
Panel (h) of Fig. 2, TFP— its main component At a 1 1 (= (At 1 )1 ) in particular— falls in response to theshock. Although this fall adds an upward pressure on the real marginal cost, a drop in intermediate-good…rms’real marginal cost of dividend payments '0t generates the decline in wholesalers’real marginal cost
M Ct =Pt . Such a drop in '0t is because in response to the shock, intermediate-good …rms cut dividends,
which reduces their real marginal cost of dividend payments '0t .

23that the model possesses the capability to describe a slow recovery resulting from anadverse …nancial shock.

4.3

Key factors for a slow recovery from an adverse …nancialshock

Before proceeding to monetary policy analysis, this subsection investigates which factor
in the model is important for describing a slow recovery from an adverse …nancial shock.
In Fig. 2, the dashed line, labeled the “no endogenous TFP growth,”represents the caseof the model without the endogenous mechanism of TFP growth for understanding therole of this mechanism in the slow recovery. The dotted line, called the “no nominal wage
rigidity,”represents the case of the model without nominal wage rigidity to examine therole of this rigidity for the slow recovery.
The model without the endogenous TFP growth mechanism assumes that TFP grows
exogenously at the same steady-state rate, as shown in Panel (h) of the …gure. In themodel there is neither technology innovation nor adoption. In short, such a model is astandard DSGE model with the …nancial friction and shock as in Jermann and Quadrini(2012). When the adverse …nancial shock;1 =0:01 hits the economy in period 1,

output drops below the steady-state balanced growth path (starting from period 0) by
about 0:4 percentage point, about less than half of the drop in the benchmark model.
It then returns to the path, in sharp contrast with the permanent decline in output(relative to the path) in the benchmark model. Therefore, the endogenous mechanismof TFP growth is a crucially important factor for describing the slow recovery from theadverse …nancial shock.
Another important factor for describing the slow recovery is nominal wage rigidity.
The model without such a rigidity assumes that the degree of the rigidity is set atw= 0. In response to the adverse …nancial shock;1 =0:01, output drops below

the steady-state balanced growth path (starting from period 0) by about 0:8 percentage

24

point and then approaches the path faster than in the benchmark model. Although
output does not return to the path because of the presence of the endogenous TFP
growth mechanism, the magnitude of the permanent decline in output (relative to thepath) is much smaller than in the benchmark model. In 40 quarters (10 years), output
approaches the path much more closely than in the benchmark model. In reaction to theadverse …nancial shock, nominal wage rigidity causes nominal wages to decline less andlabor to drop more than in the absence of the rigidity. This drop in labor reduces output
Yt directly through the aggregate production function (22). Moreover, in the presenceof nominal wage rigidity, the level of labor continues to be lower than in the absence ofthe rigidity, which decreases the value of an adopted idea Vt through intermediate-good…rms’demand curve for adopted ideas (21). This decline in the value of an adopted idea
slows the growth rates of At and TFP, as indicated above. Consequently, the permanent
decline in output is larger in the benchmark model. Therefore, nominal wage rigidity is
another key factor for describing the slow recovery from the …nancial shock.

5

Monetary Policy Analysis

This section examines how monetary policy should react to the …nancial shocks. To
this end, the section begins by deriving a welfare measure from the utility functions ofhouseholds. With this welfare measure, a welfare-maximizing monetary policy rule iscomputed and characterized. Last, under the welfare-maximizing rule and other rules, a…nancial crisis scenario simulation is carried out.

5.1

Welfare measure

The welfare measure is the unconditional expectation of the average utility function overhouseholds, given by
SW = (1

)E

"Z

0

1
1X

t

log(Ct )

t=0

25

n

1 + 1=

1+1=

nf;t

#

df ;

(51)

where E is the unconditional expectation operator, and the scaling factor (1) is mul-

tiplied for normalization. Because TFP grows endogenously over time, a deterministic
trend with the steady-state rate of technological change

is subtracted from this welfare

measure SW for the ease of computation. Letting SW denote the resulting stationary
welfare measure, Appendix B shows that this welfare measure can be approximatedaround the steady state, up to the second order, as
SWV ar (ct )+2c2
1

V ar ( t )+2 ( )2n V ar (nt )

2

+

"c
+
c 1

"

n "n

n

1 + 1=" w;(52)

where V ar denotes the unconditional variance operator, ct (= Ct =At 1 ) is detrended consumption, c is its steady-state value, "x = E(xt )x is the “bias”between the uncondiR1
tional mean and the steady-state value of variable xt , and w;t = 0 (Wf;t =Wt ) n (1+1= ) df

denotes wage dispersion arising from the staggered wage setting of households. Note thatin the second-order approximation, the bias can exist; that is, the unconditional mean
does not necessarily coincide with the steady-state value. The approximation (52) showsthat the stationary welfare measure SW is negatively related to the bias in labor andwage dispersion and the unconditional variances of detrended consumption, the rate oftechnological change, and labor (i.e., "n , " w , V ar (ct ), V ar ( t ), V ar (nt )) and is positively related to the bias in detrended consumption and the rate of technological change(i.e., "c , " ). A distinctive feature of the welfare measure (52) lies in the presence ofthe terms related to the rate of technological changet (i.e., ", V ar ( t )). In standard

DSGE models where TFP growth is exogenously given, the bias and the unconditionalvariance of the rate of technological change are also exogenously given and independentof policy. In our model, however, TFP grows endogenously and depends on policy, sothat thet -related terms constitute social welfare relevant to policy evaluation.

Let SWb and SWa denote the values of the welfare measure SW attained underthe benchmark monetary policy rule (i.e., the rule (50) with the benchmark parameterization presented in Table 1) and under an alternative monetary policy rule, and let26

SW = SWa

SWb . Then, this di¤erence also equals the corresponding di¤erence interms of the welfare measure (51); that is,

SW = SWa

SWb , where SWb and SWa

denote the values of the welfare measure (51) under the benchmark rule and under thealternative rule, because the subtracted deterministic trend in the technological level
At is identical between SWb and SWa . Therefore, the welfare di¤erence

SW , if it ispositive, represents the welfare gain from adopting the alternative rule relative to thebenchmark rule. Moreover, g = 1(1

2 SW )1=2 represents the welfare gain in termsof permanent increase in consumption, because by de…nition, this welfare gain measureg must satisfy
SWa = (1

)E

"Z

0

1
1X

t

log((1 + g) Cb;t )t=0n

1 + 1=

1+1=
nb;f;t#df ;where fCb;t ; fnb;f;t gg is the pair of equilibrium consumption and labor under the benchmark monetary policy rule, and then it follows
SWb +SW = SWa = SWb + log(1 + g)

SWb + g1 2
g ;2

where the last approximation uses the second-order approximation to log(1 + g) aroundg = 0.
Using the welfare measure (52) and the welfare gain measure g, the next subsections
analyze a welfare-maximizing monetary policy rule in reaction to the …nancial shocks.

5.2

Features of welfare-maximizing monetary policy rule in reaction to …nancial shocks

This paper considers a class of simple monetary policy rules that adjust the current policy
rate in response to the past policy rates and the current rates of in‡ation and output
growth. Speci…cally, two forms of such rules are analyzed. One form is, of course, therule (50). The present paper refers to this rule as “‡exible in‡ation targeting.”Moreover,in this form, the speci…cation of
speci…cation of=dy = 0 is called “strict in‡ation targeting,” while thedy is called “nominal GDP growth targeting.” The other form is27

the so-called “…rst-di¤erence rule,” where the change in the policy rate responds to its
past change and the current rates of in‡ation and output growth20
log rt log rt 1 =r (log rt 1

log rt 2 )+(1

r)

(log

t

log ) +

dy

log

Yt
Yt 1

log
(53)

This rule is referred to as “‡exible price-level targeting,” and in this form, the speci…cation ofdy = 0 is called “strict price-level targeting” and the speci…cation of=dy

is called “nominal GDP level targeting.”21 These labels are because these speci…cations
are implied respectively by such targeting rules.22
In each speci…cation of the monetary policy rules, three requirements are imposedon the coe¢ cients, following Schmitt-Grohé and Uribe (2007b). First, the coe¢ cients
guarantee local determinacy of the rational expectations equilibrium. Second, they satisfy 1

10, 0

dy

10, and 0r< 1. Last, they meet the conditionon the volatility of the policy rate, 2(V ar(rt ))0:5 < r

1. Then, a combination of thecoe¢ cients that ful…lls these three requirements and maximizes the welfare measure (52)is computed using the second-order approximation to the equilibrium conditions of themodel around the steady state.
In deriving a welfare-maximizing monetary policy rule, this paper focuses on the…nancial shock only. That is, such a rule is derived under the condition that only the…nancial shocks occur in the economy. This exclusive focus allows us to characterize
the welfare-maximizing rule from the perspective of the …nancial shock, which not only
constitutes one of the most important driving forces in U.S. business cycles, as argued byJermann and Quadrini (2012), but also causes a slow recovery in our model, as shown in
20

For …rst-di¤erence rules, see, e.g., Orphanides (2003).

21

For recent discussions on nominal GDP level targeting, see, for example, Woodford (2012) andEnglish, López-Salido, and Tetlow (2013).
22

One point emphasized here is that our speci…cations of the price-level targeting rules and the nominal
GDP level targeting rule are more implementable than the “original”speci…cations in which the current
policy rate is adjusted in response to the past policy rate and the current deviations of the price-level
and the GDP level from their target paths, because the original speci…cations grant leeway in the choiceof the target paths.

28:

the preceding section. Therefore, the …nancial shock is worth analyzing independently
from other shocks. In computing the welfare-maximizing rule, the standard deviation of
the …nancial shock is set at 0:98 percent as in Table 2 of Jermann and Quadrini (2012).
For each speci…cation of the monetary policy rules, Table 2 shows a welfare-maximizing
combination of its coe¢ cients in reaction to the …nancial shocks. In this table, three…ndings are detected. First of all, a welfare-maximizing monetary policy rule features astrong response to output. Within the rule speci…cations and coe¢ cient requirements,
the welfare-maximizing rule is the ‡exible in‡ation-targeting rule (50) withdy

= 10, andr

= 1,

= 0:98. In this rule, the policy response to output hits its upperbound, while the one to in‡ation hits its lower bound. Even if the policy response
to wage in‡ation,w(log( t Wt =Wt 1 )log( w )), is introduced in the rule (50) as in

Schmitt-Grohé and Uribe (2006, 2007a), along with the requirement 0

10, thew

welfare-maximizing rule remains the same as in the absence of such a policy response(i.e., the welfare-maximizing coe¢ cients are= 1,

dy = 10,r = 0:98, andw= 0).23

The …nding that the welfare-maximizing rule calls for a strong response to output
contrasts starkly with Schmitt-Grohé and Uribe (2006, 2007a, b), who argue that a
welfare-maximizing monetary policy rule features a muted response to output. This
contrast arises from two factors. First, the type of the shock considered in deriving awelfare-maximizing monetary policy rule is di¤erent. Our paper focuses only on the…nancial shock, while their papers consider mainly a TFP shock. Second, SchmittGrohé and Uribe (2006, 2007a) include a policy response to wage in‡ation in their policy
rules, and Schmitt-Grohé and Uribe (2007b) assume no nominal wage rigidity in theirmodel. Indeed, when an exogenous TFP shock is introduced in our model instead of23

As emphasized in the preceding section, nominal wage rigidity is a crucially important factor fordescribing a slow recovery from an adverse …nancial shock. In the absence of this rigidity, the magnitudeof a permanent decline in output in response to an adverse …nancial shock is much smaller than in thepresence of the rigidity. As a consequence, if the rigidity is abstracted from our model as in SchmittGrohé and Uribe (2007b), the ‡exible in‡ation-targeting rule (50) has its welfare-maximizing coe¢ cients= 3:84, dy = 2:85, and r = 0:87.

29

the …nancial shock and follows the stationary …rst-order autoregressive process with thepersistence parameter of 0:9457 and the innovation standard deviation of 0:45 percent
as in Table 2 of Jermann and Quadrini (2012), the ‡exible in‡ation-targeting rule (50)contains its welfare-maximizing coe¢ cients= 10,

dy = 5:86, andr = 0:86, so thatthe rule shows a stronger response to in‡ation than to output. Then, if the rule (50)allows a policy response to wage in‡ation, the resulting rule has its welfare-maximizingcoe¢ cients= 4:39,

dy

= 0,

r

= 0, andw= 10, so that it shows no response

to output in line with their result. Furthermore, if nominal wage rigidity is abstracted
from our model as in Schmitt-Grohé and Uribe (2007b), the ‡exible in‡ation-targeting
rule (50) has its welfare-maximizing coe¢ cients= 10,

dy = 0, andr = 0, so that it

shows no response to output in line with their result.
The second …nding we can see in the table is that the welfare gain from output stabilization is much more substantial than in the model where TFP growth is exogenously
given. The welfare gain from adopting the welfare-maximizing rule relative to the benchmark rule (i.e., the ‡exible in‡ation-targeting rule (50) withdy = 0:25, and= 1:5,

r = 0:7) is huge. It is indeed a permanent increase in consumption of 22:40 percentage

points. This gain is about two orders of magnitude greater than that attained under
the welfare-maximizing rule in the model without the endogenous mechanism of TFP
growth, which is the ‡exible price-level targeting rule (53) withand24
r = 0.

= 7:82,dy = 4:36,

Moreover, the table demonstrates that the huge welfare gain arises mostly

from an improvement in the bias of the rate of technological changetin the welfare

measure (52). An adverse …nancial shock generates a slowdown in TFP growth andhence balanced growth, and thereby causes a permanent decline in consumption. Thisdecline induces a welfare loss, which is captured as a decrease in the bias of the rate oftechnological change. In the model, monetary policy has an in‡uence on TFP. Thus, the24Notice that in the model without the endogenous TFP growth mechanism, output stabilization is
not welfare-maximizing, so that there is a welfare loss from it relative to the welfare-maximizing rule.

30

strong policy response to output under the welfare-maximizing rule subdues the slowdown in TFP growth and thereby ameliorates social welfare through an improvement in
the bias.
Last, the strict in‡ation or price-level targeting rule induces a sizable welfare loss relative to the welfare-maximizing rule. The strict in‡ation targeting rule with its welfaremaximizing coe¢ cients= 10 andr = 0 yields lower welfare by a 1:38 percentage

point permanent decline in consumption relative to the welfare-maximizing rule, andthe strict price-level targeting rule with its welfare-maximizing coe¢ cientsr= 10 and= 0 generates lower welfare by a 1:21 percentage point permanent decline in con-sumption. This is because these rules have no policy response to output and thus cannot
directly mitigate a slowdown in TFP growth caused by an adverse …nancial shock. On
the other hand, the nominal GDP growth or level targeting rule performs well, evencompared with the welfare-maximizing rule. Indeed, the welfare gain from adopting
the welfare-maximizing rule relative to the nominal GDP growth targeting rule with its
welfare-maximizing coe¢ cients=dy = 10 andr = 0:96 is a permanent increase in

consumption of only 0:04 percentage point, while the one relative to the nominal GDP
level targeting rule with its welfare-maximizing coe¢ cients=dy = 1 andr = 0:68 isa permanent increase in consumption of only 0:03 percentage point. Because the actual
policy responses to in‡ation in the welfare-maximizing rule, the nominal GDP growthtargeting rule, and the nominal GDP level targeting rule,(1r ), are respectively

0:02, 0:39, and 0:32, the welfare-maximizing rule contains a much weaker response toin‡ation than the two nominal GDP targeting rules. This implies that the size of thepolicy response to in‡ation has a minor e¤ect on welfare in reacting to the …nancial
shocks. One point emphasized here is that both the nominal GDP targeting rules induce
higher interest-rate volatility than the welfare-maximizing rule. This higher volatility
arises from the stronger policy response to in‡ation under the nominal GDP targeting
rules.
31

5.3

Financial crisis scenario simulations

Under the welfare-maximizing monetary policy rule and other rules analyzed above, thissubsection conducts simulations in an illustrative …nancial crisis scenario.
In the scenario, the economy is hit by an adverse …nancial shock of;t =0:04 forthree periods (t = 1; 2; 3), and this is anticipated by all economic agents in the model
when the …rst shock emerges in period 1. A …nancial shock of a similar size occurredin the U.S. during the Great Recession, as can be seen in the estimate of the …nancial
shock by Jermann and Quadrini (2012).25 The anticipated …nancial shocks subsequent
to the emergence of the …rst shock seem to be reasonable, because once a …nancial crisis
occurs, the resulting …nancial turbulence tends to continue unfolding.
Fig. 3 plots the developments of intratemporal loans, total investment (i.e., the sum ofcapital investment, technology adoption investment, and R&D investment), TFP, output,the (annualized) in‡ation rate, and the (annualized) interest rate under the benchmark
monetary policy rule (the solid line), the welfare-maximizing rule (the dashed line), thenominal GDP level targeting rule (the dotted line), and the strict price-level targeting
rule (the dot-dashed line) in the …nancial crisis scenario. Note that the coe¢ cients in thenominal GDP level targeting rule and the strict price-level targeting rule are the welfaremaximizing ones presented in Table 2. The …gure provides us with three …ndings.
First, in response to the severe …nancial shocks, intratemporal loans drop sharply
under the benchmark rule, whereas the decline in the loans is subdued under the welfaremaximizing rule. Hence, slowdowns in total investment growth and TFP growth aremuch less pronounced under the welfare-maximizing rule than under the benchmark
rule. Consequently, output approaches the pre-crisis balanced growth path under thewelfare-maximizing rule, while it does not under the benchmark rule, implying that thewelfare gain from adopting the former rule relative to the latter is huge, as shown in the25

According to Fig. 2 of Jermann and Quadrini (2012), their estimated …nancial shock decreased by
4 percentage points, from about 1 percent to about 3 percent during the Great Recession.

32

preceding subsection. The in‡ation rate then drops under the benchmark rule, whereas it
rises under the welfare-maximizing rule. This rise is because the decline in intratemporalloans of intermediate-good …rms is smaller than that in the value of their collateral (i.e.,
net assets held by the …rms), which tightens the borrowing constraint (6) and increases
the associated Lagrange multipliert (i.e., real marginal cost of funds), thereby raisingwholesalers’real marginal cost and hence in‡ation. According to these developments ofin‡ation and output growth, the benchmark rule lowers the interest rate below a rateof zero, while the interest rate cut is subdued and the rate does not hit a rate of zerounder the welfare-maximizing rule, which contains a weak policy response to in‡ation,
i.e.,

(1

r ) = 0:02.

Second, under the nominal GDP level targeting rule, the achieved levels of output
and total investment are almost the same as those under the welfare-maximizing rule,
implying that the welfare gain from adopting the welfare-maximizing rule relative to thenominal GDP level targeting rule is small, as shown in the preceding subsection. The
in‡ation rate then rises for the same reason as that under the welfare-maximizing rulementioned above. This rise in in‡ation induces an initial increase in the interest rate
under the nominal GDP level targeting rule— which contains a relatively strong response
to in‡ation, i.e.,(1r ) = 0:32— even in the …nancial crisis scenario, and then theinterest rate is lowered to hit a rate of zero, causing relatively high interest-rate volatility,
as noted in the preceding subsection.
Last, under the strict price-level targeting rule, its strong policy response to in‡ation(i.e.,(1r ) = 10) stabilizes in‡ation much more than under the welfare-maximizing

rule, which contains a weak response to in‡ation (i.e.,(1r ) = 0:02). Yet the strict

price-level targeting rule cannot directly mitigate a slowdown in TFP growth caused by
the severe …nancial shocks, because it has no response to output. Consequently, output
and total investment recover to the pre-crisis balanced growth path more slowly thanunder the welfare-maximizing rule, implying that the welfare loss from the strict price33

level targeting rule relative to the welfare-maximizing rule is sizable, as shown in thepreceding subsection.

6

Concluding Remarks

This paper has developed a model that can describe a slow recovery resulting from anadverse …nancial shock such as the slow recoveries observed in many economies after the
recent …nancial crisis and subsequent recession. Speci…cally, the Jermann and Quadrini(2012) …nancial friction and shock and the Comin and Gertler (2006) endogenous TFP
growth mechanism have been introduced into an otherwise canonical DSGE model. With
this model, the paper has examined how monetary policy should react to the …nancial
shock in terms of social welfare. It has been shown that in the face of the …nancial
shocks, a welfare-maximizing monetary policy rule features a strong response to output,
and the welfare gain from output stabilization is much more substantial than in themodel where TFP growth is exogenously given. In the presence of the endogenous TFP
growth mechanism, it is crucial to take into account a welfare loss from a permanent
decline in consumption caused by a slowdown in TFP growth. Moreover, compared withthis rule, a strict in‡ation or price-level targeting rule induces a sizable welfare loss,
whereas a nominal GDP growth or level targeting rule performs well, although it causes
relatively high interest-rate volatility.
The paper also has conducted a …nancial crisis scenario simulation under the monetary policy rules. In this simulation, a slowdown in TFP growth is much less pronounced
under the welfare-maximizing monetary policy rule than under the strict price-level targeting rule, and as a consequence, output recovers to its pre-crisis growth trend faster
under the welfare-maximizing rule. Under the nominal GDP level targeting rule, theachieved levels of TFP and output are almost the same as those under the welfaremaximizing rule, and a smaller decline in …rms’ loans than that in the value of theircollateral tightens their borrowing constraint and raises the marginal cost of funds and34

hence in‡ation. Under the nominal GDP level targeting rule, this rise in in‡ation induces
an initial increase in the interest rate even in the crisis scenario, and then the interest
rate is lowered to hit a rate of zero, causing relatively high interest-rate volatility.
This paper has studied interest rate policy only. After lowering the policy rate virtually to the zero lower bound, central banks in advanced economies have been underpinning economic recovery in the wake of the recent global …nancial crisis using unconventional policy tools, such as forward guidance and asset purchases. The analysis of these
unconventional policies in the model is left for future work.

35

Appendix
A

Equilibrium conditions and the steady state of themodelThis appendix presents equilibrium conditions and the steady state of the model in termsof stationary variables.

A.1

Equilibrium conditions

With 33 stationary variables yt = Yt =At 1 , ct = Ct =At 1 , it = It =At 1 , kt = Kt =At 1 ,wt = Wt =At 1 , lt = Lt =At 1 , dt = Dt =At 1 , bt = Bt =At 1 , id;t = Id;t =At 1 , st = St =At a 1 1 ,ia;t = Ia;t At 1 =At 1 , vt = Vt At 1 =At 1 , jt = Jt At 1 =At 1 , at = At =Zt ,
t

TFP
t

= At =At 1 ,rt , 't , '0t ,k;t , and= T F Pt =T F Pt 1 ,

t,

t,

p;t ,

p1;t ,

p2;t ,

w1;t ,t= At =At 1 ,w2;t , ut , nt , rt ,t,0k;t , the system of equilibrium conditions consists of the following 33

equations.
d (dt

d)2 ;

(A1)

'0t = 1 + 2 d (dt

d);

(A2)

't = dt +

a
1

t =

1

(A3)

;

t

1

p;t 1

TFP
=
t

(A4)

;

t 1
p;t

k;t =

k +

1 (ut

1) +

0
k;t =

1+

2 (ut

1);

rt = 1 + (1

2

2

1);

lt = wt nt + it + vt [ t(1t

kt + v t t

0=

0 1
x st ' t n tbt;rt
u t kt 1
t 1

1

=

1)2 ;

(A5)
(A6)

)(rt

lt =

(ut

(A7)
(A8)

a )];

(A9)
+

bt
rt

wt nt

it

wt nt
;
0
k;t ut kt 1 = t 1

vt [ t

(1

a )]

't

bt 1

;

(A10)

t 1 t

(A11)

36

1
+
'0t
2

st =

t

0
k;t

1

wt

nt+1
kt = tst+1 ut+1
6 c
6t
1 = Et 6
4 t ct+1
1 = Et

2

yt =

1

p;t

t (1

t)

ut+1 kt+ (11='0t +

t (1

t+1

3

7
7
7;
5

0
a )vt+1 1='t+1 +

t
t)

;

(A13)

(A14)
t+1

3

7
7;
5

(A15)

(A16)

t 1
1

1 = (1p2;tyt+
p2;t =
ct

p Et

k;t )

p Et

"

"

(A17)

;
t

p1;t+1t+1
yp2;t+1
t+1

#

(A18)

;

(A19)

y

+ p

p2;t

#

;

y

y

kt 1

y

y

1

p1;t

p)

kt = (1

+ p

y

0 yt
+
x st ' tctp;t = (1

1

y

p1;t

p)

p1;t =

0k;t+1 ) 1='t+1 +

+ (1

0 rt
;
t t 'trt1)st+1 n1t+1

ut kt 1n1t

11='0t +

ct rt '0t+0t ct+1 t+1 't+1

6 ct ( xvt = Et 6
4 ct+1
t

(A12)

;

1

(A20)

p;t 1 ;t

(A21)

+ it ;t 1
t =!
0 ia;t ;t = (1

jt =

(A22)

a)

1+

ia;t + (1ia;t = ! (1
1
= (1
at
1=

z (1

1 = Et

a)

t

1
t

at 1

1

a)

t vt + (1

vt

Et

(A23)

;
ct
jt+1
t ct+1t ) Etct
jt+1
t ct+1

;

id;t
1
+ z
;
t at 1t at 11
ct
Et
jt+1 ;
a)1
at 1 id;tt ct+1

;

(A24)
(A25)
(A26)

a)

(A27)

c t rt;t ct+1 t+1

(A28)

37

y t = c t + it +1 = (11+
w1;t = nt

n n

+

w Et

rt
=
r

w Et

"

wt
t+1 wt+1

"

1

wt 1
t wt
t 1
1
n (1+ )

nw1;t+1t
1wt
t+1 wt+1

t

r)

log

rt 1
+ (1
r

r log

(A29)

1 + id;t ;

at 1
+ w

w2;t

1

wt nt
+
w2;t =ctlog

1n
1+ n =

w1;t

w)

1

d)2 + ia;t

d (dt

n

w2;t+1t+#dy log

#

;

(A30)

;

(A31)
(A32)

;

yt
yt 1

t 1

(A33)

:

When a (stationary) TFP shock is introduced in the model, it will appear in theequilibrium conditions (A4), (A10), (A12), (A13), (A15), and (A16).

A.2

The steady state

The strategy for computing the steady state is to set target values for labor n, the rate oftechnological change, the technology adoption rate , and the R&D investment-output

ratio id =y and to pin down the values of the parametersn,z,

0 , anda instead.

In the steady state, labor is normalized to unity, i.e., n = 1. The capital utilization
rate is unity, i.e., u = 1. Equilibrium conditions (A2)–(A5), and (A28) yield
1'0 = 1;= ( )1

TFP= ( ) a 1;

;

k =

k;

1

r
r

1 :

r=

;

and then (A7) and (A14) lead tor = 1 + (1

) (r

1) ;

=

Combining (A17)–(A20) generates
1

s=

;

x y

p = 1:

Equilibrium conditions (A11)–(A13), (A16), and (A21) yield
1
s

k=
w=

s(1
1+

[1 + (1
)

k

;

y=

1

)]

s
1 =
1+

1

(1
k

k )(1 +

;

i=

38

1

)

;
1

k

k;

1

k

;

and then (A6) leads to0k =For each value ofof

1:

a , the equations below generate a value of id =y. Thus, seek a value

a that attains the target value for id =y. Equilibrium condition (A15) yieldsv=s( x 1))](1[1 + (1ka )(1 +;)and then (A8)–(A10) lead tol = w + i + v[
d =

k

xs

(1

a )];

1
r

1

+

l

b=r k+v
b

w

i

v[

;
(1

a )]:

Besides, (A1) generates' = d:
Solving (A24) and (A25) for j and ia leads to
j=

v(1
!)
a )(1
;
(1
(1 !)]
a )[1

ia =

! v(1
(1

a )[

(1
(1

a )[1

Equilibrium conditions (A22) and (A23) yield
0 =

i!a

;

a= 1+

Solving (A26) and (A27) for id and
id =

(1

1

1

1

1

:

a

z leads to

a )[

(1

a )]

a

j;

(1
id

z =

a)

so that id =y can be obtained.
Equilibrium condition (A29) yields
c=y

i

1
a

ia

1

id :

Combining (A30)–(A32) generates
w1 =

1
1

;

w2 =

w

1
1

w
;
w c

n =

Last, (A18) and (A19) lead to
p1 =

xs

1

y
;
p c

p2 =

39

1
1

y
:
p c

w
:
nc

;

a )]

!)]

:

B

The second-order approximation to the welfare ofhouseholds

This appendix derives a second-order approximation around the steady state to theunconditional expectation of the average utility function over households, given by (51).
Substituting the demand curve for each type of specialized labor, (44), in equation (51)yields
SW = (1

)E

"1
X

t

nt

1 + 1=

t=0

where

1+

n

log(Ct )

1

w;t

#

;

w;t denotes wage dispersion given by

w;t =

Z 1
0

Wf;t
Wt

n

df:

Under the staggered wage setting of households,
w;t = (1n (1+1= )1+ n =

w1;t

w)

n n

w2;t

and its steady-state value is

w = 1.

(1+ 1 )

w;t can be expressed recursively as

wt 1
t wt

+ w

n

(1+ 1 )
w;t 1 ;

(B1)

t 1

Using ct = Ct =At 1 , the welfare measure SW canbe rewritten as
SW = (1

)E

"1
X

t

log (ct ) + log At 1

t=0

1+1=

n

1 + 1=

nt

w;t

#

:

(B2)

Because log (At ) follows, by de…nition, the process log (At ) = log At 1 + log ( t ),P
tlog At 1 , where At is the deterministic trend governed bysubtracting (1) 1t=0
A 1 = A 1 , At =At 1 , from both sides of (B2) makes the resulting welfare measure

SW stationary, given by
SW = SW
= (1

1
X

(1

)

)E

" 1 t=0Xttlog At 1log(ct ) + log

t=0

At 1
At 1

n

1 + 1=

1+ 1
nt
w;t

#

:

(B3)

We now approximate the stationary welfare measure SW around the steady state
up to the second order. The term related to detrended consumption ct in (B3) is ap40

proximated around the steady state as
"1
#
X
t
(1
)E
log(ct )log (c) +t=0

where "c = E(ct )"ccV ar (ct )
;
2c2

(B4)

c denotes the bias associated with detrended consumption ct and isof the second order. The term related to At 1 =At 1 in (B3) is approximated as
"1
#
"
!#
1
t 1
X
X
Y
A
t 1
t
t
h
(1
)E
log
= (1
)
E log
A
t 1
t=0
t=0
h=0
"t 1
#
1
1
X
X
X
t
t
t
h
= (1
)
E
log
= E log
(1
)
t
t=0

=
where "

E log

1

t=0

h=0

"

t

V ar ( t )2 ( )2

1;(B5)

denotes the bias associated with the rate of technological change= E( t )t and is of the second order. The term related to labor in (B2) is approximated as

(1

)E

1
X

1
t 1+
nt
w;t

1+ 1+

t=0

where n =w

w;t

"n + " w +1 + 1= V ar (nt );2= 1 is used to derive this approximation and where "n = E(nt )and " w = E( w;t )dispersion

1

(B6)
n

w denote the biases associated with labor nt and with the wage

and are of the second order.

From (B4)–(B6), the second-order approximation to SW in (B3) around the steadystate is given by (52), where terms independent of monetary policy are subtracted.

41

References[1] Barlevy, Gadi. (2004) “The Cost of Business Cycles under Endogenous Growth.”
American Economic Review, 94(4), 964–990.
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45

Table 1: Parameterization of the quarterly model.
Parameter Description
Standard parameters in DSGE models
Subjective discount factor
Steady-state gross rate of technological changenSteady-state labor
Elasticity of labor supply
Capital elasticity of output
uSteady-state capital utilization rate
Steady-state capital depreciation ratek
Steady-state elasticity of capital depreciation
2= 1;
Degree of price/wage rigidity
p w
Elasticity of substitution among wholesale goods/labory; nSteady-state gross in‡ation rate
Policy rate smoothingr
Policy response to in‡ation
Policy response to output growthdyParameters regarding technology innovation and adoption
Elasticity of substitution among intermediate/…nal goods
x; aSteady-state probability of technology adoption!
Elasticity of technology adoption probability
Elasticity of R&D productivity
id =ySteady-state ratio of R&D investment to output
Parameters regarding …nancial friction and shock
Steady-state probability of foreclosure
Elasticity of dividend payment costsdTax bene…tFinancial shock persistence

46

Value
0:9975
1:0025
1
1
0:36
1
0:025
0:5
0:75
11
1:005
0:7
1:5
0:25
2:67
0:025
0:95
0:8
0:025
0:16340:146
0:35
0:9703

Table 2: Welfare-maximizing combinations of coe¢ cients of monetary policy rules inreaction to …nancial shocks.
Policy rule speci…cation(V ar(rt ))0:5

Welfare gain g
Benchmark model
Flexible in‡ation targeting
1:00 10:00 0:98
0:138%
22:3953%
Strict in‡ation targeting
10:00— 0:000:095%
21:0159%
Nominal GDP growth targeting 10:00 10:00 0:96
0:237%
22:3584%
Flexible price-level targeting
1:00 10:00 0:98
0:319%
22:3946%
Strict price-level targeting
10:00— 0:000:072%
21:1864%
Nominal GDP level targeting
1:00 1:00 0:68
0:278%
22:3676%
Model without the endogenous TFP growth mechanism
Flexible in‡ation targeting
3:33 2:84 0:96
0:063%
0:0625%Flexible price-level targeting
7:82 4:36 0:00
0:245%
0:1070%
dy

r

-bias
99:6%
100:5%
99:6%
99:7%
100:4%
99:5%

Note: For each of the monetary policy rules, the welfare gain g denotes the one from adopting this rule
relative to the benchmark rule (i.e., the ‡exible in‡ation-targeting rule (50) with
= 1:5, dy = 0:25,
and r = 0:7) in terms of a permanent increase in consumption, and the term “ -bias” shows thefraction in the total welfare gain of the welfare gain arising from an improvement in the bias of the rateof technological change t .

47

—
—

(a) Real GDP per capita (log, level)
CY 93

95

97

99

01

(b) TFP (Solow residual) (log, level)
03

05

07

120

CY 93

95

97

99

01

03

05

07

09

11

13

95

97

99

01

03

05

07

09

11

13

05

07

05

07

110
pre-crisis trend
USEuro area
105

UK
Japan

110

100

100
95

90
CY 03

90
05

07

09

11

13

01

03

CY 03

(c) Bank lending (% chg.)
CY 93

95

97

99

(d) CPI (% chg.)
05

07

CY 93

20

5

15

4

10

3

5

2

0

1

-5

0

-10
CY 03

-1
05

07

09

11

13

CY 03

Figure 1: Economic developments around recent …nancial crises. Notes: In each panelof the …gure, the scale of years at the top is for Japan only, while that at the bottom isfor the other three economies. In Panels (a) and (b), the pre-crisis trend grows at a ratethat is average over the four economies during the …ve years before each crisis. The data
on TFP come from the Conference Board Total Economy Database.

48

(a) Intratemporal loans

0
-0.5
-1
-1.5
-2

0

-1
-1.5
10

20

30

% diff. from SS

0
-0.2
-0.4
0

10

20

30

% dev. from SS

-0.05
-0.1
0

10

20

Benchmark

30

30

40

30

40

30

40

30

40

-0.4
-0.6
-0.8
0

10

20

(f) Inflation

0
-0.05
-0.1
0

10

20

(h) TFP

0
-0.1
-0.2
-0.3
-0.4

40

20

(d) Output

0.1

0

-0.15

10

-0.2

-0.15

40

(g) Interest rate

0.05

0

0.05

0.2

-0.6

-1

-1

40

(e) Consumption

0.4

-0.5

0

-0.5

0

0

-1.5

40

% dev. from SS% dev. from SS

30

0

-2

% dev. from SS

20(c) Capital investment

0.5% diff. from SS

10(b) Labor

0.5% dev. from SS% dev. from SS

0.5

0No endogenous TFP growth10

20

No nominal wage rigidity

Figure 2: Impulse responses to an adverse …nancial shock. Note: This …gure expresses
labor in terms of percentage deviations from its steady-state value and the rates ofin‡ation and interest in terms of percentage di¤erences from their steady-state values,
while the others are expressed in terms of percentage deviations from their steady-state
growth paths starting from period 0.
49

(a) Intratemporal loans

5

5

0

0

-5
-10
-15
-20

0

5

10

15

(c) TFP

0

5

10

15

20

15

20

(d) Output

10
5

2

log level

log level

-10

-20

20

3

1
0

0
-5
-10

-1
0

5

10

15

-15

20

(e) Inflation

6
5

5

4

4

3
2
1
0
-1
0

0

5

10

(f) Interest rate

6%, annualized%, annualized

-5

-15

4

-2

(b) Total investment

10

log level

log level

10

3
2
1
0

5
Benchmark

10

15

-1

20

Welfare-maximizing

05

Nominal GDP level

10

15

20

Strict price-level

Figure 3: Financial crisis scenario simulations. Note: The coe¢ cients in each monetary
policy rule are presented in Table 2, where the welfare-maximizing monetary policy ruleis the ‡exible in‡ation targeting one in the benchmark model.

50