Monday’s Macro Memo: Indeterminacy, the Belief Function and Reinventing IS-LM

This is my final post featuring research presented at the conference on Applications of Behavioural Economics and Multiple Equilibrium Models to Macroeconomics Policy Conference held at the Bank of England on July 3rd and 4th 2017.

Today I will talk about the work of two of my graduate students and co-authors, Giovanni Nicolò and Konstantin Platonov. Both of them gave presentations at the conference.

Giovanni is in his final year of the Ph.D. programme at UCLA and he will be looking for a job this coming January at the annual ASSA meetings. This year they will be held in Philadelphia. He has already published one paper in the Journal of Economic Dynamics and Control, co-authored with myself and Vadim Khramov. He has a co-authored paper with Francesco Bianchi that is under revision for Quantitative Economics, and a third  paper co-authored with me, Keynesian Economics without the Phillips Curve, that we wrote for an upcoming conference at Gerzensee Switzerland in October. At the Bank of England Conference, Giovanni presented a fourth paper. This is his single-authored job-market paper “Monetary Policy, Expectations and Business Cycles in the U.S. Postwar Period”. 

Giovanni’s research is on the empirics of models with multiple equilibria and sunspots. He began working on this topic when Vadim and I invited him to join us on the project, “Solving and estimating indeterminate DSGE models”, (Farmer Khramov and Nicolò FKN) that now appears in the JEDC. In that paper, we showed how to use standard software packages such as Chris Sim’s matlab code, GENSYS, and the computational package DYNARE, to solve models in which the steady state of the model is indeterminate. This has been a hot topic for empirical macroeconomics ever since Thomas Lubik and Frank Schorfheide showed, in 2004, that the Federal Reserve Board, prior to 1979, followed a policy in which the equilibrium of the economy was indeterminate and subject to non-fundamental belief shocks, aka, sunspot fluctuations.

In order to estimate a model driven by sunspots, the researcher must make distributional assumptions about the nature of non-fundamental uncertainty and how it co-varies with other fundamental shocks to demand and supply. The parameters of this distribution are part of what I call the belief function.  Before we wrote our paper (FKN 2015), researchers who wanted to estimate an indeterminate model by applying the Lubik-Schorfheide method were faced with a complicated programming problem. We showed how to side-step this computational problem and instead to estimate an indeterminate model using the widely-used software package, DYNARE.

In his paper with Francesco Bianchi, Giovanni took this agenda one step further. To estimate an indeterminate DSGE model using the FKN method, the researcher needed first to know if a particular parameterization of the model is determinate or indeterminate. For a simple model such as the three equation New-Keynesian model, it is possible to partition the parameter space into determinate and indeterminate regions analytically. For more complicated models, no such analytic partition is possible. Bianchi and Nicolò (BN 2017) develop a computational method for which no analytic expression is needed. Their work allows researchers to estimate medium to large scale models without imposing the assumption, a priori, that all of the shocks to the model are fundamental.

Models of indeterminacy are identified in data by the fact that they have richer propagation mechanisms than models with a unique determinate steady state. Giovanni’s independent work takes off from the observation (Beyer and Farmer 2004) that it may in practice be difficult to tell the difference between models with an indeterminate steady state and models with a unique steady state but richer internal propagation mechanisms. To put his method through its paces, he estimates a complete medium scale DSGE model of the type constructed by Frank Smets and Raf Wouters. He finds that the Lubik-Schorfheide result carries over to the complete Smets-Wouters model, a result that could not have been discovered without the method that Giovanni developed with Francesco. This is a very nice piece of work and if you are looking to hire an exceptionally smart young macroeconomist with strong theoretical and empirical skills, Giovanni comes highly recommended!  You can hear him discuss his research here or below.

The final conference paper that I will discuss in this series, “Animal Spirits in a Monetary Economy”, was co-authored by myself and Konstantin Platonov. Konstantin presented our paper at the conference and we wrote about our work for VOX here.

I have been critical of the IS-LM model in several of my posts. My paper with Konstantin  fixes some of the more salient problems of IS-LM by reintroducing two key ideas from Keynes. 1. The confidence fairy is real. 2. If confidence remains depressed, high unemployment can exist forever.  Our Vox piece presents the key findings of the paper in simple language. Here are some excerpts…

“Larry Summers has argued that market economies may get stuck in permanently inefficient equilibria. He calls this ‘secular stagnation’ (Summers 2014). In this equilibrium, unemployment may be permanently ‘too high’ and output may remain permanently below potential, because private investors are pessimistic about the prospects for future growth. Our most recent research attempts to explain why secular stagnation occurs and how economic policy may be used to escape it (Farmer and Platonov 2016)

In the wake of the Great Recession, macroeconomic orthodoxy is under attack. Paul Krugman (2011) has called for a return to the IS-LM model, an approach that was developed by Sir John Hicks (1937). We are sympathetic to that call but we believe that the IS-LM model needs to be redesigned. We suggest a different way of thinking about the effect of monetary policy that we call the ‘IS-LM-NAC’ model. It is part of a broader research agenda ( Farmer 2010, 2012, 2014, 2016a, 2016b) that studies models in which beliefs independently influence outcomes…” continue reading

Konstantin has another year at UCLA but he will be on the market in January of 2019. He is an exceptionally talented young economist who also comes highly recommended. In addition to his co-authored paper with me, he has some exciting new work of his own that extends Farmer’s Keynesian search model to an international framework with two or more countries. Konstantin presented his single-authored paper at the European Economic Association meetings in Lisbon last summer.

This brings me full circle and ties together my own research with the other pieces you have heard in the series of linked video clips.