Kieler Studien Kiel Studies 334 Dennis Snower (Editor) Kiel Institute for World Economics

Transcription

1 Kieler Studien Kiel Studies 334 Dennis Snower (Editor) Kiel Institute for World Economics

2 Jan Gottschalk Monetary Policy and the German Unemployment Problem in Macroeconomic Models Theory and Evidence Springer

3 Dr. Jan Gottschalk 1217 F Street NE Washington DC JGottschaik@imf.org Cataloging-in-Publication Data Library of Congress Control Number: ISSN ISBN Springer Berlin Heidelberg New York This work is subject to copyright. All rights are reserved, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilm or in any other way, and storage in data banks. Duplication of this publication or parts thereof is permitted only under the provisions of the German Copyright Law of September 9, 1965, in its current version, and permission for use must always be obtained from Springer. Violations are liable for prosecution under the German Copyright Law. Springer is a part of Springer Science+Business Media springeronline.com Springer-Verlag Berlin Heidelberg 2005 Printed in Germany The use of general descriptive names, registered names, trademarks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. Cover design: Erich Kirchner, Heidelberg Printed on acid-free paper 42/ I 0

4 Preface Persistently high unemployment has plagued Germany for the better part of the past 25 years. Whereas most observers would attribute this to supply-side rigidities in the German economy and a very formidable body of literature has formed over the years to substantiate this view another camp identifies overly tight demand-side policies, in particular monetary policy, as another cause for high unemployment, advocating a more expansionary monetary and fiscal policy stance as part of the solution. The present study takes a closer look at the latter proposition, with a particular focus on the role of monetary policy for unemployment. Macroeconomic theory has evolved considerably over the past forty years, and views on the long-run effectiveness of monetary policy have changed substantially. These different views provide the background for the policy debate in Germany on the role of demand policies for unemployment, which this study illuminates by providing an in-depth review of the different theoretical strands of macroeconomics and their policy implications. This is complemented by empirical investigations uncovering the implications of different theories for key macroeconomic variables, and testing their consistency with long-run trends in German data. While this study cannot resolve the underlying theoretical differences conclusively, given that macroeconomic theory continues to evolve and that there are inherent limits to econometric testing, it does provide tentative conclusions that point to a role of demand policies for unemployment, but this role is limited in size and in time. This study is the final result of a long process, a process in which I benefited from the help and encouragement of many colleagues and friends without whom the research project on monetary policy and the German unemployment problem could not have been completed. First of all, I would like to thank Professor Gerd Hansen for his support during a critical phase of the project and for his many valuable comments, and Professor Thomas Lux for his support in thefinalphase. In general, the project benefited from many fruitful discussions with my colleagues at the Business Cycle Research Department of the Kiel Institute for World Economics, and I am grateful for the freedom afforded to me by Professor Horst Siebert and Professor Joachim Scheide to pursue the research project. Particularly important for the success of the project was Jorg Dopke, who was my de facto mentor in the Institute and who has been critical for both the theoretical and empirical parts of this book. I am grateful to Christian Schumacher, Ulrich Fritsche and Kai Carstensen for many helpful comments; The theoretical part benefited from suggestions by Christophe Kamps, particularly regarding the programming of the New Keynesian model in Matlab. Of course, all remaining

5 VI Preface errors are mine alone. Moreover, I would like to acknowledge the financial support of the Marga and Kurt Moellgaard Foundation. Finally, I would like to thank Dietmar Gebert and Kerstin Stark for their patience and their valuable contributions to the editing of this study, and its preparation for the print stage. Washington DC, May 2005 Jan Gottschalk

6 Contents 1 Introduction 1 2 Keynesian and Monetarist Views on the German Unemployment Problem Keynesian and Monetarist Explanations of Unemployment and Inflation The Keynesian Perspective The Monetarist Challenge The Keynesian Response to the Monetarist Revolution: TheNAIRU The Long-Run Phillips Curve and the Source of Business Cycle Fluctuations in Germany The Unemployment-Inflation Relationship in Germany Estimating Keynesian and Monetarist Phillips Curves for Germany Conclusion 94 3 The Rational Expectations Revolution New Classical Economics Real Business Cycle Models The New Keynesian Research Program Empirical Evidence on the Effects of Systematic Policy Revisiting the Policy Ineffectiveness Proposition The Building Blocks of New Keynesian Economics Monetary Policy in the New Keynesian Model Deriving the Core Equations of the New Keynesian Model The New Keynesian Phillips Curve The New IS Curve The Interest Rate Rule Simulating the New Keynesian Model The Standard New Keynesian Model 138

7 VIII Contents A.22 The Extended New Keynesian Model The Sources of Business Cycle Fluctuations in the New Keynesian Model The Effects of Systematic Policy New Keynesian Economics and the Policy Debate in Germany Introducing Nonlinearities into the New Keynesian Model Nonlinearities in the Aggregate Supply Curve Nonlinearities in the Supply Curve and Credit Market Imperfections Nonlinearities in the Supply Curve and Downward Nominal Rigidities Empirical Evidence on Nonlinearities in the Supply Curve Policy ImpHcations Nonlinearities in the Welfare Function The Inefficiency Gap and Business Cycle Fluctuations The Welfare Effects of the Inefficiency Gap Revisiting the Natural Rate Hypothesis A Preliminary Look at the Data A Framework for Cointegration Analysis The Aggregate Demand Equation in the VECM The Aggregate Supply Equation The Policy Rule Results of a Multivariate Cointegration Analysis for Germany Testing for a Structural Break Univariate Unit Root Tests Results of the Multivariate Cointegration Analysis for the Period Results of the Multivariate Cointegration Analysis for the Period A Long-Run Phillips Curve Explaining the Long-Run Phillips Curve Asymmetric Information Models Nonlinearities in the Long-Run Phillips Curve Disinflation and Hysteresis Effects 229

8 Contents IX Using Monetary Policy to Lower the Unemployment Rate Permanently A New Keynesian Model with Hysteresis Concluding Remarks 238 Appendix 241 A. 1 Appendix for Chapter A.2 Appendix for Chapter A.3 An Introduction into the SVAR Methodology 245 A.3.1 Introduction 245 A.3.2 Identification in Macroeconometric Models: A Traditional Perspective 246 A.3.3 The SVAR Methodology 254 A.3.4 Objections to the SVAR Methodology 266 A.3.5 Conclusion 274 References 276

9 List of Tables Table 2.1: Sample Correlation of Unemployment and Inflation 38 Table 2.2: Unit Root Tests 40 Table 2.3: Trace Test for the Cointegration Rank 43 Table 2.4: Forecast Error Variance Decomposition in the Keynesian Phillips Curve Model: Contribution of Demand Shocks 61 Table 2.5: Forecast Error Variance Decomposition in the "Natural Rate" Phillips Curve Model: Contribution of Demand Shocks 64 Table 2.6: Forecast Error Variance Decomposition in the "Money as a Monetary Phenomenon" Phillips Curve Model: Contribution of Demand Shocks 70 Table 4.1: Variance Decomposition Using the McCallum Specification of Shock Variances 153 Table 4.2: Variance Decomposition Using the Baseline Specification of Shock Variances 154 Table 4.3: Variance Decomposition for the Baseline Specification with p = Table 5.1: Cross Correlations between the Inefficiency Gap and Its Components for Various Lags (/) 191 Table 5.2: Welfare Costs (-) and Benefits (+) of Boom/Recession Episodes 203 Table 6.1: VAR Specification Statistics 215 Table 6.2: Results from ADF Tests 217 Table 6.3: Cointegration Statistics for the Period Table 6.4: Cointegration Statistics for the Period Table 6.5: Restrictions on the Cointegration Vectors 220 raz?/e^7; MisspecificationTests 242

10 List of Figures Figure 2.1: The Phillips Curve 8 Figure 2.2: Business Cycle Fluctuations: The Keynesian View 10 Figure 2.3: Business Cycle Fluctuations: The Monetarist View 19 F/gwr^2.^;TheNAIRU 25 Figure 2.5: Indicators of Trend Unemployment in Germany 31 Figure 2.6: Indicators of Trend Unemployment in the USA 32 Figure 2.7: Unemployment and Inflation in Germany, Figure 2.8: Cyclical and Trend Components of Unemployment and Inflation in Germany 38 Figure 2.9: Recursive Estimation of the Trace Test for the Cointegration Rank 45 Figure 2.10a: The Trade-Off between Inflation and Unemployment in the Keynesian Phillips Curve 57 Figure 2.10b: The Effects of Supply Shocks in the Keynesian Phillips Curve Model 58 Figure 2.11a: The Trade-Off between Inflation and Unemployment in the Monetarist Phillips Curve: "Natural Rate" Identification 65 Figure 2.11b: The Effects of Supply Shocks in the Monetarist Phillips Curve Model: "Natural Rate" Identification 66 Figure 2.12a: The Trade-Off between Inflation and Unemployment in the Monetarist Phillips Curve: "Inflation as a Monetary Phenomenon" Identification 68 Figure 2.12b: The Effects of Supply Shocks in the Monetarist Phillips Curve Model: "Inflation as a Monetary Phenomenon" Identification 69 Figure 2.13: Business Cycle Fluctuations in the Unemployment Rate: Keynesian Phillips Curve Model 80

11 XII List of Tables Figure 2.14: Business Cycle Fluctuations in the Inflation Variable: Keynesian Phillips Curve Model 81 Figure 2.15: Historical Decomposition of the Unemployment Rate: Keynesian Phillips Curve Model 82 Figure 2.16: Historical Decomposition of the Inflation Rate: Keynesian Phillips Curve Model 83 Figure 2.17: Business Cycle Fluctuations in the Unemployment Rate: "Natural Rate" Identification 85 Figure 2.18: Business Cycle Fluctuations in the Inflation Rate: "Natural Rate" Identification 86 Figure 2.19: Historical Decomposition of the Unemployment Rate: "Natural Rate" Identification 87 Figure 2.20: Historical Decomposition of the Inflation Rate: "Natural Rate" Identification 88 Figure 2.21: Business Cycle Fluctuations in the Unemployment Rate: "Inflation as a Monetary Phenomenon" Identification 90 Figure 2.22: Business Cycle Fluctuations in the Inflation Rate: "Inflation as a Monetary Phenomenon" Identification 91 Figure 2.23: Historical Decomposition of the Unemployment Rate: "Inflation as a Monetary Phenomenon" Identification 92 Figure 2.24: Historical Decomposition of the Inflation Rate: "Inflation as a Monetary Phenomenon" 93 Figure 4.1: Impulse Response Functions for the Standard New Keynesian Model 140 Figure 4.2: Cross Correlation between Inflation and the Lagged Output Gap in Germany 143 Figure 4.3: Impulse Response Functions for the Extended New Keynesian Model 150 Figure 4.4: Simulating the New Keynesian Model with a Neutral Policy Rule 160 Figure 4.5: The Effects of Systematic Policy 161

12 List of Tables XIII Figure 4.6: The Taylor Rule and the Short-Term Interest Rate for Germany 167 Figure 5.1: A Convex Short-Run Aggregate Supply Curve 172 Figure 5.2: Distribution of the Output Gap Using the Band Pass Filter 177 Figure 5.3: Distribution of the Output Gap Using a Segmented Trend Model 177 Figure 5.4: Disinflation in a Model with a Convex Short-Run Aggregate Supply Curve 179 Figure 5.5: The Business Cycle and Wage and Price Markups 181 Figure 5.6: The Inefficiency Gap 189 Figure 5.7: The Inefficiency Gap and Its Components 190 Figure 5.8a: The Implied Output Gap of the Inefficiency Gap: The Band Pass Filter Estimate 194 Figure 5.8b: The Implied Output Gap of the Inefficiency Gap: The Segmented Trend Model Estimate 195 Figure 5.9: The Price Markup Estimate 196 Figure 5.10: Welfare and the Inefficiency Gap 200 Figure 5.11: Welfare Effects of Business Cycle Fluctuations 201 Figure 6.1: The Relationship between Inflation and Unemployment in Germany, and Figure 6.2: The Real Short-Term Interest Rate and Its Mean in Germany 215 Figure 6.3: The Relation between the Vacancy Rate and the Unemployment Rate in Germany 225 Figure 6.4: A Nonlinear Long-Run Phillips Curve 229 Figure 6.5: The Length of Disinflation and Unemployment in Germany and the United States 230 Figure 6.6: Impulse Response Functions for the New Keynesian Model 236

13 XIV List of Tables Figure Al: Estimating the Phillips Curve: The Time Series 241 Figure A2: Stability of the Reduced-Form Phillips Curve Relationship 242 Figure A3a: Structural Break Test: Full Sample Period 243 Figure A3b: Structural Break Test: Figure A3c: Structural Break Test: Figure A4: The Time Series and Their Trend Components 244 Figure A5: Identifying the Money Supply Schedule 250 Figure A6: The Impulse Response Function of Output in Response to an Impulse in u^ 257

14 List of Symbols Section 2.1 a(l) A ^t m P Ap Ap' u u ^NAIRU W^^ Aw X y y ^t lag polynomial index of excess demand serially uncorrelated error term money stock price level inflation rate expected inflation rate unemployment rate steady state unemployment rate NAIRU unemployment rate no-shock NAIRU unemployment rate change in nominal wages vector of variables capturing the interest-rate and transactiontechnology influence on money demand (real) level of output natural level of output vector of supply shock variables ^md ^s A V 0 money demand shock supply side shock productivity component in nominal wage growth velocity sensitivity of unemployment to unexpected inflation Section 2.2 d^^d E demand shocks expectations operator

15 XVI List of Symbols e, vector containing reduced-form shocks F forward operator L lag operator m shock to the inflation process s, e^ supply shocks Xf vector containing growth in the money stock and in output variables / vector containing endogenous variables Yxy long-run effect of variable y on variable x residual in the price or unemployment equations e^ exogenous real shock "" exogenous monetary policy shock ^ vector containing the real and the monetary policy shock variables T] real disturbance A^ contemporaneous effect of variable y on variable x p autocorrelation parameter in the inflation process I variance-covariance matrix a covariance parameter (7^ variance parameter Chapter 4 B government bond cwj contract wage negotiated in period / G government consumption g shock to aggregate demand M nominal money stock MC(i) real marginal costs of firm / MC^ (i) nominal marginal costs of firm i N{i) labor input into the production of Y{i) P aggregate price level P{i) price level of the differentiated good i P* (i) desired price of firm / A/7 inflation rate R nominal interest rate

16 List of Symbols XVII J? long-run equilibrium of the nominal short-term interest rate R* target of the nominal short-term interest rate r real rate of interest r natural rate of interest U{C, M') time-separable utility function in consumption (C) and in the real money stock (M'') V lump-sum tax W'' real wage rate w nominal wage per unit of labor input X output gap Y aggregate output level Y(i) output level ofthe differentiated good/ y natural level of output A, a technological factor common to all firms in the production of Y(i) P discount factor Y e elasticity of marginal utility of real money balances price elasticity of demand e^ labor supply shock 8^ cost-push shock ^ monetary policy shock T] expectation errors with respect to inflation 6 probability for each firm to keep its price constant ^^ price markup V preference shock 7t deviation of inflation from the inflation target ^ inflation target ^ elasticity of substitution of consumption 0;,^2 central bank reaction function parameters regarding the output gap and deviation of inflation from the inflation target Chapter 5 A{t) c trend component in the production function consumption per capita

17 XVIII c gap gap K,L mc'' mpn fhpn mrs n n n p Uc, Uj^ ulc W{N) w Y y y,c z List of Symbols consumption gap inefficiency gap demeaned inefficiency gap capital and labor input, respectively, in the CES production function nominal marginal costs of production marginal productivity of labor estimate of the marginal productivity of labor marginal rate of substitution between labor and consumption labor supply (hours worked per capita) natural rate of employment percent deviation of employment from its natural level aggregate price level marginal utility of consumption and (dis)utility of labor, respectively real unit labor costs net welfare effect of producing one unit of output compensation per unit of labor input output in the CES production function output per capita natural level of output and consumption, respectively variable capturing capital and technological factors in a stylized production function A utility loss or gain from reallocating labor relative to the natural rate of employment 5 marginal disutility of labor e variable capturing low frequency shifts in preferences over consumption and leisure rf(^y elasticity of the natural rate of consumption with respect to the natural rate of output ju steady state markup fip p,p jw" a price markup observable component of the price markup wage markup relative risk aversion

18 List of Symbols XIX (fi,v,a,d distribution, homogeneity, efficiency, and substitution parameters in the CES production function, respectively Chapter 6 F u u X natural rate of interest unemployment rate natural rate of unemployment vector containing the variables R (nominal interest rate), 4P (inflation), and u (unemployment) z, V, w vectors containing stationary disturbances z, V, w vectors containing constants a vector containing short-run adjustment parameters ^ vector containing cointegration relationships TT inflation target 2" variance-covariance matrix

19 List of Abbreviations ADF test AR CES DFGLS ECB EMS KPSS test ERAS LRN LRSN LSW proposition MA NAIRU NAWRU NRH-GAP OLS RBC model SRASI SRASII SVAR model SVR VAR model VECM augmented Dickey-Fuller test autoregressive constant elasticity of substitution modified Dickey-Fuller test statistic European Central Bank European Monetary System test statistic for unit root tests proposed by Kwiatkowski et al. (1992) long-run aggregate supply curve long-run neutrality long-run supemeutrality Lucas-Sargent-Wallace proposition moving average non-accelerating inflation rate of unemployment non-accelerating wage rate of unemployment natural rate hypothesis - gradual adjustment of prices ordinary least squares real business cycle model linear short-run aggregate supply curve convex short-run aggregate supply curve structural vector autoregression model Sachverstandigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung (Council of Economic Experts) vector autoregression model vector error correction model