Macroeconomic theory has made progress during the last decades.
Dynamic stochastic general equilibrium (DSGE) models allow researchers to assess sign and size of the effect that certain changes have on a model economy. As this model economy is built up on the grounds of utility maximizing households and profit maximizing firms, one can infer the reaction of each agent to these changes, be they stochastic disturbances or policy switches.
Game theory, applied to macroeconomics, allows researchers to find out - among other things – how a group of policy authorities interacts and how this affects macroeco-nomic outcomes. Questions of coordination, timing of decisions and policy rules can be answered in this context.
The microfounded nature of modern macroeconomic models allows researchers to calculate welfare from a quadratic approximation of the household utility. Thus, wel-fare effects of inflation and output variability can be examined. Given a set of assump-tions, within a DSGE model researchers can calculate the welfare maximum and, if an economic policy authority is included in the model, derive implications for economic policy.
Economic policy has a direct influence on some important macroeconomic variables:
taxes, subsidies and government spending on the fiscal side, the short term interest rate, money supply and refinancing conditions on the monetary side, and it has the power to influence all economic agents.
As economic policy decisions are made for a maximization purpose, information on the functioning of the economy has a positive value, and macroeconomic theory has
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the potential to provide this information. Hence, economic policy has and should have an interest in the developments of macroeconomic theory.
The goal of this maximization does not matter in general, it is itself the object of eco-nomic theory. Most probably it is maximization of utility, something between the util-ity of those who decide about policy and the utilutil-ity of all agents, i.e., welfare.
Macroeconomic theory claims to know something as promising as the “optimal policy”
that maximizes welfare.
It is thus well prepared to give advice. This advice should take into account both the limitations of theory and the constraints of policy, and it should consider the conse-quences that came about with these.
In this dissertation, I provide three examples of questions economic policy might have.
Three models are used that apply current macroeconomic theory to address these questions. I give answers to the questions and analyze the scope of applicability of model results to reality.
The first question to be addressed is: What are the welfare effects if there are conflicts of interest between different policy authorities in a heterogeneous monetary union?
In light of the ongoing enlargement of the European Economic and Monetary Union (EMU), the economic differences between old member countries and the accessing middle and Eastern European countries come more into focus. The resulting hetero-geneities between the member countries increase the probability that the respective fiscal policy authorities differ in their interests. At the same time, the common mone-tary policy authority continues to look at the monemone-tary union as a whole.
In addressing the above question in joint work with Oliver Grimm, we make use of two of the three aforementioned progresses in research, namely game theory applied to macroeconomics and welfare derivation. We develop a model of two regions that form a monetary union, but still afford regional fiscal policies. All three policy author-ities, one monetary and two fiscal, use their policy instruments to influence output and inflation in their respective desired direction. However, there are two crucial dif-ferences between the policy authorities. First, while the monetary authority considers aggregate union-wide variables, each fiscal authority considers merely the respective regional variables. Second, the authorities do not agree on the maximization problem.
Specifically, we assume that monetary policy maximizes union-wide welfare, but fis-cal policies deviate from maximizing the respective regional welfare. The result of this setting is a game between the three policy authorities, and the outcomes of this game
depend on the timing of action and the degree of cooperation between the authori-ties. We explore what happens to the results when we deviate from the assumption of symmetric regions. Beginning with the size of the regions, we investigate the effects of heterogeneities in a set of model parameters on the economic outcomes in the regions and the union, keeping a focus on welfare.
The second exemplary question that economic policy is eager to have answered be-longs to the field of real estate. House price movements in the United States, the United Kingdom and recently in Spain have found increasing attention by domestic politicians, who wonder how to react to them and whether or not specific action is de-manded. The research project here, carried out jointly with Harald Uhlig, was inspired by a discussion forum on the recent developments in the real estate market at the Ger-man Ministry of Economics and Technology. To find out to what extent current house price developments can be explained by economic theory, we use a standard DSGE model that incorporates the real estate market. We take this as our specific research question: Is it possible to explain the house price to GDP ratio and the house price to stock price ratio as being generally constant, deviating from its respective mean only because of shocks to productivity? If so, economic policy may be little concerned about current price fluctuations, but should strongly focus on the improvement of long-term growth conditions. The DSGE model we build has two sectors, one for consumption goods and one for real estate. Real estate is produced using capital and finite land; it provides housing services that enter the household utility function. We specifically fo-cus on trend productivity and productivity growth to examine to what extent expected future productivity increases can explain current house price movements.
The third example of policy questions belongs to the field of monetary economics.
Personal discussions both at the Deutsche Bundesbank and at the Oesterreichische Nationalbank confirmed that there is an interest in building a small scale state-of-the-art New Keynesian DSGE model to be used for the conduct of monetary policy. The New Keynesian paradigm is currently dominating the field of monetary economics; it incorporates the Keynesian assumption of sticky prices (and/or wages) into the DSGE framework with rational expectations that was earlier used mainly by Real Business Cy-cle theorists. While the canonical New Keynesian model for a closed economy is well documented, e. g. in Clarida, Galí, and Gertler (1999) or Woodford (2003), the litera-ture is not yet clear about a definitive New Keynesian open economy model. For the case of a small open economy, the paper by Galí and Monacelli (2005b) is a potential candidate.
Just like the canonical closed economy model, the Galí and Monacelli (2005b) model
is of small to medium scale and reasonably simple. The restricted scale of the model is often favored by economists in (and out of ) central banks, because with a small-scale model it is easier to get an intuition of what is happening and which are the driving forces. The drawback of this is the lack of sufficient modeling features to replicate a multitude of stylized facts that have been derived from the data. This is the old debate between simplicity of a model and its proximity to reality. If one decides in favor of simplicity, how much does it cost in terms of deviation from reality? If a model terribly fails to replicate a certain list of stylized facts, these costs are high, and so is the prob-ability that relying on this model alone will be misleading. In this research project, I test the Galí and Monacelli (2005b) model for its closeness to reality with respect to six stylized facts in international macroeconomics, as documented in Obstfeld and Rogoff (2001). This is done by choosing a set of model parameters to minimize the distance between certain moments of the model and those of the data. To simplify the task, I first estimate a Taylor-type rule for the small open economy’s monetary policy instead of using the strict targeting rules that are used in the original paper. In a second step, I test the hypothesis of Obstfeld and Rogoff (2000b) whether trade costs help to get the model closer to the data.
In the next section, I review the literature that is relevant to each specific research prob-lem.