The popular Taylor rule is meant to inform monetary policy in economies that are closed. Its main open-economy alternative, i.e., the Ball (1999) rule based on a Monetary Conditions Index, cannot offer guidance for the day-to-day conduct of monetary policy because it may perform poorly in the face of specific exchange rate shocks. In this paper we examine the performance of various monetary policy rules suitable for small open economies vis-a-vis existing rules. This entails comparing the asymptotic properties of a two-sector open-economy dynamic stochastic general equilibrium model calibrated on UK data under different rules. We find that an inflation-forecast-based rule is a good rule in this respect, one that also proves robust to different shocks. Adding a separate response to the level of the real exchange rate improves stabilisation only marginally.

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Forecasting with measurement errors in dynamic models

Published in International Journal of Forecasting, 2005

(with George Kapetanios and Tony Yates)

In this paper, we explore the consequences for forecasting of the following two facts: first, that over time statistics agencies revise and improve published data, so that observations on more recent events are those that are least well measured. Second, that economies are such that observations on the most recent events contain the largest signal about the future. We discuss a variety of forecasting problems in this environment, and present an application using a univariate model of the quarterly growth of UK private consumption expenditure.

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The danger of inflating expectations of macroeconomic stability: heuristic switching in an overlapping-generations monetary model

Published in International Journal of Central Banking, 2008

(with Alex Brazier, Mervyn King and Tony Yates)

We discuss the cause and durability of the marked fall in the volatility of inflation in recent decades using a monetary overlapping-generations model. Agents forecast inflation using two “heuristics”, one based on lagged inflation, the other on an inflation target announced by the central bank. Agents switch between heuristics based on an imperfect assessment of how each has performed in the past. Movements in the proportions of agents using each heuristic generate fluctuations in small-sample measures of economic volatility. We find that, relative to the rule that would be optimal under rational expectations, a rule that responds to both productivity shocks and inflation expectations better stabilizes the economy but does not prevent agents from switching between heuristics.

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On the application and use of DSGE models

Published in Journal of Economic Dynamics and Control, 2008

(with Pedro Alvarez-Lois, Laura Piscitelli and Alasdair Scott)

We study the communication of analysis based on DSGE models to policymakersby comparing the ‘core/non-core’ approach used in the Bank of England Quarterly Model, comparing it with two others: the ‘measurement error’ approach of Ireland and the ‘shocks-in-parameters’ approach utilised by Smets and Wouters and others. Using a mock forecast scenario for illustration, we argue that each of these approaches would present model users with difficulties in communicating with policymakers. We conjecture that it is this problem, not theory or fitting the data, that currently hinders more widespread influence of DSGE-type models on policy-making.

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Practical tools for policy analysis in DSGE models with missing shocks

Published in Journal of Applied Econometrics, 2014

(with Dario Caldara and Anna Lipińska)

In this paper we analyze the propagation of shocks originating in sectors that are not present in a baseline dynamic stochastic general equilibrium (DSGE) model. Specifically, we proxy the missing sector through a small set of factors that feed into the structural shocks of the DSGE model to create correlated disturbances. We estimate the factor structure by either matching impulse responses of the augmented DSGE model to those generated by an auxiliary model or by using Bayesian techniques. We apply this methodology to track the effects of oil shocks and housing demand shocks in models without energy or housing sectors.

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Estimating the effects of forward guidance in rational expectations models

Published in European Economic Review, 2015

This paper argues that simulations of forward guidance in rational expectations models should be assessed using the “modest policy interventions” framework introduced by Eric Leeper and Tao Zha. The estimated effects of a policy intervention should be considered reliable only if that intervention is unlikely to trigger a revision in private sector beliefs about the conduct of monetary policy. I show how to constrain simulations of forward guidance to ensure that they are regarded as modest policy interventions and illustrate the technique using a medium-scale DSGE model estimated on US data. I find that many experiments that generate the large responses of macroeconomic variables deemed implausible by many economists – the so-called “forward guidance puzzle” – are not modest policy interventions. Such experiments should be treated with caution and more reliable results can be obtained by constraining the experiment to be a modest policy intervention. In the cases I study, the quantitative effects on macroeconomic variables are more plausible when this constraint is imposed.

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Threshold-based forward guidance

Published in Journal of Economic Dynamics and Control, 2018

(with Lena Boneva and Matt Waldron)

When the monetary policy rate is at the zero bound, “threshold-based forward guidance” (TBFG) is a state-contingent promise to delay liftoff from the zero bound until macroeconomic variables breach particular “thresholds”. We study TBFG within a stochastic version of the workhorse New Keynesian model. We show that TBFG can be used to provide temporary stimulus, while also limiting the time inconsistency of policy promises. Existence of a unique equilibrium requires the policymaker to specify how the thresholds should be interpreted, as well as their values. With an appropriate choice of thresholds, TBFG outperforms forward guidance based purely on calendar time and substantially reduces welfare losses compared to the optimal time-consistent policy.

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Uncertain policy promises

Published in European Economic Review, 2019

(with Alex Haberis and Matt Waldron)

We develop a general method for analyzing the effects of macroeconomic policy promises about which the private sector is uncertain. We illustrate the method in two applications to a central bank’s ‘forward guidance’ about the path for its policy rate. We demonstrate that uncertainty about forward guidance resulting from its potential to be imperfectly credible makes it much less powerful than in textbook models. In an application to the FOMC’s ‘threshold-based’ guidance, we show that increasing the precision of the conditions under which the policy rate ‘lifts off’ from the zero bound requires a lower unemployment threshold to deliver a given amount of stimulus.

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DSGE-based priors for BVARs and quasi-Bayesian DSGE estimation

Published in Econometrics and Statistics, 2020

(with Thomai Filippeli and Konstantinos Theodoridis)

This paper developes a new method for estimating Bayesian vector autoregression (VAR) models using priors from a dynamic stochastic general equilibrium (DSGE) models. The DSGE model priors are used to determine the moments of an independent Normal-Wishart prior for the VAR parameters. Two hyper-parameters control the tightness of the DSGE-implied priors on the autoregressive coefficients and the residual covariance matrix respectively. Selecting the values of the hyper-parameters that maximize the marginal likelihood of the Bayesian VAR provides a method for isolating subsets of DSGE parameter priors that are at odds with the data.

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House price dynamics, optimal LTV limits and the liquidity trap

Published in The Review of Economic Studies, 2024

(with Andrea Ferrero and Benjamin Nelson)

This paper studies the optimal design of a loan-to-value (LTV) limit and its implications for monetary policy in a model with nominal rigidities and financial frictions. The welfare-based loss function features a role for macro-prudential policy to enhance risk-sharing. In a house price boom-bust episode, the active use of LTV limits alleviates debt-deleveraging dynamics and prevents the economy from falling into a liquidity trap.

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The Brexit vote, productivity growth and macroeconomic adjustments in the United Kingdom

Published in The Review of Economic Studies, 2024

(with Ben Broadbent, Federico Di Pace, Thomas Drechsel and Silvana Tenreyro)

The U.K. economy experienced significant macroeconomic adjustments following the 2016 referendum on its withdrawal from the European Union. To understand these adjustments, this paper presents empirical facts using novel U.K. macroeconomic data and estimates a small open economy model with tradable and non-tradable sectors. We demonstrate that the referendum outcome can be interpreted as news about a future decline in productivity growth in the tradable sector. An immediate fall in the relative price of non-tradable goods induces a temporary “sweet spot” for tradable producers. Economic activity in the tradable sector expands in the short run, while the non-tradable sector contracts. Aggregate output, consumption, and investment growth decelerate.

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The central bank balance sheet as a policy tool: lessons from the Bank of England’s experience

Published in Journal of Financial Services Research, 2024

(with Andrew Bailey, Jonathan Bridges, Josh Jones and Aakash Mankodi)

This paper examines lessons from the previously unconventional monetary policy measures deployed since the Global Financial Crisis and the emerging evidence on policy responses to the Covid-19 pandemic in 2020. The Bank of England’s quantitative easing (QE) response to the Covid-19 shock was both large in scale and rapid in pace. The QE response also occurred against the backdrop of heightened market dysfunction, suggesting a particular form of “state contingency” of QE. The paper considers some potential implications of this state contingency for future central bank balance sheet policies and the operational framework to support them.

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workingpapers

Evaluating and estimating a DSGE model for the United Kingdom

Published: February 16, 2010

(with Ozlem Öomen)

We build a small open economy dynamic stochastic general equilibrium model, featuring many types of nominal and real frictions that have become standard in the literature. In recent years it has become possible to estimate such models using Bayesian methods. These exercises typically involve augmenting a stochastically singular model with a number of shocks to structural equations to make estimation feasible, even though the motivation for the choice of these shocks is often unspecified. In an attempt to put this approach on a more formal basis, we estimate the model in two stages. First, we evaluate a calibrated version of the stochastically singular model. Then, we augment the model with structural shocks motivated by the results of the evaluation stage and estimate the resulting model using UK data using a Bayesian approach. Finally, we reassess the adequacy of this augmented and estimated model in reconciling the dynamics of the model with the data. Our findings suggest that the shock processes play a crucial role in helping to match the data.

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The impact of permanent energy price shocks on the UK economy

Published: July 08, 2011

(with Ryland Thomas and Iain de Weymarn)

This paper builds a dynamic general equilibrium model that includes a variety of channels through which energy prices affect demand and supply. On the demand side we model household consumption of final energy goods (petrol and utilities) separately from other goods and services. On the supply side, we model the production of final energy goods and the way that they enter the production process of other goods and services. We calibrate the model using UK data and examine how the various channels in the model contribute to the responses to permanent energy price shocks of a similar magnitude to those observed in the recent data. We show the effects of such shocks have important implications for monetary policy.

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Asset purchase policy at the effective lower bound for interest rates

Published: January 27, 2012

This paper studies optimal policy in a stylised New Keynesian model that is extended to incorporate imperfect substitutability between short-term and long-term bonds, providing a channel through which central bank asset purchases can affect aggregate demand. However, the imperfect substitutability between bonds that gives asset purchases their traction also reduces the potency of conventional monetary policy. Nevertheless, a policy in which the central bank uses asset purchases as an additional policy instrument can improve outcomes in the face of a negative demand shock that drives the short-term policy rate to its lower bound.

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Misperceptions, heterogeneous expectations and macroeconomic dynamics

Published: May 18, 2012

(with Tim Taylor)

We investigate the extent to which misperceptions about the economy can become self-reinforcing and thereby contribute to time-varying macroeconomic dynamics using a New Keynesian model with long-horizon expectations and dynamic predictor selection. Agents have access to a set of alternative predictors to form expectations and choose among them based on noisy measures of their recent performance. This dynamic predictor selection generates endogenous fluctuations in the proportions of agents using each predictor, contributing to macroeconomic dynamics. The presence of a ‘persistent predictor’ can lead to changes in beliefs which are self-reinforcing, giving rise to endogenous fluctuations in the time-series properties of the economy. Such fluctuations arise even if we replace the ‘persistent predictor’ with learning under constant gain.

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Non-rational expectations and the transmission mechanism

Published: May 18, 2012

(with Tim Taylor)

This paper compares two approaches to modelling behaviour under non-rational expectations in a benchmark New Keynesian model. The ‘Euler equation’ approach modifies the equations derived under the assumption of rational expectations by replacing the rational expectations operator with an alternative assumption about expectations formation. The ‘long-horizon’ expectations approach solves the decision rules of households and firms conditional on their expectations for future events that are outside of their control, so that spending and price-setting decisions depend on expectations extending into the distant future. We show that both approaches have very similar implications for macroeconomic dynamics when departures from rational expectations are relatively small, but as expectations depart further from rationality the two approaches can generate significantly different macroeconomic implications.

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The Bank of England’s forecasting platform: COMPASS, MAPS, EASE and the suite of models

Published: May 17, 2013

(with Stephen Burgess, Emilio Fernandez-Corugedo, Charlotta Groth, Francesca Monti, Konstantinos Theodoridis and Matt Waldron)

This paper describes the Bank of England’s forecasting platform and provides examples of its application to practical forecasting problems. The platform consists of four components: COMPASS, a structural central organising model; a suite of models, used to fill in the gaps in the economics of COMPASS and provide cross-checks on the forecast; MAPS, a macroeconomic modelling and projection toolkit; and EASE, a user interface.

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Optimal quantitative easing

Published: September 22, 2017

This paper studies optimal monetary policy in a simple New Keynesian model with portfolio adjustment costs. Purchases of long-term debt by the central bank (quantitative easing; ‘QE’) alter the average portfolio return and hence influence aggregate demand and inflation. The central bank chooses the short-term policy rate and QE to minimise a welfare-based loss function under discretion. Adoption of QE is rapid, with large-scale asset purchases triggered when the policy rate hits the zero bound, consistent with observed policy responses to the Global Financial Crisis. Optimal exit is gradual. Despite the presence of portfolio adjustment costs, a policy of ‘permanent QE’ in which the central bank holds a constant stock of long-term bonds does not improve welfare.

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Concerted efforts? Monetary policy and macro-prudential tools

Published: May 25, 2018

(with Andrea Ferrero and Benjamin Nelson)

We study the coordination of monetary and macro-prudential policies in a model with nominal rigidities, housing, incomplete risk-sharing between borrowers and savers, and macro-prudential tools in the form of loan-to-value limits and bank capital requirements. A welfare-based loss function suggests a role for active macro-prudential policy to enhance risk sharing, though complete macro-prudential stabilization is not generally possible. Nonetheless, simulations of a house price boom and subsequent correction suggest that macro-prudential tools could alleviate debt-deleveraging and help avoid zero lower bound episodes, even when macro-prudential tools themselves impose only occasionally binding constraints on debt dynamics in the economy.

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Monetary financing with interest-bearing money

Published: March 08, 2019

(with Ryland Thomas)

Recent results suggesting that monetary financing is more expansionary than bond financing in standard New Keynesian models rely on a duality between policy rules for the rate of money growth and the short-term bond rate, rather than a special role for money. We incorporate two features into a simple sticky-price model to generalize these results. First, that money may earn a strictly positive rate of return, allowing money-financed transfers to be used as a policy instrument at the effective lower bound, without giving up the ability to use the short-term bond rate to stabilize the economy in normal times. Second, a simple financial friction generates a wealth effect on household spending from government liabilities. Though temporary money-financed transfers to households can stimulate spending and inflation when the short-term bond rate is constrained by a lower bound, similar effects could be achieved by bond-financed tax cuts.

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Optimal policy with occasionally binding constraints: piecewise linear solution methods

Published: February 26, 2021

(with Matt Waldron)

This paper develops a piecewise linear toolkit for optimal policy analysis of linear rational expectations models, subject to occasionally binding constraints on (multiple) policy instruments and other variables. The flexibility and applicability of the toolkit to very large models is demonstrated in a variety of applications.

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Flexible inflation targeting with active fiscal policy

Published: July 02, 2021

This paper studies optimal time-consistent monetary policy in a simple New Keynesian model with long-term nominal government debt. Fiscal policy is ‘active’, so that stabilisation of the government debt stock is a binding constraint on monetary policy. Away from the lower bound on the monetary policy rate, optimal monetary policy cannot fully offset the effects of shocks to the natural rate of interest, reducing welfare. At the lower bound, active fiscal policy mitigates the effects of recessionary shocks by inducing a rise in inflation expectations, increasing welfare. If debt duration is long enough, improved performance at the lower bound may outweigh higher welfare losses in normal times.

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Structural change, global R* and the missing-investment puzzle

Published: October 20, 2022

(with Andrew Bailey, Ambrogio Cesa-Bianchi, Marco Garofalo, Nick McLaren, Sophie Piton and Rana Sajedi)

This paper focuses on two key trends: the secular decline in risk-free interest rates; and the recorded weakness in investment, despite an increasing wedge between the return on capital and the risk-free rate. The first trend suggests a fall in the long-run global equilibrium interest rate, Global R* and analysis using a structural model finds that rising longevity and falling productivity growth were the main drivers of this decline. We use industry-level data for the United Kingdom to investigate the second trend and find a strong role for intangible capital.

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Global R*

Published: October 01, 2023

(with Ambrogio Cesa-Bianchi and Rana Sajedi - October 2023 update)

We use a structural overlapping-generations model to quantify the effects of five exogenous forces that drive the global trend equilibrium real interest rate, Global R*. We find that Global R* rises from the mid-1950s to the mid-1970s, declining steadily thereafter. The decline is driven predominantly by slowing productivity growth and increasing longevity.

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Optimal quantitative easing and tightening

Published: March 08, 2024

This paper studies optimal use of the central bank balance sheet in a simple New Keynesian model with portfolio frictions. Optimal quantitative easing (QE) entails large and rapid purchases of government debt when the short-term policy rate hits the lower bound. Optimal balance sheet reduction (quantitative tightening, QT) is more gradual. QT strategies similar to those pursued by the Federal Reserve and Bank of England can achieve similar welfare to optimal policy as long as the pace of QT is appropriately calibrated.

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Richard Harrison

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