Financial markets and policythrough the lens of macroeconomics

São Paulo, August 11 2016

Jouko Vilmunen (BoF)

Disclaimer

The usual disclaimer applies: the views do not necessarilyreflect those of the Bank of Finland

A word of warning

• I am (mostly) a macroeconomist• Although not grumpy, being (mostly) a macroeconomist

may bias my views on macropru and financial regulation• Looking the relevant issues through the lens of

macroeconomics and, in particular, monetar policy• DSGE has a special role, both explicitly and implicitly

Systemic risk

• Systemic risk in the debate as a rationale for prudent policy making

• Hansen (2012): should systemic risk be an explicit target for measurement or relegated to a buzz word, a code word being used to rationalize regulatory discretion?• Systemic risk: risks of breakdown or a major dysfunction in financial markets

• Not to be confused with systematic risk which is well studied and supported byextensive modelling and measurement

Sytemic risk or unertainty?

• Systemic risk still a fairly poorly undrstood concept

• → there’s no ”off-the-shelf ” model we can use to measure it

• In the short-run: coarse approximations?• If so, how do we bext express scepticism in our probabilistic measurement of systemic risk?

(Hansen, 2012)• Models simplify, hence are by their very nature wrong: gaps remain• Critical: which gaps are non-trivial

• Often we suspect some of the gaps are non-trivial• Challenge: how to express skepticism?

Systemic risk and uncertainty cntd

• Simple models, although incomplete along some dimensions, canprovide powerful insights, so• How do we embrace such models while acknowledging skepticism that

should justifiably go along with them (Hansen, 2012)• Enduring problem in the use of DSGE models• Progress has been made, but maybe we need to abandon the presumption

that we can measure systemic risk and go after the conceptually moredemanding notion of quantifying systemic uncertainty (á la Knight)

No off-the-shelf macromodels

• Financial mkt disruptions and the macroeconomy: serious attempts to understand this requires more than just off-the-shelf DSGE models

• Many of the existing DSGE models: well suited for estimations and business cycle related shock simulation

• However, these are ”small shocks” models (mostly) using localapproximations

• Crisis times (some critical constraints bind): separate local approximations• Some progress, eg. Gertler – Kiyotaki (2010)

DSGE models, financial frictions and monetarypolicy

• Recent advances in DSGE modelling have only scratched the surfaceon how to extend these models to improve our understanding of themacroeconomic consequences to upheaval in financial mkts• And to improve the quality of policy advice

• Deep open research questions remain from how to best modelfinancial constraints to how to best model the consequences of financial constraints/frictions to the trade-off faced by policy makers

DSGE models cntd

• Walsh (2009, p. 28):• Just as time-varying tax and subsidies may constitutea better tool to deal with mark-up

shocks, time-varying and targeted financial regulation are better instruments than monetarypolicy for mitigating many of the effects of these frictions. But if regulation fails to do so, central banks cannot ignore financial frictions and financial stability. […] and financialmarket disturbances may force central banks to make trade-offs in the inflation and output objectives

• Q: What’s the best research agenda to follow in seeking answers to allthese relevant questions? One based on DSGE modelling? Somethingelse?

DSGE models cntd

• DSGE modelling imposes fairly strict constraint to macroeconomic modelling, as some of the critics have argued

• Korinek (2015) has an extremely well thought notes on this

• See also Caballero’s critical remarks (JEP, 2010)

Summarizing: modelling financial frictions, need more methodological diversity and out of

box thinking?• As much as I want to endorse DSGE modelling as a long-term research aim,

I am increasingly stabbed by the idea that maybe DSGE platform is not theideal one think about and test which financial frictions (and shocks theygenerate) are the most relevant for the macroeconomy and what is the idealway of modelling them in a macroeconomic context

• Is it so that we need more out of box thinking and methodological diversity, in particular over shorter-run issues, to test new ideas and aim to incorporatethem in DSGE models only ultimately, once we have found the best way to formalize them and to model them in a macroeconomic context

Summarizing cntd

• This is particularly important when it comes to monetary policy objectives, the pursue of which is potentialy heavily affected by various financial market imperfections and frictions

• Perhaps more importantly, should we abandon the notion that business cycles can beanalyzed separately from longer-run growth, so that business cycles are to be understood as shorter-run fluctuations in the longer-run growth rate of the economy

• If so, this forces us to think about the role of the financial mkts, frictions or not, and monetary policy within the context of longer-run growth

• Food for thought!

THANK YOU FOR YOUR ATTENTION