Final Report Summary - MACROMOD (New Issues in Macro Modeling) The project has delivered new theoretical and empirical models to understand and analyze relationships between main macroeconomic variables. A closed-form solution for a long-run Phillips curve relating average output gap to average wage inflation is derived via a dynamic general equilibrium model featuring downward nominal rigidities in the paper “Inflation-output trade-off with downward nominal wage rigidities”, published in The American Economic Review Vol. 101, No. 4, pp. 1436-1466, (2011), authored by P. Benigno and L.A. Ricci. The Phillips curve is virtually vertical at high inflation and flattens at low inflation. Macroeconomic volatility shifts the curve outwards and reduces output. The results imply that stabilization policies play an important role, and that optimal inflation may be positive and differ across countries with different macroeconomic volatility. A new role for volatility is also found in the paper “Unemployment and productivity in the long run: the role of macroeconomic volatility,” forthcoming in the Review of Economics and Statistics, authored by P. Benigno, P. Surico and L.A. Ricci, discussing new empirical regularity between the volatility of productivity growth and long-run unemployment, for a given level of long-run productivity growth. A theoretical framework based on asymmetric real wage rigidities is shown to have the potential to rationalize this finding. The model tends to fit U.S. long-run unemployment better than a specification based on long-run productivity growth only, especially during the Great Moderation and the Great Recession. International home bias in equity, a puzzle in the international finance literature, can be explained by an old argument—hedging real exchange rate risk—using however two new frameworks which are discussed in the paper “International Portfolio Allocation under Model Uncertainty,” published in the American Economic Journal: Macroeconomics, 4(1): 144-189, (2012), authored by P. Benigno and S. Nisticò. The two frameworks consist of a model with uncertainty and ambiguity aversion and a model with preferences à la Epstein and Zin. The novelty is to show that the relevant risk to be hedged is the medium-to-long run risk as opposed to the short-run risk. Domestic equity is found to be a good hedge with respect to long-run real exchange rate risk even when bonds are traded. The model is able to explain a large share of the observed US international portfolio home bias. Along these lines of research, asset prices and the equity premium might reflect doubts and pessimism. Introducing these features in an otherwise standard New-Keynesian model improves substantially the inflation-output trade-off so that average output can rise without much inflation costs as shown in “Monetary policy, doubts and asset prices,” published in the Journal of Monetary Economics 64, pp. 85-98 (2014), authored by P. Benigno and L. Paciello. A "paternalistic" policymaker chooses a more accommodating policy towards productivity shocks and inflates the equity premium than what is usually found in the literature.New empirical evidence on the importance of time-varying uncertainty for the exchange rate and the excess return in currency markets is discussed in the paper “Risk, Monetary Policy and The Exchange Rate,” published in D. Acemoglu and M. Woodford, eds., NBER Macroeconomics Annual 2011, vol. 26(1), pp. 247-309 authored by G. Benigno, P. Benigno and S. Nisticò. An integrated theory of exchange rate determination based on level factors and on time-varying uncertainty is proposed, driven by the specification of monetary policy and the role of exogenous risk factors in addressing the main regularities observed in international finance. In the model, the behaviour of the exchange rate following nominal and real volatility shocks is consistent with the empirical evidence. To the end of supporting this analysis through a coherent methodological framework, the paper “Second-order approximation of dynamic models with time-varying risk,” published in the Journal of Economic Dynamics and Control, 37(3), pp. 1231-1247, (2013), authored by P. Benigno, G. Benigno and S. Nisticò has provided the theoretical background for using solution methods based on first and second-order approximations of non-linear dynamic stochastic models in which the exogenous state variables follow conditionally-linear stochastic processes displaying time-varying risk. Deleveraging from high debt can provoke deep recessions with significant international side effects, as shown in the paper “Debt deleveraging and the exchange rate,” published in the Journal of International Economics 93, pp. 1-16 (2014), authored by P. Benigno and F. Romei. Swings in the nominal exchange rate and large variations in consumption, output, terms of trade can happen during the adjustment. All these movements are inefficient and interesting trade-offs emerge from the perspective of global welfare. The optimal adjustment to global imbalances should not necessarily require large movements in the nominal exchange rate.
