by Liberty Street Economics
Third in a five-part series. This series examines the Federal Reserve Bank of New York’s dynamic stochastic general equilibrium (FRBNY DSGE) model – a structural model used by Bank researchers to understand the workings of the U.S. economy and provide economic forecasts.The severe recession experienced by the U.S. economy between December 2007 and June 2009 has given way to a disappointing recovery. It took three and a half years for GDP to return to its pre-recession peak, and by most accounts this broad measure of economic activity remains below trend today.
What precipitated the U.S. economy into the worst recession since the Great Depression? And what headwinds are holding back the recovery? Are these headwinds permanent, calling for a revision of our assessment of the economy’s speed limit? Or are they transitory, although very long-lasting, as the historical record on the persistent damages inflicted by financial crisis seems to suggest? In this post, we address these questions through the lens of the FRBNY DSGE model.
DSGE models are a particularly suitable tool to look under the economy’s hood and illuminate its inner workings. Their structure allows us to decompose the evolution of the key macroeconomic variables that we can measure—such as GDP and inflation—in terms of their underlying driving forces, which are unobserved. In terms of the automotive metaphor, with a model of the car/economy in hand, we can trace back its observed behavior—direction and speed, say—to its fundamental determinants, such as the conditions of the road and the actions of the driver on the accelerator and the brakes. The key difference of course is that the economy is much more complicated than a car, and does not have one driver behind the wheel. Therefore our model can only provide a simplified, and in many cases imperfect, account of its workings. Even with these simplifications, however, the model provides useful insights.
The FRBNY DSGE model attributes the observed movements in macroeconomic variables to several fundamental disturbances, as explained in the previous post in this series and in more detail in our staff report. As it turns out, only four of these shocks account for the bulk of the movements in GDP and inflation since the Great Recession.
- A shock to total factor productivity (TFP), which affects the overall ability of the economy to produce output from any given amount of labor and capital inputs. A positive TFP shock results in higher GDP and, at the same time, in lower costs of production and hence lower inflation. In our model, shifts in TFP have a permanent effect on the economy’s productive potential. They capture a whole range of “structural†factors that will affect the growth trajectory of the economy for the foreseeable future.
- A financial (or spread) shock stemming from increases in the perceived riskiness of borrowers, which induces banks and other intermediaries to charge higher interest rates on loans, thereby widening credit spreads. An increase in perceived risk (a positive realization of this shock) leads to a large increase in the cost of capital for entrepreneurs, which depresses investment demand and hence GDP growth. As a result of the lower demand, inflation also falls. Although the spikes in spreads associated with this shock tend to be relatively short-lived, as they were during the crisis, their effects can linger well past the most acute phase of market disruptions, with persistently tight credit conditions depressing demand, and hence output and inflation, for several years. Unlike the TFP shocks, however, these financial disturbances are not permanent, and their effects will ultimately dissipate, returning the economy to its pre-crisis growth trajectory.
- A shock to investment demand, whose negative realizations persistently depress capital formation, leading to lower growth and lower inflation. This shock has very similar macroeconomic effects to the risk shock we just described, with the crucial difference that it does not move credit spreads. Therefore, this disturbance can be thought of as capturing financial and other factors that do not manifest themselves in higher spreads, but that nonetheless affect firms’ willingness or ability to invest. Examples of such factors are a reluctance to lend by banks that does not lead to higher interest rates on loans, but for instance to a rationing of credit to certain borrowers, as well as the perception by firms of a particularly uncertain outlook, which delays their investment decisions.
- Shocks to monetary policy, capturing changes in the monetary policy stance not reflected in the policy rate, such as the introduction of forward guidance.
