Research Projects

DFG Project No. 510995673

The most commonly used models for analyzing fiscal policy measures are based on representative agent models. The financial crisis in 2008 and the impacts of the ongoing COVID-19 crisis have demonstrated the drawbacks of this simplified approach to the analysis of government interventions and modeling business cycles. Moreover, further inequalities became apparent during the COVID-19 crisis, which cannot be modeled by the current work horse models in macroeconomics. The research project aims to develop new macroeconomic models and solution methods that allow taking distributional consequences into account. Such heterogeneous agent models can contribute to quantifying the effects of policy measures and identifying new channels of action.

DFG Project No. 268475812

Phase 1:
This project is intended to develop a benchmark New-Keynesian model in continuous time together with the required numerical solution methods in order to provide new insights on the effects of different monetary interventions and fiscal measures, and their effects on financial markets and the real economy.

New Keynesian (NK) models of the business cycle have become a fundamental tool, being the workhorse models in the study of aggregate fluctuations and in the design of monetary and fiscal policies. They are extensively used by central banks around the world to assess the effects of different monetary interventions and/or fiscal measures on financial markets and the real economy.
Nearly all of this extensive literature has worked with a formulation of the model in discrete time. This was in part because of the familiarity of macroeconomist with previous models of the business cycle, as the discrete-time real business cycle model, and in part because of the natural mapping of discrete-time models with empirical data, which come by construction in discrete observations. Motivated by the advantages of a powerful set of mathematical tools (numerical and analytical) and recent advances in empirical analysis (using mixed-frequency data) in comparison to existing approaches, we want to set up and provide methods to solve a NK-model in continuous time. This new formulation of the NK-model should serve as a benchmark to answer empirical relevant questions, at the same time retain a flexible and user-friendly implementation. This project provides new insights to the following questions: What are the effects of increased uncertainty on economic decisions? What are the effects of different monetary interventions and fiscal measures in times when the standard policy instrument, i.e., the nominal interest rate, is no longer available to the central bank because of the presence of a zero-lower-bound (ZLB)? What are the effects of rare, but periodically occurring events such as financial crises on the design of monetary and fiscal policies? With this project we built on the previous literature. In particular, we set up and solve a continuous-time NK-model in which firms can only change prices following a Calvo’s pricing rule. We illustrate the advantages of the continuous-time formulation in three applications.

Phase 2:
New-Keynesian (NK) models of the business cycle are still the workhorse models in the study of aggregate fluctuations and in the design of monetary and fiscal policies. In the aftermath of the financial crisis, with an prolonged zero-interest rate policy (ZIRP) period, the theory has fallen on hard times and has been criticized on both the theoretical and empirical ends. In contrast to alternative doctrines (e.g., Old-Keynesian models and the monetarist view) the NK models predict that quantitative easing operations are irrelevant for inflation, but at the same time they predict counterfactual dynamics and policy paradoxes. In this project we approach this criticism and try to develop potential solutions to the problems. In a recent contribution we show that the ability to explain the facts, including a ZIRP with an active Taylor rule, crucially depends on the way we interpret and solve the model. A joint view of monetary and fiscal policy, in particular implementing the ideas from the fiscal theory of the price level (FTPL), allows us to select different equilibria and thus potentially gives alternative explanations. Including financial frictions, without which unconventional monetary policies in the form of large scale asset purchases – also known as “Quantitative Easing” operations – would be irrelevant, will enable us to model the important channels and it provides insights for a comprehensive understanding of the recent episodes. Our goal is to develop new (joint) strategies for monetary and fiscal policy to cope with future financial crises, or even circumvent them.

Status: completed

The aim of the DFG project was to develop the New Keynesian reference model in continuous time and to provide new numerical solution methods. This objective was successfully achieved. Over the course of the project, the advantages of the continuous-time formulation became particularly clear for integrating data observed at different frequencies, for numerical solution methods, and therefore for analyzing the effects of uncertainty in dynamic stochastic equilibrium models. In the second funding period, we further developed the New Keynesian model to analyze government debt and the interaction between monetary and fiscal policy. In this context, incorporating the fiscal theory of the price level (FTPL) into the reference model proved particularly useful for explaining inflation dynamics following the unprecedented fiscal policy measures and the sharp increase in public debt in the wake of the COVID-19 pandemic. Overall, nine publications emerged from the DFG-funded project, five of which have already been published in leading international journals (Journal of Econometrics, Journal of Economic Dynamics and Control, Quantitative Economics, European Economic Review, and Oxford Bulletin of Economics and Statistics).

DFG Project No. 446166239

In the aftermath of the financial crisis of 2007/2008 fiscal sustainability became a vital problem for nearly all economies. The need to implement sustainable policies is reflected in soaring government debt levels, the effects of unconventional monetary policies on central bank balance sheets and interdependencies of financial- and debt crises with the real economy. The New-Keynesian (NK) modeling framework plays a central role for monetary and fiscal policy and in the analysis of business cycles. However, the financial crisis highlighted some major weaknesses of the simple NK model, as it partially suggests paradox results and policy recommendations. These flaws highlight the need to develop new theories and models. A promising route giving more weight on the fiscal dimension of macroeconomics is the fiscal theory of the price level (FTPL), which has received renewed attention in the academic debates in recent years. By embedding FTPL in the NK modeling framework, many of the above weaknesses are resolved. Based on extensions to the continuous time NK-FTPL framework of Sims (2011) and Cochrane (2018), we plan to develop new solution strategies and policy recommendations. Under the premise of sustainable fiscal and monetary policy, a particular focus will be on the important questions regarding high levels of government debt, the consequences of austerity, the rise of central bank balance sheets due to the unconventional monetary policy measures and the role of risk premiums on government bonds in the emergence of sovereign defaults. Those strategies based on a new synthesis of monetary and fiscal policies, which ensure a sustainable effectiveness of their policy instruments, should help to alleviate the real consequences of future debt crises, or even avoid them entirely.

This project is intended to provide new insights to the following questions: How do soaring government debt levels impact the ability of policy makers to deal with future economic crises? What are the effects of (unconventional) monetary and fiscal interdependencies on the implementation of a sustainable monetary policy? What is the role of risk premia on government bonds in the emergence of sovereign default?

Status: completed

The aim of the DFG project was to study the interaction between sustainable fiscal policy and monetary policy within the fiscal theory of the price level. To this end, we developed a continuous-time macroeconomic framework that jointly captures government debt, the maturity structure of government bonds, and monetary and fiscal policy rules. The results show that not only the level of public debt, but also its maturity structure is crucial for how fiscal measures and monetary policy decisions affect inflation, bond prices, and the broader economy. When government debt has a long maturity, adjustments in bond prices can absorb a substantial part of the effects of changes in monetary policy. At the same time, high debt ratios increase the importance of the interaction between monetary and fiscal policy. The design of fiscal rules and taxation is therefore central to debt sustainability and macroeconomic stability. Extending the framework to include physical capital also made it possible to study the effects of different tax instruments and the conditions under which economically plausible equilibria arise. In the second funding period, the project was extended in two main directions. First, we developed a theory of the term structure of interest rates in a sticky-price New Keynesian model in which inflation is determined endogenously. This makes it possible to analyze how macroeconomic shocks and monetary policy affect interest rates at different maturities and the compensation investors require for bearing risk. The results show in particular that sticky prices are crucial for how macroeconomic risks are transmitted through inflation
and monetary policy into the nominal term structure and bond risk premia. Second, new Kalman–Bucy filtering methods were developed that allow unobserved economic states and structural shocks to be recovered from data and model parameters to be estimated. The analysis also establishes the conditions under which high-frequency and mixed stock–flow data can be used to recover structural shocks in real time. These methods provide the basis for an empirical analysis of the model framework developed in the project. Overall, six working papers have emerged from the DFG project. The models and methods developed in the project also provide a foundation for further research on government debt, risk premia, and the interaction between monetary and fiscal policy.