IDEAS home Printed from https://ideas.repec.org/p/bca/bocawp/17-21.html
   My bibliography  Save this paper

Should Central Banks Worry About Nonlinearities of their Large-Scale Macroeconomic Models?

Author

Listed:
  • Vadym Lepetyuk
  • Lilia Maliar
  • Serguei Maliar

Abstract

How wrong could policymakers be when using linearized solutions to their macroeconomic models instead of nonlinear global solutions? This question became of much practical interest during the Great Recession and the recent zero lower bound crisis. We assess the importance of nonlinearities in a scaled-down version of the Terms of Trade Economic Model (ToTEM), the main projection and policy analysis model of the Bank of Canada. In a meticulously calibrated “baby” ToTEM model with 21 state variables, we find that local and global solutions have similar qualitative implications in the context of the recent episode of the effective lower bound on nominal interest rates in Canada. We conclude that the Bank of Canada’s analysis would not improve significantly by using global nonlinear methods instead of a simple linearization method augmented to include occasionally binding constraints. However, we also find that even minor modifications in the model's assumptions, such as a variation in the closing condition, can make nonlinearities quantitatively important.

Suggested Citation

  • Vadym Lepetyuk & Lilia Maliar & Serguei Maliar, 2017. "Should Central Banks Worry About Nonlinearities of their Large-Scale Macroeconomic Models?," Staff Working Papers 17-21, Bank of Canada.
  • Handle: RePEc:bca:bocawp:17-21
    as

    Download full text from publisher

    File URL: https://www.bankofcanada.ca/wp-content/uploads/2017/06/swp2017-21.pdf
    Download Restriction: no

    References listed on IDEAS

    as
    1. Lawrence J. Christiano & Martin S. Eichenbaum & Mathias Trabandt, 2015. "Understanding the Great Recession," American Economic Journal: Macroeconomics, American Economic Association, vol. 7(1), pages 110-167, January.
    2. repec:oup:restud:v:85:y:2018:i:1:p:87-118. is not listed on IDEAS
    3. Aruoba, S. Boragan & Fernandez-Villaverde, Jesus & Rubio-Ramirez, Juan F., 2006. "Comparing solution methods for dynamic equilibrium economies," Journal of Economic Dynamics and Control, Elsevier, vol. 30(12), pages 2477-2508, December.
    4. Schmitt-Grohé, Stephanie & Uribe, Martín, 2012. "The Making Of A Great Contraction With A Liquidity Trap and A Jobless Recovery," CEPR Discussion Papers 9237, C.E.P.R. Discussion Papers.
    5. Maliar, Serguei & Maliar, Lilia & Judd, Kenneth, 2011. "Solving the multi-country real business cycle model using ergodic set methods," Journal of Economic Dynamics and Control, Elsevier, vol. 35(2), pages 207-228, February.
    6. Brayton, Flint & Levin, Andrew & Lyon, Ralph & Williams, John C., 1997. "The evolution of macro models at the Federal Reserve Board," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 47(1), pages 43-81, December.
    7. Fernández-Villaverde, Jesús & Gordon, Grey & Guerrón-Quintana, Pablo & Rubio-Ramírez, Juan F., 2015. "Nonlinear adventures at the zero lower bound," Journal of Economic Dynamics and Control, Elsevier, vol. 57(C), pages 182-204.
    8. Cook, David & Devereux, Michael B, 2016. "Exchange rate flexibility under the zero lower bound," Journal of International Economics, Elsevier, vol. 101(C), pages 52-69.
    9. Paul R. Krugman, 1998. "It's Baaack: Japan's Slump and the Return of the Liquidity Trap," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 137-206.
    10. Gali, Jordi & Gertler, Mark, 1999. "Inflation dynamics: A structural econometric analysis," Journal of Monetary Economics, Elsevier, vol. 44(2), pages 195-222, October.
    11. S Borağan Aruoba & Pablo Cuba-Borda & Frank Schorfheide, 2018. "Macroeconomic Dynamics Near the ZLB: A Tale of Two Countries," Review of Economic Studies, Oxford University Press, vol. 85(1), pages 87-118.
    12. José Dorich & Michael K. Johnston & Rhys R. Mendes & Stephen Murchison & Yang Zhang, 2013. "ToTEM II: An Updated Version of the Bank of Canada’s Quarterly Projection Model," Technical Reports 100, Bank of Canada.
    13. Kollmann, Robert & Maliar, Serguei & Malin, Benjamin A. & Pichler, Paul, 2011. "Comparison of solutions to the multi-country Real Business Cycle model," Journal of Economic Dynamics and Control, Elsevier, vol. 35(2), pages 186-202, February.
    14. Lilia Maliar & Serguei Maliar & Sébastien Villemot, 2013. "Taking Perturbation to the Accuracy Frontier: A Hybrid of Local and Global Solutions," Computational Economics, Springer;Society for Computational Economics, vol. 42(3), pages 307-325, October.
    15. Schmitt-Grohe, Stephanie & Uribe, Martin, 2003. "Closing small open economy models," Journal of International Economics, Elsevier, vol. 61(1), pages 163-185, October.
    16. Lim, G.C. & McNelis, Paul D., 2008. "Computational Macroeconomics for the Open Economy," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262123061, March.
    17. Backus, David K & Kehoe, Patrick J & Kydland, Finn E, 1992. "International Real Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 100(4), pages 745-775, August.
    18. Taisuke Nakata & Sebastian Schmidt & Timothy Hills, 2016. "The Risky Steady State and the Interest Rate Lower Bound," 2016 Meeting Papers 39, Society for Economic Dynamics.
    19. Christopher Gust & Edward Herbst & David López-Salido & Matthew E. Smith, 2017. "The Empirical Implications of the Interest-Rate Lower Bound," American Economic Review, American Economic Association, vol. 107(7), pages 1971-2006, July.
    20. Guido Ascari & Argia M. Sbordone, 2014. "The Macroeconomics of Trend Inflation," Journal of Economic Literature, American Economic Association, vol. 52(3), pages 679-739, September.
    21. Caballero, Ricardo & Farhi, Emmanuel & Gourinchas, Pierre-Olivier, 2015. "Global Imbalances and Currency Wars at the ZLB," CEPR Discussion Papers 10905, C.E.P.R. Discussion Papers.
    22. David Cook & Michael B. Devereux, 2013. "Sharing the Burden: Monetary and Fiscal Responses to a World Liquidity Trap," American Economic Journal: Macroeconomics, American Economic Association, vol. 5(3), pages 190-228, July.
    23. Hess Chung & Jean‐Philippe Laforte & David Reifschneider & John C. Williams, 2012. "Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44, pages 47-82, February.
    24. Stefan Laséen & Lars E.O. Svensson, 2011. "Anticipated Alternative policy Rate Paths in Plicy Simulations," International Journal of Central Banking, International Journal of Central Banking, vol. 7(3), pages 1-35, September.
    25. Fernández, Andrés & Schmitt-Grohé, Stephanie & Uribe, Martín, 2017. "World shocks, world prices, and business cycles: An empirical investigation," Journal of International Economics, Elsevier, vol. 108(S1), pages 2-14.
    26. Coenen, Günter & McAdam, Peter & Straub, Roland, 2008. "Tax reform and labour-market performance in the euro area: A simulation-based analysis using the New Area-Wide Model," Journal of Economic Dynamics and Control, Elsevier, vol. 32(8), pages 2543-2583, August.
    27. Gauti B. Eggertsson & Neil R. Mehrotra & Sanjay R. Singh & Lawrence H. Summers, 2016. "A Contagious Malady? Open Economy Dimensions of Secular Stagnation," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 64(4), pages 581-634, November.
    28. Karel R. S. M. Mertens & Morten O. Ravn, 2014. "Fiscal Policy in an Expectations-Driven Liquidity Trap," Review of Economic Studies, Oxford University Press, vol. 81(4), pages 1637-1667.
    29. Olivier Gervais & Marc-André Gosselin, 2014. "Analyzing and Forecasting the Canadian Economy through the LENS Model," Technical Reports 102, Bank of Canada.
    30. Sofía Bauducco & Lawrence Christiano & Claudio Raddatz, 2014. "Macroeconomic and Financial Stability: An Overview," Central Banking, Analysis, and Economic Policies Book Series,in: Sofía Bauducco & Lawrence Christiano & Claudio Raddatz (ed.), Macroeconomic and Financial Stability: challenges for Monetary Policy, edition 1, volume 19, chapter 1, pages 1-22 Central Bank of Chile.
    31. Lawrence H. Summers, 1991. "Panel discussion: price stability ; How should long-term monetary policy be determined?," Proceedings, Federal Reserve Bank of Cleveland, pages 625-631.
    32. Olivier Coibion & Yuriy Gorodnichenko & Johannes Wieland, 2012. "The Optimal Inflation Rate in New Keynesian Models: Should Central Banks Raise Their Inflation Targets in Light of the Zero Lower Bound?," Review of Economic Studies, Oxford University Press, vol. 79(4), pages 1371-1406.
    33. Schmitt-Grohe, Stephanie & Uribe, Martin, 2004. "Solving dynamic general equilibrium models using a second-order approximation to the policy function," Journal of Economic Dynamics and Control, Elsevier, vol. 28(4), pages 755-775, January.
    34. Boneva, Lena Mareen & Braun, R. Anton & Waki, Yuichiro, 2016. "Some unpleasant properties of loglinearized solutions when the nominal rate is zero," Journal of Monetary Economics, Elsevier, vol. 84(C), pages 216-232.
    35. Giancarlo Corsetti & Keith Kuester & Gernot J. Müller, 2016. "The Case for Flexible Exchange Rates in a Great Recession," Cambridge Working Papers in Economics 1644, Faculty of Economics, University of Cambridge.
    36. Ippei Fujiwara, 2010. "Export shocks and the zero bound trap," Globalization Institute Working Papers 63, Federal Reserve Bank of Dallas.
    37. Oleksiy Kryvtsov & Rhys R. Mendes, 2015. "The Optimal Level of the Inflation Target: A Selective Review of the Literature and Outstanding Issues," Discussion Papers 15-8, Bank of Canada.
    38. Martin M Andreasen & Jesús Fernández-Villaverde & Juan F Rubio-Ramírez, 2018. "The Pruned State-Space System for Non-Linear DSGE Models: Theory and Empirical Applications," Review of Economic Studies, Oxford University Press, vol. 85(1), pages 1-49.
    39. Olivier Coibion & Yuriy Gorodnichenko & Johannes Wieland, 2012. "The Optimal Inflation Rate in New Keynesian Models: Should Central Banks Raise Their Inflation Targets in Light of the Zero Lower Bound?," Review of Economic Studies, Oxford University Press, vol. 79(4), pages 1371-1406.
    40. Christopher J. Erceg & Luca Guerrieri & Christopher Gust, 2006. "SIGMA: A New Open Economy Model for Policy Analysis," International Journal of Central Banking, International Journal of Central Banking, vol. 2(1), March.
    41. Kenneth L. Judd & Lilia Maliar & Serguei Maliar, 2011. "Numerically stable and accurate stochastic simulation approaches for solving dynamic economic models," Quantitative Economics, Econometric Society, vol. 2(2), pages 173-210, July.
    42. Guerrieri, Luca & Iacoviello, Matteo, 2015. "OccBin: A toolkit for solving dynamic models with occasionally binding constraints easily," Journal of Monetary Economics, Elsevier, vol. 70(C), pages 22-38.
    43. Kenneth Judd & Lilia Maliar & Serguei Maliar, 2012. "Merging simulation and projection approaches to solve high-dimensional problems," Working Papers. Serie AD 2012-20, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie).
    44. Eggertsson, Gauti B. & Singh, Sanjay R., 2019. "Log-linear approximation versus an exact solution at the ZLB in the New Keynesian model," Journal of Economic Dynamics and Control, Elsevier, vol. 105(C), pages 21-43.
    45. Laurence M. Ball, 2013. "The Case for Four Percent Inflation," Central Bank Review, Research and Monetary Policy Department, Central Bank of the Republic of Turkey, vol. 13(2), pages 17-31.
    46. Stephen Murchison & Andrew Rennison, 2006. "ToTEM: The Bank of Canada's New Quarterly Projection Model," Technical Reports 97, Bank of Canada.
    47. Straub, Roland & Jacquinot, Pascal, 2008. "Globalisation and the euro area: simulation based analysis using the New Area Wide Model," Working Paper Series 907, European Central Bank.
    48. Galí, Jordi & Gertler, Mark, 1999. "Inflation Dynamics: A Structural Economic Analysis," CEPR Discussion Papers 2246, C.E.P.R. Discussion Papers.
    49. Burgess, Stephen & Fernandez-Corugedo, Emilio & Groth, Charlotta & Harrison, Richard & Monti, Francesca & Theodoridis, Konstantinos & Waldron, Matt, 2013. "The Bank of England's forecasting platform: COMPASS, MAPS, EASE and the suite of models," Bank of England working papers 471, Bank of England.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Business fluctuations and cycles; Econometric and statistical methods; Economic models;

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • C68 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computable General Equilibrium Models
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:bca:bocawp:17-21. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (). General contact details of provider: http://edirc.repec.org/data/bocgvca.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.