1. Monetary Policy and a Stock Market Boom-Bust Cycle
Lawrence Christiano, Roberto Motto and Massimo Rostagno

2. Inflation has been relatively stable for a while
Attention has shifted to other issues: stock market volatility

3. Stock market has been volatile:
Is it ‘excessively’ volatile in the welfare sense?
What role (if any) does (should) monetary policy play?
Conventional wisdom –
Bernanke-Gertler: ‘leave it alone’
In any case, inflation targeting will automatically stabilize

4. Inflation appears to be falling
during the start-up of boom-bust
episodes in US.

5. ‘Stock Market Boom-Bust Cycle’
Episode in which:
Stock prices, consumption, investment, output, employment rise sharply and then fall
Inflation low during boom
US examples:
Interwar period
Mid 1950s - mid 1970s
Mid 1990s - present
We’re going back to the drawing board to build a model of a boom-bust cycle.

6. Rational Theory of Boom-Bust
Follow Beaudry-Portier (see also more recently Jaimovich-Rebelo)
Boom-bust cycle triggered by:
Expectation that technology will be strong in future
Expectation ultimately not realized
Examples:
Fiber-optic cable
Motorola satellites
In principle, there are lots of models you could build. At the broadest level there is the question of whether it is a rational one or a bubble model. We follow the lead of Beaudry-Portier and build a rational bubble.

7. Key Findings
Start by trying to build a non-monetary theory of boom-bust cycle
With investment adjustment costs, habit persistence, can almost get successful theory
However, miss on several key dimensions
Stock market goes wrong way, highly volatile real rate, no persistence
When we integrate sticky (allocative) wages and an inflation-targeting central bank, we obtain a more successful theory.
perhaps boom-bust cycles reflect interaction of sticky wages and inflation targeting monetary policy
an example of Levin, et al point that inflation targeting not optimal when wages are sticky

8. Outline Boom-bust in non-monetary economy
Bring in sticky wages/prices and monetary policy as simply as possible
Redo analysis in model with additional financial frictions
banking system (CCE), agency costs (BGG)
permits addressing role of credit and monetary aggregates

10. Parameterization of RBC Model
Model is specialized version of model with many frictions estimated for US by Christiano-Motto-Rostagno (2006)
Parameters:
Steady state:

11. Results for RBC Model
Habit persistence in preference and adjustment costs on change in investment crucial for getting ‘close’ to stock-market boom-bust…
However,
Stock market wrong
Real interest rate highly volatile
No persistence

12. All wrong!

13. Adding habit persistence and investment adjustment costs.

14. Using Static Adjustment Costs Doesn’t Help
Static (‘standard’ adjustment costs)

16. Static adjustment costs
don’t help.

17. Conclusions so far: Need:
habit persistence
need adjustment costs in changing the flow of investment (for economic interpretation of this formulation, see Matsuyama and Lucca).
Still, not good enough…..not great on persistence
Increase lead time in signal (p) from 4 to 12

20. What do Agents Expect After Seeing a Signal?

23. Why Does Price of Capital Fall?
Standard Present Value Formula:
Real rate spikes up – not surprising PV falls

24. Why Does Price of Capital Fall?...
Price of capital from implication that price equals marginal cost:
High anticipated investment implies that investment
today reduces future adjustment costs

25. ‘Monetizing the Model’
We add:
Calvo sticky price setup (‘Phillips curve’)
Calvo sticky wage equations
Intertemporal Euler equation for bonds
Take limit where money demand goes to zero
Monetary policy rule

26. Goods Production Final goods: Intermediate goods:
firms reoptimize and instead set price as follows:

27. Sticky Wages (Erceg, Henderson, Levin)
Homogeneous labor assembled from specialized household labor services:
households reoptimize wage in given period and set their wage as follows:

28. Demand for Money Money in the utility function:
We drive coefficient on money balances to zero in equilibrium conditions.

29. Monetary Policy ‘Target interest rate’ Actual interest rate:
Parameters of monetary model

31. Findings Now have a (sort of) reasonable model of boom-bust
highly persistent
ex post real interest rate moves only a very small amount
Stock price moves in ‘right’ way (though a little anemic).
Quantity movements in monetary model swamp movements in RBC model
Boom-bust (though triggered by real event) is primarily a monetary policy phenomenon

32. Basic Diagnosis Application of logic in
Erceg, Christopher, Dale Henderson, and Andrew Levin, 2000, `Optimal Monetary Policy with Staggered Wage and Price Contracts,' Journal of Monetary Economics, 46,
Levin, A., Onatski, A., Williams, J., Williams, N., "Monetary Policy under Uncertainty in Microfounded Macroeconometric Models." In: NBER Macroeconomics Annual 2005, Gertler, M., Rogoff, K., eds. Cambridge, MA: MIT Press.
Sticky wages are the key, sticky prices unimportant
Inflation targeting important
Real wage ‘should’ rise in boom, but is prevented:
wage is sticky
price is sticky downward, because of monetary policy

34. Sticky prices
don’t matter!

35. Sticky wages matter!

36. Wage indexation
matters

37. Inflation
targeting important!

38. ‘Full’ Model has Credit, Monetary Aggregates
Model incorporates banking sector, as in Chari, Christiano and Eichenbaum.
M1, M3, demand deposits, currency, bank reserves.
Financial frictions as in Bernanke, Gertler and Gilchrist.
Total credit (borrowing of working capital by banks, plus loans to entrepreneurs).

39. M1 ~ currency + demand deposis M2/M3 ~ M1 + savings deposits
Credit ~ total borrowing (includes time deposits, but not currency)
Entrepreneurs:
own and rent out
capital
Firms:
need working
capital to pay factors
Banks
(hold reserves)
Demand deposits,
Savings deposits,
Time deposits
Households

40. Findings
BGG financial frictions attenuate somewhat the effects of boom-bust
Rationalizes monetary policy of looking at credit.

45. Conclusion
With habit persistence and cost-of-change adjustment costs, can make progress on generating stock market boom-bust.
But, problems…
Bring in sticky wages and inflation targeting, and can generate boom-bust
Perhaps monetary policy should react to other variables, such as credit growth.