Assessing macro-financial linkages: A model comparison exercise

Abstract

Abstract:The recent global financial crisis has increased interest in macroeconomic models that incorporate financial linkages. Here, we compare the simulation properties of five mediumsized general equilibrium models used in Eurosystem central banks which incorporate such linkages. The financial frictions typically considered are the financial accelerator mechanism (convex "spread" costs related to firms' leverage ratios) and collateral constraints (based on asset values). The harmonized shocks we consider illustrate the workings and mechanisms underlying the financial-macro linkages embodied in the models. We also look at historical shock decompositions of real GDP growth across the models since 2005 in order to shed light on the common driving factors underlying the recent financial crisis. In these exercises, the models share qualitatively similar and interpretable features. This gives us confidence that we have some broad understanding of the mechanisms involved.In addition, we also survey the current and developing trends in the literature on financial frictions. Non-technical summaryThe global financial crisis has increased the demand for general equilibrium models that can account for the interaction between financial markets, inflation and the real economy. Yet, many existing policy models largely assume frictionless financial markets (with a few notable exceptions, such as Christiano et al., 2003). This reflects, to some degree, academic and empirical controversy as to the importance of financial channels. Some analyzes stress them as a key amplifier and source of business-cycle fluctuations (e.g. Bernanke et al., 1999) whilst others suggest their impact may be confined to periods of deep financial distress (see Meier and Mueller, 2006). Our paper surveys the strength and nature of financial channels and frictions in a number of prominent central bank models of the European System of Central Banks (hereafter, ESCB), when examined over common simulation and historical exercises. The examined models (five in all) represent a useful cross section since three are estimated on the euro area data, one is estimated from Swedish data and one from Polish data -the latter two being interesting as examples of countries outside the single currency.We present harmonized simulation evidence from the models. Such experiments or model comparison exercises are useful for a number of reasons: First, if -for commonly scaled shocks -the models share qualitatively similar and interpretable features, this gives us confidence that we have some broad understanding of the mechanisms involved. Second, model development is a continuous process and so comparisons of model reactions allows us to build up robustness and common knowledge in the development and assessment of those models. The common shocks that we consider are: a standard monetary shock, an equivalent interest rate spread shock, a loan-to-value ratio shock, and a so-called valuation shock.Overall, we find that the models considered share qualitatively similar and in...

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