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Thesis advisor: Susanto Basu / The Great Recession is arguably the most important macroeconomic event of the last three decades. Prior to the collapse of national output during 2008 and 2009, the United States experienced a sustained period of good economic outcomes with only two mild and short recessions. In addition to the severity of the recession, several characteristics of this recession signify it as as a unique event in the recent economic history of the United States. Some of these unique features include the following: Large Increase in Uncertainty About the Future: The Great Recession and its subsequent slow recovery have been marked by a large increase in uncertainty about the future. Uncertainty, as measured by the VIX index of implied stock market volatility, peaked at the end of 2008 and has remained volatile over the past few years. Many economists and the financial press believe the large increase in uncertainty may have played a role in the Great Recession and subsequent slow recovery. For example, Kocherlakota (2010) states, ``I've been emphasizing uncertainties in the labor market. More generally, I believe that overall uncertainty is a large drag on the economic recovery.'' In addition, Nobel laureate economist Peter Diamond argues, ``What's critical right now is not the functioning of the labor market, but the limits on the demand for labor coming from the great caution on the side of both consumers and firms because of the great uncertainty of what's going to happen next.'' Zero Bound on Nominal Interest Rates: The Federal Reserve plays a key role in offsetting the negative impact of fluctuations in the economy. During normal times, the central bank typically lowers nominal short-term interest rates in response to declines in inflation and output. Since the end of 2008, however, the Federal Reserve has been unable to lower its nominal policy rate due to the zero lower bound on nominal interest rates. Prior to the Great Recession, the Federal Reserve had not encountered the zero lower bound in the modern post-war period. The zero lower bound represents a significant constraint monetary policy's ability to fully stabilize the economy. Unprecedented Use of Forward Guidance: Even though the Federal Reserve remains constrained by the zero lower bound, the monetary authority can still affect the economy through expectations about future nominal policy rates. By providing agents in the economy with forward guidance on the future path of policy rates, monetary policy can stimulate the economy even when current policy rates remain constrained. Throughout the Great Recession and the subsequent recovery, the Federal Reserve provided the economy with explicit statements about the future path of monetary policy. In particular, the central bank has discussed the timing and macroeconomic conditions necessary to begin raising its nominal policy rate. Using this policy tool, the Federal Reserve continues to respond to the state of the economy at the zero lower bound. Large Fiscal Expansion: During the Great Recession, the United States engaged in a very large program of government spending and tax reductions. The massive fiscal expansion was designed to raise national income and help mitigate the severe economic contraction. A common justification for the fiscal expansion is the reduced capacity of the monetary authority to stimulate the economy at the zero lower bound. Many economists argue that the benefits of increasing government spending are significantly higher when the monetary authority is constrained by the zero lower bound. The goal of this dissertation is to better understand how these various elements contributed to the macroeconomic outcomes during and after the Great Recession. In addition to understanding each of the elements above in isolation, a key component of this analysis focuses on the interaction between the above elements. A key unifying theme between all of the elements is the role in monetary policy. In modern models of the macroeconomy, the monetary authority is crucial in determining how a particular economic mechanism affects the macroeconomy. In the first and second chapters, I show that monetary policy plays a key role in offsetting the negative effects of increased uncertainty about the future. My third chapter highlights how assumptions about monetary policy can change the impact of various shocks and policy interventions. For example, suppose the fiscal authority wants to increase national output by increasing government spending. A key calculation in this situation is the fiscal multiplier, which is dollar increase in national income for each dollar of government spending. I show that fiscal multipliers are dramatically affected by the assumptions about monetary policy even if the monetary authority is constrained by the zero lower bound. The unique nature of the elements discussed above makes analyzing their contribution difficult using standard macroeconomic tools. The most popular method for analyzing dynamic, stochastic general equilibrium models of the macroeconomy relies on linearizing the model around its deterministic steady state and examining the local dynamics around that approximation. However, the nature of the unique elements above make it impossible to fully capture dynamics using local linearization methods. For example, the zero lower bound on nominal interest rates often occurs far from the deterministic steady state of the model. Therefore, linearization around the steady state cannot capture the dynamics associated with the zero lower bound. The overall goal of this dissertation is to use and develop tools in computational macroeconomics to help better understand the Great Recession. Each of the chapters outlined below examine at least one of the topics listed above and its impact in explaining the macroeconomics of the Great Recession. In particular, the essays highlight the role of the monetary authority in generating the observed macroeconomic outcomes over the past several years. Can increased uncertainty about the future cause a contraction in output and its components? In joint work with Susanto Basu, my first chapter examines the role of uncertainty shocks in a one-sector, representative-agent, dynamic, stochastic general-equilibrium model. When prices are flexible, uncertainty shocks are not capable of producing business-cycle comovements among key macroeconomic variables. With countercyclical markups through sticky prices, however, uncertainty shocks can generate fluctuations that are consistent with business cycles. Monetary policy usually plays a key role in offsetting the negative impact of uncertainty shocks. If the central bank is constrained by the zero lower bound, then monetary policy can no longer perform its usual stabilizing function and higher uncertainty has even more negative effects on the economy. We calibrate the size of uncertainty shocks using fluctuations in the VIX and find that increased uncertainty about the future may indeed have played a significant role in worsening the Great Recession, which is consistent with statements by policymakers, economists, and the financial press. In sole-authored work, the second chapter continues to explore the interactions between the zero lower bound and increased uncertainty about the future. From a positive perspective, the essay further shows why increased uncertainty about the future can reduce a central bank's ability to stabilize the economy. The inability to offset contractionary shocks at the zero lower bound endogenously generates downside risk for the economy. This increase in risk induces precautionary saving by households, which causes larger contractions in output and inflation and prolongs the zero lower bound episode. The essay also examines the normative implications of uncertainty and shows how monetary policy can attenuate the negative effects of higher uncertainty. When the economy faces significant uncertainty, optimal monetary policy implies further lowering real rates by committing to a higher price-level target. Under optimal policy, the monetary authority accepts higher inflation risk in the future to minimize downside risk when the economy hits the zero lower bound. In the face of large shocks, raising the central bank's inflation target can attenuate much of the downside risk posed by the zero lower bound. In my third chapter, I examine how assumptions about monetary policy affect the economy at the zero lower bound. Even when current policy rates are zero, I argue that assumptions regarding the future conduct of monetary policy are crucial in determining the effects of real fluctuations at the zero lower bound. Under standard Taylor (1993)-type policy rules, government spending multipliers are large, improvements in technology cause large contractions in output, and structural reforms that decrease firm market power are bad for the economy. However, these policy rules imply that the central bank stops responding to the economy at the zero lower bound. This assumption is inconsistent with recent statements and actions by monetary policymakers. If monetary policy endogenously responds to current economic conditions using expectations about future policy, then spending multipliers are much smaller and increases in technology and firm competitiveness remain expansionary. Thus, the model-implied benefits of higher government spending are highly sensitive to the specification of monetary policy. / Thesis (PhD) — Boston College, 2014. / Submitted to: Boston College. Graduate School of Arts and Sciences. / Discipline: Economics.

This dissertation consists of three chapters that aim to build a framework which can be used to study interactions between the labour market and macroeconomic dynamics. To achieve this, we reformulate a standard New Keynesian dynamic stochastic general equilibrium (DSGE) model to include search and matching frictions in the labour market and heterogeneity in price and wage stickiness. The first chapter, coauthored with Professor Engin Kara, builds a real business cycle model with labour search frictions and heterogeneity in wage stickiness. Shimer’s (2005) critique on labour search models, that it cannot explain observed unemployment movements, reignited a long-standing debate on unemployment fluctuations and wage determination. Gertler and Trigari (2009) introduce wage stickiness to the model to match unemployment volatility, while Pissarides (2009) finds this modification not satisfactory, citing evidence on high wage cyclicality. We find heterogeneity in wage stickiness in microdata on wages. Our model, which reflects this heterogeneity, matches the data better than its one sector alternatives. The second chapter, coauthored with Professor Engin Kara, studies output dynamics in New Keynesian models with the standard labour market and heterogeneity in price stickiness. We analytically and numerically show that these models can reproduce a hump-shaped output response to persistent monetary shocks, which is a key feature of monetary transmission mechanism. The version of models without heterogeneity cannot generate a hump. Flexible prices in models with heterogeneity play a crucial role, by generating inertia to price-setting and output. The third chapter studies how the labour search frictions affect output dynamics in New Keynesian models, when combined with heterogeneity in nominal rigidities. Long-term employment relationship, that arises under search and matching framework, makes marginal costs history dependent. We show that this history dependence generates inertia in the model. Heterogeneity in nominal rigidities significantly reinforces this inertia, resulting in a hump-shaped output response to persistent monetary shocks. The model without the search frictions cannot replicate a hump even when monetary shocks are persistent, when wages are sticky.

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Conforme enfatizado por Dib (2003), recentemente tem sido observado um crescente interesse no desenvolvimento de modelos econômicos que destacam o papel da rigidez no preço nominal, pautados no comportamento otimizador de agentes racionais em um ambiente dinâmico, estocástico e de equilíbrio geral (DSGE). Entretanto, apesar das vantagens apresentadas por esta classe de modelos, observa-se que os choques de política monetária geram apenas fraca persistência nas variáveis reais e nominais, o que vai de encontro com a maior parte das evidências, que indicam que os efeitos destes choques duram vários trimestres. Desta forma, no presente trabalho foi feita, através de métodos bayesianos, a estimação para o Brasil do modelo DSGE desenvolvido por Dib (2003), que combina rigidez nominal na forma de custos de ajustamento de preços e rigidez real na forma de custos de ajustamento de capital e/ou emprego. O objetivo foi verificar se a inserção de rigidez real aumenta a rigidez nominal e, consequentemente, a persistência de choques de política monetária. Os resultados de estimação mostraram que a inserção de rigidez real contribuiu para o aumento da rigidez nominal, em especial quando aquela foi inserida na forma de custos de ajustamento de emprego. Ainda, exercícios de simulação mostraram que quando o modelo contém rigidez real, os choques de oferta de moeda, de demanda de moeda e de tecnologia têm impactos mais persistentes sobre algumas variáveis macroeconômicas. / According to the emphasis by Dib (2003), recently there has been a growing interest in the development of economic models that outline the role of rigidities in nominal price, based on the optimizing behavior of rational agents in a dynamic, stochastic, general-equilibrium (DSGE) environment. Although, there are advantages shown by these models, it was observed that the money supply shocks create only weak persistence of real and nominal variables, which conflicts with the majority of evidences, pointing that the effects of this shocks lasting for many quarters. Therefore, in this present work it was carried out, through Bayesian methods, the estimation of Dib’s (2003) model for the Brazilian economy, which combines the nominal rigidities in the form of costly price adjustment and real rigidities in the form of cost of adjusting capital and/or employment. The objective was to verify if the insertion of the real rigidities increases the nominal rigidities and, consequently, the persistence of monetary policy shocks. The results of this estimation showed that the insertion of real rigidities contributed to the increase of nominal rigidities, especially when the former is inserted in the form of employment adjusting costs. In addition, exercises of simulation demonstrated that when the real rigidities are present in the model, the money supply, the money demands and the technology shocks have impacts more persistent over some macroeconomic variables.

Conforme enfatizado por Dib (2003), recentemente tem sido observado um crescente interesse no desenvolvimento de modelos econômicos que destacam o papel da rigidez no preço nominal, pautados no comportamento otimizador de agentes racionais em um ambiente dinâmico, estocástico e de equilíbrio geral (DSGE). Entretanto, apesar das vantagens apresentadas por esta classe de modelos, observa-se que os choques de política monetária geram apenas fraca persistência nas variáveis reais e nominais, o que vai de encontro com a maior parte das evidências, que indicam que os efeitos destes choques duram vários trimestres. Desta forma, no presente trabalho foi feita, através de métodos bayesianos, a estimação para o Brasil do modelo DSGE desenvolvido por Dib (2003), que combina rigidez nominal na forma de custos de ajustamento de preços e rigidez real na forma de custos de ajustamento de capital e/ou emprego. O objetivo foi verificar se a inserção de rigidez real aumenta a rigidez nominal e, consequentemente, a persistência de choques de política monetária. Os resultados de estimação mostraram que a inserção de rigidez real contribuiu para o aumento da rigidez nominal, em especial quando aquela foi inserida na forma de custos de ajustamento de emprego. Ainda, exercícios de simulação mostraram que quando o modelo contém rigidez real, os choques de oferta de moeda, de demanda de moeda e de tecnologia têm impactos mais persistentes sobre algumas variáveis macroeconômicas. / According to the emphasis by Dib (2003), recently there has been a growing interest in the development of economic models that outline the role of rigidities in nominal price, based on the optimizing behavior of rational agents in a dynamic, stochastic, general-equilibrium (DSGE) environment. Although, there are advantages shown by these models, it was observed that the money supply shocks create only weak persistence of real and nominal variables, which conflicts with the majority of evidences, pointing that the effects of this shocks lasting for many quarters. Therefore, in this present work it was carried out, through Bayesian methods, the estimation of Dib’s (2003) model for the Brazilian economy, which combines the nominal rigidities in the form of costly price adjustment and real rigidities in the form of cost of adjusting capital and/or employment. The objective was to verify if the insertion of the real rigidities increases the nominal rigidities and, consequently, the persistence of monetary policy shocks. The results of this estimation showed that the insertion of real rigidities contributed to the increase of nominal rigidities, especially when the former is inserted in the form of employment adjusting costs. In addition, exercises of simulation demonstrated that when the real rigidities are present in the model, the money supply, the money demands and the technology shocks have impacts more persistent over some macroeconomic variables.

Conforme enfatizado por Dib (2003), recentemente tem sido observado um crescente interesse no desenvolvimento de modelos econômicos que destacam o papel da rigidez no preço nominal, pautados no comportamento otimizador de agentes racionais em um ambiente dinâmico, estocástico e de equilíbrio geral (DSGE). Entretanto, apesar das vantagens apresentadas por esta classe de modelos, observa-se que os choques de política monetária geram apenas fraca persistência nas variáveis reais e nominais, o que vai de encontro com a maior parte das evidências, que indicam que os efeitos destes choques duram vários trimestres. Desta forma, no presente trabalho foi feita, através de métodos bayesianos, a estimação para o Brasil do modelo DSGE desenvolvido por Dib (2003), que combina rigidez nominal na forma de custos de ajustamento de preços e rigidez real na forma de custos de ajustamento de capital e/ou emprego. O objetivo foi verificar se a inserção de rigidez real aumenta a rigidez nominal e, consequentemente, a persistência de choques de política monetária. Os resultados de estimação mostraram que a inserção de rigidez real contribuiu para o aumento da rigidez nominal, em especial quando aquela foi inserida na forma de custos de ajustamento de emprego. Ainda, exercícios de simulação mostraram que quando o modelo contém rigidez real, os choques de oferta de moeda, de demanda de moeda e de tecnologia têm impactos mais persistentes sobre algumas variáveis macroeconômicas. / According to the emphasis by Dib (2003), recently there has been a growing interest in the development of economic models that outline the role of rigidities in nominal price, based on the optimizing behavior of rational agents in a dynamic, stochastic, general-equilibrium (DSGE) environment. Although, there are advantages shown by these models, it was observed that the money supply shocks create only weak persistence of real and nominal variables, which conflicts with the majority of evidences, pointing that the effects of this shocks lasting for many quarters. Therefore, in this present work it was carried out, through Bayesian methods, the estimation of Dib’s (2003) model for the Brazilian economy, which combines the nominal rigidities in the form of costly price adjustment and real rigidities in the form of cost of adjusting capital and/or employment. The objective was to verify if the insertion of the real rigidities increases the nominal rigidities and, consequently, the persistence of monetary policy shocks. The results of this estimation showed that the insertion of real rigidities contributed to the increase of nominal rigidities, especially when the former is inserted in the form of employment adjusting costs. In addition, exercises of simulation demonstrated that when the real rigidities are present in the model, the money supply, the money demands and the technology shocks have impacts more persistent over some macroeconomic variables.