Estimation and Simulation of Macroeconomic Models with Transitions to a Zero Interest Rate and Low Inflation Equilibrium

• Applicant: Professor Dr. Maik Wolters
• Subject Area: Economic Policy, Applied Economics ; Statistics and Econometrics
• Term: since 2022
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 508470100

The main objective of this project is the estimation of non-linear macroeconomic models suited for analyzing periods of persistently low interest rates and low inflation. The models will be estimated for the euro area, the US and Japan using a particle filter for the first time. On this basis, we will study policy options, especially for bringing inflation back to target and exiting the zero lower bound (ZLB) on nominal interest rates. Over the last years, many central banks have lowered their policy rates to the ZLB. According to the Fed’s and the ECB’s recently concluded strategy reviews, liquidity traps are one of the major monetary policy challenges. ZLB periods have turned out to be highly persistent, but most macroeconomic models do not reflect this development. In these models the ZLB constrains monetary policy only temporarily, because it is assumed that inflation expectations remain anchored at steady state, even if adverse shocks persistently disturb the economy. Macroeconomic models that allow for a de-anchoring of inflation expectations, so that low inflation and interest rate periods can persist, might be more suitable to study recent developments of inflation and interest rates. In this project, we estimate and analyze such models. These models transition between a target equilibrium with inflation fluctuating around target and the policy rate being mostly positive, and a below target equilibrium with inflation fluctuating below target and the ZLB being mostly binding. Inflation expectations and a decrease of the natural interest rate play a crucial role for a transition. The model framework is sufficiently flexible to account for situations in which an equilibrium transition is interrupted or reversed by an increase in inflation, as recently observed in the US and the euro area. Existing empirical studies on equilibrium transitions focus either on the US or Japan. They use models that are linearly estimated. Equilibrium transitions are accounted for only after the estimation. Instead, we estimate non-linear models allowing for transitions during the estimation period. This approach is highly computationally intensive, as it requires the usage of a particle filter. Another innovation is the estimation and analyzis of a model for the euro area. Previous studies suggest that the US is still close to the target equilibrium and Japan is best characterized by a below target equilibrium. The euro area might be possibly in between, so that this is the most interesting case as policy implications for such a situation have not been studied yet. We will conduct a number of policy experiments to analyze possibilities to initiate transitioning back to the target equilibrium. Unlike previous studies that consider only one cause, we empirically decompose different causes of a liquidity trap, including a decrease in the natural interest rate and non-fundamental expectation shocks, to derive more reliable policy implications.

• DFG Programme: Research Grants