The business cycle and monetary policy: what changed after the GFC?

Abstract

To examine changes in the nature of the business cycle and its interaction with monetary policy we estimate a small open economy New Keynesian model using two time periods, one prior to the Global Financial Crisis (GFC) of 2007–2009 and one post the financial crisis. The model has the standard features of sticky prices and monopolistic competition. To fit the data the model also allows for households with a degree of habit persistence and a proportion of firms whose pricing decisions are simply to index to past inflation. Our results indicate the main difference pre- and post-GFC is that the economy has become less interest rate sensitive. Therefore, to stabilize the output and inflation, monetary policy actions need to be stronger than they were prior to the GFC. Moreover, the reduction in neutral interest rates post-GFC has resulted in additional transitional dynamics that have lowered inflation and output.

KEYWORDS:

• Business cycles
• monetary policy
• neutral interest rates
• New Zealand
• Global Financial Crisis

JEL Classifications:

• E32
• E52

Acknowledgement

We are grateful to an anonymous NZEP referee for valuable comments on an earlier version.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Correction Statement

This article has been republished with minor changes. These changes do not impact the academic content of the article.

Notes

1 Persistence characteristics have not, however, been significantly different. So, as reflected in the modelling and results below, an AR(1) model can parsimoniously capture fluctuations in the dynamics of the output gap, inflation, interest rate and exchange rate variables we are interested in.

2 Consistent with stylised business cycle facts-based and macro model-based approaches to business cycle work, the (deviations from trend/gaps-based) cycles investigated in this paper are growth cycles rather than classical business cycles. For measures of New Zealand’s classical business cycle recessions and recoveries, see Hall and McDermott (2016).

3 The model used here has a number of features similar to those formulated in Kirker (2008). Two particular differences are that Kirker includes foreign output in the IS equation and allows parameters to vary across time. Another important difference is that we use two different samples to examine changes in the dynamics of the economy following the GFC. The underlying trends of the model such as those for neutral interest rates and potential output have changed too rapidly for the time varying parameter approach to be reliable.

4 Lubik and Schorfheide (2007, p. 1071) refer to Gali and Monacelli (2005) for details on the derivation of reduced form equations.

5 See Kim, Buckle, and Hall (1994) and Hall, Thomson, and McKelvie (2017) for evidence of contemporaneously asynchronous behaviour of government expenditure and the countercyclical behaviour of net exports.

6 We use the Dynare package to estimate our model, Adjemian et al. (2018).

7 The details of the MH MCMCM algorithm can be found in DeJong and Dave (2007), Canova (2007), and Gelman, Carlin, Stern, and Rubin (2004).

8 Leading examples are Smets and Wouter (2003), Del Negro and Schorfheide (2004), and Del Negro, Schorfheide, Smets, and Wouter (2007).

9 No correction for GST was made to the series even though the Reserve Bank will look through such one-off price changes. However, the high degree of interest rate smoothing makes this less important as a GST change does not result in persistent changes to inflation.

10 Organization for Economic Co-operation and Development, Real Effective Exchange Rates Based on Manufacturing Consumer Price Index for New Zealand [CCRETT01NZQ661N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CCRETT01NZQ661N, November 12, 2019.

11 A parameter is consider statistically significant if its probability interval excludes zero.

12 Using an ‘expanding’ window approach, Culling et al. (2019) only show the response of inflation and output to a monetary policy shock evolving from 2007 onwards. They do not formally test for any structural breaks after the GFC.

13 The choice of the persistence parameter is arbitrary, but it does not affect the qualitative nature of the results.