Pietro Enrico Ferri, Ph.D and Anna Maria Variato, Ph.D.. Dep. of Economics, University of Bergamo, Italy, Via Dei Caniana 2, Bergamo, 24127, Italy
A macro model with an investment function based upon both real and financial aspects and a labor market ruled by imperfect competition can generate endogenous fluctuations, when one uses values of the parameters derived from econometric studies. In the paper the model is enriched by a monetary policy rule and by several different hypotheses about expectations. Simulations show the persistence of oscillations when agents forecast according to a time series strategy based upon a Markov process and monetary authorities learns about the NAIRU.
The following are the main results of the paper:
1. We have already shown that this type of model can create oscillations in the rate of growth of output and inflation that are persistent for a long period of time (see Fazzari et al, 2005). In this framework, the two main sources of endogeneity in the dynamics are analyzed: i) cash flows and debts are endogenously determined and have a powerful influence on investment, a primary factor in the creation of business cycles; ii) the process of learning induce further dynamics.
2. In the present paper, we show that these results are robust to different specifications of the rule and different expectational hypotheses. Because the model utilizes a rule, our results may shed light on the policy debate centered on that idea (e.g. Woodford, 2003, Clarida et al., 1999,, 1999, and Svensson, 2003). The principle in the "new neo-classical synthesis models" is based on an understanding of the monetary transmission mechanism that relies on price stickiness and substitution effects caused by changes in the real interest rate. The structure of our model is different because policy-induced changes in interest rates can also alter the values of such variables as cash flows and debts. In particular, the manipulation of the coefficient that relates to inflation in the rule can create stability only for a limited "corridor of stability". In contrast, manipulation of the coefficient relating to unemployment seems to be more stabilizing, a rather neglected result by the advocates of a more active policy. In fact, they usually support a stronger reaction to inflation than to unemployment.
3. A strategic element in shaping the dynamics of the system is how expectations are formulated. If one abandons the world of perfect foresight and introduces uncertainty and learning, the possibility of checking the cycle becomes even more difficult. Fluctuations persist despite changes in the parameters of the equations. These results are robust to changes in the specification of the rule and to the information structure of the model.