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CKM’s Business Cycle Accounting

CKM’s Business Cycle Accounting. Lawrence J. Christiano Joshua M. Davis. Background. A strategy for identifying promising directions for model development Fit simple RBC model to data Identify ‘wedges’

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CKM’s Business Cycle Accounting

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  1. CKM’s Business Cycle Accounting Lawrence J. Christiano Joshua M. Davis

  2. Background • A strategy for identifying promising directions for model development • Fit simple RBC model to data • Identify ‘wedges’ • Distortions between marginal rates of substitution in preferences and technology necessary to reconcile model and data • Decompose movements in data into components due to various wedges

  3. CKM’s Conclusion • Frictions that Enter Household Intertemporal Margin (i.e. Investment) not Important for Understanding the US Great Depression • Standard models of financial frictions (e.g. Carlstrom-Fuerst and Bernanke-Gertler-Gilchrist) not useful directions for research

  4. CKM Finding Potentially of Major Interest • Early Phases of Great Depression Accompanied By Major Decline in the Stock Market Unusually Massive Decline in Investment • Numerous Students of Great Depression Infer that Financial Market Imperfections Were Important • CKM Finding Purports to Eliminate a Major Hypothesis About Great Depression From Further Consideration

  5. CKM’s Result of Significant Interest • Early phases of Great Depression accompanied by massive decline in investment and the stock market • Numerous students of Great Depression infer that financial market imperfections were important • CKM’s results oppose this conventional wisdom

  6. Our Points: • Small Changes in CKM Analysis Overturn their Conclusion • Fundamental (Fatal?) Identification Problem Complicates the Analysis

  7. Computational Details • CKM Approach: • Estimate Model Based on Linear Approximation of Solution, and Linear Kalman Filter in Estimation • Recover Wedges Using Nonlinear Approximation to Model • Our Approach • Do Nonlinear Approximation In Estimation and Wedge Recovery • Turns Out: Our Strategy and CKM Computational Strategy Yield Similar Results

  8. Results • First, We Reproduce CKM Calculations… • CKM Results Suggest Financial Frictions Not Important for Output, Investment and Employment • Our CKM Simulation Assumptions No Adjustment Costs • Same Finding With Alternative Identification

  9. A Problem with the Preceding Result Based on Adjustment Costs • When We Estimate Adjustment Cost Parameter Maximum Likelihood Does Not Like It (Drives a=0) • But, A Priori Considerations Also Seem to Go Against CF Friction for Great Depression • A Tightening of Financial Frictions Implies, According to CF, that the Price of Capital Should Have Gone Up • But, the Price of Capital Seems to Have Fallen During Great Depression (See Stock Market). • This Motivates Considering an Alternative Form of Financial Friction

  10. When We Estimate Adjustment Costs with BGG Wedge, Parameter, a, Wants to be Very High (a=70). • We Set a Conservatively: • Tobin’s q Elasticity = 1.28 Percent • a=10

  11. Conclusion • Key Conclusion of CKM Analysis: Financial Frictions that Enter Intertemporal Euler Equation Not Important for Understanding Great Depression • Our Finding: Small Changes in CKM Environment Overturn Their Conclusion • We Estimate Degree of Adjustment Costs and Use a More A Priori Plausible Model of Financial Frictions • Estimate That Financial Frictions Account for 30-40% of fall in output • Deeper Identification Problem to Worry About

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