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Abstract:The recent global financial crisis has increased interest in macroeconomic models that incorporate financial linkages. Here, we compare the simulation properties of five mediumsized general equilibrium models used in Eurosystem central banks which incorporate such linkages. The financial frictions typically considered are the financial accelerator mechanism (convex "spread" costs related to firms' leverage ratios) and collateral constraints (based on asset values). The harmonized shocks we consider illustrate the workings and mechanisms underlying the financial-macro linkages embodied in the models. We also look at historical shock decompositions of real GDP growth across the models since 2005 in order to shed light on the common driving factors underlying the recent financial crisis. In these exercises, the models share qualitatively similar and interpretable features. This gives us confidence that we have some broad understanding of the mechanisms involved.In addition, we also survey the current and developing trends in the literature on financial frictions. Non-technical summaryThe global financial crisis has increased the demand for general equilibrium models that can account for the interaction between financial markets, inflation and the real economy. Yet, many existing policy models largely assume frictionless financial markets (with a few notable exceptions, such as Christiano et al., 2003). This reflects, to some degree, academic and empirical controversy as to the importance of financial channels. Some analyzes stress them as a key amplifier and source of business-cycle fluctuations (e.g. Bernanke et al., 1999) whilst others suggest their impact may be confined to periods of deep financial distress (see Meier and Mueller, 2006). Our paper surveys the strength and nature of financial channels and frictions in a number of prominent central bank models of the European System of Central Banks (hereafter, ESCB), when examined over common simulation and historical exercises. The examined models (five in all) represent a useful cross section since three are estimated on the euro area data, one is estimated from Swedish data and one from Polish data -the latter two being interesting as examples of countries outside the single currency.We present harmonized simulation evidence from the models. Such experiments or model comparison exercises are useful for a number of reasons: First, if -for commonly scaled shocks -the models share qualitatively similar and interpretable features, this gives us confidence that we have some broad understanding of the mechanisms involved. Second, model development is a continuous process and so comparisons of model reactions allows us to build up robustness and common knowledge in the development and assessment of those models. The common shocks that we consider are: a standard monetary shock, an equivalent interest rate spread shock, a loan-to-value ratio shock, and a so-called valuation shock.Overall, we find that the models considered share qualitatively similar and in...

Empirical evidence on whether euro area monetary transmission has changed is, at best, mixed. We argue that this inconclusiveness is likely to be due to the fact that existing empirical studies concentrate on the effects of particular developments on specific transmission channels. Such analyses typically require strong assumptions. Moreover, specific changes could have off-setting effects regarding the overall effectiveness of monetary policy. In order to shed light on this issue, we investigate whether there has been a significant change in the overall transmission of monetary policy to inflation and output by estimating a standard VAR for the euro area and by endogenously searching for possible break dates. We find a significant break point around 1996 and some evidence for a second one around 1999. We compare the effects of monetary policy shocks for these episodes and find that the wellknown "stylized facts" of monetary policy transmission remain valid. Therefore, we argue that the general guiding principles of the Eurosystem monetary policy remain adequate. Moreover, it seems that monetary transmission after 1998 is not very different from before 1996, but probably very different compared to the interim period. This implies that existing evidence for the euro area could be biased by this "atypical" interim period 1996-1999. JEL classification: E44, E52, E58, G21

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Abstract:Recent research has shown that optimal monetary policy may display considerable price-level drift. Proponents of price-level targeting have argued that the costs of eliminating the price-level drift may be reduced if the central bank responds flexibly by returning the price level only gradually to the target path (Gaspar et al., 2010). We revisit this argument in two variants of the New Keynesian model. We show that in a two-sector version of the model which allows for changes in relative prices across sectors, the costs of stabilisation under price-level targeting remain much higher than under inflation targeting for all policy-relevant horizons. Our conclusion is that extending the policy horizon is not a panacea to reduce the costs of eliminating pricelevel drift.Keywords: price-level targeting, optimal monetary policy, commitment JEL-Classification: E58, E42, E31 Non technical summaryIn the canonical New Keynesian model, the optimal monetary policy response to shocks implies a stationary price level. This remarkable result has been put forward as an argument in favour of price-level targeting. However, the optimality of a stationary price level is a very special result, and recent research has shown that optimal monetary policy may display price-level drift if the canonical model is only slightly modified.If optimal monetary policy involves a non-stationary price level, reverting the price level to the target path will inevitably stabilise prices too much and, consequently, lead to higher volatility of other variables. Yet, to our knowledge, the potential costs of eliminating price-level drift have not been analysed systematically so far. Instead, proponents of price-level targeting have argued that the costs of eliminating the pricelevel drift may decline if the central bank responds flexibly by returning the price level only gradually to its steady state. In this paper we show one example in which the argument is correct and one example in which it is not.In our first example, a New Keynesian model with price-level drift, we find that (i) bringing back the price level to its target at a very short policy horizon leads to high volatility and welfare costs, (ii) inflation targeting is better than price-level targeting for policy horizons longer than two quarters, but (iii) for a policy horizon of two years or longer the costs of stabilisation under price-level targeting are not notably higher than those under inflation targeting.In our second example, a two-sector extension of the New Keynesian model, we illustrate that the costs of stabilisation under price-level targeting remain high over a policy-relevant horizon. Specifically, we find that (i) targeting the price level or the inflation rate at short policy horizons leads to high volatility in other welfare-relevant variables and thus to high welfare losses, (ii) inflation targeting is better than price-level targeting for policy horizons longer than two quarters, and (iii) in contrast to inflation targeting the costs of stabilisation under price...