Macroeconomic Models for Monetary Policy: A Critical Review from a Finance Perspective

Abstract

We provide a critical review of macroeconomic models used for monetary policy at central banks from a finance perspective. We review the history of monetary policy modeling, survey the core monetary models used by major central banks, and construct an illustrative model for those readers who are unfamiliar with the literature. Within this framework, we highlight several important limitations of current models and methods, including the fact that local-linearization approximations omit important nonlinear dynamics, yielding biased impulse-response analysis and parameter estimates. We also propose new features for the next generation of macrofinancial policy models, including a substantial role for the financial sector, the government balance sheet, and unconventional monetary policies; heterogeneity, reallocation, and redistribution effects;the macroeconomic impact of large nonlinear risk premium dynamics; time-varying uncertainty; financial sector and systemic risks; imperfect product market and markups; and further advances in solution, estimation, and evaluation methods for dynamic quantitative structural models.

Macro-Finance Models with Nonlinear Dynamics

“…The primary goal of this article is to provide motivation, insight, and guidance for the next generation of young scholars, especially those at the intersection of macroeconomics and financial economics. This article complements the work of Dou et al (2020), which focuses on macroeconomic models used for monetary policy from a finance perspective.…”

“…They provide compelling evidence that CIP deviation spikes at the quarter end when banks need to report their leverage to regulatory authorities. Dou, Kogan & Wu (2021) rely on the well-documented fact that fund managers care about fund size, which in turn is driven by fund returns and fund flows. They provide a rich set of evidence showing that active equity funds hedge against fund flow fluctuations by tilting their portfolios toward stocks with low-flow betas.…”

Navigating Uncharted Waters: The Transformation of the Bank of Korea’s Monetary Policy in Response to Global Economic Uncertainty

“…The effectiveness of interest rate policies in managing these shocks varies. Under a rigid framework, as suggested by Dou et al [34], Agoba et al [35], and Dokas et al [36], central banks may struggle to adjust rates sufficiently to counteract inflation without stifling growth. Conversely, a more flexible policy regime, as studied by Boucekkine et al [37] and Nyati et al [38], allows for more dynamic adjustments, catering to both immediate economic needs and long-term stability goals.…”

Essays on Bounded Rationality in Financial Macroeconomics

“…The outbreak of the Global Financial Crisis (GFC) and the lengthy, deep and global REAL economic downturn that followed, have confounded macroeconomics and undoubtedly embedded the relevance of financial sector conditions for the macroeconomy. For instance, Dou et al (2020) highlight how the GFC and the Great Recession that followed revealed serious gaps in commonly used approaches to define, measure, and manage financial sector activities that pose risks to the macroeconomy as a whole (see also Brunnermeier and Sannikov, 2014). Similarly, Ingrao and Sardoni (2019) look at how the treatment of banks and finance from the macroeconomic perspective evolved during the 20th century to the present, and show how the urge generated by the GFC favoured the flourishing of many works concerned with the macroeconomic interactions between the financial and real sectors of the economy, to the extent that it is hard to find mainstream macroeconomic models that do not incorporate, in one way or another, some form of financial intermediation (see also Gorton and Winton, 2017).…”