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Optimizing the currency area
, 2010
"... 15 This paper addresses two challenges that the European Central Bank (ECB) faces and makes concrete suggestions for ways to resolve them. 1 The first challenge concerns financial stability, which historically was the initial motivation for setting up central banks. My first suggestion is to refocus ..."
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15 This paper addresses two challenges that the European Central Bank (ECB) faces and makes concrete suggestions for ways to resolve them. 1 The first challenge concerns financial stability, which historically was the initial motivation for setting up central banks. My first suggestion is to refocus the rationale for the ECB’s monetary pillar toward financial stability. This would provide clear guidance for designing the appropriate monetary aggregates as inputs for monetary policy decisions. The second challenge concerns the large and persistent dispersion in price stability across the member states of the euro area. For many years, inflation has been significantly higher in some states than in others. Imbalances have been building and are likely to lead to difficult adjustments in the future. My second suggestion is to actively use a regionally differentiated “haircut policy” and “national macroprudential regulation ” as monetary policy tools. For example, mortgagebacked securities that are based on mortgages granted in a euro member with high inflation should be subject to higher haircuts. This recommendation is a sharp departure from the ECB’s current policy, which sets haircuts more from a risk management point of view that attempts to minimize default risk. The beauty of a regionally differentiated approach is that, while the ECB can set only one shortterm interest rate, it can set regionally specific haircuts, which should translate into differentiated longterm rates for risky loans.
2014), “RegimeSwitching Perturbation for NonLinear Equilibrium Models,” working paper
"... Salient macroeconomic problems often lead to highly nonlinear models – for instance models incorporating endogenous crises or the zerolowerbound on interest. Accurately capturing nonlinearity in equilibria often makes estimation infeasible. Local solution methods are limited since they struggle ..."
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Salient macroeconomic problems often lead to highly nonlinear models – for instance models incorporating endogenous crises or the zerolowerbound on interest. Accurately capturing nonlinearity in equilibria often makes estimation infeasible. Local solution methods are limited since they struggle to capture nonlinearities, and the curse of dimensionality plagues global methods. This paper introduces a local approach to solving highly nonlinear models, generalizing perturbation to handle the class of piecewise smooth rational expectations models. First, I formalize the notion of an endogenous regime by introducing a regimeswitching equilibrium (RSE) concept. This framework uses nonlinear model features to explain macroeconomic regime changes, and makes the distribution of the regime an equilibrium object instead of imposing an external regimeswitching structure. Then, I demonstrate how to apply perturbation within a slackened model and approximate the policy functions associated with a given belief about the regime. Finally, I solve for the equilibrium regime distribution using backwards induction. This approach (1) accounts for expectational effects due to the probability of regime change; (2) provides a framework for modeling regimeswitching from first principles; and (3) connects macroeconomic theory to reducedform regimeswitching econometric models.