CKMs Business Cycle Accounting

Lawrence J. ChristianoJoshua M. Davis

BackgroundA strategy for identifying promising directions for model development

Fit simple RBC model to data

Identify wedgesDistortions 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

CKMs 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

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

CKMs Result of Significant InterestEarly 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

CKMs results oppose this conventional wisdom

Our Points:

Small Changes in CKM Analysis Overturn their Conclusion

Fundamental (Fatal?) Identification Problem Complicates the Analysis

Computational DetailsCKM 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

ResultsFirst, 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

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

When We Estimate Adjustment Costs with BGG Wedge, Parameter, a, Wants to be Very High (a=70).

We Set a Conservatively:

Tobins q Elasticity = 1.28 Percent

a=10

ConclusionKey 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 FrictionsEstimate That Financial Frictions Account for 30-40% of fall in outputDeeper Identification Problem to Worry About

Go over this stuff quickly. There will be lots of elaboration later.No need to dwell on this stuffDo point out that the fall in dow is roughly same percent as fall in investmentThe fall in investment is really out of this world, and unlike what we see in other business cycles.Simple, sweetNo need to make a huge big deal about the government stuffHere you could say that the background models have sticky prices and sticky wages, so that a shock in one place will travel to all the other placesI thought it best to focus on tobins q elasticity, rather than the bloodless parameter, aHere, you should point out that the fact that the DOW and Investment fall by about the same percent is consistent with a Tobins q elasticity in a neighborhood of 1This is similar to the problem I discussed in class. Its a little deeper, though. The choice of w does not influence the equilibrium. Its not just that it has no effect on the second moment properties of s(t).Transitional slideIts always important to go over the conclusion slowly, because this will bring things together for people