Gali

Monetary Policy and Bubbles
in a New Keynesian Model

with Overlapping Generations
Jordi Gal
CREI, UPF and Barcelona GSE
August 2016
Jordi Gal (CREI, UPF and Barcelona GSE)
August 2016
1 / 22
Motivation
Asset price bubbles: present in the policy debate...
- key source of macro instability
- monetary policy as cause and cure
...but absent in modern monetary models
- no room for bubbles in the New Keynesian model
- no discussion of possible role of monetary policy
Present paper: modication of the NK model to allow for bubbles
Key ingredients:
(i) nitely-lived consumers (Blanchard (1984), Yaari (1965))
(ii) stochastic retirement (Gertler (1996))
August 2016
2 / 22
Related Literature
Real models of rational bubbles: Tirole (1985),..., Martn-Ventura (2012)
Monetary models with bubbles: Samuelson (1958),..., Asriyan et al.
(2016)
) exible prices
New Keynesian models with overlapping-generations la Blanchard-Yaari:
Piergallini (2018), Nistic (2012), Del Negro et al. (2015)
) no discussion of bubbles
Monetary policy, sticky prices and bubbles:
- Bernanke and Gertler (1999,2001): ad-hoc bubble specication
- Gal (2014). Main dierences here:
- variable employment and output
- many-period, stochastic lifetimes (Blanchard-Yaari)
- nests standard NK model as a limiting case
August 2016
3 / 22
A New Keynesian Model with Overlapping Generations

Survival probability:
Size of cohort born in period s:
(1
) t
Total population size: 1

Two types of individuals:
- "Active": manages own rm, works for others.
- "Retired": consume nancial wealth
Probability of remaining active:
Labor force (and measure of rms):
1
1
2 (0, 1]
August 2016
4 / 22
Consumers
Consumers problem:
max E0
( )t log Ct js
t =0
Z
1
Pt
Pt (i )Ct js (i )di + Et ft,t +1 Zt +1 js g = At js + Wt Nt js

At js = Zt js /
Optimality conditions:
Ct j s ( i ) =
Pt ( i )
Pt
t,t +1 =
Ct j s
Ct + 1 j s
lim T Et t,t +T At +T js
T !
Ct j s
=0
August 2016
5 / 22
Firms (I)
Technology
Yt (i ) = t Nt (i )
where
1+g
Calvo price setting: a fraction of rms keeps prices unchanged

Law of motion for the price level
pt = pt
+ (1
)pt
Optimal price setting

pt = + ( 1
( )k Et fpt +k + wt +k g
k =0
where wt
log(Wt /t ) and
1
1 +r .
Assumption: < 1.
August 2016
6 / 22
Firms (II)
Implied ination equation
t = Et f t +1 g + (wt
where
w)
(1 )(1 )
.
Remark: in the standard NK model, =

(i.e. r = (1 + )(1 + g )
1 ' + g ).
August 2016
7 / 22
Asset Markets (I)

Nominally riskless bond
1
= Et
1 + it
t,t +1
Pt
Pt + 1
Valuation of individual stocks

QtF (i ) =
()k Et ft,t +k Dt +k (i )g
k =0
where Dt (i )
Yt ( i )
P t (i )
Pt
Wt
Aggregate stock market

Z
QtF
QtF (i )di
()k Et ft,t +k Dt +k g
k =0
August 2016
8 / 22
Asset Markets (II)

Bubbly asset
with QtB (j )
QtB (j ) = Et ft,t +1 QtB+1 (j )g

0 for all t. Recursively:
QtB (j ) = Et ft,t +T QtB+T (j )g
for T = 1, 2, 3, ...
Remark: in the standard NK model
0 = lim Et ft,t +T At +T g
T !
implying QtB (j ) = 0.
n
o
lim Et t,t +T QtB+T (j ) = QtB (j )
T !
August 2016
9 / 22
Asset Markets (III)

Aggregate bubble:
QtB = Ut + QtBjt
where QtBjt k
Q B (j )dj
j 2Bt k t
Equilibrium condition:
QtB = Et ft,t +1 QtB+1 jt g

Financial wealth "at birth":
At jt = QtFjt + Ut /(1
Remark: in the absence of bubble creation

QtB = Et ft,t +1 QtB+1 g
At jt = QtFjt
since Ut = 0 and QtB+1 jt = QtB for all t

August 2016
10 / 22
Labor Markets and Monetary Policy

Wage equation:
Wt =
R
where Wt
Wt /t and Nt
Natural level of output
Nt
Nt (i )di.
Ytn = t M
t Y
New Keynesian Phillips curve

t = Et f t +1 g + b
yt
where , and ybt
Monetary Policy
where bit
it
B
log 11+
+ r , qt
log(Yt /Ytn ).
B
bit = t + q
q bt
Q tB
t Y
August 2016
11 / 22
Market Clearing
Goods market
Yt ( i ) = ( 1
s=
Ct j s ( i )
for all i 2 [0, ], implying

t
Yt = ( 1
Labor market
Nt =
where Yt
Yt
/t
Asset markets
s=
Z
0
s=
Ct j s = Ct
Nt (i )di = pt Yt ' Yt
(1
At js = QtF + QtB
August 2016
12 / 22
Balanced Growth Paths

Consumption function (age j, normalized by productivity)
(i) active individuals:
Cj = (1
) Aaj +
WN
(ii) retired individuals
Cj = (1
) Arj
Aggregate consumption function
C = (1
= (1
using QF = D /(1
) QF + QB +
) QB +
) and Y = W N + D .
WN
August 2016
13 / 22

Bubbleless BGP (QB = 0)
or, equivalently,
r = (1 + )(1 + g )
Remark #1 : = 1 ) r = (1 + )(1 + g )
1>g
Remark #2 : < , r < g
August 2016
14 / 22

Recall:
or, letting qtB
Q tB
t Y
QtB = Et ft,t +1 QtB+1 jt g

Ut
t Y
and ut
qtB
= Et ft,t +1 qtB+1 jt g
= Et ft,t +1 (qtB+1
ut +1 )g
Bubbly BGP with no bubble creation (QB > 0, ut = 0 all t):

= 1
or, equivalently,
r =g
Implied bubble size:
qB =
(1
( )
)(1 )
qB
Monetary
Policy and Bubbles
Remark: necessary and su cient
condition
for existence: <August
2016
15 / 22

Bubbly BGP with bubble creation (QB > 0, ut = u > 0 all t):
qB =
(1
u=
( )
)(1 )
1
qB
where
> 1 , r < g
, r > (1 + )(1 + g ) 1
Remark #1 : necessary and su cient condition for existence: <

<
Remark #2 : continuum of bubbly BGPs fq B , u g indexed by

r 2 ((1 + )(1 + g ) 1, g )
Remark #3 : q B increasing in r , with limr !g q B = q B
August 2016
16 / 22
Figure 1. Balanced Growth Paths
r
+g
-1
Bubbly without creation

Bubbly with creation
Bubbleless
Figure 2. Balanced Growth Paths: Bubble Size
Bubbly without creation

Bubbly with creation
Bubbleless
Some Numbers
Life expectancy (at 20): (80
20)
Average retirement age: (63

(conditional on survival)
20)
4 = 240 quarters ) = 0.9958
4 = 172 quarters ) = 0.9983
Condition for existence of bubbles: > 0.9983

Average real interest rate (1960-2015): r = 1.4%
Average growth rate (1960-2015): g = 1.6%
4 = 0.35%
4 = 0.4%
Consumersdiscount factor on future income: ' 0.995 < 1
August 2016
17 / 22
Equilibrium Dynamics (I)

Aggregate consumption function:
where
b
xt
b
ct = ( 1
()k Et fybt +k g
k =0
= Et fb
xt +1 g + ybt
)(q
btB + b
xt )
()k Et fbit +k
1 k =0
b
( it
1
t +k +1 g
Et f t +1 g)
) solution to the forward guidance puzzle? (Del Negro et al. (2016))

Aggregate bubble dynamics:
q
btB = Et fq
btB+1 g q B (bit Et f t +1 g)
) role of monetary policy (Gal (2014)):
Et fb
qtB+1 g =
q
btB +
qB b
( it
Et f t +1 g)
August 2016
18 / 22
Equilibrium Dynamics (II)

New Keynesian Phillips curve
t = Et f t +1 g + b
yt
Monetary Policy
Goods market clearing
B
bit = t + q
q bt
b
ct = ybt
August 2016
19 / 22
Equilibrium Fluctuations: The Bubbleless Case

Equilibrium dynamics
ybt = Et fybt +1 g
t =
(bit
Et f t +1 g)
Et f t +1 g + b
yt
bit = t
Local uniqueness
> max 1,
<
1 +
) "reinforced Taylor principle"
Forward guidance puzzle remains
August 2016
20 / 22
Figure 3a
Monetary Policy and Equilibrium Uniqueness
around the Bubbleless BGP
Figure 3b
Bubbly Equilibrium Fluctuations

Equilibrium dynamics
ybt =
Et fybt +1 g + b
qtB
Et f t +1 g)
t = Et f t +1 g + b
yt
q
btB = Et fq
btB+1 g
where
b
(it
(1 )(1 )
,
q B (bit
B
bit = t + q
q bt
1+
Et f t +1 g)
(1 )( 1 )
1
, qB =
( )
(1 )(1 )
Particular case #1 (no bubble creation): = = 1 ; q B = q B

Particular case #2 (about bubbleless BGP): = =
Intermediate cases: 2 1,
; qB = 0
, q B 2 0, q B
August 2016
21 / 22
Figure 4
Monetary Policy and Equilibrium Uniqueness:
The Case of No Bubble Creation (r=g=0.004)
Figure 6a
around a Bubbly BGP with Bubble Creation (r=0.003935 )
Figure 6b
around a Bubbly BGP with Bubble Creation (r=0.003931 )
Figure 5
Figure 8
Macro Volatility and Leaning against the Bubble Policies
(type II bubbles, r=0.39% )
Main Messages and Next Steps

Reminder of the possibility of bubbly equilibria once we depart from the
innite-lived representative consumer framework
- more likely in an environment of low natural interest rates
Perils of using interest rate policy to tame asset price bubbles
- indeterminacy more likely
- risk of larger uctuations
Caveats
- rational bubbles
- no role for credit supply factors
Next steps:
- Welfare and role of monetary policy
- Global equilibrium dynamics (nonlinearities, switching equilibria)
August 2016
22 / 22

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Monetary Policy and Bubbles

in a New Keynesian Model

Jordi Gal (CREI, UPF and Barcelona GSE)

Monetary Policy and Bubbles

Jordi Gal (CREI, UPF and Barcelona GSE)

Monetary Policy and Bubbles

Monetary Policy and Bubbles

A New Keynesian Model with Overlapping Generations

Total population size: 1

Jordi Gal (CREI, UPF and Barcelona GSE)

Monetary Policy and Bubbles

Pt (i )Ct js (i )di + Et ft,t +1 Zt +1 js g = At js + Wt Nt js

Monetary Policy and Bubbles

Calvo price setting: a fraction of rms keeps prices unchanged

Optimal price setting

Jordi Gal (CREI, UPF and Barcelona GSE)

Monetary Policy and Bubbles

Remark: in the standard NK model, =

Jordi Gal (CREI, UPF and Barcelona GSE)

Monetary Policy and Bubbles

Asset Markets (I)

Valuation of individual stocks

Aggregate stock market

Monetary Policy and Bubbles

Asset Markets (II)

QtB (j ) = Et ft,t +1 QtB+1 (j )g

Jordi Gal (CREI, UPF and Barcelona GSE)

Monetary Policy and Bubbles

Asset Markets (III)

QtB = Et ft,t +1 QtB+1 jt g

Remark: in the absence of bubble creation

since Ut = 0 and QtB+1 jt = QtB for all t

Monetary Policy and Bubbles

Labor Markets and Monetary Policy

New Keynesian Phillips curve

Jordi Gal (CREI, UPF and Barcelona GSE)

Monetary Policy and Bubbles

for all i 2 [0, ], implying

Monetary Policy and Bubbles

Balanced Growth Paths

(ii) retired individuals

Aggregate consumption function

Jordi Gal (CREI, UPF and Barcelona GSE)

Monetary Policy and Bubbles

Balanced Growth Paths

Remark #2 : < , r < g

Jordi Gal (CREI, UPF and Barcelona GSE)

Monetary Policy and Bubbles

Balanced Growth Paths

QtB = Et ft,t +1 QtB+1 jt g

Bubbly BGP with no bubble creation (QB > 0, ut = 0 all t):

Jordi Gal (CREI, UPF and Barcelona GSE)

Balanced Growth Paths

Remark #1 : necessary and su cient condition for existence: <

Remark #2 : continuum of bubbly BGPs fq B , u g indexed by

Jordi Gal (CREI, UPF and Barcelona GSE)

Monetary Policy and Bubbles

Figure 1. Balanced Growth Paths

Bubbly without creation

Figure 2. Balanced Growth Paths: Bubble Size

Bubbly without creation

Average retirement age: (63

4 = 240 quarters ) = 0.9958

4 = 172 quarters ) = 0.9983