Noisy News in Business Cycles

Transcription

1 Noisy News in Business Cycles Mario Forni 1 Luca Gambetti 2 Marco Lippi 3 Luca Sala 4 1 Università di Modena e Reggio Emilia and CEPR 2 Universitat Autonoma de Barcelona and Barcelona GSE 3 EIEF and CEPR 4 Università Bocconi, IGIER and Centro Baffi IV conference in memory of Prof. Carlo Giannini Pavia, March 2014

2 The stripped down model: preview We have news and noise

3 The stripped down model: preview We have news and noise News shocks. Fundamental: a t = a t 1 + ε t 1 Agents know ε t Agents decisions depend on ε t.

4 The stripped down model: preview We have news and noise News shocks. Fundamental: a t = a t 1 + ε t 1 Agents know ε t Agents decisions depend on ε t. What if agents (and econometrician) face a signal extraction problem? Signal: s t = ε t + v t

5 The stripped down model: preview We have news and noise News shocks. Fundamental: a t = a t 1 + ε t 1 Agents know ε t Agents decisions depend on ε t. What if agents (and econometrician) face a signal extraction problem? Signal: s t = ε t + v t Consumption: c t = lim j E(a t+j I t )

6 The stripped down model: preview We have news and noise News shocks. Fundamental: a t = a t 1 + ε t 1 Agents know ε t Agents decisions depend on ε t. What if agents (and econometrician) face a signal extraction problem? Signal: s t = ε t + v t Consumption: c t = lim j E(a t+j I t ) What happens if one tries to identify shocks ε t and v t?

7 In this paper Two contributions: New VAR approach: identify economic shocks in a situation where agents can only observe a noisy signal. Investigate the role of noise (v t ) and news (ε t ) as sources of business cycle fluctuations.

8 In this paper Two contributions: New VAR approach: identify economic shocks in a situation where agents can only observe a noisy signal. Investigate the role of noise (v t ) and news (ε t ) as sources of business cycle fluctuations. Main results: 1. Noise (v t ) and news (ε t ) together explain more than half of the fluctuations of GDP, consumption and investment. 2. One third of fluctuations is due to noise (v t ) shocks.

9 Motivation (1/2) Renewed interest in the idea (Pigou, 1927) that news about future changes in fundamentals can generate business cycles through changes in expectations.

10 Motivation (1/2) Renewed interest in the idea (Pigou, 1927) that news about future changes in fundamentals can generate business cycles through changes in expectations. Many papers assume perfect information (Beaudry and Portier, 2006): agents observe ε t (but maybe not the econometrician...).

11 Motivation (1/2) Renewed interest in the idea (Pigou, 1927) that news about future changes in fundamentals can generate business cycles through changes in expectations. Many papers assume perfect information (Beaudry and Portier, 2006): agents observe ε t (but maybe not the econometrician...). Economic fluctuations are generated by expected changes in future economic conditions which always materialize.

12 Motivation (2/2) Few works have relaxed the assumption of perfect observability.

13 Motivation (2/2) Few works have relaxed the assumption of perfect observability. Imperfect information: agents receive imperfect signals about economic fundamentals (among others, Lorenzoni, 2009, Angeletos and La O, 2010, Blanchard, Lorenzoni and L Huillier, 2012, BLLH, Barsky and Sims, BS, 2011).

14 Motivation (2/2) Few works have relaxed the assumption of perfect observability. Imperfect information: agents receive imperfect signals about economic fundamentals (among others, Lorenzoni, 2009, Angeletos and La O, 2010, Blanchard, Lorenzoni and L Huillier, 2012, BLLH, Barsky and Sims, BS, 2011). Business cycles can be driven by expected changes in future economic conditions which do not materialize.

15 Implications (1/3) Imperfect shocks observability very intriguing and realistic idea but...

16 Implications (1/3) Imperfect shocks observability very intriguing and realistic idea but has dramatic implications for empirical analysis based on VAR models. Let s see why.

17 Implications (2/3) In a VAR, the innovation e t is function of present and past Y : e t = Y t proj(y t Y t 1, Y t 2,...)

18 Implications (2/3) In a VAR, the innovation e t is function of present and past Y : e t = Y t proj(y t Y t 1, Y t 2,...) If agents do not observe the shocks, current and past realizations of the data cannot provide enough information to estimate the shocks (non-fundamentalness). (More)

19 Implications (2/3) In a VAR, the innovation e t is function of present and past Y : e t = Y t proj(y t Y t 1, Y t 2,...) If agents do not observe the shocks, current and past realizations of the data cannot provide enough information to estimate the shocks (non-fundamentalness). (More) Structural shocks ε t do not contemporaneously live in the agents innovations: ε t Ke t

20 Implications (2/3) In a VAR, the innovation e t is function of present and past Y : e t = Y t proj(y t Y t 1, Y t 2,...) If agents do not observe the shocks, current and past realizations of the data cannot provide enough information to estimate the shocks (non-fundamentalness). (More) Structural shocks ε t do not contemporaneously live in the agents innovations: ε t Ke t Implication: standard VAR analysis will fail.

21 Implications (3/3) Question: shall we dismiss VAR models under the assumption of imperfect information?

22 Implications (3/3) Question: shall we dismiss VAR models under the assumption of imperfect information? YES: BLLH (2013), BS (2012).

23 Implications (3/3) Question: shall we dismiss VAR models under the assumption of imperfect information? YES: BLLH (2013), BS (2012). Our answer is NO.

24 A simple model (1/3) Fundamental: a t = a t 1 + ε t 1, where ε t is white noise.

25 A simple model (1/3) Fundamental: a t = a t 1 + ε t 1, where ε t is white noise. Agents observe a noisy signal: s t = ε t + v t v t, the noise shock, is a white noise, uncorrelated with ε t.

26 A simple model (1/3) Fundamental: a t = a t 1 + ε t 1, where ε t is white noise. Agents observe a noisy signal: s t = ε t + v t v t, the noise shock, is a white noise, uncorrelated with ε t. Agents information set: I t = span(a t k, s t k, k 0).

27 A simple model (1/3) Fundamental: a t = a t 1 + ε t 1, where ε t is white noise. Agents observe a noisy signal: s t = ε t + v t v t, the noise shock, is a white noise, uncorrelated with ε t. Agents information set: I t = span(a t k, s t k, k 0). Consumption is set on the basis of expected long-run fundamentals c t = lim j E(a t+j I t )

28 A simple model (2/3) Given the process for a t : E(a t+j I t ) = a t + E(ε t I t ) = a t + γs t where E(ε t I t ) = γs t is the projection of ε t on s t (γ = σ 2 ε/σ 2 s).

29 A simple model (2/3) Given the process for a t : E(a t+j I t ) = a t + E(ε t I t ) = a t + γs t where E(ε t I t ) = γs t is the projection of ε t on s t (γ = σ 2 ε/σ 2 s). Consumption: c t = a t + γ(ε t + v t )

30 A simple model (2/3) Given the process for a t : E(a t+j I t ) = a t + E(ε t I t ) = a t + γs t where E(ε t I t ) = γs t is the projection of ε t on s t (γ = σ 2 ε/σ 2 s). Consumption: c t = a t + γ(ε t + v t ) Change in consumption: c t = a t + γ s t = γε t + (1 γ)ε t 1 + γv t γv t 1

31 A simple model (3/3) c t = a t + γ s t = γε t + (1 γ)ε t 1 + γv t γv t 1 Remarks: Noise v t can generate temporary fluctuations in consumption.

32 A simple model (3/3) c t = a t + γ s t = γε t + (1 γ)ε t 1 + γv t γv t 1 Remarks: Noise v t can generate temporary fluctuations in consumption. Business cycles can be driven by expected changes in fundamentals which never materialize.

33 The failure of standard structural VAR methods Interesting econometric implications. Model solution is: ( ) at = s t ( ) ( ) L 0 εt 1 1 v t The polynomial matrix has rank = 1 when L = 0.

34 The failure of standard structural VAR methods Interesting econometric implications. Model solution is: ( ) at = s t ( ) ( ) L 0 εt 1 1 v t The polynomial matrix has rank = 1 when L = 0. the MA is non-invertible

35 The failure of standard structural VAR methods Interesting econometric implications. Model solution is: ( ) at = s t ( ) ( ) L 0 εt 1 1 v t The polynomial matrix has rank = 1 when L = 0. the MA is non-invertible A VAR representation in the structural shocks does not exist

36 What does a VAR do? Rewrite the structural representation: ( ) ( ) ( ) at L 0 εt = 1 1 as the Wold representation (estimated with VAR): ( ) ( ) ( ) at 1 Lσ 2 = ε /σs 2 ut 0 1 where: ( ut s t s t ) = s t ( L σ2 v σ 2 s v t s t ) (εt ) L σ2 ε σs 2, 1 1 v t The innovations (u t s t ) are combinations of present and past values of the structural shocks (recall: ε t Ke t ).

37 The existing solution Estimate directly the model with the Kalman filter as in BLLH or BS.

38 The existing solution Estimate directly the model with the Kalman filter as in BLLH or BS. Problem: tight restrictions.

39 The existing solution Estimate directly the model with the Kalman filter as in BLLH or BS. Problem: tight restrictions. BLLH and BS find opposite results. (BLLH and BS)

40 A solution: intuition The mapping between structural and fundamental shocks:

41 A solution: intuition The mapping between structural and fundamental shocks: ) = v t ( εt L 1 L 1 σ 2 ε σs 2 σ 2 v σs 2 ( ) ut s t

42 A solution: intuition The mapping between structural and fundamental shocks: ) = v t ( εt L 1 L 1 σ 2 ε σs 2 σ 2 v σs 2 ( ) ut s t The structural shocks can be obtained as a combination of future and present values of the fundamental innovations.

43 A solution: intuition The mapping between structural and fundamental shocks: ) = v t ( εt L 1 L 1 σ 2 ε σs 2 σ 2 v σs 2 ( ) ut s t The structural shocks can be obtained as a combination of future and present values of the fundamental innovations. Intuition: at time t + 1 agents look back and understand whether it was noise or news at time t.

44 Econometric model (1/3) General process for a t : where c(0) = 0 (news shock). a t = c(l)ε t,

45 Econometric model (1/3) General process for a t : where c(0) = 0 (news shock). a t = c(l)ε t, The structural non-fundamental representation ( ) ( ) ( ) at c(l) 0 εt =, 1 1 s t v t

46 Econometric model (2/3) The fundamental representation is where ( ) at = s t ( ut s t ) = and the Blaschke factor: ( c(l) b(l) ( b(l) σ2 v σ 2 s b(l) = c(l)σ 2 ε σ 2 s 0 1 ) (ut s t ), ) (εt ) b(l) σ2 ε σs v t n j=1 L r j 1 r j L where r j, j = 1,..., n, are the roots of c(l) which are smaller than one in modulus and r j is the complex conjugate of r j.

47 Econometric model (3/3) Assume that the signal is not observable to the econometrician. There is an observable variable, z t, which reveals the signal: z t = d(l)u t + f(l)s t

48 Econometric model (3/3) Assume that the signal is not observable to the econometrician. There is an observable variable, z t, which reveals the signal: z t = d(l)u t + f(l)s t Therefore, ( ) at z t = ( c(l)σu b(l) d(l)σ u c(l)σ 2 ε σ s f(l)σ s ) (ut ) /σ u s t /σ s

49 Econometric model (3/3) Assume that the signal is not observable to the econometrician. There is an observable variable, z t, which reveals the signal: z t = d(l)u t + f(l)s t Therefore, ( ) at z t = = ( c(l)σu b(l) d(l)σ u ( c(l)σu b(l) d(l)σ u c(l)σ 2 ε σ s ) (ut ) /σ u f(l)σ s s t /σ s ) ( b(l)σv c(l)σ 2 ε σ s f(l)σ s s σ ε σ s b(l)σε σ s σ v σ s ) (εt ) /σ ε v t /σ v

50 Econometric model (3/3) The signal is not observable to the econometrician. There is an observable variable, z t, which reveals the signal: z t = d(l)u t + f(l)s t Therefore, ( ) at z t = = ( c(l)σu b(l) ( c(l)σu b(l) d(l)σ u ) c(l)σ 2 (ut ) ε /σ σ u s f(l)σ s s t /σ s ) c(l)σ 2 ε σ s d(l)σ u f(l)σ s }{{} Step 1 ( b(l)σv s σ ε σ s b(l)σε σ s σ v σ s ) (εt ) /σ ε v t /σ v

51 Econometric model (3/3) The signal is not observable to the econometrician. There is an observable variable, z t, which reveals the signal: z t = d(l)u t + f(l)s t Therefore, ( ) at z t = = ( c(l)σu b(l) ( c(l)σu b(l) d(l)σ u ) c(l)σ 2 (ut ) ε /σ σ u s f(l)σ s s t /σ s ) c(l)σ 2 ε σ s d(l)σ u f(l)σ s }{{} Step 1 ( b(l)σv s b(l)σε σ s σ ε σ v } σ s {{ σ s } Step 2 ) ( ) εt /σ ε v t /σ v

52 Dynamic identification

53 Dynamic identification 1. Estimate an unrestricted VAR for a t and z t and identify with a Cholesky scheme (c(0) = 0).

54 Dynamic identification 1. Estimate an unrestricted VAR for a t and z t and identify with a Cholesky scheme (c(0) = 0). ) ( b(l)σv ( ) at = z t ( c(l)σu b(l) d(l)σ u c(l)σ 2 ε σ s f(l)σ s s σ ε σ s b(l)σε σ s σ v σ s ) (εt ) /σ ε v t /σ v

55 Dynamic identification 1. Estimate an unrestricted VAR for a t and z t and identify with a Cholesky scheme (c(0) = 0). ) ( b(l)σv ( ) at = z t ( c(l)σu b(l) d(l)σ u c(l)σ 2 ε σ s f(l)σ s s σ ε σ s b(l)σε σ s σ v σ s ) (εt ) /σ ε v t /σ v 2. Estimate b(l) by computing the roots of c(l) σ2 ε σ s roots which are smaller than one in modulus. ( ) at = z t ( c(l)σu b(l) d(l)σ u c(l)σ 2 ε σ s f(l)σ s ) ( b(l)σv s σ ε σ s and selecting the b(l)σε σ s σ v σ s ) (εt ) /σ ε v t /σ v

56 Dynamic identification 1. Estimate an unrestricted VAR for a t and z t and identify with a Cholesky scheme (c(0) = 0). ) ( b(l)σv ( ) at = z t ( c(l)σu b(l) d(l)σ u c(l)σ 2 ε σ s f(l)σ s s σ ε σ s b(l)σε σ s σ v σ s ) (εt ) /σ ε v t /σ v 2. Estimate b(l) by computing the roots of c(l) σ2 ε σ s roots which are smaller than one in modulus. ( ) at = z t ( c(l)σu b(l) d(l)σ u c(l)σ 2 ε σ s f(l)σ s ) ( b(l)σv s σ ε σ s and selecting the b(l)σε σ s σ v σ s ) (εt ) /σ ε v t /σ v 3. σ ε σ v = c(1)σ2 ε σ s ( ) at = z t / c(1)σu. σ ε b(1) σ s = sin(arctan( σε σ v )). ) ( b(l)σv ( c(l)σu b(l) d(l)σ u c(l)σ 2 ε σ s f(l)σ s s σ ε σ s σ v σ s = cos(arctan( σε σ v )). b(l)σε σ s σ v σ s ) (εt ) /σ ε v t /σ v

57 Empirical specification VAR model for:

58 Empirical specification VAR model for: a t : log of US per-capita potential GDP from the CBO.

59 Empirical specification VAR model for: a t : log of US per-capita potential GDP from the CBO. z t, the variable that reveals the signal s t : expected business conditions within the next 12 months (Michigan Consumer Survey).

60 Empirical specification VAR model for: a t : log of US per-capita potential GDP from the CBO. z t, the variable that reveals the signal s t : expected business conditions within the next 12 months (Michigan Consumer Survey). Add log real per-capita GDP, consumption, and investment. (Multivariate model)

61 IRF: news (real) ε t - noise v t (1/2)

62 IRF: news (real) ε t - noise v t (2/2)

63 Variance decomposition Variable Horizon Impact 1-Year 2-Years 4-Years 10-Years News (Real) ε t Potential Sentiment GDP CONS INV Noise v t Potential Sentiment GDP CONS INV News (Real) + Noise Potential Sentiment GDP CONS INV Learning u t Potential Sentiment GDP CONS INV Signal s t Potential Sentiment GDP CONS INV

64 Historical decomposition of GDP Top: GDP y-to-y growth rate (solid); noise (dashed) Bottom: Business cycle GDP y-to-y growth rate (solid); noise (dashed)

65 A companion paper: Noise Bubbles Price equation: p t = k 1 ρ + 1 ρ ρ j=1 ρj E t d t+j dt: (log) dividends. pt: (log) prices. Dividends process: d t = d t 1 + a t 1 at: real (news) shock. Signal: s t = a t + e t et: noise shock. Price equation solution: p t = ( Price growth solution: p t = σ2 a σs 2 k 1 ρ + d t + E t a t a t + σ2 e σ 2 a ) a t 1 + σ2 a σ (e s 2 t e t 1 )

66 Impulse response functions

67 Historical decomposition of S&P500 Dashed: S&P500 - Solid: noise comp. - Dotted: S&P500-noise

68 Conclusions 1. Expectations of future changes in economic fundamentals, which in part do not eventually materialize should be considered a major source of business cycle fluctuations.

69 Conclusions 1. Expectations of future changes in economic fundamentals, which in part do not eventually materialize should be considered a major source of business cycle fluctuations. 2. VAR can be successfully employed under the assumption of imperfect information.

70 Conclusions 1. Expectations of future changes in economic fundamentals, which in part do not eventually materialize should be considered a major source of business cycle fluctuations. 2. VAR can be successfully employed under the assumption of imperfect information. 3. Quite general identification procedure. Requirement: a variable clean of noise.

71 Conclusions 1. Expectations of future changes in economic fundamentals, which in part do not eventually materialize should be considered a major source of business cycle fluctuations. 2. VAR can be successfully employed under the assumption of imperfect information. 3. Quite general identification procedure. Requirement: a variable clean of noise. 4. Companion paper on stock prices. We show noise can generate stock prices fluctuations independent on economic fundamentals.

72 Additional slides (1)

73 Fundamentalness (1/2) a) Econometrician and agents have the same information but they cannot uncover shocks (as in this paper). (Back)

74 Fundamentalness (2/2) b) Econometrician has less info than agents: more info might help.

75 Fundamentalness (2/2) b) Econometrician has less info than agents: more info might help. Forni, Gambetti, Sala (2013): Lucas tree model. TFP: a t = a t 1 + ε t 2 + η t, Agents maximize E t t=0 βt c t, observe ε t and η t at time t.

76 Fundamentalness (2/2) b) Econometrician has less info than agents: more info might help. Forni, Gambetti, Sala (2013): Lucas tree model. TFP: a t = a t 1 + ε t 2 + η t, Agents maximize E t t=0 βt c t, observe ε t and η t at time t. The equilibrium value for asset prices is: p t = β j E ta t+j j=1

77 Fundamentalness (2/2) b) Econometrician has less info than agents: more info might help. Forni, Gambetti, Sala (2013): Lucas tree model. TFP: a t = a t 1 + ε t 2 + η t, Agents maximize E t t=0 βt c t, observe ε t and η t at time t. The equilibrium value for asset prices is: p t = β j E ta t+j j=1 The structural MA: ( ) ( at L 2 = β p 2 t + βl 1 β 1 β 1 β ) (εt ) η t det(.) = 0 for L = 1 and L = β. As β < 1, the shocks η t and ε t are non-fundamental for the variables p t and a t. The econometrician observing productivity and stock prices cannot recover ε t by estimating a VAR on a t and p t. (Back)

78 Blanchard, Lorenzoni and L Huillier Fundamental driven by 2 components, transitory and temporary: a t = x t + z t x t = ρ x t 1 + ε t z t = ρz t 1 + η t s t = x t + v t The structural non-fundamental representation: ( ) ( ) at (1 ρl) 1 0 (1 L)(1 ρl) = 1 ε t v s t t η t 2 variables, 3 shocks: no way to recover 3 shocks with 2 variables! (Back)

79 Barsky and Sims Fundamental driven by 2 components: a t = a t 1 + g t 1 + ε a,t g t = (1 ρ)g + ρg t 1 + ε ga,t s t = g t + ε s,t Again, 2 variables (a t and s t ), 3 shocks: no way to recover 3 shocks with 2 variables! (Back)

80 Multivariate specification a t = c(l)ε t + g(l)e t, The innovation representations is a c(l)σ u c(l)σ 2 ε t z t b(l) σ s g(l) = d(l)σ u f(l)σ s p(l) u t/σ u s t /σ s w t q(l) h(l) m(l) e t where g(0) = p(0) = 0 and c(0) = 0. From fundamental to structural (non-fundamental) shocks: u t /σ u s t /σ s = e t b(l)σε σ s 0 ε t /σ ε σ v σ s 0 v t /σ v 0 0 I e t b(l)σ v s σ ε σ s (Back)

81 Testing for fundamentalness A VAR is fundamental if the shocks are orthogonal to past information (econometrician fundamentalness)

82 Testing for fundamentalness A VAR is fundamental if the shocks are orthogonal to past information (econometrician fundamentalness) VAR for 5 variables above is fundamental.

83 Testing for fundamentalness A VAR is fundamental if the shocks are orthogonal to past information (econometrician fundamentalness) VAR for 5 variables above is fundamental. Signal (s t ) and learning (u t ) shocks are orthogonal to past information (summarized in PC)

84 On impact, Identification 1: a t z t = w t k c(0) 0 0 X X 0 ε t/σ ε v t /σ v X X X e t Identification 2: w t a t = X 0 0 X k c(0) 0 e t ε t /σ ε z t X X X v t /σ v (Back)

85 IRF: learning u t - signal s t (1/2)

86 IRF: learning u t - signal s t (2/2)

87 IRF: z t ordered last

88 IRF: z t ordered last

89 IRF: 3 leading variables

90 Historical decomposition of GDP (with S&P500)

91 Historical decomposition of GDP (with leading indicator)