Summary:
The major purpose of monetary policy is to stabilize the fluctuations in economic variables and smooth the development of the macro-economy. Obviously, different exogenous shocks yield significant heterogeneous effects on the transmission mechanism and monetary policy choices. Hence, identifying the sources and characteristics of the crucial driving forces of economic dynamics is the prime task of the monetary authority. In the literature on real business cycles, including research on monetary policy in the New Keynesian framework, neutral technology shocks are treated as the main driving forces of economic variations. However, empirical evidence from structural vector auto-regressions shows that economic fluctuations probably result from other exogenous shocks, such as investment-specific, labor supply, real interest rate, consumption, and housing demand shocks. The role of investment-specific shocks on the real business cycle is gradually attracting research interest. Several studies show that investment-specific shocks explain only about 30% of the volatility in aggregate output since World War Two. Yet some investigations of investment-specific shocks on economic cycles in China find that these shocks account for 90%, 62%, and 66% fluctuations of GDP, investment, and capital accumulation, respectively. Inspired by these findings, we first construct a two-sector DSGE economy featuring durable and non-durable goods. The non-durable goods can only be used for consumption, whereas the durable goods can be used either for consumption by entering the household utility function, or as investment and capital goods entering firm production in both sectors. Based on the DSGE model mentioned above, we analyze the implications of investment-specific shocks for optimal monetary policy design and the welfare consequences of alternative monetary policy rules. Our findings are as follows. First, the optimal monetary policy is unable to stabilize price inflation and output simultaneously. It is optimal to increase the variation in the price of durables relative to non-durable goods, which in turn reduces the impact of investment-specific shocks on the real marginal cost and the incentive for firms in non-durable sectors to adjust prices, thus improving social welfare. Meanwhile, the rise in fluctuation of the relative price of durables amplifies the variation in output in non-durable and durable sectors, household consumption, and aggregate investment. Second, we compare the welfare results of three different monetary policy targeting regimes, targeting non-durable PPI inflation, weighted average PPI inflation, and CPI inflation. Under all exogenous shocks, targeting non-durable PPI inflation is always able to increase social welfare, targeting weighted average PPI inflation has the worst effect on social welfare, and targeting CPI inflation has an effect somewhere between those of the other two. When monetary authorities choose to target non-durable PPI inflation, the welfare performance under investment-specific shocks is about twice that under a neutral technology shock. The comparison illustrates that the monetary policy trade-offs between stabilizing price inflation and stabilizing output are tensioned by investment-specific shocks. A sensitivity analysis shows that the results are robust when key structural parameters are changed, such as the steady-state weight of durable consumption goods in aggregate consumption, the Frisch labor supply elasticity, and the depreciation rate of durable goods. The conclusions of this study lead to the following suggestions for monetary policy by the People's Bank of China. First, in a dynamic stochastic general equilibrium featuring multi-sector, the central bank should consider the variations in relative prices in different sectors, and pay attention to their role in stabilizing price levels and real GDP. The operation space for monetary policy could be improved by reasonable movements in relative price. Second, the central bank should take into account the properties of different exogenous shocks. Taking our benchmark model for example, the monetary bias or stance under an investment-specific shock is obviously different from that under a neutral technology shock.
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