Working Papers

2022-

• Reading between the lines: Uncovering asymmetry in the central bank loss function
  Bank of Finland Research Discussion Paper no 6/2024
  with Markus Haavio, Joni Heikkinen, Pirkka Jalasjoki, Maritta Paloviita and Ilona Vänni
  
  We depart from the common reaction function-based approach used to infer central bank preferences. Instead, we extract the tone from the textual information in the central bank communication using both a lexicon-based approach and a language model. We combine the tone with real-time information available to the monetary policy decision-maker and directly estimate the loss function. We find strong and robust evidence of asymmetry in the case of the European Central Bank during 1999-2021: the slope of the loss function was roughly three times steeper when inflation exceeded the target compared to when it was below the target. This represents a significant departure from the quadratic and symmetric monetary policy loss function typically applied in macro models.

• Monetary policy and inequality: The Finnish case
  Bank of Finland Discussion paper no 3/2022
  with Petri Mäki-Fränti, Aino Silvo and Adam Gulan
  
  We use Finnish household-level registry and survey data to study the effects of ECB’s monetary policy on the distribution of income and wealth. We find that monetary easing has a large positive effect on aggregate economic activity in Finland, but its overall net impact on income and wealth inequality is negligible. Monetary easing increases households’ gross income by reducing unemployment and leading to a general rise in wages, while at the same time it boosts asset prices. These different channels have counteracting effects on income and wealth inequality, as measured by the Gini coefficient and the ratios of income and wealth of the 90th percentile to the 50th percentile. The reduction in aggregate unemployment benefits especially households in lower income quintiles, where the initial rate of unemployment is high. Households in the upper income quintiles, where the rate of employment is higher, benefit relatively more from an increase in wages. An increase in house prices benefits all homeowners. In terms of net wealth, households with large mortgages, in the lower wealth quintiles, benefit the most from an increase in house prices due to a leverage effect. An increase in stock prices, in turn, benefits mainly households in the top wealth quintile.

2017-2021

• Review of macroeconomic modelling in the Eurosystem: current practices and scope for improvement
  ECB Occasional Paper Series No 267 / September 2021
  with Matthieu Darracq Paries and Alessandro Notarpietro
  
  This paper provides an assessment of the macroeconomic models regularly used for forecasting and policy analysis in the Eurosystem. These include semi-structural, structural and time-series models covering specific jurisdictions and the euro area within a closed economy, small open economy, multi-country or global setting. Models are used as analytical frameworks for building baseline projections and for supporting the preparation of monetary policy decisions. The paper delivers four main contributions. First, it provides a survey of the macroeconomic modelling portfolios currently used or under development within the Eurosystem. Second, it explores the analytical gaps in the Eurosystem models and investigates the scope for further enhancement of the main projection and policy models, and the creation of new models. Third, it reviews current practices in model-based analysis for monetary policy preparation and forecasting and provides recommendations and suggestions for improvement. Finally, it reviews existing cooperation modalities on model development and proposes alternative sourcing and organisational strategies to remedy any knowledge or analytical gaps identified.

• Revisiting intertemporal elasticity of substitution in a sticky price model
  Bank of Finland Discussion paper no 9/2021
  with  Jouko Vilmunen and Oskari Vähämaa
  
  Macroeconomic models typically assume additively separable preferences where consumption enters the utility function in a logarithmic form. This restriction implies that consumption growth is highly sensitive to movements in real interest rates, which in turn implies an unrealistically steep demand curve and intertemporal trade-off. We re-estimate the stylized New Keynesian Model with US data using King-Plosser-Rebelo (1988) preferences with and without habits and show that the equilibrium real interest rate elasticity of output is in the range of 0.05 − 0.20 in the US. Such low real interest rate elasticity is better in line with the empirical consumption Euler equation literature and implies relatively weak transmission of monetary policy to output and inflation.

• Reading between the lines : Using text analysis to estimate the loss function of the ECB
  Bank of Finland Discussion paper no 12/2020
  with Maritta Paloviita, Markus Haavio, Pirkka Jalasjoki and Ilona Vänni
  
  We apply textual analysis to extract the tone (sentiment) from the introductory statements to the ECB’s press conferences regarding economic outlook. By combining this information with Eurosystem/ECB staff macroeconomic projections, we are able to directly estimate the Governing Council’s loss function. Our analysis suggests that prior to the new monetary policy strategy announced in July 2021, the de facto inflation aim of the ECB may have been considerably below 2%. We also find evidence that the loss function has been asymmetric, which would mean that the ECB has been more averse to inflation above 2% than below 2%. The ECB’s new definition of price stability implies a symmetric loss function with a bliss point at 2.0%. Hence our results indicate that the new strategy will bring about a clear change in the Governing Council’s policy preferences.

• Can large trade shocks cause crises? The case of the Finnish-Soviet trade collapse
  Bank of Finland Discussion paper no 9/2019
  with Adam Gulan and Markus Haavio

We study macroeconomic consequences of a major trade disruption using the example of the Finnish-Soviet trade collapse in 1991. This is a rare case of a well-identified large trade shock in a developed economy. We find that the shock had a significant effect on Finnish output. While the direct trade channel effect was rather moderate, the shock led to significant tightening of financial conditions. It was therefore endogenously amplified due to the propagation through the domestic financial sector. Even so, the trade collapse was insufficient to generate an all-out economic crisis. It can account for only a part of the Finnish Great Depression (1990 − 1993). The crisis was triggered and prolonged by the meltdown of the overheated financial and banking sectors since 1989. We show that the financial system remained a major independent source of shocks throughout the depression.

• What does "below, but close to, two percent" mean? Assessing the ECB's reaction function with real time data
  Bank of Finland Discussion paper no 29/2017
  with Maritta Paloviita, Markus Haavio and Pirkka Jalasjoki

Using unique real time quarterly macroeconomic projections of the Eurosystem/ECB staff, we estimate competing specifications of the ECB’s monetary policy reaction function. We consider specifications which include inflation and output growth projections, a past inflation gap, a time varying natural real interest rate and different inflation targets. Our first key finding is that the de facto inflation target of the ECB lies between 1.6% and 1.8%. Our second key finding is that the ECB reacts both to short term macroeconomic projections and to past deviations of inflation from its de facto target.

2012-2016

• Testing the Q theory of investment in the frequency domain
  Bank of Finland Discussion paper no 32/2016
  with Fabio Verona
  
  We revisit the empirical performance of the Q theory of investment, explicitly taking into account the frequency dependence of investment, Tobin’s Q, and cash flow. The time series are decomposed into orthogonal components of different frequencies using wavelet multiresolution analysis. We find that the Q theory fits the data much better than might be expected (both in-sample and out-of-sample) when the frequency relationship between the variables is taken into account. Merging the wavelet approach and proxies for Q recently suggested in the investment literature also significantly improves the quality of short-term forecasts.

• The Aino 2.0 model
  Bank of Finland Discussion paper no 16/2016
  with Seppo Orjasniemi, Antti Ripatti and Fabio Verona
  
  This paper presents Aino 2.0 – the dynamic stochastic general equilibrium (DSGE) model currently used at the Bank of Finland for forecasting and policy analysis. The paper provides a detailed theoretical description of the model, its estimation and how it can be used to interpret the evolution of the Finnish economy between 1995 and 2014, including the rise and fall of the electronics industry, the global financial crisis, and the stagnant growth performance since the end of the financial crisis.

• Comparing Fiscal Multipliers Across Models and Countries in Europe
  European Central Bank Working Paper Series 1760/2015
  with Massimiliano Pisani, Sebastian Schmidt, Vesna Corbo, Tibor Hledik, Josef Hollmayr, Samuel Hurtado, Paulo Júlio, Dmitry Kulikov, Matthieu Lemoine, Matija Lozej, Henrik Lundvall, José R. Maria, Brian Micallef, Dimitris Papageorgiou, Jakub Rysanek, Dimitrios Sideris, Carlos Thomas and Gregory De Walque
  
  This paper employs fifteen dynamic macroeconomic models maintained within the European System of Central Banks to assess the size of fiscal multipliers in European countries. Using a set of common simulations, we consider transitory and permanent shocks to government expenditures and different taxes. We investigate how the baseline multipliers change when monetary policy is transitorily constrained by the zero nominal interest rate bound, certain crisis-related structural features of the economy such as the share of liquidity-constrained households change, and the endogenous fiscal rule that ensures fiscal sustainability in the long run is specified in terms of labour income taxes instead of lump-sum taxes.

• Kiss me deadly: From Finnish great depression to great recession
  Bank of Finland Discussion paper no 24/2014
  with Adam Gulan and Markus Haavio
  
  We investigate the causes of the Finnish Great Depression, 1990-1993. We find that the collapse of the overheated financial and banking sectors starting in 1989 was the trigger of the economic crisis. Foreign shocks, which include the collapse of trade with USSR in 1991, can account for at most about half of the slump, and these shocks occurred only when the economy was already in free fall. Also, the deleveraging and restructuring process of the financial system substantially prolonged the subsequent recovery. Our methodology involves estimating a structural VAR model with sign and exogeneity restrictions. Importantly, we are able to distinguish between financial shocks affecting the demand for intermediated loans and those shifting the loan supply curve. Hence we also contribute to the discussion on which financial shocks actually matter.

• Welfare and bond pricing implications of fiscal stabilization policies
  Bank of Finland Discussion paper no 32/2013
  with Kai Christoffel and Ivan Jaccard
  
  How do cyclical fiscal stabilisation policies affect welfare and government bond risk premia? Using a new Keynesian model we find that the effects of fiscal policy rules on the bond premium and welfare crucially depend on the source of business cycle fluctuations. The overall effect is estimated using Bayesian methods and the mechanism is deconstructed by examining the propagation mechanism of the different shocks. We find that the impact of fiscal policy cyclicality on welfare and risk premia is highly non-linear and that these effects are of a policy relevant magnitude. Finally, we find that the welfare cost of highly procyclical fiscal policies are very large, but also excessive fiscal stabilization can generate non- negligible welfare losses. 

• Estimating intertemporal elasticity of substitution in a sticky price model
  Bank of Finland Discussion paper no 9/2013
  with Jouko Vilmunen and Oskari Vähämaa
  
  Cancellation of income and substitution effect implied by King-Plosser-Rebelo (1988) preferences breaks tight coefficient restriction between the slope of the Phillips curve and the elasticity of consumption with respect to real interest rate in a sticky price macro model. This facilitates the estimation of intertemporal elasticity of substitution using full information Bayesian Maximum Likelihood techniques within a structural model. The US data from the period 1984 - 2007 supports low intertemporal elasticity of substitution and strongly rejects a logarithmic and an additively separable utility specification commonly applied in the New Keynesian literature.

• Sovereign risk, European crisis resolution policies and bond yields
  Bank of Finland Discussion paper no 22/2012
  with Helinä Laakkonen and Jouko Vilmunen
  
  We study the effects of the ECB monetary policy and the European crises resolution policies on the 10 year sovereign bond yields of seven European countries. We find that some of the decisions have had significant impact on sovereign bond yields and have succeeded in reducing stress in the financial markets. However, the impact of the same policy decision might have been positive for some countries while negative for others, suggesting that contagion effects may be important. The economically most significant effects on the bond yields have been due to the announcement of ECB's Securities Market Programme.

2007-2010

• New evidence on implicit contracts from linked employer-employee data
  Bank of Finland Discussion paper no 12/2010
  with Torsten Santavirta
  
  We improve the precision of the test of the implicit contract model that Beaudry and DiNardo proposed twenty years ago. Our data set allows us to define the precise industry and plant of a particular employment relationship, link local labour market characteristics and company characteristics to the individual level of wages, and control for composition effects. We find evidence in favour of the spot market model of wage setting in the whole sample, but there is significant variation across industries and educational levels. In particular, the spot market matters most for low-skill workers, while the implicit contract model with one-sided limited commitment applies better to high-skill workers.

• Productivity and job flows : heterogeneity of new hires and continuing jobs in the business cycle
  Bank of Finland Discussion paper no 15/2009
  with Juuso Vanhala
  
  This paper focuses on productivity dynamics of a firm-worker match as a potential explanation for the 'unemployment volatility puzzle'. We let new matches and continuing jobs differ in terms of productivity level and sensitivity to aggregate productivity shocks. As a result, new matches have a higher destruction rate and lower, but more volatile, wages than old matches, as new hires receive technology associated with the latest vintage. In our model, an aggregate productivity shock generates a persistent productivity difference between the two types of matches, creating an incentive to open new productive vacancies and to destroy old matches that are temporarily less productive. The model produces a well behaved Beveridge curve, despite endogenous job destruction and more volatile vacancies and unemployment, without needing to rely on differing wage setting mechanisms for new and continuing jobs. 

• Productivity and job flows : heterogeneity of new hires and continuing jobs in the business cycle
  European Central Bank Working Paper Series 1080/2009
  with Juuso Vanhala
  
  This paper focuses on tenure driven productivity dynamics of a firm-worker match as a potential explanation of "unemployment volatility puzzle". We let new matches and continuing jobs differ by their productivity levels and by their sensitivity to aggregate productivity shocks. As a result, new matches have a higher destruction rate and lower, but more volatile, wages than old matches, as new hires receive technology associated with the latest vintage. Our contribution is to produce model driven stickiness of old jobs’ wages which does not rely on ad hoc assumptions on wage rigidity. In our model, an aggregate productivity shock generates a persistent productivity difference between the two types of matches, creating an incentive to open new productive vacancies and to destroy old matches that are temporarily less productive. The model produces a well behaving Beveridge curve, despite endogenous job destruction, and more volatile vacancies and unemployment, without a need to rely on differing wage setting mechanisms of new and continuing jobs. Price rigidities do not alter the basic mechanism and the transmission of monetary policy shock is very similar to the standard New Keynesian model with search frictions.

• Euler consumption equation with non-separable preferences over consumption and leisure and collateral constraints
  Bank of Finland Discussion paper no 9/2009
  
  This paper derives and estimates an aggregate Euler consumption equation which allows one to compare the importance of collateral constraints and non-separability of consumption and leisure as alternative sources of excess sensitivity of consumption to current income. Estimation results suggest that during a severe financial distress both non-separability and collateral constraints are needed to capture excess sensitivity of consumption to current economic conditions. During more tranquil times, evidence on collateral effects is more limited and non-separability is sufficient to make the Euler consumption equation agree well with the data. 

• Why do growth rates differ? : Evidence from cross-country data on private sector production
  Bank of Finland Discussion paper no 13/2008
  with Matti Virén
  
  We estimate a standard production function with a new cross-country data set on business sector production, wages and R&D investment for a selection of 14 OECD countries including the United States. The data sample covers the years 1960-2004. The data suggest that growth differences can largely be explained by capital deepening and an ability to produce new technology in the form of new patents. The importance of patents is magnified by the openness of the economy. We find some evidence of increasing elasticity of substitution over time, all though the results are sensitive to assumptions on the nature of technological progress. 

• Demografia ja talouden sopeutumismekanismit - muutamia lisänäkökulmia ikääntymiskeskusteluun
  Valtioneuvoston kanslian julkaisusarja 20, 2007: 123-134
  with Helvi Kinnunen

• The lending channel under optimal choice of monetary policy
  Bank of Finland Discussion paper no 33/2007
  with Alistair Milne
  
  Building on Cecchetti and Li (2005), we show that the bank lending channel affects monetary policy trade-offs only when interest rates affect marginal costs of production (ie when there is a cost channel of monetary policy) in the New Keynesian monetary policy model. In our calibrated model the resulting impact of the bank lending channel on output-inflation trade-offs is quantitatively small and of ambiguous sign. When bank capital varies counter cyclically and bank loan rates have a relatively large impact on marginal costs, variation of bank loan margins improves monetary policy trade-offs. The new Basel accord, by increasing capital requirements during economic downturns, offsets this beneficial impact. 

• GDP at risk in a DSGE model : an application to banking sector stress testing
  Bank of Finland Discussion paper no 26/2007
  with Esa Jokivuolle and Tero Kuusi
  
  We suggest a complementary tool for financial stability analysis based on stochastic simulation of a dynamic stochastic general equilibrium model (DSGE) of the macro economy. The paper relates to financial stability research in which financial aggregates crucial to financial stability are modelled as functions of macroeconomic variables. In these models, stress tests for eg banking sector loan losses can be generated by considering adverse scenarios of macro variables. A DSGE model provides a systematic way of generating coherent macro scenarios which can be given a rigorous economic interpretation. The approach is illustrated using a DSGE model of the Finnish economy and a simple model of Finnish banking sector loan losses.

• When do R&D subsidies boost innovation? : revisiting the inverted U-shape
  Bank of Finland Discussion paper no 10/2007
  with Torsten Santavirta
  
  We show theoretically that a proportional R&D subsidy accelerates innovation activity at all degrees of competition in the modern Schumpeterian growth model, but less so at high degrees of competition. We then use company-level data on patenting activity, product market competition and R&D subsidies of Finnish firms during 1990 2001 to test the theoretical prediction. The empirical findings can be summarized as follows. Firstly, we find relatively strong evidence in favour of the inverted U-shape between competition and innovation. Secondly, we find some evidence that a direct R&D subsidy increases innovative activity at all but very high degrees of competition. This can be interpreted so mean that the R&D subsidy reinforces the Schumpeterian effect due to the negative cross-effect of R&D subsidy and competition. This is evident from the finding that an increase in the R&D subsidy steepens the inverted U relationship when competition is fierce.

• Discretion and the transmission lags of monetary policy
  Bank of Finland Discussion paper no 8/2007
  with Kai Leitemo
  
  Monetary policy transmission lags create credibility problems for the inflationtargeting policy maker who acts under discretion. We show that if prices react to monetary policy with a longer lag than output, the welfare maximizing inflationtargeting policy implies no policy stabilization of cost-push shocks in the canonical New Keynesian model. The reason is simple: for the period monetary policy influences output, inflation is predetermined and the best discretionary policy is to stabilize the output gap fully. We find that money growth targeting comes close to replicating the welfare-maximizing policy under commitment if there are transmission lags.

1999-2006

• Population ageing in a small open economy : some policy experiments with a tractable general equilibrium model
  Bank of Finland Discussion paper no 28/2006
  with Helvi Kinnunen and Antti Ripatti
  
  This paper extends Gertler's (1999) tractable overlapping generations model with life-cycle features by allowing for distortionary taxation, demographic transition and stochastic variation in demographic structure.The model is then used to study demographic change in the small open economy of Finland. Simulations highlight the key role played by labour market responses to ageing.When the responses of labour supply, wages, and hence private consumption, to higher taxation are consistently accounted for, population ageing has clearly much larger effects on public finance, when compared to mechanical sustainability calculations.Stochastic simulations suggest that lengthening of working time has only a modest alleviating effect on the fiscal burden of ageing.This is due to the fact that stochastic variation in the length of working time has only a relatively small effect on the model's dependency ratio.Variation in life expectancy is clearly much more important.

• Labour and product market competition in a small open economy – Simulation results using a DGE model of the Finnish economy
  Bank of Finland Discussion paper no 5/2006
  with Antti Ripatti
  
  Using the DGE model of the Finnish Economy (the 'Aino' model), we study the response of the economy to reforms in both labour and product markets.The reforms are two-fold.We assume that the wage mark-up, ie the monopoly power of wage-setters is gradually reduced by 5 percentage points.At the same time, the degree of competition is increased, ie price margins are exogenously reduced by 2 percentage points.These reforms imply a very favourable outcome of the economy.Both consumption and employment increases permanently and the reforms are welfare enhancing.Public balances improve giving room for 1.5 percentage point cut in income taxes.Our simulation exercises clearly demonstrate that such reforms may help in financing the future fiscal burden of an ageing population.

• Robustness in monetary policymaking : a case for the Friedman rule
  Bank of Finland Discussion paper no 4/2006
  with Kai Leitemo
  
  Inflation targeting involves using all available information in stabilizing inflation around some target rate (Svensson, 2003). Inflation is typically at the very end of the transmission mechanism and hence its determination is subject to much model uncertainty which the central bank will want to guard against using robust policies. Such robustness comes however with the cost of increased social loss under the most likely description of the economy. We show that with a sufficiently high degree of model uncertainty, adherence to the Friedman rule of increasing the money stock by k percent will be superior as the price paid for robustness is smaller.

• Robust expectations and uncertain models : a robust contol approach with application to the new Keynesian economy
  Bank of Finland Discussion paper no 5/2004
  
  This paper extends Svensson and Woodford's (2003) partial information framework by allowing the private agents to achieve robustness against incomplete information about the structure of the economy by distorting their expectations in a particular direction.It shows how a linear rational expectations equilibrium under concern for robustness can be solved by exploiting the recursive structure of the problem and appropriately modifying the Bellman equations in their framework.The standard Kalman filter is then used for information updating under imperfect measurement of the state variables.The standard New Keynesian model is used for illustrating how concern for modelling errors interacts with imperfect information.Agents achieve robustness by simultaneously over-estimating the persistence of exogenous shocks, but under-estimating the policy response to the output gap.This under-estimation, combined with imperfect measurement, leads to larger and more persistent responses of private consumption to government expenditure shocks under robust expectations.

• A Positive theory of monetary policy and robust control
  Bank of Finland Discussion paper no 18/2003
  
  This paper applies the robust control approach to a simple positive theory of monetary policy, when the central bank's model of the economy is subject to misspecifications.It is shown that a central bank should react more aggressively to supply shocks when the model misspecifications grow larger. Moreover, the model misspecifications aggravate the inflation bias and a trade-off between output stabilisation and inflation worsens when the uncertainty surrounding the central bank's model increases.This implies that the larger the model misspecifications are, the more inflation-averse the central bank should be. 

• Central bank independence and wage bargaining structure: Empirical evidence
  Bank of Finland Discussion paper no 9/1999
  
  This paper studies the relationship between central bank independence, wage bargaining structure and macroeconomic performance in OECD countries.A cross-sectional time-series (TSCS) model for inflation, nominal wage growth and unemployment for the period 1973-1996 is estimated using different and updated measures of central bank independence.The importance of the price stability objective in the central bank statute is used as a proxy for the degree of conservativeness of the central bank.A recently published data set on wage bargaining structure is used, and a distinction is made between coordination of wage bargaining and formal centralization.A new measure of union power is constructed, which combines formal centralization and union density.The implications of the large differences that can be seen between coverage and unionization rates in some countries are briefly discussed.Two important results emerge.First, the central bank's political independence and personnel independence contribute most importantly to a successful inflation policy.Second, a high level of coordination contributes to moderate inflation rates and unemployment, while union monopoly power tends to increase inflation.

• The inflation target and the structure of labour markets : Implications for common monetary policy
  Bank of Finland Discussion paper no 7/1999
  
  Both the optimal inflation target and the optimal degree of output stabilization are found to be conditional on the prevailing wage bargaining structure.If monopolistic wage setters act as strategic leaders of the monetary policy game, an explicit inflation targeting regime removes inflation bias from monetary policy, but does not remove the trade-off related to average level of output and output stabilization.In contrast to usual results on inflation targeting, appointing a central banker who is more conservative than the government leads to welfare gains for society.If centralization within the national labor markets increases in the common monetary policy area, the monetary policy game with regard to the European Central Bank might be conducted under the strategic leadership of trade union confederations. This leads to a Pareto loss.