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Should Central Banks Worry About Nonlinearities of their Large-Scale Macroeconomic Models?

Vadym Lepetyuk, Lilia Maliar and Serguei Maliar

Staff Working Papers from Bank of Canada

Abstract: How wrong could policymakers be when using linearized solutions to their macroeconomic models instead of nonlinear global solutions? This question became of much practical interest during the Great Recession and the recent zero lower bound crisis. We assess the importance of nonlinearities in a scaled-down version of the Terms of Trade Economic Model (ToTEM), the main projection and policy analysis model of the Bank of Canada. In a meticulously calibrated “baby” ToTEM model with 21 state variables, we find that local and global solutions have similar qualitative implications in the context of the recent episode of the effective lower bound on nominal interest rates in Canada. We conclude that the Bank of Canada’s analysis would not improve significantly by using global nonlinear methods instead of a simple linearization method augmented to include occasionally binding constraints. However, we also find that even minor modifications in the model's assumptions, such as a variation in the closing condition, can make nonlinearities quantitatively important.

Keywords: Business fluctuations and cycles; Econometric and statistical methods; Economic models (search for similar items in EconPapers)
JEL-codes: C61 C63 C68 E31 E52 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cmp, nep-dge, nep-mac and nep-mon
Date: 2017
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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:17-21

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