nep-cba New Economics Papers
on Central Banking
Issue of 2005‒06‒14
nineteen papers chosen by
Roberto Santillan

  1. What We Don't Know About the Monetary Transmission Mechanism and Why We Don't Know It By Beyer, Andreas; Farmer, Roger E A
  2. Inflation Scares and Forecast-Based Monetary Policy By Orphanides, Athanasios; Williams, John C
  3. Optimal Monetary Policy Rules, Asset Prices and Credit Frictions By Faia, Ester; Monacelli, Tommaso
  4. Parameter Instability, Model Uncertainty and the Choice of Monetary Policy By Favero, Carlo A; Milani, Fabio
  5. Money Demand and Macroeconomic Stability Revisited By Schabert, Andreas; Stoltenberg, Christian
  6. On the Identification of Monetary (and Other) Shocks By Martin Menner; Hugo Rodriguez Mendizabal
  7. Non-linear dynamics in output, real exchange rates and real money balances: Norway, 1830-2003 By Q. Farooq Akram; Øyvind Eitrheim; Lucio Sarno
  8. Monetary and Fiscal policy Interaction in the Euro Area with Different Assumptions on the Phillips Curve By Bofinger, Peter; Mayer, Eric
  9. Globalization and Disinflation: A Note By Razin, Assaf
  10. Monetary Policy Uncertainty and the Stock Market By Locarno, Alberto; Massa, Massimo
  11. The Reliability of Inflation Forecasts Based on Output Gap Estimates in Real Time By Orphanides, Athanasios; van Norden, Simon
  12. Granger Causality of the Inflation-Growth Mirror in Accession Countries By Gillman, Max; Nakov, Anton
  13. Globalization and Disinflation: The Efficiency Channel By Loungani, Prakash; Razin, Assaf
  14. Legal, Actual and Desirable Independence: A Case Study of the Bank of Israel By Cukierman, Alex
  15. Time Consistency of Fiscal and Monetary Policy: A Solution By Persson, Torsten; Persson, Mats; Svensson, Lars E O
  16. Insurance Policies for Monetary Policy in the Euro Area By Küster, Keith; Wieland, Volker
  17. Rule-Based Monetary Policy Under Central Banking Learning By Aoki, Kosuke; Nikolov, Kalin
  18. Robust Monetary Policy in a Small Open Economy By Leitemo, Kai; Söderström, Ulf
  19. Monetary Policy with Judgement: Forecast Targeting By Svensson, Lars E O

  1. By: Beyer, Andreas; Farmer, Roger E A
    Abstract: We study identification in a class of linear rational expectations models. For any given exactly identified model, we provide an algorithm that generates a class of equivalent models that have the same reduced form. We use our algorithm to show that a model proposed by Benhabib and Farmer [1] is observationally equivalent to the standard new-Keynesian model when observed over a single policy regime. However, the two models have different implications for the design of an optimal policy rule.
    Keywords: Benhabib-Farmer model; Identification; indeterminacy; new-Keynesian model
    JEL: C39 C62 D51 E52 E58
    Date: 2004–12
  2. By: Orphanides, Athanasios; Williams, John C
    Abstract: Central bankers frequently emphasize the critical importance of anchoring private inflation expectations for successful monetary policy and macroeconomic stabilization. In most monetary policy models, however, expectations are already anchored through the assumption of rational expectations and perfect knowledge of the economy. In this Paper, we re-examine the role of inflation expectations by positing, instead, that agents have imperfect knowledge of the precise structure of the economy and policy-makers' preferences, and rely on a perpetual learning technology to form expectations. We find that with learning, disturbances can give rise to endogenous inflation scares, that is, significant and persistent deviations of inflation expectations from those implied by rational expectations, even at long horizons. The presence of learning increases the sensitivity of inflation expectations and the term structure of interest rates to economic shocks, in line with the empirical evidence. We also explore the role of private inflation expectations for the conduct of efficient monetary policy. Under rational expectations, inflation expectations equal a linear combination of macroeconomic variables and as such provide no additional information to the policy-maker. In contrast, under learning, private inflation expectations follow a time-varying process and provide useful information for the conduct of monetary policy.
    Keywords: inflation forecasts; learning; policy rules; rational expectations
    JEL: E52
    Date: 2005–01
  3. By: Faia, Ester; Monacelli, Tommaso
    Abstract: We study optimal monetary policy in two prototype economies with sticky prices and credit market frictions. In the first economy, credit frictions apply to the financing of the capital stock, generate acceleration in response to shocks and the ‘financial markup’ (i.e., the premium on external funds) is countercyclical and negatively correlated with the asset price. In the second economy, credit frictions apply to the flow of investment, generate persistence, and the financial markup is procyclical and positively correlated with the asset price. We model monetary policy in terms of welfare-maximizing interest rate rules. The main finding of our analysis is that strict inflation stabilization is a robust optimal monetary policy prescription. The intuition is that, in both models, credit frictions work in the direction of dampening the cyclical behaviour of inflation relative to its credit-frictionless level. Thus neither economy, despite yielding different inflation and investment dynamics, generates a trade-off between price and financial markup stabilization. A corollary of this result is that reacting to asset prices does not bear any independent welfare role in the conduct of monetary policy.
    Keywords: asset prices; financial distortions; optimal monetary policy rules; price stability
    JEL: E52 F41
    Date: 2005–01
  4. By: Favero, Carlo A; Milani, Fabio
    Abstract: This paper starts from the observation that parameter instability and model uncertainty are relevant problems for the analysis of monetary policy in small macroeconomic models. We propose to deal with these two problems by implementing a novel ‘thick recursive modelling’ approach. At each point in time we estimate all models generated by the combinations of a base-set of k observable regressors for aggregate demand and supply. We compute optimal monetary policies for all possible models and consider alternative ways of summarizing their distribution. Our main results show that thick recursive modelling delivers optimal policy rates that track the observed policy rates better than the optimal policy rates obtained under a constant parameter specification, with no role for model uncertainty.
    Keywords: model uncertainty; optimal monetary policy; parameter instability
    JEL: E44 E52 F41
    Date: 2005–02
  5. By: Schabert, Andreas; Stoltenberg, Christian
    Abstract: This paper examines how money demand induced real balance effects contribute to the determination of the price level, as suggested by Patinkin (1949,1965), and if they affect conditions for local equilibrium uniqueness and stability. There exists a unique price level sequence that is consistent with an equilibrium under interest rate policy, only if beginning-of-period money enters the utility function. Real money can then serve as a state variable, implying that interest rate setting must be passive for unique, stable, and non-oscillatory equilibrium sequences. When end-of-period money provides utility, an equilibrium is consistent with infinitely many price level sequences, and equilibrium uniqueness requires an active interest rate setting. The stability results are, in general, independent of the magnitude of real balance effects, and apply also when prices are sticky. In contrast, under a constant money growth policy, equilibrium sequences are (likely to be) locally stable and unique for all model variants.
    Keywords: monetary policy rules; predetermined money; price level determination; real balance effects; real determinacy
    JEL: E32 E41 E52
    Date: 2005–03
  6. By: Martin Menner; Hugo Rodriguez Mendizabal
    Abstract: The purpose of this paper is twofold. First, we construct a DSGE model which spells out explicitly the instrumentation of monetary policy. The interest rate is determined every period depending on the supply and demand for reserves which in turn are affected by fundamental shocks: unforeseeable changes in cash withdrawal, autonomous factors, technology and government spending. Unexpected changes in the monetary conditions of the economy are interpreted as monetary shocks. We show that these monetary shocks have the usual effects on economic activity without the need of imposing additional frictions as limited participation in asset markets or sticky prices. Second, we show that this view of monetary policy may have important consequences for empirical research. In the model, the contemporaneous correlations between interest rates, prices and output are due to the simultaneous effect of all fundamental shocks. We provide an example where these contemporaneous correlations may be misinterpreted as a Taylor rule. In addition, we use the sign of the impact responses of all shocks on output, prices and interest rates derived from the model to identify the sources of shocks in the data.
    Keywords: Monetary Policy, Shocks, Identification, Taylor Rules
    JEL: E32 E52 E58
    Date: 2005–05–27
  7. By: Q. Farooq Akram (Norges Bank); Øyvind Eitrheim (Norges Bank); Lucio Sarno (Norges Bank)
    Abstract: We characterise the behaviour of Norwegian output, the real exchange rate and real money balances over a period of almost two centuries. The empirical analysis is based on a new annual data set that has recently been compiled and covers the period 1830{2003. We apply multivariate linear and smooth transition regression models proposed by Terasvirta (1998) to capture broad trends, and take into account non-linear features of the time series. We particularly investigate and characterise the form of the relationship between output and monetary policy variables. It appears that allowance for statedependent behaviour and response to shocks increases the explanatory powers of the models and helps bring forward new aspects of the dynamic behaviour of output, the real exchange rate and real money balances.
    Keywords: Business cycles, real exchange rates, money demand, non-linear modelling, smooth transition regressions.
    JEL: C51 E32 E41 F31
    Date: 2005–06–09
  8. By: Bofinger, Peter; Mayer, Eric
    Abstract: In this Paper we carry over a static version of a New Keynesian Macromodel a la Clarida Gali Gertler (1999) to a monetary union. We will show in particular that a harmonious functioning of a monetary union critically depends on the correlation of shocks that hit the currency area. Additionally a high degree of integration in product markets is advantageous for the ECB as it prevents that national real interest rates can drive a wedge between macroeconomic outcomes across member states. In particular small countries are vulnerable and therefore in need of fiscal policy as an independent stabilization agent with room to breath.
    Keywords: fiscal policy; inflation targeting; monetary policy; policy coordination
    JEL: E50 E60 H70
    Date: 2004–12
  9. By: Razin, Assaf
    Abstract: We analyse how globalization forces induce monetary authorities, guided in their policies by the welfare criterion of a representative household, to put greater emphasis on reducing the inflation rate than on narrowing the output gaps. Specifically, I demonstrate how the relative weight of the output gap term in a utility-based loss function shrinks when the economy is open to international trade in goods, and is integrated to the world capital markets.
    Keywords: aggregate supply; captial market openness; inflation-output tradeoff; trade openness
    JEL: E50 F02
    Date: 2005–01
  10. By: Locarno, Alberto; Massa, Massimo
    Abstract: We study the relationship between inflation and stock returns focusing on the signalling content of inflation. Investors use inflation to learn about the stance of the monetary policy. Depending on investors’ beliefs, a change in consumption prices has different effects on the risk premium. A change in consumption prices that confirms investors' beliefs reduces stock risk premia, while a change that contradicts them increases risk premia. This may generate a negative correlation between returns and inflation that explains the Fisher puzzle. We model this intuition and test its implication on US data. We construct a market-based proxy of monetary policy uncertainty, we show that it is priced and that, by conditioning on it, the Fisher puzzle disappears.
    Keywords: asset pricing; learning risk; monetary policy uncertainty; risk factors
    JEL: G11 G12 G14
    Date: 2005–01
  11. By: Orphanides, Athanasios; van Norden, Simon
    Abstract: A stable predictive relationship between inflation and the output gap, often referred to as a Phillips curve, provides the basis for countercyclical monetary policy in many models. In this paper, we evaluate the usefulness of alternative univariate and multivariate estimates of the output gap for predicting inflation. Many of the ex post output gap measures we examine appear to be quite useful for predicting inflation. However, forecasts using real-time estimates of the same measures do not perform nearly as well. The relative usefulness of real-time output gap estimates diminishes further when compared to simple bivariate forecasting models which use past inflation and output growth. Forecast performance also appears to be unstable over time, with models often performing differently over periods of high and low inflation. These results call into question the practical usefulness of the output gap concept for forecasting inflation.
    Keywords: inflation forecasts; output gap; Phillips curve; real-timing data
    JEL: C53 E37
    Date: 2005–01
  12. By: Gillman, Max; Nakov, Anton
    Abstract: The Paper presents a model in which the exogenous money supply causes changes in the inflation rate and the output growth rate. While inflation and growth rate changes occur simultaneously, the inflation acts as a tax on the return to human capital and in this sense induces the growth rate decrease. Shifts in the model’s credit sector productivity cause shifts in the income velocity of money that can break the otherwise stable relation between money, inflation, and output growth. Applied to two accession countries, Hungary and Poland, a VAR system is estimated for each that incorporates endogenously determined multiple structural breaks. Results indicate Granger causality positively from money to inflation and negatively from inflation to growth for both Hungary and Poland, as suggested by the model, although there is some feedback to money for Poland. Three structural breaks are found for each country that are linked to changes in velocity trends, and to the breaks found in the other country.
    Keywords: Granger causality; growth; inflation; structural breaks; transition; VAR; velocity
    JEL: C22 E31 O42
    Date: 2005–01
  13. By: Loungani, Prakash; Razin, Assaf
    Abstract: The paper analyses how globalization forces induce monetary authorities, guided in their policies by the welfare criterion of a representative household, to put greater emphasis on reducing the inflation rate than on narrowing the output gaps. We demonstrate that the marginal rate of substitution between the output gap and the inflation (at a constant value of the utility-based loss function) rises when the economy is opening up to international trade in goods, and is integrated to the world capital markets. We associate the marginal rate of substitution with the sacrifice ratio, and provide evidence on trade and capital openness effects on inflation, through the efficiency channel.
    Keywords: capital-account openness; trade openness; utility-based loss function
    JEL: E50 F40
    Date: 2005–02
  14. By: Cukierman, Alex
    Abstract: This paper documents the evolution of the legal independence of the Bank of Israel since its creation in 1954 to present times, provides an international comparison, and assesses the changes in the actual independence of the Bank on a yearly basis following the 1985 stabilization of inflation. The data developed in the paper makes it possible to compare the evolution of actual and of legal independence after the 1985 stabilization and to compare the legal independence of the bank with that of other countries at different points in time. The paper also evaluates the level of legal independence embedded in the Levin’s committee recommendations for reform of the Bank of Israel law. The paper shows that various institutional changes have induced, since 1985, substantial changes in the actual independence of the bank without any legislative change. The paper also identifies domestic and international factors that stimulated those changes and evaluates the desirable level of independence for the future. In particular the paper evaluates the pros and the cons of assigning to the bank growth targets, in addition to inflation targets.
    Keywords: central banks; independence - legal and actual; Israel; monetary institutions and policy
    JEL: E40 E50 K40 P50
    Date: 2005–02
  15. By: Persson, Torsten; Persson, Mats; Svensson, Lars E O
    Abstract: This paper demonstrates how time consistency of the Ramsey policy (the optimal fiscal and monetary policy under commitment) can be achieved. Each government should leave its successor with a unique maturity structure for the nominal and indexed debt, such that the marginal benefit of a surprise inflation exactly balances the marginal cost. Unlike in earlier papers on the topic, the result holds for quite general Ramsey policies, including time-varying polices with positive inflation and positive nominal interest rates. We compare our results with those in Persson, Persson and Svensson (1987), Calvo and Obstfeld (1990), and Alvarez, Kehoe and Neumeyer (2004).
    Keywords: ramsey policy; surprise inflation; time consistency
    JEL: E31 E52 H21
    Date: 2005–03
  16. By: Küster, Keith; Wieland, Volker
    Abstract: In this paper, we examine the cost of insurance against model uncertainty for the euro area considering four alternative reference models, all of which are used for policy analysis at the ECB. We find that maximal insurance across this model range in terms of a Minimax policy comes at moderate costs in terms of lower expected performance. We extract priors that would rationalize the Minimax policy from a Bayesian perspective. These priors indicate that full insurance is strongly oriented towards the model with highest baseline losses. Furthermore, this policy is not as tolerant towards small perturbations of policy parameters as the Bayesian policy rule. We propose to strike a compromise and use preferences for policy design that allow for intermediate degrees of ambiguity-aversion. These preferences allow the specification of priors but also give extra weight to the worst uncertain outcomes in a given context.
    Keywords: euro area; minimax; model uncertainty; monetary policy rules; robustness
    JEL: E52 E58 E61
    Date: 2005–03
  17. By: Aoki, Kosuke; Nikolov, Kalin
    Abstract: The paper evaluates the performance of three popular monetary policy rules when the central bank is learning about the parameter values of a simple New Keynesian model. The three policies are: (1) the optimal non-inertial rule; (2) the optimal history-dependent rule; (3) the optimal price-level targeting rule. Under rational expectations rules (2) and (3) both implement the fully optimal equilibrium by improving the output-inflation trade off. When imperfect information about the model parameters is introduced, it is found that the central bank makes monetary policy mistakes, which affect welfare to a different degree under the three rules. The optimal history-dependent rule is worst affected and delivers the lowest welfare. Price level targeting performs best under learning and maintains the advantages of conducting policy under commitment. These findings are related to the literatures on feedback control and robustness. The paper argues that adopting integral representations of rules designed under full information is desirable because they deliver the beneficial output-inflation trade-off of commitment policy while being robust to implementation errors.
    Keywords: learning; monetary policy rules
    JEL: E31 E50
    Date: 2005–05
  18. By: Leitemo, Kai; Söderström, Ulf
    Abstract: This paper studies how a central bank’s preference for robustness against model misspecification affects the design of monetary policy in a New-Keynesian model of a small open economy. Due to the simple model structure, we are able to solve analytically for the optimal robust policy rule, and we separately analyse the effects of robustness against misspecification concerning the determination of inflation, output and the exchange rate. We show that an increased central bank preference for robustness makes monetary policy respond more aggressively or more cautiously to shocks, depending on the type of shock and the source of misspecification.
    Keywords: Knightian uncertainty; min-max policies; model uncertainty; robust control
    JEL: E52 E58 F41
    Date: 2005–05
  19. By: Svensson, Lars E O
    Abstract: ‘Forecast targeting’, forward-looking monetary policy that uses central-bank judgment to construct optimal policy projections of the target variables and the instrument rate, may perform substantially better than monetary policy that disregards judgment and follows a given instrument rule. This is demonstrated in a few examples for two empirical models of the US economy, one forward looking and one backward looking. A complicated infinite-horizon central bank projection model of the economy can be closely approximated by a simple finite system of linear equations, which is easily solved for the optimal policy projections. Optimal policy projections corresponding to the optimal policy under commitment in a timeless perspective can easily be constructed. The whole projection path of the instrument rate is more important than the current instrument setting. The resulting reduced-form reaction function for the current instrument rate is a very complex function of all inputs in the monetary-policy decision process, including the central bank’s judgment. It cannot be summarized as a simple reaction function such as a Taylor rule. Fortunately, it need not be made explicit.
    Keywords: forecasts; inflation targeting; optimal monetary policy
    JEL: E42 E52 E58
    Date: 2005–05

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