nep-cba New Economics Papers
on Central Banking
Issue of 2005‒10‒04
sixty-two papers chosen by
Roberto Santillan

  1. Central bank transparency and private information in a dynamic macroeconomic model By Joseph G. Pearlman
  2. Financial Liberalization and Inflationary Dynamics in the Context of a Small Open Economy By Rangan Gupta
  3. The role of central bank capital revisited By Ulrich Bindseil; Andres Manzanares; Benedict Weller
  4. Gains from international monetary policy coordination - does it pay to be different? By Zheng Liu; Evi Pappa
  5. Inflation persistence - facts or artefacts? By Carlos Robalo Marques
  6. The Effect of Financial Depth on Monetary Transmission By Danny Pitzel; Lenno Uusküla
  7. Monetary and fiscal interactions in open economies By Giovanni Lombardo; Alan Sutherland
  8. Communication and exchange rate policy By Marcel Fratzscher
  9. Optimal monetary and fiscal policy: A linear-quadratic approach. By Pierpaolo Benigno; Michael Woodford
  10. The decline of activist stabilization policy: Natural rate misperceptions, learning and expectations. By Athanasios Orphanides; John C. Williams
  11. Inflation persistence and robust monetary policy design By Günter Coenen
  12. Optimal monetary policy under commitment with a zero bound on nominal interest rates By Klaus Adam; Roberto M. Billi
  13. Unions, wage setting and monetary policy uncertainty By Hans Peter Grüner; Bernd Hayo; Carsten Hefeker
  14. Parameter misspecification and robust monetary policy rules By Carl E.Walsh
  15. The optimal degree of discretion in monetary policy. By Susan Athey; Andrew Atkeson; Patrick J. Kehoe
  16. The operational target of monetary policy and the rise and fall of reserve position doctrine By Ulrich Bindseil
  17. Monetary discretion, pricing complementarity and dynamic multiple equilibria. By Robert G. King; Alexander L.Wolman
  18. Money demand and macroeconomic stability revisited By Andreas Schabert; Christian Stoltenberg
  19. Monetary policy with judgment - forecast targeting By Lars E. O. Svensson
  20. The credibility of the monetary policy ‘free lunch’ By James Yetman
  21. Euro area inflation differentials By Ignazio Angeloni; Michael Ehrmann
  22. Money supply and the implementation of interest rate targets By Andreas Schabert
  23. Measuring the time-inconsitency of US monetary policy By Paolo Surico
  24. The European Monetary Union as a commitment device for new EU member states By Federico Ravenna
  25. Insurance policies for monetary policy in the euro area By Keith Küster; Volker Wieland
  26. Communication and decision-making by central bank committees - different strategies, same effectiveness? By Michael Ehrmann; Marcel Fratzscher
  27. Monetary policy predictability in the euro area: an international comparison By Bjørn-Roger Wilhelmsen; Andrea Zaghini
  28. Optimal allotment policy in the eurosystem’s main refinancing operations? By Christian Ewerhart; Nuno Cassola; Steen Ejerskov; Natacha Valla
  29. Consumer inflation expectations in Poland By Tomasz Lyziak
  30. Exchange-rate policy and the zero bound on nominal interest rates By Günter Coenen; Volker Wieland
  31. Liquidity, information, and the overnight rate By Christian Ewerhart; Nuno Cassola; Steen Ejerskov; Natacha Valla
  32. Inflation persistence during periods of structural change - an assessment using Greek data By George Hondroyiannis; Sophia Lazaretou
  33. The real effects of money growth in dynamic general equilibrium By Liam Graham; Dennis J. Snower
  34. Inflation persistence in the European Union, the euro area, and the United States By Gregory Gadzinski; Fabrice Orlandi
  35. Break in the mean and persistence of inflation - a sectoral analysis of French CPI By Laurent Bilke
  36. Government deficits, wealth effects and the price level in an optimizing model By Barbara Annicchiarico
  37. Adopting the Euro in Central Europe: Challenges of the Next Step in European Integration By Schadler, Susan; Drummond, Paulo Flavio Nacif; Kuijs, Louis; Murgasova, Zuzana; van Elkan, Rachel
  38. Monetary policy shocks in the euro area and global liquidity spillovers By João Sousa; Andrea Zaghini
  39. The great inflation, limited asset markets participation and aggregate demand: FED policy was better than you think By Florin O. Bilbiie
  40. Structural filters for monetary analysis - the inflationary movements of money in the euro area By Annick Bruggeman; Gonzalo Camba-Méndez; Björn Fischer; João Sousa
  41. Excess reserves and the implementation of monetary policy of the ECB By Ulrich Bindseil; Gonzalo Camba-Mendez; Astrid Hirsch; Benedict Weller
  42. Monetary policy analysis with potentially misspecified models By Marco Del Negro; Frank Schorfheide
  43. Explicit inflation objectives and macroeconomic outcomes By Andrew T. Levin; Fabio M. Natalucci; Jeremy M. Piger
  44. The great inflation of the 1970s. By Fabrice Collard; Harris Dellas
  45. The determinants of the overnight interest rate in the euro area By Julius Moschitz
  46. The demand for euro area currencies By Björn Fischer; Petra Köhler; Franz Seitz
  47. Optimal monetary policy rules for the euro area: an analysis using the area wide model By Alistair Dieppe; Keith Küster; Peter McAdam
  48. The longer term refinancing operations of the ECB By Ulrich Bindseil; Tobias Linzert; Dieter Nautz
  49. Taking stock: monetary policy transmission to equity markets By Michael Ehrmann; Marcel Fratzscher
  50. Asset price booms and monetary policy By Carsten Detken; Frank Smets
  51. Money and prices in models of bounded rationality in high inflation economies By Albert Marcet; Juan Pablo Nicolini
  52. Market Concentration, Macroeconomic Uncertainty and Monetary Policy. By Juan de Dios Tena; Francesco Giovannoni
  53. Ramsey monetary policy and international relative prices. By Ester Faia; Tommaso Monacelli
  54. Interest Rate Setting and the Colombian Monetary Transmission Mechanism By Carlos Andrés Amaya
  55. The great depression and the Friedman-Schwartz hypothesis By Lawrence Christiano; Roberto Motto; Massimo Rostagno
  56. Longer-term effects of monetary growth on real and nominal variables, major industrial countries, 1880-2001 By Alfred A. Haug; William G. Dewald
  57. Cross-country differences in monetary policy transmission By Robert-Paul Berben; Alberto Locarno; Julian Morgan; Javier Valles
  58. Forecasting euro area inflation using dynamic factor measures of underlying inflation By Gonzalo Camba-Méndez; George Kapetanios
  59. Fiscal and monetary rules for a currency union By Andrea Ferrero
  60. Fleshing out the monetary transmission mechanism - output composition and the role of financial frictions By André Meier; Gernot J. Müller
  61. Strategic interactions between monetary and fiscal authorities in a monetary union By Valeria De Bonis; Pompeo Della Posta
  62. Transparency, disclosure and the Federal Reserve By Michael Ehrmann; Marcel Fratzscher

  1. By: Joseph G. Pearlman (London Metropolitan University – Department of Economics, Finance and International Business (EFIB), 84 Morgate, London EC2M 6SQ, United Kingdom.)
    Abstract: We investigate the role of economic transparency within the framework of one of Townsend’s models of ‘forecasting the forecasts of others’. The equilibrium has the property that ‘higher order beliefs’ are coordinated into a finite-dimensional setup that is amenable to address monetary policy issues. We focus here on the role of public information about the money supply, and find that it should be fully revealing.
    Keywords: Transparency; central banks; asymmetric information; public information.
    JEL: D82 E58
    Date: 2005–03
  2. By: Rangan Gupta (University of Connecticut and University of Pretoria)
    Abstract: The paper develops a short-run model of a small open financially repressed economy characterized by unorganized money markets, capital good imports, capital mobility, wage indexation, and flexible exchange rates. The analysis shows that financial liberalization, in the form of an increased rate of interest on deposits and tight monetary policy, unambiguously and unconditionally causes deflation. Moreover, the results do not depend on the degree of capital mobility and structure of wage setting. The paper recommends that a small open developing economy should deregulate interest rates and tighten monetary policy if reducing inflation is a priority. The pre-requisite for such a policy, however, requires the establishment of a flexible exchange rate regime.
    Keywords: Financial Liberalization; Inflation; Small open economy.
    JEL: E31 E44 E52 F41
    Date: 2005–07
  3. By: Ulrich Bindseil (European Central Bank, Kaiserstrasse 29, D-60311, Frankfurt am Main, Germany.); Andres Manzanares (European Central Bank, Kaiserstrasse 29, D-60311, Frankfurt am Main, Germany.); Benedict Weller (European Central Bank, Kaiserstrasse 29, D-60311, Frankfurt am Main, Germany.)
    Abstract: This paper explores the role of central bank capital in ensuring that central banks focus on price stability in monetary policy decisions. The paper goes beyond the existing literature on this topic by developing a simple, but comprehensive, model of the relationship between a central bank's balance sheet structure and its inflation performance. The first part of the paper looks at solvency, i.e. under which conditions the "economic" capital (i.e. the discounted long term P&L) of a central bank always remains positive, despite adverse shocks, assuming a stability oriented monetary policy. The second part shows that in practice, capital is important for central banks beyond the issue of positive economic capital, when taking realistic assumptions regarding central bank independence. Capital thus remains a key tool to ensure that central banks are unconstrained in their focus on price stability in monetary policy decisions.
    Keywords: Central Bank Capital; Central Bank Independence.
    JEL: E42 E58
    Date: 2004–09
  4. By: Zheng Liu (Department of Economics, Emory University,Atlanta, GA 30322, USA, and CIRPÉE, Canada); Evi Pappa (Department of Economics,The London School of Economics and Political Science, Houghton Street, London WC2A 2AE, UK, and IGIER – Bocconi University and CEP, Italy)
    Abstract: This paper presents a new argument for international monetary policy coordination based on considerations of structural asymmetries across countries. In a two-country world with a traded and a non-traded sector in each country, optimal independent monetary policy cannot replicate the natural-rate allocations. There are potential welfare gains from coordination since the planner under a cooperating regime internalizes a terms-of-trade externality that independent central banks tend to overlook. Yet, with symmetric structures across countries, the gains are quantitatively small. If the size of the traded sector differs across countries, the gains can be sizable and increase with the degree of asymmetry. The planner's optimal policy not only internalizes the terms-of-trade externality, it also creates a terms-of-trade bias in favor the country with a larger traded sector. Further, the planner tries to balance the terms-of-trade bias against the need to stabilize fluctuations in the terms-of-trade gap.
    Keywords: International Policy Coordination; Optimal Monetary Policy; Asymmetric Structures; Terms-of-Trade Bias.
    JEL: E52 F41 F42
    Date: 2005–08
  5. By: Carlos Robalo Marques (Bank of Portugal)
    Abstract: This paper addresses some issues concerning the definition and measurement of inflation persistence in the context of the univariate approach. First, it is stressed that any estimate of persistence should be seen as conditional on the given assumption for the long run level of inflation and that such long run level should be allowed to vary through time. Second, a non-parametric measure of persistence is suggested which explores the relation between persistence and mean reversion. Third, inflation persistence in the U.S. and the Euro Area is re-evaluated allowing for a time varying mean and it is found that estimates of persistence crucially depend on the function used to proxy the mean of inflation. In particular, the widespread belief that inflation has been more persistent in the sixties and seventies than in the last twenty years is shown to obtain only for the U.S. and for the special case of a constant mean.
    Keywords: Inflation persistence; univariate approach; time varying mean; mean reversion.
    JEL: E31 C22 E52
    Date: 2004–06
  6. By: Danny Pitzel; Lenno Uusküla
    Abstract: Several papers have looked at the relationship between country-specific factors and the strength of monetary transmission. Cecchetti (1999) concentrated on legal aspects, De Grauwe and Storti (2004) more on the financial structure of the economy. The objective of this paper is to measure how financial development variables influence the strength of monetary transmission in European countries. This paper employs a meta-analysis technique that has gained much popularity in recent years. According to the results, monetary transmission in Europe is strongly influenced by financial depth and structure.
    Keywords: monetary transmission, financial depth, meta-analysis
    JEL: E3 E4 E5 E6
  7. By: Giovanni Lombardo (Deutsche Bundesbank, Postfach 100602, D-60006 Frankfurt am Main, Germany.); Alan Sutherland (Department of Economics, University of St Andrews, St Andrews, Fife, KY16 9AL, UK.)
    Abstract: A two-country sticky-price model is used to analyse the interactions between fiscal and monetary policy. The role of an ‘activist’ fiscal policy as a stabilisation tool is considered and a measure of the welfare gains from international fiscal policy cooperation is derived. It is found that welfare gains from fiscal cooperation do exist provided monetary policy is set cooperatively. There are also welfare gains from fiscal policy cooperation in a monetary union. However, it is found that a ‘non-activist’ fiscal policy can be better than non-cooperative fiscal policy when the international correlation of shocks is strongly negative. And non-cooperative fiscal policy can be better than cooperative fiscal policy if monetary policy is not set cooperatively.
    Keywords: Fiscal and monetary policy; policy coordination.
    JEL: E52 E58 F42
    Date: 2003–11
  8. By: Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper deals with the very short-term influence of "oral interventions" on the exchange rate of major currencies. The paper finds that official communication, as reported by wire services, are effective in influencing the US dollar-euro and yen-US dollar exchange rates in the desired direction on intervention days. Oral interventions are found to be substantially more effective if they deviate from the prevalent policy "mantra". They also tend to reduce market volatility whereas actual interventions raise volatility. A key result of the paper is that oral interventions are effective independently from the stance and direction of monetary policy as well as the occurrence of actual interventions. This suggests that oral interventions might constitute, on a short-term basis, an effective and largely autonomous policy tool.
    Keywords: communication; exchange rate; intervention; policy; United States; euro area; Japan.
    JEL: E61 E58 F31
    Date: 2004–05
  9. By: Pierpaolo Benigno (New York University, Department of Economics, 269 Mercer Street, New York, NY 10003, USA.); Michael Woodford (Columbia University, Department of Economics, 420 W. 118th Street, New York, NY 10027, USA.)
    Abstract: We propose an integrated treatment of the problems of optimal monetary and fiscal policy, for an economy in which prices are sticky and the only available sources of government revenue are distorting taxes. Our linear-quadratic approach allows us to nest both conventional analyses of optimal monetary stabilization policy and analyses of optimal tax-smoothing as special cases of our more general framework. We show how a linear-quadratic policy problem can be derived which yields a correct linear approximation to the optimal policy rules from the point of view of the maximization of expected discounted utility in a dynamic stochastic general-equilibrium model. Finally, we derive targeting rules through which the monetary and fiscal authorities may implement the optimal equilibrium.
    Keywords: Loss function, output gap, tax smoothing, targeting rules.
    JEL: E52 E61 E63
    Date: 2004–04
  10. By: Athanasios Orphanides (Board of Governors of the Federal Reserve System, Federal Reserve Board,Washington, D.C. 20551,USA.); John C. Williams (Federal Reserve Bank of San Francisco, 101 Market Street, San Francisco, CA 94105,USA.)
    Abstract: We develop an estimated model of the U.S. economy in which agents form expectations by continually updating their beliefs regarding the behavior of the economy and monetary policy. We explore the effects of policymakers' misperceptions of the natural rate of unemployment during the late 1960s and 1970s on the formation of expectations and macroeconomic outcomes. We find that the combination of monetary policy directed at tight stabilization of unemployment near its perceived natural rate and large real-time errors in estimates of the natural rate uprooted heretofore quiescent inflation expectations and destabilized the economy. Had policy reacted less aggressively to perceived unemployment gaps, inflation expectations would have remained anchored and the stagflation of the 1970s would have been avoided. Learning from the experience of the 1970s, policymakers eschewed activist policies in favor of policies that concentrated on the achievement of price stability, contributing to the subsequent improvements in macroeconomic performance.
    Keywords: Monetary policy; stagflation; rational expectations; learning.
    JEL: E52
    Date: 2004–04
  11. By: Günter Coenen (Directorate General Research, European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.)
    Abstract: This paper investigates the performance of optimised interest rate rules when there is uncertainty about a key determinant of the monetary transmission mechanism, namely the degree of persistence characterising the inflation process. The paper focuses on the euro area and utilises two variants of an estimated small-scale macroeconomic model featuring distinct types of staggered contracts specifications which induce quite different degrees of inflation persistence. The paper shows that a cautious monetary policy-maker is welladvised to design and implement interest rate policies under the assumption that inflation persistence is high when uncertainty about the prevailing degree of inflation persistence is pervasive.
    Keywords: Macroeconomic modelling; staggered contracts; inflation persistence; monetary policy rules; robustness; euro area.
    JEL: E31 E52 E58 E61
    Date: 2003–11
  12. By: Klaus Adam (European Central Bank, DG Research); Roberto M. Billi (Center for Financial Studies)
    Abstract: We determine optimal monetary policy under commitment in a forwardlooking New Keynesian model when nominal interest rates are bounded below by zero. The lower bound represents an occasionally binding constraint that causes the model and optimal policy to be nonlinear. A calibration to the U.S. economy suggests that policy should reduce nominal interest rates more aggressively than suggested by a model without lower bound. Rational agents anticipate the possibility of reaching the lower bound in the future and this amplifies the effects of adverse shocks well before the bound is reached. While the empirical magnitude of U.S. mark-up shocks seems too small to entail zero nominal interest rates, shocks affecting the natural real interest rate plausibly lead to a binding lower bound. Under optimal policy, however, this occurs quite infrequently and does not require targeting a positive average rate of inflation.
    Keywords: nonlinear optimal policy, zero interest rate bound, commitment, liquidity trap, New Keynesian.
    JEL: C63 E31 E52
    Date: 2004–07
  13. By: Hans Peter Grüner (University of Mannheim, IZA, Bonn, and CEPR, London. Postal Address: University of Mannheim, Department of Economics, L7, 3-5, D-68131 Mannheim, Germany); Bernd Hayo (Philipps-University Marburg and ZEI, University of Bonn; Postal Address: Philipps-University Marburg, Department of Economics, (FB02), Universitaetsstr. 24, D-35032 Marburg, Germany); Carsten Hefeker (University of Siegen,HWWA, Hamburg, and CESifo, Munich; Postal Address:HWWA Institute of International Economics, Neuer Jungfernstieg 21, 20347 Hamburg, Germany)
    Abstract: Recent theoretical research has studied extensively the link between wage setting and monetary policymaking in unionized economies. This paper addresses the question of the role of monetary uncertainty from both an empirical and theoretical point of view. Our analysis is based on a simple model that derives the influence of monetary uncertainty on unionized wage setting. We construct an indicator of monetary policy uncertainty and test our model with data for the G5 countries. The central finding is that monetary policy uncertainty has a negative impact on nominal wage growth in countries where wage setting is relatively centralized. This result is consistent with recent theoretical approaches to central bank transparency and wage setting.
    Keywords: Monetary policy uncertainty; centralized wage setting; union behavior.
    JEL: E58
    Date: 2005–06
  14. By: Carl E.Walsh (Professor, University of California, Santa Cruz and Visiting Scholar, Federal Reserve Bank of San Francisco. Corresponding address: Department of Economics, University of California, Santa Cruz, CA 95064, USA)
    Abstract: In this paper, I evaluate the performance deterioration that occurs when the central bank employs an optimal targeting rule that is based on incorrect parameter values. I focus on two parameters — the degree of inflation inertia and the degree of price stickiness. I explicitly account for the effects of the structural parameters on the objective function used to evaluate outcomes, as well as on the model’s behavioral equations. The costs of using simple rules relative to the costs of parameter misspecification are also assessed.
    Keywords: Monetary Policy, Robustness, Misspecification.
    JEL: E52 E58
    Date: 2005–04
  15. By: Susan Athey (Stanford University and National Bureau of Economic Research,Stanford University, Stanford, CA 94305-6072, USA.); Andrew Atkeson (University of California, Los Angeles,CA, USA. Federal Reserve Bank of Minneapolis, and National Bureau of Economic Research.); Patrick J. Kehoe (Federal Reserve Bank of Minneapolis, University of Minnesota, and National Bureau of Economic Research)
    Abstract: How much discretion should the monetary authority have in setting its policy? This question is analyzed in an economy with an agreed-upon social welfare function that depends on the randomly fluctuating state of the economy. The monetary authority has private information about that state. In the model, well-designed rules trade off society’s desire to give the monetary authority discretion to react to its private information against society’s need to guard against the time inconsistency problem arising from the temptation to stimulate the economy with unexpected inflation. Although this dynamic mechanism design problem seems complex, society can implement the optimal policy simply by legislating an inflation cap that specifies the highest allowable inflation rate. The more severe the time inconsistency problem, the more tightly the cap constrains policy and the smaller is the degree of discretion. As this problem becomes sufficiently severe, the optimal degree of discretion is none.
    Keywords: Rules vs. discretion; time inconsistency; optimal monetary policy; inflation targets; inflation caps.
    JEL: E5 E6 E52 E58 E61
    Date: 2004–04
  16. By: Ulrich Bindseil (DG Human Resources, Budget and Organisation, European Central Bank)
    Abstract: Before 1914, there was little doubt that central bank policy meant first of all control of short term interest rates. This changed dramatically in the early 1920s with the birth of “reserve position doctrine” (RPD) in the US, according to which a central bank should, via open market operation, steer some reserve concept, which would impact via the money multiplier on monetary aggregates and ultimate goals. While the Fed returned to an unambiguous steering of short term interest rates only in the 1990s, for example the Bank of England never adopted RPD. This paper explains the astonishing rise and fall of RPD. The endurance of RPD is explained by a symbiosis of central bankers who may have partially sympathised with RPD since it masked their responsibility for short term interest rates, and academics who were too eager to simplify away some key features of money markets and central bank operations.
    Keywords: operational target of monetary policy, monetary policy instruments, monetary policy implementation, instruments’ choice problem
    JEL: E43 E52 B22
    Date: 2004–06
  17. By: Robert G. King (Boston University,Postal: 270 Bay State Road, Boston, MA 02215, USA.); Alexander L.Wolman (Federal Reserve Bank of Richmond P.O. Box 27622 Richmond VA 23261, USA.)
    Abstract: In a plain-vanilla New Keynesian model with two-period staggered price-setting, discretionary monetary policy leads to multiple equilibria. Complementarity between pricing decisions of forward-looking firms underlies the multiplicity, which is intrinsically dynamic in nature. At each point in time, the discretionary monetary authority optimally accommodates the level of predetermined prices when setting the money supply because it is concerned solely about real activity. Hence, if other firms set a high price in the current period, an individual firm will optimally choose a high price because it knows that the monetary authority next period will accommodate with a high money supply. Under commitment, the mechanism generating complementarity is absent: the monetary authority commits not to respond to future predetermined prices. Multiple equilibria also arise in other similar contexts where (i) a policymaker cannot commit, and (ii) forward-looking agents determine a state variable to which future policy responds.
    Keywords: monetary policy; discretion; time-consistency; multiple equilibria; complementarity.
    JEL: E5 E61 D78
    Date: 2004–05
  18. By: Andreas Schabert (University of Amsterdam, Department of Economics, Roeterstraat 11, 1018 WB Amsterdam,The Netherlands.); Christian Stoltenberg (Humboldt University Berlin, Department of Economics, D-10178 Berlin, Germany)
    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-ofperiod 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: Real balance effects; predetermined money; price level determination; real determinacy; monetary policy rules.
    JEL: E32 E41 E52
    Date: 2005–03
  19. By: Lars E. O. Svensson (Department of Economics, Fischer Hall, Princeton University, Princeton, NJ 08544-1021, United States)
    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 U.S. economy, one forward looking and one backward looking. A practical finite-horizon approximation is used. 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: Inflation targeting; optimal monetary policy; forecasts.
    JEL: E42 E52 E58
    Date: 2005–04
  20. By: James Yetman (School of Economics and Finance, University of Hong Kong, Pokfulam Road, Hong Kong.)
    Abstract: Price level targeting has been proposed as an alternative to inflation targeting that may confer benefits if a central bank sets policy under discretion, even if society’s loss function is specified in terms of inflation (instead of price level) volatility. This paper demonstrates the sensitivity of this argument. If even a small portion of agents use a rule-of-thumb to form inflation expectations, or does not fully understand the nature of the target, price level targeting may in fact impose costs on society rather than benefits. While rational expectations and perfect credibility are generally beneficial with either a price level or an inflation target, an inflation target is more robust to alternative assumptions. These results suggest that caution should be exercised in considering a price level target as the basis for monetary policy, unless society has preferences specified in terms of price level, rather than inflation, volatility.
    Keywords: Price Level Targeting; Inflation Targeting; Credibility; Free Lunch; Discretion.
    JEL: E52
    Date: 2003–11
  21. By: Ignazio Angeloni (Dipartimento del Tesoro, Mnistero dell'Economia e delle Finanze.); Michael Ehrmann (Directorate General Research, European Central Bank, Kaiserstrasse, 29, 60311, Frankfurt am Main, Germany.)
    Abstract: We build a stylised 12-country model of the euro area and use it to analyse why differences in national inflation and growth rates arise within the European monetary union. We find that inflation persistence is a key potential explanatory factor. Other more frequently mentioned reasons, like country-specific shocks or differences in the monetary transmission mechanism across countries, count less. We also look at how a monetary policy geared to area-wide average inflation affects these differentials. Our model suggests that area-wide inflation stability and low inflation differentials are complementary.
    Keywords: Currency union; inflation differentials; inflation persistence; euro area.
    JEL: E31 E32 E52 F42
    Date: 2004–09
  22. By: Andreas Schabert (University of Amsterdam, Department of Economics, Roeterstraat 11, 1018 WB Amsterdam,The Netherlands)
    Abstract: In this paper, we analyze the relation between interest rate targets and money supply in a (bubble-free) rational expectations equilibrium of a standard cash-in-advance model. We examine contingent monetary injections aimed to implement interest rate sequences that satisfy interest rate target rules. An interest rate target with a positive inflation feedback in general corresponds to money growth rates rising with inflation. When prices are not completely flexible, this implies that a non-destabilizing money supply cannot implement a forward-looking and active interest rate rule. This principle also applies for an alternative model version with an interest elastic money demand. The implementation of a Taylor-rule then requires a money supply that leads to explosive or oscillatory equilibrium sequences. In contrast, an inertial interest rate target can be implemented by a non-destabilizing money supply, even if the inflation feedback exceeds one, which is often found in interest rate rule regressions.
    Keywords: Interest rate rules; contingent money supply; macroeconomic stability; policy equivalence; interest rate inertia.
    JEL: E52 E41 E32
    Date: 2005–05
  23. By: Paolo Surico (Istituto di Economia Politica, Università Bocconi,Via Gobbi 5, 20136 Milan, Italy.)
    Abstract: This paper offers an alternative explanation for the behavior of postwar US inflation by measuring a novel source of monetary policy time-inconsistency due to Cukierman (2002). In the presence of asymmetric preferences, the monetary authorities end up generating a systematic inflation bias through the private sector expectations of a larger policy response in recessions than in booms. Reduced-form estimates of US monetary policy rules indicate that while the inflation target declines from the pre- to the post-Volcker regime, the average inflation bias, which is about one percent before 1979, tends to disappear over the last two decades. This result can be rationalized in terms of the preference on output stabilization, which is found to be large and asymmetric in the former but not in the latter period.
    Keywords: Asymmetric preferences; time-inconsistency; average inflation bias; US inflation.
    JEL: E52 E58
    Date: 2003–11
  24. By: Federico Ravenna (Economics Department, 401 E2 Building, University of California, Santa Cruz, CA 95064, US)
    Abstract: This paper shows that the credibility gain from permanently committing to a fixed exchange rate by joining the European Monetary Union can outweigh the loss from giving up independent monetary policy. When the central bank enjoys only limited credibility a pegged exchange rate regime yields a lower loss compared to an inflation targeting policy, even if this policy ranking would be reversed in a fullcredibility environment. There exists an initial stock of credibility that must be achieved for a policy-maker to adopt inflation targeting over a strict exchange rate targeting regime. Full credibility is not a precondition, but exposure to foreign and financial shocks and high steady state inflation make joining the EMU relatively more attractive for a given level of credibility. The theoretical results are consistent with empirical evidence we provide on the relationship between credibility and monetary regimes using a Bank of England survey of 81 central banks.
    Keywords: Inflation targeting; Credibility; Open Economy; Exchange Rate. Regimes, Monetary Policy
    JEL: E52 E31 F02 F41
    Date: 2005–08
  25. By: Keith Küster (Johann-Wolfgang-Goethe Universität, Mertonstrasse 17, D-60325 Frankfurt am Main, Germany); Volker Wieland (Professur für Geldtheorie und -politik, Johann-Wolfgang-Goethe Universität, Mertonstrasse 17, D-60325 Frankfurt am Main, Germany)
    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: Model uncertainty; robustness; monetary policy rules; minimax; euro area.
    JEL: E52 E58 E61
    Date: 2005–04
  26. By: Michael Ehrmann (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany); Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany)
    Abstract: The paper assesses the communication strategies of the Federal Reserve, the Bank of England and the European Central Bank and their effectiveness. We find that the effectiveness of communication is not independent from the decisionmaking process in the committee. The paper shows that the Federal Reserve has been pursuing a rather individualistic communication strategy amid a collegial approach to decision-making, while the Bank of England is using a collegial communication strategy and highly individualistic decision-making. The ECB has chosen a collegial approach both in its communication and in its decisionmaking. Assessing these strategies, we find that predictability of policy decisions and the responsiveness of financial markets to communication are equally good for the Federal Reserve and the ECB. This suggests that there may not be a single best approach to designing a central bank communication and decisionmaking strategy.
    Keywords: Communication; monetary policy; committee; effectiveness; strategies; Federal Reserve; Bank of England; European Central Bank.
    JEL: E43 E52 E58 G12
    Date: 2005–05
  27. By: Bjørn-Roger Wilhelmsen (Norges Bank, Bankplassen 2, 0107 Oslo, Norway); Andrea Zaghini (Banca d’Italia, Servizio Studi, Via Nazionale 91, 00184 Roma, Italy)
    Abstract: The paper evaluates the ability of market participants to anticipate monetary policy decisions in the euro area and in 13 other countries. First, by looking at the magnitude and the volatility of the changes in the money market rates we show that the days of policy meetings are special days for financial markets. Second, we find that the predictability of the ECB’s monetary policy is fully comparable (and sometimes slightly better) to that of the FED and the Bank of England. Finally, an econometric analysis of the ability of market participants to incorporate in the current money rates the expected changes in the key policy rate shows that in the euro area policy decisions are anticipated well in advance.
    Keywords: Monetary policy; Predictability; Money market rates.
    JEL: E4 E5 G1
    Date: 2005–07
  28. By: Christian Ewerhart (Institute for Empirical Research in Economics (IEW), University of Zurich, Bluemlisalpstrasse 10, CH-8006 Zurich, Switzerland.); Nuno Cassola (European Central Bank, Postfach 160319, 60311 Frankfurt am Main, Germany); Steen Ejerskov (European Central Bank, Postfach 160319, 60311 Frankfurt am Main, Germany); Natacha Valla (Banque de France, Paris, France)
    Abstract: On several occasions during the period 2001-2003, the European Central Bank (ECB) decided to deviate from its “neutral” benchmark allotment rule, with the effect of not alleviating a temporary liquidity shortage in the banking system. This is remarkable because it implied the possibility of short-term interest rates raising significantly above the main policy rate. In the present paper, we show that when the monetary authority cares for both liquidity and interest rate conditions, the optimal allotment policy may entail a discontinuous reaction to initial conditions. More precisely, we prove that there is a threshold level for the accumulated aggregate liquidity position in the banking system prior to the last operation in a given maintenance period, so that the benchmark allotment is optimal whenever liquidity conditions are above the threshold, and a tight allotment is optimal whenever liquidity conditions are below the threshold.
    Keywords: euro; monetary policy instruments; operational framework; refinancing operations.
    JEL: E43 E52
    Date: 2003–12
  29. By: Tomasz Lyziak (National Bank of Poland, Bureau of Macroeconomic Research, ul. ?wi?tokrzyska 11/21, 00-919 Warsaw, Poland.)
    Abstract: Inflation expectations constitute a subject of particular contemporary interest to central banks, especially those pursuing a monetary policy based on a strategy of direct inflation targeting. Macroeconomic theory indicates that the transmission of monetary policy impulses and their impact on the real and nominal sectors of the economy bear a close relationship to properties of inflation expectations. Qualitative data on inflation expectations, as obtained from surveys, can be quantified with the use of probability or regression methods. This paper presents the results of two versions of the probability method, implemented in order to estimate numerical measures of Polish consumer inflation expectations, based on the monthly Ipsos-Demoskop survey. In addition, the unbiasedness and macroeconomic efficiency of Polish consumer inflation expectations are tested, as are the way in which these are formed. The pattern of responses to the survey question and quantified measures of Polish consumer inflation expectations are also compared with the respective findings for the euro area.
    Keywords: Inflation expectations; Surveys; Rationality; Poland; Euro Area.
    JEL: C42 D12 D84 E58
    Date: 2003–11
  30. By: Günter Coenen (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt/Main, Germany.); Volker Wieland (Professur für Geldtheorie und -politik, Johann-Wolfgang-Goethe Universität, Mertonstrasse 17, D-60325 Frankfurt am Main, Germany.)
    Abstract: In this paper, we study the effectiveness of monetary policy in a severe recession and deflation when nominal interest rates are bounded at zero. We compare two alternative proposals for ameliorating the effect of the zero bound: an exchange-rate peg and price-level targeting. We conduct this quantitative comparison in an empirical macroeconometric model of Japan, the United States and the euro area. Furthermore, we use a stylized micro-founded two-country model to check our qualitative findings. We find that both proposals succeed in generating inflationary expectations and work almost equally well under full credibility of monetary policy. However, price-level targeting may be less effective under imperfect credibility, because the announced price-level target path is not directly observable.
    Keywords: monetary policy rules; zero-interest-rate bound; liquidity trap; nominal rigidities; exchange rates.
    JEL: E31 E52 E58 E61
    Date: 2004–04
  31. By: Christian Ewerhart (Institute for Empirical Research in Economics (IEW)); Nuno Cassola (European Central Bank, DG Market Operations); Steen Ejerskov (Danmarks Nationalbank, Economics); Natacha Valla (Banque de France (Bank of France))
    Abstract: We model the interbank market for overnight credit with heterogeneous banks and asymmetric information. An unsophisticated bank just trades to compensate its liquidity imbalance, while a sophisticated bank will exploit its private information about the liquidity situation in the market. It is shown that with positive probability, the liquidity effect (Hamilton, 1997) is reversed, i.e., a liquidity drainage from the banking system may generate an overall decrease in the market rate. The phenomenon does not disappear when the number of banks increases. We also show that private information mitigates the effect of an unexpected liquidity shock on the market rate, suggesting a conservative information policy from a central bank perspective.
    Keywords: Liquidity effect, asymmetric information, monetary policy implementation.
    JEL: G14 G21 E52
    Date: 2004–07
  32. By: George Hondroyiannis (Economic Research Department, Bank of Greece); Sophia Lazaretou (Economic Research Department, Bank of Greece)
    Abstract: The paper estimates inflation persistence in Greece from 1975 to 2003, a period of high variation in inflation and changes in policy regimes. Two empirical methodologies, univariate autoregressive (AR) modelling and second-generation random coefficient (RC) modelling, are employed to estimate inflation persistence. The empirical results from all the procedures suggest that inflation persistence was high during the inflationary period and the first six years of the disinflationary period, while it started to decline after 1997, when inflationary expectations seem to have been stabilised, and thus, monetary policy was effective at reducing inflation. Empirical findings also detect a sluggish response of inflation to changes in monetary policy. This observed delay seems to have changed little over time.
    Keywords: CPI inflation, persistence, structural change.
    JEL: E31 E37
    Date: 2004–06
  33. By: Liam Graham (Corresponding author : Department of Economics, University of Warwick, Coventry, CV4 7AL, UK.); Dennis J. Snower (Department of Economics, Birkbeck College, University of London, 7 Gresse Street, London W1P 2LL, UK.)
    Abstract: We analyse the effects of money growth within a standard New Keynesian framework and show that the interaction between staggered nominal contracts and money growth leads to a long-run trade-off between output and money growth. We explore the microeconomic mechanisms that lead to this trade-off, and show that it remains even when the contract length is endogenised.
    Keywords: Inflation; unemployment; Phillips curve; nominal inertia; monetary policy; dynamic general equilibrium.
    JEL: E20 E40 E50
    Date: 2004–11
  34. By: Gregory Gadzinski (GREQAM, Université de la Mediterraneé.); Fabrice Orlandi (Corresponding author: DG Economics, EU Countries Division, Forecasting and Monitoring Unit; European Central Bank, Kaiserstrasse 29, D-60311, Frankfurt am Main, Germany.)
    Abstract: In this paper we report results on inflation persistence using 79 inflation series covering the EU countries, the euro area and the US for five different inflation variables. The picture that emerges is one of moderate inflation persistence across the board. In particular we find euro area inflation persistence to be broadly in line with US inflation persistence. The issue of allowing for intercept dummies in the underlying inflation models is found to be of paramount importance to avoid overestimation of the level of persistence. The use of alternative measures of persistence is found to be commendable on the grounds that they complement each other in practice.
    Keywords: Inflation dynamics; structural change; median unbiased estimates.
    JEL: E31 E52 C22 C12
    Date: 2004–11
  35. By: Laurent Bilke (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany)
    Abstract: This paper uses disaggregated CPI time series to show that a break in the mean of French inflation occurred in the mid-eighties and that the 1983 monetary policy shift mostly accounted for it. CPI average yearly growth declined from nearly 11% before the break date (May 1985) to 2.1% after. No other break in the 1973-2004 sample period can be found. Controlling for this mean break, both aggregate and sectoral inflation persistence are stable and low, with the unit root lying far in the tail of the persistence estimates. However, persistence differs dramatically across sectors. Finally, the duration between two price changes (at the firm level) appears positively related with inflation persistence (at the aggregate level).
    Keywords: Multiple breaks test; inflation persistence; monetary policy; sectoral prices.
    JEL: E31 C12 C22
    Date: 2005–03
  36. By: Barbara Annicchiarico (Ceis, Facoltà di Economia, Università di Roma “Tor Vergata”,Via Columbia 2, 00133 Rome, Italy.)
    Abstract: This paper investigates the inflationary effects of fiscal policy in an optimising general equilibrium monetary model with capital accumulation, flexible prices and wealth effects. The model is calibrated to Euro Area quarterly data. Simulation results show that government deficits, high debt level and slow fiscal adjustment adversely affect price stability in the presence of an independent monetary authority adopting a monetary targeting regime. The mechanism through which fiscal policy affects the dynamics of the price level presents monetarist properties, since the price level is determined in the monetary market. The effects produced by fiscal expansions on price dynamics are due to the behaviour of consumers, sharing the burden of fiscal adjustment with future generations. Fiscal variables are shown to influence the consumption plan of individuals and the demand for real money balances, thus affecting the equilibrium conditions in the money market where the price level is determined.
    Keywords: Price Stability; Fiscal Policy and Government Debt.
    JEL: E31 E62
    Date: 2003–11
  37. By: Schadler, Susan; Drummond, Paulo Flavio Nacif; Kuijs, Louis; Murgasova, Zuzana; van Elkan, Rachel
    Abstract: Upon entry into the European Union (EU), countries become members of the Economic and Monetary Union (EMU), with a derogation from adopting the euro as their currency (that is, each country joining the EU commits to replace its national currency with the euro, but can choose when to request permission to do so). For most of these countries, adopting the euro will entail major economic change. This paper examines likely economic developments and policy challenges for the five former transition countries in central Europe--the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia--that joined the EU in May 2004 and operate independent monetary policies but have not yet achieved policy convergence with the rest of the euro area.
    Date: 2005
  38. By: João Sousa (Banco de Portugal,Av. Almirante Reis 71, P-1150-012 Lisbon, Portugal.); Andrea Zaghini (European Central Bank, Directorate Monetary Policy, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.)
    Abstract: This paper analyses the international transmission of monetary shocks with a special focus on the effects of foreign money ("global liquidity") on the euro area. We estimate structural VAR models for the euro area and the global economy including a global liquidity aggregate. The impulse responses obtained show that a positive shock to extra-euro area liquidity leads to permanent increases in the euro area M3 aggregate and the price level, a temporary rise in real output and a temporary appreciation of the real effective exchange rate of the euro. Moreover, we find that innovations in global liquidity play an important role in explaining price and output fluctuations in the euro area and in the global economy.
    Keywords: Monetary policy; Structural VAR; International spillovers.
    JEL: E52 F01
    Date: 2004–02
  39. By: Florin O. Bilbiie (Nuffield College, University of Oxford, New Road, Oxford, OX1 1NF, United Kingdom.)
    Abstract: When enough agents do not participate in asset markets, the slope of the aggregate demand curve is reversed. Monetary policy should be passive, to ensure equilibrium determinacy and to minimize variations in output and inflation. This paper presents evidence that asset markets participation in the US was limited over the Great Inflation period and the slope of the IS curve had the ’wrong’ sign. Our results may help explain the ’Great Inflation’ and give optimism for FED policy. If the economy was characterized by a relatively higher degree of financial frictions over that period: (i) policy implied a determinate equilibrium and ruled out sunspot fluctuations; (ii) policy was closer to optimal than conventional wisdom dictates; (iii) responses and variability of macroeconomic variables conditional upon fundamental shocks are close to their estimated counterparts for a wide range of reasonable parameterizations. Notably, ’cost-push’ shocks are enough to generate a Great Inflation.
    Keywords: The Great Inflation; monetary policy rules; Taylor Principle; real (in)determinacy; limited asset markets participation.
    JEL: E31 E32 E44 E58 E65
    Date: 2004–11
  40. By: Annick Bruggeman (National Bank of Belgium, Boulevard de Berlaimont 14, B-1000 Brussels, Belgium); Gonzalo Camba-Méndez (European Central Bank, Kaiserstraße 29, D-60311 Frankfurt am Main, Germany); Björn Fischer (European Central Bank, Kaiserstraße 29, D-60311 Frankfurt am Main, Germany); João Sousa (Bank of Portugal, Rua Francisco Ribeiro 2, P-1100-150, Lisboa, Portugal)
    Abstract: The quantity theory of money predicts a positive relationship between monetary growth and inflation over long-run horizons. However, in the short-run, transitory shocks to either money or inflation can obscure the inflationary signal stemming from money. The spectral analysis of time series provides filtering tools for removing fluctuations associated with certain frequency movements. However, use of these techniques in isolation is often criticised as being an oversimplistic statistical exercise potentially void of economic content. The objective of this paper is to develop ‘structural’ filtering techniques that rely on the use of spectral analysis in combination with a structural economic model with well identified shocks. A ‘money augmented’ Phillips curve that links inflation to money tightness and demand shocks of medium to long-term persistence is presented. It is shown that medium to long-term movements in inflation are mostly associated with the estimated monetary indicators.
    Keywords: Inflation; Money.
    JEL: E31 E50 C32
    Date: 2005–04
  41. By: Ulrich Bindseil (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Gonzalo Camba-Mendez (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Astrid Hirsch (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Benedict Weller (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper explains to what extent excess reserves are and should be relevant today in the implementation of monetary policy, focusing on the specific case of the operational framework of the Eurosystem. In particular, this paper studies the impact that changes to the operational framework for monetary policy implementation have on the level and volatility of excess reserves. A ‘transaction costs’ model that replicates the rather specific intra-reserve maintenance period pattern of excess reserves in the euro area is developed. Simulation results presented not only show that excess reserves may increase considerably under some changes to the operational framework, but also that their volatility and hence unpredictability could.
    Keywords: excess reserves; monetary policy implementation; liquidity management.
    JEL: E52 E58
    Date: 2004–05
  42. By: Marco Del Negro (Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree St NE, Atlanta GA 30309-4470, USA); Frank Schorfheide (Department of Economics, 3718 Locust Walk, University of Pennsylvania, Philadelphia, PA 19104-6297, USA)
    Abstract: This paper proposes a novel method for conducting policy analysis with potentially misspecified dynamic stochastic general equilibrium (DSGE) models and applies it to a New Keynesian DSGE model along the lines of Christiano, Eichenbaum, and Evans (JPE 2005) and Smets and Wouters (JEEA 2003). Specifically, we are studying the effects of coefficient changes in interest-rate feedback rules on the volatility of output growth, inflation, and nominal rates. The paper illustrates the sensitivity of the results to assumptions on the policy invariance of model misspecifications.
    Keywords: Bayesian Analysis; DSGE Models; Model Misspecification.
    JEL: C32
    Date: 2005–04
  43. By: Andrew T. Levin (Federal Reserve Board of Governors); Fabio M. Natalucci (Federal Reserve Board of Governors); Jeremy M. Piger (Federal Reserve Bank of St. Louis, Research Department)
    Abstract: We find evidence that adopting an explicit inflation objective plays a role in anchoring long-run inflation expectations and in reducing the intrinsic persistence of inflation. For the period 1994-2003, private-sector long-run inflation forecasts exhibit significant correlation with lagged inflation for a number of industrial economies, including the United States. In contrast, this correlation is largely absent for the five countries that maintained explicit inflation objectives over this period, indicating that these central banks have been reasonably successful in delinking expectations from realized inflation. We also show that the null hypothesis of a random walk in core CPI inflation can be clearly rejected for four of these five countries, but not for most of the other industrial countries. Finally, we provide some evidence concerning the initial effects of the adoption of explicit inflation objectives in a number of emerging-market economies.
    Keywords: Inflation expectations, Consensus Forecasts, inflation persistence.
    JEL: E31 E52 E58
    Date: 2004–08
  44. By: Fabrice Collard (CNRS-GREMAQ, Manufacture des Tabacs, bât. F, 21 allée de Brienne, 31000 Toulouse, France.); Harris Dellas (Department of Economics, University of Bern, CEPR, IMOP. Address:VWI, Gesellschaftsstrasse 49, CH 3012 Bern, Switzerland.)
    Abstract: Was the high inflation of the 1970s mostly due to incomplete information about the structure of the economy (an unavoidable mistake as suggested by Orphanides, 2000)? Or, to weak reaction to expected inflation and/or excessive policy activism that led to indeterminacies (a policy mistake, a scenario suggested by Clarida, Gali and Gertler, 2000)? We study this question within the NNS model with policy commitment and imperfect information, requiring that the model have satisfactory overall empirical performance. We find that both explanations do a good job in accounting for the great inflation. Even with the commonly used specification of the interest policy rule, high and persistent inflation can occur following a significant productivity slowdown if policymakers significantly and persistently underestimate ”core” inflation.
    Keywords: Inflation; imperfect information; Kalman filter; policy rule; indeterminacy.
    JEL: E32 E52
    Date: 2004–04
  45. By: Julius Moschitz (Universitat Autònoma de Barcelona, Dept. d’Economia i d’Història Econòmica, 08193 Bellaterra, Barcelona, Spain.)
    Abstract: The overnight interest rate is the price paid for one day loans and defines the short end of the yield curve. It is the equilibrium outcome of supply and demand for bank reserves. This paper models the intertemporal decision problems in the reserve market for both central and commercial banks. All important institutional features of the euro area reserve market are included. The model is then estimated with euro area data. A permanent change in reserve supply of one billion euro moves the overnight rate by eight basis points into the opposite direction, hence, there is a substantial liquidity effect. Most of the predictable patterns for the mean and the volatility of the overnight rate are related to monetary policy implementation, but also some calendar day effects are present. Banks react sluggishly to new information. Implications for market efficiency, endogeneity of reserve supply and underbidding are studied.
    Keywords: Money markets; EONIA rate; Liquidity effect; Central bank operating procedures.
    JEL: E52 E58 E43
    Date: 2004–09
  46. By: Björn Fischer (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany); Petra Köhler (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany); Franz Seitz (Fachhochscule Amberg-Weiden)
    Abstract: The present paper analyses currency in circulation in the euro area since the beginning of the 1980s. After a comprehensive literature review on this topic we present some stylised facts on currency holdings in the euro area countries as well as at an aggregate euro area level. The next chapter develops a theoretical model, which extends traditional money demand models to also incorporate arguments for the informal economy and foreign demand for specific currencies. In the empirical sections we first estimate the demand for euro legacy currencies in total and for small and large denominations within a cointegration framework. We find significant differences between the determinants of holdings of small and large denominations as well as overall currency demand. While small-value banknotes are mainly driven by domestic transactions, the demand for large-value banknotes depends on a short-term interest rate, the exchange rate of the euro as a proxy for foreign demand and inflation variability. Large-value banknotes seem to be therefore used to an important extent as a store of value domestically and abroad. As monetary policy is mainly interested in getting information on the demand for currency used for domestic transactions we also try several approaches in this direction. All the methods applied result in rather low levels of transaction balances used within the euro area of around 25% to 35% of total currency. After this we deal with possibly changing cost-benefit-considerations of the use of cash due to the introduction of euro notes and coins. Overall, there seems no evidence so far of a substantial decline of the demand for currency in the euro area. The analysis of currency in circulation and in particular estimates on the share of currency which is likely to be used for domestic transactions therefore help to explain monetary developments and are informative for monetary policy.
    Keywords: currency in circulation; Cointegration; Purposes of holding currency
    JEL: E41 E52 E58
    Date: 2004–04
  47. By: Alistair Dieppe (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Keith Küster (Chair for Monetary Theory and Policy, Johann Wolfgang Goethe-University Postbox 94, D-60054 Frankfurt/Main.); Peter McAdam (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: In this paper, we analyze optimal monetary policy rules in a model of the euro area, namely the ECB’s Area Wide Model, which embodies a high degree of intrinsic persistence and a limited role for forward-looking expectations. These features allow us, in large measure, to differentiate our results from many of those prevailing in New Keynesian paradigm models. Specifi- cally, our exercises involve analyzing the performance of various generalized Taylor rules both from the literature and optimized to the reference model. Given the features of our modelling framework, we find that optimal policy smoothing need only be relatively mild. Furthermore, there is substantial gain from implementing forecast-based as opposed to outcome-based policies with the optimal forecast horizon for inflation ranging between two and three years. Benchmarking against fully optimal policies, we further highlight that the gain of additional states in the rule may compensate for a reduction of communicability. Thus, the paper contributes to the debate on optimal monetary policy in the euro area, as well as to the conduct of monetary policy in face of substantial persistence in the transmission mechanism.
    Keywords: euro area; monetary policy rule; optimization.
    JEL: E4 E5
    Date: 2004–05
  48. By: Ulrich Bindseil (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Tobias Linzert (Goethe University Frankfurt, Department of Economics, Mertonstr. 17-21, 60054 Frankfurt am Main, Germany.); Dieter Nautz (Goethe University Frankfurt, Department of Economics, Mertonstr. 17-21, 60054 Frankfurt am Main, Germany.)
    Abstract: This paper employs individual bidding data to analyze the empirical performance of the longer term refinancing operations (LTROs) of the European Central Bank (ECB). We investigate how banks’ bidding behavior is related to a series of exogenous variables such as collateral costs, interest rate expectations, market volatility and to individual bank characteristics like country of origin, size, and experience. Panel regressions reveal that a bank’s bidding depends on bank characteristics. Yet, different bidding behavior generally does not translate into differences concerning bidder success. In contrast to the ECB’s main refinancing operations, we find evidence for the winner’s curse effect in LTROs. Our results indicate that LTROs do neither lead to market distortions nor to unfair auction outcomes.
    Keywords: Monetary Policy Instruments of the ECB; Auctions; Winner’s Curse; Panel Analysis of Bidding Behavior.
    JEL: E52 D44
    Date: 2004–05
  49. By: Michael Ehrmann (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt/Main, Germany;); Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt/Main, Germany;)
    Abstract: This paper analyses the effects of US monetary policy on stock markets. We find that, on average, a tightening of 50 basis points reduces returns by about 3%. Moreover, returns react more strongly when no change had been expected, when there is a directional change in the monetary policy stance and during periods of high market uncertainty. We show that individual stocks react in a highly heterogeneous fashion and relate this heterogeneity to financial constraints and Tobin's q. First, we show that there are strong industry-specific effects of US monetary policy. Second, we find that for the individual stocks comprising the S&P500 those with low cashflows, small size, poor credit ratings, low debt to capital ratios, high price-earnings ratios or high Tobin's q are affected significantly more. The use of propensity score matching allows us to distinguish between firmand industry-specific effects, and confirms that both play an important role.
    Keywords: monetary policy; stock market; credit channel; Tobin’s q; financial constraints; S&P500; propensity score matching.
    JEL: G14 E44 E52
    Date: 2004–05
  50. By: Carsten Detken (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Frank Smets (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: The paper aims at deriving some stylised facts for financial, real, and monetary policy developments during asset price booms. We observe various macroeconomic variables in a pre-boom, boom and post-boom phase. Not all booms lead to large output losses. We analyse the differences between highcost and low-cost booms. High-cost booms are clearly those in which real estate prices and investment crash in the post-boom periods. In general it is difficult to distinguish a high-cost from a low-cost boom at an early stage. However, high-cost booms seem to follow very rapid growth in the real money and real credit stocks just before the boom and at the early stages of a boom. There is also evidence that high-cost booms are associated with significantly looser monetary policy conditions over the boom period, especially towards the late stage of a boom. We finally discuss the results with regard to the theoretical literature.
    Keywords: asset price booms; asset price bubbles; optimal monetary policy; over-investment; real estate prices.
    JEL: E44 E52 E58
    Date: 2004–05
  51. By: Albert Marcet (Institut d’Anàlisi Econòmica (CSIC), and Departament d’Economia i Empresa,Universitat Pompeu Fabra, C/ Ramon Trias Fargas, 23-25, 08005, Barcelona, Spain;); Juan Pablo Nicolini (Universidad Torcuato Di Tella, C/Miñones 2177, C1428ATG Buenos Aires, Argentina)
    Abstract: This paper studies the short run correlation of inflation and money growth. We study whether a model of learning does better or worse than a model of rational expectations, and we focus our study on countries of high inflation. We take the money process as an exogenous variable, estimated from the data through a switching regime process. We find that the rational expectations model and the model of learning both offer very good explanations for the joint behavior of money and prices.
    Keywords: Inflation and money growth; switching regimes; quasi-rationality.
    JEL: D83 E17 E31
    Date: 2005–04
  52. By: Juan de Dios Tena; Francesco Giovannoni
    Abstract: This paper studies the effect of market structure and macroeconomic uncertainty on the transmission of monetary policy. We motivate our analysis with a simple model which predicts that: 1) investment and production in more concentrated sectors are more affected by demand changes and 2) high uncertainty makes investment and production more sensitive to demand changes. The empirical analysis estimates the effect of monetary shocks on sectoral output for different sectors in the US using different structural vector autoregressive VAR approaches. The results are largely consistent with the proposed theory.
    Keywords: Market concentration, macroeconomic uncertainty, monetary policy transmission, vector autoregressive models.
    JEL: E22 E32 E52 D43
    Date: 2005–08
  53. By: Ester Faia (Universitat Pompeu Fabra, Ramon Trias Fargas 25, Barcelona, Spain.); Tommaso Monacelli (IGIER Universita’ Bocconi,Via Salasco 3/5, 20136 Milan, Italy.)
    Abstract: We analyze welfare maximizing monetary policy in a dynamic two-country model with price stickiness and imperfect competition. In this context, a typical terms of trade externality affects policy interaction between independent monetary authorities. Unlike the existing literature, we remain consistent to a public finance approach by an explicit consideration of all the distortions that are relevant to the Ramsey planner. This strategy entails two main advantages. First, it allows an accurate characterization of optimal policy in an economy that evolves around a steady-state which is not necessarily efficient. Second, it allows to describe a full range of alternative dynamic equilibria when price setters in both countries are completely forwardlooking and households’ preferences are not restricted. In this context, we study optimal policy both in the long-run and along a dynamic path, and we compare optimal commitment policy under Nash competition and under cooperation. By deriving a second order accurate solution to the policy functions, we also characterize the welfare gains from international policy cooperation.
    Keywords: Optimal Monetary Policy; Ramsey planner; Nash equilibrium; Cooperation; sticky prices; imperfect competition.
    JEL: E52 F41
    Date: 2004–04
  54. By: Carlos Andrés Amaya
    Abstract: This paper is concerned with interest rate setting by commercial banks and how the transmission of monetary policy is re°ected in these rates. For this purpose we study the case of the Colombian banking industry for the period 1996-2004. Using microdata, the Certi¯cate of Deposit(CD) market and the credit market are studied for a balanced panel of 21 and 16 banks, respectively. The paper motivates the discussion with a theoretical model that explains how banks set their interest rates and how these are a®ected by the policy rate. Overcoming some of the empirical di±culties presented in other studies, this paper deals with them by performing panel unit root tests and panel cointegration tests. The results suggest that the transmission of the policy rate to the CD rate and the credit rate is on average high and quick. Additionally, rates react strongly to in°ation shocks, specially credit rates. Finally, the evidence presented shows the importance of banks' characteristics and in°ation as long-run drivers of interest rates.
    Keywords: Banks, Monetary Policy, Interest Rates, Panel Data
    JEL: C33 E43 E52 E58
  55. By: Lawrence Christiano (Department of Economics, Northwestern University, 2001 Sheridan Road, Evanston, Illinois 60208, USA); Roberto Motto (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany); Massimo Rostagno (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany)
    Abstract: We evaluate the Friedman-Schwartz hypothesis that a more accommodative monetary policy could have greatly reduced the severity of the Great Depression. To do this, we first estimate a dynamic, general equilibrium model using data from the 1920s and 1930s. Although the model includes eight shocks, the story it tells about the Great Depression turns out to be a simple and familiar one. The contraction phase was primarily a consequence of a shock that induced a shift away from privately intermediated liabilities, such as demand deposits and liabilities that resemble equity, and towards currency. The slowness of the recovery from the Depression was due to a shock that increased the market power of workers. We identify a monetary base rule which responds only to the money demand shocks in the model. We solve the model with this counterfactual monetary policy rule. We then simulate the dynamic response of this model to all the estimated shocks. Based on the model analysis, we conclude that if the counterfactual policy rule had been in place in the 1930s, the Great Depression would have been relatively mild.
    Keywords: General equilibrium; Lower bound; Deflation; Shocks
    JEL: E31 E40 E51 E52 E58 N12
    Date: 2004–03
  56. By: Alfred A. Haug (Department of Economics, York University); William G. Dewald (Ohio State University, Department of Economics.)
    Abstract: We study how fluctuations in money growth correlate with fluctuations in real and nominal output growth and inflation. We pick cycles from each time series that last 2 to 8 (business cycles) and 8 to 40 (longer-term cycles) years, using band-pass filters. We employ a data set from 1880 to 2001 for eleven countries, without gaps. Fluctuations in money growth do not play a systematic and important role at the business cycle frequency. However, money growth leads or contemporaneously affects nominal output growth and inflation in the longer run. This result holds despite differences in policies and institutions across countries.
    Keywords: Band-pass filters; 2 to 8 year cycles; 8 to 40 year cycles.
    JEL: E3
    Date: 2004–08
  57. By: Robert-Paul Berben (De Nederlandsche Bank, Monetary and Economic Policy Department, Westeinde 1, P.O. Box 98, 1017 ZN Amsterdam, Netherlands.); Alberto Locarno (Banca d´Italia,Via Nazionale 91, 00184 Rome, Italy.); Julian Morgan (European Central Bank, Kaiserstrasse 29, D-60311, Frankfurt am Main, Germany.); Javier Valles (Banco de España, Research Department, Alcalá 50, 28014 Madrid, Spain.)
    Abstract: This paper examines possible explanations for observed differences in the transmission of euro area monetary policy in central bank large-scale macroeconomic models. In particular it considers the extent to which these differences are due to differences in the underlying economies or (possibly unrelated) differences in the modelling strategies adopted for each country. It finds that, against most yardsticks, the cross-country variations in the results are found to be plausible in the sense that they correspond with other evidence or observed characteristics of the economies in question. Nevertheless, the role of differing modelling strategies may also play a role. Important features of the models - for instance in the treatment of expectations or wealth - can have a major bearing on the results that may not necessarily reflect differences in the underlying economies.
    Keywords: Monetary transmission; macroeconometric models; euro area differences.
    JEL: C53 E52 E37
    Date: 2004–10
  58. By: Gonzalo Camba-Méndez (Corresponding author. European Central Bank, Kaiserstrasse 29, D-60311, Frankfurt am Main, Germany.); George Kapetanios (Department of Economics, Queen Mary, University of London, Mile End Road, London E1 4N, United Kingdom.)
    Abstract: Standard measures of prices are often contaminated by transitory shocks. This has prompted economists to suggest the use of measures of underlying inflation to formulate monetary policy and assist in forecasting observed inflation. Recent work has concentrated on modelling large datasets using factor models. In this paper we estimate factors from datasets of disaggregated price indices for European countries. We then assess the forecasting ability of these factor estimates against other measures of underlying inflation built from more traditional methods. The power to forecast headline inflation over horizons of 12 to 18 months is adopted as a valid criterion to assess forecasting. Empirical results for the five largest euro area countries as well as for the euro area are presented.
    Keywords: Core Inflation; Dynamic Factor Models; Forecasting.
    JEL: E31 C13 C32
    Date: 2004–11
  59. By: Andrea Ferrero (Department of Economics, New York University, 269 Mercer Street – 7th floor, New York, NY 10003, USA)
    Abstract: This paper addresses the question of the joint conduct of fiscal and monetary policy in a currency union. The problem is studied using a two-country DSGE framework with staggered price setting, monopolistic competition in the goods market, distortionary taxation and nominal debt. The two countries form a currency union but retain fiscal policy independence. The policy problem can be cast in terms of a tractable linear-quadratic setup. The stabilization properties and the welfare implications of the optimal commitment plan are compared with the outcome obtained under simple implementable rules. The central result is that fiscal policy plays a key role to smooth appropriately the impact of idiosyncratic exogenous shocks. Fiscal rules that respond to a measure of real activity have the potential to approximate accurately the optimal plan and lead to large welfare gains as compared to balanced budget rules. Monetary policy shall focus on maintaining price stability.
    Keywords: Currency Union; Optimal Policy; Flexibility; Welfare.
    JEL: E63 F33 F42
    Date: 2005–07
  60. By: André Meier (European University Institute,Via della Piazzuola 43, 50133 Firenze, Italy); Gernot J. Müller (Goethe University Frankfurt, Mertonstr. 17, 60054 Frankfurt am Main, Germany)
    Abstract: Financial frictions affect the way in which different components of GDP respond to a monetary policy shock. We embed the financial accelerator of Bernanke, Gertler and Gilchrist (1999) into a medium-scale Dynamic General Equilibrium model and evaluate the relative importance of financial frictions in explaining monetary transmission. Specifically, we match the impulse responses generated by the model with empirical impulse response functions obtained from a vector autoregression on US time series data. This allows us to provide estimates for the structural parameters of our model and judge the relevance of different model features. In addition, we propose a set of simple and instructive specification tests that can be used to assess the relative fit of various restricted models. Although our point estimates suggest some role for financial accelerator effects, they are actually of minor importance for the descriptive success of the model.
    Keywords: Monetary Policy; Output Composition; Financial Frictions; Minimum Distance Estimation.
    JEL: E32 E44 E51
    Date: 2005–07
  61. By: Valeria De Bonis (Dipartimento di Scienze Economiche, University of Pisa); Pompeo Della Posta (Dipartimento di Scienze economiche, University of Pisa)
    Abstract: In this paper we extend Nordhaus’ (1994) results to an environment which may represent the current European situation, characterised by a single monetary authority and several fiscal bodies. We show that: a) co-operation among national fiscal authorities is welfare improving only if they also co-operate with the central bank; b) when this condition is not satisfied, fiscal rules, as those envisaged in the Maastricht Treaty and in the Stability and Growth Pact, may work as co-ordination devices that improve welfare; c) the relationship between several treasuries and a single central bank makes the fiscal leadership solution collapse to the Nash one, so that, contrary to Nordhaus (1994) and Dixit and Luisa Lambertini (2001), when moving from the Nash to the Stackelberg solution, fiscal discipline no longer obtains. Also in this case we thus argue in favour of fiscal rules in a monetary union.
    Keywords: Fiscal and monetary policy co-ordination; monetary union;international fiscal issues
    JEL: E61 F42 H87
    Date: 2005–09
  62. By: Michael Ehrmann (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper assesses the change in Federal Reserve policy introduced in 1999, with the publication of statements about the outlook for monetary policy (and later about the balance of risks) immediately after each FOMC meeting. We find that markets anticipated monetary policy decisions equally well under this new disclosure regime than before, but arrived at their expectations in different ways. Under the new regime, markets extract information from the statements, whereas before, they needed to revert to other types of Fed communication in the inter-meeting periods, and come to their own assessment of the implications of macroeconomic data releases. Taken together, these findings suggest that the Fed's new disclosure practice may indeed have improved transparency in the sense that information is now released to the markets at an earlier time and with clearer signals, but that the Fed can extract less information from observing market reactions to macroeconomic data releases.
    Keywords: Transparency; monetary policy; announcements; communication; disclosure.
    JEL: E43 E52 E58 G12
    Date: 2005–03

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