nep-cba New Economics Papers
on Central Banking
Issue of 2005‒12‒09
twenty-one papers chosen by
Roberto Santillan

  1. Optimal Monetary and Fiscal Policy in a Currency Union By Jordi Gali; Tommaso Monacelli
  2. Assessing the value of indicators of underlying inflation for monetary policy By Pietro Catte; Torsten Sløk
  3. Communication in Monetary Policy Committees By Jan Marc Berk; Beata K. Bierut
  4. Monetary Policy in the Presence Of Imperfect Observability Of The Objectives Of Central Bankers By Francesco Salsano
  5. The Optimality of the Friedman Rule When Some Distorting Taxes Are Exogenous By Alexandre B. Cunha
  6. How should central banks communicate? By Michael Ehrmann; Marcel Fratzscher
  7. Reaction functions in a small open economy: What role for non-traded inflation? By Ana Maria Santacreu;
  8. Transparency of Monetary Policy: Theory and Practice By Petra Geraats
  9. Optimal discretionary policy and uncertainty about inflation persistence By Richhild Moessner
  10. Central Bank Credibility and Monetary Policy: Evidence from Small Scale Macroeconomic Model of Indonesia By Enrico Tanuwidjaja; Choy Keen Meng
  11. And if one size fit all after all ? A counterfactual examination of the ECB monetary policy under Duisenberg presidency. By Jérôme Héricourt
  12. Are Long-Run Price Stability and Short-run Output Stabilization All that Monetary Policy Can Aim For? By Giuseppe Fontana; Alfonso Palacio- Vera
  13. Canaries and Vultures: A Quantitative History of Monetary Mismanagement in Brazil By Pedro H. Albuquerque; Solange Gouvea
  14. Do Capital Adequacy Requirements Matter for Monetary Policy? By Stephen G. Cecchetti; Lianfi Li
  15. A happy "halfway-house"? Medium term inflation targeting in New Zealand By Sam Warburton; Kirdan Lees
  16. Monetary Policy Strategies of the European Central Bank and the Federal Reserve Bank of the U.S. By L. Randall Wray; C. Sardoni
  17. Fiscal-Monetary Policy Interactions in the Presence of Unionized Labour Markets By Cukierman, Alex; Dalmazzo, Alberto
  18. Empirical analysis on the real effects of inflation and exchange rate uncertainty: The case of Colombia By Isabel Ruiz
  19. Ireland in EMU: More Shocks, Less Insulation? By Honohan, Patrick; Leddin, Anthony J
  20. Real-Time Model Uncertainty in the United States: the Fed from 1996-2003 By Ironside, Brian; Tetlow, Robert J.
  21. The pricing behaviour of firms in the euro area : new survey evidence By S. Fabiani; M. Druant; I. Hernando; C. Kwapil; B. Landau; C. Loupias; F. Martins; T. Mathä; R. Sabbatini; H. Stahl; A. Stokman

  1. By: Jordi Gali; Tommaso Monacelli
    Abstract: We lay out a tractable model for fiscal and monetary policy analysis in a currency union, and analyze its implications for the optimal design of such policies. Monetary policy is conducted by a common central bank, which sets the interest rate for the union as a whole. Fiscal policy is implemented at the country level, through the choice of government spending level. The model incorporates country-specific shocks and nominal rigidities. Under our assumptions, the optimal monetary policy requires that inflation be stabilized at the union level. On the other hand, the relinquishment of an independent monetary policy, coupled with nominal price rigidities, generates a stabilization role for fiscal policy, one beyond the efficient provision of public goods. Interestingly, the stabilizing role for fiscal policy is shown to be desirable not only from the viewpoint of each individual country, but also from that of the union as a whole. In addition, our paper offers some insights on two aspects of policy design in currency unions: (i) the conditions for equilibrium determinacy and (ii) the effects of exogenous government spending variations.
    JEL: E52 F41 E62
    Date: 2005–12
  2. By: Pietro Catte; Torsten Sløk
    Abstract: This paper considers a number of different measures of core inflation and tries to identify those containing the most useful information about future movements in headline inflation rates over the horizons relevant for monetary policy for the United States, the euro area, Japan, the United Kingdom and Canada. The paper shows that the adjusted indicators do considerably better than the headline rate at determining the underlying inflation trend and, being considerably less volatile, can also be used at higher frequencies to provide more timely information. Most of these indicators also contain information relevant to predicting future headline inflation and which is additional to that contained in the headline rate. However, the relative performance of different indicators varies considerably across economies, and in some cases across sample periods. There is evidence that headline inflation tends to converge toward core inflation over time horizons of between 12 and 24 months. However, the estimated model incorporating this relationship between headline and core inflation does rather poorly in out-of-sample tests, althoughout-of-sample performance is much better for other specifications. <P>Evaluer l’utilité des indicateurs de l’inflation sous-jacente pour la politique monétaire Ce document examine un certain nombre de mesures de l’inflation sous-jacente et tente d’identifier celles qui donnent les informations les plus utiles afin d’appréhender les mouvements à venir de l’inflation totale en vue de la politique monétaire pour les États-Unis, la zone euro, le Japon, le Royaume-Uni et le Canada. L’étude montre que ces indicateurs ajustés sont plus efficaces que le taux d’inflation total lorsqu’il s’agit de déterminer la tendance sous-jacente de l'inflation. De plus, étant considérablement moins volatiles, ces indicateurs peuvent aussi être utilisés à des intervalles plus courts afin d’apporter les informations les plus récentes. La plupart de ces indicateurs contiennent aussi des informations pertinentes pour prévoir les taux d’inflation futurs, et qui sont complémentaires à celles contenues dans le taux d’inflation total. Cependant, la performance relative des différents indicateurs varie énormément d’une économie à l’autre, et dans certains cas d’une période à l’autre. On observe que l’inflation totale tend à converger vers l’inflation sous-jacente à un horizon de 12 à 24 mois. Toutefois, le modèle estimé incorporant cette relation entre inflation totale et inflation sous-jacente se révèle plutôt médiocre dans des essais hors échantillon, bien que les résultats hors échantillon soient bien meilleurs dans des autres spécifications.
    Keywords: monetary policy, politique monétaire, inflation, inflation, core inflation, inflation sous-jacente
    JEL: E31
    Date: 2005–11–25
  3. By: Jan Marc Berk; Beata K. Bierut
    Abstract: This paper models monetary policy decisions as being taken by an interacting group of heterogeneous policy makers, organized in a MPC. We show that communication between members generally improves the quality of monetary policy by increasing knowledge about uncertain future economic developments. Interestingly, we find that it is sometimes beneficial to restrict communication to a subset of MPC members. We also show that the optimal size of a communicating MPC is generally smaller than otherwise. Compared with expanding the MPC, communication is a cost-e.ective way of increasing the quality of monetary policy.
    Keywords: monetary policy committees; deliberations; voting
    Date: 2005–11
  4. By: Francesco Salsano (School of Economics, Mathematics & Statistics, Birkbeck College)
    Abstract: The paper presents a theoretical model for analysis of the imperfect observability of central bank preferences by the private sector on the decisions taken by the monetary authority, and therefore on the infation rate. It examines in particular the connection which, in the presence of a time inconsistency problem, arises between the observability of the monetary institution?s goals and its equilibrium strategies. The model yields innovative results from the technical and economic points of view. From the technical point of view, the study of equilibrium strategies in a simple signalling model allows derivation of the equilibrium outcomes of a monetary policy game already examined by D'Amato and Pistoresi (1996) and Sibert (2002), without the restrictions that those authors impose on the basis of the types of monetary institution. It is thus possible to identify the conditions on the model's parameters under which a pure separating equilibrium arises, and the conditions under which there instead exists a hybrid equilibrium in which some types of Central Bankers adopt separating strategies (Vickers 1986; D?Amato and Pistoresi 1996; Sibert 2002) while others adopt pooling strategies similar to those studied by Backus and Driffill (1985). From an economic point of view, the paper shows a number of relations that arise, in equilibrium, between the degree of observability and transparency of the Central Banker's goals and the infation rate set by the Central Banker.
    Keywords: Monetary Policy, Central Bank
    JEL: E31 E58 E61
    Date: 2005–11
  5. By: Alexandre B. Cunha (IBMEC Business School - Rio de Janeiro)
    Abstract: The Friedman rule is a feature of second-best policies in several monetary models. We extend this result by establishing that zero nominal interest rates can be optimal even if the Ramsey planner is not able to select many distorting tax rates. However, we show that the optimality of that policy prescription does depend on the set of tax rates the planner is able to choose. We also provide an intuitive way of assessing whether the Friedman rule is optimal for each particular set of tax rates the Ramsey planner is allowed to select.
    Keywords: Friedman rule, optimal monetary policy, exogenous taxes
    JEL: E31 E52 E63 H21
    Date: 2005–11–30
  6. By: Michael Ehrmann (Correspondence to: European Central Bank, Postfach 160319, 60066 Frankfurt am Main, Germany); Marcel Fratzscher (European Central Bank, Postfach 160319, 60066 Frankfurt am Main, Germany)
    Abstract: The paper shows that central bank communication is a key determinant of the market’s ability to anticipate monetary policy decisions and the future path of interest rates. Comparing communication policies by the Federal Reserve, the Bank of England and the ECB since 1999, we find that communicating the diversity of views among committee members about monetary policy lowers the market’s ability to anticipate policy decisions as well as the future path of interest rates. This effect is sizeable, accounting for instance for one third to half of the prediction errors of FOMC policy decisions. By contrast, individualistic communication regarding the economic outlook is found to be beneficial for the Federal Reserve, enabling market participants to better anticipate the future path of interest rates. Thus, it is the collegiality of views on monetary policy but the diversity of views on the economic outlook that enhance the effectiveness of central bank communication.
    Keywords: Communication; monetary policy; committee; effectiveness; economic outlook; Federal Reserve; Bank of England; European Central Bank.
    JEL: E43 E52 E58 G12
    Date: 2005–11
  7. By: Ana Maria Santacreu; (Reserve Bank of New Zealand)
    Abstract: I develop a structural general equilibrium model and estimate it for New Zealand using Bayesian techniques. The estimated model considers a monetary policy regime where the central bank targets overall inflation but is also concerned about output, exchange rate movements, and interest rate smoothing. Taking the posterior mean of the estimated parameters as representing the characteristics of the New Zealand economy, I compare the consequences that two alternative reaction functions have on the central bank's loss, for different specifications of its preferences. I obtain conditions under which the monetary authority should respond directly to non-tradable inflation instead of overall inflation. In particular, if preferences are relatively biased towards inflation stabilization, responding directly to overall inflation results in better macroeconomic outcomes. If instead the central bank places relatively more weight on output stabilization, responding directly to non-traded inflation is a better strategy.
    JEL: C51 E52 F41
  8. By: Petra Geraats
    Abstract: Transparency has become one of the main features of monetary policymaking during the last decade. This paper establishes some stylized facts. In addition, it provides a systematic overview of the practice of monetary policy transparency around the world. It shows much diversity in information disclosure, even for central banks with the same monetary policy framework, including inflation targeting. Nevertheless, the paper finds significant differences in transparency across monetary policy frameworks. The empirical findings are explained using key insights distilled from the theoretical literature. Thus, this paper aims to bridge the gap between the theory and practice of monetary policy transparency.
    Keywords: transparency, monetary policy, central bank communication
    JEL: D82 E58
    Date: 2005
  9. By: Richhild Moessner (Bank for International Settlements, Basel, Switzerland)
    Abstract: This paper studies optimal discretionary policy with parameter uncertainty about inflation inertia. Optimal policy rules and impulse responses are presented within a hybrid New-Keynesian model estimated for the euro area by Smets (2003). We find that it may be optimal for policy to respond more aggressively to cost-push shocks and real interest rate shocks in the presence of uncertainty about inflation inertia, depending on the form of the central bank’s objective function. Moreover, in the cases where optimal policy is not certainty equivalent, we find that inflation returns slightly more gradually to equilibrium following a shock when the degree of inflation inertia is uncertain.
    Keywords: Monetary policy; inflation persistence; uncertainty..
    JEL: E52 E58
    Date: 2005–11
  10. By: Enrico Tanuwidjaja (Singapore Centre for Applied and Policy Economics, Department of Economics, National University of Singapore); Choy Keen Meng (Division of Economics, School of Humanities and Social Sciences, Nanyang Technological University, Singapore)
    Abstract: In this paper, we develop a forward-looking small scale macroeconomic model (SSMM) of the Indonesian economy which is potentially useful for carrying out monetary policy analysis. The Batini-Haldane (1999) model is used as the theoretical underpinning for the development of the model along with the well -known Taylor policy rule (1993). The tracking performance of the model is found to be satisfactory. We conduct deterministic and stochastic simulations to examine the role of the central bank’s credibility in achieving the inflation target and to suggest appropriate monetary policy responses. Policy simulations indicate that it is crucial for the Indonesian authority to address its credibility for Indonesia to achieve a lower inflation rate. Simulations to trace out the inflation-output tradeoff frontier also show that a monetary policy rule that targeted both the inflation and output gap will result in less macroeconomic volatility. We also found that the inclusion of the exchange rate into the monetary policy rule as an additional feedback variable warrants serious consideration in the future course of monetary policy management.
    Keywords: Small Scale Macroeconomic Model, Monetary Policy, Central Bank Credibility, Policy Frontier, Indonesia
    JEL: C15 C51 E17 E52 O53
  11. By: Jérôme Héricourt (TEAM)
    Abstract: How did European Central Bank (ECB) fit the disparate macroeconomic needs of euro zone members? The purpose of this paper consists in providing quantitative answers to this question presenting an original methodology. After estimating unified frameworks of monetary transmission mechanisms for nine euro zone countries, we compute the national evolutions of output gap and inflation since 1999, in a fictitious context where the euro has never been launched. Using a loss function as a standard for macroeconomic stabilization, these simulations are then compared with the actual outcomes over the period 1999-2003. Our major result is that the ECB did a far better stabilization job for euro zone countries than national central banks would have done.
    Keywords: Taylor rules, monetary policy transmission, alternative world, simulations, stabilisation.
    JEL: E52 E58 F47
    Date: 2004–01
  12. By: Giuseppe Fontana (University of Leeds, UK); Alfonso Palacio- Vera (Universidad Complutense de Madrid, Spain)
    Abstract: A central tenet of the so-called new consensus view in macroeconomics is that there is no long-run trade-off between inflation and unemployment. The main policy implication of this principle is that all monetary policy can aim for is (modest) short-run output stabilization and long- run price stability—i.e., monetary policy is neutral with respect to output and employment in the long run. However, research on the different sources of path dependency in the economy suggests that persistent but nevertheless transitory changes in aggregate demand may have a permanent effect on output and employment. If this is the case, then, the way monetary policy is run does have long-run effects on real variables. This paper provides an overview of this research and explores how monetary policy should be implemented once these long-run effects are acknowledged.
    Keywords: monetary policy, new consensus, path dependency, opportunistic approach
    JEL: E5 E52
    Date: 2005–11–23
  13. By: Pedro H. Albuquerque (Texas A&M International University); Solange Gouvea (Central Bank of Brazil)
    Abstract: During the last two decades of the twentieth century, Brazil went through a sequence of failed stabilization plans that tried to cope with an enduring hyperinflation. This paper uses a money demand model to evaluate monetary policies during those episodes. The consistency between the money supply and the expected conditional money demand growth rates is considered for each plan. It is shown that the unsuccessful programs were marked by excessive liquidity. The results not only suggest that the mismanagement of the monetary aggregates led to the failure of the plans, but also that the excessive liquidity could have been predicted.
    Keywords: Money Demand, Money Supply, Monetary Policy, Inflation, Stabilization, Brazil
    JEL: O23 O54 N16
    Date: 2005–11–23
  14. By: Stephen G. Cecchetti; Lianfi Li
    Abstract: Central bankers and financial supervisors often have different goals. While monetary policymakers want to ensure that there are always sufficient lending activities to maintain high and stable economic growth, supervisors work to limit banks. lending capacities in order to prevent excessive risk-taking. To avoid working at cross-purposes, central bankers need to adopt a policy strategy that accounts for the impact of capital adequacy requirements. In this paper we derive an optimal monetary policy that reinforces prudential capital requirements at the same time that it stabilizes aggregate economic activity. We go on to show that policymakers at the Federal Reserve adjust interest rate policy in a way that would neutralize the procyclical impact of bank capital requirements. By contrast, central bankers in Germany and Japan clearly do not act as the theory suggests they should.
    JEL: E52 E58 G21
    Date: 2005–12
  15. By: Sam Warburton; Kirdan Lees (Reserve Bank of New Zealand)
    Abstract: The 2002 Policy Targets Agreement (PTA) between the Reserve Bank of New Zealand and the government asks the Reserve Bank to target inflation "over the medium term" rather than over an annual target. This medium term objective shifts inflation targeting towards a "halfway-house" between inflation targeting and price level targeting. Extending the inflation averaging horizon to the medium term improves the inflation-output tradeoff by influencing inflation expectations. But how long should the medium term be? Characterizing the New Zealand economy with a small new-Keynesian model, we show that the happiest halfway house is located around a two or three year averaging horizon which leads to mild, but non-trivial, improvements in the efficiency of monetary policy.
    JEL: E52 E58 E61
    Date: 2005–10
  16. By: L. Randall Wray (The Levy Economics Institute & University of Missouri, Kansas City); C. Sardoni (University of Rome “La Sapienza)
    Abstract: In the debate on monetary policy strategies on both sides of the Atlantic, it is now almost a commonplace to contrast the Fed and the ECB by pointing out the former’s flexibility and capacity to adjust rigidity, and the latter’s extreme caution, and obsession with low inflation. In looking at the foundations of the two banks’ strategies, however, we do not find differences that can provide a simple explanation for their divergent behavior, nor for the very different economic performance in the U.S. and Euroland in recent years. Not surprisingly, both central banks share the same conviction that money is neutral in the long period, and even their short-term policies are based on similar fundamental principles. The two policy approaches really differ only in terms of implementation, timing, competence, etc., but not in terms of the underlying theoretical orientation. We then draw the conclusion that monetary policy cannot represent a significant variable in the explanation of the different economic performances of Euroland and U.S. The two economic areas’ differences must be explained by considering other factors among which the most important is fiscal policy.
    Keywords: monetary policy, federal reserve, European central bank, fiscal policy, aggregate demand, growth
    JEL: E12 E42 E58 E62
    Date: 2005–11–23
  17. By: Cukierman, Alex; Dalmazzo, Alberto
    Abstract: This paper develops a framework for studying the interactions between labour unions, fiscal policy, monetary policy and monopolistically competitive firms. The framework is used to investigate the effects of labour taxes, the replacement ratio, labour market institutions and monetary policy-making institutions on economic performance in the presence of strategic interactions between labour unions and the central bank. Given fiscal variables, higher levels of either centralization of wage bargaining, or of central bank conservativeness are associated with lower unemployment and inflation. However the forward shifting of changes in either labour taxes or in unemployment benefits to labours costs is larger the higher are those institutional variables. The paper also considers the effects of those institutions on the choice of labour taxes and of unemployment benefits by governments concerned with the costs of inflation and unemployment, as well as with redistribution to particular constituencies. A main result is that higher levels of centralization and conservativeness induce government to set higher labour taxes if the replacement ratio and the tax wedge are sufficiently small.
    Keywords: central bank conservativeness; collective wage bargaining; competitiveness; inflation; labour taxes; redistribution; unemployment; unemployment benefits
    JEL: E5 E6 H2 J3 J5 L1
    Date: 2005–10
  18. By: Isabel Ruiz (Western Michigan University)
    Abstract: This paper re-examines the effects of inflation and exchange rate uncertainty on real economic activity. The existent literature has treated both issues as separate subject matters. It has emphasized either the issue of inflation uncertainty or exchange rate uncertainty on economic growth or on different measures of economic activity. This paper attempts dealing with both issues by analyzing the magnitudes and direction of the effect of both: inflation and exchange rate uncertainty on real economic activity. By introducing dummy variables, we control for monetary policy change (the change to inflation targeting and flexible exchange rate). By using a generalized autoregressive conditional variance (GARCH) model of inflation and exchange rates, the conditional variances of the model’s forecast errors were extracted as measures of uncertainty. The results suggest that higher levels of inflation Granger cause more uncertainty and vice versa for the Colombian economy. Also, only inflation uncertainty matters for output by exerting a negative influence.
    Keywords: Inflation Targeting, Inflation Uncertainty, Exchange Rate, Uncertainty, GARCH models, Granger causality
    JEL: F3 F4
    Date: 2005–11–27
  19. By: Honohan, Patrick; Leddin, Anthony J
    Abstract: Despite anchoring the Irish monetary system to a common zone-wide exchange rate and interest rate, EMU has triggered sizable exchange rate and especially interest rate shocks to the Irish economy (albeit not appreciably greater than those experienced under previous exchange rate regimes). Interest rate movements have deviated widely from what a standard Taylor monetary policy rule would have counseled - though here again the deviations have been no worse in this regard than those of the previous regime. The most important shock has been associated with the large and sustained initial fall in nominal interest rates as EMU began. Through mechanisms which we formally model, the interest rate fall has had a lasting effect on property prices, construction activity and on the capacity of the labour market to absorb sizable net immigration, despite a sharp deterioration in wage competitiveness since 2002. As the long drawn-out impact of this shock subsides, the failure of the wage-bargaining system promptly to claw back the loss of competitiveness resulting from exogenous exchange rate movements is increasingly likely to show up in weaker aggregate employment performance.
    Keywords: asymmetric shocks; European Monetary Union; Ireland
    JEL: E32 E42 F4
    Date: 2005–11
  20. By: Ironside, Brian; Tetlow, Robert J.
    Abstract: We study 30 vintages of FRB/US, the principal macro model used by the Federal Reserve Board staff for forecasting and policy analysis. To do this, we exploit archives of the model code, coefficients, baseline databases and stochastic shock sets stored after each FOMC meeting from the model’s inception in July 1996 until November 2003. The period of study was one of important changes in the US economy with a productivity boom, a stock market boom and bust, a recession, the Asia crisis, the Russian debt default, and an abrupt change in fiscal policy. We document the surprisingly large and consequential changes in model properties that occurred during this period and compute optimal Taylor-type rules for each vintage. We compare these optimal rules against plausible alternatives. Model uncertainty is shown to be a substantial problem; the efficacy of purportedly optimal policy rules should not be taken on faith. We also find that previous findings that simple rules are robust to model uncertainty may be an overly sanguine conclusion.
    Keywords: monetary policy; real-time analysis; uncertainty
    JEL: C5 C6 E37 E5
    Date: 2005–10
  21. By: S. Fabiani (Banca d’Italia); M. Druant (Banque Nationale de Belgique); I. Hernando (Banco de España); C. Kwapil (Oesterreichische Nationalbank); B. Landau (European Central Bank); C. Loupias (Banque de France); F. Martins (Banco de Portugal); T. Mathä (Banque centrale du Luxembourg); R. Sabbatini (Banca d’Italia); H. Stahl (Deutsche Bundesbank); A. Stokman (De Nederlandsche Bank)
    Abstract: This study investigates the pricing behaviour of firms in the euro area on the basis of surveys conducted by nine Eurosystem national central banks. Overall, more than 11,000 firms participated in the survey. The results are very robust across countries. Firms operate in monopolistically competitive markets, where prices are mostly set following mark-up rules and where price discrimination is a common practice. Our evidence suggests that both time- and state-dependent pricing strategies are applied by firms in the euro area: around one-third of the companies follow mainly time-dependent pricing rules while two-thirds use pricing rules with some element of state-dependence. Although the majority of firms take into account a wide range of information, including past and expected economic developments, about one-third adopts a purely backward-looking behaviour. The pattern of results lends support to the recent wave of estimations of hybrid versions of the New Keynesian Phillips Curve. Price stickiness arises both at the stage when firms review their prices and again when they actually change prices. The most relevant factors underlying price rigidity are customer relationships - as expressed in the theories about explicit and implicit contracts - and thus, are mainly found at the price changing (second) stage of the price adjustment process. Finally, we provide evidence that firms adjust prices asymmetrically in response to shocks, depending on the direction of the adjustment and the source of the shock: while cost shocks have a greater impact when prices have to be raised than when they have to be reduced, reductions in demand are more likely to induce a price change than increases in demand.
    Keywords: price setting, nominal rigidity, real rigidity, inflation persistence, survey data.
    JEL: E30 D40
    Date: 2005–11

This nep-cba issue is ©2005 by Roberto Santillan. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.