nep-cba New Economics Papers
on Central Banking
Issue of 2006‒08‒26
39 papers chosen by
Alexander Mihailov
University of Essex

  1. Reflections on One Year at the Bank of Israel By Stanley Fischer
  2. Optimal Simple and Implementable Monetary and Fiscal Rules: Expanded Version By Stephanie Schmitt-Grohé; Martín Uribe
  3. Endogenous Monetary Policy Regime Change By Troy Davig; Eric M. Leeper
  4. Can Central Banks Target Bond Prices? By Kenneth Kuttner
  5. Money and capital as competing media of exchange By Ricardo Lagos; Guillaume Rocheteau
  6. Expectations, Asset Prices, and Monetary Policy: The Role of Learning By Simon Gilchrist; Masashi Saito
  7. Modern macroeconomics in practice: how theory is shaping policy By V. V. Chari; Patrick J. Kehoe
  8. Capital Controls: Myth and Reality A Portfolio Balance Approach to Capital Controls By Nicolas Magud; Carmen Reinhart; Kenneth Rogoff
  9. Price Rigidity and Flexibility: Recent Theoretical Developments By Daniel Levy
  10. The frequency of price adjustment and New Keynesian business cycle dynamics By Richard Dennis
  11. Noisy Macroeconomic Announcements, Monetary Policy, and Asset Prices By Roberto Rigobon; Brian Sack
  12. The EMU after Three Years: Lessons and Challenges By Peter Bofinger
  13. Signaling Credibility --- Choosing Optimal Debt and International Reserves By Joshua Aizenman; Jorge Fernández-Ruiz
  14. Delegation versus Communication in the Organization of Government By Rodney D. Ludema; Anders Olofsgård
  15. Real Exchange Rate, Monetary Policy and Employment By Roberto Frenkel; Lance Taylor
  16. Monetary Equilibria in a Cash-in-Advance Economy with Incomplete Financial Markets By Jinhui H. Bai; Ingolf Schwarz
  17. Market Power, Price Adjustment, and Inflation By Allen Head; Alok Kumar; Beverly Lapham
  18. Non-Separability, Heterogeneous Labor Supply, Investment, and the Business Cycle By Pablo A. Guerron
  19. Time-Dependent Portfolio Adjustment: Yet Another Look at the Dynamics By Pablo A. Guerron
  20. Why do Central Bankers Intervene in the Foreign Exchange Market? Some New Evidence and Theory By Pablo A. Guerron
  21. Intra-Day Seasonality in Activities of the Foreign Exchange Markets: Evidence From the Electronic Broking System By Takatoshi Ito; Yuko Hashimoto
  22. The Rationality and Heterogeneity of Survey Forecasts of the Yen-Dollar Exchange Rate: A Reexamination By Carl Bonham; Richard Cohen; Shigeyuki Abe
  23. On the Determinants of Exporters' Currency Pricing: History vs. Expectations By Shin-ichi Fukuda; Masanori Ono
  24. Insurance Underwriter or Financial Development Fund: What Role for Reserve Pooling in Latin America? By Barry Eichengreen
  25. Persistence in Law-Of-One-Price Deviations: Evidence from Micro-Data By Mario J. Crucini; Mototsugu Shintani
  26. E-Stability vis-a-vis Determinacy Results for a Broad Class of Linear Rational Expectations Models By Bennett T. McCallum
  27. Financial Globalization, Governance, and the Evolution of the Home Bias By Bong-Chan Kho; René M. Stulz; Francis E. Warnock
  28. Intertemporal Consumption Choices, Transaction Costs and Limited Participation to Financial Markets: Reconciling Data and Theory By Orazio P. Attanasio; Monica Paiella
  29. On the Coexistence of Banks and Markets By Hans Gersbach; Harald Uhlig
  30. Beveridge-Nelson Decomposition with Markov Switching By Chin Nam Low; Heather Anderson; Ralph D. Snyder
  31. Recursive Competitive Equilibrium By Rajnish Mehra
  32. What is the Most Effective Monetary Policy for Aid-Receiving Countries? By Alessandro Prati; Thierry Tressel
  33. Fiscal and monetary policy in the enlarged European Union. By Sabina Pogorelec
  34. The Role of the Housing Market in Monetary Transmission By Gergely Kiss; Gábor Vadas
  35. International Real Business Cycles By Mario J. Crucini
  36. The Comovement between Fuel Prices and the General Price level in Australia By Lei Lei Song
  37. Understanding the Long-Term Growth Performance of the East European and CIS Economies By Rumen Dobrinsky; Dieter Hesse; Rolf Traeger
  38. The expected effect of the euro on the Hungarian monetary transmission By Gábor Orbán; Zoltán Szalai
  39. What Determines the Demand for Money in the Asian-Pacific Countries? An Empirical Panel Investigation By Valadkhani, Abbas

  1. By: Stanley Fischer
    Abstract: In this paper I reflect on my first year as Governor of the Bank of Israel, which I joined in May 2005. I start by describing the current state of the Israeli economy and monetary policy and economic developments during the past year. I then review a series of issues that have arisen during the past year. Among them are: the monetary mechanism, which is unusual because exchange rate changes have a very rapid impact on prices; the role of inflation and interest rate expectations in policy decisions; the role of the interest rate gap with the US; the role of the Governor as chief economic adviser to the Government; banking supervision; and management and political issues.
    JEL: E50 E65
    Date: 2006–08
  2. By: Stephanie Schmitt-Grohé; Martín Uribe
    Abstract: This paper computes welfare-maximizing monetary and fiscal policy rules in a real business cycle model augmented with sticky prices, a demand for money, taxation, and stochastic government consumption. We consider simple feedback rules whereby the nominal interest rate is set as a function of output and inflation, and taxes are set as a function of total government liabilities. We implement a second-order accurate solution to the model. Our main findings are: First, the size of the inflation coefficient in the interest-rate rule plays a minor role for welfare. It matters only insofar as it affects the determinacy of equilibrium. Second, optimal monetary policy features a muted response to output. More importantly, interest rate rules that feature a positive response to output can lead to significant welfare losses. Third, the welfare gains from interest-rate smoothing are negligible. Fourth, optimal fiscal policy is passive. Finally, the optimal monetary and fiscal rule combination attains virtually the same level of welfare as the Ramsey optimal policy.
    JEL: E52 E61 E63
    Date: 2006–08
  3. By: Troy Davig; Eric M. Leeper
    Abstract: This paper makes changes in monetary policy rules (or regimes) endogenous. Changes are triggered when certain endogenous variables cross specified thresholds. Rational expectations equilibria are examined in three models of threshold switching to illustrate that (i) expectations formation effects generated by the possibility of regime change can be quantitatively important; (ii) symmetric shocks can have asymmetric effects; (iii) endogenous switching is a natural way to formally model preemptive policy actions. In a conventional calibrated model, preemptive policy shifts agents' expectations, enhancing the ability of policy to offset demand shocks; this yields a quantitatively significant "preemption dividend."
    JEL: E31 E32 E52 E58
    Date: 2006–08
  4. By: Kenneth Kuttner
    Abstract: This paper addresses the possible role of bond prices as operating or intermediate targets for monetary policy. The paper begins with a brief review of the mechanisms through which a central bank could, in theory, influence long-term interest rates, and continues with a brief narrative overview of debt management policies in the U.S., tracing their effects on the maturity distribution of outstanding publicly-held Treasury debt and the composition of the assets held by the Federal Reserve System. The empirical section presents new econometric evidence on the effects of these policies on expected excess holding returns (“term premia”), demonstrating that changes in the Fed’s holdings of long-term securities have had statistically significant and economically meaningful effects on the term premia associated with Treasury securities with maturities in the two- to five-year range.
    JEL: E43 E58 E63
    Date: 2006–08
  5. By: Ricardo Lagos; Guillaume Rocheteau
    Abstract: We construct a model in which capital competes with fiat money as a medium of exchange, and establish conditions on fundamentals under which fiat money can be both valued and socially beneficial. When the socially efficient stock of capital is too low to provide the liquidity agents need, they overaccumulate productive assets to use as media of exchange. When this is the case, there exists a monetary equilibrium that dominates the nonmonetary one in terms of welfare. Under the Friedman rule, fiat money provides just enough liquidity so that agents choose to accumulate the same capital stock a social planner would.
    Keywords: Money
    Date: 2006
  6. By: Simon Gilchrist; Masashi Saito
    Abstract: This paper studies the implications of financial market imperfections represented by a countercyclical external finance premium and the gradual recognition of changes in the drift of technology growth for the design of an interest rate rule. Asset price movements induced by changes in trend growth influence balance-sheet conditions that determine the external finance premium. Such movements are magnified when the private sector is imperfectly informed regarding the trend growth rate of technology. The presence of financial market imperfections provides a motivation for responding to the gap between the observed asset prices and the potential level of asset prices in addition to responding strongly to inflation. This is because the asset price gap represents distortions in the resource allocation induced by financial market imperfections more distinctly than inflation. The policymaker's imperfect information about the drift of technology growth renders imprecise the calculation of the potential and thus reduces the benefit of responding to the asset price gap. A policy that responds to the level of asset prices which does not take into account changes in potential tends to be welfare reducing.
    JEL: E44 E52 O41
    Date: 2006–08
  7. By: V. V. Chari; Patrick J. Kehoe
    Abstract: Theoretical advances in macroeconomics made in the last three decades have had a major influence on macroeconomic policy analysis. Moreover, over the last several decades, the United States and other countries have undertaken a variety of policy changes that are precisely what macroeconomic theory of the last 30 years suggests. The three key developments that have shaped macroeconomic policy analysis are the Lucas critique of policy evaluation due to Robert Lucas, the time inconsistency critique of discretionary policy due to Finn Kydland and Edward Prescott, and the development of quantitative dynamic stochastic general equilibrium models following Finn Kydland and Edward Prescott.
    Date: 2006
  8. By: Nicolas Magud (University of Oregon Economics Department); Carmen Reinhart (University of Maryland and NBER); Kenneth Rogoff (Harvard University and NBER)
    Abstract: The literature on capital controls has (at least) four very serious apples-to-oranges problems: (i) There is no unified theoretical framework to analyze the macroeconomic consequences of controls; (ii) there is significant heterogeneity across countries and time in the control measures implemented; (iii) there are multiple definitions of what constitutes a “success” and (iv) the empirical studies lack a common methodology-furthermore these are significantly “overweighted” by a couple of country cases (Chile and Malaysia). In this paper, we attempt to address some of these shortcomings by: being very explicit about what measures are construed as capital controls. Also, given that success is measured so differently across studies, we sought to “standardize” the results of over 30 empirical studies we summarize in this paper. The standardization was done by constructing two indices of capital controls: Capital Controls Effectiveness Index (CCE Index), and Weighted Capital Control Effectiveness Index (WCCE Index). The difference between them lies only in that the WCCE controls for the differentiated degree of methodological rigor applied to draw conclusions in each of the considered papers. Inasmuch as possible, we bring to bear the experiences of less well known episodes than those of Chile and Malaysia. Then, using a portfolio balance approach we model the effects of imposing short-term capital controls. We find that there should exist country-specific characteristics for capital controls to be effective. From these simple perspective, this rationalizes why some capital controls were effective and some were not. We also show that the equivalence in effects of price- vs. quantity-capital control are conditional on the level of short–term capital flows.
    Keywords: Capital controls
    JEL: F30
    Date: 2005–01–11
  9. By: Daniel Levy
    Abstract: The price system, the adjustment of prices to changes in market conditions, is the primary mechanism by which markets function and by which the three most basic questions get answered; what to produce, how much to produce and for whom to produce. To the behaviour of price and price system, therefore, have fundamental implications for many key issues in microeconomics and industrial organization, as well as in macroeconomics and monetary economics. In microeconomics, managerial economics, and industrial organization, economists focus on the price system efficiency. In macroeconomics and monetary economics, economists focus on the extent to which nominal prices fail to adjust to changes in market conditions. Nominal price rigidities play particularly important role in modern monetary economics and in the conduct of monetary policy because of their ability to explain short-run monetary non-neutrality. The behaviour of prices, and in particular the extent of their rigidity and flexibility, therefore, is of central importance in economics.
    Date: 2006–08
  10. By: Richard Dennis
    Abstract: The Calvo pricing model that lies at the heart of many New Keynesian business cycle models has been roundly criticized for being inconsistent both with time series data on inflation and with micro-data on the frequency of price changes. In this paper we show that a modified version of the Gali and Gertler (1999) model, which allows for "rule-ofthumb" price setters, and whose structure can be interpreted in terms of menu costs and information gathering/processing costs, largely resolves both criticisms. Moreover, the resulting Phillips curve shares the explanatory power of the partial-indexation model and dominates the full-indexation model and the Calvo model. Estimating a small-scale New Keynesian business cycle model, our results indicate that the share of firms that change prices each quarter is just over 60 percent, broadly in line with the Bils and Klenow (2004) study of Bureau of Labor Statistics price data. Reflecting the importance of information gathering/processing costs, we find that most firms that change prices are rule-of-thumb price setters. Finally, compared to specifications containing either the Calvo model or the full-indexation model, the data provide much greater support for the Gali-Gertler model.
    Keywords: Prices ; Inflation (Finance)
    Date: 2006
  11. By: Roberto Rigobon; Brian Sack
    Abstract: The current literature has provided a number of important insights about the effects of macroeconomic data releases on monetary policy expectations and asset prices. However, one puzzling aspect of that literature is that the estimated responses are quite small. Indeed, these studies typically find that the major economic releases, taken together, account for only a small amount of the variation in asset prices—even those closely tied to near-term policy expectations. In this paper we argue that this apparent detachment arises in part from the difficulties associated with measuring macroeconomic news. We propose two new econometric approaches that allow us to account for the noise in measured data surprises. Using these estimators, we find that asset prices and monetary policy expectations are much more responsive to incoming news than previously believed. Our results also clarify the set of facts that should be captured by any model attempting to understand the interactions between economic data, monetary policy, and asset prices.
    JEL: E44 E47 E52
    Date: 2006–08
  12. By: Peter Bofinger (University of Wuerzburg)
    Abstract: The paper provides an analysis of the first three years of the European Monetary Union. It discusses the changeover to Euro notes, the performance of monetary policy in terms of price stability and real growth, the establishment of credibility for the ECB, and the two pillar strategy. The weakness of the euro's exchange value during the first three years is explained. Some aspects of the eastern enlargement of the eurozone are examined especially the problems that may be associated with the lack of real convergence. Other issues such as the importance of a Balassa-Samuelson effect and the need for appropriate fiscal policies are discussed.
    Keywords: European Monetary Union, European Central Bank, Euro, monetary policy
    JEL: E42 E58 E60
  13. By: Joshua Aizenman; Jorge Fernández-Ruiz
    Abstract: This paper evaluates the challenges facing developing countries when there is uncertainty about the policy maker type. We consider a country characterized by volatile output, inelastic demand for fiscal outlays, high tax collection costs, and sovereign risk, where future output depends on the type of policymaker in place today. There are two policymakers -- type T chooses debt and international reserves to smooth tax collection costs; type S has higher discount factor, aiming at obtaining current resources for narrow interest groups, and preferring not to undertake costly reforms that may enhance future output. Financial markets do not know the type of policymaker in place and try to infer its type by looking at its financial choices. We show that various adverse shocks (lower output, higher real interest rate, etc.) can induce a switch from an equilibrium where each policy maker chooses its preferred policy to another where T distorts its policies in order to separate itself from S in the least costly way. This is accomplished by type T reducing both international reserves and external debt. Further decline in output would induce type T to lower debt, and reserves would fall at a higher rate than otherwise expected.
    JEL: F31 F34 F36
    Date: 2006–08
  14. By: Rodney D. Ludema; Anders Olofsgård (Department of Economics, Georgetown University)
    Abstract: When a government creates an agency to gather information relevant to policymaking, it faces two critical organizational questions: whether the agency should be given authority to decide on policy or merely supply advice, and what should the policy goals of the agency be. Existing literature on the first question is unable to address the second, because the question of authority becomes moot if the government can simply replicate its preferences within the agency. In contrast, this paper examines both questions within a model of policymaking under time inconsistency, a setting in which the government has a well-known incentive to create an agency with preferences that differ from its own. Thus, our framework permits a meaningful analysis of delegation versus communication with an endogenously chosen agent. The first main finding of the paper is that the government can do equally well with a strategic choice of agent, from which it solicits advice, instead of delegating authority, as long as the time inconsistency problem is not too severe. The second main finding is that the government may strictly prefer seeking advice to delegating authority if there is prior uncertainty with respect to what is the optimal policy. Classification-JEL Codes: D02, D23, D73, D8, H1
    Keywords: Political Economy, Delegation, Communication, Organizational Design, Time Inconsistency.
  15. By: Roberto Frenkel; Lance Taylor
    Abstract: The exchange rate affects the economy through many channels and, consequently, has diverse macroeconomic and development impacts. Five are analysed in this paper: resource allocation, economic development, finance, external balance and inflation. The use of the exchange rate as a developmental tool in conjunction with its other uses (often in coordination with monetary policy) is at the focus of the discussion.
    Keywords: exchange rate, development policy
    JEL: F3 F4 O2
    Date: 2006–02
  16. By: Jinhui H. Bai; Ingolf Schwarz (Department of Economics, Georgetown University)
    Abstract: The general equilibrium model with incomplete financial markets (GEI) is extended by adding fiat money, fiscal and monetary policy and a cash-in-advance constraint. The central bank either pegs the interest rate or money supply while the fiscal authority sets a Ricardian or a non-Ricardian fiscal plan. We prove the existence of equilibria in all four scenarios. In Ricardian economies, the conditions required for existence are not more restrictive than in standard GEI. In non-Ricardian economies, the sufficient conditions for existence are more demanding. In the Ricardian economy, neither the price level nor the equivalent martingale measure is determinate. Classification-JEL Codes: D52; E40; E50
    Keywords: Money; Incomplete Markets; Fiscal Policy; Indeterminacy
  17. By: Allen Head (Queen's University); Alok Kumar (University of Victoria); Beverly Lapham (Queen's University)
    Abstract: We study the responses of real and nominal prices to random flutuations in costs and money growth using a monetary search economy in which there are no costs or temporal restrictions on sellers' ability to change prices. The economy exhibits a form of price stickiness in that the price level may react incompletely to either type of shock as a result of endogenous changes in the average mark-up driven by movements in consumers' search intensity. The average mark-up falls as inflation rises, a finding consistent with emprical observations. As a result of this reduction in market power, prices become more responsive to shocks as inflation rises. Our results are consistent with empirical findings that the degree of price adjustment in response to both cost and money growth shocks is increasing in the average rate of inflation, that the variance of inflation increases with its average level, and that positive and negative shocks to money growth have asymmetric effects.
    Keywords: Search, Mark-up, Inflation, Price Dispersion, Pass-through
    JEL: E31 D43 E42
    Date: 2006–01
  18. By: Pablo A. Guerron (Department of Economics, North Carolina State University)
    Abstract: I study the effects of a monetary shock in an economy characterized by heterogenous labor schedules and non-separability between consumption and labor in the utility function. To that end, I develop a simple method to deal with household heterogeneity arising from wealth differentials. Compared to competing models in the literature, the estimated version of my model fits better the responses of output, consumption, and wages after a monetary shock. Notably, my model requires no adjustment cost in investment, and smaller degrees of habit formation preference for consumption, and wage stickiness than other standard models. Furthermore, I show that non-separability is an important source of amplification of the effects of a monetary shock on output and investment.
    Keywords: Heterogeneous Choices, Impulse Responses, Monetary Policy
    JEL: E3 E4 E5
    Date: 2006–05
  19. By: Pablo A. Guerron (Department of Economics, North Carolina State University)
    Abstract: The interest semi-elasticity of money demand has been a long standing puzzle in the monetary economics literature. Researchers consistently have estimated low short-run semi-elasticities, usually around 1, and high long-run semi-elasticities of 10. Given the crucial role of interest semi-elasticity in determining the welfare costs of inflation and the effectiviness of tax cuts, we must understand why these short- and long-run estimates are so different. To explore this issue, I formulate and estimate a model of the demand for money that simultaneously accounts for low short- and high long-run semi-elasticities. In my formulation, re-balancing money holdings between money for purchases and money for financial investment is costly. I model this re-balancing cost by assuming that households re-optimize their money holdings subject to an exogenous probability. In the log-linearized version of my model, velocity depends on both its own past value and households' present and future expectations of the interest rate. I use this equilibrium condition to estimate my model's parameters by employing generalized method of moments. My estimates for the short-run and long-run interest semi-elasticities are 0.96 and 12.62, respectively. When I apply my model of money demand to explain the increase in the volatility of real balances after 1980, my model indicates that the late-1970s financial innovations, which facilitated portfolio re-balancing, lie behind this rise.
    Keywords: Interest Semi-Elasticity of Money Demand, Time-Dependent Portfolio Adjustment, Volatility, GMM.
    JEL: C32 E41 E47
    Date: 2006–01
  20. By: Pablo A. Guerron (Department of Economics, North Carolina State University)
    Abstract: I provide new empirical and theoretical evidence about the effectiveness of sterilized interventions on exchange rates. These new developments are particularly important to understand why central bankers from developing countries tend to intervene during periods of financial distress. In the first half of the paper, I apply a VAR formulation to measure the effects of sterilized interventions on the U.S. bilateral exchange rate. Information from the Exchange Stabilization Fund in the U.S. for the period 1974 -- 2000 is used to identify a shock that is orthogonal to the U.S. money supply and therefore mimics the role of sterilized interventions. According to my identification strategy, a sterilized intervention shock in favor of the U.S. dollar would appreciate it against a trade-weighted currency index by roughly 1 percent. This appreciation is statistically significant, lasts for about 1 year, and is robust to alternative identification strategies. Then, I devote the second part of the paper to rationalize the results from the empirical section by studying sterilized interventions within a two-country general equilibrium model. I find that if trading bonds is costly worldwide and asset markets are incomplete, a domestic government purchase of domestic bonds accompanied by a sale of foreign bonds, a sterilized intervention, appreciates the domestic currency. Accordingly, a calibrated version of the model renders similar results to those from the VAR formulation.
    Keywords: Exchange Rate, Sterilized Intervention, VAR, Open Economy
    JEL: C32 F3 E58
    Date: 2006–01
  21. By: Takatoshi Ito; Yuko Hashimoto
    Abstract: This paper examines intra-day patterns of the exchange rate behavior, using the “firm” bid-ask quotes and transactions of USD-JPY and Euro-USD recorded in the electronic broking system of the spot foreign exchange markets. The U-shape of intra-day activities (deals and price changes) and return volatility is confirmed for Tokyo and London participants, but not for New York participants. Activities and volatility do not increase toward the end of business hours in the New York market, even on Fridays (ahead of weekend hours of non-trading). It is found that there exists a high positive correlation between volatility and activities and a negative correlation between volatility and the bid-ask spread. A negative correlation is observed between the number of deals and the width of bid-ask spread during business hours.
    JEL: F31 F33 G15
    Date: 2006–08
  22. By: Carl Bonham (Department of Economics, University of Hawaii at Manoa); Richard Cohen (College of Business and Public Policy, University of Alaska Anchorage); Shigeyuki Abe (Center for Contemporary Asian Studies, Doshisha University)
    Abstract: This paper examines the rationality and diversity of industry-level forecasts of the yen-dollar exchange rate collected by the Japan Center for International Finance. In several ways we update and extend the seminal work by Ito (1990). We compare three specifications for testing rationality: the ”conventional” bivariate regression, the univariate regression of a forecast error on a constant and other information set variables, and an error correction model (ECM). We find that the bivariate specification, while producing consistent estimates, suers from two defects: first, the conventional restrictions are sucient but not necessary for unbiasedness; second, the test has low power. However, before we can apply the univariate specification, we must conduct pretests for the stationarity of the forecast error. We find a unit root in the six-month horizon forecast error for all groups, thereby rejecting unbiasedness and weak eciency at the pretest stage. For the other two horizons, we find much evidence in favor of unbiasedness but not weak eciency. Our ECM rejects unbiasedness for all forecasters at all horizons. We conjecture that these results, too, occur because the restrictions test suciency, not necessity. In our systems estimation and micro- homogeneity testing, we use an innovative GMM technique (Bonham and Cohen (2001)) that allows for forecaster cross-correlation due to the existence of common shocks and/or herd eects. Tests of micro-homogeneity uniformly reject the hypothesis that forecasters across the four industries exhibit similar rationality characteristics.
    Keywords: Rational Expectations, Heterogeneity, Exchange Rate, Survey Forecast
    Date: 2006
  23. By: Shin-ichi Fukuda; Masanori Ono
    Abstract: The purpose of this paper is to investigate why the choice of invoice currency under exchange rate uncertainty depends not only on expectations but also on history. The analysis is motivated by the fact that the U.S. dollar has historically been the dominant vehicle currency in developing countries. The theoretical analysis is based on an open economy model of monopolistic competition. When the market is competitive enough, the exporting firms tend to set their prices not to deviate from those of the competitors. As a result, a coordination failure can lead the third currency to be a less efficient equilibrium invoice currency. The role of expectations is important in selecting the equilibrium in the static framework. However, in the dynamic model with staggered price-setting, the role of history becomes another key determinant of the equilibrium currency pricing. The role of history may dominate the role of expectations when the firms are myopic, particularly in the competitive local market. It also becomes dominant in the staggered price setting when a small fraction of the new price setters are backward-looking. The result suggests the importance of history in explaining why the firm tends to choose the US dollar as vehicle currency.
    JEL: F12 F31 F33
    Date: 2006–08
  24. By: Barry Eichengreen
    Abstract: The accumulation of international reserves by emerging markets raises the question of how to best utilize these funds. This paper explores two routes through which the pooling of reserves could enhance stability and welfare. First, the reserve pool could be used for emergency lending in response to sudden stops. Second, a portion of the reserve pool along with borrowed funds could be used to purchase contingent debt securities issued by governments and corporations, helping to solve the first-mover problem that limits the liquidity of markets in these instruments and hinders their acceptance by private investors. This paper argues that the second option is more likely to be feasible and productive.
    JEL: F0 F02 F39
    Date: 2006–08
  25. By: Mario J. Crucini (Department of Economics, Vanderbilt University); Mototsugu Shintani (Department of Economics, Vanderbilt University)
    Abstract: We study the dynamics of good-by-good real exchange rates using a micro-panel of 270 goods prices drawn from major cities in 63 countries and 258 goods prices drawn from 13 major U.S. cities. We find the half-life of deviations from the Law-of-One-Price for the average good is about 1 year. The average half-life is very similar across the OECD, the LCD and within the U.S., suggesting little in the way of nominal exchange rate regime influences. The average non-traded good has a half-life of 1.9 years compared to 1.2 years for traded-goods, for the OECD, with modest differences elsewhere. Aggregating the micro-data increases persistence in the OECD by 6 months to 1.5 years, well below levels obtained using aggregate CPI data. We attribute these differences to conceptual and methodological factors and argue in favor of increased use of micro-price data in applied theory.
    Keywords: Real exchange rates, purchasing power parity, law of one price, dynamic panel
    JEL: E31 F31 D40
    Date: 2002–12
  26. By: Bennett T. McCallum
    Abstract: It is argued that learnability/E-stability is a necessary condition for a RE solution to be plausible. A class of linear models considered by Evans and Honkapohja (2001) is shown to include all models of the form used by King and Watson (1998) and Klein (2000), which permits any number of lags, leads, and lags of leads. For this broad class it is shown that, if current-period information is available in the learning process, determinacy is a sufficient condition for E-stability. It is not a necessary condition, however; there exist cases with more than one stable solution in which the solution based on the decreasing-modulus ordering of the system’s eigenvalues is E-stable. If in such a case the other stable solution(s) are not E-stable, then the condition of indeterminacy may not be important for practical issues.
    JEL: C62 C63 D84 E00
    Date: 2006–08
  27. By: Bong-Chan Kho; René M. Stulz; Francis E. Warnock
    Abstract: Despite the disappearance of formal barriers to international investment across countries, we find that the average home bias of U.S. investors towards the 46 countries with the largest equity markets did not fall from 1994 to 2004 when countries are equally weighted but fell when countries are weighted by market capitalization. This evidence is inconsistent with portfolio theory explanations of the home bias, but is consistent with what we call the optimal insider ownership theory of the home bias. Since foreign investors can only own shares not held by insiders, there will be a large home bias towards countries in which insiders own large stakes in corporations. Consequently, for the home bias to fall substantially, insider ownership has to fall in countries where it is high. Poor governance leads to concentrated insider ownership, so that governance improvements make it possible for corporate ownership to become more dispersed and for the home bias to fall. We find that the home bias of U.S. investors decreased the most towards countries in which the ownership by corporate insiders is low and countries in which ownership by corporate insiders fell. Using firm-level data for Korea, we find that portfolio equity investment by foreign investors in Korean firms is inversely related to insider ownership and that the firms that attract the most foreign portfolio equity investment are large firms with dispersed ownership.
    JEL: F36 F30 G32 G30 G11 G15
    Date: 2006–07
  28. By: Orazio P. Attanasio; Monica Paiella
    Abstract: This paper builds a unifying framework that, within the theory of intertemporal consumption choices, brings together the limited participation -based explanation of the poor empirical performance of the C-CAPM and the transaction costs-based explanation of incomplete portfolios. Using the implications of the consumption model and observed household consumption and portfolio choices, we identify the preference parameters of interest and a lower bound for the costs rationalizing non-participation in financial markets, in the presence of unobserved heterogeneity in tastes for consumption and portfolio allocation. Using the US Consumer Expenditure Survey and assuming isoelastic preferences, we estimate the coefficient of relative risk aversion at 1.7 and a cost bound of 0.4 percent of non-durable consumption. Our estimate of the preference parameter is theoretically plausible and the bound sufficiently small to be likely to be exceeded by the actual total (observable and unobservable) costs of participating to financial markets.
    JEL: G11 G12
    Date: 2006–08
  29. By: Hans Gersbach; Harald Uhlig
    Abstract: We examine the coexistence of banks and financial markets, studying a credit market where the qualities of investment projects are not observable and the investment decisions of entrepreneurs are not contractible. Standard banks can alleviate moral-hazard problems by securing a portion of a repayment in the case of non-investment. Financial markets operated by investment banks and rating agencies have screening know-how and can alleviate adverse-selection problems. In competition, standard banks are forced to increase repayments, since financial markets can attract the highest-quality borrowers. This, in turn, increases the share of shirkers and may make lending unprofitable for standard banks. The coexistence of financial markets and standard banks is socially inefficient. The same inefficiency can happen with the entrance of sophisticated banks, operating with a combination of rating and ongoing monitoring technologies.
    Keywords: contract, debt contract, adverse selection, moral hazard, coexistence of financial intermediaries, regulation
    JEL: G24 G28 G32 G38 D80 D92 D43
    Date: 2006–03
  30. By: Chin Nam Low; Heather Anderson; Ralph D. Snyder
    Abstract: This paper considers Beveridge-Nelson decomposition in a context where the permanent and transitory components both follow a Markov switching process. Our approach incorporates Markov switching into a single source of error state-space framework, allowing business cycle asymmetries and regime switches in the long run multiplier.
    Keywords: Beveridge-Nelson decomposition, Markov switching, Single source of error state space models
    JEL: C22 C51 E32
    Date: 2006–08
  31. By: Rajnish Mehra
    Abstract: In this article we define a Recursive Competitive Equilibrium, provide an example and review the related literature. The article is an entry prepared for The New Palgrave: A Dictionary of Economics, 2nd Edition (Palgrave Macmillan: New York).
    JEL: D5 D51 D61 D91 D92 E21 E22 E23 G12
    Date: 2006–08
  32. By: Alessandro Prati; Thierry Tressel
    Abstract: This paper analyses how monetary policy can enhance the effectiveness of volatile aid fl ows. We find that monetary policy is effective in reducing trade balance volatility. We propose the following taxonomy, excluding the case of emergency assistance. Monetary policy should slow down consumption growth and build up international reserves when aid is abundant and deplete them to finance imports and support consumption when aid is scarce. If foreign aid also affects productivity growth, monetary policy should take this productivity effect into account in responding to aid flows.
    Keywords: Aid effectiveness, monetary policy, real exchange rate, Dutch disease
    JEL: O11 O4 O23 E5 F35
    Date: 2006–02
  33. By: Sabina Pogorelec (European Investment Bank, 100 boulevard Konrad Adenauer, L-2950 Luxembourg, Luxembourg.)
    Abstract: I build a quantitative two-country DSGE model of the European Union (EU) and investigate whether there are welfare gains from fiscal policy cooperation between the new EU members and the euro area (EMU). Fiscal cooperation is defined in terms ofjoint maximization of the weighted average of households’ welfare. I find that fiscal policy cooperation is welfare-reducing for both groups of countries. This result depends on a realistic assumption about the presence of foreign ownership of firms in the new EU countries. When there is no foreign ownership in the new EU countries, the euro area is indifferent between cooperating and not cooperating, but the new EU members still prefer not to cooperate with EMU in terms of fiscal policy. JEL Classification: E63; F42.
    Keywords: Fiscal policy cooperation; Foreign ownership of firms; Fiscal-monetary interactions; Enlarged European Union; Central and eastern European countries.
    Date: 2006–07
  34. By: Gergely Kiss (Magyar Nemzeti Bank); Gábor Vadas (Magyar Nemzeti Bank)
    Abstract: As part of the monetary transmission studies of the Magyar Nemzeti Bank, this paper attempts to analyse the role of the housing market in the monetary transmission mechanism of Hungary. The housing market can influence monetary transmission through three channels, namely, the nature of the interest burden of mortgage loans, asset (house) prices, and the credit channel. The study first summarises the experiences of developed countries, paying special attention to issues arising from the monetary union. It then examines the developments in the Hungarian housing and mortgage markets in the last 15 years, as well as the expected developments and changes attendant to the adoption of the euro. Using panel econometric techniques, the study investigates the link between macroeconomic variables and house prices in Hungary, and the effect of monetary policy on housing investment and consumption through the wealth effect and house equity withdrawal.
    Keywords: Housing, Monetary transmission, Mortgage market, Panel econometrics.
    JEL: E52
    Date: 2005
  35. By: Mario J. Crucini (Department of Economics, Vanderbilt University)
    Abstract: This paper is a non-technical review of research developments in the international real business cycle literature. International business cycle facts are summarize with particular attention to the sources of output variance from the expenditure side of the NIPA and the production side, using a familiar neoclassical production function. Theoretical developments focus on the how consumption smoothing and investment dynamics shape the current account; the search for sources and propagation mechanisms of international business cycle comovement and key facets of relative price determination (the real exchange rate and the terms of trade).
    Keywords: International business cycles, current account, real exchange rates
    JEL: A1 F4 E3
    Date: 2006–07
  36. By: Lei Lei Song (Melbourne Institute of Applied Economic and Social Research, The University of Melbourne)
    Abstract: This paper examines the relationship between the general price level and the relative price of fuel by measuring correlation from VAR forecast errors. The results suggest a significant positive correlation between quarterly changes in the relative price of fuel and the CPI, at least in the short to medium term from two to four years. The finding has important implications for measuring the long-term trend in inflation as relative price changes in fuel contain important information about future inflation.
    JEL: E31 E37
    Date: 2006–08
  37. By: Rumen Dobrinsky (United Nations Economic Commission for Europe); Dieter Hesse (United Nations Economic Commission for Europe); Rolf Traeger (United Nations Economic Commission for Europe)
    Abstract: The paper analyses the determinants of long-term economic performance of east European and CIS economies in two periods: 1960-1989 (the era of central planning) and 1990-2005 (the transition to the market economy system). Throughout the 1960s and 1970s economic growth in eastern Europe progressively weakened and during the 1980s most of these economies plunged into a prolonged stagnation or recession, which contributed to the collapse of communism and central planning. The transition from plan to market began with the transformational recession, which persisted until the mid-1990s in eastern Europe, but was longer and deeper in the CIS. Since then, the east European and CIS economies have embarked on a path of strong economic growth. The recovery has been accompanied by a surge in fixed investment, often complemented by large inflows of FDI. Despite robust output growth, however, there has not been - at least so far - a noteworthy recovery in employment. The main feature of the recent strong economic growth in the region has been a remarkable upturn in both labour productivity and total factor productivity. The considerable gains in productive efficiency and rapid technological change were triggered by wide-ranging market reforms and the modernization of the capital stock. Gains in aggregate output per person employed have outpaced by a large margin increases in real GDP per capita. In terms of average productivity and real per capita income levels relative to those of the more developed, industrialized countries, the east European and CIS economies still face a long catching up process.
    Keywords: economic growth, East Europe, CIS, transition economies
    JEL: O11 O47 O52 E22 E24 J24 N14
  38. By: Gábor Orbán (Magyar Nemzeti Bank); Zoltán Szalai (Magyar Nemzeti Bank)
    Abstract: The most important mechanism through which monetary policy affects the real economy in Hungary is the exchange rate channel. With euro adoption, this mechanism will largely disappear and the impact of monetary policy will be transmitted via the interest rate channel, presently seen as rather weak. This has raised concerns that the influence of monetary policy on the real economy in Hungary could be very limited after euro adoption. On top of this, other concerns have been voiced as regards potential asymmetries in the wage-setting behaviour, the exchange rate and credit channels. Based on the experience of today’s euro area participating countries and the structural characteristics of the Hungarian economy, this paper argues that after euro adoption 1) we may expect a broadening of the scope of the interest rate channel of monetary policy after euro adoption, 2) there are no institutional obstacles in the way of the effective functioning of the expectations channel in Hungary 3) substantially different monetary conditions from that in the euro area as a result of a different trade orientation are unlikely, and, finally 4) some asymmetries in the balance sheet channel may continue to exist for some time between Hungary and the core euro area countries but its effect will be significantly smaller after euro zone entry.
    Keywords: monetary transmission mechanism, transmission channels, EMU participation.
    JEL: E52 E58
    Date: 2005
  39. By: Valadkhani, Abbas (University of Wollongong)
    Abstract: This paper examines the long- and short-run determinants of the demand for money in six countries in the Asian-Pacific region using panel data (1975-2002). Various country-specific coefficients are allowed to capture inter-country heterogeneities. Consistent with theoretical postulates, it is found that (a) the demand for money in the long-run positively responds to real income and inversely to the interest rate spread, inflation, the real effective exchange rate, and the US real interest rate; (b) the long-run income elasticity is greater than unity; and (c) both the currency substitution and capital mobility hypotheses hold only in the long run.
    Keywords: Demand for Money; Money and Interest Rate Spread; Panel Data
    JEL: E41 E52 C33 O11
    Date: 2006

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