nep-cba New Economics Papers
on Central Banking
Issue of 2006‒10‒21
forty-two papers chosen by
Alexander Mihailov
University of Reading

  1. Inflation persistence and price-setting behaviour in the euro area : a summary of the Inflation Persistence Network evidence By Filippo Altissimo; Michael Ehrmann; Frank Smets
  2. How wages change : micro evidence from the International Wage Flexibility Project By William T. Dickens; Lorenz Goette; Erica L. Groshen; Steinar Holden; Julian Messina; Mark E. Schweitzer; Jarkko Turunen; Melanie E. Ward
  3. Price and wage setting in an integrating Europe : firm level evidence By Filip Abraham; Jozef Konings; Stijn Vanormelingen
  4. The structural dynamics of output growth and inflation: some international evidence By Fabio Canova; Luca Gambetti; Evi Pappa
  5. A new Keynesian model with unemployment By Olivier Blanchard; Jordi Gali
  6. Why the marginal MRO rate exceeds the ECB policy rate? By Välimäki , Tuomas
  7. Losing our Marbles in the New Century? The Great Rebalancing in Historical Perspective By Christopher M. Meissner; Alan M. Taylor
  8. How to Advance Theory with Structural VARs: Use the Sims-Cogley-Nason Approach By Patrick J. Kehoe
  9. Shooting the Auctioneer By Roger E. A. Farmer; Andrew Hollenhorst
  10. Optimal Interest Rate Stabilization in a Basic Sticky-Price Model By Matthias Paustian; Christian Stoltenberg
  11. Robust monetary policy in a small open economy By Leitemo , Kai; Söderström , Ulf
  12. Robustness in monetary policymaking: a case for the Friedman rule By Kilponen, Juha; Leitemo, Kai
  13. Identifying the interdependence between US monetary policy and the stock market By Bjørnland , Hilde; Leitemo, Kai
  14. The role of expectations in the inflation process in the euro area By Paloviita , Maritta; Virén , Matti
  15. Comparing alternative Phillips curve specifications: European results with survey-based expectations By Paloviita , Maritta
  16. Inflation expectations and regime shifts in the euro area By Virén , Matti
  17. Policy words and policy deeds: the ECB and the euro By Siklos, Pierre; Bohl , Martin
  18. Exchange rate volatility without the contrivance of fundamentals and the failure of PPP By Bask, Mikael
  19. Fundamentals and technical trading: behaviour of exchange rates in the CEECs By Bask , Mikael; Fidrmuc , Jarko
  20. Announcement effects on exchange rate movements: continuity as a selection criterion among the REE By Bask , Mikael
  21. Adaptive learning in an expectational difference equation with several lags: selecting among learnable REE By Bask, Mikael
  22. Simulation, estimation and welfare implications of monetary policies in a 3-country NOEM model By Joseph Plasmans; Tomasz Michalak; Jorge Fornero
  23. Money market volatility, A simulation study By Kempa , Michal
  24. Fiscal Sustainability in a New Keynesian Model By Campbell Leith and Simon Wren-Lewis
  25. The effect of a transaction tax on exchange rate volatility By Lanne , Markku; Vesala , Timo
  26. General Equilibrium Model of Arbitrage Trade and Real Exchange Rate Persistence By Berka, Martin
  27. Real Balance Effects, Timing and Equilibrium Determination By Christian Stoltenberg
  28. Comovements and heterogeneity in the Comovements and heterogeneity in the dynamic factor model By Eickmeier, Sandra
  29. Dynamics and monetary policy in a fair wage model of the business cycle By David de la Croix; Gregory de Walque; Rafael Wouters
  30. International economic spillovers and the liquidity trap By Tarkka , Juha; Kortelainen , Mika
  31. Nominal wage rigidities in a new Keynesian model with frictional unemployment By Vincent Bodart; Gregory de Walque; Olivier Pierrard; Henri R. Sneessens; Raf Wouters
  32. The mixed oligopoly of cross-border payment systems By Kauko, Karlo
  33. Monetary Equilibria in a Baumol-Tobin Economy By Ingolf Schwarz
  34. Productivity differentials and external balance in ERM II By Henriksson , Marketta
  35. Labour taxation and shock propagation in a New Keynesian model with search frictions By Vanhala, Juuso
  36. How hard is the euro are core? An evaluation of growth cycles using wavelet analysis By Crowley , Patrick; Maraun , Douglas; Mayes , David
  37. Producer Prices in the Transition to a Common Currency By Andrén, Niclas; Oxelheim, Lars
  38. Open market operations: beyond the new consensus By Toporowski , Jan
  39. Macroeconomic fluctuations and firm entry : theory and evidence By Vivien Lewis
  40. Why do bank runs look like panic? A new explanation By Chen, Yehning; Hasan, Iftekhar
  41. Monetary Policy and Inflation Expectations in Latin America: Long-run Effects and Volatility Spillovers By OECD
  42. The Interplay between Money Market Development and Changes in Monetary Policy Operations in Small European Countries, 1980–2000 By Forssbaeck, Jens; Oxelheim, Lars

  1. By: Filippo Altissimo (European Central Bank); Michael Ehrmann (European Central Bank); Frank Smets (European Central Bank)
    Abstract: This paper provides a summary of current knowledge on inflation persistence and price stickiness in the euro area, based on research findings that have been produced in the context of the Inflation Persistence Network. The main findings are: i) Under the current monetary policy regime, the estimated degree of inflation persistence in the euro area is moderate; ii) Retail prices in the euro area are more sticky than in the US; iii) There is significant sectoral heterogeneity in the degree of price stickiness; iv) Price decreases are not uncommon. The paper also investigates some of the policy implications of these findings
    Keywords: price-setting; inflation persistence; monetary policy; EMU
    JEL: E31 E42 E52
    Date: 2006–10
  2. By: William T. Dickens (The Brookings Institution, Washington, D.C.); Lorenz Goette (University of Zurich); Erica L. Groshen (Federal Reserve Bank of New York; Institute for the Study of Labor (IZA), Bonn); Steinar Holden (University of Oslo; Research Fellow, Center for Economic Studies--Information and Forschung Institute (CESifo), Munich); Julian Messina (European Central Bank; Universitat de Girona, Italy; Centre for Studies in Economics and Finance (CSEF), Università di Salerno, Italy); Mark E. Schweitzer (Federal Reserve Bank of Cleveland, Ohio); Jarkko Turunen (European Central Bank); Melanie E. Ward (European Central Bank; Institute for the Study of Labor (IZA), Bonn)
    Abstract: How do the complex institutions involved in wage setting affect wage changes? The International Wage Flexibility Project provides new microeconomic evidence on how wages change for continuing workers. We analyze individuals’ earnings in 31 different data sets from sixteen countries, from which we obtain a total of 360 wage change distributions. We find a remarkable amount of variation in wage changes across workers. Wage changes have a notably non-normal distribution; they are tightly clustered around the median and also have many extreme values. Furthermore, nearly all countries show asymmetry in their wage distributions below the median. Indeed, we find evidence of both downward nominal and real wage rigidities. We also find that the extent of both these rigidities varies substantially across countries. Our results suggest that variations in the extent of union presence in wage bargaining play a role in explaining differing degrees of rigidities among countries
    Keywords: Wage setting, Wage change distributions, Downward nominal wage rigidity, Downward real wage rigidity
    JEL: E3 J3 J5
    Date: 2006–10
  3. By: Filip Abraham (Faculty of Economics and Applied Economics, Katholieke Universiteit Leuven); Jozef Konings (Faculty of Economics and Applied Economics, Katholieke Universiteit Leuven; LICOS, Centre for Transition Economics; Katholieke Universiteit Leuven; CEPR, London); Stijn Vanormelingen (Faculty of Economics and Applied Economics, Katholieke Universiteit Leuven)
    Abstract: Europe has witnessed the last decade an accelerated process of economic integration. Trade barriers were removed, the euro was introduced and ten new member states entered the European Union. Economic integration is likely to have an impact on both labor and product markets. Unlike most other papers, that focus on product and labor markets separately, we look at the link between globalization and product and labor market imperfections simultaneously. To this end, we rely on a rich panel of manufacturing firms in Belgium, a small open economy. We find that union bargaining power is higher in sectors characterized by high price cost margins. Moreover, ignoring imperfections on the labor market, leads to an underestimation of product market power. Concerning the influence of globalization, our main findings are that both price cost margins and union bargaining power are typically lower in sectors that are subject higher international competition. This result is especially true for competition from low wage countries
    Keywords: Mark-ups, Trade Unions, International Trade
    JEL: F16 J50 L13
    Date: 2006–10
  4. By: Fabio Canova; Luca Gambetti; Evi Pappa
    Abstract: We examine the dynamics of output growth and inflation in the US, Euro area and UK using a structural time varying coe¢ cient VAR. There are important similarities in structural inflation dynamics across countries; output growth dynamics differ. Swings in the magnitude of inflation and output growth volatilities and persistences are accounted for by a combination of three structural shocks. Changes over time in the structure of the economy are limited and permanent variations largely absent. Changes in the volatilities of structural shocks matter
    Keywords: Variability, Persistence, Transmission, Structural time varying VARs
    JEL: C11 E12 E32 E62
    Date: 2006–04
  5. By: Olivier Blanchard (MIT; NBER); Jordi Gali (Barcelona, Universitat Pompeu Fabra (UPF), Centre de Recerca en Economia Internacional (CREI); CEPR; NBER)
    Abstract: We develop a utility based model of fluctuations, with nominal rigidities, and unemployment. In doing so, we combine two strands of research: the New Keynesian model with its focus on nominal rigidities, and the Diamond-Mortensen-Pissarides model, with its focus on labor market frictions and unemployment. In developing this model, we proceed in two steps. We first leave nominal rigidities aside. We show that, under a standard utility specification, productivity shocks have no effect on unemployment in the constrained efficient allocation. We then focus on the implications of alternative real wage setting mechanisms for fluctuations in unemployment. We then introduce nominal rigidities in the form of staggered price setting by firms. We derive the relation between inflation and unemployment and discuss how it is influenced by the presence of real wage rigidities. We show the nature of the tradeoff between inflation and unemployment stabilization, and we draw the implications for optimal monetary policy
    Keywords: new Keynesian model, labor market frictions, search model, unemployment, sticky prices, real wage rigidities
    JEL: E32 E50
    Date: 2006–10
  6. By: Välimäki , Tuomas (Bank of Finland)
    Abstract: In the Eurosystem, banks’ interest rate expectations should no longer have resulted in a non-zero tender spread, the difference between marginal and minimum price for liquidity, when the ECB reformed its op-erational framework for monetary policy implementation in March 2004 so that the policy rates remain constant within reserves maintenance periods. Yet, the tender spread was wider in 2005 than in any single year after 2000, when the ECB switched from fixed to variable rate tenders. Parts of the relevant literature have argued that because of the ECB’s asymmetric preferences over deviations of the market rates up and down from the policy rate, the shortest euro interest rates persistently exceed the policy rate This paper argues, however, that when the central bank applies a quantity oriented liquidity policy, a positive tender spread may result from money market inefficiencies and banks’ risk aversion even if the central bank preferences are symmetric and the markets do not anticipate any changes in the policy rates. In such a case, the driving force behind the tender spread is banks’ uncertainty about their individual allotments at the marginal rate for the Eurosystem main refinancing operations (MROs). Furthermore, the allotment uncertainty is shown to be significantly related to the amount of liquidity supplied in each operation. Hence, the expansion in the MRO volumes experienced since 2002 may have had a major contribution to the emergence and observed growth of the tender spread.
    Keywords: main refinancing operations; liquidity; tender spread; allotments
    JEL: D44 E58
    Date: 2006–10–03
  7. By: Christopher M. Meissner; Alan M. Taylor
    Abstract: Great attention is now being paid to global imbalances, the growing U.S. current account deficit financed by growing surpluses in the rest of the world. How can the issue be understood in a more historical perspective? We seek a meaningful comparison between the two eras of globalization: "then" (the period 1870 to 1913) and "now" (the period since the 1970s). We look at the two hegemons in each era: Britain then, and the United States now. And adducing historical data to match what we know from the contemporary record, we proceed in the tradition of New Comparative Economic History to see what lessons the past might have for the present. We consider two of the most controversial and pressing questions in the current debate. First, are current imbalances being sustained, at least in part, by return differentials? And if so, is this reassuring? Second, how will adjustment take place? Will it be a hard or soft landing? Pessimistically, we find no historical evidence that return differentials last forever, even for hegemons. Optimistically, we find that adjustments to imbalances in the past have generally been smooth, even under a regime as hard as the gold standard.
    JEL: F20 F30 F32 F40 F50 N10 N20
    Date: 2006–10
  8. By: Patrick J. Kehoe
    Abstract: The common approach to evaluating a model in the structural VAR literature is to compare the impulse responses from structural VARs run on the data to the theoretical impulse responses from the model. The Sims-Cogley-Nason approach instead compares the structural VARs run on the data to identical structural VARs run on data from the model of the same length as the actual data. Chari, Kehoe, and McGrattan (2006) argue that the inappropriate comparison made by the common approach is the root of the problems in the SVAR literature. In practice, the problems can be solved simply. Switching from the common approach to the Sims-Cogley-Nason approach basically involves changing a few lines of computer code and a few lines of text. This switch will vastly increase the value of the structural VAR literature for economic theory.
    JEL: C32 C51 C52 E13 E17 E21 E27 E32 E37
    Date: 2006–10
  9. By: Roger E. A. Farmer; Andrew Hollenhorst
    Abstract: Most dynamic stochastic general equilibrium models of the macroeconomy assume that labor is traded in a spot market. Two exceptions by David Andolfatto and Monika Merz combine a two-sided search model with a one-sector real business cycle model. These hybrid models are successful, in some dimensions, but they cannot account for observed volatility in unemployment and vacancies. Following suggestions by Robert Hall and Robert Shimer, this paper shows that a relatively standard DSGE model with sticky wages can account for these facts. Using a second-order approximation to the policy function we simulate moments of an artificial economy with and without sticky wages and we document the dependence of unemployment and vacancy volatility on two key parameters; the disutility of effort and the degree of wage stickiness. We compute the welfare costs of the sticky wage equilibrium and find them to be small.
    JEL: E32 J6
    Date: 2006–10
  10. By: Matthias Paustian; Christian Stoltenberg
    Abstract: This paper studies optimal monetary policy with the nominal interest rate as the single policy instrument in an economy, where firms set prices in a staggered way without indexation and real money balances contribute separately to households' utility. The optimal deterministic steady state under commitment is the Friedman rule - even if the importance assigned to the utility of money is small relative to consumption and leisure. We approximate the model around the optimal steady state as the long-run policy target. Optimal monetary policy is characterized by stabilization of the nominal interest rate instead of inflation stabilization as the predominant principle.
    Keywords: Optimal monetary policy, commitment, timeless perspective, optimal steady state, staggered price setting, monetary friction, Friedman's rule
    JEL: E32 E52 E58
    Date: 2006–10
  11. By: Leitemo , Kai (Norwegian School of Management (BI)); Söderström , Ulf (Department of Economics and IGIER, Università Bocconi)
    Abstract: This paper studies how a central bank’s preference for robustness against model misspecification affects the design of monetary policy in a New-Keynesian model of a small open economy. Due to the simple model structure, we are able to solve analytically solve the optimal robust policy rule, and separately ana-lyze the effects of robustness against misspecification concerning the determination of inflation, output and the exchange rate. We show that an increased central bank preference for robustness makes monetary policy respond more aggressively or more cautiously to shocks, depending on the type of shock and the source of misspecification.
    Keywords: Knightian uncertainty; model uncertainty; robust control; min-max policies
    JEL: E52 E58 F41
    Date: 2005–10–11
  12. By: Kilponen, Juha (Bank of Finland Research); Leitemo, Kai (Norwegian School of Management (BI))
    Abstract: Inflation targeting involves using all available information in stabilizing inflation around some target rate (Svensson, 2003). Inflation is typically at the very end of the transmission mechanism and hence its de-termination is subject to much model uncertainty which the central bank will want to guard against using robust policies. Such robustness comes however with the cost of increased social loss under the most likely description of the economy. We show that with a sufficiently high degree of model uncertainty, ad-herence to the Friedman rule of increasing the money stock by k percent will be superior as the price paid for robustness is smaller.
    Keywords: policy robustness; money growth targeting; inflation targeting; Friedman rule
    JEL: E42 E52 E58 E61
    Date: 2006–04–19
  13. By: Bjørnland , Hilde (University of Oslo, Department of Economics); Leitemo, Kai (Department of Economics, Norwegian School of Management BI)
    Abstract: We estimate the interdependence between US monetary policy and the S&P 500 using structural VAR methodology. A solution is proposed to the simultaneity problem of identifying monetary and stock price shocks by using a combination of short-run and long-run restrictions that maintains the qualitative proper-ties of a monetary policy shock found in the established literature (CEE 1999). We find great interde-pendence between interest rate setting and stock prices. Stock prices immediately fall by 1.5 per cent due to a monetary policy shock that raises the federal funds rate by ten basis points. A stock price shock in-creasing stock prices by one per cent leads to an increase in the interest rate of five basis points. Stock price shocks are orthogonal to the information set in the VAR model and can be interpreted as non-fundamental shocks. We attribute a major part of the surge in stock prices at the end of the 1990s to these non-fundamental shocks.
    Keywords: VAR; monetary policy; asset prices; identification
    JEL: E43 E52 E61
    Date: 2005–07–11
  14. By: Paloviita , Maritta (Bank of Finland Research); Virén , Matti (University of Turku)
    Abstract: This paper analyses the role of inflation expectations in the euro area. On one hand, the question is how inflation expectations affect both inflation and output, and, on the other hand, how inflation expectations reflect developments in these variables. The analyses make use of a simple VAR model of inflation, inflation expectations and the output gap that allows for an analysis of the dynamic interrelationship between these variables. This model is estimated on aggregate euro area data, pooled euro area country data and individual country data for the period 1979–2003. The empirical results give strong support for the idea that inflation expectations are the key ingredient of the inflationary process for the whole euro area and for most individual countries as well. Inflation expectations also have a significant negative impact on output. As for the determination of inflation expectations, it turns out that they are relatively persistent, almost as persistent as output. Even so, and especially in the medium term, inflation expectations adapt to developments in both output and (actual) inflation.
    Keywords: inflation; expectations; monetary policy; Phillips curve
    JEL: E31 E52
    Date: 2005–02–13
  15. By: Paloviita , Maritta (Bank of Finland Research)
    Abstract: This paper examines inflation dynamics in Europe. Econometric specification tests with pooled European data are used to compare the empirical performance of the New Classical, New Keynesian and Hybrid specifications of the Phillips curve. Instead of imposing any specific form of expectations formation, di-rect measures, ie Consensus Economics survey data are used to proxy economic agents’ inflation expecta-tions. According to the results, the New Classical Phillips curve has satisfactory statistical properties. Moreover, the purely forward-looking New Keynesian Phillips curve is clearly outperformed by the New Classical and Hybrid Phillips curves. We interpret our results as indicating that the European inflation process is not purely forward-looking, and inflation cannot instantaneously adjust to changes in expecta-tions. Consequently, even allowing for possible non-rationality in expectations, a lagged inflation term enters the New Keynesian Phillips curve for inflation dynamics in Europe.
    Keywords: Phillips curve; expectations; Europe
    JEL: C52 E31
    Date: 2005–10–11
  16. By: Virén , Matti (Bank of Finland and University of Turku)
    Abstract: This paper focuses on the determination of inflation expectations. The following two questions are exam-ined: How much do inflation expectations reflect different economic and institutional regime shifts and in which way do inflation expectations adjust to past inflation? The basic idea in the analysis is an assump-tion that inflation expectations do not mechanically reflect past inflation as may econometric specification de facto assume but rather they depend on the relevant economic regime. Also the adjustment of expecta-tions to past inflation is different in different inflation regimes. The regime analysis is based on panel data from EMU/EU countries for the period 1973–2004, while the inflation adjustment analysis mainly uses the Kalman filter technique for individual countries for the same period. Expectations (forecasts) are de-rived from OECD data. Empirical results strongly favour the regime-sensitivity hypothesis and provide an explanation for the poor performance of conventional estimation procedures in the context of Phillips curves.
    Keywords: inflation expectations; Kalman filter; stability
    JEL: E32 E37
    Date: 2005–10–11
  17. By: Siklos, Pierre (Department of Economics and Viessmann Research Centre on Modern Europe, Wilfrid Laurier University); Bohl , Martin (Department of Economics, Westfälische Wilhelms University Münster)
    Abstract: This paper examines the role of the ECB communication activities on daily Eurodollar exchange rate and interest rates. We estimate the relationship between monetary policy and the exchange rate using a technique that explicitly recognises the joint determination of both the levels and volatilities of these variables. We also consider more traditional estimation strategies as a test of the robustness of our main results. We introduce a new indicator of ECB communications policies that focuses on what the ECB says about the future economic outlook for the euro area along five different economic dimensions. The impact of ECB communications policies is more apparent in the time series framework than in the heteroskedasticity estimator approach. Previous studies that conclude that news effects are significant at the daily frequency may have reached such a conclusion because the measurement of news was too highly aggregated. The endogeneity of the exchange rate – interest rate relationship is more apparent when the proxy for monetary policy is the euro area – US differential than when any other proxy for monetary policy is employed. Finally, interest rate changes generally have a much larger impact on exchange rate movements, and their volatility, than do ECB verbal pronouncements.
    Keywords: communication policy; exchange rates; interest rates; volatility
    JEL: E50 E60 F30
    Date: 2006–04–11
  18. By: Bask, Mikael (Bank of Finland Research)
    Abstract: Since the magnitude of exchange rate overshooting may not be the same for different exchange rates of a currency, a monetary expansion or contraction in, for example, the EMU, will affect the exchange rate between the U.S. dollar and the yen, even though there are no changes in monetary fundamentals in the U.S. or Japan. This fact is demonstrated in a sticky-price monetary model due originally to Dornbusch (1976) that is enlarged with currency traders that use Chartism in the form of moving averages. It is also demonstrated that purchasing power parity (PPP) does not necessarily hold in long-run equilibrium. The-se results are interesting since, according to the empirical literature, there are often large movements in nominal exchange rates that are apparently unexplained by macroeconomic fundamentals, and there is also a weak support for PPP.
    Keywords: Chartism; foreign exchange; macroeconomic fundamentals; moving averages; overshooting and PPP
    JEL: F31 F41
    Date: 2006–10–10
  19. By: Bask , Mikael (Bank of Finland Research); Fidrmuc , Jarko (Department of Economics, University of Munich, CESifo and Comenius University in Bratislava)
    Abstract: We present a model of exchange rates, which incorporates the monetary approach and technical trading, and we present the reduced form based on the minimal state variable solution, where both fundamentals and backward-looking term determine the spot exchange rates. Finally, we estimate the impact of the monetary fundamentals for a panel of Central and Eastern European countries (Czech Republic, Poland, Romania and Slovakia) in the second half of the 1990s as well as the complete model of exchange rate determination for daily data over the more recent free-floating period.
    Keywords: foreign exchange market; fundamental analysis; panel cointegration; technical analysis
    JEL: C23 F31 F36
    Date: 2006–06–12
  20. By: Bask , Mikael (Bank of Finland Research)
    Abstract: The aim of this paper is to analyse the announcement effects on exchange rate movements using the basic asset pricing model, where currency trade is partly determined by technical trading in the form of moving averages since it is the most commonly used technique according to questionnaire surveys. Specifically, the announcement and implementation of temporary as well as permanent monetary policy are analysed, where the exchange rate model developed is summarised in a linear difference equation in current exoge-nous fundamentals, a large number of lags of the endogenous exchange rate and time-t dating of exchange rate expectations. However, since there are a large number of rational expectations equilibria, continuity is proposed as a selection criterion among the equilibria, meaning that the parameter for the time-t – 1 ex-change rate should have the limit 0 when there is no technical trading to have an economically meaning-ful equilibrium. It turns out that there is a unique rational expectations equilibrium that satisfy the conti-nuity criterion, and focusing on this equilibrium, it is shown that the exchange rate is much more sensitive to changes in money supply than when technical trading is absent in currency trade. This result is impor-tant since it sheds light on the so-called exchange rate disconnect puzzle in international finance.
    Keywords: asset pricing; exchange rate disconnect puzzle; heterogeneous agents; least squares learnability; monetary policy and technical trading
    JEL: E51 E52 F31 G12
    Date: 2006–06–07
  21. By: Bask, Mikael (Bank of Finland Research)
    Abstract: It is demonstrated in this paper that adaptive learning in least squares sense may be incapable to reduce, in a satisfactory way, the number of attainable equilibria in a rational expectations model. The model inves-tigated, as an illustration, is the monetary approach to exchange rate determination that is augmented with technical trading in the currency market in the form of moving averages since it is the most commonly used technique according to questionnaire surveys. Because of technical trading in foreign exchange, the current exchange rate is dependent on jmax lags of the exchange rate, and the model has, therefore jmax + 1 nonbubble rational expectations equilibria (REE), where most of them are adaptively learnable. Howe-ver, by assuming that a solution to the model should have a solution to a nested model as its limit, it is possible to single out a unique equilibrium among the adaptively learnable equilibria that is economically meaningful.
    Keywords: asset pricing; heterogenous agents; least squares learnability; rational expectations equilibria and technical trading
    JEL: C62 F31 G12
    Date: 2006–06–07
  22. By: Joseph Plasmans (Department of Economics, University of Antwerp); Tomasz Michalak (Department of Economics, University of Antwerp); Jorge Fornero (Department of Economics, University of Antwerp)
    Abstract: In this paper we derive a microfounded macro New Keynesian model for open economies, be them large or small. We consider habit formation in consumption, sectoral linkages, domestic and foreign governments, tradable and non-tradable final and intermediate goods and imperfect pass-through in these sectors. Sticky nominal prices and wages are modeled in a Calvo way. The model economy is composed of a continuum of infinitely-lived consumers and producers for three regions (countries). Numerical simulations and econometric estimations are presented with a focus on a small open economy member of the EMU. Welfare implications of the involved price and wage rigidities are discussed
    Keywords: New Keynesian open economy model, tradable and non-tradable sectors, final and intermediate goods, monetary policy rules, numerical simulations, Bayesian estimation, welfare implications
    JEL: E31 D21 F41 P24
    Date: 2006–10
  23. By: Kempa , Michal (RUESG, University of Helsinki and Bank of Finland)
    Abstract: This paper analyses different operational central bank policies and their impact on the behaviour of the money market interest rate. The model combines profit maximising behaviour by commercial banks with the central bank supplying the liquidity that keeps the market rate on target. It seems that frequent liquid-ity supplying operations represent an efficient tool to control money market rates. An averaging provision reduces the use of standing facilities and interest rates volatility in all days except for the last day of the maintenance period. Whenever banks have different maintenance horizons both the spikes in volatility and use of standing facilities disappear. The paper also compares two different liquidity supply policies and finds that the level of liquidity necessary to keep the rates on target depends on not only the aggregate but also assets values of individual banks.
    Keywords: Interbank market; interest rate volatility; central bank procedures; open market operations
    JEL: E43 E44 E52
    Date: 2006–06–12
  24. By: Campbell Leith and Simon Wren-Lewis
    Abstract: Most recent work deriving optimal monetary policy utilising New Neo-Classical Synthesis (NNCS) models abstract from the impact of monetary policy on the government’s finances, by assuming the existence of lump sum taxes. In this paper, we assume that the government does not have access to such taxes to satisfy its intertemporal budget constraint in the face of shocks. We then consider optimal monetary and fiscal policies under discretion and commitment in the face of technology, preference and cost-push shocks. We find that the optimal precommitment policy implies a random walk in the steady-state level of debt, generalising earlier results that involved only a single fiscal instrument. We also find that the time-inconsistency in the optimal precommitment policy is such that governments are tempted, given inflationary expectations, to utilise their monetary and fiscal instruments in the initial period to change the ultimate debt burden they need to service. We show that this temptation is only eliminated if following shocks, the new steady-state debt is equal to the original (efficient) debt level. This implies that under a discretionary policy the random walk result is overturned: debt will always be returned to this initial steady-state even although there is no explicit debt target in the government’s objective function. Analytically and in a series of numerical simulations we show which instrument is used to stabilise the debt depends crucially on the degree of nominal inertia and the size of the debt-stock. We also show that the welfare consequences of introducing debt are negligible for precommitment policies, but can be significant for discretionary policy.
    JEL: E60
  25. By: Lanne , Markku (Economics Department, European University Institute); Vesala , Timo (RUESG/Department of Economics, University of Helsinki)
    Abstract: We argue that a transaction tax is likely to amplify, not dampen, volatility in the foreign exchange mar-kets. Our argument stems from the decentralised trading practice and the presumable discrepancy be-tween ‘informed’ and ‘uninformed’ traders’ valuations. Since informed traders’ valuations are likely to be less dispersed, a transaction tax penalises informed trades disproportionately, leading to increased volatil-ity. Empirical support for this prediction is found by investigating the effect of transaction costs on the volatility of DEM/USD and JPY/USD returns. High-frequency data are used and an increase in transac-tion costs is found to have a significant positive effect on volatility.
    Keywords: transaction tax; exchange rates; volatility
    JEL: F31 F42 G15 G28
    Date: 2006–10–10
  26. By: Berka, Martin
    Abstract: Modelling of the physical characteristics of goods and geography can explain both the puzzling persistence and volatility in the deviations of the international relative prices and the real exchange rate (the PPP persistence puzzle). In a two-country, three-good general equilibrium model, arbitrage firms trade goods across borders using a linear transportation technology. Distance and product weights (their physical mass) determine the costs to arbitrage trade, while the differences in the endowments between countries create profitable trading opportunities. Tradability of goods is endogenous, in that only goods with a deviation from the law of one price in excess of their trade cost are traded. The adjustment of prices across borders is non-linear, with heterogeneous thresholds that depend positively on the weight of a product and distance { an empirical regularity. Aggregation of the law of one price deviations implies a smooth threshold non-linearity in the real exchange rate, justifying a reoccurring finding in the recent empirical literature. When stochastic endowments follow an AR(1) process calibrated to match the quarterly HP-filtered US and EU GDPs, and the aggregate trade costs consume 1.7% of the GDP, the half-life of deviation in the real exchange rate matches the persistence found in the data. A model with quadratic adjustment costs in the volume of trade is also capable of creating real exchange rate volatility, and so can explain the PPP puzzle entirely as a trade phenomenon.
    Keywords: Arbitrage trade; real exchange rate; persistence; volatility
    JEL: F41 F19 F49
    Date: 2005–08
  27. By: Christian Stoltenberg
    Abstract: This paper examines whether the existence and the timing of real balance effects contribute to the determination of the absolute price level, as suggested by Patinkin (1949,1965), and if they affect conditions for local equilibrium uniqueness and stability. I show that there exists a unique price level sequence that is consistent with an equilibrium under interest rate policy, only if beginning-of-period money yields transaction services. Predetermined real money balances can then serve as a state variable, implying that interest rate setting must be passive - a violation of the Taylor-principle - for unique, stable, and non-oscillatory equilibrium sequences. On the contrary, when the end-of-period money stock facilitates transactions, the equilibrium displays nominal indeterminacy and equilibrium uniqueness requires an interest rate setting consistent with the Taylor-principle.
    Keywords: Real balance effects, predetermined money, price level determination, real determinacy, monetary policy rules, flexible prices
    JEL: E32 E41 E52
    Date: 2006–10
  28. By: Eickmeier, Sandra
    Abstract: This paper seeks to assess comovements and heterogeneity in the euro area by fitting a nonstationary dynamic factor model (Bai and Ng, 2004), augmented with a structural factor setup (Forni and Reichlin, 1998), to a large set of euro-area macroeconomic variables observed between 1982 and 2003. This framework allows us to estimate stationary and non-stationary common factors and idiosyncratic components, to identify the structural shocks behind the common factors and assess their transmission to individual EMU countries. Our most important findings are the following. EMU countries share five common trends. However, the source of non-stationarity of individual countries’ key macroeconomic variables is not only pervasive. Instead, most countries’ output and inflation are also affected by long-lasting idiosyncratic shocks. Unweighted dispersion is primarily due to idiosyncratic shocks rather than the asymmetric spread of common shocks. However, the latter seems to be the main driving force of weighted dispersion of output at the end of the 1980s and the beginning of the 1990s and again from 1999 on and of inflation in the mid-1980s and the mid-1990s. To examine the transmission of common shocks to individual EMU countries in more detail, we identify five structural common shocks, namely two euro-area supply shocks, one euro-area demand shock, one common monetary policy shock and a US shock. We find similar output and inflation responses across countries (with some exceptions), and similarity generally increases with the horizon.
    Keywords: Dynamic factor models, sign restrictions, common trends, common cycles, international business cycles, EMU, output and inflation differentials
    JEL: C3 E32 E5 F00
    Date: 2006
  29. By: David de la Croix (Department of economics, Université catholique de Louvain; CORE); Gregory de Walque (National Bank of Belgium, Research department; Department of Economics, University of Namur); Rafael Wouters (National Bank of Belgium, Research department)
    Abstract: We first build a fair wage model in which effort varies over the business cycle. This mechanism decreases the need for other sources of sluggishness to explain the observed high inflation persistence. Second, we confront empirically our fair wage model with a New Keynesian model based on the standard assumption of monopolistic competition in the labor market. We show that, in terms of overall fit, the fair wage model outperforms the New Keynesian one. The extension of the fair wage model with lagged wage is judged insignificant by the data, but the extension based on a rent sharing argument including firm’s productivity gains in the fair wage is not. Looking at the implications for monetary policy, we conclude that the additional trade-off problem created by the inefficient real wage behavior significantly affects nominal interest rates and inflation outcomes
    Keywords: Efficiency wage, effort, inflation persistence, monetary policy
    JEL: E4 E5
    Date: 2006–10
  30. By: Tarkka , Juha (Bank of Finland Research); Kortelainen , Mika (Bank of Finland Research)
    Abstract: We study the effect of the zero bound constraint of interest rates on international transmission of eco-nomic policy and supply shocks. After some preliminary analysis with a simple theoretical model, we ap-ply a rich two-country simulation model to the problem. The model framework consists of EDGE, Bank of Finland’s dynamic equilibrium model for the euro area, linked to a similar model calibrated to resem-ble the US economy. The models have new Keynesian properties because of price rigidities and forward-looking pricing, consumption and investment behaviour. We assume freely floating exchange rates. Monetary policies are modelled with Taylor type policy rules, taking into account the zero bound con-straint for interest rates. We find that effects of policy and supply side shocks differ significantly from the ‘normal’ situation if one of the countries is in the ‘liquidity trap’, ie if the interest rate is constrained by the zero bound. Being in the liquidity trap amplifies the domestic effects of fiscal policy, but mitigates its spillover to abroad. Changing the long run inflation target, which does not have international spillovers in the normal case, does have effects abroad if the country where the target is changed is in a temporary li-quidity trap. The effects of supply shocks are also very different in the liquidity trap case compared to the normal case.
    Keywords: zero bound; liquidity trap; international spillovers; edge
    JEL: F42 F47
    Date: 2005–07–11
  31. By: Vincent Bodart (Department of Economics, Université catholique de Louvain); Gregory de Walque (National Bank of Belgium, Research department; Department of Economics, University of Namur); Olivier Pierrard (Department of Economics, Université catholique de Louvain; Banque centrale du Luxembourg); Henri R. Sneessens (Department of Economics, Université catholique de Louvain); Raf Wouters (National Bank of Belgium, Research department)
    Abstract: In this paper, we propose a search and matching model with nominal stickiness à la Calvo in the wage bargaining. We analyze the properties of the model, first, in the context of a typical real business cycle model driven by stochastic productivity shocks and second, in a fully specified monetary DSGE model with various real and nominal rigidities and multiple shocks. The model generates realistic statistics for the important labor market variables
    Keywords: DSGE, Search and Matching, Nominal Wage Rigidity, Monetary Policy
    JEL: E31 E32 E52 J64
    Date: 2006–10
  32. By: Kauko, Karlo (Bank of Finland Research)
    Abstract: This paper presents a model depicting cross-border payment systems as a mixed oligopoly. A private net settlement system that maximises profit competes with the central banks’ gross settlement system that maximises welfare. It may be optimal for the central bank system to encourage increased use of the private system by charging fees that exceed the marginal cost. The central bank system is not only a competitor but also an essential service provider, because central bank money is needed for net settlement of payments in the private system. In some cases the central bank system can paradoxically induce the private system to charge lower fees by making it expensive to use central bank money for settlement purposes.
    Keywords: payment systems; network economics; mixed oligopolies
    JEL: F36 G29 L13 L44
    Date: 2005–05–11
  33. By: Ingolf Schwarz (Max Planck Institute for Research on Collective Goods, Bonn)
    Abstract: This paper provides a non-steady state general equilibrium foundation for the transactions demand for money going back to Baumol (1952) and Tobin (1956). In our economy, money competes against real capital as a store of value. We prove existence of a monetary general equilibrium in which both real capital and fiat money are voluntarily held over time. The demand for money is generated by fixed transactions costs. More precisely, we assume that house-holds have two physically separated accounts. On the first account they finance consumption and might want to hold money over time. On the second account households receive their wages, hold claims on capital and earn interest income from renting capital to firms. Every transfer of wealth between the two accounts requires fixed resources. In equilibrium, households space apart the transaction dates in time. Between these transaction dates, money is held as a store of value on the first account for transactions purposes. The number of periods over which money is held is endogenous and the nonconvexity of the problem is explicitly taken into account.
    Keywords: Baumol-Tobin, Monetary Theory, General Equilibrium Theory
    JEL: D50 E40 E41
    Date: 2006–06
  34. By: Henriksson , Marketta (Ministry of Finance)
    Abstract: Differences in growth, productivity and inflation levels are going to be a prominent feature of the future of EMU, as the convergence process is still on-going in the new Member States. This convergence process can be described by the Balassa-Samuelson proposition, which states that faster growth in the traded goods sector than in the non-traded goods sector results in a rise in the price of non-traded goods and an appreciation of the trend real exchange rate. In this study, the aim is to construct a small open economy model that enables examination of the effects of Balassa-Samuelson-type growth in an intertemporal fixed exchange rate framework with a focus on the external balance. To address the well-known problems with small open economy models, an endogenous discount rate is used. The results imply that faster productivity growth in the traded than in the non-traded goods sector may induce external imbalances, leading to increased vulnerability of the economy. However, trade account deficits would appear to be a temporary phenomenon, as this line of development can be reversed by the natural shift in the composition of consumption towards non-traded goods that is characteristic of catch-up economies. In the meantime, fiscal policy plays a key role.
    Keywords: small open economy; Balassa-Samuelson effect; ERM II; external balance
    JEL: F32 F33 F41
    Date: 2005–02–01
  35. By: Vanhala, Juuso (Bank of Finland Research)
    Abstract: This paper studies the implications of labour taxation in determining the sensitivity of an economy to macroeconomic shocks. We construct a New Keynesian business cycle model with matching frictions of the labour market, where sluggish employment adjustment implies a key role for labour markets in de-termining shock propagation. We consider three policy instruments to analyze the steady state and dy-namic effects of tax reforms: the marginal tax rate and replacement ratio amplify shock responses whereas employment subsidies weaken them. The tax instruments affect the degree to which the wage absorbs shocks. We show that the relative effects of the tax instruments and thus the effects of tax pro-gression are sensitive to the initial degree of tax progression in the economy. Increasing tax progression when taxation is initially progressive is harmful for steady state employment and output, and amplifies the sensitivity of macroeconomic variables to shocks. When taxation is initially proportional, increasing progression is beneficial for output and employment and dampens shock responses of macroeconomic variables.
    Keywords: matching; income taxation; business cycles
    JEL: E24 E32 J64
    Date: 2006–06–12
  36. By: Crowley , Patrick (College of Business, Texas A&M University); Maraun , Douglas (Nonlinear Dynamics Group Physics Institute, University of Potsdam); Mayes , David (Monetary Policy and Research Department,)
    Abstract: Using recent advances in time-varying spectral methods, this research analyses the growth cycles of the core of the euro area in terms of frequency content and phasing of cycles. The methodology uses the con-tinuous wavelet transform (CWT) and also Hilbert wavelet pairs in the setting of a non-decimated discrete wavelet transform in order to analyse bivariate time series in terms of conventional frequency domain measures from spectral analysis. The findings are that coherence and phasing between the three core members of the euro area (France, Germany and Italy) have increased since the launch of the euro.
    Keywords: time-varying spectral analysis; coherence; phase; business cycles; EMU; growth cycles; Hilbert trans-form; wavelet analysis
    JEL: C19 C63 C65 E32 E39 E58 F40
    Date: 2006–09–27
  37. By: Andrén, Niclas (Institute of Economic Research); Oxelheim, Lars (Research Institute of Industrial Economics)
    Abstract: We analyze producer price developments in the transition from a national exchange rate regime to a monetary union. The focus is on the European Economic and Monetary Union (EMU). Stylized facts witness about an exploding gaps in producer-price inflation during the years immediately following the completion of the EMU. Price convergence is found to be an important driver throughout the entire euro period (1999-2005), but with no significant differences in speed compared to the pre euro period. Productivity growth had its primary effect in the first years and effective exchange-rate changes in the later years of the euro period.
    Keywords: Producer prices; Relative prices; Price convergence; Euro; Balassa-Samuelson
    JEL: E31 E44 F15 F23 G34
    Date: 2006–09–22
  38. By: Toporowski , Jan (SOAS, University of London)
    Abstract: The emergence of the New Consensus in monetary policy has been followed by a renewal of interest in central banks’ operating procedures, and specifically in the role of open market operations. There is a general view that overnight interest rates are most effectively controlled by standing or discount window facilities, rather than open market operations, and this view will probably now extend also to lender-of-last-resort intervention. The paper argues that this reduced role for open market operations is only in the context of controlling overnight rates of interest. In spite of the emphasis on control of overnight interest rates, medium and long-term interest rates remain the crucial instruments in the monetary transmission mechanism. Longer-term interest rates are susceptible to influence by open market operations, and their importance grows with financial development.
    Keywords: central banks; monetary policy; open market operations
    JEL: E52 E58
    Date: 2006–06–21
  39. By: Vivien Lewis (Center for Economic Studies, Catholic University Leuven)
    Abstract: This paper studies the behaviour of firm entry and exit in response to macroeconomic shocks. We formulate a dynamic stochastic general equilibrium model with an endogenous number of producers. From the calibrated model, we derive a minimum set of robust sign restrictions to identify four kinds of macroeconomic shocks in a vector autoregression, namely supply, demand, monetary and entry cost shocks. The variables entering the VAR are output, inflation, the nominal interest rate, profits and firm entry. The response of firm entry to the various shocks is freely estimated. Our main finding is that entry responds significantly to all types of shocks. The results also show a crowding-in of firm entry following an exogenous rise in demand, consistent with the effect of a consumption preference shock predicted by the model
    Keywords: firm entry, VAR, business cycles
    JEL: E30 E32
    Date: 2006–10
  40. By: Chen, Yehning (National Taiwan University); Hasan, Iftekhar (Rensselaer Polytechnic Institute and Bank of Finland.)
    Abstract: This paper demonstrates that, even if depositors are fully rational and always choose the Pareto dominant equilibrium when there are multiple equilibria, a bank run may still occur when depositors’ expectations of the bank’s fundamentals do not change. More specifically, a bank run may occur when depositors learn that noisy bank-specific information is revealed, or when they learn that precise bank-specific information is not revealed. The results in this paper are consistent with empirical evidence about bank runs. It also implies that suspension of convertibility can improve the efficiency of bank runs.
    Keywords: bank run; banking panic; suspension of convertibility
    JEL: G21 G28
    Date: 2006–09–27
  41. By: OECD
    Abstract: The current monetary policy framework in several Latin American countries, combining inflation targeting and a floating exchange-rate regime, has contributed to disinflation by anchoring expectations around low, stable levels. This paper uses co-integration analysis to estimate simultaneously a monetary reaction function and the determinants of expected inflation for Brazil, Chile, Colombia and Mexico in the post-1999 period. It also tests for the presence of volatility spillovers between the monetary stance and inflation expectations based on M-GARCH modelling. The results of the empirical analysis show that: i) there are long-term relationships between the interest rate, expected inflation and the inflation target, suggesting that monetary policy has been conducted in a forward-looking manner and helped anchor inflation expectations in the countries under examination, and ii) greater volatility in the monetary stance leads to higher volatility in expected inflation in Brazil, Colombia and Mexico, suggesting that interest-rate smoothing contributes to reducing inflation expectations volatility. No volatility spillover effect was detected in the case of Chile. <P>Politique monétaire et anticipations d'inflation en Amérique latine : Effets à long terme et spillovers de volatilité <BR>Le cadre courant de la politique monétaire dans plusieurs pays d'Amérique latine, qui combine un ciblage d'inflation et un régime de taux de change flottant, a contribué à la désinflation par ancrage des anticipations d'inflation à un niveau bas et stable. Ce document utilise une analyse de co-intégration pour estimer simultanément une fonction de réaction da la politique monétaire et les déterminants des anticipations d'inflation pour le Brésil, le Chili, la Colombie et le Mexique depuis 1999. Des tests sont aussi présentés sur la présence d'effets de spillover de volatilité entre la politique monétaire et les anticipations d'inflation, en s'appuyant sur le modèle M-GARCH. Les résultats de l'analyse empirique montrent que : i) il existe des relations de long terme entre le taux d'intérêt, les anticipations d'inflation et la cible d'inflation. Cela suggère que la politique monétaire a été conduite selon une méthode prospective et a assuré l'ancrage des anticipations d'inflation; et ii) une plus grande volatilité de la politique monétaire entraîne une plus importante volatilité des anticipations d'inflation au Brésil, en Colombie et au Mexique, cela laisse penser qu'un lissage des taux d'intérêt contribue à une réduction de la volatilité des anticipations d'inflation. Aucun spillover de volatilité n'a été détecté dans le cas du Chili.
    Keywords: Mexico, Mexique, Brazil, Brésil, inflation target, cible d'inflation, Chile, Chili, Colombia, Colombie, multiple co-integration, co-intégration multiple, volatility spillover, spillover de volatilité, M-GARCH modelling, M-GARCH
    JEL: C22 E52 O54
    Date: 2006–10–04
  42. By: Forssbaeck, Jens (Lund Institute of Economics Research); Oxelheim, Lars (Research Institute of Industrial Economics)
    Abstract: We study the interplay between money market development and changes in monetary policy operating procedures in 11 European countries from c. 1980 up to the launch of EMU. Aspects of money market development such as the size and structure of different market segments, and institutional and regulatory changes, are addressed. We recount and empirically examine the extent of reorientation of monetary policy instruments away from quantitative direct control instruments toward indirect market-based instruments. The process of financial deregulation is uniform across the countries. The path of money market development varies substantially, whereas changes in central bank instruments show both similarities and differences. We hypothesise a relationship between the two processes and provide tentative evidence.
    Keywords: Monetary policy operations; Money market; European Union; Deregulation
    JEL: E52 E58 G28 N24
    Date: 2006–09–22

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