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on Central Banking |
| By: | Woodford, Michael |
| Abstract: | I consider some of the leading arguments for assigning an important role to tracking the growth of monetary aggregates when making decisions about monetary policy. First, I consider whether ignoring money means returning to the conceptual framework that allowed the high inflation of the 1970s. Second, I consider whether models of inflation determination with no role for money are incomplete, or inconsistent with elementary economic principles. Third, I consider the implications for monetary policy strategy of the empirical evidence for a long-run relationship between money growth and inflation. (Here I give particular attention to the implications of ``two-pillar Phillips curves'' of the kind proposed by Gerlach (2004).) And fourth, I consider reasons why a monetary policy strategy based solely on short-run inflation forecasts derived from a Phillips curve may not be a reliable way of controlling inflation. I argue that none of these considerations provide a compelling reason to assign a prominent role to monetary aggregates in the conduct of monetary policy. |
| Keywords: | monetarism; monetary targeting; new Keynesian model; two-pillar strategy |
| JEL: | E52 E58 |
| Date: | 2007–03 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:6211&r=cba |
| By: | Jasmina Arifovic; James B. Bullard; Olena Kostyshyna |
| Abstract: | We analyze the effects of social learning in a widely-studied monetary policy context. Social learning might be viewed as more descriptive of actual learning behavior in complex market economies. Ideas about how best to forecast the economy's state vector are initially heterogeneous. Agents can copy better forecasting techniques and discard those techniques which are less successful. We seek to understand whether the economy will converge to a rational expectations equilibrium under this more realistic learning dynamic. A key result from the literature in the version of the model we study is that the Taylor Principle governs both the uniqueness and the expectational stability of the rational expectations equilibrium when all agents learn homogeneously using recursive algorithms. We find that the Taylor Principle is not necessary for convergence in a social learning context. We also contribute to the use of genetic algorithm learning in stochastic environments. |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedlwp:2007-007&r=cba |
| By: | James B. Bullard; George W. Evans; Seppo Honkapohja |
| Abstract: | We study how the use of judgment or "add-factors" in forecasting may disturb the set of equilibrium outcomes when agents learn using recursive methods. We isolate conditions under which new phenomena, which we call exuberance equilibria, can exist in a standard self-referential environment. Local indeterminacy is not a requirement for existence. We construct a simple asset pricing example and find that exuberance equilibria, when they exist, can be extremely volatile relative to fundamental equilibria. |
| Keywords: | Monetary policy ; Rational expectations (Economic theory) |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedlwp:2007-009&r=cba |
| By: | James B. Bullard; George W. Evans; Seppo Honkapohja |
| Abstract: | We study how the use of judgment or "add-factors" in macroeconomic forecasting may disturb the set of equilibrium outcomes when agents learn using recursive methods. We examine the possibility of a new phenomenon, which we call exuberance equilibria, in the New Keynesian monetary policy framework. Inclusion of judgment in forecasts can lead to self-fulfilling fluctuations in a subset of the determinacy region. We study how policymakers can minimize the risk of exuberance equilibria. |
| Keywords: | Rational expectations (Economic theory) ; Monetary policy |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedlwp:2007-008&r=cba |
| By: | Evans, George W; Honkapohja, Seppo; Mitra, Kaushik |
| Abstract: | We consider the impact of anticipated policy changes when agents form expectations using adaptive learning rather than rational expectations. To model this we assume that agents combine limited structural knowledge with a standard adaptive learning rule. We analyze these issues using two well-known set-ups, an endowment economy and the Ramsey model. In our set-up there are important deviations from both rational expectations and purely adaptive learning. Our approach could be applied to many macroeconomic frameworks. |
| Keywords: | expectations; Ramsey model; taxation |
| JEL: | D84 E21 E43 E62 |
| Date: | 2007–03 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:6216&r=cba |
| By: | Frank Smets (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Rafael Wouters (National Bank of Belgium, Boulevard de Berlaimont 14, B-1000 Brussels, Belgium.) |
| Abstract: | Using a Bayesian likelihood approach, we estimate a dynamic stochastic general equilibrium model for the US economy using seven macro-economic time series. The model incorporates many types of real and nominal frictions and seven types of structural shocks. We show that this model is able to compete with Bayesian Vector Autoregression models in out-of-sample prediction. We investigate the relative empirical importance of the various frictions. Finally, using the estimated model we address a number of key issues in business cycle analysis: What are the sources of business cycle fluctuations? Can the model explain the cross-correlation between output and inflation? What are the effects of productivity on hours worked? What are the sources of the “Great Moderation”? JEL Classification: E4-E5. |
| Keywords: | Keywords: DSGE models; monetary policy |
| Date: | 2007–02 |
| URL: | http://d.repec.org/n?u=RePEc:ecb:ecbwps:20070722&r=cba |
| By: | Guenter W. Beck (Frankfurt University and CFS); Volker Wieland (Frankfurt University, CFS and CEPR) |
| Abstract: | The European Central Bank has assigned a special role to money in its two pillar strategy and has received much criticism for this decision. In this paper, we explore possible justifications. The case against including money in the central bank’s interest rate rule is based on a standard model of the monetary transmission process that underlies many contributions to research on monetary policy in the last two decades. Of course, if one allows for a direct effect of money on output or inflation as in the empirical “two-pillar” Phillips curves estimated in some recent contributions, it would be optimal to include a measure of (long-run) money growth in the rule. In this paper, we develop a justification for including money in the interest rate rule by allowing for imperfect knowledge regarding unobservables such as potential output and equilibrium interest rates. We formulate a novel characterization of ECB-style monetary cross-checking and show that it can generate substantial stabilization benefits in the event of persistent policy misperceptions regarding potential output. Such misperceptions cause a bias in policy setting. We find that cross-checking and changing interest rates in response to sustained deviations of long-run money growth helps the central bank to overcome this bias. Our argument in favor of ECB-style cross-checking does not require direct effects of money on output or inflation. |
| Keywords: | Monetary Policy, Quantity Theory, Phillips Curve, European Central Bank Policy Under Uncertainty |
| JEL: | E32 E41 E43 E52 E58 |
| Date: | 2007–03–22 |
| URL: | http://d.repec.org/n?u=RePEc:cfs:cfswop:wp200717&r=cba |
| By: | Devereux, Michael B; Sutherland, Alan |
| Abstract: | This paper presents a general approximation method for characterizing time-varying equilibrium portfolios in a two-country dynamic general equilibrium model. The method can be easily adapted to most dynamic general equilibrium models, it applies to environments in which markets are complete or incomplete, and it can be used for models of any dimension. Moreover, the approximation provides simple, easily interpretable closed form solutions for the dynamics of equilibrium portfolios. |
| Keywords: | country portfolios; solution methods |
| JEL: | E52 E58 F41 |
| Date: | 2007–03 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:6208&r=cba |
| By: | Cédric Tille; Eric van Wincoop |
| Abstract: | The sharp increase in both gross and net international capital flows over the past two decades has prompted renewed interest in their determinants. Most existing theories of international capital flows are based on one-asset models, which have implications only for net capital flows, not for gross flows. Moreover, because there is no portfolio choice, these models allow no role for capital flows as a result of assets? changing expected returns and risk characteristics. In this paper, we develop a method for solving dynamic stochastic general equilibrium open-economy models with portfolio choice. After showing why standard first- and second-order solution methods no longer work in the presence of portfolio choice, we extend these methods, giving special treatment to the optimality conditions for portfolio choice. We apply our solution method to a particular two-country, two-good, two-asset model and show that it leads to a much richer understanding of both gross and net capital flows. The approach identifies the time-varying portfolio shares that result from assets? time-varying expected returns and risk characteristics as a potential key source of international capital flows. |
| Keywords: | Capital movements ; International finance ; Portfolio management |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fednsr:280&r=cba |
| By: | Michael D. Bordo; Christopher Erceg; Andrew Levin; Ryan Michaels |
| Abstract: | This paper analyzes the role of transparency and credibility in accounting for the widely divergent macroeconomic effects of three episodes of deliberate monetary contraction: the post-Civil War deflation, the post-WWI deflation, and the Volcker disinflation. Using a dynamic general equilibrium model in which private agents use optimal filtering to infer the central bank's nominal anchor, we demonstrate that the salient features of these three historical episodes can be explained by differences in the design and transparency of monetary policy, even without any time variation in economic structure or model parameters. For a policy regime with relatively high credibility, our analysis highlights the benefits of a gradualist approach (as in the 1870s) rather than a sudden change in policy (as in 1920-21). In contrast, for a policy institution with relatively low credibility (such as the Federal Reserve in late 1980), an aggressive policy stance can play an important signalling role by making the policy shift more evident to private agents. |
| JEL: | E32 E42 E52 E58 |
| Date: | 2007–03 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:12982&r=cba |
| By: | Javier Andrés; J. David López-Salido; Edward Nelson |
| Abstract: | We examine the role of money, allowing for three competing environments: the New Keynesian model with separable utility and static money demand; a non-separable utility variant with habit formation; and a version with adjustment costs for holding real balances. The last two variants imply forward-looking behavior of real money balances, as it is optimal for agents to allow their forecast of future interest rates to affect current portfolio decisions. We distinguish between these specifications by conducting a structural econometric analysis for the U.S. and the euro area. FIML estimates confirm the forward-looking character of money demand. Using these estimates we find that, in response to preference and technology shocks, real money balances are valuable in anticipating future variations in the natural interest rate. |
| Keywords: | Money ; Interest rates |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedlwp:2007-005&r=cba |
| By: | Sharon Kozicki; P.A. Tinsley |
| Abstract: | This paper uses real-time briefing forecasts prepared for the Federal Open Market Committee (FOMC) to provide estimates of historical changes in the design of U.S. monetary policy and in the implied central-bank target for inflation. Empirical results support a description of policy with an effective inflation target of roughly 7 percent in the 1970s. Moreover, the evidence suggests that mismeasurement of the degree of economic slack was largely irrelevant for explaining the Great Inflation while favouring a passive-policy description of monetary policy. FOMC transcripts provide a neglected interpretation of the source of passive policy--intermediate targeting of monetary aggregates. |
| Keywords: | Central bank research; Monetary aggregates; Monetary policy implementation |
| JEL: | E3 E5 N1 |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:bca:bocawp:07-19&r=cba |
| By: | Magnus Andersson (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.) |
| Abstract: | This paper examines bond and stock market volatility reactions in the euro area and the US following their respective economies’ monetary policy decisions, over a uniform sample period (April 1999 to May 2006). For this purpose, intraday data on the US and euro area bond and stock markets are used. A strong upsurge in intraday volatility at the time of the release of the monetary policy decisions by the two central banks is found, which is more pronounced for the US financial markets following Fed monetary policy decisions. Part of the increase in intraday volatility in the two economies surrounding monetary policy decisions can be explained by both news of the level of monetary policy and revisions in the expected future monetary policy path. The observed strong discrepancy between asset price reactions in the US and in the euro area following monetary policy decisions still remains a puzzle, although some tentative explanations are provided in the paper. JEL Classification: E52; E58; G14. |
| Keywords: | Monetary policy; intraday data. |
| Date: | 2007–02 |
| URL: | http://d.repec.org/n?u=RePEc:ecb:ecbwps:20070726&r=cba |
| By: | Fernando Alvarez; Andrew Atkeson; Patrick J. Kehoe |
| Abstract: | The key question asked by standard monetary models used for policy analysis is how do changes in short term interest rates affect the economy. All of the standard models imply that such changes in interest rates affect the economy by altering the conditional means of the macroeconomic aggregates and have no effect on the conditional variances of these aggregates. We argue that the data on exchange rates imply nearly the opposite: fluctuations in interest rates are associated with nearly one-for-one changes in conditional variances and nearly no changes in conditional means. In this sense standard monetary models capture essentially none of what is going on in the data. We thus argue that almost everything we say about monetary policy using these models is wrong. |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedmwp:650&r=cba |
| By: | Erwan Gautier (Banque de France, 39, rue Croix-des-Petits-Champs, F-75049 Paris Cedex 01.); Ignacio Hernando (Banco de España, Alcalá 50, E-28014 Madrid, España.); Philip Vermeulen (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Daniel Dias (Banco de Portugal, 148, rua do Comerico, 1150 Lisbon, Portugal.); Maarten Dossche (National Bank of Belgium, Boulevard de Berlaimont 14, B-1000 Brussels, Belgium.); Roberto Sabbatini (Banca dÍtalia – Research Department, Via Nazionale 91, 00184 Roma, Italy.); Harald Stahl (Deutsche Bundesbank, Economics Department, Wilhelm-Epstein-Strasse 14, D-60431 Frankfurt am Main, Germany.) |
| Abstract: | This paper documents producer price setting in 6 countries of the euro area: Germany, France, Italy, Spain, Belgium and Portugal. It collects evidence from available studies on each of those countries and also provides new evidence. These studies use monthly producer price data. The following five stylised facts emerge consistently across countries. First, producer prices change infrequently: each month around 21% of prices change. Second, there is substantial cross-sector heterogeneity in the frequency of price changes: prices change very often in the energy sector, less often in food and intermediate goods and least often in non-durable nonfood and durable goods. Third, countries have a similar ranking of industries in terms of frequency of price changes. Fourth, there is no evidence of downward nominal rigidity: price changes are for about 45% decreases and 55% increases. Fifth, price changes are sizeable compared to the inflation rate. The paper also examines the factors driving producer price changes. It finds that costs structure, competition, seasonality, inflation and attractive pricing all play a role in driving producer price changes. In addition producer prices tend to be more flexible than consumer prices. JEL Classification: E31, D40, C25 |
| Keywords: | Price-setting, producer prices |
| Date: | 2007–02 |
| URL: | http://d.repec.org/n?u=RePEc:ecb:ecbwps:20070727&r=cba |
| By: | Ricardo Mestre (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.) |
| Abstract: | This paper contributes to the old theme of testing for rationality of inflation expectations in surveys, using two very different surveys in parallel. Focusing on the euro area and using two well-known surveys that include questions on inflation expectations, the Consensus Forecast survey and the European Commission Household survey, a battery of tests is applied to inflation forecasts. Tests are based on a preliminary discussion of the meaning of Rational Expectations in the macroeconomic literature, and how this maps into specific econometric tests. Tests used are both standard ones already reported in the literature and less standard ones of potential interest within the framework discussed. Tests focus on in-sample properties of the forecasts, both in static and dynamic settings, and in out-of sample tests to explore the performance of the forecasts in a simulated out-of-sample setting. As a general conclusion, both surveys are found to contain potentially useful information. Although the Consensus Forecasts survey is the best one in terms of quality of the forecasts, rationality in the European Commission Household survey, once measurement issues are taken into account, cannot be ruled out. JEL Classification:C40; C42; C50; C53; E37. |
| Keywords: | Rational expectations; tests of rationality; inflation forecasting. |
| Date: | 2007–02 |
| URL: | http://d.repec.org/n?u=RePEc:ecb:ecbwps:20070721&r=cba |
| By: | Gaspar, Vítor; Levin, Andrew; Martins, Fernando Manuel; Smets, Frank |
| Abstract: | Understanding the features and the determinants of individual price setting behaviour is important for the formulation of monetary policy. These behavioural mechanisms play a fundamental role in influencing the characteristics of aggregate inflation and in determining how monetary policy affects inflation and real economic activity. The Inflation Persistence Network, a collaborative research effort of the Eurosystem, analysed a large number of panel data sets of individual price records and conducted surveys of price-setting managers in many euro area countries. This paper discusses to what extent the extensive evidence coming from those two data sources provides support for some basic elements of the New Keynesian perspective. It analyses the implications of the micro evidence for distinguishing between competing theories of price stickiness and provides some brief reflections about the lessons for monetary policy. |
| Keywords: | monetary policy; New Keynesian models; price setting; price stickiness |
| JEL: | D4 E1 E3 |
| Date: | 2007–03 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:6227&r=cba |
| By: | Filippo Altissimo (Brevan Howard, Almack House, 28 King Street, London, SW1Y 6XA, UK.); Benoît Mojon (Federal Reserve Bank of Chicago, 230 S La Salle St., Chicago, IL 60604, USA.); Paolo Zaffaroni (Tanaka Business School, Imperial College London, South Kensington campus, London SW7 2AZ, UK.) |
| Abstract: | An aggregation exercise is proposed that aims at investigating whether the fast average adjustment of the disaggregate inflation series of the euro area CPI translates into the slow adjustment of euro area aggregate inflation. We first estimate a dynamic factor model for 404 inflation sub-indices of the euro area CPI. This allows to decompose the dynamics of inflation sub-indices in two parts: one due to a common "macroeconomic" shock and one due to sector specific "idiosyncratic" shocks. Although "idiosyncratic" shocks dominate the variance of sectoral prices, one common factor, which accounts for 30 per cent of the overall variance of the 404 disaggregate in.ation series, is the main driver of aggregate dynamics. In addition, the heterogenous propagation of this common shock across sectoral inflation rates, and in particular its slow propagation to inflation rates of services, generates the persistence of aggregate in.ation. We conclude that the aggregation process explains a fair amount of aggregate in.ation persistence. JEL Classification: E31; E32. |
| Keywords: | Inflation dynamics; aggregation and persistence; euro area. |
| Date: | 2007–02 |
| URL: | http://d.repec.org/n?u=RePEc:ecb:ecbwps:20070729&r=cba |
| By: | Honohan, Patrick |
| Abstract: | Although the worldwide growth in dollarization of bank deposits has recently slowed, it has already reached very high levels in dozens of countries. Building on earlier findings that allowed the main cross-country variations in the share of dollars to be explained in terms of national policies and institutions, this paper turns to analysis of short-run variations, particularly the response of dollarization to exchange rate changes, which is shown to be too small to warrant ‘fear of floating’ by dollarized economies. But high dollarization is shown to increase the risk of depreciation and even suspension, as indicated by interest rate spreads. While specific policy is needed to deal with the risks associated with dollarization, the underlying causes of unwanted dollarization should also be tackled. |
| Keywords: | Banking; Developing countries; Dollarization; Exchange rates |
| JEL: | E44 F36 O24 |
| Date: | 2007–03 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:6205&r=cba |
| By: | Imbs, Jean; Jondeau, Eric; Pelgrin, Florian |
| Abstract: | The New Keynesian Phillips Curve is at the centre of two raging empirical debates. First, how can purely forward looking pricing account for the observed persistence in aggregate inflation. Second, price-setting responds to movements in marginal costs, which should therefore be the driving force to observed inflation dynamics. This is not always the case in typical estimations. In this paper, we show how heterogeneity in pricing behaviour is relevant to both questions. We detail the conditions under which imposing homogeneity results in overestimating a backward-looking component in (aggregate) inflation, and underestimating the importance of (aggregate) marginal costs for (aggregate) inflation. We provide intuition for the direction of these biases, and verify them in French data with information on prices and marginal costs at the industry level. We show that the apparent discrepancy in the estimated duration of nominal rigidities, as implied from aggregate or microeconomic data, can be fully attributable to a heterogeneity bias. |
| Keywords: | heterogeneity; inflation persistence; marginal costs; New Keynesian Phillips Curve; nominal rigidities |
| JEL: | C10 C22 E31 E52 |
| Date: | 2007–03 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:6184&r=cba |
| By: | Joshua Hausman; Jon Wongswan |
| Abstract: | This paper documents the impact of U.S. monetary policy announcement surprises on foreign equity indexes, short- and long-term interest rates, and exchange rates in 49 countries. We use two proxies for monetary policy surprises: the surprise change to the current target federal funds rate (target surprise) and the revision to the path of future monetary policy (path surprise). We find that different asset classes respond to different components of the monetary policy surprises. Global equity indexes respond mainly to the target surprise; exchange rates and long-term interest rates respond mainly to the path surprise; and short-term interest rates respond to both surprises. On average, a hypothetical surprise 25-basis-point cut in the federal funds target rate is associated with about a 1 percent increase in foreign equity indexes and a 5 basis point decline in foreign short-term interest rates. A surprise 25-basis-point downward revision in the path of future policy is associated with about a ½ percent decline in the exchange value of the dollar against foreign currencies and 5 and 8 basis points declines in short- and long-term interest rates, respectively. We also find that asset prices’ responses to FOMC announcements vary greatly across countries, and that these cross-country variations in the response are related to a country’s exchange rate regime. Equity indexes and interest rates in countries with a less flexible exchange rate regime respond more to U.S. monetary policy surprises. In addition, the cross-country variation in the equity market response is strongly related to the percentage of each country’s equity market capitalization owned by U.S. investors (a financial linkage), and the cross-country variation in short-term interest rates’ responses is strongly related to the share of each country’s trade that is with the United States (a real linkage) |
| Keywords: | Interest rates ; Foreign exchange rates ; Monetary policy ; International finance |
| Date: | 2006 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedgif:886&r=cba |
| By: | Marc-André Gosselin |
| Abstract: | The inflation targeting (IT) regime is 17 years old. With practice of IT now in more than 21 countries, there is enough evidence gathered to take stock of the IT experience. In this paper, we analyze the inflation record of IT central banks. We extend the work of Albagli and Schmidt-Hebbel (2004) by looking at a broad range of factors that can influence inflation target deviations and by identifying the empirical determinants of successful monetary policy under IT. We find that part of the cross-country and time variation in inflation deviations from targets can be explained by exchange rate movements, fiscal deficits, and differences in financial sector development. With respect to the components of the IT framework, we find that a higher inflation target and a larger inflation control range are associated with more variable inflation (and output) outcomes. Although the literature tends to suggest that greater central bank transparency is desirable, our findings imply that transparency might be associated with less satisfactory inflation performance. Interestingly, central banks using economic models do a better job of stabilizing inflation around the target and output around trend. |
| Keywords: | Central bank research; Inflation targets; Monetary policy framework |
| JEL: | E31 E52 E58 |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:bca:bocawp:07-18&r=cba |
| By: | Roc Armenter; Martin Bodenstein |
| Abstract: | We argue that there are conditions such that any inflation targeting regime is preferable to full policy discretion, even if long-run inflation rates are identical across regimes. The key observation is that strict inflation targeting outperforms the discretionary policy response to sufficiently persistent shocks. Under full policy discretion, inflation expectations over the medium term respond to the shock and thereby amplify its impact on output. As a result, little output stabilization is achieved at the cost of large and persistent inflation fluctuations. |
| Keywords: | Inflation (Finance) ; Anti-inflationary policies ; Monetary policy |
| Date: | 2006 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedgif:885&r=cba |
| By: | Paul Castillo; Carlos Montoro; Vicente Tuesta |
| Abstract: | This paper provides a fully micro-founded New Keynesian framework to study the interactionbetween oil price volatility, pricing behavior of firms and monetary policy. We show that when oilhas low substitutability, firms find it optimal to charge higher relative prices as a premium incompensation for the risk that oil price volatility generates on their marginal costs. Overall, in generalequilibrium, the interaction of the aforementioned mechanisms produces a positive relationshipbetween oil price volatility and average inflation, which we denominate inflation premium. Wecharacterize analytically this relationship by using the perturbation method to solve the rationalexpectations equilibrium of the model up to second order of accuracy. The solution implies that theinflation premium is higher when: a) oil has low substitutability, b) the Phillips Curve is convex, andc) the central bank puts higher weight on output fluctuations. We also provide some quantitativeevidence showing that a calibrated model for the US with an estimated active Taylor rule produces asizable inflation premium, similar to the levels observed in the US during the 70s. |
| Keywords: | Second Order Solution, Oil Price Shocks, Endogenous Trade-off |
| JEL: | E52 E42 E12 C63 |
| Date: | 2007–03 |
| URL: | http://d.repec.org/n?u=RePEc:cep:cepdps:dp0782&r=cba |
| By: | Carlos Montoro (Central Bank of Peru, LSE) |
| Abstract: | We extend the New Keynesian Monetary Policy literature relaxing the assumption that the decisions are taken by a single policymaker, considering instead that monetary policy decisions are taken collectively in a committee. We introduce a Monetary Policy Committee (MPC), whose members have different preferences between output and inflation variability and have to vote on the level of the interest rate. This paper helps to explain interest rate smoothing from a political economy point of view, in which MPC members face a bargaining problem on the level of the interest rate. In this framework, the interest rate is a non-linear reaction function on the lagged interest rate and the expected inflation. This result comes from a political equilibrium in which there is a strategic behaviour of the agenda setter with respect to the rest MPC’s members. Our approach can also reproduce both features documented by the empirical evidence on interest rate smoothing: a) the modest response of the interest rate to inflation. and output gap; and. b) the dependence on lagged interest rate. Features that are difficult to reproduce alltogether in standard New Keynesian models. It also provides a theoretical framework on how disagreement among policymakers can slow down the adjustment on interest rates and on “menu costs” in interest rate decisions. Furthermore, a numerical excercise shows that this inertial behaviour of the interest rate is internalised by the economic agents through an increase in expected inflation. |
| Keywords: | Monetary Policy Committees , Interest Rate Smoothing, New Keynesian Economics, Political Economy |
| JEL: | E43 E52 D72 |
| Date: | 2007–03 |
| URL: | http://d.repec.org/n?u=RePEc:rbp:wpaper:2007-003&r=cba |
| By: | Carlos Montoro |
| Abstract: | We extend the New Keynesian Monetary Policy literature relaxing the assumption that the decisionsare taken by a single policymaker, considering instead that monetary policy decisions are takencollectively in a committee. We introduce a Monetary Policy Committee (MPC), whose membershave different preferences between output and inflation variability and have to vote on the level of theinterest rate. This paper helps to explain interest rate smoothing from a political economy point ofview, in which MPC members face a bargaining problem on the level of the interest rate. In thisframework, the interest rate is a non-linear reaction function on the lagged interest rate and theexpected inflation. This result comes from a political equilibrium in which there is a strategicbehaviour of the agenda setter with respect to the rest of the MPC's members. Our approach can alsoreproduce both features documented by the empirical evidence on interest rate smoothing: a) themodest response of the interest rate to inflation and output gap; and b) the dependence on laggedinterest rate; features that are difficult to reproduce in standard New Keynesian models all together. Italso provides a theoretical framework on how disagreement among policymakers can slow down theadjustment on interest rates and on "menu costs" in interest rate decisions. Furthermore, a numericalexercise shows that this inertial behaviour of the interest rate is internalised by the economic agentsthrough an increase in expected inflation. |
| Keywords: | Monetary Policy Committee, interest rate smoothing, New KeynesianEconomics, political economy |
| JEL: | E43 E52 D72 |
| Date: | 2007–02 |
| URL: | http://d.repec.org/n?u=RePEc:cep:cepdps:dp0780&r=cba |
| By: | Vasco Curdia |
| Abstract: | This paper proposes a model to investigate the effects of monetary policy in an emerging market economy that experiences a sudden stop of capital inflows. The model features credit frictions, debt denominated in foreign currency, imported inputs, and households that have access to the international capital market only indirectly, through their ownership of leveraged firms. The sudden stop is modeled as a change in the perceptions of foreign lenders that brings about an increase in the cost of borrowing. I show that the higher the elasticity of foreign demand, the lower the contraction in output - leading, at the extreme, to the possibility of an expansion, depending on policy. A second result is that the recession is most severe in a fixed exchange rate regime. Taylor rules that react to inflation and output are more stabilizing. A comparison of alternative rules shows that low commitment to inflation stabilization allows for less contraction in output and even expansion but at the cost of much stronger contraction in capital inflows and higher interest rates. Credibility is also shown to have an important role, with low credibility and the risk of loose policy implying increased trade-offs, stronger contraction of the economy, and higher interest rates. |
| Keywords: | Emerging markets ; Monetary policy ; Capital movements ; Loans, Foreign |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fednsr:278&r=cba |
| By: | Jonathan H. Wright; Joseph E. Gagnon |
| Abstract: | This paper considers the prediction of large depreciations (both nominal and real) in a panel of industrialized countries using a probit methodology. The current account balance/GDP ratio has a modest but statistically significant effect on the estimated probability of a large depreciation, and gives slight predictive power in an out-of-sample forecasting exercise. The CPI inflation rate also has a modest but statistically significant effect in predicting nominal depreciations and has slight predictive power, but this effect is not present for real exchange rates. The GDP growth rate occasionally has a significant effect. A higher current account balance (surplus) tends to reduce the probability of a sharp depreciation; a higher inflation rate tends to increase the probability of a sharp depreciation; and a higher GDP growth rate perhaps tends to reduce the probability of a sharp depreciation. |
| Keywords: | Foreign exchange rates ; Econometric models |
| Date: | 2006 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedgif:881&r=cba |
| By: | W.H. Buiter |
| Abstract: | The paper discusses some fundamental problems in monetary economics associated with thedetermination and role of the numéraire. The issues are introduced by formalising a proposal,attributed to Eisler, to remove the zero lower bound on nominal interest rates by unbundling thenuméraire and medium of exchange/means of payment functions of money. The monetary authoritiesmanage the exchange rate between the numéraire ('sterling') and the means of payment ('drachma').The short nominal interest rate on sterling bonds can then be used to target stability for the sterlingprice level. The paper puts question marks behind two key bits of conventional wisdom incontemporary monetary economics. The first is the assumption that the monetary authorities defineand determine the numéraire used in private transactions. The second is the proposition that pricestability in terms of that numéraire is the appropriate objective of monetary policy. The paper alsodiscusses the merits of the next step following the decoupling of the numéraire from the currency:doing away with currency altogether - the cashless economy. Because the unit of account plays such a central role in New-Keynesian models with nominalrigidities, monetary economics needs to devote more attention to numérairology - the study of theindividual and collective choice processes that govern the adoption of a unit of account and its role in economic behaviour. |
| Keywords: | Zero lower bound, cashless economy, price level determinacy, optimal inflation |
| JEL: | E3 E4 E5 E6 |
| Date: | 2007–01 |
| URL: | http://d.repec.org/n?u=RePEc:cep:cepdps:dp0776&r=cba |
| By: | Ullrich, Katrin |
| Abstract: | The discussion about country-specific influence on the interest rate decisions of the European Central Bank does not cease. To investigate the possibility of regional influence on the determination of the policy rate, we estimate Taylor-type reaction functions for the period from 1999 to 2005 and include country-specific variables of the euro zone member states. We do not find convincing evidence that country-specific economic developments influence the decisions of the ECB Governing Council. However, the maximum inflation rate and the minimum economic sentiment of the euro area seem to have an effect on the decisions. |
| Keywords: | Taylor rule, ECB, monetary policy |
| JEL: | E52 E58 |
| Date: | 2006 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:zewdip:5442&r=cba |
| By: | Eijffinger, Sylvester C W; Goderis, Benedikt |
| Abstract: | This paper examines the effect of monetary policy on the exchange rate during currency crises. Using data for a number of crisis episodes between 1986 and 2004, we find strong evidence that raising the interest rate: (i) has larger adverse balance sheet effects and is therefore less effective in countries with high domestic corporate short-term debt; (ii) is more credible and therefore more effective in countries with high-quality institutions; iii) is more credible and therefore more effective in countries with high external debt; and (iv) is less effective in countries with high capital account openness. We predict that monetary policy would have had the conventional supportive effect on the exchange rate during five of the crisis episodes in our sample, while it would have had the perverse effect during seven other episodes. For four episodes, we predict a statistically insignificant effect. Our results support the idea that the effect of monetary policy depends on its impact on fundamentals, as well as its credibility, as suggested in the recent theoretical literature. They also provide an explanation for the mixed findings in the empirical literature. |
| Keywords: | capital account openness; currency crises; external debt; institutions; monetary policy; short-term debt |
| JEL: | E52 E58 |
| Date: | 2007–03 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:6217&r=cba |
| By: | Ramón Adalid (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Carsten Detken (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.) |
| Abstract: | We provide systematic evidence for the association of liquidity shocks and aggregate asset prices during mechanically identified asset price boom/bust episodes for 18 OECD countries since the 1970s, while taking care of the endogeneity of money and credit. Our derivation of liquidity shocks allows for frequent shifts in velocity as they are derived as structural shocks from VARs in growth rates. Residential property price developments and money growth shocks accumulated over the boom periods are able to well explain the depth of post-boom recessions. We further suggest that liquidity shocks are a driving factor for real estate prices during boom episodes. During normal times however, the relative predictive power of liquidity shocks seems to shift from asset price inflation to consumer price inflation. The results only hold for broad money growth based liquidity shocks and not for private credit growth shocks. JEL Classification: C33, E41, E51, E58 |
| Keywords: | Liquidity shocks; asset price booms; money and credit aggregates; role of money; monetary policy; real estate prices. |
| Date: | 2007–02 |
| URL: | http://d.repec.org/n?u=RePEc:ecb:ecbwps:20070732&r=cba |
| By: | Marcelo Sánchez (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.) |
| Abstract: | This paper investigates the role of domestic and external factors in explaining business cycle and international trade developments in fifteen emerging market economies. Results from sign-restricted VARs show that developments in real output, inflation, real exchange rates and international trade variables are dominated by domestic shocks. External shocks on average explain a fraction of no more than 10% of the variation in the endogenous variables considered. Moreover, real imports fail to display a cross-regional pattern, while technology shocks appear to be the disturbances playing a somewhat more important role in explaining consumer prices developments. Consumer prices and – depending on the disturbance considered – real imports are the variables showing larger impulse responses to unit shocks. JEL Classification: C32; E32; F41. |
| Keywords: | Business cycles; international trade; emerging markets; structural shocks. |
| Date: | 2007–02 |
| URL: | http://d.repec.org/n?u=RePEc:ecb:ecbwps:20070730&r=cba |
| By: | Singh, Rajesh; Subramanian, Chetan |
| Abstract: | This is an Appendix to "The Optimal Choice of Monetary Policy Instruments in a Small Open Economy" Forthcoming in the Canadian Journal of Economics. |
| Date: | 2007–03–25 |
| URL: | http://d.repec.org/n?u=RePEc:isu:genres:12768&r=cba |
| By: | Matteo Ciccarelli (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Carlo Altavilla (University of Naples "Parthenope", Via Medina 40, 80133 Naples, Italy.) |
| Abstract: | This paper explores the role that inflation forecasts play in the uncertainty surrounding the estimated effects of alternative monetary rules on unemployment dynamics in the euro area and the US. We use the inflation forecasts of 8 competing models in a standard Bayesian VAR to analyse the size and the timing of these effects, as well as to quantify the uncertainty relative to the different inflation models under two rules. The results suggest that model uncertainty can be a serious issue and strengthen the case for a policy strategy that takes into account several sources of information. We find that combining inflation forecasts from many models not only yields more accurate forecasts than those of any specific model, but also reduces the uncertainty associated with the real effects of policy decisions. These results are in line with the model-combination approach that central banks already follow when conceiving their strategy. JEL Classification: C53; E24; E37. |
| Keywords: | Inflation forecasts; unemployment; model uncertainty. |
| Date: | 2007–02 |
| URL: | http://d.repec.org/n?u=RePEc:ecb:ecbwps:20070725&r=cba |
| By: | Angel Asensio (CEPN - Centre d'économie de l'Université de Paris Nord - [CNRS : UMR7115] - [Université Paris-Nord - Paris XIII]) |
| Abstract: | Extending Asensio's closed-economy framework (2005a,b) to a monetary union, we show that the<br />principles of governance which emanate from the so called "New Consensus in Macroeconomics"<br />(NCM), and therefore have been designed for presumed stationary regimes, may cause severe<br />dysfunctions, such as depressive macroeconomic policies and unemployment traps, in non-ergodic<br />regimes. The Keynesian approach, on the other hand, pleads in favour of important changes in the<br />current governance of the eurozone. First, since the European Central Bank can not repress distributive<br />inflationary pressures without having non-temporary depressive effects on aggregate demand and<br />employment, authorities should recognize that the best way for controlling this type of inflation rests<br />on a consensual distribution of income. Second, authorities should abandon any "optimal rule"<br />designed in order to stabilize the economy near to an imaginary "natural" trend. Keynesian uncertainty<br />rather suggests a gradual and pragmatic approach to macroeconomic policy. From this perspective, we<br />show that the European Monetary Union could take advantage of the complementarity between the<br />common monetary policy and the national budgetary and fiscal instruments. |
| Keywords: | Monetary policy, Fiscal policy, Monetary union, Macroeconomic governance,<br />Post-Keynesian |
| Date: | 2007–03–28 |
| URL: | http://d.repec.org/n?u=RePEc:hal:papers:halshs-00139025_v1&r=cba |
| By: | A. Kia (Department of Economics, Carleton University) |
| Abstract: | This paper focuses on internal and external factors, which influence the inflation rate in developing countries. A monetary model of inflation rate, capable of incorporating both monetary and fiscal policies as well as other internal and external factors, was developed and tested on Iranian data. It was found that, over the long run, a higher exchange rate leads to a higher price and that the fiscal policy is very effective to fight inflation. The major factors affecting inflation in Iran, over the long run, are internal rather than external. However, over the short run, the sources of inflation are both external and internal. |
| Keywords: | Demand for money, inflation, fiscal and monetary policies, external and internal factors |
| JEL: | E31 E41 E62 |
| Date: | 2006–03–15 |
| URL: | http://d.repec.org/n?u=RePEc:car:carecp:06-03&r=cba |
| By: | Jacek Krawczyk; Rishab Sethi (Reserve Bank of New Zealand) |
| Abstract: | Computing the optimal trajectory over time of key variables is a standard exercise in decision-making and the analysis of many dynamic systems. In practice however, it is often enough to ensure that these variables evolve within certain bounds. In this paper we study the problem of setting monetary policy in a `good enough' sense, rather than in the optimising sense more common in the literature. Important advantages of our satisficing approach over policy optimisation include greater robustness to model, parameter, and shock uncertainty, and a better characterisation of imprecisely defined monetary policy goals. Also, optimisation may be unsuitable for determining prescriptive policy in that it suggests a unique `best' solution while many solutions may be satisficing. Our analysis frames the monetary policy problem in the context of viability theory which rigorously captures the notion of satisficing. We estimate a simple closed economy model on New Zealand data and use viability theory to discuss how inflation, output, and interest rate may be maintained within some acceptable bounds. We derive monetary policy rules that achieve such an outcome endogenously. |
| JEL: | C60 E58 |
| Date: | 2007–03 |
| URL: | http://d.repec.org/n?u=RePEc:nzb:nzbdps:2007/03&r=cba |
| By: | Riccardo DiCecio; Edward Nelson |
| Abstract: | We estimate the dynamic stochastic general equilibrium model of Christiano, Eichenbaum, and Evans (2005) on United Kingdom data. Our estimates suggest that price stickiness is a more important source of nominal rigidity in the U.K. than wage stickiness. Our estimates of parameters governing investment behavior are only well behaved when post-1979 observations are included, which reflects government policies until the late 1970s that obstructed the influence of market forces on investment. |
| Keywords: | Equilibrium (Economics) - Mathematical models ; Economic policy - Great Britain |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedlwp:2007-006&r=cba |
| By: | Roberto Frenkel |
| Abstract: | This article, originally published in Spanish in La Nación, December 31, 2006, explains the mechanics of the Argentine Central Bank's intervention in exchange rates markets to target a stable and competitive exchange rate, a macroeconomic policy that has played a significant role in Argentina's economic growth since 2002. |
| JEL: | E58 E52 E42 |
| Date: | 2007–02 |
| URL: | http://d.repec.org/n?u=RePEc:epo:papers:2007-3&r=cba |
| By: | Claude Lavoie; Hope Pioro |
| Abstract: | The authors assess the performance of the Canadian economy under a variety of interest rate rules when the zero bound on nominal interest rates can bind. Their assessment is based on numerical simulations of a dynamic stochastic general-equilibrium model in a stochastic environment. Consistent with the literature, the authors find that the probability and consequences of the zero bound depend strongly on the targeted rate of inflation and that price-level targeting generally leads to better outcomes. Their results show that a non-linear rule is preferable to a linear rule under both inflation and price-level targeting, because of the zero-bound issue. This suggests that central banks should be pre-emptive and adopt an aggressive monetary policy when expected inflation falls below its desired level. The authors' results also show that the monetary authority must be much more forward looking under price-level targeting than under inflation targeting. |
| Keywords: | Inflation: costs and benefits; Interest rates; Monetary policy framework |
| JEL: | E43 E47 E52 |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:bca:bocadp:07-1&r=cba |
| By: | Samu Kurri (Bank of Finland, Monetary Policy and Research, PO Box 160, FI-00101 Helsinki, Finland.) |
| Abstract: | In this paper we analyse the Finnish consumer price changes from February 1997 to December 2004 on the basis of a set of microdata which covers over half of the items included in the Finnish CPI. Our findings can be summarised with four stylised facts. Firstly, only a small fraction of prices change monthly. In the period under review, an average 80% of prices remained unchanged in consecutive months. Secondly, price changes can be large in both directions. Thirdly, positive inflation is due to the higher number of price increases compared to decreases, and the magnitude of price changes is more or less in balance. Finally, the decomposition of monthly inflation to the weighted fraction of products with price changes and the weighted average of those price changes seems to give support for the time-dependent modelling of Finnish consumer prices, although signs of state-dependent pricing can also be found in the data. JEL Classification: E31, D40, L11. |
| Keywords: | consumer prices, rigidity, time-dependent pricing, state-dependent pricing. |
| Date: | 2007–02 |
| URL: | http://d.repec.org/n?u=RePEc:ecb:ecbwps:20070728&r=cba |
| By: | Paul Castillo (Central Reserve Bank of Peru); Alberto Humala (Central Reserve Bank of Peru); Vicente Tuesta (Central Reserve Bank of Peru) |
| Abstract: | This paper evaluates the link between inflation and inflation uncertainty in a context of monetary policy regime shifts for the Peruvian economy. We use a model of unobserved components subject to regime shifts to evaluate this link. We verify that periods of high(low) inflation me an were accompanied by periods of high(low) both short -and long- run uncertainty in inflation. Interestingly, unlike developed countries, short run uncertainty is important. These relationaships are consistent with the presence of three clearly differentiated regimes. First, a period of price stability, then a high -inflation high-volatility regime, and finally a hyperinflation period. We also verify that during a recent period of price stability, both permanent and transitory shocks to inflation have decreased in volatility. Finally, we find evidence that inflation and money growth rates share similar regime shifts. |
| Keywords: | inflation dynamics, monetary policy, Markov-switching models, unobserved component models, sthocastic trends |
| JEL: | C22 E31 E42 E52 |
| Date: | 2007–03 |
| URL: | http://d.repec.org/n?u=RePEc:rbp:wpaper:2007-005&r=cba |