nep-cba New Economics Papers
on Central Banking
Issue of 2007‒05‒19
24 papers chosen by
Alexander Mihailov
University of Reading

  1. Welfare-maximizing monetary policy under parameter uncertainty By Rochelle M. Edge; Thomas Laubach; John C. Williams
  2. On the Determinacy of Monetary Policy under Expectational Error By Chadha, J.S.; Corrado, L.
  3. End-user order flow and exchange rate dynamics By Reitz, Stefan; Schmidt, Markus; Taylor, Mark P.
  4. Monetary Policy Analysis with Potentially Misspecified Models By Marco Del Negro; Frank Schorfheide
  5. Robust Taylor rules in an open economy with heterogeneous expectations and least squares learning By Bask, Mikael; Selander, Carina
  6. Learning Stability for Monetary Policy Rules in a Two-Country Model By Wang, Q.
  7. Seigniorage By Buiter, Willem H.
  8. Do fiscal rules cause budgetary outcomes? By Signe Krogstrup; Sébastien Wälti
  9. Long Run Macroeconomic Relations in the Global Economy By Dees, Stephane; Holly, Sean; Pesaran, M. Hashem; Smith, L. Vanessa
  10. Should Central Banks Adjust Their Target Horizons in Response to House-Price Bubbles? By Meenakshi Basant Roi; Rhys R. Mendes
  11. Debt and Interest Rates: The U.S. and the Euro Area By Chinn, Menzie; Frankel, Jeffrey
  12. The NOK/euro exhange rate after inflation targeting: The interest rate rules By Roger Bjørnstad and Eilev S. Jansen
  13. Money-based interest rate rules: lessons from German data By Gerberding, Christina; Seitz, Franz; Worms, Andreas
  15. Fear of Floating and Social Welfare By Tambakis, D.N.
  16. Foreign Exchange Intervention and the Political Business Cycle : A Panel Data Analysis By Axel Dreher; Roland Vaubel
  17. The Importance of Interest Rate Volatility in Empirical Tests of Uncovered Interest Parity By Metodij Hadzi-Vaskov; Clemens Kool
  18. Monetary Policy Rules in Theory and in Practice: Evidence from the UK and the US By Páez-Farrell, Juan
  19. The Role of the Real Interest Rate in US Macroeconomic History By Ernst Juerg Weber
  20. When Do Firms Adjust Prices? Evidence from Micro Panel Data By Sarah M. Rupprecht
  21. Micro Foundations of Price-Setting Behaviour: Evidence from Canadian Firms By Daniel de Munnik; Kuan Xu
  22. An Idealized View of Financial Intermediation By Sissoko, Carolyn
  23. The Maastricht Inflation Criterion: "Saints" and "Sinners" By Ales Bulir; Jaromir Hurnik
  24. A Tale of Two Monetary Reforms: Argentinean Convertibility in Historical Perspective By Esteban Pérez-Caldentey; Matías Vernengo

  1. By: Rochelle M. Edge; Thomas Laubach; John C. Williams
    Abstract: This paper examines welfare-maximizing monetary policy in an estimated micro-founded general equilibrium model of the U.S. economy where the policymaker faces uncertainty about model parameters. Uncertainty about parameters describing preferences and technology implies not only uncertainty about the dynamics of the economy. It also implies uncertainty about the model's utility-based welfare criterion and about the eonomy's natural rate measures of interest and output. We analyze the characteristics and performance of alternative monetary policy rules given the estimated uncertainty regarding parameter estimates. We find that the natural rates of interest and output are imprecisely estimated. We then show that, relative to the case of known parameters, optimal policy under parameter uncertainty responds less to natural-rate terms and more to other variables, such as price and wage inflation and measures of tightness or slack that do not depend on natural rates.
    Keywords: Monetary policy
    Date: 2007
  2. By: Chadha, J.S.; Corrado, L.
    Abstract: Forward looking agents with expectational errors provide a problem for monetary policy. We show that under such conditions a standard interest rate rule may not achieve determinacy. We suggest a modification to the standard policy rule that guarantees determinacy in this setting, which involves the policy maker co-ordinating inflation dynamics by responding to each of past, current and expected inflation. We show that this solution maps directly into Woodford's (2000) timeless perspective. We trace the responses in an artificial economy and illustrate the extent to which macroeconomic persistence is reduced following the adoption of this rule.
    Keywords: Expectational Errors; Indeterminacy; Monetary Policy Rules.
    JEL: C62 E31 E58
    Date: 2007–05
  3. By: Reitz, Stefan; Schmidt, Markus; Taylor, Mark P.
    Abstract: In this paper we provide evidence for Evans and Lyons' (2005b) model of an information aggregation process in FX markets using a German bank's end-user order flow from 2002 to 2003. Though customer order flow is unambiguously the vehicle incorporating non-public information into exchange rates over time, our empirical analysis does not support the widespread optimism in the market microstructure literature that customer order flow is the high-powered source of information easily exploitable for short-run speculation. Moreover, commercial customers' order flow produces negative coefficients in contemporaneous return regressions, stressing their role as liquidity providers.
    Keywords: Foreign exchange, market microstructure, end-user order flow
    JEL: F31
    Date: 2007
  4. By: Marco Del Negro; Frank Schorfheide
    Abstract: Policy analysis with potentially misspecified dynamic stochastic general equilibrium (DSGE) models faces two challenges: estimation of parameters that are relevant for policy trade-offs and treatment of estimated deviations from the cross-equation restrictions. This paper develops and explores policy analysis approaches that are either based on a generalized shock structure for the DSGE model or the explicit modelling of deviations from cross-equation restrictions. Using post-1982 U.S. data we first quantify the degree of misspecification in a state-of-the-art DSGE model and then document the performance of different interest-rate feedback rules. We find that many of the policy prescriptions derived from the benchmark DSGE model are robust to the various treatments of misspecifications considered in this paper, but that quantitatively the cost of deviating from such prescriptions varies substantially.
    JEL: C32 E52
    Date: 2007–05
  5. By: Bask, Mikael (Bank of Finland Research); Selander, Carina (Umeå University)
    Abstract: The aim of this paper is threefold: (i) to investigate if there is a unique rational expectations equilibrium (REE) in the small open economy in Galí and Monacelli (2005) that is augmented with technical trading in the foreign exchange market; (ii) to investigate if the unique REE is adaptively learnable in a recursive least squares sense; and (iii) to investigate if the unique and adaptively learnable REE is desirable in an inflation rate targeting regime in the sense that a low and not too variable CPI inflation rate in equilibrium is achieved. The monetary authority is using a Taylor rule when setting the nominal interest rate, and we investigate numerically the properties of the model developed. A main conclusion is that the monetary authority should increase (decrease) the interest rate when the CPI inflation rate increases (decreases) and when the currency gets stronger (weaker) to have a desirable rule that is robust with respect to the degree of technical trading in the foreign exchange market. Thus, the value of the currency is a better response variable than the output gap in the most desirable parametrizations of the interest rate rule.
    Keywords: determinacy; foreign exchange; inflation rate targeting regime; interest rate rule; robust monetary policy; technical trading
    JEL: E52 F31
    Date: 2007–05–09
  6. By: Wang, Q.
    Abstract: This work evaluates whether or not the interest rate rules under different exchange rate regimes lead to a REE that is both locally determinate and stable under adaptive learning by private agents. I find that monetary interdependence among countries is crucial for the determinacy and learning stability of the economy in the open economy case, even without the coordination of the policymakers. Under floating exchange rate regime, both countries should follow aggressive interest rate rules simultaneously, in order to obtain determinate and learnable REE. Furthermore, the openness diminishes the regions for the determinate and learnable rules relative to its closed economy counterpart under the .oating regime, while in other exchange rate regime, the additional reaction towards the level or change of nominal exchange rate will enlarge this region.
    Keywords: Adaptive learning, interest rate rules, open economy, exchange rate regime, determinacy, learnability
    JEL: E52 E42 E31 D84 F41 F42
    Date: 2006–12
  7. By: Buiter, Willem H.
    Abstract: Governments through the ages have appropriated real resources through the monopoly of the ‘coinage’. In modern fiat money economies, the monopoly of the issue of legal tender is generally assigned to an agency of the state, the Central Bank, which may have varying degrees of operational and target independence from the government of the day. In this paper I analyse four different but related concepts, each of which highlights some aspect of the way in which the state acquires command over real resources through its ability to issue fiat money. They are (1) seigniorage (the change in the monetary base), (2) Central Bank revenue (the interest bill saved by the authorities on the outstanding stock of base money liabilities), (3) the inflation tax (the reduction in the real value of the stock of base money due to inflation and (4) the operating profits of the central bank, or the taxes paid by the Central Bank to the Treasury. To understand the relationship between these four concepts, an explicitly intertemporal approach is required, which focuses on the present discounted value of the current and future resource transfers between the private sector and the state. Furthermore, when the Central Bank is operationally independent, it is essential to decompose the familiar consolidated ‘government budget constraint’ and consolidated ‘government intertemporal budget constraint’ into the separate accounts and budget constraints of the Central Bank and the Treasury. Only by doing this can we appreciate the financial constraints on the Central Bank’s ability to pursue and achieve an inflation target, and the importance of cooperation and coordination between the Treasury and the Central Bank when faced with financial sector crises involving the need for long-term recapitalisation or when confronted with the need to mimick Milton Friedman’s helicopter drop of money in an economy faced with a liquidity trap.
    Keywords: inflation tax, central bank budget constraint, coordination of monetary and fiscal policy
    JEL: E4 E5 E6 H6
    Date: 2007
  8. By: Signe Krogstrup (IUHEI, The Graduate Institute of International Studies, Geneva); Sébastien Wälti
    Abstract: This paper focuses on the observed empirical relationship between fiscal rules and budget deficits, and examines whether this correlation is driven by an omitted variable, namely voter preferences. We make use of two different estimation methods to capture voter preferences in a panel of Swiss sub-federal jurisdictions. First, we include a recently constructed measure of fiscal preferences. Second, we capture preferences through fixed effects with a structural break as women are enfranchised. We find that fiscal rules continue to have a significant impact on real budget balances.
    Keywords: Fiscal policy; fiscal rules; fiscal institutions; budget deficits; fiscal preferences; endogeneity
    JEL: C2 D7 E6 H6
    Date: 2007–05
  9. By: Dees, Stephane; Holly, Sean; Pesaran, M. Hashem; Smith, L. Vanessa
    Abstract: This paper focuses on testing long run macroeconomic relations for interest rates, equity, prices and exchange rates within a model of the global economy. It considers a number of plausible long run relationships suggested by arbitrage in financial and goods markets, and uses the global vector autoregressive (GVAR) model developed in Dees, di Mauro, Pesaran and Smith (2007) to test for long run restrictions in each country/region conditioning on the rest of the world. Bootstrapping is used to compute both the empirical distribution of the impulse responses and the log-likelihood ratio statistic for over-identifying restrictions. The paper also examines the speed with which adjustments to the long run relations take place via the persistence profiles. We find strong evidence in favour of the uncovered interest parity and to a lesser extent the Fisher equation across a number of countries, but our results for the PPP are much weaker. Also as to be expected, the transmission of shocks and subsequent adjustments in financial markets are much faster than those in goods markets.
    Keywords: Global VAR, interdependencies, Fisher relationship, Uncovered Interest Rate Parity, Purchasing Power Parity, persistence profile
    JEL: C32 E17 F47 R11
    Date: 2007
  10. By: Meenakshi Basant Roi; Rhys R. Mendes
    Abstract: The authors investigate the implications of house-price bubbles for the optimal inflation-target horizon using a dynamic general-equilibrium model with credit frictions, house-price bubbles, and small open-economy features. They find that, given the distribution of shocks and inflation persistence over the past 25 years, the optimal target horizon for Canada tends to be at the lower end of the six- to eight-quarter range that has characterized the Bank of Canada's policy since the inception of the inflation-targeting regime. The authors' results also suggest that it may be appropriate to take a longer view of the inflation-target horizon when the economy faces a houseprice bubble.
    Keywords: Central bank research; Economic models; Monetary policy framework; Credit and credit aggregates; Inflation targets; Transmission of monetary policy
    JEL: E5 E42 E44 E52 E58 E61
    Date: 2007
  11. By: Chinn, Menzie; Frankel, Jeffrey
    Abstract: We find that real interest rates paid on government debt depend significantly upon current and expected future levels of debt, in Europe as in the US. But this result only emerges when we condition on foreign interest rates, illustrating financial international integration. The previously strong effect of debt on US interest rates has been diluted by the addition of 2004-2006 data to the sample, perhaps reflecting the effect of massive purchases of US securities by foreign central banks. Another finding is that the asymmetry in the effect of US interest rates on European interest rates has not disappeared with the coming of European Economic and Monetary Union in 1999, as one might have thought.
    Keywords: interest rates, inflation, debt, financial integration
    JEL: E43 E58 F41
    Date: 2007
  12. By: Roger Bjørnstad and Eilev S. Jansen (Statistics Norway)
    Abstract: Norway adopted a flexible inflation target in March 2001 following a long period with exchange rate targeting in various forms. The regime shift reverses the causal ordering between changes in the nominal exchange rate and changes in the interest rate. When the central bank targets the exchange rate, interest rates are rarely changed independently of foreign interest rates and only to counteract large movements in the exchange rate after interventions have failed to stabilise the exchange rate. With inflation targeting the interest rate is used to stabilise the domestic economy and has a strong impact on the exchange rate. The long run (steady state) relationship between the interest rate and the exchange rate is on the other hand not altered by the change in monetary policy regime. This means that the fundamental equilibrating mechanism - that is the PPP condition augmented with a risk premium - remains the same across regimes.
    Keywords: monetary policy regime shift; NOK/euro exchange rate; role of interest rates; equilibrium real exchange rate; purchasing power parity; uncovered interest parity
    JEL: C51 C52 C53 E42 F31
    Date: 2007–05
  13. By: Gerberding, Christina; Seitz, Franz; Worms, Andreas
    Abstract: The paper derives the monetary policy reaction function implied by money growth targeting. It consists of an interest rate response to deviations of the inflation rate from target, to the change in the output gap, to money demand shocks and to the lagged interest rate. In the second part, it is shown that this type of inertial interest rate rule characterises the Bundesbank’s monetary policy from 1979 to 1998 quite well. This result is robust to the use of real-time or ex post data and to the consideration of serially correlated errors. The main lesson is that, in addition to anchoring long-term inflation expectations, monetary targeting introduces inertia and history-dependence into the monetary policy rule. This is advantageous when private agents have forward-looking expectations and when the level of the output gap is subject to persistent measurement errors.
    Keywords: Monetary policy, Taylor rule, money growth targets, history dependence
    JEL: E43 E52 E58
    Date: 2007
  14. By: Marc Hofstetter
    Abstract: This paper studies the behavior of several macroeconomic variables during disinflationary episodes in Latin-America and the Caribbean (LAC). In particular, it focuses on disinflations from low and moderate peaks for the period 1973-2001. The methodology used for studying the average behavior of macroeconomic variables across disinflations overcomes the traditional problem of scarce long time series (of high frequency data) that has hindered the empirical research of monetary shocks in many LAC countries. Some of the important findings are as follows: (i) while GDP growth slowed down during the disinflations of the 70s and 80s, there is no evidence of this for the 90s; (ii) the trade balance significantly deteriorated during the disinflations; (iii) the nominal devaluation rate slowed down during the episodes; and (iv) the real exchange rate appreciated during the episodes.
    Date: 2007–03–05
  15. By: Tambakis, D.N.
    Abstract: This paper studies the welfare implications of financial stability and inflation stabilization as distinct monetary policy objectives. Introducing asymmetric aversion to exchange rate depreciation in the Barro-Gordon model mitigates inflation bias due to credibility problems. The net welfare impact of fear of floating depends on the economy’s recent track record, the credibility of monetary policy, and the central bank’s discount factor. It is shown that fear of floating is more appropriate for financially fragile developing countries with imperfectly credible monetary policy than for advanced economies.
    Keywords: Fear of floating, financial stability, policy credibility, emerging market economies.
    JEL: E52 E58 F33
    Date: 2007–05
  16. By: Axel Dreher (KOF Swiss Economic Institute, ETH Zurich Switzerland and CESifo, Germany); Roland Vaubel (University of Mannheim, Dept. of Economics, Mannheim, Germany,)
    Abstract: By combining expansionary open market operations with sales of foreign exchange, the central bank can expand the monetary base without depreciating the exchange rate. Thus, if there is a monetary political business cycle, sales of foreign exchange are especially likely before elections. Our panel data analysis for up to 146 countries in 1975-2001 supports this hypothesis. Foreign exchange reserves relative to trend GDP depend negatively on the preelection index. The relationship is significant and robust irrespective of the type of electoral variable, the choice of control variables and the estimation technique.
    Keywords: Foreign exchange interventions, political business cycles
    JEL: F31 E58
    Date: 2007–04
  17. By: Metodij Hadzi-Vaskov; Clemens Kool
    Abstract: Uncovered interest rate parity provides a crucial theoretical underpinning for many models in international finance and international monetary economics. Though theoretically sound, this concept has not been supported by the empirical evidence. Typically, econometric tests not only reject the null hypothesis, but also find significant slope coefficients with the wrong sign. Following the approach employed in Kool and Thornton (2004), we show that the empirical procedure conventionally used to test for UIP may produce biased slope coefficients if the true data-generating process slightly differs from the theoretically expected one. Using monthly data for ten industrial countries during the period W75-2004,we estimate the UIP relation for all possible bilateral country pairs for each of the six fiveyear sub-periods. The evidence supports the biasedness hypothesis: when the interest rate volatility of the anchor country is very high (very low), this estimation procedure reports significantly higher (lower) slope coefficients.
    Keywords: International Financial Markets, Estimation Bias, Exchange Rate Volatility
    JEL: F31 G15 C5
    Date: 2006–10
  18. By: Páez-Farrell, Juan (Cardiff Business School)
    Abstract: Given the large amount of interaction between research on monetary policy and its practice, this paper examines whether some simple monetary policy rules that have been proposed in the academic literature, part of which has originated from within central banks, provide a reasonable characterisation of actual policy in the UK and the US. The paper finds that the simple rule that describes best actual US monetary policy is a speed limit rule with dynamics, whilst for the UK it is a forward-looking rule. The simpler dynamics in the UK's monetary policy rule are reflective of the lower persistence of inflation as a result of its policy of inflation targeting.
    Date: 2007–05
  19. By: Ernst Juerg Weber (UWA Business School, The University of Western Australia)
    Abstract: A negative real interest rate has guaranteed macroeconomic equilibrium during every national emergency in the United States since the early 19th century, except the Great Depression in the 1930s when deflation interfered with the interest rate mechanism. During the Great Depression, the interest rate mechanism failed because the zero bound on the nominal interest rate implies that the real interest rate cannot be negative if there is deflation. This points to a monetary explanation of the Great Depression, and it suggests that central banks should suspend monetary policy rules that target inflation if there is an adverse political or economic shock that creates consumer pessimism.
    JEL: D91 E21 E52 G12 N21
    Date: 2007
  20. By: Sarah M. Rupprecht (KOF Swiss Economic Institute, ETH Zurich, Switzerland)
    Abstract: This paper analyzes the price setting behavior of firms using data from a large panel of quarterly firm surveys from 1984 to 2006. These data allow to track changes in firms’ prices, their price expectations and several other firm-specific developments such as changes in costs for input products and capacity utilization rates. The analysis shows that state dependent pricing is clearly important and that variables measuring the current situation of the firm add a lot to the explanatory power of a price adjustment probability model, compared to purely time dependent features. Although the rate of inflation is a significant explanatory variable, the inclusion of macroeconomic variables adds only marginally to the explanatory power of the model with the firm specific variables. Furthermore, when taking into account sticky plan models by excluding possibly predetermined price changes, the importance of state dependent factors becomes even larger. The data also display features that suggest that sticky information plays a role for price setting.
    Keywords: Price setting behavior, time dependent pricing, state dependent pricing, sticky prices, sticky plans, sticky information
    JEL: E31 E32 E50
    Date: 2007–04
  21. By: Daniel de Munnik; Kuan Xu
    Abstract: How do firms adjust prices in the marketplace? Do they tend to adjust prices infrequently in response to changes in market conditions? If so, why? These remain key questions in macroeconomics, particularly for central banks that work to keep inflation low and stable. The authors use the Bank of Canada's 2002-03 price-setting survey data to investigate Canadian firms' price-setting behaviour; they also analyze the micro foundations for the firms' pricing behaviour using count data and probit models. The authors find that, all else being equal, firms tend to adjust prices more frequently if they are state-dependent price-setters, operate in the trade sector, or have large variable costs or more direct competitors. There are various sticky-price theories; in the Bank's price-setting survey, the senior management of firms were read a simple statement in non-technical language that paraphrased each sticky-price theory, and were then asked whether the statement applied to their firm. The most frequently recognized sticky-price theories are customer relations, cost-based pricing, and coordination failure. The authors' analysis indicates that if firms recognize coordination failure on price increases, sticky information, menu costs, factor stability, or customer relations as being important, they tend to adjust prices less frequently. The authors also find that the patterns discernible within firms' recognition of stickyprice theories are strongly associated with firms' micro foundations.
    Keywords: Inflation and prices; Transmission of monetary policy
    JEL: D40 E30 L11
    Date: 2007
  22. By: Sissoko, Carolyn
    Abstract: Using the monetary model developed in Sissoko (2007), where the general equilibrium assumption that every agent buys and sells simultaneously is relaxed, we observe that in this environment fiat money can implement a Pareto optimum only if taxes are type-specific. We then consider intermediated money by assuming that financial intermediaries whose liabilities circulate as money have an important identifying characteristic: they are widely viewed as default-free. The paper demonstrates that default-free intermediaries who issue credit lines to consumers can resolve the monetary problem and make it possible for the economy to reach a Pareto optimum. We argue that our idealized concept of financial intermediation is a starting point for studying the monetary use of credit.
    Keywords: Fiat Money, Cash-in-advance, Financial Intermediation
    JEL: E5 G2
    Date: 2007
  23. By: Ales Bulir; Jaromir Hurnik
    Abstract: The Maastricht inflation criterion, designed in the early 1990s to bring “high-inflation†EU countries into line with “low-inflation†countries prior to the introduction of the euro, poses challenges for both new EU member countries and the European Central Bank. While the criterion has positively influenced the public stance toward low inflation, it has biased the choice of the disinflation strategy toward short-run, fiat measures—rather than adopting structural reforms with longer-term benefits—with unpleasant consequences for the efficiency of the eurozone transmission mechanism. The criterion is also unnecessarily tight for new member countries, as it mainly reflects cyclical developments.
    Keywords: ERM2, Maastricht inflation criterion, new EU member countries.
    JEL: E31 E32 E42 F33
    Date: 2006–12
  24. By: Esteban Pérez-Caldentey; Matías Vernengo
    Abstract: Argentina adopted currency type board arrangements to put an end to monetary instability in the nineteenth and the twentieth centuries under very different historical circumstances and contexts with very different results. The first currency board functioned within an international system that functioned in manner similar to a closed economy. The second currency board experiment the historical conditions. The poor export performance, and the unsustainable trade and current account deficits, resulting from the process of external liberalization, and the process of international financial liberalization eventually led to the collapse of the Convertibility experiment. The role of economic ideas – in particular, the incorrect lessons taken from the first globalization period – in furthering the economic imbalances were central to the failure of the 1991 Convertibility experiment.
    Keywords: Globalization, Monetary Reform, Argentina
    JEL: F33 N26 O54
    Date: 2007–01

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