nep-cba New Economics Papers
on Central Banking
Issue of 2007‒06‒18
twenty papers chosen by
Alexander Mihailov
University of Reading

  1. Liquidity Traps, Learning and Stagnation By George W. Evans; Eran Guse; Seppo Honkapohja
  2. Interest Rate Rules, Inflation Stabilization, and Imperfect Credibility: The Small Open Economy Case By Guillermo A. Calvo
  3. How Structural Are Structural Parameters? By Jesús Fernández-Villaverde; Juan F. Rubio-Ramírez
  4. Portfolio Choices with Near Rational Agents: A Solution to Some International-Finance Puzzles By Pierpaolo Benigno
  5. What explains the US net income balance? By Alexandra Heath
  6. Globalisation and inflation: New cross-country evidence on the global determinants of domestic inflation By Claudio E. V. Borio; Andrew Filardo
  7. Correcting Global Imbalances with Exchange Rate Realignment? No thanks! By Francis Cripps; Alex Izurieta and Terry McKinley; Terry McKinley
  8. A Hybrid Sticky-Price and Sticky-Information Model By Bruchez, Pierre-Alain
  9. The euro as a reserve currency: a challenge to the pre-eminence of the US dollar? By Gabriele Galati; Philip D. Wooldridge
  10. Monetary and prudential policies at a crossroads? New challenges in the new century By Claudio E. V. Borio
  11. Do tax distortions lead to more indeterminacy? A New Keynesian perspective By Di Bartolomeo, Giovanni; Manzo, Marco
  12. Fair Wages, Fair Prices, and Monetary Policy By Cenesiz, Alper
  13. Devaluations, output and the balance sheet effect: a structural econometric analysis By Camilo E Tovar
  14. A Framework for Identifying the Sources of Local-Currency Price Stability with an Empirical Application By Pinelopi K. Goldberg; Rebecca Hellerstein
  15. "Fiscal Policy in a Stock-Flow Consistent (SFC) Model" By Wynne Godley; Marc Lavoie
  16. Phoenix miracles in emerging markets: recovering without credit from systemic financial crises By Alejandro Izquierdo; Ernesto Talvi; Guillermo A Calvo
  17. Central banks as agents of employment creation By Gerald Epstein
  18. Estimation of Asian effective exchange rates: a technical note By San Sau Fung; Marc Klau; Guonan Ma; Robert N. McCauley
  19. Economic reforms and exchange rate pass-through to domestic prices in India By Jeevan K Khundrakpam
  20. Terms and conditions for the implementation of Inflation targeting in Croatia By Tomislav Čorić

  1. By: George W. Evans (University of Oregon Economics Department); Eran Guse (University of Cambridge); Seppo Honkapohja (University of Cambridge)
    Abstract: We examine global economic dynamics under learning in a New Keynesian model in which the interest-rate rule is subject to the zero lower bound. Under normal monetary and fiscal policy, the intended steady state is locally but not globally stable. Large pessimistic shocks to expectations can lead to deflationary spirals with falling prices and falling output. To avoid this outcome we recommend augmenting normal policies with aggressive monetary and fiscal policy that guarantee a lower bound on inflation. In contrast, policies geared toward ensuring an output lower bound are insufficient for avoiding deflationary spirals.
    Keywords: Adaptive Learning, Monetary Policy, Fiscal Policy, Zero Interest Rate Lower Bound, Indeterminacy
    JEL: E63 E52 E58
    Date: 2007–06–05
  2. By: Guillermo A. Calvo
    Abstract: The paper examines the robustness of Interest Rate Rules, IRRs, in the context of an imperfectly credible stabilization program, closely following the format of much of the literature in open-economy models, e.g., Calvo and Végh (1993 and 1999). A basic result is that IRRs, like Exchange Rate Based Stabilization, ERBS, programs, could give rise to macroeconomic distortion, e.g., underutilization of capacity and real exchange rate misalignment. However, while under imperfect credibility EBRS is associated with overheating and current account deficits, IRRs give rise to somewhat opposite results. Moreover, the paper shows that popular policies to counteract misalignment, like Strategic Foreign Exchange Market Intervention or Controls on International Capital Mobility may not be effective or could even become counterproductive. The bottom line is that the greater exchange rate flexibility granted by IRRs is by far not a sure shot against the macroeconomic costs infringed by imperfect credibility.
    JEL: E52 E58 F32 F41
    Date: 2007–06
  3. By: Jesús Fernández-Villaverde; Juan F. Rubio-Ramírez
    Abstract: This paper studies how stable over time are the so-called "structural parameters" of dynamic stochastic general equilibrium (DSGE) models. To answer this question, we estimate a medium-scale DSGE model with real and nominal rigidities using U.S. data. In our model, we allow for parameter drifting and rational expectations of the agents with respect to this drift. We document that there is strong evidence that parameters change within our sample. We illustrate variations in the parameters describing the monetary policy reaction function and in the parameters characterizing the pricing behavior of firms and households. Moreover, we show how the movements in the pricing parameters are correlated with inflation. Thus, our results cast doubts on the empirical relevance of Calvo models.
    JEL: C11 C15 E10 E32
    Date: 2007–06
  4. By: Pierpaolo Benigno
    Abstract: A dynamic model of consumption and portfolio decisions is analyzed in which agents seek robust choices against some misspecification of the model probability distribution. This near-rational environment can at the same time explain an imperfect international portfolio diversification and break the link between cross-country consumption correlation and real exchange rate as it is usually implied by standard preference specifications. Portfolio decisions imply moment restrictions on asset prices that are useful to extract information on the degree of near-rationality present in the data.
    JEL: F41 G11 G15
    Date: 2007–06
  5. By: Alexandra Heath
    Abstract: Despite a significant deterioration in the US net foreign asset position, there has not been a corresponding deterioration in the net income balance. In fact, there has generally been a net income surplus. Two factors have been particularly important for the positive net income balance over the past 15 years or so. The first is that the United States has a positive net external equity balance and a negative net external debt balance. This contributes to a net income surplus because the income yield on equity has been higher than the income yield on debt.
    Keywords: Net income balance, dark matter, income yields, foreign direct investment
    JEL: F32 F41
    Date: 2007–01
  6. By: Claudio E. V. Borio; Andrew Filardo
    Abstract: There has been mounting evidence that the inflation process has been changing. Inflation is now much lower and much more stable around the globe. And its sensitivity to measures of economic slack and increases in input costs appears to have declined. Probably the most widely supported explanation for this phenomenon is that monetary policy has been much more effective. There is no doubt in our mind that this explanation goes a long way towards explaining the better inflation performance we have observed. In this paper, however, we begin to explore a complementary, rather than alternative, explanation. We argue that prevailing models of inflation are too "country-centric", in the sense that they fail to take sufficient account of the role of global factors in influencing the inflation process. The relevance of a more "globe-centric" approach is likely to have increased as the process of integration of the world economy has gathered momentum, a process commonly referred to as "globalisation". In a large cross-section of countries, we find some rather striking prima facie evidence that this has indeed been the case. In particular, proxies for global economic slack add considerable explanatory power to traditional benchmark inflation rate equations, even allowing for the influence of traditional indicators of external influences on domestic inflation, such as import and oil prices. Moreover, the role of such global factors has been growing over time, especially since the 1990s. And in a number of cases, global factors appear to have supplanted the role of domestic measures of economic slack.
    Keywords: Globalisation, inflation, monetary policy, Phillips curve
    Date: 2007–05
  7. By: Francis Cripps (Alphametrics Co., Ltd); Alex Izurieta and Terry McKinley (Cambridge Endowment for Research in Finance,University of Cambridge); Terry McKinley (International Poverty Centre)
    Keywords: Poverty, Exchange Rate
    Date: 2007–06
  8. By: Bruchez, Pierre-Alain
    Abstract: This paper shows that a hybrid of the sticky-price and sticky-information models of price adjustment is able to deliver a hump-shaped inflation response to monetary shocks without counterfactually implying, as in Mankiw and Reis (2002) or Altig et al. (2005), that individual firms' prices change each quarter (whether they respond or not to the shock). Under the assumption that firms' price-setting decisions are strategically neutral, the inflation response to a transitory shock to the money-supply growth rate is hump-shaped for the hybrid model, whereas it is monotonic for both the sticky-price and sticky information models. If the shock is permanent, then this response is hump-shaped for the sticky-information and the hybrid models, whereas it is flat for the sticky-price model.
    Keywords: hump-shaped impulse response; inflation persistence; Phillips curve; strategic complementarity
    JEL: E31
    Date: 2007–04–02
  9. By: Gabriele Galati; Philip D. Wooldridge
    Abstract: Well developed financial markets are a necessary condition for a currency to play a role as a reserve currency. The introduction of the euro greatly improved the functioning of euro financial markets. This paper investigates whether euro financial markets have developed sufficiently to facilitate the emergence of the euro as a reserve currency on par with the US dollar. We find that the liquidity and breadth of euro financial markets are fast approaching those of dollar markets, and as a result the euro is eroding some of the advantages that have historically supported the pre-eminence of the US dollar as a reserve currency. This strengthens the incentive for monetary authorities to reconsider the currency composition of their reserves. Nevertheless, the introduction of the euro has not yet resulted in a significant change in the currency composition of official reserve holdings. The US dollar has maintained its place as the dominant reserve currency, supported perhaps by the edge that dollar financial markets still have over euro markets in terms of size, credit quality and liquidity, as well as inertia in the use of international currencies.
    Keywords: international currency, foreign exchange reserves, currency composition, dollar, euro, financial markets
    JEL: E58 F30 F31 G11 G15
    Date: 2006–10
  10. By: Claudio E. V. Borio
    Abstract: It is hard to find a period in the post-war era in which inflation-adjusted interest rates have been so low for so long and monetary and credit aggregates have expanded so much without igniting inflation (the "Great Liquidity Expansion puzzle"). What lies behind these developments? How benign are they? This paper argues that financial liberalisation, the establishment of credible anti-inflation monetary policies and (real-side) globalisation have resulted in subtle but profound changes in the dynamics of the economy and in the challenges faced by policymakers. In the new environment which has gradually been taking shape, the main "structural" risk may not be so much run away inflation. Rather, it may be the damage caused by the unwinding of financial imbalances that occasionally build up over the longer expansion phases of the economy, typically spanning more than one higher-frequency business cycle. Depending on its intensity, the unwinding can lead to economic weakness, unwelcome disinflation and possibly financial strains. The analysis has implications for monetary and prudential policies. It calls for a firmer long-term focus, for greater symmetry in policy responses between upswings and downswings, with more attention being paid to actions during upswings, and for closer cooperation between monetary and prudential authorities. In recent years, the intellectual climate and policy frameworks have gradually evolved in a direction more consistent with this perspective. At the same time, obstacles to further progress remain. They are of an analytical, institutional and, above all, political economy nature. Removing them calls for further analytical and educational efforts.
    Keywords: business fluctuations, globalisation, prudential and monetary policy, financial imbalances, monetary and financial stability, liquidity
    Date: 2006–09
  11. By: Di Bartolomeo, Giovanni; Manzo, Marco
    Abstract: Following the recent developments of the literature on stabilization policies, this paper investigates the effect of tax distortions on equilibrium determinacy in a New Keynesian economy with rule-of-thumb consumers and capital accumulation. In particular, we focus on the inter-action between monetary policy and tax distortions in supporting the saddle-path equilibrium under the assumptions of balanced budget and monetary policy satisfying a Taylor rule.
    Keywords: Rule-of-thumb consumers; equilibrium determinacy; fiscal and monetary policy inter-actions; and tax distortions.
    JEL: E61 E63
    Date: 2007–05
  12. By: Cenesiz, Alper
    Abstract: Empirical research on inflation and output dynamics has revealed that inflation lags output following a shock to monetary policy. To account for this fact, researchers rely on price and wage setting assumptions that are not in line with the stylized facts of wage and price setting behavior. Fair wages and fair prices, however, can explain the observed wage and price setting behavior. Hence, I develop and analyze a general-equilibrium model with fair wages and fair prices. The model can explain the observed lag-lead relation between inflation and output. Furthermore, results with respect to other key macroeconomic aggregates are also in line with their empirical counterparts.
    Keywords: Inflation dynamics; Price adjustment; Efficiency wages; Monetary policy.
    JEL: E32 E52 E31
    Date: 2007–05
  13. By: Camilo E Tovar
    Abstract: This paper estimates a new open economy macroeconomic model for South Korea to determine the output effect of currency devaluations. Three transmission mechanisms are considered: the expenditure-switching, the balance sheet, and a monetary channel associated to a nominal exchange rate target. Devaluations are defined as an increase in this target. This allows to isolate the effects of an explicit exogenous devaluationary policy shock. Ceteris paribus, a devaluation is found to be expansionary. Output contractions in South Korea should then be associated with a different shock such as an adverse shock on the international interest rate or on export demand.
    Keywords: structural estimation, DSGE, financial accelerator, devaluations, balance sheet effect, interest rate rule, exchange rate target, new open economy macroeconomics
    JEL: F31 F41
    Date: 2006–09
  14. By: Pinelopi K. Goldberg; Rebecca Hellerstein
    Abstract: The inertia of the local-currency prices of traded goods in the face of exchange-rate changes is a well-documented phenomenon in International Economics. This paper develops a framework for identifying the sources of local-currency price stability. The empirical approach exploits manufacturers' and retailers' first-order conditions in conjunction with detailed information on the frequency of price adjustments in response to exchange-rate changes, in order to quantify the relative importance of fixed costs of repricing, local-cost non-traded components, and markup adjustment by manufacturers and retailers in the incomplete transmission of exchange-rate changes to prices. The approach is applied to micro data from the beer market. We find that: (a) wholesale prices appear more rigid than retail prices; (b) price adjustment costs account on average for up to 0.5% of revenue at the wholesale level, but only 0.1% of revenue at the retail level; (c) overall, 54.1% of the incomplete exchange rate pass-through is due to local non-traded costs; 33.7% to markup adjustment; and 12.2% to the existence of price adjustment costs.
    JEL: E30 F10 F30 L10
    Date: 2007–06
  15. By: Wynne Godley; Marc Lavoie
    Abstract: This paper deploys a simple stock-flow consistent (SFC) model in order to examine various contentions regarding fiscal and monetary policy. It follows from the model that if the fiscal stance is not set in the appropriate fashion—that is, at a well-defined level and growth rate—then full employment and low inflation will not be achieved in a sustainable way. We also show that fiscal policy on its own could achieve both full employment and a target rate of inflation. Finally, we arrive at two unconventional conclusions: first, that an economy (described within an SFC framework) with a real rate of interest net of taxes that exceeds the real growth rate will not generate explosive interest flows, even when the government is not targeting primary surpluses; and, second, that it cannot be assumed that a debtor country requires a trade surplus if interest payments on debt are not to explode.
    Date: 2007–04
  16. By: Alejandro Izquierdo; Ernesto Talvi; Guillermo A Calvo
    Abstract: Using a sample of emerging markets that are integrated into global bond markets, we analyse the collapse and recovery phase of output collapses that coincide with systemic sudden stops, defined as periods of skyrocketing aggregate bond spreads and large capital flow reversals. Our findings indicate the presence of a very similar pattern across different episodes: output recovers with virtually no recovery in either domestic or foreign credit, a phenomenon that we call Phoenix Miracle, where output "rises from its ashes", suggesting that firms go through a process of financial engineering to restore liquidity outside the formal credit markets. Moreover, we show that the US Great Depression could be catalogued as a Phoenix Miracle. However, in contrast to the US Great Depression, EM output collapses occur in a context of accelerating price inflation and falling real wages, casting doubts on price deflation and nominal wage rigidity as key elements in explaining output collapse, and suggesting that financial factors are prominent for understanding these collapses.
    Keywords: Output collapse, systemic crises, Balance of Payments crisis, Sudden Stop, capital flows, Phoenix Miracle, credit crunch, Great Depression
    JEL: F31 F32 F34 F41
    Date: 2006–12
  17. By: Gerald Epstein
    Abstract: Employment creation has dropped off the direct agenda of most central banks. The so-called “global best practice” approach to central banking has not focused on economic growth or employment generation but rather on keeping inflation in the low single digits. However, the policy record shows that employment generation and economic growth are often not by-products of inflation focused central bank policy. This chapter argues that there should be a return to the historical norm of central bank policy in which employment creation and more rapid economic growth join inflation and stabilization more generally as key goals of central bank policy. Supporting this argument, the chapter summarizes major lessons of a multi-country research project undertaken by an international team of economists which show that, within the constraints of contemporary economic conditions, there are viable alternatives to inflation targeting that can focus more on important social, real sector outcomes such as employment generation and poverty reduction.
    Keywords: inflation targeting; employment; central bank; poverty reduction.
    JEL: E5 E6 N1 N2 O2
    Date: 2007–07
  18. By: San Sau Fung; Marc Klau; Guonan Ma; Robert N. McCauley
    Abstract: Discussion of exchange rate policy in Asia would benefit from appropriate measures of exchange rates on a multilateral basis. The purpose of this paper is to refine the construction of the effective exchange rates (EERs) for Asian economies, to make allowances for the role of Hong Kong SAR as an entrepôt and to reflect the fast-growing intra-regional trade. For the scenarios under consideration, it turns out that adjusting for re-export trade through Hong Kong SAR is generally more important in the determination of trade weights than updating the base year. The proposed refinements have important policy implications, particularly in estimating the relative sizes of currency blocs, should the region's exchange rate policies become more oriented to trade baskets than to bilateral dollar rates.
    Keywords: effective exchange rates, intra-regional trade
    JEL: F10 F31
    Date: 2006–10
  19. By: Jeevan K Khundrakpam
    Abstract: This paper examines the behaviour of exchange rate pass-through to domestic prices in India during the post-economic reforms initiated since the major devaluation of July 1991. It observes that there is no clear-cut evidence of a fall in exchange rate pass-through to domestic prices. Further, there is asymmetry in pass-through between appreciation and depreciation, and between sizes of the exchange rate change. Based on the empirical evidence provided in the literature, the paper conjectures that reductions in import tariffs, the removal of trade restrictions, the increased import penetration ratio and openness of the economy and the change in the composition of imports following the economic liberalisation could have transitorily negated the impact of lower inflation on pass-through. Part of the non-decline in long-run pass-through is due to a rise in inflation persistence. This could follow from the dismantling of price controls in an environment of periodic spurts in inflation around a non-declining inflationary trend, combined with a rise in the government deficit, which has a nexus with inflation in India.
    Keywords: pass-through, prices, exchange rate
    JEL: E31 E52 F41
    Date: 2007–02
  20. By: Tomislav Čorić (Faculty of Economics and Business, University of Zagreb)
    Abstract: Since the introduction of the Stabilization program in 1993, the Croatian National Bank has been following the monetary strategy of exchange rate anchor. During the first several years (from 1993 to 1997) this monetary strategy achieved acceptable results, accompanied with a low inflation rate and high GDP growth rates. However, the macroeconomic situation has changed in the last decade. The indicators of Croatian economy, such as trade balance, the level of external debt and GDP growth rates, are not satisfying. The criticizers of exchange rate anchor monetary strategy argue that appreciated kuna lowers the competitiveness of the domestic economy. Due to that, the current monetary strategy is in the focus of various economists' discussions. One of the alternatives to the exchange rate anchor is inflation targeting. There are different theoretical and practical issues connected to the implementation of this, very popular, monetary strategy. Before the implementation of inflation targeting, the following conditions need to be fulfilled: (1) the independence of monetary authorities in choosing the monetary instruments should be achieved, (2) at least one monetary policy instrument should be efficient, and (3) the transparency of monetary policy should be accomplished. The process itself consists of several decisions, such as choosing the proper measure of inflation, the level of targeted inflation, targeted range or point etc., which is still a matter of theoretical debates. The purpose of this paper is to contribute to the above mentioned debate. After the theoretical discussion, the inflation targeting will be analyzed from the two perspectives. Firstly, in order to evaluate the capability of Croatia to implement the inflation targeting, the analysis of the Croatian monetary system will be given. Secondly, in order to asses the suitability of the inflation targeting as Croatian monetary strategy, both positive and negative characteristics of this strategy will be considered.
    Keywords: inflation targeting, monetary strategy, Croatia
    JEL: E42 E52 E58
    Date: 2007–06–13

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