nep-cba New Economics Papers
on Central Banking
Issue of 2007‒12‒08
thirty-six papers chosen by
Alexander Mihailov
University of Reading

  1. The transmission of domestic shocks in the open economy By Christopher J. Erceg; Christopher Gust; David Lopez-Salido
  2. Inertia in Taylor Rules By John Driffill; Zeno Rotondi
  3. The yield curve and macroeconomic dynamics By Peter Hördahl; Oreste Tristani; David Vestin
  4. Fear of Appreciation By Eduardo Levy Yeyati and Federico Sturzenegger
  5. A Balance-Sheet Approach to Fiscal Sustainability By Eduardo Levy Yeyati and Federico Sturzenegger
  6. Toward a Bias Corrected Currency Equivalent Index By William Barnett; John Keating; Logan Kelly
  7. Federal Reserve Information During the Great Moderation By D'Agostino, A; Whelan, K
  8. Walsh’s Contract and Transparency about Central Bank Preferences for Robust Control. By Meixing DAI; Eleftherios SPYROMITROS
  9. "Trying to Make Sense of the Bank of Japan's Monetary Policy since the Exit from Quantitative Easing" By Kazuo Ueda
  10. Theoretical models of fiscal policies in the Euroland: The Lisbon Strategy, Macroeconomic Stability and the Dilemma of Governance with Governments By Stefan Collignon
  11. Potential output growth in several industrialised countries: a comparison By Christophe Cahn; Arthur Saint-Guilhem
  12. The term structure of euro area break-even inflation rates - the impact of seasonality By Jacob Ejsing; Juan Angel García; Thomas Werner
  13. The Friedman Rule in an Overlapping Generations Model: Social Security in Reverse By Benjamin Eden
  14. Forecasting using Bayesian and information theoretic model averaging: an application to UK in flation By George Kapetanios; Vincent Labhard; Simon Price
  15. International frictions and optimal monetary policy cooperation - analytical solutions By Matthieu Darracq Pariès
  16. Explaining and forecasting euro area exports - which competitiveness indicator performs best? By Michele Ca’ Zorzi; Bernd Schnatz
  17. How Global Rules are established and stabilized By Horst Siebert
  18. Exchange rate volatility, macro announcements and the choice of intraday seasonality filtering method By Laakkonen, Helinä
  19. Why Bayes Rules: A Note on Bayesian vs. Classical Inference in Regime Switching Models By Dennis Gaertner
  20. US shocks and global exchange rate configurations By Marcel Fratzscher
  21. How is real convergence driving nominal convergence in the new EU Member States?. By Sarah M. Lein-Rupprecht; Miguel A. León-Ledesma; Carolin Nerlich
  22. Are the facts of UK inflation persistence to be explained by nominal rigidity or changes in monetary regime? By David Meenagh; Patrick Minford; Eric Nowell; Prakriti Sofat; Naveen Srinivasan
  23. Deficit sustainability and inflation in EMU: An analysis from the fiscal theory of the price level By Oscar Bajo-Rubio; Carmen Díaz-Roldán; Vicente Esteve
  24. The Relative Price of Non-traded Goods in an Imperfectly Competitive Economy: Empirical Evidence for G7 Countries By Javier Coto-Martinez; Juan Reboredo
  25. Private Money and Bank Runs By Hongfei Sun; Xiuhua Huangfu
  26. Banking, Inside Money and Outside Money By Hongfei Sun
  27. Monetary and Financial Cooperation among Central Banks in East Asia and the Pacific By Hans Genberg; Dong He
  28. The Changing Dynamics of the East Asian Real Exchange Rates after the Financial Crisis: Further Evidence on Mean Reversion By Baharumshah, Ahmad Zubaidi; Chan, Tze-Haw; Aggarwal, Raj
  29. Business Cycle Accounting for the Japanese Economy Using the Parameterized Expectations Algorithm By INABA Masaru
  30. Monetary Policy Rules For Manging Aid Surges In Africa By Christopher Adam; Stephen O’Connell; Edward Buffie
  31. Modelling inflation in China - a regional perspective By Aaron Mehrotra; Tuomas Peltonen; Alvaro Santos Rivera
  32. Woodford goes to Africa By Kang Yong Tan; David Vines
  33. New Zealand’s Exchange Rate Regime, the Collapse of Bretton Woods,and the Twilight of the Sterling Area By Catherine Schenk; John Singleton
  34. Is the Hong Kong Dollar Exchange Rate "Bounded" in the Convertibility Zone? By Cho-Hoi Hui; Tom Fong
  35. Revisiting the Coyne Affair: A Singular Event That Changed the Course of Canadian Monetary History By Pierre Siklos
  36. Monetary Policy Objectives in Pakistan: An Empirical Investigation By Wasim Shahid Malik

  1. By: Christopher J. Erceg; Christopher Gust; David Lopez-Salido
    Abstract: This paper uses an open economy DSGE model to explore how trade openness affects the transmission of domestic shocks. For some calibrations, closed and open economies appear dramatically different, reminiscent of the implications of Mundell-Fleming style models. However, we argue such stark differences hinge on calibrations that impose an implausibly high trade price elasticity and Frisch elasticity of labor supply. Overall, our results suggest that the main effects of openness are on the composition of expenditure, and on the wedge between consumer and domestic prices, rather than on the response of aggregate output and domestic prices.
    Date: 2007
  2. By: John Driffill (Birkbeck, University of London); Zeno Rotondi (University of Ferrara)
    Abstract: The inertia found in econometric estimates of interest rate rules is a continuing puzzle. Many reasons for it have been offered, though unsatisfactorily, and the issue remains open. In the empirical literature on interest rate rules, inertia in setting interest rates is typically modeled by specifying a Taylor rule with the lagged policy rate on the right hand side. We argue that inertia in the policy rule may simply reflect the inertia in the economy itself, since optimal rules typically inherit the inertia present in the model of the economy. Our hypothesis receives some support from US data. Hence we agree with Rudebusch (2002) that monetary inertia is, at least partly, an illusion, but for different reasons.
    Keywords: Monetary Policy, Interest Rate Rules, Taylor rule, Interest Rate Smoothing, Monetary Policy Inertia, Predictability of Interest Rates, Term Structure, Expectations Hypothesis
    JEL: E52 E58
    Date: 2007–11
  3. By: Peter Hördahl (Bank for International Settlements (BIS), Centralbahnplatz 2, CH-4002 Basel, Switzerland.); Oreste Tristani (Corresponding author, European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.); David Vestin (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: We show that microfounded DSGE models with nominal rigidities can be successful in replicating features of bond yield data which have previously been considered puzzling in general equilibrium frameworks. Consistent with empirical evidence, we obtain average holding period returns that are positive, increasing in maturity and sizable, as well as long-maturity bond yields that are almost as volatile as short-term interest rates. At the same time, we are able to fit sample moments of consumption and inflation relatively well. To improve our understanding of these results, we derive analytical solutions for yields that are valid up to a second order approximation and generally applicable, We demonstrate that the improved model performance does not arise directly from the presence of nominal rigidities: ceteris paribus, the introduction of sticky-prices in a simple model tend to reduce premia. Sticky prices help indirectly because they imply (short-run) monetary non-neutrality, so that the policy rule followed by the central bank affects consumption dynamics and the pricing of yields. A very high degree of “interest rate smoothing” in the policy rule is essential for our results. JEL Classification: E43, E44.
    Keywords: DSGE models, policy rules, term structure of interest rates, risk premia, second order approximations.
    Date: 2007–11
  4. By: Eduardo Levy Yeyati and Federico Sturzenegger
    Abstract: In recent years the term "fear of floating" has been used to describe exchange rate regimes that, while officially flexible, in practice intervene heavily to avoid sudden or large depreciations. However, the data reveals that in most cases (and increasingly so in the 2000s) intervention has been aimed at limiting appreciations rather than depreciations, often motivated by the neomercantilist view of a depreciated real exchange rate as protection for domestic industries. As a first step to address the broader question of whether this view delivers on its promise, we examine whether this “fear of appreciation” has a positive impact on growth performance in developing economies. We show that depreciated exchange rates appear to induce higher growth, but that the effect, rather than through import substitution or export booms as argued by the mercantilist view, works largely through the deepening of domestic savings and capital accumulation.
    Date: 2007
  5. By: Eduardo Levy Yeyati and Federico Sturzenegger
    Abstract: Recent empirical research on emerging markets debt, currency crises and fiscal sustainability has placed a significant focus on the role of currency mismatches with the emphasis placed on the currency composition of explicit government liabilities . The key insight of this paper is that these liabilities, while relevant, usually represent a small share of actual government liabilities: indeed, as an indicator of fiscal solvency, they are relatively uninformative –and possibly misleading– if not matched with the remaining liabilities (promises of wage and pension payments among others) and the asset side of the government’s balance sheet: financial and real government assets as well as the present value of future tax collection. These non-debt liabilities and assets may be affected by changes in the real exchange rate in a way that dwarfs the effect on the explicit liabilities which are typically the focus of attention. With this in mind, this paper contributes proposes a balance-sheet approach that, as illustrated by the practical applications included here, may radically alter the results from traditional sustainability evaluations –and, more generally, the perception of a country’s fiscal vulnerability.
    Date: 2007
  6. By: William Barnett (Department of Economics, The University of Kansas); John Keating (Department of Economics, The University of Kansas); Logan Kelly (School of Business and Economics, College of Charleston)
    Abstract: Measuring the economic stock of money, defined to be the present value of current and future monetary service flows, is a difficult asset pricing problem, because most monetary assets yield interest. Thus, an interest yielding monetary asset is a joint product: a durable good providing a monetary service flow and a financial asset yielding a return. The currency equilivant index provides an elegant solution, but it does so by making strong assumptions about expectations of future monetary service flows. These assumptions cause the currency equivalent index to exhibit significant downward bias. In this paper, we propose an extension to the currency equivalent index that will correct for a significant amount of this bias.
    Keywords: Currency Equilivant Index, Monetary Aggregation, Money Stock
    JEL: E49
    Date: 2007–11
  7. By: D'Agostino, A; Whelan, K
    Abstract: Using data from the period 1970-1991, Romer and Romer (2000) showed that Federal Reserve forecasts of inflation and output were superior to those provided by commercial forecasters. In this paper, we show that this superior forecasting performance deteriorated after 1991. Over the decade 1992-2001, the superior forecast accuracy of the Fed held only over a very short time horizon and was limited to its forecasts of inflation. In addition, the performance of both the Fed and the commercial forecasters in predicting inflation and output, relative to that of "naive" benchmark models, dropped remarkably during this period.
    JEL: C53 E52
    Date: 2007–12
  8. By: Meixing DAI; Eleftherios SPYROMITROS
    Abstract: Within a New Keynesian model subject to misspecification, we examine the quadratic contracts in a delegation framework where government and private agents are uncertain about central bank preferences for model robustness. We show that, in the case of complete transparency, the optimal penalty is decreasing in terms of the preference for robustness. In effect, a central bank reacts more aggressively to supply shocks when the model misspecification grows larger. Furthermore, beginning from the equilibrium of perfect transparency and assuming that the average preference for robustness is sufficiently high, the central bank has then an incentive to be less transparent in order to reduce the optimal penalty. Under similar conditions, we also find that greater opacity will increase inflation and output variability.
    Keywords: Walsh’s contract, robust control, model uncertainty, central bank transparency.
    JEL: E42 E52 E58
    Date: 2007
  9. By: Kazuo Ueda (Faculty of Economics, University of Tokyo)
    Abstract: In this short note I review the Bank of Japan's monetary policy since its exit from the so-called quantitative easing regime early in 2006. The major characteristic of the policy stance during the period, called Strategy 2 below, has been to adjust the policy interest rate gradually upward in response to a healthy real economy despite stagnant behavior in consumer prices. Such a policy stance can be contrasted with a hypothetical strategy, Strategy 1, whereby the Bank of Japan would have kept the policy rate at lower levels, possibly at zero percent, until inflation starts to show an upward trend more clearly. The two strategies are compared on many fronts with particular attention to well-known recent empirical regularities about inflation -a smaller response of inflation to output and larger uncertainties about the response. Various comparisons of the two strategies offered here, though far from conclusive, tend to support Strategy 1 over Strategy 2. In my discussion of the two strategies I also comment on some of the major features of the Nishimura article in this issue.
    Date: 2007–12
  10. By: Stefan Collignon
    Abstract: Due to collective action problems, the Eurozone is stuck in a sub-optimal macro-policy mix of too expansionary fiscal policy and too restrictive monetary policy. Although the Lisbon Strategy pays lip service to macro-economic policy coordination, no mechanisms, institutions or effective rules are established in order to overcome the collective action problem. Empirically, the failure is demonstrated by comparing the Eurozone policy mix with the US policy mix and attributing it to the low investment performance which resulted in low average GDP growth and low average productivity growth – contrary to the aims of the Lisbon Strategy to make the EU the world’s most dynamic economy. The paper also argues that in order to overcome these difficulties, a proper government for the European Union is needed. More delegation to the European level is only legitimate if European citizens can exert their democratic rights.
    Keywords: democracy; economic growth; European Central Bank; fiscal policy; legitimacy; policy coordination
    Date: 2007–11–15
  11. By: Christophe Cahn (Corresponding author: Banque de France, DAMEP, 31 rue Croix des Petits Champs, 75049 Paris Cedex, France.); Arthur Saint-Guilhem (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: In this paper, we present international comparisons of potential output growth among several economies — Canada, the euro area, France, Germany, Italy, Japan, the Netherlands, the United Kingdom, and the United States — for the period 1991-2004. The main estimates rely on a structural approach where output of the whole economy is described by a Cobb-Douglas function. This framework enables us to take temporal considerations into account, depending on the assumed volatility of potential output. Moreover, this study presents two original features, in other words, the construction of consistent and homogenous capital stock series, and long-run estimates including capital-deepening effects based on a stable capital/output ratio in value terms, whereas standard estimations assume a stable ratio in volume terms. Lastly, we use univariate methods as a benchmark. Even though the final estimates are obviously sensitive to each method and the assumptions made for each of them, this paper might help to understand why some economies remained below their potential growth rate during the recent period by identifying the sources of long-run potential. JEL Classification: C51, E32, O11, O47.
    Keywords: potential growth, production function, total factor productivity, age of equipments.
    Date: 2007–11
  12. By: Jacob Ejsing (Capital markets and financial structure division, DG-E, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Juan Angel García (Capital markets and financial structure division, DG-E, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Thomas Werner (Corresponding author: Capital markets and financial structure division, DG-E, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper provides a toolkit for extracting accurate information about inflation expectations using inflation-linked bonds. First, we show how to estimate term structures of zero-coupon real rates and break-even inflation rates (BEIRs) in the euro area. This improves the analysis of developments in inflation expectations by providing constant maturity measures. Second, we show that seasonality in consumer prices introduces misleading and quantitatively important time-varying distortions in the calculated BEIRs. We explain how to correct for this in the estimation of the term structure, and thus provide a unified framework for extracting constant maturity BEIRs corrected for seasonality. JEL Classification: E31, E43, G12.
    Keywords: Term structure, break-even inflation rates, inflation-linked bonds, inflation seasonality.
    Date: 2007–11
  13. By: Benjamin Eden (Department of Economics, Vanderbilt University)
    Abstract: The welfare gains from adopting a zero nominal interest policy depend on the implementation details. Here I focus on a government loan program that crowds out lending and borrowing and other money substitutes. Since money can be costlessly created the resources spent on creating money substitutes are a "social waste". Moving from an economy with strictly positive nominal interest rate to an economy with zero nominal interest rate will increase consumption by the amount of resources spent on lending and borrowing. But in general welfare will increase by more than that because consumption smoothing is better under zero nominal interest rate.
    Keywords: Welfare cost of inflation, money substitutes, wealth redistribution, Friedman rule
    JEL: E42 E51 E52 E58 H20 H21 H26
    Date: 2007–11
  14. By: George Kapetanios (Queen Mary University of London); Vincent Labhard (Bank of England); Simon Price (Department of Economics, City University, London)
    Abstract: Model averaging often improves forecast accuracy over individual forecasts. It may also be seen as a means of forecasting in data-rich environments. Bayesian model averaging methods have been widely advocated, but a neglected frequentist approach is to use information theoretic based weights. We consider the use of information-theoretic model averaging in forecasting UK inflation, with a large data set, and find that it can be a powerful alternative to Bayesian averaging schemes.
    Keywords: forecasting, inflation, Bayesian model averaging, Akaike criteria, forecast combining.
    JEL: C11 C15 C53
    Date: 2007–11
  15. By: Matthieu Darracq Pariès (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper analyzes the implications of price-setting and incomplete financial markets for optimal monetary cooperation. The main objective is to provide the basic intuitions concerning the role of the main international frictions on optimal policy within a simple Dynamic Stochastic General Equilibrium model. We concentrate on a symmetric two-country DSGE with home bias, incomplete financial markets internationally and imperfect competition together with nominal price rigidities in which the export prices can be denominated either in the producer currency (PCP) or in the consumer currency (LCP). In addition, the model can account both for efficient and inefficient shocks. Our main results are derived in polar cases with efficient steady state and for which the design of the optimal policy is specifically illustrative and can be expressed in terms of targeting rules. In particular, the paper gives some new insights on the optimal exchange rate regime given the structure of shocks and the exchange rate pass-through, as well as on the optimal stabilization of CPI and PPI inflation. We also put into perspective the implication of financial autarky on the optimal management of international spillovers. JEL Classification: E5, F4.
    Keywords: DSGE models, optimal monetary policy, new open economy macroeconomics.
    Date: 2007–11
  16. By: Michele Ca’ Zorzi (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Bernd Schnatz (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: From a conceptual point of view there is little consensus of what should be the “ideal indicator” of international cost and price competitiveness as each of the standard measures typically employed has its own merits and drawbacks. This calls for addressing the question from an empirical angle, searching for the indicator that best explains and helps forecast export developments. This paper constitutes a first attempt to systematically compare the properties of the alternative cost and price competitiveness measures of the euro area. Although they diverge sometimes, we find little evidence that there is one indicator consistently outperforming the other in terms of explaining and forecasting euro area exports. This suggests that the measures based on consumer and producer prices, which offer some advantages in terms of quality and timeliness, are good approximations of euro area price and cost competitiveness. JEL Classification: F17, F31, F41.
    Keywords: Real exchange rate, trade, exports, price competitiveness, euro area, forecast.
    Date: 2007–11
  17. By: Horst Siebert
    Abstract: This paper analyzes how international rules are established and stabilized, i.e. how an international institutional order develops. Rules emerge mainly through learning from negative experience and serve to reduce transaction costs. The paper looks at mechanisms that stabilize rule systems, at bargaining procedures for cooperation gains, dispute settlement, sanctions, side payments, self-enforcing contracts, waivers and regional integrations within a multilateral order. In addition it analyzes the prevention of negative spillovers, international courts and global public goods.
    Keywords: International rules, transaction costs, institutional competition, gains from cooperation, bargaining for cooperation gains, positive mechanisms, dispute settlement, sanctions, side payments, self-enforcing contracts, negative spillovers, international courts, global public goods
    JEL: A12 F02 F15 K00 N00 P00
    Date: 2007–12
  18. By: Laakkonen, Helinä (University of Jyväskylä)
    Abstract: Filtering intraday seasonality in volatility is crucial for using high frequency data in econometric analysis. This paper studies the effects of filtering on statistical inference concerning the impact of news on exchange rate volatility. The properties of different methods are studied using a 5-minute frequency USD/EUR data set and simulated returns. The simulation results suggest that all the methods tend to produce downward-biased estimates of news coefficients, some more than others. The study supports the Flexible Fourier Form method as the best for seasonality filtering.
    Keywords: high-frequency; volatility; macro announcements; seasonality
    JEL: C22 C49 C52 E44
    Date: 2007–11–28
  19. By: Dennis Gaertner (Socioeconomic Institute, University of Zurich)
    Abstract: By means of a very simple example, this note illustrates the appeal of using Bayesian rather than classical methods to produce inference on hidden states in models of Markovian regime switching.
    Keywords: Bayesian analysis, switching regression, regime changes, nonlinear filtering
    JEL: C11 C22
    Date: 2007–12
  20. By: Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: The paper analyses the heterogeneity in the link between macroeconomic fundamentals and exchange rates. For a set of important US-specific economic shocks, it shows that such shocks have exerted a remarkably heterogeneous effect on global exchange rate configurations over the past 25 years. Despite a significant decline over time, this heterogeneity remains high as primarily currencies of a few industrialized countries provide the largest contribution to the adjustment of the effective US dollar exchange rate. The paper finds that this heterogeneity is not only due to policy choices of inflexible exchange rate regimes, but to an important extent due to market forces, in particular business cycle synchronization and the degree of financial integration – foremost in portfolio investment – but not to trade. The findings have implications for a potential unwinding of global imbalances and future exchange rate adjustment, as well as for monetary policy choices in emerging market economies. JEL Classification: F31, F4, G1.
    Keywords: Exchange rate, US dollar, cross-rates, shocks heterogeneity, global distribution, transmission channels.
    Date: 2007–11
  21. By: Sarah M. Lein-Rupprecht (KOF Swiss Economic Institute ETH Zurich, Weinbergstrasse 35, CH-8092 Zürich, Switzerland.); Miguel A. León-Ledesma (Department of Economics, University of Kent, Canterbury, Kent, CT27NP, United Kingdom.); Carolin Nerlich (European Central Bank, DG-Economics, Kaiserstraße 29, 60311 Frankfurt, Germany.)
    Abstract: The purpose of this paper is to evaluate the empirical relevance of real convergence on the process of nominal convergence for the new EU Member States. We discuss two of the main channels through which real convergence could affect relative prices with respect to the euro area - productivity growth and increased trade openness. Productivity growth can have a positive effect on price levels via the Balassa Samuelson effect, whereas increased openness leads to reductions in mark ups and costs and therefore can have a negative impact on prices. In order to assess their empirical relevance, we used a Structural VAR model to which we applied a model reduction algorithm. This method accounts for endogeneity and simultaneity and circumvents the problem of limited data availability. Our findings show that, in general, openness has had a negative impact and productivity growth a positive one on price level convergence with respect to the euro area. JEL Classification: O52, E31.
    Keywords: Real convergence, nominal convergence, inflation, new EU Member States.
    Date: 2007–11
  22. By: David Meenagh (Cardiff University); Patrick Minford (Cardiff University / CEPR); Eric Nowell (University of Liverpool); Prakriti Sofat (IDEAglobal (Singapore)); Naveen Srinivasan (Indira Gandhi Institute of Development Research)
    Abstract: It has been widely argued that inflation persistence since WWII has been widespread and durable and that it can only be accounted for by models with a high degree of nominal rigidity. We examine UK post-war data and find that the varying persistence it reveals is largely due to changing monetary regimes and that models with moderate or even no nominal rigidity are best equipped to explain it.
    Date: 2007–07
  23. By: Oscar Bajo-Rubio (Universidad de Castilla-La Mancha and Instituto de Estudios Fiscales); Carmen Díaz-Roldán (Universidad de Castilla-La Mancha); Vicente Esteve (Universidad de Valencia)
    Abstract: Price determination theory typically focuses on monetary plicy, while the role of fiscal policy is ussually neglected. From a different point of view, the Fiscal Theory of Price Level takes into account monetary and fiscal policy interactions and assumes that fiscal policy may determine the price level, even if monetary authorities pursue an inflation targeting strategy. In this paper we try to test empirically whether the time path of the government budget in EMU countries would have affected price level determination. Our results point to the sustainability of fiscal policy in all the EMU countries but Finland, although no firm conclusions can be drawn about the prevalence of either monetary or fiscal dominance.
    Keywords: Fiscal Theory of the Price Level, monetary and fiscal dominance, central bank independence, fiscal solvency, inflation
    JEL: E62 H62 O52
    Date: 2007–04
  24. By: Javier Coto-Martinez (Department of Economics, City University, London); Juan Reboredo (Universidade de Santiago de Compostela)
    Abstract: In this paper, we consider the role of imperfect competition in explaining the relative price of non-traded to traded goods within the Balassa-Samuelson framework. Under imperfect competition in the two sectors, relative prices depend on both productivity differentials and mark-up differentials. We test this implication using a panel of sectors for the seven major OECD countries. The empirical evidence suggests that relative price movements are well explained by productivity and mark-up differentials. Unlike the original Balassa-Samuelson model, aggregate demand could affect the real exchange rate by changing the mark ups. The empirical results show that aggregate demand fluctuations lead to changes on the mark-ups.
    Keywords: Balassa-Samuelson hypothesis, real exchange rate, relative prices, imperfect competition.
    JEL: F31 F36 C23
    Date: 2007–11
  25. By: Hongfei Sun (Queen's University); Xiuhua Huangfu (University of Sydney)
    Abstract: This paper studies bank runs in a model with coexistence of fiat money and private money. When fiat money is the only medium of exchange, there exist a bank run equilibrium and an equilibrium that achieves the optimal risk sharing. In contrast, when private money is also a medium of exchange, there exists a unique equilibrium where no one demands early withdrawals of fiat money and agents in need of liquidity only use private money to finance consumption. The unique equilibrium achieves the first-best outcome and eliminates bank runs without having resort to any government intervention.
    Keywords: private money, fiat money, bank runs
    JEL: E4 G2
    Date: 2007–12
  26. By: Hongfei Sun (Queen's University)
    Abstract: This paper presents an integrated theory of money and banking. I address the following question: when both individuals and banks have private information, what is the optimal way to settle debts? I develop a dynamic model with micro-founded roles for banks and a medium of exchange. I establish two main results: first, markets can improve upon the optimal dynamic contract at the presence of private information. Market prices fully reveal the aggregate states and help solve the incentive problem of the bank. Secondly, it is optimal for the bank to require loans be settled with short-term inside money, i.e., bank money that expires immediately after the settlement of debts. Short-term inside money makes it less costly to induce truthful revelation and achieve more efficient risk sharing.
    Keywords: banking, inside money, outside money
    JEL: E4 G2
    Date: 2007–12
  27. By: Hans Genberg (Research Department, Hong Kong Monetary Authority); Dong He (Research Department, Hong Kong Monetary Authority)
    Abstract: In this paper we show that monetary policy frameworks in the East Asia and Pacific region are heterogeneous, with exchange rate policies being subordinate to domestic price stability objectives in most regional economies. We then argue that in this environment it is undesirable to focus regional cooperation on exchange rate policies because of the risk of creating conflicts with domestic objectives that would lead to loss of central bank credibility and possibly speculative attacks. We also argue that the case for coordinated exchange rate policies is in fact weak, even after taking into account the region¡¦s traditional emphasis on export performance and increasing regional trade integration. Rather than focusing cooperation on the setting of policy instruments, we suggest an alternative that centres on developing more liquid financial markets in the region in the foreseeable future, and on harmonising the objectives of monetary policy and designing institutions that could form the basis of deeper forms of cooperation in the longer-term future.
    Keywords: Regional monetary cooperation, exchange rate coordination, East Asia
    JEL: E42 F33 F36
    Date: 2007–11
  28. By: Baharumshah, Ahmad Zubaidi; Chan, Tze-Haw; Aggarwal, Raj
    Abstract: Using an improved statistical methodology including tests designed for heterogeneous panels, this paper tests for mean reversion in monthly US Dollar based real exchange rates for nine East Asian countries, including those that were severely affected by the 1997 Asian financial crises. The empirical results reveals mean reversion in real Asian exchange rates is a feature of the post-crises sub-period (1997-2005) but not of the pre-crises sub-period (1981-1996). Additionally, we make a point that a faster speed of convergence to PPP and lower adjustment half-lives for real exchange rates compared to those reported for major industrialized country currencies and especially so for the post-crises period in Asia.
    Keywords: Purchasing power parity; Panel unit root tests; Asian financial crisis
    JEL: F40 C12 C23 F31
    Date: 2006–05
  29. By: INABA Masaru
    Abstract: We propose an application of the parameterized expectations algorithm (PEA) to business cycle accounting (BCA). The PEA has an advantage in that it is simple and easier to understand and implement than the other non-linear solution methods for the dynamic stochastic general equilibrium model. Moreover, we apply BCA to the Japanese economy using the PEA which relaxes the perfect foresight assumption and show that the result is similar to the main result in the deterministic BCA by Kobayashi and Inaba (2006). The effects of the investment wedge are not a significant cause of the persistent recession during the 1990s. The output due to the efficiency wedge roughly replicates actual output, while the discrepancy widened during the 1990s. The labor wedge had a large depressing effect on output during 1989-2005. The efficiency wedge explains the recent economic recovery.
    Date: 2007–11
  30. By: Christopher Adam (University of Oxford); Stephen O’Connell (Swarthmore College); Edward Buffie (Indiana University; International Monetary Fund)
    Abstract: We examine the properties of alternative monetary policy rules in response to large aid surges in low-income countries characterized by incomplete capital market integration and currency substitution. Using a dynamic stochastic general equilibrium model, we show that simple monetary rules that stabilize the path of expected future seigniorage for a given aid flow have attractive properties relative to a range of conventional alternatives including those involving heavy reliance on bond sterilization or a commitment to a pure exchange rate float. These simple rules, which are shown to be robust across a range of fiscal responses to aid inflows, appear to be consistent with actual responses to recent aid surges in a range of post-stabilization countries in Sub-Saharan Africa.
    Keywords: Basle Committee, capital adequacy, financial governance, financial architecture, financial reform, international standards, capital flows, poor countries, cost of capital, international development
    Date: 2007–02
  31. By: Aaron Mehrotra (Corresponding author: Bank of Finland, BOFIT, PO Box 160, 00101 Helsinki, Finland.); Tuomas Peltonen (European Central Bank, Directorate General International and European Relations, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Alvaro Santos Rivera (European Central Bank, Directorate General International and European Relations, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: We model provincial inflation in China during the reform period. In particular, we are interested in the ability of the hybrid New Keynesian Phillips Curve (NKPC) to capture the inflation process at the provincial level. The study highlights differences in inflation formation and shows that the NKPC provides a reasonable description of the inflation process only for the coastal provinces. A probit analysis suggests that the forwardlooking inflation component and the output gap are important inflation drivers in provinces that have advanced most in marketisation of the economy and have most likely experienced excess demand pressures. These results have implications for the relative effectiveness of monetary policy across the Chinese provinces. JEL Classification: E31, C22.
    Keywords: China, Inflation, Regional, New Keynesian Phillips Curve, GMM.
    Date: 2007–11
  32. By: Kang Yong Tan (University of Oxford); David Vines (University of Oxford)
    Abstract: This paper analyses the effects of inflation shocks, demands shocks, and aid shocks on low-income, quasi-emerging-market economies, and discusses how monetary policy can be used to manage these effects. We make use of a model developed for such economies by Adam et al. (2007). We examine the e¤ects of four things which this model features, which we take to be typical of such economies. These are: the existence of a tradeables/non-tradeables production structure, the fact that international capital movements are - at least initially - confined to the effects of currency substitution by domestic residents, the use of targets for financial assets in the implementation of monetary policy, and the pursuit, in some countries, of a fixed exchange rate. We then modify the model to examine the effect on such economies of three major changes, changes which we take to be part of the transition by such economies towards more fully- fledged emerging-market status: an opening of the capital account so that uncovered- interest-parity comes to hold, a move to floating exchange rates, and the replacement of fixed stocks of financial aggregates by the pursuit of a Taylor rule in the conduct of monetary policy.
    Keywords: currency substitution, emerging market macroeconomics, interactions between fiscal and monetary policy, Taylor rule
    JEL: E5 E61 O11
    Date: 2007–07
  33. By: Catherine Schenk (University of Glasgow); John Singleton (Victoria University of Wellington)
    Abstract: How did developing countries adapt to the collapse of the Bretton Woods system? Using new archival evidence, we argue that New Zealand offers an interesting case study of decision-making in a small economy dependent on primary production with close economic and political links to two larger partners – Britain and Australia – with divergent domestic policies. After some experimentation, New Zealand adopted an innovative intermediate solution for the exchange rate that aimed to generate stability for primary producers during a period when the direction of trade was diversifying and most currencies were floating. This imaginative policy was not accompanied by comparable changes in reserves management, and until 1975 New Zealand continued to hold the bulk of its reserves in sterling. The article explores the different priorities and institutional constraints affecting the choice of anchor currency and reserve currency in this context.
    Date: 2007–10
  34. By: Cho-Hoi Hui (Research Department, Hong Kong Monetary Authority); Tom Fong (Research Department, Hong Kong Monetary Authority)
    Abstract: The empirical results show that after the introduction of the three refinements to the Linked Exchange Rate system in May 2005 the Hong Kong dollar follows a bounded process that is consistent with a fully credible exchange rate band. The bounded process will limit the movements of the exchange rate to between the strong- and weak-side limits because its variance vanishes at the Convertibility Undertakings making it inaccessible to the limits. The Hong Kong dollar does not show any strong tendency to revert towards the centre of the Convertibility Zone. This is perhaps not surprising as there have been no interventions in the foreign exchange market since May 2005. There may be few forces or incentives for market participants to drive the exchange rate towards 7.80.
    Keywords: Linked Exchange Rate system, target zone, mean reversion, bounded process
    JEL: F31 G13
    Date: 2007–09
  35. By: Pierre Siklos (Wilfrid Laurier University)
    Abstract: The Coyne affair is the greatest institutional crisis faced by the Bank of Canada in its history. The crisis took place in 1959-1961 and led to the resignation of the Governor, once he was cleared of any wrongdoing. The crisis eventually resulted in a major reform of the Bank of Canada. The paper highlights the critical role played by the directive in central banking legislation. Archival and empirical evidence is used to assess the performance of monetary policy throughout the 1950s. In doing so, a real-time dataset is constructed for both Canada and the US that permits estimation of reaction functions. I find that the case against James Coyne is \'not proven\'.
    Keywords: Coyne Affair; monetary policy stance; Taylor rules; real-time data
    JEL: N10 E52 E58 C52
    Date: 2007
  36. By: Wasim Shahid Malik (Pakistan Institute of Development Economics, Islamabad.)
    Abstract: The Taylor rule (1993) focuses only on two objectives: output and inflation. In practice, the central bank’s loss function (especially in developing countries) contains objectives other than these two, like the interest rate smoothing, exchange rate stabilisation, etc. In this study, the monetary policy reaction function has been estimated, including five objectives for monetary policy as well as controlling for the effect of three other factors. Whereas the results confirm the counter-cyclical response of monetary policy to the factors in the loss function, the response of interest rate to changes in the foreign exchange reserves and the government borrowing has been negative. Variance decomposition shows that most of the variation in the interest rate is explained by its own lagged values. Other variables, in explaining variation in the interest rate, can be ranked as inflation, government borrowing, exchange rate, output gap, trade deficit, and, finally, the foreign exchange reserves.
    Keywords: Monetary Policy Objectives, Variance Decomposition, Call Money Rate
    JEL: E52 E52 E58
    Date: 2007

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