nep-cba New Economics Papers
on Central Banking
Issue of 2011‒08‒09
forty-four papers chosen by
Alexander Mihailov
University of Reading

  1. Inflation Forecast Contracts By Hans Gersbach; Volker Hahn
  2. Optimal monetary policy in an operational medium-sized DSGE model By Malin Adolfson; Stefan Laséen; Jesper Lindé; Lars E.O. Svensson
  3. What's Next for the Dollar? By Martin S. Feldstein
  4. Global Asset Pricing By Karen K. Lewis
  5. Stories of the Twentieth Century for the Twenty-First By Pierre-Olivier Gourinchas; Maurice Obstfeld
  6. Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes By Ana Fostel; John Geanakoplos
  7. Financial frictions and optimal monetary policy in an open economy By Marcin Kolasa; Giovanni Lombardo
  8. Dollar illiquidity and central bank swap arrangements during the global financial crisis By Andrew K. Rose; Mark M. Spiegel
  9. The importance of time series extrapolation for macroeconomic expectations By Michael W.M. Roos; Ulrich Schmidt
  10. An estimated DSGE model of energy, costs and inflation in the United Kingdom By Millard, Stephen
  11. The impact of permanent energy price shocks on the UK economy By Harrison, Richard; Thomas, Ryland; de Weymarn, Iain
  12. Monetary union, fiscal crisis and the preemption of democracy By Scharpf, Fritz W.
  13. A model of commodity money with minting and melting By Angela Redish; Warren E. Weber
  14. Understanding and forecasting aggregate and disaggregate price dynamics By Colin Bermingham; Antonello D’Agostino
  15. L'intermédiation financière dans l'analyse macroéconomique : le défi de la crise. By Eleni Iliopulos; Thepthida Sopraseuth
  16. On Measuring the Efficiency of Monetary Policy By Walter Briec; Emmanuelle Gabillon; Laurence Lasselle; Hermann Ratsimbanierana
  17. A SVECM Model of the UK Economy and The Term Premium By MARDI DUNGEY; M.TUGRUL VEHBI
  18. Monetary Policy, Determinacy, and the Natural Rate Hypothesis By Alexander Meyer-Gohde
  19. The marginal utility of money: A modern Marshallian approach to consumer choice By József Sákovics and Daniel Friedman (University of California at Santa Cruz)
  20. Have market views on the sustainability of fiscal burdens influenced monetary authorities' credibility? By Gabriele Galati; John Lewis; Steven Poelhekke; Chen Zhou
  21. Identifying the Effects of Government Spending Shocks with and without Expected Reversal: an Approach Based on U.S. Real-Time Data By Jacopo Cimadomo, Sebastian Hauptmeier, Sergio Sola
  22. Countercyclical Markups and News-Driven Business Cycles By Oscar Pavlov; Mark Weder
  23. Estimation of Forward-Looking Relationships in Closed Form: An Application to the New Keynesian Phillips Curve By Barnes, Michelle L.; Gumbau-Brisa, Fabià; Lie, Denny; Olivei, Giovanni P.
  24. A Response to Cogley and Sbordone's Comment on "Closed-Form Estimates of the New Keynesian Phillips Curve with Time-Varying Trend Inflation" By Gumbau-Brisa, Fabià; Lie, Denny; Olivei, Giovanni P.
  25. Evolving UK and US macroeconomic dynamics through the lens of a model of deterministic structural change By Kapetanios, George; Yates, Tony
  26. Will the SARB always succeed in fighting inflation with contractionary policy? By Guangling (Dave) Liu
  27. Predicting Short-Term Interest Rates: Does Bayesian Model Averaging Provide Forecast Improvement? By Chew Lian Chua; Sandy Suardi; Sarantis Tsiaplias
  28. The Demonetization of Gold: Transactions and the Change in Control By Thomas Quint; Martin Shubik
  29. Asymmetric Price Impacts of Order Flow on Exchange Rate Dynamics By Viet Hoang Nguyen; Yongcheol Shin
  30. Home bias in interbank lending and banks’ resolution regimes By Michele Manna
  31. The International Transmission of Euro Area Monetary Policy Shocks By Nils Jannsen; Melanie Klein
  32. How have global shocks impacted the real effective exchange rates of individual euro area countries since the euro's creation? By Bussière, M.; Chudik, A.; Mehl, A.
  33. What determines European real exchange rates? By Berka, Martin; Devereux, Michael B.
  34. Price setting in a leading Swiss online supermarket By Berka, Martin; Devereux, Michael B.; Rudolph, Thomas
  35. An unexpected crisis? Looking at pricing effectiveness of different banks By Valerio Vacca
  36. Consumer Misperceptions, Uncertain Fundamentals, and the Business Cycle By Patrick Hürtgen
  37. Properties of Foreign Exchange Risk Premiums By Sarno, Lucio; Schneider, Paul; Wagner, Christian
  38. Dual-Track Interest Rates and the Conduct of Monetary Policy in China By Dong He; Honglin Wang
  39. Bayesian Analysis of Time-Varying Parameter Vector Autoregressive Model with the Ordering of Variables for the Japanese Economy and Monetary Policy By Jouchi Nakajima; Toshiaki Watanabe
  40. The fiscal theory of the price level and the backing theory of money By Sproul, Michael
  41. Sticky wages in search and matching models in the short and long run By Christopher Reicher
  42. Approximations to viability kernels for sustainable macroeconomic policies By Krawczyk, Jacek; Pharo, Alastair; Simpson, Mark
  43. Forecasting Under Strucural Break Uncertainty By Jing Tian; Heather M. Anderson
  44. An unobserved components common cycle for Australasia? Implications for a common currency By Hall, Viv B; McDermott, C John

  1. By: Hans Gersbach (ETH Zurich, Switzerland); Volker Hahn (ETH Zurich, Switzerland)
    Abstract: We introduce a new type of incentive contract for central bankers: inflation forecast contracts, which make central bankers’ remunerations contingent on the precision of their inflation forecasts. We show that such contracts enable central bankers to influence inflation expectations more effectively, thus facilitating more successful stabilization of current inflation. Inflation forecast contracts improve the accuracy of inflation forecasts, but have adverse consequences for output. On balance, paying central bankers according to their forecasting performance improves welfare.
    Keywords: central banks, incentive contracts, transparency, inflation targeting, inflation forecast targeting, intermediate targets
    JEL: E58
    Date: 2011–07
  2. By: Malin Adolfson; Stefan Laséen; Jesper Lindé; Lars E.O. Svensson
    Abstract: We show how to construct optimal policy projections in Ramses, the Riksbank's open-economy medium-sized DSGE model for forecasting and policy analysis. Bayesian estimation of the parameters of the model indicates that they are relatively invariant to alternative policy assumptions and supports our view that the model parameters may be regarded as unaffected by the monetary policy specification. We discuss how monetary policy, and in particular the choice of output gap measure, affects the transmission of shocks. Finally, we use the model to assess the recent Great Recession in the world economy and how its impact on the economic development in Sweden depends on the conduct of monetary policy. This provides an illustration on how Rames incoporates large international spillover effects.
    Date: 2011
  3. By: Martin S. Feldstein
    Abstract: The real trade weighted value of the dollar fell 11 percent against the Federal Reserve Bank’s index of major currencies during the 12 months through May 2011 and 31 percent during the past ten years. Four strong market forces are likely to cause further declines over the next several years: a portfolio rebalancing by major international investors who regard their portfolios as overweight dollars, the large US current account deficit, a Chinese policy to raise consumption, and interest rate differences that make dollar investments less attractive. A declining dollar could have a powerful positive effect on the short-run performance of the American economy by raising exports (now more than $1.3 trillion) and inducing American consumers to shift from imports to American made products and services. Without a boost to demand from an increase in net exports, the U.S. recovery is likely to remain weak and could run out of steam. There are of course also negative effects of a falling dollar: reducing the real value of any given level of personal incomes by raising the cost to households of the imported products that they consume and creating inflationary pressures as import prices rise.
    JEL: E3 F0 F31 F4
    Date: 2011–07
  4. By: Karen K. Lewis
    Abstract: Financial markets have become increasingly global in recent decades, yet the pricing of internationally traded assets continues to depend strongly upon local risk factors, leading to several observations that are difficult to explain with standard frameworks. Equity returns depend upon both domestic and global risk factors. Further, local investors tend to overweight their asset portfolios in local equity. The stock prices of firms that begin to trade across borders increase in response to this information. Foreign exchange markets also display anomalous relationships. The forward rate predicts the wrong sign of future movements in the exchange rate, implying that traders can make profits by borrowing in lower interest rate currencies and investing in higher interest rate currencies. Furthermore, the sign of the foreign exchange premium changes over time, a fact difficult to reconcile with consumption variability. In this review, I describe the implications of the current body of research for addressing these and other global asset pricing challenges.
    JEL: G11 G12 G13 G14 G15
    Date: 2011–07
  5. By: Pierre-Olivier Gourinchas; Maurice Obstfeld
    Abstract: A key precursor of twentieth-century financial crises in emerging and advanced economies alike was the rapid buildup of leverage. Those emerging economies that avoided leverage booms during the 2000s also were most likely to avoid the worst effects of the twenty-first century's first global crisis. A discrete-choice panel analysis using 1973-2010 data suggests that domestic credit expansion and real currency appreciation have been the most robust and significant predictors of financial crises, regardless of whether a country is emerging or advanced. For emerging economies, however, higher foreign exchange reserves predict a sharply reduced probability of a subsequent crisis.
    JEL: E32 E51 F32 F34 G15 G21
    Date: 2011–07
  6. By: Ana Fostel; John Geanakoplos
    Date: 2011–07–31
  7. By: Marcin Kolasa (National Bank of Poland, Economic Institute; Warsaw School of Economics); Giovanni Lombardo (European Central Bank)
    Abstract: A growing number of papers have studied positive and normative implications of financial frictions in DSGE models. We contribute to this literature by studying the welfare-based monetary policy in a two-country model characterized by financial frictions, alongside a number of key features, like capital accumulation, non-traded goods and foreign-currency debt denomination. We compare the cooperative Ramsey monetary policy with standard policy benchmarks (e.g. PPI stability) as well as with the optimal Ramsey policy in a currency area. We show that the two-country perspective offers new insights on the trade-offs faced by the monetary authority. Our main results are the following. First, strict PPI targeting (nearly optimal in our model if credit frictions are absent) becomes excessively procyclical in response to positive productivity shocks in the presence of financial frictions. The related welfare losses are non-negligible, especially if financial imperfections interact with nontradable production. Second, (asymmetric) foreign currency debt denomination affects the optimal monetary policy and has important implications for exchange rate regimes. In particular, the larger the variance of domestic productivity shocks relative to foreign, the closer the PPI-stability policy is to the optimal policy and the farther is the currency union case. Third, we find that central banks should allow for deviations from price stability to offset the effects of balance sheet shocks. Finally, while financial frictions substantially decrease attractiveness of all price targeting regimes, they do not have a significant effect on the performance of a monetary union agreement.
    Keywords: financial frictions, open economy, optimal monetary policy
    JEL: E52 E61 E44 F36 F41
    Date: 2011
  8. By: Andrew K. Rose; Mark M. Spiegel
    Abstract: While the global financial crisis was centered in the United States, it led to a surprising appreciation in the dollar, suggesting global dollar illiquidity. In response, the Federal Reserve partnered with other central banks to inject dollars into the international financial system. Empirical studies of the success of these efforts have yielded mixed results, in part because their timing is likely to be endogenous. In this paper, we examine the cross-sectional impact of these interventions. Theory consistent with dollar appreciation in the crisis suggests that their impact should be greater for countries that have greater exposure to the United States through trade and financial channels, less transparent holdings of dollar assets, and greater illiquidity difficulties. We examine these predictions for observed cross-sectional changes in CDS spreads, using a new proxy for innovations in perceived changes in sovereign risk based upon Google-search data. We find robust evidence that auctions of dollar assets by foreign central banks disproportionately benefited countries that were more exposed to the United States through either trade linkages or asset exposure. We obtain weaker results for differences in asset transparency or illiquidity. However, several of the important announcements concerning the international swap programs disproportionately benefited countries exhibiting greater asset opaqueness.
    Keywords: Global financial crisis ; Liquidity (Economics) ; Dollar
    Date: 2011
  9. By: Michael W.M. Roos; Ulrich Schmidt
    Abstract: This paper presents a simple experiment on how laypeople form macroeconomic expectations. Subjects have to forecast inflation and GDP growth. By varying the information provided in different treatments, we can assess the importance of historical time-series information versus information acquired outside the experimental setting such as knowledge of expert forecasts. It turns out that the availability of historical data has a dominant impact on expectations and wipes out the influence of outside-lab information completely. Consequently, backward-looking behavior can be identified unambiguously as a decisive factor in expectation formation
    Keywords: expectations, macroeconomic experiment, use of information, inflation forecasts
    JEL: D83 D84 E37
    Date: 2011–08
  10. By: Millard, Stephen (Bank of England)
    Abstract: In this paper, I estimate a dynamic stochastic general equilibrium (DSGE) model of the United Kingdom. The basic building blocks of the model are standard in the literature. The main complication is that there are three consumption goods: non-energy output, petrol and utilities; given relative prices and their overall wealth, consumers choose how much of each of these goods to consume in order to maximise their utility. Each of the consumption goods is produced according to a sector-specific production function and sticky prices in each sector imply sector-specific New Keynesian Phillips Curves. I show how this model, once estimated, could form a useful additional input within a policymaker’s ‘suite of models’ by considering its implications for the responses of various macroeconomic variables to different economic shocks and by decomposing recent movements of energy and non-energy output and inflation into the proportions caused by each of the shocks.
    Keywords: Dynamic stochastic general equilibrium model; Energy prices and inflation
    JEL: E13 E31
    Date: 2011–07–26
  11. By: Harrison, Richard (Bank of England); Thomas, Ryland (Bank of England); de Weymarn, Iain (Bank of England)
    Abstract: This paper outlines the properties of one of the models used at the Bank of England for analysing the impact of energy prices on the UK economy. We build a dynamic general equilibrium model that includes a variety of channels through which energy prices affect demand and supply. On the demand side we model household consumption of final energy goods (petrol and utilities) separately from other goods and services. On the supply side, we model the production of final energy goods and the way that they enter the production process of other goods and services. We calibrate the model using UK data and examine how the various channels in the model contribute to the responses to permanent energy price shocks of a similar magnitude to those observed in the recent data. We show the effects of such shocks have important implications for monetary policy.
    Keywords: Energy; prices.
    JEL: E27 E37
    Date: 2011–07–26
  12. By: Scharpf, Fritz W.
    Abstract: The European Monetary Union (EMU) has removed crucial instruments of macroeconomic management from the control of democratically accountable governments. Worse still, the EMU has systemically caused destabilizing macroeconomic imbalances that member states found difficult or impossible to counteract with their remaining policy instruments. And even though the international financial crisis had its origins beyond Europe, the EMU has greatly increased the vulnerability of some member states to its repercussions. Its effects have undermined the economic and fiscal viability of some EMU member states and have frustrated political demands and expectations to an extent that may yet transform the economic crisis into a crisis of democratic legitimacy. Moreover, present efforts by EMU governments to 'rescue the euro' will do little to correct the economic imbalances and vulnerabilities, but are likely to deepen economic problems and political alienation in both the rescued and the rescuing polities. -- Die Europäische Währungsunion hat ihren Mitgliedstaaten die wesentlichen Instrumente der makroökonomischen Politik entzogen. Zugleich ist die einheitliche europäische Geldpolitik die strukturelle Ursache makroökonomischer Ungleichgewichte, die die Mitgliedstaaten mit den verbliebenen Mitteln nicht ausgleichen können. Und obwohl die internationale Finanzkrise nicht von Europa ausging, hat die Währungsunion die Verwundbarkeit einiger Mitgliedstaaten für deren Auswirkungen beträchtlich gesteigert. Die Folgen für die Wirtschaft der betroffenen Länder sind verheerend, und je mehr deren Politik gezwungen wird, die Forderungen und Erwartungen ihrer Bürger zu enttäuschen, desto eher kann die ökonomische Krise auch die demokratische Legitimität zerstören. Überdies ignorieren die gegenwärtigen Maßnahmen zur 'Rettung des Euro' die strukturellen Ursachen der ökonomischen Ungleichgewichte, und sie werden deshalb eher zur Verschärfung der ökonomischen Probleme und der politischen Frustration in den Geber- wie in den Nehmerländern beitragen.
    Date: 2011
  13. By: Angela Redish; Warren E. Weber
    Abstract: We construct a random matching model of a monetary economy with commodity money in the form of potentially different types of silver coins that are distinguishable by the quantity of metal they contain. The quantity of silver in the economy is assumed to be fixed, but agents can mint and melt coins. Coins yield no utility, but can be traded. Uncoined silver yields direct utility to the holder. We find that optimal coin size increases with the probability of trade and with the stock of silver. We use these predictions of our model to analyze the coinage decisions of the monetary authorities in medieval Venice and England. Our model provides theoretical support for the view that decisions about coin sizes and types during the medieval period reflected a desire to improve the economic welfare of the general population, not just the desire for seigniorage revenue.
    Date: 2011
  14. By: Colin Bermingham (Central Bank of Ireland, Dame Street, Dublin 2, Ireland.); Antonello D’Agostino (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany and Central Bank of Ireland.)
    Abstract: The issue of forecast aggregation is to determine whether it is better to forecast a series directly or instead construct forecasts of its components and then sum these component forecasts. Notwithstanding some underlying theoretical results, it is generally accepted that forecast aggregation is an empirical issue. Empirical results in the literature often go unexplained. This leaves forecasters in the dark when confronted with the option of forecast aggregation. We take our empirical exercise a step further by considering the underlying issues in more detail. We analyse two price datasets, one for the United States and one for the Euro Area, which have distinctive dynamics and provide a guide to model choice. We also consider multiple levels of aggregation for each dataset. The models include an autoregressive model, a factor augmented autoregressive model, a large Bayesian VAR and a time-varying model with stochastic volatility. We find that once the appropriate model has been found, forecast aggregation can significantly improve forecast performance. These results are robust to the choice of data transformation. JEL Classification: E17, E31, C11, C38.
    Keywords: Aggregation, Forecasting, Inflation.
    Date: 2011–08
  15. By: Eleni Iliopulos (Centre d'Economie de la Sorbonne - Paris School of Economics et CEPREMAP); Thepthida Sopraseuth (GAINS-TEPP - Université du Maine et CEPREMAP)
    Abstract: In this paper, we review the macroeconomic literature on financial frictions and banking in a dynamic general equilibrium framework. Our work focuses first on the pioneer articles that have analyzed the amplification effects associated to the financial accelerator. We then shift our attention towards the recent literature that flourished in the aftermath of the financial crisis. Indeed, the crisis has challenged several assumptions and modeling tools that were commonly used in the DSGE literature. We thus review the main recent contributions that have tried to overcome the limits of old models.
    Keywords: Financial frictions, banking, monetary policy, business cycle.
    JEL: E3 E4 E5 G21
    Date: 2011–07
  16. By: Walter Briec; Emmanuelle Gabillon; Laurence Lasselle; Hermann Ratsimbanierana
    Abstract: Cecchetti et al. (2006) develop a method for allocating macroeconomic performance changes among the structure of the economy, variability of supply shocks and monetary policy. We propose a dual approach of their method by borrowing well-known tools from production theory, namely the Farrell measure and the Malmquist index. Following Färe et al (1994) we propose a decomposition of the efficiency of monetary policy. It is shown that the global efficiency changes can be rewritten as the product of the changes in macroeconomic performance, minimum quadratic loss, and efficiency frontier.
    Keywords: efficiency frontier, inflation variability, Farrell measure, Malmquist index.
    JEL: E52 E58
    Date: 2011–01
    Abstract: The term premium is estimated from an empirically coherent open economy VAR model of the UK economy where the model specifically accounts for the mixed nature of the data and cointegration between some variables. Using this framework the estimated negative term premia for 1980-2007 is decomposed into its contributing shocks, where the role of inflation and monetary policy shocks are shown to be dominant in the evolution of the term premium. Projecting into the 2008 crisis period reveals the extent of the shocks to the UK economy, and also shows the similarities in term premia behaviour with those experienced during the 1998 Russian crisis.
    JEL: E43 E52 C51 C32
    Date: 2011–08
  18. By: Alexander Meyer-Gohde
    Abstract: Imposing the natural rate hypothesis (NRH) can dramatically alter the determinacy bounds on monetary policy by closing the output gap in the long run. I show that the hypothesis eliminates any role for the output gap in determinacy and renders the conditions for determinacy identical for all conforming supply equations. Specializing further to IS demand, determinacy depends only on the parameters in the interest rate rule and a pure forward or backward-looking inflation target is inconsistent with determinacy. Monetary policy that embodies the Taylor principle with respect to contemporaneous inflation delivers a determinate equilibrium in all models that satisfy the NRH.
    Keywords: Time Series,Natural rate hypothesis; Phillips curve; Taylor Principle
    JEL: C62 E31 E43 E52
    Date: 2011–08
  19. By: József Sákovics and Daniel Friedman (University of California at Santa Cruz)
    Abstract: We reformulate neoclassical consumer choice by focusing on lamda, the marginal utility of money. As the opportunity cost of current expenditure, lamda is approximated by the slope of the indirect utility function of the continuation. We argue that lamda can largely supplant the role of an arbitrary budget constraint in partial equilibrium analysis. The result is a better grounded, more flexible and more intuitive approach to consumer choice.
    Keywords: budget constraint, separability, value for money
    JEL: D01 D11
    Date: 2011–08–02
  20. By: Gabriele Galati; John Lewis; Steven Poelhekke; Chen Zhou
    Abstract: During the Great Crisis, most governments in industrial countries supported their domestic financial sector under stress and responded to strong declines in output growth with fiscal stimulus packages. Starting in 2010, attention focused on the sustainability of the resulting debt burdens. We conduct an empirical study to test whether in the United States, the euro area and the United Kingdom, views on the sustainability of fiscal burdens have influenced markets’ assessment of central banks’ commitment to price stability. Using a daily measure of inflation expectations extracted from nominal and indexed-linked government bonds, or inflation swaps, we test whether these react to alternative measures of fiscal burdens. These include rescue package announcements, credit default swap (CDS) spreads and changes in either the outlook or the credit rating of governments. We find no evidence of a significant effect of market participants’ perceptions of fiscal burdens on long-term inflation expectations in the United States, the euro area and the United Kingdom. These results are broadly consistent with the view that long term inflation expectations have remained well anchored.
    Keywords: fiscal policy; monetary policy; inflation and inflation compensation; anchors for expectations; crisis
    JEL: E31 E44 E52 H63 H68
    Date: 2011–07
  21. By: Jacopo Cimadomo, Sebastian Hauptmeier, Sergio Sola (IHEID, The Graduate Institute of International and Development Studies, Geneva)
    Abstract: This paper investigates how expectations about future government spending affect the transmission of fiscal policy shocks. We study the effects of two different types of government spending shocks in the United States: (i) spending shocks that are accompanied by an expected reversal of public spending growth below trend; (ii) spending shocks that are accompanied by expectations of future spending growth above trend. We use the Ramey (2011)’s time series of military build-ups to measure exogenous spending shocks, and deviations of forecasts of public spending with respect to past trends, evaluated in real-time, to distinguish shocks into these two categories. Based on a structural VAR analysis, our results suggest that shocks associated with an expected spending reversal exert expansionary effects on the economy and accelerate the correction of the initial increase in public debt. Shocks associated with expected spending growth above trend, instead, are characterized by a contraction in aggregate demand and a more persistent increase in public debt. The main channel of transmission seems to run through agents’ perception of the future macroeconomic environment.
    Keywords: Government spending shocks, Survey of Professional Forecasters, Real-time data, Spending reversal, Fiscal multipliers.
    JEL: E62 E65 H20
    Date: 2011–07
  22. By: Oscar Pavlov (School of Economics, University of Adelaide); Mark Weder (School of Economics, University of Adelaide)
    Abstract: The standard one-sector real business cycle model is unable to generate expectations-driven business cycles. The current paper shows that this conundrum can be solved by adding countercyclical markups and modest capital adjustment costs.
    Keywords: expectations-driven business cycles, markups
    JEL: E32
    Date: 2011–07
  23. By: Barnes, Michelle L.; Gumbau-Brisa, Fabià; Lie, Denny; Olivei, Giovanni P.
    Abstract: We illustrate the importance of placing model-consistent restrictions on expectations in the estimation of forward-looking Euler equations. In two-stage limited-information settings where first-stage estimates are used to proxy for expectations, parameter estimates can differ substantially, depending on whether these restrictions are imposed or not. This is shown in an application to the New Keynesian Phillips Curve (NKPC), first in a Monte Carlo exercise, and then on actual data. The closed-form (CF) estimates require by construction that expectations of inflation be model-consistent at all points in time, while the difference-equation (DE) estimates impose no model discipline on expectations. Between those two polar extremes there is a wide range of alternative DE specifications, based on the same dynamic relationship, that explicitly impose model restrictions on expectations for a finite number of periods. In our application, these last estimates quickly converge to the CF estimates, and illustrate that the DE estimates in Cogley and Sbordone (2008) are not robust to imposing modest model requirements on expectations. In particular, our estimates show that the NKPC is not purely forward-looking, and thus that time-varying trend inflation is insufficient to explain inflation persistence.
    Keywords: time-varying trend inflation; forward- looking Euler equation; New Keynesian Phillips curve; model-consistent expectations; closed form
    Date: 2011–06
  24. By: Gumbau-Brisa, Fabià; Lie, Denny; Olivei, Giovanni P.
    Abstract: In their 2010 comment (which we refer to as CS10), Cogley and Sbordone argue that: (i) our estimates are not entirely closed form, and hence are arbitrary; (ii) we cannot guarantee that our estimates are valid, while their estimates (Cogley and Sbordone 2008, henceforth CS08) always are; and (iii) the estimates in CS08, in terms of goodness of fit, are just as good as other, much different estimates in our paper. We show in this reply that the exact closed-form estimates are virtually the same as the "quasi" closed-form estimates. Our estimates are consistent with the implicit assumptions underlying the first-stage VAR used to form expectations, while the estimates in CS08 are not. As a result, the estimates in CS08 point towards model misspecification. We also rebut the goodness of fit comparisons in CS10, and provide a more credible exercise that illustrates that our estimates outperform CS08's estimates.
    Keywords: time-varying trend inflation; forward-looking Euler equation; New Keynesian Phillips curve; model-consistent expectations; closed form
    Date: 2011–06
  25. By: Kapetanios, George (Queen Mary and Westfield College and Bank of England); Yates, Tony (Bank of England)
    Abstract: Using a model of deterministic structural change, we revisit several topics in inflation dynamics explored previously using stochastic, time-varying parameter models. We document significant reductions in inflation persistence and predictability. We estimate that changes in the volatility of shocks were decisive in accounting for the great moderations of the United States and the United Kingdom. We also show that the magnitude and the persistence of the response of inflation and output to monetary policy shocks has fallen in these two countries. These findings should be of interest in those seeking to resolve theoretical debates about the sources of apparent nominal and real frictions in the macroeconomy, and the causes of the Great Moderation.
    JEL: C10 C14
    Date: 2011–07–28
  26. By: Guangling (Dave) Liu (Department of Economics)
    Abstract: The conventional view is that a monetary policy shock has both supply-side and demand-side effects, at least in the short run. Barth and Ramey (2001) show that the supply-side effect of a monetary policy shock may be greater than the demand-side effect. We argue that it is crucial for monetary authorities to understand whether an increase in expected future inflation is due to supply shocks or demand shocks before applying contractionary policy to forestall inflation. Using a standard New Keynesian dynamic stochastic general equilibrium model with the cost-channel of monetary transmission, we show that whether the South African Reserve Bank should apply contractionary policy to fight inflation depends critically on the nature of the disturbance. If an increase in expected future inflation is mainly due to supply shocks, the South African Reserve Bank should not apply contractionary policy to fight inflation, as this would lead to a persistent increase in inflation and a greater loss in output.
    Keywords: Monetary policy, price puzzle, inflation targeting, New Keynesian model
    JEL: E52 E31 E58 E12
    Date: 2011
  27. By: Chew Lian Chua (Melbourne Institute of Applied Economic and Social Research, The University of Melbourne); Sandy Suardi (School of Economics and Finance, La Trobe University); Sarantis Tsiaplias (KPMG, Australia)
    Abstract: This paper examines the forecasting qualities of Bayesian Model Averaging (BMA) over a set of single factor models of short-term interest rates. Using weekly and high frequency data for the one-month Eurodollar rate, BMA produces predictive likelihoods that are considerably better than the majority of the short-rate models, but marginally worse off than the best model in each dataset. We observe preference for models incorporating volatility clustering for weekly data and simpler short rate models for high frequency data. This is contrary to the popular belief that a diffusion process with volatility clustering best characterizes the short rate.
    Keywords: Bayesian model averaging, out-of-sample forecasts
    JEL: C11 C53
    Date: 2011–01
  28. By: Thomas Quint (Dept. of Mathematics, University of Nevada, Reno); Martin Shubik (Cowles Foundation, Yale University)
    Abstract: Three models of a monetary economy are considered, in order to show the effects of a gold demonetization: the first with a gold money, the second with demonetized gold but no central bank, and the third with demonetized gold, but with a central bank. The distinctions between ownership and control are discussed.
    Keywords: Gold demonetization, Gold backed paper, Reserves
    JEL: C72 E50 E58
    Date: 2011–08
  29. By: Viet Hoang Nguyen (Melbourne Institute of Applied Economic and Social Research, The University of Melbourne); Yongcheol Shin (Leeds University Business School, The University of Leeds)
    Abstract: We generalize the portfolio shifts model advanced by Evans and Lyons (2002a; b), and develop the dynamic asymmetric portfolio shifts (DAPS) model by explicitly allowing for possible market under- and overreactions and for asymmetric pricing impacts of order flows. Using the Reuters D2000-1 daily trading data for eight currency markets over a four-month period from 1 May to 31 August 1996, we find strong evidence of a nonlinear cointegrating relationship between exchange rates and (cumulative) order flows: The price impact of negative order flows (selling pressure) is overwhelmingly stronger than that of the positive ones (buying pressure). Through the dynamic multiplier analysis, we find two typical patterns of the price discovery process. The markets following overreactions tend to display a delayed overshooting and a volatile but faster adjustment towards equilibrium whereas the markets following underreactions are generally characterized by a gradual but persistent adjustment. In our model, these heterogeneous adjustment patterns reflect different liquidity provisions associated with different market conditions following under- and overreactions. In addition, the larger is the mispricing, the faster is the overall adjustment speed, a finding consistent with Abreu and Brunnermeier (2002) and Cai et al. (2011). We also find that underreactions are followed mostly by positive feedback trading while overreactions are characterized by delayed overshooting in the short run but corrected by negative feedback trading at longer horizons, the finding is consistent with Barberis et al. (1998) who show that positive short-run autocorrelations (momentum) signal underreaction while negative long-run autocorrelations (reversal) signal overreaction.
    Keywords: Exchange rate, order flow, under- and overreaction, asymmetric pricing impacts, asymmetric cointegrating relationship and dynamic multipliers
    JEL: C22 F31 G15
    Date: 2011–06
  30. By: Michele Manna (Bank of Italy)
    Abstract: In recent years, banks have become increasingly aware of the credit risk borne in lending in the interbank market and they select their counterparties accordingly. They may also fear that if they come across a bad borrower, rescue plans will be skewed towards domestic creditors; moreover, lenders may prefer to defend their rights in their own regulatory and legal jurisdiction. Using 2004-09 data, this paper argues that these elements, the “resolution edge” of the domestic creditor, contributed to the increase in the home bias of interbank lending by euro-area banks from mid-2007 on, while a more consistent downward pattern emerges in the home bias of banks from five non-euro-area countries (including the US and the UK). The intuition is that when the crisis broke out, euro-area banks reckoned that within-the-area cross-border interbank loans carried a distinct risk compared with domestic loans. By contrast, a large Swiss bank, for example, did not need to wait until 2007 to gauge that its business in New York was a very different matter from a deal in Zürich.
    Keywords: home bias, interbank market, euro area, banks resolution procedures
    JEL: C33 G11 G15 G21 K20
    Date: 2011–07
  31. By: Nils Jannsen; Melanie Klein
    Abstract: This paper analyzes the international transmission effects of euro area monetary policy shocks in to other western European countries, namely the United Kingdom, Sweden, Switzerland, Denmark, and Norway. For this purpose, we use a structural VAR model of the euro area and augment it consecutively by the foreign variables of interest. We find that a monetary policy shock in the euro area leads to a largely similar change in the interest rate and in GDP in these other western European countries. The effects on their exchange rates are limited and their trade balances usually are unaffected. Our results suggest that the income absorption effect to be more important than the expenditure switching effect in the international transmission of monetary policy and that exchange rate stabilization seems to be of some concern to monetary policy makers in small open economies
    Keywords: Monetary policy, international transmission, euro area, vector autoregression
    JEL: C32 E52 F41
    Date: 2011–07
  32. By: Bussière, M.; Chudik, A.; Mehl, A.
    Abstract: This paper uncovers the response pattern to global shocks of euro area countries' real effective exchange rates before and after the start of Economic and Monetary Union (EMU), a largely open ended question when the euro was created. We apply to that end a newly developed methodology based on high dimensional VAR theory. This approach features a dominant unit to a large set of over 60 countries' real effective exchange rates and is based on the comparison of two estimated systems: one before and one after EMU. We find strong evidence that the pattern of responses depends crucially on the nature of global shocks. In particular, post-EMU responses to global US dollar shocks have become similar to Germany's response before EMU, i.e. to that of the economy that used to issue Europe's most credible legacy currency. By contrast, post-EMU responses of euro area countries to global risk aversion shocks have become similar to those of Italy, Portugal or Spain before EMU, i.e. of economies of the euro area's periphery. Our findings also suggest that the divergence in external competitiveness among euro area countries over the last decade, which is at the core of today's debate on the future of the euro area, is more likely due to country-specific shocks than to global shocks.
    Keywords: Euro, Real Effective Exchange Rates, Weak and Strong Cross Sectional Dependence, High-Dimensional VAR, Identification of Shocks.
    JEL: C21 C23
    Date: 2011
  33. By: Berka, Martin; Devereux, Michael B.
    Abstract: We study a newly constructed panel data set of relative prices for a large number of consumer goods among 31 European countries over a 15 year period. The data set includes eurozone members both before and after the inception of the euro, floating exchange rate countries of western Europe, and emerging market economies of Eastern and Southern Europe. We find that there is a substantial and continuing deviation from PPP at all levels of aggregation, both for traded and non-traded goods, even among eurozone members. Real exchange rates exhibit two clear properties in the sample; a) they are closely tied to GDP per capita relative to the European average, at all levels of aggregation and for both cross country time series variation, b) they are highly positively correlated with cross country and time series variation in the relative price of non-traded goods. We then construct a simple two-sector endowment economy model of real exchange rate determination which exhibits these two properties, calibrated to match the data. Simulating the model using the historical relative GDP per capita for each country, we find that for most countries, there is a very close fit between the actual and simulated real exchange rate.
    Keywords: real exchange rate, GDP, European countries, relative prices,
    Date: 2011–07–07
  34. By: Berka, Martin; Devereux, Michael B.; Rudolph, Thomas
    Abstract: We study a newly released data set of scanner prices for food products in a large Swiss online supermarket. We find that average prices change about every two months, but when we exclude temporary sales, prices are extremely sticky, changing on average once every three years. Non-sale price behavior is broadly consistent with menu cost models of sticky prices. When we focus specifically on the behavior of sale prices, however, we find that the characteristics of price adjustment seems to be substantially at odds with standard theory.
    Keywords: online supermarket, price behavior, sticky price,
    Date: 2011–07–07
  35. By: Valerio Vacca (Bank of Italy)
    Abstract: This paper shows how credit quality transition matrices of loans to Italian firms changed during a cyclical downturn (2008-09), compared with a previous time of growth (2006-07). Once transition matrices were linked to interest rates, banks appear to have been remarkably able at calibrating required risk premiums to actual idiosyncratic risk, both during expansion and recession. However, the uncertainty generated by the crisis accentuated the unexpected component of credit worsening, thus lowering pricing effectiveness. The main finding is that larger banking groups were more affected by the sudden deterioration of credit quality than smaller ones, as far as ability to price risk is concerned. The bank-size effect can be tackled through an efficient use of hard or soft information: both rating users and decentralized banks showed an above-average ability in calibrating rates to risk during the crisis; banks with a stronger relationship with borrowers smoothed the risk-price curve in normal times.
    Keywords: banking, crisis, credit migration, credit risk pricing
    JEL: G21 E43 E32
    Date: 2011–07
  36. By: Patrick Hürtgen
    Abstract: This paper explores the importance of shocks to consumer misperceptions, or "noise shocks", in a quantitative business cycle model. I embed imperfect information as in Lorenzoni (2009) into a new Keynesian model with price and wage rigidities. Agents learn about the components of labor productivity by only observing aggregate productivity and a noisy signal. Noise shocks lead to expectational errors about the true fundamentals triggering aggregate fluctuations. Estimating the model with Bayesian methods on US data shows that noise shocks contribute to 20 percent of consumption fluctuations at short horizons. Wage rigidity is pivotal for the importance of noise shocks.
    Keywords: Imperfect Information, Noise Shocks, Aggregate Fluctuations, Bayesian Estimation
    JEL: D83 E32
    Date: 2011–01
  37. By: Sarno, Lucio; Schneider, Paul; Wagner, Christian
    Abstract: We study the properties of foreign exchange risk premiums that can explain the forward bias puzzle, defined as the tendency of high-interest rate currencies to appreciate rather than depreciate. These risk premiums arise endogenously from the no-arbitrage condition relating the term structure of interest rates and exchange rates. Estimating affine (multi-currency) term structure models reveals a noticeable tradeoff between matching depreciation rates and accuracy in pricing bonds. Risk premiums implied by our global affine model generate unbiased predictions for currency excess returns and are closely related to global risk aversion, the business cycle, and traditional exchange rate fundamentals.
    Keywords: exchange rates; forward bias; predictability; term structure
    JEL: E43 F31 G10
    Date: 2011–08
  38. By: Dong He (Hong Kong Monetary Authority and Hong Kong Institute for Monetary Research); Honglin Wang (Hong Kong Monetary Authority and Hong Kong Institute for Monetary Research)
    Abstract: China has a dual-track interest-rate system: bank deposit and lending rates are regulated, but money and bond market rates are market-determined. At the same time, the central bank also imposes an indicative target, which may not be binding at all times, on total credit in the banking system. We develop and calibrate a theoretical model to illustrate the conduct of monetary policy within the framework of dual-track interest rates and a juxtaposition of both price- and quantity-based policy instruments. We model the transmission of monetary policy instruments to market interest rates, which, together with the quantitative credit target in the banking system, ultimately serve as the lever by which monetary policy affects the real economy. The model shows that market interest rates are most sensitive to changes in the benchmark deposit interest rates, significantly responsive to changes in the reserve requirements, but not particularly reactive to open market operations. These theoretical predictions are verified and supported by both linear and GARCH models using daily money and bond market data. Overall, the results of this study help us understand why the central bank conducts monetary policy in China the way it does: a combination of price and quantitative instruments, with various degrees of potency in terms of their influence on the cost of credit.
    Keywords: Monetary Policy, People's Bank of China, Dual-Track Interest Rates, Interest Rate Liberalization
    JEL: E52 E58 C25 C32
    Date: 2011–07
  39. By: Jouchi Nakajima; Toshiaki Watanabe
    Abstract: This paper applies the time-varying parameter vector autoregressive model to the Japanese economy. The both parameters and volatilities, which are assumed to follow a random-walk process, are estimated using a Bayesian method with MCMC. The recursive structure is assumed for identification and the reversible jump MCMC is used for the ordering of variables. The empirical result reveals the time-varying structure of the Japanese economy and monetary policy during the period from 1981 to 2008 and provides evidence that the order of variables may change by the introduction of zero interest rate policy.
    Keywords: Bayesian inference, Monetary policy, Reversible jump Markov chain Monte Carlo, Stochastic volatility, Time-varying parameter VAR
    JEL: C11 C15 E52
    Date: 2011–07
  40. By: Sproul, Michael
    Abstract: A numerical example of privately issued money is used to illustrate the fiscal theory of the price level, and to show that the fiscal theory is best understood as a subset of the backing theory of money. Government issuance of money or debt is shown to be potentially inflationary only when the government’s net worth is negative, and when the government’s assets do not rise in step with its liabilities. The backing theory is used to examine whether inflation can be avoided by a sufficiently tough central bank, and to criticize the view that fiscal policies affect inflation through their wealth effects.
    Keywords: Money; price level; fiscal; real bills; backing theory
    JEL: E50
    Date: 2011–07
  41. By: Christopher Reicher
    Abstract: This paper documents the short run and long run behavior of the search and matching model with staggered Nash wage bargaining. It turns out that there is a strong tradeoff inherent in assuming that previously bargained sticky wages apply to new hires. If sticky wages apply to new hires, then the staggered Nash bargaining model can generate realistic volatility in labor input, but it predicts a strong counterfactually negative long run relationship between inflation and unemployment. This finding is robust to including a microeconomically realistic degree of indexation of wages to inflation. The lack of a negative long run relationship between trend inflation and unemployment provides indirect evidence against the proposed mechanism that high inflation systematically makes new hiring more profitable by depressing the real wages of new hires
    Keywords: Sticky wages, staggered Nash bargaining, trend inflation, unemployment, search and matching
    JEL: E24 E25 J23 J31
    Date: 2011–07
  42. By: Krawczyk, Jacek; Pharo, Alastair; Simpson, Mark
    Abstract: Maintaining an open economy within certain bounds on inflation, output gap and exchange rate can help sustainable economic development. Macroeconomics proposes monetary-policy models that describe evolution of the above quantities. We use one such model, constituted by a four-metastate one-control system, to compute viability kernel approximations that one can use to assist the central bank to establish "sustainable" policies. We propose a simple heuristic algorithm that leads to kernel approximations for this and similar models.
    Keywords: monetary policy, viability kernel, algorithm, MATLAB,
    Date: 2011–02–18
  43. By: Jing Tian; Heather M. Anderson
    Abstract: This paper proposes two new weighting schemes that average forecasts using different estimation windows to account for structural change. We let the weights reflect the probability of each time point being the most-recent break point, and we use the reversed ordered Cusum test statistics to capture this intuition. The second weighting method simply imposes heavier weights on those forecasts that use more recent information. The proposed combination forecasts are evaluated using Monte Carlo techniques, and we compare them with forecasts based on other methods that try to account for structural change, including average forecasts weighted by past forecasting performance and techniques that first estimate a break point and then forecast using the post break data. Simulation results show that our proposed weighting methods often outperform the others in the presence of structural breaks. An empirical application based on a NAIRU Phillips curve model for the United States indicates that it is possible to outperform the random walk forecasting model when we employ forecasting methods that account for break uncertainty.
    Keywords: Forecasting with Structural breaks, Parameter Shifts, break Uncertainty, Structural break Tests, Choice of Estimation Sample, Forecast Combinations, NAIRU Phillips Curve.
    JEL: C22 C53 E37
    Date: 2011–07
  44. By: Hall, Viv B; McDermott, C John
    Abstract: We use unobserved components methodology to establish an Australasian common cycle, and assess the extent to which region-specific cycles of Australian States and New Zealand are additionally important. West Australian and New Zealand region-specific growth cycles have exhibited distinctively different features, relative to the common cycle. For every Australasian region, the region-specific cycle variance dominates that of the common cycle, in contrast to findings for U.S. BEA regions and prior work for Australian States. The distinctiveness of New Zealand’s output and employment cycles is consistent with New Zealand retaining the flexibility of a separate currency and monetary policy, for periods when significant region-specific shocks occur.
    Keywords: Australasian common cycle, regional cycles, Unobserved components, common currency, New Zealand, Australia,
    Date: 2011–03–11

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