nep-cba New Economics Papers
on Central Banking
Issue of 2013‒09‒26
twenty-two papers chosen by
Maria Semenova
Higher School of Economics

  1. Limits of Monetary Policy Autonomy and Exchange Rate Flexibility by East Asian Central Banks By Axel Löffler; Gunther Schnabl; Franziska Schobert
  2. Sovereign Default Risk and Banks in a Monetary Union By Uhlig, Harald
  3. The Great Recession and the Two Dimensions of European Central Bank Credibility By Timo Henckel; Gordon D. Menzies; Daniel J. Zizzo
  4. Rethinking Macro Policy II: Getting Granular By Olivier J. Blanchard; Giovanni Dell'Ariccia; Paolo Mauro
  5. Statistics and indicators for financial stability analysis and policy By Israël, Jean-Marc; Sandars, Patrick; Schubert, Aurel; Fischer, Björn
  6. Is monetary policy a science? the interaction of theory and practice over the last 50 years By William R. White
  7. Rules, Discretion, and Macro-Prudential Policy By Itai Agur; Sunil Sharma
  8. Exchange Rates and Interest Parity By Charles Engel
  9. The Ties that Bind: Monetary Policy and Government Debt Management By Jagjit S. Chadha; Philip Turner; Fabrizio Zampolli
  10. The Manipulation of Basel Risk-Weights By Mariathasan, Mike; Merrouche, Ouarda
  11. Measuring and Mending Monetary Policy Effectiveness Under Capital Account Restrictions—Lessons from Mauritania By Robert Blotevogel
  12. Monetary Policy in Emerging Markets: Taming the Cycle By Donal McGettigan; Kenji Moriyama; Jean F Noah Ndela Ntsama; Francois Painchaud; Haonan Qu; Chad Steinberg
  13. Exchange Rate Predictability By Rossi, Barbara
  14. HEAT! A Bank Health Assessment Tool By Li L. Ong; Phakawa Jeasakul; Sarah Kwoh
  15. Sudden stops, time inconsistency, and the duration of sovereign debt By Juan Carlos Hatchondo; Leonardo Martinez
  16. World Food Prices, the Terms of Trade-Real Exchange Rate Nexus, and Monetary Policy By Luis Catão; Roberto Chang
  17. State Dependent Monetary Policy By Francesco Lippi; Stefania Ragni; Nicholas Trachter
  18. Italian Sovereign Spreads: Their Determinants and Pass-through to Bank Funding Costs and Lending Conditions By Edda Zoli
  19. Approaches to Shadow Banking Regulation - Monitoring and Policy Framework By Jenny Poschmann
  20. A Schumpeterian Analysis of Monetary Policy, Innovation and North-South Technology Transfer By Chu, Angus C.; Cozzi, Guido; Furukawa, Yuichi
  21. Deep Financial Crises, Reforming the IMF and Building Regional Autonomy:Towards a New Hybrid Global Financial Architecture By Khan, Haider
  22. Post-Crisis Capital Account Regulation in South Korea and South Africa By Brittany Baumann; Kevin Gallagher

  1. By: Axel Löffler; Gunther Schnabl (Institute for Economic Policy, University of Leipzig); Franziska Schobert
    Abstract: Given low interest rates in the large industrial countries and buoyant capital inflows into the emerging markets East Asian central banks have accumulated large stocks of foreign reserves. As the resulting easing of monetary conditions has become a threat to domestic price and financial stability, the East Asian central banks have embarked on substantial sterilization operations to absorb what we call 'surplus liquidity' from the domestic banking systems. This has brought the East Asian central banks into debtor positions versus the domestic banking systems. We show based on a central bank loss function that given buoyant capital inflows and exchange rate stabilization the absorption of surplus liquidity leads either to financial repression, or rising inflation or both. Assuming that a debtor central bank moved towards a freely floating exchange rate to gain monetary policy independence, we show that monetary policy independence is undermined by sterilization costs and revaluation losses on foreign reserves.
    Keywords: Debtor Central Banks, Monetary Policy Autonomy, Sterilization, Exchange Rate Regime, East Asia
    JEL: E52 E58 F31
    Date: 2013–08–22
  2. By: Uhlig, Harald
    Abstract: This paper seeks to understand the interplay between banks, bank regulation, sovereign default risk and central bank guarantees in a monetary union. I assume that banks can use sovereign bonds for repurchase agreements with a common central bank, and that their sovereign partially backs up any losses, should the banks not be able to repurchase the bonds. I argue that regulators in risky countries have an incentive to allow their banks to hold home risky bonds and risk defaults, while regulators in other “safe” countries will impose tighter regulation. As a result, governments in risky countries get to borrow more cheaply, effectively shifting the risk of some of the potential sovereign default losses on the common central bank.
    Keywords: bank regulation; common central bank; ECB; Euro zone crisis; European Central Bank; haircuts; repurchase operations; risk shifting; sovereign default risk
    JEL: E51 E58 E61 E65 G21 G28 H63
    Date: 2013–08
  3. By: Timo Henckel; Gordon D. Menzies; Daniel J. Zizzo
    Abstract: A puzzle from the Great Recession is an apparent mismatch between a fall in the persistence of European inflation rates, and the increased variability of expert forecasts of inflation. We explain this puzzle and show how country specific beliefs about inflation are still quite close to the European Central Bank target of 2% (what we call official target credibility) but the degree of anchoring to this target has gone down, implying an erosion of what we call anchoring credibility. A decline in anchoring credibility can explain increased forecast variance independently of any changes in inflation persistence, contrary to standard time series models.
    Keywords: central bank credibility, excess volatility, euro, inferential expectations, inflation
    JEL: C51 D84 E31 E52
    Date: 2013–09
  4. By: Olivier J. Blanchard; Giovanni Dell'Ariccia; Paolo Mauro
    Abstract: This note explores how the economic thinking about macroeconomic management has evolved since the crisis began. It discusses developments in monetary policy, including unconventional measures; the challenges associated with increased public debt; and the policy potential, risks, and institutional challenges associated with new macroprudential measures. Rationale: The note contributes to the ongoing debate on several aspects of macroeconomic policy. It follows up on the earlier “Rethinking†paper, refining the analysis in light of the events of the past two years. Given the relatively fluid state of the debate (e.g., recent challenges to central bank independence), it is useful to highlight that while many of the tenets of the pre-crisis consensus have been challenged, others (such as the desirability of central bank independence) remain valid.
    Keywords: Monetary policy;Central banks;Inflation targeting;Liquidity;Interest rates;Capital flows;Fiscal policy;Public debt;Fiscal consolidation;Macroprudential Policy;Stabilization measures;Monetary policy, Inflation targets, Zero lower bound, Fiscal consolidation, Fiscal multipliers, Financial stability, Macroprudential policy
    Date: 2013–04–15
  5. By: Israël, Jean-Marc; Sandars, Patrick; Schubert, Aurel; Fischer, Björn
    Abstract: Timely and accurate data are key to the preparation of macro-prudential policy recommendations and decisions by the ESRB, as well as to monitoring policy decisions in terms of their impact on, or transmission to, the financial and non-financial economy. This paper illustrates the work that has been carried out by the European Central Bank, the European Systemic Risk Board and the European Supervisory Authorities over a period of more than two years from 2010 to 2012 to prepare, develop, implement and manage the initial set of statistical and supervisory information necessary to support the European Systemic Risk Board, from its inception in January 2011. The paper also touches on the statistical information that is provided to support the financial stability function of the European Central Bank. JEL Classification: F31, F47, F30
    Keywords: financial stability statistics, financial statistics, systemic risk
    Date: 2013–04
  6. By: William R. White
    Abstract: In recent decades, the declarations of “independent” central banks and the conduct of monetary policy have been assigned an ever increasing role in the pursuit of economic and financial stability. This is curious since there is, in practice, no body of scientific knowledge (evidence based beliefs) solid enough to have ensured agreement among central banks on the best way to conduct monetary policy. Moreover, beliefs pertaining to every aspect of monetary policy have also changed markedly and repeatedly. This paper documents how the objectives of monetary policy, the optimal exchange rate framework, beliefs about the transmission mechanism, the mechanism of political oversight, and many other aspects of domestic monetary frameworks have all been subject to great flux over the last fifty years. ; The paper also suggests ways in which the current economic and financial crisis seems likely to affect the conduct of monetary policy in the future. One possibility is that it might lead to yet another fundamental reexamination of our beliefs about how best to conduct monetary policy in an increasingly globalized world. The role played by money and credit, the interactions between price stability and financial stability, the possible medium term risks generated by “ultra easy” monetary policies, and the facilitating role played by the international monetary (non) system all need urgent attention. The paper concludes that, absent the degree of knowledge required about its effects, monetary policy is currently being relied on too heavily in the pursuit of “strong, balanced and sustainable growth.”
    Keywords: National security
    Date: 2013
  7. By: Itai Agur; Sunil Sharma
    Abstract: The paper examines the implementation of macro-prudential policy. Given the coordination, flow of information, analysis, and communication required, macro-prudential frameworks will have weaknesses that make it hard to implement policy. And dealing with the political economy is also likely to be challenging. But limiting discretion through the formulation of macro-prudential rules is complicated by the difficulties in detecting and measuring systemic risk. The paper suggests that oversight is best served by having a strong baseline regulatory regime on which a time-varying macro-prudential policy can be added as conditions warrant and permit.
    Keywords: Macroprudential Policy;Monetary policy;Political economy;Financial systems;Financial risk;Macro-prudential policy, systemic risk, financial stability, regulation
    Date: 2013–03–08
  8. By: Charles Engel
    Abstract: This paper surveys recent theoretical and empirical contributions on foreign exchange rate determination. The paper first considers monetary models under uncovered interest parity and rational expectations. Then the paper considers deviations from UIP/rational expectations: foreign exchange risk premium, private information, near-rational expectations, and peso problems.
    JEL: F31 F41 G15
    Date: 2013–08
  9. By: Jagjit S. Chadha; Philip Turner; Fabrizio Zampolli
    Abstract: The financial crisis and subsequent economic recession led to a rapid increase in the issuance of public debt. But large-scale purchases of bonds by the Federal Reserve, and other major central banks, have significantly reduced the scale and maturity of public debt that would otherwise have been held by the private sector. We present new evidence that tilting the maturity structure of private sector holdings significantly influences term premia, even outside crisis times. Our framework helps explain both the bond yield conundrum and the effectiveness of quantitative easing. We suggest that these findings raise two important policy questions. One is: should a central bank, contrary to recent orthodoxy, use its balance sheet as an additional complementary instrument of monetary policy to influence, as part of the monetary transmission mechanism, the long-term interest rate? The second is: how should central banks and governments ensure that debt management properly takes account of the implications for both monetary and financial stability?
    Keywords: Quantitative easing; sovereign debt management; long-term interest rate; portfolio balance effect; exit strategy
    JEL: E43 E52 E63
    Date: 2013–09
  10. By: Mariathasan, Mike; Merrouche, Ouarda
    Abstract: In this paper, we examine the relationship between banks’ approval for the internal ratings-based (IRB) approaches of Basel II and the ratio of risk-weighted over total assets. Analysing a panel of 115 banks from 21 OECD countries that were eventually approved for applying the IRB to their credit portfolio, we find that risk-weight density is lower once regulatory approval is granted. The effect persists when we control for different loan categories, and we provide evidence showing that it cannot be explained by flawed modelling, or improved risk-measurement alone. Consistent with theories of risk-weight manipulation, we find the decline in risk-weights to be particularly prevalent among weakly capitalised banks, when the legal framework for supervision is weak, and in countries where supervisors are overseeing many IRB banks. We conclude that part of the decline in reported riskiness under the IRB results from banks’ strategic risk-modelling.
    Keywords: Basel II; capital regulation; internal ratings-based approach
    JEL: G20 G21 G28
    Date: 2013–05
  11. By: Robert Blotevogel
    Abstract: I propose a new approach to identifying exogenous monetary policy shocks in low-income countries with capital account restrictions. In the case of Mauritania, a domestic repatriation requirement is the key institutional characteristic that allows me to establish exogeneity. Unlike in advanced countries, I find no evidence for a statistically significant impact of exogenous monetary policy shocks on bank lending. Using a unique bank-level dataset on monthly balance sheets of six Mauritanian banks over the period 2006–11, I estimate structural vector autoregressions and two-stage least square panel models to demonstrate the ineffectiveness of monetary policy. Finally, I discuss how a reduction in banks’ loan concentration ratios and improvements in the liquidity management framework could make monetary stimuli more effective.
    Keywords: Monetary policy;Mauritania;Banking sector;Capital account;Low-income developing countries;monetary policy effectiveness, exogenous monetary policy shocks, capital account restrictions, low-income countries, liquidity management, loan concentration.
    Date: 2013–03–27
  12. By: Donal McGettigan; Kenji Moriyama; Jean F Noah Ndela Ntsama; Francois Painchaud; Haonan Qu; Chad Steinberg
    Abstract: In contrast to advanced markets (AMs), procyclical monetary policy has been a problem for emerging markets (EMs), with macroeconomic policies amplifying economic upswings and deepening downturns. The stark difference in policy has not been subject to extensive study and this paper attempts to address the gap. Key findings, using a large sample of EMs over the past 50 years, are: (i) EMs have adopted increasingly countercyclical monetary policy over time, although large differences remain among EMs and policies became more procyclical during the recent crisis. (ii) Inflation targeting and better institutions have been key factors behind the move to countercyclicality. (iii) Only deep financial markets allow EMs with flexible exchange rate regimes turn countercyclical. (iv) More countercyclical policy is associated with far less volatile output. The economically meaningful impact of IT on monetary policy countercyclicality and output variability is another reason in its favor, over and above better inflation outcomes.
    Keywords: Monetary policy;Emerging markets;Chile;Inflation targeting;Business cycles;Monetary Policy, Countercyclical Policy, Emerging Markets
    Date: 2013–05–03
  13. By: Rossi, Barbara
    Abstract: The main goal of this article is to provide an answer to the question: "Does anything forecast exchange rates, and if so, which variables?". It is well known that exchange rate fluctuations are very difficult to predict using economic models, and that a random walk forecasts exchange rates better than any economic model (the Meese and Rogoff puzzle). However, the recent literature has identified a series of fundamentals/methodologies that claim to have resolved the puzzle. This article provides a critical review of the recent literature on exchange rate forecasting and illustrates the new methodologies and fundamentals that have been recently proposed in an up-to-date, thorough empirical analysis. Overall, our analysis of the literature and the data suggests that the answer to the question: "Are exchange rates predictable?" is, "It depends" on the choice of predictor, forecast horizon, sample period, model, and forecast evaluation method. Predictability is most apparent when one or more of the following hold: the predictors are Taylor rule or net foreign assets, the model is linear, and a small number of parameters are estimated. The toughest benchmark is the random walk without drift.
    Keywords: Exchange Rates; Forecast Evaluation; Forecasting; Instability
    JEL: C5 F3
    Date: 2013–07
  14. By: Li L. Ong; Phakawa Jeasakul; Sarah Kwoh
    Abstract: Developments during the global financial crisis have highlighted the importance of differentiating across financial systems and institutions. Assessments of financial stability have increasingly considered the characteristics of individual banks within a financial system, as well as those with significant international reach, to identify vulnerabilities and inform policy decisions. This paper proposes a simple measure of bank soundness, the Bank Health Index (BHI), to facilitate preliminary analyses of individual financial institutions relative to their peers. The evidence suggests that the BHI is useful for a first-pass identification of bank soundness conditions. Automated spreadsheet templates of the bank Health Assessment Tool (HEAT!) are provided for users with access to the BankScope, Bloomberg and/or SNL database(s).
    Keywords: Banks;Financial institutions;Bank soundness;Financial systems;asset quality, Bank Health Index, bank soundness, capital adequacy, earnings, HEAT!, heatmap, leverage, liquidity.
    Date: 2013–08–09
  15. By: Juan Carlos Hatchondo; Leonardo Martinez
    Abstract: We study the sovereign debt duration chosen by the government in the context of a standard model of sovereign default. The government balances off increasing the duration of its debt to mitigate rollover risk and lowering duration to mitigate the debt dilution problem. We present two main results. First, when the government decides the debt duration on a sequential basis, sudden stop risk increases the average duration by 1 year. Second, we illustrate the time inconsistency problem in the choice of sovereign debt duration: governments would like to commit to a duration that is 1.7 years shorter than the one they choose when decisions are made sequentially.
    Keywords: Sovereign debt;Borrowing;Economic models;sovereign debt, default, sudden stops, debt dilution, time inconsistency, debt maturity
    Date: 2013–07–19
  16. By: Luis Catão; Roberto Chang
    Abstract: How should monetary policy respond to large fluctuations in world food prices? We study this question in an open economy model in which imported food has a larger weight in domestic consumption than abroad and international risk sharing can be imperfect. A key novelty is that the real exchange rate and the terms of trade can move in opposite directions in response to world food price shocks. This exacerbates the policy trade-off between stabilizing output prices vis a vis the real exchange rate, to an extent that depends on risk sharing and the price elasticity of exports. Under perfect risk sharing, targeting the headline CPI welfare-dominates targeting the PPI if the variance of food price shocks is not too small and the export price elasticity is realistically high. In such a case, however, targeting forecast CPI is a superior choice. With incomplete risk sharing, PPI targeting is clearly a winner.
    Keywords: Commodity price fluctuations;External shocks;Producer price indexes;Terms of trade;Exchange rate appreciation;Monetary policy;Economic models;Commodity Price Shocks, Inflation Targeting, Taylor rules, Incomplete Markets
    Date: 2013–05–17
  17. By: Francesco Lippi (University of Sassari and EIEF); Stefania Ragni (University of Sassari); Nicholas Trachter (EIEF)
    Abstract: We study the optimal anticipated monetary policy in a flexible-price economy featuring heterogenous agents and incomplete markets which give rise to a business cycle. The optimal policy prescribes monetary expansions in recessions, when insurance is most needed by cash-poor unproductive agents. To minimize the inflationary effect of these expansions the policy prescribes monetary contractions in good times. Although the optimal monetary policy varies greatly through the business cycle it "echoes" Friedman's principle in the sense that the money supply is regulated such that its expected real return approaches the rate of time preference.
    Date: 2013
  18. By: Edda Zoli
    Abstract: Volatility in Italian sovereign spreads has increased since mid-2011. This paper finds that news on the euro area debt crisis and country specific events were important drivers of sovereign spreads. Movements in sovereign spreads affect CDS spreads and bond yields of Italian banks, and are transmitted rapidly to firm lending rates. Banks with lower capital ratios and higher nonperforming loans were found to be more sensitive to swings in sovereign spreads. Credit supply constraints due to bank funding shortages from the sovereign debt crisis were a major factor behind the lending slowdown in late 2011, while in 2012 weak demand appears to have been driving changes in credit more than supply.
    Keywords: Banking sector;Italy;Sovereign debt;Loans;Financial instruments;Italian sovereign spreads, bank funding costs, lending conditions.
    Date: 2013–04–03
  19. By: Jenny Poschmann (School of Economics and Business Administration, Friedrich-Schiller-University Jena)
    Abstract: In the recent years the shadow banking system had moved into the focus of regulators. New regulatory approaches affected the overall appearance of financial markets. The G20 detected the shadow banking system as remaining issue for sound and efficient regulation to ensure a stable financial system. The FSB was tasked to develop, in collaboration with other standard setting bodies, a policy framework to monitor and supervise shadow banking activities and entities. This work aims to outline the proposed recommendations of five workstreams and reflect their relevance critically.
    Keywords: Non-Bank financial institutions, Shadow Banking, Financial Regulation
    JEL: G21 G23 G24 K22
    Date: 2013–08–22
  20. By: Chu, Angus C.; Cozzi, Guido; Furukawa, Yuichi
    Abstract: This study analyzes the cross-country effects of monetary policy on innovation and international technology transfer. We consider a scale-invariant North-South quality-ladder model that features innovative R&D in the North and adaptive R&D in the South. To model money demand, we impose cash-in-advance constraints on these two types of R&D investment. We find that an increase in the Southern nominal interest rate causes a permanent decrease in the rate of international technology transfer, a permanent increase in the North-South wage gap, and a temporary decrease in the rate of Northern innovation. An increase in the Northern nominal interest rate causes a temporary decrease in the rate of Northern innovation, a permanent decrease in the North-South wage gap, and an ambiguous effect on the rate of international technology transfer depending on the relative size of the two economies. We also calibrate the model to China-US data and find that the cross-country welfare effects of monetary policy are quantitatively significant. Specifically, permanently decreasing the nominal interest rate to zero in China leads to a welfare gain of 3.37% in China and a welfare gain of 1.25% in the US. Permanently decreasing the nominal interest rate to zero in the US leads to welfare gains of 0.33% in the US and 1.24% in China.
    Keywords: Monetary policy, economic growth, R&D, North-South product cycles, FDI
    JEL: O30 O40 E41 F43
    Date: 2013–09
  21. By: Khan, Haider
    Abstract: This paper analyzes the problems of creating and expanding national macroeconomic policy space and economic governance. It develops a critical constructivist evolutionary theory of international financial institutions and arrangements within a framework of dynamic complex adaptive economic systems(DCAES). More specifically, the paper analyzes the following aspects: • The IMF’s response to recent and emerging global economic and challenges, and the evolving nature of its role. • The most appropriate role of regional arrangements in financial stabilization, based on experiences with such arrangements in this and prior episodes of crisis. The role of IMF under the present globalization arrangements and repeated financial crises is studied by following such a critical constructivist evolutionary theory of international financial institutions within a rigorous DCAES framework. It is shown that IMF must and can change in a direction which allows for greater national policy autonomy. It is also shown that the IMF needs complementary regional institutions of cooperation in order to create a stabilizing hybrid global financial architecture that will be more democratic and pro-development in terms of its governance structure and behavior. Thus regional financial architectures will need to be integral parts of any new global financial architecture (GFA).The tentative steps taken towards regional cooperation in Asia since Asian financial crisis are discussed to illustrate the opportunities and challenges posed by the need to evolve towards a hybrid GFA. The opportunities and challenges arising from the current global crisis are also analyzed in this context.
    Keywords: dynamic complex adaptive economic systems; financial crises; global financial architecture; regional financial architectures; a hybrid GFA; regional cooperation; the IMF
    JEL: F3
    Date: 2013–08
  22. By: Brittany Baumann; Kevin Gallagher
    Abstract: In the immediate aftermath of the global financial crisis, the world economy was characterized as experiencing a ‘two-speed’ recovery. Industrialized nations, where the crisis occurred, saw slow growth whereas many emerging market and developing countries grew significantly. These growth differentials, coupled with significant interest rate differentials across the globe, triggered significant flows of financial capital to the emerging market and developing countries. As a result, many countries experienced sharp appreciations of their currencies and associated concerns about the development of asset bubbles. This paper examines measures taken to mitigate the harmful effects of excessive capital flows in South Korea and South Africa. Each of these nations experienced similar surges in inflows with associated exchange rate and asset bubble woes, but each took quite different approaches in an attempt to mitigate those effects. South Korea devised a series of capital account regulations on the inflow of capital whereas South Africa liberalized their existing regulations on capital outflows. We econometrically analyze the effectiveness of these measures and find some limited evidence that both countries’ measures were successful in lessening the appreciation and volatility of their exchanges rates. These nations were less successful in stemming asset bubbles.
    JEL: E65 F32 F36 F41
    Date: 2013

This nep-cba issue is ©2013 by Maria Semenova. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.