nep-cba New Economics Papers
on Central Banking
Issue of 2014‒12‒08
twenty-two papers chosen by
Maria Semenova
Higher School of Economics

  1. Monetary Policy as an Optimum Currency Area Criterion By Dominik Groll
  2. Does the Clarity of Inflation Reports Affect Volatility in Financial Markets? By Ales Bulir; Martin Cihak; David-Jan Jansen
  3. Financial Frictions and Optimal Monetary Policy in a Small Open Economy By Jesús A. Bejarano; Luisa F. Charry
  4. Assessing the macroeconomic effects of inflation targeting: Evidence from OECD Economies By BEN ROMDHANE, Ikram; MENSI, Sami
  5. Unraveling the Monetary Policy Transmission Mechanism in Sri Lanka By Manuk Ghazanchyan
  6. The Neutral Rate of Interest in Canada By Rhys R. Mendes
  7. In lands of foreign currency credit, bank lending channels run through? The effects of monetary policy at home and abroad on the currency denomination of the supply of credit By Ongena, Steven; Schindele, Ibolya; Vonnák, Dzsamila
  8. Effectiveness of the Easing of Monetary Policy in the Japanese Economy, Incorporating Energy Prices By Naoyuki Yoshino; Farhad Taghizadeh-Hesary
  9. Does a leverage ratio requirement increase bank stability? By Kiema, Ilkka; Jokivuolle, Esa
  10. Central bank macroeconomic forecasting during the global financial crisis: the European Central Bank and Federal Reserve Bank of New York experiences By Alessi, Lucia; Ghysels, Eric; Onorante, Luca; Peach, Richard; Potter, Simon
  11. Macroeconomic Policy Games By Bodenstein, Martin; Guerrieri, Luca; LaBriola, Joe
  12. Inflation Experience and Inflation Expectations: Dispersion and Disagreement Within Demographic Groups By Johannsen, Benjamin K.
  13. Taking Uncertainty Seriously: Simplicity versus Complexity in Financial Regulation By Aikman, David; Galesic, Mirta; Gigerenzer, Gerd; Kapadia, Sujit; Katsikopolous, Konstantinos; Kothiyal, Amit; Murphy, Emma; Neumann, Tobias
  14. Pre-crisis credit standards: monetary policy or the savings glut? By A. Penalver
  15. The Bank Capital Regulation (BCR) Model By Hyejin Cho
  16. Monetary Policy Regime Shifts Under the Zero Lower Bound: An Application of a Stochastic Rational Expectations Equilibrium to a Markov Switching DSGE Model By IIBOSHI Hirokuni
  17. The limits of model-based regulation By Behn, Markus Wilhelm; Haselmann, Rainer; Vig, Vikrant
  18. Contagion in the European Sovereign Debt Crisis By Brent Glover; Seth Richards-Shubik
  19. Macroeconomic policy in Brazil: inflation targeting, public debt structure and credit policies By Fernando López Vicente; José María Serena Garralda
  20. Financial Risk Capacity By Saki Bigio
  21. Can the 'single point of entry' strategy be used to recapitalize a failing bank? By Peter J. Wallison; Paul H. Kupiec
  22. Friedman Redux: External Adjustment and Exchange Rate Flexibility By Atish R. Ghosh; Mahvash Saeed Qureshi; Charalambos G. Tsangarides

  1. By: Dominik Groll
    Abstract: Whether countries benefit from forming a monetary union depends critically on the way monetary policy is conducted. This is mainly because monetary policy determines whether and to what extent a flexible nominal exchange rate fosters or hampers macroeconomic stabilization, even if monetary policy does not target the nominal exchange rate explicitly
    Keywords: Monetary union, macroeconomic stabilization, welfare analysis, optimum currency area theory, trade openness
    JEL: F33 F41 E52
    Date: 2014–11
  2. By: Ales Bulir; Martin Cihak; David-Jan Jansen
    Abstract: We study whether clarity of central bank inflation reports affects return volatility in financial markets. We measure clarity of reports by the Czech National Bank, the European Central Bank, the Bank of England, and Sveriges Riksbank using the Flesch-Kincaid grade level, a standard readability measure. We find some evidence, mainly for the euro area, of a negative relationship between clarity and market volatility prior to and during the early stage of the global financial crisis. As the crisis unfolded, there is no longer robust evidence of a negative connection. We conclude that reducing noise using clear reports is possible but not without challenges, especially in times of crisis.
    Keywords: Inflation;Central banks;Public information;Capital market volatility;Financial markets;central bank communication, clarity, financial markets, inflation reports, volatility
    Date: 2014–09–24
  3. By: Jesús A. Bejarano; Luisa F. Charry
    Abstract: In this paper we set up a small open economy model with financial frictions, following Curdia and Woodford (2010)’s model. Unlike other results in the literature such as Curdia and Woodford (2010), McCulley and Ramin (2008) and Taylor (2008), we find that optimal monetary policy should not respond to changes in domestic interest rate spreads when the source of fluctuations are exogenous financial shocks. A novel result here is that the optimal size of policy responses to changes in the credit spread is large when the disturbance source are shocks to the foreign interest rate. Our results suggest that such a response is welfare enhancing.
    Keywords: Financial frictions, optimal interest rate rules, interest rate spreads, welfare, small open economy, second order approximation
    JEL: E44 E50 E52 E58 F41
    Date: 2014–11–13
  4. By: BEN ROMDHANE, Ikram; MENSI, Sami
    Abstract: With the numerous monetary policy reforms undertaken during the 1990s, inflation targeting emerged as one of the possible solutions. The macroeconomic performance of this regime has attracted the attention of recent research, yet no final consensus on its role is reached. The aim of this paper is to contribute to this debate through a panoply of mixed results proven by the recent literature. Empirically, the purpose of this study is to assess the impact of inflation targeting on inflation and output based on a panel of 30 OECD countries over the period 1980_2012, using the “differences-in- differences” approach of Ball and Sheridan (2005). Our results indicate that inflation targeting helps to improve macroeconomic performance of targeters OECD countries more than non- targeters in terms of average inflation and volatility. Our findings corroborate previous studies like those of Wu (2004), Ball and Sheridan (2005) and Manai,O (2014). However, our results point to an insignificant impact of this regime on output consistent with Gonçalves- Salles (2008) and Ftiti & Essadi (2013). However, our results contrast those of S-Hebbel (2007) and Ftiti J. Goux (2011) which assume that there is no difference between targeters and non-targeters OECD countries.
    Keywords: Inflation targeting, Performance, Macroeconomic Dimensions, Monetary Policy, Panel Analysis.
    JEL: E52 E58 G21
    Date: 2014–11–21
  5. By: Manuk Ghazanchyan
    Abstract: In this paper we examine the channels through which innovations to policy variables— policy rates or monetary aggregates—affect such macroeconomic variables as output and inflation in Sri Lanka. The effectiveness of monetary policy instruments is judged through the prism of conventional policy channels (money/interest rate, bank lending, exchange rate and asset price channels) in VAR models. The timing and magnitude of these effects are assessed using impulse response functions, and through the pass-through coefficients from policy to money market and lending rates. Our results show that (i) the interest rate channel (money view) has the strongest Granger effect (helps predict) on output with a 0.6 percent decrease in output after the second quarter and a cumulative 0.5 percent decline within a three-year period in response to innovations in the policy rate; (ii) the contribution from the bank lending channel is statistically significant (adding 0.2 percentage point to the baseline effect of policy rates) in affecting both output and prices but with a lag of about five quarters for output and longer for prices; and (iii) the exchange rate and asset price channels are ineffective and do not have Granger effects on either output or prices.
    Keywords: Monetary policy;Sri Lanka;Monetary transmission mechanism;Monetary aggregates;Vector autoregression;Econometric models;Monetary Policy, Central Bank Policies, Financial Markets, Sri Lanka
    Date: 2014–10–22
  6. By: Rhys R. Mendes
    Abstract: A measure of the neutral policy interest rate can be used to gauge the stance of monetary policy. We define the neutral rate as the real policy rate consistent with output at its potential level and inflation equal to target after the effects of all cyclical shocks have dissipated. This is a medium- to longer-run concept of the neutral rate. Under this definition, the neutral rate in Canada is determined by the longer-run forces that influence savings and investment in both the Canadian and global economies. Structural forces have likely reduced the neutral rate by more than a percentage point since the mid-2000s. The Bank’s estimates of the real neutral policy rate currently stand in the 1 to 2 per cent range, or 3 to 4 per cent in nominal terms. The current gap between the policy rate and the neutral rate reflects policy stimulus in response to significant excess supply and in the face of continuing headwinds. As long as these headwinds persist, a policy rate below neutral will be required to maintain inflation sustainably at target.
    Keywords: Interest rates, Transmission of monetary policy
    JEL: E40 E42 E43 E50 E52 E58
    Date: 2014
  7. By: Ongena, Steven; Schindele, Ibolya; Vonnák, Dzsamila
    Abstract: We analyze the differential impact of domestic and foreign monetary policy on the local supply of bank credit in domestic and foreign currencies. We analyze a novel, supervisory dataset from Hungary that records all bank lending to firms including its currency denomination. Accounting for time-varying firm-specific heterogeneity in loan demand, we find that a lower domestic interest rate expands the supply of credit in the domestic but not in the foreign currency. A lower foreign interest rate on the other hand expands lending by lowly versus highly capitalized banks relatively more in the foreign than in the domestic currency.
    Keywords: Bank balance-sheet channel,monetary policy,foreign currency lending
    JEL: E51 F3 G21
    Date: 2014
  8. By: Naoyuki Yoshino (Asian Development Bank Institute (ADBI)); Farhad Taghizadeh-Hesary
    Abstract: Japan has reached the limits of conventional macroeconomic policy. In order to overcome deflation and achieve sustainable economic growth, the Bank of Japan (BOJ) recently set an inflation target of 2% and implemented an aggressive monetary policy so this target could be achieved as soon as possible. Although prices started to rise after the BOJ implemented monetary easing, this may have been for other reasons, such as higher oil prices. Oil became expensive as a result of the depreciated Japanese yen and this was one of the main causes of the rise in inflation. This paper shows that quantitative easing may not have stimulated the Japanese economy either. Aggregate demand, which includes private investment, did not increase significantly in Japan with lower interest rates. Private investment displays this unconventional behavior because of uncertainty about the future and because Japan’s population is aging. We believe that the remedy for Japan’s economic policy is not to be found in monetary policy. The government needs to implement serious structural changes and growth strategies.
    Keywords: Easing of Monetary Policy, the Japanese economy, energy price, Bank of Japan, aging population
    JEL: E47 E52 Q41 Q43
    Date: 2014–11
  9. By: Kiema, Ilkka; Jokivuolle, Esa
    Abstract: Basel III has introduced a non-risk-weighted leverage ratio requirement (LRR) which complements the internal ratings based (IRB) capital requirements. It provides a backstop against model risk which arises if some loans get incorrectly rated and become toxic. We study the effects of the LRR on lending strategies and its implications for banks’ stability. We show that the LRR might induce banks with low-risk lending strategies to diversify their portfolios into high-risk loans until the LRR is no longer the binding capital constraint on them. If the LRR is lower than the average bank’s IRB requirement, the aggregate capital costs of banks do not increase. However, because the diversification makes banks’ portfolios more alike the banking sector as a whole may become more exposed to model risk in each loan category. This may undermine banking sec- tor stability. On balance, our calibrated model motivates a significantly higher LRR than the current one. JEL Classification: D41, D82, G14, G21, G28
    Keywords: bank regulation, Basel III, capital requirements, credit risk, leverage ratio
    Date: 2014–05
  10. By: Alessi, Lucia; Ghysels, Eric; Onorante, Luca; Peach, Richard; Potter, Simon
    Abstract: This paper documents macroeconomic forecasting during the global financial crisis by two key central banks: the European Central Bank and the Federal Reserve Bank of New York. The paper is the result of a collaborative effort between staff at the two institutions, allowing us to study the time-stamped forecasts as they were made throughout the crisis. The analysis does not exclusively focuses on point forecast performance. It also examines methodological contributions, including how financial market data could have been incorporated into the forecasting process. JEL Classification: C53, E37
    Keywords: forecast evaluation, mixed frequency data sampling
    Date: 2014–07
  11. By: Bodenstein, Martin (National University of Singapore); Guerrieri, Luca (Board of Governors of the Federal Reserve System (U.S.)); LaBriola, Joe (University of California, Berkeley)
    Abstract: Strategic interactions between policymakers arise whenever each policymaker has distinct objectives. Deviating from full cooperation can result in large welfare losses. To facilitate the study of strategic interactions, we develop a toolbox that characterizes the welfare-maximizing cooperative Ramsey policies under full commitment and open-loop Nash games. Two examples for the use of our toolbox offer some novel results. The first example revisits the case of monetary policy coordination in a two-country model to confirm that our approach replicates well-known results in the literature and extends these results by highlighting their sensitivity to the choice of policy instrument. For the second example, a central bank and a macroprudential regulator are assigned distinct objectives in a model with financial frictions. Lack of coordination leads to large welfare losses even if technology shocks are the only source of fluctuations.
    Keywords: Optimal policy; strategic interaction; welfare analysis; monetary policy cooperation; marcroprudential regulation
    JEL: E44 E61 F42
    Date: 2014–09–23
  12. By: Johannsen, Benjamin K. (Board of Governors of the Federal Reserve System (U.S.))
    Abstract: Using consumption data from the Consumer Expenditure Survey, I document persistent differences across demographic groups in the dispersion of household-specific rates of inflation. Using survey data on inflation expectations, I show that demographic groups with greater dispersion in experienced inflation also disagree more about future inflation. I argue that these results can be rationalized from the perspective of an imperfect information model in which idiosyncratic inflation experience serves as a signal about aggregate inflation. These empirical regularities pose a challenge to several other popular models of the expectations formation process of households.
    Keywords: Inflation; expectations; inflation experience
    Date: 2014–10–22
  13. By: Aikman, David; Galesic, Mirta; Gigerenzer, Gerd; Kapadia, Sujit; Katsikopolous, Konstantinos; Kothiyal, Amit; Murphy, Emma; Neumann, Tobias
    Abstract: Distinguishing between risk and uncertainty, this paper draws on the psychological literature on heuristics to consider whether and when simpler approaches may out-perform more complex methods for modelling and regulating the financial system. We find that: (i) simple methods can sometimes dominate more complex modelling approaches for calculating banks’ capital requirements, especially if limited data are available for estimating models or the underlying risks are characterised by fat-tailed distributions; (ii) simple indicators often outperformed more complex metrics in predicting individual bank failure during the global financial crisis; (iii) when combining information from different indicators to predict bank failure, “fast-and-frugal” decision trees can perform comparably to standard, but more information-intensive, regression techniques, while being simpler and easier to communicate.
    Keywords: Bank regulation; financial regulation; uncertainty; simplicity; heuristics; Basel 2; risk modelling
    JEL: A12 G28
    Date: 2014–05–02
  14. By: A. Penalver
    Abstract: This paper presents a theoretical model of how banks set their credit standards. It examines how a monopoly bank sets its monitoring intensity in order to manage credit risk when it makes long duration loans to borrowers who have private knowledge of their project's stochastic profitability. In contrast to standard models, it has a recursive structure and a general equilibrium. The bank loan contract considered specifies the interest rate, the monitoring intensity and a profitability covenant. Within this class of contract, the bank chooses the terms which maximise steady-state profits subject to the constraint that it must have as many deposits as loans. The model is then used to consider whether the reduction in credit standards and credit spreads observed before the financial crisis could have been caused by low official interest rates or a positive deposit shock. The model rejects a risk-taking channel of monetary policy and endorses the savings glut hypothesis.
    Keywords: credit standards, credit risk, monitoring, risk-taking channel, savings glut.
    JEL: G21
    Date: 2014
  15. By: Hyejin Cho (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris I - Panthéon-Sorbonne)
    Abstract: The motivation of this article is to induce the bank capital management solution for banks and regulation bodies on commercial banks. The goal of the paper is intended to mitigate the risk of a banking area and also provide the right incentive for banks to support the real economy.
    Keywords: Demand Deposit, On-balance-sheet risks and off-balance-sheet risks, Portfolio composition, Minimum equity capital regulation.
    Date: 2014–09–22
  16. By: IIBOSHI Hirokuni
    Abstract: I extend a simple new Keynesian model with the Markov-switching-type Taylor rule introduced by Davig and Leeper (2007 ) by incorporating the constraint of the zero lower bound (ZLB), using the concept and algorithms of the stochastic rational expectations equilibrium proposed by Billi (2013). According to the calibration, when an economy does not face the ZLB constraint, there is no gap in the fluctuation of output and inflation between stochastic expectations and perfect foresight because of the linear policy functions. In contrast, once negative aggregate demand shocks make the nominal interest rate hit the ZLB under stochastic expectations, unlike perfect foresight, intensifying uncertainty plays an important role in further declines of the output and price level even in response to the same shock, regardless of the monetary policy regime adopted. The calibration also indicates the possibility that the steady states of a model, in the absence of the ZLB, are underestimated in periods of deflation, since the means often used as estimates of the steady states are biased downward from these. The analysis sheds light on an exit strategy from the zero interest rate policy, since a passive policy regime reduces the expected interest rate and induces both the expected output and the inflation to increase under the ZLB.
    Date: 2014–11
  17. By: Behn, Markus Wilhelm; Haselmann, Rainer; Vig, Vikrant
    Abstract: In this paper, we investigate how the introduction of complex, model-based capital regulation affected credit risk of financial institutions. Model-based regulation was meant to enhance the stability of the financial sector by making capital charges more sensitive to risk. Exploiting the staggered introduction of the model-based approach in Germany and the richness of our loan-level data set, we show that (1) internal risk estimates employed for regulatory purposes systematically underpredict actual default rates by 0.5 to 1 percentage points; (2) both default rates and loss rates are higher for loans that were originated under the model-based approach, while corresponding risk-weights are significantly lower; and (3) interest rates are higher for loans originated under the model-based approach, suggesting that banks were aware of the higher risk associated with these loans and priced them accordingly. Further, we document that large banks benefited from the reform as they experienced a reduction in capital charges and consequently expanded their lending at the expense of smaller banks that did not introduce the model-based approach. Counter to the stated objectives, the introduction of complex regulation adversely affected the credit risk of financial institutions. Overall, our results highlight the pitfalls of complex regulation and suggest that simpler rules may increase the efficacy of financial regulation.
    Keywords: capital regulation,internal ratings,Basel regulation
    JEL: G01 G21 G28
    Date: 2014
  18. By: Brent Glover; Seth Richards-Shubik
    Abstract: We use a network model of credit risk to measure market expectations of the potential spillovers from a sovereign default. Specifically, we develop an empirical model, based on the recent theoretical literature on contagion in financial networks, and estimate it with data on sovereign credit default swap spreads and the detailed structure of financial linkages among thirteen European sovereigns from 2005 to 2011. Simulations from the estimated model show that a sovereign default generates only small spillovers to other sovereigns. These results imply that credit markets do not demand a significant premium for the interconnectedness of sovereign debt in Europe.
    JEL: D85 F34 F36 G01 L14
    Date: 2014–10
  19. By: Fernando López Vicente (Banco de España); José María Serena Garralda (Banco de España)
    Abstract: Macroeconomic policy in Latin America underwent significant changes in the late nineties. Brazil is an outstanding example: inflation targeting was introduced in 1999 and a new fiscal policy framework was set up in 2000 with the Fiscal Responsibility Law. However, two elements of the Brazilian economy constrained the apparently state-of-the-art macroeconomic policy framework: the composition of public debt and the structure of the banking system. This paper discusses why macroeconomic policies were restricted by those factors and how they have evolved differently. The structure of public debt, characterised by indexation, short-term maturities and short US dollar positions, imposed significant constraints on macroeconomic policies during the 2000s. Nevertheless, these vulnerabilities were gradually overcome and the composition of public debt has remained stable in the aftermath of the global financial crisis. At the same time, the structure of the banking system was characterised by credit segmentation and high interest spreads, and these characteristics are still present today. These features have become key elements in understanding current macroeconomic developments, credit dynamics and the economic policy stance.
    Keywords: public debt, central banking, credit policies, Brazil.
    JEL: H30 E58 E63
    Date: 2014–10
  20. By: Saki Bigio (Columbia Business School)
    Abstract: Financial crises seem particularly severe and lengthy when banks fail to recapitalize after large losses. I explain this failure and the consequent depth of financial crises through a model in which banks provide intermediation in markets with informational asymmetries. Large equity losses reduce a bank's capacity to bear further losses. Losing this capacity leads to reductions in intermediation and exacerbates adverse selection. Adverse selection, in turn, lowers profits from intermediation, which explains the failure to attract equity injections or retain earnings quickly. Financial crises are infrequent events characterized by low economic growth that is overcome only as banks slowly recover by retaining earnings. I explore several policy interventions.
    Keywords: Financial Crisis, Adverse Selection, Capacity Constraints
    Date: 2014–11
  21. By: Peter J. Wallison (American Enterprise Institute); Paul H. Kupiec (American Enterprise Institute)
    Abstract: The failure of the largest banks will not generally endanger the solvency of their parent bank holding companies (BHCs), preventing the secretary of the Treasury from using single point of entry (SPOE).  However, many large BHCs would face bankruptcy if their subsidiary bank failed, and here SPOE expands the government safety net thereby reinforcing TBTF.  On balance, the evidence suggests that SPOE has not solved TBTF.
    Keywords: banking, Dodd-Frank, The Ledger
    JEL: A
    Date: 2014–11
  22. By: Atish R. Ghosh; Mahvash Saeed Qureshi; Charalambos G. Tsangarides
    Abstract: Milton Friedman argued that flexible exchange rates would facilitate external adjustment. Recent studies find surprisingly little robust evidence that they do. We argue that this is because they use composite (or aggregate) exchange rate regime classifications, which often mask very heterogeneous bilateral relationships between countries. Constructing a novel dataset of bilateral exchange rate regimes that differentiates by the degree of exchange rate flexibility, as well as by direct and indirect exchange rate relationships, for 181 countries over 1980–2011, we find a significant and empirically robust relationship between exchange rate flexibility and the speed of external adjustment. Our results are supported by several “natural experiments†of exogenous changes in bilateral exchange rate regimes.
    Keywords: Flexible exchange rates;Exchange rate adjustments;Exchange rate regimes;Balance of trade;Current account balances;external dynamics, exchange rate regimes, global imbalances
    Date: 2014–08–08

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