nep-cba New Economics Papers
on Central Banking
Issue of 2019‒01‒28
twenty-six papers chosen by
Sergey E. Pekarski
Higher School of Economics

  1. Quantitative easing and sovereign bond yields: a global perspective By Dimitris Malliaropulos; Petros Migiakis
  2. Estimating the monetary policy interest-rate-to-performance sensitivity of the European banking sector at the zero lower bound By Bernd Hayo; Kai Henseler; Marc Steffen Rapp
  3. The Scarcity Effect of Quantitative Easing on Repo Rates: Evidence from the Euro Area By William Arrata; Benoit Nguyen; Imene Rahmouni-Rousseau; Miklos Vari
  4. Monetary-fiscal interaction and quantitative easing By Hollmayr, Josef; Kühl, Michael
  5. On money, debt, trust and central banking By Claudio Borio
  6. Shifting Inflation Expectations and Monetary Policy By Agustín Arias; Markus Kirchner
  7. Banking Panics and the Lender of Last Resort in a Monetary Economy By Makoto (M.) Watanabe; Tarishi Matsuoka
  8. Transmission of foreign monetary shocks to a small open economy under structural instability: the case of Russia By Anna Kruglova; Konstantin Styrin; Yulia Ushakova
  9. Monetary Policy Communication Shocks and the Macroeconomy By Goodhead, Robert; Kolb, Benedikt
  10. Shall We Twist? By Sophie Altermatt, Simon Beyeler
  11. Global Banking, Financial Spillovers, and Macroprudential Policy Coordination By Pierre-Richard Agénor; Luiz Awazu Pereira da Silva
  12. Exchange Rate Overshooting: A Reassessment in a Monetary Framework By Ghosh, Taniya; Bhadury, Soumya Suvra
  13. Banks’ Trading after the Lehman Crisis – The Role of Unconventional Monetary Policy By Isabel Schnabel; Johannes Tischer
  14. What is the Impact of Monetary Policy on Wealth Inequality? By Sutirtha Bagchi; Michael Patrick Curran; Matthew J. Fagerstrom
  15. The Impact of Exogenous Liquidity Shocks on Banks Funding Costs: Microevidence from the Unsecured Interbank Market By Miguel Sarmiento; ;
  16. Gains from Policy Cooperation in Capital Controls and Financial Market Incompleteness By Shigeto Kitano; Kenya Takaku
  17. Bank Capital Regulation in a Zero Interest Environment By Döttling, Robin
  18. Deposit Spreads and the Welfare Cost of Inflation By Pablo Kurlat
  19. Monetary policy, trade, and endogenous growth under different international financial market structures By Michael Donadelli; Patrick Grüning; Aurelija Proskute
  20. Bank capital buffers in a dynamic model By Mankart, Jochen; Michaelides, Alexander; Pagratis, Spyros
  21. The Micro Impact of Macroprudential Policies: Firm-Level Evidence By Meghana Ayyagari; Thorsten Beck; Maria Soledad Martinez Peria
  22. Intrinsic Moral Hazard By Korkut Alp Erturk
  23. Reconciling VAR-based Forecasts with Survey Forecasts By Doh, Taeyoung; Smith, Andrew Lee
  24. The Founding of the Federal Reserve, the Great Depression and the Evolution of the U.S. Interbank Network By Jaremski, Matthew; Wheelock, David C.
  25. Forecasting inflation in Russia by Dynamic Model Averaging By Konstantin Styrin
  26. Has Money Lost Its Relevance? Resolving the Exchange Rate Disconnect Puzzle By Ghosh, Taniya; Bhadury, Soumya Suvra

  1. By: Dimitris Malliaropulos (Bank of Greece); Petros Migiakis (Bank of Greece)
    Abstract: We document the existence of a global monetary policy factor in sovereign bond yields in a panel of 45 countries, consisting of both developed and emerging economies. This global factor is related to the size of the aggregate balance sheet of the four major central banks (Fed, ECB, Bank of Japan and Bank of England). Our estimates suggest that large-scale asset purchases and liquidity provision of major central banks following the Global Financial Crisis have contributed to a significant and permanent decline in long-term yields globally, ranging from 250 basis points for AAA rated sovereigns to 330 basis points for B rated sovereigns. Fiscally weaker Eurozone countries benefited most from Quantitative Easing, with their sovereign yields declining by 600-750 basis points, depending on the rating of their sovereigns. Our findings have important policy implications: normalizing monetary policy by scaling down the expanded balance sheets of major central banks to pre-crisis levels may lead to sharp increases in sovereign bond yields globally with severe consequences for financial stability, vulnerable sovereigns and the global economy
    Keywords: monetary policy; quantitative easing; sovereign bonds; interest rates; panel cointegration.
    JEL: E42 E43 G12 G15
    Date: 2018–11
  2. By: Bernd Hayo (Philipps-Universitaet Marburg); Kai Henseler (Philipps-Universitaet Marburg); Marc Steffen Rapp (Philipps-Universitaet Marburg)
    Abstract: Using an event-study design, we investigate monetary policy interest-rate-to-performance sensitivity of the European banking sector over the 07/2012–06/2017 period when interest rates were (close to) zero. We apply the Wordscores approach to introductory statements of ECB's Governing Council press conferences to estimate a ‘shadow prime rate’. Based on short-run intraday event windows, we find shadow prime rate changes positively affect changes in the EURO-STOXX-Banks Future. Our findings add to the recent evidence documenting that banks benefit from increasing interest rate levels in a low-interest-rate environment.
    Keywords: ECB, central bank communication, banking sector, interest rate sensitivity, textual analysis, Wordscores
    JEL: E43 E52 E58 G14 G21
    Date: 2019
  3. By: William Arrata; Benoit Nguyen; Imene Rahmouni-Rousseau; Miklos Vari
    Abstract: Most short-term interest rates in the Euro area are below the European Central Bank deposit facility rate, the rate at which the central bank remunerates banks’ excess reserves. This unexpected development coincided with the start of the Public Sector Purchase Program (PSPP). In this paper, we explore empirically the interactions between the PSPP and repo rates. We document different channels through which asset purchases may affect them. Using proprietary data from PSPP purchases and repo transactions for specific (“special") securities, we assess the scarcity channel of PSPP and its impact on repo rates. We estimate that purchasing 1 percent of a bond outstanding is associated with a decline of its repo rate of 0.78 bps. Using an instrumental variable, we find that the full effect may be up to six times higher.
    Keywords: Central banks and their policies;Repurchase agreements;Monetary policy;Money markets;Interest rates;Assets;Specialness, repo market, asset purchases, money market
    Date: 2018–12–07
  4. By: Hollmayr, Josef; Kühl, Michael
    Abstract: This paper analyzes the monetary-fiscal interaction if the central bank conducts quantitative easing. Although asset purchases have similar effects on the real economy under monetary and fiscal dominance, wealth effects yield a qualitatively different response on the rate of inflation. Our results show that under fiscal dominance, unconventional monetary policy has similar effects to conventional monetary policy on inflation because these wealth effects exert downward pressure on prices. The longer the average maturity, the more volatile is the transmission of quantitative easing to the real economy.
    Keywords: Monetary Policy,Fiscal Policy,Asset Purchase Program
    JEL: E32 E44 E62
    Date: 2018
  5. By: Claudio Borio
    Abstract: This essay examines in detail the properties of a well functioning monetary system - defined as money plus the mechanisms to execute payments - in both the short and long run, drawing on both theory and the lessons from history. It stresses the importance of trust and of the institutions needed to secure it. Ensuring price and financial stability is critical to nurturing and maintaining that trust. In the process, the essay addresses several related questions, such as the relationship between money and debt, the viability of cryptocurrencies as money, money neutrality, and the nexus between monetary and financial stability. While the present monetary system, with central banks and a prudential apparatus at its core, can and must be improved, it still provides the best basis to build on.
    Keywords: monetary system, money, debt, payments, trust, monetary stability, financial stability, central bank
    JEL: E00 E30 E40 E50 G21 N20
    Date: 2019–01
  6. By: Agustín Arias; Markus Kirchner
    Abstract: The idea of “anchored” inflation expectations is often understood as a situation in which long-run expected inflation does not significantly respond to new information. Furthermore, expectations are thought to become “unanchored” only after a long enough sequence of inflation surprises. In this paper we conceptualize this idea in a monetary DSGE model with a time-varying learning mechanism, in which the sensitivity of agents to incoming data depends on accumulated inflation forecast errors. The latter affect the learning gain that agents use to update their beliefs on future inflation. We show how this mechanism improves the fit of the model to macroeconomic data, including expected inflation, for the Chilean inflation targeting period. In particular, we show that observed episodes with anchored and unanchored expectations are well captured by the estimated time-varying learning gain. We then use the estimated model to assess the role of monetary policy to anchor inflation expectations over time.
    Date: 2019–01
  7. By: Makoto (M.) Watanabe (VU Amsterdam); Tarishi Matsuoka (Tokyo Metropolitan University)
    Abstract: This paper studies the role of a lender of last resort (LLR) in a monetary model where a shortage of bank’s monetary reserves (or a banking panic) occurs endogenously. We show that while a discount window policy introduced by the LLR is welfare improving, it reduces the banks’ ex ante incentive to hold reserves, which increases the probability of a panic, and causes moral hazard in asset investments. We also examine the combined effect of other related policies such as a penalty in lending rate, liquidity requirements, and constructive ambiguity.
    Keywords: Monetary Equilibrium; Banking Panic; Moral Hazard; Lender of Last Resort
    JEL: E40
    Date: 2019–01–11
  8. By: Anna Kruglova (University of Washington (Bank of Russia at the time of participating in this study)); Konstantin Styrin (Bank of Russia, Russian Federation); Yulia Ushakova (Bank of Russia, Russian Federation)
    Abstract: This paper studies the transmission of monetary policy shocks in the U.S. to a small open economy by estimating their effect on lending based on bank-level balance sheet data of Russian banks for 2000-2018. To identify the causal effect at the bank level we exploit heterogeneity across banks in terms of their reliance on cross-border funding. We find evidence that the effect of U.S. monetary policy shocks has been statistically and economically significant. Surprisingly, the magnitude of the effect remained roughly the same even after the monetary policy in Russia transited from exchange rate to inflation targeting. This finding suggests that a free floating regime does not attenuate the effect of foreign monetary policy shocks on domestic lending.
    Keywords: monetary policy, international spillovers, cross-border transmission
    JEL: E52 F34 G21
    Date: 2018–12
  9. By: Goodhead, Robert (Central Bank of Ireland); Kolb, Benedikt (Deutsche Bundesbank)
    Abstract: Using federal funds futures data, we show the importance of suprise communication as a component of monetary policy for U.S. macro variables, both before and after 2008. We distinguish between monetary policy action and "communication shocks" (suprise announcements about future policy moves) by decomposing futures price movements across contract maturities. Our results indicate that it is mainly communication shocks- as opposed to actual rate-change suprises- that affect production in the ways traditionally associated with monetary policy shocks between 1994 and 2008. Covering the zero-lower bound period using Eurodollar futures, we find strong effects of long-horizon communication on inflation.
    Keywords: Federal Funds Futures, FOMC, Monetary Policy, VAR Model
    JEL: E52 E58 G23 C32
    Date: 2018–12
  10. By: Sophie Altermatt, Simon Beyeler
    Abstract: In recent monetary history, central banks around the world have started to introduce unconventional monetary policy measures, such as extending or restructuring the asset side of their balance sheet. The origin of these mon- etary policy tools goes back to an intervention by the U.S. Federal Reserve System under the Kennedy administration in 1961 known as Operation Twist. Operation Twist serves as a perfect laboratory to study the e ectiveness of such balance sheet policies, because interest rates neither were at their lower bound nor was the economy in a historical turmoil. We assess the actions of the FED and the Treasury under Operation Twist based on balance sheet data and evaluate their success using modern time series techniques. We nd that, although being of rather moderate size, the joint policy actions were e ective in compressing the long-short spreads of the Treasury bond rates.
    Keywords: Operation Twist, Monetary Policy, Interest Rates, Yield Curve, Time Series
    JEL: C22 E43 E52 E63 E65
    Date: 2018–05
  11. By: Pierre-Richard Agénor; Luiz Awazu Pereira da Silva
    Abstract: The gains from international macroprudential policy coordination are studied in a two-region, core-periphery macroeconomic model with imperfect financial integration and cross-border banking. Financial frictions occur at two levels: between firms and banks in each region, and between periphery banks and a global bank in the core region. Macroprudential regulation takes the form of a countercyclical tax on bank loans to domestic capital goods producers, which responds to real credit growth and is subject to a cost in terms of welfare. Numerical experiments, based on a parameterized version of the model, show that the welfare gains from macroprudential policy coordination are positive, albeit not large, for the world economy. In addition, these gains tend to increase with the degree of international financial integration. However, depending on the origin of financial shocks, they can also be highly asymmetric across regions.
    Keywords: global banking, financial spillovers, macroprudential policy coordination
    JEL: E58 F42
    Date: 2019–01
  12. By: Ghosh, Taniya; Bhadury, Soumya Suvra
    Abstract: Most empirical studies on monetary policies have found exchange rate effects that are inconsistent with Dornbusch's overshooting hypothesis. Bjornland (2009) finds evidence of exchange rate overshooting by using interest rate alone as the monetary policy instrument. However, theoretically consistent way of identifying monetary policy requires capturing dual interaction between central bank's reaction to economic conditions and private sector's response to policy action. This calls for the introduction of "monetary‟ aggregates back in the models of exchange rate determination. Motivated by Bjornland's result, identification is achieved by imposing short-run and long-run restrictions while keeping the short-run interactions between monetary policy and exchange rate free. Using more appropriate econometric technique in a model aligned to theory, our paper rediscovers the validity of Dornbusch Overshooting hypothesis for Australia, Canada, New Zealand and Sweden more accurately and more robustly than Bjornland's original model.
    Keywords: Monetary Policy; Money Demand; Structural VAR; Exchange Rate Overshooting
    JEL: E4 E5 E50 F0 F3 F30
    Date: 2017–11
  13. By: Isabel Schnabel; Johannes Tischer
    Abstract: Based on a unique trade-level dataset, we analyze the proprietary trading reaction of German banks to the Lehman collapse and the subsequent unconventional monetary policy measures in 2008. After the Lehman collapse, we observe that market liquidity tightened. However, there is no evidence of broad-based fire sales in the German banking sector. Instead, we observe a flight to liquidity. The European Central Bank’s unconventional measures had a strong impact on banks’ trading behavior by inducing shifts towards eligible securities and reducing pressure on market liquidity. This suggests that the unconventional measures helped stabilizing the financial system after the Lehman collapse.
    Keywords: Proprietary trading, fire sales, flight to liquidity, Lehman crisis, market liquidity, unconventional monetary policy
    JEL: E44 E50 G01 G11 G21
    Date: 2018–08
  14. By: Sutirtha Bagchi (Department of Economics, Villanova School of Business, Villanova University); Michael Patrick Curran (Department of Economics, Villanova School of Business, Villanova University); Matthew J. Fagerstrom (Department of Economics, Villanova School of Business, Villanova University)
    Abstract: We construct a global panel data set to examine the relationship between monetary policy and wealth inequality. Dynamic panel estimates suggest that both overall and inherited wealth inequality increase with growth in the base money supply. These results hold for countries with at least one billionaire and for OECD countries. Interest rates have an insigni cant distributional impact overall, but this relationship becomes signi cant in a sample of OECD countries.
    Keywords: Cantillon effect; wealth inequality; money nonneutrality
    JEL: F30 F31 F41 G15
    Date: 2019–01
  15. By: Miguel Sarmiento (Central Bank of Colombia); ;
    Abstract: This paper examines the impact of exogenous liquidity shocks in the unsecured interbank market. We evaluate the effects of idiosyncratic liquidity shocks—arising from deposits outflow at the bank level—and of the aggregate liquidity shock related to the U.S. tapering observed between May and September of 2013. We find that both liquidity shocks are associated with higher interbank loan prices, albeit the magnitude of the overprice and the impact on the access to interbank liquidity differ depending on the borrower-specific characteristics. More capitalized and liquid banks tend to pay less for liquidity—concurrent with evidence on market discipline—but also can absorb better the impact of exogenous liquidity shocks, suggesting benefits from capital and liquidity ratios. Our results suggest that lending relationships can alleviate funding costs during idiosyncratic liquidity shocks, while central bank liquidity contributes to smooth the impact of aggregate liquidity shocks. Results have implications for both financial stability and monetary policy transmission.
    Keywords: interbank markets; market discipline; liquidity shocks; monetary policy; financial stability.
    JEL: E43 E58 L14 G12 G21
    Date: 2019–01
  16. By: Shigeto Kitano (Research Institute for Economics & Business Administration (RIEB), Kobe University, Japan); Kenya Takaku (Faculty of International Studies, Hiroshima City University, Japan)
    Abstract: We examine how the degree of financial market incompleteness affects welfare gains from policy cooperation in capital controls. When financial markets are incomplete, international risk sharing is disturbed. However, the optimal global policy significantly reverses the welfare deterioration due to inefficient risk-sharing. We find that when financial markets are more incomplete, the welfare gap between the optimal global policy and the Nash equilibrium increases, and the welfare gains from policy cooperation in capital controls then become larger.
    Keywords: Financial markets; Incomplete markets; Policy cooperation; Capital controls; Optimal policy; Welfare; Ramsey policy; Open-loop Nash game
    JEL: D52 E61 F32 F42 G15
    Date: 2019–01
  17. By: Döttling, Robin
    Abstract: How do near-zero deposit rates affect (optimal) bank capital regulation and risk taking? I study these questions in a tractable, dynamic equilibrium model, in which forward-looking banks compete imperfectly for deposit funding, subject to a (zero) lower bound constraint on deposit rates (ZLB). At the ZLB, capital requirements become less effective in curbing excessive risk-taking incentives, as they disproportionately hurt franchise values. As a consequence, optimal dynamic capital requirements vary with the level of interest rates if the ZLB binds occasionally. Subsidizing bank funding costs at the ZLB dampens risk-taking, but may reduce overall welfare.
    Keywords: Zero lower bound,Search for yield,Capital regulation,Bank competition,Franchise value
    JEL: G21 G28 E43
    Date: 2019
  18. By: Pablo Kurlat
    Abstract: Since bank deposits and currency are substitutes and banks have monopoly power, higher nominal interest rates lead to higher deposit spreads. This raises the cost of transaction services, increases bank profits and attracts entry into the banking sector. Taking these effects into account, a one percentage point increase in inflation has a welfare cost of 0.086% of GDP, 6.9 times higher than traditional estimates.
    JEL: D43 E31 E41 G21
    Date: 2018–12
  19. By: Michael Donadelli (Ca'Foscari University of Venice); Patrick Grüning (CEFER, Bank of Lithuania and Vilnius University); Aurelija Proskute (Bank of Lithuania)
    Abstract: This study develops a symmetric two-country New-Keynesian general equilibrium model with endogenous growth, Calvo-style price and wage rigidities, and international trade of final consumption goods and intermediate goods. The equilibrium implications of two financial market structures are compared: financial autarky and complete markets. In the case of financial autarky, no international bond is traded. In the case of complete markets, the households have access to a full set of international nominal state-contingent bonds. We find that assuming complete markets instead of financial autarky leads to higher co-movement of most macroeconomic growth rates across countries, higher co-movement of inflation rates across countries, lower uncovered interest rate parity regression coefficients, and a lower correlation between exchange rate growth and consumption growth differentials. These results are mostly in line with US and UK data from 1950-2015, which are split into two samples, 1950-1970 and 1971-2015, in order to be compared to the model with financial autarky and the model with complete markets, respectively.
    Keywords: International financial markets, Monetary policy, Nominal rigidities, Endogenous growth
    JEL: E30 E44 F44 G12 O30
    Date: 2019–01–11
  20. By: Mankart, Jochen; Michaelides, Alexander; Pagratis, Spyros
    Abstract: We estimate a dynamic structural banking model to examine the interaction between risk-weighted capital adequacy and unweighted leverage requirements, their differential impact on bank lending, and equity buffer accumulation in excess of regulatory minima. Tighter risk-weighted capital requirements reduce loan supply and lead to an endogenous fall in bank profitability, reducing bank incentives to accumulate equity buffers and, therefore, increasing the incidence of bank failure. Tighter leverage requirements, on the other hand, increase lending, preserve bank charter value and incentives to accumulate equity buffers, therefore leading to lower bank failure rates.
    Keywords: Banking,Equity Buffers,Regulatory Interactions
    JEL: E44 G21 G38
    Date: 2018
  21. By: Meghana Ayyagari; Thorsten Beck; Maria Soledad Martinez Peria
    Abstract: Combining balance sheet data on 900,000 firms from 48 countries with information on the adoption of macroprudential policies during 2003-2011, we find that these policies are associated with lower credit growth. These effects are especially significant for micro, small and medium enterprises (MSMEs) and young firms that, according to the literature, are more financially constrained and bank dependent. Among MSMEs and young firms, those with weaker balance sheets exhibit lower credit growth in conjunction with the adoption of macroprudential policies, suggesting that these policies can enhance financial stability. Finally, our results show that macroprudential policies have real effects, as they are associated with lower investment and sales growth.
    Keywords: Macroprudential policies and financial stability;Balance sheets;Public enterprises;financial development; macroprudential policies; firm financing
    Date: 2018–12–07
  22. By: Korkut Alp Erturk
    Abstract: The paper argues that financial deregulation incentivized financial firms to take excessive risks and over-expand because it turned social insurance against systemic risk into a common pool (or open) resource. The increased size and complexity of deregulated financial markets in turn raised the social cost of imposing discipline in financial markets to prohibitive levels. Because this undermined the credibility of the regulators’ threats of sanction, their deterrence strategy was from then on subgame imperfect. This suggests that moral hazard can be explained by the market expectation that regulators would act like a rational maximizer rather than by the things they irrationally did or not do.
    Keywords: systemic risk, moral hazard, financial deregulation, coordination failure, excessive risk taking and financial crisis JEL Classification: D72, C70,G20, G18
    Date: 2019
  23. By: Doh, Taeyoung (Federal Reserve Bank of Kansas City); Smith, Andrew Lee (Federal Reserve Bank of Kansas City)
    Abstract: This paper proposes a novel Bayesian approach to jointly model realized data and survey forecasts of the same variable in a vector autoregression (VAR). In particular, our method imposes a prior distribution on the consistency between the forecast implied by the VAR and the survey forecast for the same variable. When the prior is placed on unconditional forecasts from the VAR, the prior shapes the posterior of the reduced-form VAR coefficients. When the prior is placed on conditional forecasts (specifically, impulse responses), the prior shapes the posterior of the structural VAR coefficients. {{p}} To implement our prior, we combine importance sampling with a maximum entropy prior for forecast consistency to obtain posterior draws of VAR parameters at low computational cost. We use two empirical examples to illustrate some potential applications of our methodology: (i) the evolution of tail risks for inflation in a time-varying parameter VAR model and (ii) the identification of forward guidance shocks using sign and forecast-consistency restrictions in a monetary VAR model.
    Keywords: Vector Autoregression (VAR); Survey Forecasts; Bayesian VAR; Inflation Risk; Forward Guidance
    JEL: C11 C32 E31
    Date: 2018–12–01
  24. By: Jaremski, Matthew (Utah State University); Wheelock, David C. (Federal Reserve Bank of St. Louis)
    Abstract: Financial network structure is an important determinant of systemic risk. This paper examines how the establishment of the Federal Reserve and Great Depression affected U.S. interbank network structure. Seeking liquidity sources, banks generally preferred to connect to Federal Reserve member banks in cities with Fed offices or clearinghouses. Overall network concentration declined initially as banks connected to Federal Reserve cities other than New York, but increased in the Depression. Banks that survived the Depression generally had higher percentages of connections to Federal Reserve cities and to correspondent banks that also survived.
    Keywords: Interbank Networks; Bank Concentration; Contagion; Systemically Important Financial Institutions; Federal Reserve Act; Great Depression
    JEL: G21 L14 N22
    Date: 2019–01–17
  25. By: Konstantin Styrin (Bank of Russia, Russian Federation)
    Abstract: In this study, I forecast CPI inflation in Russia by the method of Dynamic Model Averaging (Raftery et al., 2010; Koop and Korobilis, 2012) pseudo out-of-sample on historical data. This method can be viewed as an extension of the Bayesian Model Averaging where the identity of a model that generates data and model parameters are allowed to change over time. The DMA is shown not to produce forecasts superior to simpler benchmarks even if a subset of individual predictors is pre-selected “with the benefit of hindsight” on the full sample. The two groups of predictors that feature the highest average values of the posterior inclusion probability are loans to non-financial firms and individuals along with actual and anticipated wages.
    Keywords: Bayesian model averaging, model uncertainty, econometric modeling, high-dimension model, inflation forecast.
    JEL: C5 C53 E37
    Date: 2018–12
  26. By: Ghosh, Taniya; Bhadury, Soumya Suvra
    Abstract: The objective of this study is to identify the monetary policy shock causing exchange rate fluctuations in the economies of India, Poland and the UK. For this purpose, an open-economy structural vector auto-regression model is used, resorting to data covering the period 2000-2015. The model used in the paper is appropriate for the small, open economies being analysed here as it facilitates estimation of theoretically correct and significant responses in terms of the price, output, and exchange rate to monetary policy tightening. The importance of monetary policy shock is established by examining the variance decomposition of forecast error, impulse response function, and out-of-sample forecast. The model also allows for the precise measurement of money through the adoption of a new monetary measure, namely, aggregation–theoretic Divisia monetary aggregate. The empirical results lead to three critical findings. Firstly, it is imperative to consider the estimated responses of output, prices, money and exchange rate to monetary policy shocks in models using monetary aggregates. Secondly, the incorporation of Divisia money in monetary policy helps in explaining fluctuations in the exchange rate. Thirdly, the inclusion of Divisia money also promotes better out-of-sample forecasting of the exchange rate.
    Keywords: Monetary policy, Monetary aggregates, Divisia, Structural VAR, Exchange rate overshooting, Liquidity puzzle, Price puzzle, Exchange rate disconnect puzzle, Forward discount bias puzzle
    JEL: E5 F00
    Date: 2018–10–02

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