nep-mon New Economics Papers
on Monetary Economics
Issue of 2005‒07‒25
seventeen papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Underlying Inflation: Concepts, Measurement and Performance By Ivan Roberts
  2. No euro please, We’re British! By Lucio Valerio Spagnolo, Mario Cerrato
  3. The intraday price of money: evidence from the e-MID market By Angelo Baglioni; Andrea Monticini
  5. The Price Puzzle and Indeterminacy By Efrem Castelnuovo; Paolo Surico
  6. Are Europe's Interest Rates led by FED Announcements? By Andrea Monticini; Giacomo Vaciago
  7. Measuring inflation persistence: a structural time series approach By Maarten Dossche; Gerdie Everaert
  8. A theory of low inflation in a non Ricardian economy with credit Constraints. By Xavier Ragot
  9. Choice of Monetary and Exchange Regimes in ECOWAS: An Optimum Currency Area Analysis By Chantal Dupasquier; Patrick N. Osakwe; Shandre M. Thangavelu
  10. Estonian Inflation Model By Urmas Sepp; Andres Vesilind; Ülo Kaasik
  11. Assessment of the Euro\'s implications for European economic development By Iika Korhonen; Mare Randveer
  12. The monetary sector under a currency board arrangement : specification and estimation of a model with Estonian data By Rasmus Pikkani
  13. Monetary transmission mechanism in Estonia - some theorethical considerations and stylized aspects By Raoul Lättemäe
  14. Monetary transmission mechanism in Estonia - empirical model By Rasmus Pikkani
  15. Accession to EMU and exchange rate policies in Central Europe - decision under institutional constraints By Andreas Freytag
  16. Integrated monetary and exchange rate frameworks: are there empirical differences? By Lucio Vinhas de Souza
  17. Aspects of the Sustainability of Estonian Currency Board Arrangement By Urmas Sepp; Martti Randveer

  1. By: Ivan Roberts (Reserve Bank of Australia)
    Abstract: This paper explores the concept of underlying inflation and the properties of various measures of underlying inflation in the Australian context. Underlying inflation measures are routinely calculated and monitored by central banks in many countries, including the Reserve Bank of Australia. Alternative measurement concepts are explored, and a range of measures that have been calculated for Australia are discussed and evaluated on the basis of statistical criteria. These criteria capture the intuition that a good measure of underlying inflation should be less volatile than CPI (or headline) inflation, be unbiased with respect to CPI inflation, and capture the 'trend' in CPI inflation so that, on average, CPI inflation will tend to adjust towards the measure of underlying inflation. In the Australian context, statistical measures of underlying inflation, such as the trimmed mean or weighted median, perform fairly satisfactorily against these criteria. The performance of these measures can be further improved by seasonally adjusting prices at the CPI component level. Although underlying inflation measures have become less necessary in the past decade as inflation itself has become less volatile, these findings suggest that underlying inflation measures can still add value to the analysis of inflationary trends.
    Keywords: underlying inflation; core inflation; trimmed mean; weighted median; volatility-weighted measures
    JEL: C43 E31
    Date: 2005–07
  2. By: Lucio Valerio Spagnolo, Mario Cerrato (CELPE-DISES, Università degli Studi di Salerno)
    Abstract: Comparing the economic performances between UK and Euroland, the appropriate and obvious question should be: why does not Euroland replace its euro with the British pound? However, economy does not represent all the interests of the human beings. They believe in values beyond the economy. Right! It may well be that Euroland citizens, once with the euro, feel much more confiance in themselves, as part of a larger world, as they trust the monetary and political decision makers of the EU Institutions. If that was the truth, the European integration process should proceed just like a ball thrown against standing skittle-pins waiting to be got down! Unfortunately, that is not the case. The authors try to point out some reasons to understand those British people who love to look at the euro experience, sitting in their armchairs and, above all, without loosing their national pound.
    Date: 2005–06
  3. By: Angelo Baglioni (Università Cattolica del Sacro Cuore); Andrea Monticini (University of Exeter)
    Abstract: We present a simple model, where intraday and overnight interest rates are linked by a no-arbitrage argument. The hourly interest rate is shown to be a function of the intraday term structure of the overnight rate. This property holds under both assumptions, where an explicit intraday market for interbank loans exists and when it does not. In the first case, such a property is an equilibrium condition; in the second one it holds by definition, as a synthetic hourly loan is a portfolio of overnight contracts. We then provide empirical evidence, based on tick- by-tick data for the e-MID money market (covering the whole 2003). The overnight rate shows a clear downward pattern throughout the operating day. A positive hourly interest rate emerges from the intraday term structure of the overnight rate: we estimate the market price of a one hour interbank loan to be slightly above a half basis point.
    Keywords: intraday interest rate, overnight interbank loans, money market.
    JEL: G21 E43
    Date: 2005–07–21
  4. By: Grand Nathalie (Institut de la Méditerranée, Marseille, FRANCE); Dropsy Vincent (California State University, Fullerton, USA)
    Abstract: Morocco and Tunisia have started to open their markets to international trade and capital flows in order to bolster investment and growth. These liberalization programs require important adjustments in their economic policies, in particular their exchange rate regimes and monetary policies. This objective of this paper is to examine why Morocco and Tunisia should progressively opt for greater exchange rate flexibility as well as a monetary policy based on inflation targeting rather than exchange rate targeting and money-growth rules, as their markets are increasingly liberalized. First, their past economic policies are reviewed and analyzed. Second, the theoretical sources of inflation (cost push and demand pull factors as well as factors due to financial liberalization) are identified. Third, a Markov switching model with time-varying transition probabilities is estimated for Morocco and Tunisia to provide important information concerning the mechanisms underlying inflation regime changes. The empirical results provide evidence that high inflation regimes are more persistent in Morocco than in Tunisia, and that inflation regime switches can be explained by external shocks in the 1970s, and by the sound fiscal and monetary policies in the mid-1980s. Finally the institutional and operational conditions for the success of an inflation-targeting framework are outlined.
    Keywords: Markov switching; Inflation; Inflation targeting, Monetary policy, Central Banks; Policy Designs and Consistency; Policy Coordination; Morocco; Tunisia
    JEL: E
    Date: 2005–07–18
  5. By: Efrem Castelnuovo (University of Padua); Paolo Surico (Bank of England & University of Bari)
    Abstract: This paper re-examines the empirical evidence on the price puzzle and proposes a new theoretical interpretation. Using structural VARs and two different identification strategies based on zero restrictions and sign restrictions, we find that the positive response of price to a monetary policy shock is historically limited to the sub-samples associated with a weak central bank response to inflation. These sub-samples correspond to the pre-Volcker period for the US and the pre-inflation targeting regime for the UK. Using a micro-founded DSGE sticky price model of the US economy, we then show that the structural VARs are capable of reproducing the price puzzle on artificial data only when monetary policy is passive and hence multiple equilibria arise. In contrast, the DSGE model never generates on impact a positive inflation response to a policy shock. The omission in the VARs of a variable capturing the high persistence of expected inflation under indeterminacy is found to account for the price puzzle observed on actual data.
    Keywords: Price puzzle, DSGE model, Taylor principle, Indeterminacy, SVARs
    JEL: E30 E52
    Date: 2005–07–20
  6. By: Andrea Monticini (University of Exeter); Giacomo Vaciago (Università Cattolica del Sacro Cuore)
    Abstract: This paper investigates the degree and nature of economic and monetary policy relations among the United States, the Euro area, and Great Britain. Using daily interest rates, we estimate the impact of monetary policy announcements of a Central Bank on its domestic market and in what measure those announcements are able to influence other financial markets. In particular, we analyse the effect of the FED, ECB, and BoE monetary policy announcements on European markets. We find that Europe’s interest rates have a relevant response to FED announcements.
    Keywords: Monetary policy; Term structure of interest rates.
    JEL: E4 E43 E52 F42
    Date: 2005–07–21
  7. By: Maarten Dossche (National Bank of Belgium, Research Department); Gerdie Everaert (Ghent University, Study Hive for Economic Research and Public Policy Analysis (SHERPPA))
    Abstract: Time series estimates of inflation persistence incur an upward bias if shifts in the inflation target of the central bank remain unaccounted for. Using a structural time series approach we measure different sorts of inflation persistence allowing for an unobserved timevarying inflation target. Unobserved components are identified using Kalman filtering and smoothing techniques. Posterior densities of the model parameters and the unobserved components are obtained in a Bayesian framework based on importance sampling. We find that inflation persistence, expressed by the halflife of a shock, can range from 1 quarter in case of a costpush shock to several years for a shock to longrun inflation expectations or the output gap.
    Keywords: Inflation persistence, inflation target, Kalman filter, Bayesian analysis.
    JEL: C11 C13 C22 C32 E31
    Date: 2005–06
  8. By: Xavier Ragot
    Abstract: This paper explores the relationship between the severity of credit constraints and long run inflation in a simple non Ricardian setting. It is shown that a low positive inflation can loosen credit constraints and that this effect yields a theory of the optimal long run inflation target with no assumption concerning nominal rigidities or expectation errors. Credit constraints introduce an un-priced negative effect of the real interest rate on investment. Because of this effect, the standard characterization of economic efficiency with the Golden Rule fails to apply. When fiscal policy is optimally designed, the first best allocation can be achieved thanks to a positive inflation rate and a proportional tax on consumption.
    Date: 2005
  9. By: Chantal Dupasquier (UN Economic Commission for Africa); Patrick N. Osakwe (UN Economic Commission for Africa); Shandre M. Thangavelu (Department of Economics, National University of Singapore)
    Abstract: There are plans by five West African countries to establish a second monetary zone in the sub-region by December 2009. In this paper we ask whether a monetary union is the appropriate exchange rate regime for the sub-region based on economic criteria. We address the issue using a rigorous theoretical framework that captures the crucial trade-off between the savings in transaction costs, resulting from a common currency, and the macroeconomic stabilization benefits of a flexible exchange rate regime. The main result is that a flexible exchange rate regime dominates a monetary union in the ECOWAS subregion.
    Keywords: Exchange rates; Regimes; Welfare; Transaction costs; West Africa
    JEL: E52 F33 F41
  10. By: Urmas Sepp; Andres Vesilind; Ülo Kaasik
    Abstract: The objective of model-building was an inflation model suitable for prognosis as well as for simulation. The model serves two purposes. First of all, it is a tool for analysing inflation. Secondly, it is part of the model of Estonian economy, which completes the adjustment loop of the macromodel. The theoretical background of the inflation model derives from four basic features of Estonian economy. Namely, Estonia is: a small and open economy, a transitional economy, economy under currency board arrangement and a market economy. When estimating the model, inflation was decomposed into a) underlying inflation which is a long-run process and b) inflation deviations from the equilibrium which are caused by the short-run impact of inflation factors. The underlying inflation, which reflects the convergence, is determined as a trend. The latter was specified as a time function, ARMA process, moving average and HP filter, whereas the best result was obtained with time function. According to modelling output the short run dynamics of the inflation are determined by three main factors - demand pressure reflected by the GDP gap, exchange rate of the US dollar (which is proxy for foreign prices), and administrative action for correcting regulated prices. The adequacy of the model has been tested on the basis of ex post and ex ante prognosis. The model provided acceptable results in the simulation of endogenous and exogenous shocks
  11. By: Iika Korhonen; Mare Randveer
    Abstract: This paper assesses the impacts of Economic and Monetary Union and the euro on developments within the EU and globally. The emphasis is on euro-11 countries and the eight most advanced accession candidates in Central and Eastern Europe. The single currency completes the project for a single market in Europe, and overall, clear efficiency gains for participating countries are expected. Low, stable interest rates should spur investment and the single currency should promote the formation of large, liquid capital markets, eventually transforming the structure of financial intermediation within the euro area. Although participating countries achieved a high degree of nominal convergence in the 1990s, this process now appears to have ended. Moreover, the conduct of a common monetary policy becomes more problematic with countries at different phases in the economic cycle. Accession candidates may use a variety of foreign exchange rate regimes before they join the EU, but ultimately their economic policies become a matter of common interest. Pressure to peg to the euro obviously increases as membership approaches, but there is compelling evidence that countries should hold back on pegging to the euro until they have achieved sufficient convergence to attain credibility for a policy of fixed exchange rates.
  12. By: Rasmus Pikkani
    Abstract: Modelling work on Estonian data indicates that external financing of the private sector has strong impact on domestic demand, which implies that valuable insights may be gained in this case from understanding the behavioural relationships in the monetary sector. The current paper provides a theoretical analysis of the monetary sector under a currency board regime and applies specification tests to Estonian data. As a final product, empirical equations for average lending rate, loans provided to the private sector and money demand are estimated. While estimations herein use monthly data, quarterly modifications of the model will be inserted into Eesti Pank\'s quarterly macromodel in the future.
  13. By: Raoul Lättemäe
    Abstract: The monetary system in Estonia is based on the currency board arrangement. The strong commitments and rule-based features of currency board imply that there is no active monetary policy in Estonia - all necessarily monetary adjustments are left to the market forces. Under fixed exchange rate and free capital mobility Estonian monetary conditions are therefore closely linked with monetary policy in Europe - in addition to the changes in Estonian risk-premium, interest rate developments in Europe can directly influence Estonian interest rates. Those monetary signals transmit widely into Estonian financial sector and ultimately into Estonian real sector through various channels. Some theoretical and intuitive aspects that can affect this process in Estonia have gained special attention in this paper.
  14. By: Rasmus Pikkani
    Abstract: Estonia has conducted effectively monetary policy according to currency board arrangement for nine years already. For this Estonia has traded off its freedom in active monetary policy operations for nominal anchoring economy through exchange rate. In this context Estonian own monetary policy actions could hardly make any difference and Estonian monetary conditions are heavily relying on decisions made by the issuer of anchor currency. At the same time, there are number of factors having influence on the degree of dependence on foreign monetary factors, most important of which is the openness of the economy to all balance of payments flows and the strength of the domestic banking sector. A mix of all possible factors and decision-making rules in the economy specifies directly the speed and the strength of transmission of foreign monetary signal into domestic economy. The aim of the current paper is to study transmission of ECB monetary policy decisions into Estonian economy. Additionally, absorption of unanticipated foreign and domestic monetary shocks are analysed. For this, rather small macroeconometric model with 11 behavioural equations is specified and estimated. Special emphasis is given on the formation of domestic interest rates and on the intermediation of domestic and foreign funds by domestic banking sector over shock periods. As a result, it is found that the transmission of ECB monetary policy actions over European inter-bank money market into Estonian economy is relatively fast. This is probably mostly due to high openness of the economy and to high price and wage flexibility in Estonia.
  15. By: Andreas Freytag
    Abstract: Currently, five Central and Eastern European (CEE) countries are negotiating about the membership in the European Union: Czech Republic, Estonia, Hungary, Poland and Slovak Republic. There is a broad consensus that they will eventually become members of the European Monetary Union. This requires careful analysis of the appropriate exchange rate regime prior to the accession. The exchange rate arrangement of the EU applicants plays an important - but not exclusive - role in their policy-mix. The history of transition economies as well as of other emerging markets illustrates that exchange rate policies as such are not a distinctive factor for the success and failure of monetary policy with respect to price stability. In this paper it is argued that this outcome has not emerged by chance. There is no naturally superior exchange rate regime that can be applied to all advanced countries in transition aiming at stability. By way of contrast, an exchange rate arrangement is part of the monetary regime, which itself is a component of the economic order. The latter consists of both politically chosen and spontaneously evolved institutions. This leads to the hypothesis that the choice of an exchange rate arrangement in CEE is constrained by this institutional setting. The theoretical considerations as well as empirical evidence indeed suggest that for guaranteeing stability, beside the legal monetary commitment (part of which being the exchange rate regime) the institutional framework in the country is decisive. If the latter matches the commitment, the credibility of a monetary regime is relatively high, obviously encouraging monetary stability. Therefore, the institutional setting in each country should be analysed extensively before an exchange rate arrangement is chosen.
  16. By: Lucio Vinhas de Souza
    Abstract: The aim of the paper is to empirically estimate whether the different monetary and exchange rate frameworks observed in the accession countries of Central and Eastern Europe and the Baltic States do yield different outcomes in terms of level and variance of a set of nominal and real variables. The author follows and extends the methodology developed by Kuttner and Posen (2001), who perform a combined analysis of the individual effects of exchange rate regimes, central bank independence and announced targets in nominal variables for a large set of developed and developing countries. They also estimate that a set-up combining a free float, an independent currency board and inflation targeting yields an outcome that mimics the price stabilisation advantages of a hard peg without its drawbacks in terms of extreme volatility. This sample of countries, not covered by the Kuttner and Posen study, supports their conclusions for both nominal and real variables, testing for both the individual and combined effects of the frameworks and indicating that a flexible exchange rate regime, coupled with CBI and DIT, would be Pareto-improving when compared to harder regimes.
  17. By: Urmas Sepp; Martti Randveer
    Abstract: The main aim of the paper is to examine different aspects of the sustainability of Estonian CBA. For this purpose the paper gives an overview of CBA in general, describes the rationale for the choice of the CBA in Estonia and uses model simulations to assess its sustainability. It also analyses whether the preconditions for the successful performance of the CBA are in place in Estonia and discusses the compatibility of Estonian CBA to the EMU and ERM 2. The analysis in the paper shows that CBA is a suitable exchange rate regime for Estonia. It is argued that the preconditions for a well-functioning CBA - resilient financial sector, flexible wage and employment system and prudent fiscal policy - are in place. The sustainability of the CBA is also supported by model simulations, which show that shocks hitting Estonian economy do not cause convergence of the Estonian economy from the long-run path. Based on the above-mentioned results, the paper concludes that the currency board arrangement is the best exchange rate regime for Estonia before the full participation in the third stage of the EMU.

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