nep-mon New Economics Papers
on Monetary Economics
Issue of 2006‒03‒18
fifteen papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Is the ECB so special? A qualitative and quantitative analysis By Fourçans, André; Vranceanu, Radu
  2. Discretionary Policy, Potential Output Uncertainty, and Optimal Learning By James Yetman
  3. The monetary transmission mechanism By Peter N. Ireland
  4. Inflation-Target Expectations and Optimal Monetary Policy By Sujit Kapadia
  5. Limited Asset Markets Participation, Monetary Policy and (Inverted) Keynesian Logic By Florin Bilbiie
  6. Optimal Monetary Policy under Hysteresis By Sujit Kapadia
  7. Pegged exchange rate regimes -- a trap? By Joshua Aizenman; Reuven Glick
  8. "Tinbergen Rules the Taylor Rule" By Thomas R. Michl
  9. Deus ex machina wanted: time inconsistency of time consistency solutions in monetary policy By Florin Bilbiie
  10. Monetary policy shocks, inventory dynamics, and price-setting behavior By Yongseung Jung; Tack Yun
  11. Interest rate rules, endogenous cycles, and chaotic dynamics in open economies By Marco Airaudo; Luis-Felipe Zanna
  12. Market-based measures of monetary policy expectations By Refet S. Gürkaynak; Brian Sack; Eric Swanson
  13. Testing for Rate-Dependence and Asymmetry in Inflation Uncertainty:Evidence from the G7 Economies By Olan T. Henry; Nilss Olekalns; Sandy Suardi
  14. The Impact of Monetary Union on EU-15 Sovereign Debt Yield Spreads By Marta Gómez-Puig
  15. The Utopia of Implementing Monetary Policy Cooperation through Domestic Institutions By Florin Bilbiie

  1. By: Fourçans, André (ESSEC Business School); Vranceanu, Radu (ESSEC Business School)
    Abstract: This paper analyses the European Central Bank (ECB) monetary policy over the period 1999-2005, both from a qualitative and a quantitative perspective, and compares it with the Federal Reserve Bank. The qualitative approach builds on information conveyed by various speeches of the central bank officers, mainly the President of the ECB, Jean-Claude Trichet. The quantitative analysis provides several estimates of what could have been the ECB and Fed interest rate rules. It also develops a VAR model of both the Euro zone and the US economy so as to analyze dynamic effects of an interest rate shock. Both the qualitative and quantitative analyses point to the difficult task of the ECB, which must build credibility while managing monetary policy under major uncertainty about the structure of the new Euro area. They also suggest that, apart from the ECB’s credibility building, differences between the observed behaviour of the ECB and the Fed over the time period under investigation should be accounted for by differences in the economic outlook of the two areas, rather than in the goals of the central bankers.
    Keywords: ECB and Fed; Euro area; Monetary policy; Taylor rule; VAR
    JEL: E52 E58 F01
    Date: 2006–03
  2. By: James Yetman (Reserve Bank of New Zealand)
    Abstract: We compare inflation targeting, price level targeting, and speed limit policies when a central bank sets monetary policy under discretion, and must learn about the level of potential output over time. We show that if the central bank learns optimally over time, a speed limit policy dominates [is dominated by] a price level target if society places a high [low] weight on inflation stability. Inefficient learning on the part of the central bank can radically change this conclusion. A speed limit policy is favoured if the central bank places too much weight on recent data when estimating potential output, while a price level target is favoured if the central bank places too much weight on historical data.
    JEL: E52
    Date: 2005–12
  3. By: Peter N. Ireland
    Abstract: The monetary transmission mechanism describes how policy-induced changes in the nominal money stock or the short-term nominal interest rate impact real variables such as aggregate output and employment. Specific channels of monetary transmission operate through the effects that monetary policy has on interest rates, exchange rates, equity and real estate prices, bank lending, and firm balance sheets. Recent research on the transmission mechanism seeks to understand how these channels work in the context of dynamic, stochastic, general equilibrium models.
    Keywords: Monetary policy
    Date: 2005
  4. By: Sujit Kapadia
    Abstract: In countries with credible inflation targeting, it seems plausible to suggest that instead of forming a rational expectation, some firms ("inflation-targeters") might simply expect future inflation to always equal its target. This paper analyses the implications of this for optimal monetary policy in a standard new-Keynesian model. Under discretion, we show that if shocks have any persistence, inflation is more stable, loss is reduced, and the optimal policy frontier is improved as the proportion of inflation-targeters increases. Considering the commitment case, we show that the benefits of commitment are diminished (stabilisation bias is reduced) in the presence of inflation-targeters, but overall loss is still reduced relative to the rational expectations benchmark for plausible parameter values and mild persistence in the shock. Taken together, these results formally illustrate how policies which encourage expectations anchoring may be beneficial for the economy.
    Keywords: Inflation Targeting, Monetary Policy, Expectations, Stabilisation Bias
    JEL: E52 E58 E31 E32 D84
    Date: 2005
  5. By: Florin Bilbiie (Nuffield College, Oxford and CEP, London School of Economics and EUI, Florence)
    Abstract: This paper incorporates limited asset markets participation in dynamic general equilibrium and develops a simple analytical framework for monetary policy analysis. Aggregate dynamics and stability properties of an otherwise standard business cycle model depend nonlinearly on the degree of asset market participation. While 'moderate' participation rates strengthen the role of monetary policy, low enough participation causes an inversion of results dictated by ('Keynesian') conventional wisdom. The slope of the 'IS' curve changes sign, the 'Taylor principle' is inverted, optimal welfare-maximizing monetary policy requires a passive policy rule and the effects and propagation of shocks are changed. The conditions for these results to hold are relatively mild compared to some existing empirical evidence. Our results may help explain the 'Great Inflation' and justify Fed behavior during that period.
    Keywords: limited asset markets participation, dynamic general equilibrium, aggregate demand, Taylor Principle, optimal monetary policy, real (in)determinacy
    JEL: E32 G11 E44 E31 E52 E58
    Date: 2006–03–10
  6. By: Sujit Kapadia
    Abstract: This paper analyses a new-Keynesian model incorporating hysteresis in output. Specifically, we assume that the natural rate of output sluggishly adjusts towards current output. We also assume that the natural rate has an upper bound and that, in addition to having standard objectives, the policymaker seeks to minimise deviations of actual output from this upper bound. We then solve for optimal monetary policy under a range of Phillips curve specifications. Our results suggest that despite increasing inflation temporarily, gradual demand expansions are usually desirable when the natural rate is low. Our model also offers a new explanation for inflation persistence.
    Keywords: Monetary Policy, Hysteresis, Unemployment, Inflation Persistence, Demand Expansions
    JEL: E52 E24 E31
    Date: 2005
  7. By: Joshua Aizenman; Reuven Glick
    Abstract: This paper studies the empirical and theoretical association between the duration of a pegged exchange rate and the cost experienced upon exiting the regime. We confirm empirically that exits from pegged exchange rate regimes during the past two decades have often been accompanied by crises, the cost of which increases with the duration of the peg before the crisis. We explain these observations in a framework in which the exchange rate peg is used as a commitment mechanism to achieve inflation stability, but multiple equilibria are possible. We show that there are ex ante large gains from choosing a more conservative not only in order to mitigate the inflation bias from the well-known time inconsistency problem, but also to steer the economy away from the high inflation equilibria. These gains, however, come at a cost in the form of the monetary authority's lesser responsiveness to output shocks. In these circumstances, using a pegged exchange rate as an anti-inflation commitment device can create a "trap" whereby the regime initially confers gains in anti-inflation credibility, but ultimately results in an exit occasioned by a big enough adverse real shock that creates large welfare losses to the economy. We also show that the more conservative is the regime in place and the larger is the cost of regime change, the longer will be the average spell of the fixed exchange rate regime, and the greater the output contraction at the time of a regime change.
    Keywords: Foreign exchange rates ; Monetary policy
    Date: 2005
  8. By: Thomas R. Michl
    Abstract: This paper elaborates a simple model of growth with a Taylor-like monetary policy rule that includes inflation targeting as a special case. When the inflation process originates in the product market, inflation targeting locks in the unemployment rate prevailing at the time the policy matures. Even though there is an apparent NAIRU and Phillips curve, this long-run position depends on initial conditions; in the presence of stochastic shocks, it would be path dependent. Even with an employment target in the Taylor Rule, the monetary authority will generally achieve a steady state that misses both its targets since there are multiple equilibria. With only one policy instrument, Tinbergen's Rule dictates that policy can only achieve one goal, which can take the form of a linear combination of the two targets.
    Date: 2006–03
  9. By: Florin Bilbiie (Nuffield College, Oxford and CEP, London School of Economics and EUI, Florence)
    Abstract: This paper argues that delegation (optimal institutional design) is not a solution to the dynamic inconcistency problem, and can even reinforce it. We show that 'optimal' delegation is not consistent with government's incentives. We solve for delegation schemes that are consistent with these incentives and find that they imply 'no delegation'. Introducing a cost of reappointing the central banker just postpones the problem, and can only solve it if the government is infinitely averse to changing central bank's contract. Our results hint to: (i) alternative explanations for good anti-inflationary performance; (ii) strengthening central bank independence and (iii) giving a more prominent role to Central Bank reputation building in fighting inflation.
    Date: 2006–03–10
  10. By: Yongseung Jung; Tack Yun
    Abstract: In this paper, we estimate a VAR model to present an empirical finding that an unexpected rise in the federal funds rate decreases the ratio of sales to stocks available for sales, while it increases finished goods inventories. In addition, dynamic responses of these variables reach their peaks several quarters after a monetary shock. In order to understand the observed relationship between monetary policy and finished goods inventories, we allow for the accumulation of finished goods inventories in an optimizing sticky price model, where prices are set in a staggered fashion. In our model, holding finished inventories helps firms to generate more sales at given their prices. We then show that the model can generate the observed relationship between monetary shocks and finished goods inventories. Furthermore, we find that allowing for inventory holdings leads to a Phillips curve equation, which makes the inflation rate depend on the expected present-value of future marginal cost as well as the current periodicals marginal cost and the expected rate of future inflation.
    Keywords: Business cycles ; Monetary policy ; Phillips curve
    Date: 2005
  11. By: Marco Airaudo; Luis-Felipe Zanna
    Abstract: In this paper we present an extensive analysis of the consequences for global equilibrium determinacy of implementing active interest rate rules (i.e. monetary rules where the nominal interest rate responds more than proportionally to changes in inflation) in flexible-price open economies. We show that conditions under which these rules generate aggregate instability by inducing cyclical and chaotic equilibrium dynamics depend on particular characteristics of open economies such as the degree of (trade) openness and the degree of exchange rate pass-through implied by the presence of non-traded distribution costs. For instance, we find that a forward-looking rule is more prone to induce endogenous cyclical and chaotic dynamics the more open the economy and the higher the degree of exchange rate pass-through. The existence of these dynamics and their dependence on the degree of openness are in general robust to different timings of the rule (forward-looking versus contemporaneous rules), to the use of alternative measures of inflation in the rule (CPI versus Core inflation), as well as to changes in the timing of real money balances in liquidity services ("cash-when-I-am-done" timing versus "cash-in-advance" timing).
    Keywords: Interest rates ; Equilibrium (Economics)
    Date: 2005
  12. By: Refet S. Gürkaynak; Brian Sack; Eric Swanson
    Abstract: A number of recent papers have used different financial market instruments to measure near-term expectations of the federal funds rate and the high-frequency changes in these instruments around FOMC announcements to measure monetary policy shocks. This paper evaluates the empirical success of a variety of financial market instruments in predicting the future path of monetary policy. All of the instruments we consider provide forecasts that are clearly superior to those of standard time series models at all of the horizons considered. Among financial market instruments, we find that federal funds futures dominate all the other securities in forecasting monetary policy at horizons out to six months. For longer horizons, the predictive power of many of the instruments we consider is very similar. In addition, we present evidence that monetary policy shocks computed using the current-month federal funds futures contract are influenced by changes in the timing of policy actions that do not influence the expected course of policy beyond a horizon of about six weeks. We propose an alternative shock measure that captures changes in market expectations of policy over slightly longer horizons.
    Keywords: Monetary policy ; Federal funds rate ; Financial markets
    Date: 2006
  13. By: Olan T. Henry; Nilss Olekalns; Sandy Suardi
    Abstract: The Friedman-Ball hypothesis implies a link between the inflation rate and inflation uncertainty. In this paper we employ a new test for the joint null hypothesis of no dependence effects and no asymmetry in the G7 inflation volatility. The results show that higher inflationrates operate additively via the conditional variance of inflation to induce greater inflation uncertainty in the U.S., U.K. and Canada. In addition, positive inflationary shocks are found to generate greater inflation uncertainty than negative shocks of a similar magnitude in the U.K. and Canada.
    Keywords: Friedman-Ball hypothesis, Asymmetry, Davies’ Problem
    JEL: E39
    Date: 2006
  14. By: Marta Gómez-Puig (Universitat de Barcelona)
    Abstract: With European Monetary Union (EMU), there was an increase in the adjusted spreads (corrected from the foreign exchange risk) of euro participating countries' sovereign securities over Germany and a decrease in those of non-euro countries. The objective of this paper is to study the reasons for this result, and in particular, whether the change in the price assigned by markets was due to domestic factors such as credit risk and/or market liquidity, or to international risk factors. The empirical evidence suggests that market size scale economies have increased since EMU for all European markets, so the effect of the various risk factors, even though it differs between euro and non-euro countries, is always dependent on the size of the market.
    Keywords: Monetary integration, sovereign securities markets, international and domestic credit risk, and market liquidity.
    JEL: E44 F36 G15
    Date: 2006
  15. By: Florin Bilbiie (Nuffield College, Oxford and CEP, London School of Economics and EUI, Florence)
    Abstract: In a wide variety of international macro models monetary policy cooperation is optimal, non-cooperative policies are inefficient, but optimal policies can be attained noncooperatively by optimal design of domestic institutions. We show that given endogenous instititional design, inefficiencies of noncooperation cannot and will not be eliminated. Credible contracts are introduced as the contracts that would be chosen by the governments based on their individual rationality. These will be inefficient when compared to the optimal ones. Implementation of the latter implicity embeds an assumption about cooperation at the delegation stage, which is inconsistent with the advocated non-cooperative nature of the solution. A general solution method for credible contracts and an example from international monetary policy cooperation are considered. Our results could explain some inefficiencies of existing delegation schemes and hint to a stronger coordinating role for supranational authorities in international policy coordination.
    Date: 2006–03–10

This nep-mon issue is ©2006 by Bernd Hayo. 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.