nep-mon New Economics Papers
on Monetary Economics
Issue of 2006‒04‒01
twenty-two papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Reaction Functions of Bank of England MPC Members: Insiders versus Outsiders By Christopher Spencer
  2. Does central bank transparancy reduce interes rates? By Geraats,Petra M.; Eijffinger,Sylvester C.W.; Cruijsen,Carin A.B. van der
  3. Does inflation targeting anchor long-run inflation expectations? evidence from long-term bond yields in the U.S., U.K., and Sweden By Refet S. Gürkaynak; Andrew T. Levin; Eric T. Swanson
  4. Inflation Forecast-Based-Rules and Indeterminacy: A Puzzle and a Resolution By Paul Levine; Peter McAdam; Joseph Pearlman
  5. Time-varying risk, interest rates, and exchange rates in general equilibrium By Fernando Alvarez; Andrew Atkeson; Patrick J. Kehoe
  6. The road to price stability By Athanasios Orphanides
  7. Ireland and Switzerland: the jagged edges of the Great Inflation By Edward Nelson
  8. "Exchange Rate Changes and Inflation in Post-Crisis Asian Economies: VAR Analysis of the Exchange Rate Pass-Through" By Takatoshi Ito; Kiyotaka Sato
  9. Central Bank Independence and the `Free Lunch Puzzle': A New Perspective By Ali al-Nowaihi; Paul Levine; Alex Mandilaras
  10. Monetary and fiscal theories of the price level: the irreconcilable differences By Bennett T. McCallum; Edward Nelson
  11. On Optimal Monetary and Fiscal Policy Interactions in Open Economies By Chiara Forlati
  12. The Dissent Voting Behaviour of Bank of England MPC Members By Christopher Spencer
  13. Openness and inflation volatility: Cross-country evidence By Christopher Bowdler; Adeel Malik
  14. Public Debt Maturity and Currency Crises By Paul Levine; Alexandros Mandilaras; Jun Wang
  15. Inflation: do expectations trump the gap? By Jeremy M. Piger; Robert H. Rasche
  16. Imperfect Common Knowledge in First Generation Models of Currency Crises By Gara Minguez-Afonso
  17. Openness, exchange rate regimes and the Phillips curve By Christopher Bowdler
  18. A Roadmap for the Asian Exchange Rate Mechanism By Gongpil Choi; Deok Ryong Yoon
  19. Interest Rate Rules and Macroeconomic Stabilization By Mark Weder
  20. Exchange-rate pass-through in the G-7 countries By Jane E. Ihrig; Mario Marazzi; Alexander D. Rothenberg
  21. Determinants of Capital Flows: A Cross-Country Analysis By Mukesh Ralhan
  22. Testing for Purchasing Power Parity Under a Target Zone Exchange Rate Regime By J. Isaac Miller

  1. By: Christopher Spencer (University of Surrey)
    Abstract: In 1997, the Bank of England was granted operational responsibility for setting interest rates to meet a Government inflation target of RPIX 2.5 percent. As part of the shift towards independence, operational decisions on monetary policy were delegated to a Monetary Policy Committee. Using voting data obtained from Minutes of Monetary Policy Committee Meetings, I show that as a group, internally appointed MPC members (insiders) on average prefer higher interest rates than external appointees (outsiders). Further, ordered logit analysis demonstrates that insiders and outsiders are motivated by different concerns when setting interest rates, with the interest rate setting behaviour of outsiders being less easy to predict than those of insiders.
    Keywords: Monetary Policy Committee, insiders, outsiders, voting
    Date: 2006–03
  2. By: Geraats,Petra M.; Eijffinger,Sylvester C.W.; Cruijsen,Carin A.B. van der (Tilburg University, Center for Economic Research)
    Abstract: Central banks have become increasingly transparent during the last decade. One of the main bene ts of transparency predicted by theoreticalmodels is that it enhances the credibility, reputation, and exibility of monetary policy, which suggests that increased transparency should result in lower nominal interest rates. This paper exploits a detailed transparency data set to investigate this relationship for eight major central banks. It appears that for all central banks, the level of interest rates is a¤ected by the degree of central bank transparency. In particular, the majority of the improvements in transparency are associated with signi cant e¤ects on interest rates, controlling for economic conditions. In most of these cases, interest rates are lower, often by around 50 basis points, although in some instances transparency appears to have had a detrimental e¤ect on interest rates
    Keywords: central bank transparency;monetary policy;interest rates
    JEL: E52 E58
    Date: 2006
  3. By: Refet S. Gürkaynak; Andrew T. Levin; Eric T. Swanson
    Abstract: We investigate the extent to which inflation targeting helps anchor long-run inflation expectations by comparing the behavior of daily bond yield data in the United Kingdom and Sweden--both inflation targeters--to that in the United States, a non-inflation-targeter. Using the difference between far-ahead forward rates on nominal and inflation-indexed bonds as a measure of compensation for expected inflation and inflation risk at long horizons, we examine how much, if at all, far-ahead forward inflation compensation moves in response to macroeconomic data releases and monetary policy announcements. In the U.S., we find that forward inflation compensation exhibits highly significant responses to economic news. In the U.K., we find a level of sensitivity similar to that in the U.S. prior to the Bank of England gaining independence in 1997, but a striking absence of such sensitivity since the central bank became independent. In Sweden, we find that forward inflation compensation has been insensitive to economic news over the whole period for which we have data. Our findings support the view that a well-known and credible inflation target helps to anchor the private sector's perceptions of the distribution of long-run inflation outcomes.
    Keywords: Inflation (Finance) ; Prices ; Monetary policy
    Date: 2006
  4. By: Paul Levine (University of Surrey); Peter McAdam (European Central Bank); Joseph Pearlman (London Metropolitan University)
    Abstract: We examine an interesting puzzle in monetary economics between what monetary authorities claim (namely to be forward-looking and pre-emptive) and the poor stabilization properties routinely reported for forecast-based rules. Our resolution is that central banks should be viewed as following ‘Calvo-type’ inflation-forecast-based (IFB) interest rate rules which depend on a discounted sum of current and future rates of inflation. Such rules might be regarded as both within the legal frameworks, and potentially mimicking central bankers’ practice. We find that Calvo-type IFB interest rate rules are first: less prone to indeterminacy than standard rules with a finite forward horizon. Second, for such rules in difference form the indeterminacy problem disappears altogether. Third, optimized forms have good stabilization properties as they become more forward-looking, a property that sharply contrasts that of standard IFB rules. Fourth, they appear potentially data coherent when incorporated into a well-known estimated DSGE model of the Euro-area.
    Keywords: Inflation-forecast-based interest rate rules, Calvo-type interest rate rules, indeterminacy
    JEL: E52 E37 E58
    Date: 2006–02
  5. By: Fernando Alvarez; Andrew Atkeson; Patrick J. Kehoe
    Abstract: Under mild assumptions, the data indicate that time-varying risk is the primary force driving nominal interest rate differentials on currency-denominated bonds. This finding is an immediate implication of the fact that exchange rates are roughly random walks. A general equilibrium monetary model with an endogenous source of risk variation—a variable degree of asset market segmentation—can produce key features of actual interest rates and exchange rates. In this model, the endogenous segmentation arises from a fixed cost for agents to exchange money for assets. As inflation varies, so does the benefit of asset market participation, and that changes the fraction of agents participating. These effects lead the risk premium to vary systematically with the level of inflation. This model produces variation in the risk premium even though the fundamental shocks have constant conditional variances.
    Date: 2006
  6. By: Athanasios Orphanides
    Abstract: Nearly a quarter-century after Paul Volcker's declaration of war on inflation on October 6, 1979, Alan Greenspan declared that the goal had been achieved. Drawing on the extensive historical record, I examine the views of Chairmen Volcker and Greenspan on some aspects of the evolving monetary policy debate and explore some of the distinguishing characteristics of the disinflation.
    Keywords: Anti-inflationary policies ; Monetary policy ; Greenspan, Alan ; Volcker, Paul A.
    Date: 2006
  7. By: Edward Nelson
    Abstract: Ireland and Switzerland both had rising inflation during the early 1970s, but their experiences diverged thereafter, so that they form a rare example of two countries whose inflation rates are poorly correlated with one another over the Great Inflation period. In addition, each of the two countries' records is anomalous in important respects relative to other economies' 1970s inflations. This paper proposes that the monetary policy neglect hypothesis can account for the anomalies, providing a consistent explanation for the Great Inflation across countries. Extensive archival evidence is considered from each country regarding the doctrines that guided 1970s policymaking. This evidence establishes that Switzerland*s better record is accounted for by the competition between monetary and nonmonetary views of inflation being resolved earlier and more decisively in favor of the monetary view. In Ireland, by contrast, nonmonetary views of inflation dominated policymaking throughout the 1970s.
    Keywords: Inflation (Finance) ; Ireland ; Switzerland
    Date: 2006
  8. By: Takatoshi Ito (Faculty of Economics, University of Tokyo); Kiyotaka Sato (Faculty of Economics, Yokohama National University)
    Abstract: The pass-through effects of exchange rate changes on the domestic prices in the East Asian countries are examined using a VAR analysis including several price indices and domestic macroeconomic variables as well as the exchange rate. Results from the VAR analysis show that (1) the degree of exchange rate pass-through to import prices was quite high in the crisis-hit countries; (2) the pass-through to CPI was generally low, with a notable exception of Indonesia: and (3) in Indonesia, both the impulse response of monetary policy variables to exchange rate shocks and that of CPI to monetary policy shocks are positive, large and statistically significant. Thus, Indonesia's accommodative monetary policy as well as the high degree of the CPI responsiveness to exchange rate changes was important factors that resulted in the spiraling effects of domestic price inflation and sharp nominal exchange rate depreciation in the post-crisis period.
    Date: 2006–03
  9. By: Ali al-Nowaihi (University of Leicester); Paul Levine (University of Surrey); Alex Mandilaras (University of Surrey)
    Abstract: A new perspective is provided on a puzzle that has emerged from the empirical lit- erature suggesting that government-independent central banks provide a `free lunch': lower in°ation is apparently achieved at no cost in terms of greater output variance. We assess the various explanations provided by the theoretical literature. After revis- iting the free lunch puzzle and con¯rming the empirical importance of open-economy effects, we develop a Rogoff-style delegation model that combines the latter with po- litical monetary cycle e®ects. We show that if all countries delegate monetary policy to government independent banks, as economies become more integrated then a low inflation, higher output variance trade-off re-emerges.
    Keywords: central bank independence, open economy, political uncertainty
    JEL: C72 E61
    Date: 2006–03
  10. By: Bennett T. McCallum; Edward Nelson
    Abstract: The fiscal theory of the price level (FTPL) has attracted much attention but disagreement remains concerning its defining characteristics. Some writers have emphasized implications regarding interest-rate pegging and determinacy of RE solutions, whereas others have stressed its capacity to generate equilibria in which price level trajectories mimic those of bonds and differ drastically from those of money supplies. We argue that the FTPL attained prominence precisely because it appeared to provide a theory whose implications differ greatly from conventional monetary analysis; accordingly we review monetarist writings to identify the primary distinctions. In addition, we review recent findings concerning learnability - and therefore plausibility - of competing RE equilibria. These indicate that when FTPL and monetarist equilibria differ, the latter are more plausible in the vast majority of cases. Under Ricardian assumptions, necessary for clear distinctions, theoretical analysis indicates that fiscal and monetary coordination is not necessary for macroeconomic stability.
    Keywords: Monetary policy ; Fiscal policy
    Date: 2006
  11. By: Chiara Forlati
    Abstract: This paper studies monetary and fiscal policy interactions in a two country model, where taxes on firms’ sales are optimally chosen and the monetary policy is set cooperatively. It turns out that in a two country setting non-cooperative fiscal policy makers have an incentive to change taxes on sales depending on shocks realizations in order to reduce output production. Therefore whether the fiscal policy is set cooperatively or not matters for optimal monetary policy decisions. Indeed, as already shown in the literature, the cooperative monetary policy maker implements the flexible price allocation only when special conditions on the value of the distortions underlying the economy are met. However, if non-cooperative fiscal policy makers set the taxes on firms’ sales depending on shocks realizations, these conditions cannot be satisfied; conversely, when fiscal policy is cooperative, these conditions are fulfilled. We conclude that whether implementing the flexible price allocation is optimal or not depends on the fiscal policy regime.
    Keywords: Monetary and Fiscal Policy, Policy Coordination
    JEL: E52 E58 E62 F42
    Date: 2004–07
  12. By: Christopher Spencer (University of Surrey)
    Abstract: I examine the propensity of Bank of England Monetary Policy Committee (BoEMPC) members to cast dissenting votes. In particular, I compare the type and frequency of dissenting votes cast by socalled insiders (members of the committee chosen from within the ranks of bank staff) and outsiders (committee members chosen from outside the ranks of bank staff). Significant differences in the dissent voting behaviour associated with these groups is evidenced. Outsiders are significantly more likely to dissent than insiders; however, whereas outsiders tend to dissent on the side of monetary ease, insiders do so on the side of monetary tightness. I also seek to rationalise why such differences might arise, and in particular, why BoEMPC members might be incentivised to dissent. Amongst other factors, the impact of career backgrounds on dissent voting is examined. Estimates from logit analysis suggest that the effect of career backgrounds is negligible.
    Keywords: Monetary Policy Committee, insiders, outsiders, dissent voting, career backgrounds, appointment procedures
    Date: 2006–03
  13. By: Christopher Bowdler (Nuffield College, Oxford University); Adeel Malik (Centre for the Study of African Economies, University of Oxford)
    Abstract: Recent decades have seen a considerable expansion of global trade and a simultaneous decline in inflation volatility. This paper investigates whether greater openness to trade helps achieve inflation stability. Using panel data for a sample of developing and industrial countries over the period 1961-2000, we document a negative and statistically significant effect of openness on inflation volatility. This relationship is estimated after controlling for the potential endogeneity of openness, and the average rate of inflation. We conduct a battery of robustness tests, showing in particular the robustness of our conclusions to controlling for the choice of exchange rate regime. A sub-sample analysis suggests that the relationship between openness and inflation volatility is more pronounced in developing and emerging market economies than in OECD countries. We also identify potential channels underpinning this relationship. In particular, we provide evidence that openness may promote inflation stability through dampening monetary and terms of trade shocks.
    Keywords: Openness, inflation, globalization, volatility, panel data.
    JEL: E31 F41 O57
    Date: 2005–03–15
  14. By: Paul Levine (University of Surrey); Alexandros Mandilaras (University of Surrey); Jun Wang (University of Surrey)
    Abstract: This paper provides a theoretical and empirical examination of the e®ect of debt structure on the probability of a currency crisis and the slope of the yield curve. We employ an open-economy version of the Barro-Gordon model with public debt, as in Benigno and Missale (2004) and generalize the analysis to allow for the case where the monetary authority can fully commit itself to an escape clause monetary rule. Comparing the latter with the discretionary outcomes motivates the asymmetric information game where the signalling e®ect of defending the parity competes with the fundamentals of the debt burden. Two key predictions of the model are tested with positive results.
    Keywords: Currency crisis, debt management
    JEL: F31
    Date: 2006–03
  15. By: Jeremy M. Piger; Robert H. Rasche
    Abstract: We measure the relative contribution of the deviation of real activity from its equilibrium (the gap), *supply shock* variables, and long-horizon inflation expectations for explaining the U.S. inflation rate in the post-war period. For alternative specifications for the inflation driving process and measures of inflation and the gap we reach a similar conclusion: the contribution of changes in long-horizon inflation expectations dominates that for the gap and supply shock variables. Put another way, variation in long-horizon inflation expectations explains the bulk of the movement in realized inflation. We also use our preferred specification for the inflation driving process to compute a history of model-based forecasts of the inflation rate. For both short and long horizons these forecasts are close to those observed from surveys.
    Keywords: Government securities ; Inflation (Finance)
    Date: 2006
  16. By: Gara Minguez-Afonso
    Abstract: First generation models assume that the level of reserves of a Central Bank in a fixed exchange rate regime is common knowledge among consummers, and therefore the timing of the attack on the currency, in an economy with persistent deficit, can be correctly anticipated. In these models, the collapse of the peg leads to no discrete change in the exchange rate. We relax the assumption of perfect information and introduce uncertainty about the willingness of a Central Bank to defend the peg. In this new setting, there is a unique equilibrium at which the fixed exchange is abandoned. In our model, the lack of common knowledge will lead to a discrete devaluation of the local currency once the peg finally collapses.
    Date: 2006–02
  17. By: Christopher Bowdler (Nuffield College, Oxford University)
    Abstract: A number of theoretical models predict that the slope of the Phillips curve increases with trade openness, but cross-country studies provide little evidence for such a correlation. We highlight two reasons for this finding. Firstly, the strength of the relationship may depend on the extent of exchange rate adjustment, which is a potential determinant of output and inflation dynamics in open economies, but previous studies have not made a distinction between fixed and floating exchange rate regimes. Secondly, existing estimates of the Phillips curve slope are based on data from the 1950s through the 1980s, and are therefore likely affected by price and wage controls, inflationary oil price hikes and the role played by fiscal policy in driving output and inflation (the underlying theory requires that monetary shocks dominate). We calculate new measures of the Phillips curve slope using data from 1981-98, a period during which these factors were arguably less important. Regressions based on the new measures indicate that the Phillips curve slope increases with trade openness amongst countries maintaining flexible and semi-flexible exchange rate regimes, but is unrelated to openness amongst countries maintaining fixed exchange rate regimes.
    Keywords: Openness, inflation, Phillips curve, sacrifice ratio, exchange rate regime.
    JEL: E31 E32 F41
    Date: 2005–10–01
  18. By: Gongpil Choi (Korea Institute of Finance); Deok Ryong Yoon (Korea Institute for Internation Economic Policy)
    Abstract: Given the increasing importance of capital market development for financial stability and multilateral cooperation for sustained growth, a country's choice of exchange rate regime is hardly trivial. Instead of relying on a series of individually managed floats, it would be better for each country to target its currency against a basket of other currencies. A still much better alternative would be to form a regional block, which would tie Asian currencies together and create a regional currency while allowing them to float against major currencies. Whether the type is an individual peg to a tailored basket or a multilateral peg to a common basket remains to be determined. Under any plausible scenario, some type of regional currency needs to be developed to promote an environment suitable for financial and monetary cooperation that is, in turn, conducive to capital market development. Since conditions in the region are increasingly favourable for an OCA (Optimal Currency Area), such cooperation would be mutually beneficial as well as globally desirable.
    Keywords: ACU, Asian Exchange rate,
    JEL: F33 F36
    Date: 2005–12
  19. By: Mark Weder (School of Economics, University of Adelaide)
    Abstract: High degrees of relative risk aversion induce indeterminacy in cash- in-advance economies. This paper finds that Taylor-style policies can pre-empt such sunspot equilibria. Specific policy recommendations depend on the fundamentals of the economy, i.e. the empirically true value of coecient of relative risk aversion.
    Keywords: Cash-in-Advance Economies, Taylor Rules, Sunspot Equilibria.
    JEL: E32 E52
    Date: 2006–01
  20. By: Jane E. Ihrig; Mario Marazzi; Alexander D. Rothenberg
    Abstract: This paper examines the current thinking on exchange-rate pass-through to both import prices and consumer prices and estimates the extent to which they have fallen in the G-7 countries since the late 1970s and 1980s. For import-price pass-through we find that all countries experience a numerical decline in the responsiveness of import prices to exchange-rate movements; for nearly half of these countries the decline between 1975-1989 and 1990-2004 is statistically significant. We estimate that while a 10 percent depreciation in the local currency would have increased import prices by nearly 7 percent on average across these countries in the late 1970s and 1980s, it would have only increased import prices by 4 percent in the last 15 years. The responsiveness of consumer prices to exchange-rate movements declines for nearly every country, with the decline being statistically significant for two countries. Specifically, while a 10 percent depreciation in the local currency would have increased consumer prices by almost 2 percent on average in the late 1970s and 1980s, it would have had a neutral effect on consumer prices in the last 15 years.
    Keywords: Foreign exchange rates ; Pricing ; Group of Seven countries
    Date: 2006
  21. By: Mukesh Ralhan (Department of Economics, University of Victoria)
    Abstract: There are two basic approaches to identifying the determinants of capital flows, viz. the traditional and the portfolio (or modern) approach. Although most econometric models have by now forsaken the traditional capital flow equations in favour of modelling financial linkages via arbitrage type interest rate parity relations, the importance of fundamentals in explaining particular capital flow developments cannot be denied (International Monetary Fund, 1992). This paper identifies the determinants of capital flows using the conventional approach, and is based on a cross-sectional study of eight countries, viz. Australia, India, Indonesia, Argentina, Brazil, Chile, Columbia and Mexico. Non-linear Seemingly Unrelated Regression estimation has been used to allow for cross-country effects in the error structure.
    Keywords: Capital Flows, Seemingly Unrelated Regressions (SUR) Model
    JEL: C3 F21
    Date: 2006–03–22
  22. By: J. Isaac Miller (Department of Economics, University of Missouri-Columbia)
    Abstract: We show that typical tests for purchasing power parity (PPP) using exchange rates governed by a target zone regime are inherently misspecified. Regardless of whether or not long-run PPP holds, the real exchange rate cannot be mean-reverting in the usual sense, since the nominal exchange rate is generated by a nonlinear transformation of a nonstationary economic fundamental. As an alternative, we propose basing the real exchange rate (and thus a PPP test) on conditional expectations of this unobservable fundamental. As an illustration, we test for long-run PPP between Denmark and the Euro area.
    Keywords: Target Zone Exchange Rates, Purchasing Power Parity, Nonlinear Transformations, Extended Kalman Filter
    JEL: C13 C22 C32
    Date: 2006–03–02

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