nep-mon New Economics Papers
on Monetary Economics
Issue of 2006‒05‒20
fourteen papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. The elusive welfare economics of price stability as a monetary policy objective - why New Keynesian central bankers should validate core inflation By Willem H. Buiter
  2. Do financial markets react to Bank of England communication? By Rachel Reeves; Michael Sawicki
  3. An Experimental Test of Taylor-Type Rules with Inexperienced Central Bankers By Jim Engle-Warnick; Nurlan Turdaliev
  4. Interaction of Fiscal Policies on the Euro Area: How Much Pressure on the ECB? By Luca Onorante
  5. Asymmetry of Shocks and Convergence in Selected Asean Countries: A Dynamic Analysis By Carlos Cortinhas
  6. The Case for an International Reserve Diversification Standard By Edwin M. Truman; Anna Wong
  7. The French Monetary Management in the Inter-war Period: the Dismissal of Open Market Procedure? By Nicolas Barbaroux
  8. Welfare-based monetary policy rules in an estimated DSGE model of the US economy By Michel Juillard; Philippe Karam; Douglas Laxton; Paolo Pesenti
  9. Political Instability and Inflation Volatility By Ari Aisen; Francisco José Veiga
  10. Financial integration, GDP correlation and the endogeneity of optimum currency areas By Stefano Schiavo
  11. Monetary Unions, External Shocks and Economic Performance: A Latin American Perspective By Sebastian Edwards
  12. Expenditure Switching vs. Real Exchange Rate Stabilization: Competing Objectives for Exchange Rate Policy By Michael B. Devereux; Charles Engel
  13. Learning, Inflation Cycles, and Depression By Ryo Horii; Yoshiyasu Ono
  14. Inflation Taxation and Welfare with Externalities and Leisure By Ho, W-M, Zeng, J.; Jie Zhang

  1. By: Willem H. Buiter (European Institute, London School of Economics, Houghton Street, London WC2A 2AE, United Kingdom.)
    Abstract: The paper studies the inflation rate associated with optimal monetary and fiscal policy in a number of standard dynamic stochastic general equilibrium models with nominal price rigidities. While the focus is on Calvo-style nominal price contracts with a range of indexation rules for constrained price setters, the conclusions have much wider validity - (1) Regardless of whether nominal price and/or wage rigidities are due to New-Keynesian, Old-Keynesian or sticky-information Phillips curves, optimal inflation policy requires the validation, that is, the full accommodation of core producer inflation by actual producer price inflation;(2) Optimal monetary policy implements Bailey-Friedman optimal quantity of money rule. No welfare-economics based argument for price stability as an objective (let alone the overriding objective) of monetary policy can be established for the class of DSGE models with nominal rigidities for which they have been proposed by Woodford and others.
    Keywords: Inflation targeting, Nominal price rigidities, New Keynesian macroeconomics, DSGE.
    JEL: E3 E4 E5 E6
    Date: 2006–04
  2. By: Rachel Reeves; Michael Sawicki
    Abstract: The effectiveness of a central bank's monetary policymaking is determined by the merit of its policy actions and their perceived credibility. Since the 1990s central banks have placed more emphasis on clear communications and transparency as additional levers to help achieve their goals. In this paper we examine how UK financial markets react to Bank of England communication. We might expect interest rate expectations, and potentially other asset prices, to react to official communication if such communication helps inform market participants. We find evidence that the publication of the Minutes of the Monetary Policy Committee meetings and the Inflation Report significantly affect near-term interest rate expectations, an effect particularly visible in intraday data. Speeches and parliamentary committee hearings appear to have less of an impact. Our results for the UK are arguably less strong than Kohn and Sack's (2003) findings for US Federal Reserve communication. Although differences in institutional frameworks between the UK and US mean communications are not directly comparable, our results might also reflect the different mandates of the FOMC and the MPC, with the Federal Reserve having greater freedom to interpret its objectives.
    Date: 2005
  3. By: Jim Engle-Warnick; Nurlan Turdaliev
    Abstract: We experimentally test whether a class of monetary policy decision rules describes decision making in a population of inexperienced central bankers. In our experiments, subjects repeatedly set the short-term interest rate for a computer economy with inflation as their target. A large majority of subjects learn to successfully control inflation. We find that Taylor-type rules fit the choice data well, and are instrumental in characterizing heterogeneity in decision making. Our experiment is the first to begin to organize data experimentally with an eye on monetary policy rules for this, one of the most widely watched and analyzed decisions in economics. <P>Nous avons mené une étude expérimentale dans le but de savoir si les règles de décision en matière de politique monétaire sont utilisées par les banquiers inexpérimentés au sein des banques centrales. Au cours de nos expériences, des sujets établissaient un taux d’intérêt à court terme dans un contexte d’économie informatisée dans le but de maîtriser l’inflation. Une grande majorité des sujets ont appris à maîtriser efficacement l’inflation. Nous sommes d’avis que les règles du type Taylor correspondent bien aux données liées aux choix et contribuent grandement à établir l’hétérogénéité du processus de décision. Notre étude est la première à recourir à l’organisation expérimentale des données sans, pour autant, perdre de vue les règles liées à la politique monétaire qui fait le plus l’objet de surveillance et d’analyse dans le domaine de l’économie.
    Keywords: experimental economics, monetary policy, repeated games, Taylor rule, économie expérimentale, jeux répétés, politique monétaire, règle Taylor
    JEL: C91 E42
    Date: 2006–05–01
  4. By: Luca Onorante
    Abstract: Since the Helsinki European Council of December 1999, a process of increased coordination of fiscal policies in the area of the Euro seems to be on its way. In this paper I examine this process from the point of view of the independence of the European Central Bank (ECB). The interaction of the governments and the ECB is addressed in a game theoretical framework. First, the conditions under which the national governments are able to put pressure on the ECB are made explicit. Then the main question is addressed: would a greater fiscal coordination reduce or increase the capacity of the monetary authority of targeting long run inflation? Formal and informal, discretional (positive) and rule-based (negative) coordination and their interactions are examined as possible solutions of the game. I conclude that the main point is not how much fiscal coordination is there, but the form it takes. It turns out that a mix of informal political coordination and binding rules is the one that best preserves the independence of the ECB. For negative coordination, it is shown that a simple change in the definition of "excessive deficit" can at the same time allow more stabilization of output after a shock and a better control of inflation by the ECB.
    Keywords: European Montary Union, European Central Bank, game theory, fiscal policy, monetary policy, policy coordination
    JEL: C7 E0 E3 E6 H5
    Date: 2006
  5. By: Carlos Cortinhas (Universidade do Minho - NIPE)
    Abstract: This paper aims to investigate whether structural shocks among ASEAN countries are becoming more symmetrical over time, thus indicating whether this region is becoming better prepared to introduce a common monetary policy. For that purpose a dynamic space-state model that complements the conventional Structural VAR models used in the existing literature was estimated by using the Kalman filter so that the evolution of the degree of shock symmetry and, therefore, the evolution in the degree of convergence could be identified over time, distinguishing between a country’s convergence with a regional partner and a more general trend of convergence with the rest of the world. The results showed that in the majority of cases there has been an increase in the degree of convergence of demand shocks in recent years. More importantly, it also showed an increase in divergence in supply shocks for most cases since the beginning of the 90’s even when taking into account the Asian Financial Crisis. This is especially true for the periphery countries suggesting that the Philippines and Thailand are not only not converging but actually diverging from the core group. These results have important implications for the prospects of the creation of a common monetary policy in the region.
    Keywords: Optimum currency areas; Monetary integration; Asymmetric shocks; Convergence; Asean.
    JEL: F15 F33 E42
    Date: 2006
  6. By: Edwin M. Truman (Institute for International Economics); Anna Wong (Institute for International Economics)
    Abstract: Rumors about the actual or potential currency diversification of countries’ foreign exchange holdings out of dollars are not a new phenomenon. This working paper argues that such concerns about reserve diversification are exaggerated. We present evidence that the extent of actual diversification has been modest to date. Nevertheless, the potential for reserve diversification adds volatility to foreign exchange markets and can catalyze abrupt exchange rate movements. We argue that policymakers acting in their own national interests can do something constructive to reduce the volatility introduced into foreign exchange and financial markets by rumors of large-scale international foreign exchange reserve diversification. We propose the voluntary adoption by major foreign exchange reserve holders in particular of an International Reserve Diversification Standard consisting of two elements: (1) routine disclosure of the currency composition of official foreign exchange holdings and (2) a commitment by each adherent to adjust gradually the actual currency composition of its reserves to any new benchmark for those holdings.
    Keywords: Foreign Exchange Reserves, Central Banks, International Investment and Long-Term Capital Movements, International Monetary Arrangements and Institutions
    JEL: F31 E58 F21 F33
    Date: 2006–05
  7. By: Nicolas Barbaroux (CREUSET (EA 3724) - Centre de Recherche Economique de l'Université de Saint Etienne - [Université Jean Monnet - Saint-Etienne])
    Abstract: The notion of rule surrounded the gold standard system. For instance, it is not seldom to present the gold standard system under the 1925 Keynesian expression as the rules of the game. However, it is nowadays quite crystal clear that gold standard system was not such a self regulating system in which automatic rules prevailed (Eichengreen 1996; Mouré 2001). At the same time, the behaviour of the French bank of issue in the inter-war period gave rise to polemic (Nurkse 1944). The paper proposes to examine the conduct of the French monetary management in the inter-war period by focusing on the context and behaviour adopted by Bank of France. Three points emerge from the study. (1) Before explaining the way franc was managed, we need to make a short recall on the state of the French economy after WWI and on the way the French banker system functioned. (2) The monetary management implemented by the Bank of France is both characterized by a discount rate policy and by the total rejection of open-market operations. This way of managing the franc can be explained by the French historical background and by the conflict between the two leading economists of the moment: C.Rist and P.Quesnay. (3) In order to illustrate the French monetary policymaking the paper will expose the peculiar policy implemented by Bank of France between 1928 and 1932. This way of behaving -based on the gold gathering at the expense of the other countries- was roughly criticized in Europe since France was accused of being responsible of the 1930's international depression.
    Keywords: Histoire économique; Politique monétaire; Banque de France
    Date: 2006–04–20
  8. By: Michel Juillard (CEPREMAP and University Paris 8, 2 rue de la Liberté, 93526 Saint-Denis Cedex 02, France.); Philippe Karam (International Monetary Fund (IMF), 700 19th Street NW, Washington, DC 20431, United States.); Douglas Laxton (International Monetary Fund (IMF), 700 19th Street NW, Washington, DC 20431, United States.); Paolo Pesenti (NBER, CEPR and Federal Reserve Bank of New York, 33 Liberty Street, New York, NY 10045, United States.)
    Abstract: We develop and estimate a stylized micro-founded model of the US economy. Next we compute the parameters of a simple interest rate policy rule that maximizes the unconditional mean of utility. We show that such a welfare-based rule lies close to the Taylor efficiency frontier. A counterfactual analysis assesses to what extent using such a rule as a guideline for monetary policy would have helped to avoid the inflationary swings of the 1970s and reduce the severity of boom and bust cycles. The paper also provides estimates of the welfare implications of business cycle variability and discusses their relevance.
    Keywords: Competition, Markups, Monetary Policy, Taylor Rule.
    JEL: C51 E31 E52
    Date: 2006–04
  9. By: Ari Aisen (International Monetary Fund); Francisco José Veiga (Universidade do Minho - NIPE)
    Abstract: The purpose of this paper is to empirically determine the causes of the worldwide diversity of inflation volatility. We show that higher degrees of political instability, ideological polarization and political fragmentation are associated with higher inflation volatility.
    Keywords: Inflation, volatility, political instability, institutions.
    JEL: E31 E63
    Date: 2006
  10. By: Stefano Schiavo (University of Trento)
    Abstract: The paper analyzes the relationship between trade, financial integration and business cycle synchronization in the euro area. The introduction of the euro has had a noticeable impact on European financial markets: we find evidence that capital markets integration exerts a positive effect on output correlation. This in turn has two major implications. First, it corroborates the hypothesis of the endogeneity of optimum currency areas, whereby after joining a monetary union countries fit better standard OCA criteria; second, it provides European policymakers with yet another reason to purse financial integration in the euro area (and in prospective members as well).
    Keywords: business cycle; EMU; endogeneity; integration; optimum currency areas;
    JEL: E32 E44 F36
    Date: 2005–09
  11. By: Sebastian Edwards
    Abstract: During the last few years there has been a renewed analysis in currency unions as a form of monetary arrangement. This new interest has been largely triggered by the Euro experience. Scholars and policy makers have asked about the optimal number of currencies in the world economy. They have analyzed whether different countries satisfy the traditional “optimal currency area” criteria. These include, among other: (a) the synchronization of the business cycle; (b) the degree of factor mobility; and (c) the extent of trade and financial integration. In this paper I analyze the desirability of a monetary union from a Latin American perspective. First, I review the existing literature on the subject. Second, I use a large data set to analyze the evidence on economic performance in currency union countries. I investigate these countries’ performance on four dimensions: (a) whether countries without a national currency have a lower occurrence of “sudden stop” episodes; (b) whether they have a lower occurrence of “current account reversal” episodes; (c) what is their ability to absorb international terms of trade shocks; and (d) what is their ability to absorb “sudden stops” and “current account reversals” shocks. I find that belonging to a currency union has not lower the probability of facing a sudden stop or a current account reversal. I also find that external shocks have been amplified in currency union countries. The degree of amplification is particularly large when compared to flexible exchange rate countries.
    JEL: F02 F43 O11
    Date: 2006–05
  12. By: Michael B. Devereux; Charles Engel
    Abstract: This paper develops a view of exchange rate policy as a trade-off between the desire to smooth fluctuations in real exchange rates so as to reduce distortions in consumption allocations, and the need to allow flexibility in the nominal exchange rate so as to facilitate terms of trade adjustment. We show that optimal nominal exchange rate volatility will reflect these competing objectives. The key determinants of how much the exchange rate should respond to shocks will depend on the extent and source of price stickiness, the elasticity of substitution between home and foreign goods, and the amount of home bias in production. Quantitatively, we find the optimal exchange rate volatility should be significantly less than would be inferred based solely on terms of trade considerations. Moreover, we find that the relationship between price stickiness and optimal exchange rate volatility may be non-monotonic.
    JEL: F3 F4 E5
    Date: 2006–05
  13. By: Ryo Horii (Graduate School of Economics, Osaka University); Yoshiyasu Ono (Institute of Social and Economic Research, Osaka University)
    Abstract: This paper constructs a model that describes inflation cycles and prolonged depression as generated by the learning behavior of households who face a random liquidity shock in which money is needed. Households update the subjective probability of the shock based on the observation and change their liquidity preference accordingly. In this setting, we first derive a stationary cycles under perfect price adjustment, which is characterized by periods of gradual inflation and sudden sporadic falls of the price level. When the nominal stickiness is introduced, the liquidity shock is followed by a period of depression in which unemployment exists and deflation occurs gradually. Depression is deep and prolonged when the economy has experienced a long period of boom before encountering a liquidity shock.
    Keywords: Bayesian Learning in Continuous Time, Hamilton-Jacobi-Bellman Equations, Markov Modulated Poisson Processes, Partial Delay Differential Equations, Liquidity Preference.
    JEL: D83 E41 E32
    Date: 2006–05
  14. By: Ho, W-M, Zeng, J.; Jie Zhang (MRG - School of Economics, The University of Queensland)
    Abstract: This paper examines how inflation taxation a ects resource allocation and welfare in a neoclassical growth model with leisure, a production externality and money in the utility function. Switching from consumption taxation to inflation taxation to finance government spending reduces real money balances relative to income, but increases consumption, labor, capital and output. The net welfare effect of this switch depends crucially on the strength of the externality and on the elasticity of intertemporal substitution: While it is always negative without the externality, it is likely to be positive with a strong externality and elastic intertemporal substitution.

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