nep-mon New Economics Papers
on Monetary Economics
Issue of 2006‒06‒03
27 papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Long-run money demand in the new EU Member States with exchange rate effects By Christian Dreger; Hans-Eggert Reimers; Barbara Roffia
  2. Should monetary policy attempt to reduce exchange rate volatility in New Zealand? By Dominick Stephens
  3. Other stabilisation objectives within an inflation targeting regime: Some stochastic simulation experiments By James Twaddle; David Hargreaves; Tim Hampton
  4. What Explains the Varying Monetary Response to Technology SHocks in G7-Countries By Athena T. Theodorou; Neville R. Francis; Michael T. Owyang
  5. Implications of monetary union for catching-up member states By Marcelo Sánchez
  6. The Price Puzzle: Fact or Artifact? By Efrem Castelnuovo; Paolo Surico
  7. Global Financial Transmission of Monetary Policy Shocks By Michael Ehrmann; Marcel Fratzscher
  9. The Walsh Contracts for Central Bankers Are Optimal After All! By Georgios E. Chortareas; Stephen M. Miller
  10. Monetary Policy and Asset Prices : What Role for Central Banks in New EU Member States? By Frait, Jan; Komarek, Lubos
  11. Assessing predetermined expectations in the standard sticky-price model - a Bayesian approach By Peter Welz
  12. Foreign reserves management subject to a policy objective By Joachim Coche; Matti Koivu; Ken Nyholm; Vesa Poikonen
  13. Cyclical inflation divergence and different labor market institutions in the EMU By Alessia Campolmi; Ester Faia
  16. Modelling currency in circulation in Malawi By kisu simwaka
  17. Dollarization Traps By John Duffy; Maxim Nikitin
  18. Which news moves the euro area bond market? By Magnus Andersson; Lars Jul Hansen; Szabolcs Sebestyén
  19. Exchange-rate policies and trade in the MENA countries By Amina Lahrèche-Révil; Juliette Milgram
  20. The Euro-changeoverand Euro-inflation: Evidence from Eurostat's HICP By Marco G. Ercolani and Jayasri Dutta
  21. The Challenges of EMU Accession Faced by Catching-up Countries: A Slovak Republic Case Study By Anne-Marie Brook
  22. Modelling inflation in the Euro Area By Eilev S. Jansen
  23. Inflation and Nominal Rigidities in Spanish Regions: The Ball and Mankiw Approach By Carlos Usabiaga; María Ángeles Caraballo
  24. Before and After the Black Death: Money, Prices, and Wages in Fourteenth-Century England By John H. A. Munro
  25. Firm-specific capital, nominal rigidities, and the Taylor principle By Tommy Sveen; Lutz Weinke
  26. Profits and Speculation in Intra-Day Foreign Exchange Trading By Mende, Alexander; Menkhoff, Lukas
  27. A market microstructure analysis of foreign exchange intervention By Paolo Vitale

  1. By: Christian Dreger (German Institute for Economic Research (DIW) Berlin, 14191 Berlin, Germany.); Hans-Eggert Reimers (Hochschule Wismar, University of Technology, Business and Design, PF 1210, 23952 Wismar, Germany.); Barbara Roffia (Directorate General Economics, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: Generally speaking, money demand models represent a natural benchmark against which monetary developments can be assessed. In particular, the existence of a well-specified and stable relationship between money and prices can be perceived as a prerequisite for the use of monetary aggregates in the conduct of monetary policy. In this study a money demand analysis in the new Member States of the European Union (EU) is conducted using panel cointegration methods. A well-behaved long-run money demand relationship can be identified only if the exchange rate as part of the opportunity cost is included. In the long-run cointegrating vector the income elasticity exceeds unity. Moreover, over the whole sample period the exchange rates vis-à-vis the US dollar turn out to be significant and a more appropriate variable in the money demand than the euro exchange rate. The present analysis is of importance for the new EU Member States as they are expected to join in the future years the euro area, where money is deemed to be highly relevant - within the two-pillar monetary strategy of the European Central Bank (ECB) - in order to detect risks to price stability over the medium term.
    Keywords: Money demand, new EU Member States, exchange rate, panel cointegration.
    JEL: C23 E41 E52
    Date: 2006–05
  2. By: Dominick Stephens (Reserve Bank of New Zealand)
    Abstract: Previous research has suggested that including exchange rate stabilisation within the goals of monetary policy significantly increases the volatility of inflation, output and interest rates, and that the benefits of exchange rate stabilisation therefore do not justify the costs. The current paper tests whether this finding is robust when various alternative models of exchange rate determination are considered. The analysis is carried out in the context of optimal full-information monetary policy rules in a New Keynesian model that is calibrated to represent the New Zealand economy. For the models that feature rational expectations, we support the conclusion that seeking to avoid exchange rate volatility would have more costs than benefits. Indeed, a major cost of including the exchange rate within the goals of monetary policy is that inflation expectations become less anchored to the inflation target, meaning that larger movements in nominal interest rates are required to control inflation.
    JEL: E52 E58
    Date: 2006–05
  3. By: James Twaddle; David Hargreaves; Tim Hampton (Reserve Bank of New Zealand)
    Abstract: We use the Reserve Bank of New Zealand's macroeconomic model (FPS) to look at the feasibility of using monetary policy to reduce variability in output, the exchange rate and interest rates while maintaining an inflation target. Our experiment suggests that policy could be altered to increase the stability of interest rates, the exchange rate, inflation, or output, relative to the base case reaction function in FPS, but such a policy would incur some cost in terms of the variability of the other variables. In particular, we find that greater exchange rate stability would have relatively large costs in terms of the stability of all three other variables, primarily because monetary policy that leans too dramatically against exchange rate disturbances can create significant real economy variability. Relative to West (2003), we find larger costs of operating monetary policy to achieve exchange rate stabilisation. We attribute this finding to the relatively inertial inflation expectation process in FPS.
    JEL: E52 E58 F47
    Date: 2006–05
  4. By: Athena T. Theodorou; Neville R. Francis; Michael T. Owyang
    Abstract: Structural vector autoregressions (SVARs) have become a standard tool used to determine the roles of monetary policy shocks in generating cyclical fluctuations in the United States. Using both long- and short-run identifying restrictions, various authors have explored the empirical response of the economy to exogenous monetary innovations. While the majority of the studies of monetary policy have focused on the effect of exogenous money growth or interest rate shocks, recent research has begun to investigate the effect of endogenous monetary policy -- that is, the central bank's reaction to non-monetary shocks. One exogenous shock that many economists believe contributes to the business cycle fluctuations that feed into the Taylor rule is the technology shock. In an effort to identify the empirical effects of technology shocks, Gali (1999) estimated two models: a bivariate model of productivity and hours and a five-variable model adding money, inflation, and interest rates. His identification estimates a decomposition of productivity and hours into innovations to technology and non-technology components by assuming that only the former can have long-run effects on labor productivity. Empirical identification of the technology shock was a key first step in developing a unified reduced-form framework with which to examine the role that monetary policy has played in smoothing economic fluctuations. Along these lines, Gali, Lopez-Salido, and Valles (2003 -- henceforth GLV) examined the endogenous response of monetary policy to identified technology shocks in the United States. GLV examine a four-variable structural VAR for the United States with labor productivity, labor hours, the real interest rate, and inflation. Using the Gali (1999) identification, they find that during the Volcker-Greenspan (VG) era the Fed's response to the technology shock is to raise the nominal interest rate, while during the Martin-Burns-Miller (MBM) era the Fed lowers the nominal rate. Moreover, they find that the inflation and hours responses in the two periods differ in sign. Our goal is to expand the scope of GLV to an international context to determine whether the effect of technology shocks is consistent across the major industrialized countries. In particular, we are interested in how the different central banks respond to technology shocks. We investigate the possibility that technology shocks in different countries produce fundamentally different inflation and employment responses and to what extent those effects alter the monetary response. Using a theoretical model adapted from King and Wolman (1996), we find that the empirical responses can be matched with theoretical responses. Differences in these theoretical responses can be attributed to alternative policy rules and changes in the cost of capital adjustment. Further tests verify that these country characteristics could, indeed, have some explanatory power. Our results are by no means conclusive; however, they do suggest a number of theoretically consistent similarities across countries in each subgroup. While we believe more investigation into these cross-country comparisons is warranted, the initial indication is that the manner in which monetary policy is conducted and the degree of rigidity in capital markets may be determining factors in a country's response to technology shocks. Gali, Jordi (1999). "Technology, Employment, and the Business Cycle: Do Technology Shocks Explain Aggregate Fluctuations?" American Economic Review, March 1999, 89(1), pp. 249-271. Gali, Jordi; Lopez-Salido, J. David; and Valles, Javier (2003). "Technology Shocks and Monetary Policy: Assessing the Fed's Performance." Journal of Monetary Economics, May 2003, 50(4), pp. 723-743. King, Robert G., and Wolman, Alexander L. (1996). "Inflation Targetting in a St. Louis Model of the 21st Century." Federal Reserve Bank of St. Louis Review, May/June 1996, 78(3), pp. 83-107.
    Keywords: Technology, Productivity, Monetary Policy, Taylor Rule, Capital Adjustment Costs
    JEL: C32 E2 E52
    Date: 2004–08–11
  5. By: Marcelo Sánchez (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: We examine the implications of monetary union for macroeconomic stabilisation in catching up participating countries. We allow member states’supply conditions to differ inside the union, especially with regard to sectoral characteristics. Sectoral productivity shocks on balance hamper the stabilisation properties of a currency union. In the face of aggregate supply disturbances, the stabilisation costs of renouncing monetary autonomy diminish with a flatter output-inflation tradeoff and - barring idiosyncratic shocks - with a larger reference country size, more homogeneous supply slopes and a higher preference for price stability.
    Keywords: Monetary union, Balassa-Samuelson effect, Exchange rates, Price stability.
    JEL: E52 E58 F33 F40
    Date: 2006–05
  6. By: Efrem Castelnuovo (University of Padua); Paolo Surico (University of Bari and Bank of England)
    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 New Keynesian monetary policy model for 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, this 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.
    JEL: E30 E52
    Date: 2006–05
  7. By: Michael Ehrmann; Marcel Fratzscher
    Abstract: The paper shows that US monetary policy has been an important determinant of global equity markets. Analysing 50 equity markets worldwide, we find that returns fall on average around 3.8% in response to a 100 basis point tightening of US monetary policy, ranging from a zero response in some to a reaction of 10% or more in other countries, as well as significant cross-sector heterogeneity. Distinguishing different transmission channels, we find that in particular the transmission via US and foreign short-term interest rates and the exchange rate play an important role. As to the determinants of the strength of transmission to individual countries, we test the relevance of their macroeconomic policies and the degree of real and financial integration, thus linking the strength of asset price transmission to underlying trade and asset holdings, and find that in particular the degree of global integration of countries – and not a country’s bilateral integration with the United States – is a key determinant for the transmission process.
    Keywords: global financial markets, monetary policy, transmission, financial integration, United States, advanced economies, emerging market economies
    JEL: F30 F36 G15
    Date: 2006
  8. By: Daniel Daianu; Ella Kallai;
    Abstract: Disinflation has been pursued successfully in Romania in recent years. Inflation came down from over 40 per cent in 2001 to 14 per cent in 2003 and is expected to be cca 9.5 per cent in 2004. By 2007 it should come down to around 3%. The benefits of a lowinflation environment are unquestionable, as price stability is the ultimate objective of monetary policy. In addition, low inflation is a pre-condition for EU accession. There only remains the other critical question, namely, what is the proper strategy to achieve the ultimate objective. Different central banks have adopted strategies which place different emphasize on the various pieces of information, or elements of their decision-making process or different aspects of their communication policies. Inflation targeting (IT) is one of those strategies.
    Keywords: inflation-targeting, transition economy, EU accession
    JEL: E52 F41 P44
    Date: 2005–11–01
  9. By: Georgios E. Chortareas (University of Essex); Stephen M. Miller (University of Connecticut and University of Nevada, Las Vegas)
    Abstract: Candel-Sánchez and Campoy-Miñarro (2004) argue that the Walsh linear inflation contract does not prove optimal when the government concerns itself about the cost of the central bank contract. This result relies on the authors. assumption that the participation constraint does not represent an effective constraint on the central banker's decision. Instead, the government can "impose" or "force" the contract on the central banker, even though the contract violates the participation constraint. We argue that such a contract does not make sense. The government can impose it, but it does not affect the central banker's incentives. The policy outcomes do not match those of commitment. Then we show that the Walsh linear inflation contract does produce the optimal outcome, even when the government cares about the cost of the contract.
    Keywords: central banks, contracts, Walsh
    JEL: E42 E52 E58
    Date: 2006–04
  10. By: Frait, Jan (Czech National Bank, Prague); Komarek, Lubos (Czech National Bank, Prague and Prague School of Economics)
    Abstract: The paper deals with the relationship between monetary policy and asset prices. Besides surveying the general discussion, it attempts to extend it to recent developments in the new Member States of the EU (NMS), namely the Czech Republic, Hungary, Poland and Slovakia (the EU4). After a brief description of the current macroeconomic situation in the NMS, the appropriate reaction of monetary policy to asset price bubbles is dealt with and the main pros and cons associated with this reaction are summarised. Afterwards, the risks of asset market bubbles in the EU4 countries are evaluated. Since the capital markets are still underdeveloped and the real estate price boom seems to be a natural reaction to the initial undervaluation, the risks are viewed as rather small. The conclusion is thus that it is crucial for central banks in mature economies as well as in the NMS to conduct their monetary policies as well as their supervisory and regulatory roles in a way that does not promote the build-up of asset market bubbles. In exceptional times, central banks of small open economies must be ready to use monetary policy steps as a kind of insurance against the adverse effects of potential asset market bubbles.
    Keywords: Monetary Policy ; Asset Markets ; Central Banking ; New EU Member States
    JEL: E52 E58 G12
    Date: 2006
  11. By: Peter Welz (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper analyses the empirical performance of a New Keynesian sticky-price model with delayed effects of monetary impulses on inflation and output for the German pre-EMU economy. The model is augmented with rule-of-thumb behaviour in consumption and price setting. Using recently developed Bayesian estimation techniques, endogenous persistence is found to play a dominant role in consumption whereas forward-looking behaviour is greater for inflation. The model’s dynamics following a monetary shock and a preference shock are comparable to those of an identified VAR model.
    Keywords: DSGE-Model, identified VAR, predetermined expectations, Bayesian estimation.
    JEL: E43 E52 C51
    Date: 2006–05
  12. By: Joachim Coche (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Matti Koivu (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Ken Nyholm (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Vesa Poikonen (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper studies the implications of introducing an explicit policy objective to the management of foreign reserves at a central bank. A dynamic model is developed which links together reserves management and the exchange rate by foreign exchange interventions. The exchange rate is modelled as a mean-reverting autoregressive process incorporating a linear response to interventions. The premise is that it is the objective of the central bank to prevent undervaluation of its currency. Given this objective, the model is formulated in a one- and a multi-period setting and solved to find the optimal asset allocation. The results show that asset allocation can significantly help in achieving the desired policy objective.
    Keywords: Foreign reserves management, foreign exchange intervention, exchange rate modelling, optimal asset allocation.
    JEL: G11 F31
    Date: 2006–05
  13. By: Alessia Campolmi (Department of Economics, Universitat Pompeu Fabra, Ramon Trias Fargas 25-27, 08005, Barcelona, Spain.); Ester Faia (Department of Economics, Universitat Pompeu Fabra, Ramon Trias Fargas 25-27, 08005, Barcelona, Spain.)
    Abstract: This paper relates the size of the cyclical inflation differentials, currently observed for euro area countries, to the differences in labor market institutions across the same set of countries. It does that by using a DSGE model for a currency area with sticky prices and labor market frictions. We show that differences in labor market institutions account well for cyclical inflation differentials. The proposed mechanism is a supply side one in which differences in labor market institutions generate different dynamics in real wages and consequently in marginal costs and inflations. We test this mechanism in the data and find that the model replicates well the empirical facts.
    Keywords: Cyclical inflation divergence, labor market institutions, EMU.
    JEL: E52 E24
    Date: 2006–05
  14. By: Peter W Jones (Economic Development Institute)
    Abstract: We are more than a little bit surprised at the seeming reticence of the central bank's governor, Mr Derrick Latibeaudiere, to the idea of a monetary policy committee, being proposed by the private sector. The suggestion forms part of the package of proposals of the so-called Partners for Progress group, who have been seeking a framework for sustained growth in the Jamaican economy. This group has not only been talking. They have been prepared to back the strength of their convictions with substantial action. Indeed, they have been attempting to convince domestic financial institutions to convert high-cost Jamaican dollar loans to other forms of debt instruments that would ease the short-term interest burden and provide an opportunity for the Government to begin to seriously address the public sector deficit. Reasonably, those who are putting together this programme want to be assured that the administration establishes the environment in which concessions made by the private sector translate into real macro- economic value. One way to help ensure this is through transparency in policy formulation. A monetary policy committee is but one instrument, so far as the partners are concerned, to add value to the idea. Mr Latibeaudiere's reservation, it seems, rests on his argument that such committees usually operate in the context of independent central banks, which are removed from direct political control and which have control over monetary policy formulation. Perhaps! Indeed, this newspaper supports the idea of an independent central bank, whose principal officers are removed from the whim of political control and have the authority, under law, to limit lending to the government. This is an ideal for which we must strive - the sooner the better. However, we do not see an independent central bank and a monetary policy committee in the context of the existing structure of the Bank of Jamaica as mutually exclusive. The truth be told, senior officials who speak of the operation of the BOJ often hail its relative independence and the creative tension which usually exists between the central bank and the finance ministry. In fact, there is a healthy bit of chest-thumping at Nethersole Place. In any event, we would have thought that in the absence of its independence, a monetary policy committee, involving key economic players, would be a development welcomed by the central bank and its top managers. Such a committee would, on the face of it, provide the central bank with some level of insulation from political controllers or politicised and over-reaching bureaucrats at the finance ministry. Indeed, the timely publication of the minutes of the meeting on which the decisions of the committee were made would provide powerful moral authority against a Government that was intent on running roughshod over the wishes of the committee. We, for instance, would like to know the thinking, and technical arguments, behind the decision in the first quarter of last year to push interest rates well beyond 30 per cent to defend the Jamaican dollar. It would be interesting to know what was the stance of the professional central bankers on offering investors such high levels of real return on their money. The fundamental argument is that better decisions are likely to be made in an environment of openness and transparency and on the basis of access to other than a narrow slate of views. Moreover, the kind of committee which is being proposed could well be a fundamental first step to an independent central bank.
    Keywords: Central Bank,Jamaica,Jamaica Central bank,Central Bank Jamaica
    JEL: O P
    Date: 2004–11–03
  15. By: Juan de Dios Tena; A. R. Tremayne
    Abstract: This paper studies the transmission of monetary policy to industrial output in the UK. In order to capture asymmetries, a system of threshold equations is considered. However, unlike previous research, endogenous threshold parameters are allowed to be different for each equation. This approach is consistent with economic intuition and is shown to be of tangible importance after suitable econometric evaluation. Results show evidence of cross-sectional differences across industries and asymmetries in some sectors. These findings contribute to the debate about the importance of alternative economic theories to explain these asymmetries and support the use of a sectorally disaggregated approach to the analysis of monetary transmission.
    Date: 2006–05
  16. By: kisu simwaka (Reserve Bank of Malawi)
    Abstract: The purpose of this study is therefore twofold. First, to establish the claim that currency in circulation has been rising. Second, to empirically quantify and give a full account of the reasons determining the dynamics and volatility of currency in circulation. Using annual data for the 1965-2004 period, this paper confirms that currency in circulation as a proportion of money stock has increased. From the initial estimation results, the paper establishes strong positive effects of inflation rate, underground economy activities, financial deepening on the CU/M2 ratio, and significant negative effect of interest rates on this ratio. The other highlight result from this study is the positive and significant association between small-scale agriculture produce and CU/M2 ratio. Using annual data, among other things, this study confirms findings from other studies that cash preference is a function of real interest rates. However, one striking finding here is the importance small-scale agriculture as a determinant of currency in circulation. This reflects the agriculture-dependent nature of the economy. Better performance of this sector injects cash in the economy and because of the lack of banking facilities in rural areas, most of the injected cash remains in circulation. The message from empirical results using monthly data is similar, with interest rates, financial deepening, tobacco selling season dummy and inflation rate playing significant roles in determining movements in currency in circulation. As expected, technological innovations in the banking system or payment systems, particularly cash dispensers (ATMs) have a significant impact on the overall level of currency in circulation, whereas no major impact seems to come from the MALSWITCH smart card, however, initial indications reveal its negative effect on the CU/M2 ratio. Policy implications from these results are many. First, of late the Bank has reduced the bank rate and as is normally the case, all other interest rates were similarly adjusted. While the policy move has or is on course to achieve its intended goals, it has other side repercussions such as deposit taking capabilities by commercial banks. Currently, the minimum saving rate for the four major commercial banks averages around 7.5%. This against the current monthly inflation rate of 12.2 (for October 2004) leaves real savings rate of around –4.7% which rationally discourages savings mobilisation and consequent reduction in the availability of loanable funds for productive investment and economic growth. The public is most likely to hold their assets in cash rather than bank deposit form since the opportunity cost of doing so is essentially zero. However, due to high inflation in the past, savers in Malawi were used to high interest rates so that current demand deposits are considered as unattractive and non-worthwhile form of holding money. It is time the public get used to lower interest rates as in other countries and on the belief that causality direction is from interest rates to inflation, the reduction in the bank rate could eventually lead to a drop in inflation and, therefore, an increase in the real interest rate. Second, if the Bank intends to focus on reducing the CU/M2 ratio, intensification of smart card use and publicity could play an important role. The smart card is a direct alternative of cash as a means of payment so that its widespread use can directly reduce currency in circulation. This, as is the case in other countries could also reduce the positive impact of ATM transactions on the overall level of currency in circulation. Third, the overall civic education on the use of banking facilities, in rural areas as well as to small-scale business men (vendors) is important for increased deposit taking and, therefore, the reduction in the amount of currency in circulation.
    Keywords: Currency in circulation, Seasonality, Money demand model
    JEL: E
    Date: 2005–04–13
  17. By: John Duffy; Maxim Nikitin
    Abstract: We study unofficial dollarization, i.e., the use of foreign money alongside the domestic currency, in an environment where spatial separation and limited communication create a role for currency and banks arise endogenously to provide insurance against liquidity preference shocks. Unofficial dollarization has been a common phenomenon in emerging market economies during high inflations. However, successful disinflations have not necessarily been followed by dedollarization. In particular, Argentina, Bolivia, Peru, Russia, and Ukraine remained highly dollarized long after the inflation rate was reduced to single digits. We refer to this phenomenon as a "dollarization hysteresis paradox." It has also been observed in these economies that higher inflation has a negative impact on output and financial intermediation, that dollarization and capital flight adversely affect capital accumulation, and that post-stabilization output growth is impeded by dollarization. This paper presents an overlapping-generations model with random relocation of agents between two locations that explains the dollarization hysteresis paradox and several other stylized facts. The key link between inflation, dollarization, and capital accumulation in the model is that high inflation undermines financial intermediation, which leads to the adoption of a less efficient production technology. As a result, it is possible for economies to become stuck in low output "development traps," where the marginal product of capital is the same as the return from holding dollars. In such an environment, we show how dollarization can preclude further capital accumulation, even in the presence of successful inflation stabilization policies. We complement previous work on dollarization by allowing the "hard" currency to compete with domestic capital as a store of value instead of focusing on either currency substitution (where the use of a "hard" currency replaces the domestic currency as a medium of exchange) or official dollarization (where the domestic currency is abandoned altogether and replaced with the US dollar). We assume that in the first period of life, agents inelastically supply labor and receive the competitive market wage. A given fraction of agents will be relocated to another location, and they can take only domestic currency with them. Competitive banks arise endogenously in this environment to insure against liquidity (relocation) shock. They issue demand deposits and hold portfolios of domestic currency and the capital market assets, which may include productive capital and dollars. There are two different productive technologies that banks can invest in. The first one is a primitive autarkic technology that they can use directly. The second one is an advanced technology that requires the use of a financial center. The financial center is a profit-maximizing natural monopoly. Its profit depends positively on the scale of intermediation and production. Our model predicts that an increase in inflation will reduce the capital stock, output and the scale of intermediation. If inflation is low enough, the financial center makes a positive profit, and the advanced technology is used. However, when inflation exceeds a certain threshold, the profit of the center falls below zero, and it shuts down. Hence competitive banks switch to the inefficient autarkic technology. Even though the capital stock falls, the marginal product of capital falls as well due to the switch in technology. This creates the possibility of a "dollarization trap," in which dollars are held as a store of value alongside the autarkic productive capital. The arbitrage condition between the return on dollars and the marginal product of capital determines the capital stock and output. A subsequent disinflation does not affect this arbitrage condition, and thus has no effect on capital accumulation. Therefore, as long as the economy gets stuck in the dollarization trap during a high inflation episode, a successful stabilization of inflation is followed neither by dedollarization nor by output recovery.
    Keywords: Dollarization, Inflation, Financial Intermediation, Asset Substitution, Hysteresis
    JEL: E40 E50 F41
    Date: 2004–08–11
  18. By: Magnus Andersson (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Lars Jul Hansen (Danmarks Nationalbank, Havnegade 5, 1093 Copenhagen, Denmark); Szabolcs Sebestyén (Department of Fundamentos del Análisis Económico, University of Alicante, 03080 San Vicente del Raspeig, Spain.)
    Abstract: This paper explores a long dataset (1999-2005) of intraday prices on German long-term bond futures and examines market responses to major macroeconomic announcements and ECB monetary policy releases. In general, adjustments in prices are quick and new information is usually incorporated into prices within five minutes of announcements. The volatility adjustment is more long-lasting than that in the conditional mean, and excess volatility can be observed up to 30 minutes after the releases. Overall, German bond markets tend to react more strongly to the surprise component in US macro releases compared to euro area and domestic releases, and the strength of those reactions to US releases has increased over the period considered. The paper also provides evidence that the outcome of German unemployment figures has been known to investors ahead of the prescheduled release.
    Keywords: Monetary policy, intraday data, macroeconomic announcements.
    JEL: E43 E44 E58
    Date: 2006–05
  19. By: Amina Lahrèche-Révil (University of Picardie); Juliette Milgram (Department of Economic Theory and Economic History, University of Granada.)
    Abstract: Compared to the new European members (NEM) and to the new candidate countries, the Middle-East and North African (MENA) countries are a very heterogeneous and fragmented EU frontier. As far as monetary issues are concerned, exchange rate regimes are very different and bilateral exchange rates quite volatile. Moreover, weak trade integration and generalized capital controls constitute major obstacles to economic and financial integration. Existing works yet suggest that anchoring to the euro would undoubtedly be the best exchange-rate strategy for most MENA countries. Monetary integration and trade integration are interdependent. This is especially the case when trade flows are sensitive to the volatility of exchange rates or to movements in relative prices. The objective of this paper is to evaluate the potential of monetary integration in the South Mediterranean area, in a context of trade liberalization and of a strong orientation of trade flows towards the EU. The empirical part of the paper would rely on a gravity equation of trade which would include exchange rates volatility and relative prices, in order to gauge the impact of de facto exchange-rate and monetary conditions on trade integration. The sample of countries is large (OECD, NEM, MENA and Asian countries) in order both to have robust estimates and to investigate whether the MENA countries exhibit a specific sensitivity of trade flows to exchange-rate volatility and exchange-rate misalignments. The impact of the competitiveness of third countries will also be investigated. This latter issue is especially important, though seldom assessed, when it comes to the potential trade-diverting effect of the latest EU enlargement on MENA trade wit the EU. The gravity setting also allows simulating the consequences for the trade of MENA countries of a deeper monetary integration, by comparing the impact on trade of a regional monetary integration and of a euro peg.
    Keywords: Exchange rate regime, trade, regional integration, Euro, MENA
    JEL: F15 F31 F33
    Date: 2006–05–31
  20. By: Marco G. Ercolani and Jayasri Dutta
    Abstract: Though anecdotal evidence suggests that retail price inflation increased tem- porarily in January 2002 when Euro notes and coins were introduced, the evi- dence from official statistics largely refutes this. We test for the presence of a sudden temporary increase in inflation for Euro-changeover countries. We use the countries that did not join the Euro: Denmark, Sweden and the UK; as a control group. Though the results are sensitive to the estimation method, we do uncover weak evidence of a minor increase in aggregate inflation in January 2002 for the countries that did join the Euro. Similar tests for the Restaurant sector find a strong Euro-changeover effect on temporary inflation. Summary tests for 129 other price sub-categories are also discussed.
    JEL: D12 D40 D84 E31 E52 E63 L89
    Date: 2006–02
  21. By: Anne-Marie Brook
    Abstract: The Maastricht criteria for accession to the euro area can be difficult for any economy to achieve, not least because of the challenges posed by the “impossible trinity”, which suggests that it is not possible to target both a stable exchange rate and stable inflation at the same time as maintaining free capital mobility. But for poorer economies which are catching up to the living standards of the wealthier EMU members, the challenges are magnified. This is because economies with very high productivity growth may have larger Balassa-Samuelson effects, resulting in higher steady state inflation rates as well as gradually appreciating equilibrium real exchange rates. While some nominal appreciation is permitted during ERM-II membership, the rules do not make it easy to signal the magnitude of expected appreciation. This may lead to poorly anchored exchange rates, making the catching-up economies more vulnerable to the challenges of the impossible trinity. Moreover, countries that have recently introduced fully-funded pension pillars which involve high transition costs, may find it difficult to meet the Maastricht criteria for government finances. It is unclear whether recent changes to the Stability and Growth Pact will alleviate the short-term fiscal pressure on countries that have improved the long-term sustainability of their government finances at the cost of short-term deterioration to their fiscal deficits. The example of Slovakia is used to illustrate these points, and a number of policy guidelines are proposed to minimise the risks. This Working Paper relates to the 2005 OECD Economic Survey of the Slovak Republic ( <P>Problèmes posés aux pays en phase de rattrapage par l'adhésion à l'UME Toute économie peut éprouver des difficultés à répondre aux critères de Maastricht pour adhérer à la zone euro, surtout en raison des problèmes posés par l’«impossible trinité», selon laquelle il n’est pas possible de poursuivre à la fois les objectifs de stabilité du taux de change et de l’inflation tout en maintenant la liberté des mouvements de capitaux. Cependant, pour les économies plus défavorisées qui sont en train de rattraper le niveau de vie des membres les plus riches de l’UME, les difficultés sont encore amplifiées. Cela s’explique par le fait que les économies dont la croissance de la productivité est très rapide peuvent enregistrer des effets Balassa-Samuelson plus marqués, se traduisant par des taux d’inflation constamment plus élevés ainsi que par une appréciation progressive des taux de change réels d’équilibre. Si une certaine appréciation nominale est autorisée durant la phase de participation au MCE-II, les réglementations applicables ne permettent pas aisément d’indiquer l’ampleur de l’appréciation attendue. Cela peut se traduire par une instabilité des taux de change et rendre les économies en phase de rattrapage plus vulnérables aux défis de l’impossible trinité. De plus, les pays qui ont instauré récemment des piliers de système de retraite par capitalisation entraînant des coûts de transition élevés pourraient éprouver des difficultés à respecter les critères de Maastricht en matière de finances publiques. On ne sait pas encore si les modifications récentes du Pacte de stabilité et de croissance allègeront la pression fiscale à court terme sur les pays qui ont amélioré la viabilité à long terme de leurs finances publiques au prix d’une détérioration à court terme de leurs déficits budgétaires. L’exemple de la Slovaquie est utilisé pour illustrer ces points et un certain nombre d’orientations de politique économique sont proposées pour minimiser les risques. Ce Document de travail se rapporte à l'Étude économique de l'OCDE de la République slovaque, 2005 (
    Keywords: stability and growth pact, pacte de stabilité et de croissance, impossible trinity, Balassa-Samuelson effect, EMU accession, Maastricht criteria, impossible trinité, effet Balassa-Samuelson, adhésion à l'UME, critère de Maastricht
    JEL: F31 F33 O52
    Date: 2005–09–21
  22. By: Eilev S. Jansen (Norges Bank and Norwegian University of Science and Technology)
    Abstract: The paper presents an incomplete competition model (ICM), where inflation is determined jointly with unit labour cost growth. The ICM is estimated on data for the Euro area and evaluated against existing models, i.e. the implicit inflation equation of the Area Wide model (AWM) - cf. Fagan, Henry and Mestre (2001) - and estimated versions of the (single equation) P* model and a hybrid New Keynesian Phillips curve. The evidence from these comparisons does not invite decisive conclusions. There is, however, some support in favour of the (reduced form) AWM inflation equation. It is the only model that encompasses a general unrestricted model and it forecast encompasses the competitors when tested on 20 quarters of one step ahead forecasts.
    Keywords: inflation, incomplete competition model, Area Wide model, P*-model, New Keynesian Phillips curve, model evaluation, forecast encompassing.
    JEL: C22 C32 C52 C53 E31
    Date: 2004–06–20
  23. By: Carlos Usabiaga; María Ángeles Caraballo
    Abstract: In this work we centre on the menu cost models of new keynesian economics and, more concretely, on the empirical testing line proposed by Ball and Mankiw (1994, 1995), authors that confront in a monopolistic competition model the explanation of why a shock that affects relative prices also affects mean inflation. Their conclusion is that if mean inflation is near to zero the inflation-skewness relation is stronger than the inflation-variability relation, whereas in the case of a high mean inflation the inflation-variability relation is stronger. Following their approach in our analysis mean inflation is the explained variable, whereas skewness and variability of the distribution of price changes are the main explanatory variables. Our type of analysis has different applications. Firstly, in the case that we confront a relative price shock, if variability and skewness, or some of their transformations, affect inflation it means that our economy is vulnerable, so it makes especially difficult to control inflation. A second application refers to a feasible way to measure core inflation, eliminating from inflation the transitory effects introduced by skewness. Finally, this approach can contribute to test if downward price rigidity is an exogenous phenomenon or the response of optimizing agents that confront menu costs in an inflationary context. Despite these utilities, the Ball and Mankiw (1995) approximation has been rarely applied to Spanish economy.In essence, our work tries to answer whether menu costs à la Ball and Mankiw are plausible for Spanish economy, and whether exists homogeneity of the Spanish regions at this respect. The structure of the work is the following: a) exposition of the basic data and variables, the methodology followed, and the results of our first approximation to Ball and Mankiw (1995); b) consideration of alternative measures of variability and skewness; c) analysis of the role of kurtosis and introduction of two real variables (unemployment and production) as control variables; d) analysis of the causality problem; and e) after the analysis at regional level, we study whether the regions jointly present an homogeneous behavior in this area. Our period of analysis is 1994.01-2001.12. We have chosen this low inflation period because around an annual 4-5% is placed the upper limit for which the model predicts a strong inflation-skewness relation. The essential data that we use come from the series of monthly variation rate of consumer price index, disaggregated by regions and goods and services (33 subgroups), elaborated by the Instituto Nacional de Estadística (INE). In general, we observe an homogeneous behavior of the "structure" of inflation for the Spanish regions. Our analysis corroborates the results of Ball and Mankiw (1995) about the importance of the skewness of the distribution of price changes. Their results in the line that the variability coefficient is higher than the skewness coefficient, and that the estimations containing skewness present a higher coefficient of determination are also confirmed. The significance of skewness and variability at regional level shows the vulnerability of Spanish inflation in terms of relative price shocks.
    Date: 2004–08
  24. By: John H. A. Munro
    Abstract: One of the most common myths in European economic history, and indeed in Economics itself, is that the Black Death of 1347-48, followed by other waves of bubonic plague, led to an abrupt rise in real wages, for both agricultural labourers and urban artisans – one that led to the so-called ‘Golden Age of the English Labourer’, lasting until the early 16th century. While there is no doubt that real-wages in mid- to late- 15th century England did reach a peak far higher than that ever achieved in past centuries, real wages in England did not, in fact, rise in the immediate aftermath of the Black Death. In southern England, real wages of building craftsmen (rural and urban), having plummeted with the natural disaster of the Great Famine (1315-21), thereafter rose to a new peak in 1336-40. But then their real wages fell during the 1340s, and continued their decline after the onslaught of the Black Death, indeed into the 1360s. Not until the later 1370s – almost thirty years after the Black Death – did real wages finally recover and then rapidly surpass the peak achieved in the late 1330s. Thereafter, the rise in real wages was more or less continuous, though at generally slower rates, during the 15th century, reaching a peak in 1476-80 – at a level not thereafter surpassed until 1886-90, by the usual methods of calculating real wages with index numbers: i.e., by NWI/CPI = RWI [nominal wage index divided by the consumer price index equals the real wage index]. Most of the textbooks that still perpetuate the myth about the role of the Black Death in raising real wages, as an almost immediate consequence, employ a demographic model based on Ricardian economics, which predicts (ceteris paribus) that depopulation will result in falling grain prices and thus in falling rents on grain-producing lands (on land in general) and in rising real wages. The fall in population – perhaps as much as 50 percent by the late 15th century (from the 1310 peak) – presumably altered the land:labour ratio sufficiently to increase the marginal productivity of labour and thus its real wage (though in economic theory the real wage is determined by the marginal revenue product of labour). The rise in real wages would also have been a product of the fall in the cost of living, chiefly determined by bread-grain prices, whose decline would have been the inevitable result of both the abandonment of high-cost marginal lands and the rise in the marginal productivity of agricultural labour. But the evidence produced in this study demonstrates that the Black Death was followed, in England, by almost thirty years of high grain prices – high in both nominal and real terms; and that was a principal reason for the post-Plague behaviour of real wages. This study differs from all traditional models by examining the role of monetary forces in producing deflation in the second and final quarters of the fourteenth century, but severe inflation in between those quarters (i.e., from the early 1340s to the mid 1370s). The analysis of the evidence on money, prices, and wages in this study concludes that monetary forces and the consequent behaviour of the price level – in terms of those deflations and intervening inflation – were the most powerful determinant of the level of real wages (i.e., in terms of the formula: NWI/CPI = RWI). Thus the undisputed rise in nominal or money wages following the Black Death was literally ‘swamped’ by the post-Plague inflation, so that real wages fell. Conversely, the rise of real wages in the second quarter of the fourteenth century was principally due to a deflation in which consumer prices fell much more than did nominal wages. In the final quarter of the century, the even stronger rise in real wages was principally due to another deflation in which consumer prices fell sharply, but one in which, for the first time in recorded English history, nominal wages did not fall: an era that inaugurated the predominance of wage-stickiness in English labour markets for the next six centuries. But that perplexing phenomenon of downward wage-stickiness must be left to other studies. The 14th century is the most violent one before the 20th; and violent disruptions from plague, war, and civil unrest undoubtedly produced severe supply shocks and high (relative) prices. Europe also experienced more severe oscillations in monetary changes and consequently in price levels – i.e., the aforesaid deflations and intervening inflation – during the 14th century than in any other before the 20th.
    Keywords: inflation, deflation, coinage debasements, monetary flows, prices, nominal wages, real wages, labour, marginal productivity of labour, Black Death, bubonic plagues, depopulation, agricultural labourers, building craftsmen, labour markets
    JEL: E3 E4 E5 I1 I3 J1 J2 J3 J4 N1 N3 N4
    Date: 2005–03–11
  25. By: Tommy Sveen (Norges Bank (Central Bank of Norway)); Lutz Weinke (Duke University)
    Abstract: In the presence of firm-specific capital the Taylor principle can generate multiple equilibria. Sveen and Weinke (2005b) obtain that result in the context of a Calvo-tyle sticky price model. One potential criticism is that the price stickiness which is needed for our theoretical result to be relevant from a practical point of view is somewhat to the high part of available empirical estimates. In the present paper we show that if nominal wages are not fully flexible (which is an uncontroversial empirical fact) then the Taylor principle fails already for some minor degree of price stickiness. We use our model to explain the consequences of both nominal rigidities for the desirability of alternative interest rate rules.
    Keywords: Nominal Rigidities, Aggregate Investment, Monetary Policy.
    JEL: E22 E31
    Date: 2006–05–31
  26. By: Mende, Alexander; Menkhoff, Lukas
    Abstract: This study examines profits and speculation in the USD/EUR trading of a bank in Germany over a four-month period. Dealing activity at the bank generates profits but speculation does not seem to contribute to this. We find that speculative positions fail to become profitable within a 30-minutes' horizon. Also, the suggestion that exchange rate volatility would foster speculative profits cannot be confirmed. To explain daily revenues, neither the bank's speculative trading volume nor its inventory position, but only customer trading emerges as a significant determinant. Furthermore, a spread analysis reveals that there is hardly any room for revenues from speculation.
    Keywords: foreign exchange markets, speculation, profits, market microstructure, flow analysis
    JEL: G15 F31
    Date: 2006–06
  27. By: Paolo Vitale (Department of Economics and Land History, Gabriele D‘Annunzio University, Viale Pindaro 42, 65127 Pescara (Italy).)
    Abstract: We formulate a market microstructure model of exchange determination we employ to investigate the impact of foreign exchange intervention on exchange rates and on foreign exchange (FX) market conditions. With our formulation we show i) how foreign exchange intervention influences exchange rates via both a portfolio-balance and a signalling channel and ii) derive a series of testable implications which are coherent with a large body of empirical research. Our investigation also proposes some normative recommendations, as we show i) that in extreme circumstances large scale foreign exchange intervention can have destabilizing effects for the functioning of FX markets and ii) that the route chosen for the implementation of official intervention has important implications for its impact on exchange rates and on market conditions.
    Keywords: Official Intervention, Order Flow, Foreign Exchange Micro Structure, Exchange Rate Dynamics.
    JEL: D82 G14 G15
    Date: 2006–05

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