nep-mon New Economics Papers
on Monetary Economics
Issue of 2006‒07‒09
twenty-one papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Monetary policy implementation without averaging or rate corridors By William Whitesell
  2. Inflation risk and optimal monetary policy By William T. Gavin; Benjamin D. Keen; Michael R. Pakko
  3. Can the U.S. monetary policy fall (again) in an expectation trap? By Roc Armenter; Martin Bodenstein
  4. Why Has U.S. Inflation Become Harder to Forecast? By James H. Stock; Mark W. Watson
  5. Inflation targeting under imperfect knowledge By Athanasios Orphanides; John C. Williams
  6. Optimal Monetary Policy with Real-time Signal Extraction from the Bond Market By Kristoffer Nimark
  7. Monetary policy, determinacy, and learnability in a two-block world economy By James B. Bullard; Eric Schaling
  8. Evaluating Inflation Targeting Using a Macroeconometric Model By Ray C. Fair
  9. Worldwide macroeconomic stability and monetary policy rules By James B. Bullard; Aarti Singh
  10. Imperfect knowledge, adaptive learning and the bias against activist monetary policies By Alberto Locarno
  11. Targeting inflation and the fiscal balance : what is the optimal policy mix? By Marcela Meirelles Aurelio
  12. Optimal Stationary Monetary and Fiscal Policy under Nominal Rigidity By Michal Horvath
  13. The Lending Channel in Emerging Economics: Are Foreign Banks Different? By Marco Arena; Carmen Reinhart; Francisco Vázquez
  14. Optimal Currency Shares in International Reserves: The Impact of the Euro and the Prospects for the Dollar By Elias Papaioannou; Richard Portes; Gregorios Siourounis
  15. Implicit Bands in the Yen/Dollar Exchange Rate By Francisco Ledesma-Rodríguez; Manuel Navarro-Ibáñez; Jorge Pérez-Rodríguez; Simón Sosvilla-Rivero
  16. Revisiting the empirical evidence on firms’ money demand By Francesca Lotti; Juri Marcucci
  17. Adaptive Learning, Endogenous Inattention, and Changes in Monetary Policy By Wiliam Branch; John Carlson; George W. Evans; Bruce McGough
  18. An empirical analysis of national differences in the retail bank interest rates of the euro area By Massimiliano Affinito; Fabio Farabullini
  19. Inflation as a Redistribution Shock: Effects on Aggregates and Welfare By Matthias Doepke; Martin Schneider
  20. Liquidity Insurance in a Financially Dollarized Economy By Eduardo Levy Yeyati
  21. Public feed back for better banknote design By Hans de Heij

  1. By: William Whitesell
    Abstract: Most central banks now implement monetary policy by trying to hit a target overnight interest rate using one of two types of frameworks. The first involves arrangements for depository institutions to hold a minimum account balance over a multi-day averaging period. The second uses the central bank's lending rate as a ceiling and its deposit rate as a floor for overnight interest rates. Either averaging or a rate corridor can help a central bank hit a target interest rate, but each framework can also have weaknesses in achieving that goal and, in some cases, other associated drawbacks. This paper discusses an alternative possible policy implementation regime, involving a specially designed facility for the payment of interest on a daily basis on balances held at the central bank. This new type of regime could potentially allow smooth monetary policy implementation without the problems associated with averaging or a rate corridor.
    Date: 2006
  2. By: William T. Gavin; Benjamin D. Keen; Michael R. Pakko
    Abstract: This paper shows that the optimal monetary policies recommended by New Keynesian models still imply a large amount of inflation risk. We calculate the term structure of inflation uncertainty in New Keynesian models when the monetary authority adopts the optimal policy*the policy that minimizes the gap between output in the New Keynesian model and output in a flexible wage and price model. When the monetary policy rules are modified to include a small weight on a price path, the economy achieves equilibria with substantially lower long-run inflation risk. With sticky prices, the price path target reduces long-run inflation uncertainty with no measurable increase in the variability of the output gap. With sticky wages, a tradeoff exists between short-run output stabilization and long-run inflation risk.
    Keywords: Monetary policy ; Inflation (Finance)
    Date: 2006
  3. By: Roc Armenter; Martin Bodenstein
    Abstract: We provide a tractable model to study monetary policy under discretion. We focus on Markov equilibria. For all parametrizations with an equilibrium inflation rate around 2%, there is a second equilibrium with an inflation rate just above 10%. Thus the model can simultaneously account for the low and high inflation episodes in the U.S. We carefully characterize the set of Markov equilibria along the parameter space and find our results to be robust.
    Keywords: Inflation (Finance) ; Econometric models ; Equilibrium (Economics) ; Monetary policy
    Date: 2006
  4. By: James H. Stock; Mark W. Watson
    Abstract: Forecasts of the rate of price inflation play a central role in the formulation of monetary policy, and forecasting inflation is a key job for economists at the Federal Reserve Board. This paper examines whether this job has become harder and, to the extent that it has, what changes in the inflation process have made it so. The main finding is that the univariate inflation process is well described by an unobserved component trend-cycle model with stochastic volatility or, equivalently, an integrated moving average process with time-varying parameters; this model explains a variety of recent univariate inflation forecasting puzzles. It appears currently to be difficult for multivariate forecasts to improve on forecasts made using this time-varying univariate model.
    JEL: C53 E37
    Date: 2006–06
  5. By: Athanasios Orphanides; John C. Williams
    Abstract: A central tenet of inflation targeting is that establishing and maintaining well-anchored inflation expectations are essential. In this paper, we reexamine the role of key elements of the inflation targeting framework towards this end, in the context of an economy where economic agents have an imperfect understanding of the macroeconomic landscape within which the public forms expectations and policymakers must formulate and implement monetary policy. Using an estimated model of the U.S. economy, we show that monetary policy rules that would perform well under the assumption of rational expectations can perform very poorly when we introduce imperfect knowledge. We then examine the performance of an easily implemented policy rule that incorporates three key characteristics of inflation targeting: transparency, commitment to maintaining price stability, and close monitoring of inflation expectations, and find that all three play an important role in assuring its success. Our analysis suggests that simple difference rules in the spirit of Knut Wicksell excel at tethering inflation expectations to the central bank's goal and in so doing achieve superior stabilization of inflation and economic activity in an environment of imperfect knowledge.
    Date: 2006
  6. By: Kristoffer Nimark (Reserve Bank of Australia)
    Abstract: Monetary policy is conducted in an environment of uncertainty. This paper sets up a model where the central bank uses real-time data from the bond market together with standard macroeconomic indicators to estimate the current state of the economy more efficiently, while taking into account that its own actions influence what it observes. The timeliness of bond market data allows for quicker responses of monetary policy to disturbances compared to the case when the central bank has to rely solely on collected aggregate data. The information content of the term structure creates a link between the bond market and the macroeconomy that is novel to the literature. To quantify the importance of the bond market as a source of information, the model is estimated on data for the United States and Australia using Bayesian methods. The empirical exercise suggests that there is some information in the US term structure that helps the Federal Reserve to identify shocks to the economy on a timely basis. Australian bond prices seem to be less informative than their US counterparts, perhaps because Australia is a relatively small and open economy.
    Keywords: monetary policy; imperfect information; bond market; term structure of interest rates
    JEL: E32 E43 E52
    Date: 2006–06
  7. By: James B. Bullard; Eric Schaling
    Abstract: We study how determinacy and learnability of worldwide rational expectations equilibrium may be affected by monetary policy in a simple, two country, New Keynesian framework under both fixed and flexible exchange rates. We find that open economy considerations may alter conditions for determinacy and learnability relative to closed economy analyses, and that new concerns can arise in the analysis of classic topics such as the desirability of exchange rate targeting and monetary policy cooperation.
    Keywords: Monetary policy ; Foreign exchange
    Date: 2006
  8. By: Ray C. Fair
    Abstract: Inflation targeting is evaluated in this paper using a structurally estimated macroeconometric model, denoted the MC model. This model differs substantially from the New Keynesian (NK) model, which is currently the workhorse macro model in the literature. Section 2 compares the two models and argues that the NK model is unlikely to be a good approximation of the economy and that one of its key features regarding the effects of monetary policy on the economy seems wrong. Section 3 then examines inflation targeting using the MC model. Various interest rate rules are tried with differing weights on inflation and output, and various optimal control problems are solved using differing weights on inflation and output targets. Price-level targeting is also considered. The results show that 1) there are output costs to inflation targeting, especially for price shocks, 2) price-level targeting is dominated by inflation targeting, 3) the estimated interest rate rule of the Fed (in Table 3) is consistent with the Fed placing equal weights on inflation and unemployment in a loss function, 4) the estimated interest rate rule does a fairly good job at lowering variability, and 5) considerable economic variability is left after the Fed has done its best. Overall, the results suggest that the Fed should continue to behave as it has in the past and not switch to inflation targeting.
    Keywords: Inflation targeting, Interest rate rules, Optimal control
    JEL: E52
    Date: 2006–06
  9. By: James B. Bullard; Aarti Singh
    Abstract: We study the interaction of multiple large economies in dynamic stochastic general equilibrium. Each economy has a monetary policymaker that attempts to control the economy through the use of a linear nominal interest rate feedback rule. We show how the determinacy of worldwide equilibrium depends on the joint behavior of policymakers worldwide. We also show how indeterminacy exposes all economies to endogenous volatility, even ones where monetary policy may be judged appropriate from a closed economy perspective. We construct and discuss two quantitative cases. In the 1970s, worldwide equilibrium was characterized by a two-dimensional indeterminacy, despite U.S. adherence to a version of the Taylor principle. In the last 15 years, worldwide equilibrium was still characterized by a one-dimensional indeterminacy, leaving all economies exposed to endogenous volatility. Our analysis provides a rationale for a type of international policy coordination, and the gains to coordination in the sense of avoiding indeterminacy may be large.
    Keywords: Keynesian economics ; Monetary policy ; Inflation (Finance)
    Date: 2006
  10. By: Alberto Locarno (Banca d'Italia)
    Abstract: When the economy is subject to recurrent structural shifts, the monetary authority cannot credibly commit to a systematic approach to policy, since consistency between promises and actions is not easily verifiable; moreover, since agents have incomplete knowledge of the surrounding environment, they form expectations that may deviate substantially from the full-information case. The present paper studies the implications for the effectiveness of discretionary monetary policymaking of departing from the benchmark of rational expectations and assuming instead that agents learn adaptively. It focuses on two issues, namely whether imperfect knowledge generates a bias against stabilisation policies and whether the optimal monetary strategy takes the form of an inflation cap. Rules featuring an inflation cap are not only justified on theoretical grounds, but are also appealing because they seem appropriate to deal with imperfect knowledge and learning: by setting explicit bounds on inflation, they seem better suited to restrain expectations from drifting significantly away from target, thus removing one of the main sources of policy ineffectiveness. The main findings of the paper are the following. First, when agents do not possess complete knowledge on the structure of the economy and rely on an adaptive learning technology, a bias toward conservativeness arises. Second, a policy that involves a cap on inflation is helpful in reducing output and inflation variability, but it is not uniformly superior to a strategy aimed at minimising a quadratic loss function. Third, the bias against stabilisation policies and towards conservativeness does not depend on whether agents have finite or infinite memory.
    Keywords: Adaptive learning, optimal degree of monetary policy discretion, bias against activist policies
    JEL: E52 E31 D84
    Date: 2006–05
  11. By: Marcela Meirelles Aurelio
    Abstract: This paper identifies optimal policy rules in the presence of explicit targets for both the inflation rate and public debt. This issue is investigated in the context of a dynamic stochastic general equilibrium model that describes a small open economy with capital accumulation, distortionary taxation and nominal price rigidities. The model is solved using a second-order approximation to the equilibrium conditions. Optimal policy features a strong anti-inflation stance and strict fiscal discipline. Targeting a domestic inflation index - as opposed to CPI - improves welfare because it reduces the inefficiencies that stem from both price stickiness and income taxes.
    Keywords: Inflation (Finance) ; Prices ; Fiscal policy
    Date: 2006
  12. By: Michal Horvath
    Abstract: Several papers have recently argued that price stickiness implies non-stationarity in models of monetary-fiscal interactions. The policy implication is that policy makers should allow a permanent drift in variables such as public debt or the tax rate in response to shocks. At the same time, a growing volume of literature advocates formulating optimal policies by minimizing expected welfare losses over unconditional rather than conditional expectations. We demonstrate that policies that maximize the unconditional expectation of the welfare objective in a forward-looking linear-quadratic framework necessarily imply mean reversion for all policy-relevant endogenous variables. This has important practical and theoretical implications.
    Keywords: Optimal monetary and fiscal policy, timeless perspective, unconditional expectation, time consistency.
    JEL: C61 E52 E61 E63
    Date: 2006–06
  13. By: Marco Arena; Carmen Reinhart; Francisco Vázquez
    Abstract: This paper assembles a dataset comprising 1,565 banks in 20 Asian and Latin American countries during 1989-2001 and compares the response of the volume of loans, deposits, and bank-specific interest rates on loans and deposits, to various measures of monetary conditions, across domestic and foreign banks. It also looks for systematic differences in the behavior of domestic and foreign banks during periods of financial distress and tranquil times. Using differences in bank ownership as a proxy for financial constraints on banks, the paper finds weak evidence that foreign banks have a lower sensitivity of credit to monetary conditions relative to their domestic competitors, with the differences driven by banks with lower asset liquidity and/or capitalization. At the same time, the lending and deposit rates of foreign banks tend to be smoother during periods of financial distress, albeit the differences with domestic banks do not appear to be strong. These results provide weak support to the existence of supply-side effects in credit markets and suggest that foreign bank entry in emerging economies may have contributed somewhat to stability in credit markets.
    JEL: E51 G21
    Date: 2006–06
  14. By: Elias Papaioannou; Richard Portes; Gregorios Siourounis
    Abstract: Foreign exchange reserve accumulation has risen dramatically in recent years. The introduction of the euro, greater liquidity in other major currencies, and the rising current account deficits and external debt of the United States have increased the pressure on central banks to diversify away from the US dollar. A major portfolio shift would significantly affect exchange rates and the status of the dollar as the dominant international currency. We develop a dynamic mean-variance optimization framework with portfolio rebalancing costs to estimate optimal portfolio weights among the main international currencies. Making various assumptions on expected currency returns and the variance-covariance structure, we assess how the euro has changed this allocation. We then perform simulations for the optimal currency allocations of four large emerging market countries (Brazil, Russia, India and China), adding constraints that reflect a central bank’s desire to hold a sizable portion of its portfolio in the currencies of its peg, its foreign debt and its international trade. Our main results are: (i) The optimizer can match the large share of the US dollar in reserves, when the dollar is the reference (risk-free) currency. (ii) The optimum portfolios show a much lower weight for the euro than is observed. This suggests that the euro may already enjoy an enhanced role as an international reserve currency ("punching above its weight"). (iii) Growth in issuance of euro-denominated securities, a rise in euro zone trade with key emerging markets, and increased use of the euro as a currency peg, would all work towards raising the optimal euro shares, with the last factor being quantitatively the most important.
    JEL: F02 F30 G11 G15
    Date: 2006–06
  15. By: Francisco Ledesma-Rodríguez; Manuel Navarro-Ibáñez; Jorge Pérez-Rodríguez; Simón Sosvilla-Rivero
    Abstract: This paper attempts to identify implicit exchange rate regimes for the Yen/Dollar exchange rate. To that end, we apply a sequential procedure that considers both the dynamics of exchange rates and central bank interventions to data covering the period from 1971 to 2003. Our results would suggest that implicit bands existed in two subperiods: April-December 1980 and March-December 1987, the latter coinciding with the Louvre Accord. Furthermore, the study of the credibility of such implicit bands indicates the high degree of confidence attributed by economic agents to the evolution of the Yen/Dollar exchange rate within the detected implicit band rate, thus lending further support to the relevance of such implicit bands.
  16. By: Francesca Lotti (Banca d'Italia); Juri Marcucci (Banca d'Italia)
    Abstract: In this paper we estimate the demand for liquidity by US non financial firms using data from COMPUSTAT database. In contrast to the previous literature, we consider firm-specific effects, such as cost-of-capital and wages. From the balanced and unbalanced panel estimations we infer that there are economies of scale in money demand by US business firms, because estimated sales elasticities are smaller than unity. In particular, they are lower than in previous empirical studies, suggesting that economies of scale in the demand for money are even bigger than formerly thought. In addition, it emerges that labor is not a substitute for money.
    Keywords: Panel Data, Liquidity, Demand for Money, COMPUSTAT
    JEL: E41 L60 C23
    Date: 2006–05
  17. By: Wiliam Branch (University of Californis - Irvine); John Carlson (Federal Reserve Bank of Cleveland); George W. Evans (University of Oregon Economics Department); Bruce McGough (Oregon State University)
    Abstract: This paper develops an adaptive learning formulation of an extension to the Ball, Mankiw and Reis (2005) sticky information model that incorporates endogenous inattention. We show that, following an exogenous increase in the policymaker's preferences for price vs. output stability, the learning process can converge to a new equilibrium in which both output and price volatility are lower.
    Keywords: expectations, optimal monetary policy, bounded rationality, economic stability, adaptive learning.
    JEL: E52 E31 D83 D84
    Date: 2006–06–22
  18. By: Massimiliano Affinito (Banca d'Italia); Fabio Farabullini (Banca d'Italia)
    Abstract: The availability of new harmonized data on bank interest rates allows a rigorous assessment to be made of cross-country price homogeneity/heterogeneity in euro area retail credit markets. Econometric analysis shows that the banking market is still highly segmented and that the degree of integration in a single country (Italy, taken as a benchmark for integration) is greater than in the euro area. However, national differences can be partially explained by variables reflecting the characteristics of domestic depositors and borrowers (“demand side” regressors, such as risk exposure, disposable income, alternative financing sources, average firm size) and the characteristics of the banking systems (“supply side” regressors, such as banking market concentration, asset and liability structure). The euro area prices appear different because national banking products appear different or because they are differentiated by national factors. Once these factors have been controlled for, many differences disappear.
    Keywords: bank interest rates, convergence, integration
    JEL: E43 E44 G21
    Date: 2006–05
  19. By: Matthias Doepke; Martin Schneider
    Abstract: Episodes of unanticipated inflation reduce the real value of nominal claims and thus redistribute wealth from lenders to borrowers. In this study, we consider redistribution as a channel for aggregate and welfare effects of inflation. We model an inflation episode as an unanticipated shock to the wealth distribution in a quantitative overlapping-generations model of the U.S. economy. While the redistribution shock is zero sum, households react asymmetrically, mostly because borrowers are younger on average than lenders. As a result, inflation generates a decrease in labor supply as well as an increase in savings. Even though inflation-induced redistribution has a persistent negative effect on output, it improves the weighted welfare of domestic households.
    JEL: D31 D58 E31 E50
    Date: 2006–06
  20. By: Eduardo Levy Yeyati
    Abstract: Unlike the financial dollarization (FD) of external liabilities, the dollarization of domestic financial assets (domestic FD) has received comparatively less attention until very recently, when it has been increasingly seen as a key source of balance sheet exposure. This paper focuses on a complementary –and often overlooked– angle of domestic FD: the limit it imposes on the central bank as domestic lender of last resort, and the resulting exposure to dollar liquidity runs. The paper discusses the incidence of FD on banking crisis propensity, shows that FD has been an important motive for self insurance in the form of international reserves, and highlights the moral hazard associated with centralized reserve accumulation. Next, it illustrates the authorities’ belated recourse to suspension of convertibility in two recent banking crises (Argentina 2001 and Uruguay 2002). Finally, it argues for a combined scheme of decentralized reserves (liquid asset requirements on individual banks) to limit moral hazard, and an ex-ante suspension-of-convertibility clause (“circuit breakers”) to reduce self-insurance costs while limiting bank losses in the event of a run.
    JEL: G2 F3
    Date: 2006–06
  21. By: Hans de Heij
    Abstract: The euro banknotes recently celebrated their 4th year anniversary (2002 – 2006)! DNB has monitored the Dutch public’s acceptance of the euro banknotes through surveys in 2002, 2003 and 2005, contrasting its findings with those for the former guilder notes as well as the results of other recent consumer surveys conducted by the US Treasury (2002), Bank of Canada (2003) and several others. A unique time line is presented of the public’s knowledge of security features in the Netherlands over the years 1983- 2005. Keywords : market research, consumer research, public information , public awareness of banknotes, measuring method for the public’s awareness of security features, measuring method for the public's appreciation of banknotes, questionnaire/public opinion poll on banknotes, design of banknotes.</td>
    Date: 2006–06

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