nep-mon New Economics Papers
on Monetary Economics
Issue of 2006‒07‒28
twenty-two papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Monetary conservatism and fiscal policy By Klaus Adam; Roberto M. Billi
  2. The impact of ECB monetary policy decisions and communication on the yield curve By Claus Brand; Daniel Buncic; Jarkko Turunen
  3. Money and Production, and Liquidity Trap By Pradeep Dubey; John Geanakoplos
  4. House Prices and Monetary Policy in Colombia By Martha López
  5. Inflation forecast-based-rules and indeterminacy: a puzzle and a resolution. By Paul Levine; Peter McAdam; Joseph Pearlman
  6. Monetary policy rules in the pre-EMU era - Is there a common rule? By Maria Eleftheriou; Dieter Gerdesmeier; Barbara Roffia
  8. Employment targeting By Jean-Pascal Bénassy
  9. Adaptive learning, persistence, and optimal monetary policy. By Vitor Gaspar; Frank Smets; David Vestin
  10. Monetary and Fiscal Policy Interactions: The Role of the Quality of Institutions in a Dynamic Environment By Ourania Dimakou
  11. Did capital market convergence lower the effectiveness of the interest rate as a monetary policy tool? By Jansen, Pieter W.
  12. Identifying the role of labor markets for monetary policy in an estimated DSGE model. By Kai Philipp Christoffel; Keith Kuester; Tobias Linzert
  13. Optimal monetary policy with uncertainty about financial frictions. By Richhild Moessner
  14. A structural break in the effects of Japanese foreign exchange intervention on yen/dollar exchange rate volatility. By Eric Hillebrand; Gunther Schnabl
  15. The 90-Day DTF Interest Rate: Why Does It Remain Constant? By Peter Rowland
  16. The Theory of Money and Financial Institutions: A Summary of a Game Theoretic Approach By Martin Shubik
  17. Inflation Expectations and Regime Shifts By Matti Viren
  18. Foreign Exchange Risk Premium Determinants: Case of Armenia By Tigran Poghosyan; Evzen Kocenda
  19. Monetary and fiscal policy interactions in a New Keynesian model with capital accumulation and non-Ricardian consumers. By Campell Leith; Leopold von Thadden
  20. Consumer price adjustment under the microscope - Germany in a period of low inflation By Johannes Hoffmann; Jeong-Ryeol Kurz-Kim
  21. Exchange rate stabilization in developed and underdeveloped capital markets. By Viera Chemlarova; Gunter Schnabl
  22. On the determinants of external imbalances and net international portfolio flows - a global perspective By Roberto A. De Santis; Melanie Lührmann

  1. By: Klaus Adam (Corresponding author: European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Roberto M. Billi (Federal Reserve Bank of Kansas City, 925 Grand Blvd, Kansas City, MO 64198, United States.)
    Abstract: Does an inflation conservative central bank à la Rogoff (1985) remain desirable in a setting with endogenous fiscal policy? To provide an answer we study monetary and fiscal policy games without commitment in a dynamic stochastic sticky price economy with monopolistic distortions. Monetary policy determines nominal interest rates and fiscal policy provides public goods generating private utility. We find that lack of fiscal commitment gives rise to excessive public spending. The optimal inflation rate internalizing this distortion is positive, but lack of monetary commitment robustly generates too much inflation. A conservative monetary authority thus remains desirable. Exclusive focus on inflation by the central bank recoups large part - in some cases all - of the steady state welfare losses associated with lack of monetary and fiscal commitment. An inflation conservative central bank tends to improve also the conduct of stabilization policy. JEL Classification: E52, E62, E63.
    Keywords: Banking, sequential non-cooperative policy games, discretionary policy, time consistent policy, conservative monetary policy.
    Date: 2006–07
  2. By: Claus Brand (Corresponding author: European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Daniel Buncic (School of Economics, University of New South Wales, Sydney Australia.); Jarkko Turunen (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: We analyse high-frequency changes in the euro area money market yield curve on dates when the ECB regularly sets and communicates decisions on policy interest rates to construct different indicators of monetary policy news relating to policy decisions and to central bank communication. The indicators show that ECB communication during the press conference may result in significant changes in market expectations of the path of monetary policy. Furthermore, our results suggest that these changes have a significant and sizeable impact on medium to long-term interest rates. JEL Classification: E43, E58.
    Keywords: Money market rates, yield curve, ECB, central bank communication.
    Date: 2006–07
  3. By: Pradeep Dubey (Dept. of Economics, Stony Brook); John Geanakoplos (Cowles Foundation, Yale University)
    Abstract: We prove the existence of monetary equilibrium in a finite horizon economy with production. We also show that if agents expect the monetary authority to significantly decrease the supply of bank money available for short term loans in the future, then the economy will fall into a liquidity trap today.
    Keywords: Central bank, Inside money, Outside money, Incomplete assets, Production, Monetary equilibrium, Liquidity, Liquidity trap
    JEL: D50 D51 D52 D58 D60 E12 E31 E32 E41 E42 E43 E44 E50 E51 E52 E58 E63
    Date: 2006–07
  4. By: Martha López
    Abstract: This paper investigates the possible responses of an inflation-targeting monetary policy in the face of asset price deviations from fundamental values. Focusing on the housing sector of the Colombian economy, we consider a general equilibrium model with frictions in credit market and bubbles in housing prices. We show that monetary policy is less efficient when it responds directly to asset price of housing than a policy that reacts only to deviations of expected inflation (CPI) from target. Some prudential regulation may provide a better outcome in terms of output and inflation variability.
    Keywords: House price bubbles, interest rate rules, monetary policy, inflation Targeting.
    JEL: E32 E40 E47 E52
  5. By: Paul Levine (University of Surrey - Department of Economics, Guildford, Surrey GU2 7XH, United Kingdom.); Peter McAdam (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Joseph Pearlman (London Metropolitan University, Department of Economics, Finance and International Business, 31Jewry Street, London EC3N 2EY, United Kingdom.)
    Abstract: We examine an interesting puzzle in monetary economics between what monetary authorities claim (namely to be forward-looking and pre-emptive) and the poor stabilization properties routinely reported for forecast-based-rules. Our resolution is that central banks should be viewed as following 'Calvo-type' inflation-forecast-based(IFB)interest rate rules which depend on a discounted sum of current and future rates of inflation. Such rules might be regarded as both within the legal frame- works, and potentially mimicking central bankers' practice. We find that Calvo-type IFB interest rate rules are first - less prone to indeterminacy than standard rules with a finite forward horizon. Second, for such rules in difference form, the indeterminacy problem disappears altogether. Third, optimized forms have good stabilization properties as they become more forward-looking, a property that sharply contrasts that of standard IFB rules. Fourth, they appear data coherent when incorporated into a well-known estimated DSGE model of the Euro-area. JEL Classification: E52; E37; E58.
    Keywords: Inflation-forecast-based interest rate rules; Calvo-type interest rate rules.
    Date: 2006–06
  6. By: Maria Eleftheriou (European University Institute, Economics Department.); Dieter Gerdesmeier (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Barbara Roffia (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: Despite the great importance and final success of the convergence process that led to the establishment of the European Monetary Union, there is no clear agreement regarding the monetary policy pursued in the member countries during the convergence process. This paper contributes to the literature with an empirical analysis of the period from 1993 to 1998 that encompasses eleven EMU countries. In particular, Taylor-type interest rate rules are estimated with monthly national data to find that, despite certain similarities and exceptions, the rule followed by each country is distinct and differs substantially from the standard Taylor rule. However, for most countries, the parameter estimates reflect the principles proclaimed by the monetary policy authorities and, in addition, it is shown that in most cases the estimated rules reproduce the policy setting quite closely. JEL Classification: E58, F41.
    Keywords: Taylor rule, ERM, output gap, monetary policy.
    Date: 2006–07
  7. By: Timo Henckel
    Abstract: Some authors have argued that multiplicative uncertainty may be beneficial to society as the cautionary move reduces the inflation bias. Contrary to this claim, I show that, when there are non-atomistic wage setters, an increase in multiplicative uncertainty rises the real wage premium and unemployment and hence may reduce welfare. Furthermore, since central bank preferences also affect real variables, delegating policy to an independent central banker with an optimal degree of conservatism cannot, in general, deliver a second-best outcome.
    JEL: E52
    Date: 2006–07
  8. By: Jean-Pascal Bénassy
    Abstract: Many recent discussions on the conduct of monetary policy through interest rate rules have given a very central role to inflation, both as an objective and as an intermediate instrument. We want to show that other variables like employment can be as important or even more. For that we construct a dynamic stochastic general equilibrium (DSGE) model where the economy is subject to demand and supply shocks. We compute closed form solutions for the optimal interest rate rules and find that they can be function of employment only, which then dominates inflation for use in the policy rule.
    Date: 2006
  9. By: Vitor Gaspar (Banco de Portugal, 148 Rua do Comercio, P - 1101 Lisbon Codex, Portugal.); Frank Smets (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); David Vestin (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: We show that, when private sector expectations are determined in line with adaptive learning, optimal policy responds persistently to cost-push shocks. The optimal response is stronger and more persistent, the higher is the initial level of perceived inflation persistence by the private sector. Such a sophisticated policy reduces inflation persistence and inflation volatility at little cost in terms of output gap volatility. Persistent responses to cost-push shocks and stability of inflation expectations resemble optimal policy under commitment and rational expectations. Nevertheless, it is clear that the mechanism at play is very different. In the case of commitment it relies on expectations of future policy actions affecting inflation expectations; in the case of sophisticated central banking it relies on the reduction in the estimated inflation persistence parameter based on inflation data generated by shocks and policy responses. JEL Classification: E52.
    Keywords: Adaptive learning; rational expectations; policy rules; optimal policy.
    Date: 2006–06
  10. By: Ourania Dimakou (School of Economics, Mathematics & Statistics, Birkbeck)
    Abstract: This paper analyses the interaction between fiscal and monetary policy using the original Barro and Gordon (1983) model extended to include fiscal policy, dynamics and the level of institutional quality, measured as bureaucratic corruption. It is found that delegating monetary policy to an independent central bank (i.e. not fiscally dominated) the second best solution of the model is achievable only if there is no bureaucratic corruption. Otherwise, when institutional quality is not optimal, unless a less conservative than the government, regarding output considerations, independent central bank is delegated, the second best is not restored. The government has the incentive to increase debt strategically in an attempt to increase second period inflation. This result is augmented by the quality of institutions and poses difficulties on the achievement of both price stability and a balanced debt process. Quality of institutions, hence, can provide an explanation for the poorer inflation performance, due to debt boosts, of countries with lower institutional quality despite the introduction of central bank independence.
    Keywords: Monetary and Fiscal policy, time-inconsistency, independent central bank, corruption
    JEL: E58 E61 E63
    Date: 2006–07
  11. By: Jansen, Pieter W. (Vrije Universiteit Amsterdam, Faculteit der Economische Wetenschappen en Econometrie (Free University Amsterdam, Faculty of Economics Sciences, Business Administration and Economitrics)
    Abstract: International capital market convergence reduces the ability for monetary authorities to set domestic monetary conditions. Traditionally, monetary policy transmission is channelled through the short-term interest rate. Savings and investment decisions are effected through the response of the bond yield to changes in the short-term interest rate. We find that capital market integration increased correlation between long-term interest rates across countries. Short-term interest rates also show more integration across countries and the correlation with the international business cycle has increased. A stronger linkage between international economic conditions and bond yields has important implications for the effectiveness of monetary policy. Monetary policy makers, especially in small countries, will face more difficulties in influencing domestic conditions in the bond market when they apply the traditional monetary policy framework in case of a country specific shock.
    Keywords: Monetary policy; Term structure of interest rates; International capital market convergence
    JEL: E43
    Date: 2006
  12. By: Kai Philipp Christoffel (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Keith Kuester (Goethe University Frankfurt, Senckenberganlage 31, 60054 Frankfurt am Main, Germany.); Tobias Linzert (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: We focus on a quantitative assessment of rigid labor markets in an environment of stable monetary policy. We ask how wages and labor market shocks feed into the inflation process and derive monetary policy implications. Towards that aim, we structurally model matching frictions and rigid wages in line with an optimizing rationale in a New Keynesian closed economy DSGE model. We estimate the model using Bayesian techniques for German data from the late 1970s to present. Given the pre-euro heterogeneity in wage bargaining we take this as the first-best approximation at hand for modelling monetary policy in the presence of labor market frictions in the current European regime. In our framework, we find that labor market structure is of prime importance for the evolution of the business cycle, and for monetary policy in particular. Yet shocks originating in the labor market itself may contain only limited information for the conduct of stabilization policy. JEL Classification: E32; E52; J64; C11.
    Keywords: Labor market; wage rigidity; bargaining; Bayesian estimation.
    Date: 2006–06
  13. By: Richhild Moessner (Bank of England, Threadneedle Street, London, EC2R 8AH, United Kingdom.)
    Abstract: This paper studies optimal discretionary monetary policy in the presence of uncertainty about the degree of financial frictions. Changes in the degree of financial frictions are modelled as changes in parameters of a hybrid New-Keynesian model calibrated for the UK, following Bean, Larsen and Nikolov (2002). Uncertainty about the degree of financial frictions is modelled as Markov switching between regimes without and with strong financial frictions. Optimal monetary policy is determined for different scenarios of permanent and temporary regime shifts in financial frictions, as well as for variations in financial frictions over the business cycle. Optimal monetary policy is found to be state-dependent. In each state, optimal monetary policy depends on the transition probabilities between the different regimes. JEL Classification: E52; E58; E61; E44.
    Keywords: Monetary policy; uncertainty; financial frictions.
    Date: 2006–06
  14. By: Eric Hillebrand (Department of Economics, Louisiana State University, Baton Rouge, LA 70803, USA.); Gunther Schnabl (Department of Economics and Business Administration, Leipzig University, Marschenerstr. 31, 04109 Leipzig, Germany.)
    Abstract: While up to the late 1990s Japanese foreign exchange intervention was fully sterilized, Japanese monetary authorities left foreign exchange intervention unsterilized when Japan entered the liquidity trap in 1999. According to previous research on foreign exchange intervention, unsterilized intervention has a higher probability of success than sterilized intervention. Based on a GARCH framework and change point detection, we test for a structural break in the effectiveness of Japanese foreign exchange intervention. We find a changing impact of Japanese foreign exchange intervention on exchange rate volatility at the turn of the millennium when Japanese foreign exchange intervention started to remain unsterilized. JEL Classification: E58; F31; F33; G15.
    Keywords: Japan; foreign exchange intervention; exchange rate volatility; GARCH; change point detection; structural breaks.
    Date: 2006–06
  15. By: Peter Rowland
    Abstract: Since mid-July 2002 this rate has remained more or less constant at around 7.8 percent. More importantly, it did not react to any of two 100-basis-point increases in the overnight repo rate, the main tool of monetary policy that Banco de la República has to influence domestic interest rates, which has rendered the repo rate rather inefficient as a monetary policy tool. This paper studies the DTF rate and its development over time. It shows that a significant pass-through from the overnight interest rates to the DTF rate that was present before July 2002 thereafter seems to have vanished. It also provides a number of explanations to why the DTF rate has remained constant: Overnight rates have in real terms been negative and might, therefore, have been more out of the market than the DTF rate; due to heavy government borrowing, the yield curve has been too steep to allow a further lowering of the DTF rate; competition in the financial system is low, leading to sticky interest rates; the DTF rate is not a free-market auction rate but an offer rate set by the banks; and the DTF rate is a very dominant benchmark.
  16. By: Martin Shubik (Cowles Foundation, Yale University)
    Abstract: A game theoretic approach to the theory of money and financial institution is given utilizing both the strategic and coalitional forms for describing the economy. The economy is first modeled as a strategic market game, then the strategic form is used to calculate several cooperative forms that differ from each other in their utilization of money and credit and their treatment of threats. It is shown that there are natural upper and lower bounds to the monetary needs of an economy, but even in the extreme structures the concept of "enough money" can be defined usefully, and for large economies the games obtained from the lower and upper bounds have cores that approach the same limit that is an efficient price system. The role of disequilibrium is then discussed.
    Keywords: Money, Prices, Core, Threat, Market game, Strategic market game
    JEL: C71 C72 E40
    Date: 2006–07
  17. By: Matti Viren (Department of Economics, University of Turku)
    Abstract: This paper focuses on the determination of inflation expectations. The following two questions are examined: How much do inflation expectations reflect different economic and institutional regime shifts and in which way do inflation expectations adjust to past inflation? The basic idea in the analysis is an assumption that inflation expectations do not mechanically reflect past inflation as may econometric specification de facto assume but rather they depend on the relevant economic regime. Also the adjustment of expectations to past inflation is different in different inflation regimes. The regime analysis is based on panel data from EMU/EU countries for the period 1973–2004, while the inflation adjustment analysis mainly uses the Kalman filter technique for individual countries for the same period. Expectations (forecasts) are derived from OECD data. Empirical results strongly favour the regime-sensitivity hypothesis and provide an explanation for the poor performance of conventional estimation procedures in the context of Phillips curves
    Keywords: inflation expectations, Kalman filter, stability
    JEL: E32 E37
    Date: 2006–04
  18. By: Tigran Poghosyan; Evzen Kocenda
    Abstract: This paper studies foreign exchange risk premium using the uncovered interest rate parity framework in a model economy. The analysis is performed using weekly data on foreign and domestic currency deposits in the Armenian banking system. Results of the study indicate that contrary to the established view there is a positive correspondence between exchange rate depreciation and interest rate differentials. Further, it is shown that a systematic positive risk premium required by economic agents for foreign exchange transactions increases over the investment horizon. One-factor two-currency affine term structure framework applied in the paper is not sufficient to explain the driving forces behind the positive exchange rate risk premium. GARCH approach shows that central bank interventions and deposit volumes are two factors explaining time-varying exchange rate risk premium.
    Keywords: “Forward premium” puzzle, exchange rate risk, time-varying risk premium, affine term structure models, GARCH-in-Mean, foreign and domestic deposits, transition and emerging markets, Armenia.
    JEL: E43 E58 F31 G15 O16 P20
    Date: 2006–05
  19. By: Campell Leith (University of Glasgow, Department of Economics, Adam Smith Building, Glasgow G12 8RT, Scotland, United Kingdom.); Leopold von Thadden (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper develops a small New Keynesian model with capital accumulation and government debt dynamics. The paper discusses the design of simple monetary and fiscal policy rules consistent with determinate equilibrium dynamics in the absence of Ricardian equivalence. Under this assumption, government debt turns into a relevant state variable which needs to be accounted for in the analysis of equilibrium dynamics. The key analytical finding is that without explicit reference to the level of government debt it is not possible to infer how strongly the monetary and fiscal instruments should be used to ensure determinate equilibrium dynamics. Specifically, we identify in our model discontinuities associated with threshold values of steady-state debt, leading to qualitative changes in the local determinacy requirements. These features extend the logic of Leeper (1991) to an environment in which fiscal policy is non-neutral. Naturally, this non-neutrality increases the importance of fiscal aspects for the design of policy rules consistent with determinate dynamics. JEL Classification: E52; E63.
    Keywords: Monetary policy; fiscal regimes.
    Date: 2006–06
  20. By: Johannes Hoffmann (Deutsche Bundesbank, Economics Department, Wilhelm-Epstein-Straße 14, D-60431 Frankfurt am Main, Germany.); Jeong-Ryeol Kurz-Kim (Deutsche Bundesbank, Economics Department, Wilhelm-Epstein-Straße 14, D-60431 Frankfurt am Main, Germany.)
    Abstract: We analyse the adjustment of retail and services prices in a period of low inflation, using a set of individual price data from the German Consumer Price Index that covers the years 1998 to 2003. We strong find evidence of time- and statedependent price adjustment. Most importantly, the differences in “unconditional” sectoral price flexibility are found to be linked to input price volatility. JEL Classification: E31, D43, L11.
    Keywords: Price rigidity, price flexibility, Consumer Price Index, Germany.
    Date: 2006–07
  21. By: Viera Chemlarova (Sam Houston State University - Department of Economics and International Business, SHSU Box 2118, Huntsville , TX 77341-2118, United States.); Gunter Schnabl (University of Leipzig - Faculty of Economics and Business Administration, Marschnerstrasse 31, D-04109 Leipzig, Germany.)
    Abstract: The target zone model by Krugman (1991) assumes that foreign exchange intervention targets exchange rate levels. We argue that the fit of this model depends on the stage of development of capital markets. Foreign exchange intervention of countries with highly developed capital markets is in line with Krugman's (1991) model as the exchange rate level is targeted (mostly to sustain the competitiveness of exports) and the volatility of day-to-day exchange rate changes are left to market forces. In contrast, countries with underdeveloped capital markets control both volatility of day-to-day exchange rate changes as well as long-term fluctuations of the exchange rate levels to sustain the competitiveness of exports as well as to reduce the risk for short-term and long-term payment flows. Estimations of foreign exchange intervention reaction functions for Japan and Croatia trace the asymmetric pattern of foreign exchange intervention in countries with developed and underdeveloped capital markets. JEL Classification: F31.
    Keywords: Foreign exchange intervention; target zones; underdeveloped capital markets.
    Date: 2006–06
  22. By: Roberto A. De Santis (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Melanie Lührmann (Institute for Fiscal Studies, 7, Ridgmount Street, WC1E 7AE London, United Kingdom.)
    Abstract: In a panel covering a large number of countries from 1970 to 2003, we show that net portfolio flows play an important role in correcting external imbalances, since they are driven by common determinants represented by countries’ demographic profiles, the quality of institutions, monetary aggregates and initial net financial asset positions. Population ageing causes current account deficits, net equity inflows and net outflows in debt instruments. A higher money to GDP ratio – associated with lower interest rates – favours international investments in domestic stocks to the detriment of the less attractive domestic bonds. Additionally, current account balances are driven negatively by real GDP growth, losses in competitiveness and increases in the quality of the institutions; net equity flows are driven positively by the quality of the institutions and negatively by per capita income; while net flows in debt instruments are driven by long-term interest rate differentials and deviations from the UIP. JEL Classification: F21, F32, F41, O16.
    Keywords: Current accounts, net portfolio flows, panel regressions.
    Date: 2006–07

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