nep-mon New Economics Papers
on Monetary Economics
Issue of 2006‒09‒23
fifteen papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Monetary Policy Strategy: How Did We Get Here? By Frederic S. Mishkin
  2. Simple efficient policy rules and inflation control in Iceland By Ben Hunt
  3. Generalizing the Taylor Principle By Troy Davig; Eric M. Leeper
  4. Inflation, Variability, and the Evolution of Human Capital in a Model with Transactions Costs By Dimitrios Varvarigos
  5. The optimal degree of exchange rate flexibility: A target zone approach By Jesús Rodríguez López; Hugo Rodríguez Mendizábal
  6. The Evolution of the Fed's Inflation Target in an Estimated Model under RE and Learning By Fabio Milani
  8. Banks’ regulatory buffers, liquidity networks and monetary policy transmission By Merkl, Christian; Stolz, Stéphanie
  9. Estimating the Inflation-Output Variability Frontier with Inflation Targeting: A VAR Approach By W. Douglas McMillin; James S. Fackler
  10. Inflation Targeting, Exchange Rate Pass-Through and 'Fear of Floating' By Reginaldo P. Nogueira Jnr
  12. Generic Determinacy and Money Non-Neutrality of International Monetary Equilibria By Dimitrios P. Tsomocos
  13. Endogenous Monetary Policy Regime Change By Troy Davig; Eric M. Leeper
  14. Can a time-varying equilibrium real interest rate explain the excess sensitivity puzzle? By Alexius, Annika; Welz, Peter
  15. A Comparison of Five Federal Reserve Chairmen: Was Greenspan the Best? By Ray C. Fair

  1. By: Frederic S. Mishkin
    Abstract: This paper, which is the introductory chapter in my book, Monetary Policy Strategy, forthcoming from MIT Press, outlines how thinking in academia and central banks about monetary policy strategy has evolved over time. It shows that six ideas that are now accepted by monetary authorities and governments in almost all countries of the world have led to improved monetary performance: 1) there is no long-run tradeoff between output (employment) and inflation; 2) expectations are critical to monetary policy outcomes; 3) inflation has high costs; 4) monetary policy is subject to the time-inconsistency problem; 5) central bank independence helps improve the efficacy of monetary policy; and 6) a strong nominal anchor is the key to producing good monetary policy outcomes.
    JEL: E52 E58
    Date: 2006–09
  2. By: Ben Hunt
    Abstract: In March 2001 Iceland introduced inflation targeting. In the three years that followed, inflation was quickly stabilized at the target rate and fluctuated well within the Central Bank's tolerance band. However, since February 2005 inflation has often been above the upper tolerance limit. This raises the question of how tightly is it feasible to control inflation in a very small open economy like Iceland. This paper attempts to provide some empirical answers to this question using small estimated macroeconomic models of Iceland, New Zealand, Canada, the United Kingdom and the United States. These models are used to derive efficient monetary policy frontiers that trace of the locus of the lowest combinations of inflation and output variability that are achievable under a range of alternative rules for operating monetary policy. These efficient policy frontiers illustrate that inflation stabilization is a considerably more daunting challenge in Iceland than in other industrial countries, even other very small industrial countries like New Zealand. The key reason for this result is the relative magnitudes of the shocks to which the economy is subjected. If inflation outside the target band undermines the credibility of monetary policy, thereby increasing the real cost of maintaining price stability, these results suggest that the inflation targeting framework will need to continue to evolve to reduce the probability that targeted inflation will breach the tolerance range. Further, other macroeconomic policy changes, such more systematic coordination between monetary and fiscal policy, should be considered to help further reduce inflation and output variability in Iceland.
    Date: 2006–08
  3. By: Troy Davig (Federal Reserve Bank of Kansas City); Eric M. Leeper (Indiana University Bloomington)
    Abstract: The paper generalizes the Taylor principle—the proposition that central banks can stabilize the macroeconomy by raising their interest rate instrument more than one-for-one in response to higher inflation—to an environment in which reaction coefficients in the monetary policy rule evolve according to a Markov process. We derive a long-run Taylor principle that delivers unique bounded equilibria in two standard models. Policy can satisfy the Taylor principle in the long run, even while deviating from it substantially for brief periods or modestly for prolonged periods. Macroeconomic volatility can be higher in periods when the Taylor principle is not satisfied, not because of indeterminacy, but because monetary policy amplifies the impacts of fundamental shocks. Regime change alters the qualitative and quantitative predictions of a conventional new Keynesian model, yielding fresh interpretations of existing empirical work.
    Keywords: regime change, indeterminacy, monetary policy
    JEL: E31 E52 C62
    Date: 2006–08
  4. By: Dimitrios Varvarigos (Dept of Economics, Loughborough University)
    Abstract: In a monetary growth model, I show that average inflation inhibits growth while inflation volatility enhances it. The effect of nominal volatility on human capital accumulation depends on the response of money demand and the corresponding extent of transactions costs rather than from a direct, precautionary motive.
    Keywords: money; growth; volatility.
    JEL: E32 E60 O42
    Date: 2006–07
  5. By: Jesús Rodríguez López (Department of Economics, Universidad Pablo de Olavide); Hugo Rodríguez Mendizábal (Department of Economics, Universidad Autónoma de Barcelona)
    Abstract: This paper presents a benchmark model that rationalizes the choice of the degree of exchange rate flexibility. We show that the monetary authority may gain efficiency by reducing volatility of both the exchange rate and the interest rate at the same time. Furthermore, the model is consistent with some known stylized facts in the empirical literature on target zones that previous models were not able to generate jointly, namely, the positive relation between the exchange rate and the interest rate differential, the degree of non-linearity of the function linking the exchage rate to fundamentals and the shape of the exchange rate stochastic distribution.
    Keywords: Target zones, exchange rate agreements, monetary policy, time consistency.
    JEL: E52 F31 F33
    Date: 2006–09
  6. By: Fabio Milani (Department of Economics, University of California-Irvine)
    Abstract: This paper aims to infer the evolving Fed's inflation target by estimating a monetary model under the assumptions of RE and learning. The results emphasize how different assumptions about expectations may have important effects on the inferred target movements.
    Keywords: Time-varying inflation target; Learning, Expectations, Bayesian estimation
    JEL: E50 E52 E58
    Date: 2006–09
  7. By: Jim Engle-Warnick; Nurlan Turdaliev
    Abstract: We experimentally test whether a class of monetary policy decision rules describes decision making in a population of inexperienced central bankers. In our experiments, subjects repeatedly set the short-term interest rate for a computer economy with inflation as their target. A large majority of subjects learn to successfully control inflation. We find that Taylor-type rules fit the choice data well, and are instrumental in characterizing heterogeneity in decision making. Our experiment is the first to begin to organize data experimentally with an eye on monetary policy rules for this, one of the most widely watched and analyzed decisions in economics.
    JEL: C91 E42
    Date: 2006–09
  8. By: Merkl, Christian; Stolz, Stéphanie
    Abstract: Based on a quarterly regulatory dataset for German banks from 1999 to 2004, this paper analyzes the effects of banks’ regulatory capital on the transmission of monetary policy in a system of liquidity networks. The dynamic panel regression results provide evidence in favor of the bank capital channel theory. Banks holding less regulatory capital and less interbank liquidity react more restrictively to a monetary tightening than their peers.
    Keywords: monetary policy transmission, bank lending channel, bank capital channel, liquidity networks
    JEL: C23 E52 G21 G28
    Date: 2006
  9. By: W. Douglas McMillin; James S. Fackler
    Abstract: This paper (i) illustrates how a VAR model can be used to evaluate inflation targeting, (ii) derives the policy frontier available to the central bank using counterfactual experiments with real time data, and (iii) estimates how this frontier has changed over time in terms of the position and slope of the available tradeoff between output gap variability and inflation variability under inflation targeting. Various inflation targets are considered as are tolerance bands of varying width around these targets. The results indicate that over time (i) a given reduction in inflation variability is associated with a smaller rise in output variability and that (ii) a given inflation variability is achieved with smaller interest rate volatility. Consistent with the data, our results require federal funds rate persistence, though no instrument instability was observed. One interpretation of these results is that they reflect the growing credibility of the Federal Reserve.
  10. By: Reginaldo P. Nogueira Jnr
    Abstract: The paper presents evidence on exchange rate pass-through and the "Fear of Floating" hypothesis before and after Inflation Targeting for a set of developed and emerging market economies. We use a structural VAR model to estimate the effect of depreciations on prices. The results support the view of the previous literature that the pass-through is higher for emerging than for developed economies, and that it has decreased after the adoption of Inflation Targeting. We then use several different methodologies to examine the existence of "Fear of Floating" practices. We observe a drastic reduction in direct foreign exchange market intervention after the adoption of Inflation Targeting. As the exchange rate pass-through still matters for the attainment of the inflation targets, "Fear of Floating" seems to play only a minor role for most economies in our sample.
    Keywords: Inflation Targeting; Exchange Rate Pass-Through, 'Fear of Floating'
    JEL: E31 E52 F31 F41
    Date: 2006–09
  11. By: Jan Libich
    Abstract: This paper shows an avenue through which a numerical inflation target ensures low inflation and high credibility: one that is independent of the usual Walsh incentive contract. Our novel game theoretic framework - a generalization of alternating move games - formalizes the fact that since the target is explicit/legislated, it cannot be frequently reconsidered. The "explicitness" therefore serves as a commitment device. There are two key results. First, it is shown that if the inflation target is sufficiently rigid (explicit) relative to the public's wages, low inflation is time consistent and hence credible even if the policymaker's output target is above potential. Second, it is found that the central banker's optimal explicitness level is decreasing in the degree of her patience/independence (due to their substitutability in achieving credibility). Our analysis therefore offers an explanation for the "inflation and credibility convergence" over the past two decades as well as the fact that inflation targets were legislated primarily by countries that had lacked central bank independence like New Zealand, Canada and the UK rather than the US, Germany, or Switzerland. We show that there exists fair empirical support for all the predictions of our analysis.
    JEL: E42 E61 C70 C72
    Date: 2006–09
  12. By: Dimitrios P. Tsomocos
    Abstract: I address the issue of the 'number' of International Monetary Equilibria that the international finance model of Geanakoplos and Tsomocos (2002) possesses. The mainstream competitive model has locally unique equilibria with respect to the real side of the economy; however, it manifests nominal indeterminacy. Kareken and Wallace (1981) extend the O.L.G. indeterminacy result to a monetary model of the international economy. However, the role of monetary sector together with the market and agent heterogeneity remove real and nominal indeterminacy in the Geanakoplos and Tsomocos model. In particular, nominal indeterminacy abruptly disappears when private liquid wealth is non-zero. Finally, monetary policy becomes non-neutral since monetary changes affect nominal variables which in turn determine different real allocations. Lucas did not find these non-neutral effects in his model of international finance because he postulated a 'sell-all model' in which every agent sells everything he owns in every period. Thus, the number of transactions remain unaffected by definition regardless of any policy changes. Instead, when transactions emerge endogenously in equilibrium monetary policy has non-neutral effects provided that there exist potential gains to trade at the initial allocation of goods.
    Keywords: Determinacy, exchange rates, liquid wealth, non-neutrality, monetary policy
    JEL: D5 E5 E6 F1 F2 F3
    Date: 2006
  13. By: Troy Davig (Federal Reserve Bank of Kansas City); Eric M. Leeper (Indiana University Bloomington)
    Abstract: This paper makes changes in monetary policy rules (or regimes) endogenous. Changes are triggered when certain endogenous variables cross specified thresholds. Rational expectations equilibria are examined in three models of threshold switching to illustrate that (i) expectations formation effects generated by the possibility of regime change can be quantitatively important; (ii) symmetric shocks can have asymmetric effects; (iii) endogenous switching is a natural way to formally model preemptive policy actions. In a conventional calibrated model, preemptive policy shifts agents’ expectations, enhancing the ability of policy to offset demand shocks; this yields a quantitatively significant “preemption dividend.”
    Keywords: Markov switching, Taylor rule, expectations formation
    JEL: E31 E32 E52 E58
    Date: 2006–08
  14. By: Alexius, Annika (Department of Economics); Welz, Peter (Riksbanken)
    Abstract: The strong response of long-term interest rates to macroeconomic shocks has typically been explained in terms of informational asymmetries between the central bank and private agents. The standard models assume that the equilibrium real interest rate is constant over time and independent of structural shocks. We incorporate time-variation in the equilibrium real interest rate as function of structural shocks to e.g. productivity and demand. This extended model implies that forward interest rates at long horizons move about 40 basis points as the short-term interest rate increases one percentage point. In terms of regressions of changes in long-term interest rates on changes in the short-term interest rate, including a time-varying equilibrium real interest rate explains about half of the puzzle.
    Keywords: Term structure; equilibrium real interest rate; unobserved components model
    JEL: C51 E43 E52
    Date: 2006–09–11
  15. By: Ray C. Fair (Cowles Foundation, Yale University)
    Abstract: This paper examines the performances of the past five Federal Reserve chairmen using optimal control techniques and a macroeconometric model. Each chairman is judged by the actual performance of the economy under his term relative to what the performance would have been had he behaved optimally. Comparing chairmen only on the basis of the actual performance of the economy is not appropriate because it does not control for different exogenous-variable values and shocks that the Fed has no control over. The results suggest that Greenspan was indeed the best, but followed closely by Martin. Volcker also does well, but probably not quite as well as Greenspan and Martin. However, Volcker does much better than one would conclude he did by just looking at the actual state of the economy during his term. Miller and Burns do poorly; they should have been considerably tighter than they were.
    Keywords: Fed chairmen, Optimal control, Economic performance
    JEL: E52
    Date: 2006–09

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