nep-mon New Economics Papers
on Monetary Economics
Issue of 2006‒10‒14
twenty-six papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. The anchoring of European inflation expectations By Jan Marc Berk; Gerbert Hebbink
  2. Monetary Transmission and Bank Lending in Portugal: A Sectoral Approach By José Alberto Fuinhas
  3. Monetary base By Richard G. Anderson
  4. Does the time inconsistency problem make flexible exchange rates look worse than you think? By Roc Armenter; Martin Bodenstein
  5. Bank Behavior and the Cost Channel of Monetary Transmission By Oliver Hülsewig; Eric Mayer; Timo Wollmershäuser
  6. An economic explanation of the early Bank of Amsterdam, debasement, bills of exchange, and the emergence of the first central bank By Stephen Quinn; William Roberds
  7. The New Consensus in Monetary Policy: Is the NKM fit for the purpose of inflation targeting? By Peter N. Smith; Mike Wickens
  8. Using Taylor Rules to Assess the Relative Activism of the European Central Bank, the Bank of England and the Federal Reserve Board By David Cobham
  9. Learning about the term structure and optimal rules for inflation targeting By Tesfaselassie,Mewael F.; Schaling,Eric; Eijffinger,Sylvester
  10. What do robust policies look like for open economy inflation targeters? By Kirdan Lees
  11. The great inflation and early disinflation in Japan and Germany By Edward Nelson
  12. Non-Linear Effects of Monetary Policy and Real Exchange Rate Shocks in Partially Dollarized Economies: An Empirical Study for Peru By Saki Bigio; Jorge Salas
  13. Endogenous monetary policy regime change By Troy Davig; Eric Leeper
  14. The Lucas critique and the stability of empirical models By Thomas A. Lubik; Paolo Surico
  15. The Optimal Monetary Policy Response to Exchange Rate Misalignments By Cambell Leith; Simon Wren-Lewis
  16. Expected Money Growth, Markov Trends and the Instability of Money Demand in the Euro Area By Sylvia Kaufmann; Peter Kugler
  17. Is there Really a Unit Root in the Inflation Rate? More Evidence from Panel Data Models By Basher, Syed A.; Westerlund, Joakim
  18. International Capital Flows and U.S. Interest Rates By Francis E. Warnock; Veronica Cacdac Warnock
  19. Bretton Woods and the U.S. decision to intervene in the foreign-exchange market, 1957-1962 By Michael D. Bordo; Owen F. Humpage; Anna J. Schwartz
  20. The Uneasy Case for Fractional-Reserve Free Banking By van den Hauwe, Ludwig
  21. Which price index for Eurozone Index-Linked Bonds? By Arnold, Ivo
  22. Local Currency Bond Markets By John D. Burger; Francis E. Warnock
  23. Indeterminacy in a Forward Looking Regime Switching Model By Roger E. A. Farmer; Daniel F. Waggoner; Tao Zha
  24. High Dimensional Yield Curves: Models and Forecasting By Clive Bowsher; Roland Meeks
  25. Money Velocity in an Endogenous Growth Business Cycle with Credit Shocks By Szilárd Benk; Max Gillman; Michal Kejak

  1. By: Jan Marc Berk; Gerbert Hebbink
    Abstract: This paper analyses the usefulness of direct measures of consumers’ perceptions and expectations of inflation for monetary policy and investigates the degree to which these variables are anchored. We inter alia seek to xplore whether there is a difference in reaction of consumers in countries with more credible central banks and those from countries with less credible central banks. We moreover investigate whether the introduction of euro coins and banknotes in 2002, that can be interpreted as a structural shock, has significantly affected the inflation rate as perceived by consumers. We find that European inflation expectations are relatively robust to sudden changes in inflation or monetary policy surprises, regardless of the credibility of the central bank. The introduction of the euro, however, significantly affected the inflation perception of European consumers.
    Keywords: Inflation expectations; Monetary policy; Survey data
    JEL: C31 C32 E58
    Date: 2006–10
  2. By: José Alberto Fuinhas (Departamento de Gestão e Economia, Universidade da Beira Interior)
    Abstract: This paper investigates the role of bank lending in the monetary transmission process in Portugal. We estimate a small sectoral VAR model of the Portuguese macroeconomy. This model is then used to simulate the effects of an exogenous monetary policy shock upon asset prices, bank balance sheet variables and final target variables (activity and prices), for the personal and corporate sectors. Significant sectoral differences are found among the channels of monetary transmission. In addition, the use of sectoral data facilitates the identification of distinct money and credit channels in the transmission of monetary policy. These results contrast with the ambiguous findings on the roles of money and credit in the literature to date. Our study suggests that there is a bank-lending channel in Portugal.
    Keywords: Credit channel; bank lending; and monetary transmission
    JEL: C32 E44 E51 E52
    Date: 2006
  3. By: Richard G. Anderson
    Abstract: This brief essay is a working draft of an article in preparation for the forthcoming International Encyclopedia of the Social Sciences, 2nd ed., examining the role of the monetary base in monetary economics and monetary policymaking. Comments are welcome.
    Keywords: Money supply ; Monetary policy
    Date: 2006
  4. By: Roc Armenter; Martin Bodenstein
    Abstract: The Barro-Gordon inflation bias has provided the most influential argument for fixed exchange rate regimes. However, with low inflation rates now widespread, credibility concerns seem no longer relevant. Why give up independent monetary policy to contain an inflation bias that is already under control? We argue that credibility problems do not end with the inflation bias and they are a larger drawback for flexible exchange rates than usually thought. Absent commitment, independent monetary policy can induce expectation traps---that is, welfare ranked multiple equilibria---and perverse policy responses to real shocks, i.e., an equilibrium policy response that is welfare inferior to policy inaction. Both possibilities imply that flexible exchange rates feature unnecessary macroeconomic volatility.
    Keywords: Foreign exchange rates ; Inflation (Finance) ; Monetary policy
    Date: 2006
  5. By: Oliver Hülsewig; Eric Mayer; Timo Wollmershäuser
    Abstract: This paper presents a New Keynesian model that dwells on the role of banks in the cost channel of monetary policy. Banks extend loans to firms in an environment of monopolistic competition by setting the loan rate according to a Calvo-type staggered price setting approach, which means that the adjustment of the aggregate loan rate to a monetary policy shock is sticky. We estimate the model for the Euro area by adopting a minimum distance approach. Our findings exhibit that, first, frictions on the loan market influence the propagation of monetary policy shocks as the pass-through of a change in the money market rate to the loan rate is incomplete, and, second, the cost channel is operating, but the effect is weak since inflation is driven by real unit labor costs rather than the loan rate. Our main conclusion is that the strength of the cost channel is mitigated as banks shelter firms from monetary policy shocks by smoothing lending rates.
    Keywords: bank behavior, cost channel, minimum distance estimation
    JEL: E44 E52 E58
    Date: 2006
  6. By: Stephen Quinn; William Roberds
    Abstract: The Bank of Amsterdam, founded in 1609, was the first public bank to offer accounts not directly convertible to coin. As such, it can be described as the first true central bank. The debut of central bank money did not result from any conscious policy decision, however, but instead arose almost by accident, in response to the chaotic monetary conditions during the early years of the Dutch Republic. This paper examines the history of this momentous development from the perspective of modern monetary theory.
    Date: 2006
  7. By: Peter N. Smith; Mike Wickens
    Abstract: In this paper we examine whether or not the NKM is .t for the purpose of providing a suitable basis for the conduct of monetary policy through inflation targeting. We focus on a number of issues: the dynamic response of inflation to interest rates in a theoretical NKM under discretion and commitment to a Taylor rule; the implications for the specification of the New Keynesian Phillips equation of alternative models of imperfect competition in a closed and an open economy; the general equilibrium underpinnings of the IS function; the extent of empirical support for the NKM; what the empirical evidence on the NKM implies for inflation targeting. Our findings reveal a number of problems with the NKM. Theoretically, the NKM predicts that a discretionary increase in interest rates will increase inflation, not reduce it. This is supported by our VAR evidence. Estimates of the NKM indicate a negative relation between interest rates and inflation, but the signs in the structural equations are inconsistent with the theory. We conclude that the standard specifications of the inflation and output equations are inadequate and that these equations should be embedded in a larger model.
    Keywords: Inflation targeting, monetary policy, New Keynesian model
    JEL: E3 E5
    Date: 2006–09
  8. By: David Cobham
    Abstract: This paper attempts to assess the relative activism of these three central banks, with reference to the debate on interest rate smoothing. It investigates smoothing in terms of the pattern of interest rate changes, and estimates a series of Taylor-type policy rules for each bank, using quarterly and monthly data, with ‘backward’ and ‘forward’-looking arguments, and with and without lagged dependent variables. It also examines the effect of introducing an auto-correlated error term. There is some (non-robust) evidence that the FRB is more activist, but it also seems to be more smooth; the ECB seems to adjust faster but less strongly in the long run; and the BoE’s behaviour is more difficult to identify. However, these standard policy rules are out of kilter with central banks’ own descriptions of what they do, while the long lags involved raise questions about the relevance of the Taylor principle as conventionally applied. It is therefore suggested that researchers should pay more attention to the institutional context of central banks’ behaviour, in order to produce better estimates of their policy rules which would in turn shed more light on the issues of activism and smoothing.
    Keywords: Monetary policy, activism, interest rate smoothing, central banks.
    JEL: E43 E52
    Date: 2006–09
  9. By: Tesfaselassie,Mewael F.; Schaling,Eric; Eijffinger,Sylvester (Tilburg University, Center for Economic Research)
    Abstract: In this paper we incorporate the term structure of interest rates in a standard inflation forecast targeting framework. We find that under flexible inflation targeting and uncertainty in the degree of persistence in the economy, allowing for active learning possibilities has e®ects on the optimal interest rate rule followed by the central bank. For a wide range of possible initial beliefs about the unknown parameter, the dynamically optimal rule is in general more activist, in the sense of responding aggressively to the state of the economy, than the myopic rule for small to moderate deviations of the state variable from its target. On the other hand, for large deviations, the optimal policy is less activist than the myopic and the certainty equivalence policies.
    Keywords: Learning;Rational Expectations;Separation Principle;Term Structure of Interest Rates
    JEL: C53 E43 E52 F33
    Date: 2006
  10. By: Kirdan Lees (Reserve Bank of New Zealand)
    Abstract: Typical New Keynesian open economy models suggest a limited response to the exchange rate. This paper examines the role of the open economy in determining robust rules when the central bank fears various model misspecification errors. The paper calibrates a hybrid New Keynesian model to broadly fit the economies of three archetypal open economy inflation targeters - Australia, Canada, and New Zealand - and seeks robust time-consistent policy. We find that policies robust to model misspecification react more aggressively to not only the exchange rate, but also inflation, the output gap and their associated shocks. This result generalizes to the context of a flexible inflation targeting central bank that cares about the volatility of the real exchange rate. However, when the central bank places only a small weight on interest rate smoothing and fears misspecification in only exchange rate determination, a more cautious policy is recommended for all but an exchange rate shock. It is also shown that the benefits of an exchange rate channel far outweigh the concomitant costs of uncertain exchange rate determination.
    JEL: C51 E52 F41
    Date: 2006–09
  11. By: Edward Nelson
    Abstract: This paper considers the Great Inflation of the 1970s in Japan and Germany. From 1975 onward these countries had low inflation relative to other large economies. Traditionally, this success is attributed to a stronger discipline on the part of Japan and Germany*s monetary authorities*for example, more willingness to accept temporary unemployment, or stronger determination not to monetize government deficits. I instead attribute the success of these countries from the mid-1970s to their governments* and monetary authorities* acceptance that inflation is a monetary phenomenon. Symmetrically, their higher inflation in the first half of the 1970s is attributable to the fact that their policymakers over this period embraced nonmonetary theories of inflation.
    Keywords: Inflation (Finance) ; Economic conditions - Japan ; Economic conditions - Germany
    Date: 2006
  12. By: Saki Bigio (New York University and Central Bank of Peru); Jorge Salas (Central Bank of Peru)
    Abstract: We study whether monetary policy and real exchange rate shocks have non-linear effects on output and inflation in a partially dollarized economy such as Peru. For this purpose, we use a Smooth Transition Vector Autoregression methodology and then report impulse-response functions for shocks of different sign and size, and conditional to the initial position in the business cycle. We find evidence of non-linearities which imply a convex aggregate supply curve: in particular, monetary policy is more likely to affect the output during recessions than in booms, while the opposite is found for the inflation. Regarding real exchange rate shocks, we show that depreciations have greater negative effects during economic downturns and a higher pass-through rate in the positive side of the business cycle.
    Keywords: Non-linearities, Monetary Policy, Smooth Transition VAR, Dollarization
    JEL: E32 E52 E58 C32
    Date: 2006–08
  13. By: Troy Davig; Eric Leeper
    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: Monetary policy
    Date: 2006
  14. By: Thomas A. Lubik; Paolo Surico
    Abstract: This paper re-considers the empirical relevance of the Lucas critique using a DSGE sticky price model in which a weak central bank response to inflation generates equilibrium indeterminacy. The model is calibrated on the magnitude of the historical shift in the Federal Reserve’s policy rule and is capable of generating the decline in the volatility of inflation and real activity observed in U.S. data. Using Monte Carlo simulations and a backward-looking model of aggregate supply and demand, we show that shifts in the policy rule induce breaks in both the reduced-form coefficients and the reduced-form error variances. The statistics of popular parameter stability tests are shown to have low power if such heteroskedasticity is neglected. In contrast, when the instability of the reduced-form error variances is accounted for, the Lucas critique is found to be empirically relevant for both artificial and actual data.
    Keywords: Monetary policy ; Econometric models
    Date: 2006
  15. By: Cambell Leith; Simon Wren-Lewis
    Abstract: A common feature of exchange rate misalignments is that they produce a divergence between traded and non-traded goods sectors, which appears to pose a dilemma for policy makers. In this paper we develop a small open economy model which features traded and non-traded goods sectors with which to assess the extent to which monetary policy should respond to exchange rate misalignments. To do so we initially contrast the efficient outcome of the model with that under flexible prices and find that the flex price equilibrium exhibits an excessive exchange rate appreciation in the face of a positive UIP shock. By introducing sticky prices in both sectors we provide a role for policy in the face of UIP shocks. We then derive a quadratic approximation to welfare which comprises quadratic terms in the output gaps in both sectors as well as sectoral rates of inflation. These can be rewritten in terms of the usual aggregate variables, but only after including terms in relative sectoral prices and/or the terms of trade to capture the sectoral composition of aggregates. We derive optimal policy analytically before giving numerical examples of the optimal response to UIP shocks. Finally, we contrast the optimal policy with a number of alternative policy stances and assess the robustness of results to changes in model parameters.
    Date: 2006–09
  16. By: Sylvia Kaufmann (Oesterreichische Nationalbank, Economic Studies Division); Peter Kugler (University of Basel, WWZ, Petersgraben 51, CH-4003 Basel)
    Abstract: This paper analyzes the recently documented instability of money demand in the euro area in the framework of a Markov switching trend model. First, we consider a standard flexible price model with stable money demand, rational expectations, and an exogenous income-money ratio which follows a Markov trend. This framework, which implies an influence of expected future money on prices, leads to a cointegrating relationship between (log) prices and the (log of the) money-income ratio with a switching intercept term. Of course, this likely leads to a rejection of cointegration by standard tests and to the erroneous conclusion of an unstable money demand. Second, a more general model allowing for endogeneity and more general dynamics is estimated with Bayesian methods for euro area data from 1975-2003. This exercise provides support for our model and a stable demand for M3 in the euro area.
    Keywords: Bayesian cointegration analysis, Markov trend, Markov chain Monte Carlo, money demand.
    JEL: C11 C32 E41
    Date: 2006–09–15
  17. By: Basher, Syed A.; Westerlund, Joakim
    Abstract: Time series unit root evidence suggests that inflation is nonstationary. By contrast, when using more powerful panel unit root tests, Culver and Papell (1997) find that inflation is stationary. In this paper, we test the robustness of this result by applying a battery of recent panel unit root tests. The results suggest that the stationarity of inflation holds even after controlling for crosssectional dependence and structural change.
    Keywords: Unit Root; Inflation; Cross-Sectional Dependence; Structural Change.
    JEL: C32 E31 C33
    Date: 2006
  18. By: Francis E. Warnock; Veronica Cacdac Warnock
    Abstract: Foreign official purchases of U.S. government bonds have an economically large and statistically significant impact on long-term interest rates. Federal Reserve credibility, as evidenced by dramatic reductions in both long-term inflation expectations and the volatility of long rates, contributed much to the decline of long rates in the 1990s. More recently, however, foreign flows have become important. Controlling for various factors given by a standard macroeconomic model, we estimate that had there been no foreign official flows into U.S. government bonds over the past year, the 10-year Treasury yield would currently be 90 basis points higher. Our results are robust to a number of alternative specifications.
    JEL: E43 E44 F21
    Date: 2006–10
  19. By: Michael D. Bordo; Owen F. Humpage; Anna J. Schwartz
    Abstract: The deterioration in the U.S. balance of payments after 1957 and an accelerating loss of gold reserves prompted U.S. monetary authorities to undertake foreign-exchange-market interventions beginning in 1961. We discuss the events leading up to these interventions, the institutional arrangements developed for that purpose, and the controversies that ensued. Although these interventions forestalled a loss of U.S. gold reserves, in the end, they only delayed more fundamental adjustments and, in that respect, were a failure.
    Keywords: Foreign exchange administration ; Bretton Woods Agreements Act
    Date: 2006
  20. By: van den Hauwe, Ludwig
    Abstract: Since a few decades several sub-disciplines within economics have witnessed a reorientation towards institutional analysis. This development has in particular also affected the fields of macroeconomics and monetary theory where it has led to several proposals for far-reaching financial and monetary reform. One of the more successful of these proposals advocates a fractional-reserve free banking system, that is, a system with no central bank, but with permission for the banks to operate with a fractional reserve. This article exposes several conceptual flaws in this proposal. In particular several claims of the fractional-reserve free bankers with respect to the purported working characteristics of this system are criticized from the perspective of economic theory. In particular, the claim that a fractional-reserve free banking system would lead to the disappearance of the business cycle is recognized as false. Furthermore an invisible-hand analysis is performed, reinforcing the conclusion that fractional-reserve free banking is incompatible with the ethical and juridical principles underlying a free society.
    Keywords: monetary and banking regimes; comparative institutional analysis; central banking versus free banking controversy; fractional-reserve free banking; Law and Economics of money and banking;
    JEL: E50 E32 E42 B53 K39 G18 P34 H11
    Date: 2006–10–05
  21. By: Arnold, Ivo (Nyenrode Business Universiteit)
    Abstract: Index-linked bonds (ILBs) constitute a small but growing segment of the eurozone bond market. Issuers of index-linked bonds face a choice between linking to either a eurozone or a national price index. This paper examines this choice both theoretically and empirically and ends up with the following conclusions. First, ILBs linked to eurozone inflation are much less useful for diversification purposes than nationally indexed ILBs. This is hard to square with the intended use of these bonds. Second, ILBs linked to national price indices are imperfect hedges for national inflation. The latter finding is counterintuitive and arises because of monetary union.
    Keywords: Index-linked bonds; inflation; EMU
    Date: 2006
  22. By: John D. Burger; Francis E. Warnock
    Abstract: We analyze the development of 49 local bond markets. Our main finding is that policies and laws matter: Countries with stable inflation rates and strong creditor rights have more developed local bond markets and rely less on foreign-currency-denominated bonds. The results suggest that “original sin†is a misnomer. Emerging economies are not inherently dependent upon foreign-currency debt. Rather, by improving policy performance and strengthening institutions they may develop local currency bond markets, reduce their currency mismatch, and lessen the likelihood of future crises.
    JEL: F30 G15 O16
    Date: 2006–10
  23. By: Roger E. A. Farmer; Daniel F. Waggoner; Tao Zha
    Abstract: This paper is about the properties of Markov switching rational expectations (MSRE) models. We present a simple monetary policy model that switches between two regimes with known transition probabilities. The first regime, treated in isolation, has a unique determinate rational expectations equilibrium and the second contains a set of indeterminate sunspot equilibria. We show that the Markov switching model, which randomizes between these two regimes, may contain a continuum of indeterminate equilibria. We provide examples of stationary sunspot equilibria and bounded sunspot equilibria which exist even when the MSRE model satisfies a 'generalized Taylor principle'. Our result suggests that it may be more difficult to rule out non-fundamental equilibria in MRSE models than in the single regime case where the Taylor principle is known to guarantee local uniqueness.
    JEL: E31 E4 E52
    Date: 2006–09
  24. By: Clive Bowsher (Nuffield College, University of Oxford); Roland Meeks (Nuffield College, University of Oxford)
    Abstract: Functional Signal plus Noise (FSN) models are proposed for analysing the dynamics of a large cross-section of yields or asset prices in which contemporaneous observations are functionally related. The FSN models are used to forecast high dimensional yield curves for US Treasury bonds at the one month ahead horizon. The models achieve large reductions in mean square forecast errors relative to a random walk for yields and readily dominate both the Diebold and Li (2006) and random walk forecasts across all maturities studied. We show that the Expectations Theory (ET) of the term structure completely determines the conditional mean of any zero-coupon yield curve. This enables a novel evaluation of the ET in which its 1-step ahead forecasts are compared with those of rival methods such as the FSN models, with the results strongly supporting the growing body of empirical evidence against the ET. Yield spreads do provide important information for forecasting the yield curve, especially in the case of shorter maturities, but not in the manner prescribed by the Expectations Theory.
    Keywords: Yield curve, term structure, expectations theory, FSN models, functional time series, forecasting, state space form, cubic spline.
    JEL: C33 C51 C53 E47 G12
    Date: 2006–10–02
  25. By: Szilárd Benk; Max Gillman; Michal Kejak
    Abstract: The explanation of velocity has been based in substitution and income effects, since Keynes’s (1923) interest rate explanation and Friedman’s (1956) application of the permanent income hypothesis to money demand. Modern real business cycle theory relies on a goods productivity shocks to mimic the data’s procyclic velocity feature, as in Friedman’s explanation, while finding money shocks unimportant and not integrating financial innovation explanations. This paper sets the model within endogenous growth and adds credit shocks. It models velocity more closely, with significant roles for money shocks and credit shocks, along with the goods productivity shocks. Endogenous growth is key to the construction of the money and credit shocks since they have similar effects on velocity, through substitution effects from changes in the nominal interest rate and in the cost of financial intermediation, but opposite effects upon growth, through permanent income effects that are absent with exogenous growth.
    Keywords: Velocity, business cycle, credit shocks, endogenous growth.
    JEL: E13 E32 E44
    Date: 2006–09
  26. By: Svitlana Maksymenko
    Date: 2006–01

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