nep-mon New Economics Papers
on Monetary Economics
Issue of 2006‒11‒04
35 papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. The political economy of monetary policy conduct and central bank design By Manfred Gärtner
  2. Exchange Rate Pass-Through and Monetary Policy: Evindence from OECD countries By Cesar Carrera; Mahir Binici
  3. Money at Low Frequencies By Assenmacher-Wesche, Katrin; Gerlach, Stefan
  4. Monetary policy in the media By Helge Berger; Michael Ehrmann; Marcel Fratzscher
  5. The role of expectations in monetary policy By Maria Demertzis
  7. Regional inflation dynamics within and across euro area countries and a comparison with the US By Günter W. Beck; Kirstin Hubrich; Massimiliano Marcellino
  8. David Laidler on Monetarism By Michael Bordo; Anna J. Schwartz
  9. Short-Run and Long-Run Causality between Monetary Policy Variables and Stock Prices By Jean-Marie Dufour; David Tessier
  10. Learning About the Term Structure and Optimal Rules for Inflation Targeting By Eijffinger, Sylvester C W; Schaling, Eric; Tesfaselassie, Mewael F.
  11. Revealing the Secrets of the Temple: The Value of Publishing Central Bank Interest Rate Projections By Glenn D. Rudebusch; John C. Williams
  12. Fiscal Policy in a Monetary Union Under Alternative Labour-Market Structures. By Moïse Sidiropoulos; Eleftherios Spyromitros
  13. Learning to manage external constraints : Belgian monetary policy during the Bretton Woods era (1944-1971) By Philippe, LEDENT; Isabelle, CASSIERS
  14. Robust Control and Monetary Policy Delegation. By Giuseppe Diana; Moise Sidiropoulos
  15. The Structural Dynamics of US Output and Inflation: What Explains the Changes? By Canova, Fabio; Gambetti, Luca; Pappa, Evi
  16. Forecasting Food Price Inflation in Developing Countries with Inflation Targeting Regimes: the Colombian Case By Eliana González; Miguel I. Gómez; Luis F. Melo; José Luis Torres
  17. Disinflation in an Open-Economy Staggered-Wage DGE Model: Exchange-Rate Pegging, Booms and the Role of Preannouncement By John Fender; Neil Rankin
  18. INTEREST RATE PASS-THROUGH IN COLOMBIA: A MICRO-BANKING PERSPECTIVE By Rocio Betancourt; Hernando Vargas; Norberto Rodríguez
  19. Supply Shocks and Currency Crises: The Policy Dilemma Reconsidered By García-Fronti, Javier; Miller, Marcus; Zhang, Lei
  20. Openness and Inflation By Dudley Cooke
  21. The geography of international portfolio flows, international CAPM and the role of monetary policy frameworks By Roberto A. De Santis
  22. The Conquest of South American Inflation By Thomas Sargent; Noah Williams; Tao Zha
  23. Monetary Intervention Mitigated Banking Panics During the Great Depression: Quasi-Experimental Evidence from the Federal Reserve District Border in Mississippi, 1929 to 1933 By Gary Richardson; William Troost
  24. Price setting behaviour and price setting regulations at the euro changeover By Thomas A. Eife
  25. Is reversion to PPP in euro exchange rates non-linear? By Bernd Schnatz
  26. Profitability of simple trading strategies exploiting the forward premium bias in foreign exchange markets and the time premium in yield curves By Andres Vesilind
  27. BALANCE OF PAYMENTS CRISES UNDER FIXED EXCHANGE RATE IN COLOMBIA: 1938-1967 By Fabio Sánchez; Andrés Fernández; Armando Armenta
  28. Equilibrium Yield Curves By Monika Piazzesi; Martin Schneider
  29. The Returns to Currency Speculation By Burnside, A Craig; Eichenbaum, Martin; Kleshchelski, Isaac; Rebelo, Sérgio
  30. A Simple Test of the Effect of Interest Rate Defense By Allan Drazen; Stefan Hubrich
  31. The Obstinate Passion of Foreign Exchange Professionals : Technical Analysis By Menkhoff, Lukas; Taylor, Mark P.
  32. Discrete Devaluations and Multiple Equilibria in a First Generation Model of Currency Crises By Broner, Fernando A
  33. Bank Distress During the Great Contraction, 1929 to 1933, New Data from the Archives of the Board of Governors By Gary Richardson
  34. Forecasting measures of inflation for the Estonian economy By Agostino Consolo
  35. Tracing the Impact of Bank Liquidity Shocks: Evidence from an Emerging Market By Atif Mian; Asim Ijaz Khwaja

  1. By: Manfred Gärtner
    Abstract: This paper provides a concise overview of the state of the art on monetary policy and central banking from a public choice perspective. It starts with a brief look at the roots of today’s view of monetary policy conduct and the design of pertinent institutions in early work on political business cycles, and then proceeds to a discussion of the inflationstabilization dilemma along with proposed solutions in the form of central bank independence and conservativeness, incentive contracts, and inflation policy targets. The last section addresses current developments. These include the proper choice of monetary policy targets, the role of New Keynesian and sticky-information aggregate-supply curves and the quest for simple and efficient rules for monetary policy that has been triggered by the proposal and widespread polularity of the Taylor rule.
    Keywords: Monetary policy, central banking, rules, discretion, stabilization, inflation, bias, public choice
    JEL: E31 E32 E52 E58
    Date: 2006–10
  2. By: Cesar Carrera (University of California, Santa Cruz and Central Bank of Peru); Mahir Binici (University of California, Santa Cruz and Central Bank of Turkey)
    Abstract: We provide an empirical analysis about the relationship between exchange rate and different price indexes for each OECD country. We were focused on how different inflation environments could explain a decreasing degree of the exchange rate pass-through over prices in each country. In a second stage, we estimate the relationship between pass-through and prices using individual-country pass-through. We find evidence in favor of the hypothesis that the exchange rate pass-through is lower when it is taken into account environments in which it is observed lower and stables rates of inflation, result which would be associated with a more effective monetary policy in terms of transparency and inflation control.
    Keywords: Pass-through, Exchange rate, Inflation, Monetary Policy
    JEL: E31 E52 F3 F4 C22 C31
    Date: 2006–10
  3. By: Assenmacher-Wesche, Katrin; Gerlach, Stefan
    Abstract: Many central banks have abandoned monetary targeting because the link between money growth and inflation seemed to disappear in the 1980s. Using spectral regression techniques, we show that for the euro area, Japan, the UK and the US there is a unit relationship between money growth and inflation at low frequencies when the impact of interest rate changes on money demand is accounted for. We estimate Phillips-curve equations in which the low-frequency information from money growth is combined with high-frequency information from the output gap to explain movements in inflation.
    Keywords: frequency domain; Phillips curve; Quantity theory; spectral regression
    JEL: C22 E3
    Date: 2006–10
  4. By: Helge Berger (Free University Berlin, Department of Economics, Boltzmannstr. 20, 14195 Berlin, Germany & CESifo.); Michael Ehrmann (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: Media coverage of monetary policy actions is a central channel of a central bank’s communication with the wider public, and thus an important factor for its credibility and policy effectiveness. This paper analyses the coverage which ECB monetary policy decisions receive in the print media, and the determinants of its extent and of its favorableness. We find that that the press critically discusses the ECB’s policy decisions in the context of prior market expectations and of the inflation environment, and that the media’s coverage of decisions is generally highly responsive to ECB communication – in particular its Press Conference on meeting days. However, the paper also finds clear limitations in this regard, thus underlining the critical monitoring role assumed by the media. JEL Classification: E52, E58.
    Keywords: Monetary policy, ECB, communication, media, press, coverage, transparency, accountability.
    Date: 2006–09
  5. By: Maria Demertzis
    Abstract: Recent literature on monetary policy has emphasised the role of expectations and the merits of tying them down through credible commitment. However, although always in favour of reaping the benefits of having committed, Central Banks worry about the fact that in real time, it is not always easy to assume that they are in such a position. Decisions need to be taken then, under the assumption of predetermined expectations. We argue that in these circumstances, the provision of clear inflation objectives helps agents understand Central Bank objectives better and is thus beneficial to all.
    Keywords: expectations; information games; inflation targets
    JEL: C70 C78 E58
    Date: 2006–10
  6. By: Juan Manuel Julio Román
    Abstract: Abstract. We distinguish two types of monetary policy rules: those depen- dent on particular models and loss functions and those robust to them. While dependent rules are useful for monetary policy implementation, robust rules are powerful tools to characterize the behavior of the monetary authority over a time span. Robust rules are estimated directly from observable data usually under the assumption that the targets, the nominal interest rate and the infla- tion rate are stationary. During the transition from a moderately high level of in°ation to a stable, internationally accepted level ¼, the commitment with this goal imply that the in°ation rate, targets, nominal interest rates and nominal equilibrium interest rates are non-stationary. Acknowledging this later fact has important implications for the dynamic behavior of transmission mechanisms models during the transition. In this note we set up a robust monetary policy rule useful to characterize the behavior of a central bank during the transition to a stable inflation level. As in previous research, estimation may be carried out by GMM on a nonlinear equation. We illustrate these results by charac- terizing the behavior of the Colombian central bank during the period of full in°ation targeting, that is after 2000. Our results agree with the prevailing policy in the sample span: A gentle in°ation stabilization program, a stronger one on the output gap, and a high degree of interest rate smoothing. Combin- ing these evidence with that of previous works our results suggests that the policy rule is time varying, a useful fact for policy implementation.
  7. By: Günter W. Beck (Goethe University Frankfurt and CFS. Contact: Faculty of Economics and Business Administration, Goethe University Frankfurt, Mertonstrasse 17, 60325 Frankfurt, Germany.); Kirstin Hubrich (Corresponding author: Research Department, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Massimiliano Marcellino (IEP-Bocconi University, IGIER and CEPR. Contact: Bocconi University, IGIER, Via Salasco, 5, Milano 20136, Italy.)
    Abstract: We investigate co-movements and heterogeneity in inflation dynamics of different regions within and across euro area countries using a novel disaggregate dataset to improve the understanding of inflation differentials in the European Monetary Union. We employ a model where regional inflation dynamics are explained by common euro area and country specific factors as well as an idiosyncratic regional component. Our findings indicate a substantial common area wide component, that can be related to the common monetary policy in the euro area and to external developments, in particular exchange rate movements and changes in oil prices. The effects of the area wide factors differ across regions, however. We relate these differences to structural economic characteristics of the various regions. We also find a substantial national component. Our findings do not differ substantially before and after the formal introduction of the euro in 1999, suggesting that convergence has largely taken place before the mid 90s. Analysing US regional inflation developments yields similar results regarding the relevance of common US factors. Finally, we find that disaggregate regional inflation information, as summarised by the area wide factors, is important in explaining aggregate euro area and US inflation rates, even after conditioning on macroeconomic variables. Therefore, monitoring regional inflation rates within euro area countries can enhance the monetary policy maker’s understanding of aggregate area wide inflation dynamics. JEL Classification: E31, E52, E58, C33.
    Keywords: Regional inflation dynamics, euro area and US, common factor models.
    Date: 2006–10
  8. By: Michael Bordo; Anna J. Schwartz
    Abstract: David Laidler has been a major player in the development of the monetarist tradition. As the monetarist approach lost influence on policy makers he kept defending the importance of many of its principles. In this paper we survey and assess the impact on monetary economics of Laidler's work on the demand for money and the quantity theory of money; the transmission mechanism on the link between money and nominal income; the Phillips Curve; the monetary approach to the balance of payments; and monetary policy.
    JEL: E00 E50
    Date: 2006–10
  9. By: Jean-Marie Dufour; David Tessier
    Abstract: The authors examine simultaneously the causal links connecting monetary policy variables, real activity, and stock returns. Their interest lies in the fact that the dynamics of asset prices can provide key insights--in terms of information--for the conduct of monetary policy, since asset prices constitute a class of potentially leading indicators of either economic activity or inflation. This is of particular interest in the context of an inflation-targeting regime, where the monetary policy stance is set according to inflation forecasts. While most empirical studies on causality have examined this issue using Granger's (1969) original definition, the authors examine the causality relations through the generalization proposed in Dufour and Renault (1998). For the United States, the authors find no support for stock returns as a leading indicator of the macroeconomic variables considered, or for stock returns being influenced by those macroeconomic variables, except for one case: fluctuations in M1 tend to anticipate fluctuations in stock returns. Furthermore, the authors' empirical methodology allows them to infer that monetary aggregates may have significant predictive power for income and prices at longer horizons. It is therefore incorrect to dismiss the importance of monetary aggregates based on the usual Granger causality criteria. The causality pattern inferred by the authors' procedure is consistent with the Phillips curve (for the inflation dynamics) and with the Taylor rule in the case of the interest rate. For Canada, the results are much different. The authors show that there is a potential role for asset prices as a predictor of some important macroeconomic variables, namely interest rates, inflation, and output at policy-relevant horizons. Furthermore, some measures of monetary aggregates tend to dominate the interest rate as robust causal variables for output growth and inflation. However, the authors do not find strong evidence in favour of the Phillips curve and the Taylor rule. Finally, for both Canada and the United States, the authors show that seasonal adjustments can highly distort the inferred causality structure.
    Keywords: Monetary and financial indicators
    JEL: C1 C12 C15 C32 C51 C53 E52
    Date: 2006
  10. By: Eijffinger, Sylvester C W; Schaling, Eric; Tesfaselassie, Mewael F.
    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 effects 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
  11. By: Glenn D. Rudebusch; John C. Williams
    Abstract: The modern view of monetary policy stresses its role in shaping the entire yield curve of interest rates in order to achieve various macroeconomic objectives. A crucial element of this process involves guiding financial market expectations of future central bank actions. Recently, a few central banks have started to explicitly signal their future policy intentions to the public, and two of these banks have even begun publishing their internal interest rate projections. We examine the macroeconomic effects of direct revelation of a central bank's expectations about the future path of the policy rate. We show that, in an economy where private agents have imperfect information about the determination of monetary policy, central bank communication of interest rate projections can help shape financial market expectations and may improve macroeconomic performance.
    JEL: E43 E52
    Date: 2006–10
  12. By: Moïse Sidiropoulos; Eleftherios Spyromitros
    Abstract: This paper examines the welfare and stabilisation implications of alterna- tive fiscal decision rules in a monetary union with a common monetary policy, such as the European Monetary Union (EMU). We develop a two-country model under monetary union in presnece of asymmetries. Fiscal policies are assumed alternatively non-cooperative (decentralised) and cooperative (centralised) and labour markets are characterised by decentralised and centralised wage setting. The central issue of the paper is the design of the appropriate fiscal policy rule by comparing and evaluating the performance of alternative arrangements to distribute the power over fiscal authorities between the centre of the union and the individual members of the union. The main result of this paper reveals that a decentralized fiscal policy rule, where the member states conduct independent fiscal policies, with centralised wage setting in labour markets of monetary union members is the appropriate institutional design. This institutional arrangement would improve the social welfare and stabilize better than others the idiosyncratic shocks hitting the economies of the monetary union members.
    Keywords: Policy-mix, EMU, labor market institutions.
    JEL: E58 E52 E63
    Date: 2006
  13. By: Philippe, LEDENT (UNIVERSITE CATHOLIQUE DE LOUVAIN, Department of Economics); Isabelle, CASSIERS
    Abstract: This paper analyses the Belgian monetary and exchange rate policies at the time of Bretton Woods. It sheds light on the groping adjustment process by which internal economic policies are hit by or adapt to the external constraints. In 1944, an ambitious monetary reform laid down the economic policy objectives that remained in force for two decades, namely price stability and strong currency. However, we point out different incompatibilities between these objectives and the economic context of the 1950s and 1960s that could have negative consequences on Belgian economic growth?. More precisely, the long lasting European currencies inconvertibility (1944-1958) contradicted the orthodox approach of the monetary policy favoured by the Central Bank. When total convertability was finally achieved, the huge increase of capital movements led to a progressive loss of the monetary policy autonomy, despite the setting up of a two-tier exchange market, which can be viewed as an institutional innovation responding to new constraints.
    Keywords: Monetary policy, Bretton Woods, Currency inconvertibility, Capital movements, Two-tier exchange market
    JEL: N14 N24 E58 E65
  14. By: Giuseppe Diana; Moise Sidiropoulos
    Abstract: This paper adapts in a simple static context the Rogoff's (1985) analysis of monetary policy delegation to a conservative central banker to the robust control framework. In this framework, uncertainty means that policymakers are unsure about their model, in the sense that there is a group of approximate models that they also consider as possibly true, and their objective is to choose a rule that will work under a range of di¤erent model specifications. We find that robustness reveals the emergence of a precautionary behaviour in the case of unstructured model uncertainty, reducing thus government's willingness to delegate monetary policy to a conservative central banker.
    Keywords: Robust control, Monetary policy delegation, Central bank conservativeness.
    JEL: E52 E58
    Date: 2006
  15. By: Canova, Fabio; Gambetti, Luca; Pappa, Evi
    Abstract: We examine the dynamics of US output and inflation using a structural time varying coefficient VAR. We show that there are changes in the volatility of both variables and in the persistence of inflation. Technology shocks explain changes in output volatility, while a combination of technology, demand and monetary shocks explain variations in the persistence and volatility of inflation. We detect changes over time in the transmission of technology shocks and in the variance of technology and of monetary policy shocks. Hours and labour productivity always increase in response to technology shocks.
    Keywords: persistence; structural time varying VARs; transmission; variability
    JEL: C11 E12 E32 E62
    Date: 2006–10
  16. By: Eliana González; Miguel I. Gómez; Luis F. Melo; José Luis Torres
    Abstract: Many developing countries are adopting inflation targeting regimes to guide monetary policy decisions. In such countries the share of food in the consumption basket is high and policy makers often employ total inflation (as opposed to core inflation) to set inflationary targets. Therefore, central banks need to develop reliable models to forecast food inflation. Our literature review suggests that little has been done in the construction of models to forecast short-run food inflation in developing countries. We develop a model to improve short-run food inflation forecasts in Colombia. The model disaggregates food items according to economic theory and employs Flexible Least Squares given the presence of structural changes in the inflation series. We compare the performance of this new model to current models employed by the central bank. Next, we apply econometric methods to combine forecasts from alternative models and test whether such combination outperforms individual models. Our results indicate that forecasts can be improved by classifying food basket items according to unprocessed, processed and food away from home and by employing forecast combination techniques.
    Date: 2006–10–20
  17. By: John Fender; Neil Rankin
    Abstract: A dynamic general equilibrium model of an open economy with staggered wages is constructed. We analyse disinflation through pegging the exchange rate. In accordance with the stylised facts, an initial boom in output can result, depending on the exact level of the peg. The reason is an element of preannouncement in the policy. Disinflation through reducing monetary growth is shown to be equivalent to disinflation through pegging the exchange rate, if the latter includes an initial currency revaluation. This helps explain why such disinflation causes a short-run slump. The model can also help explain inflation persistence.
    Keywords: Exchange-rate-based disinflation, money-based disinflation, staggered wages, preannouncement effects.
    JEL: F52 E41
    Date: 2006–10
  18. By: Rocio Betancourt; Hernando Vargas; Norberto Rodríguez
    Abstract: Banks and other credit institutions are key players in the transmission of monetary policy, especially in emerging market economies, where the responses of deposit and loan interest rates to shifts in policy rates are among the most important channels. This pass-through depends on the conditions prevailing in the loan and deposit markets, which are, in turn, affected by macroeconomic factors. Hence, when setting their policy, monetary authorities must take into account those conditions and the behavior of banks. This paper illustrates this point by means of a theoretical micro-banking model and shows empirical evidence for Colombia suggesting that some aspects of the model might be relevant features of the transmission mechanism.
    Keywords: Monetary Transmission Mechanisms, Interest Rate Pass-Through, Banking Classification JEL: G21; E43; E44; E52.
  19. By: García-Fronti, Javier; Miller, Marcus; Zhang, Lei
    Abstract: The stylised facts of currency crises in emerging markets include output contraction coming hard on the heels of devaluation, with a prominent role for the adverse balance-sheet effects of liability dollarisation. In the light of the South East Asian experience, we propose an eclectic blend of the supply-side account of Aghion, Bacchetta and Banerjee (2000) with a demand recession triggered by balance sheet effects (Krugman, 1999). This sharpens the dilemma facing the monetary authorities - how to defend the currency without depressing the economy. But, with credible commitment or complementary policy actions, excessive output losses can, in principle, be avoided.
    Keywords: contractionary devaluation; financial crises; Keynesian recession; supply and demand shocks
    JEL: E12 E4 E51 F34 G18
    Date: 2006–10
  20. By: Dudley Cooke
    Abstract: A general equilibrium model of a small open economy is developed to analyze the optimal rate of inflation under discretion. Once agents' welfare is the sole policy objective it is possible to show that openness and inflation no longer have a simple inverse relationship. A greater degree of openness may lead the policy maker to want to exploit the short-run Phillips curve more aggressively, even if involves a smaller short-run benefit, because changes in export demand affect the terms of trade. Inflation can then be higher in a more open economy.
    Date: 2006–10–25
  21. By: Roberto A. De Santis (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: Using bilateral data on international equity and bond flows, we find that the prediction of the International Capital Asset Pricing Model is partially met and that global equity markets might be more integrated than global bond markets. Moreover, over the turbulent 1998-2001 period characterised by an equity bubble and the subsequent burst, we find evidence that investors preferred portfolio assets of countries where the central bank gave relative importance to money. As for EMU, once controlling for diversification benefits and the elimination of the exchange rate risk, we show that cross-border portfolio flows among euro area countries have increased due to the catalyst effect of EMU. Country's shares in the world market portfolio, home bias, initial degree of misallocation across countries, past returns, diversification benefits and EMU can explain 35-40% of the total variation in equity and bond asset flows. JEL Classification: C13, C21, F37, G11.
    Keywords: Capital flows, Home bias, Risk diversification, EMU, Monetary policy.
    Date: 2006–09
  22. By: Thomas Sargent; Noah Williams; Tao Zha
    Abstract: We infer determinants of Latin American hyperinflations and stabilizations by using the method of maximum likelihood to estimate a hidden Markov model that potentially assigns roles both to fundamentals in the form of government deficits that are financed by money creation and to destabilizing expectations dynamics that can occasionally divorce inflation from fundamentals. Our maximum likelihood estimates allow us to interpret observed inflation rates in terms of variations in the deficits, sequences of shocks that trigger temporary episodes of expectations driven hyperinflations, and occasional superficial reforms that cut inflation without reforming deficits. Our estimates also allow us to infer the deficit adjustments that seem to have permanently stabilized inflation processes.
    JEL: D83 E31 E52
    Date: 2006–10
  23. By: Gary Richardson; William Troost
    Abstract: The Federal Reserve Act of 1913 divided Mississippi between the 6th (Atlanta) and 8th (St. Louis) Federal Reserve Districts. Before and during the Great Depression, these districts' policies differed. The Atlanta Fed championed monetary activism and the extension of credit to troubled banks. The St. Louis Fed adhered to the doctrine of real bills and eschewed expansionary initiatives. Outcomes differed across districts. In the 6th District, banks failed at lower rates than in the 8th District, particularly during the banking panic in the fall of 1930. The pattern suggests that discount lending reduced failure rates during periods of panic. Historical evidence and statistical analysis corroborates this conclusion.
    JEL: E5 E6 E65 N1 N2
    Date: 2006–10
  24. By: Thomas A. Eife
    Abstract: This paper documents that the impact of the euro changeover in January 2002 on prices was not uniform across the 12 participating countries. There are countries where prices increased significantly, but there are also countries where price-setting behaviour during the changeover does not appear to be very different from other points in time. This paper argues that the above difference can be explained by looking at the way countries regulated price setting during the changeover, and that any impact of the changeover could have been avoided with appropriate regulations. The gap between the actual and the perceived impact is addressed and policy recommendations for future changeovers are provided
    Keywords: currency changeover, euro, economic policy, prices, perceived inflation
    JEL: E31 E60 L11
    Date: 2006–10–10
  25. By: Bernd Schnatz (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: The paper tests for nonlinearities in the adjustment of the euro exchange rate towards purchasing power parity (PPP). It presents new survey based evidence consistent with non-linear patterns in euro exchange rate dynamics. Moreover, based on an exponential smooth transition autoregressive (ESTAR-) model, it finds strong evidence that the speed of mean reversion in euro exchange rates increases non-linearly with the magnitude of the PPP deviation. Accordingly, while the euro real exchange rate can be well approximated by a random walk if PPP deviations are small, in periods of significant deviations, gravitational forces are set to take root and bring the exchange rate back towards its long-term trend. Consistent with higher euro-dollar volatility, deviations from the PPP equilibrium for this pair need to be stronger in order to reach the same adjustment intensity as for other currencies. JEL Classification: F31.
    Keywords: Purchasing power parity, real exchange rate, non-linearities, STAR models.
    Date: 2006–10
  26. By: Andres Vesilind
    Abstract: This paper focuses on two actively studied inefficiencies in financial markets: the forward premium bias in foreign exchange markets (see, for example, Hansen and Hodrick 1980, Fama 1984, Bansal and Dahlquist 2000, etc.) and the empirical finding that the time expectations theory performs relatively poorly in describing the average shape of yield curves (for a list of papers see, for example, Backus et al. 1998, p 1). The goal of the article is to test whether these two inefficiencies can still offer the possibilities of earning positive and stable excess return for investors. For that purpose, first two very simple trading strategies are tested based on the abovementioned inefficiencies: buying the currencies of the countries with higher short-term interest rates against the currencies of the countries with lower short-term interest rates (i.e. simple FX carry-strategy) and holding long-only positions in longerterm interest rate futures. The results show that the two studied risk premiums are still present in the markets and enable investors to earn excess returns even with simple strategies. Additional tests show that the performance of these simple strategies can be further improved by the inclusion of a risk factor in the foreign exchange carry-strategy and by the addition of monetary policy direction and yield curve steepness filters in the long-only strategy in interest rate futures.
    Keywords: trading rules, forward premium bias, time expectations theory
    JEL: E44 E47 E58 F37 G11 G15
    Date: 2006–10–10
  27. By: Fabio Sánchez; Andrés Fernández; Armando Armenta
    Abstract: Between 1938 and 1967, including the Bretton Woods period after 1947, Colombia pegged its currency to the dollar. Although the exchange rate was fixed, the peso was devaluated more than 12% on six occasions. The devaluation episodes were complex, traumatic, highly politicized and had costly macroeconomic effects. The Bretton Woods agreement stated that countries could only devalue their exchange rate in the presence of fundamental imbalances driven, for example, by structural terms of trade deterioration. However, this paper states that in Colombia, the imbalance in the money market was a key factor in explaining the exchange rate crises during the period. The paper is organized as follows: first, a simple theoretical model of a small open economy with imperfect capital mobility is described in order to examine the possible causes of nominal devaluations; second, a narrative approach is used to describe the economic circumstances that surrounded each of the devaluation episodes; finally, a set of econometric tests are used in order to identify the key variables behind the macroeconomic imbalances that preceded each exchange rate crisis. The results show that the external imbalances were mainly associated with the imbalances in the money market. Terms of trade deterioration account for just a small part of current account crises
    Date: 2006–02–02
  28. By: Monika Piazzesi; Martin Schneider
    Abstract: This paper considers how the role of inflation as a leading business-cycle indicator affects the pricing of nominal bonds. We examine a representative agent asset pricing model with recursive utility preferences and exogenous consumption growth and inflation. We solve for yields under various assumptions on the evolution of investor beliefs. If inflation is bad news for consumption growth, the nominal yield curve slopes up. Moreover, the level of nominal interest rates and term spreads are high in times when inflation news are harder to interpret. This is relevant for periods such as the early 1980s, when the joint dynamics of inflation and growth was not well understood.
    JEL: E0 E3 E4 G0 G12
    Date: 2006–10
  29. By: Burnside, A Craig; Eichenbaum, Martin; Kleshchelski, Isaac; Rebelo, Sérgio
    Abstract: Currencies that are at a forward premium tend to depreciate. This ‘forward-premium puzzle’ represents an egregious deviation from uncovered interest parity. We document the properties of returns to currency speculation strategies that exploit this anomaly. The first strategy, known as the carry trade, is widely used by practitioners. This strategy involves selling currencies forward that are at a forward premium and buying currencies forward that are at a forward discount. The second strategy relies on a particular regression to forecast the payoff to selling currencies forward. We show that these strategies yield high Sharpe ratios which are not a compensation for risk. However, these Sharpe ratios do not represent unexploited profit opportunities. In the presence of microstructure frictions, spot and forward exchange rates move against traders as they increase their positions. The resulting ‘price pressure’ drives a wedge between average and marginal Sharpe ratios. We argue that marginal Sharpe ratios are zero even though average Sharpe ratios are positive.
    Keywords: carry trade; exchange rates; uncovered interest parity
    JEL: F31
    Date: 2006–10
  30. By: Allan Drazen; Stefan Hubrich
    Abstract: High interest rates to defend the exchange rate signal that a government is committed to fixed exchange rates, but may also signal weak fundamentals. We test the effectiveness of the interest rate defense by disaggregating into the effects on future interest rates differentials, expectations of future exchange rates, and risk premia. While much previous empirical work has been inconclusive due to offsetting effects, tests that “disaggregate” the effects provide significant information. Raising overnight interest rates strengthens the exchange rate over the short-term, but also leads to an expected depreciation at a horizon of a year and longer and an increase in the risk premium, consistent with the argument that it also signals weak fundamentals.
    JEL: F31 F33
    Date: 2006–10
  31. By: Menkhoff, Lukas (University of Hannover); Taylor, Mark P. (University of Warwick and Centre for Economic Policy Research)
    Abstract: Technical analysis involves the prediction of future exchange rate (or other assetprice) movements from an inductive analysis of past movements. A reading of the large literature on this topic allows us to establish a set of stylised facts, including the facts that technical analysis is an important and widely used method of analysis in the foreign exchange market and that applying certain technical trading rules over a sustained period may lead to significant positive excess returns. We then analyze four arguments that have been put forward to explain the continuing widespread use of technical analysis and its apparent profitability: that the foreign exchange market may be characterised by not-fully-rational behaviour; that technical analysis may exploit the influence of central bank interventions; that technical analysis may be an efficient form of information processing ; and finally that it may provide information on nonfundamental influences on foreign exchange movements. Although all of these positions may be relevant to some degree, neither non-rationality nor official interventions seem to be widespread and persistent enough to explain the obstinate passion of foreign exchange professionals for technical analysis.
    Keywords: foreign exchange market ; technical analysis ; market microstructure
    JEL: F31
    Date: 2006
  32. By: Broner, Fernando A
    Abstract: The first generation models of currency crises have often been criticized because they predict that, in the absence of very large triggering shocks, currency attacks should be predictable and lead to small devaluations. This paper shows that these features of first generation models are not robust to the inclusion of private information. In particular, this paper analyzes a generalization of the Krugman-Flood-Garber (KFG) model, which relaxes the assumption that all consumers are perfectly informed about the level of fundamentals. In this environment, the KFG equilibrium of zero devaluation is only one of many possible equilibria. In all the other equilibria, the lack of perfect information delays the attack on the currency past the point at which the shadow exchange rate equals the peg, giving rise to unpredictable and discrete devaluations.
    Keywords: currency crises; discrete devaluations; first generation models; multiple equilibria; private information
    JEL: D8 E58 F31 F32
    Date: 2006–10
  33. By: Gary Richardson
    Abstract: During the contraction from 1929 through 1933, the Federal Reserve System tracked changes in the status of all banks operating in the United States and determined the cause of each bank suspension. This essay introduces that hitherto dormant data and analyzes chronological patterns in aggregate series constructed from it. The analysis demonstrates both illiquidity and insolvency were substantial sources of bank distress. Contagion (via correspondent networks and bank runs) propagated the initial banking panics. As the depression deepened and asset values declined, insolvency loomed as the principal threat to depository institutions. These patterns corroborate some and question other conjectures concerning the causes and consequences of the financial crisis during the Great Contraction.
    JEL: E42 E5 E65 N1 N12
    Date: 2006–10
  34. By: Agostino Consolo
    Abstract: The aim of this paper is to forecast some of the most important measures of inflation of the Estonian economy by making use of linear and non-linear models. Results from comparing classes of optimal models are similar to those in the forecasting literature. In particular, there are gains from using more sophisticated methods such as factor analysis and time-varying parameters methods. Model discrimination is based on evaluation criteria which are computed by a real-time dynamic estimation procedure. Moreover, forecasts uncertainty is appropriately taken into account: Fan Charts can exhaustively describe the final output for what concerns out-of-sample forecasting.
    Keywords: Estonian Economy, forecasting, inflation modelling
    JEL: C22 C32 C53 E31
    Date: 2006–10–10
  35. By: Atif Mian; Asim Ijaz Khwaja
    Abstract: Do liquidity shocks matter? While even a simple `yes' or `no' presents identification challenges, going beyond this entails tracing how such shocks to lenders are passed on to borrowers, and whether borrowers can in turn cushion these shocks through the credit market. This paper does so by using data that follows all loans made by lenders to borrowing firms in Pakistan, and exploiting cross-bank variation in liquidity shocks induced by the unanticipated nuclear tests in 1998. We isolate the causal impact of the bank lending channel by showing that for the same firm borrowing from two different banks, its loan from the bank experiencing a 1% larger decline in liquidity drops by an additional 0.6%. The liquidity shock also lowers the probability of continued lending to old clients and extending credit to new ones. Although this lending channel affects all firms significantly, large firms and those with strong business and political ties completely compensate the effect by borrowing more from more liquid banks - both through existing and new banking relationships. In contrast, small unconnected firms are entirely unable to hedge and face large drops in overall borrowing and increased financial distress. The liquidity shocks thus have large distributional consequences.
    JEL: E44 E5 E51 G21 G3
    Date: 2006–10

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