nep-mon New Economics Papers
on Monetary Economics
Issue of 2006‒12‒04
25 papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Monetary Policy before Euro Adoption: Challenges for EU New Members By Filacek, Jan; Horvath, Roman; Skorepa, Michal
  2. Inflation Targeting in an Emerging Market: the Case of Korea By Michael S. Hanson; Kwanghee Nam
  3. Monetary-Exchange Rate Policy and Current Account Dynamics By Malik, Hamza
  4. Monetary Policy with Judgment: Forecast Targeting By Svensson, Lars O
  5. Romania: From the quantitative monetary aggregates to inflation targeting By Voicu, Ionut Cristian; Constantin, Floricel
  6. Targeting Rules with Intrinsic Persistence and Endogenous Policy Inertia. By Michael S. Hanson; Pavel Kapinos
  8. Monetary Policy Neglect and the Great Inflation in Canada, Australia, and New Zealand. By Nelson, Edward
  9. Linking Real Activity and Financial Markets: The Bonds, Equity, and Money (BEAM) Model By Céline Gauthier; Fu Chun Li
  10. The reflections of new economy on monetary policy and central banking By Haydar, Akyazi; Seyfettin, Artan
  11. Uncovering the Hit-list for Small Inflation Targeters: A Bayesian Structural Analysis By Timothy Kim; Kirdan Lees; Philip Liu
  13. Varying Monetary Policy Regimes: A Vector Autoregressive Investigation By Michael S. Hanson
  14. Committees Versus Individuals: An Experimental Analysis of Monetary Policy Decision Making By Lombardelli, Clare; Proudman, James; Talbot, James
  15. Financial Accelerator Effects in the Balance Sheets of Czech Firms By Horvath, Roman
  16. Price Level vs. Nominal Income Targeting: Aggregate Demand Shocks and the Cost Channel of Monetary Policy Transmission By Malik, Hamza
  17. MONETARY POLICY RULES AND FISCAL EQUILIBRIUM IN BRAZIL By Helder Ferreira de Mendonça; Manoel Carlos de Castro Pires
  18. Is Price Flexibility De-Stabilizing? A Reconsideration By Malik, Hamza; Scarth, William
  19. Optimal Policy Projections By Svensson, Lars O; Tetlow, Robert J
  20. INFLATION TARGETING IN EMERGING COUNTRIES: THE CASE OF BRAZIL By Philip Arestis; Luiz Fernando de Paula; Fernando Ferrari-Filho
  21. How Should Monetary Policy Respond to Asset-Price Bubbles? By Gruen, David; Plumb, Michael; Stone, Andrew
  22. Dollar Shortages and Crises By Rajan, Raghuram G.; Tokatlidis, Ioannis
  23. Liquidity, Risk Taking, and the Lender of Last Resort By Repullo, Rafael
  25. THE NATURAL RATE OF INTEREST IN BRAZIL BETWEEN 1999 AND 2005 By Paulo Chananeco F. de Barcellos Neto; Marcelo Savino Portugal

  1. By: Filacek, Jan; Horvath, Roman; Skorepa, Michal
    Abstract: This article analyzes the main issues for monetary policy in new EU member states before their euro adoption. These are typically rooted in the challenge of fulfilling concurrently of the Maastricht inflation and exchange rate criterion, as these countries are experiencing equilibrium real exchange rate appreciation. In this article we first distinguish between the wording, written interpretation and “revealed” interpretation of the inflation and exchange rate criteria. Then we discuss the options for monetary policy in the period of fulfilment of these criteria in terms of its transparency, its continuity with the previous monetary policy regime, the choice of central parity for the ERM II, the setting of the fluctuation bandwidth, the probability of fulfilment of both criteria and the impact on economic stability.
    Keywords: monetary policy; euro adoption; ERM II; EU
    JEL: E58 F42 F33 E52
    Date: 2006–09–25
  2. By: Michael S. Hanson (Department of Economics, Wesleyan University); Kwanghee Nam (School of Economics, Kookmin University, Jeongneung-dong)
    Abstract: To evaluate the effectiveness of targeting monetary policy strategies in a small open economy, we develop a dynamic optimizing model calibrated to recent Korean data. We then explore the consequences of alternative specifications of the loss function for society and the central bank, with particular focus on exchange rate volatility. Policy simulations include variations on inflation targeting, nominal income growth targeting and exchange rate targeting. Our results indicate that inflation targeting remains the most preferred policy regime, even when an explicit motive for exchange rate smoothing is introduced. In this case, the optimal inflation targeting and nominal income growth targeting policies are characterized by a “conservative” central bank that places greater weight on both the primary target variable and on the exchange rate than in society’s objective function. However, the optimal policy reacts to changes in degree of exchange rate pass-though in a non-linear fashion, complicating the robustness of inflation targeting recommendations for emerging markets.
    Keywords: Korean economy, inflation targeting, optimal monetary policy, small open economy
    JEL: E52 F41
    Date: 2005–09
  3. By: Malik, Hamza
    Abstract: A dynamic stochastic general equilibrium monetary model with incomplete and imperfect asset markets, monopolistic competition and staggered nominal price rigidities is developed to shed light on the role of exchange rate and its relation with current account dynamics in the formulation of monetary-exchange rate policies. The paper shows that because of incomplete risk sharing, due to incomplete asset markets, the dynamic relationship between real exchange rate and net foreign assets affect the behaviour of domestic inflation and aggregate output. This, in turn, implies that the optimal monetary policy entail a response to net foreign asset position or the real exchange rate gap defined as the difference between actual real exchange rate and the value that would prevail with flexible prices and complete asset markets. In comparing the performance of alternative monetary-exchange rate policy rules, an interesting and fairly robust result that stands out is that ‘dirty floating’ out-performs flexible exchange rate regime with domestic inflation targeting.
    Keywords: optimal monetary policy; incomplete asset markets; net foreign assets; current account dynamics; inflation targeting; exchange rate policy.
    JEL: E52 F41
    Date: 2005–08
  4. By: Svensson, Lars O
    Abstract: Monetary Policy with Judgment: Forecast Targeting by Lars E O Svensson Princeton University Abstract "Forecast targeting", forward-looking monetary policy that uses central-bank judgment to construct optimal policy projections of the target variables and the instrument rate, may perform substantially better than monetary policy that disregards judgment and follows a given instrument rule. This is demonstrated in a few examples for two empirical models of the U.S. economy, one forward looking and one backward looking. A complicated infinite-horizon central-bank projection model of the economy can be closely approximated by a simple finite system of linear equations, which is easily solved for the optimal policy projections. Optimal policy projections corresponding to the optimal policy under commitment in a timeless perspective can easily be constructed. The whole projection path of the instrument rate is more important than the current instrument setting. The resulting reduced-form reaction function for the current instrument rate is a very complex function of all inputs in the monetary-policy decision process, including the central bank’s judgment. It cannot be summarized as a simple reaction function such as a Taylor rule. Fortunately, it need not be made explicit.
    Keywords: Inflation targeting; optimal monetary policy; forecasts
    JEL: G00 G0
    Date: 2005–02–08
  5. By: Voicu, Ionut Cristian; Constantin, Floricel
    Abstract: For Romania, the shift from monetary targeting toward inflation targeting was done under the influences of following events: - The existing pressure coming from refinancing the public debt and from the necessity to remain in certain boundary with the budgetary deficit. - NBR assigned monetary control and liquidity management functions on the mechanism of minimum required reserves. - Romanian strategy was deeply hurt by the low development of its financial markets, and the low level of monetization. - A precondition of potential success in the case of inflation targeting was fulfilled - the improvement of taxes collection and the reduction of money laundry. - The important amounts of quantitative increases in Foreign Direct Investment (yearly Euro 4 billion), and also in the rest of M2’s components, forced the necessity of a new strategy based mainly on non-monetary aggregates
    Keywords: monetary policy; inflation targeting; Romania; monetary aggregates
    JEL: E58
    Date: 2006–06
  6. By: Michael S. Hanson (Department of Economics, Wesleyan University); Pavel Kapinos (Department of Economics, Carleton College)
    Abstract: We investigate the optimality of monetary policy targeting rules in a macroeconomic model based on explicit micro-foundations for intrinsic persistence in inflation and real output. For the corresponding social welfare loss function to be minimized by the central bank, inertia arises endogenously in both the inflation and output gap stabilization objectives. In this framework, inflation targeting closely approximates the optimal precommitment policy for empirically relevant parameter values. Alternative policy rules, such as nominal income growth targeting, “speed-limit” targeting, or price level targeting, do not performas well. Previous research has demonstrated lower social welfare losses with these alternative targeting rules; such findings are shown to be primarily a consequence of assuming the central bank minimizes a simple social loss function that is not consistent with the micro-foundations of a model with intrinsic persistence.
    Keywords: Habit formation, inflation persistence, targeting rules, time consistency, institutional design of monetary policy
    JEL: E52 E58
    Date: 2006–06
  7. By: Wilson Luiz Rotatori
    Date: 2006
  8. By: Nelson, Edward
    Abstract: This paper studies the Great Inflation in Canada, Australia, and New Zealand. Newspaper coverage and policymakers’ statements are used to analyze the views on the inflation process that led to the 1970s macroeconomic policies, and the different movement in each country away from 1970s views. I argue that to understand the course of policy in each country, it is crucial to use the monetary policy neglect hypothesis, which claims that the Great Inflation occurred because policymakers delegated inflation control to nonmonetary devices. This hypothesis helps explain why, unlike Canada, Australia and New Zealand continued to suffer high inflation in the mid-1980s. The delayed disinflation in these countries reflected the continuing importance accorded to nonmonetary views of inflation.
    JEL: G00 G0
    Date: 2005–01–25
  9. By: Céline Gauthier; Fu Chun Li
    Abstract: The authors estimate a small monthly macroeconometric model (BEAM, for bonds, equity, and money) of the Canadian economy built around three cointegrating relationships linking financial and real variables over the 1975–2002 period. One of the cointegrating relationships allows the identification of a supply shock as the only shock that permanently affects the stock market, and a demand shock that leads to important transitory stock market overvaluation. The authors propose a monetary policy reaction function in which the impact of a permanent inflation shock on the overnight rate is simulated and the future path of the overnight rate adjusted accordingly, to prevent any forecast persistent deviation from the inflation target. They introduce a technical innovation by showing under which conditions permanent shocks can be identified in a vector error-correction model with exogenous variables.
    Keywords: Financial markets; Financial stability
    JEL: C5 E4
    Date: 2006
  10. By: Haydar, Akyazi; Seyfettin, Artan
    Abstract: Developments in the information and communication technologies have been causing significant changes on the working mechanisms of the economy both at the national and international areas. Some of the developments can be indicated as follows: the dramatic increasing of capital movements amongst nations; the speeding of global economic integration; the effects of world’s financial markets; the creation of new payment mechanisms; the decreasing of transaction and knowledge costs; getting the information in a permanent and fast way; the fluctuations in financial markets; increasing potential growth and productivity rates. It is possible to summarize the mentioned developments with the concept of “new economy”. In this paper, the reflections of new economy on monetary policy and central banking are examined. According to the results of this study, the views about monetary policy and central banks will no longer exist in the future is not realistic. As far as we are concerned, central banks will continue to guarantee the stability of financial system all over the world as was the case in the past.
    Keywords: New economy; monetary policy; electronic money; central banking
    JEL: O33 E58 E52 E44
    Date: 2006–05–24
  11. By: Timothy Kim; Kirdan Lees; Philip Liu (Reserve Bank of New Zealand)
    Abstract: We estimate underlying macroeconomic policy objectives of three of the earliest explicit inflation targeters - Australia, Canada and New Zealand - within the context of a small open economy DSGE model. We assume central banks set policy optimally, such that we can reverse engineer policy objectives from observed time series data. We find that none of the central banks show a concern for stabilizing the real exchange rate. However, all three central banks share a concern for minimizing the volatility in the change in the nominal interest rate. The Reserve Bank of Australia places the most weight on minimizing the deviation of output from trend. Tests of the posterior distributions of these policy preference parameters suggest that the central banks have very similar objectives.
    JEL: C51 E52 F41
    Date: 2006–11
  12. By: Jose Angelo Divino
    Date: 2006
  13. By: Michael S. Hanson (Economics Department, Wesleyan University)
    Abstract: Recently, two stylized facts about the behavior of the U.S. economy have emerged: first, macroeconomic aggregates appear to be less volatile post-1984 than in the preceding two decades; second, monetary policy appears more responsive to inflationary pressures—and thereby more “stabilizing” — during the Volcker/Greenspan chairmanships relative to earlier regimes. Does a causal relationship exist between these two observations? In particular, has “better” policy by the Federal Reserve Board contributed significantly to the lessened volatility of the U.S. economy? This paper uses a structural vector autoregressive (VAR) specification to address these questions, examining the advantages and limitations of such an approach. In contrast with much of the existing research on these topics, I find that most of the quantitatively significant changes in volatility are attributed to breaks in the non-policy portion of the structural VAR, and not to the identified policy equation.
    Keywords: Monetary policy reaction function, structural VAR models, Taylor rule, Volcker disinflation, parameter instability
    JEL: E52 E58 E31 C32
    Date: 2006–01
  14. By: Lombardelli, Clare; Proudman, James; Talbot, James
    Abstract: We report the results of an experimental analysis of monetary policy decision making under uncertainty. A large sample of economics students played a simple monetary policy game, both as individuals and in committees of five players. Our findings - that groups make better decisions than individuals - accord with previous work by Blinder and Morgan. We also attempt to establish why this is so. Some of the improvement is related to the ability of committees to strip out the effect of bad play, but there is a significant additional improvement, which we associate with players learning from each other’s interest rate decisions.
    Keywords: Monetary policy; experimental economics; central banking; uncertainty
    JEL: G00 G0
    Date: 2005–02–08
  15. By: Horvath, Roman
    Abstract: The paper examines a financial accelerator mechanism in analyzing determinants of corporate interest rates. Using a panel of the financial statements of 448 Czech firms from 1996–2002, we find that balance sheet indicators matter interest rates paid by firms. Market access is particularly important in this regard. The strength of corporate balance sheets seem to vary with firm size. There is also evidence that monetary policy has a stronger effect on smaller than on larger firms. On the other hand, we find no asymmetry in the monetary policy effects over the business cycle.
    Keywords: balance sheet channel; financial accelerator; interest rates; monetary policy transmission
    JEL: G32 E52
    Date: 2006–11–14
  16. By: Malik, Hamza
    Abstract: This paper incorporates both the traditional aggregate demand-interest rate channel and the cost channel of monetary policy in a baseline ‘new Keynesian’ model and study two targeting regimes --- price-level targeting and nominal income targeting. In light of empirical considerations, alternative specifications for the aggregate demand and aggregate supply side of the economy also considered. The main result is that the cost channel matters: in case of a moderate policy response and with the cost channel operating the volatility of real output decreases under both price-level and nominal income targeting, while it increases in case of an aggressive policy response. The paper also finds that nominal income targeting performs better than price level targeting in bringing down the volatility of real output in almost all the specifications of the macro models used in the analysis.
    Keywords: the cost channel; price level targeting; nominal income targeting
    JEL: E31 E52 E30
    Date: 2005–03
  17. By: Helder Ferreira de Mendonça; Manoel Carlos de Castro Pires
    Date: 2006
  18. By: Malik, Hamza; Scarth, William
    Abstract: Using a New Neoclassical Synthesis model of monetary policy for a small open economy, this paper explores the impact of an increased degree of price flexibility on output volatility. Previous analysis of this question – based on the earlier generation of descriptive macro systems with model-consistent expectations – offered mixed conclusions, especially in an open economy context. We update that literature by reconsidering the issue within models that involve optimization-based behavioural equations. We find clear support for Keynes’ concern that a higher degree of price flexibility raises output volatility – but only under flexible exchange rates. We discuss the implications of our findings for current macro policy discussions in both European and other economies.
    Keywords: price flexibility; exchange rate policy; monetary policy in an open economy
    JEL: E52 F41
    Date: 2005–07
  19. By: Svensson, Lars O; Tetlow, Robert J
    Abstract: We outline a method to provide advice on optimal monetary policy while taking policymakers’ judgment into account. The method constructs optimal policy projections (OPPs) by extracting the judgment terms that allow a model, such as the Federal Reserve Board staff economic model, FRB/US, to reproduce a forecast, such as the Greenbook forecast. Given an intertemporal loss function that represents monetary policy objectives, OPPs are the projections — of target variables, instruments, and other variables of interest — that minimize that loss function for given judgment terms. The method is illustrated by revisiting the economy of early 1997 as seen in the Greenbook forecasts of February 1997 and November 1999. In both cases, we use the vintage of the FRB/US model that was in place at that time. These two particular forecasts were chosen, in part, because they were at the beginning and the peak, respectively, of the late 1990s boom period. As such, they differ markedly in their implied judgments of the state of the world in 1997 and our OPPs illustrate this difference. For a conventional loss function, our OPPs provide significantly better performance than Taylor-rule simulations.
    JEL: G00 G0
    Date: 2005–08–08
  20. By: Philip Arestis; Luiz Fernando de Paula; Fernando Ferrari-Filho
    Date: 2006
  21. By: Gruen, David; Plumb, Michael; Stone, Andrew
    Abstract: We present a simple macroeconomic model that includes a role for an asset-price bubble. We then derive optimal monetary policy settings for two policymakers: a skeptic, for whom the best forecast of future asset prices is the current price; and an activist, whose policy recommendations take into account the complete stochastic implications of the bubble. We show that the activist’s recommendations depend sensitively on the detailed stochastic properties of the bubble. In some circumstances the activist clearly recommends tighter policy than the skeptic, but in others the appropriate recommendation is to be looser. Our results highlight the stringent informational requirements inherent in an activist policy approach to handling asset-price bubbles.
    JEL: G00 G0
    Date: 2005–05–24
  22. By: Rajan, Raghuram G.; Tokatlidis, Ioannis
    Abstract: Emerging markets do not handle adverse shocks well. In this paper, we lay out an argument about why emerging markets are so fragile, and why they may adopt contractual mechanisms—such as a dollarized banking system—that increase their fragility. We draw on this analysis to explain why dollarized economies may be prone to dollar shortages and twin crises. The model of crises described here differs in some important aspects from what are now termed the first-, second-, and third-generation models of crises. We then examine how domestic policies, especially monetary policy, can mitigate the adverse effects of these crises. Finally, we consider the role, potentially constructive, that international financial institutions may undertake both in helping to prevent the crises and in helping to resolve them.
    JEL: G00 G0
    Date: 2005–03–14
  23. By: Repullo, Rafael
    Abstract: This paper studies the strategic interaction between a bank whose deposits are randomly withdrawn and a lender of last resort (LLR) that bases its decision on supervisory information on the quality of the bank’s assets. The bank is subject to a capital requirement and chooses the liquidity buffer that it wants to hold and the risk of its loan portfolio. The equilibrium choice of risk is shown to be decreasing in the capital requirement and increasing in the interest rate charged by the LLR. Moreover, when the LLR does not charge penalty rates, the bank chooses the same level of risk and a smaller liquidity buffer than in the absence of an LLR. Thus, in contrast with the general view, the existence of an LLR does not increase the incentives to take risk, while penalty rates do.
    JEL: G00 G0
    Date: 2005–02–28
  24. By: Christiane R. Albuquerque; Marcelo S. Portugal
    Date: 2006
  25. By: Paulo Chananeco F. de Barcellos Neto; Marcelo Savino Portugal
    Date: 2006

This nep-mon issue is ©2006 by Bernd Hayo. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.