nep-mon New Economics Papers
on Monetary Economics
Issue of 2007‒01‒13
35 papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Establishing Credibility: Evolving Perceptions of the European Central Bank By Linda S. Goldberg; Michael W. Klein
  2. Optimal Monetary Policy in a Channel System of Interest-Rate Control By Aleksander Berentzen; Cyril Monnet
  3. Monetary and Exchange Rate Stability in South East Asia By Christian Bauer; Bernhard Herz
  4. Taking Personalities out of Monetary Policy Decision Making? Interactions, Heterogeneity and Committee Decisions in the Bank of England’s MPC By Arnab Bhattacharjee; Sean Holly
  5. Uncovering the Goodhart's Law: Theory and Evidence By Yosuke Takeda; Atsuko Ueda
  6. The yield curve as a predictor and emerging economies By Mehl, Arnaud
  7. Monetary Policy Uncertainty: Is There a Difference Between Bank of England and the Bundesbank/ECB? By Iris Biefang-Frisancho Mariscal; Peter Howells
  8. Time-Varying U.S. Inflation Dynamics and the New Keynesian Phillips Curve By Kevin J. Lansing
  9. Inflation Shocks and Interest Rate Rules By Barbara Annicchiarico; Alessandro Piegallini
  10. Monetary Policy Rules and Exchange Rates:A Structural VAR Identified by No Arbitrage By Sen Dong
  11. The Bank Capital Channel of Monetary Policy By Skander Van den Heuvel
  12. Global Monetary Policy Shocks in the G5: A SVAR Approach By Joao Miguel Sousa; Andrea Zaghini
  13. A Model of Money and Credit, with Application to the Credit Card Debt Puzzle By Irina A. Telyukova; Randall Wright
  14. Monetary Exchange with Multilateral Matching By Benoit Julien; John Kennes; Ian King
  15. Optimal monetary policy with imperfect unemployment insurance By Tomoyuki Nakajima
  16. General Equilibrium with NonConvexities, Sunspots and Money By Guillaume Rocheteau; Peter Rupert; Karl Shell; Randall Wright
  17. Relative Price Distortions and Inflation Persistence By Tatiana Damjanovic; Charles Nolan
  18. The Dynamic (In)efficiency of Monetary Policy by Committee By Alessandro Riboni; Francisco Ruge-Murcia
  19. Precautionary Balances and the Velocity of Circulation of Money By Miquel Faig; Belen Jerez
  20. International Seigniorage Payments By Benjamin Eden
  21. Optimal cheating in monetary policy with individual evolutionary learning By Jasmina Arifovic; Olena Kostyshyna
  22. Monetary Policy, Endogenous Inattention, and the Volatility Trade-off By William Branch; John Carlson; George W. Evans; Bruce McGough
  23. The Renminbi's Dollar Peg at the Crossroads By Maurice Obstfeld
  24. The Returns to Currency Speculation By Craig Burnside; Martin Eichenbaum; Isaac Kleshchelski; Sergio Rebelo
  25. Transactions, Credit, and Central Banking in a Model of Segmented Markets By Stephen D. Williamson
  26. Monetary Policy and Household Mobility: The Effects of Mortgage Interest Rats. By John Quigley
  27. Bias in Federal Reserve Inflation Forecasts: Is the Federal Reserve Irrational or Just Cautious? By Carlos Carmona
  28. Divisible money with partially directed search By Dror Goldberg
  29. The Performance of Trimmed Mean Measures of Underlying Inflation By Andrea Brischetto; Anthony Richards
  30. (Un)Employment Dynamics: The Case of Monetary Policy Shocks By Helge Braun
  31. Motelling: A Hotelling Model with Money By Dean Corbae; Borghan N. Narajabad
  32. Commodity Money Equilibrium in a Walrasian Trading Post Model: An Example By Ross Starr
  33. Modeling the Term Structure of Exchange Rate Expectations By Christian Bauer; Sebastian Horlemann
  34. "Lender of Last Resort and Selection of Banks in Pre-war Japan"(in Japanese) By Tetsuji Okazaki
  35. Efficient Propagation of Shocks and the Optimal Return of Money By Ricardo Cavalcanti; Andres Erosa

  1. By: Linda S. Goldberg; Michael W. Klein
    Abstract: The perceptions of a central bank’s inflation aversion may reflect institutional structure or, more dynamically, the history of its policy decisions. In this paper, we present a novel empirical framework that uses high frequency data to test for persistent variation in market perceptions of central bank inflation aversion. The first years of the European Central Bank (ECB) provide a natural experiment for this model. Tests of the effect of news announcements on the slope of yield curves in the euro-area, and on the euro/dollar exchange rate, suggest that the market’s perception of the policy stance of the ECB during its first six years of operation significantly evolved, with a belief in its inflation aversion increasing in the wake of its monetary tightening. In contrast, tests based on the response of the slope of the United States yield curve to news offer no comparable evidence of any change in market perceptions of the inflation aversion of the Federal Reserve.
    Keywords: Central Banking, European Central Bank, Federal Reserve, inflation, exchange rate, monetary policy, credibility, yield curve
    Date: 2007–01–05
  2. By: Aleksander Berentzen (University of Basel); Cyril Monnet
    Abstract: This paper studies optimal interest-rate policies when the central bank operates a channel system of interest-rate control. We conduct our analysis in a dynamic general equilibrium model with infinitely-lived agents who are subject to idiosyncratic trading shocks which generate random liquidity needs. In response to these shocks agents either borrow against collateral or deposit money at the central bank at the specified rates. We show that it is optimal to have a strictly positive interest-rate corridor if the opportunity cost of holding collateral is strictly positive and that the optimal corridor is strictly decreasing in the collateral's real return
    Keywords: Optimal Monetary Policy, Channel System, Interest Rate Rule, Essential Money
    JEL: E4 E5
    Date: 2006–12–03
  3. By: Christian Bauer; Bernhard Herz
    Abstract: Regaining exchange rate stability has been a major monetary policy goal of East Asian countries in the aftermath of the 1997/98 currency crisis. While most countries have abstained from re-establishing a formal US Dollar peg, they have typically managed the US Dollar exchange rate de facto. We show that most of these countries were able to regain their monetary credibility within a relatively short time period. The Argentine crisis in 2001 caused a minor setback in this process for some countries. We measure the credibility of monetary policy by separating the fundamental and excess volatility of the exchange rate on the basis of a chartist fundamentalist model. The degree of excess volatility is interpreted as the ability of the central bank to manage the exchange rate via the coordination channel.
    Keywords: monetary policy, exchange rate policy, credibility, technical trading, East Asia
    JEL: D84 E42 F31
  4. By: Arnab Bhattacharjee; Sean Holly
    Abstract: The transparency of the monetary policymaking process at the Bank of England has provided very detailed data on both the votes of individual members of the Monetary Policy Committee and the information on which they are based. In this paper we consider interval censored responses of individual committee members in the context of a model in which inflation forecast targeting is used but there is both heterogeneity and interaction among the members of the committee. We find substantial heterogeneity in the policy reaction function across members. Further, we identify significant interactions between individual decisions of the committee members. The nature of these interdependencies inform about information sharing and strategic interactions within the Bank of England’s Monetary Policy Committee.
    Keywords: Monetary policy; Interest rates; Committee decision making; Expectation-Maximisation Algorithm; Spatial Weights Matrix; Spatial Error Model.
    JEL: E42 E43 E50 E58 C31 C34
    Date: 2006–12
  5. By: Yosuke Takeda (Sophia University public); Atsuko Ueda
    Abstract: This paper addresses the Goodhart's Law in a cash-in-advance economy with monetary policy regime switching. Using the Japanese data of the money velocity, we found that although our cash-credit model fails to generate a downward trend in the actual velocity, the model succeeds in terms of velocity's variation and correlations with money growth rates or nominal interest rates, with procyclicality of velocity unpredictable.
    Keywords: Goodhart' Law; velocity of money; Taylor rule; Markov regime swiching; cash-credit model
    JEL: E41 E52
    Date: 2006–12–03
  6. By: Mehl, Arnaud (BOFIT)
    Abstract: This paper investigates the extent to which the slope of the yield curve in emerging economies predicts domestic inflation and growth. It also examines international financial linkages and how the US and euro area yield curves help to predict. It finds that the domes-tic yield curve in emerging economies contains in-sample information even after control-ling for inflation and growth persistence, at both short and long forecast horizons, and that it often improves out-of-sample forecasting performance. Differences across countries are seemingly linked to market liquidity. The paper further finds that the US and euro area yield curves also contain in- and out-of-sample information for future inflation and growth in emerging economies. In particular, for emerging economies with exchange rates pegged to the US dollar, the US yield curve is often found to be a better predictor than the domes-tic curves and to causally explain their movements. This suggests that monetary policy changes and short-term interest rate pass-through are key drivers of international financial linkages through movements at the low end of the yield curve.
    Keywords: emerging economies; yield curve; forecasting; international linkages
    JEL: C50 E44 F30
    Date: 2006–12–20
  7. By: Iris Biefang-Frisancho Mariscal; Peter Howells (School of Economics, University of the West of England)
    Abstract: It is widely believed that institutional arrangements influence the quality of monetary policy outcomes. Judged on its ‘transparency’ characteristics, therefore the Bank of England should do better than both the Bundesbank and ECB. However, studies based on market evidence show that on average, agents anticipate policy moves by both banks equally well. Since benefits from transparency should also show in a narrowing of the diversity in cross sectional forecasts, this paper extends the existing literature in an attempt to reconcile the contradictory evidence on ‘transparency’ of both banks. We show that the diversity in interest rate forecasts is greater under the Bundesbank/ECB than the Bank of England. Other factors than ‘transparency’ do not seem to affect interest rate uncertainty in Germany. Increasing difficulty in forecasting inflation appears to explain in part UK interest rate forecast dispersion.
    Keywords: transparency, yield curve, forecasting uncertainty, Bank of England, Bundesbank, ECB
    JEL: E58
    Date: 2006–11
  8. By: Kevin J. Lansing
    Abstract: This paper introduces a form of boundedly-rational expectations into an otherwise standard New-Keynesian Phillips curve. The representative agent's forecast rule is optimal (in the sense of minimizing mean squared forecast errors), conditional on a perceived law of motion for inflation and observed moments of the inflation time series. The perceived law of motion allows for both temporary and permanent shocks to inflation, the latter intended to capture the possibility of evolving shifts in the central bank's inflation target. In this case, the agent's optimal forecast rule defined by the Kalman filter coincides with adaptive expectations, as shown originally by Muth (1960). I show that the perceived optimal value of the gain parameter assigned to the last observed inflation rate is given by the fixed point of a nonlinear map that relates the gain parameter to the autocorrelation of inflation changes. The model allows for either a constant gain or variable gain, depending on the length of the sample period used by the agent to compute the autocorrelation of inflation changes. In the variable-gain setup, the equilibrium law of motion for inflation is nonlinear and can generate time-varying inflation dynamics similar to those observed in long-run U.S. data. The model's inflation dynamics are driven solely by white-noise fundamental shocks propagated via the expectations feedback mechanism; all monetary policy-dependent parameters are held constant
    Keywords: Inflation Expectations, Phillips Curve, Time-Varying Persistence & Volatility
    JEL: E31 E37
    Date: 2006–12–03
  9. By: Barbara Annicchiarico (Department of Economics, University of Rome "Tor Vergata"); Alessandro Piegallini (Department of Economics, University of Rome "Tor Vergata")
    Abstract: Recent empirical evidence by Fair (2002, 2005) and Giordani (2003) shows that a positive inflation shock with the nominal interest rate held constant has contractionary effects. These results cannot be reconciled with the standard "New Synthesis" literature. This paper reconsiders the effects of inflation shocks in a simple New Keynesian framework extended to include wealth effects. It is demonstrated that, following an inflation shock, the decline of output coupled with passive interest rate rules is not puzzling.
    Keywords: Interest Rate Rules; Nominal Rigidities; Overlapping Generations; Inflation Shocks.
    JEL: E52 E58
    Date: 2006–06–01
  10. By: Sen Dong (Finance and Ecnomomics Department Columbia University)
    Abstract: Expected exchange rate changes are determined by interest rate differentials across countries and risk premia, while unexpected changes are driven by innovations to macroeconomic variables, which are amplified by time-varying market prices of risk. In a model where short rates respond to the output gap and inflation in each country, I identify macro and monetary policy risk premia by specifying no-arbitrage dynamics of each country's term structure of interest rates and the exchange rate. Estimating the model with US/German data, I find that the correlation between the model-implied exchange rate changes and the data is over 60%. The model implies a countercyclical foreign exchange risk premium with macro risk premia playing an important role in matching the deviations from Uncovered Interest Rate Parity. I find that the output gap and inflation drive about 70% of the variance of forecasting the conditional mean of exchange rate changes
    Keywords: exchange rate, monetary policy,term structure, no arbitrage
    JEL: C13 E43 E52
    Date: 2006–12–03
  11. By: Skander Van den Heuvel (Finance Department University of Pennsylvania)
    Abstract: This paper examines the role of bank lending in the transmission of monetary policy in the presence of capital adequacy regulations. I develop a dynamic model of bank asset and liability management that incorporates risk-based capital requirements and an imperfect market for bank equity. These conditions imply a failure of the Modigliani-Miller theorem for the bank: its lending will depend on the bank’s financial structure, as well as on lending opportunities and market interest rates. Combined with a maturity mismatch on the bank’s balance sheet, this gives rise to a ‘bank capital channel’ by which monetary policy affects bank lending through its impact on bank equity capital. This mechanism does not rely on any particular role of bank reserves and thus falls outside the conventional ‘bank lending channel’. I analyze the dynamics of the new channel. An important result is that monetary policy effects on bank lending depend on the capital adequacy of the banking sector; lending by banks with low capital has a delayed and then amplified reaction to interest rate shocks, relative to well-capitalized banks. Other implications are that bank capital affects lending even when the regulatory constraint is not momentarily binding, and that shocks to bank profits, such as loan defaults, can have a persistent impact on lending
    Keywords: Monetary Policy, Bank Capital, Capital Requirements, Bank Lending Channel
    JEL: E44 E52 G28
    Date: 2006–12–03
  12. By: Joao Miguel Sousa (Banco de Portugal); Andrea Zaghini (Banca d'Italia and CFS)
    Abstract: The paper constructs a global monetary aggregate, namely the sum of the key monetary aggregates of the G5 economies (US, Euro area, Japan, UK, and Canada), and analyses its indicator properties for global output and inflation. Using a structural VAR approach we find that after a monetary policy shock output declines temporarily, with the downward effect reaching a peak within the second year, and the global monetary aggregate drops significantly. In addition, the price level rises permanently in response to a positive shock to the global liquidity aggregate. The similarity of our results with those found in country studies might supports the use of a global monetary aggregate as a summary measure of worldwide monetary trends.
    Keywords: Monetary Policy, Structural VAR, Global Eco
    JEL: E52 F01
    Date: 2006–12–20
  13. By: Irina A. Telyukova; Randall Wright
    Abstract: Many individuals simultaneously have significant credit card debt and money in the bank. The so-called credit card debt puzzle is, given high interest rates on credit cards and low interest rates on bank accounts, why not pay down this debt? Economists have gone to some lengths to explain this. As an alternative, we present a natural extension of the standard model in monetary economics to incorporate consumer debt, which we think is interesting in its own right, and which shows that the coexistence of debt and money in the bank is no puzzle
    Keywords: Money, credit, monetary search models, credit card debt puzzle
    JEL: E44 E51
    Date: 2006–12–03
  14. By: Benoit Julien (Economics Australian Graduate School of Management); John Kennes; Ian King
    Abstract: This paper analyzes monetary exchange in a search model allowing for multilateral matches to be formed, according to a standard urn-ball process. We consider three physical environments: indivisible goods and money, divisible goods and indivisible money, and divisible goods and money. We compare the results with Kiyotaki and Wright (1993), Trejos and Wright (1995), and Lagos and Wright (2005) respectively. We …nd that the multilateral matching setting generates very simple and intuitive equilibrium allocations that are similar to those in the other papers, but which have important di¤erences. In particular, sur- plus maximization can be achieved in this setting, in equilibrium, with a positive money supply. Moreover, with ‡exible prices and directed search, the …rst best allocation can be attained through price posting or through auctions with lotteries, but not through auctions without lotteries. Finally, analysis of the case of divisible goods and money can be performed without the assumption of large families (as in Shi (1997)) or the day and night structure of Lagos and Wright (2005)
    Keywords: Matching, Money, Directed Search
    JEL: C78 D44 E40
    Date: 2006–12–03
  15. By: Tomoyuki Nakajima (Kyoto University)
    Abstract: We consider an efficiency-wage model with the Calvo-type sticky prices and analyze optimal monetary policy when unemployment insurance is not perfect. With imperfect risk sharing, strict zero-inflation policy is no longer optimal even if the zero-inflation steady-state equilibrium is assumed to be (conditionally) efficient. Quantitative result depends on how idiosyncratic earning losses, measured by the (inverse of the) relative income of the unemployed to the employed, vary over business cycles. If idiosyncratic income losses are acyclical, optimal policy differs very little from the zero-inflation policy. However, if they vary countercyclically, as evidence suggests, the deviation of optimal policy from complete price stabilization becomes quantitatively significant. Furthermore, optimal policy in such a case involves stabilization of output to a much larger extent
    Keywords: optimal monetary policy, efficiency wage, unemployment, nominal rigidities
    JEL: E3 E5
    Date: 2006–12–03
  16. By: Guillaume Rocheteau (Federal Reserve Bank of Cleveland public); Peter Rupert; Karl Shell; Randall Wright
    Abstract: We study general equilibrium with nonconvexities. In these economies there exist sunspot equilibria without the usual assumptions needed in convex economies, and they have good welfare properties. Moreover, in these equilibria, agents act as if they have quasi-linear utility. Hence wealth effects vanish. We use this to construct a new model of monetary exchange. As in Lagos-Wright, trade occurs in both centralized and decentralized markets, but while that model requires quasi-linearity, we have general preferences. Given our specification looks much like the textbook Arrow-Debreu model, we think this constitutes progress on the classic problem of integrating money and general equilibrium theory. We also use the model to discuss another classic issue: the relation between inflation and unemployment
    Keywords: Money, Indivisibilities, Sunspots.
    JEL: E40 E50
    Date: 2006–12–03
  17. By: Tatiana Damjanovic; Charles Nolan
    Abstract: Many sticky-price models suggest that relative price distortion is one of the major costs of inflation. We show that this resource misallocation is costly even at quite low rates of inflation. This is because inflation strongly affects price dispersion which in turn has an impact on the economy qualitatively similar to, and of the order of magnitude of, a negative shift in productivity. Similarly, the utility cost of price dispersion is large. We incorporate price dispersion in a linearized model. This radically affects how shocks are transmitted through the economy. Notably, a contractionary nominal shock has a persistent, negative hump-shaped impact on inflation, but may have a positive hump-shaped impact on output. Observed persistence in the policy rate is not due to the policy rule per se.
    Keywords: Price stickiness; optimal fiscal and monetary policies; price dispersion.
    JEL: E52 E61 E63
    Date: 2006–11
  18. By: Alessandro Riboni; Francisco Ruge-Murcia (Economics University of Montreal)
    Abstract: This paper develops a model where the value of the monetary policy instrument is selected by a heterogenous committee engaged in a dynamic voting game. Committee members differ in their institutional power and, in certain states of nature, they also differ in their preferred instrument value. Preference heterogeneity and concern for the future interact to generate decisions that are dynamically inefficient and inertial around the previously-agreed instrument value. This model endogenously generates autocorrelation in the policy variable and provides an explanation for the empirical observation that the nominal interest rate under the central bank's control is infrequently adjusted
    Keywords: Committees, status-quo bias, interest-rate smoothing, dynamic voting
    JEL: E58 D02
    Date: 2006–12–03
  19. By: Miquel Faig (Department of Economics University of Toronto); Belen Jerez
    Abstract: The low velocity of circulation of money implies that households hold more money than they normally spend. This behavior is explained if households face uncertain expenditure needs, so that they have a precautionary motive for holding money. We investigate this motive in a search model where households are subject to preference shocks. The model predicts that the velocity is not only low but also interest elastic. The model closely fits United States data on velocity and interest rates (1892-2003). The empirical analysis reveals a dramatic reduction in precautionary balances towards the end of our sample, which is important for policy issues
    Keywords: Precautionary Balances, Velocity of Circulation of Money, Demand for Money
    JEL: E41 E52
    Date: 2006–12–03
  20. By: Benjamin Eden (Department of Economics, Vanderbilt University)
    Abstract: What are the "liquidity services" provided by ìover-pricedî assets? How do international seigniorage payments affect the choice of monetary policies? Does a country gain when other hold its ìover-pricedî assets? These questions are analyzed here in a model in which demand uncertainty (taste shocks) and sequential trade are key. It is shown that a country with a relatively stable demand may issue "over priced" debt and get seigniorage payments from countries with unstable demand. But this does not necessarily improve welfare in the stable demand country.
    Keywords: Seigniorage, liquidity, rate of return dominance, optimal monetary policy
    JEL: E42 F00 G00 H62
    Date: 2006–11
  21. By: Jasmina Arifovic; Olena Kostyshyna
    Abstract: We study individual evolutionary learning in the setup developed by Deissenberg and Gonzalez (2002). They study a version of the Kydland-Prescott model in which in each time period monetary authority optimizes weighted payoff function (with selfishness parameter as a weight on its own and agent's payoffs) with respect to inflation announcement, actual inflation and the selfishness parameter. And also each period agent makes probabilistic decision on whether to believe in monetary authority's announcement. The probability of how trustful the agent should be is updated using reinforcement learning. The inflation announcement is always different from the actual inflation, and the private agent chooses to believe in the announcement if the monetary authority is selfish at levels tolerable to the agent. As a result, both the agent and the monetary authority are better off in this model of optimal cheating. In our simulations, both the agent and the monetary authority adapt using a model of individual evolutionary learning (Arifovic and Ledyard, 2003): the agent learns about her probabilistic decision, and the monetary authority learns about what level of announcement to use and how selfish to be. We performed simulations with two different ways of payoffs computation - simple (selfishness weighted payoff from Deissenberg/Gonzales model) and "expected" (selfishness weighted payoffs in believe and not believe outcomes weighted by the probability of agent to believe). The results for the first type of simulations include those with very altruistic monetary authority and the agent that believes the monetary authority when it sets announcement of inflation at low levels (lower than critical value). In the simulations with "expected" payoffs, monetary authority learned to set announcement at zero that brought zero actual inflation. This Ramsey outcome gives the highest possible payoff to both the agent and the monetary authority. Both types of simulations can also explain changes in average inflation over longer time horizons. When monetary authority starts experimenting with its announcement or selfishness, it can happen that agent is better off by changing her believe (not believe) action into the opposite one that entails changes in actual inflation
    JEL: C63 E5
    Date: 2005–11–11
  22. By: William Branch (Economics University of California, Irvine); John Carlson; George W. Evans; Bruce McGough
    Abstract: This paper addresses the output-price volatility puzzle by studying the interaction of optimal monetary policy and agents' beliefs. We assume that agents choose their information acquisition rate by minimizing a loss function that depends on expected forecast errors and information costs. Endogenous inattention is a Nash equilibrium in the information processing rate. Although a decline of policy activism directly increases output volatility, it indirectly anchors expectations, which decreases output volatility. If the indirect effect dominates then the usual trade-off between output and price volatility breaks down. This provides a potential explanation for the `Great Moderation' that began in the 1980's
    Keywords: optimal policy, expectations, adaptive learning
    JEL: E52 E31 D83
    Date: 2006–12–03
  23. By: Maurice Obstfeld (University of California, Berkeley)
    Abstract: In the face of huge balance of payments surpluses and internal inflationary pressures, China has been in a classic conflict between internal and external balance under its dollar currency peg. Over the longer term, China's large, modernizing, and diverse economy will need exchange rate flexibility and, eventually, convertibility with open capital markets. A feasible and attractive exit strategy from the essentially fixed RMB exchange rate would be a two-stage approach, consistent with the steps already taken since July 2005, but going beyond them. First, establish a limited trading band for the RMB relative to a basket of major trading partner currencies. Set the band so that it allows some initial revaluation of the RMB against the dollar, manage the basket rate within the band if necessary, and widen the band over time as domestic foreign exchange markets develop. Second, put on hold ad hoc measures of financial account liberalization. They will be less helpful for relieving exchange rate pressures once the RMB/basket rate is allowed to move flexibly within a band, and they are best postponed until domestic foreign exchange markets develop further, the exchange rate is fully flexible, and the domestic financial system has been strengthened and placed on a market-oriented basis.
    Keywords: Renminbi, China currency, China balance of payments, fixed exchange rate exit strategy,
    Date: 2006–07–11
  24. By: Craig Burnside (Department of Economics Duke University); Martin Eichenbaum; Isaac Kleshchelski; Sergio Rebelo
    Abstract: Currencies that are at a forward premium tend to depreciate. This `forward premium-depreciation anomaly' represents an egregious deviation from uncovered interest parity. We document the 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 those 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. We display a simple microstructure model that simultaneously rationalizes `price pressure' and the forward premium-depreciation puzzle. The central feature of this model is that market makers face an adverse selection problem that is less severe when, based on public information, the currency is expected to appreciate
    Keywords: uncovered interest parity, BGT regressions, price pressure
    JEL: G12 G13 G15
    Date: 2006–12–03
  25. By: Stephen D. Williamson (Department of Economics University of Iowa)
    Abstract: A segmented markets model is constructed in which transactions are conducted using credit and currency. Goods market segmentation plays an important role, in addition to the role played by conventional segmentation of asset markets. An important novelty of the paper is to show how the diffusion of a money injection by the central bank depends not only on the interaction of agents in exchanging money for goods, but on the arrangements for clearing and settlement of credit instruments. The model permits open market operations, daylight overdrafts, reserve-holding, and overnight lending and borrowing, allowing us to consider a rich array of central banking arrangements and their implications
    Keywords: Money, Segmented Markets, Credit, Central Banking
    JEL: E4
    Date: 2006–12–03
  26. By: John Quigley (University of California, Berkeley)
    Abstract: This paper tests the "lock−in" effect of mortgage contract terms and establishes the link between changes in market interest rates and homeowner mobility. The analysis is based on the Panel Study of Income Dynamics during 1990−1993, when mortgage interest rates declined by almost 30 percent.
    Keywords: Households, Mortgage,
    Date: 2006–06–27
  27. By: Carlos Carmona (University of California, San Diego)
    Abstract: Inflation forecasts of the Federal Reserve systematically under-predicted inflation before Volcker and systematically over-predicted it afterward. Furthermore, under quadratic loss, commercial forecasts have information not contained in those forecasts. To investigate the cause, this paper recovers the loss function implied by Federal Reserve's forecasts. It finds that the cost of having inflation above an implicit time-varying target was larger than the cost of having inflation below it for the period since Volcker, and that the opposite was true for the pre-Volcker era. Once these asymmetries are taken into account, the Federal Reserve is found to be rational. (JEL C53, E52)
    Keywords: Inflation Forecasts, Asymmetric Loss, Federal Reserve,
    Date: 2005–07–01
  28. By: Dror Goldberg (Department of Economics Texas A&M University)
    Abstract: Monetary search models are difficult to analyze unless the distribution of money holdings is made degenerate. Popular techniques include using an infinitely large household (Shi 1997) and adding a centralized market with quasi-linear utility (Lagos and Wright 2005). Wallace (2002) suggests as an alternative to have two-member households who can somehow direct their search, thus creating a degenerate distribution in a different way. This idea is modelled here for the first time by modifying the partially directed search model of Goldberg (forthcoming). The Friedman rule is optimal, but the costs of deviating from it are different from the above mentioned models
    Keywords: directed search, Friedman rule
    JEL: E31 E40 E50
    Date: 2006–12–03
  29. By: Andrea Brischetto (Reserve Bank of Australia); Anthony Richards (Reserve Bank of Australia)
    Abstract: This paper uses data for Australia, the United States, Japan and the euro area to examine the relative performance of the headline CPI, exclusion-based ‘cores’, and trimmed means as measures of underlying inflation. Overall, we find that trimmed means tend to outperform headline and exclusion measures on a range of different criteria, indicating that they can be thought of as having better signal-to-noise ratios. We also find that there is a wide range of trims that perform well. One innovation for the United States is to break up the large implicit rent component in the US CPI into four regional components, which improves the performance of trimmed means, especially large trims such as the weighted median. The results lend support to the use of trimmed means as useful measures of underlying inflation at the current juncture where the growth of China and other emerging markets is having two offsetting effects on global inflation. Whereas some central banks have tended to focus on headline inflation and others have focused more on exclusion measures, our results provide some justification for a middle path, namely using trimmed mean measures which deal with outliers at both ends of the distribution of price changes in a symmetric manner.
    Keywords: underlying inflation; core inflation; trimmed means; Australia; United States; Japan; euro area
    JEL: E31 E52 E58
    Date: 2006–12
  30. By: Helge Braun (Department of Economics Northwestern University)
    Abstract: This paper estimates an identified VAR on US data to gauge the dynamic response of the job finding rate, the worker separation rate, and vacancies to monetary policy shocks. I develop a general equilibrium model that can account for the large and persistent responses of vacancies, the job finding rate, the smaller but distinct response of the separation rate, and the inertial response of inflation. The model incorporates labor market frictions, capital accumulation, and nominal price rigidities. Special attention is paid to the role of different propagation mechanisms and the impact of search frictions on marginal costs. Estimates of selected parameters of the model show that wage rigidity, moderate search costs, and a high value of non-market activities are important in explaining the dynamic response of the economy. The analysis extends to a broader set of aggregate shocks and can be used to understand and design monetary, labor market, and other policies in the presence of labor market frictions
    Keywords: Unemployment, Inflation, Labor Market Frictions
    JEL: E30 J63 J64
    Date: 2006–12–03
  31. By: Dean Corbae (University of Texas); Borghan N. Narajabad
    Abstract: We apply a mechanism design approach to a trading post environment where the household type space (tastes over variety) is continuous and it is costly to set up shops that trade differentiated goods. In this framework, we address Hotelling's <cite>Hot</cite> venerable question about where shops will endogenously locate in variety space across environments with and without money. Money has a role in our environment due to anonymity. Our specific question is whether monetary exchange leads to more product variety than an environment without money (i.e. a barter economy). We show that an efficient monetary mechanism does in fact lead to more product variety available to households provided the discount factor is sufficiently high, costs of operating shops are sufficiently low, and there is sufficient heterogeneity in tastes and abilities. We then show how this allocation can be implemented in a trading post economy with money. The paper is an attempt to integrate monetary theory and industrial organization
    Keywords: Matching Models of Money, Trading Posts
    JEL: E4
    Date: 2006–12–03
  32. By: Ross Starr (University of California, San Diego)
    Abstract: This paper posits an example of Walrasian general competitive equilibrium in an exchange economy with commodity-pairwise trading posts and transaction costs. Budget balance is enforced for each transaction at each trading post separately. Commodity-denominated bid and ask prices at each post allow the post to cover transaction costs through the bid/ask spread. In the absence of double coincidence of wants, the lower transaction-cost commodity (with the narrowest bid/ask spread) becomes the common medium of exchange, commidty money. Selection of the monetary commodity and adoption of a monetary pattern of trad results from price-guided equilibrium without central direction, fiat, or government
    Keywords: Transaction cost, bid/ask spread, money, Arrow-Debreu general equilibrium,
    Date: 2006–06–01
  33. By: Christian Bauer; Sebastian Horlemann
    Abstract: Recent approaches in international finance on exchange rates explicitly account for the maturity of interest rates. We integrate the interest parity idea into a modern microstructure model of foreign exchange and national bond markets and develop a model of the term structure of exchange rate expectations. The reaction function of the spot rate on changes of the basic economic variables such as the interest rate is generalized. This capital market model is able to reproduce standard results (e.g. overshooting) without reference to macroeconomic variables like rigid prices. In addition, the semi-elasticity of the spot exchange rate on interest rate changes depends on both the term structure of interest rates in both countries and determinants of the financial markets. The effects of interest rate changes on the spot exchange rate are diminished, if the exchange rate expectations for short and for long horizons have opposite signs. Finally, we show that there are several rational methods of building expectations which are not mutually consistent. This ambiguity of rational expectation building might contribute to explanations of the diversity of empirical results in the literature known as UIP puzzle.
    Keywords: exchange rates, expectation, term structure, interest parity
    JEL: F31 D84 E43
  34. By: Tetsuji Okazaki (Faculty of Economics, University of Tokyo)
    Abstract: The central bank as the Lender of Last Resort (LLR) is faced with a trade off between the stability of the financial system and the moral hazard of banks. In this paper we explore how this trade off was dealt with by the Bank of Japan (BOJ) in the pre-war period, and how LLR lending by the BOJ affected the financial system. In providing an LLR loan, the BOJ adopted the policy of favoring banks which already had a transaction relationship with the BOJ. Meanwhile, the BOJ was selective in having transaction relationship with banks, and it ceased the relationship, in case the performance of a transaction counterpart declined. The analysis of the bank exits data suggests that the BOJ could successfully bail out illiquid but solvent banks, and thereby avoided the moral hazard that the LLR policy might otherwise have incurred.
    Date: 2006–01
  35. By: Ricardo Cavalcanti; Andres Erosa
    Abstract: We show that price stickiness is predicted by the theory of second best, applied to a random- matching model of money. The economy is hit with iid, aggregate, preference shocks, and allocations are allowed to be history dependent. Due to individual anonymity and lack of commitment, implementable allocations must satisfy participation constraints. Price stickiness becomes necessary for optimality, in terms of average, ex-ante welfare, when aggregate uncen- tainty is present but not too severe, and the degree of patience is neither too low or too high. By applying mechanism design to an alternative economy with centralized markets, we also Þnd important that macroeconomic policies, such as the taxation of money holdings, are unable to implement the Þrst best for price stckiness to have a social role
    Keywords: Mechanism Design, monetary theory, history dependence
    JEL: E10 E50
    Date: 2006–12–03

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