nep-mon New Economics Papers
on Monetary Economics
Issue of 2007‒01‒28
twenty-six papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Does Inflation Targeting Matter for EMEs? By René Cabral
  2. Is Numerairology the Future of Monetary Economics? Unbundling numeraire and medium of exchange through a virtual currency and a shadow exchange rate By Willem H. Buiter
  3. Excess Liquidity in Guyana: Theoretical and Policy Implications By Khemraj, Tarron
  4. Monetary Policy in a Small Open Economy with a Preference for Robustness By Dennis, Richard; Leitemo, Kai; Söderström, Ulf
  5. The Central Banker as a Risk Manager: Estimating the Federal Reserve's Preferences under Greenspan By Kilian, Lutz; Manganelli, Simone
  6. The Optimal Quantity of Money Consistent with Positive Nominal Interest Rates By Harashima, Taiji
  7. Anticipated Raw Materials Price Shocks and Monetary Policy Response - A New Keynesian Approach By Wohltmann, Hans-Werner; Winkler, Roland
  8. Exchange Market Pressure: Some Caveats In Empirical Applications By Simone Bertoli; Giampiero Gallo; Giorgio Ricchiuti
  9. Progress toward a Common Currency Basket System in East Asia By OGAWA Eiji; SHIMIZU Junko
  10. Optimal Monetary and Fiscal Policy in an Economy with Non-Ricardian Agents By Michal Horvath
  11. Exchange Rate Pass-Through in ASEAN: Implications for the Prospects of Monetary Integration in the Region By Carlos Cortinhas
  12. Term structure of interest rate. european financial integration. By Hortènsia Fontanals; Elisabet Ruiz; Catalina Bolancé
  13. Revealing the naked truth behind price determinacy, infinite-horizon rational expectations, and inflation targeting By Eagle, David
  14. Reforming China’s Exchange Rate Policy By John Ryan
  15. The Economic Impact of Central Bank Transparency: A Survey By Eijffinger, Sylvester C W; van der Cruijsen, Carin A B
  16. Bank Imputed Interest Rates: Unbiased Estimates of Offered Rates? By Örs, Evren; Rice, Tara
  17. An Evolutionary Theory of Inflation Inertia By Alexis Anagnostopoulos; Omar Licandro; Italo Bove; Karl Schlag
  18. Persistence and Nominal Inertia in a Generalized Taylor Economy: How Longer Contracts Dominate Shorter Contracts By Dixon, Huw; Kara, Engin
  19. Evaluating An Estimated New Keynesian Small Open Economy Model By Adolfson, Malin; Laséen, Stefan; Lindé, Jesper; Villani, Mattias
  20. Structural Breaks and the Demand for Money in Fiji By Rao, B. Bhaskara; Kumar, Saten
  21. Technological change and the demand for currency: An analysis with household data By Lippi, Francesco; Secchi, Alessandro
  22. Macroeconomic imbalances and exchange rate regime shifts By Post, Erik
  23. Cointegration, structural breaks and the demand for money in Bangladesh By Rao, B. Bhaskara; Kumar, Saten
  24. Backing, the Quantity Theory, and the Transition to the U.S. Dollar, 1723-1850 By Peter L. Rousseau
  25. Random Walk Expectations and the Forward Discount Puzzle By Philippe Bacchetta; Eric van Wincoop
  26. How the Removal of Deposit Rate Ceilings Has Changed Monetary Transmission in the US: Theory and Evidence By Karel Mertens

  1. By: René Cabral
    Abstract: This paper presents an empirical assessment of the performance of EMEs that have adopted inflation targets to conduct monetary policy. In contrast to the evidence previously found for industrial economies, we observe that IT has really mattered for EMEs' price stability. Cross-section and panel estimations consistently suggest that IT has significantly contributed to EMEs' disinflation.
    Keywords: Inflation, Prices, EME, EMEs
    JEL: E31
    Date: 2006–07
  2. By: Willem H. Buiter
    Abstract: The paper discusses some fundamental problems in monetary economics associated with the determination and role of the numeraire. The issues are introduced by formalising a proposal, attributed to Eisler, to remove the zero lower bound on nominal interest rates by unbundling the numeraire and medium of exchange/means of payment functions of money. The monetary authorities manage the exchange rate between the numeraire ('sterling') and the means of payment ('drachma'). The short nominal interest rate on sterling bonds can then be used to target stability for the sterling price level. The paper puts question marks behind two key bits of conventional wisdom in contemporary monetary economics. The first is the assumption that the monetary authorities define and determine the numeraire used in private transactions. The second is the proposition that price stability in terms of that numeraire is the appropriate objective of monetary policy. The paper also discusses the merits of the next step following the decoupling of the numeraire from the currency: doing away with currency altogether - the cashless economy. Because the unit of account plays such a central role in New-Keynesian models with nominal rigidities, monetary economics needs to devote more attention to numerairology - the study of the individual and collective choice processes that govern the adoption of a unit of account and its role in economic behaviour.
    JEL: E3 E4 E5 E6
    Date: 2007–01
  3. By: Khemraj, Tarron
    Abstract: Banks demand non-remunerative excess reserves because of (i) minimum markup interest rates in the loan market and the government security market; and (ii) a foreign currency constraint in the foreign exchange market. The minimum markup interest rates are consistent with an oligopolistic banking sector. The non-competitive nature of the government security market implies (i) there is no exogenous domestic interest rate to pin down the domestic term structure; and (ii) the theory of the banking firm when applied to underdeveloped economies has to be implemented in an open economy context. Indirect monetary policy which aims at managing excess bank reserves has very limited influence on the loan market.
    Keywords: excess liquidity; oligopoly banking; minimum interest rate; foreign currency constraint
    JEL: O16 E52 E5 F30
    Date: 2007–01
  4. By: Dennis, Richard; Leitemo, Kai; Söderström, Ulf
    Abstract: We use robust control techniques to study the effects of model uncertainty on monetary policy in an estimated, semi-structural, small-open-economy model of the U.K. Compared to the closed economy, the presence of an exchange rate channel for monetary policy not only produces new trade-offs for monetary policy, but it also introduces an additional source of specification errors. We find that exchange rate shocks are an important contributor to volatility in the model, and that the exchange rate equation is particularly vulnerable to model misspecification, along with the equation for domestic inflation. However, when policy is set with discretion, the cost of insuring against model misspecification appears reasonably small.
    Keywords: model misspecification; model uncertainty; robust control
    JEL: E52 E61 F41
    Date: 2007–01
  5. By: Kilian, Lutz; Manganelli, Simone
    Abstract: Motivated by policy statements of central bankers, we propose to regard the central banker as a risk manager who aims at containing inflation and the deviation of output from potential within pre-specified bounds. We develop formal tools of risk management that may be used to quantify the risks of failing to attain that objective. Risk measures inherently depend on the loss function of the user. We propose a simple, yet flexible class of loss functions that nests the standard assumption of quadratic symmetric preferences, while being congruent with a risk management model. We show how the parameters of this loss function under weak assumptions may be estimated from realizations for inflation and output gap data even in the absence of a fully specified structural model of the economy. We present estimates of the Federal Reserve’s risk aversion parameters with respect to the inflation and output objectives during the Greenspan period. We formally test for and reject the standard assumptions of quadratic and symmetric preference that underlies the derivation of the Taylor rule. Our results suggest that Fed policy decisions under Greenspan are better understood in terms of the Fed weighing upside and downside risks to their objectives rather than simply responding to the conditional mean of inflation and of the output gap. We derive a natural generalization of the Taylor rule that links changes in the interest rate to the balance of the risks implied by the dual objective of sustainable economic growth and price stability. Unlike standard Taylor rules, this generalized policy rule is consistent with the wording of policy decisions by the Federal Reserve.
    Keywords: Greenspan; inflation; monetary policy; output; policy rule; preferences; risk
    JEL: E31 E52 E58
    Date: 2007–01
  6. By: Harashima, Taiji
    Abstract: The Friedman rule is strongly immune to most model modifications although it has not actually been observed. The Friedman rule implicitly assumes that a government is perfectly under the control of the representative household. This paper shows that, if a government is not perfectly under the control of the representative household, but also pursues political objectives, the optimal quantity of money generally is accompanied by positive nominal interest and inflation rates through the simultaneous optimization of government and the representative household. The fact that nominal interest and inflation rates are usually positive conversely implies that a government usually pursues political objectives.
    Keywords: The Optimal Quantity of Money; The Friedman rule; Inflation; The fiscal theory of the price level; Leviathan
    JEL: E42 E41 E51 E63
    Date: 2007–01–16
  7. By: Wohltmann, Hans-Werner; Winkler, Roland
    Abstract: The paper analyzes the dynamic effects of anticipated raw materials price increases for small open oil-dependent economies and investigates the con- sequences of several monetary policy rules in response to commodity price shocks. Based on a calibrated New Keynesian open economy model the analysis shows that anticipated increases in the price of oil will involve oil- dependent economies both in temporary inflation and deflation as well as in output expansion and contraction. Compared to an interest rate Taylor rule a money growth rule is more appropriate to reduce the volatility of the CPI in°ation rate whereas just the opposite holds for stabilizing the output gap.
    Keywords: Oil price shocks, Monetary Policy, Open Economy
    JEL: E32 E52 F41 Q43
    Date: 2006
  8. By: Simone Bertoli (Università degli Studi di Firenze, Dipartimento di Economia); Giampiero Gallo (Università degli Studi di Firenze, Dipartimento di Statistica "G. Parenti"); Giorgio Ricchiuti (Università degli Studi di Firenze,Dipartimento di Economia)
    Abstract: The Exchange Market Pressure (EMP) Index, developed by Eichengreen et al. [1994], is widely used to study currency crises as a tool to signal whether pressures on a currency are softened or warded off through monetary authorities’ interventions or whether a currency crisis has originated. In this paper we show how the index is sensitive to some assumptions behind the aggregation of the information available (exchange rates, interest rates and reserves), especially when emerging countries are involved. Specifically, we address the way exchange rate variations are computed and the impact of different definitions of the reserves, and we question the constancy of the weights adopted. These issues compound with the choice of a fixed threshold when crisis episodes are identified through EMP. As a result, the dichotomous crisis variable thus derived when adopted as a dependent variable may lead to varied results in subsequent econometric analysis.
  9. By: OGAWA Eiji; SHIMIZU Junko
    Abstract: Ogawa and Shimizu (2005, 2006a) have proposed a possible way to create an Asian Monetary Unit (AMU) as a weighted average of the thirteen East Asian currencies (ASEAN + China, Japan, and Korea) and developed AMU Deviation Indicators for a surveillance process under the Chiang Mai Initiative. Both the AMU and the AMU Deviation Indicators are important in helping the countries in the region to recognize the necessity of moving toward a common currency basket system. However, there remains an open question about how to implement this system in East Asian countries. The purpose of this paper is to compile the latest issues of currency basket itself and to develop concrete steps toward a common currency basket system in East Asia. Particularly, we simulate possible individual currency basket weights based on trade shares of each East Asian country and convert them to G3 currency (the US dollar, the euro, and the Japanese yen) basket weights. We also investigate the discrepancies between the converted G3 currency basket weight of the AMU and the weights of the common G3 currency basket, which is to illustrate the reality of implementing a common currency basket system. We propose a possible way to shift from an individual G3 currency basket system to the AMU currency basket system. In this process, we expect that the Japanese yen would play a varying role at each stage toward monetary coordination in East Asia.
  10. By: Michal Horvath
    Abstract: The optimal policy mix maximizes a quadratic welfare objective which follows from the agents. utility function and depends only on inflation and output gap volatility. We analyze the optimal response of the economy to a rise in government spending. We find that the optimal economy moves along an analogue of a conventional inflation-output variance frontier, as the population share of non-Ricardian agents rises. Output should optimally vary more, as this is to the benefit of the liquidity-constrained agents via net real wages, while optimal inflation volatility falls as there is less of a need to use inflation to maintain fiscal solvency. There is little evidence that increased government spending would crowd in private consumption. The tax rate varies to contain pressures on prices by shifting the natural rate of output towards its preference-driven target level. We identify the size of the target deviation in output and the interest rate elasticity of demand as the key determinants of the optimal interest rate policy.
    Keywords: Optimal Monetary and Fiscal Policy, Macroeconomic Stabilization, Non-Ricardian Agents.
    JEL: E61 E63
    Date: 2007–01
  11. By: Carlos Cortinhas (Universidade do Minho - NIPE)
    Abstract: This paper investigates, for the first time, the degree of exchange rate pass-through to domestic prices in all five founding members of ASEAN. For this purpose, a three variable recursive VAR model was applied which uses the Choleski decomposition method along the distribution chain of pricing, using data for the period 1968 to 2001. The results show that a strong case for entering a currency union can only be made for the cases of Singapore and Malaysia as in these countries there appears to be a case of exchange rate disconnect. A case for a common currency can also be made for Indonesia but for entirely different reasons. For this country, an independent monetary policy is a clear source of shocks to the economy and therefore a currency union would tend to eliminate then. A weaker case for a common currency can be made for the Philippines as evidence of some exchange rate pass-through to inflation was found but not to import prices. Finally, Thailand exhibits a clear case of exchange rate pass-through to import prices (but not to inflation) and thus evidence that a flexible exchange rate might be preferable as it provides the means to improve the country’s price competitiveness.
    Keywords: Exchange Rate Pass-Through; Monetary Integration; Asean
    JEL: F31 F33 E42
    Date: 2007
  12. By: Hortènsia Fontanals (Faculty of Economics, University of Barcelona.); Elisabet Ruiz (Universitat Oberta de Catalunya.); Catalina Bolancé (Faculty of Economics, University of Barcelona.)
    Abstract: In this paper we estimate, analyze and compare the term structures of interest rate in six different countries, during the period 1992-2004. We apply Nelson and Siegel model to obtain them with a weekly frequency. Four European Monetary Union countries, Spain, France, Germany and Italy are included. UK is also included as a European country, but not integrated in the Monetary Union. Finally US completes the analysis. The goal is to determine the differences in the shape of curves between these countries. Likewise, we can determinate the most usual term structure shapes that appear in every country.
    Keywords: Term structure of interest rate, parsimonious models, level parameter, slope parameter, European interest rate.
    JEL: C14 C51 C82 E43 G15
    Date: 2006–12
  13. By: Eagle, David
    Abstract: The economic profession should demand that that price-determinacy literature adhere to normal academic standards and burdens of proof. By presenting two examples where the non-exploding criterion fails miserably, we demonstrate that that criterion does not universally apply. Therefore, the previous price-determinacy literature has the burden to prove that the non-explosive criterion does apply, but has not met and probably cannot meet that burden. This paper looks at an economy with an arbitrarily large, but finite horizon and concludes that inflation targeting leads to price indeterminacy even with a Taylor-like feedback rule for setting the nominal interest rate.
    Keywords: non-explosive criterion; price determinacy; inflation targeting; stability criterion; saddle-point criterion; infinite-horizon economies; pegging the interest rate
    JEL: E42 E31 E52 E58
    Date: 2007–01–18
  14. By: John Ryan (European Business School, Regent’s College)
    Abstract: This paper is aimed at analysing the decision of the Chinese central bank to reform the exchange rate of the national currency and to gauge the effects of this change in regime on the Chinese economy and the world currency markets. Although many nations have been largely disappointed by the relatively small revaluation of 2%, it will be argued that moving away from the dollar-peg is a step in the right direction in moving to a floating exchange rate, and the reform should be expected to occur in two-stages over a longer time frame The paper focuses on those studies attempting to estimate the under-valuation of the Renminbi and the effects of the change in policy. To enable the reader to understand the degree of misalignment of the. Renminbi this paper will examine various factors that determine whether the currency is undervalued. This will then allow the review of the policy options available to the central bank for facilitating an appreciation and the potential effects of a regime change will be reported. The expected outcomes on the currencies, US treasuries and trade deficit will also be analysed and the study will find that, post-revaluation, the dollar depreciates, the Yen moves in line with the Renminbi and the Euro strengthens, as was expected. The implications for the U.S. treasury market, after a move to a currency basket, is that China will reduce their dollar holdings by selling treasuries, however the region will still remain a net-buyer.
    Keywords: Renminbi, China, United States, Dollar, Euro and Yen
    JEL: D53 E41 E42 E44 F31
    Date: 2006
  15. By: Eijffinger, Sylvester C W; van der Cruijsen, Carin A B
    Abstract: We provide an up-to-date overview of the literature on the desirability of central bank transparency from an economic viewpoint. Since the move towards more transparency, a lot of research on its effects has been carried out. First, we show how the theoretical literature has evolved, by looking into branches inspired by Cukierman and Meltzer (1986) and by investigating several, more recent, research strands (e.g. coordination and learning). Then, we summarize the empirical literature which has been growing more recently. Last, we discuss whether: i) the empirical research resolves all theoretical question marks, ii) how the findings of the literature match the actual practice of central banks, and iii) where there is scope for more research.
    Keywords: central bank transparency; monetary policy; survey
    JEL: E31 E52 E58
    Date: 2007–01
  16. By: Örs, Evren; Rice, Tara
    Abstract: We examine whether “imputed” interest rates obtained from bank financial statements are unbiased estimates of “offered” interest rates that the same banks report in surveys. We find evidence of a statistically significant amount of bias. However, the statistical bias that we document does not appear to be economically significant. When used as dependent variables in regression analysis, imputed rates and offered rates lead to the same policy conclusions. Our work has important methodological implications for empirical research that examines the product market competition among depository institutions.
    Keywords: deposit rates; imputed prices; product market; transaction prices
    JEL: G21 L11
    Date: 2007–01
  17. By: Alexis Anagnostopoulos; Omar Licandro; Italo Bove; Karl Schlag
    Abstract: We provide a simple theory of inflation inertia in a staggered price setting framework a la Calvo (1983). Contrary to Calvo.s formulation, the frequency of price changes is allowed to vary according to an evolutionary criterion. Inertia is the direct result of gradual adjustment in this frequency following a permanent change in the rate of money growth.
    Date: 2006
  18. By: Dixon, Huw (Cardiff Business School); Kara, Engin
    Abstract: We develop the Generalized Taylor Economy (GTE) in which there are many sectors with overlapping contracts of different lengths. In economies with the same average contract length, monetary shocks will be more persistent when longer contracts are present. Using the Bils-Klenow distribution of contract lengths, we find that the corresponding GTE tracks the US data well. When we choose a GTE with the same distribution of completed contract lengths as the Calvo, the economies behave in a similar manner.
    Keywords: Persistence; Taylor contract; Calvo
    JEL: E50 E24 E32 E52
    Date: 2007–01
  19. By: Adolfson, Malin; Laséen, Stefan; Lindé, Jesper; Villani, Mattias
    Abstract: This paper estimates and tests a new Keynesian small open economy model in the tradition of Christiano, Eichenbaum, and Evans (2005) and Smets and Wouters (2003) using Bayesian estimation techniques on Swedish data. To account for the switch to an inflation targeting regime in 1993 we allow for a discrete break in the central bank's instrument rule. A key equation in the model - the uncovered interest rate parity (UIP) condition - is well known to be rejected empirically. Therefore we explore the consequences of modifying the UIP condition to allow for a negative correlation between the risk premium and the expected change in the nominal exchange rate. The results show that the modification increases the persistence and volatility in the real exchange rate and that this model has an empirical advantage compared with the standard UIP specification.
    Keywords: Bayesian inference; DSGE model; DSGE-VAR model; DSGE-VECM model; open economy
    JEL: C11 C53 E17
    Date: 2007–01
  20. By: Rao, B. Bhaskara; Kumar, Saten
    Abstract: This paper fills a gap in the empirical work on the demand for money for Fiji. We allowed for structural breaks in the cointegrating equation, within the Gregory and Hansen framework, and found that there is a cointegrating relationship between real narrow money, real income and the nominal rate of interest in all the three types of their models. However, only the model with an intercept shift for the 1987 political coup yields a meaningful cointegrating relationship. We tested for its temporal stability and found that the demand for money in Fiji is stable.
    Keywords: Structural break; Cointegration; Gregory and Hansen; Demand for money; Fiji
    JEL: E4
    Date: 2006–07
  21. By: Lippi, Francesco; Secchi, Alessandro
    Abstract: Advances in the transaction technology allow agents to economize on the cost of cash management. We argue that accounting for the impact of new transaction technologies on currency holding behaviour is important to obtain theoretically consistent estimates of the demand for money. We modify a standard inventory model to study the effect of the withdrawal technology on the demand for currency. An empirical specification for the households demand schedule is suggested in which both the level of currency holdings and the interest rate elasticity of the demand depend on the withdrawal technology available to agents (e.g. ATM card ownership or a high/low density of bank branches, ATMs). The theoretical implications are tested using a unique panel of Italian household data (on currency holdings, deposit interest rates, consumption, development of banking services, etc.) for the 1989-2004 period.
    Keywords: inventory models; money demand; technological change
    JEL: E5
    Date: 2007–01
  22. By: Post, Erik (Department of Economics)
    Abstract: This paper uses a dynamic stochastic rational expectations model of a small open economy to shed some light on factors determining exits from a fixed to a flexible exchange rate regime. Exits are in the model determined by a concern for macroeconomic stabilization. If cost-push shocks are important relative to demand shocks exits should occur more likely in times of low consumption and output, high interest rates, negative asset holdings, current account deficits, high inflation and high domestic prices. If the policy maker is more sensitive to negative rather than positive output deviations the probability of exits increases overall and is tilted toward exits with accompanying depreciation.
    Keywords: exchange rates; exchange rate regimes; rational expectations model
    JEL: E42 E44 E47
    Date: 2007–01–16
  23. By: Rao, B. Bhaskara; Kumar, Saten
    Abstract: This paper allows for endogenous structural breaks in the cointegration equation and investigates if there is a stable demand for money for Bangladesh. We have used the Gregory and Hansen framework and found that there was an intercept shift and a well- determined and stable demand for money in Bangladesh exists.
    Keywords: Endogenous structural breaks; Gregory and Hansen method; Demand for money; Bangladesh.
    JEL: E40 E4
    Date: 2007–01–16
  24. By: Peter L. Rousseau
    Abstract: Among the thirteen original colonies, Pennsylvania was most successful at issuing paper money with only minimal effects on prices -- so much so that the colony's experience is sometimes seen as violating the classical quantity theory of money. Quantity theorists usually attribute this apparent anomaly to mismeasurement of the money stock. In contrast, I use data on money, prices, and real activity in Pennsylvania from 1723 to 1774 and for the United States as a whole from 1790 to 1850 (when the money stock is better measured) to show that the long-run behavior of money and prices is well explained by the quantity theory in both periods, despite the differences in institutional arrangements, once growth in monetized transactions is taken into account.
    JEL: E31 E42 N11
    Date: 2007–01
  25. By: Philippe Bacchetta (Study Center Gerzensee); Eric van Wincoop (University of Virginia)
    Abstract: Two well-known, but seemingly contradictory, features of exchange rates are that they are close to a random walk while at the same time exchange rate changes are predictable by interest rate dierentials. In this paper we investigate whether these two features of the data may in fact be related. In particular, we ask whether the predictability of exchange rates by interest dierentials naturally results when participants in the FX market adopt random walk expectations. We nd that random walk expectations can explain the forward premium puzzle, but only if FX portfolio positions are revised infrequently. In contrast, with frequent portfolio adjustment and random walk expectations, we nd that high interest rate currencies depreciate much more than what UIP would predict.
    Date: 2007–01
  26. By: Karel Mertens
    Abstract: A test for the cointegrating rank of a vector autoregressive (VAR) process with a possible shift and broken linear trend is proposed. The break point is assumed to be known. The setup is a VAR process for cointegrated variables. The tests are not likelihood ratio tests but the deterministic terms including the broken trends are removed first by a GLS procedure and a likelihood ratio type test is applied to the adjusted series. The asymptotic null distribution of the test is derived and it is shown by a Monte Carlo experiment that the test has better small sample properties in many cases than a corresponding Gaussian likelihood ratio test for the cointegrating rank.
    Keywords: Cointegration, structural break, vector autoregressive process, error correction model
    JEL: C32
    Date: 2006

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