nep-mon New Economics Papers
on Monetary Economics
Issue of 2007‒03‒24
35 papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Are there gains from including monetary aggregates and stock market indices in the monetary policy reaction function? A simulation study of recent U.S. monetary policy By Mandler, Martin
  2. The Quest for Price Stability in Central America and the Dominican Republic By Luis Ignacio Jácome; Eric Parrado
  3. Gradualism, Transparency and Improved Operational Framework: A Look at the Overnight Volatility Transmission By Silvio Colarossi; Andrea Zaghini
  4. Robustly Optimal Monetary Policy with Near-Rational Expectations By Michael Woodford
  5. Fixed Exchange Rates and the Autonomy of Monetary Policy: The Franc Zone Case By Romain Veyrune
  6. The Narrative Approach for the Identification of Monetary Policy Shocks in a Small Open Economy By Eleni Angelopoulou
  8. Inflation and Growth in the Euro Zone By Dino Martellato
  9. Is core money growth a good and stable inflation predictor in the euro area? By Kai Carstensen
  10. The effect of monetary policy on exchange rates during currency crisis : the role of debt, institutions and financial openness By Eijffinger,Sylvester C.W.; Goderis,Benedikt
  11. Is the Quantity of Government Debt a Constraint for Monetary Policy? By Srobona Mitra
  12. Sources of Inflation in Sub-Saharan Africa By Shanaka J. Peiris; Regis Barnichon
  13. Why does overnight liquidity cost more than intraday liquidity? By Bhattacharya, Joydeep; Haslag, Joseph; Martin, Antoine
  14. Foreign Exchange Intervention and Equilibrium Real Exchange Rates By Dimitrios A. Sideris
  15. Central bank intervention, sterilization and monetary independence: the case of Pakistan By Waheed, Muhammad
  16. Inflation in Poland: How Much Can Globalization Explain? By Celine Allard
  17. Identifying the Role of Labor Markets for Monetary Policy in an Estimated DSGE Model By Kai Christoffel; Keith Kuester; Tobias Linzert
  18. The Mistake of 1937: A General Equilibrium Analysis By Gauti B. Eggertsson; Benjamin Pugsley
  19. Does Capital Account Openness Lower Inflation? By Abhijit Sen Gupta
  20. The Lending Channel in Emerging Economies: Are Foreign Banks Different? By Francisco F. Vázquez; Marco Arena; Carmen Reinhart
  21. Mortgage Markets, Collateral Constraints, and Monetary Policy: Do Institutional Factors Matter? By Alessandro Calza; Tommaso Monacelli; Livio Stracca
  22. Total Factor Productivity and Monetary Policy: Evidence from Conditional Volatility By Nicholas Apergis; Stephen M. Miller
  23. On the Welfare Benefits of an International Currency By Prakash Kannan
  24. Money and Inflation By Ansgar Belke; Thorsten Polleit
  25. Precautionary Monetary and Fiscal Policies By Pelin Berkmen
  26. Money Illusion and Housing Frenzies By Brunnermeier, Markus K; Julliard, Christian
  27. Three Great American Disinflations By Michael Bordo; Christopher Erceg; Andrew Levin; Ryan Michaels
  28. Sticky Prices and Monetary Policy: Evidence from Disaggregated U.S. Data By Jean Boivin; Marc P. Giannoni; Ilian Mihov
  29. A "Simple" Currency Union Model with Labor Market Frictions, Real Wage Rigidities and Equilibrium Unemployment By Mirko Abbritti
  30. Forecasts of US Short-term Interest Rates: A Flexible Forecast Combination Approach By Guidolin, Massimo; Timmermann, Allan G
  31. Bayesian and Adaptive Optimal Policy under Model Uncertainty By Lars E.O. Svensson; Noah Williams
  32. Exchange Rate Policy and Liability Dollarization: An Empirical Study By Pelin Berkmen; Eduardo E. Cavallo
  33. A Dynamic New Keynesian Life-Cycle Model: Societal Ageing, Demographics and Monetary Policy By Ippei Fujiwara; Yuki Teranishi
  34. Nonlinear Exchange Rate Adjustment in the Enlarged Euro zone. Evidence and Implications for Candidate Countries. By Nikolaos Giannellis; Athanasios Papadopoulos
  35. Identification of a Loan Supply Function: A Cross-Country Test for the Existence of a Bank Lending Channel By Sophocles N. Brissimis; Matthaios D. Delis

  1. By: Mandler, Martin
    Abstract: We study how the inclusion of growth rates of monetary aggregates or changes in stock market indices affects the stabilization performance of optimal monetary policy rules when there is uncertainty about the structure of the economy. With a simulation model of the U.S. economy we show that the performance of monetary policy rules that include these variables deteriorates much stronger than that of rules without them if the true economic structure deviates from the one used to derive the rule. We also investigate whether money growth and changes in stock market indices help explaining the Fed's recent monetary policy.
    Keywords: optimal monetary policy; monetary policy reaction function; robust monetary policy
    JEL: E52 E47 C15
    Date: 2006
  2. By: Luis Ignacio Jácome; Eric Parrado
    Abstract: This paper addresses the question of why inflation has not yet converged to price stability in Central America and the Dominican Republic and is currently relatively high by Latin American standards. It suggests that despite the institutional strengthening of monetary policy, important flaws remain in most central banks, in particular a lack of a clear policy mandate and little political autonomy, which are adversely affecting the consistency of policy implementation. Empirical analysis reveals that all central banks raise interest rates to curtail inflation but only some of them increase it sufficiently to effectively tackle inflation pressures. It also shows that some central banks care simultaneously about exchange rate stability. The potential policy conflict arising from a dual central bank mandate and the unpredictable policy response is probably undermining markets' confidence in central banks' commitment to price stability, thereby perpetuating an inflation bias.
    Keywords: Monetary policy , inflation , Central America , monetary policy rules , Price stabilization , Central America , Dominican Republic ,
    Date: 2007–03–09
  3. By: Silvio Colarossi (Banca d'Italia); Andrea Zaghini (Banca d'Italia and CFS)
    Abstract: This paper proposes a possible way of assessing the effect of interest rate dynamics on changes in the decision-making approach, communication strategy and operational framework of a Central bank. Through a GARCH specification we show that the USA and Euro area displayed a limited but significant spillover of volatility from money market to longer-term rates. We then checked the stability of this phenomenon in the most recent period of improved policymaking and found empirical evidence that the transmission of overnight volatility along the yield curve vanished soon after specific policy changes of the FED and ECB.
    Keywords: Monetary Policy, Yield Curve, GARCH
    JEL: E4 E5 G1
    Date: 2007–03–09
  4. By: Michael Woodford (Columbia University)
    Abstract: The paper considers optimal monetary stabilization policy in a forward-looking model, when the central bank recognizes that private-sector expectations need not be precisely model-consistent, and wishes to choose a policy that will be as good as possible in the case of any beliefs that are close enough to model-consistency. It is found that commitment continues to be important for optimal policy, that the optimal long-run inflation target is unaffected by the degree of potential distortion of beliefs, and that optimal policy is even more history-dependent than if rational expectations are assumed.
    Keywords: Optimal Monetary Policy, Commitment, History-Dependent Policy
    JEL: E42 E52 E58
    Date: 2007–02–19
  5. By: Romain Veyrune
    Abstract: This paper compares monetary policy of currency boards with that of the franc zone during the period 1956-2005. It concludes that monetary policy in the zone was more autonomous than under a currency board, even though both systems faced the same exchange rate constraint. So far, the contingency line provided by the French treasury and capital controls have allowed the zone to combine a fixed exchange rate and a relatively autonomous monetary policy. Financial development and zone enlargement would challenge this relative autonomy for two reasons: (1) the potential cost to the French treasury would increase; and (2) residents would potentially be able to avoid capital controls. For the zone to maintain its fixed exchange rate, close targeting of foreign reserves would become important.
    Keywords: Franc zone , currency boards , monetary policy , fixed exchange rate , Exchange rate policy , Monetary unions , Currency boards , Monetary policy ,
    Date: 2007–02–21
  6. By: Eleni Angelopoulou (Bank of Greece and Athens University of Economics and Business)
    Abstract: This paper reviews 22 years of UK monetary policy in the pre-inflation targeting period (1971-1992) using official record from the Bank of England Quarterly Bulletin. A transparent definition of policy episodes is used. The empirical analysis shows that output displays the usual hump-shaped response after a shock to the policy indicator. All variables display theory-consistent behaviour. Monetary policy and exchange rate volatility are found to cause substantial output fluctuation in a four year horizon. The “narrative model” extended to a small open economy compares well with a structural VAR.
    Keywords: Monetary Policy Shocks; Narrative Approach; UK.
    JEL: E52 E58
    Date: 2007–02
  7. By: Robert Pollin (Department of Economics and Political Economy); James Heintz (Research Institute, University of Massachusetts-Amherst)
    Abstract: This IPC Country Study by Robert Pollin and James Heintz examines three policy areas related to monetary policies in Kenya: inflation dynamics and the relationship between inflation and long-run growth; monetary policy targets and instruments; and exchange rate dynamics and the country’s external balance. It concludes with five main policy recommendations.
    JEL: B41 D11 D12 E31 I32 O54
    Date: 2007–03
  8. By: Dino Martellato (Department of Economics, University Of Venice Ca’ Foscari)
    Abstract: Although euro area-wide inflation was from 1999 to 2005 almost right, i.e. “close to balance, but below 2%”, and although it combined with real growth as predicted by the long-run money demand equation in the euro area, the picture that emerges at country level is more scattered. Inside a monetary union, inflation divergences could be destabilizing and an excessive dispersion could be a problem, thus the scattered performance of the single members in terms of HICP inflation and real growth is an issue that the euro area governance is illprepared to manage. It may be of interest, therefore, to understand whether observed differences come from the money market or from the costs side or from the interaction between supply and demand when agents are forward looking. The paper sets out to ascertain whether the patterns of inflation and growth data observed in the twelve members and Slovenia compare to what is predicted by the long-run money demand equation in the euro area, the Balassa-Samuelson construct or the New Keynesian model.
    Keywords: Inflation, stability, euro zone
    JEL: E12 E41 E52 E63
    Date: 2006
  9. By: Kai Carstensen
    Abstract: In this paper, it is analyzed whether core money growth helps to predict future inflation in a useful and reliable way. Using an out-of-sample forecasting exercise and a stability analysis, it is shown that core money growth carries important information not contained in the inflation history, that its inclusion in a forecasting model can increase the forecasting accuracy, and that it has had a strong and stable long-run link to inflation over the last decades. A particularly promising forecasting model at all horizons is the one proposed by Gerlach (2004) that includes the inflation gap, the difference between core money growth and core inflation, and the output gap. This model has a very good track record, exhibits stable parameters over both the pre-EMU and the EMU era. What makes it appealing from a more theoretical perspective is that it relies on the stable long-run relationship between money growth and inflation.
    Keywords: Forecasting, core money growth, stability, filter
    JEL: E47 E58
    Date: 2007–02
  10. By: Eijffinger,Sylvester C.W.; Goderis,Benedikt (Tilburg University, Center for Economic Research)
    Abstract: This paper examines the effect of monetary policy on the exchange rate during currency crises. Using data for a number of crisis episodes between 1986 and 2004, we find strong evidence that raising the interest rate: (i) has larger adverse balance sheet effects and is therefore less effective in countries with high domestic corporate short-term debt; (ii) is more credible and therefore more effective in countries with high-quality institutions; iii) is more credible and therefore more effective in countries with high external debt; and (iv) is less effective in countries with high capital account openness. We predict that monetary policy would have had the conventional supportive effect on the exchange rate during five of the crisis episodes in our sample, while it would have had the perverse effect during seven other episodes. For four episodes, we predict a statistically insignificant effect. Our results support the idea that the effect of monetary policy depends on its impact on fundamentals, as well as its credibility, as suggested in the recent theoretical literature. They also provide an explanation for the mixed findings in the empirical literature.
    Keywords: currency crisis;institutions;monetary policy;short-term debt;external debt; capital account openness
    JEL: E52 E58
    Date: 2007
  11. By: Srobona Mitra
    Abstract: This paper derives an interest rate rule for monetary policy in which the interest rate response of the central bank toward an increase in expected inflation falls as debts increase beyond a certain threshold level. A debt-constrained interest rate rule and the threshold level of debt are jointly estimated for Canada during the first decade of its inflation targeting regime of the 1990s. There are three main findings of this paper. First, a high government debt could constrain monetary policy if government spending-rather than taxes-is expected to adjust in future in line with debt service costs. The 'constraint' operates through an altered policy transmission mechanism through changes in the IS curve. Second, the effects of the debt-constraint on monetary policy are quite different during booms and recessions. Third, empirical estimates show that Canadian monetary policy might have been constrained by a high government debt-GDP ratio during the 1990s. Policy was less loose than what inflation indicators called for.
    Keywords: Monetary policy , government debt , interest rate rule , Canada ,
    Date: 2007–03–15
  12. By: Shanaka J. Peiris; Regis Barnichon
    Abstract: This paper explores the sources of inflation in Sub-Saharan Africa by examining the relationship between inflation, the output gap, and the real money gap. Using heterogeneous panel cointegration estimation techniques, we estimate cointegrating vectors for the production function and the real money demand function to recover the structural output and money gaps for seventeen African countries. The central finding is that both gaps contain significant information regarding the evolution of inflation, albeit with a larger role played by the money gap. There is no significant evidence of asymmetry in the relationship.
    Keywords: Inflation , Phillips curve , money demand , panel cointegration , growth accounting , Inflation , Sub-Saharan Africa , Demand for money , Production , Accounting , Economic models ,
    Date: 2007–02–21
  13. By: Bhattacharya, Joydeep; Haslag, Joseph; Martin, Antoine
    Abstract: In this paper, we argue that the observed difference in the cost of intraday and overnight liquidity is part of an optimal payments system design. In our environment, the interest charged on overnight liquidity affects output while the cost of intraday liquidity only affects the distribution of resources between money holders and non-money holders. The low cost of intraday liquidity follows from the Friedman rule and it is optimal to deviate from the the Friedman rule with respect to overnight liquidity. The cost differential simultaneously reduces the incentive to overuse money and encourages risk sharing.
    Keywords: Friedman rule; monetary policy; random-relocation models.
    JEL: E5
    Date: 2007–03–20
  14. By: Dimitrios A. Sideris (Bank of Greece and University of Ioannina)
    Abstract: Monetary authorities intervene in the currency markets in order to pursue a monetary rule and/or to smooth exchange rate volatility caused by speculative attacks. In the present paper we investigate for possible intervention effects on the volatility of nominal exchange rates and the estimated equilibrium behaviour of real exchange rates. The main argument of the paper is that omission of intervention effects -when they are significant- would bias the ability to detect any PPP-based behaviour of the real exchange rates in the long run. Positive evidence for this argument comes from the experience of six Central and Eastern European economies, whose exchange markets are characterised by frequent interventions.
    Keywords: Foreign Exchange Market Intervention; Real Exchange Rates; PPP.
    JEL: F31 C32 E58
    Date: 2007–02
  15. By: Waheed, Muhammad
    Abstract: This paper analyzes the response of the State bank of Pakistan—the central bank, to foreign exchange inflows for the period of 2001:1 to 2006:8. In this context, we estimated sterilization and offset coefficients using vector autoregression (VAR) model to account for the issue of endogeneity of domestic credit with the foreign exchange interventions. In addition, the paper also analyzes the role of foreign and domestic interest rate differentials in pulling in or pushing out of these foreign exchange flows. We found that the offset coefficient is very small and insignificant (0.16) implying that changes in credit resulted in very minimal offsetting reserve flows. The study found out that for the sample period, SBP only partially sterilized the inflows with magnitude of coefficient at (0.50) confirming the stylized facts. Results also indicate that inflows were neither pulled into the country due to high domestic interest rates due to some domestic policy nor they are pushed into Pakistan owing to low interest rates abroad.
    Keywords: Sterilization; Monetary independence; VAR
    JEL: E58 C32
    Date: 2007–03–16
  16. By: Celine Allard
    Abstract: This paper analyses how globalization has affected inflation in the New EU Members States (NMS), and Poland in particular, since 1995. It finds prices have become less sensitive to domestic economic conditions as trade integration rose, possibly because monetary policy incentives increasingly shifted toward meeting price stability objectives. Quantitatively, globalization appears to have lowered Polish prices by ½ to 1 percentage point annually since 1995, substantially more than in advanced economies. However, future inflation-dampening effects in the NMS are likely to be smaller as the pace of increases in trade openness moderates.
    Keywords: Globalization , inflation , transition , Inflation , Poland , Globalization , Trade policy ,
    Date: 2007–02–26
  17. By: Kai Christoffel (European Central Bank); Keith Kuester (European Central Bank); Tobias Linzert (European Central Bank)
    Abstract: We focus on a quantitative assessment of rigid labor markets in an environment of stable monetary policy. We ask how wages and labor market shocks feed into the inflation process and derive monetary policy implications. Towards that aim, we structurally model matching frictions and rigid wages in line with an optimizing rationale in a New Keynesian closed economy DSGE model. We estimate the model using Bayesian techniques for German data from the late 1970s to present. Given the pre-euro heterogeneity in wage bargaining we take this as the first-best approximation at hand for modelling monetary policy in the presence of labor market frictions in the current European regime. In our framework, we find that labor market structure is of prime importance for the evolution of the business cycle, and for monetary policy in particular. Yet shocks originating in the labor market itself may contain only limited information for the conduct of stabilization policy.
    Keywords: Labor Market, Wage Rigidity, Bargaining, Bayesian Estimation
    JEL: E32 E52 J64 C11
    Date: 2007–02–14
  18. By: Gauti B. Eggertsson (Federal Reserve Bank of New York); Benjamin Pugsley (University of Chicago)
    Abstract: This paper studies a dynamic general equilibrium model with sticky prices and rational expectations in an environment of low interest rates and deflationary pressures. We show that small changes in the public’s beliefs about the future inflation target of the government can lead to large swings in both inflation and output. This effect is much larger at low interest rates than under regular circumstances. This highlights the importance of effective communication policy at zero interest rates. We argue that confusing communications by the US Federal Reserve, the President of the United States, and key administration officials about future price objectives were responsible for the sharp recession in the US in 1937-38, one of the sharpest recessions in US economic history. Poor communication policy is the mistake of 1937. Before committing the mistake of 1937 the US policy makers faced economic conditions that are similar in some respect to those confronted by Japanese policy makers in the first half of 2006.
    Keywords: Sticky Prices, Central Bank Communication, Stochastic General Equilibrium Model
    JEL: E61 E52 E32
    Date: 2007–02–12
  19. By: Abhijit Sen Gupta (Indian Council for Research on International Economic Relations)
    Abstract: This paper investigates the relationship between capital account openness and inflation since the 1980s. It argues that widespread capital account liberalization during the last two decades appears to have contributed to the worldwide disinflation observed during the same period. The paper builds a theoretical model to motivate the presence of a negative link between financial integration and inflation. It tests the prediction of the theoretical model by employing static and dynamic panel data procedures. Financial integration appears to discipline monetary authorities, or to help them convince the private sector that they will be more disciplined in the future.
    Keywords: Capital Account Openness, Inflation, Seignorage, Discipline Effect
    JEL: F36 F41 E32
    Date: 2007–01
  20. By: Francisco F. Vázquez; Marco Arena; Carmen Reinhart
    Abstract: This paper exploits a panel dataset comprising 1,565 banks in 20 emerging countries during 1989- 2001 and compares the response of the volume of loans and the rates on loans and deposits to various measures of monetary conditions across domestic and foreign banks. It also looks for systematic differences in the behavior of domestic and foreign banks during periods of financial distress and tranquil times. Using differences in bank ownership as a proxy for financial constraints, the paper finds weak evidence that foreign banks have a lower sensitivity of credit to monetary conditions relative to their domestic competitors, with the differences driven by banks with lower asset liquidity and/or capitalization. The lending and deposit rates of foreign banks tend to be smoother during periods of financial distress. However, the differences across domestic and foreign banks do not appear to be strong. These results provide weak support to the existence of supply-side effects in credit markets and suggest that foreign bank entry in emerging countries may have contributed somewhat to stability in credit markets.
    Keywords: Lending channel , monetary transmission , credit markets , foreign banks , Banking , Emerging markets , Credit ,
    Date: 2007–03–06
  21. By: Alessandro Calza (European Central Bank); Tommaso Monacelli (Bocconi University); Livio Stracca (European Central Bank)
    Abstract: We study the role of institutional characteristics of mortgage markets in affecting the strength and timing of the effects of monetary policy shocks on house prices and consumption in a sample of OECD countries. We document three facts: (1) there is significant divergence in the structure of mortgage markets across the main industrialised countries; (2) at the business cycle frequency, the correlation between consumption and house prices increases with the degree of flexibility/development of mortgage markets; (3) the transmission of monetary policy shocks on consumption and house prices is stronger in countries with more flexible/developed mortgage markets. We then build a two-sector dynamic general equilibrium model with price stickiness and collateral constraints, where the ability of borrowing is endogenously linked to the nominal value of a durable asset (housing). We study how the response of consumption to monetary policy shocks is affected by alternative values of three key institutional parameters: (i) down-payment rate; (ii) mortgage repayment rate; (iii) interest rate mortgage structure (variable vs. fixed interest rate). In line with our empirical evidence, the sensitivity of consumption to monetary policy shocks increases with lower values of (i) and (ii), and is larger under a variable-rate mortgage structure.
    Keywords: House Prices, Mortgage Markets, Collateral Constraints, Monetary Policy
    JEL: E21 E44 E52
    Date: 2007–02–16
  22. By: Nicholas Apergis (University of Macedonia); Stephen M. Miller (University of Connecticut and University of Nevada, Las Vegas)
    Abstract: This paper empirically assesses whether monetary policy affects real economic activity through its affect on the aggregate supply side of the macroeconomy. Analysts typically argue that monetary policy either does not affect the real economy, the classical dichotomy, or only affects the real economy in the short run through aggregate demand %G–%@ new Keynesian or new classical theories. Real business cycle theorists try to explain the business cycle with supply-side productivity shocks. We provide some preliminary evidence about how monetary policy affects the aggregate supply side of the macroeconomy through its affect on total factor productivity, an important measure of supply-side performance. The results show that monetary policy exerts a positive and statistically significant effect on the supply-side of the macroeconomy. Moreover, the findings buttress the importance of countercyclical monetary policy as well as support the adoption of an optimal money supply rule. Our results also prove consistent with the effective role of monetary policy in the Great Moderation as well as the more recent rise in productivity growth.
    Keywords: Total Factor Productivity; Monetary Policy; Volatility; GARCH models
    JEL: E32 E51
    Date: 2007–03
  23. By: Prakash Kannan
    Abstract: Is it beneficial for a country's currency to be used internationally? And, if so, can we quantify the benefit? Since the emergence of the euro, there has been great interest in the consequences of a transfer of the US dollar's premier international role to the euro. Building on recent advancements in the literature on search models of money, this paper presents a novel model-based approach towards assessing the welfare benefits associated with the international use of a country's currency. The welfare gain for the Euro area in having the euro internationally used ranges from 1.7% to 2.1% of consumption.
    Keywords: International curency , search models of money , Currencies , Money , Economic models ,
    Date: 2007–03–06
  24. By: Ansgar Belke; Thorsten Polleit
    Abstract: We turn our attention to the role of money for determining nominal magnitudes. Using US data, we find that the aggregate “nominal output plus and stock market capitalisation” is closely related to the money stock, lending support to one of Milton Friedman’s key monetarist propositions. This finding should be particularly important for ECB monetary policy: an inflation-free euro plays a crucial role for European economic and political integration. We conclude that monetary policy must keep a very close eye on money supply if it wants to prevent consumer and asset price inflation.
    JEL: C22 E52 G12
    Date: 2007
  25. By: Pelin Berkmen
    Abstract: This paper explains why the debt reduction motive for countries that are subject to borrowing constraints and a volatile environment is greater than for those with a more stable environment and relatively better access to the financial markets. In particular, it shows that the possibility of losing the ability to borrow in the future induces precautionary debt reduction. When a government loses its ability to borrow, shocks are more costly to the economy, since they cannot be spread over time. The precautionary motive arises from the need to make these adjustments less painful when the borrowing constraints bind. To avoid large losses in the constrained period, the government prefers to raise taxes and inflation in earlier periods more than would be implied otherwise, leaving less debt to the future periods, and thereby shifting some of the required adjustment to the earlier periods. In other words, the coexistence of large shocks and borrowing constraints forces the government to be more prudent in its management of debt.
    Keywords: Monetary policy , fiscal policy , debt , precautionary motive , Monetary policy , Fiscal policy , Debt ,
    Date: 2007–02–15
  26. By: Brunnermeier, Markus K; Julliard, Christian
    Abstract: A reduction in inflation can fuel run-ups in housing prices if people suffer from money illusion. For example, investors who decide whether to rent or buy a house by simply comparing monthly rent and mortgage payments do not take into account that inflation lowers future real mortgage costs. We decompose the price-rent ratio in a rational component — meant to capture the proxy effect and risk premia — and an implied mispricing. We find that inflation and nominal interest rates explain a large share of the time-series variation of the mispricing, and that the tilt effect is very unlikely to rationalize this finding.
    Keywords: behavioural finance; housing; inflation illusion; interest rate; money illusion; mortgages; real estate
    JEL: G12 R2
    Date: 2007–03
  27. By: Michael Bordo (Rutgers and Cambridge University); Christopher Erceg (Board of Governors of the Federal Reserve System); Andrew Levin (Board of Governors of the Federal Reserve System); Ryan Michaels (University of Michigan)
    Abstract: In this paper, we examine three famous episodes of deliberate deflation (or disinflation) in U.S. history, including episodes following the Civil War, World War I, and the Volcker disinflation of the early 1980s. These episodes were associated with widely divergent effects on the real economy, which we attribute both to differences in the policy actions undertaken, and to the transparency and credibility of the monetary authorities. We attempt to account for the salient features of each episode within the context of a stylized DSGE model. Our model simulations indicate how a more predictable policy of gradual deflation could have helped avoid the sharp post-WWI depression. But our analysis also suggests that the strong argument for gradualism under a transparent monetary regime becomes less persuasive if the monetary authority lacks credibility; in this case, an aggressive policy stance (as under Volcker) can play a useful signalling role by making a policy shift more apparent to private agents.
    Keywords: DSGE Model, Credibility, Deflation
    JEL: E31 E32 E52
    Date: 2007–02–09
  28. By: Jean Boivin (HEC Montréal); Marc P. Giannoni (Columbia Business School); Ilian Mihov (INSEAD)
    Abstract: This paper uses factor-augmented vector autoregressions (FAVAR) estimated using a large data set to disentangle fluctuations in disaggregated consumer and producer prices which are due to macroeconomic factors from those due to sectorial conditions. This allows us to provide consistent estimates of the effects of US monetary policy on disaggregated prices. While sectorial prices respond quickly to sector-specific shocks, we find that for a large number of price series, there is a significant delay in the response of prices to monetary policy shocks. In addition, price responses display little evidence of a “price puzzle,” contrary to existing studies based on traditional VARs. The observed dispersion in the reaction of producer prices is relatively well explained by the degree of market power, as predicted by models with monopolistic competition.
    Keywords: Sticky Prices, Monetary Policy, Disaggregated Prices, Imperfect Competition, Factor-Augmented Vector Autoregression Model (FAVAR)
    JEL: E32 E52
    Date: 2007–02–20
  29. By: Mirko Abbritti (IUHEI, The Graduate Institute of International Studies, Geneva)
    Abstract: This paper derives a DSGE currency union model with labor market frictions, real wage rigidities and price staggering. The model combines many realistic features, but it is still tractable: like standard open-economy models, it can be closed in six equations. We derive and discuss the constrained efficient allocation and the decentralised equilibrium, under both flexible and sticky prices. We use the model to analyse how different labor market institutions or degrees of real wage rigidities influence the functioning of the currency union and the size and persistence of inflation and output differentials. We show that the presence of non trivial real imperfections affects substantially the transmission mechanism of shocks in general and, in particular, of monetary policy. Interestingly, we find that the implications of real wage rigidities and labor market frictions for business cycle fluctuations are likely to operate in opposite directions: a high degree of real wage rigidities tends to amplify the response of the real economy to shocks; when labor market are more sclerotic, instead, unemployment volatility tends to decrease while inflation volatility increases.
    Keywords: Currency Union, labor market frictions, real wage rigidities, unemployment, sticky prices, inflation and output differentials
    JEL: E32 E52 F41
    Date: 2007–01
  30. By: Guidolin, Massimo; Timmermann, Allan G
    Abstract: This paper develops a flexible approach to combine forecasts of future spot rates with forecasts from time-series models or macroeconomic variables. We find empirical evidence that accounting for both regimes in interest rate dynamics and combining forecasts from different models helps improve the out-of-sample forecasting performance for US short-term rates. Imposing restrictions from the expectations hypothesis on the forecasting model are found to help at long forecasting horizons.
    Keywords: forecast combinations; term structure of interest rates
    JEL: C53 G12
    Date: 2007–03
  31. By: Lars E.O. Svensson (Princeton University); Noah Williams (Princeton University)
    Abstract: We study the problem of a policymaker who seeks to set policy optimally in an economy where the true economic structure is unobserved, and policymakers optimally learn from their observations of the economy. This is a classic problem of learning and control, variants of which have been studied in the past, but little with forward-looking variables which are a key component of modern policy-relevant models. As in most Bayesian learning problems, the optimal policy typically includes an experimentation component reflecting the endogeneity of information. We develop algorithms to solve numerically for the Bayesian optimal policy (BOP). However the BOP is only feasible in relatively small models, and thus we also consider a simpler specification we term adaptive optimal policy (AOP) which allows policymakers to update their beliefs but shortcuts the experimentation motive. In our setting, the AOP is significantly easier to compute, and in many cases provides a good approximation to the BOP. We provide a simple example to illustrate the role of learning and experimentation in an MJLQ framework.
    Keywords: Optimal Monetary Policy, Learning, Recursive Saddlepoint Method
    JEL: E42 E52 E58
    Date: 2007–02–16
  32. By: Pelin Berkmen; Eduardo E. Cavallo
    Abstract: The paper identifies the contemporaneous relationship between the exchange rate policy and external debt dollarization in a panel of industrial and developing countries. The presence of endogeneity makes the task of empirical identification elusive. The paper uses the method of "identification through heteroskedasticity" developed by Rigobon (2003) to solve the problem of identification in the present context. It finds that, controlling for endogeneity, countries with aggregate liability dollarization tend to be more actively involved in exchange rate stabilization operations, but it finds mixed results for the reverse causality.
    Keywords: Dollarization , exchange rate policy , Dollarization , Exchange rate policy , External debt ,
    Date: 2007–02–21
  33. By: Ippei Fujiwara (Director and Senior Economist, Institute for Monetary and Economic Studies, Bank of Japan (E-mail:; Yuki Teranishi (Bank of Japan and Columbia University (E-mail:
    Abstract: In this paper, we first construct a dynamic new Keynesian model that incorporates life-cycle behavior a la Gertler (1999), in order to study whether structural shocks to the economy have asymmetric effects on heterogeneous agents, namely workers and retirees. We also examine whether considerations of life-cycle and demographic structure alter the dynamic properties of the monetary business cycle model, specifically the degree of amplification in impulse responses. According to our simulation results, shocks indeed have asymmetric impacts on different households and the demographic structure does alter the size of responses against shocks by changing the degree of the trade-off between substitution and income effects.
    Keywords: Heterogenous Agents, Life-Cycle, New Keynesian Model
    JEL: E32 E50 J14
    Date: 2007–03
  34. By: Nikolaos Giannellis (Department of Economics, University of Crete, Greece); Athanasios Papadopoulos (Department of Economics, University of Crete, Greece)
    Abstract: This paper sheds light on the importance of the validity of PPP hypothesis for the accessing process of the candidate countries towards EMU. The evidence of nonlinear adjustment in real exchange rates insists the estimation of a nonlinear SETAR model. While linear half-life estimates are biased upward (5 years on average), SETAR half-life estimates imply a faster reverting process (1.5 years on average). As a consequence, the evidence in favor of PPP hypothesis and the fast equilibrium adjustment of real exchange rates (setting Euro as the numeraire currency) imply that candidate countries follow a normal integration process towards EMU.
    Keywords: EMU enlargement; PPP; Half-life; Nonlinearity; SETAR.
    JEL: C22 F31
    Date: 2007–01–10
  35. By: Sophocles N. Brissimis (Bank of Greece and University of Piraeus); Matthaios D. Delis (Athens University of Economics and Business)
    Abstract: Using the theoretical predictions of the Bernanke-Blinder (1988) model, we seek to examine the existence of a bank lending channel through the empirical identification of a loan supply function and to assess the impact of differential bank characteristics on banks’ ability to supply loans. To this end, we estimate a loan supply model and test for the restrictions implied by perfect substitutability between loans and bonds in bank portfolios. Estimations are carried out on bank panel data for 16 OECD countries, the results showing that a bank lending channel is at work in only two of them. Moreover, and contrary to standard accounts, we find that the relevance of bank characteristics is hardly a decisive factor in the identification of a loan supply function.
    Keywords: Bank lending channel; financial structure; dynamic panels
    JEL: C23 C52 E44 E52
    Date: 2007–01

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