nep-mon New Economics Papers
on Monetary Economics
Issue of 2007‒06‒18
ten papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Terms and conditions for the implementation of Inflation targeting in Croatia By Tomislav Čorić
  2. Fair Wages, Fair Prices, and Monetary Policy By Cenesiz, Alper
  3. The euro as a reserve currency: a challenge to the pre-eminence of the US dollar? By Gabriele Galati; Philip D. Wooldridge
  4. Liquidity Traps, Learning and Stagnation By George W. Evans; Eran Guse; Seppo Honkapohja
  5. Globalisation and inflation: New cross-country evidence on the global determinants of domestic inflation By Claudio E. V. Borio; Andrew Filardo
  6. Monetary and prudential policies at a crossroads? New challenges in the new century By Claudio E. V. Borio
  7. Devaluations, output and the balance sheet effect: a structural econometric analysis By Camilo E Tovar
  8. Central banks as agents of employment creation By Gerald Epstein
  9. Single Equation Models, Co-Integration and the Expectations Hypothesis of the Term Structure of Interest Rates By Fabrizio Casalin
  10. Interest Rate Rules, Inflation Stabilization, and Imperfect Credibility: The Small Open Economy Case By Guillermo A. Calvo

  1. By: Tomislav Čorić (Faculty of Economics and Business, University of Zagreb)
    Abstract: Since the introduction of the Stabilization program in 1993, the Croatian National Bank has been following the monetary strategy of exchange rate anchor. During the first several years (from 1993 to 1997) this monetary strategy achieved acceptable results, accompanied with a low inflation rate and high GDP growth rates. However, the macroeconomic situation has changed in the last decade. The indicators of Croatian economy, such as trade balance, the level of external debt and GDP growth rates, are not satisfying. The criticizers of exchange rate anchor monetary strategy argue that appreciated kuna lowers the competitiveness of the domestic economy. Due to that, the current monetary strategy is in the focus of various economists' discussions. One of the alternatives to the exchange rate anchor is inflation targeting. There are different theoretical and practical issues connected to the implementation of this, very popular, monetary strategy. Before the implementation of inflation targeting, the following conditions need to be fulfilled: (1) the independence of monetary authorities in choosing the monetary instruments should be achieved, (2) at least one monetary policy instrument should be efficient, and (3) the transparency of monetary policy should be accomplished. The process itself consists of several decisions, such as choosing the proper measure of inflation, the level of targeted inflation, targeted range or point etc., which is still a matter of theoretical debates. The purpose of this paper is to contribute to the above mentioned debate. After the theoretical discussion, the inflation targeting will be analyzed from the two perspectives. Firstly, in order to evaluate the capability of Croatia to implement the inflation targeting, the analysis of the Croatian monetary system will be given. Secondly, in order to asses the suitability of the inflation targeting as Croatian monetary strategy, both positive and negative characteristics of this strategy will be considered.
    Keywords: inflation targeting, monetary strategy, Croatia
    JEL: E42 E52 E58
    Date: 2007–06–13
  2. By: Cenesiz, Alper
    Abstract: Empirical research on inflation and output dynamics has revealed that inflation lags output following a shock to monetary policy. To account for this fact, researchers rely on price and wage setting assumptions that are not in line with the stylized facts of wage and price setting behavior. Fair wages and fair prices, however, can explain the observed wage and price setting behavior. Hence, I develop and analyze a general-equilibrium model with fair wages and fair prices. The model can explain the observed lag-lead relation between inflation and output. Furthermore, results with respect to other key macroeconomic aggregates are also in line with their empirical counterparts.
    Keywords: Inflation dynamics; Price adjustment; Efficiency wages; Monetary policy.
    JEL: E32 E52 E31
    Date: 2007–05
  3. By: Gabriele Galati; Philip D. Wooldridge
    Abstract: Well developed financial markets are a necessary condition for a currency to play a role as a reserve currency. The introduction of the euro greatly improved the functioning of euro financial markets. This paper investigates whether euro financial markets have developed sufficiently to facilitate the emergence of the euro as a reserve currency on par with the US dollar. We find that the liquidity and breadth of euro financial markets are fast approaching those of dollar markets, and as a result the euro is eroding some of the advantages that have historically supported the pre-eminence of the US dollar as a reserve currency. This strengthens the incentive for monetary authorities to reconsider the currency composition of their reserves. Nevertheless, the introduction of the euro has not yet resulted in a significant change in the currency composition of official reserve holdings. The US dollar has maintained its place as the dominant reserve currency, supported perhaps by the edge that dollar financial markets still have over euro markets in terms of size, credit quality and liquidity, as well as inertia in the use of international currencies.
    Keywords: international currency, foreign exchange reserves, currency composition, dollar, euro, financial markets
    JEL: E58 F30 F31 G11 G15
    Date: 2006–10
  4. By: George W. Evans (University of Oregon Economics Department); Eran Guse (University of Cambridge); Seppo Honkapohja (University of Cambridge)
    Abstract: We examine global economic dynamics under learning in a New Keynesian model in which the interest-rate rule is subject to the zero lower bound. Under normal monetary and fiscal policy, the intended steady state is locally but not globally stable. Large pessimistic shocks to expectations can lead to deflationary spirals with falling prices and falling output. To avoid this outcome we recommend augmenting normal policies with aggressive monetary and fiscal policy that guarantee a lower bound on inflation. In contrast, policies geared toward ensuring an output lower bound are insufficient for avoiding deflationary spirals.
    Keywords: Adaptive Learning, Monetary Policy, Fiscal Policy, Zero Interest Rate Lower Bound, Indeterminacy
    JEL: E63 E52 E58
    Date: 2007–06–05
  5. By: Claudio E. V. Borio; Andrew Filardo
    Abstract: There has been mounting evidence that the inflation process has been changing. Inflation is now much lower and much more stable around the globe. And its sensitivity to measures of economic slack and increases in input costs appears to have declined. Probably the most widely supported explanation for this phenomenon is that monetary policy has been much more effective. There is no doubt in our mind that this explanation goes a long way towards explaining the better inflation performance we have observed. In this paper, however, we begin to explore a complementary, rather than alternative, explanation. We argue that prevailing models of inflation are too "country-centric", in the sense that they fail to take sufficient account of the role of global factors in influencing the inflation process. The relevance of a more "globe-centric" approach is likely to have increased as the process of integration of the world economy has gathered momentum, a process commonly referred to as "globalisation". In a large cross-section of countries, we find some rather striking prima facie evidence that this has indeed been the case. In particular, proxies for global economic slack add considerable explanatory power to traditional benchmark inflation rate equations, even allowing for the influence of traditional indicators of external influences on domestic inflation, such as import and oil prices. Moreover, the role of such global factors has been growing over time, especially since the 1990s. And in a number of cases, global factors appear to have supplanted the role of domestic measures of economic slack.
    Keywords: Globalisation, inflation, monetary policy, Phillips curve
    Date: 2007–05
  6. By: Claudio E. V. Borio
    Abstract: It is hard to find a period in the post-war era in which inflation-adjusted interest rates have been so low for so long and monetary and credit aggregates have expanded so much without igniting inflation (the "Great Liquidity Expansion puzzle"). What lies behind these developments? How benign are they? This paper argues that financial liberalisation, the establishment of credible anti-inflation monetary policies and (real-side) globalisation have resulted in subtle but profound changes in the dynamics of the economy and in the challenges faced by policymakers. In the new environment which has gradually been taking shape, the main "structural" risk may not be so much run away inflation. Rather, it may be the damage caused by the unwinding of financial imbalances that occasionally build up over the longer expansion phases of the economy, typically spanning more than one higher-frequency business cycle. Depending on its intensity, the unwinding can lead to economic weakness, unwelcome disinflation and possibly financial strains. The analysis has implications for monetary and prudential policies. It calls for a firmer long-term focus, for greater symmetry in policy responses between upswings and downswings, with more attention being paid to actions during upswings, and for closer cooperation between monetary and prudential authorities. In recent years, the intellectual climate and policy frameworks have gradually evolved in a direction more consistent with this perspective. At the same time, obstacles to further progress remain. They are of an analytical, institutional and, above all, political economy nature. Removing them calls for further analytical and educational efforts.
    Keywords: business fluctuations, globalisation, prudential and monetary policy, financial imbalances, monetary and financial stability, liquidity
    Date: 2006–09
  7. By: Camilo E Tovar
    Abstract: This paper estimates a new open economy macroeconomic model for South Korea to determine the output effect of currency devaluations. Three transmission mechanisms are considered: the expenditure-switching, the balance sheet, and a monetary channel associated to a nominal exchange rate target. Devaluations are defined as an increase in this target. This allows to isolate the effects of an explicit exogenous devaluationary policy shock. Ceteris paribus, a devaluation is found to be expansionary. Output contractions in South Korea should then be associated with a different shock such as an adverse shock on the international interest rate or on export demand.
    Keywords: structural estimation, DSGE, financial accelerator, devaluations, balance sheet effect, interest rate rule, exchange rate target, new open economy macroeconomics
    JEL: F31 F41
    Date: 2006–09
  8. By: Gerald Epstein
    Abstract: Employment creation has dropped off the direct agenda of most central banks. The so-called “global best practice” approach to central banking has not focused on economic growth or employment generation but rather on keeping inflation in the low single digits. However, the policy record shows that employment generation and economic growth are often not by-products of inflation focused central bank policy. This chapter argues that there should be a return to the historical norm of central bank policy in which employment creation and more rapid economic growth join inflation and stabilization more generally as key goals of central bank policy. Supporting this argument, the chapter summarizes major lessons of a multi-country research project undertaken by an international team of economists which show that, within the constraints of contemporary economic conditions, there are viable alternatives to inflation targeting that can focus more on important social, real sector outcomes such as employment generation and poverty reduction.
    Keywords: inflation targeting; employment; central bank; poverty reduction.
    JEL: E5 E6 N1 N2 O2
    Date: 2007–07
  9. By: Fabrizio Casalin
    Abstract: The purpose of this paper is twofold. First, by focusing on Single Equation and VECM techniques commonly employed to test for the Expectations Hypothesis of the Term Structure of interest rates (EHTS), it sheds light on the conditions - in terms of the different classes of stochastic processes of the spot and forward rates - that must hold for the EHTS to be valid. In doing so, the existing linkage between the two strands of literature is highlighted. Second, by using kalman filter and maximum likelihood, estimates of a permanent-transitory components model for spot and forward interest rates are carried out. The simple parametric model helps discern the relative contributions of both departures from rational expectation and time varying term premium to the invalidation of the EHTS. Departures from rational expectations turn out to have negligible impact on the rejection of the EHTS. Estimates of the time varying term premia for the short-end of the term structure spectrum are persistent and reasonable in magnitude, and exhibit sign fluctuations.
    Date: 2007–06
  10. By: Guillermo A. Calvo
    Abstract: The paper examines the robustness of Interest Rate Rules, IRRs, in the context of an imperfectly credible stabilization program, closely following the format of much of the literature in open-economy models, e.g., Calvo and Végh (1993 and 1999). A basic result is that IRRs, like Exchange Rate Based Stabilization, ERBS, programs, could give rise to macroeconomic distortion, e.g., underutilization of capacity and real exchange rate misalignment. However, while under imperfect credibility EBRS is associated with overheating and current account deficits, IRRs give rise to somewhat opposite results. Moreover, the paper shows that popular policies to counteract misalignment, like Strategic Foreign Exchange Market Intervention or Controls on International Capital Mobility may not be effective or could even become counterproductive. The bottom line is that the greater exchange rate flexibility granted by IRRs is by far not a sure shot against the macroeconomic costs infringed by imperfect credibility.
    JEL: E52 E58 F32 F41
    Date: 2007–06

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