nep-mon New Economics Papers
on Monetary Economics
Issue of 2007‒08‒18
24 papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. "A Post-Keynesian View of Central Bank Independence, Policy Targets, and the Rules-versus-Discretion Debate" By L. Randall Wray
  2. Monetary policy responses amid credit and asset booms and busts By Pavasuthipaisit, Robert
  3. Simple Monetary Rules under Fiscal Dominance By Michael, Kumhof; Ricardo, Nunes; Irina, Yakadina
  4. "The Fed's Real Reaction Function Monetary Policy, Inflation, Unemployment, Inequality-and Presidential Politics" By James K. Galbraith; Olivier Giovannoni; Ann J. Russo
  5. Money Velocity in an Endogenous Growth Business Cycle with Credit Shocks By Szilárd Benk; Max Gillman; Michal Kejak
  6. Rules versus discretion in managing the Hong Kong dollar, 1983-2006 By Tony Latter
  7. Can Excess Liquidity Signal an Asset Price Boom? By Annick Bruggeman
  8. More Potent Monetary Policy? Insights from a Threshold Model By Jarkko Jääskelä
  9. Banking, Inside Money and Outside Money By Sun, Hongfei
  10. Pass-Through to Import Prices: Evidence from Developing Countries By Miguel Fuentes
  11. What Explains Persistent Inflation Differentials Across Transition Economies? By Felix Hammermann; Mark Flanagan
  12. Business Expectations for a Common Currency in the Arabian Gulf By Rutledge, Emilie
  13. Is Sterilized Intervention Effective? New International Evidence By Pierre L. Siklos; Diana N. Weymark
  14. Rediscounting under aggregate risk with moral hazard By James T. E. Chapman; Antoine Martin
  15. Expectations and Exchange Rate Policy By Michael B. Devereux; Charles Engel
  16. The Overvaluation of Renminbi Undervaluation By Yin-wong Cheung; Menzie D. Chinn; Eiji Fujii
  17. Nominal Exchange Rate Flexibility and Real Exchange Rate Adjustment: New Evidence from Dual Exchange Rates in Developing Countries By Yin-wong Cheung; Kon S. Lai
  18. Enlarging the EMU to the east: What effects on trade? By Ansgar Belke; Julia Spies
  19. China as a Reserve Sink: The Evidence from Offset and Sterilization Coefficients By Alice Y. Ouyang; Ramkishen S. Rajan; Thomas D. Willett
  20. Hoarding of International Reserves: Mrs Machlup¡¦s Wardrobe and the Joneses By Yin-wong Cheung; XingWang Qian
  21. The Evolutionary Chain of International Financial Centers By Michele Fratianni
  22. An Open Economy Model of the Credit Channel Applied to Four Asian Economies By Spiros Bougheas; Paul Mizen; Cihan Yalcin
  23. Price-Level Computation: Illustrations By Sydney N. Afriat; Carlo Milana
  24. Specifying the Forecast Generating Process for Exchange Rate Survey Forecasts By Richard H. Cohen; Carl Bonham

  1. By: L. Randall Wray
    Abstract: This paper addresses three issues surrounding monetary policy formation: policy independence, choice of operating targets, and rules versus discretion. According to the New Monetary Consensus, the central bank needs policy independence to build credibility; the operating target is the overnight interbank lending rate, and the ultimate goal is price stability. This paper provides an alternative view, arguing that an effective central bank cannot be independent as conventionally defined, where effectiveness is indicated by ability to hit an overnight nominal interest rate target. Discretionary policy is rejected, as are conventional views of the central bank's ability to achieve traditional goals such as robust growth, low inflation, and high employment. Thus, the paper returns to Keynes's call for low interest rates and euthanasia of the rentier.
    Date: 2007–08
  2. By: Pavasuthipaisit, Robert
    Abstract: This paper examines the conduct of monetary policy in the presence of credit and asset booms and busts. Conventional wisdom is for the central bank to respond to asset prices and other financial indicators insofar as these factors affect the forecasts of inflation. This paper finds that such strategy is far from being optimal. This paper derives optimal policy under commitment in a standard financial accelerator model and finds that in the optimal equilibrium, the central bank responds to a rise in productivity growth by making a credible commitment to keep the rate of return on capital below the trend. This causes net worth to be countercyclical, which is the key mechanism that allows the central bank to successfully stabilize the economy. The countercyclicality of net worth is consistent with what can be found in the data on the periods following the Volcker chairmanship of the FOMC.
    Keywords: Financial accelerator; optimal policy under commitment; asset prices; credit market frictions; countercyclicality of net worth
    JEL: E58 E50 E44
    Date: 2007–06
  3. By: Michael, Kumhof; Ricardo, Nunes; Irina, Yakadina
    Abstract: This paper asks whether an aggressive monetary policy response to inflation is feasible in countries that suffer from fiscal dominance, as long as monetary policy also responds to fiscal variables. We find that if nominal interest rates are allowed to respond to government debt, even aggressive rules that satisfy the Taylor principle can produce unique equilibria. But following such rules results in extremely volatile inflation. This leads to very frequent violations of the zero lower bound on nominal interest rates that make such rules infeasible. Even within the set of feasible rules the optimal response to inflation is highly negative, and more aggressive inflation fighting is inferior from a welfare point of view. The welfare gain from responding to fiscal variables is minimal compared to the gain from eliminating fiscal dominance.
    Keywords: Optimal simple policy rules; fiscal dominance
    JEL: E40
    Date: 2007–08
  4. By: James K. Galbraith; Olivier Giovannoni; Ann J. Russo
    Abstract: Using a VAR model of the American economy from 1984 to 2003, we find that, contrary to official claims, the Federal Reserve does not target inflation or react to "inflation signals." Rather, the Fed reacts to the very "real" signal sent by unemployment, in a way that suggests that a baseless fear of full employment is a principal force behind monetary policy. Tests of variations in the workings of a Taylor Rule, using dummy variable regressions, on data going back to 1969 suggest that after 1983 the Federal Reserve largely ceased reacting to inflation or high unemployment, but continued to react when unemployment fell "too low." Further, we find that monetary policy (measured by the yield curve) has significant causal impact on pay inequality-a domain where the Fed refuses responsibility. Finally, we test whether Federal Reserve policy has exhibited a pattern of partisan bias in presidential election years, with results that suggest the presence of such bias, after controlling for the effects of inflation and unemployment.
    Date: 2007–08
  5. By: Szilárd Benk (Magyar Nemzeti Bank); Max Gillman (Cardiff Business School); Michal Kejak (CERGE-EI)
    Abstract: The paper sets the neoclassical monetary business cycle model within endogenous growth, adds exchange credit shocks, and finds that money and credit shocks explain much of the velocity variation. The role of the shocks varies across sub-periods in an intuitive fashion. Endogenous growth is key to the construction of the money and credit shocks since these have similar effects on velocity, but opposite effects upon growth. The model matches the data's average velocity and simulates well velocity volatility. Its Cagan-like money demand means that money and credit shocks cause greater velocity variation the higher is the nominal interest rate.
    Keywords: Velocity, business cycle, credit shocks, endogenous growth.
    JEL: E13 E32 E44
    Date: 2007
  6. By: Tony Latter (Hong Kong Institute for Monetary Research)
    Abstract: This paper examines the way in which Hong Kong¡¦s currency board has operated since its re-introduction in 1983. It discusses currency board design and the extent to which Hong Kong has conformed to particular principles. The core of the paper is an assessment of the rules-versus-discretion question. From 1983 to 1988 the currency board convertibility obligation applied, in effect, to physical cash only. Arbitrage could not be relied upon to ensure that the market rate converged to 7.80, so intervention ¡V mostly in the foreign exchange market ¡V played a significant role. In 1988 the authorities acquired the means to apply currency board principles also to the reserve balance of the banking system, but over the next ten years they did not exploit that to full advantage in the currency board context. They gave no convertibility promise for the reserve balance and seldom allowed foreign exchange transactions to trigger currency-board-type adjustment. They concentrated instead on managing bank liquidity or interest rates, very often via money market intervention, albeit subject to the overriding goal of a stable exchange rate. But the range which defined that stability was never revealed. Although this exercise of discretion and the departures from strict currency board principles were not obviously damaging, they may have complicated official procedures unnecessarily, and may have raised doubts as to the authorities¡¦ longterm commitment to 7.80. In other words, rather than helping to settle markets, the tactics may at times have disturbed them. Reforms in 1998 included a weak-side convertibility undertaking for banks¡¦ reserve money at 7.80 (after transition), but left strong-side intervention to the discretion of the Monetary Authority. It was only in 2005 that a firm strong-side undertaking was introduced at 7.75, with the weak side bound being moved to 7.85 in order to provide symmetry. Now, only one minor element of discretion ¡V for intrazone intervention ¡V remains. Whereas discretionary interventions were probably very necessary in the early years after 1983, the authorities could have moved more quickly after 1988 to reach the almost completely rule-based status of today. But the stability of the exchange rate over the entire period speaks for itself, and it is not obvious that stricter adherence to currency board principles would have delivered a materially different outcome.
    Date: 2007–01
  7. By: Annick Bruggeman (National Bank of Belgium, Research Department)
    Abstract: This paper analyses the relationship between the prevailing liquidity conditions (such as measures of money, credit and interest rates) and developments in asset prices from a monetary analysis perspective. After having identified periods of sustained excess liquidity, we analyse under which conditions they are more likely to be followed by an asset price boom. The results from a descriptive analysis of the developments in a number of macroeconomic and financial variables suggest that periods of sustained excess liquidity that are accompanied by strong economic activity, low interest rates, high real credit growth and low inflation have a higher likelihood of being followed by an asset price boom. This conclusion is also confirmed by a logit analysis.
    Keywords: excess liquidity, asset prices, logit model
    JEL: E41 E51 E52
    Date: 2007–08
  8. By: Jarkko Jääskelä (Reserve Bank of Australia)
    Abstract: It has been argued that the effect of a change in the monetary policy interest rate on aggregate demand may be larger at higher levels of indebtedness through its impact on cash flows. However, the extent of credit constraints may be at least as important, if not more so. In particular, monetary policy could have a larger impact on aggregate demand when credit constraints are pervasive (which could be the case at low or high levels of indebtedness, or both). This paper examines the extent to which the strength of credit growth, which can be seen as a proxy for credit constraints, may affect the transmission of monetary policy in a way that cannot be captured in linear models. The results reveal that GDP growth is more responsive to interest rate shocks when credit growth is low. Separate models for household and business credit growth confirm this finding: consumption and business investment are more responsive to interest rate shocks when credit is growing slowly for the household and business sectors, respectively.
    Keywords: monetary policy; business-cycle asymmetries; threshold models
    JEL: C51 C52 E37 E52
    Date: 2007–07
  9. By: Sun, Hongfei
    Abstract: This paper presents an integrated theory of money and banking. I address the following question: when both individuals and banks have private information, what is the optimal way to settle debts? I develop a dynamic model with micro-founded roles for banks and a medium of exchange. I establish two main results: first, markets can improve upon the optimal dynamic contract at the presence of private information. Market prices fully reveal the aggregate states and help solve the incentive problem of the bank. Secondly, it is optimal for the bank to require loans be settled with short-term inside money, i.e. bank money that expires immediately after the settlement of debts. Short-term inside money dominates outside money because the former makes it less costly to induce truthful revelation and achieve more efficient risk sharing.
    Keywords: banking; inside money; outside money
    JEL: G2 E4
    Date: 2007–08
  10. By: Miguel Fuentes (Instituto de Economía. Pontificia Universidad Católica de Chile.)
    Abstract: In this paper I study the pass-through of nominal exchange rate changes to the price of imported goods in four developing countries. The results indicate that 75% of changes in the exchange rate are passed-through to the domestic currency price of imported goods within one quarter. Complete pass-through is attained within one year. There is no evidence that exchange rate pass-through to the price of imported goods has declined over time even in those countries that have managed to reduce inflation significantly and open their economies to foreign competition.
    Keywords: Exchange Rate Pass-Through, Local Currency Pricing, Macroeconomics of Developing Countries
    JEL: F31 F41
    Date: 2007
  11. By: Felix Hammermann; Mark Flanagan
    Abstract: Panel estimates based on 19 transition economies suggests that some central banks may aim at comparatively high inflation rates mainly to make up for, and to perhaps exploit, lagging internal and external liberalization in their economies. Out-of-sample forecasts, based on expected developments in the underlying structure of these economies, and assuming no changes in institutions, suggest that incentives may be diminishing, but not to the point where inflation levels below 5 percent could credibly be announced as targets. Greater economic liberalization would help reduce incentives for higher inflation, and enhancements to central bank independence could help shield these central banks from pressures.
    Keywords: inflation, transition economies, panel data
    JEL: E58 P24
    Date: 2007–08
  12. By: Rutledge, Emilie
    Abstract: Purpose – As the 2010 launch date for a common currency in the Arabian Gulf approaches, one important aspect policymakers should consider is the impact of the change of monetary system on private sector businesses. The purpose of this paper is to provide primary evidence on business attitudes towards, and preparedness for, the proposed Gulf single currency. Design/Methodology/approach – Prior to the launch of the EMU surveys assessed European business expectations and preparedness for the euro. This is the first GCC wide business survey designed to ascertain the opinions of businesses regarding the proposed Gulf currency union. Findings - Overall, businesses are in favour of the currency union and expect it to have a positive impact, but they consider non-monetary factors to be more significant to their future growth. Nevertheless, not one respondent was actively preparing for the single currency. This may very well be because regional institutions have yet to provide any business-centric information regarding the planned currency union. The paper contends that if participating governments do not soon start making policy orientated preparations – not least assisting businesses to prepare – then the existing positive sentiment may erode. Research Implications/Limitations – This study provides evidence on the microeconomic implications of a Gulf currency union and its potential impact on the business community. Practical Implications – In order to ensure a smooth transition to the single currency regional policymakers must move towards meeting a credible timetable for currency union and take immediate steps to inform and assist businesses in preparing for it.
    Keywords: Business survey; economic and monetary integration; single currency; monetary union; Gulf Cooperation Council states
    JEL: F15 E52 M20 O53
    Date: 2007–04
  13. By: Pierre L. Siklos (Wilfrid Laurier University); Diana N. Weymark (Vanderbilt University)
    Abstract: This paper applies a new measure of the effectiveness of sterilized interventions to data for 16 economies. The measure is defined as the difference between ex ante(xaEMP) and ex post exchange market pressure(xpEMP). xaEMP is calculated on the basis of a counterfactual that no intervention takes place and this is the rationally expected policy. xpEMP is the degree of exchange market pressure that remains based on the actual intervention policy in place. Based on a sample of 12 emerging markets, and Hong Kong, Korea, Japan, and Singapore, we conclude that sterilized interventions have persistent exchange rate effects. However, we also show empirically that this success also took place during a period of substantial growth in foreign exchange reserves.
    Keywords: exchange market pressure, foreign exchange intervention, emerging markets
    JEL: F31
    Date: 2007–07
  14. By: James T. E. Chapman; Antoine Martin
    Abstract: In a 1999 paper, Freeman proposes a model in which discount window lending and open market operations have different outcomes - an important development because in most of the literature the results of these policy tools are indistinguishable. Freeman's conclusion that the central bank should absorb losses related to default to provide risk-sharing goes against the concern that central banks should limit their exposure to credit risk. We extend Freeman's model by introducing moral hazard. With moral hazard, the central bank should avoid absorbing losses, contrary to Freeman's argument. However, we show that the outcomes of discount window lending and open market operations can still be distinguished in this new framework. The optimal policy would be for the central bank to make a restricted number of creditors compete for funds. By restricting the number of agents, the central bank can limit the moral hazard problem. And by making agents compete with each other, the central bank can exploit market information that reveals the state of the economy.
    Keywords: Discount window ; Open market operations ; Banks and banking, Central ; Credit
    Date: 2007
  15. By: Michael B. Devereux (University of British Columbia); Charles Engel (University of Wisconsin)
    Abstract: Both empirical evidence and theoretical discussion has long emphasized the impact of ¡¥news¡¦ on exchange rates. In most exchange rate models, the exchange rate acts as an asset price, and as such responds to news about future returns on assets. But the exchange rate also plays a role in determining the relative price of non-durable goods. In this paper we argue that these two roles may conflict with one another when nominal goods prices are sticky. If news about future asset returns causes movements in current exchange rates, then when nominal prices are slow to adjust, this may cause changes in current relative goods prices that have no efficiency rationale. In this sense, anticipations of future shocks to fundamentals can cause current exchange rate misalignments. We outline a series of models in which an optimal policy eliminates news shocks on exchange rates.
    Date: 2007–03
  16. By: Yin-wong Cheung (University of California, Santa Cruz); Menzie D. Chinn (University of Wisconsin, Madison and NBER); Eiji Fujii (University of Tsukuba)
    Abstract: We evaluate whether the Renminbi (RMB) is misaligned, relying upon conventional statistical methods of inference. A framework built around the relationship between relative price and relative output levels is used. We find that, once sampling uncertainty and serial correlation are accounted for, there is little statistical evidence that the RMB is undervalued. The result is robust to various choices of country samples and sample periods, as well as to the inclusion of control variables.
    Keywords: absolute purchasing power parity, exchange rates, real income, capital controls, currency misalignment.
    JEL: F31 F41
    Date: 2007–06
  17. By: Yin-wong Cheung (University of California, Santa Cruz); Kon S. Lai (California State University, Los Angeles)
    Abstract: This study investigates whether greater nominal exchange rate flexibility aids real exchange rate adjustment based on data from dual exchange rates in developing countries. Specifically, we analyze whether the more flexible parallel market rate produces faster real exchange rate adjustment than the less flexible official rate does. Half-life estimates of adjustment speeds are obtained from fractional time series analysis. We find no systematic evidence that greater exchange rate flexibility tends to produce either faster or slower real exchange rate adjustment, albeit there is substantial cross-country heterogeneity in speed estimates. With official rates pegged to the dollar, many developing countries use parallel exchange markets as a back-door channel to facilitate real exchange rate adjustment. The evidence suggests, however, that these parallel markets often fail to speed up real rate adjustment.
    Keywords: Real exchange rate; Fractional time series; Half life; Adjustment speed
    JEL: C22 F31
    Date: 2007–05
  18. By: Ansgar Belke; Julia Spies
    Abstract: The purpose of this paper is to assess the implications of the Economic and Monetary Union (EMU) accession of eight Central and Eastern European Countries (CEECs) on their share in EMU-12 imports. Overcoming biases related to endogeneity, omitted variables and sample selection, our results indicate that the common currency has boosted intra-EMU imports by 7%. Under the assumption that the same relationship between the explanatory variables and imports will hold for EMU-CEEC trade, we are able to predict the future impact of the euro. Our findings suggest that except for the least integrated countries, Poland, Latvia and Lithuania, all CEECs can expect increases in the EMU-12 import share.
    Keywords: Central and Eastern European countries, Euro area enlargement, gravity model, panel estimation
    JEL: F15 F41
    Date: 2007–07
  19. By: Alice Y. Ouyang (Claremont Graduate University); Ramkishen S. Rajan (George Mason University); Thomas D. Willett (Claremont Graduate University)
    Abstract: China has been stockpiling international reserves at an extremely rapid pace since the late 1990s and has surpassed Japan to become the largest reserve holder in the world. This paper undertakes an empirical investigation to assess the extent of de facto sterilization and capital mobility using monthly data between mid 1999 and late 2005. We find that China has been able to successfully sterilize most of these reserve increases, thus making it a reserve sink such as Germany was under the Bretton Woods system. Recursive estimation of offset coefficients, however, finds evidence of increasing mobile capital flows that may undercut China¡¦s ability to continue high levels of sterilization.
    Keywords: Balance of payments, China, Capital Mobility, Reserves, Sterilization
    JEL: E51 E52 E58
    Date: 2007–05
  20. By: Yin-wong Cheung (University of California, Santa Cruz); XingWang Qian (UUniversity of California, Santa Cruz)
    Abstract: Motivated by the observed international reserve hoarding behavior in the post-1997 crisis period, we explore the Mrs Machlup¡¦s wardrobe hypothesis and the related keeping up with the Joneses argument. It is conceived that, in addition to psychological reasons, holding a relatively high level of international reserves reduces the vulnerability to speculative attacks and promotes growth. A stylized model is constructed to illustrate this type of hoarding behavior. The relevance of the keeping up with the Joneses effect is examined using a few plausible empirical specifications and data from ten East Asian economies. Panel-based regression results are suggestive of the presence of the Joneses effect; especially in the post-1997 crisis period. Individual economy estimation results, however, show that the Joneses effect varies across economies.
    Keywords: Demand for International reserves, Excessive International reserve Accumulation, Speculative Attack, Keeping Up with the Joneses
    JEL: F3 F4
    Date: 2007–07
  21. By: Michele Fratianni (Department of Business Economics and Public Policy, Indiana University Kelley School of Business)
    Abstract: Financial products are unstandardized and subject to a great deal of uncertainty. They tend to concentrate geographically because of the reduction in information costs resulting from close contacts. Concentration leads to economies of scale and encourages external economies. Great financial centers enjoy a high degree of persistence but are not immune from decline and eventual demise. Yet, their achievements are passed along in a an evolutionary manner. In revisiting the historical record of seven international financial centers – Florence, Venice, Genoa, Antwerp, Amsterdam, London and New York — the paper finds evidence of a long evolutionary chain of banking and finance. As to the present and the future, the forces of integration are likely to give an additional boost to the persistence of international financial centers.
    Keywords: banking, evolution, finance, money, Genoa, Venice, Florence, Antwerp, Amsterdam, London, New York
    JEL: G15 G21 H63 N20
    Date: 2007–08
  22. By: Spiros Bougheas (University of Nottingham); Paul Mizen (University of Nottingham); Cihan Yalcin (University of Nottingham)
    Abstract: This paper provides a theoretical model of an open economy credit channel including currency mismatch and financial fragility where exporting firms have access to international credit but non-exporting firms do not. It considers the post-crisis outcome which is predicted to be dramatically different for exporters/ non-exporters. We examine firms¡¦ access to external finance in four Asian economies after 1997 using a large panel of balance sheet data. Our paper demonstrates that firm heterogeneity is critical to understanding the open economy credit channel effects post-crisis since smaller and less profitable firms are indeed less likely to obtain credit than larger, export-oriented firms.
    Keywords: Credit Channel, External Finance, Asian Crisis
    JEL: E32 E44 E51
    Date: 2007–04
  23. By: Sydney N. Afriat; Carlo Milana
    Abstract: It has been submitted that, for the very large number of different traditional type formulae to determine price indices associated with a pair of periods, which are joined with the longstanding question of which one to choose, they should all be abandoned. For the method proposed instead, price levels associated with periods are first all computed together, subject to a consistency of the data, and then price indices that are true taken together are determined from their ratios. An approximation method can apply in the case of inconsistency. Here are illustrations of the method.
    Keywords: index-number problem, inflation, non-parametric, price index, price level, revealed preference.
    JEL: C43 E31
    Date: 2007–07
  24. By: Richard H. Cohen (College of Business and Public Policy, University of Alaska Anchorage); Carl Bonham (Department of Economics and University of Hawaii Economic Research Organization, University of Hawaii at Manoa)
    Abstract: This paper contributes to the literature on the modeling of survey forecasts using learning variables. We use individual industry data on yen-dollar exchange rate predictions at the two week, three month, and six month horizons supplied by the Japan Center for International Finance. Compared to earlier studies, our focus is not on testing a single type of learning model, whether univariate or mixed, but on searching over many types of learning models to determine if any are congruent. In addition to including the standard expectational variables (adaptive, extrapolative, and regressive), we also include a set of interactive variables which allow for lagged dependence of one industry’s forecast on the others. Our search produces a remarkably small number of congruent specifications-even when we allow for 1) a flexible lag specification, 2) endogenous break points and 3) an expansion of the initial list of regressors to include lagged dependent variables and use a General-to-Specific modeling strategy. We conclude that, regardless of forecasters’ ability to produce rational forecasts, they are not only “different,” but different in ways that cannot be adequately represented by learning models.
    Keywords: Learning Models, Exchange Rate, Survey Forecasts
    Date: 2007–07–25

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