nep-mon New Economics Papers
on Monetary Economics
Issue of 2007‒09‒02
eighteen papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. How Important is Money in the Conduct of Monetary Policy? By Michael Woodford
  2. Inflation-linked bonds from a central bank perspective By Juan Angel Garcia; Adrian van Rixtel
  3. Monetary Policy in East Asia: the Case of Singapore By Bennett T. McCallum
  4. Modelling inflation in China – a regional perspective By Mehrotra, Aaron; Peltonen, Tuomas; Santos Rivera, Alvaro
  5. Do China's capital controls still bind? Implications for monetary autonomy and capital liberalisation By Guonan Ma; Robert N. McCauley
  6. Listening Without Understanding By Menno Middeldorp; Clemens Kool; Stephanie Rosenkranz
  7. The Renminbifs Dollar Peg at the Crossroads By Maurice Obstfeld
  8. Central Bank Independence and inflation: the case of Greece By PANAGIOTIDIS, Theodore; TRIAMPELLA, Afroditi
  9. An affine macro-finance term structure model for the euro area By Lemke, Wolfgang
  10. Optimal Monetary Policy Committee Size: Theory and Cross Country Evidence By Szilárd Erhart; Jose Luis Vasquez-Paz
  11. Monetary Policy and Exchange Rate Regime: Proposal for a Small and Less Developed Economy By Jian Gao; Gang Gong; Xue-Zhong He
  12. Price-Level Targeting By Agathe Côté
  13. A Microfounded Sectoral Model for Open Economies By Plasmans, J.E.J.; Fornero, J.; Michalak, T.
  14. Independence and Accountability of Monetary and Fiscal Policy Committees By Mihailov, Alexander; Ullrich, Katrin
  15. Exchange rate dynamics in a target zone: a heterogeneous expectations approach By Bauer, Christian; De Grauwe, Paul; Reitz, Stefan
  16. The Influence of Actual and Unrequited Interventions By Kathryn M. E. Dominguez; Freyan Panthaki
  17. Testing for Instability in Factor Structure of Yield Curves By Dennis Philip; Chihwa Kao; Giovanni Urga
  18. Output Gaps and Inflation in Mainland China By Stefan Gerlach; Wensheng Peng

  1. By: Michael Woodford
    Date: 2007–08–24
  2. By: Juan Angel Garcia (Europena Central Bank); Adrian van Rixtel (Banco de España)
    Abstract: Inflation-linked bond markets have experienced significant growth in recent years. This growth is somewhat surprising, for inflation-linked bonds cannot be considered a financial innovation and their development has taken place in a period of historically low global inflation and inflation expectations. In this context, the purpose of this paper is twofold. First, it provides a selective survey of the key arguments for and against the issuance of inflation-linked debt, and some of the factors that help to understand their recent growth. Second, it illustrates the use of these instruments to better monitor investors’ inflation expectations and growth prospects from a central bank perspective.
    Keywords: central banks, monetary policy, inflation-linked bonds, break-even inflation rates
    JEL: E44 E52 E58 G10
    Date: 2007–08
  3. By: Bennett T. McCallum (Carnegie Mellon University and National Bureau of Economic Research (E-mail:
    Abstract: The Monetary Authority of Singapore (MAS) conducts policy by adjusting the Singapore dollarfs effective exchange rate so as to achieve macroeconomic goals for the economyfs inflation rate and output gap. Estimates of a policy rule of the Taylor type, except with exchange rate appreciation serving as the instrument/indicator variable, substantiate this interpretation. That this rule reflects policy that is much like inflation targeting is evidenced by the absence of any significant role for the real exchange rate as a distinct target variable in addition to inflation and the output gap. Simulations with a dynamic model of a small open economy illustrate that this type of rule can be relatively more advantageous in economies that (like Singapore) are extremely open to international trade. The analysis illustrates that monetary policy and exchange-rate policy are two sides of the same coin, which suggests that assignment of exchange-rate management to a nationfs fiscal authority is an anachronism.
    Keywords: exchange rate, inflation targeting, instrument variable, target variable, open economy, monetary policy
    JEL: E42 E58 F31 F41
    Date: 2007–08
  4. By: Mehrotra, Aaron (BOFIT); Peltonen, Tuomas (BOFIT); Santos Rivera, Alvaro (BOFIT)
    Abstract: We model provincial inflation in China during the reform period. In particular, we are interested in the ability of the hybrid New Keynesian Phillips Curve (NKPC) to capture the inflation process at the provincial level. The study highlights differences in inflation formation and shows that the NKPC provides a reasonable description of the inflation process only for the coastal provinces. A probit analysis suggests that the forward-looking inflation component and the output gap are important inflation drivers in provinces that have advanced most in marketisation of the economy and have most likely experienced excess demand pressures. These results have implications for the relative effectiveness of monetary policy across the Chinese provinces.
    Keywords: China; inflation; regional; New Keynesian Philips Curve; GMM
    JEL: C22 E31
    Date: 2007–08–29
  5. By: Guonan Ma; Robert N. McCauley
    Abstract: The paper argues that China's capital controls remain substantially binding. This has allowed the Chinese authorities to retain some degree of short-term monetary autonomy, despite the fixed exchange rate up to July 2005. Although the Chinese capital controls have not been watertight, we find sustained and significant gaps between onshore and offshore renminbi interest rates and persistent dollar/renminbi interest rate differentials during the period of a de facto dollar peg. While some cross-border flows do respond to market expectations and relative yields, they have not been large enough to equalise onshore and offshore renminbi yields.
    Keywords: Foreign exchange market, capital flows, capital controls, monetary policy, financial stability and the Chinese economy
    Date: 2007–08
  6. By: Menno Middeldorp; Clemens Kool; Stephanie Rosenkranz
    Abstract: The trend of monetary policy transparency has recently extended itself to the practice of providing guidance on the likely direction of policy rates. There is a risk that communicating the central bank’s own outlook for interest rates actually undermines the financial markets’ ability to predict monetary policy. This paper analyzes this risk using the Diamond (1985) model of a financial market, which includes both costly private information acquisition and a costless public signal. We demonstrate that a sufficiently precise signal from the central bank can result in a deterioration of the financial market’s ability to predict monetary policy through the crowding out of private information acquisition. Central banks could alleviate this risk with a policy of limiting the guidance offered to the financial market in order to leave sufficient scope for private information acquisition.
    Keywords: Interest Rates, Monetary Policy, Information and Financial Market Efficiency, Communication, Transparency, Information Acquisition
    JEL: E43 E52 G14
    Date: 2007–08
  7. By: Maurice Obstfeld (University of California, Berkeley (E-mail:
    Abstract: In the face of huge balance of payments surpluses and internal inflationary pressures, China has been in a classic conflict between internal and external balance under its dollar currency peg. Over the longer term, Chinafs large, modernizing, and diverse economy will need exchange rate flexibility and, eventually, convertibility with open capital markets. A feasible and attractive exit strategy from the essentially fixed RMB exchange rate would be a two-stage approach, consistent with the steps already taken since July 2005, but going beyond them. First, establish a limited trading band for the RMB relative to a basket of major trading partner currencies. Set the band so that it allows some initial revaluation of the RMB against the dollar, manage the basket rate within the band if necessary, and widen the band over time as domestic foreign exchange markets develop. The ultimate goal is a floating exchange rate coupled with some relative of inflation targeting. Second, put on hold ad hoc measures of financial account liberalization. They will be less helpful for relieving exchange rate pressures once the yuan/basket rate is allowed to move flexibly within a band, and they are best postponed until domestic foreign exchange markets develop further, the exchange rate is fully flexible, and the domestic financial system has been strengthened and placed fully on a market-oriented basis.
    Keywords: Renminbi, China Currency, China Balance of Payments, Fixed Exchange Rate Exit Strategy
    JEL: F32
    Date: 2007–08
  8. By: PANAGIOTIDIS, Theodore; TRIAMPELLA, Afroditi
    Abstract: This paper discusses the argument for Central Bank Independence (CBI) in the case of Greece. Using a time series approach and the last data available before Greece joined the EMU , the hypothesis that Central Bank Independence is important for controlling inflation is examined. Employing two indices, which serve as proxies for CBI, LegalCBI and TOR, the inverse relationship between CBI and inflation was confirmed. The interactions between the variability of inflation and CBI were also investigated. Furthermore, evidence was found to suggest that the rate of turnover Granger causes inflation.
    Date: 2006–01–01
  9. By: Lemke, Wolfgang
    Abstract: A joint model of macroeconomic and term structure dynamics is specified and estimated for the euro area. The model comprises a backward-looking Phillips curve, a dynamic IS equation, a monetary policy rule as well as a specification of the dynamics of trend growth and the natural real interest rate. Under the condition of no arbitrage, yields of all maturities are affine functions of the macroeconomic driving forces. With the exception of a shock to potential output growth, the response of short-term yields to macroeconomic shocks is generally stronger than that of long-term yields. Impulse responses of all bond yields are fairly persistent, which reflects the persistence of their macroeconomic driving forces. Across the whole maturity spectrum, about ninety percent of the variation in yields is explained jointly by monetary policy shocks and shocks to the natural real rate of interest; the relative contribution of the latter shock increases with time to maturity. Cost-push shocks explain at most eight percent, while shocks to the output gap play an even less important role.
    Keywords: affine term structure models, monetary policy, euro area
    JEL: E32 E43 G12
    Date: 2007
  10. By: Szilárd Erhart; Jose Luis Vasquez-Paz
    Abstract: Theoretical and empirical studies of different sciences suggest that an optimal committee consists of roughly 5-9 members, although it can swell mildly under specific circumstances. This paper develops a conceptual model in order to analyze the issue in case of monetary policy formulation. The optimal monetary policy committee (MPC) size varies according to the uncertainty of MPC members’ information influenced by the size of the monetary zone and overall economic stability. Our conceptual model is backed up with econometric evidence using a survey of 85 countries. The MPC size of large monetary zones (EMU, USA, Japan) is close to the estimated optimal level, but there exist several smaller countries with too many or too few MPC members.
    JEL: E50 E58
    Date: 2007–03
  11. By: Jian Gao (China Development Bank); Gang Gong (School of Economics and Management, Tsinghua University); Xue-Zhong He (School of Finance and Economics, University of Technology, Sydney)
    Abstract: We investigate monetary policy under the assumption that a country?s capital market is ?open? under the WTO framework while the exchange rate is fixed. Our purpose is to determine if it is possible in this case for the economy to maintain an effective monetary policy for stabilizing the domestic economy. For this, we suggest two institutional restrictions. Given the restrictions, we demonstrate within a macro-dynamic model that monetary policy can still be effective. The implication of such an institutional design for an exchange rate regime is also discussed with special reference to small and less development economies.
    Keywords: open economy trilemma; macroeconomic stability; exchange rate regime
    JEL: E12 E32 C62
    Date: 2007–07–01
  12. By: Agathe Côté
    Abstract: In November 2006, the Bank of Canada announced its intention to lead a concerted research program over the next few years on the type of monetary policy framework that would best contribute to the economic well-being of Canadians in the decades ahead. The research will focus on two broad questions: whether economic welfare might be improved by targeting a rate of inflation lower than 2 per cent, and whether economic welfare might be improved by moving from an inflation-targeting (IT) framework to some form of price-level targeting (PLT). This paper focuses on the second question. The author provides an overview of the main conclusions in the literature on the relative merits of replacing IT with PLT, identifies some key outstanding questions, and outlines the Bank's research program. The author concludes that, compared with the conventional wisdom that prevailed a decade ago, recent analysis is more promising for PLT. Nevertheless, the models that have been used so far often ignore some of the key potential benefits, or some of the key potential costs, associated with PLT. More research is needed before one can draw strong conclusions.
    Keywords: Monetary policy framework
    JEL: E52 E58
    Date: 2007
  13. By: Plasmans, J.E.J.; Fornero, J.; Michalak, T. (Tilburg University, Center for Economic Research)
    Abstract: Numerical simulations of the two-country sectoral model are provided for a relatively large number of structural shocks as domestic and foreign productivity shocks in final tradables and non-tradables, money demand shocks and a shock in the exchange rate. Such a model is well suited for monetary policy analysis at the international level and risk analysis.
    Keywords: New Keynesian open economy model;tradable and non-tradable sectors;final and intermediate goods;log-linearization.
    JEL: E31 D21 F41 P24
    Date: 2007
  14. By: Mihailov, Alexander; Ullrich, Katrin
    Abstract: The democratic accountability of policymaking institutions which are autonomous within delegated mandates has not received as much attention as their independence. We analyze in a theoretical model the effects of accountability in the form of possible overriding of economic policy decisions by the government under different degrees of independence of expert committees conducting monetary and fiscal policy. The equilibrium outcomes of such alternative institution-design frameworks are compared according to key macroeconomic performance criteria. Our results stress the trade-off between anchoring inflation expectations on target and output stabilization that is not solved with accountability.
    Keywords: Independence, accountability, monetary policy, fiscal policy, expert committees, institution design
    JEL: E52 E58 E61 E63
    Date: 2007
  15. By: Bauer, Christian; De Grauwe, Paul; Reitz, Stefan
    Abstract: We present a simple behavioral model with chartists and fundamentalists and analyze their trading behavior in a floating regime and in a target zone regime. Regarding the floating regime the model replicates the well-known stylized facts like excessive volatility, fat tails, volatility clustering and the exchange rate disconnect. When introducing a credible target zone the exchange rate remains for a considerably long period in the center of the band albeit the fundamental exchange rate does not exhibit mean reversion tendencies. The resulting hump-shaped distribution of the exchange rate greatly reduces the frequency of central bank intervention. The introduction of a target zone regime significantly reduces exchange rate volatility by decreasing speculative activity in the FX market.
    Keywords: Exchange rate, heterogeneous agents, target zones
    JEL: F31 F41
    Date: 2007
  16. By: Kathryn M. E. Dominguez (University of Michigan and NBER); Freyan Panthaki (London School of Economics)
    Abstract: Intervention operations are used by governments to manage their exchange rates but officials rarely confirm their presence in the market, leading inevitably to erroneous reports in the financial press. There are also reports of what we term, unrequited interventions, interventions that the market expects but do not materialize. In this paper we examine the effects of various types of intervention news on intra-day exchange rate behavior. We find that unrequited interventions have a statistically significant influence on returns, volatility and order flow, suggesting that the expectation of intervention, even when governments do not intervene, can affect currency values.
    JEL: F31 F33 G15
    Date: 2007
  17. By: Dennis Philip (Cass Business School, City University, 106 Bunhill Road, London EC1Y 8TZ, UK); Chihwa Kao (Center for Policy Research, Maxwell School, Syracuse University, Syracuse, NY 13244-1020); Giovanni Urga (Cass Business School, City University, 106 Bunhill Row, London EC1Y 8TZ, U.K.)
    Abstract: A widely relied upon but a formally untested consideration is the issue of stability in actors underlying the term structure of interest rates. In testing for stability, practitioners as well as academics have employed ad yhoc techniques such as splitting the sample into a few sub-periods and determining whether the factor loadings have appeared to be similar over all sub-periods. Various authors have found mixed evidence on stability in the actors. In this paper we develop a formal testing procedure to evaluate the factor structure stability of the US zero coupon yield term structure. We find the factor structure of level to be unstable over the sample period considered. The slope and curvature factor structures are however found to be stable. Common structural changes affecting all interest rate maturities have fostered instability in the level factor. We corroborate the literature that variances (volatility) explained by the level, slope, and curvature factors are unstable over time. We find that the volatility of slope factor is sensitive to shocks affecting the short rates and the volatility of curvature factor is sensitive to shocks affecting the medium and long rates. Finally, we find evidence of the presence of common economic shocks affecting the level and slope factors, unlike slope and curvature factors that responded differently to economic shocks and were unaffected by any common instabilities.
    Keywords: Stability, factor structure, principal component analysis, term structure of interest rates.
    JEL: C12 C13 C14 C51
    Date: 2007–07
  18. By: Stefan Gerlach (Bank for International Settlements); Wensheng Peng (Hong Kong Monetary Authority)
    Abstract: We estimate output gaps using three methods for Mainland China on annual data spanning 1982-2003. The estimates are similar and appear to co-move with inflation. Standard Phillips curves, however, do not fit the data well. This may reflect the omission of some important variable(s) such as the effect of price deregulation, trade liberalisation and/or changes in the exchange rate regime. We reestimate the Phillips curves assuming that there is an unobserved variable that follows an AR(2) process. The modified model fits the data much better and accounts for some of the surprising features of the simple Phillips curve estimates.
    Keywords: output gap, Phillips curve, China, omitted variab les
    JEL: C22 E30 E40 E53
    Date: 2005–11

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