nep-mon New Economics Papers
on Monetary Economics
Issue of 2007‒09‒24
twenty-six papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Monetary Policy Under a Currency Board By Marius Jurgilas
  2. Monetary Policy and the Hybrid Phillips Curve By Christopher Martin; Costas Milas
  3. Inflation Determination With Taylor Rules: A Critical Review By John H. Cochrane
  4. Central Bank Independence and Monetary Policymaking Institutions - Past Present and Future By Cukierman, Alex
  5. Convergence and Anchoring of Yield Curves in the Euro Area By Ehrmann, Michael; Fratzscher, Marcel; Gürkaynak, Refet S.; Swanson, Eric T
  6. Does Money Matter for the Identification of Monetary Policy Shocks: A DSGE Perspective. By Céline Poilly
  7. Identification with Taylor Rules: A Critical Review By John H. Cochrane
  8. Monetary Policy Regimes in Brazil By Elcyon C. R. Lima; Alexis Maka; Mário Mendonça
  9. Macroeconomic Model of Transition Economy: A Stochastic Calculus Approach By Sarajevs, Vadims
  10. Monetary Policy Committee Size and Inflation Volatility By Szilárd Erhart; Harmen Lehment; Jose L. Vasquez Paz
  11. Model misspecification, the equilibrium natural interest rate and the equity premium. By Oreste Tristani
  12. The role of search frictions for output and inflation dynamics: a Bayesian assessment By Martin Menner
  13. Uncovered interest oparity at distant horizons - evidence on emerging economies & nonlinearities. By Arnaud Mehl; Lorenzo Cappiello
  14. Cracking the Conundrum By David K. Backus; Jonathan H. Wright
  15. Measuring the Economic Stock of Money By Kelly, Logan
  16. The Maastricht inflation criterion : what is the effect of expansion of the European Union ? By John Lewis; Karsten Staehr
  17. Financial Innovation and the Transactions Demand for Cash By Fernando E. Alvarez; Francesco Lippi
  18. Monetary Persistence, Imperfect Competition, and Staggering Complementarities By Christian Merkl; Dennis J. Snower
  19. Bayesian and Adaptive Optimal Policy under Model Uncertainty By Lars E.O. Svensson; Noah M. Williams
  20. Structural change and the bond yield conundrum By Taboga, Marco
  21. Financial Exchange Rates and International Currency Exposures By Philip R. Lane; Jay C. Shambaugh
  22. Pigou's theory of business cycle as an inquiry into unemployment: on the relative effects of the gold standard and the wage rigidity in the twenties By Norikazu TAKAMI
  23. Currency Boards in the Baltic Countries: What Have We Learned? By Korhonen , Iikka
  24. Investor sentiment in the US-dollar: longer-term, nonlinear orientation on PPP By Menkhoff, Lukas; Rebitzky, Rafael
  25. Does The Euro Have A Chance to Challenge The Dollar By Idil Goksel
  26. Currency Crisis Theories – Some Explanations for the Russian Case By Komulainen, Tuomas

  1. By: Marius Jurgilas (University of Connecticut and Elon University)
    Abstract: The consensus view is that central banks under currency boards do not have tools for active monetary policy. In this paper, we analyze the foreign exchange fee as a monetary policy instrument that can be used by a central bank under a currency board. We develop a general equilibrium model showing that changes in this fee may have the same effects as a change in the monetary policy stance. Thus central banks under the currency board are shown to have an avenue to implement active monetary policy.
    Keywords: interbank market, monetary policy, currency board
    JEL: E52 E58
    Date: 2007–09
  2. By: Christopher Martin (Brunel University); Costas Milas (Keele University, Centre for Economic Research and School of Economic and Management Studies)
    Abstract: This paper argues that existing empirical models of interest rate rules are too simplistic. The hybrid Phillips curve implies that policymakers should respond to both current and expected future inflation rates, in contrast to existing models. We provide evidence that UK policymakers do this.
    Keywords: Optimal monetary policy; inflation persistence; Phillips curve
    JEL: C51 C52 E52 E58
    Date: 2007–09
  3. By: John H. Cochrane
    Abstract: The new-Keynesian, Taylor-rule theory of inflation determination relies on explosive dynamics. By raising interest rates in response to inflation, the Fed does not directly stabilize future inflation. Rather, the Fed threatens hyperinflation, unless inflation jumps to one particular value on each date. However, there is nothing in economics to rule out hyperinflationary or deflationary solutions. Therefore, inflation is just as indeterminate under "active" interest rate targets as it is under standard fixed interest rate targets. Inflation determination requires ingredients beyond an interest-rate policy that follows the Taylor principle.
    JEL: E31 E52 E58
    Date: 2007–09
  4. By: Cukierman, Alex
    Abstract: This is an extensive survey of worldwide developments in the area of monetary policymaking institutions during the second half of the twentieth century and beyond. In addition the last section discusses current open issues and future challenges. Section 2 reviews the changes that have occurred in the area of central bank independence (CBI) during the last twenty years, discusses reasons for those developments and provides an overview of accumulated empirical evidence on the relation between CBI and the performance of the economy. Section 3 discusses lessons from stabilization of inflation, reviews the evidence and implications of asymmetric central bank objectives and considers the issue of CBI within the broader context of choosing a nominal anchor. Section 4 reviews the impact of effective conservativeness (or independence) on economic performance in the presence of labour unions. A main insight is that, in the presence of large wage setters, CBI affects real variables like the rate of unemployment implying that conservativeness affects economic performance even in the long run. Section 5 considers future challenges facing modern central banks. The discussion presumes that CBI and price stability are here to stay and focuses on issues relating to the conduct of monetary policy by independent central banks in an era of price stability. The section discusses the risks associated with flexible inflation targeting, issues of accountability and transparency and the impact of central bank capital and finances on its independence.
    Keywords: central bank independence; economic performance; monetary institutions and future challenges; nominal anchors
    JEL: E31 E50 E52
    Date: 2007–08
  5. By: Ehrmann, Michael; Fratzscher, Marcel; Gürkaynak, Refet S.; Swanson, Eric T
    Abstract: We study the convergence of European bond markets and the anchoring of inflation expectations in euro area countries using high-frequency bond yield data for France, Germany, Italy and Spain. We find that Economic and Monetary Union (EMU) has led to substantial convergence in euro area sovereign bond markets in terms of interest rate levels, unconditional daily fluctuations, and conditional responses to major macroeconomic data announcements. Our findings also suggest a substantial increase in the anchoring of long-term inflation expectations since EMU, particularly for Italy and Spain, which since monetary union have seen their long-term interest rates become much lower, much less volatile, and much better anchored in response to news. Finally, the reaction of far-ahead forward interest rates to macroeconomic announcements has converged substantially across euro area countries and even been eliminated over time, thus underlining not only market integration but also the credibility that financial markets attach to monetary policy in the euro area.
    Keywords: anchoring; bond markets; convergence; credibility; EMU; euro area; monetary policy
    JEL: E52 E58
    Date: 2007–09
  6. By: Céline Poilly (Banque de France, DGEI-DIR, Service de Recherche en économie et finance, and University of Cergy-Pontoise,THEMA)
    Abstract: This paper investigates how the identification assumptions of monetary policy shocks modify the inference in a standard DSGE model. Considering SVAR models in which either the interest rate is predetermined for money or these two monetary variables are simultaneously determined, two DSGE models are estimated by Minimum Distance Estimation. We emphasize that real balance effects are necessary to replicate the high persistence implied by the simultaneity assumption. In addition, the estimated monetary policy rule is strongly sensitive to the identification scheme. This suggests that the way to introduce money in the identification scheme is not neutral for estimation of DSGE models.
    Keywords: SVAR model; DSGE model; Non recursive identification; Money.
    JEL: E41 E52 C52
    Date: 2007
  7. By: John H. Cochrane
    Abstract: The parameters of the Taylor rule relating interest rates to inflation and other variables are not identified in new-Keynesian models. Thus, Taylor rule regressions cannot be used to argue that the Fed conquered inflation by moving from a "passive" to an "active" policy in the early 1980s.
    JEL: E3 E31 E52 E58
    Date: 2007–09
  8. By: Elcyon C. R. Lima; Alexis Maka; Mário Mendonça
    Abstract: This article estimates the monetary policy rule followed by the Brazilian Central Bank for setting its main policy instrument, the SELIC rate, for the period after the Real Plan. In order to overcome the uncertainty over the dates at which changes in parameters occurred, this paper uses regime-dependent-switching probabilities according to a hidden Markov chain to model possible deviations from a simple linear reaction function. From July 1996 to January 2006 the Brazilian monetary policy can be fully characterized by four policy regimes. The changes in monetary policy in this period are best described by recurring regime changes, instead of once-and-for-all shifts. We have identified substantial differences in the way monetary policy was conducted in the subperiods before and after 1999, when the Brazilian exchange rate policy regime changed from crawling peg to free-floating. At each of these subperiods there are two recurring regimes and the two regimes of one subperiod differ from the two regimes of the other.
    Date: 2007–06
  9. By: Sarajevs, Vadims (BOFIT)
    Abstract: An integrated stochastic macroeconomic model of transition economy at the early stage of reforms with optimising representative risk averse agents is constructed. The equilibrium growth rate of the economy, real asset returns, domestic money demand, and expected inflation rate are determined as functions of the exogenous risks in the economy. The main issue addressed are: domestic money demand, currency substitution ratio, expected rate of inflation, real asset returns, the equilibrium growth rate of the economy as well as government ability to control these variables. Analysis of the model finds that the equilibrium growth rate of the economy is not independent on the monetary and fiscal policies but can be affected by the government through its ability to fix the real cost of capital for the firm, expenditure and monetary policy parameters.
    JEL: D80 D90 E41 E44 E52 F41 O11 O23
    Date: 2007–09–14
  10. By: Szilárd Erhart; Harmen Lehment; Jose L. Vasquez Paz
    Abstract: Previous research on the optimal size of a monetary policy committee (MPC) focused on theoretical analyses and experimental studies. These studies suggest that the ideal monetary policy committee may not have many more than five members. In this paper we conduct an empirical cross-country study to explore whether there is a link between the size of an MPC and inflation volatility. The analysis for 75 countries which have adopted MPCs provides some support for the above suggestion: countries with less than five MPC members tend to have larger deviations from trend inflation than MPCs with five members; raising the number of MPC members above five does not contribute to a further reduction in volatility.
    Keywords: Monetary Policy Committee; Inflation Volatility
    JEL: E31 E42 E58
    Date: 2007–09
  11. By: Oreste Tristani (European Central Bank, Kaiserstraße 29, 60311 Frankfurt, Germany.)
    Abstract: This paper analyses the determinants of the natural rate of interest in a non-linear model where agents are uncertain over both future technology growth and the future course of monetary policy. I show that the real natural rate can be affected by sizable uncertainty premia, including premia associated with monetary uncertainty. This result is potentially problematic for both the estimation of the natural rate and its use as a policy indicator. Monetary uncertainty can also contribute to amplify the equity premium, and to account for its apparent, positive link with inflation. JEL Classification: E43, G11.
    Keywords: Natural rate of interest, equity premium puzzle, risk-free rate puzzle, robust control, model misspecification.
    Date: 2007–09
  12. By: Martin Menner
    Abstract: Search frictions in the goods market have proven to be a fruitful deviation from the fiction of a centralized Walrasian market providing a micro-foundation of the use of money as a medium of exchange. Moreover, persistent propagation of monetary shocks can arise in search-theoretic monetary models through the interaction of search-frictions in the goods and labor markets, and inventory holdings. Here, a search-theoretic monetary DSGE model with capital and inventory investment is estimated, and its implications on output and inflation dynamics are contrasted with those of standard flexible price monetary models: a cash-in-advance and a portfolio adjustment cost model. Model estimation and comparison is conducted in a Bayesian way in order to account for possible model misspecification. The search model can track inflation and output data better, as well as it dominates the other models in the ability to predict the autocorrelations of inflation and the persistent disinflation process after a technology shock. It generates a hump-shaped but not strong enough output response to a monetary shock. Current and near current correlations between output growth inflation are predicted well.
    Date: 2007–09
  13. By: Arnaud Mehl (European Central Bank, Kaiserstraße 29, 60311 Frankfurt, Germany.); Lorenzo Cappiello (European Central Bank, Kaiserstraße 29, 60311 Frankfurt, Germany.)
    Abstract: This paper tests for uncovered interest parity (UIP) at distant horizons for the US and its main trading partners, including both mature and emerging market economies, also exploring the existence of nonlinearities. At long and medium horizons, it finds support in favour of the standard, linear, specification of UIP for dollar rates vis-à-vis major floating currencies, but not vis-à-vis emerging market currencies. Moreover, the paper finds evidence that, not only yield differentials widen, but that US bond yields do react in anticipation of exchange rate movements, notably when these take place vis-à-vis major floating currencies. Last, the paper detects signs of nonlinearities in UIP at the medium term horizon for dollar rates vis-à-vis some of the major floating currencies, albeit surrounded by some uncertainty. JEL Classification: E43, F31, F41.
    Keywords: Uncovered interest parity, distant horizon, emerging economies, nonlinearities.
    Date: 2007–08
  14. By: David K. Backus; Jonathan H. Wright
    Abstract: From 2004 to 2006, the FOMC raised the target federal funds rate by 4.25%, yet long-maturity yields and forward rates fell. We consider several possible explanations for this "conundrum." The most likely, in our view, is a fall in the term premium, probably associated with some combination of diminished macroeconomic and financial market volatility, more predictable monetary policy, and the state of the business cycle.
    JEL: E43 E52 G12
    Date: 2007–09
  15. By: Kelly, Logan
    Abstract: Aggregation theoretic measures of the capital stock of money have in the past been criticized for their dependence on future expectations. I attempt to answer some of those objections by using several forecasting methods to generate expectations needed for calculating the economic stock of money. I show that targeted factor model forecasting improves the accuracy of monetary capital stock measurements slightly. However, I also find, as has previous research, that monetary capital stock calculations are robust to assumptions about future expectation. I believe these findings tend to support the conclusion that concerns about the dependency of theoretical monetary stock aggregates on forecasted future expectations have been overstated.
    Keywords: Monetary Aggregation; Money Stoc; ; Economic Stock of Money; Targeted Factor Models
    JEL: E49
    Date: 2007–09–13
  16. By: John Lewis; Karsten Staehr
    Abstract: Following the Maastricht criteria, a country seeking to join the European Monetary Union cannot have inflation in excess of 1.5 percent plus the average inflation in the three \"best performing\" EU countries. This inflation reference value is a non-increasing function of the number of EU members. Looking backwards, the effect of increasing the number of EU countries from 15 to 27 would have been sizeable in 2003 and 2004, but relatively modest since 2005. Monte Carlo simulations show that the expansion of the EU from 15 to 27 members reduces the expected inflation reference value by 0.15-0.2 percentage points, but with a considerable probability of a larger reduction. The treatment of countries with negative inflation in the calculation of the reference value has a major impact on the results
    Keywords: Maastricht Treaty, European Monetary Union, inflation, convergence
    JEL: E31 E42 E63
    Date: 2007–09–14
  17. By: Fernando E. Alvarez; Francesco Lippi
    Abstract: We document cash management patterns for households that are at odds with the predictions of deterministic inventory models that abstract from precautionary motives. We extend the Baumol-Tobin cash inventory model to a dynamic environment that allows for the possibility of withdrawing cash at random times at a low cost. This modification introduces a precautionary motive for holding cash and naturally captures developments in withdrawal technology, such as the increasing diffusion of bank branches and ATM terminals. We characterize the solution of the model and show that qualitatively it is able to reproduce the empirical patterns. Estimating the structural parameters we show that the model quantitatively accounts for key features of the data. The estimates are used to quantify the expenditure and interest rate elasticity of money demand, the impact of financial innovation on money demand, the welfare cost of inflation, the gains of disinflation and the benefit of ATM ownership.
    JEL: E31 E4 E41
    Date: 2007–09
  18. By: Christian Merkl (Kiel Institute for the World Economy, University of Kiel and IZA); Dennis J. Snower (Kiel Institute for the World Economy, University of Kiel and IZA)
    Abstract: This paper explores the influence of wage and price staggering on monetary persistence. We show that, for plausible parameter values, wage and price staggering are complementary in generating monetary persistence. We do so by proposing the new measure of "quantitative inertia," after discussing weaknesses of the "contract multiplier," a standard measure of monetary persistence. The existence of complementarities means that beyond understanding how wage and price staggering work in isolation, it is important to investigate their interactions. Furthermore, our analysis indicates that the degree of monetary persistence generated by wage vis-à-vis price staggering depends on the relative competitiveness of the labor and product markets. We show that the conventional finding that wage staggering generates more persistence than price staggering holds under homogenous capital accumulation. Under firm-specific capital, wage staggering generates more persistence only when the labor market is sufficiently competitive relative to the product market.
    Keywords: monetary persistence, price staggering, wage staggering, firm-specific capital
    JEL: E40 E50 E52
    Date: 2007–08
  19. By: Lars E.O. Svensson; Noah M. Williams
    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 he optimally learns from observations of the economy. This is a classic problem of learning and control, variants of which have been studied in the past, but seldom 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, computing 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 some simple examples to illustrate the role of learning and experimentation in an MJLQ framework.
    JEL: D81 E42 E52 E58
    Date: 2007–09
  20. By: Taboga, Marco
    Abstract: In recent years, US and euro area long-term bond yields experienced a remarkable decline and remained at historically low levels even in the face of rising short-term rates. This unusual phenomenon (the so called ”conundrum”) has been the subject of numerous debates and extensive research. The most commonly held opinion is that it was primarily driven by an unprecedented reduction in risk premia. I partly counter this view by showing that, although risk premia played an important role in the ”conundrum” episode, other two equally important forces were at play, i.e. a decline in the real natural rate of interest and a structural reduction in inflation expectations. I use a small-scale macroeconometric model to provide evidence that structural changes in the economy lowered expectations about the future path of short-term policy rates and that, although risk premia did diminish, their current level is not unusual if considered from an historical perspective.
    JEL: G12
    Date: 2007–07
  21. By: Philip R. Lane; Jay C. Shambaugh
    Abstract: Our goal in this project is to gain a better empirical understanding of the international financial implications of currency movements. To this end, we construct a database of international currency exposures for a large panel of countries over 1990-2004. We show that trade-weighted exchange rate indices are insufficient to understand the financial impact of currency movements. Further, we demonstrate that many developing countries hold short foreign-currency positions, leaving them open to negative valuation effects when the domestic currency depreciates. However, we also show that many of these countries have substantially reduced their foreign currency exposure over the last decade. Last, we show that our currency measure has high explanatory power for the valuation term in net foreign asset dynamics: exchange rate valuation shocks are sizable, not quickly reversed and may entail substantial wealth shocks.
    Keywords: Financial integration, capital flows, external assets and liabilities
    Date: 2007–09–12
  22. By: Norikazu TAKAMI (Graduate School of Economics, Osaka University)
    Abstract: In this paper I examine A. C. Pigou's views on the unemployment policies, based on the premise that, as he himself acknowledged, his theory of business fluctuations was one integral part of his whole thought about unemployment. In his Industrial Fluctuations (1927), Pigou gave the most extensive treatment to the monetary policy among the measures against business fluctuations. There he advocated more prompt and smooth action by the Bank of England in order to effectively stabilize the movement of general prices and the economy as a whole. In order for its action not to be affected by external monetary shocks, he suggested the withdrawal from the gold standard should the public opinion and international diplomatic relations allow it. Pigou, meanwhile, placed much less importance on wage adjustment as a palliative against business cycle. The recent studies direct attention to the fact that Pigou pointed out that after World War I money wages were made rigid by such factors as contemporary institutional changes in labor markets. This picture, however, lacks a more important element of his thought: the monetary cause due to the gold standard on the prewar parity. Putting his indirect remarks on this influence together, I argue that Pigou was well aware of the monetary situation and seemed to place greater importance on the monetary influence than the wage rigidity.
    Keywords: history of economic thought, Pigou, unemployment
    JEL: B13 B31 E24
    Date: 2007–09
  23. By: Korhonen , Iikka (BOFIT)
    Abstract: Straightforward exchange rate arrangements known as currency boards have gained popularity during the past dec-ade. Among transition economies, Estonia first introduced a currency board in 1992, followed by Lithuania in 1994 and Bulgaria in 1997. Currency boards have been useful in achieving macroeconomic stabilization, and they may have helped the Baltics become the first countries of the former Soviet Union (FSU) to achieve economic growth after the slump in production of the early 1990s. Moreover, Baltic inflation performance has been substantially better than in other FSU countries. Both in Estonia and Lithuania, the present exchange rate system has been ac-companied by strong real appreciation of the currency. Both in Estonia and Lithuania the present exchange rate system has been accompanied by strong real appreciation of the currency, although it is widely accepted that the currencies were very much undervalued at the beginning of their pegs. However, if rapid real appreciation is ac-companied with increases in the labor productivity, the present pegs can be maintained. Banking crises in Estonia and Lithuania have not been particularly severe, so apparently rigid currency pegs have not been accompanied by excessive financial sector instability. The tight fiscal policies pursued in both countries, especially Estonia, have been instrumental to the success of these currency board arrangements.
    Keywords: exchange rate; currency board; Baltic countries
    JEL: E50 E60 P20
    Date: 2007–09–14
  24. By: Menkhoff, Lukas; Rebitzky, Rafael
    Abstract: How is it possible that exchange rates move in the long run towards fundamentals, while professionals form consistently irrational exchange rate expectations? We look at this puzzle from a different perspective by analyzing investor sentiment in the US-dollar market. First, long-horizon regressions show that investor sentiment is connected with exchange rate returns at longer horizons, i.e. more than two years. Second, sentiment is cointegrated with fundamentals, whereas third, this relation becomes stronger, the larger exchange rate's misalignment from long-run PPP. In sum, investor sentiment's behavior in the US-dollar market closely matches with established facts of empirical exchange rate research.
    Keywords: Exchange rates, investor sentiment, long-horizon regression, threshold VECM
    JEL: F31 G14
    Date: 2007–09
  25. By: Idil Goksel (Department of Economics, Izmir University of Economics)
    Date: 2007–08
  26. By: Komulainen, Tuomas (BOFIT)
    Abstract: The paper examines currency crisis theories and applies them in searching for the main causes of the Russian crisis. We first study the determination of the exchange rate and then the first and second generation theories on currency crisis and finally the recent theoretical discussions of the Asian crisis. The main reason for the Russian crisis was the long-standing federal budget deficit. During the last years the deficits were financed mainly via short-term domestic debt. This created expectations of government insolvency and central bank financing. Moreover, the Russian economy has its own basic weaknesses, which render the country incapable of growth and prone to crisis. The Asian crisis was a trigger for the Russian crisis. Lower prices for Russian export products, inadequate financial regulations and lack of information in emerging markets in general are factors explaining this contagion effect. But the main mistakes that led to the crisis were those of the Russians themselves - the federal budget deficits. Thus the repair work should also start from there.
    Keywords: currency crisis; Russia; budget; contagion
    Date: 2007–09–14

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