nep-mon New Economics Papers
on Monetary Economics
Issue of 2007‒10‒20
twenty papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Two Reasons Why Money and Credit May be Useful in Monetary Policy By Lawrence Christiano; Roberto Motto; Massimo Rostagno
  2. Monetary policy, expected inflation and inflation risk premia By Ravenna , Federico; Seppälä, Juha
  3. Interest Rate Rules and Welfare in Open Economies By Ozge Senay
  4. Modelling Inflation in Croatia By Maruška Vizek; Tanja Broz
  5. A Model of an Optimum Currency Area By Ricci, Luca Antonio
  6. Actual versus Perceived Central Bank Transparency: The Case of the European Central Bank By Cruijsen, C. van der; Eijffinger, S.C.W.
  7. Endogenous Indexing and Monetary Policy Models By Mash, Richard
  8. Monetary Policy and Swedish Unemployment Fluctuations By Alexius, Annika; Holmlund, Bertil
  9. Monetary policy in the New-Keynesian model: An application to the Euro-Area By Moons C.; Garretsen H.; Van Aarle B.; Fornero J.
  10. Monetary Policy Shocks in the Euro Area and Global Liquidity Spillovers By Joao Sousa; Andrea Zaghini
  11. Declining Valuations And Equilibrium Bidding In Central Bank Refinancing Operations By Christian Ewerhart; Nuno Cassola; Natacha Valla
  12. Nominal Rigidities and The Real Effects of Monetary Policy in a Structural VAR Model By Pham The Anh
  13. Is Unemployment More Costly Than Inflation? By David G. Blanchflower
  14. Accession to the Euro-Area: A Stylized Analysis Using a NK Model By Van Aarle B.; Garretsen H.; Moons C.
  15. Consumer Credit, Liquidity, and Monetary Policy: May the Lending Channel (finally) Rest in Peace By Ryan R. Brady
  16. The Shrinking Endogeneity of Optimum Currency Areas Criteria: Evidence from the European Monetary Union – A Beta Regression Approach. By João Silvestre; António Mendonça; José Passos
  17. The performance of credit rating systems in the assessment of collateral used in Eurosystem monetary policy operations By François Coppens; Fernando Gonzáles; Gerhard Winkler
  18. Learning in Real Time: Theory and Empirical Evidence from the Term Structure of Survey Forecasts By Patton, Andrew J; Timmermann, Allan G
  19. Forecasting the Yield Curve Using Priors from No Arbitrage Affine Term Structure Models By Andrea Carriero
  20. Central Banks and Payment Instruments: a Serious Case of Schizophrenia By VAN HOVE, Leo

  1. By: Lawrence Christiano; Roberto Motto; Massimo Rostagno
    Abstract: We describe two examples which illustrate in different ways how money and credit may be useful in the conduct of monetary policy. Our first example shows how monitoring money and credit can help anchor private sector expectations about inflation. Our second example shows that a monetary policy that focuses too narrowly on inflation may inadvertently contribute to welfare-reducing boom-bust cycles in real and financial variables. The example is of some interest because it is based on a monetary policy rule fit to aggregate data. We show that a policy of monetary tightening when credit growth is strong can mitigate the problems identified in our second example.
    JEL: E41 E44 E52 E58
    Date: 2007–10
  2. By: Ravenna , Federico (University of California, Department of Economics.); Seppälä, Juha (University of Illinois, Department of Economics)
    Abstract: Within a New Keynesian business cycle model, we study variables that are normally unobservable but are very important for the conduct of monetary policy, namely expected inflation and inflation risk premia. We solve the model using a third-order approximation that allows us to study time-varying risk premia. Our model is consistent with rejection of the expectations hypothesis and the business-cycle behaviour of nominal interest rates in US data. We find that inflation risk premia are very small and display little volatility. Hence, monetary policy authorities can use the difference between nominal and real interest rates from index-linked bonds as a proxy for inflation expectations. Moreover, for short maturities current inflation is a good predictor of inflation risk premia. We also find that short-term real interest rates and expected inflation are significantly negatively correlated and that short-term real interest rates display greater volatility than expected inflation. These results are consistent with empirical studies that use survey data and index-linked bonds to obtain measures of expected inflation and real interest rates. Finally, we show that our economy is consistent with the Mundell-Tobin effect: increases in inflation are associated with higher nominal interest rates, but lower real interest rates.
    Keywords: term structure of interest rates; monetary policy; expected inflation; inflation risk premia; Mundell-Tobin effect
    JEL: E43 E44 E50 G12
    Date: 2007–10–11
  3. By: Ozge Senay
    Abstract: This paper analyses the welfare performance of a set of five alternative interest rate rules in an open economy stochastic dynamic general equilibrium model with nominal rigidities. A rule with a lagged interest rate term, high feedback on inflation and low feedback on output is found to yield the highest welfare for a small open economy. This result is robust across different degrees of openness, different sources of home and foreign shocks, alternative foreign monetary rules and different specifications for price setting behaviour. The same rule emerges as both the Nash and cooperative equilibria in a two-country version of the model.
    Keywords: Welfare, Monetary Policy, Interest Rate Rules, Second Order Approximation.
    JEL: E52 E58 F41
    Date: 2007–10
  4. By: Maruška Vizek; Tanja Broz (The Institute of Economics, Zagreb)
    Abstract: The aim of this paper is to construct a quarterly inflation model for Croatia. In order to model inflation dynamics se use the general-to-specific approach. The advantage of this approach is its ability to deliver results based on underlying economic theories of inflation, which are also consistent with the properties of the data. A two step procedure is followed. In the first step, the long-run sectoral analysis of inflation sources is conducted, yielding long-run determinants of inflation (mark-up, excess money, nominal effective exchange rate and the output gap). In the second step, we estimate an equilibrium error correction model of inflation deploying, among other variables of interest, long-run solutions derived in the first step. The derived model of inflation suggests that mark-up and excess money relationships are very important for explaining the short-run behaviour of inflation, as well as the output gap and nominal effective exchange rate, import prices, interest rates and narrow money. Comparing the results of the model suggests that short-run inflation is more responsive to supply side and exchange rate changes than to monetary conditions.
    Keywords: inflation modelling, cointegration, general-to-specific, Croatia
    JEL: C51 C53 E31 E37
    Date: 2007–06
  5. By: Ricci, Luca Antonio
    Abstract: This paper develops a model of the circumstances under which it is beneficial to participate in a currency area. The proposed two-country monetary model of trade with nominal rigidities encompasses the real and monetary arguments suggested by the optimum currency area literature: correlation of real and monetary shocks, international factor mobility, fiscal adjustment, openness, difference in national inflationary biases, and transactions costs. The effect of openness on the net benefits is ambiguous, contrary to the usual argument that more open economies are better candidates for a currency area. Also, prospective member countries do not necessarily agree on whether a given currency union should be created.
    Keywords: Optimum currency areas, cost-benefit analysis, exchange rate regimes, currency union, monetary integration
    JEL: E42 E52 E61 F02 F31 F33 F36 F4 H77 J61
    Date: 2007
  6. By: Cruijsen, C. van der; Eijffinger, S.C.W. (Tilburg University, Center for Economic Research)
    Abstract: Central banks have become more and more transparent about their monetary policy making process. In the central bank transparency lit- erature the distinction between actual and perceived central bank trans- parency is often lacking. However, as perceptions are crucial for the ac- tions of economic agents this distinction matters. A discrepancy between actual and perceived transparency may exist because of incomplete or in- correct transparency knowledge and other (psychological) factors. Even financial experts, the most important channel through which the central bank can influence the economy, might suffer from misaligned perceptions. We investigate the mismatch between actual and perceived transparency and its relevance by analyzing data of a Dutch household survey on the European Central Bank?s transparency. To benefit from higher trans- parency perceptions the European Central Bank might feel tempted to stress its transparency strengths, but hide its transparency weaknesses.
    Keywords: Central bank transparency;Perceptions;Survey;CentERpanel;Behavioral Economics.
    JEL: D80 E52 E58
    Date: 2007
  7. By: Mash, Richard
    Abstract: Models in which firms use a rule of thumb or partial indexing in price setting are prominent in the recent monetary policy literature. The extent to which these firms adjust their prices to lagged inflation has been taken as fixed. We consider the implications of firms choosing the optimal degree of indexation so these simple pricing rules deliver prices as close as possible to those which would be chosen optimally. We find that the degree of indexation depends on the extent of persistence in the economy such that models with constant indexation are vulnerable to the Lucas critique. We also study the interactions between firms’ price setting and the macroeconomic environment finding that, for the models which appear most plausible on microeconomic grounds, the Nash equilibrium between firms and the policy maker is characterised by zero indexation and zero macroeconomic persistence.
    Keywords: Indexing, Monetary Policy, Phillips Curve, Inflation Persistence, Microfoundations
    JEL: E22 E52 E58
    Date: 2007
  8. By: Alexius, Annika; Holmlund, Bertil
    Abstract: A widely spread belief among economists is that monetary policy has relatively short-lived effects on real variables such as unemployment. Previous studies indicate that monetary policy affects the output gap only at business cycle frequencies, but the effects on unemployment may well be more persistent in countries with highly regulated labor markets. We study the Swedish experience of unemployment and monetary policy. Using a structural VAR we find that around 30 percent of the fluctuations in unemployment are caused by shocks to monetary policy. The effects are also quite persistent. In the preferred model, almost 30 percent of the maximum effect of a shock still remains after ten years.
    Keywords: Unemployment, Monetary policy, structural VARs
    JEL: E24 J60
    Date: 2007
  9. By: Moons C.; Garretsen H.; Van Aarle B.; Fornero J.
    Abstract: This paper analyses monetary policy in a stylized new-Keynesian model. A number of issues are focused upon: (i) optimal monetary policy under commitment or discretion vs. ad-hoc monetary policy based on simple rules, (ii) the effects of fiscal policies and foreign variables on monetary policy, (iii) the effects of fiscal deficit and interest rate smoothing objectives and the amount of forward-looking in the model. The model is estimated for the Euro-Area. Using simulations of the estimated model, it is analyzed how these aspects might affect monetary policy of the ECB and macro-economic fluctuations in the Euro-Area.
    Date: 2007–06
  10. By: Joao Sousa (Banco de Portugal); Andrea Zaghini (Banca d’Italia)
    Abstract: We analyse the international transmission of monetary policy shocks with a focus on the effects of foreign liquidity on the euro area. We estimate two domestic structural VAR models for the euro area and then we introduce a global liquidity aggregate. The impulse responses show that a positive shock to foreign liquidity leads for the euro area to a permanent increases in M3 and in the price level, a temporary rise in real output and a temporary appreciation of the euro real effective exchange rate. Moreover, we find that innovations in global liquidity play an important role in explaining price and output fluctuations.
    Keywords: Monetary policy, Structural VAR, International spillovers
    JEL: E52 F01
    Date: 2007–06
  11. By: Christian Ewerhart (University of Zurich); Nuno Cassola (European Central Bank); Natacha Valla (Banque de France)
    Abstract: Among the most puzzling observations for the euro money market are the bid shading in the weekly refinancing operations and the development of interest rate spreads. To explain these observations, we consider a standard divisible-good auction à la Klemperer and Meyer (1989) with uniform or discriminatory pricing, and place it in the context of a secondary market for interbank credit. The analysis links the observations for the euro area to the endogenous choice of collateral in credit transactions. We also discuss the Eurosystem’s apparent preference for the discriminatory pricing rule.
    Keywords: Eurosystem, discriminatory auction, bid shading, collateral
    JEL: D44 E52
    Date: 2007–07
  12. By: Pham The Anh (Department of Economics, National Economics University, Vietnam)
    Abstract: The paper proposes an empirical VAR for the UK open economy in order to measure the effects of monetary policy shocks from 1981 to 2003. The identification of the VAR structure is based on short-run restrictions that are consistent with the general implications of a New Keynesian model. The identification scheme used in the paper is successful in identifying monetary policy shocks and solving the puzzles and anomalies regarding the effects of monetary policy shocks. The estimated dynamic impulse responses and the forecast error variance decompositions show a consistency with the New Keynesian approach and other available theories.
    Keywords: Structural VAR; Nominal Rigidities; Monetary Policy Shocks; New Keynesian Theory
    JEL: C30 E30 E32 E52
    Date: 2007–06
  13. By: David G. Blanchflower
    Abstract: Previous literature has found that both unemployment and inflation lower happiness. This paper extends the literature by looking at more countries over a longer time period. It also considers the impacts on happiness of GDP per capita and interest rates. I find, conventionally, that both higher unemployment and higher inflation lower happiness. Interest rates are also found to enter happiness equations negatively. Changes in GDP per capita have little impact on more economically developed countries, but do have a positive impact in the poorest countries -- consistent with the Easterlin hypothesis. I find that unemployment depresses well-being more than inflation. The least educated and the old are more concerned about unemployment than inflation. Conversely, the young and the most educated are more concerned about inflation. An individual's experience of high inflation over their adult lifetime lowers their current happiness over and above the effects from inflation and unemployment. Unemployment appears to be more costly than inflation in terms of its impact on wellbeing.
    JEL: E24 E31
    Date: 2007–10
  14. By: Van Aarle B.; Garretsen H.; Moons C.
    Abstract: This paper analyses the accession to the Euro-Area by new members using a stylized new-Keynesian model. We analyze macro-economic adjustment in the pre- and post accession case and calculate welfare in both situations to obtain net benefit/loss from accession. It is shown how the effects of accession is related to the conduct of monetary policy and fiscal policy in the pre- and post accession case. The simulation examples point at the potential costs that accession might entail due its consequences on monetary and fiscal policy design. These consequences from accession in terms of macro-economic stabilization ability of monetary and fiscal policies have not always been fully acknowledged and need attention in our opinion.
    Date: 2007–06
  15. By: Ryan R. Brady (United States Naval Academy)
    Abstract: That households bear the weight of the loan-supply effect, even after many calls for the lending channel’s obsolesce, is at first glance a compelling notion given the growth in consumer credit. However, this paper shows with disaggregated consumer loan data that not only is the loan-supply effect irrelevant for consumer lending, but that this is likely due to the fact that in the aggregate households are awash in liquidity. These insights, gained in part by comparing aggregate credit balances to the unused portions of credit card lines, have important implications for further research on the monetary transmission mechanism and for business cycle research in general.
    Date: 2007–10
  16. By: João Silvestre; António Mendonça; José Passos
    Abstract: The endogeneity of optimum currency areas criteria has been widely studied since Frankel and Rose (1998) seminal paper. Literature normally suggests that there is a positive relationship between trade and business cycles correlation. This paper develops work on this subject (Silvestre and Mendonça, 2007) where we confirm this hypothesis in euro area countries and UE-15 for 1967-2003 period using OLS and 2SLS estimates. However, we also find then that trade influence on cycles synchronization diminished in the last years. Now our goal was precisely to evaluate this question. Using a non-linear model based on Beta distribution in the same sample, we concluded that trade has a decreasing marginal effect on business cycles correlation. This result shows that trade flows are important in the first stages of economic integration, but become less important as trade intensity increases. Other factors must then be considered.
    Keywords: European Monetary Union (EMU); Business Cycles Correlation; Optimum Currency Areas; International Trade; Beta Regression.
    JEL: E32 E42
    Date: 2007
  17. By: François Coppens (National Bank of Belgium, Microeconomic Information Department); Fernando Gonzáles (European Central Bank); Gerhard Winkler (Oesterreichische Nationalbank)
    Abstract: The aims of this paper are twofold: first, we attempt to express the threshold of a single “A” rating as issued by major international rating agencies in terms of annualised probabilities of default. We use data from Standard & Poor’s and Moody’s publicly available rating histories to construct confidence intervals for the level of probability of default to be associated with the single “A” rating. The focus on the single A rating level is not accidental, as this is the credit quality level at which the Eurosystem considers financial assets to be eligible collateral for its monetary policy operations. The second aim is to review various existing validation models for the probability of default which enable the analyst to check the ability of credit assessment systems to forecast future default events. Within this context the paper proposes a simple mechanism for the comparison of the performance of major rating agencies and that of other credit assessment systems, such as the internal ratings-based systems of commercial banks under the Basel II regime. This is done to provide a simple validation yardstick to help in the monitoring of the performance of the different credit assessment systems participating in the assessment of eligible collateral underlying Eurosystem monetary policy operations. Contrary to the widely used confidence interval approach, our proposal, based on an interpretation of p-values as frequencies, guarantees a convergence to an ex ante fixed probability of default (PD) value. Given the general characteristics of the problem considered, we consider this simple mechanism to also be applicable in other contexts.
    Keywords: credit risk, rating, probability of default (PD), performance checking, backtesting
    JEL: G20 G28 C49
    Date: 2007–09
  18. By: Patton, Andrew J; Timmermann, Allan G
    Abstract: We develop a theoretical framework for understanding how agents form expectations about economic variables with a partially predictable component. Our model incorporates the effect of measurement errors and heterogeneity in individual forecasters' prior beliefs and their information signals and also accounts for agents' learning in real time about past, current and future values of economic variables. We use the model to develop insights into the term structure of forecast errors, and test its implications on a data set comprising survey forecasts of annual GDP growth and inflation with horizons ranging from 1 to 24 months. The model is found to closely match the term structure of forecast errors for consensus beliefs and is able to replicate the cross-sectional dispersion in forecasts of GDP growth but not for inflation - the latter appearing to be too high in the data at short horizons. Our analysis also suggests that agents systematically underestimated the persistent component of GDP growth but overestimated it for inflation during most of the 1990s.
    Keywords: real time learning; survey forecasts; term structure of forecasts
    JEL: C53 E37
    Date: 2007–10
  19. By: Andrea Carriero (Queen Mary, University of London)
    Abstract: In this paper we propose a strategy for forecasting the term structure of interest rates which may produce significant gains in predictive accuracy. The key idea is to use the restrictions implied by Affine Term Structure Models (ATSM) on a vector autoregression (VAR) as prior information rather than imposing them dogmatically. This allows to account for possible model misspecification. We apply the method to a system of five US yields, and we find that the gains in predictive accuracy can be substantial. In particular, for horizons longer than 1-step ahead, our proposed method produces systematically better forecasts than those obtained by using a pure ATSM or an unrestricted VAR, and it also outperforms very competitive benchmarks as the Minnesota prior, the Diebold-Li (2006) model, and the random walk.
    Keywords: Bayesian methods, Forecasting, Term structure
    JEL: C11 C53 E43 E47
    Date: 2007–10
  20. By: VAN HOVE, Leo
    Abstract: This article analyses the competition between cash and payment cards against the backdrop of the dual role of central banks - as issuers of cash and as institutions with a mandate to foster the efficiency of payment systems in general. It is argued that this dual role results in a number of policy dilemmas, namely concerning pricing, traceability of banknotes and the choice of denominations of coins and banknotes. On a general level, the article argues that central banks should place greater emphasis on improving the efficiency of retail payments and less on protecting their self-interest. More concretely, the article repeats the suggestion - originally put forward in VAN HOVE & VUCHELEN (1996) - that the ECB should place the upper limit of its banknote series at EUR 50 instead of EUR 500. It is also argued that policy makers should explicitly foster the use of cost-based pricing and in particular create a legal environment that makes it possible for commercial banks to start using it.
    Keywords: payment instruments; central banks; cash; banknotes; payment cards; public policy; efficiency.
    JEL: G2 E6
    Date: 2007–06

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