nep-mon New Economics Papers
on Monetary Economics
Issue of 2007‒11‒03
24 papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Interest rate versus money supply instruments: on the implementation of Markov-perfect optimal monetary policy By Michael Dotsey; Andreas Hornstein
  2. Monetary Policy Operations of Debtor Central Banks in MENA Countries By Schnabl, Gunther; Schobert, Franziska
  3. Will Monetary Policy Become More of a Science? By Frederic S. Mishkin
  4. The High-Frequency Response of the EUR-US Dollar Exchange Rate to ECB Monetary Policy Announcements By Christian Conrad; Michael J. Lamla
  5. Optimal Monetary Policy in a Small Open Economy Under Segmented Asset Markets and Sticky Prices By Ruy Lama; Juan Pablo Medina
  7. Price-Level Targeting and Stabilization Policy: A Review By Steve Ambler
  8. A Theory of Linkage between Monetary Policy and Banking Failure in Developing Countries By Cadet, Raulin Lincifort
  9. Inflation Expectations of Experts and ECB Communication By Ullrich, Katrin
  10. The Impact of Milton Friedman on Modern Monetary Economics: Setting the Record Straight on Paul Krugman's "Who Was Milton Friedman?" By Edward Nelson; Anna J. Schwartz
  11. Low Interest Rates and High Asset Prices: An Interpretation in Terms of Changing Popular Models By Robert J. Shiller
  12. The llong road tto EMU:: The long road to EMU: The Economic and Political Reasoning behind Maastricht By Francisco Torres
  13. The Liquidity Effect in Bank-Based and Market-Based Financial Systems By Johann Scharler
  14. On the efficiency-legitimacy trade-off in EMU By Francisco Torres
  15. The Speed of Euro Adoption By Columba, Francesco
  16. Optimal Monetary Policy and the Sources of Local-Currency Price Stability By Giancarlo Corsetti; Luca Dedola; Sylvain Leduc
  17. Oil and the Great Moderation By Antón Nákov; Andrea Pescatori
  18. Robust Learning Stability with Operational Monetary Policy Rules By George Evans; Seppo Honkapohja
  19. The Broad Yen Carry Trade By Masazumi Hattori; Hyun Song Shin
  20. The role of other financial intermediaries in monetary and credit developments in the euro area By Philippe Moutot; Dieter Gerdesmeier; Adriana Lojschová; Julian von Landesberger
  21. Explaining the Rent-OER Inflation Divergence, 1999-2006 By Robert Poole; Randal Verbrugge
  22. Exact prediction of inflation and unemployment in Japan By Kitov, Ivan
  23. Do Inflation-Linked Bonds Still Diversify? By Marie Brière; Ombretta Signori
  24. Euro area in‡ation persistence in an estimated nonlinear DSGE model By Gianni Amisano; Oreste Tristani

  1. By: Michael Dotsey; Andreas Hornstein
    Abstract: Currently there is a growing literature exploring the features of optimal monetary policy in New Keynesian models under both commitment and discretion. With respect to time consistent policy, the literature focuses on solving for allocations. Recently, however, King and Wolman (2004) have examined implementation issues involved under time consistent policy when the monetary authority chooses nominal money balances. Surprisingly, they find that equilibria are no longer unique under a money stock regime. Indeed, there exist multiple steady states. Dotsey and Hornstein find that King and Wolman's conclusion of non-uniqueness of Markov-perfect equilibria is sensitive to the instrument of choice. If, instead, the monetary authority chooses the nominal interest rate rather than nominal money balances, there exists a unique Markov-perfect steady state and point-in-time equilibria are unique as well. Thus, in King and Wolman's language, monetary policy is implementable using an interest rate instrument while it is not implementable using a money stock instrument.
    Keywords: Markov processes ; Monetary policy ; Money supply
    Date: 2007
  2. By: Schnabl, Gunther; Schobert, Franziska
    Abstract: The paper analyses the monetary policy operations of central banks in the Middle East and North Africa (MENA). We distinguish the pattern of monetary policy operations of the liquidity providing central banks of the large industrialized countries (creditor central banks) and the liquidity absorb-ing central banks of emerging market economies (debtor central banks). Many debtor central banks provide liquidity through foreign exchange intervention in reaction to foreign exchange inflows. If the respective liquidity expansion is regarded as a threat to domestic price and financial stability, liquidity is partly absorbed through sterilization operations. The paper finds that most MENA coun-tries are debtor central banks due to a general pattern of excessive liquidity creation as well as due to country specific reasons.
    Keywords: Emerging Markets; Debtor Central Banks; Foreign Exchange Inflows; Sterilization.
    JEL: F31
    Date: 2007–10
  3. By: Frederic S. Mishkin
    Abstract: This paper reviews the progress that the science of monetary policy has made over recent decades. This progress has significantly expanded the degree to which the practice of monetary policy reflects the application of a core set of "scientific principles". However, there remains, and will likely always remain, elements of art in the conduct of monetary policy: in other words, substantial judgment will always be needed to achieve desirable outcomes on both the inflation and employment fronts. However, as case studies discussed here suggest, even through art will always be a key element in the conduct of monetary policy, the more it is informed by good science, the more successful monetary policy will be.
    JEL: E2 E44 E52 E58
    Date: 2007–10
  4. By: Christian Conrad (Department of Management, Technology, and Economics, ETH Zurich); Michael J. Lamla (Department of Management, Technology, and Economics, ETH Zurich)
    Abstract: We investigate the impact of the European Central Bank's monetary policy an- nouncements on the level and volatility of the EUR-US Dollar exchange rate em- ploying an AR-FIGARCH specification. Using high-frequency data we estimate the individual and complementary effects of the release of the interest rate decision, the ECB's introductory statement and the question and answer session. Surprise interest rate changes explain the movements in the exchange rate immediately after press release. During the introductory statement, communication with respect to future price developments is most relevant and has two important functions: (i) it explains the previously announced decision and (ii) it serves as a guide for the future path of monetary policy.
    Keywords: European Central Bank, monetary policy announcements, communication, exchange rate, expectations, long memory GARCH processes
    JEL: C22 E52 E58 F31
    Date: 2007–09
  5. By: Ruy Lama; Juan Pablo Medina
    Abstract: This paper studies optimal monetary policy in a two-sector small open economy model under segmented asset markets and sticky prices. We solve the Ramsey problem under full commitment, and characterize the optimal monetary policy in a calibrated version of the model. The findings of the paper are threefold. First, the Ramsey solution mimics the allocations under flexible prices. Second, under the optimal policy the volatility of non-tradable inflation is close to zero. Third, stabilizing nontradable inflation is optimal regardless of the financial structure of the small open economy. Even for a moderate degree of price stickiness, implementing a monetary policy that mitigates asset market segmentation is highly distortionary. This last result suggests that policymakers should resort to other policy instruments in order to correct financial imperfections.
    Keywords: Working Paper , Monetary policy , Prices , Financial assets , Markets , Economic models ,
    Date: 2007–09–17
  6. By: Svan Jari Stehn; David Vines
    Abstract: Leith and Wren-Lewis (2007) have shown that government debt is returned to its pre-shock level in a New Keynesian model under optimal discretionary policy. This has two important implications for monetary and fiscal policy. First, in a high-debt economy, it may be optimal for discretionary monetary policy to cut the interest rate in response to a cost-push shock - thereby violating the Taylor principle - although this will not be true if inflation is significantly persistent. Second, the optimal fiscal response to such a shock is more active under discretion than commitment, whatever the degree of inflation persistence.
    JEL: E52 E60 E61 E63
    Date: 2007–10
  7. By: Steve Ambler
    Abstract: The author surveys recent articles on the costs and benefits of price-level targeting versus inflation targeting, focusing on the benefits and costs of price-level targeting as a tool for stabilization policy. He reviews papers that examine how price-level targeting affects the short-run trade-off between output and inflation variability by influencing expectations of future inflation. The author looks at the implications of this argument for assigning an objective based on price-level targeting to a central bank that is unable to commit to its future policies. He discusses some recent papers that examine how price-level targeting can help to avoid the zero-bound problem, and papers that examine the incentives created by price-level targeting to change the degree of indexation of private contracts.
    Keywords: Monetary policy framework
    JEL: E31 E32 E52
    Date: 2007
  8. By: Cadet, Raulin Lincifort
    Abstract: This paper presents a model of the banking sector that maximize profit and an individual bank which is a price taker, in a developing country. The interest rate on treasury bills is included in the model to measure monetary policy. The mathematical expression of the probability of banking failure is calculated; And, I show that, in developing countries, a tightening monetary policy may induce efficient banking failure.
    Keywords: Banking Failure; Monetary Policy; Interest Rate; Developing Countries
    JEL: G23 G21 E52
    Date: 2006–12
  9. By: Ullrich, Katrin
    Abstract: The communication policy of the European Central Bank attracts a lot of attention from financial markets. This paper analyses the informational content of the monthly introductory statements of the ECB president explaining interest rate decisions with regard to inflation expectations of financial market experts for the euro area from February 1999 to June 2007. Estimations are conducted for the influence of ECB communication on expectations formation besides other macroeconomic variables. As the results indicate, the indicator measuring the informational content of ECB rhetoric contributes to the explanation of inflation expectations formation.
    Keywords: inflation expectations formation, central bank communication, Carlson-Parkin method, survey expectations
    JEL: D83 D84 E52 E58
    Date: 2007
  10. By: Edward Nelson; Anna J. Schwartz
    Abstract: Paul Krugman's essay "Who Was Milton Friedman?" seriously mischaracterizes Friedman's economics and his legacy. In this paper we provide a rejoinder to Krugman on these issues. In the course of setting the record straight, we provide a self-contained guide to Milton Friedman's impact on modern monetary economics and on today's central banks. We also refute the conclusions that Krugman draws about monetary policy from the experiences of the United States in the 1930s and of Japan in the 1990s.
    JEL: E31 E51 E58
    Date: 2007–10
  11. By: Robert J. Shiller (Cowles Foundation, Yale University)
    Abstract: There has been a widespread perception in the past few years that long-term asset prices are generally high because monetary authorities have effectively kept long-term interest rates, which the market uses to discount cash flows, low. This perception is not accurate. Long-term interest rates have not been especially low. What has changed to produce high asset prices appears instead to be changes in popular economic models that people actually rely on when valuing assets. The public has mostly forgotten the concept of "real interest rate." Money illusion appears to be an important factor to consider.
    Keywords: Long-term interest rates, Stock prices, Housing prices, Real interest rates, Liquidity, Money illusion
    JEL: G12
    Date: 2007–10
  12. By: Francisco Torres (Universidade Moderna de Lisboa,Universidade Católica)
    Abstract: This paper aims to examine whether the economic and political reasoning behind Maastricht is consistent with earlier approaches to monetary integration. In doing so, it revisits the intellectual debate on monetary integration in Europe at different stages. It concludes that Economic and Monetary Union (EMU) as agreed at Maastricht reflected a compromise between two different but converging preferences, in the context of the experience of the European Monetary System (EMS) and other developments in national and European politics as well as in economic thought, on the role of monetary policy and institutions; the fall of the Berlin Wall may have added a new political dimension that might have made it easier to agree on the blueprint and on the calendar for the realisation of EMU. The various (political and economic) motivations for the convergence of initially different views on the role of monetary policy and successive interpretations of the objectives of EMU are discussed within the wider context of the process of European integration.
    Keywords: Economic and Monetary Union; Bretton Woods; European integration; Werner plan; European Monetary System; inflation; convergence of preferences; epistemic communities; currency crisis; monetary sovereignty; Maastricht treaty; convergence requirements.
    JEL: N14 E52 E58 E61 E65
    Date: 2007
  13. By: Johann Scharler (Department of Economics, Johannes Kepler University Linz, Austria)
    Abstract: This paper assesses how the financial system influences the strength of the liquidity effect in a calibrated limited participation model of the monetary transmission mechanism. The model suggests that bankbased systems should be characterized by smaller liquidity effects since monetary injections are spread out over a larger number of firms.
    Keywords: limited participation; transmission mechanism; financial systems
    JEL: E32 E52 E58
    Date: 2007–10
  14. By: Francisco Torres (Universidade Moderna de Lisboa,Universidade Católica)
    Abstract: This paper addresses the question whether the process of European monetary integration implies efficiency-legitimacy trade-off. The paper considers that the process of monetary policy delegation to the European Central Bank (ECB), ratified by all European Union (EU) parliaments, was a non-zero-sum game, increasing both the efficiency and the legitimacy of monetary policy in the eurozone. There was however a change in the nature of delegation: the initial principal (EU national governments and/or parliaments) delegated to the agent (the ECB) control over its behaviour in regard to monetary policy. The paper distinguishes two types of constraints for monetary policy: credibility constraints and political constraints. The change in the nature of delegation of monetary policy (tying the hands of the principal) was a means of dealing with credibility constraints. The paper goes on investigating whether, and if so to what extent, the European Parliament (EP) is fit to function as a principal of the ECB as a means of dealing with political constraints. Thus, the paper analyses the European Parliament’s increased involvement in overseeing the Central Bank’s activities, aiming at understanding whether and how that new and special role (an informal institution of dialogue) could affect the trade-off between efficiency and legitimacy in the conduct of eurozone.
    Keywords: Economic and Monetary Union; monetary policy delegation: efficiency and legitimacy; accountability; responsiveness; principal-agent relations; governance.
    JEL: E58 E61 E65
    Date: 2007
  15. By: Columba, Francesco
    Abstract: This paper estimates the speed and determinants of euro adoption across Italian provinces by exploiting the natural experiment in early 2002 when euro and lira dually circulated as legal tender. A unique data set with daily observations on the net flows of euro banknotes from the branches of the Bank of Italy, province by province, is used. The speed of euro adoption differs according to the availability of transaction technology and demographic characteristics. Lessons for countries adopting a new currency are obtained.
    Keywords: currency; euro; financial innovation; monetary transition
    JEL: E51 E42
    Date: 2007
  16. By: Giancarlo Corsetti; Luca Dedola; Sylvain Leduc
    Abstract: We analyze the policy trade-offs generated by local currency price stability of imports in economies where upstream producers strategically interact with downstream firms selling the final goods to consumers. We study the effects of staggered price setting at the downstream level on the optimal price (and markup) chosen by upstream producers and show that downstream price movements affect the desired markup of upstream producers, magnifying their price response to shocks. We revisit the international dimensions of optimal monetary policy, unveiling an argument in favor of consumer price stability as the main prescription for monetary policy. Since stable consumer prices feed back into a low volatility of markups among upstream producers, this contains inefficient deviations from the law of one price at the border. However, efficient stabilization of different CPI components will not generally result into perfect stabilization of headline inflation. National policies optimally respond to the same shocks in a similar way, thus containing volatility of the terms of trade, but not necessarily of the real exchange rate. The latter will be more volatile, among other things, the larger the home bias in expenditure and the content of local inputs in consumer goods.
    JEL: F31 F33 F41 F42
    Date: 2007–10
  17. By: Antón Nákov (Banco de España); Andrea Pescatori (Federal Reserve Bank of Cleveland)
    Abstract: We assess the extent to which the great US macroeconomic stability since the mid-1980s can be accounted for by changes in oil shocks and the oil share in GDP. To do this we estimate a DSGE model with an oil-producing sector before and after 1984 and perform counterfactual simulations. We nest two popular explanations for the Great Moderation: (1) smaller (non-oil) real shocks; and (2) better monetary policy. We find that the reduced oil share accounted for as much as one-third of the inflation moderation, and 13% of the growth moderation, while smaller oil shocks accounted for 11% of the inflation moderation and 7% of the growth moderation. This notwithstanding, better monetary policy explains the bulk of the inflation moderation, while most of the growth moderation is explained by smaller TFP shocks.
    Keywords: Great Moderation, oil shocks, Bayesian estimation, counterfactual simulations
    JEL: E32 E52 Q43
    Date: 2007–10
  18. By: George Evans; Seppo Honkapohja
    Abstract: We consider robust stability under learning of alternative interest-rate rules. By “robust stability” we mean stability of the rational expectations equilibrium, under discounted (constant gain) least-squares learning, for a range of gain parameters. We find that many interest-rate rules are not robust, in this sense, when operational forms of policy rules are employed. Rules are considered operational if they do not depend on contemporaneous values of endogenous aggregate variables. We consider a variety of interest-rate rules, including instrument rules, optimal reaction functions under discretion or commitment, and rules that approximate optimal policy under commitment. For some of the rules that aim to achieve optimal policy, we allow for an interest-rate stabilization motive in the policy objective. The expectations-based rules proposed in Evans and Honkapohja (2003, 2006) deliver robust learning stability. In contrast, many proposed alternatives become unstable under learning even at small values of the gain parameter.
    Keywords: Commitment, interest-rate setting, adaptive learning, stability, determinacy.
    JEL: E52 E31 D84
    Date: 2007–10
  19. By: Masazumi Hattori (Deputy Head of Economics Section, Institute for Monetary and Economic Studies, Bank of Japan (E-mail:; Hyun Song Shin (Professor of Economics, Princeton University (E-mail:
    Abstract: Yen carry trades have traditionally been viewed in narrow terms purely as a foreign exchange transaction. However, evidence from the waxing and waning of balance sheets of foreign banks operating in Japan points to a broader notion of the carry trade. Yen liabilities fund not only pure currency carry trades, but also fund the general increase in balance sheets of hedge funds and financial intermediaries. The difference in overnight rates across countries is a crucial determinant of balance sheet changes. Domestic monetary policy thus has a global dimension.
    Keywords: Yen carry trade, liquidity, risk appetite, monetary policy
    JEL: F31 G21 G24
    Date: 2007–10
  20. By: Philippe Moutot (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Dieter Gerdesmeier (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Adriana Lojschová (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Julian von Landesberger (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: Monetary growth has increased significantly in the euro area in recent years, raising concerns about the risks to price stability. Viewed from a sectoral perspective, this increase reflects to a large extent the deposit holdings of other financial intermediaries (OFIs). This paper presents analytical work on the role of OFIs in monetary and credit developments in the euro area. Although, at the moment, some shortcomings in the data available – such as the lack of long time series data – seriously limit the analysis of the role of OFIs in monetary and credit aggregates, it seems clear that OFIs have gained considerable importance in recent years, not only as a factor affecting monetary developments, but also for the functioning of the financial system. This gain in importance may be due to financial deregulation and liberalisation, as well as financial innovation. These developments are reflected in the integration and deepening of euro area financial markets, as well as in investors’ attitude to risk.
    Date: 2007–10
  21. By: Robert Poole (U.S. Bureau of Labor Statistics); Randal Verbrugge (U.S. Bureau of Labor Statistics)
    Abstract: Between 1999 and 2006, there were two episodes during which inflation in the Rent index in the CPI diverged markedly from inflation in the index for Owner’s Equivalent Rent (OER); early in 2007, these series began to diverge again. Such divergence often prompts many to question CPI methods. A key difference between these two series is that OER indexes are based upon rents which have received a utilities adjustment – an adjustment which is necessary because the OER index is intended to track pure rent-of-shelter, not shelter-plus-utilities. Critics have claimed that the Rent-OER inflation divergences stem from an inappropriate utilities adjustment. This claim is false. In this paper, we decompose the Rent-OER inflation differential into its various determinants, and explore the multiple causes of this divergence over time. There is only one divergence episode – of only six months duration – which is primarily attributable to the utilities adjustment procedure. Indeed, the utilities adjustment sometimes reduced potential divergence between the two series. Instead, the main culprit is rental market segmentation; that is, different rent inflation rates were experienced by different parts of the rental market. Before 2003, the Rent-OER inflation divergence mainly resulted from divergent rental inflation rates within metropolitan areas: areas with a higher proportion of renters experienced higher rental inflation. After 2004, similar divergent inflation across metropolitan areas resulted in higher Rent inflation. Compared to other units, rent control units experienced higher inflation in 2004 (and, to a lesser extent, before mid-2001 and in 2006), which increased Rent inflation but not OER inflation. Finally, in early 2007, there was a sizable divergence between OER and Rent inflation, driven mostly by divergent rental inflation rates within metropolitan areas; the extent of the divergence only becomes evident once the effect of the utilities adjustment is accounted for.
    Keywords: Owners' Equivalent Rent, Utilities Adjustment, Rental Market Segmentation, Rent Control, Inflation Measurement, Core Inflation
    JEL: R31 R21 E31 C81 C82 O47
    Date: 2007–10
  22. By: Kitov, Ivan
    Abstract: Past and future evolution of inflation, p(t), and unemployment, UE(t), in Japan is modeled. Both variables are represented as linear functions of the change rate of labor force level. These models provide an accurate description for disinflation in the 1990s and deflationary period in the 2000s. In Japan, there exists a statistically reliable (R2=0.68) Phillips curve. This Phillips curve is characterized by a negative relation between inflation and unemployment and their synchronous evolution: UE(t) = -0.94p(t) + 0.045. Effectively, growing unemployment has resulted in decreasing inflation since 1982. A linear and lagged generalized relationship between inflation, unemployment and labor force has been also obtained for Japan: p(t) = 2.8*dLF(t)/LF(t) + 0.9*UE(t) - 0.0392. Labor force projections allow a reliable prediction of inflation and unemployment in Japan: CPI inflation will be negative (between -0.5% and -1% per year) during the next 40 years. Unemployment will increase from 4.0% in 2010 to 5.3% in 2050
    Keywords: inflation; unemployment; labor force; modeling; Japan
    JEL: E24 J20 O11 E27
    Date: 2007–10
  23. By: Marie Brière (Centre Emile Bernheim, Solvay Business School, Université Libre de Bruxelles, Brussel and Credit Agricole Asset Management SGR, Paris.); Ombretta Signori (Credit Agricole Asset Management SGR, Paris.)
    Abstract: This paper examines the dynamics of conditional volatilities and correlations of three asset classes: inflation-linked (IL) bonds, nominal bonds and equities in the United States and Europe for the period 1997-2007. Using a DCC-MVGARCH model, we highlight the significant change that has taken place in the dynamics of correlations and volatilities since 2003. Inflation-linked bonds have become much more volatile and, at the same time, much more highly correlated with nominal bonds. Monthly portfolio optimization since 1997, using our estimates of conditional correlations and volatilities, clearly demonstrates the decreasing weight of inflation-linked bonds in an optimal allocation. This weighting should now be partially reallocated to equities in a US portfolio, while in Europe, the decreased weight of IL bonds is redistributed, with about one-third going to equities and two-thirds to nominal bonds.
    Keywords: inflation-linked bonds, optimal allocation, portfolio choice, conditional volatility, conditional correlation.
    JEL: G11 G12
    Date: 2007–10
  24. By: Gianni Amisano (European Central Bank, University of Brescia and The Rimini Centre for Economics Analysis, Rimini, Italy.); Oreste Tristani (European Central Bank.)
    Abstract: We estimate the approximate nonlinear solution of a small DSGE model on euro area data, using the conditional particle …lter to compute the model likelihood. Our results are consistent with previous …ndings, based on simulated data, suggesting that this approach delivers sharper inference compared to the estimation of the linearised model. We also show that the nonlinear model can account for richer economic dynamics: the impulse responses to structural shocks vary depending on initial conditions selected within our estimation sample.
    Keywords: DSGE models, in‡ation persistence, second order approximations, sequential Monte Carlo, Bayesian estimation.
    JEL: C11 C15 E31 E32 E52
    Date: 2007–07

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