nep-mon New Economics Papers
on Monetary Economics
Issue of 2007‒12‒08
23 papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Monetary Policy Objectives in Pakistan: An Empirical Investigation By Wasim Shahid Malik
  2. Inertia in Taylor Rules By John Driffill; Zeno Rotondi
  3. The term structure of euro area break-even inflation rates - the impact of seasonality By Jacob Ejsing; Juan Angel García; Thomas Werner
  4. Toward a Bias Corrected Currency Equivalent Index By William Barnett; John Keating; Logan Kelly
  5. Modelling inflation in China - a regional perspective By Aaron Mehrotra; Tuomas Peltonen; Alvaro Santos Rivera
  6. Private Money and Bank Runs By Hongfei Sun; Xiuhua Huangfu
  7. Deficit sustainability and inflation in EMU: An analysis from the fiscal theory of the price level By Oscar Bajo-Rubio; Carmen Díaz-Roldán; Vicente Esteve
  8. "Trying to Make Sense of the Bank of Japan's Monetary Policy since the Exit from Quantitative Easing" By Kazuo Ueda
  9. The yield curve and macroeconomic dynamics By Peter Hördahl; Oreste Tristani; David Vestin
  10. Are the facts of UK inflation persistence to be explained by nominal rigidity or changes in monetary regime? By David Meenagh; Patrick Minford; Eric Nowell; Prakriti Sofat; Naveen Srinivasan
  11. Revisiting the Coyne Affair: A Singular Event That Changed the Course of Canadian Monetary History By Pierre Siklos
  12. The Friedman Rule in an Overlapping Generations Model: Social Security in Reverse By Benjamin Eden
  13. Woodford goes to Africa By Kang Yong Tan; David Vines
  14. Walsh’s Contract and Transparency about Central Bank Preferences for Robust Control. By Meixing DAI; Eleftherios SPYROMITROS
  15. International frictions and optimal monetary policy cooperation - analytical solutions By Matthieu Darracq Pariès
  16. Monetary and Financial Cooperation among Central Banks in East Asia and the Pacific By Hans Genberg; Dong He
  17. Credit and inflation under borrower’s lack of commitment By Antonia Diaz; Fernando Perera-Tallo
  18. Banking, Inside Money and Outside Money By Hongfei Sun
  19. Federal Reserve Information During the Great Moderation By D'Agostino, A; Whelan, K
  20. Economic and Financial Integration between Hong Kong and Mainland China before the Open Door Policy 1965-75 By Catherine R Schenk
  21. Monetary Policy Rules For Manging Aid Surges In Africa By Christopher Adam; Stephen O’Connell; Edward Buffie
  22. New Zealand’s Exchange Rate Regime, the Collapse of Bretton Woods,and the Twilight of the Sterling Area By Catherine Schenk; John Singleton
  23. Is the Hong Kong Dollar Exchange Rate "Bounded" in the Convertibility Zone? By Cho-Hoi Hui; Tom Fong

  1. By: Wasim Shahid Malik (Pakistan Institute of Development Economics, Islamabad.)
    Abstract: The Taylor rule (1993) focuses only on two objectives: output and inflation. In practice, the central bank’s loss function (especially in developing countries) contains objectives other than these two, like the interest rate smoothing, exchange rate stabilisation, etc. In this study, the monetary policy reaction function has been estimated, including five objectives for monetary policy as well as controlling for the effect of three other factors. Whereas the results confirm the counter-cyclical response of monetary policy to the factors in the loss function, the response of interest rate to changes in the foreign exchange reserves and the government borrowing has been negative. Variance decomposition shows that most of the variation in the interest rate is explained by its own lagged values. Other variables, in explaining variation in the interest rate, can be ranked as inflation, government borrowing, exchange rate, output gap, trade deficit, and, finally, the foreign exchange reserves.
    Keywords: Monetary Policy Objectives, Variance Decomposition, Call Money Rate
    JEL: E52 E52 E58
    Date: 2007
  2. By: John Driffill (Birkbeck, University of London); Zeno Rotondi (University of Ferrara)
    Abstract: The inertia found in econometric estimates of interest rate rules is a continuing puzzle. Many reasons for it have been offered, though unsatisfactorily, and the issue remains open. In the empirical literature on interest rate rules, inertia in setting interest rates is typically modeled by specifying a Taylor rule with the lagged policy rate on the right hand side. We argue that inertia in the policy rule may simply reflect the inertia in the economy itself, since optimal rules typically inherit the inertia present in the model of the economy. Our hypothesis receives some support from US data. Hence we agree with Rudebusch (2002) that monetary inertia is, at least partly, an illusion, but for different reasons.
    Keywords: Monetary Policy, Interest Rate Rules, Taylor rule, Interest Rate Smoothing, Monetary Policy Inertia, Predictability of Interest Rates, Term Structure, Expectations Hypothesis
    JEL: E52 E58
    Date: 2007–11
  3. By: Jacob Ejsing (Capital markets and financial structure division, DG-E, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Juan Angel García (Capital markets and financial structure division, DG-E, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Thomas Werner (Corresponding author: Capital markets and financial structure division, DG-E, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper provides a toolkit for extracting accurate information about inflation expectations using inflation-linked bonds. First, we show how to estimate term structures of zero-coupon real rates and break-even inflation rates (BEIRs) in the euro area. This improves the analysis of developments in inflation expectations by providing constant maturity measures. Second, we show that seasonality in consumer prices introduces misleading and quantitatively important time-varying distortions in the calculated BEIRs. We explain how to correct for this in the estimation of the term structure, and thus provide a unified framework for extracting constant maturity BEIRs corrected for seasonality. JEL Classification: E31, E43, G12.
    Keywords: Term structure, break-even inflation rates, inflation-linked bonds, inflation seasonality.
    Date: 2007–11
  4. By: William Barnett (Department of Economics, The University of Kansas); John Keating (Department of Economics, The University of Kansas); Logan Kelly (School of Business and Economics, College of Charleston)
    Abstract: Measuring the economic stock of money, defined to be the present value of current and future monetary service flows, is a difficult asset pricing problem, because most monetary assets yield interest. Thus, an interest yielding monetary asset is a joint product: a durable good providing a monetary service flow and a financial asset yielding a return. The currency equilivant index provides an elegant solution, but it does so by making strong assumptions about expectations of future monetary service flows. These assumptions cause the currency equivalent index to exhibit significant downward bias. In this paper, we propose an extension to the currency equivalent index that will correct for a significant amount of this bias.
    Keywords: Currency Equilivant Index, Monetary Aggregation, Money Stock
    JEL: E49
    Date: 2007–11
  5. By: Aaron Mehrotra (Corresponding author: Bank of Finland, BOFIT, PO Box 160, 00101 Helsinki, Finland.); Tuomas Peltonen (European Central Bank, Directorate General International and European Relations, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Alvaro Santos Rivera (European Central Bank, Directorate General International and European Relations, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    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 forwardlooking 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. JEL Classification: E31, C22.
    Keywords: China, Inflation, Regional, New Keynesian Phillips Curve, GMM.
    Date: 2007–11
  6. By: Hongfei Sun (Queen's University); Xiuhua Huangfu (University of Sydney)
    Abstract: This paper studies bank runs in a model with coexistence of fiat money and private money. When fiat money is the only medium of exchange, there exist a bank run equilibrium and an equilibrium that achieves the optimal risk sharing. In contrast, when private money is also a medium of exchange, there exists a unique equilibrium where no one demands early withdrawals of fiat money and agents in need of liquidity only use private money to finance consumption. The unique equilibrium achieves the first-best outcome and eliminates bank runs without having resort to any government intervention.
    Keywords: private money, fiat money, bank runs
    JEL: E4 G2
    Date: 2007–12
  7. By: Oscar Bajo-Rubio (Universidad de Castilla-La Mancha and Instituto de Estudios Fiscales); Carmen Díaz-Roldán (Universidad de Castilla-La Mancha); Vicente Esteve (Universidad de Valencia)
    Abstract: Price determination theory typically focuses on monetary plicy, while the role of fiscal policy is ussually neglected. From a different point of view, the Fiscal Theory of Price Level takes into account monetary and fiscal policy interactions and assumes that fiscal policy may determine the price level, even if monetary authorities pursue an inflation targeting strategy. In this paper we try to test empirically whether the time path of the government budget in EMU countries would have affected price level determination. Our results point to the sustainability of fiscal policy in all the EMU countries but Finland, although no firm conclusions can be drawn about the prevalence of either monetary or fiscal dominance.
    Keywords: Fiscal Theory of the Price Level, monetary and fiscal dominance, central bank independence, fiscal solvency, inflation
    JEL: E62 H62 O52
    Date: 2007–04
  8. By: Kazuo Ueda (Faculty of Economics, University of Tokyo)
    Abstract: In this short note I review the Bank of Japan's monetary policy since its exit from the so-called quantitative easing regime early in 2006. The major characteristic of the policy stance during the period, called Strategy 2 below, has been to adjust the policy interest rate gradually upward in response to a healthy real economy despite stagnant behavior in consumer prices. Such a policy stance can be contrasted with a hypothetical strategy, Strategy 1, whereby the Bank of Japan would have kept the policy rate at lower levels, possibly at zero percent, until inflation starts to show an upward trend more clearly. The two strategies are compared on many fronts with particular attention to well-known recent empirical regularities about inflation -a smaller response of inflation to output and larger uncertainties about the response. Various comparisons of the two strategies offered here, though far from conclusive, tend to support Strategy 1 over Strategy 2. In my discussion of the two strategies I also comment on some of the major features of the Nishimura article in this issue.
    Date: 2007–12
  9. By: Peter Hördahl (Bank for International Settlements (BIS), Centralbahnplatz 2, CH-4002 Basel, Switzerland.); Oreste Tristani (Corresponding author, European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.); David Vestin (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: We show that microfounded DSGE models with nominal rigidities can be successful in replicating features of bond yield data which have previously been considered puzzling in general equilibrium frameworks. Consistent with empirical evidence, we obtain average holding period returns that are positive, increasing in maturity and sizable, as well as long-maturity bond yields that are almost as volatile as short-term interest rates. At the same time, we are able to fit sample moments of consumption and inflation relatively well. To improve our understanding of these results, we derive analytical solutions for yields that are valid up to a second order approximation and generally applicable, We demonstrate that the improved model performance does not arise directly from the presence of nominal rigidities: ceteris paribus, the introduction of sticky-prices in a simple model tend to reduce premia. Sticky prices help indirectly because they imply (short-run) monetary non-neutrality, so that the policy rule followed by the central bank affects consumption dynamics and the pricing of yields. A very high degree of “interest rate smoothing” in the policy rule is essential for our results. JEL Classification: E43, E44.
    Keywords: DSGE models, policy rules, term structure of interest rates, risk premia, second order approximations.
    Date: 2007–11
  10. By: David Meenagh (Cardiff University); Patrick Minford (Cardiff University / CEPR); Eric Nowell (University of Liverpool); Prakriti Sofat (IDEAglobal (Singapore)); Naveen Srinivasan (Indira Gandhi Institute of Development Research)
    Abstract: It has been widely argued that inflation persistence since WWII has been widespread and durable and that it can only be accounted for by models with a high degree of nominal rigidity. We examine UK post-war data and find that the varying persistence it reveals is largely due to changing monetary regimes and that models with moderate or even no nominal rigidity are best equipped to explain it.
    Date: 2007–07
  11. By: Pierre Siklos (Wilfrid Laurier University)
    Abstract: The Coyne affair is the greatest institutional crisis faced by the Bank of Canada in its history. The crisis took place in 1959-1961 and led to the resignation of the Governor, once he was cleared of any wrongdoing. The crisis eventually resulted in a major reform of the Bank of Canada. The paper highlights the critical role played by the directive in central banking legislation. Archival and empirical evidence is used to assess the performance of monetary policy throughout the 1950s. In doing so, a real-time dataset is constructed for both Canada and the US that permits estimation of reaction functions. I find that the case against James Coyne is \'not proven\'.
    Keywords: Coyne Affair; monetary policy stance; Taylor rules; real-time data
    JEL: N10 E52 E58 C52
    Date: 2007
  12. By: Benjamin Eden (Department of Economics, Vanderbilt University)
    Abstract: The welfare gains from adopting a zero nominal interest policy depend on the implementation details. Here I focus on a government loan program that crowds out lending and borrowing and other money substitutes. Since money can be costlessly created the resources spent on creating money substitutes are a "social waste". Moving from an economy with strictly positive nominal interest rate to an economy with zero nominal interest rate will increase consumption by the amount of resources spent on lending and borrowing. But in general welfare will increase by more than that because consumption smoothing is better under zero nominal interest rate.
    Keywords: Welfare cost of inflation, money substitutes, wealth redistribution, Friedman rule
    JEL: E42 E51 E52 E58 H20 H21 H26
    Date: 2007–11
  13. By: Kang Yong Tan (University of Oxford); David Vines (University of Oxford)
    Abstract: This paper analyses the effects of inflation shocks, demands shocks, and aid shocks on low-income, quasi-emerging-market economies, and discusses how monetary policy can be used to manage these effects. We make use of a model developed for such economies by Adam et al. (2007). We examine the e¤ects of four things which this model features, which we take to be typical of such economies. These are: the existence of a tradeables/non-tradeables production structure, the fact that international capital movements are - at least initially - confined to the effects of currency substitution by domestic residents, the use of targets for financial assets in the implementation of monetary policy, and the pursuit, in some countries, of a fixed exchange rate. We then modify the model to examine the effect on such economies of three major changes, changes which we take to be part of the transition by such economies towards more fully- fledged emerging-market status: an opening of the capital account so that uncovered- interest-parity comes to hold, a move to floating exchange rates, and the replacement of fixed stocks of financial aggregates by the pursuit of a Taylor rule in the conduct of monetary policy.
    Keywords: currency substitution, emerging market macroeconomics, interactions between fiscal and monetary policy, Taylor rule
    JEL: E5 E61 O11
    Date: 2007–07
  14. By: Meixing DAI; Eleftherios SPYROMITROS
    Abstract: Within a New Keynesian model subject to misspecification, we examine the quadratic contracts in a delegation framework where government and private agents are uncertain about central bank preferences for model robustness. We show that, in the case of complete transparency, the optimal penalty is decreasing in terms of the preference for robustness. In effect, a central bank reacts more aggressively to supply shocks when the model misspecification grows larger. Furthermore, beginning from the equilibrium of perfect transparency and assuming that the average preference for robustness is sufficiently high, the central bank has then an incentive to be less transparent in order to reduce the optimal penalty. Under similar conditions, we also find that greater opacity will increase inflation and output variability.
    Keywords: Walsh’s contract, robust control, model uncertainty, central bank transparency.
    JEL: E42 E52 E58
    Date: 2007
  15. By: Matthieu Darracq Pariès (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper analyzes the implications of price-setting and incomplete financial markets for optimal monetary cooperation. The main objective is to provide the basic intuitions concerning the role of the main international frictions on optimal policy within a simple Dynamic Stochastic General Equilibrium model. We concentrate on a symmetric two-country DSGE with home bias, incomplete financial markets internationally and imperfect competition together with nominal price rigidities in which the export prices can be denominated either in the producer currency (PCP) or in the consumer currency (LCP). In addition, the model can account both for efficient and inefficient shocks. Our main results are derived in polar cases with efficient steady state and for which the design of the optimal policy is specifically illustrative and can be expressed in terms of targeting rules. In particular, the paper gives some new insights on the optimal exchange rate regime given the structure of shocks and the exchange rate pass-through, as well as on the optimal stabilization of CPI and PPI inflation. We also put into perspective the implication of financial autarky on the optimal management of international spillovers. JEL Classification: E5, F4.
    Keywords: DSGE models, optimal monetary policy, new open economy macroeconomics.
    Date: 2007–11
  16. By: Hans Genberg (Research Department, Hong Kong Monetary Authority); Dong He (Research Department, Hong Kong Monetary Authority)
    Abstract: In this paper we show that monetary policy frameworks in the East Asia and Pacific region are heterogeneous, with exchange rate policies being subordinate to domestic price stability objectives in most regional economies. We then argue that in this environment it is undesirable to focus regional cooperation on exchange rate policies because of the risk of creating conflicts with domestic objectives that would lead to loss of central bank credibility and possibly speculative attacks. We also argue that the case for coordinated exchange rate policies is in fact weak, even after taking into account the region¡¦s traditional emphasis on export performance and increasing regional trade integration. Rather than focusing cooperation on the setting of policy instruments, we suggest an alternative that centres on developing more liquid financial markets in the region in the foreseeable future, and on harmonising the objectives of monetary policy and designing institutions that could form the basis of deeper forms of cooperation in the longer-term future.
    Keywords: Regional monetary cooperation, exchange rate coordination, East Asia
    JEL: E42 F33 F36
    Date: 2007–11
  17. By: Antonia Diaz; Fernando Perera-Tallo
    Abstract: Here we investigate the existence of credit in a cash-in-advance economy where there are complete markets but for the fact that agents cannot commit to repay their debts. Defectors are banned from the credit market but they can use money balances for saving purposes. Without uncertainty, deflation crowds out credit completely. The equilibrium allocation, however, is efficient if the government deflates at the time preference rate. Efficiency can also be restored with positive inflation. For any non negative inflation rate below the optimal level, the volume of credit and the real interest rate increase with inflation. Our results hold when idiosyncratic uncertainty is introduced and households are sufficiently impatient but in one instance: efficiency cannot be restored if the deflation rate is nearby the rate of time preference. Our numerical examples suggest that the optimal inflation rate is not too large for reasonable levels of patience and risk aversion. Finally, we present a framework where the use of money arises endogenously and show that it is tantamount to our cash-in-advance framework. Our results hold in this modified environment.
    Date: 2007–11
  18. By: Hongfei Sun (Queen's University)
    Abstract: This paper presents an integrated theory of money and banking. I address the following question: when both individuals and banks have private information, what is the optimal way to settle debts? I develop a dynamic model with micro-founded roles for banks and a medium of exchange. I establish two main results: first, markets can improve upon the optimal dynamic contract at the presence of private information. Market prices fully reveal the aggregate states and help solve the incentive problem of the bank. Secondly, it is optimal for the bank to require loans be settled with short-term inside money, i.e., bank money that expires immediately after the settlement of debts. Short-term inside money makes it less costly to induce truthful revelation and achieve more efficient risk sharing.
    Keywords: banking, inside money, outside money
    JEL: E4 G2
    Date: 2007–12
  19. By: D'Agostino, A; Whelan, K
    Abstract: Using data from the period 1970-1991, Romer and Romer (2000) showed that Federal Reserve forecasts of inflation and output were superior to those provided by commercial forecasters. In this paper, we show that this superior forecasting performance deteriorated after 1991. Over the decade 1992-2001, the superior forecast accuracy of the Fed held only over a very short time horizon and was limited to its forecasts of inflation. In addition, the performance of both the Fed and the commercial forecasters in predicting inflation and output, relative to that of "naive" benchmark models, dropped remarkably during this period.
    JEL: C53 E52
    Date: 2007–12
  20. By: Catherine R Schenk (University of Glasgow)
    Abstract: The ‘one country, two systems’ structure established to govern the relationship between Hong Kong SAR and Mainland China was an innovative and comprehensive solution to particular economic and political challenges posed by the return of Hong Kong to the PRC in 1997. At the time of the drafting of the Basic Law, the integration of the colony into the regional economy of Southeast China through outward FDI had already begun, and from the mid-1980s this process facilitated the transformation of the Hong Kong economy from a manufacturing base to one dominated by financial and commercial services. It was recognised on both sides of the negotiations that the territory’s viability and future prosperity relied on retaining independence over a range of key fundamentals, including a separate and independent currency and monetary system that was at the foundation of Hong Kong’s attraction as an international financial centre for the PRC and also for the rest of the Asian region. An important credibility mechanism for the HK$ (as for the inconvertible RMB at this time) was the exchange rate link to the US$. Since this was also the anchor for the RMB after 1997, the linked rate system kept the relationship between the RMB and the HK$ stable.
    Date: 2007–04
  21. By: Christopher Adam (University of Oxford); Stephen O’Connell (Swarthmore College); Edward Buffie (Indiana University; International Monetary Fund)
    Abstract: We examine the properties of alternative monetary policy rules in response to large aid surges in low-income countries characterized by incomplete capital market integration and currency substitution. Using a dynamic stochastic general equilibrium model, we show that simple monetary rules that stabilize the path of expected future seigniorage for a given aid flow have attractive properties relative to a range of conventional alternatives including those involving heavy reliance on bond sterilization or a commitment to a pure exchange rate float. These simple rules, which are shown to be robust across a range of fiscal responses to aid inflows, appear to be consistent with actual responses to recent aid surges in a range of post-stabilization countries in Sub-Saharan Africa.
    Keywords: Basle Committee, capital adequacy, financial governance, financial architecture, financial reform, international standards, capital flows, poor countries, cost of capital, international development
    Date: 2007–02
  22. By: Catherine Schenk (University of Glasgow); John Singleton (Victoria University of Wellington)
    Abstract: How did developing countries adapt to the collapse of the Bretton Woods system? Using new archival evidence, we argue that New Zealand offers an interesting case study of decision-making in a small economy dependent on primary production with close economic and political links to two larger partners – Britain and Australia – with divergent domestic policies. After some experimentation, New Zealand adopted an innovative intermediate solution for the exchange rate that aimed to generate stability for primary producers during a period when the direction of trade was diversifying and most currencies were floating. This imaginative policy was not accompanied by comparable changes in reserves management, and until 1975 New Zealand continued to hold the bulk of its reserves in sterling. The article explores the different priorities and institutional constraints affecting the choice of anchor currency and reserve currency in this context.
    Date: 2007–10
  23. By: Cho-Hoi Hui (Research Department, Hong Kong Monetary Authority); Tom Fong (Research Department, Hong Kong Monetary Authority)
    Abstract: The empirical results show that after the introduction of the three refinements to the Linked Exchange Rate system in May 2005 the Hong Kong dollar follows a bounded process that is consistent with a fully credible exchange rate band. The bounded process will limit the movements of the exchange rate to between the strong- and weak-side limits because its variance vanishes at the Convertibility Undertakings making it inaccessible to the limits. The Hong Kong dollar does not show any strong tendency to revert towards the centre of the Convertibility Zone. This is perhaps not surprising as there have been no interventions in the foreign exchange market since May 2005. There may be few forces or incentives for market participants to drive the exchange rate towards 7.80.
    Keywords: Linked Exchange Rate system, target zone, mean reversion, bounded process
    JEL: F31 G13
    Date: 2007–09

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