nep-mon New Economics Papers
on Monetary Economics
Issue of 2010‒06‒11
twenty-six papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Currency substitution in the economies of Central Asia: How much does it cost? By ISAKOVA, Asel
  2. Optimal Monetary Policy When Agents Are Learning By Krisztina Molnár; Sergio Santoro
  3. Monetary policy mistakes and the evolution of inflation expectations By Athanasios Orphanides; John C. Williams
  4. Monetary Policy Lessons from the Crisis By Athanasios Orphanides
  5. Monetary Policy Mistakes and the Evolution of Inflation Expectations By Athanasios Orphanides; John C. Williams
  6. The Extreme Risk Problem and Monetary Policies of the Euro-Candidates By Hubert Gabrisch; L. Orlowski
  7. Macrofoundations for A (Near) 2% Inflation Target By Faugere, Christophe
  8. Taylor rules and the Canadian-US equilibrium exchange rate By T. BERGER; B. KEMPA;
  9. Microfoundations of Inflation Persistence in the New Keynesian Phillips Curve By Marcelle, Chauvet; Insu, Kim
  10. Time-varying inflation expectations and economic fluctuations in the United Kingdom: a structural VAR analysis By Barnett, Alina; Groen, Jan J J; Mumtaz, Haroon
  11. A 2-Equation Model of the North Atlantic Economies, a Dynamic Panel Study By David Kiefer
  12. What Determine China’s Inflation? By Hua Xiuping
  13. Can the New Keynesian Phillips Curve Explain Inflation Gap Persistence? By Fang Yao
  14. Forecasting Money Supply in India: Remaining Policy Issues By Das, Rituparna
  15. Policy Reactions to the Financial Crisis in Japan: Lessons from the 1990s By Uwe Vollmer; Ralf Bebenroth
  16. Systemic risk in a network model of interbank markets with central bank activity By Co-Pierre Georg; Jenny Poschmann
  17. Exchange Rate Regimes and Macroeconomic Performance in South Asia By Ashima Goyal
  18. The current financial crisis, monetary policy and Minsky's structural instability hypothesis By Domenica Tropeano
  19. Regime-Shifts & Post-Float Inflation Dynamics In Australia By Neil Dias Karunaratne; Ramprasad Bhar
  20. Forecasting Realized Volatility with Linear and Nonlinear Models By Francesco Audrino; Marcelo Cunha Medeiros
  21. Cross-border banking and the international transmission of financial distress during the crisis of 2007-2008 By Alexander Popov; Gregory F. Udell
  22. Are Inflation Forecasts from Major Swedish Forecasters Biased? By Lundholm, Michael
  23. The Taylor Principle in a medium-scale macroeconomic model By Tommy Sveen; Lutz Weinke
  24. Readdressing the trade effect of the Euro: Allowing for currency misalignment By Hogrefe, Jan; Jung, Benjamin; Kohler, Wilhelm
  25. Official intervention in Foreign Exchange Market in Malawi: A comparison of GARCH and Equilibrium Exchange Rate approaches By Simwaka, Kisu; Mkandawire, Leslie
  26. Government deficit sustainability, and monetary versus fiscal dominance: The case of Spain, 1850-2000 By Oscar Bajo-Rubio; Carmen Díaz-Roldán; Vicente Esteve

  1. By: ISAKOVA, Asel (CERGE-EI, 11121 Praha 1, Czech Republic)
    Abstract: Underdeveloped financial markets and periods of high inflation have stimulated dollarization and currency substitution in the economies of Central Asia. Some authors argue that the latter can pose serious obstacles for the effective conduct of monetary policy and can affect households' welfare. This study uses a model with money-in-the-utility function to estimate the elasticity of substitution between domestic and foreign currencies in three economies of Central Asia - Kazakhstan, the Kyrgyz Republic and Tajikistan. Utility derived from holding money balances is represented by a CES function with money holdings denominated in two currencies. The residents are assumed to diversify their monetary holdings due to instability of the domestic currency. The steady state analysis reveals that though currency substitution decreases governments' seigniorage revenue, holding foreign money can be welfare generating if domestic currency depreciates vis-ˆ-vis the currencies in which households' foreign balances holdings are denominated. De-dollarization can only be achieved through further macroeconomic stabilization that will bring price and exchange rate stability. Financial sector development will also decrease currency substitution through the provision of reliable financial instruments and the gaining of public confidence.
    Keywords: currency substitution, dollarization, monetary policy, seigniorage, welfare, transition economies
    JEL: E58 P2 E41
    Date: 2010–04–01
  2. By: Krisztina Molnár (Norwegian School of Economics and Business Administration, and Norges Bank (Central Bank of Norway)); Sergio Santoro (Bank of Italy)
    Abstract: We derive the optimal monetary policy in a sticky price model when private agents follow adaptive learning. We show that this slight departure from rationality has important implications for policy design. The central bank faces a new intertemporal trade-off, not present under rational expectations: it is optimal to forego stabilizing the economy in the present in order to facilitate private sector learning and thus ease the future intratemporal inflation-output gap trade-offs. The policy recommendation is robust: the welfare loss entailed by the optimal policy under learning if the private sector actually has rational expectations is much smaller than if the central bank mistakenly assumes rational expectations when in fact agents are learning.
    Keywords: optimal monetary policy, learning, rational expectations
    JEL: C62 D83 D84 E52
    Date: 2010–05–27
  3. By: Athanasios Orphanides; John C. Williams
    Abstract: What monetary policy framework, if adopted by the Federal Reserve, would have avoided the Great Inflation of the 1960s and 1970s? We use counterfactual simulations of an estimated model of the U.S. economy to evaluate alternative monetary policy strategies. We show that policies constructed using modern optimal control techniques aimed at stabilizing inflation, economic activity, and interest rates would have succeeded in achieving a high degree of economic stability as well as price stability only if the Federal Reserve had possessed excellent information regarding the structure of the economy or if it had acted as if it placed relatively low weight on stabilizing the real economy. Neither condition held true. We document that policymakers at the time both had an overly optimistic view of the natural rate of unemployment and put a high priority on achieving full employment. We show that in the presence of realistic informational imperfections and with an emphasis on stabilizing economic activity, an optimal control approach would have failed to keep inflation expectations well anchored, resulting in highly volatile inflation during the 1970s. Finally, we show that a strategy of following a robust first-difference policy rule would have been highly successful in the presence of informational imperfections. This robust monetary policy rule yields simulated outcomes that are close to those seen during the period of the Great Moderation starting in the mid-1980s.
    Keywords: Monetary policy ; Inflation (Finance)
    Date: 2010
  4. By: Athanasios Orphanides (Central Bank of Cyprus)
    Abstract: This paper provides a policymaker's perspective on some lessons from the recent financial crisis. It focuses on questions in three areas. First, what lessons can be drawn regarding the institutional framework for monetary policy? Has the experience changed the pre-crisis consensus that monetary policy is best performed by an independent central bank focused on achieving and maintaining price stability? Second, what lessons can be drawn regarding the monetary policy strategy that should be followed by a central bank? How activist should a central bank be in dampening macroeconomic fluctuations? Should the "output gap" serve as an important policy guide? Are there lessons regarding the stability-oriented approach followed by the ECB? How activist should a central bank be in tackling perceived asset price misalignments? Does the ECB's monetary analysis pillar help incorporate the pertinent information in formulating policy? Third, is monetary policy pursuing price stability enough to ensure overall stability in the economy? Or is there room for improvement regarding how central banks can contribute to financial stability? Should the role of monetary policy be seen as completely separate from the broader istitutional environment governing financial markets and institutions in our economy? Or would greater central bank involvement in regulation and supervision pertaining to credit and finance allow better management of overall economic stability?
    Keywords: Great ¯nancial crisis, activist stabilisation policy, real-time output gap, robust simple rules, stability-oriented monetary policy, asset prices, macro-prudential supervision,financial stability, ECB.
    JEL: E50 E52 E58
    Date: 2010–05
  5. By: Athanasios Orphanides (Central Bank of Cyprus); John C. Williams (Federal Reserve Bank of San Francisco)
    Abstract: What monetary policy framework, if adopted by the Federal Reserve, would have avoided the Great Inflation of the 1960s and 1970s? We use counterfactual simulations of an estimated model of the U.S. economy to evaluate alternative monetary policy strategies. We show that policies constructed using modern optimal control techniques aimed at stabilizing inflation, economic activity, and interest rates would have succeeded in achieving a high degree of economic stability as well as price stability only if the Federal Reserve had possessed excellent information regarding the structure of the economy or if it had acted as if it placed relatively low weight on stabilizing the real economy. Neither condition held true. We document that policymakers at the time both had an overly optimistic view of the natural rate of unemployment and put a high priority on achieving full employment. We show that in the presence of realistic informational imperfections and with an emphasis on stabilizing economic activity, an optimal control approach would have failed to keep inflation expectations well anchored, resulting in highly volatile inflation during the 1970s. Finally, we show that a strategy of following a robust first-difference policy rule would have been highly successful in the presence of informational imperfections. This robust monetary policy rule yields simulated outcomes that are close to those seen during the period of the Great Moderation starting in the mid-1980s.
    Keywords: Great Inflation, rational expectations, robust control, model uncertainty, natural rate of unemployment
    JEL: E52
    Date: 2010–05
  6. By: Hubert Gabrisch; L. Orlowski
    Abstract: We argue that monetary policies in euro-candidate countries should also aim at mitigating excessive instability of the key target and instrument variables of monetary policy during turbulent market periods. Our empirical tests show a significant degree of leptokurtosis, thus prevalence of tail-risks, in the conditional volatility series of such variables in the euro-candidate countries. Their central banks will be well-advised to use both standard and unorthodox (discretionary) tools of monetary policy to mitigate such extreme risks while steering their economies out of the crisis and through the euroconvergence process. Such policies provide flexibility that is not embedded in the Taylor-type instrument rules, or in the Maastricht convergence criteria.
    Keywords: monetary policy rules, tail-risks, convergence to the euro, global financial crisis, equity market risk, interest rate risk, exchange rate risk
    JEL: E44 F31 G15 P34
    Date: 2010–05
  7. By: Faugere, Christophe
    Abstract: Economists have argued that a long-term inflation target near 2% is optimal (Summers, 1991; Fischer, 1996; Goodfriend, 2002; Coenen et al., 2003; Bernanke, 2003). However, these arguments are really about why a low positive inflation rate is ideal to avoid a deflationary trap, not explaining why the specific value of 2% (or a value near it) happens to be the optimal long-run inflation rate. In line with the transaction motive literature (Baumol, 1952 and Tobin, 1956), I postulate that new forms of money and technological progress generate cost savings in the transaction technology by comparison to barter. I derive the optimal velocity of money, which depends on real GDP/capita and the net return on depository institutions’ assets. As long as progress is on average biased towards new forms of money, the velocity of money will grow at a pace slower than long-term real GDP/capita growth; i.e. less than 2%. The empirical tests using Johansen’s (1995) VECM approach for the U.S. over the period 1959-2007 confirm that this is indeed the case. Along with a parameter representing the type of bias in the technical progress affecting transactions, the depository institutions’ overall mean leverage ratio also appears as a key parameter in the long-run equilibrium equation describing the behavior of the velocity of narrow money (M1, M1RS and M1S). I show that a ‘naïve’ Friedman k-percent monetary rule that aims at growing the money supply at the same rate as real GDP naturally leads to a rate of inflation equal to the rate of velocity growth. Hence, setting an inflation target near but below 2% makes economic sense. In spite of previously held beliefs, a money growth objective is compatible with an interest-targeting objective; i.e. a derived Taylor (1993) type rule. A Taylor rule that embeds the optimal inflation target defined here is more flexible to account for possible changes in velocity vs. a pure money growth rule.
    Keywords: Inflation target; velocity of narrow money; M1; M1RS; M1S; real GDP per capita growth; barter; financial leverage
    JEL: E40
    Date: 2010–06
  8. By: T. BERGER; B. KEMPA;
    Abstract: This paper identifies the Canadian-US equilibrium exchange rate based on a simple structural model of the real exchange rate, in which monetary policy follows a Taylor rule interest rate reaction function. The equilibrium exchange rate is explained by relative output and inflation as observable variables, and by unobserved equilibrium rates as well as unobserved transitory components in output and the exchange rate. Using Canadian data over 1974- 2008 we jointly estimate the unobserved components and the structural parameters using the Kalman filter and Bayesian technique. We find that Canada's equilibrium exchange rate evolves smoothly and follows a trend depreciation. The transitory component is found to be very persistent but much more volatile than the equilibrium rate, resulting in few but prolonged periods of currency misalignments.
    Keywords: equilibrium exchange rate, unobserved components, Kalman filter, Bayesian analysis, Importance sampling
    Date: 2010–02
  9. By: Marcelle, Chauvet; Insu, Kim
    Abstract: This paper proposes a dynamic stochastic general equilibrium model that endogenously generates inflation persistence. We assume that although firms change prices periodically, they face convex costs that preclude optimal adjustment. In essence, the model assumes that price stickiness arises from both the frequency and size of price adjustments. The model is estimated using Bayesian techniques and the results strongly support both sources of price stickiness in the U.S. data. In contrast with traditional sticky price models, the framework yields inflation inertia, delayed effect of monetary policy shocks on inflation, and the observed "reverse dynamic" correlation between inflation and economic activity.
    Keywords: In Inflation Persistence; Phillips Curve; Sticky Prices; Convex Costs
    JEL: E30 E31
    Date: 2010–05
  10. By: Barnett, Alina (Bank of England); Groen, Jan J J (Federal Reserve Bank of New York); Mumtaz, Haroon (Bank of England)
    Abstract: This paper examines how the interaction between inflation expectations and nominal and real macroeconomic variables has evolved for the United Kingdom over the post-WWII period until 2007. We model time-variation through a Markov-switching structural vector autoregressive framework with variants of the sign restriction identification scheme to back out the time-varying effect of different structural shocks. We investigate the following questions: (i) How has the impact of the mix of real and nominal shocks on the UK economy evolved over time and did this have a specific impact on UK inflation expectations? and (ii) Has there been an autonomous impact of inflation expectations on the UK economy and has it changed over time? Our results suggest that shocks to inflation expectations had important effects on actual inflation in the 1970s, but this impact had significantly declined towards the end of our sample. This seems to be mainly due to a relatively slower response of monetary policy to these shocks in the 1970s compared to later years. Similarly, oil price shocks and real demand shocks led to important changes in macroeconomic variables in the 1970s. Beyond that period and up to the end of our sample oil price shocks became less significant for the dynamics of actual inflation and output growth. However real demand shocks became a relatively more important determinant for fluctuations in those series during the 1990s and the beginning of the 2000s. The changing response of monetary policy to this type of shock appears to be crucial for this result.
    Keywords: Inflation expectations; Markov-switching structural VAR
    JEL: C10 E50
    Date: 2010–06–03
  11. By: David Kiefer
    Abstract: Carlin and Soskice (2005) advocate a 3-equation model of stabilization policy to replace the conventional IS-LM-AS model. One of their new equations is a monetary reaction rule MR derived by assuming that governments have performance objectives, but are constrained by an augmented Phillips curve PC. They label their replacement model the IS-PC-MR. Central banks achieve the PC-MR solution by setting interest rates along an IS curve. Observing that governments have more tools than just the interest rate, we simplify their model to 2 equations. We develop a state space econometric specification as the solution of these equations, adding a random walk model of the unobserved potential growth. Applying this method to a panel of North Atlantic countries, we find it historically consistent with a few qualifications. For one, governments are more likely to target growth rates, than output gaps. And, inflation expectations are more likely backward looking, than rational, but a two-step estimation based on a forward-looking sticky-price model dramatically improves the empirical fit. Significant interdependence can be seen in the between-country covariance of inflation and growth shocks.
    Keywords: new Keynesian, Kalman filtering, open economies
    JEL: E61 E63
    Date: 2010–06
  12. By: Hua Xiuping (China Center for Economic Research)
    Abstract: We examine determinants of inflation in China. Analyses of both year‐on‐year and month‐on‐month growth data confirm excess liquidity, output gap, housing prices and stock prices positively affecting inflation. Impulse response analyses indicate that most effects occur during the initial five months and disappear after 10 months. Effects of real interest rates and exchange rates on inflation are relatively weak. Our results suggest that output gap is as important as excess liquidity in explaining inflation trajectory. The central bank should closely monitor asset prices given their spillovers to inflation. Currently liquidity measures are still central for controlling inflation, but further liberalization of interest rates and exchange rates are critical.
    Keywords: China, inflation, excess liquidity, output gap and asset prices
    JEL: E31 E58 G12 R20
    Date: 2010
  13. By: Fang Yao
    Abstract: Whelan (2007) found that the generalized Calvo-sticky-price model fails to replicate a typical feature of the empirical reduced-form Phillips curve - the positive dependence of inflation on its own lags. In this paper, I show that it is the 4-period-Taylor-contract hazard function he chose that gives rise to this result. In contrast, an empirically-based aggregate price reset hazard function can generate simulated data that are consistent with inflation gap persistence found in US CPI data. I conclude that a non-constant price reset hazard plays a crucial role for generating realistic inflation dynamics.
    Keywords: Inflation gap persistence, Trend inflation, New Keynesian Phillips curve, Hazard function
    JEL: E12 E31
    Date: 2010–06
  14. By: Das, Rituparna
    Abstract: This article analyzes the issues, unaddressed in the contemporary econometric literature on forecasting money supply in India, with the help of the relevant studies. In doing so there is an attempt to ascertain what could be the best fit model to forecast money supply in India.
    Keywords: Interest Rate; Forecast; Money Supply; Assets; Deregulation; Market
    JEL: E47
    Date: 2010
  15. By: Uwe Vollmer (University of Leipzig, Economics Department, Institute for Theoretical Economics); Ralf Bebenroth (Research Institute for Economics and Business Administration)
    Abstract: We describe the propagation of the recent financial crisis to Japan and compare current monetary policy reactions by the Bank of Japan (BoJ) with actions taken during the 1990s and with current policy reactions by other major central banks. First, we review the recent literature on the origins and propagation mechanisms of financial crises. Then, we ask how the financial crisis was transmitted to Japan and describe the policy responses by BoJ. We proceed and ask what lessons have been learned by other central banks from the financial crisis of the 1990s.
    Keywords: Financial crisis · Quantitative/qualitative easing · Exit strategy · Japan
    JEL: G21 E42 E52
    Date: 2010–05
  16. By: Co-Pierre Georg (Graduate School "Global Financial Markets - Stability and Change", Friedrich-Schiller-Universität Jena); Jenny Poschmann (School of Economics and Business Administration, Friedrich-Schiller-Universität Jena)
    Abstract: The breakdown of the interbank money markets in the face of the recent financial crisis has forced central banks and governments to take extraordinary measures to sustain financial stability. In this paper we investigate which influence central bank activity has on interbank markets. In our model, banks optimize a portfolio of risky investments and riskless excess reserves according to their risk and liquidity preferences. They are linked via interbank loans and face a stochastic supply of household deposits. We then introduce a central bank into the model and show that central bank activity enhances financial stability. We model the default of a large bank and analyse the resulting contagion effects. This is compared to a common shock that hits banks who have invested in similiar assets. Our results indicate that common shocks are not subordinate to contagion effects, but are instead the greater threat to systemic stability.
    Keywords: systemic risk, interbank markets, monetary policy, contagion, common shocks
    JEL: C63 E52 E58 G21
    Date: 2010–06–01
  17. By: Ashima Goyal (Indira Gandhi Institute of Development Research)
    Abstract: Stylized facts for South Asia show the dominance of supply shocks, amplified by macroeconomic policies and procyclical current accounts. Interest and exchange rate volatility rose initially on liberalization, but fell as markets deepened. A gradual middling through approach to openness and market development are helping the region absorb shocks without reducing growth. Diverse sources of demand, flexible exchange rates, robust domestic savings, and changing political preferences are contributing. Countercyclical policy more suited to structure, and removal of distortions raising costs, would allow better coordination of monetary and fiscal polices to further support the process.
    Keywords: South Asia, supply shocks, flexible exchange rates, diversity, distortions
    JEL: E3 E63 O11
    Date: 2010
  18. By: Domenica Tropeano (University of Macerata)
    Abstract: <p>In the paper it is argued that Minsky's theory of financial fragility, interpreted as a the-<br />ory of structural instability, is useful to interpret the current crisis. Structural instability<br />means that a small event can change the qualitative characteristic of a system and thus<br />even its dynamic properties. As Minsky wrote, beyond the uncertainty arising from ex-<br />pected inflows and outflows what matters is the state of markets when people need to take<br />positions in them. Before the financial crisis, though many agents were speculative and<br />Ponzi ones, the extreme liquidity of the markets has allowed them to operate quietly for a<br />long time. When the crisis exploded a tiny increase in the bankruptcy rate of mortgages<br />caused the breakdown of the whole financial system. The qualitative change that followed<br />in this case was the destruction of markets. Monetary policy had to use unusual tools<br />in order to cope with this event. The Federal Reserve however has changed its operating<br />procedures to overcome this problem to overcome this problem only late, as the financial<br />crisis had already propagated to the real sector. Thus the paper concludes that the Federal<br />Reserve did not perceive the potential danger for systemic stability of a huge unregulated<br />short term money market and did not switch promptly enough to the new measures once<br />the crisis started.</p>
    Date: 2010–04
  19. By: Neil Dias Karunaratne; Ramprasad Bhar (School of Economics, The University of Queensland)
    Abstract: Australia’s inflation rate and inflation uncertainty during the post-float era 1983Q3-2006Q4 have acted as important barometers of Australia’s macroeconomic performance. The conceptualisation and measurement of the nexus between inflation and inflation uncertainty is subject to complex dynamics. We use Markov regime switching heteroscedasticity (MRSH) model to capture long-run stochastic trend and short-run noisy components. This allows us to conclude that in post-float Australia the results deviate significantly from the mainstream Friedman paradigm on inflation and its uncertainty. We also critically review the plausibility of rival paradigm explaining this paradoxical behaviour. The regime shifts detected in the inflation dynamics appear to be linked to the macroeconomic policies pursued to achieve external and internal balance as implied by Keynesian Mundell-Fleming model.
    Date: 2010
  20. By: Francesco Audrino (University of St. Gallen); Marcelo Cunha Medeiros (Department of Economics PUC-Rio)
    Abstract: In this paper we propose a smooth transition tree model for both the conditional mean and variance of the short-term interest rate process. The estimation of such models is addressed and the asymptotic properties of the quasi-maximum likelihood estimator are derived. Model specification is also discussed. When the model is applied to the US short-term interest rate we find (1) leading indicators for inflation and real activity are the most relevant predictors in characterizing the multiple regimes’ structure; (2) the optimal model has three limiting regimes. Moreover, we provide empirical evidence of the power of the model in forecasting the first two conditional moments when it is used in connection with bootstrap aggregation (bagging).
    Keywords: short-term interest rate, regression tree, smooth transition, conditional variance, bagging, asymptotic theory
    Date: 2010–03
  21. By: Alexander Popov (European Central Bank, Financial Research Division, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Gregory F. Udell
    Abstract: We study the effect of financial distress in foreign parent banks on local SME financing in 14 central and eastern European countries during the early stages of the 2007-2008 financial crisis. We use survey data on applicant and non-applicant firms that enable us to disentangle effects driven by shocks to the banking system from recession-driven demand shocks that may vary across lenders. We find strong evidence that credit tightened in the relatively early stages of the crises caused by the following types of bank financial distress: 1) low equity ratio; 2) low Tier 1 capital ratio; and 3) losses on financial assets. We also find that foreign banks transmit to Main Street a larger portion of similar financial shocks than domestic banks. The observed decline in credit is greater among high-risk firms and firms with fewer tangible assets. JEL Classification: E44, E51, F34, G21.
    Keywords: credit crunch, financial crisis, bank lending channel, business lending.
    Date: 2010–06
  22. By: Lundholm, Michael (Dept. of Economics, Stockholm University)
    Abstract: Inflation forecasts made 1999-2005 by Sveriges Riksbank and Konjunkturinstitet of Swedish inflation rates 1999-2007 are tested for unbiasedness; i.e., are the mean forecast errors zero? The bias is in the order of -0.1 percentage units for horizons below one year and in the order of 0.1 and 0.6 (depending on inflation measure) above one year. Using the maximum entropy bootstrap for inference bias is significant whereas inference using HAC indicates insignificance.
    Keywords: Forecast evaluation; inflation; unbiasedness; maximum entropy bootstrap
    JEL: E37
    Date: 2010–06–03
  23. By: Tommy Sveen (Norges Bank (Central Bank of Norway)); Lutz Weinke (Humboldt-Universität zu Berlin)
    Abstract: The Taylor Principle is often used to explain macroeconomic stability (see, e.g., Clarida et al. 2000). The reason is that this simple principle guarantees determinacy, i.e., local uniqueness of rational expectations equilibrium, in many New Keynesian models. However, analyses of determinacy are generally conducted in the context of highly stylized models. In the present paper we use a medium-scale model which combines features that have been shown to explain fairly well postwar U.S. business cycles. Our main result demonstrates that the stability properties of forward-looking interest rate rules are very similar to the corresponding outcomes under current-looking rules. This is in stark contrast with many findings that have been obtained in the context of models whose empirical relevance is limited.
    Keywords: Nominal Rigidities, Real Rigidities, Monetary Policy
    JEL: E22 E31
    Date: 2010–05–28
  24. By: Hogrefe, Jan; Jung, Benjamin; Kohler, Wilhelm
    Abstract: We know that euro-area member countries have absorbed asymmetric shocks in ways that are inconsistent with a common nominal anchor. Based on a reformulation of the gravity model that allows for such bilateral misalignment, we disentangle the conventional trade cost channel and trade effects deriving from 'implicit currency misalignment'. Econometric estimation reveals that the currency misalignment channel exerts a significant trade effect on bilateral exports. We retrieve country specific estimates of the euro effect on trade based on misalignment. This reveals asymmetric trade effects and heterogeneous outlooks across countries for the costs and benefits from adopting the euro. --
    Keywords: Euro,gravity model,exchange rates,purchasing power parity,trade imbalances
    JEL: F12 F13 F15
    Date: 2010
  25. By: Simwaka, Kisu; Mkandawire, Leslie
    Abstract: The Malawi kwacha was floated in February 1994. Since then, the Reserve Bank of Malawi (RBM) has periodically intervened in the foreign exchange market. This report analyses the effectiveness of foreign exchange market interventions by RBM. We used a generalized autoregressive conditional heteroskedastic (GARCH; 1, 1) model to simultaneously estimate the effect of intervention on the mean and volatility of the kwacha. We also ran an equilibrium exchange rate model and use the equilibrium exchange rate criterion to compare results with those from the GARCH model. Using monthly exchange rates and official intervention data from January 1995 to June 2008, results from the GARCH model indicated that net sales of United States dollars by RBM depreciate, rather than appreciate, the kwacha. Empirically, this implies the RBM “leans against the wind”, i.e., the RBM intervenes to reduce, but not reverse, around-trend exchange rate depreciation. However, results from the GARCH model for the post-2003 period indicated that RBM intervention in the market stabilizes the kwacha. In general, results from both the GARCH model and the real equilibrium exchange rate criterion for the entire study period showed that RBM interventions have been associated with increased exchange rate volatility, except during the post-2003 period. The implication of this finding is that intervention can only have a temporary influence on the exchange rate, as it is difficult to find empirical evidence showing that intervention has a long-lasting, quantitatively significant effect.
    Keywords: foreign exchange market; official intervention; GARCH; equilibrium exchange rate
    JEL: E51 E58 E52 E50
    Date: 2010–04–15
  26. By: Oscar Bajo-Rubio (Universidad de Castilla-La Mancha); Carmen Díaz-Roldán (Universidad de Castilla-La Mancha); Vicente Esteve (Universidad de Valencia y Universidad de La Laguna)
    Abstract: In this paper, we provide a test of the sustainability of the Spanish government deficit over the period 1850-2000, and examine the role played by monetary and fiscal dominance in order to get fiscal solvency. The longer than usual span of the data would allow us to obtain some more robust results on the fulfilling of the intertemporal budget constraint than in most of previous analyses. First, we analyze the relationship between primary surplus and debt, following the recent critique of Bohn (2007), and investigate the possibility of structural changes occurring along the period by means of the new approach of Kejriwal and Perron (2008). The analysis is complemented in two directions: (i) performing Granger-causality tests in order to distinguish properly between a fiscal dominant and a monetary dominant regime; and (ii) presenting the impulse-response functions of debt to innovations in the primary surplus, through the approach of Canzoneri, Cumby and Diba (2001).
    Keywords: Fiscal policy, Sustainability, Fiscal Theory of the Price Level, Monetary dominance, Fiscal dominance.
    JEL: E62 H62
    Date: 2010–06

This nep-mon issue is ©2010 by Bernd Hayo. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.