nep-mon New Economics Papers
on Monetary Economics
Issue of 2010‒07‒10
eighteen papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Financial Crisis, Global Liquidity and Monetary Exit Strategies By Ansgar Belke
  2. Real-time Optimal Monetary Policy with Undistinguishable Model Parameters and Shock Processes Uncertainty By Alessandro Flamini; Costas Milas
  3. Optimal Monetary Policy with Non-Zero Net Foreign Wealth By Mykhaylova, Olena
  4. Monetary equilibrium with decentralized trade and learning By Araujo, Luis; Camargo, Braz
  5. Does Inflation Targeting Improve Fiscal Discipline? An Empirical Investigation By Rene TAPSOBA
  6. Crisis? What Crisis? Currency vs. Banking in the Financial Crisis of 1931 By Albrecht Ritschl; Samad Salferaz
  7. Determinants of Time-Varying Sensitivity of MENA Countries to Global Shocks: A State Space Approach By Bedri Kamil Onur Tas
  8. Liquidity Risk, Credit Risk and the Overnight Interest Rate Spread: A Stochastic Volatility Modelling Approach By John Beirne; Guglielmo Maria Caporale; Nicola Spagnolo
  9. Monetary Policy and Commodity Prices: an endogenous analysis using an SVAR approach By Luz Adriana Flórez
  10. On European monetary integration and the persistence of real effective exchange rates By Robinson Kruse
  11. Interbank overnight interest rates - gains from systemic importance By Q. Farooq Akram; Casper Christophersen
  12. Search-Theoretic Money, Capital and International Exchange Rate Fluctuations By Gomis-Porqueras, Pere; Kam, Timothy; Lee, Junsang
  13. Monetary policy and country risk By Kuhl Teles, Vladimir; P. Andrade, Joaquim
  14. Currency Unions in Prospect and Retrospect By J. M. C. Santos Silva; Silvana Tenreyro
  15. Micro-based estimates of heterogeneous pricing rules: the united states vs. The euro area By Luis J. Álvarez; Pablo Burriel
  16. Bad money and distributive conflict By Angel Asensio
  17. Regionality Revisited: An Examination of the Direction of Spread of Currency Crisis By Amil Dasgupta; Leon-Gonzalez; Roberto; Anja Shortland
  18. Devaluation of the Rupee: Tale of Two Years, 1966 and 1991 By Devika Johri; Mark Miller

  1. By: Ansgar Belke
    Abstract: We develop a roadmap of how the ECB should further reduce the volume of money (money supply) and roll back credit easing in order to prevent inflation. The exits should be step-by-step rather than one-off . Communicating about the exit strategy must be an integral part of the exit strategy. Price stability should take precedence in all decisions. Due to vagabonding global liquidity, there is a strong case for globally coordinating monetary exit strategies. Given unsurmountable practical problems of coordinating exit with asymmetric country interests, however, the ECB should go ahead – perhaps joint with some Far Eastern economies. Coordination of monetary and fiscal exit would undermine ECB independence and is also technically out of reach within the euro area.
    Keywords: Exit strategies; international policy coordination and transmission; open market operations; unorthodox monetary policy
    JEL: E52 E58 F42 E63
    Date: 2010–04
  2. By: Alessandro Flamini (Department of Economics, The University of Sheffield); Costas Milas
    Abstract: This paper studies optimal real-time monetary policy when the central bank takes the exogenous volatility of the output gap and inflation as proxy of the undistinguishable uncertainty on the exogenous disturbances and the parameters of its model. The paper shows that when the exogenous volatility surrounding a specific state variable increases, the optimal policy response to that variable should increase too, while the optimal response to the remaining state variables should attenuate or be unaffected. In this way the central bank moves preemptively to reduce the risk of large deviations of the economy from the steady state that would deteriorate the distribution forecasts of the output gap and inflation. When an empirical test is carried out on the US economy the model predictions tend to be consistent with the data.
    Keywords: Multiplicative uncertainty, Markov jump linear quadratic systems, optimal monetary policy
    JEL: C51 C52 E52 E58
    Date: 2010–06
  3. By: Mykhaylova, Olena
    Abstract: I study the impact of net foreign wealth on the optimal monetary policy of an open economy in a two-country DSGE model with incomplete markets, sticky prices and deviations from the Law of One Price. I find that by optimally manipulating monetary policy, central banks can affect the timing of interest receipts (or payments) and therefore increase the risk-sharing role of the internationally traded asset. In particular, debtor nations find it optimal to allow their currency to float relatively more freely than do creditor nations. In order to maximize consumer welfare, in most specifications of the model central bank should target a weighted average of CPI inflation and changes in the nominal exchange rate.
    Keywords: Optimal monetary policy; welfare; open economy; net foreign wealth.
    JEL: F34 F32 E52 E44
    Date: 2010–07–01
  4. By: Araujo, Luis; Camargo, Braz
    Abstract: This paper analyzes the stability of monetary regimes in an economy where fiat money isendogenously created by the government, information about its value is imperfect, and learningis decentralized. We show that monetary stability depends crucially on the speed of informationtransmission in the economy. Our model generates a dynamic on the acceptability of fiat moneythat resembles historical accounts of the rise and eventual collapse of overissued paper money.It also provides an explanation of the fact that, despite its obvious advantages, the widespreaduse of fiat money is only a recent development.
    Date: 2010–06–25
  5. By: Rene TAPSOBA (Centre d'Etudes et de Recherches sur le Développement International)
    Abstract: Based on panel data of 58 countries, of which 22 Inflation Targeters and 36 non Inflation Targeters, over the period 1980-2003, this paper highlights the effect of Inflation Targeting – IT- on Fiscal Discipline –FD-. We make four contributions to the literature. Firstly, by applying the 2SLS on the data, we estimate the effect of IT on central government FD as measured by Structural Primary Fiscal Balances. Secondly, we found that the effect of IT on FD takes place only on the Developing Countries sub-sample. Thirdly, the positive effect of IT on FD is stronger when the Central Bank –CB- adopts "Partial" IT rather than Full-Fledged IT –FFIT-. Fourthly, the positive effect of IT on FD is heterogeneous: it is conditional to the degree of CB independence, the level of financial deepening, the instability in the terms of trade and the length of exposure to IT -the effect is not immediate but cumulative over time-. Our results are robust to alternative specifications - using Propensity Score Matching Method, "System GMM" estimator, LAD estimator and applying 2SLS on annual data rather than triennial averages data- Our results could contribute importantly to the debate about the relevance of IT adoption by Developing Countries -due to their bad fiscal stances-.The results suggest that these countries could successfully adopt IT and improve their fiscal stances, provided that they adopt it gradually, establish flexible framework allowing them to react temporally to short-term external shocks and accompanies it with a greater independence of their CB and a deepening of their financial systems.
    Keywords: Inflation Targeting, Fiscal Discipline, Central Bank, Monetary Policy, Fiscal Policy, Public Debt Monetization, Developing Countries.
    JEL: E63 E62 E58 E52
    Date: 2010
  6. By: Albrecht Ritschl; Samad Salferaz
    Abstract: This paper examines the role of currency and banking in the German financial crisis of 1931for both Germany and the U.S. We specify a structural dynamic factor model to identifyfinancial and monetary factors separately for each of the two economies. We find thatmonetary transmission through the Gold Standard played only a minor role in causing andpropagating the crisis, while financial distress was important. We also find evidence of crisispropagation from Germany to the U.S. via the banking channel. Banking distress in botheconomies was apparently not endogenous to monetary policy. Results confirm Bernanke's(1983) conjecture that an independent, non-monetary financial channel of crisis propagationwas operative in the Great Depression.
    Keywords: Great Depression, 1931 financial crisis, international business cycle transmission,Bayesian factor analysis, currency, banking
    JEL: N12 N13 E37 E47 C53
    Date: 2010–05
  7. By: Bedri Kamil Onur Tas (TOBB ETU Department of Economics)
    Abstract: This paper examines whether the mechanism by which global shocks are transmitted into MENA countries changes over time. Three main questions are investigated by implementing TVC-VAR methodology. 1) Do MENA countries respond differently to global economic shocks? 2) Do the reactions of countries to global economic shocks vary over time? 3) What are the structural factors that determine the sensitivity of a country to global shocks? The responses of countries to shocks, to global GDP and oil price are investigated. The empirical results indicate that the reaction of countries to global shocks differs significantly among MENA countries. Also, the response of an individual country varies over time. Finally, economic factors like the exchange rate regime, monetary policy, transparency of the central bank and institutional quality play significant roles in the reaction of domestic GDP to shocks, to global GDP and oil price. The results of this paper have significant policy implications especially for AGCC countries.
    Date: 2010–06
  8. By: John Beirne; Guglielmo Maria Caporale; Nicola Spagnolo
    Abstract: In this paper we model the volatility of the spread between the overnight interest rate and the central bank policy rate (the policy spread) for the euro area and the UK during the two main phases of the financial crisis that began in late 2007. During the crisis, the policy spread exhibited signs of volatility, owing to the breakdown in interbank market activity. The determinants of this volatility are assessed using Stochastic Volatility models to gauge the role played by liquidity risk, credit risk (financial and sovereign), and interest rate expectations. Our results suggest that liquidity risk is the main determinant of the volatility of the policy spread, but also that private bank credit risk has become more apparent in the post-Lehman collapse phase of the crisis for the euro area as financial CDS premia rose due to possible default fears. In addition, the ECB appears to have been more effective in addressing liquidity risk since the onset of the crisis, and this may be related to its greater direct access to a broader range of counterparties and its acceptance of a broader range of eligible collateral. The main implication is that, in crisis times, a sufficiently flexible operational framework for monetary policy implementation produces the most timely response to market tensions.
    Keywords: Overnight Interest Rate Spread, Liquidity Risk, Credit Risk, Stochastic Volatility
    JEL: C32 E52 E58
    Date: 2010
  9. By: Luz Adriana Flórez
    Abstract: This work analyzes the relationship between real interest rates and commodity prices. According to Frankel’s hypothesis (1986-2006): “low real interest rates lead to high real commodity prices”. However, some empirical evidence suggests that commodity prices can predict monetary policy. In this way, there is an endogeneity between commodity prices and monetary policy. Using Frankel’s model we include a Taylor rule equation in this theoretical model, which let us analyze the endogeneity problem. In order to find empirical support of this model, we estimate SVAR and, using quarterly data from 1962:Q1 to 2009:Q1, we find that the overshooting of commodity prices to 1% increase of real interest rate can be a minimum of 2.86% and a maximum of 5.97% depending on the chosen model. The increase of real interest rate given a 1% increase in commodity prices is positive and significant but of small magnitude (0.20% - 0.05%).
    Date: 2010–06–27
  10. By: Robinson Kruse (Aarhus University, School of Economics and Management, CREATES)
    Abstract: This paper deals with the possibility of changing persistence in European real effective exchange rates as initially analyzed by Gadea and Gracia (2009). By applying a CUSUM of squares-based test for constant versus changing persistence with desirable statistical properties, an OECD data set is reconsidered. The empirical results suggest that persistence remains constant over time for nearly all time series. Thus, European monetary integration has not affected the persistence of external competitiveness significantly. Moreover, strong evidence for non-stationarity is found. Explanations for the sharp contrast of new results towards the ones by Gadea and Gracia (2009) are provided.
    Keywords: Changing persistence, unit roots, structural breaks, European monetary integration
    JEL: C22 E61 F31 F42
    Date: 2010–03–01
  11. By: Q. Farooq Akram (Norges Bank (Central Bank of Norway)); Casper Christophersen (Norges Bank (Central Bank of Norway))
    Abstract: We study overnight interbank interest rates paid by banks in Norway over the period 2006-2009. We observe large variations in interest rates across banks and over time. During the financial crisis, the interest rates are found to be substantially below indicative quotes of interest rates provided by major banks. Our econometric model attributes the interest rate variation partly to differences in banks' characteristics including relative size and connectedness, implying favorable terms for banks of systemic importance. Moreover, interest rates are found to depend not only on overall liquidity in the interbank market, but possibly on its distribution among banks as well, suggesting exploitation of market power by banks with surplus liquidity. There is also evidence of stronger effects on interest rates of systemic importance, credit ratings and liquidity demand and supply since the start of the current financial crisis.
    Keywords: Interbank money market, Interest rates, Systemic importance
    JEL: G21 E42 E43 E58
    Date: 2010–06–30
  12. By: Gomis-Porqueras, Pere; Kam, Timothy; Lee, Junsang
    Abstract: In this paper we develop a two-country global monetary economy where a monetary equilibrium exists because of fundamentaldecentralized trade frictions ? a Lagos-Wright search and matching friction. In the decentralized markets (DM), the terms of trade can be determined either by bargaining or by competitive price taking (baseline model). We show that the baseline model is capable of generating quite realistic real and nominal exchange rate volatility observed in the data, without relying on more ad-hoc sticky price assumptions commonly used in the international macroeconomics literature. The key mechanism lies in the role of search and matching frictions and a primitive technological assumption ? that capital is also a complementary input to production in the DM. This creates an internal propagation mechanism by modifying asset-pricing relations and relative price dynamics in the model.
    Keywords: Search-theoretic Money, Open Economy, Real Exchange Rate Puzzle
    JEL: E31 E32 E43 E44
    Date: 2010–06
  13. By: Kuhl Teles, Vladimir; P. Andrade, Joaquim
    Abstract: This article develops an econometric model in order to study country risk behavior forsix emerging economies (Argentina, Mexico, Russia, Thailand, Korea and Indonesia),by expanding the Country Beta Risk Model of Harvey and Zhou (1993), Erb et. al.(1996a, 1996b) and Gangemi et. al. (2000). Toward this end, we have analyzed theimpact of macroeconomic variables, especially monetary policy, upon country risk,by way of a time varying parameter approach. The results indicate an inefficient andunstable effect of monetary policy upon country risk in periods of crisis. However, thiseffect is stable in other periods, and the Favero-Giavazzi effect is not verified for alleconomies, with an opposite effect being observed in many cases.
    Date: 2010–06–29
  14. By: J. M. C. Santos Silva; Silvana Tenreyro
    Abstract: We critically review the recent literature on currency unions, and discuss the methodologicalchallenges posed by the empirical assessment of their costs and benefits. In the process, weprovide evidence on the economic effects of the euro. In particular, and in contrast withestimates of the trade effect of other currency unions, we find that the impact of the euro ontrade has been close to zero. After reviewing the costs and benefits, we conclude with someopen questions on normative and positive aspects of the theory of currency unions,emphasizing the need for a unified welfare-based framework to weigh their costs and gains.
    Keywords: Currency union, Integration, Exchange Rage, Trade
    JEL: F00 F02 F15 F31 F42
    Date: 2010–06
  15. By: Luis J. Álvarez (Banco de España); Pablo Burriel (Banco de España)
    Abstract: This paper presents US and euro area estimates for a fully heterogeneous model, in which there is a continuum of f rms setting prices with a constant probability of adjustment, which may differ from f rm to f rm. The estimated model accurately matches the empirical distribution function of individual price durations for the US and the euro area. Incorporating these micro based pricing rules into a DSGE model, we f nd that nominal shocks have a greater real impact in the fully heterogeneous economy than in the standard Calvo model. We also f nd that nominal and real shocks bring about a reallocation of resources among sectors. Monetary policy is found to have a greater real impact in the euro area than in the United States.
    Keywords: price setting, heterogeneity, DSGE, Calvo model
    JEL: C40 D40 E30
    Date: 2010–06
  16. By: Angel Asensio (CEPN - Centre d'économie de l'Université de Paris Nord - CNRS : UMR7115 - Université Paris-Nord - Paris XIII)
    Abstract: The paper argues that the world economy might experiment inflationary pressures (or restrictive policies aimed at fighting them) when the economic depression triggered by the financial crisis is stabilized. The primary cause is that bad money has been (endogenously) delivered which did not lead to a proportionate increase of real wealth, thereby creating an artificial purchasing power into the economic system. According to Keynes and Post Keynesians 'true inflation' develops when the quantity of effective demand increases at full employment, but financial 'inventiveness' proved to be capable of creating the possibility for houses and assets prices to inflate whatever the level of unemployment is. If the ongoing reinforced regulations get to limit the artificial increase of assets prices, the circulating bad money may trigger a generalized inflationary process. Public deficits have been seriously damaged during the depression; in addition, authorities have provided the required liquidity to the banking system in exchange of private bad debt, part of which might have turned out irrecoverable. The paper also points out that this amounts to a collectivization of private losses, which carries lasting difficulties in terms of a trade-off between inflation and higher unemployment. Some general policy principles are suggested to relieve the post crisis growth regime of the bad debts/bad money plague.
    Keywords: inflation; stagflation; economic crisis; bad debts, money
    Date: 2009–12
  17. By: Amil Dasgupta; Leon-Gonzalez; Roberto; Anja Shortland
    Abstract: What determines the direction of spread of currency crises? We examine data on waves of currency crises in 1992, 1994, 1997, and 1998 to evaluate several hypotheses on the determinants of contagion. We simultaneously consider trade competition, financial links, and institutional similarity to the "ground-zero" country as potential drivers of contagion. To overcome data limitations and account for model uncertainty, we utilize Bayesian methodologies hitherto unused in the empirical literature on contagion. In particular, we use the Bayesian averaging of binary models which allows us to take into account the uncertainty regarding the appropriate set of regressors. We find that institutional similarity to the ground-zero country plays an important role in determining the direction of contagion in all the emerging market currency crises in our dataset. We thus provide persuasive evidence in favour of the "wake up call" hypothesis for financial contagion. Trade and financial links may also play a role in determining the direction of contagion, but their importance varies amongst the crisis periods.
    Keywords: Financial contagion, exchange rate, institutions, Bayesian model averaging
    JEL: F31 F32 C11
    Date: 2010
  18. By: Devika Johri; Mark Miller
    Abstract: Foreign exchange reserves are an extremely critical aspect of any country’s ability to engage in commerce with other countries. A large stock of foreign currency reserves facilitates trade with other nations and lowers transaction costs associated with international commerce. If a nation depletes its foreign currency reserves and finds that its own currency is not accepted abroad, the only option left to the country is to borrow from abroad. However, borrowing in foreign currency is built upon the obligation of the borrowing nation to pay back the loan in the lender’s own currency or in some other “hard†currency. If the debtor nation is not credit-worthy enough to borrow from a private bank or from an institution such as the IMF, then the nation has no way of paying for imports and a financial crisis accompanied by devaluation and capital flight results.[Working Paper No. 0028]
    Date: 2010

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.