nep-mon New Economics Papers
on Monetary Economics
Issue of 2011‒04‒09
twenty papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Asset Prices, Nominal Rigidities, and Monetary Policy: Role of Price Indexation By Nutahara, Kengo
  2. The Great Inflation: Did the Shadow Know Better? By William Poole; Robert H. Rasche; David C. Wheelock
  3. Bretton Woods Fixed Exchange Rate System versus Floating Exchange Rate System By Geza, Paula; Giurca Vasilescu, Laura
  4. Trilemma Stability and International Macroeconomic Archetypes in Developing Economies By Helen Popper; Alex Mandilaras; Graham Bird
  5. Where it all began: lending of last resort and the Bank of England during the Overend-Gurney panic of 1866 By Marc Flandreau; Stefano Ugolini
  6. Daytime is money By Sébastien Kraenzlin; Thomas Nellen
  7. The optimal inflation rate revisited By Giovanni Di Bartolomeo; Patrizio Tirelli; Nicola Acocella
  8. The real effects of financial stress in the Euro zone By Sushanta K. Mallick; Ricardo M. Sousa
  9. A win-win monetary policy in Canada By Kitov, Oleg; Kitov, Ivan
  10. Markets, Income and Policy By Hongfei Sun
  11. Foreign Currency Loans - Demand or Supply Driven? By Martin Brown; Karolin Kirschenmann; Steven Ongena
  12. What International Monetary System for a Fast-Changing World Economy? By Agnes Benassy-Quere; Jean Pisani-Ferry
  13. Tail Behaviour of the Euro By John Cotter
  14. Frictions, Persistence, and Central Bank Policy in an Experimental Dynamic Stochastic General Equilibrium Economy By Noussair, C.N.; Pfajfar, D.; Zsiros, J.
  15. Repo Market Microstructure in Unusual Monetary Policy Conditions By Dunne, Peter; Fleming, Michael J.; Zholos, Andrey
  16. Realised and Optimal Monetary Policy Rules in an Estimated Markov-Switching DSGE Model of the United Kingdom By Xiaoshan Chen; Ronald MacDonald
  17. Exploring an uncharted market: Evidence on the unsecured Swiss franc money market By Basil Guggenheim; Sébastien Philippe Kraenzlin; Silvio Schumacher
  18. Forecasting Long-Term Interest Rates with a Dynamic General Equilibrium Model of the Euro Area: The Role of the Feedback By Paolo Zagaglia
  19. U.S. Core Inflation: A Wavelet Analysis By kevin dowd; john cotter
  20. Intraday patterns in FX returns and order flow By Francis Breedon; Angelo Ranaldo

  1. By: Nutahara, Kengo
    Abstract: Carlstrom and Fuerst (2007) [``Asset prices, nominal rigidities, and monetary policy,'' Review of Economic Dynamics 10, 256--275] find that monetary policy response to share prices is a source of equilibrium indeterminacy because an increase in inflation implies a high real marginal cost and low share prices in a sticky-price economy. We find that if the New Keynesian Phillips curve has a lagged inflation term caused by price indexation, this effect is weakened. Moreover, equilibrium indeterminacy caused by monetary policy response to share prices never arises if all the firms that cannot re-optimize their prices follow price indexation.
    Keywords: asset prices; monetary policy; equilibrium determinacy; price indexation
    JEL: E32 E31 E52 E44
    Date: 2011–02–01
  2. By: William Poole; Robert H. Rasche; David C. Wheelock
    Abstract: The Shadow Open Market Committee was formed in 1973 in response to rising inflation and the apparent unwillingness of U.S. policymakers to implement policies necessary to maintain price stability. This paper describes how the Committee’s policy views differed from those of most Federal Reserve officials and many academic economists at the time. The Shadow argued that price stability should be the primary goal of monetary policy and favored gradual adjustment of monetary growth to a rate consistent with price stability. This paper evaluates the Shadow’s policy rule in the context of the New Keynesian macroeconomic model of Clarida, Gali, and Gertler (1999). Simulations of the model suggest that the gradual stabilization of monetary growth favored by the Shadow would have lowered inflation with less impact on output growth and less variability in inflation or output than a one-time reduction in monetary growth. We conclude that the Shadow articulated a policy that would have outperformed the policies actually implemented by the Federal Reserve during the Great Inflation era.
    JEL: E31 E32 E37 E41 E52 E58
    Date: 2011–03
  3. By: Geza, Paula; Giurca Vasilescu, Laura
    Abstract: One of the most important issues of monetary policy is to find out whether the state should intervene among the exchange rates, taking into account the fact that changes in the exchange rates represent a significant transmission channel of the effects generated by the monetary policy. Taking into consideration the failure of fixed exchange rate regimes and the recent improvement of financial markets, the return in the near future to such a regime – as for example the Bretton Woods system – is probably almost impossible.
    Keywords: Fixed exchange rate; floating exchange rate; Bretton Woods system
    JEL: E42 F31
    Date: 2011–03–29
  4. By: Helen Popper (Santa Clara University); Alex Mandilaras (University of Surrey); Graham Bird (University of Surrey)
    Abstract: In this paper, we examine the stability of international macroeconomic policies of developing countries in the post-Bretton Woods period. We use the simple geometry of the classic, open-economy trilemma to construct a new, univariate measure of inter- national macroeconomic policy stability, and to characterize international macroeconomic arrangements in terms of their semblance to definitive policy archetypes; and, we use the trilemma constraint to provide a new gauge of monetary sovereignty. Using these measures, we find that the greatest international macroeconomic stability among developing economies exists where there are capital controls and limited exchange rate flexibility. The least stable policies occur in the economies with flexible exchange rates and open financial markets. We also find that official holdings of foreign exchange re- serves seem to be weakly linked to greater policy stability, and their link is further weakened where financial markets are open.
    Keywords: Trilemma, Foreign Exchange Rate Regimes, International Reserves, Financial Openness, Fear of Floating, Monetary Sovereignty
    JEL: F3 F4 O1 O2
    Date: 2011–03
  5. By: Marc Flandreau (Graduate Institute of International and Development Studies, Geneva); Stefano Ugolini (Scuola Normale Superiore, Pisa)
    Abstract: The National Monetary Commission was deeply concerned with importing best practice. One important focus was the connection between the money market and international trade. It was said that Britain’s lead in the market for “acceptances” originating in international trade was the basis of its sterling predominance. In this article, we use a so-far unexplored source to document the portfolio of bills that was brought up to the Bank of England for discount and study the behavior of the Bank of England during the crisis of 1866 (the so-called Overend-Gurney panic) when the Bank began adopting lending of last resort policies (Bignon, Flandreau and Ugolini 2011). We compare 1865 (a “normal” year) to 1866. Important findings include: (a) the statistical predominance of foreign bills in the material brought to the Bank of England; (b) the correlation between the geography of bills and British trade patterns; (c) a marked contrast between normal times lending and crisis lending in that main financial intermediaries and the “shadow banking system” only showed up at the Bank’s window during crises; (d) the importance of money market investors (bills brokers) as chief conduit of liquidity provision in crisis; (e) the importance of Bank of England’s supervisory policies in ensuring lending-of-last-resort operations without enhancing moral hazard. An implication of our findings is that Bank of England’s ability to control moral hazard for financial intermediaries involved in acceptances was another reason for the rise of sterling as an international currency.
    Keywords: Financial crises, lending of last resort, history of monetary policy, shadow banking system, banking supervision.
    JEL: E42 E58 N13
    Date: 2011–03–29
  6. By: Sébastien Kraenzlin; Thomas Nellen
    Abstract: Based on real-time trade data from the Swiss franc overnight interbank repo market and SIX Interbank Clearing (SIC) - the Swiss real-time gross settlement (RTGS) system - we are able to gain valuable insights on the daytime value of money and its determinants: First, an implicit hourly interbank interest rate can be derived from the intraday term structure of the overnight rate. We thereby provide evidence that an implicit intraday money market exists. Second, we show that after the introduction of the foreign exchange settlement system CLS the value of intraday liquidity has increased during the hours of the CLS settlement cycle. Third, the turnover as well as the liquidity in SIC influence the intraday rate correspondingly. These facts provide evidence for the cost of immediacy. Features like RTGS, delivery-versus-payment and payment-versus-payment substitute credit risk with liquidity risk which in turn increases the value of intraday liquidity. The analysis is central bank policy relevant insofar as different designs of intraday liquidity facilities and different collateral policies result in different intraday term structures for the overnight money market.
    Keywords: interbank money market, intraday credit, term structure
    JEL: E58 G21 G28
    Date: 2010
  7. By: Giovanni Di Bartolomeo; Patrizio Tirelli; Nicola Acocella
    Abstract: We challenge the widely held belief that New-Keynesian models cannot predict optimal positive in‡ ations. We finnd that these are justified by the Phelps argument. This mainly happens because we also consider distortionary expects of public transfers. Our predictions are broadly consistent with recent estimates of the Fed inflation targets. We also contradict theview that the Ramsey policy should minimize inflation volatility and induce near-random walk dynamics of public debt in the long-run. It should instead stabilize debt-to-GDP ratios to mitigate steady-state distortions. This latter result is strikingly similar to policy analyses in the aftermath of the 2008 crisis.
    Keywords: trend inflation, monetary and fiscal policy, Ramsey plan.
    JEL: E52 E58 J51 E24
    Date: 2011–03
  8. By: Sushanta K. Mallick (Queen Mary University of London); Ricardo M. Sousa (Universidade do Minho - NIPE)
    Abstract: Using two identification strategies based on a Bayesian Structural VAR and a Sign-Restriction VAR, we examine the real effects of financial stress in the Eurozone. In particular, we assess the macroeconomic impact of: (i) a monetary policy shock; and (ii ) a financial stress shock. We find that a monetary policy contraction strongly deteriorates financial stress conditions. In addition, unexpected variation in the Financial Stress Index (FSI) plays an important role in explaining output fluctuations, and also demands an aggressive response by the monetary authority to stabilise output indicating a preference shift from targeting inflation as it is currently happening in major economies. Therefore, our paper reveals the importance of adopting a vigilant posture towards financial stress conditions, as well as the urgency of macro-prudential risk management.
    Keywords: monetary policy, financial stress, Bayesian Structural VAR, Sign-Restrictions, Euro-zone.
    JEL: E37 E52
    Date: 2011
  9. By: Kitov, Oleg; Kitov, Ivan
    Abstract: The Lucas critique has exposed the problem of the trade-off between changes in monetary policy and structural breaks in economic time series. The search for and characterisation of such breaks has been a major econometric task ever since. We have developed an integral technique similar to CUSUM using an empirical model quantitatively linking the rate of inflation and unemployment to the change in the level of labour force in Canada. Inherently, our model belongs to the class of Phillips curve models, and the link between the involved variables is a linear one with all coefficients of individual and generalized models obtained by empirical calibration. To achieve the best LSQ fit between measured and predicted time series cumulative curves are used as a simplified version of the 1-D boundary elements (integral) method. The distance between the cumulative curves (in L2 metrics) is very sensitive to structural breaks since it accumulates true differences and suppresses uncorrelated noise and systematic errors. Our previous model of inflation and unemployment in Canada is enhanced by the introduction of structural breaks and is validated by new data in the past and future. The most exiting finding is that the introduction of inflation targeting as a new monetary policy in 1991 resulted in a structural break manifested in a lowered rate of price inflation accompanied by a substantial fall in the rate of unemployment. Therefore, the new monetary policy in Canada is a win-win one.
    Keywords: structural break; inflation; unemployment; labour force; modelling; Canada; monetary policy
    JEL: E31 J21 E61
    Date: 2011–03–30
  10. By: Hongfei Sun (Queen's University)
    Abstract: I construct a unified macroeconomic framework by incorporating frictional markets in a neoclassical environment. This framework formalizes a theory that the variety and the functioning of markets reflect the status of national income. In the model, households have free access to markets with and without trading frictions. Uninsurable income risks generate money distributions and price dispersions. In equilibrium, the frictionless markets are generically used to smooth consumption and the frictional markets are only used when households have sufficiently high expected real income. Income inequality critically determines the equilibrium trading protocols across frictional markets. The optimal policy program consists of money growth, proportional income taxes and sales subsidies. Policy coordination is critical. It can be welfare-improving for the government to alleviate income taxes when the monetary authority is running deflation and to elevate income taxes under inflation.
    Keywords: markets, frictions, income, policy, competitive search
    JEL: E0 E4 E5 E6 H2 H3
    Date: 2011–03
  11. By: Martin Brown; Karolin Kirschenmann; Steven Ongena
    Abstract: Motivated by concerns over foreign currency exposures of banks in Emerging Europe, we examine the currency denomination of business loans made in Bulgaria during the period 2003-2007. We analyze a unique dataset including information on the requested and granted currency for more than hundred thousand loans granted by one bank to sixty thousand different firms. This data set allows us to disentangle demand-side from supply-side determinants of foreign currency loans. We find that 32% of the foreign currency loans disbursed in our sample were actually requested in local currency by the firm. Our analysis suggests that the bank lends in foreign currency, not only to less risky firms, but also when the firm requests a long-term loan and when the bank itself has more funding in euro. These results imply that foreign currency borrowing in Eastern Europe is not only driven by borrowers who try to benefit from lower interest rates but also by banks hesitant to lend longterm in local currency and eager to match the currency structure of their assets and liabilities.
    Keywords: foreign currency debt, banking
    JEL: G21 G30 F34 F37
    Date: 2011
  12. By: Agnes Benassy-Quere; Jean Pisani-Ferry
    Abstract: Though the renminbi is not yet convertible, the international monetary regime has already started to move towards a 'multipolar' system, with the dollar, the Chinese currency and the euro as its key likely pillars. This shift corresponds to the long-term evolution of the balance of economic weight in the world economy. Such an evolution may mitigate some flaws of the present (non-) system, such as the rigidity of key exchange rates, the asymmetry of balanceof- payments adjustments or what remains of the Triffin dilemma. However it may exacerbate other problems, such as short-run exchange rate volatility or the scope for ‘currency wars’, while leaving key questions unresolved, such as the response to capital flows global liquidity provision. Hence, in itself, a multipolar regime can be both the best and the worst of all regimes. Which of these alternatives will materialise depends on the degree of cooperation within a multilateral framework.
    Keywords: International monetary system; capital controls
    JEL: F33 F32
    Date: 2011–03
  13. By: John Cotter
    Abstract: This paper empirically analyses risk in the Euro relative to other currencies. Comparisons are made between a sub period encompassing the final transitional stage to full monetary union with a sub period prior to this. Stability in the face of speculative attack is examined using Extreme Value Theory to obtain estimates of tail exchange rate changes. The findings are encouraging. The Euro's common risk measures do not deviate substantially from other currencies. Also, the Euro is stable in the face of speculative pressure. For example, the findings consistently show the Euro being less risky than the Yen, and having similar inherent risk to the Deutsche Mark, the currency that it is essentially replacing.
    Date: 2011–03
  14. By: Noussair, C.N.; Pfajfar, D.; Zsiros, J. (Tilburg University, Center for Economic Research)
    Abstract: New Keynesian dynamic stochastic general equilibrium models are the principal paradigm currently employed for central bank policymaking. In this paper, we construct experimental economies, populated with human subjects, with the structure of a New Keynesian DSGE model. We give individuals monetary incentives to maximize the objective functions in the model, but allow scope for agents' boundedly rational behavior and expectations to influence outcomes. Subjects participate in the roles of consumer/workers, producers, or central bankers. Our objective is twofold. The first objective is general, and is to create an experimental environment for the analysis of macroeconomic policy questions. The second objective is more focused and is to consider several specific research questions relating to the persistence of shocks, the behavior of human central bankers, and the pricing behavior of firms, using our methodology. We find that the presence of menu costs is not necessary to generate persistence of output shocks, but rather that monopolistic competition in the output market is sufficient. Interest rate policies of human discretionary central bankers are characterized by persistence in interest rate shocks, the use of the Taylor principle, and lower output and welfare than under an automated instrumental rule. Pattens in price changes conform closely to stylized empirical facts.
    Keywords: Experimental Economics;DSGE economy;Monetary Policy;Menu costs.
    JEL: C91 C92 E31 E32
    Date: 2011
  15. By: Dunne, Peter (Central Bank of Ireland); Fleming, Michael J. (Federal Reserve Bank of New York); Zholos, Andrey (Queen’s University Management School)
    Abstract: The financial turmoil that began in mid-2007 produced severe stress in interbank markets and prompted significant changes in central banks’ funding operations. We examine the changing characteristics of ECB official interventions through the crisis and assess how they affected the efficiency and reliability of the secondary repo market as a mechanism for the distribution of interbank funding. The limit orderbook from the BrokerTec electronic repo trading platform is reconstructed to provide a range of indicators of participating banks’ aversion to the risk of failing to fund their liquidity needs. These indicators anticipate similar variables from ECB reverse repo auctions and are also affected by surprise outcomes of auctions.
    Keywords: Repo, Financial crisis, liquidity, market microstructure, monetary policy operations
    Date: 2011–03
  16. By: Xiaoshan Chen; Ronald MacDonald
    Abstract: This paper conducts a systematic investigation of parameter instability in a small open economy DSGE model of the UK economy over the past thirty-five years. Using Bayesian analysis, we find a number of Markov-switching versions of the model provide a better fit for the UK data than a model with time-invariant parameters. The Markov-switching DSGE model that has two independent Markov-chains - one governing the shifts in UK monetary policy and nominal price rigidity and one governing the standard deviations of shocks - is selected as the best fitting model. The preferred model is then used to evaluate and design monetary policy. For the latter, we use the Markov-Jump-Linear-Quadratic (MJLQ) model, as it incorporates abrupt changes in structural parameters into derivations of the optimal and arbitrary policy rules. It also reveals the entire forecasting distribution of the targeted variables. To our knowledge, this is the first paper that attempts to evaluate and design UK monetary policy based on an estimated open economy Markov-switching DSGE model.
    Keywords: DSGE models; Markov-switching; Bayesian analysis
    JEL: C11 C32 C51 C52
    Date: 2011–01
  17. By: Basil Guggenheim; Sébastien Philippe Kraenzlin; Silvio Schumacher
    Abstract: To date, various central banks have lacked detailed statistical evidence on developments in the unsecured interbank money market. Furfine (1999) introduced the idea of calculating unsecured overnight interbank lending by using data of a RTGS system. Based on data from the Swiss payment system (SIC) we developed an algorithm to identify unsecured interbank loans in Swiss francs. In contrast to Furfine (1999) we also identify longer-term transactions. We thereby gain a deeper insight on the size and structure of the unsecured interbank money market in Swiss francs. This is the first time that SIC data have been used to identify transactions and market rates in the unsecured Swiss franc money market. Overall, the estimates show that after the collapse of Lehman Brothers loss of confidence led to a freezing-up of the market for several months and a decrease in daily turnover.
    Keywords: unsecured interbank money market, development,money market turmoil, financial stability, Switzerland
    JEL: E40 E42 E44
    Date: 2011
  18. By: Paolo Zagaglia (Department of Economics, University of Bologna)
    Abstract: This paper studies the forecasting performance of the general equilibrium model of bond yields of Marzo, Söderström and Zagaglia (2008), where long-term interest rates are an integral part of the monetary transmission mechanism. The model is estimated with Bayesian methods on Euro area data. I compare the out-of-sample predictive performance of the model against a variety of competing specifications, including that of De Graeve, Emiris and Wouters (2009). Forecast accuracy is evaluated through both univariate and multivariate measures. I also control the statistical significance of the forecast differences using the tests of Diebold and Mariano (1995), Hansen (2005) and White (1980). I show that taking into account the impact of the term structure of interest rates on the macroeconomy generates superior out-of-sample forecasts for both real variables, such as output, and inflation, and for bond yields.
    Keywords: Yield curve, general equilibrium models, Bayesian estimation, forecasting
    JEL: E43 E44 E52
    Date: 2011–03
  19. By: kevin dowd; john cotter
    Abstract: This paper proposes the use of wavelet methods to estimate U.S. core inflation. It explains wavelet methods and suggests they are ideally suited to this task. Comparisons are made with traditional CPI-based and regression-based measures for their performance in following trend inflation and predicting future inflation. Results suggest that wavelet-based measures perform better, and sometimes much better, than the traditional approaches. These results suggest that wavelet methods are a promising avenue for future research on core inflation.
    Date: 2011–03
  20. By: Francis Breedon; Angelo Ranaldo
    Abstract: Using 10 years of high-frequency foreign exchange data, we present evidence of time-of-day effects in foreign exchange returns through a significant tendency for currencies to depreciate during local trading hours. We confirm this pattern across a range of currencies and find that, in the case of EUR/USD, it can form a simple, profitable trading strategy. We also find that this pattern is present in order flow and suggest that both patterns relate to the tendency of market participants to be net purchasers of foreign exchange in their own trading hours. Data from alternative sources appear to corroborate that interpretation.
    Keywords: Foreign Exchange, Microstructure, Order Flow, Liquidity
    JEL: G15
    Date: 2011

This nep-mon issue is ©2011 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.