nep-mon New Economics Papers
on Monetary Economics
Issue of 2011‒09‒22
twenty-one papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Central Bank Transparency and Financial Market Expectations: The Case of Emerging Markets By Matthias Neuenkirch
  2. Behind closed doors: Revealing the ECB’s Decision Rule By Bernd Hayo; Pierre-Guillaume Méon
  3. Cross-Checking Optimal Monetary Policy with Information from the Taylor Rule By Peter Tillmann
  4. International Financial Integration and National Price Levels: The Role of the Exchange Rate Regime By Mathias Hoffmann; Peter Tillmann
  5. Changing of the guard - Challenges ahead for the new ECB president By Guntram B. Wolff
  6. Communication of Central Bank Thinking and Inflation Dynamics By Man-Keung Tang; Xiangrong Yu
  7. The Optimality and Controllability of Discretionary Monetary Policy By Huiping Yuan; Stephen M. Miller
  8. De Jure versus De Facto Exchange Rate Regimes in Sub-Saharan Africa By Slavi T Slavov
  9. First Impressions Matter: Signalling as a Source of Policy Dynamics By Stephen Hansen; Michael McMahon
  10. Optimal Monetary Policy with Endogenous Entry and Product Variety By Bilbiie, Florin Ovidiu; Fujiwara, Ippei; Ghironi, Fabio
  11. Evaluating interest rate rules in an estimated DSGE model By Vasco Cúrdia; Andrea Ferrero; Ging Cee Ng; Andrea Tambalotti
  12. Capital Flows and Financial Stability: Monetary Policy and Macroprudential Responses By D. Filiz Unsal
  13. South Africa: The Cyclical Behavior of the Markups and its Implications for Monetary Policy By Nir Klein
  14. Central bank communication on financial stability By Benjamin Born; Michael Ehrmann; Marcel Fratzscher
  15. The Federal Reserve as an Informed Foreign Exchange Trader: 1973 – 1995 By Michael D. Bordo; Owen F. Humpage; Anna J. Schwartz
  16. Empirical Evidence on Inflation and Unemployment in the Long Run By Alfred A. Haug & Ian P. King
  17. When the Music Stopped: Transatlantic Contagion During the Financial Crisis of 1931 By Gary Richardson; Patrick Van Horn
  18. Renminbi Rules: The Conditional Imminence of the Reserve Currency Transition By Arvind Subramanian
  19. Information Asymmetry and Foreign Currency Borrowing by Small Firms By Brown, M.; Ongena, S.; Yesin, P.
  20. Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System By Zoltan Pozsar
  21. The Natural Rate of Interest in a Small Open Economy By Fernando de Holanda Barbosa

  1. By: Matthias Neuenkirch (University of Marburg)
    Abstract: In this paper, we study the influence of central bank transparency on the formation of money market expectations in emerging markets. The sample covers 25 countries for the period from January 1998 to December 2009. We find, first, that transparency reduces the bias (the difference between the money market rate and the weighted expected target rate over the contract period) in money market expectations. The effect is larger for non-inflation targeters, countries with low income, and countries with low financial depth. However, the biasreducing effect of transparency prevails only if inflation is relatively low. Second, three subcategories of the Eijffinger and Geraats (2006) lead to a smaller bias in expectations: operational, political, and economic transparency, with the effect being the largest for operational transparency. Finally, an intermediate level of transparency is found to have the most favourable influence on money market expectations. Neither complete secrecy nor complete transparency is optimal.
    Keywords: Central Bank Transparency, Emerging Markets, Financial Market Expectations, Interest Rates, Monetary Policy, Money Market
    JEL: E52 E58
    Date: 2011
  2. By: Bernd Hayo (University of Marburg); Pierre-Guillaume Méon (University of Brussels)
    Abstract: This paper aims at discovering the decision rule the Governing Council of the ECB uses to set interest rates. We construct a Taylor rule for each member of the council and for the euro area as a whole, and aggregate the interest rates they produce using several classes of decision-making mechanisms: chairman dominance, bargaining, consensus, voting, and voting with a chairman. We test alternative scenarios in which individual members of the council pursue either a national or a federal objective. We then compare the interest-rate path predicted by each scenario with the observed euro area’s interest rate. We find that scenarios in which all members of the Governing Council are assumed to pursue Euro-area-wide objectives are dominated by scenarios in which decisions are made collectively by a council consisting of members pursuing national objectives. The best-performing scenario is the one in which individual members of the Governing Council follow national objectives, bargain over the interest rate, and their weights are based on their country’s share of the zone’s GDP.
    Keywords: European Central Bank, Monetary Policy Committee, Decision rules
    JEL: D70 E43 E58 F33
    Date: 2011
  3. By: Peter Tillmann (University of Giessen)
    Abstract: This paper shows that monetary policy should be delegated to a central bank that cross-checks optimal policy with information from the Taylor rule. Attaching some weight to deviations of the interest rate from the interest rate prescribed by the Taylor rule is beneficial if the central bank aims at optimally stabilizing inflation and output gap variability under discretion. Placing a weight on deviations from a simple Taylor rule increases the overall relative weight of inflation volatility in the effective loss function, which reduces the stabilization bias of discretionary monetary policy. The welfare-enhancing role of this modified loss function depends on the size of the stabilization bias, i.e. on the degree of persistence in the cost-push shock process, and the relevance of demand shocks. These results can be interpreted in terms of the optimal composition of monetary policy committees.
    Keywords: optimal monetary policy, stabilization bias, monetary policy delegation, robustness, Taylor rule, monetary policy committee
    JEL: E43 E52
    Date: 2011
  4. By: Mathias Hoffmann (Deutsche Bundesbank); Peter Tillmann (University of Giessen)
    Abstract: How does international .financial integration affect national price levels? Panel evidence for 54 industrialized and emerging countries shows that a larger ratio of foreign assets and liabilities to GDP, our measure of international .financial integration, increases the national price level under .fixed and intermediate exchange rate regimes and lowers the price level under .floating exchange rates. This paper formulates a two-country open economy sticky-price model under either segmented or complete asset markets that is able to replicate these stylized facts. It is shown that the effect of financial integration, i.e. moving from segmented to complete asset markets, is regime-dependent. Under managed exchange rates financial integration raises the national price level. Under .floating exchange rates, however financial integration lowers national price levels. Thus, the paper proposes a novel argument to rationalize systematic deviations from PPP.
    Keywords: international financial integration, exchange rate regime, national price level, PPP, foreign asset position
    JEL: F21 F36 F41
    Date: 2011
  5. By: Guntram B. Wolff
    Abstract: Jean-Claude Trichet deserves praise for fighting inflation and his handling of the financial crisis of 2007-2009. But his legacy is unfinished and we still have to see whether he will be the one who saved the euro. Important challenges remain for the incoming president.First, trust of citizens in the ECB has fallenmassively according to the Eurobarometer survey inmany euro area countries, including Germany and Greece. Trust needs to be regained. Second, the ECBâ??s stance on Greece needs to be reversed both as regards financial sector participation and SMP. The SMP for Italy can be justified but can only be a temporary solution. The ECB will therefore have to further push for a fiscal lender-of-last-resort back-stop that can also exercise conditionality.Third, a rate cut should be considered at this point in time but upcoming political pressure to increase inflation needs to be resisted.
    Date: 2011–09
  6. By: Man-Keung Tang; Xiangrong Yu
    Abstract: This paper studies the role of central bank communication of its economic assessment in shaping inflation dynamics. Imperfect information about the central bank’s assessment - or the basis for monetary policy decisions - could complicate the private sector’s learning about its policy response function. We show how clear central bank communication, which facilitates agents’ understanding of policy reasoning, could bring about less volatile inflation and interest rate dynamics, and afford the authorities with greater policy flexibility. We then estimate a simple monetary model to fit the Mexican economy, and use the suggested paramters to illustrate the model’s quantitative implications in scenarios where the timing, nature and persistence of shocks are uncertain.
    Keywords: Central bank role , Central banks , Economic models , Inflation targeting , Mexico , Monetary policy , Transparency ,
    Date: 2011–08–03
  7. By: Huiping Yuan (Xiamen University); Stephen M. Miller (University of Nevada, Las Vegas and University of Connecticut)
    Abstract: This paper addresses two issues -- the time-inconsistency of optimal policy and the controllability of target variables within new-classical and new-Keynesian model structures. We can resolve both issues by delegation. That is, we design central bank loss functions by determining the two target values and the weight between the two targets. With a single decision maker, the time-inconsistency issue does not exist; the target controllability issue does. Delegating the long-run target values (target variables’ equilibriums under the Ramsey optimal policy) and the same weight as society to the central bank can achieve Ramsey optimality and path controllability. With multiple decision makers (game), both issues of time-inconsistency and target controllability exist and the delegation becomes more complicated. The long-run target values can only achieve asymptotic, not path, controllability. Path controllability requires the delegation of short-run target values, which commits or binds the central bank to follow exactly the Ramsey optimal paths. The short-run inflation target value conforms to the macroeconomic structure (i.e., Phillips curve). With path controllability, the constant average and state-contingent inflation biases are removed. To eliminate the stabilization bias, the delegated weight must differ from society in a dynamic game. When the Phillips curve exhibits output (inflation) persistence, the central bank must place more weight on output (inflation) stabilization. When the Phillips curve exhibits principally forward-looking behavior, the delegated weight can require a conservative or liberal central bank. In sum, delegating certain short-run target values and a different weight can cause discretionary monetary policy to prove Ramsey optimal and path controllable in a dynamic game.
    Keywords: Optimal Policy, Controllability, Policy Rules
    JEL: E42 E52 E58
    Date: 2011–08
  8. By: Slavi T Slavov
    Abstract: There are 22 countries in Sub-Saharan Africa (SSA) with floating exchange rate regimes, de jure. Some target the money supply or the inflation rate; others practice "managed floating." Statistical analysis on monthly data for the past decade reveals that in most cases these exchange rate regimes can be approximated surprisingly well by a soft peg to a basket dominated by the US dollar. The weight on the dollar appears to have fallen somewhat across the continent in the aftermath of the global financial crisis. Replicating the model with weekly data for The Gambia suggests that the focus on the dollar might be even more pronounced at higher data frequencies. While there might be strong arguments in favor of limiting exchange rate volatility in SSA countries, soft-pegging to the dollar does not appear to be the best fit for them, given the currency structure of their external trade and finance. The paper concludes by discussing some policy options for SSA countries with flexible exchange rates, in the context of an illustrative recent country case.
    Keywords: Cross country analysis , Currency pegs , Economic models , Exchange rate regimes , Floating exchange rates , Reserves , Sub-Saharan Africa ,
    Date: 2011–08–16
  9. By: Stephen Hansen; Michael McMahon
    Abstract: We first establish that policymakers on the Bank of England's Monetary Policy Committee choose lower interest rates with experience. We then reject increasing confidence in private information or learning about the structure of the macroeconomy as explanations for this shift. Instead, a model in which voters signal their hawkishness to observers better fits the data. The motivation for signalling is consistent with wanting to control inflation expectations, but not career concerns or pleasing colleagues. There is also no evidence of capture by industry. The paper suggests that policy-motivated reputation building may be important for explaining dynamics in experts' policy choices.
    Keywords: Signalling, learning, monetary policy
    JEL: D78 E52
    Date: 2011–09
  10. By: Bilbiie, Florin Ovidiu; Fujiwara, Ippei; Ghironi, Fabio
    Abstract: We show that deviations from long-run stability of product prices are optimal in the presence of endogenous producer entry and product variety in a sticky-price model with monopolistic competition in which price stability would be optimal in the absence of entry. Specifically, a long-run positive (negative) rate of inflation is optimal when the benefit of variety to consumers falls short of (exceeds) the market incentives for creating that variety under flexible prices, governed by the desired markup. Plausible preference specifications and parameter values justify a long-run inflation rate of two percent or higher. Price indexation implies even larger deviations from long-run price stability. However, price stability (around this non-zero trend) is close to optimal in the short run, even in the presence of time-varying flexible-price markups that distort the allocation of resources across time and states. The central bank uses its leverage over real activity in the long run, but not in the short run. Our results point to the need for continued empirical research on the determinants of markups and investigation of the benefit of product variety to consumers.
    Keywords: Entry; Optimal inflation rate; Price stability; Product variety; Ramsey-optimal monetary policy.
    JEL: E31 E32 E52
    Date: 2011–09
  11. By: Vasco Cúrdia; Andrea Ferrero; Ging Cee Ng; Andrea Tambalotti
    Abstract: The empirical DSGE (dynamic stochastic general equilibrium) literature pays surprisingly little attention to the behavior of the monetary authority. Alternative policy rule specifications abound, but their relative merit is rarely discussed. We contribute to filling this gap by comparing the fit of a large set of interest rate rules (fifty-five in total), which we estimate within a simple New Keynesian model. We find that specifications in which monetary policy responds to inflation and to deviations of output from its efficient level—the one that would prevail in the absence of distortions—have the worst fit within the set we consider. Policies that respond to measures of the output gap based on statistical filters perform better, but the best-fitting rules are those that also track the evolution of the model-consistent efficient real interest rate.
    Date: 2011
  12. By: D. Filiz Unsal
    Abstract: The resumption of capital flows to emerging market economies since mid 2009 has posed two sets of interrelated challenges for policymakers: (i) to prevent capital flows from exacerbating overheating pressures and consequent inflation, and (ii) to minimize the risk that prolonged periods of easy financing conditions will undermine financial stability. While conventional monetary policy maintains its role in counteracting the former, there are doubts that it is sufficient to guard against the risks of financial instability. In this context, there have been increased calls for the development of macroprudential measures, with an explicit focus on systemwide financial risks. Against this background, this paper analyses the interplay between monetary policy and macroprudential regulations in an open economy DSGE model with nominal and real frictions. The key result is that macroprudential measures can usefully complement monetary policy. Even under the "optimal policy," which calls for a rather aggressive monetary policy reaction to inflation, introducing macroprudential measures is found to be welfare improving. Broad macroprudential measures are shown to be more effective than those that discriminate against foreign liabilities (prudential capital controls). However, these measures are not a substitute for an appropriate moneraty policy reaction. Moreover, macroprudential measures are less useful in helping economic stability under a technology shock.
    Keywords: Capital controls , Capital flows , Capital goods , Capital inflows , Corporate sector , Economic models , Emerging markets , Financial stability , Monetary policy ,
    Date: 2011–08–08
  13. By: Nir Klein
    Abstract: The study looks at the cyclical behavior of the markups and assesses its impact on inflation dynamics. The analysis finds that the aggregate level of the private sector’s markup is relatively high, thus pointing to the lack of strong competition in South Africa’s product markets. Additionally, the results suggest that the markups tend to move in a countercyclical manner, with a short-term positive impact on inflation. This implies that the countercyclical pattern of the markups is one factor among others that contribute to the relatively weak output gap-inflation co-movement. In the context of South Africa’s inflation targeting framework, the counter-cyclical markups may also generate an asymmetric response of monetary policy to the fluctuations in economic activity.
    Date: 2011–08–22
  14. By: Benjamin Born (University of Bonn); Michael Ehrmann (European Central Bank); Marcel Fratzscher (European Central Bank)
    Abstract: Central banks regularly communicate about financial stability issues, by publishing Financial Stability Reports (FSRs) and through speeches and interviews. The paper asks how such communications affect financial markets. Building a unique dataset, it provides an empirical assessment of the reactions of stock markets to more than 1000 releases of FSRs and speeches by 37 central banks over the past 14 years. The findings suggest that FSRs have a significant and potentially long-lasting effect on stock market returns, and also tend to reduce market volatility. Speeches and interviews, in contrast, have little effect on market returns and do not generate a volatility reduction during tranquil times, but have had a substantial effect during the 2007-10 financial crisis. The findings suggest that financial stability communication by central banks are perceived by markets to contain relevant information, and they underline the importance of differentiating between communication tools, their content and the environment in which they are employed.
    Keywords: central bank, financial stability, communication, event study
    JEL: E44 E58 G12
    Date: 2011
  15. By: Michael D. Bordo; Owen F. Humpage; Anna J. Schwartz
    Abstract: If official interventions convey private information useful for price discovery in foreign-exchange markets, then they should have value as a forecast of near-term exchange-rate movements. Using a set of standard criteria, we show that approximately 60 percent of all U.S. foreign-exchange interventions between 1973 and 1995 were successful in this sense. This percentage, however, is no better than random. U.S. intervention sales and purchases of foreign exchange were incapable of forecasting dollar appreciations or depreciations. U.S. interventions, however, were associated with more moderate dollar movements in a manner consistent with leaning against the wind, but only about 22 percent of all U.S. interventions conformed to this pattern. We also found that the larger the size of an intervention, the greater was its probability of success, although some interventions were inefficiently large. Other potential characteristics of intervention, notably coordination and secrecy, did not seem to influence our success rates.
    JEL: E52 E58 F31 N22
    Date: 2011–09
  16. By: Alfred A. Haug & Ian P. King
    Abstract: We examine the relationship between inflation and unemployment in the long run,using quarterly US data from 1952 to 2010. Using a band-pass filter approach, we find strong evidence that a positive relationship exists, where inflation leads unemployment by some 3 to 3.5 years, in cycles that last from 8 to 25 or 50 years. Our statistical approach is atheoretical in nature, but provides evidence in accordance with the predictions of Friedman (1977) and the recent New Monetarist model of Berentsen, Menzio, and Wright (2011): the relationship between inflation and unemployment is positive in the long run.
    Keywords: Inflation; Unemployment; Long-Run Phillips Curve
    JEL: E24 E31
    Date: 2011
  17. By: Gary Richardson; Patrick Van Horn
    Abstract: In 1931, a financial crisis began in Austria, struck numerous European nations, forced Britain to abandon the gold standard, and spread across the Atlantic. This article describes how banks in New York City, the central money market of the United States, reacted to events in Europe. An array of data sources – including memos detailing private conversations between leading bankers the governors of the New York Federal Reserve, articles written by prominent commentators, and financial data drawn from the balance sheets of commercial banks – tell a consistent tale. Banks in New York anticipated events in Europe, prepared for them by accumulating substantial reserves, and during the crisis, continued business as usual. Leading international bankers deliberately and collectively decided on the business-as-usual policy in order to minimize the impact of the panic in the United States and Europe.
    JEL: E42 E44 G21 N1 N12 N14 N2 N22 N24
    Date: 2011–09
  18. By: Arvind Subramanian (Peterson Institute for International Economics)
    Abstract: Against the backdrop of the recent financial crisis and the ongoing rapid changes in the world economy, the fate of the dollar as the premier international reserve currency is under scrutiny. This paper attempts to answer whether the Chinese renminbi will eclipse the dollar, what will be the timing of, and the prerequisites for this transition, and which of the two countries controls the outcome. The key finding, based on analyzing the last 110 years, is that the size of an economy—measured not just in terms of GDP but also trade and the strength of the external financial position—is the key fundamental correlate of reserve currency status. Further, the conventional view that sterling persisted well beyond the strength of the UK economy is overstated. Although the United States overtook the United Kingdom in terms of GDP in the 1870s, it became dominant in a broader sense encompassing trade and finance only at the end of World War I. And since the dollar overtook sterling in the mid-1920s, the lag between currency dominance and economic dominance was about 10 years rather than the 60-plus years traditionally believed. Applying these findings to the current context suggests that the renminbi could become the premier reserve currency by the end of this decade, or early next decade. But China needs to fulfill a number of conditions—making the reniminbi convertible and opening up its financial system to create deep and liquid markets—to realize renminbi preeminence. China seems to be moving steadily in that direction, and renminbi convertibility will proceed apace not least because it offers China's policymakers a political exit out of its mercantilist growth strategy. The United States cannot in any serious way prevent China from moving in that direction.
    Keywords: Reserve Currency, Dollar, Sterling, Renminbi, China
    JEL: F02 F31 F33
    Date: 2011–09
  19. By: Brown, M.; Ongena, S.; Yesin, P. (Tilburg University, Center for Economic Research)
    Abstract: We model the choice of loan currency in a framework which features a trade-off between lower cost of debt and the risk of firm-level distress costs. Under perfect information foreign currency funds come at a lower interest rate, all foreign currency earners as well as those local currency earners with high revenues and/or low distress costs choose foreign currency loans. When the banks have imperfect information on the currency and level of firm revenues, even more local earners switch to foreign currency loans, as they do not bear the full cost of the corresponding credit risk.
    Keywords: foreign currency borrowing;competition;banking sector;market structure.
    JEL: G21 G30 F34 F37
    Date: 2011
  20. By: Zoltan Pozsar
    Abstract: Through the profiling of institutional cash pools, this paper explains the rise of the "shadow" banking system from a demand-side perspective. Explaining the rise of shadow banking from this angle paints a very different picture than the supply-side angle that views it as a story of banks’ funding preferences and arbitrage. Institutional cash pools prefer to avoid too much unsecured exposure to banks even through insured deposits. Short-term government guaranteed securities are the next best choice, but their supply is insufficient. The shadow banking system arose to fill this vacuum. One way to manage the size of the shadow banking system is by adopting the supply management of Treasury bills as a macroprudential tool.
    Keywords: Banking systems , Banks , Investment , Money , United States ,
    Date: 2011–08–08
  21. By: Fernando de Holanda Barbosa
    Abstract: The goal of this paper is two-fold. Firstly, this paper shows that the natural rate of interest in a small open economy, with access to the world capital markets, is equal to the international real rate of interest. We show this property by using the infinitely-lived overlapping generations model and we use this model to analyze both fixed and flexible exchange rate regimes. Secondly, this paper also shows that the empirical implausibility hypothesis embedded in the infinitely-lived representative-agent model, with complete asset markets, turns this framework not appropriate for a small open economy.
    Keywords: Small open economy; Natural rate of interest; Complete and incomplete asset markets
    JEL: F41
    Date: 2011

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