nep-mon New Economics Papers
on Monetary Economics
Issue of 2011‒11‒14
twenty-one papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. China's dominance hypothesis and the emergence of a tri-polar global currency system By Marcel Fratzscher; Arnaud Mehl
  2. Monetary policy in disarray By Tatom, John
  3. Loose monetary policy and excessive credit and liquidity risk-taking by banks. By Ongena, S.; Peydro, J.L.
  4. The redistributive effects of monetary policy By Olivier Ledoit
  5. Money Demand Functions for Pakistan (Divisia Approach) By Sarwar, haroon; Hussian, zakir; Awan, masood sarwar
  6. Monetary sterilization and dual nominal anchors: some Caribbean examples By Khemraj, Tarron; Pasha, Sukrishnalall
  7. Evaluating density forecasts: model combination strategies versus the RBNZ By Chris McDonald; Leif Anders Thorsrud
  8. The financial trilemma in China and a comparative analysis with India By Aizenman, Joshua; Sengupta, Rajeswari
  9. Persistent Liquidity Effects and Long Run Money Demand By Fernando E. Alvarez; Francesco Lippi
  10. Optimal Monetary Policy with Informational Frictions By George-Marios Angeletos; Jennifer La'O
  11. The simple analytics of money and credit in a quasi-linear environment By David Andolfatto
  12. Macroprudential Regulation and the Monetary Transmission Mechanism By Pierre-Richard Agénor; Luiz A. Pereira da Silva
  13. Motivations and strategies for a real revaluation of the Yuan. By Meixing Dai
  14. The Duration of Bank Retail Interest Rates By Ben R. Craig; Valeriya Dinger
  15. Exchange Rate Pass-Through to Prices: Evidence from Mexico By Carlos Capistrán; Raúl Ibarra-Ramírez; Manuel Ramos Francia
  16. The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy By Arvind Krishnamurthy; Annette Vissing-Jorgensen
  17. Inflation and asset prices By Tatom, John
  18. Trilemma and Financial Stability Configurations in Asia By Aizenman, Joshua
  19. EMU, EU, Market Integration and Consumption Smoothing By Atanas Christev; Jacques Melitz
  20. Interest rate expectations and uncertainty during ECB governing council days: evidence from intraday implied densities of 3-month Euribor By Olivier Vergote; Josep Maria Puigvert Gutiérrez
  21. The Self-insurance Role of International Reserves and the 2008-2010 Crisis By Antonio Francisco A. Silva Jr

  1. By: Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt, Germany.); Arnaud Mehl (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt, Germany.)
    Abstract: This paper assesses whether the international monetary system is already tripolar and centred around the US dollar, the euro and the Chinese renminbi (RMB). It focuses on what we call China’s “dominance hypothesis”, i.e. whether the renminbi is already the dominant currency in Asia, exerting a large influence on exchange rate and monetary policies in the region, a direct reference to the old “German dominance hypothesis” which ascribed to the German mark a dominant role in Europe in the 1980s-1990s. Using a global factor model of exchange rates and a complementary event study, we find evidence that the RMB has become a key driver of currency movements in emerging Asia since the mid-2000s, and even more so since the global financial crisis. These results are consistent with China’s dominance hypothesis and with the view that the international monetary system is already tri-polar. However, we also find that China’s currency movements are to some extent affected by those in the rest of Asia. JEL Classification: F30, F31, F33, N20.
    Keywords: International monetary system, exchange rates, tri-polarity, China, renminbi, US dollar, euro, German dominance hypothesis.
    Date: 2011–10
  2. By: Tatom, John
    Abstract: Monetary policy has become difficult to characterize or follow since 2007. A debate as to whether interest rate targets or monetary aggregate targets are better indicators of policy and prospective outcomes has given way to a new credit policy built on inflating the Federal Reserve (Fed) balance sheet to provide private sector credit. This policy grew out of the Great Depression and has led the Fed to ignore monetary growth and render a federal funds rate target impotent by pushing it to zero. To implement the more than doubling of the Fed’s assets, the Fed took up commercial banking policies. Three examples are: selling Treasury assets to fund private assets, paying subsidies to banks for holding reserves and attracting a new class of Treasury debt sterilized in Fed deposits. These actions insulated monetary aggregates and the effective monetary base from the explosion in the Fed’s balance sheet. The new credit policy severed the tight link that had existed for over 70 years between Fed credit and its effective monetary base. Fortunately, it also insulated the economy from a more than doubling of the general price level. But these actions have turned the balance sheet of the Fed into a collection of illiquid and risky private assets. A similar portfolio of government securities that has the longest duration in history and therefore the greatest interest rate risk limits the Fed’s ability to reduce its assets or the excess reserve position of banks, exceeding $1.5 trillion and costing the taxpayer over $3.3 billion, from 2009 to mid-2011. The subsidy and excess reserve levels of the first half of 2011 will cost $2.3 billion per year going forward. Finally, the paper rebuts claims by Fed officials that the Fed has successfully followed the framework of monetary policy developed by Milton Friedman. The paper concludes with recommendations for Congressional restrictions on the Fed and Treasury to ensure that the Fed focus on responsible monetary policy and not its failed credit policy.
    Keywords: monetary policy; credit policy; central banking; Milton Friedman; business cycles
    JEL: E5 E3
    Date: 2011–08–27
  3. By: Ongena, S. (Universiteit van Tilburg); Peydro, J.L.
    Date: 2011
  4. By: Olivier Ledoit
    Abstract: We introduce a model of the economy as a social network. Two agents are linked to the extent that they transact with each other. This generates well-defined topological notions of location, neighborhood and closeness. We investigate the implications of our model for monetary economics. When a central bank increases the money supply, it must inject the money somewhere in the economy. We demonstrate that the agent closest to the location where money is injected is better off, and the one furthest is worse off. This redistribution channel is independent from the ones previously noted in the literature. Symmetrically, any decrease in the money supply redistributes purchasing power in the other direction. We also outline the testable implications of our model.
    Keywords: Money, redistribution, policy, central bank, social network, topology
    JEL: E40 E50
    Date: 2011–10
  5. By: Sarwar, haroon; Hussian, zakir; Awan, masood sarwar
    Abstract: The money demand function plays a key role in monetary policy formulation. Pakistan economy witnessed severe monetary problems in last few years, which call for a thorough investigation of the root cause. The study tried to estimate money demand function using Divisia type-weighted aggregates, instead of Simple sum official aggregates. Both long run and short run money demand functions were estimated and Stability was also tested. The money demand function based on broader Divisia aggregate (DivM2) was found to be the stable money demand function for Pakistan. The results indicated that the Divisia based money demand estimates were more realistic and had more information content. The study suggested that State Bank of Pakistan should abandon the Simple sum aggregation technique and switch over to the Divisia aggregates, which have more aggregation theoretic foundations.
    JEL: B21 O12
    Date: 2011
  6. By: Khemraj, Tarron; Pasha, Sukrishnalall
    Abstract: This paper notes that a high sterilization coefficient plus a de facto pegged exchange rate indicates the existence of dual nominal anchors. The econometric evidence presented shows that several Caribbean economies with fixed exchange rate regimes also possess high sterilization coefficients. Given open capital accounts in the various economies, the paper argues that this finding contravenes the money neutrality thesis, which holds that only one nominal anchor can prevail in the long-term. The paper presents a simple theoretical model to explain this phenomenon. The model combines the liquidity preference of commercial banks with an augmented uncovered interest parity equation.
    Keywords: sterilization coefficient; dual nominal anchors; foreign exchange regime
    JEL: O11 F41 F31
    Date: 2011–03–01
  7. By: Chris McDonald; Leif Anders Thorsrud (Reserve Bank of New Zealand)
    Abstract: Forecasting the future path of the economy is essential for good monetary policy decisions. The recent financial crisis has highlighted the importance of tail events, and that assessing the central projection is not enough. The whole range of outcomes should be forecasted, evaluated and accounted for when making monetary policy decisions. As such, we construct density fore- casts using the historical performance of the Reserve Bank of New Zealand's (RBNZ) published point forecasts. We compare these implied RBNZ den- sities to similarly constructed densities from a suite of empirical models. In particular, we compare the implied RBNZ densities to combinations of density forecasts from the models. Our results reveal that the combined den- sities are comparable in performance and sometimes better than the implied RBNZ densities across many dierent horizons and variables. We also find that the combination strategies typically perform better than relying on the best model in real-time, that is the selection strategy.
    JEL: C52 C53 E52
    Date: 2011–08
  8. By: Aizenman, Joshua; Sengupta, Rajeswari
    Abstract: A key challenge facing most emerging market economies today is how to simultaneously maintain monetary independence, exchange rate stability and financial integration subject to the constraints imposed by the Trilemma, in the era of deepening globalization. In this paper we study the Trilemma choices of the two key drivers of global growth, China and India. We overview and contrast the policy choices of the two, and test their Trilemma choices and tradeoffs. China’s Trilemma configurations are unique relative to the one characterizing other emerging markets in the predominance of exchange rate stability, and in the failure of the Trilemma regression to capture any significant role for financial integration. One possible interpretation is that the segmentation of the domestic capital market in China, its array of capital controls and the large hoarding of international reserves imply that the “policy interest rate” does not reflect the stance of monetary policy. In contrast, the Trilemma configurations of India are in line with the regression results of other emerging countries, and are consistent with the predictions of the Trilemma tradeoffs. India like other emerging economies has overtime converged towards a middle ground between the three policy objectives, and has achieved comparable levels of exchange rate stability and financial integration buffered by sizeable international reserves.
    Keywords: Financial trilemma; International reserves; Foreign exchange intervention; Monetary policy; Capital account openness
    JEL: E58 F3 E52 F41
    Date: 2011–11–01
  9. By: Fernando E. Alvarez; Francesco Lippi
    Abstract: We present a monetary model in the presence of segmented asset markets that implies a persistent fall in interest rates after a once and for all increase in liquidity. The gradual propagation mechanism produced by our model is novel in the literature. We provide an analytical characterization of this mechanism, showing that the magnitude of the liquidity effect on impact, and its persistence, depend on the ratio of two parameters: the long-run interest rate elasticity of money demand and the intertemporal substitution elasticity. At the same time, the model has completely classical long-run predictions, featuring quantity theoretic and Fisherian properties. The model simultaneously explains the short-run “instability” of money demand estimates as-well-as the stability of long-run interest-elastic money demand.
    JEL: E31 E4 E41 E43 E5
    Date: 2011–11
  10. By: George-Marios Angeletos; Jennifer La'O
    Abstract: We study optimal monetary policy in an environment in which firms’ pricing and production decisions are subject to informational frictions. Our framework accommodates multiple formalizations of these frictions, including dispersed private information, sticky information, and certain forms of inattention. An appropriate notion of constrained efficiency is analyzed alongside the Ramsey policy problem. Similarly to the New-Keynesian paradigm, efficiency obtains with a subsidy that removes the monopoly distortion and a monetary policy that replicates flexible-price allocations. Nevertheless, “divine coincidence” breaks down and full price stability is no more optimal. Rather, the optimal policy is to “lean against the wind”, that is, to target a negative correlation between the price level and real economic activity.
    JEL: D61 D83 E32 E52
    Date: 2011–11
  11. By: David Andolfatto
    Abstract: Lagos and Wright (2005) demonstrate how the essential properties of a money-search model are preserved in an environment that is rendered highly tractable with the use of quasi-linear preferences. In this paper, I show that this same innovation can be applied to closely related environments used elsewhere in the literature that study insurance and credit markets under limited commitment and private information. The analysis demonstrates clearly how insurance, credit, and money are interrelated in terms of their basic functions. The analysis also leads to a heretofore neglected result pertaining to the Friedman rule. In particular, I find that the same frictions that render money essential may at the same time operate to render the Friedman rule infeasible. Thus, even if the Friedman rule is a desirable policy, an incentive-induced lower bound on the rate of deflation may nevertheless entail a strictly postive rate of inflation.
    Keywords: Money ; Credit
    Date: 2011
  12. By: Pierre-Richard Agénor; Luiz A. Pereira da Silva
    Abstract: This paper presents a simple dynamic macroeconomic model of a bank-dominated financial system that captures some of the key credit market imperfections commonly found in middle-income countries. The model is used to analyze the interactions between monetary and macroprudential policies, involving, in the latter case, changes in reserve requirements and the imposition of an upper limit on banks’ leverage ratio. Policy implications are also discussed, in the context of the post-crisis debate on the use of macroprudential tools. The analysis shows that understanding how these tools operate is essential because they may alter, possibly in substantial ways, the monetary transmission mechanism.
    Date: 2011–11
  13. By: Meixing Dai
    Abstract: Most Western economists and policymakers agree that the Yuan is significantly undervalued and push for its quick nominal revaluation. This paper defends that many domestic and foreign factors could be responsible for the Yuan’s undervaluation, and the People’s bank of China (PBC) cannot optimally invest growing foreign exchange reserves. It provides a theoretical framework to discuss the optimal strategy associating a gradual nominal revaluation of the Yuan with higher inflation, and structural and macroeconomic policies to bring the real exchange rate to its equilibrium level. This strategy allows absorbing external imbalances while laying down the foundation for China’s long-term growth.
    Keywords: Real revaluation; Yuan; Renminbi (RMB); foreign exchange reserves; external imbalance; macroeconomic adjustment measures.
    JEL: E2 E5 E6 F3
    Date: 2011
  14. By: Ben R. Craig; Valeriya Dinger (Universitaet Osnabrueck)
    Abstract: We use bank retail interest rates as price examples in a study of the determinants of price durations. The extraordinary richness of the data allows us to address some major open issues from the price rigidity literature, such as the functional form of the hazard of changing a price, the effect of firm and market characteristics on the duration of prices, and asymmetry in the speed of adjustments to positive and negative cost shocks. We find that the probability of a bank changing its retail rate initially (that is, in roughly the first six months of a spell) increases with time. The most important determinants of the duration of retail interest rates are the cumulated change in the money market interest rates and the policy rate since the last retail rate change. Among bank and market characteristics, the size of the bank, its market share in a given local market, and its geographical scope significantly modify retail rate durations. Retail rates adjust asymmetrically to positive and negative wholesale interest rate changes; the asymmetry of the adjustment is reinforced in part by the bank’s market share. This suggests that monopolistic distortions play a vital role in explaining asymmetric price adjustments.
    Keywords: price stickiness, interest rate pass-through, duration analysis, hazard rate
    Date: 2011–11–07
  15. By: Carlos Capistrán; Raúl Ibarra-Ramírez; Manuel Ramos Francia
    Abstract: This paper analyzes the pass-through of exchange rate to different price indexes in Mexico. The analysis is based on a vector autoregressive model (VAR) using monthly data from January 1997 to December 2010. The pass-through effects are calculated by means of accumulated impulse response functions to a recursively identified exchange rate shock. The results show that the exchange rate pass-through to import prices is complete, but it declines along the distribution chain in such a way that the impact on consumer prices is below 20 percent. Moreover, we find that the exchange rate pass-through seems to have decreased substantially from 2001 onwards, which coincides with the adoption of an inflation targeting regime by Banco de Mexico.
    Keywords: Exchange rate pass-through, import price, consumer price, distribution chain, inflation.
    JEL: E31 F31 F41
    Date: 2011–11
  16. By: Arvind Krishnamurthy; Annette Vissing-Jorgensen
    Abstract: We evaluate the effect of the Federal Reserve’s purchase of long-term Treasuries and other long-term bonds ("QE1" in 2008-2009 and "QE2" in 2010-2011) on interest rates. Using an event-study methodology we reach two main conclusions. First, it is inappropriate to focus only on Treasury rates as a policy target because QE works through several channels that affect particular assets differently. We find evidence for a signaling channel, a unique demand for long-term safe assets, and an inflation channel for both QE1 and QE2, and an MBS pre-payment channel and a corporate bond default risk channel for QE1. Second, effects on particular assets depend critically on which assets are purchased. The event-study suggests that (a) mortgage-backed securities purchases in QE1 were crucial for lowering mortgage-backed security yields as well as corporate credit risk and thus corporate yields for QE1, and (b) Treasuries-only purchases in QE2 had a disproportionate effect on Treasuries and Agencies relative to mortgage-backed securities and corporates, with yields on the latter falling primarily through the market’s anticipation of lower future federal funds rates.
    JEL: E4 E5 G14 G18
    Date: 2011–10
  17. By: Tatom, John
    Abstract: Changes in the general level of prices and inflation have profound effects on asset prices. There are several reasons for these effects and the influence differs depending on the source of the inflation and whether it is expected or not. To understand these effects it is important to clarify what is meant by inflation, the pure theory of the sources of inflation, how inflation affects goods and services prices and how it affects the assets that are used to finance production, both equity prices and fixed income assets. This article reviews the theory of inflation, its sources and effects on asset prices, especially equity, bond and real asset prices. The simplest and broadest economic model suggests that money is a veil and that changes in its value (the price level and its rate of depreciation (inflation) have no real effect s on the economy, especially asset prices and real rates of return on assets. There are a variety of reasons to expect that inflation is not “neutral,” however. This article focuses on several factors that give rise to real adverse effects of inflation on asset prices, including supply shocks that reduce wealth and raise prices, and tax effects of inflation that arise from a lack of full indexation of the tax system. Inflation has had large effects on asset prices in the United States, especially during the Great Inflation from 1965 to 1984. The evidence here supports these sources of real effects of inflation.
    Keywords: Inflation; asset prices; supply shocks; real rate of interest; real rate of return on equity
    JEL: E31 E44 G0
    Date: 2011–11
  18. By: Aizenman, Joshua (Asian Development Bank Institute)
    Abstract: This paper takes stock of recent research dealing with the degree to which the trilemma choices of Asian countries facilitated a smoother adjustment during the global crisis of 2008–2009, and the way the region has been coping with the adjustment to the postcrisis challenges. We point out that emerging Asia has converged to a middle ground of the trilemma configuration: limited financial integration, a degree of monetary independence, and controlled exchange rate buffered by sizable international reserves.
    Keywords: trilemma choices; financial stability; global crisis 2008–2009
    JEL: F31 F32 F33 F36
    Date: 2011–11–02
  19. By: Atanas Christev; Jacques Melitz
    Keywords: Capital market integration, consumption smoothing, currency union, European Monetary Union, European Union
    JEL: F36 F41 E00 G10 A A A A A
    Date: 2011–10
  20. By: Olivier Vergote (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt, Germany.); Josep Maria Puigvert Gutiérrez (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt, Germany.)
    Abstract: This paper analyses changes in short-term interest rate expectations and uncertainty during ECB Governing Council days. For this purpose, it first extends the estimation of risk-neutral probability density functions up to tick frequency. In particular, the non-parametric estimator of these densities, which is based on fitting implied volatility curves, is applied to estimate intraday expectations of threemonth EURIBOR three months ahead. The estimator proves to be robust to market microstructure noise and able to capture meaningful changes in expectations. Estimates of the noise impact on the statistical moments of the densities further enhance the interpretation. In addition, the paper assesses the impact of the ECB communication during Governing Council days. The results show that the whole density may react to the communication and that such repositioning of market participants’ expectations will contain information beyond that of changes in the consensus view already observed in forward rates. The results also point out the relevance of the press conference in providing extra information and triggering an adjustment process for interest rate expectations. JEL Classification: C14, E43, E52, E58, E61.
    Keywords: Risk-neutral probability density functions, option-implied densities, interest rate expecta-tions, central bank communication, intraday analysis, announcement effects, tick data.
    Date: 2011–10
  21. By: Antonio Francisco A. Silva Jr
    Abstract: There is no standard rule for the definition of an “optimal level” of international reserves and several assumptions underlie the rationale behind holding reserves. There are various theoretical approaches, but no standard for the evaluation of the performance of “optimal level” models, and their parameters are difficult to estimate. The literature suggests that the benefits of holding reserves are high, but the accumulation of reserves is a costly strategy. In fact, in a world of high liquidity and free capital flow, establishing an adequate level of international reserves is still a puzzle. The strategy of accumulating international reserves is evaluated here using data from the 2008-2010 crisis and it is shown that countries with higher international reserve levels had less adjustment costs between 2008 and 2010. The cost-benefit relationship of holding reserves in the 2008-2010 crisis is also discussed based on a sample with 71 countries.
    Date: 2011–11

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