nep-mon New Economics Papers
on Monetary Economics
Issue of 2014‒02‒15
twenty-one papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Determinants of the Trilemma Policy Combination By Ito, Hiro; Kawai, Masahiro
  2. Indeterminacy and Learning: An Analysis of Monetary Policy in the Great Inflation By Thomas A. Lubik; Christian Matthes
  3. Monetary policy and a brightening economy By Plosser, Charles I.
  4. In brief: Tough choices for a troubled euro By Christopher Pissarides
  5. Estimating Interest Rate Setting Behavior in Korea: An Ordered Probit Model Approach By Hyeongwoo Kim
  6. Monetary policy shocks and foreign investment income: evidence from a large Bayesian VAR By Auer, Simone
  7. Not all international monetary shocks are alike for the Japanese economy By Ronald A. Ratti; Joaquin L. Vespignani
  8. Money, liquidity and welfare By Wen, Yi
  9. Foreign Reserve Accumulation and the Mercantilist Motive Hypothesis By Patrick Carvalho; Renee A. Fry-McKibbin
  10. The lender of last resort in court By Winkler, Adalbert
  11. A multi-country DSGE model with incomplete Exchange Rate Pass-through: application for the Euro area By Tovonony Razafindrabe
  12. Optimal Monetary Policy with Counter-Cyclical Credit Spreads By Airaudo, Marco; Olivero, María Pía
  13. Is Increased Price Flexibility Stabilizing? Redux By Saroj Bhattarai; Gauti Eggertsson; Raphael Schoenle
  14. Monetary policy and financial stability: what role in prevention and recovery? By Claudio Borio
  15. Emerging Economies' Supply Shocks and Japan's Price Deflation: International Transmissions in a Three-Country DSGE Model By Hirakata, Naohisa; Iwasaki, Yuto; Kawai, Masahiro
  16. The global long-term interest rate, financial risks and policy choices in EMEs By Philip Turner
  17. Regional Settlement Infrastructure and Currency Internationalization: The Case of Asia and the Renminbi By Rhee, Changyong; Sumulong, Lea
  18. On the economics of committed liquidity facilities By Morten Bech; Todd Keister
  19. Financial Frictions and the Transmission of Foreign Shocks in Chile By Javier García-Cicco; Markus Kirchner; Santiago Justel
  20. Towards a Banking Union: Open issues. A report. By Christian de Boissieu
  21. Assessing the link between price and financial stability By Christophe Blot; Jérôme Creel; Paul Hubert; Fabien Labondance; Francesco Saraceno

  1. By: Ito, Hiro (Asian Development Bank Institute); Kawai, Masahiro (Asian Development Bank Institute)
    Abstract: This paper presents a theoretical framework for policy making based on the “impossible trinity” or the “trilemma” hypothesis. A simple optimization model shows that placing more weight in terms of preference for each of the three open macroeconomic policies—exchange rate stability, financial market openness, and monetary policy independence—contributes to a higher level of achievement in that particular policy. The paper goes on to develop the first empirical framework in the literature to investigate the joint determination of the triad open macroeconomic policies based on the trilemma hypothesis. Results from applying the seemingly unrelated regression estimation method and employing other robustness checks show that simple economic and structural fundamentals determine the trilemma policy combinations. Finally, the paper examines how deviations from the “optimal” trilemma policy combinations evolve around the time of a financial crisis.
    Keywords: trilemma hypothesis; macroeconomic policy; exchange rate stability; financial market openness; monetary policy independence; financial crisis; policy combination
    JEL: F15 F21 F31 F36 F41 O24
    Date: 2014–01–30
  2. By: Thomas A. Lubik; Christian Matthes
    Abstract: We argue in this paper that the Great Inflation of the 1970s can be understood as the result of equilibrium indeterminacy in which loose monetary policy engendered excess volatility in macroeconomic aggregates and prices. We show, however, that the Federal Reserve inadvertently pursued policies that were not anti-inflationary enough because it did not fully understand the economic environment it was operating in. Specifically, it had imperfect knowledge about the structure of the U.S. economy and it was subject to data misperceptions. The real-time data flow at that time did not capture the true state of the economy, as large subsequent revisions showed. It is the combination of learning about the economy and, more importantly, the use of data riddled with measurement error that resulted in policies, which the Federal Reserve believed to be optimal, but when implemented led to equilibrium indeterminacy in the economy.
    Keywords: Federal Reserve, Great Moderation, Bayesian Estimation, Least Squares Learning
    JEL: C11 C32 E52
    Date: 2014–02
  3. By: Plosser, Charles I. (Federal Reserve Bank of Philadelphia)
    Abstract: President Plosser discusses why he thinks the economy is on firmer footing than it has been for the past several years. He also discusses why he believes it is appropriate to end asset purchases and why he supported the FOMC's decision in January to continue to reduce the pace of purchases.
    Date: 2014–02–05
  4. By: Christopher Pissarides
    Abstract: Nobel laureate Christopher Pissarides thinks that either the euro should be dismantled or the direction of European economic policy reversed.
    Keywords: Europe, economic policy, euro
    Date: 2014–02
  5. By: Hyeongwoo Kim
    Abstract: We investigate the Bank of Korea's interest rate setting behavior using a discrete choice model, where the Monetary Policy Committee revises the target policy interest rate only when the gap between the current market interest rate and the optimal rate exceeds a certain threshold value. Using monthly frequency data since 2000, we evaluate an array of ordered probit models in terms of the in-sample fit. We find important roles for the output gap, inflation, and the won depreciation rate against the US dollar. We also implement out-of-sample forecast exercises with September 2008 (Lehman Brothers Bankruptcy) for a split point, finding good out-of-sample predictability of our models.
    Keywords: Monetary Policy; Bank of Korea; Ordered Probit Model; Target RP Rate; Interbank Call Rate; Taylor Rule
    JEL: E52 E58
    Date: 2014–02
  6. By: Auer, Simone (Federal Reserve Bank of Dallas)
    Abstract: This paper assesses the transmission of monetary policy in a large Bayesian vector autoregression based on the approach proposed by Banbura, Giannone and Reichlin (2010). The paper analyzes the impact of monetary policy shocks in the United States and Canada not only on a range of domestic aggregates, trade flows, and exchange rates, but also foreign investment income. The analysis provides three main results. First, a surprise monetary policy action has a statistically and economically significant impact on both gross and net foreign investment income flows in both countries. Against the background of growing foreign wealth and investment income, this result provides preliminary evidence that foreign balance-sheet channels might play an increasingly important role for monetary transmission. Second, the impact of monetary policy on foreign investment income flows differs considerably across asset categories and over time, suggesting that the investment instruments and the currency denomination of a country’s foreign assets and liabilities are potentially relevant for the way in which monetary policy affects the domestic economy. Finally, the results support existing evidence on the effectiveness of large vector autoregressions and the Bayesian shrinkage approach in addressing the curse of dimensionality and eliminating price and exchange rate puzzles.
    JEL: C53 E52 F41 F42
    Date: 2014–02–13
  7. By: Ronald A. Ratti; Joaquin L. Vespignani
    Abstract: It is found that over 1999:1-2012:12 China’s monetary expansion influences Japan through the effect of China’s growth on world commodity prices, increased demand for imports, and exchange rate policy. China’s monetary expansion is associated with significant increases in Japan’s industrial production, exports and inflation, and decreases in the trade-weighted yen. In contrast, U.S. monetary expansion results in contraction in Japan’s industrial production, exports and trade balance (expenditure-switching). Monetary expansion in the Euro area does not significantly affect Japan. Structural vector error correction models are estimated. Results are robust to various contemporaneous restrictions for the effect of international monetary variables, the interaction of foreign and domestic variables and to factor augmented VAR to identify monetary shocks.
    Keywords: International Monetary shocks, Japanese economy, Oil/commodity prices, SVEC models
    JEL: E52 F41 F42 Q43
    Date: 2014–02
  8. By: Wen, Yi (Federal Reserve Bank of St. Louis)
    Abstract: This paper develops an analytically tractable Bewley model of money demand to shed light on some important questions in monetary theory, such as the welfare cost of inflation. It is shown that when money is a vital form of liquidity to meet uncertain consumption needs, the welfare costs of inflation can be extremely large. With log utility and parameter values that best match both the aggregate money demand curve suggested by Lucas (2000) and the variance of household consumption, agents in our model are willing to reduce consumption by 3% ~ 4% to avoid 10% annual inflation. The astonishingly large welfare costs of inflation arise because inflation increases consumption risk by eroding the buffer-stock-insurance value of money, thus hindering consumption smoothing at the household level. Such an inflation-induced increase in consumption risk at the micro level cannot be captured by representative-agent models or the Bailey triangle. Although the development of financial intermediation can mitigate the problem, with realistic credit limits the welfare loss of moderate inflation still remains several times larger than estimations based on the Bailey triangle. Our findings provide not only a justification for adopting a low inflation target by central banks, but also a plausible explanation for the robust positive relationship between moderate inflation and social unrest in developing countries where money is the major form of household financial wealth.
    Keywords: Liquidity Preference; Money Demand; Financial Intermediation; Velocity; Welfare Costs of Inflation
    JEL: D10 D31 D60 E31 E41 E43 E49 E51
    Date: 2014–02–07
  9. By: Patrick Carvalho; Renee A. Fry-McKibbin
    Abstract: A fivefold increase in central bank foreign reserves across the globe over the past fifteen years has prompted the question of whether this constitutes a new form of mercantilism. According to this view, countries accumulate foreign reserves in order to support export promotion by influencing exchange rates and/or to signal relative economic strength as a modern version of bullionism. Using a unique dataset on daily foreign exchange intervention, this paper investigates the mercantilist motive hypothesis for the case of Brazil over the period 2009-2012. The findings support reserve accumulation as a byproduct of successful central bank intervention in the Brazilian foreign exchange market. The results also indicate regional currency intervention spillovers to Brazil’s neighbouring countries, including on their foreign reserve build-ups.
    Keywords: Foreign exchange intervention, currency intervention, exchange rate volatility, reserve accumulation, factor model, emerging markets
    Date: 2014–02
  10. By: Winkler, Adalbert
    Abstract: Is the OMT program in violation of the ECB's mandate? This paper applies the economic argumentation put forth by the OMT's opponents and supporters before the Federal German Constitutional Court [Bundesverfassungsgericht] to the full allotment policy practiced by the ECB since October 2008. The comparison shows that if the OMT violates the ECB's mandate, the same holds for the full allotment policy. Ultimately, therefore, the ECB is not in court because of monetary financing, but rather as a lender of last resort. Accordingly, a court decision against the OMT would endorse an economic reasoning which contradicts 150 years of modern central bank history and would expose the euro area to the instabilities of financial markets. Such a monetary union is neither sustainable nor desirable. --
    Keywords: lender of last resort,OMT program,full allotment policy
    JEL: E52 E53 F33
    Date: 2014
  11. By: Tovonony Razafindrabe
    Abstract: This paper develops an estimated multi-country open economy dynamic stochastic general equilibrium (DSGE) model with incomplete Exchange Rate Pass-Through (ERPT) for the Euro-area. It is designed to model global international linkages and to assess international transmission of shocks under an endogenous framework and incomplete ERPT assumption. On the one hand, we relax the small open economy framework (SOEF) but derive a canonical representation of the equilibrium conditions to maintain analytical tractability of the complex international transmission mechanism underlying the model. Namely, the model considers economies of different size that are open and endogenously related. On the other hand, in order to take into account international linkages, possible cointegration relationships within domestic variables and between domestic and foreign variables, and the role of common unobserved and observed global factors such as the oil price, we use the Global VAR model to estimate the steady state of observed endogenous variables of the multi-country DSGE model. Namely, steady states are computed as long-horizon forecasts from a reduced-form cointegrating GVAR model. ERPT analysis conducted from the estimated multi-country DSGE model for the Euro-area in relation with its …ve main trade partners which are the United Kingdom, the United States, China, Japan and Switzerland yields the following results. First, exchange rate volatility contributes to a large part of import price inflation variation of the Euro-area in contrast to foreign mark-up shocks. Second, deviation from inflation objective of the foreign trade partners contributes to another source of the Euro-area import price variability. Third, nominal rigidity induces a persistent but a lower impact of the exchange rate changes on import inflation.
    Keywords: Pass-through, multi-country DSGE, Bayesian estimation, monetary policy
    JEL: F31 F41 E52 C11
    Date: 2014
  12. By: Airaudo, Marco (School of Economics LeBow College of Business Drexel University); Olivero, María Pía (School of Economics LeBow College of Business Drexel University)
    Abstract: We study optimal monetary policy in a New Keynesian-DSGE model where the combination of a credit channel and customer-market features in banking gives rise to counter-cyclical credit spreads. In our setting, monopolistically competitive banks set lending rates in a forward-looking fashion as they internalize the fact that, due to borrowers. bank-specific (hence deep) habits, current interest rates also affect the future demand for loans by financially constrained. In particular, during a phase of economic expansion, banks might find it optimal to lower current lending rates to build up a larger customer base, which will be locked into a long-term relationship. The resulting counter-cyclicality of credit spreads makes optimal monetary policy depart substantially from the efficient allocation (and hence from price stability), under both discretion and commitment. Our analysis shows that the welfare costs of setting monetary policy under discretion (with respect to the optimal Ramsey plan) and of using simpler sub-optimal policy rules are strictly increasing in the magnitude of deep habits in credit markets and market power in banking.
    Keywords: Optimal monetary policy; Cost Channel; New-Keynesian model; Credit frictions; Deep habits; Credit spreads
    JEL: E32 E44 E50
    Date: 2014–01–25
  13. By: Saroj Bhattarai; Gauti Eggertsson; Raphael Schoenle
    Abstract: We study the implications of increased price flexibility on output volatility. In a simple DSGE model, we show analytically that more flexible prices always amplify output volatility for supply shocks and also amplify output volatility for demand shocks if monetary policy does not respond strongly to inflation. More flexible prices often reduce welfare, even under optimal monetary policy if full efficiency cannot be attained. We estimate a medium-scale DSGE model using post-WWII U.S. data. In a counterfactual experiment we find that if prices and wages are fully flexible, the standard deviation of annualized output growth more than doubles.
    JEL: E31 E32 E52
    Date: 2014–02
  14. By: Claudio Borio
    Abstract: If the criteria for an institution's success are diffusion and longevity, then central banking has been hugely successful. But if the criterion is the degree to which it has achieved its goals, then the evaluation has to be more nuanced. Historically, those goals have included a changing mix of financial and monetary stability. Attaining monetary and financial stability simultaneously has proved elusive across regimes. Edging closer towards that goal calls for incorporating systematically long-duration and disruptive financial booms and busts - financial cycles - in policy frameworks. For monetary policy, this means leaning more deliberately against booms and easing less aggressively and persistently during busts. What is ultimately at stake is the credibility of central banking - its ability to retain trust and legitimacy.
    Keywords: financial cycle, balance sheet recessions, expectations gap, time inconsistency, regime shifts
    Date: 2014–01
  15. By: Hirakata, Naohisa (Asian Development Bank Institute); Iwasaki, Yuto (Asian Development Bank Institute); Kawai, Masahiro (Asian Development Bank Institute)
    Abstract: This paper examines the international transmission effects that a positive supply shock in emerging economies may have on inflation in developed economies. A three-country dynamic stochastic general equilibrium (DSGE) model is constructed to analyze the impact of a supply shock in an emerging economy, the People's Republic of China (PRC), on inflation rates in two developed economies, Japan and the United States (US). The assumed asymmetric trade structures among the three countries and the PRC's choice of exchange rate regime appear to influence the international transmission of a supply shock in the PRC. Specifically, Japan is under a greater deflationary pressure than the US because of its vertical trade specialization vis-à-vis the PRC and the PRC's US-dollar-pegged regime. This outcome suggests that, even though Japan and the US may face common positive supply shocks from emerging economies, the deflationary impact of the shock is greater for Japan.
    Keywords: supply shocks; emerging economies; trade structure; exchange rate regimes; three-country DSGE model
    JEL: F32 F41 F44 F47
    Date: 2014–02–07
  16. By: Philip Turner
    Abstract: The global long-term interest rate now matters much more for the monetary policy choices facing emerging market economies than a decade ago. The low or negative term premium in the yield curve in the advanced economies from mid-2010 has pushed international investors into EM local bond markets: by lowering local long rates, this has considerably eased monetary conditions in the emerging markets. It has also encouraged much increased foreign currency borrowing in international bond markets by emerging market corporations, much of it by affiliates offshore. These developments strengthen the feedback effects between bond and foreign exchange markets. They also have significant implications for local banking systems.
    Keywords: Term premium, international corporate bonds, monetary policy triangle, currency mismatches
    Date: 2014–02
  17. By: Rhee, Changyong (Asian Development Bank Institute); Sumulong, Lea (Asian Development Bank Institute)
    Abstract: The squeeze in United States dollar liquidity that emerged with the global financial crisis highlighted the risks inherent in the current global financial system. Asia was adversely affected by the crisis not only because of its dependence on trade, but also because of its heavy reliance on the US dollar for regional and international transactions. As Asia’s role in the global economy continues to expand, its dependence on the US dollar is bound to increase, raising further its vulnerability to future liquidity shocks. The use of regional currencies for bilateral trade settlement could reduce such vulnerability. As demonstrated by the renminbi trade settlement scheme piloted between the People’s Republic of China; Hong Kong, China; and Macao, China, the existence of appropriate financial infrastructure could reduce the relatively larger costs of bilateral currency transactions compared with triangular transactions through the United States dollar. As most central banks are securities depositories of government bonds, combining trade settlement with government bond securities settlement could also have large synergy effects without substantial extra costs. This proposal does not require full liberalization of the capital account or full deregulation of capital markets, and is more politically feasible in transition. As such, extending the trade settlement scheme to the rest of Asia and appending a government bond payment and securities settlement system could be a practical solution to international monetary system reform and the diversification of settlement currencies.
    Keywords: global financial crisis; international monetary system; renminbi internationalization; renminbi trade settlement; government bond payment and settlement
    JEL: F33 F34 F42
    Date: 2014–02–05
  18. By: Morten Bech; Todd Keister
    Abstract: We study the effects of the new Basel III liquidity regulations in jurisdictions with a limited supply of high-quality liquid assets. Using a model based on Bech and Keister (2013), we show how introducing a liquidity coverage ratio in such settings can have significant side effects, leading to a large liquidity premium and pushing the short-term interest rate to the floor of the central bank's rate corridor. Adding a committed liquidity facility allows the central bank to mitigate these effects. By pricing committed liquidity appropriately, the central bank can determine either the equilibrium liquidity premium or the quantity of liquid assets held by banks, but not both. We argue that the optimal pricing arrangement will depend on local market conditions.
    Keywords: Basel III, liquidity regulation, liquidity premium, liquidity coverage ratio, committed liquidity facility
    Date: 2014–01
  19. By: Javier García-Cicco; Markus Kirchner; Santiago Justel
    Abstract: We set up and estimate a DSGE model of a small open economy to assess the role of domestic financial frictions in propagating foreign shocks. In particular, the model features two types of financial frictions: one in the relationship between depositors and banks (following Gertler and Karadi, 2011) and the other between banks and borrowers (along the lines of Bernanke et al, 1999). We use Chilean data to estimate the model, following a Bayesian approach. We find that the presence of financial frictions increases the importance of foreign shocks in explaining consumption, inflation, the policy rate, the real exchange rate and the trade balance. In contrast, under financial frictions the role of these foreign shocks in explaining output and investment is somehow reduced. The behavior of the real exchange rate and its interaction with the financial frictions is key to understand the results.
    Date: 2014–01
  20. By: Christian de Boissieu (Université Paris I (Panthéon – Sorbonne); Département des Etudes économiques européennes, Collège d'Europe)
    Abstract: The purpose of this paper is to give an account of the debates regarding the implementation of a banking union in Europe that took place in Bruges in April 2013 at a Conference co-organised by the College of Europe and the European Commission's Joint Research Centre (JRC). The benefits to be expected from the banking union are reviewed. Then its components are analysed and discussed with a special focus on supervision and resolution of banks. The challenges are both functional and institutional. They involve micro-and macro prudential considerations. As regards the ECB, will there be possible conflicts of objectives and conflicts of interest when it cumulates its monetary policy function with its new supervisory role? For banking supervision, how to combine the division of labour between the ECB and the national competent authorities with the necessary coordination between them? The same kind of challenge applies to resolution and deposit insurance. The paper relates the transition to a banking union to other structural issues such as the separation of bank activities and the financing of the real economy in the new regulatory framework.
    Keywords: banking Union, economic and monetary union, financial Integration
    JEL: F36 G21
    Date: 2014–01
  21. By: Christophe Blot (Ofce,Sciences-po); Jérôme Creel (Ofce, Sciences-po, Escp Europe); Paul Hubert (Ofce,sciences-po); Fabien Labondance (Ofce, Sciences-po); Francesco Saraceno (Ofce: Sciences-po, LUISS)
    Abstract: This paper aims at investigating first the (possibly time-varying) empirical relationship between the level and conditional variances of price and financial stability, and second, the effects of macro and policy variables on this relationship in the United States and the Eurozone. Three empirical methods are used to examine the relevance of A.J Schwartz’s conventional wisdom that price stability would yield financial stability. Using simple correlations, VAR and Dynamic Conditional Correlations, we reject the hypothesis that price stability is positively correlated to financial stability. We then discuss the empirical appropriateness of the leaning against the wind monetary policy approach.
    Keywords: Price stability, Financial stability,DCC-GARCH,VAR
    JEL: C32 E31 E44 E52
    Date: 2014–02

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