nep-mon New Economics Papers
on Monetary Economics
Issue of 2015‒05‒16
twelve papers chosen by
Bernd Hayo
Philipps-Universität Marburg

  1. Optimal Monetary and Fiscal Policy in an Economy with Inflation Persistence By Luk, Paul; Vines, David
  2. Central bank purchases of government bonds By Samuel Huber; Jaehong Kim
  3. Self-Fulfilling Debt Crises: Can Monetary Policy Really Help? By Philippe Bacchetta; Elena Perazzi; Eric van Wincoop
  4. How Can an Economy Protect Itself from the Developed Economies’ Monetary Policy? By Hock Ann Lee; Hock Tsen Wong; Huay Huay Lee
  5. Price-Level Convergence in the Eurozone By Alfredo García Hiernaux; David Esteban Guerrero Burbano
  6. Taylor Rule Deviations and Out-of-Sample Exchange Rate Predictability By Onur Ince; Tanya Molodtsova; David H. Papell
  7. Optimal Monetary and Fiscal Policy in an Economy with Endogenous Public Debt By Luk, Paul; Vines, David
  8. International Reserves for Emerging Economies: A Liquidity Approach. By Jung, Kuk Mo; Pyun, Ju Hyun
  9. Market Structure and Exchange Rate Pass-Through By Auer, Raphael; Schoenle, Raphael
  10. “On the bi-directional causal relationship between public debt and economic growth in EMU countries” By Marta Gómez-Puig; Simón Sosvilla-Rivero
  11. Europeâ??s radical banking union By Nicolas Véron
  12. Safeguarding the Banking System - a New Perspective on the Consolidation of the Macroprudential Regulation* By Irina-Raluca Badea

  1. By: Luk, Paul; Vines, David
    Abstract: This paper studies a simple New-Keynesian model of fiscal and monetary policy coordination when the policymaker acts under commitment. With a New Keynesian Phillips curve it is optimal to control inflation only through the use of monetary policy. But, when price-setters use a Steinsson (2003) Phillips curve, fiscal policy plays an active role, enabling a greater degree of consumption smoothing.
    Keywords: fiscal policy; monetary policy; New Keynesian model; Phillips curve
    JEL: E4 E5 E6
    Date: 2015–05
  2. By: Samuel Huber; Jaehong Kim
    Abstract: We develop a microfounded model, where agents have the possibility to trade money for government bonds in an over-the-counter market. It allows us to address important open questions about the effects of central bank purchases of government bonds, these being: under what conditions these purchases can be welfare-improving, what incentive problems they mitigate, and how large these effects are. Our main finding is that this policy measure can be welfare-improving, by correcting a pecuniary externality. Concretely, the value of money is increased as central bank's purchases of government bonds induce agents to increase their demand for money, which is welfare-improving.
    Keywords: Monetary theory, over-the-counter markets, quantitative easing, money demand, pecuniary externality
    JEL: E31 E40 E50 G12
    Date: 2015–04
  3. By: Philippe Bacchetta; Elena Perazzi; Eric van Wincoop
    Abstract: This paper examines quantitatively the potential for monetary policy to avoid self-fulfilling sovereign debt crises. We combine a version of the slow-moving debt crisis model proposed by Lorenzoni and Werning (2014) with a standard New Keynesian model. We consider both conventional and unconventional monetary policy. Under conventional policy the central bank can preclude a debt crisis through inflation, lowering the real interest rate and raising output. These reduce the real value of the outstanding debt and the cost of new borrowing, and increase tax revenues and seigniorage. Unconventional policies take the form of liquidity support or debt buyback policies that raise the monetary base beyond the satiation level. We find that generally the central bank cannot credibly avoid a self-fulfilling debt crisis. Conventional policies needed to avert a crisis require excessive inflation for a sustained period of time. Unconventional monetary policy can only be effective when the economy is at a structural ZLB for a sustained length of time.
    JEL: E52 E60 E63
    Date: 2015–05
  4. By: Hock Ann Lee (Universiti Malaysia Sabah); Hock Tsen Wong (Universiti Malaysia Sabah); Huay Huay Lee (University of Multimedia)
    Abstract: In theory, countries with floating exchange rates and perfect capital mobility should have monetary independence. At the other extreme, countries with pegged exchange rates may completely lose monetary independence. This is the open-economy trilemma. Countries are not possible to combine exchange rate stability, capital mobility and monetary independence. However, previous research on the effects of the choice of exchange rate regime on monetary independence has found mixed results. Given a large set of countries, their different country characteristics such as the level of economic development may have an impact on the interest rate pass-through. In explaining the link between economic development and interest rate pass-through, business cycle synchronization could be one of the plausible reasons. If a country’s business cycle is highly synchronized with foreign countries, its domestic interest rates may be highly correlated with foreign interest rates, even for countries with floating exchange rates. This complicating factor has been ignored in previous work. Thus, this study aims to re-examine this issue by incorporating the level of economic development. In doing so, this study has distinguished more developed from less developed countries. Using panel data analyses, this study uses a sample of more than 100 countries from 1995. The dataset comprises interest rates and the indicators of exchange rate regime, capital control and economic development. This study uses interest rate pass-through as the appropriate measure of monetary independence. The findings show that pegged exchange rates with no capital controls have lower monetary independence than all other regimes. In line with the theory, this study has indicated that countries will completely lose their monetary independence only if their exchange rates are rigidly pegged without capital controls. More importantly, the findings have further confirmed that the evidence of the trilemma did not differ according to sub-groups of similar level of economic development.
    Keywords: Monetary Independence, Exchange Rate Regime, the Open-Economy Trilemma
    JEL: F41
  5. By: Alfredo García Hiernaux (Departamento de Fundamentos del Análisis Económico II (Economía Cuantitativa). Universidad Complutense de Madrid.); David Esteban Guerrero Burbano (CUNEF. Colegio Universitario de Estudios Financieros.)
    Abstract: This paper shows that price level trends in many of the EMU countries evolve with different patterns and that these patterns will not converge in the long-run. We propose that the hypothesis of price convergence should be evaluated and tested employing the relative prices. To this aim, we: (i) define the asymptotic price level convergence in mean and variance, (ii) provide a model for relative price levels that includes a transition path, and (iii) show how to properly test the definitions stated. Our results show that only French and German price levels converge in mean to a zero gap in the EMU while some others, not many, converge to a nonzero significant gap. This should be a matter of concern for the European monetary policy makers as it implies that the monetary policy does not affect all the EMU members equally.
    Keywords: Price convergence; Price levels; Relative price; Inflation; EMU.
    JEL: E30 E31 E52 C22 F15
    Date: 2015–05
  6. By: Onur Ince; Tanya Molodtsova; David H. Papell
    Abstract: The Taylor rule has become the dominant model for academic evaluation of out-of-sample exchange rate predictability. Two versions of the Taylor rule model are the Taylor rule fundamentals model, where the variables that enter the Taylor rule are used to forecast exchange rate changes, and the Taylor rule differentials model, where a Taylor rule with postulated coefficients is used in the forecasting regression. We use data from 1973 to 2014 to evaluate short-run out-of-sample predictability for eight exchange rates vis-à-vis the U.S. dollar, and find strong evidence in favor of the Taylor rule fundamentals model alternative against the random walk null. The evidence of predictability is weaker with the Taylor rule differentials model, and still weaker with the traditional interest rate differential, purchasing power parity, and monetary models. The evidence of predictability for the fundamentals model is not related to deviations from the original Taylor rule for the U.S., but is related to deviations from a modified Taylor rule for the U.S. with a higher coefficient on the output gap. The evidence of predictability is also unrelated to deviations from Taylor rules for the foreign countries and adherence to the Taylor principle for the U.S. Key Words:
    Date: 2015
  7. By: Luk, Paul; Vines, David
    Abstract: This paper uses a New Keynesian framework to study the coordination of fiscal and monetary policies, in response to an inflation shock when the policymaker acts with commitment. We first show that, in the simplest New Keynesian model, fiscal policy plays no part in the optimal policy response, because of the comparative advantage which monetary policy has in the control of inflation. We then add endogenous public debt and show that the above result is no longer true. When the initial stock of debt is low, it is optimal for government spending to remain largely inactive, but when the initial stock of debt is high, government spending should play a significant stabilisation role in the first period. This finding is robust to adding endogenous capital accumulation and inflation persistence in the Phillips curve.
    Keywords: fiscal policy; government debt; monetary policy; New Keynesian model
    JEL: E4 E5 E6
    Date: 2015–05
  8. By: Jung, Kuk Mo; Pyun, Ju Hyun
    Abstract: The massive stocks of foreign exchange reserves, mostly held in the form of U.S. T-Bonds by emerging economies, are still an important puzzle. Why do emerging economies continue to willingly loan to the United States despite the low rates of return? We propose that a dynamic general equilibrium model incorporating international capital markets, characterized by a non-centralized trading mechanism and U.S. T-Bonds as facilitators of trade, can provide an answer to this question. Declining financial frictions in these over-the-counter (OTC) markets would generate rising liquidity premiums on U.S. T-Bonds. Meanwhile, the higher liquidity properties of the U.S. T-Bonds would induce recipients of foreign investments, namely emerging economies, to hold more liquidity, that is U.S. T-Bonds, in equilibrium. The prediction of our model is confirmed by an empirical simultaneous equations approach considering an endogenous relationship between OTC capital inflows and reserves holdings.
    Keywords: international reserves, over-the-counter markets, liquidity, simultaneous equations
    JEL: E44 E58 F21 F31 F36 F41
    Date: 2015–05
  9. By: Auer, Raphael; Schoenle, Raphael
    Abstract: We study firm-level pricing behavior through the lens of exchange rate pass-through and provide new evidence on how firm-level market shares and price complementarities affect pass-through decisions. Using micro-data from U.S. import prices, we identify two facts: First, exactly the firms that react the most with their prices to changes in their own costs are also the ones that react the least to changing competitor prices. Second, the response of import Prices to exchange rate changes is U-shaped in market share while it is hump-shaped in response to competitor prices. We show that both facts are consistent with a model based on Dornbusch (1987) that generates variable markups through a nested-CES demand system. Finally, based on the model, we find that direct cost pass-through and price complementarities play approximately equally important roles in determining pass-through but also partly offset each other. This suggests that equilibrium feedback effects in pricing are large. Omission of either channel in an empirical analysis results in a failure to explain how market structure affects price-setting in industry equilibrium.
    Keywords: exchange rate pass-through; price complementarities; price setting; U.S. import prices
    JEL: E3 E31 F41
    Date: 2015–05
  10. By: Marta Gómez-Puig (Faculty of Economics, University of Barcelona); Simón Sosvilla-Rivero (Universidad Complutense de Madrid)
    Abstract: New evidence is presented on the possible existence of bi-directional causal relationships between public debt and economic growth in both central and peripheral countries of the European Economic and Monetary Union. We test for heterogeneity in the bi-directional Granger-causality across both time and space during the period between 1980 and 2013. The results suggest evidence of a “diabolic loop” between low economic growth and high public debt levels in Spain after 2009. For Belgium, Greece, Italy and the Netherlands debt has a negative effect over growth from an endogenously determined breakpoint and above a debt threshold ranging from 56% to 103% depending on the country.
    Keywords: Public debt, economic growth, Granger-causality, euro area, peripheral EMU countries, central EMU countries. JEL classification:C22, F33, H63, O40, O52
    Date: 2015–05
  11. By: Nicolas Véron
    Abstract: Banking Union, even in its current incomplete form, is the single biggest structural policy success of the EU since the start of the financial crisis. This essay presents the sequence of events that led to its inception in late June 2012 and takes stock on its current status of implementation and prospects. The essay argues forcefully that the political decision to initiate banking union was the decisive factor behind the ECBâ??s OMT programme, which put an end to the most acute phase of the euro area crisis, and that it also enabled the shift in the European approach to banking crisis resolution from bail-out to bail-in, which was prevented by the earlier policy framework of national banking supervision. In this sense, the banking union decision of mid-2012 was the crucial and largely unrecognized turning point of the entire euro area crisis. The transfer of supervisory authority over all euro-area banks to the ECB, effective since last November, marks a profound change and is already resulting in more rigorous and consistent supervision. After a few years of transition, the banking union framework can be expected to lead to a better integrated, more diverse and more resilient European financial system. It will also enhance European influence in shaping global banking regulatory standards and policies.
    Date: 2015–05
  12. By: Irina-Raluca Badea (University of Craiova, Faculty of Economics and Business Administration)
    Abstract: The aftermath of the global financial crisis revealed the weaknesses of the financial system and the monetary incentives to be taken into consideration by the policy-makers. Whether it is exposed to specific risks or to systemic risk, the banking system has to be heavily regulated in order to prevent it from collapsing. The macroprudential regulation promotes the stability of the financial system as a whole, and also treats systemic risk as a trigger of a chain reaction caused by the interlinkages in the financial system. Therefore, this paper outlines the role of the macroprudential regulation for achieving the financial stability goal in the context of systemic turbulences. The safeguarding of financial stability should not be understood as a zero tolerance of bank failures or of an avoidance of market volatility but it should avoid financial disruptions that lead to real economic costs.On the one hand, an overlook on the progress of the prudential regulation points out the procyclical aspects of the regulatory requirements so far, such as capital requirements, risk assessment, provisioning; on the other hand, the present paper identifies the improvements of the most recent recommendations on banking regulations, embodied in the Basel III Accord. Hence, the Basel III requirements in terms of capital adequacy, liquidity, the capital and conservation buffers against procyclicality represent unquestionable improvements for the macroprudential regulation. Given the fact that Basel III has established phase-in arrangements from 2013 to 2019, it is important to analyze the progress of its implementation and its impact on the banking system resilience. *This work was cofinanced from the European Social Fund through Sectoral Operational Programme for Human Resources Development 2007-2013, under the project number POSDRU/159/1.5/S/140863 with the title „ Competitive Researchers in Europe in the Field of Humanities and Socio –Economic Sciences. A Multi-regional Research Network”.
    Keywords: financial stability, systemic risk, banking system, Basel III requirements, regulation
    JEL: E52 E58 G01

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