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We study optimal nominal demand policy in an economy with monopolistic competition and flexible prices when firms have imperfect common knowledge about the shocks hitting the economy. Parametrizing firms´ information imperfections by a (Shannon) capacity parameter that constrains the amount of information flowing to each firm, we study how policy that minimizes a quadratic objective in output and prices depends on this parameter. When price setting decisions of firms are strategic complements, for a large range of capacity values optimal policy nominally accommodates mark-up shocks in the short-run. This finding is robust to the policy maker observing shocks imperfectly or being uncertain about firms´ capacity parameter. With persistent mark-up shocks accommodation may increase in the medium term, but decreases in the long-run thereby generating a hump-shaped price response and a slow reduction in output. Instead, when prices are strategic substitutes, policy tends to react restrictively to mark-up shocks. However, rational expectations equilibria may then not exist with small amounts of imperfect common knowledge.
We determine optimal monetary policy under commitment in a forwardlooking New Keynesian model when nominal interest rates are bounded below by zero. The lower bound represents an occasionally binding constraint that causes the model and optimal policy to be nonlinear. A calibration to the U.S. economy suggests that policy should reduce nominal interest rates more aggressively than suggested by a model without lower bound. Rational agents anticipate the possibility of reaching the lower bound in the future and this amplifies the effects of adverse shocks well before the bound is reached. While the empirical magnitude of U.S. mark-up shocks seems too small to entail zero nominal interest rates, shocks affecting the natural real interest rate plausibly lead to a binding lower bound. Under optimal policy, however, this occurs quite infrequently and does not require targeting a positive average rate of inflation. Interestingly, the presence of binding real rate shocks alters the policy response to (non-binding) mark-up shocks. JEL Klassifikation: C63, E31, E52 .
Under a conventional policy rule, a central bank adjusts its policy rate linearly according to the gap between inflation and its target, and the gap between output and its potential. Under "the opportunistic approach to disinflation" a central bank controls inflation aggressively when inflation is far from its target, but concentrates more on output stabilization when inflation is close to its target, allowing supply shocks and unforeseen fluctuations in aggregate demand to move inflation within a certain band. We use stochastic simulations of a small-scale rational expectations model to contrast the behavior of output and inflation under opportunistic and linear rules. Klassifikation: E31, E52, E58, E61. July, 2005.
Ensuring financial stability : financial structure and the impact of monetary policy on asset prices
(2008)
This paper studies the responses of residential property and equity prices, inflation and economic activity to monetary policy shocks in 17 countries, using data spanning 1986-2006. We estimate VARs for individual economies and panel VARs in which we distinguish between groups of countries on the basis of the characteristics of their financial systems. The results suggest that using monetary policy to offset asset price movements in order to guard against financial instability may have large effects on economic activity. Furthermore, while financial structure influences the impact of policy on asset prices, its importance appears limited. Keywords: asset prices, monetary policy, panel VAR. JEL Number: C23, E52
We study the responses of residential property and equity prices, inflation and economic activity to monetary policy shocks in 17 countries, using data spanning 1986-2006, using single-country VARs and panel VARs in which we distinguish between groups of countries depending on their financial systems. The effect of monetary policy on property prices is about three times as large as its impact on GDP. Using monetary policy to guard against financial instability by offsetting asset-price movements thus has sizable effects on economic activity. While the financial structure influences the impact of policy on asset prices, its importance appears limited.
Recently, the Bank of Japan outlined a “two perspectives” approach to the conduct of monetary policy that focuses on risks to price stability over different time horizons. Interpreting this as pertaining to different frequency bands, we use band spectrum regression to study the determination of inflation in Japan. We find that inflation is related to money growth and real output growth at low frequencies and the output gap at higher frequencies. Moreover, this relationship reflects Granger causality from money growth and the output gap to inflation in the relevant frequency bands. Keywords: spectral regression, frequency domain, Phillips curve, quantity theory. JEL Numbers: C22, E3, E5
Using a set of regional inflation rates we examine the dynamics of inflation dispersion within the U.S.A., Japan and across U.S. and Canadian regions. We find that inflation rate dispersion is significant throughout the sample period in all three samples. Based on methods applied in the empirical growth literature, we provide evidence in favor of significant mean reversion (ß-convergence) in inflation rates in all considered samples. The evidence on ó-convergence is mixed, however. Observed declines in dispersion are usually associated with decreasing overall inflation levels which indicates a positive relationship between mean inflation and overall inflation rate dispersion. Our findings for the within-distribution dynamics of regional inflation rates show that dynamics are largest for Japanese prefectures, followed by U.S. metropolitan areas. For the combined U.S.-Canadian sample, we find a pattern of within-distribution dynamics that is comparable to that found for regions within the European Monetary Union (EMU). In line with findings in the so-called 'border literature' these results suggest that frictions across European markets are at least as large as they are, e.g., across North American markets. Klassifikation: E31, E52, E58
In the New-Keynesian model, optimal interest rate policy under uncertainty is formulated without reference to monetary aggregates as long as certain standard assumptions on the distributions of unobservables are satisfied. The model has been criticized for failing to explain common trends in money growth and inflation, and that therefore money should be used as a cross-check in policy formulation (see Lucas (2007)). We show that the New-Keynesian model can explain such trends if one allows for the possibility of persistent central bank misperceptions. Such misperceptions motivate the search for policies that include additional robustness checks. In earlier work, we proposed an interest rate rule that is near-optimal in normal times but includes a cross-check with monetary information. In case of unusual monetary trends, interest rates are adjusted. In this paper, we show in detail how to derive the appropriate magnitude of the interest rate adjustment following a significant cross-check with monetary information, when the New-Keynesian model is the central bank’s preferred model. The cross-check is shown to be effective in offsetting persistent deviations of inflation due to central bank misperceptions. Keywords: Monetary Policy, New-Keynesian Model, Money, Quantity Theory, European Central Bank, Policy Under Uncertainty
The European Central Bank has assigned a special role to money in its two pillar strategy and has received much criticism for this decision. In this paper, we explore possible justifications. The case against including money in the central bank’s interest rate rule is based on a standard model of the monetary transmission process that underlies many contributions to research on monetary policy in the last two decades. Of course, if one allows for a direct effect of money on output or inflation as in the empirical “two-pillar” Phillips curves estimated in some recent contributions, it would be optimal to include a measure of (long-run) money growth in the rule. In this paper, we develop a justification for including money in the interest rate rule by allowing for imperfect knowledge regarding unobservables such as potential output and equilibrium interest rates. We formulate a novel characterization of ECB-style monetary cross-checking and show that it can generate substantial stabilization benefits in the event of persistent policy misperceptions regarding potential output. Such misperceptions cause a bias in policy setting. We find that cross-checking and changing interest rates in response to sustained deviations of long-run money growth helps the central bank to overcome this bias. Our argument in favor of ECB-style cross-checking does not require direct effects of money on output or inflation. JEL Classification: E32, E41, E43, E52, E58
The European Central Bank has assigned a special role to money in its two pillar strategy and has received much criticism for this decision. The case against including money in the central bank’s interest rate rule is based on a standard model of the monetary transmission process that underlies many contributions to research on monetary policy in the last two decades. In this paper, we develop a justification for including money in the interest rate rule by allowing for imperfect knowledge regarding unobservables such as potential output and equilibrium interest rates. We formulate a novel characterization of ECB-style monetary cross-checking and show that it can generate substantial stabilization benefits in the event of persistent policy misperceptions regarding potential output. JEL Classification: E32, E41, E43, E52, E58
Opting out of the great inflation: German monetary policy after the break down of Bretton Woods
(2009)
During the turbulent 1970s and 1980s the Bundesbank established an outstanding reputation in the world of central banking. Germany achieved a high degree of domestic stability and provided safe haven for investors in times of turmoil in the international financial system. Eventually the Bundesbank provided the role model for the European Central Bank. Hence, we examine an episode of lasting importance in European monetary history. The purpose of this paper is to highlight how the Bundesbank monetary policy strategy contributed to this success. We analyze the strategy as it was conceived, communicated and refined by the Bundesbank itself. We propose a theoretical framework (following Söderström, 2005) where monetary targeting is interpreted, first and foremost, as a commitment device. In our setting, a monetary target helps anchoring inflation and inflation expectations. We derive an interest rate rule and show empirically that it approximates the way the Bundesbank conducted monetary policy over the period 1975-1998. We compare the Bundesbank´s monetary policy rule with those of the FED and of the Bank of England. We find that the Bundesbank´s policy reaction function was characterized by strong persistence of policy rates as well as a strong response to deviations of inflation from target and to the activity growth gap. In contrast, the response to the level of the output gap was not significant. In our empirical analysis we use real-time data, as available to policy-makers at the time. JEL Classification: E31, E32, E41, E52, E58
This paper uses factor-augmented vector autoregressions (FAVAR) estimated using a large data set to disentangle fluctuations in disaggregated consumer and producer prices which are due to macroeconomic factors from those due to sectorial conditions. This allows us to provide consistent estimates of the effects of US monetary policy on disaggregated prices. While sectorial prices respond quickly to sector-specific shocks, we find that for a large number of price series, there is a significant delay in the response of prices to monetary policy shocks. In addition, price responses display little evidence of a “price puzzle,” contrary to existing studies based on traditional VARs. The observed dispersion in the reaction of producer prices is relatively well explained by the degree of market power, as predicted by models with monopolistic competition. JEL Classification: E32, E52
Mortgage markets, collateral constraints, and monetary policy: do institutional factors matter?
(2006)
We study the role of institutional characteristics of mortgage markets in affecting the strength and timing of the effects of monetary policy shocks on house prices and consumption in a sample of OECD countries. We document three facts: (1) there is significant divergence in the structure of mortgage markets across the main industrialised countries; (2) at the business cycle frequency, the correlation between consumption and house prices increases with the degree of flexibility/development of mortgage markets; (3) the transmission of monetary policy shocks on consumption and house prices is stronger in countries with more flexible/developed mortgage markets. We then build a two-sector dynamic general equilibrium model with price stickiness and collateral constraints, where the ability of borrowing is endogenously linked to the nominal value of a durable asset (housing). We study how the response of consumption to monetary policy shocks is affected by alternative values of three key institutional parameters: (i) down-payment rate; (ii) mortgage repayment rate; (iii) interest rate mortgage structure (variable vs. fixed interest rate). In line with our empirical evidence, the sensitivity of consumption to monetary policy shocks increases with lower values of (i) and (ii), and is larger under a variable-rate mortgage structure. JEL Classification: E21, E44, E52
We focus on a quantitative assessment of rigid labor markets in an environment of stable monetary policy. We ask how wages and labor market shocks feed into the inflation process and derive monetary policy implications. Towards that aim, we structurally model matching frictions and rigid wages in line with an optimizing rationale in a New Keynesian closed economy DSGE model. We estimate the model using Bayesian techniques for German data from the late 1970s to present. Given the pre-euro heterogeneity in wage bargaining we take this as the first-best approximation at hand for modelling monetary policy in the presence of labor market frictions in the current European regime. In our framework, we find that labor market structure is of prime importance for the evolution of the business cycle, and for monetary policy in particular. Yet shocks originating in the labor market itself may contain only limited information for the conduct of stabilization policy. JEL Classification: E32, E52, J64, C11
In this study, we perform a quantitative assessment of the role of money as an indicator variable for monetary policy in the euro area. We document the magnitude of revisions to euro area-wide data on output, prices, and money, and find that monetary aggregates have a potentially significant role in providing information about current real output. We then proceed to analyze the information content of money in a forward-looking model in which monetary policy is optimally determined subject to incomplete information about the true state of the economy. We show that monetary aggregates may have substantial information content in an environment with high variability of output measurement errors, low variability of money demand shocks, and a strong contemporaneous linkage between money demand and real output. As a practical matter, however, we conclude that money has fairly limited information content as an indicator of contemporaneous aggregate demand in the euro area.
In this paper we estimate a small model of the euro area to be used as a laboratory for evaluating the performance of alternative monetary policy strategies. We start with the relationship between output and inflation and investigate the fit of the nominal wage contracting model due to Taylor (1980)and three different versions of the relative real wage contracting model proposed by Buiter and Jewitt (1981)and estimated by Fuhrer and Moore (1995a) for the United States. While Fuhrer and Moore reject the nominal contracting model in favor of the relative contracting model which induces more inflation persistence, we find that both models fit euro area data reasonably well. When considering France, Germany and Italy separately, however, we find that the nominal contracting model fits German data better, while the relative contracting model does quite well in countries which transitioned out of a high inflation regime such as France and Italy. We close the model by estimating an aggregate demand relationship and investigate the consequences of the different wage contracting specifications for the inflation-output variability tradeoff, when interest rates are set according to Taylor 's rule.
In this paper we study the role of the exchange rate in conducting monetary policy in an economy with near-zero nominal interest rates as experienced in Japan since the mid-1990s. Our analysis is based on an estimated model of Japan, the United States and the euro area with rational expectations and nominal rigidities. First, we provide a quantitative analysis of the impact of the zero bound on the effectiveness of interest rate policy in Japan in terms of stabilizing output and inflation. Then we evaluate three concrete proposals that focus on depreciation of the currency as a way to ameliorate the effect of the zero bound and evade a potential liquidity trap. Finally, we investigate the international consequences of these proposals.
In this paper, we study the effectiveness of monetary policy in a severe recession and deflation when nominal interest rates are bounded at zero. We compare two alternative proposals for ameliorating the effect of the zero bound: an exchange-rate peg and price-level targeting. We conduct this quantitative comparison in an empirical macroeconometric model of Japan, the United States and the euro area. Furthermore, we use a stylized micro-founded two-country model to check our qualitative findings. We find that both proposals succeed in generating inflationary expectations and work almost equally well under full credibility of monetary policy. However, price-level targeting may be less effective under imperfect credibility, because the announced price-level target path is not directly observable. Klassifikation: E31, E52, E58, E61
This paper proposes a possible way of assessing the effect of interest rate dynamics on changes in the decision-making approach, communication strategy and operational framework of a Central bank. Through a GARCH specification we show that the USA and Euro area displayed a limited but significant spillover of volatility from money market to longer-term rates. We then checked the stability of this phenomenon in the most recent period of improved policymaking and found empirical evidence that the transmission of overnight volatility along the yield curve vanished soon after specific policy changes of the FED and ECB.
This paper explores the role of trade integration—or openness—for monetary policy transmission in a medium-scale New Keynesian model. Allowing for strategic complementarities in price-setting, we highlight a new dimension of the exchange rate channel by which monetary policy directly impacts domestic inflation. Although the strength of this effect increases with economic openness, it also requires that import prices respond to exchange rate changes. In this case domestic producers find it optimal to adjust their prices to exchange rate changes which alter the domestic currency price of their foreign competitors. We pin down key parameters of the model by matching impulse responses obtained from a vector autoregression on U.S. time series relative to an aggregate of industrialized countries. While we find evidence for strong complementarities, exchange rate pass-through is limited. Openness has therefore little bearing on monetary transmission in the estimated model.