Adverse Weather Shocks and Monetary Policy in Rwanda

Monetary policy in a world of radical uncertainty

Comment on “Indian Monetary Policy in the Time of Inflation Targeting and Demonetization”

Japan’s encounter with deflation and near‐zero‐interest short‐term interest rates in the 1990s led to a surge in research on the implications of the zero lower bound (ZLB) on nominal interest rates for monetary policy around the end of that decade. Based on model simulations, the literature at that time identified a number of key implications of the ZLB (see Orphanides and Wieland [2000], Reifschneider and Williams [2000, 2002], Eggertsson and Woodford [2003], and references therein). First, with low inflation targets of the kind followed by many central banks, the ZLB will frequently be a binding constraint on monetary policy. That is, Japan’s example is not an outlier but rather a harbinger for the future. Second, at inflation targets of 1% or lower, lowering the inflation target comes at a cost of higher variability of output and inflation, although the effects on inflation variability are relatively small. This analysis provides an argument for maintaining a positive inflation target cushion above 1%. Third, in rare instances of severe prolonged recessions accompanied by deflation, standard open market operations will be insufficient to bring the inflation rate back to target, andalternative sources of stimulus to the economy, such as fiscal policy, will be needed. Fourth, central banks can significantly reduce the effects of the ZLB onmacroeconomic stability by modifying their policy actions and communication to the public when the ZLB threatens to constrain policy. Specifically, policies that cut rates aggressively when deflation is a risk and promise to temporarily target a higher rate of inflation following episodes where the ZLB binds were found to greatly reduce the effects of the ZLB in model simulations. In the decade since this researchwas initiated, the ZLB has gone froma theoretical issue applying to Japan to one that plagues many industrialized economies. Indeed, an era of overwhelming confidence in monetary policy’s power to tame the business cycle while delivering low and stable inflation has been replaced by fears that the global economy could

Graph 1.1 Consumer Price Index a/b/ (annual change; end-of-period) a/ This graph presents the forecast probability distribution on an eight-quarter time horizon. Density characterizes the prospective balance of risks with areas of 30%, 60%, and 90% probability surrounding the central forecast (mode), through a combination of densities from the Patacon and the 4GM monetary policy models. b/ The probability distribution corresponds to the forecast exercise from the January report. Source: DANE -calculations and projections by Banco de la República.

In open economy, a choice can be made between two measures of inflation for use as a target variable: CPI inflation or domestic inflation. This paper considers flexible and strict inflation targeting strategies and explores the circumstances under which a domestic inflation target is preferred to a CPI inflation target. This is done from the perspectives of the central bank and society as a whole. The quantitative results of this paper indicate that under suitable conditions the temporal properties of stochastic disturbances are instrumental in determining which inflation target is preferred. The choice of target variable from society’s viewpoint coincides almost perfectly with the choice of the central bank if the utility of the representative household serves as the welfare criterion for society. If qualitative aspects matter in the choice inflation target, then the role of temporal properties of the stochastic disturbances becomes less prominent. Policy conclusions are drawn with the help of a forward-looking model for a small open economy. This model has proper micro-foundations and exhibits two important features. First, the degree of openness affects the parameters of the IS relation and, second, under domestic inflation targeting, the existence of a direct exchange rate channel in the Phillips Curve impairs the perfect stabilising properties of monetary policy in the presence of demand-side disturbances.

Two strands of the literature suggest that PPI inflation, rather than CPI inflation, should be the targeting variable in a monetary policy rule. The distinction between these two rules would only be important if the two inflation indices do not co-move strongly. The first contribution of this paper is to document that the two inflation gauges did co-move strongly in the last century but the correlation has fallen substantially since the start of this century. The second contribution is to propose a structural explanation for this divergence based on a lengthening of world production chains since 2000. This theory implies that the decline in the correlation is likely to be permanent and a rethinking of the monetary policy rules has become more important. Our multi-stage multi-country production model has additional predictions on the behavior of CPI and PPI inflation beyond a fallen correlation, and these predictions are also confirmed in the data.

What do the prices of UK inflation-linked securities say on inflation expectations, risk premia and liquidity risks?

The objective of this paper is to investigate the monetary policy of Taiwan by using a micro-based dynamic stochastic general equilibrium (DSGE) model with a banking sector. Because Taiwan's central bank has claimed to use the M2 aggregate growth rate as the monetary target since 1992, this study essentially centers on the welfare assessments of the optimized money growth rate rule and the alternative Taylor-type interest rate rule. We find that the money growth rate rule plays a better job in stabilization and is welfare dominating over the interest rate rule for all types of real shocks. Due to the liquidity effects that the monetary aggregate supplies for consumption, controlling the growth rate of the monetary aggregate can successfully reduce both the inflation and output volatilities. The welfare superiority of the monetary aggregate rule holds for alternative specifications of the model, including the frictionless credit market, the lower international capital mobility and lower nominal rigidity. The current monetary policy, estimated by Teo (2009), follows in a similar fashion to the optimized monetary policy that this study suggests, but has smaller effects in stabilizing the CPI inflation and exchange rates. Reinforcing its endeavors in inflation and exchange rate stabilization can be welfare improving.

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Previous articleNext article FreeCommentBennett T. McCallumBennett T. McCallumCarnegie Mellon University and NBER Search for more articles by this author Carnegie Mellon University and NBERPDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinked InRedditEmailQR Code SectionsMoreI. IntroductionThis is an interesting and challenging paper, in which Atkeson and Kehoe put forth a very strong critique of current mainstream monetary policy analysis. Monetary economists have, of course, been rather pleased with the development of their subject over the past 10–15 years, current U.S. policy difficulties notwithstanding. Indeed, the tone of a prominent recent expository paper by my colleague, Marvin Goodfriend, is somewhat triumphal in spirit.1 The spirit of the Atkeson and Kehoe paper, by contrast, is conveyed by a recent publication of theirs, together with coauthor Fernando Alvarez, which bears the title “If Exchange Rates Are Random Walks, Then Almost Everything We Say about Monetary Policy Is Wrong” (Alvarez, Atkeson, and Kehoe 2007). That paper focuses on exchange rate failures, whereas the current one stresses the term structure of interest rates, but the line of argument is basically the same.The title of the 2007 paper leads me rather naturally to ask myself what it is that I would say in answer to the implied question, “What important things do monetary economists really know—or at least believe—about monetary policy?” My own answer to that question would go along the following lines: (i) We believe that if the monetary authority keeps monetary policy expansionary for a substantial length of time, the main effect will be to generate a higher inflation rate than would have prevailed otherwise, with little or no overall effect on aggregate production and employment. (ii) Nominal interest rates will be higher, also, with real rates being affected very little. (iii) If, however, the monetary authority changes policy unexpectedly and abruptly in an expansionary direction, there will most likely be an expansion in aggregate output and employment—but it will be only temporary. (iv) If these changes are in the direction of tighter policy, the signs of the above‐mentioned effects will be reversed. (v) In particular, the monetary authority has the power to generate a recession, in which output and then the inflation rate will fall. (vi) The precise nature of the mechanism that generates the real effects of monetary policy changes of this type is not very well understood. Then, if my questioner had not wandered away in boredom, I would want to add something like the following: (vii) The foregoing points refer to an expansionary or contractionary monetary policy stance—loose or tight—but how is this measured? Well, a sustained high growth rate of the stock of base money will (under most institutional arrangements) be expansionary, but matters are a little less clear‐cut when the central bank actually carries out its policy by manipulating overnight interest rates. Nevertheless, there are ways in which we can characterize tighter versus looser policy in terms of interest rate rules by reference to the implied target inflation rate, the strength of responses to deviations from target, and so forth.Now, I suspect that Atkeson and Kehoe probably do not disagree with most of these statements as to what monetary economists know (or believe), even on a substantive basis.2 But their title of the current paper, as distinct from the 2007 item, refers to a need for a new approach to monetary policy analysis. So let us turn to a consideration of what today’s mainstream approach is. As it happens there is a short statement of that type, in a paper of mine, that gives the following description. The approach is one in which “the researcher specifies a quantitative macroeconomic model that is intended to be structural (invariant to policy changes) and consistent with both theory and data. Then, by stochastic simulation or analytical means, he determines how crucial variables (such as inflation and the output gap) behave on average under various alternative policy rules. Usually, rational expectations (RE) is assumed in both stages. Evaluation of the different outcomes can be accomplished by means of an optimal control exercise, or by reference to an explicit loss function, or left to the judgment (i.e., loss function) of the implied policymaker” (McCallum 2001, 258). Here, too, I doubt that Atkeson and Kehoe have any major disagreement with this general approach. What they do disagree with, if I understand at all, is the model that is typically used in recent work and taken to be structural.3In a sense my last statement could be regarded as merely quibbling over their title. But the point seems to be one of some importance: if Atkeson and Kehoe can generate an optimizing model that incorporates reliable, quantitative estimates reflecting time‐varying “risk” (i.e., state‐dependent variances and covariances) and endogenously explains inflation and output fluctuations, then monetary economists would presumably be happy to incorporate such features in their models—and would not consider this to reflect any basically new approach. Be that as it may, in what follows I will briefly review their featured empirical regularities, discuss issues concerning their suggested modeling strategy, and provide a brief conclusion.1See “How the World Achieved Consensus on Monetary Policy” (Goodfriend 2007).2They would probably grumble, justifiably, about the vagueness of point vii.3McCallum (2001, 258) goes on to say: “There is also considerable agreement about the general, broad structure of the macroeconomic model to be used.” Atkeson and Kehoe clearly would not share in this agreement.II. Empirical RegularitiesAtkeson and Kehoe begin, in Section I, with “four key regularities regarding the dynamics of interest rates and risk that we use to guide our construction” of a model and its pricing kernel. The first two pertain to a principal components analysis of a collection of interest rates, specifically, a 3‐month T‐bill rate and zero‐coupon yields on U.S. Treasury securities with k‐year maturities for $$k=1,$$ 2, …, 13. Time series observations are monthly over 1946.12–2007.12. The first regularity is that “the first principal component accounts for over 90% of the variance of the short rate [i.e., the 3‐month rate].” The second regularity is that “the second principal component is very similar to the yield spread between the short rate and the long [i.e., 13‐year] rate.” Having demonstrated these facts—and also that the first component is correlated even more strongly with the long rate—the authors henceforth use just the short and long rates.More substantively (and more questionably), the third and fourth regularities pertain to expected excess returns in the context of term structure and international exchange rate contexts. Specifically, movements in yield spreads and exchange rate premia are “associated with movements in risk.” The way in which these regularities might be regarded by some readers as questionable is that, in many studies, “risk” is operationally the name that is given to differentials in expected returns that the analyst’s model is not able to explain.Later in the paper, in Section V.A, Atkeson and Kehoe plot short‐rate and long‐rate time series for the United States over an extended period from 1836 through 2007. In addition, they include analogous plots for the United Kingdom, France, Germany, and the Netherlands. In all of these, the fluctuations of the long rate represent “a much smaller fraction of overall fluctuations in the short rate than they are in the postwar period.” Thus, they state: “A central question in the analysis of monetary policy at the secular level then is, What institutional changes led to this pattern?” In the preliminary version of this comment, I responded to a more pointed and strongly emphasized version of this query by stating that, to me, it is no surprise that expectations of future interest rates became unanchored during the post–World War II period, because, to again quote myself,[the] collapse of the Bretton Woods system created, for the first time in history, a situation in which the world’s leading central banks were responsible for conducting monetary policy without an externally imposed monetary standard (often termed a “nominal anchor”). Previously, central banks had normally operated under the constraint of some metallic standard (e.g., a gold or silver standard), with wartime departures being understood to be temporary, i.e., of limited duration. Some readers might not think of the Bretton Woods system as one incorporating a metallic standard, but by design it certainly was, since the values of all other currencies were pegged to the U.S. dollar and the latter was pegged to gold at $35 per ounce. (McCallum 1999, 175–76)All in all, it seems that there is no difficulty in understanding why an altered monetary policy regime generated different expectations regarding inflation and therefore future short interest rates in the post–World War II era. The variability in long rates during the 1960s developed as market participants began to see that the United States was not going to be bound by its commitment to maintain the $35 per ounce price of gold. Then the variability jumps up around the time of the Bretton Woods collapse in 1971—see Atkeson and Kehoe’s figures 6A–6E—and continues to rise into the Volcker disinflation that was painful (with extremely high nominal interest rates) but that ultimately succeeded in restoring some semblance of a nominal anchor.What about the return to stability that may have occurred around 1990? That year is, of course, the year in which the first central bank (New Zealand) officially adopted a monetary policy regime of “inflation targeting” (IT). At that time, this was taken to mean a policy whose only objective was a low and stable inflation rate. Since then, the IT term has come to be applied to regimes that give more weight to output/employment stabilization, but most monetary economists understand it as continuing to emphasize, as the primary goal, inflation control. So again the timing is about right for the possible recovery of anchored expectations that the first empirical regularity is said to reflect.To this general line of argument, Atkeson and Kehoe object: “But this answer is, at best, superficial. In the prewar era, countries chose to be on the gold standard most of the time and chose to leave it when it suited their purposes. Thus, the relevant questions are, rather, What deeper forces led agents to have confidence that their governments would choose stable policy over the long term? And what forces led them to lose this confidence after World War II? Only if we can quantitatively account for this history can we give advice on how to avoid another great inflation.”In this regard it must be said that I consider an explanation of the evolution of beliefs regarding the monetary standard, held by citizens of the United States, Great Britain, Germany, and so forth, to be somewhat beyond the scope of monetary policy analysts. To think about this issue, one must recognize that historically “the gold standard” required not just that the monetary authority would stand ready to exchange gold and currency at a specified rate but also that this rate should be unchanged “forever.” That arrangement made it such that severe inflation would not occur—even the major historical gold discoveries did not generate sustained inflation on the order of 10% per year—but it did generate more cyclical instability of real variables than we have had in the postwar era. Could policy of that type win popular support in today’s environment in the United States? If not, which would be my answer, then we need an entire unified social science to provide an explanation at “a deeper level.” And such an explanation—which would need to emphasize enormous developments in the media, extensions of suffrage, evolution of religious beliefs, attitudes toward the role of government, and so on—would not be of much help to central bankers. Let us turn then to monetary policy analysis considered more narrowly.III. Basic AnalysisThe heart of Atkeson and Kehoe’s paper is a recommended response to the third and fourth of the regularities mentioned above, that is, that measured excess returns on multiperiod bonds fluctuate strongly with yield spreads for bonds of different maturities and for international exchange rates. These regularities are translated by Atkeson and Kehoe into an argument that the consumption Euler equation, some version of which (often termed an expectational IS equation) is one basic ingredient of current macro‐monetary models, performs very poorly empirically. This is, of course, true for the simplest versions, but that problem has been widely recognized by monetary economists. A nice overview of empirical weaknesses of so‐called New Keynesian models was provided some years ago in a working paper by Richard Dennis (2003), which is briefly and nontechnically summarized in Dennis (2004). (The weaknesses discussed there relate to the Calvo‐style price adjustment relation, as well as the consumption Euler equation.) Dennis distinguishes between the bare‐bones “canonical model” and a “hybrid” version that adds habit formation in consumption behavior to the basic consumption‐saving relationship and also adds a somewhat dubious dependence on lagged inflation to the basic Calvo price adjustment relation. He recognizes, following Estrella and Fuhrer (2002), that “the problem with the canonical model is that the behavior of output, consumption, prices, and interest rates suggested by the model are fundamentally at odds with observed data” (Dennis 2004, 1). The hybrid model performs better, in terms of matching quarterly data, but “there are a number of areas where the hybrid model’s responses differ importantly from” impulse responses of an identified vector autoregression (VAR; Dennis 2004, 3).The point here is that monetary economists are quite aware that current models, even with elaborations of the type utilized by Christiano, Eichenbaum, and Evans (2005) or Smets and Wouters (2007), have empirical weaknesses, and they have been active in trying to eliminate these problems by improved specification. One pertinent and recent example concerns the discouraging results reported by Canzoneri, Cumby, and Diba (2007), that is, that inclusion of habit formation in consumption behavior unrealistically increases the variability of interest rates.4 Subsequent results by Collard and Dellas (2007) indicate, however, that this deterioration obtains when the household utility function is taken to be additively separable in consumption and leisure. If instead consumption and leisure enter the function in a Cobb‐Douglas manner, then inclusion of habit results in an improved—not worsened—match of the model’s interest rate variability to that of the data.I might also remark that Atkeson and Kehoe’s way of considering the empirical failure of the Euler equation seems questionable. Specifically, they discuss the relationship in a manner that would be appropriate if the role of this equation were to explain movements in nominal interest rates of various maturities. In fact, however, the role of this equation in standard monetary policy models is to explain consumption in response to (real) interest rates and expected future consumption (and, in habit specifications, lagged consumption). No mention of the adequacy or inadequacy of the standard model’s properties with regard to consumption is provided.5Be that as it may, it is essential to consider the analytical heart of Atkeson and Kehoe's paper, which is their presentation of “a simple model of the pricing kernel that is consistent with these [observed] dynamics” pertaining to interest rates. For the one‐period nominal interest rate, it in their notation, the pricing kernel mt+1 is an unobservable random variable that is generated by a stochastic process such that the interest rate it can be determined by a relation of the form $$i_{t}=-\mathrm{log}\,E_{t}\mathrm{exp}\,( m_{t+1}) .$$ Assuming conditional lognormality, then, we have (1)it=−Emt+1−0.5Vartmt+1. Except for lognormality, the content of their model for it is then the specification of the stochastic process generating mt+1. They take it to be (2)−mt+1=δ+z1t+σ1ε1t+1=1−λ2/2z2t+z2t0.5λε2t+1+σ3ε3t+1, where $$\varepsilon _{1t},$$ $$\varepsilon _{2t},$$ and $$\varepsilon _{3t}$$ are independent, standard normal, white‐noise innovations and where (3)z1t+1=z1t+σ1ε1t+1. (4)z2t+1=1−φθ+φz2t+z2t0.5σ2ε2t+1. These processes are chosen with an eye to their implications for the term structure via the relation (5)1=Etexpmt+1+pt+1k−1, which characterizes an absence of arbitrage possibilities for k‐period bonds with prices, $$p^{k-1}_{t+1}$$. From these prices the analyst can calculate term structure measures.Finally, Atkeson and Kehoe calibrate the model by assuming that $$\lambda =\sqrt{2}$$, $$\varphi =0.99,$$ and $$\sigma _{2}=0\mathrm{.}\,017$$. This specification suffices, they report, to generate interest rates of different maturities such that the term structure features long and short rates that possess properties that have the general characteristics found in their exploration of monthly data for rates of various maturities in the U.S. data.How does this model compare in specification with the standard three‐equation framework used in recent years to model one‐period interest rates, consumption (and/or output), and inflation by Clarida, Gali, and Gertler (1999), McCallum (2001), Woodford (2003, 238–47), and dozens of other monetary economists? That framework, as is well known, consists of (i) a consumption Euler equation (aka expectational IS relation), (ii) a price adjustment relation (usually of the Calvo variety), and (iii) a monetary policy rule that specifies adjustments of the one‐period nominal policy rate it to its determinants, which include the steady state real interest rate, the central bank’s inflation target, departures of inflation from target, and departures of output from its natural (flexible price) rate. (The lagged rate it‐1 is often included as well to represent smoothing.) This framework implicitly adopts the expectations theory of the term structure, which is known to be inconsistent with the data. Notable examples of larger models that include more variables and equations but that have the same basic underlying logic are provided by Christiano et al. (2005) and Smets and Wouters (2007).One aspect of the comparison is that the Atkeson‐Kehoe model, since it pertains to an “endowment economy,” implicitly assumes that price level adjustments are complete within each period so that output is always equal to its (exogenous) natural rate, flexible price value. Only a degenerate version of the Calvo equation component of the standard model is therefore present. That removes one endogenous variable, output/consumption. For some purposes, a flexible price model can be useful for monetary policy principles, as in Woodford (2003, chap. 2). But Atkeson and Kehoe also treat inflation as exogenous. Thus, there is no possibility remaining for conducting monetary policy analysis, and it is not determined by central bank behavior. Those features are consistent with their expressed view that the central bank “simply responds to exogenous changes in real risk—specifically, to exogenous changes in the conditional variance of the real pricing kernel—with the aim of maintaining inflation close to a target level.” But this seems highly unsatisfactory. It is probably true that a substantial portion of the meeting‐to‐meeting variations in the federal funds rate in the United States represents adjustments that are responses to changes in real rates that are brought about by changes in tastes, technology, shocks from abroad, and even perhaps some random behavioral errors by private agents. In fact, this is implied by much of the analysis that represents today’s mainstream monetary policy analysis—see, for example, Woodford (2003, and But the modeling approach suggested by Atkeson and Kehoe that the its for a random that is it no in a no is provided that their model would do a of matching data on much less two variables as endogenous and by central bank by a policy rule for a variable, the model is not in for monetary et al. (2007) paper is by Atkeson and and Kehoe to believe that standard have Euler equations that include no term reflecting and Kehoe are to say that the Euler equation specification in many monetary models does not well empirically. In addition, their specification of stochastic processes for the and variables that yield a pricing kernel that term structure features that the data in important ways is and They in that models in which conditional variances of returns are variable provide an possibility for improved model specification. This is not of course, and does not of inflation and output as exogenous or to a model that leads to their highly about the nature of monetary policy in the United States (and, other and currency is a of the monetary policy that term structure that pricing with time‐varying risk premia in models along with endogenous price and monetary policy rules. Some leading examples are provided by and and et al. (2007), and These have beyond Atkeson and Kehoe in to models that the term structure regularities maintaining a framework for monetary policy analysis. the approach time‐varying conditional is not the only one of as the Collard and Dellas (2007) example In I by of the Atkeson and Kehoe critique of some features of today’s New Keynesian monetary policy models, but I their current to be in essential their of U.S. monetary policy to be and their critique of current monetary policy analysis to be a brief see Atkeson, and 2007. “If Exchange Rates Are Random Walks, Then Almost Everything We Say about Monetary Policy Is and in Cumby, and T. 2007. and of Monetary in Eichenbaum, and and the of a to Monetary of in Gali, and of Monetary A New Keynesian of in and 2007. and Monetary paper, of in Keynesian Empirical of in Keynesian and to the of in and of a of in and 2007. with of in and McCallum and the of of Monetary in 2007. “How the World Achieved Consensus on Monetary of in T. in Monetary Policy The of and of in of in Monetary Policy to and in 2007. and Monetary paper, of University of in and in and 2007. and in A in and of a of Monetary University in Previous articleNext article by NBER by the of on this by the of no articles this

To analyse the relevance of CBCA in those countries where another country’s currency is legal tender we have to discuss which factors affect central bank capital, and we have to investigate whether there is an optimal level of capital for central banks. In answering those questions, one needs to highlight the main differences between central banks in charge of monetary and exchange rate policy, and central banks without these responsibilities. In the literature, capital needs have been mainly coupled with the existence of the domestic currency and the conduct of monetary policy and exchange rate control. However, the reasons for holding capital are wider. Some are common to private companies, while others pertain to central banks alone. First, there are reasons for holding capital that apply to any central bank. As in the private sector, capital has to cover potential losses. But for a central bank, some potential losses can be incurred as a consequence of the central bank’s institutional mandate. The typical mandate for a central bank comprises conducting the monetary and foreign exchange policy, maintaining a secure payment system and a stable banking sector. So, losses can be incurred in many ways. They could be a consequence of the day-to-day management of the currency reserves,3 or brought about by sterilization operations, or follow from emergency liquidity assistance when the central bank has to grant concessional credit to rescue ailing institutions. These contingent liabilities tend both to reduce the transparency of central bank accounts and to make the assessment of a central bank’s financial position more difficult (Blejer and Schumacher 1998). Despite these potential losses deriving from a central bank’s institutional mandate, central banks may be profitable institutions, in view of their monopoly power. Central banks can enjoy seigniorage arising both from the issue of the currency and from banks’ funds held at low or zero interest with the central bank. In the long run a central bank’s profitability should be secure as long as the demand for banknotes is maintained, the central bank keeps monopoly power over money issuing and the rate of inflation is not too low. There is a link between price stability and financial autonomy. Low inflation ensures adequate demand for money, and demand for money ensures seigniorage (at a given nominal interest rate, at least) and hence financial independence. That, in turn, is key for autonomy and reputation – necessary conditions to achieve price stability. However, lower inflation eventually goes hand in hand with lower nominal interest rates, and seigniorage may be defined as the product of the nominal interest rate and the monetary base. So, lower inflation is likely to reduce seigniorage at least at some point, as was noted in the introduction to this chapter. Second, like a private bank, a new central bank needs capital to fund its start-up costs. Third, capital has also to generate continuing operating income to secure the long-term financing of operating costs. Adequate capitalization matters to ensure income to cover future costs. Finally, the amount of capital signals to stakeholders how well the institution is being managed (though this signal scrambled because central banks may incur losses for legitimate policy reasons). In any case, if the public infers from negative capital that the centralbank is poorly run, it may erode the bank’s general reputation4 (Vaez-Zadeh 1991). Moreover, approaching the government frequently would compromise the actual and perceived autonomy of the central bank. In sum, central bank autonomy can easily be eroded, unless supported by adequate financial strength. The above-mentioned factors govern central banks’ demand for capital. But they differ when the country has no domestic currency of its own. Table 6.1 highlights the main determinants of central bank capital in the two cases. In the second case, identifying potential liabilities and risks facing a central bank is much simpler. But even then one must define the central bank’s relevant overall assets or resources and its potential liabilities in the future.5 Here, the central bank’s demand for capital will vary with: (i) the level and type of risks faced, (ii) past, present and future profitability and (iii) financial arrangements regulating the relationship between the central bank and the government (profit-sharing rules, obligations of the national treasury in case of need, fiscal treatment). The central bank’s risks depend on the number of its functions, the level of development of the financial sector and the prospects for adverse events affecting its financial stability, the exchange rate regime and the level of inflation. Consequently, as far as risk assessment is concerned, we should expect that potential risks should be lower for central banks without a domestic currency given that there is no contingency for monetary and exchange rate policies and banking sector crises. Some situations where a central bank might need to deploy its resources do not apply. Such situations include requests for support to defend the exchange rate, or interventions through sterilization operations to keep the monetary aggregates under control or to inject new liquidity to rescue ailing banks. On the other hand, in order to perform its refinancing function in case of a banking crisis, we would expect a central bank without a domestic currency to hold more capital, provided that it cannot create additional liquidity by issuing a new monetary base. Since the central bank could not create additional liquidity, commercial banks would require more capital, as they lacked access to a lenderof last resort facility. However, even without its own monetary and exchange rate policies, a central bank might risk financial losses on initiatives and policy actions warranted on public interest grounds. Such initiatives include rescuing ailing institutions, safeguarding the payment system, and setting up a credit register. They might be reluctant to act without adequate financial resources to absorb such additional expenses. There are also differences in profitability and financial arrangements. In the absence of a domestic currency, the central bank has no seigniorage to exploit. Without seigniorage the central bank has to rely on government funding, returns from its own capital and any commissions or fees from regulated sectors. There is a much greater role for capital to serve as a means for generating operating income, and a greater need for adequate financial arrangements to protect it. How much equity does a central bank need? For central banks without a domestic currency, and no seigniorage income, a simple rule might calculate the amount of capital by considering the goal of covering operating costs – assuming a particular (real) rate of return. But potential losses arising from carrying out its mandate also needs to be allowed for. The more numerous the central bank’s areas of responsibility, the larger its capital needs. For instance, central banks that manage foreign exchange reserves should have higher levels of capital, as should those that run their own monetary policy. The size of the country may matter. In very small countries it is common to find simple institutional arrangements with only one monetary and financial authority, presumably widening the central bank’s responsibilities. If there are fixed costs and scale economies in operating a fully fledged central bank or financial regulator, a small country’s central bank would need proportionately more capital. For small countries this argues in favour of simpler institutional arrangements for their monetary and exchange rate regimes. It might justify sharing the burden of sustaining the central bank’s finances with others bodies (government; financial intermediaries), with implications for transparency and accountability. What institutional arrangements should define the relation between the government and the central bank? The level of central bank capital is only one aspect of the relationship between them. The nature and extent of a central bank’s financial autonomy is shaped by its relation with the government, and how that is reflected in the structure of arrangements for financing central bank activities, for sharing risks and distributing its profits and losses. There might be direct transfers from the treasury to the central bank, reducing the need for central bank capital. But pre-agreed mechanisms and rules would have to protect central bank financial autonomy. Risk treatment and risk bearing could also be affected. Risky balance sheet items or contingent liabilities could be held by the government, with the government taking over some quasi-fiscal activities from the central bank. The government could take responsibility for providing financial support to banks in difficulties. And if the central bank generates revenues, rules governing its profit distributions would be required. In practice, Ueda (2004) shows that there is a high variance in the levels of capital held by central banks around the world. He presents the ratio of capital tototal assets for a number of central banks.6 This ratio varies widely from country to country. The variance reflects differing motivations ascribed to central bank activities, different kinds and received levels of risks, and different profit and sharing rules with national governments.7 It could also suggest a lack of consensus among central banks about the desirable level of capital.

Estimate of Chinese Core Inflation Rate--The Application of Space State Model Based on Time--Varying Parameter

Open-economy inflation targeting

This paper estimates core inflation in Norway, identified as that component of inflation that has no long-run effect on GDP. The model distinguishes explicitly between domestic and imported core inflation. The results show that (domestic) core inflation is the main component of CPI inflation. CPI inflation, however, misrepresents core inflation in some periods. The differences are well explained by the other shocks identified in the model, in particular the oil price shocks of the 1970s when Norway imported inflation, and the negative noncore (supply) shocks of the late 1980s, which pushed inflation up temporarily relative to core inflation.