Alternative Policy Regimes Research Articles

A horse race of alternative monetary policy regimes under bounded rationality

We introduce bounded rationality, along the lines of Gabaix (2020), in a canonical New Keynesian model calibrated to match Canadian macroeconomic data. We use the model to provide a quantitative assessment of the macroeconomic impacts of alternative monetary policy regimes—flexible inflation targeting (FIT), average-inflation targeting (AIT) and price-level targeting (PLT)—with an effective lower bound (ELB) constraint. First, our results suggest that the benefits of adopting history-dependent monetary policy regimes rely on two important assumptions: rational expectations and the central bank’s emphasis in stabilizing real variables such as the output gap. The macro-stabilization advantage of PLT disappears even for small deviations from rational expectations, and it is especially undermined when the central bank assigns a high weight on output volatility. Second, the presence of cost-push shocks, such as the ones global economies have experienced since the recovery from the pandemic, introduces important policy trade-offs that poses practical challenges which are best tackled using an AIT regime. Third, in choosing the optimal window width under the AIT regime, a central bank that assigns some emphasis on real sector stability needs to be mindful of expectation formation. If economic agents are sufficiently far from being rational, our simulations indicate that the optimal window is between 1 and 2.5 years.

What to target? Insights from a lab experiment

This paper compares alternative monetary policy regimes within a controlled lab environment, where groups of participants are tasked with repeatedly forecasting inflation in a simple macroeconomic model featuring only the dynamics of interest rates, inflation and inflation expectations. Average-inflation targeting can replicate the price path observed under price-level targeting in the presence of disinflationary shocks and enable subjects to coordinate on simple heuristics that reflect the concern of the central bank for past inflation gaps. However, this depends on the exact specification of the policy rule. In particular, if the central bank considers more than two lags, subjects fail to form expectations that are consistent with the monetary policy rule, which results in greater inflation volatility. Reinforcing communication around the target helps somewhat anchor long-run inflation expectations.

Monetary Policy and Financial Sustainability in a Two-State Open Economy

Monetary policy and financial sustainability are linked. However, the role of monetary policy and its implementation have come under particular scrutiny after the 2008 Global Financial Crisis (GFC) and the 2010 European sovereign debt crisis, where one of the main challenges was financial sustainability. In this paper, we contribute to the literature by improving our understanding of the influence of monetary policy on financial sustainability for a monetary union. To that end, we develop a two-state open economy macroeconomic model, in which the two state economies have the same monetary policy but maintain their fiscal independence. Examples include two countries in the eurozone, two states in the United States, core and periphery countries, etc. The linkages between these two state economies are inter-state trade in goods and inter-state borrowing in bonds. We apply the calibrated model and conduct economic experiments under alternative monetary policy regimes. The model simulation shows that monetary policy is incorrect if inflation differentials persist in a monetary union, and that incorrect monetary policy leads to real interest rates that are too low for high inflation countries, which become indebted after excessive borrowing. This study sheds light on how monetary policy should be implemented if inflation differs in countries within a monetary union. Our findings draw policy implications for those “two-state” economies considering alternative macroeconomic policy regimes to achieve financial sustainability and regional economic integration.

Growth and Development under Alternative Policy Regimes in India: A Political Economy Perspective

This paper reviews the economic policies adopted by the Indian government under different policy regimes, provides a political economy perspective of economic growth in the country during 1950–2020 and examines the inclusiveness of the rapid economic growth in recent decades. The growth performance of the economy improved as the economy moved from inward-looking policy regime to the regimes of pro-business and pro-market policies. India’s political economy was supportive of the changes in policy regime. After growing at a sluggish rate during the first three decades after 1950–1951, the gross domestic product (GDP) growth accelerated significantly after the pro-business reforms in the 1980s, and there was further acceleration after the pro-market reforms since 1991–1992. It has, however, slowed down in recent years. Nevertheless, it has not been inclusive, as the benefits of growth have not reached all sections of the population and all regions of the country equally. On the contrary, disparities in income across regions and inequalities in income, wealth and consumption among individuals have exacerbated, and the problems of unemployment and poverty have been persisting in the economy.

Would households understand average inflation targeting?

Yes, they would. In a randomized control trial, we provide groups of respondents from the Bundesbank Online Panel Households with information about a hypothetical alternative ECB monetary policy regime akin to the Federal Reserve’s flexible average inflation targeting (AIT). Inflation expectations significantly increase for the treated individuals. When we provide additional information about near-term inflation, for low levels of trust in the ECB the adjustment of inflation expectations tends to be negative while it is positive for intermediate and higher levels of trust. We assess the economic significance of our findings by comparing two model economies under different monetary policy strategies, calibrated to match the difference in medium-term inflation expectations from our survey results. Under AIT, inflation is substantially less volatile and the frequency of hitting the lower bound on interest rates is considerably reduced.

Coastal dilemma: Climate change, public assistance and population displacement

• Countries with populations and economic activity concentrated in low-lying coastal regions are vulnerable to sea-level rise. • As the ocean advances inland, millions of coastal inhabitants will have to retreat, either by choice or force majeure. • Linkages among environmental stress, public assistance and population change are assessed for coastal India and Bangladesh. • Compensatory public assistance strongly dampens the migration response to rising environmental stress. • Damage compensation should direct public resources to households that choose to relocate as the coastal threat mounts. Linkages among climate change–related environmental stress, public assistance, and the spatial pattern of population change are assessed for neighboring coastal areas of India and Bangladesh. Environmental stress is measured using historical cyclone impacts, salinization, and land loss from erosion. Household migration decisions are based on current and expected future income streams in different locations. Rising environmental damage raises costs, but it may also induce increased public assistance that moderates or neutralizes those costs, diminishing migration incentives, even in areas hard-hit by climate change. Econometric estimates for the Sundarbans region shared by India and Bangladesh suggest that endogenous public assistance strongly dampens the migration response to rising environmental stress in both countries, though the assistance response and migration dampening are lower in Bangladesh. A broader analysis for the coastal region from India’s Odisha State to eastern Bangladesh finds that present and past cyclone impacts are highly significant for explaining coastal population changes, although responses are lower in India because of lower environmental stress and greater public-assistance intensity. A counterfactual simulation suggests that, as a result of cyclones since 1970, the affected regions are 8–10% less populous in Bangladesh but only 2% less populous in India. The paper’s findings motivate a discussion of the implications for alternative policy regimes as land erosion increases, and sea-level rise and salinization continue with climate change. After comparing the efficiency and equity of regimes that provide universal damage compensation or leave coastal households to fend for themselves, the paper suggests an alternative approach that focuses public resources on compensation for households that choose to relocate as the coastal threat mounts.

Growth Shocks under Alternative Macro Regimes in a Developing Economy

A key challenge facing most developing economies today is how to simultaneously maintain monetary independence, exchange rate stability, and financial integration, subject to the constraints imposed by the impossible trinity. In this paper, we contribute to the literature by examining and comparing alternative macroeconomic policy choices for a developing economy with growth shocks. To that end, we introduce a three-sector “almost small” open economy macroeconomic model, and calibrate this model to proxy the China in 2005 when it made the transition from being an economy that was bounded by the impossible trinity. We design two alternative macroeconomic policy regimes and apply the calibrated model to analyze both the short-run and the long-run responses to several domestic and external growth shocks, which appeared important for a developing economy like China during its economic reform period in the 2000s. The model simulation shows that most growth shocks cause an expansion in the real GDP level. Moreover, greater flexibility in the exchange rate allows the central bank to conduct independent monetary policy, the benefit from which increases as financial capital becomes more internationally mobile. Our findings draw policy implication for those developing countries considering alternative macroeconomic policy regimes to achieve sustainable economic growth.

Alternative monetary policy regimes in an oil-exporting economy

We assess alternative monetary policy regimes including a consumer price index (CPI) and a producer price index (PPI) targeting in a commodity-exporting economy with multiple currency practices (MCPs). Under these regimes, the central bank in our model (i) target the official exchange rate, (ii) target the growth rate of nominal monetary base, and (iii) intervene in the foreign exchange market to control the exchange rate gap. We find that using the PPI as the central bank's target produces less pro-cyclicality compared to monetary regimes with the CPI targeting. In addition, the PPI targeting results in lower welfare losses. We study these regimes under unified and MCPs as a characteristic of some commodity-exporters. We show that with a persistent external shock, MCPs could be effective at best in the short-run, while the aggregate welfare in the long-run can be diminished. We then illustrate that under both unified and MCPs regimes, the PPI targeting regime considerably performs better. Finally, we show that monetary instruments are more effective in the presence of a fiscal rule, based on commodity revenues.

Monetary Policy Regimes in Small Open Economies: The Case of Sri Lanka*

This paper quantifies the performance of five alternative monetary policy regimes in controlling macro volatility in a small open, emerging economy. The effects of supply, demand and external shocks are analyzed using a generic structural macro model and Monte Carlo simulation, calibrated to the case of Sri Lanka. Investigated regimes separately target the exchange rate, monetary aggregates, nominal GDP, the consumer price index inflation rate and a Taylor composite of output gaps and inflation. The results suggest that nominal GDP targeting minimizes real GDP volatility, and when stabilizing economic welfare is the objective, volatility is minimized under inflation targeting and Taylor policy rules. The IT regime is most effective under demand and external shocks, which have grown more prominent as product and financial markets have opened.

Inflation-targeting and inflation volatility: International evidence from the cosine-squared cepstrum

Existing empirical evidence on the effect of inflation-targeting on inflation volatility is, at best, mixed. However, comparing inflation volatility across alternative monetary policy regimes, i.e., pre- and post-inflation-targeting, begs the question. The question is not whether the volatility of inflation has changed, but instead whether the volatility is different than it otherwise would have been. Given this, our paper uses the cosine-squared cepstrum to provide overwhelming international evidence that inflation targeting has indeed reduced inflation volatility in 22 out of the 24 countries considered in our sample of established inflation-targeters, than it would have been the case if the central banks in these countries did not decide to set a target for inflation.

Monetary Policy and Financial Stability

<ns3:p>The 2008 Global Financial Crisis called into question the narrow focus on price stability of inflation targeting regimes. This paper studies the relationship between price stability and financial stability by analyzing alternative monetary policy regimes for an economy that experiences endogenous financial crises due to excessive household sector leverage. We reach four conclusions. First, a central bank can improve both price stability and financial stability by adopting an aggressive inflation targeting regime, in the absence of the zero lower bound (ZLB) constraint on nominal interest rates. Second, in the presence of the ZLB constraint, an aggressive inflation targeting regime may undermine both price stability and financial stability. Third, an aggressive price-level targeting regime can improve both price stability and financial stability, regardless of the presence of the ZLB constraint. Finally, a leaning against the wind policy can be detrimental to both price stability and financial stability when the credit cycle is driven by countercyclical household sector leverage. In this environment, leaning with credit spreads can be more effective.</ns3:p>

National Defence Under Alternative Trade Policy Regimes: Theory and Evidence from Developing Countries

Defence mechanism for any nation is the way through which internal as well as external geo-political condition can be stabilised. Moreover, defence sector can also be treated as one of the most potential sectors regarding financial transactions and the relevance of it is valid both in autarky and in the regime of international trade. Using Granger Causality for a panel of 27 developing countries across Asian and South American continents, we have found that different trade measures are playing major role in the way of functioning of national defence. For further analytical purpose and also to select the most effective trade policy regime among the alternatives, we have adopted a trade theoretic framework. In this regard, we have used a four-sector general equilibrium trade model with special emphasis on defence as well as R&D to defence to illustrate the impact of trade liberalisation on defence system. From such setup and by using bootstrap policy simulation we have found that trade liberalisation in the form foreign direct investment (specific to the R&D to defence) as the most effective trade regime to claim gains from trade in the presence of defence dualism for any small open developing economy. Such comparative statics is critical from the policy perspective. Policymakers should be cautious before defence industry liberalisation. JEL Codes: H56, C33, F11, F14, F21, D58

Finance-Growth Nexus and Relative Efficacy of Alternative Policy Regimes: An Investigation for Pakistan

Finance-Growth Nexus and Relative Efficacy of Alternative Policy Regimes: An Investigation for Pakistan

International Risk-Sharing and Optimal Monetary Policy in a Small Commodity-Exporting Economy

This paper evaluates the welfare implications of alternative monetary policy regimes for a small commodity-exporting economy. In line with the existing literature, welfare analysis shows that a flexible exchange rate regime tends to outperform a fixed nominal exchange rate. However, this paper shows that the welfare costs of a nominal peg vary considerably with the extent of international risk-sharing. In a model with complete and frictionless asset markets, real exchange rate volatility is small, and welfare losses from the nominal peg are negligible. By contrast, under financial autarky, a fixed nominal exchange rate generates significant volatility in inflation and results in large welfare costs. I also consider the welfare properties of flexible regimes, showing that core consumer inflation targeting and non-commodity domestic inflation targeting are not generally optimal, although their welfare costs are small compared to those of a fixed regime. Furthermore, the welfare ranking of these two regimes might depend on the currency in which the tradable goods are priced (producer-currency pricing vs. local-currency pricing).

Agent-Based Modeling for bioenergy sustainability assessment

Woody biomass bioenergy is an important renewable alternative to conventional fossil fuels. However, the negative land-use change impacts of biomass harvesting necessary for bioenergy production can potentially outweigh its positive benefits if poorly managed. In this paper, we explain how Agent-Based Modeling (ABM), a form of computer simulation, can be used to conduct a comprehensive bioenergy sustainability assessment to identify possible gains and trade-offs necessary to develop bioenergy in regions with large numbers of private family forest owners or smallholders who own a significant share of available biomass. We discuss how ABM simulation can overcome the barriers of existing sustainability assessment tools and provide a demonstration of the sustainability assessment capabilities of an ABM using a hypothetical case study that explores the introduction of a bioenergy conversion facility in the Western Upper Peninsula of Michigan, United States. We conduct a series of alternative futures scenarios and compare the sustainability outcomes of three alternative policy regimes using voluntary incentive programs to encourage smallholders to harvest biomass.

Monetary policy options for managing resource revenue shocks when fiscal policy is laissez-faire

This study examines the implications of alternative monetary policy regimes to deal with resource revenue shocks when fiscal policy is laissez-faire—that is, when the government spends all resource revenue windfalls contemporaneously. A three-sector dynamic stochastic general equilibrium model is used. The model features key structural characteristics of resource-rich developing economies, such as the Dutch disease, limited international capital mobility, credit constrained consumers, and limited labour mobility. The model is calibrated to match a typical resource-rich developing economy. Three alternative monetary policy regimes are considered: a flexible exchange rate, a crawling peg, and a money growth target. The policy evaluation exercise indicates that a flexible exchange rate with inflation targeting regime is the best among the policy options considered. Specifically, this option yields a meager 0.16 percent loss in welfare terms, compared with higher levels of welfare losses associated with a crawling peg with partial domestic absorption (0.17 percent), and a money growth target with full sterilization (0.26 percent).

Policy choice and riverine water quality in developing countries: An integrated hydro-economic modelling approach

Industrialization and urbanization, as a result of rapid economic development, have led to the deterioration of water quality in many rivers in developing countries. The Kelani River in Sri Lanka provides drinking water to Colombo and a range of market and non-market ecosystem services; but these services are threatened by deteriorating water quality. We apply a hydro-economic model that accounts for spatial patterns of water quality and abatement cost variability between firms in the catchment. The hydro-economic model combines a hydrological model of water quality with an economic optimization model to determine a cost-effective policy under alternate policy regimes. These include: the existing policy based on effluent concentration standards, effluent trading and effluent trading with multiple zones and an effluent tax. Tradeable permits with multiple zones are the least cost policy option that accounts for both spatial externalities and abatement costs. However, given current institutional capabilities, an effluent tax would be a more realistic second best policy as a transition from the current policy of effluent concentration standards to a policy based on the quantity of effluents.

Does crop rotation with legumes provide an efficient means to reduce nutrient loads and GHG emissions?

We investigate crop rotation with legumes from economic and environmental perspectives by asking how effective they are at providing profits and reducing nutrient runoff and greenhouse gas emissions compared with monoculture cultivation. We study this effectiveness in three alternative policy regimes: the free market optimum, the Finnish agri-environmental scheme, and socially optimal cultivation, and also design policy instruments to achieve the socially optimal outcomes in land use and fertilization. We first develop an analytical model to describe crop rotation and the role of legumes, and examine its implications for water and climate policies. Drawing on Finnish agricultural data, we then use numerical simulations and show that shifting from monoculture cultivation to crop rotation with legumes provides economically and environmentally better outcomes. Crop rotation with legumes also reduces the variability in profits caused by stochastic weather. The optimal instruments implementing the social optimum depend on nutrient and climate damage (nitrogen tax), as well as carbon sequestration and nutrient reduction benefits (buffer strip subsidy).

An Eco-Egalitarian Solution to the Capitalist Consumer Paradox: Integrating Short Food Chains and Public Market Systems

Presently, alternative agri-food networks are in a renaissance, utilizing an economy of proximity to compete against transnational agri-business and food distributors. While this is positive ecologically and socioeconomically, the overreliance on market mechanisms in short food chains has led to class distinctions in food distribution and consumption. The result has been a capitalist consumer paradox exacerbating inequality in the alternative agri-food networks. To resolve this inequality, we focused on how public policy can leverage state investment in public markets to reduce or overcome the capitalist consumer paradox in short food chains. To clarify our argument, we began by examining the benefits of short food chains in the urban food system. Then, we explained how type of consumption and policy regime effect food access. After this, we utilized Mexico City and New York City’s public market systems as representative of an alternative policy regime and the effects of moving away from state-oriented development. We concluded by describing possible conflicts and complements to the integration of public markets into short urban food chains.

Stabilizing expectations at the zero lower bound: Experimental evidence

Our study demonstrates how agents’ expectations can interact dynamically with monetary and fiscal policy at the zero lower bound. We study expectation formation near the zero lower bound using a learning-to-forecast laboratory experiment under alternative policy regimes. In our experimental economy, monetary policy targets inflation around a constant or state-dependent target. We find that subjects’ expectations significantly over-react to stochastic aggregate demand shocks and historical information, leading many economies to experience severe deflationary traps. Neither quantitatively nor qualitatively communicating the state-dependent inflation targets reduce the duration or severity of economic crises. Introducing anticipated and persistent fiscal stimulus at the zero lower bound reduces the severity of the recessions. When the recovery of fundamentals is sufficiently slow, participants’ expectations become highly pessimistic and neither monetary nor fiscal policy are effective at stabilizing the economy.