Central Bank Behavior Research Articles

Currencies, competition, and clans

We present a theoretical and empirical analysis of stable coexistence among the world's anchor currencies (G3): the dollar, euro and yen. The theoretical model presented in this paper builds on a model of spatial competition and rests on a set of assumptions related to the behavior of central banks, the working of exchange rate regimes, the geography of money, and international monetary arrangements. We show that stable coexistence in the sense of the pure-strategy equilibrium derived in our model is attainable in the case of two anchor currencies, but not in the case of three. The empirical evidence provides support for the assumptions and conclusions of the model.

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INTEREST AS AN ARTEFACT OF SELF‐VALIDATING CENTRAL BANK BELIEFS

ABSTRACTThe classical/Sraffian approach to distribution is proposed as a more congenial framework for Keynes's concept of interest as a conventional variable—resulting from the interplay between central bank behaviour and financial market sentiment—because it provides a sounder basis for multiple interest rate equilibria. While either monetary policy or market expectations can be decisive, the capacity of policy to ensure markets acquiesce in the authorities' view remains at least as plausible as Keynes supposed. Interest is a result of ‘history’ plus the beliefs of the monetary authorities, where those beliefs may be illusory but nevertheless validated by actual outcomes.

Inflation targeting supported by managed exchange rate

We compare, on a welfare loss basis, possible inflation targeting regimes supported by different exchange rate rules. For model parametrization, we estimate a forward looking monetary policy rule for Trukey. When variable inflation targets are taken into consideration, as opposed to the fixed targets used in prior research that use data from developed countries, forward looking Taylor rules provide a reasonable description of Central Bank behaviour in Turkey. By applying a calibration based on estimated parameters, we compare the loss functions under flexible inflation targeting and strict inflation targeting while taking into consideration the supporting regimes, namely a flexible exchange rate and a managed floating exchange rate. We find that the welfare loss function caused by four simultaneous shocks, namely a foreign interest rate shock, a monetary policy shock, a foreign output shock and a domestic output shock, is minimized under the flexible inflation targeting regime supported by a managed floating exchange rate rule.

A Feasible and Objective Concept of Optimal Monetary Policy: The Quadratic Loss Function in the Postwar Period

Monetary economists argue that they adopted quadratic loss functions because the latter delivered easy solutions to complex stochastic models. In that narrative, Simon (1956) and Theil (1957) are mentioned by their proofs that models with quadratic objective functions have the certainty equivalence property, which made their solutions feasible for the computers available at that time. Appearing in that narrative are Poole (1970) and Sargent and Wallace (1975), who were among the first to apply the tool to monetary economics. In this article I argue that in addition to offering “solutions feasibility,” the use of a quadratic loss function to characterize the behavior of central banks also inaugurated an objective way of talking about optimality. In this respect, the tool stabilized the discourse on optimal monetary policy.

Monetary Policy in Austria–Hungary, 1876–1913: An Econometric Analysis of the Determinants of the Central Bank’s Discount Rate and the Liquidity Ratio

This paper presents a model to explain the official discount rate of the Central Bank of Austria–Hungary from 1876 to 1913. The discount rate is assumed to depend on the liquidity ratio of the Bank, defined as the ratio of its stock of metals to banknotes issued, and on changes in foreign discount rates. The paper also presents an equation explaining the liquidity ratio. We use “not equally spaced chronologically ordered data” referring to the 50 discount rate changes enacted. The regressions confirm that the liquidity ratio was the main determinant of the discount rate and that Germany (and not Great Britain) played a significant role in determining the Austro–Hungarian discount rate and the liquidity ratios, supporting the view that the classical gold standard was a decentralized multipolar system rather than a system fully dominated by London as suggested by Keynes. The regressions also suggest that, although Austria–Hungary had an inconvertible paper currency (1879–1892) and fluctuating exchange rates (1876–1895) and formally joined the gold standard only in 1902, it “shadowed” the behaviour of gold standard Central Banks with such consistency that the stability of the estimated regressions was relatively unaffected by the frequent institutional changes.

Economic transparency and poverty

Nowadays, with the diffusion of inflation targeting, the main instrument that central banks use to achieve final objectives in the implementation of monetary policy (concerning inflation and unemployment) is the interest rate. Furthermore, recent studies point out that central bank transparency contributes to reducing asymmetric information and price stability. As inflation, unemployment and interest rates are determinants of the level of poverty, the central bank's behaviour is relevant to its reduction. Accordingly, the present paper highlights the connection betweeneconomic transparency and poverty. The theoretical and empirical results denote that central bank transparency is a useful strategy in reducing income inequality andpoverty. JEL Codes: D31, E31, E43, E52,E58, I32, I38 Keywords: Inflation, Instrument, Interest Rates, Interest, Monetary Policy, Monetary, Policy, Prices

Trasparenza economica e povertà

Nowadays, with the diffusion of inflation targeting, the main instrument that central banks use to achieve final objectives in the implementation of monetary policy (concerning inflation and unemployment) is the interest rate. Furthermore, recent studies point out that central bank transparency contributes to reducing asymmetric information and price stability. As inflation, unemployment and interest rates are determinants of the level of poverty, the central bank's behaviour is relevant to its reduction. Accordingly, the present paper highlights the connection between economic transparency and poverty. The theoretical and empirical results denote that central bank transparency is a useful strategy in reducing income inequality and poverty. JEL Codes: I32, E52

Monetary policy rules in practice: evidence from Turkey and Israel

Forward looking monetary policy rules are estimated for Israel and Turkey. When variable inflation targets are taken into consideration, as opposed to the fixed targets used in prior research that use data from developed countries, forward looking Taylor rules seem to provide reasonable description of Central Bank behaviour in both countries. In general, it can be said that monetary policy appears to be quite strong in these countries, and especially so in Turkey, when compared with developed countries.

Comment and Discussion

Glenn D. Rudebusch: This paper by David Backus and Jonathan Wright examines a timely topic of interest to macroeconomists, financial econo mists, and the general public of long-term savers and investors. They investigate the recent episode of continuing low long-term interest rates? a behavior that appears to some to be a conundrum given that short-term rates worldwide have been rising. For example, in the United States, while the Federal Reserve raised the federal funds rate from 1 percent in June 2004 to 514 percent in December 2006, the rate on ten-year U.S. Treasury notes actually edged down, on balance, from 4.7 percent to 4.6 percent. This directional divergence between shortand long-term rates is at odds with historical precedent and appears even more unusual given other eco nomic developments at the time, such as a solid economic expansion, a falling unemployment rate, rising energy prices, and a deteriorating federal fiscal situation, all of which have been associated in the past with higher long-term interest rates rather than lower. Of course, determining whether recent long-term interest rate move ments truly represent a puzzle requires a theoretical framework that takes into account the various factors that affect long-term rates. The paper takes a joint macro-finance perspective on this problem, which, as much recent research suggests,1 is a promising strategy that can capture two broad sets of determinants of long-term rates. In particular, from a macroeconomic perspective, the short-term interest rate is a policy instrument under the direct control of the central bank, which adjusts that rate to achieve its macroeconomic stabilization goals. Therefore financial market partici pants' understanding of central bank behavior, along with their views of

Asymmetric Monetary Policy Rules and the Yield Curve

Simple models of central bank behavior can produce highly complex yield curve shapes. Using the Taylor rule and its extensions as building blocks, we construct a robust framework for generating realistic yield curves and the evolution of the economy. Our main focus is the impact on the yield curve and the economy of asymmetrically accomodative policy, typically called the put. We find that for economies like the U.S. the deflation put reduces yields for all maturities. We also find that in highly leveraged economies (such as Japan) the consequence of an asymmetric deflation fighting policy may result in improved economic conditions, but also raises the possibility of higher long term yields as a consequence.

Nominal Wage Flexibility, Wage Indexation and Monetary Union

Membership in a monetary union implies stronger incentives for nominal wage flexibility in the form of wage indexation and shorter contract length than non-membership. This counteracts the stabilisation policy cost of giving up monetary independence. But more wage flexibility is only an imperfect substitute for an individual monetary policy. It is possible that an increase in wage flexibility is welfare-decreasing because of the accompanying rise in price variability. The interaction between wage setting and central bank behaviour may result in either multiple equilibria or a unique full-indexation equilibrium.

Teaching Undergraduate Macroeconomics with the Taylor-Romer Model

This paper sets out a version of the Taylor-Romer model of short-run macroeconomic equilibrium which can be used for teaching undergraduate economics principles courses. The aim is to generate a model with the proven advantages of the IS-LM framework but with a more realistic description of central bank behaviour. The paper then provides a dynamic analysis of longer-term adjustment using a phase diagram but without the need for a formal mathematical derivation.

Does Conservatism Matter? A Time‐Series Approach to Central Bank Behaviour

Empirical studies crediting ‘independent and conservative central banks’ with lowering inflation and inflation volatility have been criticised for their focus on policy outcomes instead of policies, and for their unsystematic conflation of independence and conservatism. We present results from time‐series models for the German Bundesbank that avoid these shortfalls. Conservatism matters in the following sense: (i ) more conservative Bundesbank Councils tend to react stronger to changes in inflation and output, and (ii ) an increase in conservatism leads to a more activist stabilisation policy. This is in line with simple policy models incorporating economic persistence with implementation lags for monetary policy.

Politique monétaire et prix d'actifs

Résumé L’objectif de cet article est de dresser un bilan des travaux qui étudient si les banques centrales doivent réagir aux mouvements des prix d’actifs. D’abord, l’analyse conduit à discuter des nombreuses incertitudes auxquelles les autorités monétaires devraient faire face en cas d’introduction d’une cible de prix d’actifs dans leur règle monétaire. Ensuite, cette étude évalue la façon dont les auteurs intègrent les enseignements des canaux de transmission asymétriques des prix d’actifs à la sphère réelle (accélérateur financier et canal du capital bancaire essentiellement). Lorsque c’est le cas, on observe que le comportement des autorités monétaires devrait être conditionnel au contexte financier, c’est-à-dire à la vulnérabilité ex ante des agents aux chocs financiers. Ainsi, la politique monétaire pourrait agir de façon préventive en cherchant à combattre les déséquilibres financiers lorsque les bilans des agents sont initialement dégradés (et seulement dans ce cas). Il reste néanmoins à prouver, qu’en la matière, la politique monétaire est plus efficace que la politique prudentielle.

Do central banks act asymmetrically? Empirical evidence from the ECB and the Bank of England

The paper attempts to exploit whether monetary authorities have a different behaviour during recession and expansion. To this end, a multivariate extension of Hamilton Markov-switching model is adopted. First, regime dependent Taylor-type rules are estimated for the Euro Area and the United Kingdom in order to capture the systematic behaviour of central banks. Then, impulse response functions that account for the different phases of the business cycle are analysed. In addition, a comparative analysis concerning the estimated rules as well as the different reaction of real economy to monetary shocks is implemented. The study strongly suggests that central banks cannot neglect the regime where the monetary action takes place. It follows that the phase of business cycle is an important matter in monetary policy decision process.

THE APPRENTICE WIZARD: MONTETARY POLICY, COMPLEXITY AND LEARNING

This paper investigates some central issues of monetary policy by offering a model in which a central bank tries to stabilize fluctuations in aggregate output and inflation in an adaptive complex economy. We resort to evolutionary algorithms to model the central bank behaviour under discretion, and confront the efficiency of discretion with the choice of full commitment to a fixed rule.

Learning, Inflation Reduction and Optimal Monetary Policy

In this paper we analyze disinflation in two environments.One in which the central bank has perfect knowledge, in the sense that it understands and observes the process by which private sector inflation expectations are generated, and one in which the central bank has to learn the private sector inflation forecasting rule.Here, the learning scheme we investigate is that of least-squares learning (recursive OLS) using the Kalman filter.With imperfect knowledge, results depend on the learning scheme that is employed.A novel feature of the passive learning policy - compared to the central bank s disinflation policy under perfect knowledge - is that the degree of monetary accommodation (the extent to which the central bank accommodates private sector inflation expectations) is no longer constant across the disinflation, but becomes state-dependent.This means that the central bank's behaviour changes during the disinflation as it collects more information.

Central Bank Behavior, the Institutional Framework, and Policy Regimes: Inflation Versus Noninflation Targeting Countries

This article estimates central bank reaction functions for 20 OECD countries. It bridges the gap between the Taylor reaction function literature and the political‐economy literature. Central banks react to both inflation and the output gap. Moreover, inflation‐targeting countries have been able to reduce nominal interest rate to a greater extent than have non‐inflation‐targeting countries. Countries with fixed exchange rates react more strongly to inflation but not at all to the output gap, unlike countries with floating rates. Political influences also seem relatively more important in fixed exchange rate countries. Central bank independence also helps reduce nominal interest rates. (JEL E58, C31, C32, C53)

Model Uncertainty, Optimal Monetary Policy and the Preferences of the Fed

AbstractMonetary policy in the US is characterized by a substantial degree of inertia. While in principle this may well be the outcome of an optimizing central bank behaviour, the ability of any derived policy rule to match the data relies on so large weights for interest rate smoothing into policy makers' preferences as to be theoretically flawed. In this paper we investigate whether such a puzzle can be interpreted as resulting from the concern of monetary authorities for potential misspecifications of the macroeconomic dynamics. Accordingly, we propose a novel thick modelling approach that incorporates model uncertainty into the identification of central bank's preferences. The thick robust policy rule shows the kind of smoothness observed in the data without resorting to implausible values for the preference parameters.