Central Bank Loss Function Research Articles

Regulatory Effects of the Combinations of Aggregate and Structural Monetary Policy Instruments: an application of New Keynesian DSGE model to China

This paper selects Chinese macroeconomic data from the first quarter of 2009 to the first quarter of 2020 and employs a New Keynesian dynamic stochastic general equilibrium model that incorporates the financial accelerator mechanism, price stickiness, and invisible government guarantees. The regulatory effects of different combinations of monetary policy instruments are compared from five perspectives: the shock effect of monetary policy, the magnitude of economic volatility of non-monetary policy shocks, the Central Bank loss function, the gap in the distribution of household income, and the heterogeneous firm external financing premium. Our findings indicate that the regulatory effects of the aggregate price-based and structural quantity-based monetary policy instrument combination are optimal, a conclusion that is further supported by the robustness test. It is therefore recommended that the Central Bank consider the potential benefits of a combined approach to aggregate and structural monetary policy instruments, with a view to enhancing credit availability for the real economy. This paper represents a significant contribution to the field, as it is the first to explicitly propose four distinct monetary policy instrument combinations, thereby overcoming the limitations of previous studies that have focused on a single instrument or a narrow range of instruments. The paper also contributes to the theoretical understanding of monetary policy instruments.

Progressive taxation and optimal monetary policy in a two‐country new Keynesian model

AbstractThis paper examines the effect of tax progressivity on optimal monetary policy in a two‐country new Keynesian model. We first address the issue that coefficients in both structural equations and the central bank's loss function are crucially affected by a change in tax progressivity in both countries. Second, we show that a change in tax progressivity significantly affects the properties of international monetary policy transmission. Third, we demonstrate that the impact of tax progressivity on international monetary policy transmission depends on the value of the constant relative risk‐aversion coefficients.

Time-varying monetary policy reaction function under asymmetric preferences: revisiting the Brazilian inflation targeting experience

PurposeThis paper analyzes the potential presence of time-varying asymmetries in the preference parameters of the Central Bank of Brazil during the inflation targeting regime.Design/methodology/approachGiven the econometric issues inherent to classical time-varying parameter (TVP) regressions, a Bayesian estimation procedure is implemented in order to provide more robust parameter estimates. A stochastic volatility specification is also included to take into account the potential presence of conditional heteroskedasticity.FindingsThe obtained results show that the reduced form and structural parameters were not constant during the period considered. Moreover, the subsequent analysis of the preference parameters provided evidences of short periods in which asymmetry was an important feature to the conduction of monetary policy in Brazil. Yet, during most of the sample period, the loss function was considered to be symmetrical.Originality/valueThis paper aims to contribute to the rather scarce monetary debate on time-varying central bank preferences. The study of Lopes and Aragón (2014) is, to the best of the authors’ knowledge, the only study for Brazil considering specifically TVPs. The authors applied Kalman filter estimation to data from 2000:M1 to 2011:M12. Despite the similar structure of TVPs, the present paper extends the latter study by controlling for stochastic volatility. Ignoring conditional heteroskedasticity might lead to spurious movements in time-varying variables and inaccurate inference (Hamilton, 2010). Thus, the stochastic volatility specification is included to take this issue into account. The authors follow the theoretical scheme put forward by Surico (2007) and Aragón and Portugal (2010), in which the economy is modeled from a New Keynesian perspective and the central bank loss function is assumed to be asymmetric regarding the responses to inflation and output deviations from their targets. On the empirical side, the authors propose a TVP univariate regression with stochastic volatility for the Brazilian reduced-form reaction function, following closely the Bayesian econometric procedure developed by Nakajima (2011). Given the nonlinear non-Gaussian nature of the TVP regression with stochastic volatility, the choice of a nonlinear Bayesian approach using the Markov chain Monte Carlo (MCMC) method is justified due to the intractability of the associated likelihood function (Primiceri, 2005). Finally, based on the theoretical model specification, the authors intend to recover the central bank preference parameters as to further evaluate the degree of asymmetry and its potential time-variation under the inflation targeting regime.

What do Latin American inflation targeters care about? A comparative Bayesian estimation of central bank preferences

This paper employs Bayesian estimation to uncover the central bank preferences of the five Latin American inflation targeting countries with floating exchange rates: Brazil, Chile, Colombia, Mexico, and Peru. The target weights of each country’s central bank loss function are estimated using a medium-scale small open economy New Keynesian model with imperfect exchange-rate pass-through under either complete or incomplete international asset markets. Bayesian model comparison selects: (i) unambiguously the complete markets model version; (ii) the model specification with explicit concern for real exchange rate stabilization, with the exception of Peru. Our results suggest that the central banks of Mexico and Peru are closest to following a strict inflation targeting regime, whereas Brazil, Chile, and Colombia also assign a sizeable weight to output gap and real exchange rate stabilization. Finally, the estimated preference weights for each central bank are shown to credibly reflect their legal mandates.

Should monetary policy lean against the wind? Simulations based on a DSGE model with an occasionally binding credit constraint

In this research paper, we extend the model constructed by Gambacorta and Signoretti (2014) by introducing an occasionally binding credit constraint based on a penalty function approach in line with Brzoza-Brzezina, Kolasa, and Makarski (2015) to study the performance of the Taylor rule augmented with asset prices. First, we compare the properties of the baseline model and its modified version. Then, we use both models to study the performance of the basic and extended Taylor rule. The performance of Taylor rules is examined under the optimisation of a central bank's loss function and the welfare maximisation of economic agents. The analysis delivers the following results. The model with an occasionally binding credit constraint has more favourable properties regarding the hump-shaped and asymmetric impulse responses compared to an eternally binding credit constraint model. The best rule regarding the lowest value of the central banks' loss function proves to be the rule augmented with asset prices. The optimal reactions are, however, shock- and model-dependent, and therefore, any rule-like behaviour does not seem to be appropriate. The welfare maximisation under the occasionally binding credit constraint model reveals that reacting to asset prices might not be welfare-improving for both types of economic agents – households and entrepreneurs. This result is in contradiction with the implications achieved under the eternally binding credit constraint model.

Welfare Implications of Alternative Monetary Policy Rules: A New Keynesian DSGE Model for Turkey

Abstract In recent years, there has been extensive research on the conduct of monetary policy in small open economies that are subject to inflation and output fluctuations. Policymakers should decide whether to implement strict inflation targeting or to respond to the changes in output fluctuations while conducting monetary policy rule. This study aims to examine the response of alternative monetary policy rules to Turkish economy by means of a DSGE model that is subject to demand and technology shocks. The New Keynesian model we used is borrowed from Gali (2015) and calibrated for the Turkish economy. Welfare effects of alternative Taylor rules are evaluated under different specifications of central bank loss function. One of the main findings of this paper is that in the case of a technology shock, strict inflation targeting rules provide the minimum welfare loss under all loss function configurations. On the contrary, the losses are weakened if the monetary authority responds to output fluctuations in the presence of a demand shock. Finally, there exists a trade-off between the volatility of output and inflation in case of a technology shock, while the volatility of both variables moves in the same direction in response to a demand shock.

Does international-reserves targeting decrease the vulnerability to capital flights?

Numerous episodes of financial turmoil such as the 1997–1998 East Asian currency crisis have shown that economies are more vulnerable to currency runs if their currency reserves are low and have not been targeted by central bank policies. These issues have recently become again relevant as a significant capital flight could be observed with respect to China's currency by the beginning of 2016, which however did not develop to a full fledged currency crisis due to the availability of large currency reserves by the Central Bank of China. Against this background, we study the design of optimal monetary policy rules in a theoretical framework where foreign investors react in a nonlinear manner to the evolution of the central bank's currency reserves. We show that by allowing the central bank to give some significantly positive weight to the level of precautionary foreign reserves as one of its targets, a currency crisis scenario can be avoided, while such a crisis is likely to occur when this weight is zero or sufficiently low. The effects of the central bank's monetary control on the output, the inflation rate, and the foreign reserve level corroborate the economy's vulnerability for insufficient foreign reserves targeting. By means of numerical simulations, we show that the larger the relative weight of the foreign reserves target in the central bank's loss function, the larger is the domain of attraction of the stable equilibrium where the economy is not vulnerable to capital flight shocks.

Ações sinalizam mais do que palavras: Estimando preferências do Banco Central do Brasil sob o Regime de Metas de Inflação.

In august of 2011, the Brazilian central bank took measures of monetary policy that signalized he was less committed with inflation. Such an event inspired this study. The objective of this paper is to come up with way to estimate parameters from the central bank loss function, in a way that they vary over time, during the Brazilian inflation targeting regime. This allows us to analyze if there were changes in the preferences of the central bank. To do so, state-space models were used. Results show that preferences in fact changed over time, which might be an indication of discretion in the Brazilian monetary policy.

INFLATION TARGETING WITH IMPERFECT INFORMATION*

In a global games setup with imperfect commitment technology, we show that low targets—the ones close to the optimal inflation under perfect commitment—are unattainable, leading to a trade-off between low and credible targets. Moreover, since noisy public information helps to coordinate expectations around the announced target, our article supports unconventional policy prescriptions. First, weaker countries need to impose higher targets. Second, less transparency helps to make the announced target credible and then reduces the optimally announced target. Results are based on a general central bank loss function encompassing models traditionally used to discuss central bank decisions.

Central Bank Behaviour Concerning the Level of Bitcoin Regulation as a Policy Variable

Bitcoin gains more and more attention in the general public and is already the most popular virtual currency. At the same time, the acceptance of Bitcoin as a speculative asset and also as a payment vehicle increases. This is an indication that we might now be entering an era of parallel currency systems. Therefore, one could state that the Bitcoin network and the central banking system could become two rival systems with respect to issuing payment vehicles and providing cross-border payment systems. Our aim is to analyse the central bank incentives for establishing a network model that includes hacking. With our model we are able to explain why central banks have no incentive to advance Bitcoin regulation at the current stage of development, as this would reduce the critical mass of Bitcoin users. Finally, in combination with a central bank loss function, we are able to calculate an optimal level of central regulation.

Target Controllability, Time Consistency, and the Tinbergen Rule

The Tinbergen Rule states that achieving the desired targets requires an equal number of instruments. This paper shows that time inconsistency does not exist in the case of an equal number of instruments and targets. Target uncontrollability and time inconsistency, however, emerge as problems in the case of fewer instruments than targets. In this case, we obtain a necessary and sufficient condition for joint asymptotic controllability of target values. The condition is identical under commitment and under discretion. We observe that the constant average inflation bias comes from fewer instruments than targets, rather than from time inconsistency as the literature stresses. Policy makers must address target uncontrollability before addressing time inconsistency to avoid entanglement of the two problems when addressing time inconsistency. The paper solves both problems by designing the central bank loss function that determines the central bank’s long- and short-run target values of inflation and output as well as the relative weight between stabilizing inflation and output. Intuitively, a proper target value trade-off solves target uncontrollability, whereas a proper relative weight between target stabilizations achieves optimal target variability trade-off and solves time inconsistency. As a result, target values are moderate and controllable, establishing monetary policy credibility. Discretionary policy under the designed loss function, which replicates optimal policy under the social loss function, proves optimal and time-consistent. In addition, we identify two situations where the delegated weight equals the social weight -- one-decision-maker models and static models, providing additional insight into time inconsistency.

Limits of Monetary Policy Autonomy and Exchange Rate Flexibility by East Asian Central Banks

Given low interest rates in the large industrial countries and buoyant capital inflows into the emerging markets East Asian central banks have accumulated large stocks of foreign reserves. As the resulting easing of monetary conditions has become a threat to domestic price and financial stability, the East Asian central banks have embarked on substantial sterilization operations to absorb what we call ‘surplus liquidity’ from the domestic banking systems. This has brought the East Asian central banks into debtor positions versus the domestic banking systems. We show based on a central bank loss function that given buoyant capital inflows and exchange rate stabilization the absorption of surplus liquidity leads either to financial repression, or rising inflation or both. Assuming that a debtor central bank moved towards a freely floating exchange rate to gain monetary policy independence, we show that monetary policy independence is undermined by sterilization costs and revaluation losses on foreign reserves.

Perspectives on “marginal crisis risk” and “leaning against the wind” from the capital structure of housing investments

PurposeThe purpose of this paper is to relate the marginal crisis risk of Woodford to a number of financial fragility indicators. The paper expands the interest rate gap approach by considering the capital structure of investments and systemic risk, dating back to Modigliani‐Miller. The model allows for distinct impacts from asset inflation, leverage as well as incentives for speculative investments for a central bank that aims to lean against the wind.Design/methodology/approachFramed in terms of the housing market and household behaviour, the paper sets out an augmented loss function which takes a number of financial fragility indicators into account. By moving beyond the case where all risk increasing mechanisms are driven by external monetary policy shocks, the approach shows why a central bank should be inclined to lean against the wind even in the absence of interest rate gaps.FindingsTaking the return to equity into account, and moving beyond the case where all risk increasing mechanisms are related to external monetary policy shocks, the paper shows why a central bank might be inclined to lean against the wind even in the absence of interest rate gaps. The context‐specific nature of the monetary transmission mechanism in general, and the structure of the risk taking channel more specifically, calls for both internal financial market features as well as the link between financial markets and the real economy to impact on how and when to lean.Originality/valueThere seems to be increased awareness of the need to take financial stability considerations in monetary policy. In fact, Woodford argues that the balance between financial stability objectives and price and output stability is part of the choice when choosing between alternative short run paths for monetary policy. By taking a conventional approach to the capital structure of investments, this paper integrates asset inflation, leverage and incentives for speculation into a central bank's loss function in a way that to the best of the author's knowledge is novel.

Testing asymmetries in Central Bank preferences in a small open economy: A study for Brazil

Abstract In this paper, we extend Surico's (2007a) model to an open economy and test if the Brazilian Central Bank's loss function is asymmetric with regard to positive and negative deviations of the output gap and of the inflation rate from its target. Furthermore, we use tests for structural breaks to investigate changes in the conduct of policy and monetary authority's preferences. The results revealed that the Central Bank reacted more strongly to deviations of inflation from the target and the output gap after 2003. With regard to the monetary authority's preferences, estimates indicate only an asymmetric preference over an above-target inflation rate until mid-2003. After this period, the evidence obtained by estimating the reaction function with inflation expectations showed that the Central Bank has been more averse to positive deviations of inflation from its target.

Estimating Central Bank Preferences Under Commitment and Discretion

This paper explains US macroeconomic outcomes with an empirical new-Keynesian model in which monetary policy minimizes the central bank's loss function. The presence of expectations in the model forms a well-known distinction between two modes of optimization, termed commitment and discretion. The model is estimated separately under each policy using maximum likelihood over the Volcker-Greenspan-Bernanke period. Comparisons of fit reveal that the data favor the specification with discretionary policy. Estimates of the loss function weights point to an excessive concern for interest rate smoothing in the commitment model but a more balanced concern relative to inflation and output stability in the discretionary model.

Limits of Monetary Policy Autonomy by East Asian Debtor Central Banks

Due to buoyant capital inflows East Asian central banks with exchange rate targets accumulate foreign reserves and thereby increase surplus liquidity. East Asian central banks with more flexible exchange rate regimes also face surplus liquidity that mainly emanates from past accumulation of foreign reserves. We show based on an augmented Barro-Gordon-type central bank loss function that in both cases surplus liquidity limits monetary policy autonomy. In case of fixed exchange rates East Asian central banks can escape from the impossible trinity and gain monetary policy autonomy by using non-market–based sterilization which leads to financial sector distortions. In a flexible exchange rate regime monetary policy autonomy can be gained without financial sector distortions by using market-based sterilization. As central banks face substantial sterilization costs as well as revaluation losses on foreign reserves, however, monetary policy autonomy is eroded.

Monetary Policy Inclinations

We examine whether central banks should complement their inflation forecasts with interest rate projections. Introducing a central bank loss function that accounts for deviations from announcements, we incorporate the publication of policy inclinations into a dynamic monetary model. We show that in the presence of cost-push shocks, the publication of interest rate forecasts tends to improve welfare.

Interest income taxation, optimal monetary policy, and macroeconomic volatility

This paper studies optimal discretionary monetary policy in an extension of the basic new Keynesian model that incorporates interest income taxation, focusing on the effect of changes in the interest income tax rate on macroeconomic volatility. Simulations show that high levels of taxation increase inflation volatility, the output gap volatility, and the unconditional expectation of the central bank's loss function.

THE OPTIMALITY AND CONTROLLABILITY OF MONETARY POLICY THROUGH DELEGATION WITH CONSISTENT TARGETS

ABSTRACTThis paper uses two game‐theory models, where monetary policy is first ineffective and then effective, to illustrate a delegation scheme that makes consistent policy optimal and controllable. The delegation scheme produces the minimization of both the social and the central bank loss functions. Minimizing the social loss function generates optimality conditions. Minimizing the central bank loss function produces controllability conditions. Optimality conditions depend on specific models, and controllability conditions do not. We propose a concept of consistent targets, which refer to the targets that satisfy both optimality and controllability conditions. Consistent policy proves optimal and controllable in both example models when the government delegates consistent targets to the central bank.

What does South Korean inflation targeting target?

This paper characterises South Korean monetary policy in the period of explicit inflation targeting that started in 1999. We calculate Bank of Korea's parameters in the policy objective function, conditional on an estimated macro-model. We show that this central bank appears to have pursued optimal policy geared towards achieving price stability, while displaying a considerable degree of interest rate smoothing. In addition, the central bank loss function is estimated to include negligible weights on output and exchange-rate variability.