Central Bank Reaction Function Research Articles

Independensi Kebijakan Moneter dalam Jangka Pendek: Kasus Indonesia

Using Capital Flow Model and Central Bank Reaction Function for the case of Indonesia before the current crisis, this paper found that during Indonesia implemented fixed exchange rate regime the monetary policy which was done by Bank of Indonesia has lost its independence. The regression results using Two Stage Least Square method show that the monetary policy during the period before the current crisis in Indonesia was very influenced by the behavior of private capital flows. To neutralize the liquidity effects of private capital inflows as a response to deregulation packages in financial and banking sector in the late of 1980s, Bank of Indonesia has actively implemented the sterilization policies. The regression results of the Central Bank Reaction Function indicate that Bank of Indonesia could not completely sterilize the liquidity effects of private capital inflows. This situation made the monetary policy undertaken by Bank of Indonesia lost its power to stabilize inflation in the economy. The phenomenon of high inflation which followed high economic growth (overheating economy) during the period before the current crisis has significantly reduced the index of competitiveness of Indonesian goods and services in the world market. This is one of the main factors that caused slower Indonesian export growth just before the crisis began in the mid of 1997. This situation made the level of supply of foreign exchange in domestic market dropped significantly, while on the other side the demand level increased as many big corporate businesses and government institutions needed foreign exchange to repay their foreign debt. Rupiah become unstable and public expectation for further devaluation widened. This was the beginning of the current crisis that until now put Indonesia into the deep trouble. Therefore, the most important contribution of this paper is its investigation to the linkage between deregulation and the current crisis. This paper recommends that one of the main factors that generate the Indonesian current crisis has showed up far before the crisis began. It was started when the monetary policy lost its power to stabilize inflation that was caused by behavior of private capital inflows as a response to the wrong sequence of deregulation policies in Indonesia.

Inflation Targeting As a Tool for Maintaining Price Stability of The National Bank of Ukraine

Introduction. Inflation targeting is a tool for ensuring price stability in the economy and therefore requires harmonious coordination and communication among government institutions. At the same time, the central bank must adhere to a certain policy instrument, the established legal rules, which are fixed in its mandate, or act at its discretion. Nowadays, the most common rule of monetary policy is inflation targeting.
 Aim and tasks. The purpose of the article is to explain the expediency of using the inflation targeting regime to keep inflation at a certain target level, which is determined by the central bank taking into account the current state of the economy.
 Results. The theoretical model of Taylor is considered, which is based on inflation assessment in the form of a simple interest rate rule based on monetary policy instruments that ensure convergence of the inflation forecast to the target value in the medium term. The obtained results reflect the volatility of the indicators of the objective function in the data range of 2015 Q3–2021 Q2 and confirm the weight of the gap of variable values that are estimated to be insignificant (95%). Using the GMM method, the relationship between the indicators of the objective function and their impact on the inflation rate through the use of the inflation targeting regime was verified. In particular, the volatility of variables such as the inflation gap, short-term interest rate, output gap, and exchange rate gap and their impact on the target inflation rate was revealed on the time horizon of monetary policy. Smoothing out gaps in variables is one of the goals of the central bank's reaction function under the inflation targeting regime. The use of the GMM method confirms the validity of the application of Taylor's rule regarding the feasibility of choosing an objective function with predetermined variable parameters at different sampling intervals.
 Conclusions. The increase in the volatility of variable parameters in the objective function of central banks under the inflation targeting regime is explained by global crises and the sensitivity of macroeconomic indicators to fluctuations in the economic situation. This is the main reason why central banks strictly follow the rules of monetary policy, which allow the timely smoothing of exogenous shocks in the economy.

"Monetary policy measures and strategies in the context of the adoption of the euro currency "

"The importance of knowing the effects resulting from the adoption and implementation of monetary policy decisions on economic variables is a decisive factor of this article, which directed our attention to the issue of monetary policy measures. Taking into account the thematic area, this concept falls, without exception, in the field of the monetary economy, so it allows the author to carry out a rigorous, complex analysis supported by notions found in the field of finance, economic-financial integration, international relations, as well as macroeconomics. Identifying the behavior of central banks in establishing monetary policy strategies constitutes the fundamental objective of the paper and can provide a conclusive and appropriate picture of both the objectives considered and their prioritization. A standard approach in this context is to estimate a central bank reaction function in the form of a Taylor rule. By using the previously mentioned method, the identification of the final objectives of the monetary policy authorities through the lens of the promoted policy is considered. The analysis will focus on states such as Romania, Hungary, Poland, and the Czech Republic, all committed to adopting a single currency according to the Treaty on the Functioning of the European Union. The present analysis has brought to the fore the monetary policy measures and strategies used mainly by Central and Eastern European central banks. "

Monetary policy in a world of radical uncertainty

Monetary policy in a world of radical uncertainty

The Asymmetric Effects of Monetary Policy: Evidence from the United Kingdom*

AbstractIn this paper, I analyse how the response of the UK economy to monetary policy shocks depends on the state of the economy, or the sign or size of the shock. Monetary policy shocks are identified by extending the Cloyne and Hürtgen (2016) approach to allow for time variation in the central bank reaction function. These shocks are used to estimate impulse responses by local projections to investigate asymmetries in the transmission mechanism. The main result is that shocks that occur during economic booms have significantly larger effects than those that occur during recessions. In addition, I find that expansionary shocks are more powerful than contractionary shocks, and that large shocks have a proportionally weaker effect on output than small shocks. The results are robust to alternative monetary policy shock identification methods and variations in the empirical specification.

Official Intervention and Exchange Rate Determination: Evidence from India

Despite the adoption of a market-oriented regime, Reserve Bank of India explicitly practices sterilized intervention to normalize unfavourable developments in the market. This study seeks to find empirical evidence on the intensity to which the monetary authority was able to achieve its policy objective of directing exchange rate in the anticipated trail. The study employed an Autoregressive Distributed Lag (ARDL) model to estimate the central bank reaction function in this regard. It was found that 1% purchase of foreign exchange reserve (net intervention) depreciated Indian Rupee by 0.255% for long-term. Whereas in short-term, intervention followed “leaning against the wind” policy to curb market vagueness. The findings of the study recommend that there should be more coordinated approach between official intervention policy and monetary policy formulation in consonance with the economic fundamentals for increasing the effectiveness and sustainability of the intervention operations.

Monetary Policy Expectation Errors

We use survey expectations about future monetary policy to decompose excess returns on fed funds futures and overnight index swaps into a term premium and an expectation error component. We find that excess returns are primarily driven by expectation errors, while term premia are economically small and negative on average. Most expectation errors stem from market participants underestimating how aggressively the Federal Reserve has eased policy during the last three decades. Our findings reveal that market participants are continuously learning about the central bank's reaction function and have been slow to recognize the rising importance attributed to deteriorating financial conditions and falling stock prices. We document similar results in an international sample of six major currency areas.

Macroeconomic effects of an open-ended asset purchase programme

We evaluate the effectiveness of an open-ended asset purchase programme (APP) using a New Keynesian model of euro area. We assume that the central bank does not announce the ending date of the programme, and agents form their expectations about possible additional purchases beyond the horizon of the announcement according to the central bank reaction function, that links the purchases to the expected inflation gap. It is showed that the open-ended APP is more effective in stimulating macroeconomic conditions than committing ex ante to an ending date.

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Post-Brexit Stock Market Volatility and European Central Bank Reaction Function

The European stock markets experienced enormous volatility in stock markets post-Brexit era, which wasn’t observed before the shock. The volatility in financial markets has disturbed economic fundamentals including capital flow and economic growth in several European countries. To avoid such disturbances the monetary authorities have to implement a monetary reaction function by adopting an appropriate range for short-term interest rate consistent with the volatility of stock markets and depreciation of British pound. The monetary reaction function in this case shouldn’t be only based on traditional Taylor’s rule but also needs to take into account the volatility of stock markets and depreciation of pound versus major currencies. The goal of this paper is twofold. First, it tries to estimate the effects of Brexit on stock market volatility index for British FTSE, German DAX, and French CAC using econometric models and a dummy variable for post-Brexit. Second, it uses a Vector Auto Regression (VAR) model to stimulate the monetary reaction function of the European Central Bank (ECB) to find out how it may neutralize the adverse effects of stock market volatility on macroeconomic fundamentals.

Analysing the spillover of inflation in selected Euro-area countries

We examined the spillover of inflation in selected Euro-area countries using monthly consumer price index (CPI) based inflation data covering the period 1955M1 to 2017M4. To achieve our objective, we used two recently developed methods of spillover: a time-domain spillover method, Diebold–Yilmaz (hereafter referred as DY method) and a frequency-domain method, Barunik–Krehlik (hereafter referred as BK method). We analysed 1–4 months and more than 4 months spillovers. The study has importance because the co-movement in the international inflation rates, among others, may be produced by common shocks, similarities in central bank reaction functions, international trade and the operation of purchasing power parity theory. However, to assess the synchronisation of inflation fluctuations across countries or regions, it is critical to understand the inflation behaviour and formulation of correct monetary policy.

Estimating Central Bank Reaction Functions Post 2008: USA and Switzerland

Almost all central banks worldwide have a common goal of keeping inflation low and stable while simultaneously maintaining the health of their country’s financial system. By studying the Swiss National Bank and the US Federal Reserve, this paper investigates whether a single model can be used to capture these two mandates – both in times of economic stability and in times of crisis.
 Ultimately, using differences between market interest rates as a "barometer of fears of bank insolvency" the model presented in this paper is able to detect when a crisis is occurring. Furthermore, it is able to describe the change in central bank behaviour associated with said crisis.
 The value of the model is in its simplicity, it only uses four macroeconomic variables to provide accurate forecasts. Furthermore, monetary economists are highly interested in simple models to determine the optimal interest rate. Such types of models are associated with the "Great Moderation" – a time period from the 1980s – 1990s where a reduction in the volatility of the business cycle was linked to a strict rule-based approach to monetary policy. Insight into these rules can ultimately improve the welfare of all citizens by allowing central banks to handle economic crises more effectively.

Heterogeneity across emerging market central bank reaction functions

The purpose of this study is to analyze monetary policy reaction functions of inflation targeting emerging market economies. Heterogeneity across central bank behavior is modelled using dynamic common correlated effects estimator in a panel data framework of 15 countries. The empirical method allows us to obtain country specific coefficients and shows differences across central bank reaction functions. Model results imply that central banks behave according to an extended Taylor rule and respond to deviation of inflation from the target, output gap, real exchange rate and external financial conditions. The study finds that emerging market central banks consider not only price stability, but also financial stability in setting of interest rates.

Assessing Nonlinear Dynamics of Central Bank Reaction Function: The Case of Mozambique

AbstractThis paper sheds some light on the elements governing monetary policy‐making during the period 2000Q1–2015Q1 in Mozambique. We estimate a time‐varying Taylor‐type rule for the BM, using a Markov‐switching (MS) model and a Threshold model. The general finding is that the behaviour of the BM can be characterised by two regimes. In regime 1, only changes in inflation trigger a reaction by the monetary authority. This behaviour is prominent after the establishment of the monetary policy committee in 2007 (CPMO). In regime 2, the BM reacts aggressively both to cool off the economic activity and to curb inflationary pressures. Regime 2 occurred most frequently during 2000–2006, when the fiscal policy might have played an important role in output stabilization. After the establishment of the CPMO, regime 2 occurred in the context of a steep rise in fuel and food prices in 2007–2008 and in 2010. Both the MS model and the Threshold model show similar asymmetric effects. We find evidence that inflation is viewed more seriously by the monetary authorities when it is accompanied by a high output‐gap in the previous period, which triggers a more aggressive response from the monetary authorities.

Exchange Rate Intervention by Central Bank: Based on the Influence of the Hong Kong Offshore RMB Exchange Rate

We calculate exchange intervention index to reflect the open market operation of central bank, introduce the Hong Kong's offshore RMB exchange rate (CNH) to establish Central bank reaction function and further analyze the influence that CNH has on the exchange intervention activities of China's Central Bank. We discover that the influence is not quite evident due to the insufficient development of financial market. Thus, we study the relationship between offshore Deutsche Mark rate and the exchange intervention of Deutsche Bundesbank on the basis that Mark has been completed the whole development of international currency offshore market.

Toyota group firm invests in Anellotech

This paper studies the effectiveness of FX interventions within an inflation targeting context. I estimate the central bank reaction function, using a friction model à la Rosett. Then, I use the conditional expectation of intervention, as an instrument for actual interventions in a reduced form model of exchange rate daily-returns. Results show evidence of threshold effects in the reaction function, and indicate that intervention had a dampening effect over the daily exchange rate return's volatility, but no influence over the level of exchange rate. The central bank reacted systematically to previous-day exchange rate changes and to deviations from short-term trends.

Credit Frictions and Optimal Monetary Policy

The basic (representative-household) New Keynesian model of the monetary transmission mechanism is extended to allow for a spread between the interest rate available to savers and borrowers, and investigate the consequences of a variable credit spread for the effects of a variety of shocks, and for optimal policy responses to those shocks. A simple target criterion continues to provide a good approximation to optimal policy. Such a “flexible inflation target” can be implemented by a central-bank reaction function that is similar to a forward-looking Taylor rule, but adjusted for changes in current and expected future credit spreads.

The NBU’s Balance Sheet: Before, During, and After the Crisis

Looking at the evolution of the central bank’s balance sheet gives us a unique window on the forces that have shaped our economy and central bank reaction functions. This paper considers the evolution of the NBU’s balance sheet over the period from 2001-2016, focusing on explicit and implicit monetary policy priorities at different periods. We then make simulations on the NBU’s balance sheet for the next five years assuming current NBU priorities for monetary policy. We then draw conclusions on the likely financial position of the NBU in the future and recommendations to ensure the NBU’s financial strength – essential for its continued independence.

Central Bank Intervention in USD/INR Market: Estimating Its Reaction Function and Impact on Volatility

Econometric evidence on why central banks intervene in the foreign exchange market and the impact of such intervention has remained inconclusive. We contribute to the literature with evidence from India, a managed float regime that sees consistent monitoring and intervention by Reserve Bank of India, India’s central bank. Estimation of the central bank reaction function shows that increased volatility in the foreign exchange market and misalignment from targeted rates are important objectives behind intervention. The paper further uses the GARCH framework to study how intervention influences exchange rate volatility. We find that intervention in the spot market increases volatility while that in the forward market reduces volatility.

Foreign exchange market interventions under inflation targeting: The case of Guatemala

This paper studies the effectiveness of FX interventions within an inflation targeting context. I estimate the central bank reaction function, using a friction model à la Rosett. Then, I use the conditional expectation of intervention, as an instrument for actual interventions in a reduced form model of exchange rate daily-returns. Results show evidence of threshold effects in the reaction function, and indicate that intervention had a dampening effect over the daily exchange rate return's volatility, but no influence over the level of exchange rate. The central bank reacted systematically to previous-day exchange rate changes and to deviations from short-term trends.