Central Bank Preferences Research Articles

Optimal monetary policy in the euro area in the presence of heterogeneity

This paper examines the optimal design of monetary policy in the European monetary union in the presence of structural asymmetries across union member countries. It derives analytically an optimal interest rate rule under commitment and studies the dependence of its coefficients on the parameters of the structural model of each economy, the central bank's preferences for inflation and output stabilization as shown in its loss function, and the relative size of each country. Based on a two-country, forward-looking, general equilibrium model, which is estimated for two euro area countries (Germany and France), we show that there are gains to be achieved by the ECB taking into account the heterogeneity of economic structures. This finding appears to be robust under alternative weights given by the central bank to the stabilization of the target variables. Although the implementation of the proposed rule involves difficulties relating to data and estimation constraints as well as risks of accommodating structural divergences, it is important that the ECB takes into consideration national characteristics in formulating its monetary policy, especially in view of more countries joining the European monetary union in the future. However, as monetary and financial integration advances, the welfare benefits of monetary policy responding to individual countries' variables may become less significant.

Why the Marginal MRO Rate Exceeds the ECB Policy Rate?

In the Eurosystem, banks' interest rate expectations should no longer have resulted in a non-zero tender spread, the difference between marginal and minimum price for liquidity, when the ECB reformed its operational framework for monetary policy implementation in March 2004 so that the policy rates remain constant within reserves maintenance periods. Yet, the tender spread was wider in 2005 than in any single year after 2000, when the ECB switched from fixed to variable rate tenders. Parts of the relevant literature have argued that because of the ECB's asymmetric preferences over deviations of the market rates up and down from the policy rate, the shortest euro interest rates persistently exceed the policy rate This paper argues, however, that when the central bank applies a quantity oriented liquidity policy, a positive tender spread may result from money market inefficiencies and banks' risk aversion even if the central bank preferences are symmetric and the markets do not anticipate any changes in the policy rates. In such a case, the driving force behind the tender spread is banks' uncertainty about their individual allotments at the marginal rate for the Eurosystem main refinancing operations (MROs). Furthermore, the allotment uncertainty is shown to be significantly related to the amount of liquidity supplied in each operation. Hence, the expansion in the MRO volumes experienced since 2002 may have had a major contribution to the emergence and observed growth of the tender spread.

Fiscal Leadership and Coordination in the EMU

We analyze the role of fiscal-monetary policy interactions and fiscal coordination in EMU under the assumption of strategic wage setting in unionized labour markets. We find that production subsidies and real wage distortions are strategic complements. The literature on macroeconomic stabilisation policies and policy games usually neglects this point and reaches overoptimistic conclusions about the desirable effects of accommodating fiscal policies. Central bank preferences also affect the desirability of fiscal coordination in a monetary union. In fact, contrary to Beetsma and Bovenberg (1998), we find that fiscal coordination improves outcomes in the case of a conservative central banker, whereas it leads to worse outcomes with a populist one.

Apprentissage des préférences des banques centrales

Dans un contexte d’incertitude des agents economiques sur les preferences de la banque centrale, nous examinons s’il est souhaitable que la banque centrale facilite l’apprentissage du secteur prive sur ses preferences en devoilant les aleas qui affectent la transmission de la politique monetaire. En l’absence de biais inflationniste, le critere d’efficacite de la politique monetaire pour la banque centrale est la capacite a stabiliser l’economie face aux chocs d’offre. Outre cet objectif de flexibilite, nous supposons que les erreurs d’anticipation d’inflation des agents reduisent le bien-etre social. Dans le cas ou les agents surestiment le degre d’aversion pour l’inflation de la banque centrale, nous montrons que la banque centrale prefere l’opacite alors qu’un degre intermediaire de transparence peut augmenter le bien-etre social.

Optimal monetary policy in the Euro area in the presence of heterogeneity

This paper examines the optimal design of monetary policy in the European monetary union in the presence of structural asymmetries across union member countries. It derives analytically an optimal interest rate rule under commitment and studies the dependence of its coefficients on the parameters of the structural model of each economy, the central bank's preferences for inflation and output stabilization as shown in its loss function, and the relative size of each country. Based on a twocountry, forward-looking, general equilibrium model, which is estimated for two euro area countries (Germany and France), we show that there are gains to be achieved by the ECB taking into account the heterogeneity of economic structures. This finding appears to be robust under alternative weights given by the central bank to the stabilization of the target variables. Although the implementation of the proposed rule involves difficulties relating to data and estimation constraints as well as risks of accommodating structural divergences, it is important that the ECB takes into consideration national characteristics in formulating its monetary policy, especially in view of more countries joining the European monetary union in the future. However, as monetary and financial integration advances, the welfare benefits of monetary policy responding to individual countries' variables may become less significant.

The Rise and Fall of U.S. Inflation Persistence

This paper estimates the path of inflation persistence in the United States over the last 50 years and draws implications about the evolution of the Federal Reserve's monetary-policy preferences. Standard models of central-bank optimization predict persistent inflation outcomes. Time variation of the central bank's preference for output stability should be reflected in changes in inflation persistence. We estimate an ARMA (1,q) model with a time-varying autoregressive parameter for monthly U.S. inflation data from 1955 to 2006. The coefficients provide an estimate of the inflation target and the path of inflation persistence. The estimated inflation target over the sample is approximately 2.8 percent and we find that inflation persistence declined substantially during Volcker and Greenspan's tenures to a level significantly less than one and significantly below that of the 1970s and early 1980s.

The Rise and Fall of U.S. Inflation Persistence

This paper estimates the path of inflation persistence in the United States over the last 50 years and draws implications about the evolution of the Federal Reserve's monetary-policy preferences. Standard models of central bank optimization predict that the central bank's preference for output stability is a determinant of inflation persistence. Hence, time variation of that preference should be reflected in changes in inflation persistence. We estimate an ARMA(1,q) model with a time-varying autore- gressive parameter for monthly U.S. inflation data from 1955 to 2006.The coefficients provide an estimate of the inflation target and the path of inflation persistence. The estimated inflation target over the sample is approximately 2.8 percent and we find that inflation persistence declined substantially during Volcker and Greenspan's tenures to a level significantly less than one and significantly below that of the 1970s and early 1980s.

How Important Is Precommitment for Monetary Policy?

We quantify the welfare differential between precommitment and discretionary monetary policy in three estimated models of the U.S. economy by calculating the permanent deviation of from target that in welfare terms is to moving from discretion to precommitment. Using a range of reasonable central bank preference parameters, this inflation equivalent ranges from 0.05 to 3.6 percentage points, with a mid-point of either 0.15 or 1–1.5 percentage points, depending on the model. In addition to the degree of forward-looking behavior, we show that the existence of transmission lags and/or information lags is crucial for determining the welfare gain from precommitment.

The Transparency of Central Bank Preferences

We examine whether the transparency of the weight central banks attach to employment goals compared to inflation targets is beneficial. We show that society prefers transparency if it sufficiently values the employment target, whereas it prefers opacity if it estimates inflation as sufficiently important.

New‐Keynesian Models and Monetary Policy: A Re‐examination of the Stylized Facts*

AbstractUsing an empirical New‐Keynesian model with optimal discretionary monetary policy, we estimate key parameters—the central bank's preference parameters; the degree of forward‐looking behavior in the determination of inflation and output; and the variances of inflation and output shocks—to match some broad characteristics of U.S. data. The parameterization we obtain implies a small concern for output stability but a large preference for interest rate smoothing, and a small degree of forward‐looking behavior in price‐setting but a large degree of forward‐looking in the determination of output. Our methodology also allows us to carefully examine the consequences of alternative parameterizations and to provide intuition for our results.

Robust Monetary Policy in a Small Open Economy

This paper studies how a central bank's preference for robustness against model misspecification affects the design of monetary policy in a New-Keynesian model of a small open economy. Due to the simple model structure, we are able to solve analytically for the optimal robust policy rule, and we separately analyze the effects of robustness against misspecification concerning the determination of inflation, output and the exchange rate. We show that an increased central bank preference for robustness makes monetary policy respond more aggressively or more cautiously to shocks, depending on the type of shock and the source of misspecification.

Long swing in appreciation and short swing in depreciation and does the market not know it?—the case of Taiwan

This paper finds an asymmetric swing in Taiwan's exchange rate. In contrast to the developed countries, whose exchange rates exhibit long swings in both appreciation and depreciation regimes, the long swing only exists in an appreciation regime for Taiwan. A short swing, however, is found during a depreciation regime in Taiwan. These results may reflect to some extent the central bank's preference, which is to have a let‐it‐go policy during depreciation and a slowdown policy in appreciation. In addition, it may simply reflect the Japanese yen's influences.

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.

Nonlinear Monetary Policy Rules: Some New Evidence for the U.S.

Abstract This paper derives optimal monetary policy rules in setups where certainty equivalence does not hold because either central bank preferences are not quadratic, and/or the aggregate supply relation is nonlinear. Analytical results show that these features lead to sign and size asymmetries, and nonlinearities in the policy rule. Reduced-form estimates indicate that US monetary policy can be characterized by a nonlinear policy rule after 1983, but not before 1979. This finding is consistent with the view that the Fed's inflation preferences during the Volcker-Greenspan regime differ considerably from the ones during the Burns-Miller regime.

What does Monetary Policy Reveal about a Central Bank's Preferences?

The design of monetary policy depends on the targeting strategy adopted by the central bank. This strategy describes a set of policy preferences, which are actually the structural parameters to analyse monetary policy making. Accordingly, we develop a calibration method to estimate a central bank's preferences from the estimates of an optimal Taylor–type rule. The empirical analysis on US data shows that output stabilization has not been an independent argument in the Fed's objective function during the Greenspan's era. This suggests that the output gap has entered the policy rule only as leading indicator for future inflation, therefore being only instrumental (to stabilize inflation) rather than important per se.(J.E.L.: C61, E52, E58).

Optimal Discretionary Monetary Policy in a Model of Asymmetric Central Bank Preferences

This paper considers optimal monetary policy in the context of the central bank adopting an asymmetric objective function. Our results show that under asymmetric preferences, many of the extant results on the time consistency problem need no longer hold.

Macroeconomic Stability and the Preferences of the Fed: A Formal Analysis, 1961-98

The rate of inflation in the U.S. has declined from an average of 4.5% in the period 1960–79 to an average of 3.6% in 1980–98. Between those two periods, the standard deviations of inflation and the output gap have also declined. These facts can be attributed to the interaction of three possible factors: a shift in central bank preferences, a reduction in the variability of aggregate supply shocks, and a more efficient conduct of monetary policy. In this paper we identify the relative roles of these factors. Our framework is based on the estimation of a small structural macro model for the U.S. economy jointly with the first order conditions, which solve the intertemporal optimization problem faced by the Fed. Overall, our results indicate that the policy preferences of the Fed, and in particular the (implicit) inflation target, have changed drastically with the advent of the Volcker– Greenspan era. In addition, we find that the variance of supply shocks has been lower and monetary policy has been conducted more efficiently during this period.

Why Money Talks and Wealth Whispers: Monetary Uncertainty and Mystique: A Comment

Why Money Talks and Wealth Whispers:Monetary Uncertainty and Mystique Roel M.W.J. Beetsma (bio) and Henrik Jensen (bio) Abstract We demonstrate that in important cases Propositions 3 and 4 in Eijffinger, Hoeberichts, and Schaling (Journal of Money, Credit, and Banking, May 2000) may fail. Moreover, their monetary policy delegation arrangement, which advocates that central banker preference uncertainty may be desirable, is dominated by other arrangements without any such uncertainty. Finally, their way of modelling preference uncertainty leads to arbitrary effects on average monetary policy. Without these, preference uncertainty is never desirable. In a recent article in this journal, Eijffinger, Hoeberichts, and Schaling (2000), henceforth EHS, argue that monetary policy uncertainty may be welfare enhancing. More specifically, uncertainty about the weight that the central bank attaches to inflation stabilization helps to reduce output variability, as the central bank on average reacts more vigorously to supply shocks. This gain may dominate the losses associated with weight uncertainty in their setup, which take the form of a higher inflation variability, and—if a Barro and Gordon (1983) type of credibility problem prevails—a higher inflation bias. Taking central bank preference uncertainty as a proxy for central bank secrecy, this result leads EHS to conclude that their paper "explains why high credibility institutions such as the former Bundesbank can afford to be relatively closed, and why low credibility institutions such as the Reserve Bank of New Zealand and the Bank of England need to be very open ..." (p. 231). This paper comments on EHS. Firstly, we show that precisely when the central bank has high credibility, uncertainty about its preferences may actually be undesirable. This implies that EHS' central Proposition 4 may fail and, hence, that their claim that "high credibility institutions ... can afford to be relatively closed" is [End Page 129] unwarranted. The main reason for this potential failure is that EHS' Proposition 3, which states that output variability is always minimized for a positive level of preference uncertainty, may also fail. Secondly, we argue that the role for preference uncertainty is generally much weaker than EHS claim. In their setup, preference uncertainty can be beneficial if monetary policy is delegated to a central bank with a suboptimal degree of conservatism (in the sense of Rogoff 1985), which causes inefficiently high output variability. Introducing uncertainty about the preferences of this central bank may help to correct this inefficiency because it may induce the bank to act in a more "liberal" way on average. However, imposing the appropriate inflation contract (Walsh 1995) or the appropriate inflation target (Svensson 1997) takes the economy right to the socially optimal equilibrium, thereby obviating the need for preference uncertainty. Even if these arrangements are not feasible, one might do better by choosing the optimal degree of conservatism right away. This is confirmed by numerical results for a wide range of parameter combinations. Lastly, we demonstrate that the particular direction in which preference uncertainty in EHS affects the central bank's average responses to, for example, supply shocks is arbitrary. We do this by illustrating that if uncertainty is modeled in just a slightly different (but analogous) manner, its effects on average monetary policy responses are exactly the opposite of those obtained by EHS. In order to isolate the implications of preference uncertainty on policy uncertainty, we therefore examine a preference specification adopted from Beetsma and Jensen (1998), from which the average effects of preference uncertainty are absent. With this specification, central bank preference uncertainty is unambiguously harmful for society. Hence, if one concurs with EHS that preference uncertainty is a proxy for secrecy in monetary policymaking, then one must be very careful in advocating such secrecy. 1. The EHS Model We briefly present the EHS model using their notation. Output is given by a reduced-form Lucas supply function: where y is the (log of) output, y* > 0 is the natural level of output, π is inflation, πe is expected inflation, and ε is a white noise shock with zero mean and variance σ2π. Society's loss function is where desired output exceeds the natural level if k > 1. This implies the familiar inflation bias under discretionary monetary policy (cf. Barro and Gordon 1983). [End Page 130...

How Important Is Precommitment for Monetary Policy?

Economic outcomes in dynamic economies with forward-looking agents depend crucially on whether or not the central bank can precommit, even in the absence of the traditional bias. This paper quantifies the welfare differential between precommitment and discretionary policy in both a stylized theoretical framework and in estimated data-consistent models. From the precommitment and discretionary solutions we calculate the permanent deviation of inflation from target that in welfare terms is to moving from discretion to precommitment, the equivalent. In the estimated models, using a range of reasonable central bank preference parameters, the equivalent ranges from 0.05 to 3.6 percentage points, with a mid-point of either 0.15 or 1–1.5 percentage points, depending on the model. In addition to the degree of forward-looking behavior, we show that the existence of transmission lags and/or information lags is crucial for determining the welfare gain from precommitment.

How Important is Precommitment for Monetary Policy?

Economic outcomes in dynamic economies with forward-looking agents depend crucially on whether or not the central bank can precommit, even in the absence of the traditional bias. This paper quantifies the welfare differential between precommitment and discretionary policy in both a stylized theoretical framework and in estimated data-consistent models. From the precommitment and discretionary solutions we calculate the permanent deviation of inflation from target that in welfare terms is to moving from discretion to precommitment, the equivalent. In the estimated models, using a range of reasonable central bank preference parameters, the equivalent ranges from 0.05 to 3.6 percentage points, with a mid-point of either 0.15 or 1-1.5 percentage points, depending on the model. In addition to the degree of forward-looking behavior, we show that the existence of transmission lags and/or information lags is crucial for determining the welfare gain from precommitment.