Design Of Monetary Policy Research Articles

Limited Asset Market Participation: Does it Really Matter for Monetary Policy?

We study the design of monetary policy in an economy characterized by staggered wage and price contracts together with limited asset market participation (LAMP). Contrary to previous results, we find that once nominal wage stickiness, an incontrovertible empirical fact, is considered: The Taylor Principle is restored as a necessary condition for equilibrium determinacy for any empirically plausible degree of LAMP; the implications of LAMP for the design of optimal monetary policy are minor; optimal interest rate rules become active no matter the degree of asset market participation. For these reasons we argue that LAMP is not particularly important for monetary policy.

Inventories and optimal monetary policy in a small open economy

We study how inventory investment affects the design of optimal monetary policy in a New Keynesian small open economy model. We find that under producer currency pricing, when the intratemporal elasticity of substitution is smaller than 1, optimal monetary policy in our model with inventories is similar to a standard model without inventories. However, when the intratemporal elasticity of substitution is larger than 1, inventory investment increases the importance of nominal exchange rate stabilization relative to a standard model without inventories. The importance of nominal exchange rate stabilization increases with the intratemporal elasticity of substitution.

ASSET PRICE MISALIGNMENTS AND MONETARY POLICY

ABSTRACTWe augment the standard New Keynesian Model for monetary policy design with stock prices in the economy and stock traders who use a mix of fundamental and technical analyses. In contrast with most of previous literature, we argue that the central bank should augment the interest rate rule with a term for stock price misalignments because a determinate and stable rational expectations equilibrium in the economy are then easier to achieve. This equilibrium is stable under least squares learning as well. Another finding is that inertia in monetary policy does not promote macroeconomic stability when technical analysis plays a major role in stock trading. Even worse, if the central bank in its policy only indirectly responds to stock price misalignments via its effect on the inflation rate, a combination of strong inertia in monetary policy and a significant role for technical analysis in stock trading will lead to macroeconomic instability. Copyright © 2011 John Wiley & Sons, Ltd.

Input–output interactions and optimal monetary policy

This paper deals with the implications of factor demand linkages for monetary policy design in a two-sector dynamic general equilibrium model. Part of the output of each sector serves as a production input in both sectors, in accordance with a realistic input–output structure. Strategic complementarities induced by factor demand linkages significantly alter the transmission of shocks and amplify the loss of social welfare under optimal monetary policy, compared to what is observed in standard two-sector models. The distinction between value added and gross output that naturally arises in this context is of key importance to explore the welfare properties of the model economy. A flexible inflation targeting regime is close to optimal only if the central bank balances inflation and value added variability. Otherwise, targeting gross output variability entails a substantial increase in the loss of welfare.

Signalling vs. Cost-of-Fund Effects of Monetary Policy in Nigeria: Evidence from the Post-Banking Sector Consolidation Data

The communique of the meeting of the Monetary Policy Committee provides two separate sets of information to the financial market, each of which can have separate effects on the overall policy outcome. First, it contains information on the policy decision, typically in the form of a change in the Monetary Policy Rate (MPR). This change in the MPR affects other rates in the market because it represents a change in the cost of funds to the banks. This is the so-called cost-of-funds effect of monetary policy. Secondly, the communique also typically contain some information that signal the future direction of monetary policy. These signals are likely to affect the market expectations, and therefore affect the term-structure of interest rates. This is the signalling effect of monetary policy. This paper uses daily data for the period 2009-2011 to estimate the separate effects of monetary policy signals and cost of funds on the interbank call rate and open buy-back rate. We found that the cost-of-money effect on the Open Buy Back rate is larger than it is on the call rate. The effect of monetary policy signals on both rates is however found to be quite significant. This, we argue, suggests that central bank communications is potentially a viable tool of monetary policy design and implementation in Nigeria. The paper therefore suggests that the CBN should be proactive in designing an optimal communication strategy.

Targeting Inflation in a Dollarized Economy: The Peruvian Experience

This discusses the unique experience of Peru`s Central Bank with inflation targeting in an economy characterized by a high degree of financial dollarization. The paper outlines how Peru has taken financial dollarization into consideration in the design of monetary policy, then deals with monetary policy implementation and the Central Bank`s strategy for controlling financial dollarization risks. The paper concludes with analysis and lessons drawn from the Peruvian case.

The Design and Effects of Monetary Policy in Sub-Saharan African Countries

Since the 1990s there have been a number of major changes in the design and conduct of monetary policy. In a globalised environment, there is greater need to achieve closer convergence of economic performance among trading partners. As a result, a number of developing countries have adopted exchange rate regimes with more flexibility, and thereby greater scope for monetary policy. Notable examples include a number of Sub-Saharan African countries moving from fixed exchange-rate regimes to more flexible regimes and the adoption of formal or informal inflation targeting regimes by some of these countries. These changes have triggered considerable debate on how monetary policy should be conducted and the effects it has on the real economy.

The Impact of Financial Openness on Financial Development, Growth and Volatility in Turkey: Evidence From the Ardl Bounds Tests

The aim of this paper is to investigate the impact of financial openness on financial development, growth and output volatility in Turkey. Results of the bounds test reveal that financial openness is in a long run equilibrium relationship with financial development, growth and output volatility. Granger causality tests disclose the existence of unidirectional causality from financial development to financial openness in the long run and from financial openness to output volatility in the short run. Yet, no Granger causality is detected neither from financial openness to growth nor from financial openness to financial development. Results call for further financial development and more conscientious monetary and fiscal policy design for financial openness in Turkey.

Optimal Monetary Policy with Durable Consumption Goods and Factor Demand Linkages

This paper deals with the implications of factor demand linkages for monetary policy design. We consider a dynamic general equilibrium model with two sectors that produce durable and nondurable goods, respectively. Part of the output of each sector serves as a production input in both sectors, in accordance with a realistic input-output structure. Strategic complementarities induced by factor demand linkages signi…cantly alter the transmission of exogenous shocks and amplify the loss of social welfare under optimal monetary policy, compared to what is observed in standard two-sector models. The distinction between value added and gross output that naturally arises in this context is of key importance to explore the welfare properties of the model economy. Adopting a ‡exible in‡ation targeting regime is close to optimal only if the central bank balances in‡ation and value added variability. Otherwise, targeting gross output variability entails a substantial increase in the loss of welfare.

The Design and Effects of Monetary Policy in Sub-Saharan African Countries

Since the 1990s there have been a number of major changes in the design and conduct of monetary policy. In a globalized environment, there is less time to adjust to shocks and greater need to achieve closer convergence of economic performance among trading partners. As a result, a number of developing countries have adopted exchange rate regimes with more flexibility, and thereby greater scope for monetary policy. Notable examples include a number of sub-Saharan African countries moving from fixed exchange-rate regimes to more flexible regimes and the adoption of formal or informal inflation targeting regimes by some of these countries. These changes have triggered considerable debate on how monetary policy should be conducted and the effects it has on the real economy. Mohsin Khan discusses the conventional objectives, targets, and instruments of monetary policy, including an analysis of the monetary transmission process. This paper examines the problems of dynamic inconsistency and inflationary bias, where governments deviate from their stated or target inflation level in order to obtain short-run output gains. Most economists now agree that any rules-based regime permits a margin for discretion, and they reject the idea that rules and discretion are mutually exclusive. As policymakers in many countries throughout the world have gravitated toward an approach based more on rules than on full discretion, a key issue is choosing an appropriate policy target, or nominal anchor. Khan discusses nominal anchors and current monetary frameworks before moving on to analyze the output effects of monetary policy. He looks at the relationship between the growth of GDP and different monetary aggregates in 20 sub-Saharan African economies and finds empirical support for the hypothesis that credit growth is more closely linked than is money growth to the growth of real GDP in these countries.

Monetary policy and heterogeneous expectations

This paper studies the implications for monetary policy of heterogeneous expectations in a New Keynesian model. The assumption of rational expectations is replaced with parsimonious forecasting models where agents select between predictors that are underparameterized. In a Misspecification Equilibrium agents only select the best-performing statistical models. We demonstrate that, even when monetary policy rules satisfy the Taylor principle by adjusting nominal interest rates more than one for one with inflation, there may exist equilibria with Intrinsic Heterogeneity. Under certain conditions, there may exist multiple misspecification equilibria. We show that these findings have important implications for business cycle dynamics and for the design of monetary policy.

The global recession

PurposeThe purpose of this paper is to analyze the evolution of the crisis, its causes and the corrective policy actions with the aim of drawing up from that a set of economics policy and substantive implications and conclusions.Design/methodology/approachTo throw into sharp relief the causes and particular features of the financial crisis, the paper traces the combined evolution of financial innovations and globalization which underscores the eruption of the crisis. It then analyzes the recession and the ensuing policy actions. The US actions are examined in detail by analyzing the pertinent technical, macroeconomics, and political issues. Thereafter, elements of reforms are outlined, which in part draw on the work of the Bank of International Settlements. This leads into substantive and policy conclusions of great significance.FindingsThe paper elucidates the major historic changes observed in monetary policy design and execution. It also brings out the changes in the empirical size of the various fiscal policy lags as compared with the received literature. It is argued that if the policy actions succeed the empirical relevance of the modern quantity theory and new classical macroeconomics would be thrown into question. Other set of conclusions involves setting up an internationally coordinated of financial regulations and bank supervision. It is argued that reforming the international monetary system has become unavoidable. There are also a host of specific other conclusions.Originality/valueThe conclusions and analysis contained in this paper are totally new. Given their comprehensiveness and global orientation, they will presage in future work, an overdue revision in received macroeconomic theory and financial supervision not seen since the 1960s.

Real-Time Model Uncertainty in the United States: ‘Robust’ Policies Put to the Test

I study 46 vintages of FRB/US, the principal macro model used by Federal Reserve Board staff for forecasting and policy analysis, as measures of real-time model uncertainty. I also study the implications of model uncertainty for the robustness of commonly applied, simple monetary policy rules. I first document that model uncertainty poses substantial challenges for policymakers in that key model properties differ in important ways across model vintages. Then I show that the parameterization of optimized simple policy rule--rules that are intended to be robust with respect to model uncertainty--also differ substantially across model vintages. Included in the set of rules are rules that eschew feedback on the output gap, rules that target nominal income growth, and rules that allow for time variation in the equilibrium real interest rate. I find that many rules, which previous research has shown to be robust in artificial economies, would have failed to provide adequate stabilization in the real-time, real-world environment seen by the Fed staff. However, I do identify certain policy rules that would have performed relatively well, and I characterize the key features of those rules to draw more general lessons about the design of monetary policy under model uncertainty.

Real-Time Model Uncertainty in the United States: 'Robust' Policies Put to the Test

I study 46 vintages of FRB/US, the principal macro model used by Federal Reserve Board staff for forecasting and policy analysis, as measures of real-time model uncertainty. I also study the implications of model uncertainty for the robustness of commonly applied, simple monetary policy rules. I first document that model uncertainty poses substantial challenges for policymakers in that key model properties differ in important ways across model vintages. Then I show that the parameterization of optimized simple policy rule--rules that are intended to be robust with respect to model uncertainty--also differ substantially across model vintages. Included in the set of rules are rules that eschew feedback on the output gap, rules that target nominal income growth, and rules that allow for time variation in the equilibrium real interest rate. I find that many rules, which previous research has shown to be robust in artificial economies, would have failed to provide adequate stabilization in the real-time, real-world environment seen by the Fed staff. However, I do identify certain policy rules that would have performed relatively well, and I characterize the key features of those rules to draw more general lessons about the design of monetary policy under model uncertainty.

Money in Monetary Policy Design: Monetary Cross-Checking in the New-Keynesian Model

In the New-Keynesian model, optimal interest rate policy under uncertainty is formulated without reference to monetary aggregates as long as certain standard assumptions on the distributions of unobservables are satisfied. The model has been criticized for failing to explain common trends in money growth and inflation, and that therefore money should be used as a cross-check in policy formulation (see Lucas (2007)). We show that the New-Keynesian model can explain such trends if one allows for the possibility of persistent central bank misperceptions. Such misperceptions motivate the search for policies that include additional robustness checks. In earlier work, we proposed an interest rate rule that is near-optimal in normal times but includes a cross-check with monetary information. In case of unusual monetary trends, interest rates are adjusted. In this paper, we show in detail how to derive the appropriate magnitude of the interest rate adjustment following a significant cross-check with monetary information, when the New-Keynesian model is the central bank's preferred model. The cross-check is shown to be effective in offsetting persistent deviations of inflation due to central bank misperceptions.

The Zero Lower Bound: Lessons from the Past Decade

Japan’s encounter with deflation and near‐zero‐interest short‐term interest rates in the 1990s led to a surge in research on the implications of the zero lower bound (ZLB) on nominal interest rates for monetary policy around the end of that decade. Based on model simulations, the literature at that time identified a number of key implications of the ZLB (see Orphanides and Wieland [2000], Reifschneider and Williams [2000, 2002], Eggertsson and Woodford [2003], and references therein). First, with low inflation targets of the kind followed by many central banks, the ZLB will frequently be a binding constraint on monetary policy. That is, Japan’s example is not an outlier but rather a harbinger for the future. Second, at inflation targets of 1% or lower, lowering the inflation target comes at a cost of higher variability of output and inflation, although the effects on inflation variability are relatively small. This analysis provides an argument for maintaining a positive inflation target cushion above 1%. Third, in rare instances of severe prolonged recessions accompanied by deflation, standard open market operations will be insufficient to bring the inflation rate back to target, andalternative sources of stimulus to the economy, such as fiscal policy, will be needed. Fourth, central banks can significantly reduce the effects of the ZLB onmacroeconomic stability by modifying their policy actions and communication to the public when the ZLB threatens to constrain policy. Specifically, policies that cut rates aggressively when deflation is a risk and promise to temporarily target a higher rate of inflation following episodes where the ZLB binds were found to greatly reduce the effects of the ZLB in model simulations. In the decade since this researchwas initiated, the ZLB has gone froma theoretical issue applying to Japan to one that plagues many industrialized economies. Indeed, an era of overwhelming confidence in monetary policy’s power to tame the business cycle while delivering low and stable inflation has been replaced by fears that the global economy could

Optimal monetary policy under heterogeneity in currency trade

PurposeQuestionnaire surveys made at currency markets around the world reveal that currency trade to a large extent not only is determined by an economy's performance or expected performance. Indeed, a fraction is guided by technical trading, which means that past exchange rates are assumed to provide information about future exchange rate movements. The purpose of this paper is to ask how a successful monetary policy should be designed when technical trading in the form of trend following is used in currency trading.Design/methodology/approachThe paper embeds an optimal policy rule into Galí and Monacelli's dynamic stochastic general equilibrium (DSGE) model for a small open economy, which is augmented with trend following in currency trading, to examine the prerequisites for a successful monetary policy. Specifically, the conditions for a determinate rational expectations equilibrium (REE) that also is stable under least squares learning are in focus. The paper also computes impulse‐response functions for key variables to study how the economy returns to steady state after being hit by a shock.FindingsThe paper finds that a determinate REE that also is stable under least squares learning often is the outcome when there is a limited amount of trend following in currency trading, but that a more flexible inflation rate targeting in monetary policy sometimes cause an indeterminate REE in the economy. Thus, strict, or almost strict, inflation rate targeting in monetary policy is recommended also when there is technical trading in currency trading and not only when all currency trading is guided by fundamental analysis (in the form of rational expectations). This result is a new result in the literature.Originality/valueThere are already models in the literature on monetary policy design that incorporate technical trading in currency trading into an otherwise standard DSGE model. There is also a huge amount of DSGE models in the literature in which monetary policy is optimal. However, the model in this paper is the first model, to the best of the author's knowledge, where technical trading in currency trading and optimal monetary policy are combined in the same DSGE model.

Robust monetary rules under unstructured model uncertainty

This paper revisits a widely adopted approach to robust decision making developed by Hansen and Sargent (2003, 2008)—henceforth HS—and applies it to monetary policy design in the face of model uncertainty. We pay particular attention to two issues: first, we distinguish three possible forms of the implied game between malign nature and the policymaker in the HS procedure each leading to a different robust and approximating equilibria. Second, we impose the zero lower bound (ZLB) constraint on the nominal interest rate. We show that the ZLB constraint has serious consequences for a policymaker pursuing HS-type robustness, especially when accompanied by an inability to commit.

Inventories and Optimal Monetary Policy

We introduce inventories into a standard New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model to study the effect on the design of optimal monetary policy. The possibility of inventory investment changes the transmission mechanism in the model by decoupling production from final consumption. This allows for a higher degree of consumption smoothing since firms can add excess production to their inventory holdings. We consider both Ramsey optimal monetary policy and a monetary policy that maximizes consumer welfare over a set of simple interest rate feedback rules. We find that in contrast to a model without inventories, Ramsey-optimal monetary policy in a model with inventories deviates from complete inflation stabilization. In the standard model, nominal price rigidity is a deadweight loss on the economy, which an optimizing policymaker attempts to remove. With inventories, a planner can reduce consumption volatility and raise welfare by accumulating inventories and letting prices change as an equilibrating mechanism. We find also find that the application of simple rules comes very close to replicating Ramsey optimal outcomes.

Learning and Macroeconomics

Expectations play a central role in modern macroeconomic theories. The econometric learning approach models economic agents as forming expectations by estimating and updating forecasting models in real time. The learning approach provides a stability test for rational expectations and a selection criterion in models with multiple equilibria. In addition, learning provides new dynamics if older data are discounted, if models are misspecified, or if agents choose between competing models. This paper describes the expectational stability (E-stability) principle and the stochastic approximation tools used to assess equilibria under learning. Applications of learning to a number of areas are reviewed, including the design of monetary and fiscal policy, business cycles, self-fulfilling prophecies, hyperinflation, liquidity traps, and asset prices.