Discretionary Monetary Policy Research Articles

Optimal discretionary monetary policy in a micro-founded model with a zero lower bound on nominal interest rate

This paper investigates optimal discretionary monetary policy under the zero lower bound on the nominal interest rate (ZLB) in the case of a distorted steady state due to monopoly and taxation. Solving a fully nonlinear micro-founded (FNL) model using a global method, I find that the central bank in a more distorted economy would cut the interest rate less aggressively under a particularly adverse demand shock. This occurs because inflation and nominal interest rates are higher on average, making the ZLB less likely to bind and causing the economy to escape from the ZLB sooner. However, the social planner would choose the optimal inflation rate of approximately zero. The result emerges because the unconditional benefit of avoiding the ZLB is not big enough to offset the cost of higher relative price dispersion when inflation is significantly positive. In addition, I show that the conventional linear-quadratic (LQ) method is inaccurate in the case of a sufficiently distorted steady state.

The Pros and Cons of a Discretionary Moetary Policy Strategy: An Empirical Assessment

This paper empirically assesses the pros and cons that emanates when the discretionary monetary policy maker aims to achieve the dual objectives of inflation and output. In order to facilitate theoretically plausible empirical analysis a typical case of a discretionary monetary policy s of a developing economy of Pakistan is considered. A two-step strategy is adopted to generate three novel behavioural time series indicators namely discretion indicator (DI), inflation objective indicator (IOI) and output objective indicator (OOI) using Hodrick and Prescott filter. These indicators tend to capture the discretionary behaviour of the monetary policy maker and the potential resultant corresponding behaviours in inflation and output over time respectively. ARDL bounds testing and estimation approach is used to obtain stable long and short run estimates from these behavioural indicators. The results indicate that discretion is biased towards the inflation objective in the long run. It slightly helps achieve the output objective only in the short run but its channel is not the conventional inflation-output trade-off (due to its negative relationship) rather it might accrue via the close link of money supply with the credit. The indicative welfare gains from discretion are nominal and accrue only in the short term as against disproportionately higher indicative welfare losses, which incurs in the long run.

Econometric Policy Evaluation in a Two Sector Model

This paper estimates a New-Keynesian structural model and evaluates alternative monetary policy regimes. An estimated two sector model and alternative policy regimes are used to calculate the optimal monetary policy frontier. The structural model that consists of two sectors: durable and nondurable, is estimated by the Full Information Maximum Likelihood (FIML) method. Given the structure of the economy and discretionary monetary policy regimes, we find that changes in monetary policy responses to aggregate or disaggregate inflation and output gap can imply substantial differences in long-run inflation and output variances. More importantly, this paper shows that in terms of monetary policy frontier, monetary policy could have been more effective if the central bank had focused on sectoral stabilization as opposed to traditional stabilization.

The central banker as prudential supervisor: Does independence matter?

We study whether central bank independence (CBI) and monetary policy arrangements can jointly influence the likelihood of policymakers assigning banking supervision to central banks. Our empirical analysis shows that, assuming a benevolent government, a higher degree of central bank operational (economic) independence is associated with a lower probability of supervisory powers being entrusted to the monetary authority. We interpret this result as deriving from governments’ fear of the risk of excessively discretionary monetary policy. However, there is evidence that – conditional on operational independence – central banks are more involved in supervision when they pursue tighter monetary policy goals (a specific aspect of political independence). Our interpretation is that the latter may represent a commitment to mitigate central banks’ discretion in the monetization of financial distress. Our study suggests that CBI can be relevant, not only for its alleged effects on macroeconomic variables, but also in influencing policymakers’ decisions on the allocation of banking supervisory powers.

Occupy Pennsylvania Avenue: How Politicians Caused the Financial Crisis and Why Their Reforms Failed

This summary policy analysis provides a simple diagnosis of the sub-prime lending debacle and consequent systemic financial crisis: The Fed fueled an asset bubble, housing policy steered it to housing, and the extreme leverage required to fund political housing policy magnified losses instead of profits. The financial sector bailout, housing market and homeowner bailout, and fiscal and monetary stimulus were all more of the same. A financial sector meltdown was avoided, but at the expense of greater systemic risk prospectively. The Great Recession ended, but the recovery remains weak with economic costs in the aftermath many multiples those during the lending bubble and prospective economic risks are worse still.The only relevant economic precept is the original – incentives matter. Understanding the financial crisis requires no more than an explanation of how politicians perverted them.The simple prescription to avoid future systemic financial crises is to limit discretionary monetary policy, separate subsidy from finance, impose appropriate capital requirements, improve political oversight and re-introduce market discipline, the opposite of the Dodd-Frank legislation.

Discretionary Monetary Policy in the Calvo Model

We study discretionary equilibrium in the Calvo pricing model for a monetary authority that chooses the money supply. The steady-state inflation rate is above 8 percent for a baseline calibration, but it varies substantially with alternative structural parameter values. If the initial condition involves inflation higher than steady state, discretionary policy generates an immediate drop in inflation followed by a gradual increase to the steady state. Unlike the two-period Taylor model, discretionary policy in the Calvo model does not accommodate predetermined prices in a way that inevitably leads to multiple private-sector equilibria.

Cross-checking optimal monetary policy with information from the Taylor rule

This paper shows that monetary policy should be delegated to a central bank that cross-checks optimal policy with information from the Taylor rule. Placing some weight on deviations from a Taylor rule reduces the stabilization bias of discretionary monetary policy.

Product Replacement Bias in Inflation and Its Consequences for Monetary Policy

The paper examines a New Keynesian model with product entry and exit and with two types of households. Households consume different product baskets, and therefore, face different inflation rates. The statistical bureau used in the model measures aggregate inflation, but observes product entry with a probabilistic delay. Consequently, measured inflation suffers from product replacement bias with respect to aggregate inflation. Measured inflation is less volatile but more persistent than aggregate inflation, and the correlation between aggregate inflation and aggregate output is lower than the correlation between measured inflation and measured output. When monetary policy responds to measured variables, it stabilizes aggregate inflation insufficiently. Nevertheless, under discretionary monetary policy, responding to measured variables improves welfare.

Trend inflation as a workers’ discipline device

The paper shows that a monetary policy regime that allows for a positive inflation rate disciplines monopolistic wages setters if these, when setting contracts, internalize the consequences of their choices for economic outcomes over the life of the contract. We also show that discretionary monetary policy has real effects when wage setters are non atomistic, whereas commitment to a positive inflation rate is effective irrespective of the degree of labor market centralization. Finally, the model may explain the different unemployment dynamics in Europe and in the United States, following the 1980 disinflationary episode. Our approach suggests that disinflation induced an adverse effect on the labor market wedge and that such effect was stronger in Europe, due to the particular importance of large wage setters.

Robust monetary policy in a model with financial distress

We characterise optimal discretionary monetary policy responses to cost-push shocks and to financial distress in the presence of model uncertainty. Under robust control, the central bank reacts more aggressively to both types of shocks, and less to the lagged policy rate, than if the true model is known. We document how the objective to stabilise the policy instrument conflicts with the concern for robustness to model misspecification: the higher the weight on interest rate stabilisation in the loss function, the more the robust policy deviates from the optimal policy under rational expectations. Financial distress is akin to a contractionary demand shock and does not induce a policy trade-off; thus model uncertainty does not constrain monetary policy in the face of financial shocks.

The Bulgarian Foreign and Domestic Debt – A No-Arbitrage Macrofinancial View

Bulgaria started the transition in the early 90’s with a sovereign default and debt restructuring. Later on, under a strict fiscal discipline, the country succeeded to reduce significantly its debt burden and is currently among the top EU performers in that respect. The current debt outstanding is composed mainly of local currency treasuries issued on the domestic market as well as Eurobonds and Global bonds on the international one. These instruments give rise to two risky spreads - credit and currency. The Currency Board Arrangement and the fixed exchange rate regime the country follows prevent from a discretionary monetary policy and this gives relative stability to the bonds’ yields and the risky spreads. Their financial role starts dominating over any macroeconomic one making them a natural object for investigation with financial engineering tools. The main focus of the paper is an analysis of the informational content of the risky spreads in a multifaceted way from noarbitrage, financial, and macroeconomic points of view. For the purpose we build from scratch both a reduced form model in a Heath-Jarrow-Morton setting and a structural one which extends the classical Merton model to the case of a risky sovereign. We estimate the former model and extract the priced factors. Then we relate them to a set of indicators the latter model provides as well as to suitable macrofinancial and macroeconomic variables. The setting allows to have a better understanding of the spreads’ risk drivers, which could be useful not only to the participants in the bond market, but also for drawing qualitative conclusions what kind of optimal debt issuance policy the country could follow.

A Short-Run Schumpeterian Trip to Embryonic African Monetary Zones

With the spectre of the Euro crisis looming substantially large and scaring potential monetary unions, this study is a short-run trip to embryonic African monetary zones to assess the Schumpeterian thesis for positive spillovers of financial services on growth. Causality analysis is performed with seven financial development and three growth indicators in the proposed West African Monetary Zone (WAMZ) and East African Monetary Zone (EAMZ). The journey is promising for the EAMZ and lamentable for the WAMZ. Results of the EAMZ are broadly consistent with the traditional discretionary monetary policy arrangements while those of the WAMZ are in line with the non-traditional strand of regimes in which, policy instruments in the short-run cannot be used to offset adverse shocks to output. Policy implications are discussed.

Excess Liquidity, Housing Price Booms and Policy Challenges in China

AbstractIncorporating asymmetric cost and benefit of supplying excess liquidity into an otherwise standard time inconsistency model, this paper offers an explanation of the excess liquidity and housing price booms recently experienced in China. We find that the central bank's incentive to stimulate economic growth with excess liquidity fuels real estate prices and accelerates inflation bias. Therefore, the central bank should free itself from the pressure to achieve an economic growth rate higher than the potential level, and assign an appropriate weight to the real estate price fluctuations in the central bank's objective function, so that the central bank's policy of stimulating economic growth with excess liquidity can be constrained.

TOWARDS SOUND MONETARY INSTITUTIONS

Most people see money and central banking as shrouded by an impenetrable veil of mystery, as matters that ought to be delegated to expert economists in central banks. Yet the actual performance of central banks has been less than stellar. And there are good reasons to expect unchecked, discretionary monetary policy by central bankers to produce less-than-perfect results. Not only do central bankers not have the right incentives and knowledge to make beneficial discretionary decisions, but the economy does not always behave in a predictable fashion, reacting as an automaton to discretionary policy shifts. A market-based monetary arrangement – such as Friedrich von Hayek's free banking proposal – would be preferable to a national or supranational monopoly on the issue of money. If such an arrangement is not attainable, then it is desirable, at the very least, that the behaviour of central bankers is constrained by rules, such as nominal income growth targets.

From Prosperity to Depression: Bulgaria and Romania (1996/97-2010)

Bulgaria and Romania are neighbouring countries, which have always been rivals. Following the decision on EU enlargement to include Bulgaria and Romania (late 1999) and with membership negotiations already started (2004), the race between the two countries gained momentum and comparisons of performances in the areas of economy and democracy became a regular practice. Around late 1990s the two countries took different trajectories, although in the direction of EU and market economy. The great divergence is lying primarily in the choice of monetary regime. While Romania continued to pursue and enhance its discretionary monetary policy and since 2005 has moved to inflation targeting, Bulgaria made an abrupt turn in mid-1997 and introduced a currency board arrangement. In this paper, we investigate how the monetary regimes choice shaped the structure of both economies and the behaviour of the public and private sector, how they modified the mechanisms of adjustments and how they concentrate risks. We discus the institutional compatibility of monetary regimes with EU accession and EU membership using the theoretical insights form Dooley (1997, 2000) insurance model hypothesis. One of the main hypotheses, which we illustrate empirically, says that Currency board concentrate all economic activity and risks in the private sector, hence increasing of the private debt, while discretionary monetary policy leads to greater public debt growth and lower fiscal discipline. EU integration as well as the current crisis has different effects when combination with different monetary regimes.

The Optimality and Controllability of Discretionary Monetary Policy

This paper addresses two issues – the time-inconsistency of optimal policy and the controllability of target variables within new-classical and new-Keynesian model structures. We can resolve both issues by delegation. That is, we design central bank loss functions by determining the two target values and the weight between the two targets. With a single decision maker, the time-inconsistency issue does not exist; the target controllability issue does. Delegating the long-run target values (target variables’ equilibriums under the Ramsey optimal policy) and the same weight as society to the central bank can achieve Ramsey optimality and path controllability. With multiple decision makers (game), both issues of time-inconsistency and target controllability exist and the delegation becomes more complicated. The long-run target values can only achieve asymptotic, not path, controllability. Path controllability requires the delegation of short-run target values, which commits or binds the central bank to follow exactly the Ramsey optimal paths. The short-run inflation target value conforms to the macroeconomic structure (i.e., Phillips curve). With path controllability, the constant average and state-contingent inflation biases are removed. To eliminate the stabilization bias, the delegated weight must differ from society in a dynamic game. When the Phillips curve exhibits output (inflation) persistence, the central bank must place more weight on output (inflation) stabilization. When the Phillips curve exhibits principally forward-looking behavior, the delegated weight can require a conservative or liberal central bank. In sum, delegating certain short-run target values and a different weight can cause discretionary monetary policy to prove Ramsey optimal and path controllable in a dynamic game.

THE DYNAMICS OF POST-WAR US INFLATION: THE LIMITED ROLE OF TIME INCONSISTENCY

In this paper we investigate whether the long-run relationship between inflation and unemployment has changed since Paul Volcker's appointment as Chairman of the Fed. Long-horizon vector autoregressive forecast errors provide evidence of a positive long-run relationship for the period of rising inflation, but no long-run relationship for the subsequent two decades of falling inflation. This suggests the model of discretionary monetary policy of Barro and Gordon (Journal of Political Economy, Vol. 91 (1983), pp. 589–610) is rejected in the latter period.

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.

Discretionary Monetary Policy in the Calvo Model

Discretionary Monetary Policy in the Calvo Model

Using a projection method to analyze inflation bias in a micro-founded model

Since Kydland and Prescott (1977) and Barro and Gordon (1983), most studies of the problem of the inflation bias associated with discretionary monetary policy have assumed a quadratic loss function. We depart from the conventional linear-quadratic approach in favor of a projection method approach. We investigate the size of the inflation bias that arises in a microfounded nonlinear environment with Calvo price setting. The inflation bias is found to lie between 1% and 6% for a reasonable range of parameter values, when the bias is defined as the steady-state deviation of the discretionary inflation rate from the optimal inflation rate under commitment.