Inflation Bias Research Articles

Inflation bias and markup shocks in a LAMP model with strategic interaction of monetary and fiscal policy

This paper investigates the effects generated by limited asset market participation on optimal monetary and fiscal policy, where monetary and fiscal authorities are independent and play strategically. It shows that: (i) both the long run and the short run equilibrium require a departure from zero inflation rate; (ii) in response to a markup shock, fiscal policy becomes more aggressive as the fraction of liquidity constrained agents increases and price stability is no longer optimal even under Ramsey; (iii) overall, optimal discretionary policies imply welfare losses for Ricardians, while liquidity constrained consumers experience welfare gains with respect to Ramsey.

On the Interplay between Monetary Policy and Macroprudential Policy: A Simple Analytical Framework

The paper provides a simple analytical framework for analyzing the interplay between monetary policy and macroprudential policy. Three questions are analyzed: (i) Under which assumptions is coordination necessary to implement an optimal policy mix? (ii) Are the two policy instruments substitutes or complements, i.e. should they move in opposite or the same direction as response to a shock? (iii) Can leaning against the wind in monetary policy lead to a negative inflation bias?

The Politics of Central Bank Independence

This paper reviews recent research on the political economy of monetary policy-making, both by economists and political scientists. The traditional argument for central bank independence (CBI) is based on the desire to counter inflationary biases. However, studies in political science on the determinants of central bank independence suggest that governments may choose to delegate monetary policy in order to detach it from political debates and power struggles. This argument would be especially valid in countries with coalition governments, federal structures and strongly polarized political systems. The recent financial crisis has changed the role of central banks as evidenced by the large set of new unconventional monetary and macro-prudential policy measures. But financial stability and unconventional monetary policies have much stronger distributional consequences than conventional monetary policies and this has potential implications for the central bank’s independence. It may also have changed the regime from monetary dominance to fiscal dominance. However, our results do not suggest that CBI has been reduced since the Great Financial Crisis. This holds both for legal measures of CBI and the turnover rate of central bank governors.

Inflation Bias and Markup Shocks in a LAMP Model with Strategic Interaction of Monetary and Fiscal Policy

This paper investigates the effects generated by limited asset market participation on optimal monetary and fiscal policy, where monetary and fiscal authorities are independent and play strategically. It shows that: (i) both the long run and the short run equilibrium require a departure from zero inflation rate; (ii) in response to a markup shock, fiscal policy becomes more aggressive as the fraction of liquidity constrained agents increases and price stability is no longer optimal even under Ramsey; (iii) overall, optimal discretionary policies imply welfare losses for Ricardians, while liquidity constrained consumers experience welfare gains with respect to Ramsey.

Circuits of Capital, Ground Rent and the Production of the Built Environment: A (New) Framework for Analysis

This paper develops prior work on Marxian theories of ground rent and property investment to outline a framework for interpreting the long-term rise in property prices observed in the neoliberal period. Orthodox economists and private developers have consistently maintained that the primary barrier to addressing affordability problems in expensive urban regions is excessive regulation. A diametrically contrasting view is developed in this paper. I argue the affordability crisis expresses the confluence and interaction of three primary factors: widening income and wealth disparities; the fictitious nature of land as a commodity, and the ability of property developers to extract surplus profits. Land is not a genuine commodity; and housing is a heterogeneous economic good whose production is targeted toward particular buyers of this good. Contra the hypothetical constructions of neoclassical economics, there is no “general supply” or “general demand” in urban housing markets. I show why increased production can lead the market toward higher overall levels of rents and prices. The primary counter-tendency to this basic dynamic is recurrent overproduction crises, with some modicum of affordability restored only through a collapse of prices once markets become severely overbuilt. Internal factors within the land market operate to limit the actual fall in prices, so that the longer-term trend in the neoliberal period shows a pronounced inflationary bias.

Optimal Monetary Policy with Heterogeneous Agents

Incomplete markets models with heterogeneous agents are increasingly used for policy analysis. We propose a novel methodology for solving fully dynamic optimal policy problems in models of this kind, both under discretion and commitment. We illustrate our methodology by studying optimal monetary policy in an incomplete-markets model with non-contingent nominal assets and costly inflation. Under discretion, an inflationary bias arises from the central bank’s attempt to redistribute wealth towards debtor households, which have a higher marginal utility of net wealth. Under commitment, this inflationary force is countered over time by the incentive to prevent expectations of future inflation from being priced into new bond issuances; under certain conditions, long run inflation is zero as both effects cancel out asymptotically. For a plausible calibration, we find that the optimal commitment features first-order initial inflation followed by a gradual decline towards its (near zero) long-run value. Welfare losses from discretionary policy are first-order in magnitude, affecting both debtors and creditors.

The inflation bias under Calvo and Rotemberg pricing

New Keynesian analysis relies heavily on two workhorse models of nominal inertia – due to Calvo (1983) and Rotemberg (1982), respectively – to generate a meaningful role for monetary policy. These are often used interchangeably since they imply an isomorphic linearized Phillips curve and, if the steady-state is efficient, the same policy conclusions. In this paper we compute time-consistent optimal monetary policy in the benchmark New Keynesian model containing each form of price stickiness using global solution techniques. We find that, due to an offsetting endogenous impact on average markups, the inflation bias problem under Calvo contracts is often significantly greater than under Rotemberg pricing, despite the fact that the former typically exhibits far greater welfare costs of inflation. The nonlinearities inherent in the New Keynesian model are significant and the form of nominal inertia adopted is not innocuous.

Short-term deviations from monetary policy commitment in a monetary union: the degrees of freedom of an independent central bank

The paper presents a model analyzing the degrees of freedom of an independent but committed Central Bank within a monetary union. In the model, interactions between Agents, Supranational Political Authorities and the Central Bank of the Union determine the current nominal and real outcomes. Imperfectly distributed information on shocks affecting supply, transmission channels and short-term expectations create opportunities for a Central Bank to deviate from its announced objective. This opportunity to deviate especially applies to Central Banks free from any kind of inflationary bias and committed to a strictly nominal target. Under certain conditions we show that nominal deviations from stated targets are not observable either by Agents or the Supranational Political Authority that periodically selects the membership of the Council of Monetary Policy of the Bank. Those deviations increase the variance of nominal values but dampen fluctuations of real income. Our results confirm, within a monetary union, the position defended by Cukierman and Metzler concerning the efficiency of a Central Bank’s ambiguous behaviour.

Sovereign Debt Portfolios, Bond Risks, and the Credibility of Monetary Policy

Nominal debt provides consumption-smoothing benefits if it can be inflated away during recessions. However, we document empirically that countries with more countercyclical inflation, where nominal debt provides better consumption-smoothing, issue more foreign-currency debt. We propose that monetary policy credibility explains the currency composition of sovereign debt and nominal bond risks in the presence of risk-averse investors. In our model, low credibility governments inflate during recessions, generating excessively countercyclical inflation in addition to the standard inflationary bias. With countercyclical inflation, investors require risk premia on nominal debt, making nominal debt issuance costly for low credibility governments. We provide empirical support for this mechanism, showing that countries with higher nominal bond-stock betas have significantly larger nominal bond risk premia and borrow less in local currency.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Optimal contracts for central bankers: Calls on inflation

We consider a framework featuring a central bank, private and financial agents as well as a financial market. The central bank’s objective is to maximize a functional, which measures the classical trade-off between output and inflation plus income from the sales of inflation linked calls minus payments for the liabilities that the inflation linked calls produce at maturity. Private agents have rational expectations and financial agents are averse against inflation risk. Following this route, we explain demand for inflation linked calls on the financial market from a no-arbitrage assumption and derive pricing formulas for inflation linked calls, which lead to a supply–demand equilibrium. We then study the consequences that the sales of inflation linked calls have on the observed inflation rate and price level. Similar as in Walsh (1995) we find that the inflationary bias is significantly reduced, and hence that markets for inflation linked calls provide a mechanism to implement inflation contracts as discussed in the classical literature.

The effect of entrepreneurial orientation, willingness to change, and development culture on new product exploration in small enterprises

PurposeThis study aims to assess the relationship between entrepreneurial orientation (EO) and development culture and the role of willingness-to-change in this relationship and analyzes their effect on new product exploration in small enterprises.Design/methodology/approachA model based on structural equations with partial least squares (PLS) analysis is used to test the hypotheses. This model was tested on a sample of 250 respondents from 125 small enterprises, with less than 50 employees, located in all seven emirates of the UAE.FindingsThe results suggest that EO will induce organizational members’ willingness-to-change and will favor the advancement of a development culture in small enterprises; in addition, EO, willingness-to-change and development culture can lead to new product exploration in small enterprises.Research limitations/implicationsThe study findings are subject to potential limitations. First, the research design for the quantitative study was cross-sectional and self-reported, which could cause problems of common method and inflation bias. Second, the conceptual model may not be completely representative of the perspective the authors aim to elucidate. Third, as this study is country-specific, further research investigation in other developing economies is recommended to further understand the possible influences of cultural or socioeconomic contexts on the relationships presented in the model.Practical implicationsThe article includes several practical implications about the relationships between willingness-to-change and development culture. It sheds light on the controversial link between EO and new product exploration in small enterprises.Originality/valueThe present study expands current knowledge on the EO–new product exploration relationship by investigating some key mediating variables such as willingness-to-change and development culture in an under-researched context such as UAE.

SOCIAL CHOICE AND TIME CONSISTENCY WITH LOW-PROBABILITY EVENTS

A key result in macroeconomics is the “time inconsistency of short-run optimal plans.” It is argued that inflationary bias results if central bankers do not precommit to a monetary policy rule. The macro literature, however, does not address the way in which board members arrive at the “optimal choice of inflation rate.” That is a matter of a micro subfield called social choice. If we consider that on any board, members have different priors about the states of nature for the economy, but they all receive the same signal before deciding, then they will have different posterior probabilities for the states, even if they have many data, if one state has a low probability of occurring, such as an unlikely catastrophic-risk event. Thus, it is not clear what the optimal plan is. Therefore, discretion rather than rules may be the optimal plan in social choice settings.

Real exchange rate targeting

Developing countries typically exhibit a high degree of macroeconomic variablesinstability. This feature is particularly evident as regards the volatility of the real exchange rate. The concern with these destabilizing effects generatedby real exchange rate instability has prompted some developing countries to adopt real exchange rate targeting since the late 60’s. However, this policy produces an inflation bias. This paper reviews economic literature on theoretical frameworks and empirical evidences about effects of real exchange rate targeting.

Verifying time inconsistency of the ECB monetary policy by means of a regime-switching approach

The aim of this work is to verify whether there is an inflation bias in the Euro-area monetary policy. I verify the presence of a strategic repeated game between the European Central Bank and the market, in setting actual and expected inflation, and consider the features of this game. In particular, the aim is to verify whether the market fixes the expected inflation strategically, and how the probability of the kind of monetary policy is formed. It can be concluded that the market behaves strategically, but an inflation bias does not emerge from data. The source of non-credibility cannot be the bank’s lack of commitment, but it may be a partial inability to control or to communicate economic shocks. These conclusions are robust to two different estimation strategies, which are both based on regime-switching regressions. The effects of the recent financial and sovereign-debt crises are taken into account.

The Inflation Bias Under Calvo and Rotemberg Pricing

New Keynesian models rely heavily on two workhorse models of nominal inertia - price contracts of random duration Calvo (1983) and price adjustment costs Rotemberg (1982) - to generate a meaningful role for monetary policy. These alternative descriptions of price stickiness are often used interchangeably since, to a first order of approximation they imply an identical Phillips curve and, if the steady-state is efficient, identical objectives for the policy maker and as a result in an LQ framework, identical policy conclusions. In this paper we compute time-consistent optimal monetary policy in benchmark New Keynesian models containing each form of price stickiness. Using global solution techniques we find that the inflation bias problem under Calvo contracts is significantly greater than under Rotemberg pricing, despite the fact that the former typically exhibits far greater welfare costs of inflation. The rates of inflation observed under this policy are non-trivial and suggest that the model can comfortably generate the rates of inflation at which the problematic issues highlighted in the trend inflation literature emerge, as well as the movements in trend inflation emphasized in empirical studies of the evolution of inflation. Finally, we consider the response to cost push shocks across both models and find these can also be significantly different. The choice of which form of nominal inertia to adopt is not innocuous.

Rules versus Discretion: A Reconsideration

In this paper, I evaluate the relative merits of rules versus discretion in making monetary policy, from both empirical and theoretical perspectives. Empirically, I argue that in the 2009–10 period, the Federal Open Market Committee aimed for a slow recovery, in large part because its judgments about appropriate monetary policy were unduly influenced by the Taylor rule (which was seen as a good approximation of its pre-2007 reaction function). Theoretically, I use the delegation framework of Bengt Holmstrom (1984) to show that, as long as the central bank’s inflation bias is sufficiently small, it is socially desirable to give the central bank discretion so that it can respond effectively to inflation shocks that cannot be encoded into predetermined rules.

Unconventional Policy Instruments in the New Keynesian Model

This paper analyzes the use of unconventional policy instruments in New Keynesian setups in which the ‘divine coincidence’ breaks down. The paper discusses the role of a second instrument and its coordination with conventional interest rate policy, and presents theoretical results on equilibrium determinacy, the inflation bias, the stabilization bias, and the optimal central banker’s preferences when both instruments are available. We show that the use of an unconventional instrument can help reduce the zone of equilibrium indeterminacy and the volatility of the economy. However, in some circumstances, committing not to use the second instrument may be welfare improving (a result akin to Rogoff (1985a) example of counterproductive coordination). We further show that the optimal central banker should be both aggressive against inflation, and interventionist in using the unconventional policy instrument. As long as price setting depends on expectations about the future, there are gains from establishing credibility by using any instrument that affects these expectations.

The Politics of Central Bank Independence

This paper reviews recent research on the political economy of monetary policy-making, both by economists and political scientists. The traditional argument for central bank independence (CBI) is based on the desire to counter inflationary biases. However, studies in political science on the determinants of central bank independence suggest that governments may choose to delegate monetary policy in order to detach it from political debates and power struggles. This argument would be especially valid in countries with coalition governments, federal structures and strongly polarized political systems. The recent financial crisis has changed the role of central banks as evidenced by the large set of new unconventional monetary and macro-prudential policy measures. But financial stability and unconventional monetary policies have much stronger distributional consequences than conventional monetary policies and this has potential implications for the central bank's independence. It may also have changed the regime from monetary dominance to fiscal dominance. However, our results do not suggest that CBI has been reduced since the Great Financial Crisis. This holds both for legal measures of CBI and the turnover rate of central bank governors. (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.)

Forward Guidance and Credible Monetary Policy

The effectiveness of forward guidance depends crucially on the credibility of the central bank. Instead of assuming full commitment or full discretion of the central bank, this paper sheds light on the best credible forward guidance policy a central bank can offer by solving for the whole set of sustainable sequential equilibria (SSE) in a standard New Keynesian model with the occasionally binding constraint of a nominal interest rate of zero. The inflation bias resulting from eliminating price distortion under the best SSE is much smaller than the bias under full discretion. In the presence of the zero lower bound (ZLB), while the full commitment solution implies that forward guidance has a longer duration of the nominal rate at zero bound followed by a quick revert-to-normal path, the best SSE features low but non-zero rates, and even a prolonged period of higher inflation after the recession ends. To make forward guidance credible and as stimulative as possible, the adjustment of policy rates, and in particular, the rise of policy rates, should be smooth and gradual. In other words, policy normalization does not mean non-accommodation. Ramsey equilibria are not generally implementable.

The Role of Uncertain Government Preferences for Fiscal and Monetary Policy Interaction

This paper explores the role of uncertain government preferences for fiscal and monetary policy interaction. Our analysis shows that the uncertainty about government preferences does not affect the macroeconomic equilibrium if the fiscal multiplier is known. In the case of multiplicative uncertainty, uncertain government preferences make fiscal policy more contractionary, while monetary policy becomes more expansionary. This leads to higher expected inflation and lower expected output, which means a stronger inflation bias.