Interest Elasticity Research Articles

Inflation targeting, output stabilization, and real indeterminacy in monetary models with an interest rate rule

AbstractCentral banks set the nominal interest rate to target inflation and stabilize output. In monetary models, monetary policy affects output directly via the wealth effect. I show that in these models, the response of the central bank to fluctuations in output may induce real indeterminacy even if the Taylor principle is satisfied. I find that the determinacy conditions depend on the interest elasticity of output and generally, the Taylor principle is neither necessary nor sufficient for determinacy. This is in stark contrast with the New Keynesian model where a sufficiently strong policy response to inflation or output usually ensures determinacy.

Financial Innovations and the Interest Elasticity of Money Demand in Jordan (2009-2022)

This study aimed to determine the relationship between financial innovations and the interest elasticity of money demand, and based on a set of statistical tests, the ordinary least squares method was determined to achieve this goal.Using quarterly data on the Jordanian economy for the period (2009-2022), the study estimated the demand for money as a function of income and interest rate. The empirical results reached in this study showed that all determinants of money demand have the expected signs and were statistically significant. Regarding the relationship between financial innovations and the interest elasticity of money demand, the results indicated that financial innovations after 2016 reduced the sensitivity of money demand to interest rate. Therefore, the absolute value of the interest elasticity of money demand decreased, which means an increase in the effectiveness of monetary policy as financial innovations may improve the efficiency of the financial system, in a way that facilitates the work of monetary policy and increases its effectiveness. However, monetary policy makers must monitor these innovations and developments and limit the negative changes that may accompany them, and work to design a modern monetary policy that is in line with these developments.

Analysis of the Impact of Population Aging on Inflation

The essay investigates the impact of population aging on inflation. Inflation is a long-term macroeconomic problem. For a long time, domestic and foreign experts have focused on the economic factors that cause inflation, while ignoring a major ongoing event, namely, population aging. As aging becomes more and more serious, it attracts more and more attention. Aiming at the above problems, this paper adopts the review method to carry out studies on the connection between inflation and population aging, which is divided into three major parts; the first part briefly analyzes the aging population that exists now; the second part describes the process and pattern of inflation; the third part explores the effect of population aging on inflation. It is concluded that the rate of saving will decline as the population ages, weaken the interest rate elasticity of total consumption, and reduce the labor-intensive industries, thus inhibiting the economic development of China.

The demand for money at the zero interest rate bound

SummaryThis paper undertakes both a narrow and wide replication of the estimation of a money demand function conducted by Ireland (American Economic Review, 2009). Using US data from 1980 to 2013, we show that the substantial increase in the money‐income ratio during the period of near‐zero interest rates is captured well by the log–log specification but not by the semi‐log specification, contrary to the result obtained by Ireland (2009). Our estimate of the interest elasticity of money demand over the 1980–2013 period is about one‐tenth that of Lucas's paper published in 2000, which used a log–log specification. Finally, neither specification satisfactorily fits post‐2015 US data.

Bank Interest Rates and Deposit Growth in Nepal

Nepalese banking is characterized by the fragmented system where different classes of banks and financial institutions operate simultaneously. Recently, sluggish deposit growth leads to tighter Credit to Deposit Ratio (CD-ratio) and banks suffer from deficit of loanable funds. Immediate response of banks at the time of shortfall of deposit is increasing deposit interest rate. Does bank’s strategy of increasing deposit rate work? This is key question of this paper. This study aims to find the interest elasticity of bank deposit in Nepalese commercial banks. Monthly average data of deposit and interest are used for the purpose of analysis and the result shows unitary elasticity of interest rate. Bank deposit and bank’s liquid assets holding have highly significant negative relationship. This study reveals weak association of interest rate change and deposit growth. Banks are recommended to increase banking access and enhance better banking services for sustainable deposit growth.

Revisiting intertemporal elasticity of substitution in a sticky price model

Macroeconomic models typically assume additively separable preferences where consumption enters the utility function in a logarithmic form. This restriction implies that consumption growth is highly sensitive to movements in real interest rates, which in turn implies an unrealistically steep demand curve and intertemporal trade-off. We re-estimate the stylized New Keynesian Model with US data using King et al. (1988) preferences with and without habits and show that the equilibrium real interest rate elasticity of output is in the range of 0.05–0.20 in the US. Such low real interest rate elasticity is better in line with the empirical consumption Euler equation literature and implies relatively weak transmission of monetary policy to output and inflation.

Sectoral Heterogeneity and Monetary Policy

Since sectors differ in their sensitivity to interest rates, monetary policy produces inefficient sectoral fluctuations. In a model with sectoral heterogeneity, I show that policymakers should weight sectors proportionally to their interest elasticities, account for dynamic demand effects from durable goods, and systematically utilize forward guidance to reduce sectoral volatility. A calibrated model confirms these recommendations and finds that neglecting sectoral volatility produces substantial welfare losses. The best-performing policy rule stabilizes a sectorally weighted measure of inflation, plus lags of past durable inflation. (JEL E12, E23, E24, E31, E32, E43, E52)

A meta de inflação é desestabilizadora? Lições da América Latina

ABSTRACT This paper argues that several aspects of the productive structure and the macroeconomic policies of Latin American countries, when combined with a Taylor Rule, may produce too much output volatility and a bias towards real exchange rate overvaluation. Relaying on a simple Aggregate Demand - Aggregate Supply model, we show that this is a likely outcome when: a) the real interest rate elasticity of demand is low; b) depreciations have strong contractionary effects; and c) the exchange rate pass-through is relatively large. These conditions imply that depreciations are contractionary and a have a strong effect on inflation.

A Note on nonconvex adjustment costs in lumpy investment models: Mean versus variance

AbstractThis paper revisits the canonical assumption of nonconvex capital adjustment costs in lumpy investment models as in Khan and Thomas [(2008) Econometrica 76(2), 395–436], which are assumed to follow a uniform distribution from zero to an upper bound, without distinguishing between the mean and the variance of the distribution. Unlike the usual claim that the upper bound stands for the size (represented by the mean) of a nonconvex cost, I show that in order to generate an empirically consistent interest elasticity of aggregate investment, both a sizable mean and a sizable variance are necessary. The mean governs the importance of the extensive margin in aggregate investment dynamics, while the variance governs how sensitive the extensive margin is to changes in the real interest rate. As a result, both the mean and the variance are quantitatively important for aggregate investment dynamics.

The Ownership of Oil, Democracy, and Iraq’s Past, Present, and Future

We show that the share of oil in real output is relatively large, nearly 60 percent. Effectively, the government of Iraq– not the people – owns and manages the oil wealth. This dependence on oil as the main income is also consistent with the rentier economy and the Resource Curse phenomenon. The interest elasticity of oil production with respect to global oil consumption is greater than one. This high dependence on oil as income and the sensitivity of oil production to global oil consumption would not be sustainable in the future, where there is a growing global aversion to hydrocarbon production and consumption. The developed countries aim at zero carbon by 2050. We show that the expected decline in global consumption of oil has an adverse effect on the Iraqi economy. We provide stress tests and produce dynamic stochastic projections from 2020-2050 under a number of adverse scenarios. A quick transfer of ownership of oil to the Iraqi people should guarantee a functional democracy and a better future for the Iraqis.

Long-run stability of money demand and monetary policy: The case of Algeria

Since the start of the oil counter-shock in June 2014, Algeria has experienced unprecedented twin deficits. The excessive monetisation of the public deficit coupled with other deep anomalies in the economy of this country acutely calls for reconsideration of its monetary policy. To this end a prior study of the long-run stability of money demand is needed. We estimate the demand for money for monetary aggregates M1 and M2, and cash in Algeria over the period 1979–2019, and study its long-run stability. We show that the transaction motive is significant for all three aggregates, especially for the demand for cash, reflecting the weight of informal economy “practices”. The elasticity of the scale variable is very close to unity for M2 and M1, and even equal to unity for cash demand (1.006). The elasticity of inflation is also significant for all three aggregates, although its level is higher in the case of cash demand (−6.474). Despite the persistence of certain financial repression mechanisms, interest rate elasticity is significant for all three aggregates, but higher for M1 and cash. The same observation is made for elasticity of the exchange rate, reflecting the effect of monetary substitution, especially for M1 and cash. Finally, our study concludes that the demand for money in terms of M1 remains stable, the same observation being confirmed for the M2 aggregate. However, the demand for fiat currency proves not to be stable. The consequences for the optimal design of monetary policy in Algeria are clearly stated.

Microfinance and missing markets

AbstractThe existing theoretical analysis of microfinance focuses on the nature of the loan contract such as group liability. We draw attention to the role of missing or imperfect labour markets in understanding some of the important “second generation” debates in microfinance. Our analysis helps explain a number of puzzles in microfinance including high repayment rates with high interest rates, difficulties in scaling up projects, limited economic impact on borrowing households, low take‐up rates in recent microcredit programs, conflicting views about the interest rate elasticity of demand, and spurious mission drift. Microcredit can play a role when labour markets are underdeveloped, but it may also hinder structural transformation.

Nonconvex Adjustment Cost in Lumpy Investment Models: Mean versus Variance

This paper revisits the canonical assumption of nonconvex capital adjustment costs in lumpy investment models as in Khan and Thomas (2008), which are assumed to follow a uniform distribution from zero to an upper bound, without distinguishing between the mean and the variance of the distribution. Unlike the usual claim that the upper bound stands for the size (represented by the mean) of a nonconvex cost, I show that in order to generate an empirically consistent interest elasticity of aggregate investment, both a sizable mean and a sizable variance are necessary. The mean governs the importance of the extensive margin in aggregate investment dynamics, while the variance governs how sensitive the extensive margin is to changes in the real interest rate. As a result, both the mean and the variance are quantitatively important for aggregate investment dynamics.

International evidence on long-run money demand

A dataset comprising 38 countries and relatively long sample periods, which extend in some cases to over a century, is used to study the behavior of long-run demand for M1. For a large majority of the countries, the evidence supports the existence of a stable long-run relationship between the ratio of M1 to GDP and a short-term interest rate. The log-log specification provides a good characterization of the data, with the exception of periods featuring very low interest rates. An extension of the theory that imposes limits on the amount households can borrow results in a truncated log-log specification, which is in line with what we observe in the data. We estimate the interest rate elasticity to be between 0.3 and 0.6.

Consumption and Portfolio Rebalancing Response of Households to Monetary Policy: Evidence of the HANK Channel

This paper tests one specific monetary transmission mechanism through households: portfolio rebalancing. We use a unique panel dataset of household’s credit and debit card spending, ATM withdrawals, financial investments into risky assets such as mutual funds and equities, as well as bank deposits from a leading bank in India to study the impact of the monetary policy pass-through for term depositors. The difference-in-differences estimators show that when interest rate falls, households increase consumption by 2,095 rupees (30 USD) and risky investments by 20,728 rupees (300 USD) after the expiry of term deposits. The increase in risky investment is about 10 times as much as the increase in consumption, suggesting that savers rebalance their portfolio and “reach for yield” when interest rate falls, shifting from safe assets (bank deposits) to more risky assets (mutual funds and equities). We estimate the interest elasticity of consumption to be -1.02 and interest elasticity of risky investments to be -19.5. Furthermore, we find that the effects on consumption and risky investment are larger for households holding term deposits without automatic renewal feature. The consumption effect is larger for those with less liquid wealth and the portfolio rebalancing effect on risky investment is larger for those with more liquid wealth. These results highlight how the heterogeneity in contract design and household wealth affects the monetary policy pass-through.

Time-varying money demand and real balance effects

This paper presents an analysis of the stimulants and consequences of money demand dynamics. By assuming that household's money holdings and consumption preferences are not separable, we demonstrate that the interest-elasticity of demand for money is a function of the household's preference to hold real balances, the extent to which these preferences are not separable in consumption and real balances, and trend inflation. An empirical study of U.S. data revealed that there was a gradual fall in the interest elasticity of money demand of approximately one-third during the 1970s due to high trend inflation. A further decline in the interest-elasticity of the demand for money was observed in the 1980s due to the changing household preferences that emerged in response to financial innovation. These developments led to a reduction in the welfare cost of inflation that subsequently explains the rise in monetary neutrality observed in the data.

Welfare cost of inflation in Brazil: an approach with time-varying cointegration and Kalman filter

This paper compares the time-varying cointegration and the Kalman filter techniques to estimate the Brazilian money demand between 1996 and 2015. The estimation using Kalman filtering performs better and is subsequently used to calculate the welfare cost of inflation. Taking into consideration the time variability of the interest-rate elasticity during the period, the average welfare cost amounts to 0.24% of the GDP, for an average annual inflation of 6.63%.

BREXIT perspectives: financial market dynamics, welfare aspects and problems from slower growth

In this analysis, BREXIT is considered with regard to the main consequences for financial markets; and real economic implications are taken into account while policy options are also highlighted. The role of the interest elasticity of the demand for money is emphasized for both welfare analysis of BREXIT and overshooting – assuming that that elasticity will fall post-BREXIT. Key insights emerge from aspects related to Dornbusch-type exchange rate overshooting problems and insights from the Branson model: This medium-term perspective is used to derive some short-term and long-term BREXIT implications. As regards overall welfare effects, the BREXIT welfare effect related to a lower holding of real money balances – due to a lower gross domestic product post-BREXIT in the long run – is rather high, so that adding this to the HM Treasury finding of a 10% income loss from BREXIT suggests that the long run welfare loss of the UK could be high. Moreover, the quality of financial market integration in the EU countries is highlighted: For the first time, financial services trade restrictiveness indices are empirically analyzed. This leads – on the basis of a restrictiveness index regarding international financial services and additional information about prudential supervision quality – to an assessment of the quality of financial markets. Policy conclusions take into account the new protectionist challenges and use insights from the Welfens enhanced growth model with trade and foreign direct investment.

Homeownership, Housing Demand, and Household Wealth Distribution in Turkey

ABSTRACTThis article analyzes housing market developments in Turkey over the past two decades. In particular, we estimate the permanent income elasticity, price elasticity, and interest rate elasticity of housing demand. We use 14 consecutive waves of the Turkish Statistical Institute (TURKSTAT) Household Budget Surveys (HBS) from 2003 to 2016. We find that the permanent income elasticity of housing demand is statistically significant at 26% in our restricted sample. However, we find that both the price elasticity and interest rate elasticity are not statistically significant. Therefore, our empirical analysis confirms that income is the main determinant of homeownership and housing wealth.

How Has Monetary Policy Framework Changes Affected the Model and Effect of the Money Demand Function in Thailand?

This paper investigates whether Thailand’s change to an inflation targeting monetary policy framework in 2000 changed the model and the effect of monetary policy by estimating a money demand function. It obtained fourth finding. First, the monetary policy framework change did not affect the appropriate money demand function model. Second, Adoption of an inflation targeting policy occurs structural change. Third, the effect of monetary policy changes with the adoption of an inflation targeting policy. Interest rate elasticity is positive before the framework change but negative after the framework change. Its value is weak, however. Fourth, the interest rate elasticity of the package (M2,r) is stable and predictive. This suggests that the national interest rate, rather than the exchange rate and foreign interest rates, is important to managing monetary policy. It also suggests that the same money demand function used in analyzing developed countries can be applied.