Monetary Policy Arrangements Research Articles

Report on the Latin American Economy. First half of 2020

This article analyses the recent performance of the main Latin American economies (Brazil, Mexico, Argentina, Colombia, Chile and Peru). Economic developments in the region have progressively been influenced by the global spread of the coronavirus COVID-19 pandemic. Although it has reached Latin America with some delay compared to Europe and the United States, it shows a similar pattern of dissemination. Moreover, the region faces this pandemic in an economic situation which had already beforehand shown signs of weakness owing to various idiosyncratic reasons, related in part to the bouts of social tension in the final stretch of last year. Some factors, such as high labour market informality and the improvable quality of some institutions, may act as amplifiers of the impact of the health crisis. From the economic standpoint, the pandemic is affecting the region through various key channels, namely the trade, commodities, tourism, financial and domestic demand channels. The national containment measures, the impact of the pandemic on the population, the global nature of the shock and the differential effects on the region are seeing analysts revise their GDP forecasts for 2020 notably downwards, with a balance of risks tilted to the downside. The monetary and fiscal authorities have responded, swiftly adopting measures. Although the region has in recent years consolidated progressively more robust monetary and fiscal policy arrangements, it has less monetary and fiscal space than at the start of the 2008-2009 crisis. Moreover, the Latin American economies, with the exception of Peru, have notably increased their external debt since 2008, though they have more international reserves than in the previous global crisis. Against this background, the resolute response by national policies should ideally be supported by a coordinated global response, led by the main multilateral agencies and geared to minimising the possible long-term adverse effects on the region’s economies.Three boxes accompany this report. The first considers the causes and potential effects of the social tensions in some of the region’s countries in the closing months of 2019. The second examines the process of integration of Latin America into global trade and its results, analysing the challenges outstanding if the region is to fully reap the benefits of greater trade integration. The third sets out some simulations made on the basis of a global macroeconometric model to illustrate the potential adverse effects of COVID-19 on economic activity in the main Latin American economies.

A comparative assessment of alternative ex ante measures of inflation uncertainty

The existence of unconventional monetary and fiscal policy arrangements in industrialized economies has been raising concerns about the future evolution of inflation rates ever since the onset of the financial and sovereign debt crisis in 2008. However, the question of how inflation uncertainty should be quantified is an open issue. We assess the informative content of alternative ex ante quantifications of inflation uncertainty by predicting ex post squared inflation forecast errors in an out-of-sample forecasting contest. We find that the average across distinct models’ levels of ex ante uncertainty offers a greater predictive content than other uncertainty measures based on the cross-sectional variance of point forecasts, GARCH or stochastic volatility models.

New empirics of monetary policy dynamics: evidence from the CFA franc zones

Purpose– A major lesson of the European Monetary Union crisis is that serious disequilibria in a monetary union result from arrangements not designed to be robust to a variety of shocks. With the specter of this crisis looming substantially and scarring existing monetary zones, the purpose of this paper is to complement existing literature by analyzing the effects of monetary policy on economic activity (output and prices) in the CEMAC and UEMOA CFA franc zones.Design/methodology/approach– VARs within the frameworks of Vector Error-Correction Models and Granger causality models are used to estimate the long- and short-run effects, respectively. Impulse response functions are further used to assess the tendencies of significant Granger causality findings. A battery of robustness checks are also employed to ensure consistency in the specifications and results.Findings–H1. monetary policy variables affect prices in the long-run but not in the short-run in the CFA zones (broadly untrue). This invalidity is more pronounced in CEMAC (relative to all monetary policy variables) than in UEMOA (with regard to financial dynamics of activity and size).H2. monetary policy variables influence output in the short-term but not in the long-run in the CFA zones. First, the absence of cointegration among real output and the monetary policy variables in both zones confirm the neutrality of money in the long term. With the exception of overall money supply, the significant effect of money on output in the short-run is more relevant in the UEMOA zone, than in the CEMAC zone in which only financial system efficiency and financial activity are significant.Practical implications– First, compared to the CEMAC region, the UEMOA zone’s monetary authority has more policy instruments for offsetting output shocks but fewer instruments for the management of short-run inflation. Second, the CEMAC region is more inclined to non-traditional policy regimes while the UEMOA zone dances more to the tune of traditional discretionary monetary policy arrangements. A wide range of policy implications are discussed. Inter alia: implications for the long-run neutrality of money and business cycles; implications for credit expansions and inflationary tendencies; implications of the findings to the ongoing debate; country-specific implications and measures of fighting surplus liquidity.Originality/value– The paper’s originality is reflected by the use of monetary policy variables, notably money supply, bank and financial credits, which have not been previously used, to investigate their impact on the outputs of economic activities, namely, real GDP output and inflation, in developing country monetary unions.

Lending Rate Spread Shock and Monetary Policy Arrangements: A Small Open Economy Model for ASEAN Countries

We investigate the welfare implications of monetary policy arrangements in a small open economy, considering firms' bank-based finances that are widely observed in emerging ASEAN countries. The impact of an unexpected change in the lending rate spread, or a lending rate spread shock, depends on the presence of banking activity in the economy. This presence is important in Malaysia and Vietnam, where welfare effects of this type of shock are at least comparable to those of foreign monetary policy shocks. We also find that a rigid exchange rate arrangement amplifies the effect of a shock.

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.

Escaping expectation traps: How much commitment is required?

We study the degree of precommitment that is required to eliminate multiplicity of policy equilibria, which arise if the policy maker acts under pure discretion. We apply a framework developed by Schaumburg and Tambalotti (2007) and Debertoli and Nunes (2010) to a standard New Keynesian model with government debt. We demonstrate the existence of expectation traps under limited commitment and identify the minimum degree of commitment which is needed to escape from these traps. We find that the degree of precommitment which is sufficient to generate uniqueness of the Pareto-preferred equilibrium requires the policy maker to stay in office for a period of two to five years. This is consistent with monetary policy arrangements in many developed countries.

The Interplay of Economic Reforms and Monetary Policy: The Case of the Eurozone*

AbstractThe world has been struck by a mutating systemic financial crisis that is unprecedented in terms of financial losses and fiscal costs, geographic reach, and speed and synchronization. The crisis from August 2007 to date can be divided into three main phases: the financial turmoil from August 2007 to the collapse of Lehman Brothers; the global financial crisis from September 2008 until spring 2010; and the eurozone sovereign debt crisis from spring 2010 to the current period. While each phase has brought significant challenges, the current sovereign debt crisis has been the most critical stage for the eurozone. It has brought unprecedented challenges for the monetary union and triggered extraordinary adjustments in both monetary policy and institutional arrangements at the eurozone level. The purpose of this article is to outline the features of each crisis phase, to describe the actions taken by the European Central Bank (ECB) during each phase and to explain the rationale for such measures. It also discusses the need to strengthen further the economic union in order to guarantee the sustainability of the monetary union of the eurozone. In this respect, it is argued that the recent institutional adjustments made at the European Union level would have been necessary independently of the financial crisis.

The Interplay of Economic Reforms and Monetary Policy: The Case of the Euro Area

The world has been struck by a mutating systemic financial crisis that is unprecedented in terms of financial losses and fiscal costs, geographic reach, and speed and synchronisation. The crisis from August 2007 to date can be divided into three main phases: the financial turmoil from August 2007 to the collapse of Lehman Brothers; the global financial crisis from September 2008 until spring 2010; and the euro area sovereign debt crisis from spring 2010 to the current period. While each phase has brought significant challenges, the current sovereign debt crisis has been the most critical stage for the euro area. It has brought unprecedented challenges for the monetary union and triggered extraordinary adjustments in both monetary policy and institutional arrangements at the euro area level. The purpose of this article is to outline the features of each crisis phase, to describe the actions taken by the European Central Bank (ECB) during each phase and to explain the rationale for such measures. It also discusses the need to strengthen further the economic union in order to guarantee the sustainability of the monetary union of the euro area. In this respect, it is argued that the recent institutional adjustments made at the EU level would have been necessary independently of the financial crisis. JEL Classification: D78, E52, E58, G01, H12

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.

Escaping Expectation Traps: How Much Commitment is Required?

In this paper we study the degree of precommitment that is required to eliminate multiplicity of policy equilibria, which arise if the policy maker acts under pure discretion. We apply a framework developed by Schaumburg and Tambalotti (2007) and Debortoli and Nunes (2010) to a standard New Keynesian model with government debt. We demonstrate the existence of expectation traps under limited commitment and identify the minimum degree of commitment which is needed to escape from these traps. We find that the degree of precommitment which is sufficient to generate uniqueness of the Pareto-preferred equilibrium requires the policy maker to stay in office for a period of two to five years. This is consistent with monetary policy arrangements in many developed countries.

Central Bank Transparency: Causes, Consequences and Updates

We present updated estimates of central bank for 100 countries up through 2006 and use them to analyze both the determinants and consequences of monetary policy transparency in an integrated econometric framework. We establish that there has been significant movement in the direction of greater central bank transparency in recent years. Transparent monetary policy arrangements are more likely in countries with strong and stable political institutions. They are more likely in democracies, with their culture of transparency. Using these political determinants as instruments for transparency, we show that more transparency monetary policy operating procedures is associated with less inflation variability though not also with less inflation persistence.

Is there a case for domestic inflation target?

This paper evaluates the consequences of a central bank stabilizing alternative measures of inflation in a model with several exchange rate channels of transmission for the monetary policy. The real exchange rate affects the equilibrium conditions and the utility-based welfare objective places higher weight on output gap stabilization. There is an endogenous stabilization trade-off and policy rules derived from private agents’ optimizing behavior perform better than alternative monetary policy arrangements. The optimal policy is PPI inflation target, under which the exchange rate follows a controlled floating. Contrary to central bank practices, CPI target should be considered only by highly open economies.

Sustainable fiscal policies and budgetary risk under alternative monetary policy arrangements

Early work on the theory of economic policy stressed the importance of the interactions between fiscal and monetary policy. Tinbergen, and Cooper, showed us that there would be costs in instability and protracted imbalances, in particular fiscal imbalances, if this was not recognised. Yet most models we use today treat fiscal or monetary policies as if they operated alone. This paper reviews the advantages of recognising those interactions. We consider three possibilities: fiscal leadership (in the sense of acting first), monetary leadership, and simultaneous decision making, each underpinned by independence at the central bank. This temporal separation is important because it creates an opportunity for punishment by the follower (a result from asynchronous games). Making fiscal policy lead, and monetary follow, provides fiscal precommitment and the best results for output, inflation and fiscal balances. In particular, it ensures sustainable public finances without the need for arbitrary (and easily evaded) external restrictions. We show these results are proof against override by rational governments; and robust to changes in structure caused by flattening of the Phillips curve, globalisation, market reforms, and changes in savings.

Monetary Policy in Illiquid Markets: Options for a Small Open Economy

Two impediments to effective monetary policy operation include illiquidity in bond markets and the zero bound of interest rates. Under these conditions alternative means of enacting monetary policy may be required. This paper empirically explores policy options implemented through equity and currency markets that will generate similar inflation responses at different time horizons. In terms of GDP loss the least costly means of achieving a particular long run inflation outcome is via the current monetary policy arrangements. Currency market alternatives are volatile but less expensive than the equity market in terms of output loss for short term inflation horizons.

Fiscal policy and public debt sustainability in the EMU

Monetary Union (EMU) over the last few years. Several EU members, including the three largest Euro Area countries, have repeatedly failed to fulfill the public deficit criterion of a general government (Maastricht) deficit of less than 3 percent of GDP. Moreover, although politically less spectacular, the central government debt of several countries remains not only considerably higher than the 60 percent of GDP mark prescribed by the Maastricht criteria but has also been rising during the last few years. Although generally the transition to the new common EMU currency was remarkably smooth and the euro is now generally accepted within its area of circulation, failure to meet the self-imposed fiscal policy restrictions may undermine the credibility of macroeconomic policies in Europe. In principle, there are two possible reactions to the gap between targeted and actual government deficits and debt. Either policy makers may intensify their efforts to reach the original goals in spite of increasing difficulties, like low growth and high unemployment, or the targets have to be revised downwards. In the EMU, the latter course of action was pursued in 2005 by (moderately) weakening the Stability and Growth Pact. It is clear that in no way can this amendment alleviate the problems resulting from the discrepancy between the need for fiscal prudence and the day-today pressures of partisan and interest-led politics. In particular, the long-run detrimental effects of high and increasing public debt threaten the stability of the fiscal and monetary policy arrangements in the EMU. To deal with these problems, the Ludwig Boltzmann Institute for Economic Analyses (now succeeded by the Robert Holzmann Institute for Economic

Disinflation and Monetary Policy Arrangements in Romania

Disinflation has been pursued successfully in Romania in recent years. Inflation came down from over 40 per cent in 2001 to 14 per cent in 2003 and is expected to be cca 9.5 per cent in 2004. By 2007 it should come down to around 3%. The benefits of a lowinflation environment are unquestionable, as price stability is the ultimate objective of monetary policy. In addition, low inflation is a pre-condition for EU accession. There only remains the other critical question, namely, what is the proper strategy to achieve the ultimate objective. Different central banks have adopted strategies which place different emphasize on the various pieces of information, or elements of their decision-making process or different aspects of their communication policies. Inflation targeting (IT) is one of those strategies.

The Rationale for a Single National Financial Services Regulator

The single statutory regulator for financial services which is being established in the UK (the Financial Services Authority, FSA) will be the broadest financial regulator in the world, combining prudential, conduct of business and market conduct regulation across the full range of financial services, including banking, securities, investment management and insurance. A few other countries already have single financial services regulators, but the FSA will be the first in a major international financial centre. This paper considers the rationale for establishing a single national financial services regulator. The institutional structure of financial services regulation is important because of the impact of the efficiency and effectiveness of this regulation on the direct and indirect costs of regulation and on the success of regulation in meeting its statutory objectives. To what extent should the structure of financial regulation be driven by the functions which financial services firms undertake, reflecting market developments in the financial services industry? Is there a first-best institutional arrangement which is independent of these market developments, arising perhaps from economies of scale and scope in undertaking financial regulation, or from some underlying logic linking the structure of regulation with the objectives of regulation or with the institutional arrangements for monetary policy and for addressing systemic risk? Are there also implications here for the structure of regulation internationally, not just within national borders? Although the structure of financial regulation must depend in part on what is being regulated and why it is being regulated, this paper takes as given the rationale for financial services regulation as set out in Davies (1998a), Goodhart et al (1998) and Llewellyn (1999). This is not to deny the crucial importance of determining the rationale for intervention - and indeed the key interrelationships between this rationale and the choice of the tools of supervision - but this is too large a subject to cover within this paper.

A Fiscal Theory of Sovereign Risk

This paper presents a fiscal theory of sovereign risk and default. Under certain monetary-fiscal regimes, the risk of default, and thus the emergence of sovereign risk premia, are inevitable. The paper characterizes the equilibrium processes of the sovereign risk premium and the default rate under a number of alternative monetary policy arrangements. It is argued that, given the fiscal stance, monetary policy plays a crucial role in shaping the equilibrium behaviour of the country risk premium and the default rate. For instance, under some of the monetary policy rules considered, the expected default rate and the sovereign risk premium are zero (and therefore unforecastable) although the government defaults regularly. Under other monetary regimes the default rate and the sovereign risk premium are serially correlated (and therefore forecastable). In addition, environments are characterized under which delaying default is counterproductive.

Monetary Policy in Transition: Structural Econometric Modelling and Policy Simulations

In this paper I estimate a Bayesian structural VAR models for the Czech Republic and Poland, allowing for changes in parameters between the two monetary policy arrangements. The four-variables structural VAR methodology adopted in the study is successful in identifying monetary policy shocks and their effects for the Czech and Polish economies. The time-varying model is capable of detecting a change in the policy reaction function consistent with introduction of the floating exchange rate system and switching to short-term interest rate as the main policy instrument. The results indicate the dominant role of exchange rate in the monetary transmission mechanism.

The Lag from Monetary Policy Actions to Inflation: Friedman Revisited

This paper updates and extends Friedman's (1972) evidence on the lag between monetary policy actions and the response of inflation. Our evidence is based on UK and US data for the period 1953–2001 on money growth rates, inflation and interest rates, as well as annual data on money growth and inflation. We reaffirm Friedman's result that it takes over a year before monetary policy actions have their peak effect on inflation. This result has persisted despite numerous changes in monetary policy arrangements in both countries. Similarly, advances in information processing and in financial market sophistication do not appear to have substantially shortened the lag. The empirical evaluation of dynamic general equilibrium models needs to be extended to include an assessment of these models' ability to account for the monetary transmission lags found in the data.