Optimal Monetary Policy Research Articles

Climate Change's Effect on Household Food Security in Sub-Saharan Africa and Optimal Monetary Policy

The resurgence of food insecurity in Sub-Saharan Africa during the past decade highlights the need to comprehend the phenomenon within a framework that includes all economic agents in these times of intensification of climate change. Thus, this paper, using a Dynamic Stochastic General Equilibrium (DSGE) model, analyzes the effects of climate shocks occurring in agricultural and non-agricultural sectors on household food security in Sub-Saharan Africa, while determining optimal monetary policy responses to mitigate these adverse effects. Findings highlight that climate shocks affecting the non-agricultural sector are more detrimental to long-term household food security than those affecting the agricultural sector, particularly for urban households. To mitigate these effects, flexible policies targeting food price inflation and headline inflation seem appropriate for rural and urban households, respectively. Nevertheless, in the absence of political and social pressure, flexible headline inflation targeting is optimal for mitigating climate shocks effects on Sub-Saharan Africa's food security.

Optimal Monetary and Transfer Policy in a Liquidity Trap

AbstractOptimal monetary and fiscal policy are jointly analyzed in a heterogeneous two‐agent New Keynesian environment, where fiscal policy is modeled as lump‐sum transfers. Transfer policy does not substitute for forward guidance—as it entails consumption dispersion costs—nor affect its optimal duration. The stay at the zero lower bound is indeed influenced through two offsetting channels: a shortening channel works through an initial increase in transfers that mitigates the recession (reducing the need for forward guidance), while a lengthening channel works through a later transfer cut that curbs the expansion (making forward guidance desirable for a longer horizon).

The financial accelerator, wages, and optimal monetary policy

I study the effects of labor market outcomes on firms' loan demand and credit intermediation. I first show in partial equilibrium that the presence of frictions in the banking sector lowers the capital factor demand elasticity to changes in real wages. This finding helps to connect the substitutability of labor and capital with credit conditions. Second, I use a new Keynesian banking model with an endogenous financial accelerator mechanism to study the role of lower capital factor demand elasticity in the transmission mechanism of monetary policy. Stabilizing nominal wages is close to the optimal monetary policy because it coincides with stabilizing the credit spread, the net worth gap, and the output gap. Inflation stabilization, in turn, imposes a policy trade-off with high welfare costs.

Financial friction and optimal monetary policy: analysis of DSGE model with financial friction and price sticky

Financial friction and optimal monetary policy: analysis of DSGE model with financial friction and price sticky

Optimal Monetary Policy: A Case for Price-Level Targeting

Optimal Monetary Policy: A Case for Price-Level Targeting

The Feasibility of Coordinating International Monetary Policy Strategies in the Context of Asymmetric Demand Shocks

In the context of the increasing interdependence of countries due to the development of international trade, a relevant question arises as to whether it is necessary to conduct independent monetary policies for each country or whether it is advisable to coordinate these policies. This question becomes a key in the debate on optimal monetary policy strategies in open economies. The aim of this study is to analyze the impact of asymmetric aggregate demand shocks on the appropriateness of monetary policy coordination in a simple stochastic model of two interacting countries. The analysis of equilibrium states of the monetary authorities’ interaction strategies under study was carried out analytically by minimizing the loss function and solving one-period static optimization problems. The equilibrium states of macroeconomics of interacting countries under coordination of monetary policy and in cases of lack of coordination (Nash and Stackelberg equilibrium) in the presence of asymmetric, serially uncorrelated demand shocks have been analyzed. It is proven that the response of inflation to asymmetric demand shocks is smaller in the case of coordinated policy than in the case of non-cooperative policy. The loss function analysis shows that the compensation of demand shocks is found to be more costly in Nash equilibrium than in the case of monetary authority coordination policy. The analysis of the monetary authorities’ interaction strategies showed that the real exchange rate plays an important role in balancing supply and demand in the two economies.

Money and Banking with Reserves and CBDC

ABSTRACTWe analyze the role of retail central bank digital currency (CBDC) and reserves when banks exert deposit market power and liquidity transformation entails externalities. Optimal monetary architecture minimizes the social costs of liquidity provision, and optimal monetary policy follows modified Friedman rules. Interest rates on reserves and CBDC should differ. Calibrations robustly suggest that CBDC provides liquidity more efficiently than deposits unless the central bank must refinance banks and this is very costly. Accordingly, the optimal share of CBDC in payments tends to exceed that of deposits.

Optimal monetary policy and the time-dependent price and wage Phillips curves: An international comparison

We investigate the behavior of central banks in seven advanced economies, focusing on how observed monetary policies align with optimal ones as determined by model-consistent welfare measures. Our approach stands out by emphasizing the importance of inertia’s impact on the output gap and the dynamics of prices and wages. We incorporate inertia into our model using duration-dependent adjustments. By integrating this aspect into a simple New Keynesian model, our analysis aims to identify shared patterns and distinctive features in the monetary policy approach of central banks across different countries.

Monetary Policy and Welfare with Heterogeneous Firms and Endogenous Entry

AbstractThis paper studies monetary policy and welfare in a sticky wage New Keynesian model with heterogeneous firms and endogenously variable markups. We show that stabilizing nominal wages is optimal only when product creation is based on an instantaneous zero‐profit condition and when the aggregate markup is constant. A constant markup requires strong selection effects generated by a Pareto firm‐level productivity distribution. When product creation is based on a dynamic zero‐profit condition optimal monetary policy accounts for the distribution of firms and the welfare loss from stabilizing nominal wages is between and 0.2% of steady‐state consumption.

Examining business cycles and optimal monetary policy in a regional DSGE model

I construct a dynamic stochastic general equilibrium (DSGE) model consisting of geographic regions and use state level data to estimate the effects that monetary policy and financial shocks have on the four census regions of the United States. The DSGE model I use is constructed around a centralized monetary authority and financial market with regional output, labor and investment markets. I find significant heterogeneity amongst the regional structural parameters of the model, creating different business cycle dynamics for the four regions. The estimated model aligns with other economic studies that suggest that monetary shocks have a greater impact in certain geographic regions in terms of employment, inflation, wages, and consumption. Simulating the estimated model, I find that monetary policy that considers the regional variation in output and inflation can significantly lower the volatility around national output and inflation. The paper’s results suggest that regional macroeconomic conditions should be considered in monetary policy decisions.

Stochastic credibility and optimal monetary policy

AbstractIn this paper, I study optimal monetary policy in a simple New Keynesian model with loose commitment and stochastic credibility. The loose commitment framework breaks the commitment‐discretion dichotomy in optimal monetary policy problems and allows for intermediate cases between commitment and discretion. Under this framework, the central bank is imperfectly credible, meaning that it occasionally reneges on promised policy plans. I contribute to the literature by introducing time‐variation in the central bank's credibility. I model credibility as an exogenous two‐state Markov chain and use a recursive saddlepoint functional equation to solve the model. I find that greater persistence and frequency of credibility losses increase welfare losses.

Monetary Policy, Employment Shortfalls, and the Natural Rate Hypothesis

Activity shortfalls are more costly than strong activity. I consider optimal monetary policy under discretion with an asymmetric (activity shortfalls) loss function. The model satisfies the natural rate hypothesis. The asymmetric loss function and resulting optimal monetary policy exacerbates shortfalls in activity. The additional frequency of activity shortfalls arises from the adjustment of expectations implied by the natural rate hypothesis. The shortfalls asymmetry leads to an inflationary bias, similar to results in the time-consistency literature. Mandating a central bank objective with greater symmetry than the social loss function improves outcomes. Greater symmetry lowers the magnitude of activity shortfalls. Greater symmetry also reduces inflation bias. The model also implies that an optimal monetary policy does not accommodate fluctuations from aggregate demand shocks, as is standard in such models. As a result, the analysis implies that monetary accommodation of strength in economic activity likely requires justifications other than asymmetric costs of shortfalls.

Consumption categories, household attention, and inflation expectations: Implications for optimal monetary policy

What inflation measure should central banks target? This paper highlights a mechanism where monetary policy optimally targets headline inflation if households pay limited attention to different consumption categories when forming inflation expectations. This result stands in contrast to standard rational expectations models, where optimal policy targets core inflation. The core inflation rate excludes volatile energy and food prices (non-core) from headline inflation. Using novel survey data on inflation expectations for disaggregated consumption categories, I find household expectations are disproportionately driven by beliefs about future non-core prices. A model of bounded rationality accounts for the empirical evidence. While forming inflation expectations, households pay more attention to the volatile non-core components. Embedding this framework into a multi-sector New Keynesian model, I show that targeting headline rather than core inflation provides welfare gains.

Monetary Policy and Asset Price Overshooting: A Rationale for the Wall/Main Street Disconnect

ABSTRACTWe analyze optimal monetary policy and its implications for asset prices when aggregate demand has inertia. If there is a negative output gap, the central bank optimally overshoots aggregate asset prices (above their steady‐state levels consistent with current potential output). Overshooting leads to a temporary disconnect between the performance of financial markets and the real economy, but accelerates the recovery. When there is a lower bound constraint on the discount rate, good macroeconomic news is better news for asset prices when the output gap is more negative. Finally, we document that during the COVID‐19 recovery, the policy‐induced overshooting was large.

Monetary policy, threshold of profitability and dynamics of private investment in the West African Economic and Monetary Union

This study investigates the interactions between optimal monetary policy, investment profitability thresholds, and private sector investment dynamics within the West African Economic and Monetary Union. Analyzing data from 2000 to 2021, it employs advanced econometric models (linear, asymmetric, and threshold effect dynamic panel error correction models) to provide a nuanced understanding of the investment environment in the union. The findings reveal the confluence of low returns and high borrowing costs for private investment. Notably, this study suggests that simply pursuing an expansionary monetary policy does not offer a sufficient solution. Instead, it proposes a more accommodative stance by the Central Bank, featuring lower policy rates, to alleviate the negative impact of high credit costs on private investment and ultimately stimulate economic activity.

Inefficient shocks and optimal monetary policy

Real disturbances that lead to trade-offs between inflation and output gap stabilization have not been studied much in the context of monetary policy settings in emerging markets and developing economies (EMDEs). We identify market price support present in the agriculture sectors of the EMDEs as inefficient shocks that lead to such trade-offs. Using a three-sector new Keynesian dynamic stochastic general equilibrium model, we show trade-offs between core-inflation and output gap stabilization under discretionary and commitment policies. This result departs from the popular viewpoint, stating that the strict core-inflation targeting is an optimal monetary policy for EMDEs susceptible to relative price changes.

THE RELATIONSHIP BETWEEN MONETARY AND FISCAL POLICY AUTHORITIES ON INFLATION STABILITY

This paper attempts to study the collaboration between fiscal and monetary policy in a game-theoretic approach. The significant nature of coordination between these two policymakers is essential to the growth of any economic, holding to the facts that certain decisions taken by one institution may have devastating effects on the other institution, by resulting in loss of social welfare of the citizens of that nation. In this logic, this paper derived optimal monetary and fiscal policies in one context of coordination or form of interaction using the Two-stage game with complete and perfect information in normal-form representation of the prisoners dilemma: when the two institutions minimize their losses by only taking into account their objectives or responsibilities they owed to the society, formulation of solution known as the Nash equilibrium solution; when an institution moves first in pursuance of the objectives in improving the social welfare and the other follows, in a mechanism known as the optimal solution; when institutions behave cooperatively, seeking common goals. Like in the case Brazilian economy, the two institutions simultaneously demonstrated coordination at the level were both the monetary and fiscal authorities choose the (4, 4) as the optimal point in stabilizing inflation and output remains at its maximum level, that a minimal loss is found when there is a Nash equilibrium, particularly when monetary policy is the leader of the economy and fiscal policy follows. KEYWORDS: Fiscal and Monetary Policy, Game Theory, Nash Equilibrium, Stackelberg Equilibrium, Cooperation.

Optimal monetary policy under digital technology shock

This study investigates how digital technology shocks can transform monetary policy. Using macroeconomic data from China from 2005 to 2022, this study empirically tests the time-varying dynamic correlation between digitalization, money supply, and output using the TVP-VAR model. The results show that the stimulating effect of loose monetary policy on output has gradually weakened in recent years. In contrast, digital technology has gradually become a new driving force for economic growth. Furthermore, this study incorporates a digital technology R&D department into the standard DSGE model and internalizes digital technology within the economic cycle to analyze the macroeconomic effects of digital technology shocks. Numerical simulations show digital technology shocks can effectively stimulate output and suppress inflation. Moreover, the central bank's welfare utility is maximized under a price-based, quantity-assisted monetary policy. Finally, this study begins with the price stickiness perspective to explain how digital technology weakens the effectiveness of monetary policy. This study enriches the literature on monetary policy regulation and provides insights for monetary policymakers to address the challenges the digital economy poses.

External vulnerability and optimal monetary policy in Nigeria

In this study, we assess the external vulnerability of the Nigerian economy by documenting three alternatives (zero, partial and full) oil price pass-through to inflation within a New Keynesian Dynamic Stochastic General Equilibrium (DSGE) framework. The results show that under a zero-oil price pass-through, the choice of inflation measure is immaterial, as macroeconomic responses to the shock are comparable under alternative Taylor rule specifications. The shock precipitates stagflation, transmitted via the income and exchange rate channels; and introduces an extra layer of vulnerability associated with higher external risk premium. Both core and oil inflation targeting monetary rules maximize welfare under a zero-oil price passthrough, while oil inflation targeting is shown to be welfare superior under partial or full oil price pass-through. Credibility consideration renders core inflation targeting the feasible optimal path for the central bank.

Firm Heterogeneity, Capital Misallocation and Optimal Monetary Policy

Firm Heterogeneity, Capital Misallocation and Optimal Monetary Policy