Output-inflation Trade-off Research Articles

Unconventional policies in state-dependent liquidity traps

We characterize optimal unconventional monetary and fiscal-financial policies against supply- and demand-driven liquidity traps within a tractable New Keynesian model featuring a cash-in-advance constraint and a monetary policy cost channel. Deposit subsidies circumvent the inflation-output trade-off arising from stagflationary shocks and supply-driven liquidity traps by enabling negative nominal interest rates. Additionally, deposit taxes facilitate modest interest rate hikes to escape demand-driven deflationary traps. Notably, discretionary and commitment policies with deposit taxes / subsidies deliver virtually equivalent welfare gains, rendering time-inconsistent forward guidance schedules unnecessary. We also derive robust and implementable optimal policy rules when the sources of shocks are unknown.

Inflation targeting bands and the short-run output-inflation trade-off in a new Keynesian economics perspective: evidence from South Africa

ABSTRACT The paper determines the effects of the 3–6% inflation targeting band (IT) band on short-run output-inflation trade-off in South Africa compared to inflation above 6%. In addition, we determine the region with the highest trade-off within the target band relative to its midpoint. The threshold model indicates that output-inflation tradeoff is higher within the existing IT band than above it. Within the 3–6% IT band, a higher output-inflation tradeoff is achieved when inflation is within the 3–4.5% IT band than in the 4.5–6% IT band. A 3–4.5% band will lead to bigger real effects.

Output-inflation trade-offs and the optimal inflation rate

We show that a positive superelasticity of demand, often referred to as “Marshall's Second Law of Demand,” is a new push factor of optimal inflation in staggered price models. The positive superelasticity alters the trade-offs between output and inflation in the models. It allows higher trend inflation to steepen the slope of a model-based Phillips curve and lower the steady-state average markup, and thus reduces the inflation-related weight in a model-based welfare function for higher trend inflation and the steady-state welfare cost of higher trend inflation. Consequently, the positive superelasticity can make the optimal trend inflation rate positive and lessen the welfare difference between inflation targets of 2 percent and 4 percent.

Competition and regional Phillips curve: Evidence from China.

The product market competition affects the non-neutrality of monetary policy. This paper quantitatively assesses its impact on the slope of the Phillips curve through the channels of nominal and real rigidity. We build a New Keynesian model using the Kimball aggregator and the Calvo staggered pricing scheme. We show that a more competitive market environment has opposite effects on the slope of the Phillips curve by increasing the real rigidity and lowering the nominal rigidity. We then estimated the model using regional data of China. The Bayesian estimation shows that the response of inflation-output trade-off is larger in the region with a high degree of competition. Counterfactual experiments demonstrate that nominal rigidity has a dominant role and accounts for the majority of the difference in the Phillips curve, while the contribution of real rigidity is relatively minor. Our results highlight the key role of nominal rigidity in determining the inflation-output dynamics.

Average inflation targeting: Time inconsistency and ambiguous communication

We study the implications of average inflation targeting (AIT). AIT improves the inflation-output trade-off when the private sector believes the central bank’s announcement. Ex post, the central bank has the incentive to implement inflation targeting instead to maximize social welfare. Next, we examine whether and how the central bank can convince the private sector, and find ambiguous communication helps the central bank gain credibility and improve welfare. These results apply to several key aspects of AIT announcement and do not rely on specific modeling assumptions.

Monetary-fiscal coordination: when, why and how?

PurposeThis paper aims to revisit the theme of fiscal-monetary coordination in a general equilibrium setup that allows for unconventional monetary policy, monetary policy transmission and developing country characteristics.Design/methodology/approachThis paper uses a calibrated new Keynesian dynamic stochastic general equilibrium (DSGE) model to study fiscal-monetary interaction.FindingsDebt sits at the center of monetary-fiscal interaction. Under high-debt conditions, the inflation-output trade-off rises with an increase in the strictness with which monetary policy targets inflation, undermining the standard prescription of strict inflation targeting. At the same time, the transmission of monetary policy is also impeded, due to which unconventional monetary policy becomes more appropriate. The need for coordination among the policies gets enhanced in the presence of borrowing cost channel. While the presence of borrowing cost channel increases the need for policy coordination regardless of the debt situation, features like higher share of non-Ricardian households and weaker monetary policy transmission affect monetary-fiscal interaction to a greater extent under high-debt environment.Originality/valueFirst, this paper uses inflation-output trade-off as a metric, to analyze fiscal-monetary interaction. Second, this paper considers the impact of developing country characteristics (such as a higher share of non-Ricardian households, impeded monetary policy transmission and supply constraints/borrowing cost channel) on fiscal-monetary interaction. Third, the DSGE model developed in this paper incorporates open market operations that could shed light on the role of unconventional monetary policy in the presence of high fiscal deficit and debt, which is particularly relevant in the current context of the COVID-19 pandemic. Fourth, the model also permits an investigation into monetary policy transmission under different debt regimes.

Output-inflation Trade-off in the Presence of Foreign Capital: Evidence for Vietnam

On one monthly time-series data set of Vietnam economy over 02/2008–09/2018, the Time-Varying-Coefficient VAR model records that the trade-off between inflation and output growth is mitigated by the foreign capital inflows. The inflation is mostly determined by credit supply growth, while output growth is largely driven by foreign direct investment (FDI) capital inflows. A monthly increase of FDI by USD 1 billion can raise 1.77% of monthly output growth rate. The result also holds on accounting for exchange rate fluctuation. JEL Classifications: E31, F15, F36, F43

Inflation Targeting Mattered: A Multivariate Synthetic Control Approach

We use a multivariate synthetic control method that matches the price and output dynamics jointly to evaluate the effects of the inflation targeting regime (IT) on the inflation and output growth of its early adopters (the ITers) – New Zealand, Canada, the United Kingdom, Sweden, and Australia. Once accounting for the inflation-output trade-off in the conduct of monetary policy, the ITers enjoyed lower inflation and/or higher output growth than their counterfactuals. These performances were economically important to justify IT central banks’ optimism with IT, both case-by-case and on average.

Monetary Transmission Mechanism, Confidence and Uncertainty: Evidence from a Large Emerging Market Economy

After the Global Financial Crisis, the role of uncertainty in driving optimal responses of consumers, firms and policymakers has garnered a renewed focus. In the face of uncertainty, economic agents awaiting information and clarity on future outcomes, may delay their economic decisions. Monetary policy aimed at business cycle stabilization may be rendered ineffective in such situations. We test this hypothesis for a large emerging market economy by analyzing the confidence channel of monetary transmission in India. Using a flexible, local projections-based framework, we find that uncertainty shocks resemble a negative supply shock, contrary to evidence from the developed world. This dominant supply-side effect of uncertainty is crucial in understanding the ineffectiveness of monetary policy transmission once macroeconomic uncertainty is accounted for. An unanticipated increase in uncertainty hinders private investment thereby eroding the productive capacity of the economy. This worsens the inflation-output tradeoff for monetary policy. The weaker monetary policy transmission is corroborated by a non-linear threshold model. Episodes of increased uncertainty may, therefore, require unconventional policy tools for effective management. Our findings are useful for monetary policy in an emerging economy given its objective to maintain price stability and optimize on economic growth.

Inflation-output trade-off: Old measures, new determinants?

This study analyses the determinants of the sacrifice ratio; i.e., the output cost of disinflation. The empirical literature so far has used several model specifications, indicating the degree of model uncertainty. Even for those factors where consensus on their significance has been reached, such as trade openness and central bank independence, considerable uncertainty still surrounds their estimated sign. Motivated by the above, we estimate the most important drivers of the sacrifice ratio based on Bayesian model averaging, for a panel data set of 42 countries. Our findings confirm part of the evidence reported in the prior empirical literature, while it sheds light on the importance of other factors.

Heterogeneous Consumers, Segmented Asset Markets and the Real Effects of Monetary Policy

Abstract This article proposes a novel mechanism by which changes in the distribution of money holdings have real aggregate effects. I develop a flexible-price model of segmented asset markets in which monetary policy influences the aggregate demand elasticity via heterogenous money holdings. Because varieties of consumption bundles are purchased sequentially, newly injected money disseminates slowly throughout the economy via second-round effects. The model predicts a short-term inflation-output trade-off, a liquidity effect, countercyclical markups, and pro-cyclical wages after monetary shocks. Among other correlations of financial variables, it also reproduces the empirical, negative relationship between changes in the money supply and markups.

Monetary Policy Transmission Over the Leverage Cycle: Evidence for the Euro Area

We study state dependence in the impact of monetary policy shocks over the leverage cycle for a panel of 10 euro area countries. We use a Bayesian Threshold Panel SVAR with regime classifications based on credit and house prices cycles. We find that monetary policy shocks trigger a smaller response of GDP, but a larger response of inflation during low states of the cycle. The shift in the inflation-output trade-off may result from higher macro-economic uncertainty in low leverage states. For an alternative regime classification based on turning points we find larger effects on GDP during contractions. JEL Classification: C32, E32, E44

Inflation targeting and output-inflation tradeoffs

This article assesses whether the adoption of inflation targeting (IT) helps reduce the output-inflation tradeoff. We address the self-selection problem of IT policy adoption by the endogenous switching regressions, and show that the output-inflation tradeoffs are significantly lower in IT countries not only over the whole sample but also across the developed and developing country subsamples. In addition, we also find strong evidence supporting the positive selection hypothesis, i.e., countries have higher probability of adopting IT are exactly those who benefit more (larger reduction of output-inflation tradeoff) from the implementation of IT. Additional results reveal that economies with higher trade openness, lower financial openness, and less flexible exchange rate regime are associated with larger tradeoff between output and inflation, but the effects are only statistically significant in the IT regime.

Trade Exposure and the Evolution of Inflation Dynamics

The diminished sensitivity of inflation to changes in resource utilization that has been observed in many advanced economies over the past several decades is frequently linked to the increase in global economic integration. In this paper, we examine this "globalization" hypothesis using both aggregate U.S. data on measures of inflation and economic slack and a rich panel data set containing producer prices, wages, output, and employment at a narrowly defined industry level. Our results indicate that the rising exposure of the U.S. economy to international trade can indeed help explain a significant fraction of the overall decline in responsiveness of aggregate inflation to fluctuations in economic activity. This flattening of the U.S. Phillips curve is supported strongly by our cross-sectional evidence, which shows that increased trade exposure significantly attenuates the response of inflation to fluctuations in output across industries. Our estimates indicate that the inflation-output tradeoff is about three times larger for low-trade intensity industries compared with their high-trade intensity counterparts.

Monetary Policy and Sentiment-Driven Fluctuations

I study optimal monetary policy in the presence of non-fundamental sources of fluctuations. Beliefs about aggregate demand can be self-fulfilling in models departing slightly from the complete information benchmark in the New Keynesian framework. Through its effect on aggregate variables, the stance of policy determines the precision of endogenous signals that firms receive, and consequently, the degree of coordination in firms’ production (pricing) decision. As a result, the distribution of non-fundamental shocks is no longer independent of policy, introducing a novel trade-off between stabilizing output and inflation. Strong inflation targeting increases the variance of nonfundamental shocks, which are shown to be suboptimal. The Taylor rule is no longer sufficient to rule out indeterminacy. Instead, an interest rate rule that places sufficiently low weight on inflation eliminates non-fundamental volatility and hence the output-inflation trade-off. While these results extend to the case where fluctuations are driven by both fundamental and non-fundamental shocks, a policymaker unable to distinguish between the two sources cannot eliminate non-fundamental volatility.

What Drives Inflation-Output Tradeoff Dynamics in Pakistan? An Assessment of International Linkages and Global Trends

This article illustrates the dynamics of and tradeoff between inflation and output in Pakistan by utilizing data on 18 major trading partners in a cointegration analysis. In doing so, we use key features of the global vector autoregressive approach to construct a model that captures foreign-specific variables related to Pakistan; these are analyzed empirically along with domestic data for the period 1972–2014. Our findings show that, after accounting for the impact of increasing interdependencies, trade spillovers and changing global macroeconomic conditions, a long-run equilibrium relationship exists between domestic inflation and output. The foreign variables have a significant impact on the key domestic variables. In particular, domestic inflation and trade openness, foreign inflation and world oil prices have significant explanatory power for Pakistani output. Policymakers in Pakistan should therefore account for global developments, specifically in trading partner economies.

On Nonlinear Effects of Inflation Across Countries

Many emerging market economies have a higher tolerance for inflation than industrialized economies. Recent empirical studies find nonlinear effects of inflation and that the threshold rate is higher for emerging countries. Motivated by the fact that emerging countries have higher business costs, this paper incorporates entrepreneurial occupational choices in a parsimonious monetary model and rationalizes the observed different thresholds rates. The reason is that business costs distort the occupational decisions and affect the inflation-output tradeoff.

New Keynesian Phillips Curve with time-varying parameters

I generalize the New Keynesian Phillips Curve model of Gali and Gertler (J Monet Econ 44:195–222, 1999) to allow for time-varying parameters. The parameter of interest measures the trade-off between inflation and real economic activity, and it is particularly a nonlinear function of three underlying structural parameters: the discount factor, the degree of price rigidity and the strength of backward-looking behavior or information diffusion. The empirical results show that the estimated parameter of output-inflation trade-off is time varying and is larger in high inflation periods. Specifically, the time-variation of the trade-off between inflation and economic activity stems from the degree of price rigidity, which is negatively correlated with inflation. Moreover, the forward-looking price-setting behavior plays a dominant role in explaining inflation dynamics for most part of the sample period.

Speed Limit Policy and Liquidity Traps

The zero lower bound (ZLB) constraint on interest rates makes speed limit policies (SLPs)---policies aimed at stabilizing the output growth---less effective. Away from the ZLB, the history dependence induced by a concern for output growth stabilization improves the inflation-output tradeoff for a discretionary central bank. However, in the aftermath of a deep recession with a binding ZLB, a central bank with an objective for output growth stabilization aims to engineer a more gradual increase in output than under the standard discretionary policy. The anticipation of a more restrained recovery exacerbates the declines in inflation and output when the lower bound is binding.

The CFA Franc Zone: a political re-evaluation twenty years after the advent of the Euro

ABSTRACTAlthough the CFA monetary union is not an ‘optimal’ currency area as such, it has allowed member countries to benefit from the convertibility guaranteed by the French Treasury and from enhanced policy credibility in achieving low inflation rates.Both benefits may be under threat. The convertibility is under threat due to the harder budgetary commitments imposed on France by its membership of the Eurozone and the dwindling political interest in the CFA Franc Zone shown in France.The policy credibility is becoming costlier as evidenced by output-inflation trade-offs, which, although still more favourable than in comparable sub-Saharan African countries, have been declining since the 1994 devaluation period.