Real Balance Effect Research Articles

Do Real Balance Effects Invalidate the Taylor Principle in Closed and Open Economies?

This paper examines the determinacy implications of forecast‐based monetary policy rules that set the interest rate in response to expected future inflation in a Neo‐Wicksellian model that incorporates real balance effects. We show that the presence of such effects in closed economies restricts the ability of the Taylor principle to prevent indeterminacy of the rational expectations equilibrium. The problem is exacerbated in open economies, particularly if the policy rule reacts to consumer‐price, rather than domestic‐price, inflation. However, determinacy can be restored in both closed and open economies with the addition of monetary policy inertia.

Global Recession: A Money Gift Cure?

Today, the world economy is at the brink of a major recession at zero lower bound. The recession has been fomented by the underconsumption induced by (i) the increasing income inequality, which is inherent in the neoliberal policymaking followed the last third of a century, and (ii) the declining wages being brought about by the increasing globalization and hence, international competition. And, the zero lower bound has been the aftermath of continuous interest rate reductions to confront the latent recessionary trends by stimulating investment but by increasing at the same time the prices of assets, bonds, and housing inciting several kinds of “bubbles” and inhibiting investment. The policy of “quantitative easing” in the place of interest rate reductions, a surrogate only of the latter has proved to be so far, for the simple reason that the money injections involved to spur business and household demand, are channeled towards the banking system, which withholds and does not pass on the money to the public. A money gift policy in the sense of transferring money directly to the public as a permanent asset for the private sector but not liability for the public sector, activating subsequently the Pigou effect, is advocated herein to be a viable policy alternative out of the current deadlock, ceteris paribus.

On the Monetary Approach to the Balance of Payments

The effects of inflation are considered for a small open economy with overlapping generations and a cash-in-advance constraint on consumption. In an endowment economy with one good, the model recovers the adjustment mechanism underlying the monetary approach to the balance of payments, which incorporated the real balance effect in the savings function. Nevertheless, if the model has two goods that require different degrees of cash, the factor intensities of the goods also play a crucial role in determining the response of savings. In that case, the predictions of the monetary approach may be overturned; a result that is supported numerically.

Consumption Demand and Wealth Effects of Unorthodox Monetary Policy

Unorthodox monetary policy invented by Ben Bernanke to stimulate the real economy towards a higher growth and employment path uses huge amounts of money to buy up assets on the capital market in particular government bonds and mortgage backed securities. This kind of monetary action was named by Bernanke QE, i.e. quantitative easing. The channel through which QE should operate is on the one hand the lowering of the yield curve to ease credit financing and refinancing in particular and on the other hand through the wealth effect on consumption demand. The latter should stimulate aggregate consumption through the well known real-balance effect first introduced into the Keynesian consumption function by Don Patinkin. However, there seems empirical evidence that both channels are not working as expected. After three QE periods, in particular the last QE did not lower the yield curve anymore. Additionally the wealth effect on aggregate consumption seems as well non-existent. There is no visible positive effect observable that QE has led to a higher economic growth or accelerated the decline of the unemployment rate. However, it creates a legacy of about 2.5 trillion US-Dollar of additional liquidity over the three rounds of QE. This poses a major dilemma for an exit from QE. If inflation expectations are rising and triggering higher inflation without having accomplished a higher sustainable growth and employment path of the economy, the central bank face the dilemma of fighting inflation and face huge losses on its balance sheet from those assets bought over the QE period or hedging their balance sheet and let inflation accelerate beyond its previous target. A soft landing of an exit from QE becomes highly improbable because the market reactions will tend to overshoot as soon as the central banks begin to commit towards a QE exit policy. Contrary to Milton Friedman’s recommendation for a steady monetary policy oriented towards a long-term real growth trajectory, the activist policy of QE creates endogenous boom and bust cycles.

Linear and asymmetric impacts of oil price shocks in an oil‐importing and ‐exporting economy: the case of Nigeria

AbstractGiven its economic structure, high‐energy intensity and its simultaneity as an oil‐importing and ‐exporting economy, Nigeria stands out as a special case to study the oil price–macroeconomy relation. By using a structural vector autoregressive model with 10 theoretically derived structural factorizations, this paper studies the linear and asymmetric impacts of oil price shocks on the Nigerian economy, focusing on the supply side effects, wealth transfer effects, inflation effects and real balance effects of oil price shocks between the period 1970Q1 and 2008Q4. Overall, the results show that oil price shocks have asymmetric impacts in one direction (positive) on the Nigerian economy and are not a major determinant of macroeconomic activity in Nigeria. Using Granger causality analysis, the paper also investigates the short‐run impacts of oil price shocks on the Nigerian economy. The results showed that depending on the measurement of oil price shock used, it only Granger‐caused output and inflation in the short run. This revealed that though Nigeria is a major exporter of crude oil, domestic macroeconomic trends do not significantly influence the dynamics of global oil markets, i.e. oil prices are strictly exogenous to the Nigerian economy. These insights have inspired us to recommend that the common practise of national development planning, premised on forecasts of anticipated oil prices should be de‐emphasized in Nigeria.

Oil price effects on personal consumption expenditures

This paper uses a logistic smooth transition model to examine the impact of rising oil prices on personal consumption expenditures in open and industrialized economies. The empirical results suggest a nonlinear and asymmetric relation between oil price changes and personal consumption expenditures. In particular, the effects of rising oil prices on personal consumption expenditures are greater than those of falling oil prices. While oil price changes affect personal consumption expenditures via real balance effects, smooth transition effects also come into play. Below a threshold value, an increase in oil prices reduces personal consumption expenditures. In other words, in the face of uncertainty regarding future oil prices, consumers initially rationally postpone spending. However, once oil prices above the threshold after a prolonged upward trend, the prices of domestic production factors rise. This fuels continued price hikes and further increases personal consumption expenditures until a cost-pushed inflation takes hold. Due to differences in economic developments and structures, the effects of rising oil prices vary from one country to another, with different countries usually to different monetary policies from each other. As a result, personal consumption expenditures also show various patterns across countries.

Real Balance Effects, Timing, and Equilibrium Determination

By assuming that money balances at the beginning instead of at the end of the period provide transaction services, standard results on nominal and real determinacy in monetary models are overturned. The key is that predetermined real money balances can be a state variable. Whereas the determination of the absolute price level typically depends on fiscal policy under an exogenous interest setting, nominal determinacy is now achieved even when fiscal policy is Ricardian. Also, in contrast to the Taylor principle, the interest rate policy should respond passively to changes in inflation, thus ensuring nonoscillatory and locally stable equilibrium sequences.

FORECAST DESIGN IN MONETARY CAPITAL STOCK MEASUREMENT

We design a procedure for measuring the United States capital stock of money implied by the Divisia monetary aggregate service flow, in a manner consistent with the present-value model of economic capital stock. We permit non-martingale expectations and time varying discount rates. Based on Barnett's (1991) definition of the economic stock of money, we compute the US economic stock of money by discounting to present value the flow of expected expenditure on the services of monetary assets, where expenditure on monetary services is evaluated at the user costs of the monetary components. As a theoretically consistent measure of money stock, our economic stock of money nests Rotemberg, Driscoll and Poterba's (1995) currency equivalent index as a special case, under the assumption of martingale expectations. To compute the economic stock of money without imposing martingale expectations, we define a procedure for producing the necessary forecasts based on an asymmetric vector autoregressive model and a Bayesian vector autoregressive model. In this and a companion paper (Barnett, Chae, and Keating, 2006), we find the resulting capital-stock growth-rate index to be surprisingly robust to the modeling of expectations. The primary conclusions regard robustness. It is not our intention to advocate any particular approach to modeling future expectations. We believe that further experiments with other forecasting models would confirm our robustness conclusion. Different forecasting models can produce substantial differences in forecasts into the distant future. But since the distant future is heavily discounted in our stock formula, and since alternative forecasting formulas rarely produce dramatic differences in short term forecasts, we believe that our robustness result obviates prior concerns about the dependence of theoretical monetary-capital-stock computations upon forecasts of future expected flows. Even the simple martingale forecast, which has no unknown parameters and is easily computed with current period data, produces a discounted stock measure that is adequate for most purposes. Determining an extended index, which can remove the small bias that we identify under the martingale forecast, remains a subject for our future research. At the time that Milton Friedman (1969) was at the University of Chicago, the Chicago School view on the monetary transmission mechanism was based upon the wealth called the real balance effect or Pigou (1943) effect, of open market operations. Our research identifies very large errors in the wealth effects computed from the conventional simple sum monetary aggregates and makes substantial progress in the direction of accurate measurement of monetary-policy wealth effects. Prior experience with monetary policy errors produced from monetary-aggregate-measurement errors suggests possible formidable policy relevance.

Money, capital and the Pigou effect

The effect of inflation on the capital stock is considered in an overlapping generations framework with a Cash-in-Advance constraint on consumption expenditures. The adjustment mechanism underlying the model is that of a traditional model with the real balance effect on savings.

A two-pillar DSGE monetary policy model for the euro area

The current financial crisis has revived the interest for monitoring both monetary and credit developments. Over the past two decades, consistent with the adoption of inflation targeting strategies by a growing number of central banks and the development of New Keynesian models for which monetary aggregates are largely irrelevant, money and credit have been progressively neglected in the conduct of monetary policy. A striking exception has been the Eurosystem, which has implemented a strategy known as the “two-pillar monetary policy strategy” giving a prominent role for money. In this paper, we develop a small optimizing model based on Ireland (2004), estimated on euro area data and featuring this two-pillar strategy. We evaluate an ECB-style cross-checking policy rule in a DSGE model with real balance effects of money. We find some evidence that indeed money plays a non-trivial role in explaining the euro area business cycle. This provides a rationale for the central bank to factor in monetary developments but also raises some issues regarding the reliability of M3 as an appropriate monetary indicator. We find some evidence that the ECB has systematically reacted to a filtered measure of money growth but weak evidence it has reacted more aggressively during excess money growth periods.

Does money matter for the identification of monetary policy shocks: A DSGE perspective

This paper investigates how the identification assumptions of monetary policy shocks modify the inference in a standard DSGE model. Considering SVAR models in which either the interest rate is predetermined for money or money and the interest rate are simultaneously determined, two DSGE models are estimated by minimum distance estimation. The estimation results reveal that real balance effects are necessary to replicate the high persistence implied by the simultaneity assumption. In addition, the estimated monetary policy rule is sensitive to the identification scheme. This suggests that the way money is introduced in the identification scheme is not neutral for the estimation of DSGE models.

CANDIDE et la monnaie

In this paper we deal with the financial sector of CANDIDE 1.1. We are concerned with the determination of the short-term interest rate, the term structure equations, and the channels through which monetary policy influences the real sector. The short-term rate is determined by a straightforward application of Keynesian liquidity preference theory. A serious problem arises from the directly estimated reduced form equation, which implies that the demand for high powered money, but not the demand for actual deposits, is a stable function of income and interest rates. The structural equations imply the opposite. In the term structure equations, allowance is made for the smaller variance of the long-term rates, but insufficient explanation is given for their sharper upward trend. This leads to an overstatement of the significance of the U.S. long-term rate that must perform the explanatory role. Moreover a strong structural hierarchy, by which the long Canada rate wags the industrial rate, is imposed without prior testing. In CANDIDE two channels of monetary influence are recognized: the costs of capital and the availability of credit. They affect the business fixed investment and housing sectors. The potential of the personal consumption sector is not recognized, the wealth and real balance effects are bypassed, the credit availability proxy is incorrect, the interest rate used in the real sector is nominal rather than real, and the specification of the housing sector is dubious.

Does Money Matter for the Identification of Monetary Policy Shocks: A DSGE Perspective

This paper investigates how the identification assumptions of monetary policy shocks modify the inference in a standard DSGE model. Considering SVAR models in which either the interest rate is predetermined for money or these two monetary variables are simultaneously determined, two DSGE models are estimated by Minimum Distance Estimation. We emphasize that real balance effects are necessary to replicate the high persistence implied by the simultaneity assumption. In addition, the estimated monetary policy rule is strongly sensitive to the identification scheme. This suggests that the way money is introduced in the identification scheme is not neutral for the estimation of DSGE models.

Why Investors Prefer Nominal Bonds: A Hypothesis

The paper advances an answer to a puzzle: Why is any lending or borrowing done in terms of money, when such money debt exposes the lenders' wealth to inflation risk? The 'received' answer to this question is that money bonds are just proxies for real bonds, proxies born of insufficient appreciation, or a benign neglect, of inflation risk. As mere 'proxies', this answer implies that money bonds are redundant: anything a money bond could do, a real bond could do. The thesis of the paper is that money bonds are not redundant. Money bonds have a social benefit. That benefit lies in the reduction that money bonds secure in the unpredictability of consumption that arises from the operation of real balance effects in an environment of unpredictable money shocks. It is the very vulnerability of money bonds to inflation makes them useful in immunizing the economy against unpredictable redistributions of purchasing power caused by real balance effects.

Rethinking the Role of Monetary Policy and Wage Bargaining in a World Without the Real Balance Effect

In standard macroeconomic models (new classical, AS-AD, monopolistic competition etc.) monetary policy determines the price level. Output and employment are determined in the labour market where nominal wages are set (possibly under the influence of unions), which together with the price level yield real wages. This paper shows that including nominal wages instead of real balances in the aggregate demand function of a standard monopolistic competition model changes this conclusion completely. In a model with micro-founded investment decisions, wage setters now control the price level. Monetary policy determines output and employment. Neither actor can influence real wages and profits, which are determined by the degree of monopolisation. Further, this conclusion fits well the stylised facts of the Euro area and provides an explanation for high unemployment in Europe.

Real Balance Effects and Monetary Policy

This article presents a dynamic stochastic new Keynesian model with real balance effects. I find a number of results that would not appear in the traditional framework. It is shown that the real balance effect makes the so‐called Taylor principle not necessary for determinacy of rational expectations equilibrium and that “passive” monetary rules may be feasible. In addition, within a class of policy rules constrained to be a linear function of state variables, “active” interest rate rules are more likely to be optimal under commitment rather than under discretion. (JEL E52, E58)

Woodford's Interest and Prices from the Perspective of the History and Methodology of Economic Thought: A Mini-Symposium

Michael Woodford's 2003 Interest and Prices has been regarded as the most important contribution to monetary economics since the publication of Don Patinkin's Money, Interest and Prices fifty years ago. Like Patinkin, Woodford sought inspiration in Knut Wicksell's 1898 Interest and Prices. But, while Patinkin built on Wicksell's incipient formulation of the real balance effect and stability analysis of the price level (see Boianovsky 1998), Woodford has elaborated on Wicksell's concept of a pure credit economy (called “cashless economy” in the 2003 version), a theme largely disregarded by Patinkin. This difference in perspective is in part related to the fact that Patinkin's concern was mainly monetary theory, whereas Woodford has focused on monetary policy instead. In early 2004 I invited a group of scholars to discuss Wood-ford's book from the point of view of the history of thought and methodology in a session at the History of Economics Society meetings, held in June of that year at Victoria University, Toronto. Michael Woodford was also invited to participate in the session and reply to the comments. The revised papers are published here as a mini-symposium.

Transactions Cost and Interest Rate Rules

This paper evaluates quantitatively the effect of real money balances in a New Keynesian framework. Money in our model facilitates transactions and is introduced through a transactions cost technology. This technology acts like a distortionary consumption tax which varies endogenously with the nominal interest rate. In this setup the resultant Phillips curve becomes a function of the nominal interest rate. Our analysis has important policy implications. First, we find, unlike Woodford (2003), accounting for realbalance effects does not result in the policy maker's loss function having an interest rate smoothing term. Second, we show that in the case of a temporary shock to productivity the optimal policy response under discretion is to allow for a trade-off between inflation and the output gap. This trade-off arises endogenously in our model. The quantitative effects on the macroeconomic variables are found to be significant.

The Liquidity Trap, the Real Balance Effect, and the Friedman Rule

This article studies the behavior of the economy and the efficacy of monetary policy under zero nominal interest rates using a model with population growth that nests, as a special case, the conventional specification in which there is a single infinitely lived representative agent. The article shows that with a growing population, monetary policy has distributional consequences that give rise to a real balance effect, thereby eliminating the liquidity trap. These same distributional effects, however, can also work to make many agents much worse off under zero nominal interest rates than they are when the nominal interest rate is positive.

A Reinterpretation of the so Called Money Market

In this paper, the macroeconomic market equations of a closed economy with flexible prices are set up by taking explicitly care of the fact that the central bank offers money as a credit on the capital market. Applying Walras' Law to this system of market equations shows that it is not possible to reduce the system by one equation. Instead the capital market transforms into the equation which is commonly called money market. Consequently, the problem discussed by Patinkin (1969) does in fact not emerge, if monetary policy is modeled in an institutionally correct way. This implies that it is not a real balance effect that restores a general equilibrium after a monetary shock, but a real credit effect. An economic explanation for this mathematical result is given and the effects of monetary policy in both versions of the model are shown to yield the conventional results. Finally, an empirically testable hypothesis of the real credit theory is presented.