Short-term Nominal Interest Rate Research Articles

Monetary Policy, Financial Stability, and the Zero Lower Bound

Much has happened in the world of central banking in the past decade. In this paper, I focus on three issues associated with the zero lower bound (ZLB) on short-term nominal interest rates and the nexus between monetary policy and financial stability: 1) whether we are moving toward a permanently lower long-run equilibrium real interest rate; 2) what steps can be taken to mitigate the constraints imposed by the ZLB; and 3) whether and how financial stability considerations should be incorporated in the conduct of monetary policy. These important topics deserve the attention of both academic and government professionals.

Determinants of the Movements in the Euro-Dollar Exchange Rate During the Sovereign Debt Crisis

We identify the drivers of the movements in the euro-dollar exchange rate during the sovereign debt crisis. In particular, we show that the announcement of outright monetary transactions (OMT) by the Governing Council of the ECB during the summer of 2012 played a major role in the euro’s subsequent appreciation. OMT and the reform efforts undertaken by governments at national and European level saw off the risk of a euro-area break up and prompted net capital inflows. We estimate two models. The first is a reduced form high-frequency model, in which the exchange rate is explained by the differentials between interest rates in euros and dollars at both short- and long-term horizons, the sovereign spread in euro-area countries and an index of volatility. The second is a vector autoregressive (VAR) model including GDP growth differentials, short-term nominal interest rate differentials and inflation differentials between the euro area and the U.S., an average of the sovereign spreads of selected euro-area countries, the bilateral trade balance and the euro-dollar nominal exchange rate. Both approaches suggest that the evolution of the sovereign spread supported the value of the euro following the announcement of OMT in the summer of 2012.

Los productos financieros derivados y la política monetaria: evidencia para la Reserva Federal (2000-2015)

While the use of money market derivative products was increasing, many research studies were published on how derivative products affect the implementation of monetary policies. In the theoretical framework of an interest rate forecasting model (Taylor rules), we will use the generalised method of moments (GMM) to compare the influence of financial derivative products over the Federal monetary policy carried out from the year 2000 to 2015. By means of this analysis we may conclude that the implicit volatility of the derivatives markets is an explanatory variable of the behaviour of the short-term nominal interest rate.

The Macroeconomic Effects of Low and Falling Inflation at the Zero Lower Bound

This paper assesses the macroeconomic consequences of a prolonged period of low and falling inflation when monetary policy is constrained by the zero lower bound (ZLB) on short-term nominal interest rates, the private sector is indebted in nominal terms (debt deflation mechanism) and nominal wages are downward rigid. Cost-push shocks that in normal circumstances would reduce inflation and stimulate output have contractionary effects on economic activity, once the ZLB interacts with the debt deflation mechanism. The contractionary effects are larger and more persistent when nominal wages cannot be reduced and when the private sector is highly indebted.

Asset allocation and monetary policy: Evidence from the eurozone

The eurozone has a single short-term nominal interest rate, but monetary policy conditions measured by real short-term interest rates varied substantially across countries in the period 2003–2010. We use this cross-country variation in the (local) tightness of monetary policy to examine its influence on equity and money market flows. In line with a powerful risk-shifting channel, we find that fund investors in countries with decreased real interest rates shift their portfolio investment out of the money market and into the riskier equity market, causing significant equity price inflation in countries where investment home bias is the strongest.

Nominal GDP Targeting and the Taylor Rule on an Even Playing Field

Some economists have advocated nominal GDP targeting as an alternative to the Taylor Rule. These arguments are largely based on the idea that nominal GDP targeting would require less knowledge on the part of policymakers than a traditional Taylor Rule. In particular, a nominal GDP targeting rule would not require real-time knowledge of the output gap. We examine the importance of this claim by amending a standard New Keynesian model to assume that the central bank has imperfect information about the output gap and therefore must forecast the output gap based on previous information. Forecast errors by the central bank can then potentially induce unanticipated changes in the short term nominal interest rate, distinct from a standard monetary policy shock. We show that forecast errors of the output gap by the Federal Reserve can account for up to 13% of the fluctuations in the output gap. In addition, our simulations imply that a nominal GDP targeting rule would produce lower volatility in both inflation and the output gap in comparison with the Taylor Rule under imperfect information.

Sustainable monetary policy and inflation expectations

AbstractThe short-term nominal interest rate can anchor private-sector expectations into low inflation – more precisely, into the best equilibrium reputation can sustain. I introduce nominal asset markets in an infinite horizon version of the Barro-Gordon model and characterize the subset of sustainable policies compatible with any given asset price system at date

Unveiling Special Policy Regime, Judgment And Taylor Rules In Tunisia

<p>Given limited research on monetary policy rules in revolutionary countries, this paper challenges the suitability of the Taylor rule in characterizing the monetary policy behavior of the Tunisian Central Bank (BCT), especially in turbulent times.</p><p> </p><p>More specifically, we investigate the possibility that the Taylor rule should be formulated as a threshold process and examine the validity of such nonlinear Taylor rule as a robust rule for conducting monetary policy in Tunisia.</p><p> </p><p>Using quarterly data from 1998:Q4 to 2013:Q4 to analyze the movement of nominal short-term interest rate of the BCT, we find that the nonlinear Taylor rule improves its performance with the advent of special events providing thus a better description of the Tunisian interest rate setting. In particular, our results show that the adoption of an appropriate nonlinear approach leads to a reduction in the errors of 150 basis points in 1999 and 2009, and 60 basis points in 2011, relative to the linear approach.</p>

Assessing nonlinear dynamics of Central Bank reaction function: the case of MENA countries

Empirical evidence suggests that the Taylor rule describing the interest rate setting behavior of four keyMENA central banks (Tunisia, Egypt, Jordon and Morocco) is non-linear. This is achieved using an empirical framework that allows for regime change over time or more specifically the time variance in the model parameters. Using quarterly data from 2000:Q2 to 2014:Q3 to analyze the movement of nominal short-term interest rate of MENA central banks, we find strong evidence that the real decision-making process followed by these central banks varies from one central bank to another and that it exhibits nonlinearity. In particular, considerations about economic growth (for Morocco), inflation (for Jordon), stability of REER rate (in Egypt) and concerns about hitting the zero lower bound of the nominal interest rate (in the cases of Tunisia) seem to be the major drivers of such nonlinear pattern of monetary policy.

New-Keynesian economics: An AS–AD view

A simple New-Keynesian model is set out with AS–AD graphical analysis. The model is consistent with modern central banking, which targets short-term nominal interest rates instead of money supply aggregates. This simple framework enables us to analyze the economic impact of productivity or mark-up disturbances and to study alternative monetary and fiscal policies.The framework is also suitable for studying a liquidity-trap environment, the economics of debt deleveraging, and possible solutions.The impact of the fiscal multipliers on output and the output gap can be quantified. During normal times, a short-run increase in public spending has a multiplier less than one on output and a much smaller multiplier on the output gap, while a decrease in short-run taxes has a positive multiplier on output, but negative on the output gap. When the economy is depressed because some agents are deleveraging, fiscal policy is more powerful and the multiplier can be quite big.In the AS–AD graphical view, optimal policy simplifies to nothing more than an additional line, IT, along which the trade-off between the objective of price stability and that of stabilizing the output gap can be optimally exploited.

Interest Rates, Policy Uncertainty, and Investment

In this paper, I estimate a cointegrated VAR with three long run equilibrium conditions that are consistent with the New Keynesian model. The equilibrium conditions estimated in the VAR do not provide evidence of a negative relationship between the federal funds rate and investment, or output more generally. Economic policy uncertainty, however, does have a negative and statistically significant effect on investment in the estimated model. I argue that the results support an option theory view of investment rather than the standard New Keynesian model. Also, various specifications of the model demonstrate that the findings are robust to an alternative short term nominal interest rate, the use of real interest rates rather than nominal interest rates, different classifications of investment, different measures of economic uncertainty, and a different specification of the monetary policy process. In addition, I argue that the results have implications for the weak recovery in the aftermath of the Great Recession. In particular, the results suggest that the increase in economic policy uncertainty observed after 2007 can potentially explain the weak recovery whereas the results cast doubt on the significance of the zero lower bound on nominal interest rates.

Zero Lower Bounds in New Keynesian Models and a Constrained Ramsey Problem

There exist difficulties in escaping from stagnation and/or deflation if the economy hits zero lower bounds on short-term nominal interest rates because the central bank cannot stimulate the economy further using rate cuts. How can it escape from them? Answering the question, we extend a closed-looped solution of a Ramsey problem (also known as a Stackelberg problem) by introducing zero lower bounds. Herein, we formulate a constrained Ramsey problem and derive a solution for it. In our extension, we found that the discounted Lyapunov equation is necessary to obtain the shadow price of the economy that hits the zero lower bounds. Herein we apply our method to new Keynesian models with zero lower bounds. Our simulation shows that committing to mild inflation engenders positive effects on the economy and that managing inflation expectations is necessary to escape from the bounds.

Estimating Interest Rate Setting Behavior in Brazil: A LSTR Model Approach

Given limited research on monetary policy rules in emerging markets, this paper challenges the applicability of a nonlinear Taylor rule in characterizing the monetary policy behavior of the Brazilian Central Bank. It also investigates whether and how the process of setting interest rates has been developed in response to contingencies and special events. We extend the linear Taylor rule to a regime-switching framework, where the transition from one regime to another occurs in a smooth way, using a Logistic Smooth Transition Regression (LSTR) approach. In this sense, we empirically analyze the movement of the nominal short term interest rate of the Brazilian Central Bank using quarterly data, covering the period 1994.Q4–2012.Q2. We find that the nonlinear Taylor rule provides a better description of the Brazilian interest rate setting and is consistent with historical macroeconomic events. In particular, our results show that adopting a nonlinear specification, instead of the linear, leads to a costs reduction in terms of fit: 190 basis points in 1995 and 140 basis points in the mid-2002 presidential election campaign in Brazil. Moreover, the Brazilian monetary policy exhibits nonlinear patterns that better captures special events and may contain relevant information rendering it applicable to unusual conditions, i.e., a financial crisis, which require disconnection from the automatic pilot rule and use of judgement to make decision.

Irrational Expectations and Econometric Practice Discussion of Orphanides and Williams, 'Inflation Scares and Forecast-Based Monetary Policy'

Abstract: Athanasios Orphanides and John C. Williams' excellent conference paper, Inflation Scares and Forecast-Based Monetary Policy, contributes importantly to the new and rapidly growing branch of the literature on bounded rationality and learning in macroeconomics. Their paper, like many others, derives interesting and useful theoretical results that show how the introduction of bounded rationality and learning impacts on the effects of monetary policy shocks and the characteristics of optimal monetary policy rules. This note suggests that some additional empirical work--some irrational expectations econometrics, if you will--might serve to make these purely theoretical results seem more relevant and convincing. Irrational Expectations and Econometric Practice Discussion of Orphanides and Williams, Inflation Scares And Forecast-Based Monetary Policy 1 Irrational Expectations ... Athanasios Orphanides and John C. Williams' excellent conference paper, Inflation Scares and Forecast-Based Monetary Policy, takes as one of its starting points the observation that many central banks around the world devote considerable resources towards producing their own, internal macroeconomic forecasts and towards monitoring private, external macroeconomic forecasts. And, moreover, monetary policy actions taken by central banks around the world often appear to be driven, at least in part, by changing internal and private macroeconomic forecasts. Within the Federal Reserve System, for example, the Greenbook--which presents the macroeconomic forecasts generated by the Federal Reserve Board sta.-serves as one of the principal documents guiding the policy deliberations at each meeting of the Federal Open Market Committee. Orphanides and Williams' paper takes its second starting point another observation: that most contemporary models of the monetary business cycle attach no special importance to macroeconomic forecasts in the design of monetary policy rules. To see where this result comes from, and why it holds true so generally, consider a very simple model in which, for some reason, the central bank decides to set its policy instrument, the short-term nominal interest rate [r.sub.t] at time t, as a linear function of expected or forecasted output [y.sup.e.sub.t+1] and inflation [[pi].sup.e.sub.t+1] at time t + 1, according to the policy rule [r.sub.t] = [[alpha].sub.y][y.sup.e.sub.t+1] + [[alpha].sub.[pi]][[pi].sup.e.sub.t+1], (1) where [[alpha].sub.y] and [[alpha].sub.[pi]] are coefficients chosen by the central bank that measure the sensitivity of the interest rate response to movements in expected output and inflation. Next, suppose that the structure of this simple model implies that the forecasts [y.sup.e.sub.t+1] and [[pi].sup.e.sub.t+1] of output and inflation at time t + 1 are optimally constructed as linear functions of the actual levels of output and inflation at time t, so that [y.sup.e.sub.t+1] = [[beta].sub.y][y.sub.t] + [[beta].sub.[pi]][[pi].sub.t] (2) and [[pi].sup.e.sub.t+1] = [[delta].sub.y][y.sub.t] + [[delta].sub.[pi]][[pi].sub.t], (3) where the reduced-form parameters [[beta].sub.y], [[beta].sub.[pi]], [[delta].sub.y], and [[delta].sub.[pi]] may depend in potentially complicated ways on the model's underlying structural parameters describing private agents' tastes and technologies as well as on the parameters of the monetary policy rule (1). Optimal forecasting rules take the linear form exhibited by (2) and (3) not just in this simple model but in any member of the broad class of linear or linearized rational expectations models that have been developed and used in the literature on monetary economics over the past quarter century. In more complicated models, additional lags of output and inflation as well as additional lags of other endogenous variables besides output and inflation may appear in the optimal forecasting rules. …

Monetary Policy Normalization in the United States

Because of the Federal Reserve’s unconventional approaches to monetary policy during the Great Recession and recovery, the Fed now finds itself in an unconventional situation. Short-term nominal interest rates have been close to zero for more than six years, and the Fed’s balance sheet is currently more than four times as large as in 2007. This article explains how and why the Fed got into this situation and the challenges this creates in returning Fed policy to “normal”—a state in which the Fed’s nominal interest rate target is above zero and its balance sheet is reduced in size.

Forecasts from Reduced-Form Models Under the Zero-Lower-Bound Constraint

In this paper, I consider forecasting from a reduced-form VAR under the zero lower bound (ZLB) for the short-term nominal interest rate. I develop a method that a) computes the exact moments for the first n + 1 periods when n previous periods are tracked and b) approximates moments for the periods beyond n + 1 period using techniques for truncated normal distributions and approximations a la Kim (1994). I show that the algorithm produces satisfactory results for VAR systems with moderate to high persistence even when only one previous period is tracked. For very persistent VAR systems, however, tracking more periods is needed in order to obtain reliable approximations. I also show that the method is suitable for affine term-structure modeling, where the underlying state vector includes the short-term interest rate as in Taylor rules with inertia.

Monetary Policy in Small Open Economies: The Role of Exchange Rate Rules

Understanding the costs and benefits of alternative monetary policy rules is important for economic welfare. Within the context of a small open economy model and building on the work of Mihov and Santacreu (2013), the author analyzes the economic implications of two monetary policy rules. The first is a rule in which the central bank uses the nominal exchange rate as its policy instrument and adjusts the rate whenever there are changes in the economic environment. The second is a standard interest rate rule in which the central bank adjusts the short-term nominal interest rate to changes in the economic environment. The main finding of the analysis is that, if the uncovered interest parity condition that establishes a tight link between the interest rate differential in two countries and the expected rate of depreciation of their currencies does not hold, the exchange rate rule outperforms the standard interest rate rule in lowering the volatility of key economic variables. There are two main reasons for this: First, the actual implementation of the exchange rate rule avoids the overshooting effect on exchange rates characteristic of an interest rate rule. And second, the risk premium that generates deviations from the uncovered interest parity condition is smaller and less volatile under an exchange rate rule.

Monetary Policy in Small Open Economies: The Role of Exchange Rate Rules

Understanding the costs and benefits of alternative monetary policy rules is important for economic welfare. Within the context of a small open economy model and building on the work of Mihov and Santacreu (2013), the author analyzes the economic implications of two monetary policy rules. The first is a rule in which the central bank uses the nominal exchange rate as its policy instrument and adjusts the rate whenever there are changes in the economic environment. The second is a standard interest rate rule in which the central bank adjusts the short-term nominal interest rate to changes in the economic environment. The main finding of the analysis is that, if the uncovered interest parity condition that establishes a tight link between the interest rate differential in two countries and the expected rate of depreciation of their currencies does not hold, the exchange rate rule outperforms the standard interest rate rule in lowering the volatility of key economic variables. There are two main reasons for this: First, the actual implementation of the exchange rate rule avoids the overshooting effect on exchange rates characteristic of an interest rate rule. And second, the risk premium that generates deviations from the uncovered interest parity condition is smaller and less volatile under an exchange rate rule.

A Structural Analysis of Central Banks Final Objectives Prioritization. The Case of Central and Eastern European States

This paper aims to identify the actual objectives of monetary authorities in Central and Eastern Europe (CEE) that promote an independent monetary policy. In this sense we consider the study of central banks (CBs) behavior in the Czech Republic, Poland, Romania and Hungary in establishing short-term nominal interest rate by estimating a Taylor-type monetary policy rule, with new features in terms of elements aimed at exploring the interactions between the monetary policy and financial stability. We estimate the monetary policy rule based on a dynamic structural stochastic general equilibrium model (DSGE). The main results revealed the strong orientation of the monetary authorities subject to analysis towards their fundamental objective of price stability, but in parallel, to the stabilization of the exchange rate and real economic activity. Inserting into the Taylor-type rule of financial stability-related variables has allowed us to highlight the existence of specific items that indicate a ‘leaning against the wind’ orientation of monetary policy in CEE countries.

Interest rates and structural shocks in European transition economies

European transition economies are still suffering from negative implications of economic crisis. Significant decrease in the key interest rates was followed by reduced maneuverability of central banks in providing incentives into real economies. Low interest rate environment together with effects of quantitative easing induced economists to examine sources of interest rates volatility. Responsiveness of short-term interest rates to the structural shocks provides unique platform to investigate sources of their unexpected volatility and associated effects on monetary policy decision making. Moreover, sources of interest rates volatility may help to reveal side effects of the exchange rate regime choice. Empirical investigation of interest rates determination under different exchange rate regimes highlights substantial implications of relative exchange rate diversity and its importance during the crisis period. In the paper we analyze sources of the short-term nominal interest rates volatility in ten European transition economies by employing SVAR methodology. We observed unique patterns of the short-term interest rates responsiveness in countries with different exchange rate arrangements that contributes to the fixed versus flexible exchange rate dilemma.