Time-varying Inflation Target Research Articles

NEWS SHOCKS AND THE EFFECTS OF MONETARY POLICY

Traditionally identified monetary shocks in a structural vector autoregression (SVAR) model typically result in long-lasting effects on output and total factor productivity (TFP). In this paper, I argue that the typical monetary shock has been confounded with the news shock about future technology. I propose and implement a novel SVAR approach that effectively “cleans” the technology component from the traditional Cholesky monetary shock. With the new identification, I find that a monetary shock exerts smaller and less persistent effects on output and the level of measured TFP than a traditionally identified monetary shock. Finally, I show that the SVAR impulse responses can be replicated by augmenting the standard New Keynesian model with a time-varying inflation target and a non-Ricardian fiscal policy regime.

Trend Fundamentals and Exchange Rate Dynamics

We estimate a multivariate unobserved components-stochastic volatility model to explain the dynamics of a panel of six exchange rates against the US dollar. The empirical model is based on the assumption that both countries' monetary policy strategies may be well described by Taylor rules with a time-varying inflation target, a time-varying natural rate of unemployment, and interest rate smoothing. The estimates closely track major movements along with important time-series properties of the real and nominal exchange rates across all currencies considered. The model generally outperforms a simple benchmark model that does not account for changes in trend inflation and trend unemployment.

Trend Fundamentals and Exchange Rate Dynamics

We estimate a multivariate unobserved components stochastic volatility model to explain the dynamics of a panel of six exchange rates against the US Dollar. The empirical model is based on the assumption that both countries' monetary policy strategies may be well described by Taylor rules with a time-varying inflation target, a time-varying natural rate of unemployment, and interest rate smoothing. The estimates closely track major movements along with important time series properties of real and nominal exchange rates across all currencies considered. The model generally outperforms a benchmark model that does not account for changes in trend inflation and trend unemployment. (authors' abstract)

Heterogeneous Expectations and Uncertain Inflation Target

We analyze a new Keynesian economy populated by adaptive-learning agents with heterogeneous beliefs about the time-varying inflation target. A fraction of agents is assumed to have a full and updated information set including the permanent and temporary component of the inflation target at the current period, while the remainder of agents receives a signal and use it to estimate the target components solving a Kalman filter problem. The proportion of the two strategies is endogenous and depends on a measure of past performance of predictors. We conduct stochastic simulations to assess whether different hypotheses about the information regime may affect macroeconomic stability in the short and in the long run. We find that a smaller proportion of agents using costly information is associated to larger expected losses. Nevertheless, the fraction of agents following this strategy drops signficantly in the aftermath of a shock to the inflation target because the Kalman signal extraction procedure allows to follow more closely the actual dynamics of the economy.

Macroeconomic effects of inflation target uncertainty shocks

We study the macroeconomic effects of a time-varying inflation target (IT), which stochastic volatility follows an autoregressive process. We show that the quantitative economic effects of IT uncertainty shocks depend crucially on the Taylor-rule type adopted by the monetary authority. Following this kind of disturbance, a less severe recession and deflation is observed under a more reactive interest rate rule, while an empirical plausible degree of interest rate smoothing leads output, unemployment, and inflation to react more strongly causing the recession to be more severe and deflationary.

News Shocks and the Effects of Monetary Policy

Traditionally identified monetary shocks in a structural vector autoregression (SVAR) model typically result in long-lasting effects on output and total factor productivity (TFP). In this paper, I argue that the typical monetary shock has been confounded with the news shock about future technology. I propose and implement a novel SVAR approach that effectively ``cleans'' the technology component from the traditional Cholesky monetary shock. With the new identification, I find that a monetary shock exerts smaller and less persistent effects on output and the level of measured TFP than a traditionally identified monetary shock. The new identification also predicts a ``Fisherian'' effect that an unanticipated rise in the interest rate increases inflation. The novel empirical findings can reconcile some conflicting results in the SVAR literature and hence lead to a better understanding of the effects of monetary policy. Finally, I show that the standard New Keynesian model is not fully consistent with the empirical evidence uncovered by the novel SVAR method. However, the SVAR impulse responses can be replicated by augmenting the standard New Keynesian model with a time-varying inflation target and a non-Ricardian fiscal policy regime.

Monetary Policy, Inflation Target and the Great Moderation: An Empirical Investigation

This paper compares the empirical fit of a Taylor rule featuring constant versus time-varying inflation target by estimating a Generalized New Keynesian model under positive trend inflation while allowing for indeterminacy. The estimation is conducted over two different periods covering the Great Inflation and the Great Moderation. We find that the rule embedding time variation in target inflation turns out to be empirically superior and determinacy prevails in both sample periods. Counterfactual simulations point toward both `good policy' and `good luck' as drivers of the Great Moderation. We find that better monetary policy, both in terms of a more active response to inflation gap and a more anchored inflation target, has resulted in the decline in inflation gap volatility and predictability. In contrast, the reduction in output growth variability is mainly explained by reduced volatility of technology shocks.

Money and business cycle: Evidence from India

In this paper we take a New Keynesian model with non-separable money in utility to Indian data using maximum likelihood. The identification problem in isolating the effect of money on output and inflation is solved by adjusting real balances for shifts in money demand. Estimates with an extended model with relevant features like partial indexation in prices, markup shock and time varying inflation target, show that real balances do affect output and inflation even after correcting for money demand unlike results for the United States and Eurozone. A regression estimate and multivariate structural vector autoregression give similar results. Types of money matter. Reserve money has the largest impact, pointing to the importance of the informal sector. The estimated income elasticity of narrow money is more than twice that of broad money, pointing to the dependence of firms on banks. Interest semi elasticity of money demand is close to one. Responsiveness of output to real interest rate is high. We find that interest rate setting is quite persistent. Coefficient of lagged interest rate varies from 0.71 to 0.95. We conclude that there is a significant asymmetry in the role of money in India (an emerging economy) in comparison to United States and Eurozone (advanced economies).

TIME-VARYING COEFFICIENT TAYLOR RULE AND CHINESE MONETARY POLICY: EVIDENCE FROM THE TIME-VARYING COINTEGRATION

(ProQuest: ... denotes formulae omitted.)1.INTRODUCTIONThe Chinese economy, known as the miracle, has maintained steady and fast growth for three decades, and attracts much attention from scholars and practitioners. Unlike Eastern European countries, China undergoing a gradual market-oriented reform in which its economic structure and regime are changing slowly and smoothly. For this reason, it is of great importance to study whether existing economic theory can be applied to China. In macroeconomics, the proposed by Taylor (1993), is an important monetary policy that specifies how the US Federal Reserve should adjust its targeted interest rate to the inflation and output gaps. Studying the validity of the Taylor rule for China is theoretically and practically important.There is a vast literature on the Taylor rule. For example, Taylor (1999) studied the validity of the Taylor rule using historical data covering 1897 to 1914 and 1955 to 1997, finding that the deviation of the actual interest rate from the targeted interest rate could help reflect the effectiveness of monetary policy. Kim and Nelson (2006) proposed a time-varying parameter forward-looking monetary policy rule and provided an efficient estimation using the Kalman filter. Yuksel, Metin-Ozcan, and Hatipoglu (2013) introduced an interest rate pass-through specification of the monetary transmission process in a general Taylor model. Xie and Luo (2002) were the first to check the validity of the Taylor rule for China, finding that it was a good measure for Chinese monetary policy and provided a reference for Chinese monetary policy implementation. However, Bian (2006) showed that the Taylor rule was unstable in China by using the GMM and cointegration test approach. Zheng and Liu (2010) developed a regime-switching Taylor rule with a time-varying inflation target, and showed that the Chinese monetary policy rule could be significantly divided into passive and active regimes.As Osterholm (2005) pointed out, however, previous studies ignored the nonstationarity of the variables in the Taylor rule model, despite the enormous body of literature. On one hand, the variables might not be stationary processes. Given the variable's unit root behavior, the cointegration relationships among them become essential for regression modeling. In the absence of cointegation, the model would be a spurious regression. On the other hand, the traditional fixed coefficient cointegration approach assumes a constant long-run equilibrium relationship among the variables, thus failing to capture the dynamic structure of the equilibrium relationship. China's gradual reform process is leading to a smooth structural change in the relevant economic variable and market, such as stock markets (Huang et al., 2000) and interest rate. For example, China is gradually carrying out interest rate liberalization. First, inter-bank lending and bond markets were deregulated in 1996; then, the ceiling on deposit rates and the floor on lending rates of commercial banks were relaxed; then, the Shanghai Interbank Offered Rate (Shibor) became China's benchmark rate in 2007; and then, the lending interest rate was completely decontrolled in 2013. Accordingly, this paper considers the smooth and gradual structural change occurring in China rather than abrupt structural breaks.This paper develops a time-varying coefficient Taylor rule to study China's monetary policy. Given the nonstationarity of the model's variables, the paper employs the time-varying cointegration approach of Park and Hahn (1999). To the best of our knowledge, this paper is the first to examine the Taylor rule through the time-varying cointegration approach. Kim and Nelson (2006) also considered the time-varying coefficient Taylor rule, but failed to consider the nonstationarity of the variables. By using several unit root tests, we found that the interest rate, the inflation gap and the output gap are indeed nonstationary. …

POLICY RULES, REGIME SWITCHES, AND TREND INFLATION: AN EMPIRICAL INVESTIGATION FOR THE UNITED STATES

This paper estimates Taylor rules featuring instabilities in policy parameters and switches in policy shocks’ volatility for the post-World War II (WWII) U.S. economy. We contrast a rule embedding a fixed-inflation target with another featuring trend inflation, i.e., a time-varying inflation target. The rule embedding trend inflation turns out to be (a) empirically superior according to a marginal likelihood-based comparison and (b) more able to pin down some relevant episodes of the post-WWII U.S. monetary policy history. Estimates conducted with Greenbook data confirm the empirical superiority of the rule featuring a time-varying inflation target. A comparison with recently published estimates of trend inflation is also conducted.

Policy Regimes, Policy Shifts, and U.S. Business Cycles

Using an estimated DSGE model that features monetary and fiscal policy interactions and allows for equilibrium indeterminacy, we find that a passive monetary and passive fiscal policy regime prevailed in the pre-Volcker period while an active monetary and passive fiscal policy regime prevailed post-Volcker. Since both monetary and fiscal policies were passive pre-Volcker, there was equilibrium indeterminacy that gave rise to self-fulfilling beliefs and resulted in substantially different transmission mechanisms of policy as compared to conventional models: unanticipated increases in interest rates increased inflation and output while unanticipated increases in lump-sum taxes decreased inflation and output. Unanticipated shifts in monetary and fiscal policies however, played no substantial role in explaining the variation of inflation and output at any horizon in either of the time periods. Pre-Volcker, in sharp contrast to post-Volcker, we find that a time-varying inflation target does not explain low-frequency movements in inflation. Finally, in a counterfactual exercise, we show that had the monetary policy regime of the post-Volcker era been in place pre-Volcker, inflation volatility would have been lower by 36% and the rise of inflation in the 1970s would not have occurred.

Policy Regimes, Policy Shifts, and U.S. Business Cycles

Using an estimated DSGE model that features monetary and fiscal policy interactions and allows for equilibrium indeterminacy, we find that a passive monetary and passive fiscal policy regime prevailed in the pre-Volcker period while an active monetary and passive fiscal policy regime prevailed post-Volcker. Since both monetary and fiscal policies were passive pre-Volcker, there was equilibrium indeterminacy that gave rise to self-fulfilling beliefs and resulted in substantially different transmission mechanisms of policy as compared to conventional models: unanticipated increases in interest rates increased inflation and output while unanticipated increases in lump-sum taxes decreased inflation and output. Unanticipated shifts in monetary and fiscal policies however, played no substantial role in explaining the variation of inflation and output at any horizon in either of the time periods. Pre-Volcker, in sharp contrast to post-Volcker, we find that a time-varying inflation target does not explain low-frequency movements in inflation. A combination of shocks account for the dynamics of output, inflation, and government debt, with the relative importance of a particular shock quite different in the two time-periods due to changes in the systematic responses of policy. Finally, in a counterfactual exercise, we show that had the monetary policy regime of the post-Volcker era been in place pre-Volcker, inflation volatility would have been lower by 34% and the rise of inflation in the 1970s would not have occurred.

Inflation Dynamics: The Role of Public Debt and Policy Regimes

We investigate the roles of a time-varying inflation target and monetary and fiscal policy stances on the dynamics of inflation in a DSGE model. Under an active monetary and passive fiscal policy regime, inflation closely follows the path of the inflation target and a stronger reaction of monetary policy to inflation decreases the equilibrium response of inflation to non-policy shocks. In sharp contrast, under an active fiscal and passive monetary policy regime, inflation moves in an opposite direction from the inflation target and a stronger reaction of monetary policy to inflation increases the equilibrium response of inflation to non-policy shocks. Moreover, a weaker response of fiscal policy to debt decreases the response of inflation to non-policy shocks. These results are due to variation in the value of public debt that leads to wealth effects on households. Finally, under a passive monetary and passive fiscal policy regime, both monetary and fiscal policy stances affect inflation dynamics, but because of a role for self-fulfilling beliefs due to equilibrium indeterminacy, theory provides no clear answer on the overall behavior of inflation. We characterize these results analytically in a simple model and numerically in a richer quantitative model.

Measuring Inflation Persistence: A Structural Time Series Approach

Time series estimates of inflation persistence incur an upward bias if shifts in the inflation target of the central bank remain unaccounted for. Using a structural time series approach we measure different sorts of inflation persistence allowing for an unobserved time-varying inflation target. Unobserved components are identified using Kalman filtering and smoothing techniques. Posterior densities of the model parameters and the unobserved components are obtained in a Bayesian framework based on importance sampling. We find that inflation persistence, expressed by the half-life of a shock, can range from 1 quarter in case of a cost-push shock to several years for a shock to long-run inflation expectations or the output gap.

Nonlinearity in monetary policy: A reconsideration of the opportunistic approach to disinflation

The proponents of the ‘opportunistic’ approach to disinflation suggest that, when inflation is close to the target, the central bank should not counteract inflationary pressures. Orphanides and Wilcox (2002) formalize this idea through a simple policy rule that prescribes a nonlinear adjustment to a history-dependent target for inflation. This embodies a regime change in monetary policy, which reacts to inflation only when this is far from the inflation target. Here we study the opportunistic approach in a New-Keynesian model with sizeable nominal and real rigidites in the form of a positive money demand and adjustment costs for investment. We find that the welfare gains delivered by the opportunistic rule arise from the time-varying inflation target, when welfare is measured by a quadratic approximation of household utility. The nonlinear zone of inaction on inflation improves welfare outcomes only when a central bank loss function with the absolute value of the output gap is used, as proposed by Orphanides and Wilcox (2002).

Testing the Structural Interpretation of the Price Puzzle with a Cost Channel Model

We estimate a new-Keynesian DSGE model with the cost channel to assess its ability to replicate the price puzzle ie the inflationary impact of a monetary policy shock typically arising in VAR analysis. In order to correctly identify the monetary policy shock, we distinguish between a standard policy rate shifter and a shock to trend inflation ie the time-varying inflation target set by the Fed. While offering some statistical support to the cost channel, our estimated model clearly implies a negative inflation reaction to a tightening of monetary policy. We offer a discussion of the possible sources of mismatch between the VAR evidence and our own.

Excess Sensitivity and Volatility of Long Interest Rates: The Role of Limited Information in Bond Markets

Asymmetric information between the central bank and bond markets creates an inference problem that affects the behaviour of long interest rates. This paper employs a simple macroeconomic model with a time-varying inflation target to illustrate the implications of asymmetry for the sensitivity of long rates and volatility of bond returns. When the central bank's inflation target is not communicated and macroeconomic shocks are imperfectly observed, bond markets infer the value of the target from noisy signals. This heightens the sensitivity of long-run inflation expectations to transitory shocks, thereby raising the measured reaction of long rates to monetary policy and to inflation surprises. Calibrated coeffcients from such regressions are more than twice as large when bondmarkets lack knowledge of the target compared with a full information scenario. Time variation in the inflation target is the main source of volatility, but learning adds to the ability of the model to explain the observed volatility of returns along the yield curve.

Timing Transitions Between Determinate and Indeterminate Equilibria in an Empirical DSGE Model: Benefits and Implications

We extend Lubik and Schorfheide's (2004) likelihood-based estimation of dynamic stochastic general equilibrium (DSGE) models under indeterminacy to encompass a sample period including both determinacy and indeterminacy by implementing the change-point methodology (Chib, 1998). This feature is useful because DSGE models generally are estimated with data sets that include the Great Inflation of the 1970s and the surrounding low inflation periods. Timing the transitions between determinate and indeterminate equilibria is one of the key contributions of this paper. Moreover, by letting the data provide estimates of the state transition dates and allowing the estimated structural parameters to be the same across determinacy states, we obtain more precise estimates of the differences in characteristics, such as the impulse responses, across the states. In particular, we find that positive interest rate shocks were inflationary under indeterminacy. While the change-point treatment of indeterminacy is applicable to all estimated linear DSGE models, we demonstrate our methodology by estimating the canonical Woodford model with a time-varying inflation target. Implementation of the change-point methodology coupled with Tailored Metropolis-Hastings provides a highly efficient Bayesian MCMC algorithm. Our prior-posterior updates indicate substantially lower sensitivity to hyperparameters of the prior relative to other estimated DSGE models.

The Role of Sticky Prices in an Open Economy Dsge Model: A Bayesian Investigation

In this paper we use a Dynamic Stochastic General Equilibrium (DSGE) model for an open economy to examine the role of sticky prices in explaining the joint behaviour of inflation and a fairly large set of macroeconomic variables. We find that price stickiness is an important feature for firms active in the domestic, export and import sectors, even though the model embodies variable capital utilisation, a working-capital channel and a time-varying inflation target. We also document that price stickiness in all sectors is important even if the markup shocks are allowed to be autocorrelated, although the implied average contract duration falls substantially under this assumption. (JEL: E40, E50, C11)

Measuring Inflation Persistence: A Structural Time Series Approach

Using a structural time series approach we measure different sorts of inflation persistence allowing for an unobserved time-varying inflation target. Unobserved components are identified using Kalman filtering and smoothing techniques. Posterior densities of the model parameters and the unobserved components are obtained in a Bayesian framework based on importance sampling. We find that inflation persistence, expressed by the half life of a shock, can range from 1 quarter in case of a cost-push shock to several years for a shock to long-run inflation expectations or the output gap.