Supply side inflation persistence

We explore the role of the cost channel in accounting for inflation persistence in the New Keynesian model with Calvo pricing. Hump-shaped responses of inflation to monetary shocks are obtained under purely nominal rigidities.     

Inflation and interest rates in the presence of a cost channel,wealth effect and agent heterogeneity

As far as the control of inflation is concerned, the interest rate is the most important monetary instrument. This paper examines the effectiveness of the interest rate policy in controlling inflation. The model utilized in this paper considers both demand and supply side effects of interest rate policy. These effects are used to derive not only the relevant impulse response functions but also the welfare loss to the society that arises from the supply side shocks. Based on their ability to control inflation and minimization of the overall welfare loss to the society, three policies are compared: (i) monetary policy with commitment, (ii) Taylor's rule, and (iii) inflation targeting. We argue that, in the presence of a cost channel, it is imperative that the interest rate policy is used with restraint. Our results also suggest that ignoring the cost channel of monetary policy can lead to significant under-estimation of the social welfare loss.     

Macroeconomic transitions and the transmission mechanism: Evidence from Turkey

This paper investigates changes to the macroeconomic transmission mechanism in Turkey following a major reform of monetary policy in the early 2000s. We use a Threshold VAR (TVAR) framework to test for and then estimate a model with endogenous transitions between regimes. We detect two regimes, with a clear transition between them in 2003–4. The pre-reform regime is characterized by high inflation, passive monetary policy and persistent responses to shocks. The post-reform regime is characterized by low inflation, active and credible monetary policy and markedly less persistent responses to shocks. Using a model that contains sufficient variables to capture diverse transmission mechanisms, working through the real exchange rate, domestic credit and monetary policy, we find evidence of sharp changes in transmission mechanisms. Post-reform, the response of Turkey to macroeconomic shocks has changed to be similar to those in other modern, market-orientated economies.     

Monetary Policy in Russia: Identifying exchange rate shocks

Russian monetary policy has failed persistently to achieve sustained low inflation, both in absolute terms and relative to the peer group of countries similarly exiting from Soviet-style central planning. This paper explores the reasons for this state of affairs by analysing the kind of monetary policy that has been pursued by the central bank during the period 1995 to 2009. Our contribution is to search for a possible transmission channel between the real interest rate, inflation rate, exchange rate, output growth and foreign reserve growth, after having controlled for the effect of oil price inflation. Using a vector autoregressive model in error-correction form and using sign restrictions methodology, we show that the monetary authorities’ failure to abate double-digit inflation appears to be driven by the policy of exchange rate targeting, as reflected in our identified exchange rate shocks.     

Financial frictions and optimal stabilization policy in a monetary union

Financial frictions differ across countries and thus cause international differences in the transmission of shocks. This paper shows how the optimal mix of monetary and fiscal policy depends on these country-specific financial frictions. To this end, we build a two-country DSGE-model of a monetary union. Financial frictions are captured by the cost channel approach. We show that the traditional solution to the assignment problem – the common central bank stabilizes the inflation rate at the union level and the national fiscal authorities stabilize the national economies – does not hold in a world with financial frictions. The cost channel decreases the efficiency of monetary policy and increases the need for fiscal stabilization even at the union level. Moreover, the more heterogeneous the union, the more important is fiscal policy in stabilizing shocks. Finally, we evaluate the scenarios in terms of welfare of the representative household.     

Price and liquidity puzzles of a monetary shock: Evidence from indebted African economies

Price and liquidity puzzles have been identified as two major counterintuitive findings arising from monetary shocks. We investigate their presence in eleven African countries, using a dynamic stochastic general equilibrium model designed for indebted small open-economies. Our simulations reveal that the majority of African countries report a price puzzle whereas only three countries exhibit liquidity effect. In many of the sampled countries, a positive money growth shock drives interest rates up, but consumption and output fall in contrast to the conventional view. External debt increases in response to money growth shock, exchange rate appreciates and inflation falls. Money growth shocks are transmitted to the economy through the exchange rate channel when uncovered interest rate parity condition holds. Our findings therefore appear to suggest that monetary policy in Africa should prioritize foreign debt stabilization by reacting more to output gap than to inflation.     

On the feasibility of monetary union: Does it make sense to look for shocks symmetry across countries when none of the countries constitutes an optimum currency area?

Usually, a monetary union is not considered feasible between countries if the correlations of shocks are positive but weak. This may not be so if the country with the larger output gap converges to full-employment equilibrium faster than the country with the smaller gap. We argue that common monetary policy can be destabilizing when countries' responses to non-monetary shocks are perfectly symmetric with a correlation of 1 but exhibit differing investment sensitivities to the real interest rate. We use Canada, Mexico and the United States to test the feasibility of a monetary union by documenting whether: 1) gross investments in Canada and Mexico are equally responsive to the real fund rate, and 2) Canada and Mexico's output growth and inflation respond differently to US monetary policy shocks and oil price shocks. This approach implicitly dictates whether the shocks themselves are symmetric or asymmetric. Using quarterly data and SVAR methodology, we conducted two layers of analysis. We estimated SVARs for the periods 1970–2008, 1970–1990 and 1991–2008 to find that a monetary union is feasible between Canada and the US for the first two sample periods. For Canada and Mexico, we find similar responses of output growth to US monetary policy shocks. We conducted further robustness tests by estimating two identified VARs with common US variables and oil prices for Canada and Mexico to assess commonality in responses to shocks with the US. These results affirm that a monetary union is also feasible between Canada and the US.     

Macroeconomic dynamics in Macedonia and Slovakia: Structural estimation and comparison

This paper estimates a structural macroeconomic model using data for Macedonia and Slovakia to characterize possible challenges Macedonia can face concerning macroeconomic stabilization during its transition process. A comparison of the estimated model parameters suggests that, in Slovakia, the output gap is less sensitive to real interest rate movements and prices experience greater inertia. The estimated monetary policy reaction functions show Macedonia and Slovakia as inflation targeters, with Macedonia as the more conservative one, despite its officially applied exchange rate targeting regime. The differences in the estimated parameters imply differing transmission mechanisms for Macedonia and Slovakia. Consequently, the variance of domestic variables in Slovakia is most influenced by monetary policy shocks, while there is no single dominating shock explaining the volatility of Macedonia's macroeconomic variables. The exchange rate shock, the monetary policy shock and the demand shock are jointly important in determining the volatility of Macedonia's variables. The model simulations indicate that Macedonia experiences lower output gap and inflation volatility than Slovakia. This comes, nevertheless, at the cost of higher interest rate and real exchange rate volatility in Macedonia, which could be an indication of more volatile financial markets with possible negative implications for financial stability.     

External monetary shocks and monetary integration: Evidence from the Bulgarian currency board

Starting July the 1st 1997, Bulgaria adopted a Currency Board (CB) monetary system. This paper aims at investigating if the adoption of the CB monetary system, which involves the cost of losing monetary autonomy, has provided a relatively better (with respect to other CEEC) monetary integration of Bulgaria with the European Monetary Union (EMU). Since Bulgarian monetary variables are endogenous under a CB, we focus on the ECB and FED interest rates as the main sources on monetary volatility. First, we find that ECB shocks are more rapidly absorbed and have less significant impact of domestic variables, with respect to other external monetary shocks (FED rate changes). Second, the responses of Bulgarian variables following changes in the ECB interest rate present lower persistence and significance, with respect to what the previous literature emphasized for other CEEC with monetary autonomy. This latter result still holds when accounting for different sources of cross-country heterogeneity outlined in the literature, thus supporting that the adoption of the CB may have worked as a rather good device in terms of integration of Bulgaria into the EMU.     

“Ex-ante” Taylor rules and expectation forming in emerging markets

The success of monetary policy in stabilizing inflation depends substantially on its influence on expectation formation of private agents. This paper provides a novel perspective on the expectation forming process of financial markets. Using forecasts for the short-term interest rate, the inflation rate, and output growth for 10 emerging markets in Latin-America, central and eastern Europe, we estimate expected (“ex-ante”) Taylor-type rules. We find evidence for significant differences in the expectation formation process in the sense that the well-known Taylor principle fairly holds for only some countries, while for the other countries it does not. The adaption of an explicit inflation targeting regime seems to explain this cross-country differences.     

Cross‐country asymmetries in monetary policy transmission: evidence from EMU members

This paper analyzes monetary policy asymmetries in EMU participating countries. In particular, we use a structural dynamic modelling approach to investigate asymmetric monetary transmission in Europe. Asymmetries are investigated in two different ways. First, we restrict the estimated structural models reflecting the monetary constraints each country faced during the EMS period. We obtain well‐behaved and comparable effects of monetary policy shocks. Second, efficiency frontiers for the selected EMU countries are estimated. In computing the optimal combinations of output gap and inflation volatility we use a weighted average of interest rate and exchange rate, i.e. the Monetary Condition Index (MCI), as a policy instrument. The impulse response analysis implemented with the MCI shows relatively small differences in the responses of the real economy to monetary policy shocks. Altogether the results suggest that, no matter which policy instrument is used, output gap and inflation respond to identical monetary shocks with a similar speed and movement, albeit with a different degree of effect.     

Does monetary policy credibility mitigate the fear of floating?

Based on the argument that monetary policy credibility can reduce the fear of floating, we analyze this hypothesis for a set of 47 countries (of which, 32 are developing countries, 26 are Inflation Targeting countries and 16 are Inflation Targeting developing countries). Our study is the first to empirically assess the impact of monetary policy credibility (defined as the central bank's ability to anchor inflation expectations to the target) on the central banks' reaction through the basic interest rate due to exchange rate fluctuations (fear of floating). Based on panel data methodology applied to different samples, the most important result of this paper is that monetary policy credibility is able to mitigate the fear of floating. However, this effect is weaker after the crisis. Our estimates also reveal that Inflation Targeting developing countries present stronger fear of floating, which is justified by the fear of inflation in these countries.     

Productivity Shocks and Monetary Policy in a Two-Country Model

In this paper, we examine the effects of foreign productivity shocks on monetary policy in a symmetric open economy. Our two-country model incorporates the New Keynesian features of price stickiness and monopolistic competition based on the cost channel of Ravenna and Walsh (2006). In particular, in response to asymmetric productivity shocks, firms in one country achieve a more efficient level of production than those in another economy. Because the terms of trade are directly affected by changes in both economies’ output levels, international trade creates a transmission channel for inflation dynamics in which a deflationary spiral in foreign producer prices reduces domestic output. When there is a decline in economic activity, the monetary authority should react to this adverse situation by lowering the key interest rate. The impulse response function from the model shows that a productivity shock can cause a real depreciation of the exchange rate when economies are closely integrated through international trade.     

Do asymmetries matter for European monetary policy?

In this paper we analyze the impact of economic and institutional (ECB decision rules) asymmetries on the effectiveness of monetary policy in Euroland. We consider a model where asymmetric shocks and divergent propagation of shocks in output and inflation are potential causes of tensions within the ECB concerning the conduct of common monetary (interest rate) policy. Welfare implications of the alternative decision procedures are discussed.     

Financial market imperfections and monetary policy strategy

In a model with imperfect money, credit and reserve markets, we examine if an inflation-targeting central bank applying the funds rate operating procedure to indirectly control market interest rates also needs a monetary aggregate as policy instrument. We show that if private agents use information extracted from money and financial markets to form inflation expectations and if interest rate pass-through is incomplete, the central bank can use a narrow monetary aggregate and the discount interest rate as independent and complementary policy instruments to reinforce the credibility of its announcements and the role of inflation target as a nominal anchor for inflation expectations. This study shows how a monetary policy strategy combining inflation targeting and monetary targeting can be conceived to guarantee macroeconomic stability and the credibility of monetary policy. Friedman's k-percent money growth rule, which can generate dynamic instability, and two alternative stabilizing feedback monetary targeting rules are examined.     

Monetary policy through the ‘credit-cost channel’: Italy and Germany pre- and post-EMU

We present an empirical analysis of the ‘Credit-Cost Channel’ (CCC) of monetary policy transmission. This channel combines bank credit supply and interest rates on loans as a cost to firms. The thrust of the CCC is that it makes both aggregate demand and aggregate supply dependent on monetary policy. As a consequence (1) credit market conditions (e.g. risk spreads) are important sources and indicators of macroeconomic shocks, (2) the real effects of monetary policy are larger and persistent. We have applied the Cointegrated Vector Autoregression (CVAR) econometric methodology to Italy and Germany in the ‘hard’ EMS period and in the European Monetary Union (EMU) period. The short-run and long-run effects of the CCC are detectable for both countries in both periods. Simulation of the estimated model also confirms that inflation-targeting by way of inter-bank rate control stabilizes inflation through structural shifts of the stochastic equilibrium paths of both inflation and the output.     

Effects of mineral-commodity price shocks on monetary policy in developed countries

This article investigates effects of changes in mineral commodity prices on monetary policy. Using macroeconomic data from three mineral-producing countries (Australia, Canada and New Zealand) and two non-mineral-resource countries (USA and UK), I estimate the impulse response functions of the policy interest rates and the core consumer price index (CPI) inflation rates to mineral-commodity price shocks. I find that the central banks in both groups of the examined countries significantly respond to mineral-commodity price shocks. In responses to an unexpected 10% increase in mineral commodity prices, the central banks are estimated to increase their policy interest rates by approximately 0.8 percentage points. Moreover, the central banks seem to take anticipatory policy reactions to control core CPI variations triggered by these shocks. Thus, mineral commodity prices would act as important determinants of the monetary policies in both groups of the examined countries. These findings would be useful for analysing Taylor rules in their countries. However, effects of the increase in their policy interest rates on core CPI inflation cannot be identified for the examined countries.     

Compatibility between monetary and fiscal policy under EMU

The debate over the Stability and Growth Pact (SGP) as a part of European Monetary Union, has highlighted the need to assess the extent to which fiscal policies of union members should be constrained as a pre-requisite for price stability within the union. In this paper, we develop a two country open economy model, where each country has overlapping generations of finitely lived consumers who supply labour to imperfectly competitive firms which can only change their prices infrequently. We examine the case where the two countries have formed a monetary union, but where the fiscal authorities remain independent. We show that the fiscal response required to ensure stability of the real debt stock is greater when consumers are not infinitely lived. In principle, this allows for some compensating behaviour between governments, but we show that the scope for compensation is limited. The monetary authority can abandon its active targeting of inflation to stabilise the debt of at most one fiscal authority, and any other combination of policies will either result in price level indeterminacy and/or indefinite transfers of wealth between the two economies. Finally, in a series of simulations we show that fiscal shocks have limited impact on output and inflation provided the fiscal authorities meet the (weak) requirements of fiscal solvency. However, when monetary policy is forced to abandon its active targeting of inflation, then fiscal shocks have a much greater impact on both output and inflation.     

Inflation Targeting: Some Extensions

Previous analyses of the implementation of inflation targeting are extended to monetary policy responses to different shocks, consequences of model uncertainty, and effects of interest rate smoothing and stabilization. Model uncertainty, output stabilization, and interest rate stabilization or smoothing all call for a more gradual adjustment of the conditional inflation forecast toward the inflation target. The conditional inflation forecast is the natural intermediate target during inflation targeting. The optimal way of reacting to shocks is hence to check how they affect the inflation forecast and then take the appropriate action.
JEL classification : E 42; E 52; E 58     

Forward-looking monetary policy and anticipated shocks to inflation

This paper extends a standard New Keynesian model to describe the effects of anticipated shocks to inflation and forward-looking monetary policy. Using the data generated from this modified model suggests that overlooking these two factors in the standard Cholesky structural vector autoregressive identification scheme will generate a price puzzle. Furthermore, this paper demonstrates that failing to account for these two factors may result in significant estimates of two other explanations of the price puzzle—the cost channel of transmission of monetary policy and indeterminacy due to violation of the Taylor principle—even though neither features in the data generating process.