Does money have a role in the inflation process? Evidence from Australia

Inflation, defined as a sustained increase in the price level, is considered a monetary phenomenon, as it can be explained within the framework of money‐demand and money‐supply relationships. In the extant literature, money growth is shown to remain causally related to inflation across countries and over time, irrespective of the exchange rate regime and stability of the money‐demand function. Nevertheless, emerging literature suggests a diminishing role of money in the conduct of monetary policy for price stability, especially under inflation targeting. Monetary policy in Australia under inflation targeting since 1993 is an example of policy that denies a relationship between money growth and inflation. The proposition that money does not matter insofar as inflation is concerned seems odd in both theory and the best‐practice monetary policy for price stability. This paper uses annual data for the period 1970–2017 and quarterly data for the period 1970Q1–2015Q1. It deploys both the Johansen cointegration approach and the autoregressive distributed lag (ARDL) cointegration approach to investigate for Australia whether money, real output, prices and the exchange rate (non‐stationary variables) maintain the long‐run price‐level relationship that the classical monetary theory suggests in the presence of such stationary variables as the domestic and foreign interest rates. As expected, the empirical findings for Australia are consistent with the classical long‐run price‐level relationship between money, real output, prices and the exchange rate. The error‐correction model of inflation confirms the presence of a cointegral relationship among these variables; it also provides strong evidence of a short‐run causal relationship between money supply growth and inflation. On the basis of a priori theoretical predictions and empirical findings, the paper draws the conclusion that the monetary aggregate and its growth rate matter insofar as inflation is concerned, irrespective of the strategy of monetary policy for price stability.     

MODELLING DEMAND FOR BROAD MONEY IN AUSTRALIA*

The existence of a valid long‐run money demand function is still important for the conduct of monetary policy. It is argued that previous work on the demand for money in Australia has not been very satisfactory in a number of ways. This paper examines the long‐ and short‐run determinants of the demand for broad money employing the Johansen cointegration technique. Using quarterly data for the period 1976:3–2002:2, this paper finds, inter alia, that the demand for broad money is cointegrated with real income, the rate of return on 10‐year Treasury bonds, the cash rate and inflation. It appears that a disequilibrium in the demand for money can affect the efficacy of interest rate policy in the long run via its impact on future output growth and output gap.     

Monetary transmission mechanism in Turkey under the monetary conditions index: an alternative policy rule

This study analyses monetary transmission mechanism in Turkey using a small structural macroeconomic model. The core equations of the model consist of aggregate demand, wage-price setting, uncovered interest rate parity, foreign sector and a monetary policy rule. The aim of the paper is to analyse the disinflation path, the output gap, the output level, the exchange rate and the interest rate, and also the output–inflation variance frontier of the economy under various scenarios. The first scenario assumes that a standard Taylor rule is implemented as the policy rule. In the alternative scenario, instead of the standard Taylor rule, the MCI, Monetary Conditions Index – combination of the changes in the short-term real interest rate and in the real effective exchange rate in a single variable – is used as a policy instrument. The results indicate that the economy stabilizes much more quickly and shows significantly less volatility under this new setting. Therefore, the paper concludes that the policymakers should consider using MCI as an instrument when conducting monetary policy.     

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.     

Eurosystem monetary targeting: Lessons from U.S. data

Using a small empirical model of inflation, output, and money estimated on U.S. data, we compare the relative performance of monetary targeting and inflation targeting. The results show monetary targeting to be quite inefficient, yielding both higher inflation and output variability. This is true even with a nonstochastic money demand formulation. Our results are also robust to using a P∗ model of inflation. Therefore, in these popular frameworks, there is no support for the prominent role given to money growth in the Eurosystem's monetary policy strategy.     

The role of the exchange rate in Canadian monetary policy: evidence from a TVP-BVAR model

A time-varying parameters Bayesian structural vector autoregression (TVP-BVAR) model with stochastic volatility is employed to characterize the monetary policy stance of the Bank of Canada (BoC) in terms of an interest rate rule linking the policy rate to the output gap, inflation and the exchange rate. Using quarterly bilateral Canadian–US data, we find such an interest rate rule to have little explanatory power for the early part of our sample starting in the mid-1980s, but to become more suitable to explain interest rate dynamics from the mid-1990s onwards. Whereas the exchange rate turns out to be the major determinant of the policy rate in the 1980s, its importance declines throughout the 1990s and 2000s, although it continues to be influential even towards the end of the sample period ending in 2015Q2. We also find interest rate shocks to have become more effective in influencing the macroeconomy over time, indicating that the BoC has continually gained monetary policy credibility. We associate this development with the BoC successively de-emphasizing the role of the exchange rate in informing interest rate decisions, thereby alleviating the potential monetary policy conflict between targeting the exchange rate and maintaining the price stability goal.     

A classroom experiment in monetary policy

The authors propose a classroom experiment implementing a simple version of a New Keynesian model suitable for courses in intermediate macroeconomics and money and banking. Students play as either the central bank or members of the private sector. The central banker sets interest rates to meet twin objectives for inflation and the output gap or to meet only an inflation target. In both settings, private sector agents are concerned with correctly forecasting the inflation rate. The authors show that an experiment implementing this setup is feasible and yields results that enhance understanding of the New Keynesian model of monetary policy. They propose alternative versions where the central bank is replaced by a policy rule and provide suggestions for discussing the experimental results with students.     

Exchange rate,price, and output inter-relationships in Ghana: evidence from vector autoregressions

This paper explores the dynamic inter-relationships among the currency exchange rate, consumer price inflation, and real output growth, as well as the roles of money and interest rates in output and price determination. Time series data and vector autoregression models are used. Results suggest that there are significant inter-relationships between the exchange rate and inflation, monetary shocks matter only when explaining money itself and the price level, and interest rate-dependent monetary policies in the absence of financial modernization are ineffective     

Impact of foreign prices and interest rates on canadian economy under alternative monetary and exchange rate regimes

The main objective of this paper is to analyze the impact of U.S. short- and long-term monetary policy under both flexible and managed floating systems, using the new CANDIDE Model 2.0. We have also examined the role of domestic monetary policy in the Canadian economy under both fixed and flexible exchange rate systems. The following are some of the important findings of our study:

1. Our results support the traditional view that under the fixed exchange rate regime, monetary authorities cannot successfully pursue an independent monetary policy from its trading partners — an effort to increase money supply will be almost offset by increases in the balance of payments deficit. In contrast, in the flexible exchange rate regime, monetary policy is more effective in producing an increased growth in output and employment. However the increased output growth comes at the cost of higher prices induced by increased wages and a depreciation of the Canadian dollar.
2. Our results suggest that the impact of U.S. interest rates on investment, GNE, employment, productivity, and government debt is less severe in a pure floating exchange rate regime, compared to the managed floating system. However, the impact of U.S. interest rate policy on the Canadian inflation rate is worse in the case of flexible exchange rate regime. Even though real income and inflation are less favourable in both cases, our results indicate a trade-off between output growth and inflation.
3. Our results imply that under a pure floating monetary authorities can determine the long-run rate of inflation in Canada independent of others. However, the United States and Canadian economies are interrelated during the adjustment process, even under the flexible exchange rates, through the terms of trade and the wage-price spiral channels.

     

Stability of Money Demand and Monetary Policy in Papua New Guinea (PNG): An Error Correction Model Analysis

An error correction model (ECM) is used to study the Properties of money demand and to evaluate the appropriate monetary policy in PNG. The study confirms that the determinats of money demand are real GDP, nominal interest and inflation rate. The income elasticity of money demand is very low. The demand for money in PNG was stable during 1979-95, suggesting that the monetary targeting regime by the PNG Central Bank is feasible. However, as PNG proceeds with economic reforms that Includes financial sector reform and a floating exchange rate regime, the stability of the demand for money may have to be re-examined periodically. The best approach for conducting the monetary policy in PNG is to target the inflation rate. [E41, E52, C22]     

How justified is abandoning money in the conduct of monetary policy in Australia on the grounds of instability in the money‐demand function?

The role of money in the design and conduct of monetary policy has reemerged as an important issue in both advanced and developing economies, especially since the 2007 global financial crisis. A growing body of recent literature suggests that the causal relationship between money supply growth and inflation remains intact across countries and over time and that this relation is not conditional on the stability of the money‐demand function or whether money is endogenous or exogenous. Moreover, critical for a rule‐based monetary policy is the presence of a long‐run stable money‐demand function, rather than a short‐run money‐demand model that may exhibit instability for many reasons, including problems with estimating a money‐demand model with high‐frequency data. Provided that a stable money‐demand function exists, it could be useful to establish long‐run equilibrium relations among money, output, prices, and exchange rates, as the classical monetary theory suggests. Within this analytical framework, this paper addresses the question of whether money has any role in the conduct of monetary policy in Australia. The conventional wisdom is that the money‐demand function in Australia has been unstable since the mid‐1980s due to financial deregulation and reforms; this led to a change in the strategy of monetary policy for price stability in the form of inflation targeting that ignores money insofar as inflation and its control are concerned. This paper reports empirical findings for Australia, obtained from a longer quarterly data series over the period 1960Q1–2015Q1, which suggest that instability in the narrow‐money‐demand function in Australia was primarily due to the exclusion of variables which have become important in the deregulated environment since the 1980s. These findings are confirmed by an expanded form of the narrow‐money‐demand function that was found stable over the past two decades, although it experienced multiple structural breaks over the study period. The paper draws the conclusion that abandoning the monetary aggregate as an instrument of monetary policy in Australia, under a rule‐based monetary policy such as inflation targeting, cannot be justified by instability in the money‐demand function or even by lack of a causal link between money supply growth and inflation.     

The Taylor rules and macroeconomic fluctuation in China: 1994–2006

The correlation and controllability of money supply as the intermediate object of monetary policy is gradually weakening, the argument that interest rate substitutes the money supply for the alternative object is hotly discussed. According to the Taylor rule and its extensions, this paper has a positive analysis on the efficiency of Taylor-type rules in China through historical analysis, policy reaction function approach and co-integration technology of time series analysis. This paper draws a conclusion that Taylor rule is unstable in China, and less correlation can be found between interest rate and the output gap, and the central bank focus on the inflation target rather than economic growth. Therefore, the central bank should abide by the simple rule of inflation targeting.     

Inflation volatility,economic growth and monetary policy in Bangladesh

This article provides an overview of the trends and movements of CPI-inflation in Bangladesh since the early 1950s and examines the key issues in rule-based monetary policy for price stability, implying low and stable inflation, in this country. Under a fixed exchange rate system, inflation in Bangladesh was moderately high and volatile during the 1950s and 1960s. Since the country’s independence from Pakistan in 1971, inflation in Bangladesh has remained moderately high on average and highly volatile and persistent under a fixed-pegged exchange rate system or under a managed floating system since 2003. Using data from the early 1970s or earlier depending on data availability, the article undertakes both Granger-causality and the structural vector autoregression (SVAR) analysis with two models. The first model is comprised of such variables as inflation, the real interest rate, the real exchange rate and output growth, and the second model is comprised of the volatilities of money growth, real output growth and inflation. Then, based on the empirical findings, the article concludes that a rule-based monetary policy, namely monetary targeting or inflation targeting, remains appropriate for Bangladesh provided that it adopts a more flexible, if not freely floating, exchange rate system. The article suggests that the use of monetary policy to achieve multiple objectives under a fixed-pegged exchange rate system creates a time-inconsistency problem, reduces monetary policy credibility and makes it (monetary policy) ineffective in lowering inflation and its volatility. Low credibility of monetary policy in particular raises inflation persistence. Within the present monetary-policy framework in Bangladesh, the article illustrates how the fixed-pegged exchange rate system has generated money growth volatility in the presence of large-scale inflows of overseas workers’ remittances and readymade garments export earnings. This does not seem to be a concern of the central bank of Bangladesh (Bangladesh Bank); rather, it (Bangladesh Bank) pursues monetary-base targeting to keep inflation low and stable after considering economic growth. The consequent diminishing credibility of monetary policy has kept inflation volatile and persistent, which has adversely affected economic growth.     

Fiscal and monetary effects on environmental quality,growth, and welfare

This paper examines the effect of fiscal and monetary policies on economic growth, inflation, environmental quality, and welfare. To this end, the horizontal-R&D growth model is extended to include pollution generated in the intermediate-goods production, and the demand for money through cash-in-advance (CIA) constraints on intermediate-goods production and R&D investment. Fiscal policy embodied in the taxation of pollution decreases output, profits, inflation, and wages in the intermediate-goods sector, reallocating labor to R&D that is the engine of economic growth. As it reduces pollution, it increases welfare if there are strong preferences for a clean environment. In turn, since the inflation rate is an increasing function of the nominal interest rate, the effects of changes in this monetary policy variable extend to the effects of changes in the inflation rate. An increase in the nominal interest rate penalizes employment, wages and output in the R&D sector relatively more if the respective CIA constraint is more demanding and thus economic growth decreases. As it also reduces pollution since decreases intermediate-goods production, it increases welfare if the preferences for a clean environment are strong enough.     

A stable demand for money despite financial crisis: the case of Venezuela

The demand for broad money in Venezuela is investigated over a period of financial crisis and substantial exchange rate fluctuations. The analysis shows that there exist a long-run relationship between real money, real income, inflation, the exchange rate and an interest rate differential, that remains stable over major policy changes and large shocks. The long-run properties emphasize that both inflation and exchange rate depreciations have negative effects on real money demand, whereas a higher interest rate differential has positive effects. The long-run relationship is finally embedded in a dynamic equilibrium correction model with constant parameters. These results have implications for a policy-maker. In particular, they emphasize that with a high degree of currency substitution in Venezuela, monetary aggregates will be very sensitive to changes in the economic environment.     

Monetary policy: Why money matters (and interest rates don’t)

Since the late 1980s the Fed has implemented monetary policy by adjusting its target for the overnight federal funds rate. Money’s role in monetary policy has been tertiary, at best. Indeed, several influential economists suggest that money is irrelevant for monetary policy because central banks affect economic activity and inflation by (i) controlling a very short-term nominal interest rate and (ii) influencing financial market participants’ expectation of the future policy rate. I offer an alternative perspective: Money is essential for monetary policy because it is essential for controlling the price level, and the monetary authority’s ability to control interest rates is greatly exaggerated.     

Monetary policy reactions and the exchange rate: a regime-switching structural VAR for Canada

The objective of this study is to identify monetary policy reactions in a nonlinear, structural vector autoregression (VAR) framework, with regime-switching contemporaneous policy responses in a small open economy. The key finding is that monetary policy in Canada responds contemporaneously to disturbances in the real exchange rate, as well as the output gap and inflation. The Bank of Canada is found to have much larger responses to exchange rate fluctuations during volatile periods than more stable periods. However, the Bank is found statistically to have a relatively linear reaction function with symmetric responses to output and inflation shocks across interest rate regimes. The estimates for the contemporaneous responses to the output gap in both regimes are found to be virtually identical to the 0.5 weights in the original Taylor rule for the United States, while the responses to inflation surprises are slightly smaller. Overall, the Bank of Canada is found to have operated within the range of optimal responses suggested by small-scale structural models in the normative literature on monetary policy rules.     

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.     

Does the Reserve Bank of Australia follow a forward-looking nonlinear monetary policy rule?

ABSTRACT

The conventional monetary policy rule describes a simple linear relationship between the domestic interest rate, inflation rate and output gap. An important extension to this rule is to incorporate the forward-looking behaviour of central banks, where it is assumed that they target an expected level of inflation instead of its current realised value. Using quarterly observations for the period 1993:1-2018:2, this paper investigates whether the conduct of monetary policy in Australia can be described by a forward-looking linear monetary policy rule, or by a nonlinear forward-looking monetary policy rule. In particular, the nonlinear forward-looking monetary policy rule is analysed in a regime-switching framework using a smooth logistic transition regression model. While the results show that the conventional forward-looking linear monetary policy rule describes the application of monetary policy in Australia reasonably well, the interest rate setting behaviour of the RBA is best described by a nonlinear forward-looking monetary policy rule.     

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.