Monetary instruments and policy rules in a rational expectations environment

This paper explores the implications of rational expectations and the aggregate supply theory advanced by Lucas (1973) and Barro (1976) for analysis of optimal monetary policy under uncertainty along the lines of Poole (1970), returning to a topic initially treated by Sargent and Wallace (1975). Not surprisingly, these two ‘classical’ concepts alter both the menu of feasible policy choice and the desirability of certain policy actions. In our setup, unlike that of Sargent and Wallace (1975), the systematic component of monetary policy is a relevant determinant of the magnitude of ‘business fluctuations’ that arise from shocks to the system. Central bank behavior — both the selection of monetary instruments and the framing of overall policy response to economic conditions — can work to diminish or increase the magnitude of business fluctuations. However, the ‘activist’ policies stressed by the present discussion bear little (if any) relationship to the policy options rationalized by the conventional analysis of monetary policy under uncertainty. In particular, in contrast to Poole's analysis, money supply responses to the nominal interest rate are not important determinants of real economic activity. Rather, the central bank should focus on policies that make movements in the general price level readily identifiable by economic agents.     

A wicksellian indicator of monetary policy

This paper compares actual U.S. monetary policy with an ideal policy based upon Wicksell's theory of natural and market rates of interest. For the period 1952–1971, this comparison indicates that actual policies behaved in a distinctly pro-cyclical manner with the result that monetary policies amplified the magnitude of the business cycles. The explanation offered suggests that this stems from the central bank's attempt to stabilize the interest rate which is consistent with one of the paper's findings of a highly significant positive relationship between changes in the natural rate of interest and changes in the monetary base.     

Monetary Policy Rules in an Open Economy with Heuristics: Which Model Is Best?

The choices of policy targets and the formation of agents’ expectation have been critical issues for reconsidering monetary policy management since 2008. The purpose of this article is to evaluate macroeconomic stability in a New Keynesian open economy in which agents experience cognitive limitations. The (im)perfect credibility of various monetary policies (e.g., a Taylor-type rule, strict domestic inflation targeting, strict CPI inflation targeting, exchange rate peg) may lead agents to react according to their expectation rules, and then create various degrees of booms and busts in output and inflation. Therefore, relaxation of the rational expectation hypothesis has potential consequences for policy designs. Our simulations confirm that the business cycles induced by animal spirits are enhanced by strict inflation targeting. Furthermore, a Taylor-type (CPI or domestic inflation) rule or a credible exchange rate pegging system can improve social welfare and stability in an open economy.     

The impact of COVID-19 pandemic on transmission of monetary policy to financial markets

This study uses event-study methodology to estimate the impact of the COVID-19 pandemic on the transmission of monetary policy to financial markets, based on a sample of 37 countries with severe pandemics. Financial markets include government bond, stock, exchange rate and credit default swap markets. The results suggest that the emergence of pandemic has weakened the transmission of monetary policy to financial markets to a more significant degree. During our sample period following the outbreak of pandemic, neither conventional nor unconventional monetary policies have significant effects on all four of the financial markets. Of course, the unconventional monetary policies are slightly more effective as they can affect the stock and exchange rate markets to some extent. Therefore, in the post-pandemic period, if the monetary policy is used to stimulate financial markets, stronger policy adjustments, or other macro policies such as fiscal policies, may be needed to achieve the desired effect     

The Pigou effect: An elaboration

The ‘Pigou effect’ has drawn the attention of monetary theorists for three decades. We argue in this paper that the nature and significance of Pigou's (1943, 1947) comments on Keynes have been frequently misinterpreted. In particular, we suggest that Pigou's logic implies not only that monetary policy will be successful in escaping unemployment in the liquidity trap situation, but also that it is a Pareto optimal means of doing so.     

Offsetting capital flows: A reexamination of the German case

According to Ricardo's law fixed exchange rates and perfectly integrated capital markets hinder the authorities of a small open economy to run an independent monetary policy. Any action will be completely offset by interest rate induced capital flows. The paper reexamines the German experience of the 'sixties. It is shown that the results of previous research that suggested a relatively high degree of offsetting do not hold. The evidence presented indicates that not more than about 50 percent of autonomous changes in the German monetary base were offset by interest rate induced capital flows during the same quarter     

Monetary Policy and Financial Markets

Monetary policy and financial markets are intrinsically linked. Central banks conduct monetary policy by influencing financial market prices. Financial market prices reflect the expectations of market participants about future economic and monetary developments. Monetary policy works primarily through expectations. Transparency and credibility render monetary policy more effective. However, they are no substitutes for action. If a credible central bank uses words with the explicit aim of substituting them for action, it will risk losing credibility. To avoid what has been described as “the dog chasing its tail” problem, central banks must exercise caution in basing their monetary policy decisions on financial market information. The information about expected future developments reflected in market prices must be continuously cross-checked against economic and monetary indicators in what amounts to a “checks and balances” approach to monetary policy.     

Does government ideology matter in monetary policy? A panel data analysis for OECD countries

This paper examines whether government ideology has influenced monetary policy in OECD countries. We use quarterly data in the 1980.1–2005.4 period and exclude EMU countries. Our Taylor-rule specification focuses on the interactions of a new time-variant index of central bank independence with government ideology. The results show that leftist governments have somewhat lower short-term nominal interest rates than rightwing governments when central bank independence is low. In contrast, short-term nominal interest rates are higher under leftist governments when central bank independence is high. The effect is more pronounced when exchange rates are flexible. Our findings are compatible with the view that leftist governments, in an attempt to deflect blame of their traditional constituencies, have pushed market-oriented policies by delegating monetary policy to conservative central bankers.     

Interest rate linkages within the EMS and bank credit supply

The exchange rates between the currencies of European Monetary System (EMS) members are essentially fixed between narrow bands mandated by the Exchange Rate Mechanism (ERM). the intent of such a fixed rate regime is to enhance policy co-ordination within the EMS. However, it has instead led to German policy dominance within the system according to several recent studies. We examine the optimal dynamic credit policy of a bank in an EMS country that is subject to such German ‘dominance’. Our stochastic control model reveals conditions under which German monetary policies can influence domestic bank lending behaviour. It also suggests that banks may be able to hedge such risk exposure by increasing in size. the model offers ‘credit supply' based explanations for recent regulatory reforms in Europe towards unified banking and the attempts of several EMS members to de-link their policies from that of the German Bundesbank.     

Oman's monetary policy transmission process under the fixed peg: some empirical puzzles

This paper highlights that an open economy, like Oman, could often enjoy partial monetary policy independence despite operating with a fixed peg, which may appear as a clear violation of the ‘macroeconomic trilemma'. While explaining the country-specific factors that create the scope for partial monetary policy independence, the paper underscores that for meaningful use of this partial monetary policy independence to attain domestic goals of inflation and output, the transmission mechanism of monetary policy must work effectively. Empirical analyses presented in this paper for Oman, however, suggest the presence of not only the ‘interest rate puzzle’ but also the ‘IS puzzle’ and the ‘Phillips curve puzzle’, which together signal the presence of significant transmission weaknesses. The paper, thus, concludes that costs stemming from loss of any monetary policy independence because of the fixed peg may not be very significant for Oman, and hence, any alternative exchange rate regime cannot be viewed as appropriate just on the grounds that an alternative regime could deliver greater monetary policy independence.     

Knut wicksell's norm of price stabilization and Swedish monetary policy in the 1930's

This paper examines the conduct and the effects of Swedish monetary policy in the 1930's. Three major conclusions emerge from the study: (1) The conduct of monetary policy specifically the devaluation of the Swedish currency in 1931 and the subsequent program of price stabilization, had a major effect on the aggregative behavior of the Swedish economy in the 1930's. (2) The impact of the new fiscal policy was insignificant compared to the effects of monetary measures and international developments. (3) The framing of Swedish monetary policy in the 1930's was strongly influenced by Wicksell's norm of price stabilization and the recommendations of the old generation of monetary economists represented by Gustav Cassel and Eli Heckscher.     

An optimum-currency-area odyssey

The theory of optimum-currency-areas was conceived and developed in three highly influential papers, written by (Mundell, 1961) and (McKinnon, 1963) and Kenen (1969). Those authors identified characteristics that potential members of a monetary union should ideally possess in order to make it feasible to surrender a nationally-tailored monetary policy and the adjustment of an exchange rate of a national currency. We trace the development of optimum-currency-area theory, which, after a flurry of research into the subject in the 1960s, was relegated to intellectual purgatory for about 20 years. We then discuss factors that led to a renewed interest into the subject, beginning in the early 1990s. Milton Friedman plays a pivotal role in our narrative; Friedman's work on monetary integration in the early 1950s presaged subsequent optimum-currency-area contributions; Mundell's classic formulation of an optimal currency area was aimed, in part, at refuting Friedman's “strong” case for floating exchange rates; and Friedman's work on the role of monetary policy had the effect of helping to revive interest in optimum-currency-area analysis. The paper concludes with a discussion of recent analytical work, using New Keynesian models, which has the promise of fulfilling the unfinished agenda set-out by the original contributors to the optimum-currency-area literature, that is, providing a consistent framework in which a country's characteristics can be used to determine its optimal exchange-rate regime.     

Complexities of Productivity Policies in the Finnish Public Sector: Knowing How to Do More with Less?

This paper examines public sector productivity policies as complexities between what is ‘known’ in policy principles and what is ‘done’ in everyday policy practice. Such complexities are explored in two productivity policy cases within Finnish local government: municipal amalgamations, and the low‐threshold concept of healthcare service. Utilising quantitative and qualitative data from Finnish local government the paper demonstrates the tensions between productivity policy principles, interpretations for productivity improvement (‘knowing’) and final outcomes for actually applying (‘doing’) productivity policy. The paper argues in favour of a new understanding for the research and practice of public policy and management.     

Monetary and exchange rate stability in South and East Asia

Regaining exchange rate stability has been a major monetary policy goal of East Asian countries in the aftermath of the 1997/98 currency crisis. While most countries have abstained from re-establishing a formal US Dollar peg, they have typically managed the US Dollar exchange rate de facto. We show that most of these countries were able to regain their monetary credibility within a relatively short time period. The Argentine crisis in 2001 caused a minor setback in this process for some countries. We measure the credibility of monetary policy by separating the fundamental and excess volatility of the exchange rate on the basis of a chartist-fundamentalist model. The degree of excess volatility is interpreted as the ability of the central bank to manage the exchange rate via the coordination channel.     

The CBO's policy analysis: An unquestionable misuse of a questionable theory

The analyses of fiscal and monetary policies that the Congressional Budget Office (CBO) provides Congress tend to be biased, encouraging the use of activist stabilization policies. The CBO's virtual neglect of economic uncertainties and its emphasis on very short time horizons make active policies appear much more attractive than its own model implies. Moreover, the CBO 's adoption of the macroeconometric approach fundamentally biases its analyses. Macroeconometric models do not remain invariant to changes in policy rules and are mute on the implications of alternative policies for efficiency and income distribution. The rational expectations equilibrium approach overcomes these difficulties and implies that less activist and less inflationary policies are desirable.     

Monetary versus fiscal policy in India: an SVAR analysis

Conventionally, the policymakers relied on three policy alternatives to manage business cycles – debt-financed government spending, debt-financed tax rebate and interest rate. While the first two are fiscal policy instruments, the latter is a monetary policy instrument. This paper aims to capture interactions among Indian monetary and fiscal policy actions, and the impact of such policy actions on select macroeconomic variables for the period 1990Q1–2011Q4. The policy actions are identified using the sign restrictions approach combined with magnitude restrictions in a Structural Vector Autoregression framework, and interpreted using impulse responses and variance decomposition. The results show that Indian monetary policy responds to tax rebate shocks and spending shocks differently. In the case of a tax rebate shock, Indian monetary policy responds by reducing interest rates thereby accommodating fiscal expansion. On the opposite, monetary policy seems not to accommodate expenditure shocks. Interestingly, the monetary policy shock is accompanied by a fiscal expansion that threatens the credibility of the central bank actions, thus indicating fiscal policy dominance. A comparison of the efficacy of the policies suggests that the interest rate is more effective in stimulating output. Out of the two fiscal policy instruments analysed, the tax rebate seems to be the better option for stimulating output considering the output-debt trade-off.     

开放经济下的“双支柱”调控稳定效应研究

本文研究了管理浮动汇率制下我国货币政策和宏观审慎政策双支柱的调控稳定效应。首先,本文从实证层面考察了人民币汇率升贬值对央行货币政策的非对称影响。接着,本文构建了包含银行部门与货币错配的开放宏观经济模型,重点分析了在面对美联储加息、人民币贬值压力的情况下,货币政策(包括对汇率的反应)和宏观审慎政策(对外债的逆周期调节)的配合如何影响宏观经济和金融的稳定。结论表明,如果缺少宏观审慎政策的配合,货币政策对汇率的反应将导致产出、通货膨胀和资产价格等经济金融变量的波动增大。在存在宏观审慎政策的前提下,相对于完全浮动汇率制,管理浮动汇率制从中长期看能进一步促进产出和外债等核心变量的稳定。     

Deconstructing credibility: The breaking of monetary policy rules in Brazil

Can political interference deconstruct credibility that was hardly-earned through successful stabilization policy? We analyze the recent switch in the conduct of monetary policy by the Central Bank of Brazil (BCB). Brazil is the largest Emerging Market Economy to formally target inflation, having adopted the Inflation Targeting (IT) regime in 1999. In the early years of IT, the BCB engaged in constructing credibility with price setting agents and succeeded to anchor inflation expectations to its target even under adverse conditions such as exchange rate crises. We argue that this effort to maintain IT rules-based policy ended in 2011, as a new country president and BCB board came to power. We then discuss the consequences of this credibility loss. Our main results can be summarized as follows: (i) we provide strong empirical evidence of the BCB’s shift toward looser, discretionary policy after 2011; (ii) preliminary evidence suggests that this shift has affected agents’ inflation expectations generating social and economic costs.     

Real exchange rate persistence and monetary policy rules

The objective of this paper is to analyze the effects of alternative monetary rules on real exchange rate persistence. Using a two-country stochastic dynamic general equilibrium with nominal price stickiness and local currency pricing, we will show how the persistence of purchasing power parity deviations can be related to a monetary theory of these deviations. When monetary policy lean against the wind, there is no relationship of proportionality between the time during which prices remain sticky and the persistence of the response of the real exchange rate: in this case high nominal price rigidity is not sufficient, per se, in generating any persistence following a monetary shock. Moreover, we emphasize the role of interest rates smoothing policies and relative price stickiness within countries in understanding the relationship between the real exchange rate and monetary shocks. With reasonable parameters values, a wide range of monetary policy rules can generate real exchange rate autocorrelations around the ones observed in the data.