The inflationary bias of real uncertainty and the harmonic Fisher equation

Summary. We argue that real uncertainty itself causes long-run nominal inflation. Consider an infinite horizon cash-in-advance economy with a representative agent and real uncertainty, modeled by independent, identically distributed endowments. Suppose the central bank fixes the nominal rate of interest. We show that the equilibrium long-run rate of inflation is strictly higher, on almost every path of endowment realizations, than it would be if the endowments were constant.Indeed, we present an explicit formula for the long-run rate of inflation, based on the famous Fisher equation. The Fisher equation says the short-run rate of inflation should equal the nominal rate of interest less the real rate of interest. The long-run Fisher equation for our stochastic economy is similar, but with the rate of inflation replaced by the harmonic mean of the growth rate of money.Received: 25 February 2005, Revised: 26 May 2005, JEL Classification Numbers: C7, C73, D81, E41, E58.An earlier version of this paper “Inflationary Bias in a Simple Stochastic Economy,” as a 2001 Cowles Foundation Discussion Paper No. 1333.     

Stabilizations, crises and the “exit” problem – A theoretical model

Exchange-rate-based stabilizations, even if successful, usually lack credibility initially. This is reflected in high (ex post) real interest rates and some degree of real exchange rate appreciation. Empirical observation suggests that wage inflation declines smoothly over time whilst interest rates are volatile. Our model captures these features and provides insights into: the eruption of exchange rate crises after a long period of apparently successful stabilization; the potential advantages of a heterodox approach; when to delay a stabilization attempt; and the optimal date for “exit” to a floating exchange rate.     

The optimal neglect of inflation: An alternative interpretation of UK monetary policy during the “Great Moderation”

This paper argues that UK monetary policymakers did not respond to the inflation rate during most of the “Great Moderation” that ran from the early 1990s to the mid-2000s. We derive a generalisation of the New Keynesian Phillips curve in which inflation is a non-linear function of the output gap and show that the optimal response of the policy rule to inflation depends on the slope of the Phillips curve; if this is flat, manipulation of aggregate demand through monetary policy does not affect inflation and so policymakers cannot affect inflation. We estimate the monetary policy rules implied by a variety of alternative Phillips curves; our preferred model is based on a Phillips curve that is flat when output is close to equilibrium. We find that policy rates do not respond to inflation when the output gap is small, a situation that characterised most of the “Great Moderation” period.     

China’s monetary policy: Quantity versus price rules

Two monetary policy rules, the money supply (quantity) rule and interest rate (price) rule, are explored for China in a dynamic stochastic general equilibrium model. The empirical results seem to indicate that the price rule is likely to be more effective in managing the macroeconomy than the quantity rule, favoring the government’s intention of liberalizing interest rates and making a more active use of the price instrument. Moreover, the economy would have experienced less fluctuations had interest rate responded more aggressively to inflation.     

The Optimal Inflation Tax

We determine the second best rule for the inflation tax in monetary general equilibrium models where money is dominated in rate of return. The results in the literature are ambiguous and inconsistent across different monetary environments. We derive and compare the optimal inflation tax solutions across the different environments and find that Friedman's policy recommendation of a zero nominal interest rate is the right one.Journal of Economic LiteratureClassification Numbers: E31, E41, E58, E62.     

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     

Monetary Disequilibrium, Endogenous Money, Stability and the Determinacy of Inflation

This paper examines the stability of the disequilibrium money model, with endogenous money and transitory interest rate control by the Central Bank. In the tradition of the post-Keynesian literature, the money supply is determined by bank lending and disequilibrium between money demand and supply determines the business cycle. The rate of interest is assumed to react to an inflation target and inflation responds to the business cycle. The paper examines the stability of the model under three inflation response systems: the accelerationist model, adaptive expectations and rational expectations.
(J.E.L.: E3, E4, E5).     

Monetary policy rules with PID control features: evidence from the UK,USA and EU

ABSTRACT

This paper considers the extent to which the monetary policy operations of three major central banks can be regarded as an application of Proportional-Integral-Derivative (PID) control rules. The paper outlines the general PID framework and estimates a series of dynamic models to identify how interest rate policy adjustments are affected by the rate of inflation and the level of macroeconomic activity. The paper examines data for the UK, the USA and the Eurozone. The results suggest that the PID rules can provide a useful theoretical and empirical framework for estimating central bank responses to the inflation and macroeconomic activity variables by improving the explanatory power of the Taylor rule model and determining the effect of the parameters.     

Central bank instruments, fiscal policy regimes, and the requirements for equilibrium determinacy

This paper examines the role of the monetary instrument choice for local equilibrium determinacy under sticky prices and different fiscal policy regimes. Corresponding to Benhabib et al.'s results for interest rate feedback rules [Benhabib, J., Schmitt-Grohé, S., Uribe, M., 2001. Monetary policy and multiple equilibria. American Economic Review 91, 167–185], the money growth rate should not rise by more than one for one with inflation when the primary surplus is raised with public debt. Under an exogenous primary surplus, money supply should be accommodating—such that real balances grow with inflation—to ensure local equilibrium determinacy. When the central bank links the supply of money to government bonds by controlling the bond-to-money ratio, an inflation stabilizing policy can be implemented for both fiscal policy regimes. Local determinacy is then ensured when the bond-to-money ratio is not extremely sensitive to inflation, or when interest payments on public debt are entirely tax financed, i.e., the budget is balanced.     

Inflation, Price Level and Hybrid Rules under Inflation Uncertainty

The performance and robustness of optimised interest rate rules are analysed in a New Keynesian model estimated for the euro area economy. In particular, we examine the properties of rules responding to inflation, the price level, or a combination of the two (a hybrid rule). All the rules also respond to the output gap. The optimal hybrid rule is only marginally superior when there is no model uncertainty. When there is uncertainty about the degree of inflation persistence, the inflation rule is the most robust rule and the performance of the other two rules deteriorates. However, all the rules perform well if the true degree of inflation persistence turns out to be less than policymakers’ estimate.     

Asymmetric monetary policy and the effective lower bound

We use the canonical New Keynesian model to study optimal discretionary policy when the nominal interest rate is constrained by the effective lower bound (ELB). We show that policymakers who seek to minimize a (symmetric) quadratic loss function involving deviations of inflation and output from targets will achieve an average inflation rate below target due to the contractionary effects associated with hitting the ELB. We also characterize optimal discretionary policy for policymakers who view output losses as asymmetric: they place weight on the output gap when output is below potential but place little or no weight on the gap when output is above potential. In comparison to optimal policy using the symmetric loss function, the average inflation rate is higher and closer to the central banks target. Moreover, in response to contractionary demand shocks that push the nominal interest rate to the effective lower bound, policymakers with an asymmetric loss function adopt a policy rate path that remains at the ELB longer but eventually rises more quickly than the path adopted by a policymaker with a symmetric loss function.     

Adjustment Costs,Inventories and Output

This paper analyzes the optimal adjustment strategy of an inventory‐holding firm facing price‐ and quantity‐adjustment costs in an inflationary environment. The model nests both the original menu‐cost model that allows production to be costlessly adjusted, and the later model that includes price‐ and quantity‐adjustment costs, but rules out inventory holdings. It is shown that the firm's optimal adjustment strategy may involve stockouts. At low inflation rates, output is inversely related to the inflation rate, and the length of time demand is satisfied increases with the demand elasticity but decreases with the storage cost and the real interest rate.     

The roles of relative prices,interest rates,and bequests in the consumption function

This paper investigates the roles of relative prices, interest rates, inflation expectations and bequests in the determination of consumer expenditures for four goods in the U.S. The framework employed is a life-cycle extension of the Linear Expenditure System, in which relative prices, wealth, labor income, the nominal interest rate, and anticipated rates of inflation for each good are major arguments. The results provide strong empirical support for the expenditure system employed and suggest a significant role for relative prices and for the bequest motive in shaping saving decisions. We also find that expenditure decisions respond to both interest rates and anticipated inflation in a “Fisherian” fashion, but that the interest elasticity of saving is quite low and of uncertain sign. Our model also provides an estimate of the consumer's “horizon,” defined in the sense of Friedman.     

Monetary Policy with Parameter Uncertainty in Small-Open Economy

This paper computes optimal robust monetary policy in a new Keynesian small-open economy model with Knightian uncertainty about the degree of price stickiness and the elasticity of substitution between domestic and foreign goods. Due to the simple model structure used in the paper, I can derive analytical results for the min–max solution under discretion and assess how a robust optimal Taylor rule must be set in small-open economy. I find that, in an optimal robust discretionary equilibrium, the central bank should assume that the degree of price stickiness and the elasticity of substitution between domestic and foreign goods take on their highest numerical values. In terms of interest rate setting, if the optimal discretionary robust equilibrium is implemented with a Taylor rule, the policy rate should react to inflation in a less aggressive way than in the case of complete information.     

Monetary transmission mechanism in Turkey under free float using a small-scale macroeconomic model

This study analyzes the monetary transmission mechanism in the Turkish economy following the switch to free float under informal inflation targeting scheme in the aftermath of the February 2001 crisis. A small-scale macroeconomic model is simulated using equations for output gap, exchange rate, sub-items of inflation, short-term policy rate, government borrowing rate, “Embi+ Turkey” and inflation expectations. The preliminary results indicate that, despite some slight departures, both static and dynamic simulations capture the dynamics of the fundamental economic variables. The results also show that at a time of weak domestic demand, output gap has been seemingly less significant in determining inflation. Furthermore, risk premium as measured by “Embi+ Turkey” has a high explanatory power in shaping government borrowing rate and exchange rate. Finally, forward-looking component of inflation has been effective in determining non-administered prices.     

Global slack and domestic inflation rates: A structural investigation for G-7 countries

Recent papers have argued that one implication of globalization is that domestic inflation rates may have now become more a function of “global”, rather than domestic, economic conditions, as postulated by closed-economy Phillips curves.This paper aims to assess the empirical importance of global output in determining domestic inflation rates by estimating a structural model for a sample of G-7 economies. The model can capture the potential effects of global output fluctuations on both the aggregate supply and the aggregate demand relations in the economy and it is estimated using full-information Bayesian methods.The empirical results reveal a significant effect of global output on aggregate demand in most countries. Through this channel, global economic conditions can indirectly affect inflation. The results, instead, do not seem to provide evidence in favor of altering domestic Phillips curves to include global slack as an additional driving variable for inflation.     

Painless disinflation? Monetary policy rules in Hungary, 1991‐99

We estimate a small structural model for inflation, the output gap, the domestic interest rate and the exchange rate for Hungary during the period of the transition (1991-99). The transmission of monetary policy impulses to macro variables is characterized in a similar fashion to that of advanced open industrial countries. In particular, in the context of our rational expectations, forward-looking model, the interest rate channel on aggregate demand and the exchange rate channel work together as parts of the same disinflation policy. We draw several conclusions on understanding and modeling the effects of monetary policy, and also on the desirable design of policy rules during the process of disinflation.
JEL classification: E17, E52, P24.     

The exchange rate and optimal monetary policy rules in open and developing economies: Some simple analytics

Using a simple, tractable model, this paper revisits and expands upon issues relating to optimal monetary policy rules (MPRs) in open economies. The optimality of the rule is explored through various specifications of a central bank loss function as it is the loss function that offers insight into central bank preferences. Many of the issues on this topic have centred on the role of the exchange rate: Is it optimal for the policy instrument to react to the exchange rate? What is the role of the exchange rate in a domestic inflation targeting vs CPI inflation targeting? Does a fear of floating have any bearing on the way optimal MPRs are constructed? While this paper is not empirical, the analysis is relevant for central banks in open and developing economies that face a choice between allowing exchange rates to float (and adopting an inflation targeting regime) and engaging in some degree of exchange rate fixity.     

Tax,credit constraints,and the big costs of small inflation

This paper develops a heterogeneous‐agent overlapping generations model that examines how the neutrality of the tax system with respect to inflation depends on the price elasticity of the housing supply. The model, which endogenises house prices and rents, and which incorporates detailed tax regulations and bank‐imposed credit constraints, shows (a) inflation has large effects on the tenure arrangements of young households irrespective of the housing supply elasticity; and (b) inflation can improve the welfare of some low income young households if the supply is sufficiently elastic. The welfare costs of inflation are reduced by taxing real rather than nominal interest.     

Equilibrium determinacy and inflation measures for interest rate rules

Empirical evidence suggests that goods are highly heterogeneous with respect to the degree of price rigidity. We develop a two-sector dynamic general equilibrium model to study the equilibrium determinacy properties of interest rate rules that respond to inflation measures differing in their degree of price rigidity. We find that rules responding to a headline measure, which puts some weight on the inflation of the sector with low price stickiness, are more prone to generate endogenous aggregate instability—in the form of fluctuations driven by self-fulfilling expectations and equilibria where fluctuations are unbounded—than rules that respond exclusively to a core measure, which includes only the inflation of the sector with high price stickiness. We discuss how our results depend on the elasticity of substitution across goods, the timing of the policy rule, and reacting to aggregate activity.