Managing Beliefs about Monetary Policy under Discretion

In models of monetary policy, discretionary policymaking is typically constrained in its ability to manage public beliefs. However, when a policymaker possesses private information, policy actions serve as signals to the public about unobserved economic conditions and belief management becomes an integral part of optimal discretion policies. This article derives the optimal time‐consistent policy for a general linear‐quadratic setting. The optimal policy is illustrated in a simple New Keynesian model, where analytical solutions can be derived as well. In this model, imperfect information about the policymaker's output target leads to lower policy losses.     

The Effects of Monetary Policy “News” and “Surprises”

There is substantial agreement in the monetary policy literature over the effects of exogenous monetary policy shocks. The shocks that are investigated, however, almost exclusively represent unanticipated changes in policy, which surprise the private sector and which are typically found to have a delayed and sluggish effect on output. In this paper, we estimate a New Keynesian model that incorporates news about future policies to try to disentangle the anticipated and unanticipated components of policy shocks. The paper shows that the conventional estimates confound two distinct effects on output: an effect due to unanticipated or “surprise” shocks, which is smaller and more short‐lived than the response usually obtained in the literature, and a large, delayed, and persistent effect due to anticipated policy shocks or “news.” News shocks play a larger role in influencing the business cycle than unanticipated policy shocks, although the overall fraction of economic fluctuations that can be attributed to monetary policy remains limited.     

Returns to Scale,Market Power,and the Nature of Price Rigidity in New Keynesian Models with Self‐Fulfilling Expectations

Increasing returns to scale and firms' market power are two potential sources of sunspot expectations in neoclassical models. We show that in New Keynesian models, returns to scale and market power can have fundamentally different implications for broad macroeconomic issues, including self‐fulfilling expectations, depending on the nature of price rigidity. Our findings suggest that the design of stabilization monetary policy can depend on precise knowledge about the economy's real and nominal features. Therefore, a clear understanding of the specific economic environment and its relevance to monetary policymaking for ensuring macroeconomic stability can be an integrated part of monetary policy practice.     

Private Sector Influences on Monetary Policy in the United States

I examine the extent to which the Federal Reserve's monetary policy actions are correlated with the expressed wishes of private sector lobbying groups. I update and extend work by Havrilesky (1990, 1993) regarding the effect of signals from the banking industry through the Federal Advisory Council (FAC). I also construct a new database containing statements from non-financial interest groups. I find that monetary policy actions are correlated with signals from non-financial groups before 1979 but not after, and are correlated with signals from the FAC after 1979 but not before. I also find that the Fed's policy stance more closely matches the preferred stance of the banking industry after 1979.     

Sectoral Comovement,Monetary Policy Shocks,and Input–Output Structure

The comovement of output across the sector producing nondurables (i.e., nondurable goods and services) and the sector producing durables is well established in the monetary business cycle literature. However, standard sticky‐price models that incorporate sectoral heterogeneity in price stickiness (i.e., sticky nondurables prices and flexible durables prices) cannot generate this feature. We argue that an input–output (I–O) structure provides a solution to this problem. Here, we develop a two‐sector model with an I–O structure, which is calibrated to the U.S. economy. In the model, each sector’s output affects those of the others by acting as an intermediate input. This connection between the sectors provides a channel through which sectoral comovement is induced.     

Credit booms,monetary integration and the new neoclassical synthesis

Credit to the private sector has risen rapidly in many new Central and Eastern European EU Member States (nMS) in recent years. The lending boom has recently been particularly strong in the segment of loans to households, primarily mortgage-based housing loans, and in those countries that operate currency boards or other forms of hard pegs. The main aim of this paper is to propose a conceptual framework to analyze the observed developments with a view to exploring some policy implications at a stage in which these countries are preparing for their prospective integration with the euro area. To achieve this, we first use a stylized new neoclassical synthesis (NNS) framework, which has recently been advanced by Goodfriend [Goodfriend, M., 2002. Monetary policy in the new neoclassical synthesis: A primer, Federal Reserve Bank of Richmond, July.] and Goodfriend and King [Goodfriend, M., King, R., 2001. The case for price stability. NBER Working Paper 8423]. We then discuss the implications of the NNS model for credit dynamics and ensuing monetary policy challenges. Specifically, we emphasize consumption smoothing as an important channel of the observed credit expansion and we show how it is related to and how it affects the monetary policy making in MS. In doing so, we place our discussion in the context of the monetary integration process in general and the nominal convergence process in particular.     

An investigation of the gains from commitment in monetary policy

We propose a simple framework for analyzing a continuum of monetary policy rules characterized by differing degrees of credibility, in which commitment and discretion become special cases of what we call quasi-commitment. The monetary policy authority is assumed to formulate optimal commitment plans, to be tempted to renege on them, and to succumb to this temptation with a constant exogenous probability known to the private sector. By interpreting this probability as a continuous measure of the (lack of) credibility of the monetary policy authority, we investigate the welfare effect of a marginal increase in credibility. Our main finding is that, in a simple model of the monetary transmission mechanism, most of the gains from commitment accrue at relatively low levels of credibility.     

Learning about the Term Structure and Optimal Rules for Inflation Targeting

In this paper, we incorporate the term structure of interest rates in the New Keynesian model and analyze optimal policy under uncertainty about private sector expectations and the degree of inflation persistence. The novel result of our paper is that for large deviations of inflation from its target, the active learning policy is less activist—in the sense of responding less aggressively to the state of the economy—than a myopic policy, which ignores the learning channel. Moreover, for most initial beliefs, the incentive for active learning increases as monetary policy’s leverage over the long‐term interest rate increases.     

Credit and Banking in a DSGE Model of the Euro Area

This paper studies the role of credit supply factors in business cycle fluctuations using a dynamic stochastic general equilibrium (DSGE) model with financial frictions enriched with an imperfectly competitive banking sector. Banks issue collateralized loans to both households and firms, obtain funding via deposits, and accumulate capital out of retained earnings. Loan margins depend on the banks' capital‐to‐assets ratio and on the degree of interest rate stickiness. Balance‐sheet constraints establish a link between the business cycle, which affects bank profits and thus capital, and the supply and cost of loans. The model is estimated with Bayesian techniques using data for the euro area. The analysis delivers the following results. First, the banking sector and, in particular, sticky rates attenuate the effects of monetary policy shocks, while financial intermediation increases the propagation of supply shocks. Second, shocks originating in the banking sector explain the largest share of the contraction of economic activity in 2008, while macroeconomic shocks played a limited role. Third, an unexpected destruction of bank capital may have substantial effects on the economy.     

Robust monetary policy with imperfect knowledge

We examine the performance and robustness properties of monetary policy rules in an estimated macroeconomic model in which the economy undergoes structural change and where private agents and the central bank possess imperfect knowledge about the true structure of the economy. Policymakers follow an interest rate rule aiming to maintain price stability and to minimize fluctuations of unemployment around its natural rate but are uncertain about the economy's natural rates of interest and unemployment and how private agents form expectations. In particular, we consider two models of expectations formation: rational expectations (RE) and learning. We show that in this environment the ability to stabilize the real side of the economy is significantly reduced relative to an economy under RE with perfect knowledge. Furthermore, policies that would be optimal under perfect knowledge can perform very poorly if knowledge is imperfect. Efficient policies that take account of private learning and misperceptions of natural rates call for greater policy inertia, a more aggressive response to inflation, and a smaller response to the perceived unemployment gap than would be optimal if everyone had perfect knowledge of the economy. We show that such policies are quite robust to potential misspecification of private sector learning and the magnitude of variation in natural rates.     

Identifying the Stance of Monetary Policy at the Zero Lower Bound: A Markov‐Switching Estimation Exploiting Monetary‐Fiscal Policy Interdependence

In this paper, I propose an econometric technique to estimate a Markov‐switching Taylor rule subject to the zero lower bound of interest rates. I show that linking the switching of the Taylor rule coefficients to the switching of the coefficients of an auxiliary uncensored Markov‐switching regression improves the identification of an otherwise unidentifiable prevalent monetary regime because of the presence of the zero lower bound. Using a Markov‐switching fiscal policy rule as the auxiliary regression, I apply the estimation technique to U.S. data. Results show evidence of monetary and fiscal policy comovements, with monetary policy reacting weakly to inflation when fiscal policy is focused on real activity as opposed to debt stabilization, and vice versa.     

The effect of bank ownership and deposit insurance on monetary policy transmission

In this paper we develop a theoretical model with a representative bank whose ownership is shared between state and private sector. The bank faces a risk of failure and provides private and public explicit deposit insurance. Banks owned to a larger extent by the government are more able to counteract a restrictive monetary policy because of their capacity to raise additional volume of deposits. Therefore, the greater the state’s share in the bank ownership, the less the impact of a monetary tightening on the level of loan supply.     

How Important Is Money in the Conduct of Monetary Policy?

I consider some of the leading arguments for assigning an important role to tracking the growth of monetary aggregates when making decisions about monetary policy. First, I consider whether ignoring money means returning to the conceptual framework that allowed the high inflation of the 1970s. Second, I consider whether models of inflation determination with no role for money are incomplete, or inconsistent with elementary economic principles. Third, I consider the implications for monetary policy strategy of the empirical evidence for a long‐run relationship between money growth and inflation. And fourth, I consider reasons why a monetary policy strategy based solely on short‐run inflation forecasts derived from a Phillips curve may not be a reliable way of controlling inflation. I argue that none of these considerations provides a compelling reason to assign a prominent role to monetary aggregates in the conduct of monetary policy.     

On Targeting Frameworks And Optimal Monetary Policy

We show that speed limit policy, a monetary policy strategy that focuses on stabilizing inflation and the change in the output gap, consistently outperforms flexible inflation targeting and flexible price level targeting in empirical medium‐scale DSGE models under discretionary policymaking. In contrast to small‐scale New Keynesian models, this welfare ranking of the targeting frameworks is not overturned when inflation dynamics are mostly backward‐looking. Importantly, the performance of the speed limit policy shows less sensitivity to its parameterization than other frameworks that target the inflation rate or the price level.     

MONETARY POLICY INDICATORS AS PREDICTORS OF STOCK RETURNS

We explore the linkage between stock return predictability and the monetary sector by examining alternative proxies for monetary policy. Using two complementary methods, we document that failure to condition on the Fed's broad policy stance causes a substantial understatement in the ability of monetary policy measures to predict returns. Industry analyses suggest that cross‐industry return differences are also linked to changes in monetary conditions, as monetary policy has the strongest (weakest) relation with returns for cyclical (defensive) industries. Overall, we find that monetary conditions have a prominent and systematic relation with future stock returns, even in the presence of business conditions.     

U.S. Monetary Regimes and Optimal Monetary Policy in the Euro Area

Monetary policy in the United States has been documented to have switched from reacting weakly to inflation fluctuations during the 1970s, to fighting inflation aggressively from the early 1980s onward. In this paper, I analyze the impact of the U.S. monetary policy regime switches on the Eurozone. I construct a New Keynesian two‐country model where foreign (U.S.) monetary policy switches regimes over time. I estimate the model for the U.S. and the Euro Area using quarterly data and find that the United States has switched between those two regimes, in line with existing evidence. I show that foreign regime switches affect home (Eurozone) inflation and output volatility and their responses to shocks, substantially, as long as the home central bank commits to a time‐invariant interest rate rule reacting to domestic conditions only. Optimal policy in the home country instead requires that the home central bank reacts strongly to domestic producer‐price inflation and to international variables, such as imported goods relative prices. In fact, I show that currency misalignments and relative prices play a crucial role in the transmission of foreign monetary policy regime switches internationally. Interestingly, I show that only marginal gains arise for the Euro Area when the European Central Bank (ECB) adjusts its policy according to the monetary regime in the United States. Thus, a simple time‐invariant monetary policy rule with a strong reaction to Producer Price Index (PPI) inflation and relative prices is enough to counteract the effects of monetary policy switches in the United States.     

Household Debt Overhang and Transmission of Monetary Policy

We investigate how the level of household indebtedness affects the monetary transmission mechanism in the U.S. economy. Using state‐dependent local projection methods, we find that the effects of monetary policy are less powerful during periods of high household debt. In particular, the impact of monetary policy shocks is smaller on GDP, consumption, residential investment, house prices, and household debt during a high‐debt state. We then build a partial equilibrium model of borrower households with financial constraints to rationalize these facts. The model points to the weakening of the home equity loan channel as a possible reason for the decline in monetary policy effectiveness when initial debt levels are high.     

High‐Cost Credit and Consumption Smoothing

In this paper, I show that high‐cost credit helps households smooth consumption following periods of temporary financial distress. After experiencing distress—that is, extreme weather events—I find that access to high‐cost payday lending mitigates declines in overall spending and nondurable goods spending generally. The results are particularly concentrated among households with a higher propensity to use payday credit or that have limited alternatives: lower income households, households with less than a college degree, and households with low levels of saving. These results highlight the consumption‐smoothing role that high‐cost credit plays for households with limited access to other types of credit.     

Social Security Bonds and the Concept of Reciprocal Responsibility

The current debate and parallel monologues about Social Security suffer from a failure to distinguish between money and bonds. Consequently, it is impossible to discuss intelligently the solvency or affordability of the Social Security system. In this article, we present a new graph that clarifies this crucial distinction. Bonds are evidence of loans to be repaid on a schedule. These loans can be strictly monetary, as in the private sector, or a mix of monetary and moral, as in the intergenerational reciprocity of obligations. To treat public sector bonds as strictly monetary is economic error as fundamental as denying the existence of public goods.