Testing for optimal monetary policy via moment inequalities

The specification of an optimizing model of the monetary transmission mechanism requires selecting a policy regime: commonly, commitment or discretion. In this paper we propose a new procedure for testing optimal monetary policy, relying on moment inequalities that nest commitment and discretion as two special cases. The approach is based on the derivation of bounds for inflation that are consistent with optimal policy under either policy regime. We derive testable implications that allow for specification tests and discrimination between the two alternative regimes. The proposed procedure is implemented to examine the conduct of monetary policy in the US economy.     

Finance-neutral potential output: An evaluation in an emerging market monetary policy context

In this paper, output gaps that include financial cycle information are evaluated against policy analysis models used by the Colombian central bank. This is an important feature, since policy-related models are the only relevant yardstick and emerging economies (such as Colombia) have been historically more vulnerable to financial imbalances. Unlike previous works, finance-neutral gaps were evaluated in a monetary policy context exactly as it is routinely performed by a central bank. The distribution of output gap revisions is analyzed and a metric to compare real-time robustness across models is developed. This metric constitutes a novel way to summarize the distribution of real-time uncertainty around output gaps, and policymakers should employ it for comparison purposes. Also, the real-time policy performance of finance-neutral gaps is studied, separating suggested ex post from operational ex ante usefulness. The results suggest that finance-neutral gaps are neither more robust in real time nor more operationally useful than the benchmark estimates. These results have important implications for policymakers and for the relevant literature.     

Optimal interest rate stabilization in a basic sticky-price model

This paper studies optimal monetary policy with the nominal interest rate as the single policy instrument. Firms set prices in a staggered way without indexation and real money balances contribute separately to households’ utility. The optimal deterministic steady state under commitment is the Friedman rule—even if the importance assigned to the utility of money is small relative to consumption and leisure. We approximate the model around the optimal steady state as the long-run policy target. Optimal monetary policy is characterized by stabilization of the nominal interest rate instead of inflation stabilization as the predominant principle.     

The Barnett critique after three decades: A New Keynesian analysis

This paper extends a New Keynesian model to include roles for currency and deposits as competing sources of liquidity services demanded by households. It shows that, both qualitatively and quantitatively, the Barnett critique applies: while a Divisia aggregate of monetary services tracks the true monetary aggregate almost perfectly, a simple-sum measure often behaves quite differently. The model also shows that movements in both quantity and price indexes for monetary services correlate strongly with movements in output following a variety of shocks. Finally, the analysis characterizes the optimal monetary policy response to disturbances that originate in the financial sector.     

货币政策透明度:基于中央银行视角的文献解读

货币政策透明度是指非对称信息在政策制定者与其他经济主体之间的披露程度,包括中央银行对政策相关信息的披露程度以及公众对政策信息的理解程度二层内涵;在实践中,政策制定者选择多大程度的透明度主要取决于实际的经济环境和政策目标,从纯经济学的角度来讲,政策有效性是决定是否要提高货币政策透明度的唯一原因;而从实践中来看,无论是透明还是隐秘的货币政策,都有可能实现比较理想的调控结果。     

Monetary policy transparency in a forward-looking market: Evidence from the United States

Because unsatisfactory measures of the monetary policy transparency were used, the existing literature found mixed empirical results for the relationship between the monetary policy transparency and risk/volatility. This paper extends the literature by using a recently developed monetary transparency index [Kia’s (2011) index] which is dynamic and continuous. Furthermore, the existing literature ignores the fact that market participants can be forward looking and, therefore, not policy invariant. This study also finds that the agents in the market are not policy invariant and the more transparent the monetary policy is the less risky and volatile the money market will be.     

Does Liquidity Matter? Properties of a Divisia Monetary Aggregate in the Euro Area*

This paper builds a quarterly Divisia monetary aggregate for the euro area using area‐wide data over the sample period from 1980 to 2000, finding two main results. First, it is found that the demand for this monetary aggregate has been well behaved and relatively stable over the last two decades. Secondly, the Divisia‐weighed monetary aggregate is found to have interesting information content from a forward‐looking perspective. This lends support to the view that money and – in a broader sense – liquidity services should be assigned an important role in shaping monetary policy in the euro area, although the policy maker is not interested in monetary aggregates per se.     

Coordination and non-coordination risks of monetary and macroprudential authorities: A robust welfare analysis

This study compares a central bank’s leaning against the wind approach with a mix of monetary and macroprudential policies under parameter uncertainty in an estimated DSGE model with two financial frictions. We show that uncertainty of the economic environment is an essential constituent in properly designing macroprudential policy. Although coordination between monetary and macroprudential policies minimizes the policymakers’ Bayesian risk, coordination and non-coordination risks threaten the goals of both authorities. The former describes the situation where the authorities partly resign from implementing the monetary policy objectives to stabilize macroprudential risk. The latter is when conducting a non-coordinated macroprudential policy induces higher total Bayesian risk than when only the central bank minimizes the expected total welfare loss. The robust Bayesian macroeconomic rules show that when financial shocks shrink the banks’ or entrepreneurial net worth, a contractionary macroprudential policy should be combined with an expansionary monetary policy. However, if capital adequacy ratio or risk shocks strike the economy, such a conflict in macroeconomics policy instruments disappears, thus synchronizing both policies.     

Model Selection for Monetary Policy Analysis: How Important is Empirical Validity?*

We investigate the economic significance of trading off empirical validity of models against other desirable model properties. Our investigation is based on three alternative econometric systems of the supply side, in a model that can be used to discuss optimal monetary policy in Norway. Our results caution against compromising empirical validity when selecting a model for policy analysis. We also find large costs from basing policies on the robust model, or on a suite of models, even when it contains the valid model. This confirms an important role for econometric modelling and evaluation in model choice for policy analysis.     

Monetary policy in open economies: Practical perspectives for pragmatic central bankers

This paper reviews and interprets some of the key policy implications that flow from a class of DSGE models for optimal monetary policy in the open economy. The framework suggests that good macroeconomic outcomes in open economies are possible by focusing inflation targeting that is implemented by a Taylor type rule, a rule that in equilibrium is reflected in the exchange rate as an asset price. Optimal monetary policy will not be able deliver a stationary (‘stable’) nominal exchange rate – let alone a fixed exchange rate or one that remains inside a target zone – because, absent a commitment device, optimal monetary can’t deliver a stationary domestic price level. Another feature in the data for inflation targeting countries that is consistent with monetary policy via Taylor type rule is that it will tend push the nominal exchange rate in the opposite direction from PPP in response to an ‘inflation’ shock—the ‘bad news god news’ result of Clarida and Waldman (2008. Is Bad News about Inflation Good News for the Exchange Rate. In: John Campbell, (Ed.), Asset Prices and Monetary Policy, Chicago: University of Chicago Press), Clarida and Waldman (2014. Bad News About Inflation is Good News for the Nominal Exchange Rate Under Optimal Monetary Policy: DSGE Theory and a Decade of Empirical Evidence). This is so even though in the long run of these models the nominal exchange rate must in expectation obey PPP.     

Monetary policy and asset prices in an open economy

This paper examines whether central banks should respond to asset price fluctuations in a two-country sticky price model. We compare a monetary policy rule that targets both domestic asset prices and foreign asset prices with several alternative monetary policy rules. This paper shows that this policy rule can produce preferable outcomes because the domestic central bank incorporates important information that both domestic and foreign asset prices possess into its monetary policy. Our model suggests that central banks should consider both domestic and foreign asset prices in a two country framework with asset price fluctuations.     

The role of liquid government bonds in the great transformation of American monetary policy

A fundamental shift in monetary policy occurred around 1980: the Fed went from a “passive” policy to an “active” policy. We study a model in which government bonds provide transactions services. We present two calibrations of our model, using pre- and post-1980 data. We show that estimates of pre- and post-1980 policy rules all lie within our determinacy regions. But, the pre-1980 policy was a very bad monetary policy, even if it avoided sunspot equilibria. Model simulations suggest that household welfare would have increased by 3.3 percent of permanent consumption in this period under an active policy.     

On credit and output: Is the supply of credit relevant?

The consensus that changes in the supply of credit were irrelevant to making monetary policy decisions existed among macroeconomists during the second half of the twentieth century. Transmission of shocks to the real economy through changes in the supply of credit, however, played an important role in the recent U.S. financial crisis. This paper explores the extent to which policymakers should consider changes in the supply of credit when making forecasts and monetary policy decisions. More specifically, it considers whether a measure of real credit balances offers consistent and stable information, beyond that of a real interest rate and real money balances, about future output gaps during the U.S. post-war era. Results yield evidence that changes in real credit balances are the only variable, among those considered, to provide consistent and stable information about future output gaps over the entire sample period. Each information variable, however, provides relatively little value added for forecasting future output gaps, beyond a simple autoregressive model. To improve upon forecasts and monetary policy decisions, policymakers therefore should consider a broader range of information variables and occasionally reassess the relative weightings assigned to each.     

How better monetary statistics could have signaled the financial crisis

This paper explores the disconnect of Federal Reserve data from index number theory. A consequence could have been the decreased-systemic-risk misperceptions that contributed to excess risk-taking prior to the housing bust. We find that most recessions in the past 50 years were preceded by more contractionary monetary policy than indicated by simple-sum monetary data. Divisia monetary aggregate growth rates were generally lower than simple-sum aggregate growth rates in the period preceding the Great Moderation, and higher since the mid 1980s. Monetary policy was more contractionary than likely intended before the 2001 recession and more expansionary than likely intended during the subsequent recovery.     

Time-varying impact of monetary policy shocks on US stock returns: The role of investor sentiment

This paper investigates how monetary policy shock affects the stock market of the United States (US) conditional on states of investor sentiment. In this regard, we use a recently developed estimator that uses high-frequency surprises as a proxy for the structural monetary policy shocks, which in turn is achieved by integrating the current short-term rate surprises, which are least affected by an information effect, into a vector autoregressive (VAR) model as an exogenous variable. When allowing for time-varying model parameters, we find that, compared to the low investor sentiment regime, the negative reaction of stock returns to contractionary monetary policy shocks is stronger in the state associated with relatively higher investor sentiment. Our results are robust to alternative sample period (which excludes the zero lower bound) and model specification and also have important implications for academicians, investors, and policymakers.     

How does Monetary Policy Respond to Exchange Rate Movements? New International Evidence*

This article analyzes how monetary policy has responded to exchange rate movements in six open economies, paying particular attention to the two‐way interaction between monetary policy and the exchange rate. We address this issue using a structural VAR model that is identified using a combination of sign and short‐term (zero) restrictions. Doing so we find that, while there is a instantaneous reaction in the exchange rate following a monetary policy shock in all countries, monetary policy responds significantly on impact to an exchange rate shock in only four of the six countries.     

Optimal monetary policy under incomplete markets and aggregate uncertainty: A long-run perspective

This paper examines the role of monetary policy in an environment with aggregate risk and incomplete markets. In a two-period overlapping-generations model with aggregate uncertainty, optimal monetary policy attains the ex-ante Pareto optimal allocation. This policy aims to stabilize the savings rate in the economy by changing real returns of nominal bonds via variation in expected inflation. Optimal expected inflation is procylical and on average higher than without uncertainty. Simple inflation targeting rules closely approximate the optimal monetary policy.     

Revealing the preferences of the US Federal Reserve

We use Bayesian methods to estimate changes in US post‐war monetary policy in the Smets and Wouters model. We perform the estimations by allowing for a break in monetary policy at the time of Volcker's appointment as chairman. This enables us to capture changes in the monetary policy regime introduced by Volcker during the Volcker–Greenspan period. We find support for the assumption that monetary policy in the Volcker–Greenspan period performed optimally under commitment. Our estimation strategy allows us to estimate the preferences of the US Federal Reserve in the Volcker–Greenspan period, where the main objective of policy appears to be inflation, followed by interest rate stabilization, output growth and interest rate smoothing. We find that the Great Moderation of output growth is explained by a combination of two factors: the decrease in the volatility of the structural shocks and the improved monetary policy conduct. Inflation Stabilization, however, is mainly due to the change in monetary policy that took place at the beginning of Volcker's mandate. Copyright © 2010 John Wiley & Sons, Ltd.     

Nonlinear effects of monetary policy on stock returns in a smooth transition autoregressive model

This paper employs smooth transition autoregressive (STAR) models to investigate the nonlinear effect of monetary policy on stock returns. The change in the Federal funds rate is used as an endogenous measure of monetary policy, and the growth rate of industrial production is also considered in the model. Our results show that the relationship between the monetary policy and excess returns on stock prices is positive and nonlinear. A decrease in the Federal funds rate causes a larger increase in excess returns if excess stock returns are located in the extreme low excess returns regime.