Monetary Policy Rules, Policy Preferences, and Uncertainty: Recent Empirical Evidence

We survey recent empirical evidence on monetary policy rules, and find that the emphasis in the political economy literature on institutional design (e.g. central bank independence and inflation targeting) is exaggerated. Formal institutional reform seems neither a necessary nor a sufficient condition for the observation of shifts in monetary policy rules. However, there is no doubt that in some cases (e.g. the UK following the start of inflation targeting in 1992, and Bank of England Independence in 1997), a major shift in monetary policy conduct is detectable. We also highlight the problems in explicitly testing the predictions of the political economy literature. Semi-structural modelling approaches, such as time-varying VAR models may be more useful in understanding policy rules, and the interaction between policy shifts and changes in the transmission mechanism.     

Learning about fiscal policy and the effects of policy uncertainty

In this paper we ask how uncertainty about fiscal policy affects the impact of fiscal policy changes on the economy when the government tries to counteract a deep recession. The agents in our model are uncertain about the conduct of fiscal policy and act as econometricians by estimating fiscal policy rules that might change over time.We find that assuming that agents are not instantaneously aware of the new fiscal policy regime in place leads to substantially more volatility in the short run and persistent differences in average outcomes. We highlight issues that can arise when a policymaker wants to announce a policy change. From a methodological perspective, we introduce a novel way to model learning in the face of discrete policy changes.     

Optimally derived fixed rules and indicators

Monetary targets have come to be regarded as inadequate for the conduct of short-term monetary policy, both among theoreticians and practitioners of policy. In this paper two approaches are put forward, analysed and evaluated for improving the performance of monetary targets. According to the first approach, simple rules for monetary targets are derived within an optimisation framework. These rules, related to ultimate targets, are simple so that they can be announced and are flexible so that they are subject to revision when the economy drifts away from its course due to unexpected shocks.The second approach is based on indicators and complements monetary targets with exchange rate targets through a simple feedback law for determining interest rate policy. The advantage of this feedback law is that it provides the mechanism through which policy is to be revised in response to shocks. If such a feedback law is announced, private economic agents have the means of distinguishing discretionary and arbitrary changes of policy from those which are needed to bring the economy back to the announced and committed course. This approach is used to analyse and extend the suggestions in the House of Commons Report on International Monetary Arrangements.The common ground between the two approaches is an optimisation framework with respect to the parameters of either the fixed simple rules or the simple feedback laws. This is discussed in section 1. The approach of deriving simple fixed rules is illustrated in a monetarist model in which there is a link between private sector expectations and the credible announcement of monetary targets. The model is explained in section 2 and simple fixed rules are discussed in section 3. The performance of simple rules for monetary targets is evaluated in terms of a minimax strategy with model uncertainty between the monetarist model and a Keynesian model without the assumption of announcement effects. This is discussed in section 4. Optimal feedback laws are derived and analysed in section 5. The parameter sensitivity of these feedback laws with respect to the model and the objective function, as well as their behaviour under shocks, is also examined.     

THE RISE AND DECLINE OF ECONOMIC POLICY AS AN AUTONOMOUS DISCIPLINE: A CRITICAL SURVEY

After Adam Smith's statement of market virtues, the process of gestation of economic policy as a rational set of rules for public agenda has been rather slow. Until not so long ago, economic policy as a discipline was often confined to prescribing practical rules intended to explain technical procedures of government intervention. Economic policy– as a coherent and to some extent autonomous discipline–only emerged in the late 1950s in Scandinavia, the Netherlands and Italy, when solid foundations indicating not only microeconomic but also macroeconomic market failures and a theory about the conditions for policy effectiveness and design were consistently developed. This paper intends to explain the reasons for the emergence of the discipline, the circumstances that favoured its diffusion, the reasons for its apparent setback and some factors that could facilitate its diffusion in the next years     

‘Market failure’ arguments are a poor guide to policy

‘Market failure’ is frequently offered as a justification for government intervention in the economy. Proponents of interventions can point to almost limitless examples of markets which do not meet all the criteria for Pareto optimality and argue that government taxation, subsidies or regulation can perfect them, maximising social welfare. But comparing market outcomes with an unattainable and unidentifiable ideal is not useful in a world of imperfect knowledge and government failure. It is better to compare market outcomes against realistic alternatives. Furthermore, even within the market failure paradigm, concepts such as ‘public goods’ and ‘negative externalities’ are routinely misunderstood and inconsistently applied. This leads to predictably poor policy outcomes.     

Monetary Targets and the World Economy: A Progress Report

The recent changes in the value of the dollar and the talk of an interest rate ‘war’ demonstrate again that the world finds it difficult to cope with rapid exchange rate movements. In some ways the experience - and the reactions to it - are similar to the events of 1978. As now, the world was in a recession (though on a milder scale) and there were fears that exchange rate problems would obstruct economic recovery. The main difference is that in 1978 it was the strength of the Deutschmark which caused concern whereas this time the problems are associated with the rise in the value of the dollar. In a Briefing Paper in Economic Outlook, February 1978, ‘Monetary Targets and the World Economy’ we suggested that the problem arose from inconsistencies between national monetary policies and exchange rate objectives. In general, countries dislike exchange rate changes - in either direction - and there were problems because countries would not accept the exchange rate consequences of their own or other countries' monetary policies. We estimated the required monetary policies for stable exchange rates and suggested specific national monetary targets for 1978 which would at least move the world economy towards consistent monetary policies. In this Economic Viewpoint we return to those ideas. We consider what happened in 1978 and we also revise the underlying monetary rules. More recent experience suggests that although there has been some progress towards the convergence of monetary policies there will continue to be trend changes in exchange rates. It is also clear that there will be short-term fluctuations around these trends. We believe that greater convergence of monetary policies would be desirable but failing that it is important that countries should avoid abrupt changes in monetary policy. It is also important that countries should become accustomed to exchange rate changes. They should direct monetary policy towards their objectives for inflation and should not be diverted from it by temporary or permanent changes in their exchange rates.     

Capital Is Not Enough: Innovation in Developing Economies

Economic development and social entrepreneurship often conceive of poverty as a resource allocation problem in which a lack of capital prevents the poor from increasing their income through entrepreneurship. This allocative view, however, represents only one possible approach to conceptualizing entrepreneurial opportunity. The alternative discovery‐ and creativity‐based views place a greater emphasis on innovation which implies that superior ideas are also needed if poverty is to be reduced through firm performance. Drawing from a survey of 201 small business owners involved in a microcredit programme in Nairobi, Kenya, we find that the financial, social, human capital–performance relationships are mediated in part by innovation. Further, we find that differentiation‐related innovations lead to better firm performance than novelty‐related innovations.     

Managed Floating as a Monetary Policy Strategy

Although there seems to be a broad consensus among economists that purely floating or completely fixed exchange rates (the so-called corner solutions) are the only viable alternatives of exchange rate management, many countries do not behave according to this paradigm and adopt a strategy within the broad spectrum of exchange rate regimes that is limited by the two corner solutions. Many of these intermediate regimes are characterized by significant foreign exchange market interventions and a certain degree of exchange rate flexibility with non-preannounced exchange rate targets. While academic research in this area usually concentrates on some specific aspects of intermediate regimes (such as the effectiveness of interventions or institutional aspects), managed floating has rarely been analyzed as a comprehensive monetary policy strategy. In this paper, we present a monetary policy framework in which central banks simultaneously use the exchange rate and the interest rate as operating targets of monetary policy. We explain the mechanics of foreign exchange market interventions and sterilization and we explain why a central bank has an interest of controlling simultaneously the two operating targets. We derive the monetary policy rules for the two operating targets from a simple open economy macro model in which the uncovered interest parity condition and the monetary conditions index play a central role.     

Learning about monetary policy rules when the cost-channel matters

We study how monetary policy may affect determinacy and expectational stability (E-stability) of rational expectations equilibrium when the cost channel of monetary policy matters. Focusing on instrumental Taylor-type rules and optimal target rules, we show that standard policies can induce indeterminacy and expectational instability when the cost channel is present. A naïve application of the traditional Taylor principle could be misleading, and expectations-based reaction function under discretion does not always induce determinate and E-stable equilibrium. This result contrasts with the findings of Bullard and Mitra [2002. Learning about monetary policy rules. Journal of Monetary Economics 49, 1105–1129] and Evans and Honkapohja [2003. Expectations and stability problem for optimal monetary policies. Review of Economic Studies 70, 807–824] for the standard new Keynesian model. The ability of the central bank to commit to an optimal policy is an antidote to these problems.     

Trade unions,collective bargaining and macroeconomic performance: a review

Coordination through collective bargaining is recognised as an influential determinant of labour market outcomes and macroeconomic performance. This article provides a systematic review of the empirical literature on the subject. What emerges from the review is that it is different types and coverage of bargaining coordination, rather than cross‐country variation in trade union density, that matter for economic performance. High levels of bargaining coverage tend to be associated with relatively poor economic performance, but this adverse relationship can be at least mitigated by high levels of bargaining coordination. In the absence of formal bargaining arrangements, economies often develop informal bargaining mechanisms whose effects are similar to those arising from formal bargaining provided they both operate at similar levels of coordination. The consequences of labour market coordination or absence thereof depend on the monetary policy regime as non‐accommodating monetary policy can eliminate some of the adverse unemployment consequences otherwise associated with industry‐level collective bargaining. Finally, bargaining coordination seems to matter most in times of rapid economic change rather than under more stable conditions. Overall, we conclude that it is the total ‘package’ of (formal and informal) labour market institutions that matters for the performance of the economy rather than unionisation as such or individual aspects of unionism.     

Fiscal and monetary policies in complex evolving economies

What is the most appropriate combination of fiscal and monetary policies in economies subject to banking crises and deep recessions? We study this issue using an agent-based model that is able to reproduce a wide array of macro- and micro-empirical regularities. Simulation results suggest that policy mixes associating unconstrained, counter-cyclical fiscal policy and monetary policy targeting employment is required to stabilise the economy. We also show that “discipline-guided” fiscal rules can be self-defeating, as they depress the economy without improving public finances. Finally, we find that the effects of monetary and fiscal policies become sharper as the level of income inequality increases.     

The Russian Crisis:

ABSTRACT Since 1992, the rhetoric of Russian economic reformers has been one of full-speed ahead to a free-market economy. The reality, however, has diverged significantly from this rhetoric at both a broad "rules of the game" level and specific "policy within rules" level. The resulting ambiguity of the economic environment and the lingering effects of the previous system which is supposed to be reformed has led to a continued deterioration of the Russian economy. This paper offers a modified defense of "shock therapy" as a path to a cure for Russia's economic malaise, as opposed to the cure itself.     

Combining monetary policy and prudential regulation: an agent-based modeling approach

This paper explores the interaction between monetary policy and prudential regulation in an agent-based modeling framework. Firms borrow funds from the banking system in an economy regulated by a central bank. The central bank carries out monetary policy, by setting the interest rate, and prudential regulation, by establishing the banking capital requirement. Different combinations of interest rate rule and capital requirement rule are evaluated with respect to both macroeconomic and financial stability. Several relevant policy implications were drawn. First, the efficacy of a given capital requirement rule or interest rate rule depends on the specification of the rule of the other type it is combined with. More precisely, less aggressive interest rate rules perform better when the range of variation of the capital requirement is narrower. Second, interest rate smoothing is more effective than the other interest rate rules assessed, as it outperforms those other rules with respect to financial stability and macroeconomic stability. Third, there is no tradeoff between financial and macroeconomic stability associated with a variation of either the capital requirement or the smoothing interest rate parameter. Finally, our results reinforce the cautionary finding of other studies regarding how output can be ravaged by a low inflation targeting.

     

WORLD OUTLOOK

The world economic recovery, which began in the late summer of 1980, can now be seen as premature, in as much as 1980's short, sharp recession had achieved only a limited reduction in the rate of inflation. Economic policy, particularly in the United States, is once more geared to a reduction in the inflation rate even if this imposes costs in terms of lost output and higher unemployment. The consequent appreciation of the US dollar against the European currencies has - in spite of weakening oil and non-oil commodity prices in dollar terms - produced a further boost to European inflation and a subsequent tightening of policy in some countries, notably West Germany. In these circumstances we expect little or no growth in output in the world economy until the summer of 1982.     

Lack of confidence,the zero lower bound,and the virtue of fiscal rules

In the presence of the zero lower bound, standard business cycle models with a Taylor-type monetary policy rule are prone to equilibrium multiplicity. A drop in private sector confidence can drive the economy into a liquidity trap without any change in fundamentals. I show, in the context of a standard New Keynesian model, that it is possible to design Ricardian fiscal spending rules that insulate the economy from such expectations-driven liquidity traps. In the case of price adjustment costs, desirable fiscal rules ensure that a drop in confidence does not lead to a decline in real marginal costs. In the case of nominal wage adjustment costs, desirable fiscal spending rules ensure that a drop in confidence does not lead to a decline in the ratio of the marginal rate of substitution between private consumption and hours worked relative to the real wage rate.     

Humane Capital: A Reexamination of Catholic Social Teachings in Light of the Shift to Human Capital

Human capital is the set of productive knowledge, skills, and traits that individuals possess. Productive knowledge and skills are typically learned through education and work experience. Character traits matter both for the application of knowledge and skills and for their acquisition in the first place. In the past 100 years—and with enormous social consequences—the economy has transitioned to human capital being the most important resource for individual and social outcomes. Societies responded by emphasizing schooling as the means to develop this resource. In recent decades, however, researchers have discovered that human capital acquisition depends on certain character skills best developed early in life before schooling starts, typically within families. Current research and policy are investigating which combination of early life schooling and improvement in family circumstances can best help people acquire the character skills, and then human capital, needed to flourish. These changes have important implications for the social teachings of the Catholic Church, including moral insights into the distribution of resources, emphasis on the active subject in human work, and the role of civil society in promoting ideas and institutions conducive to an ideal human ecology.     

Inferring Policy Objectives from Economic Outcomes*

Estimated policy rules are reduced‐form equations that are silent on many important policy questions. However, a structural understanding of monetary policy can be obtained by estimating a policymaker's objective function. The paper derives conditions under which the parameters in a policymaker's policy objective function can be identified and estimated. We apply these conditions to a New Keynesian sticky‐price model of the US economy. The results show that the implicit inflation target and the relative weight placed on interest rate smoothing both declined when Paul Volcker was appointed Federal Reserve chairman.