Financial imbalances and gradualism

In the last years, in the major OECD economies, while inflation has become lower and more stable, episodes of financial instability and large cycles in asset prices have shown up with (often) non-negligible effects on economic activity. These facts should call for a larger concern with financial imbalances by the central bank. Adapting the model by Caplin and Leahy (1996)—where a central bank, which is uncertain about the state of the economy and its reaction to policy, seeks an optimal search strategy to influence private agents' responses—by substituting the central bank's price stability objective with a financial stability one, we find that the monetary authority should follow a less aggressive policy than the one suggested by the original model. However, initial conditions play a crucial role in determining the degree of gradualism by the policy maker with the policy becoming more and more aggressive as the initial interest rate shrinks.     

Search frictions and labor market participation

Cross-country differences in labor market participation are often larger than differences in unemployment rates. The same holds true across demographic groups within a given economy. We argue that the interaction between labor force participation decisions and labor market frictions can help us understand these patterns. This interaction highlights dynamic aspects of the participation decision, in contrast to standard textbook treatments that emphasize static costs and benefits of participation. We extend the standard labor market search problem to allow for a third state—non-participation—and assumes that stochastic participation costs precipitate flows into and out of non-participation. We fully characterize the worker's decision problem and use numerical simulations to demonstrate how participation patterns vary with individual characteristics and with labor market conditions.     

Real and nominal effects of monetary policy shocks

Abstract.  We employ the identification scheme of Kahn, Kandel and Sarig (2002) to analyse the impact of Canadian monetary policy on ex ante real interest rates and inflationary expectations. First, we decompose nominal interest rates into ex ante real rates and inflationary expectations using the methodology of Blanchard and Quah (1989) . Then we estimate a recursive VAR model with innovations in a monetary aggregate and the overnight target interest rate as alternative measures of monetary policy shocks. We find that a negative policy shock raises both nominal and ex ante real interest rates, lowers inflationary expectations and real industrial output, and appreciates the Canadian dollar.     

Production subsidies and redistribution

Who gains from stimulating output? We explore a dynamic model with production subsidies where the population is heterogeneous in one dimension: wealth. There are two channels through which production subsidies redistribute resources across the population. First, poorer agents gain from a rise in wages, since—to the extent there is an operative wealth effect in labor supply—they work harder. Second, because a current output boost will raise consumption today relative to the future, thus lowering real interest rates, poor agents gain in relative terms since their income is based less on interest income. We examine optimal redistribution from the perspective of an arbitrary consumer in the population. We show that, if this consumer has commitment at time zero to set all present and future subsidy rates, and for a class of preferences that admits aggregation in wealth, then output stimulation, and hence redistribution, will only occur at time zero; after that, subsidies are zero. A byproduct of our analysis of this environment is a median-voter theorem: with direct voting over subsidy sequences at time zero, the sequence preferred by the median-wealth consumer is the unique outcome. We also study lack of commitment, since interest-rate manipulation is associated with time inconsistency. We analyze this case formally by looking at the Markov-perfect (time-consistent) equilibrium in a game between successive identical decision makers (e.g., the median agent). Here, subsidies persist—they are constant over time—and are more distortionary than under commitment. Moreover, whereas under commitment asset inequality changes initially—in favor of the consumer who decides on policy—it does not under lack of commitment.     

How do banks set interest rates?

This paper studies cross-sectional differences in banks interest rates. It adds to the literature in two ways. First, it analyzes systematically the micro and macroeconomic factors that influence the price-setting behaviour of banks. Second, by using banks’ prices (rather than quantities) it provides an alternative way of disentangling loan supply from loan demand shift in the “bank lending channel” literature. The results suggest that heterogeneity in the banking rates pass-through - depending on liquidity, capitalization and relationship lending - exists only in the short run.     

The Halle Economic Projection Model

In this paper we develop an open economy model explaining the joint determination of output, inflation, interest rates, unemployment and the exchange rate in a multi-country framework. Our model—the Halle Economic Projection Model (HEPM)—is closely related to studies published by Carabenciov et al. (2008a,b,c). Our main contribution is that we model the Euro area countries separately. In doing so, we consider Germany, France, and Italy which represent together about 70% of Euro area GDP. The model combines core equations of the New-Keynesian standard DSGE model with empirically useful ad-hoc equations. We estimate this model using Bayesian techniques and evaluate the forecasting properties. Additionally, we provide an impulse response analysis and historical shock decomposition.     

Future fiscal and budgetary shocks

We study the effects of future tax and budgetary shocks in a non-monetary and possibly non-Ricardian economy. An (unanticipated) temporary labor tax cut to be effective on a given future date—a delayed “debt bomb”—causes at once a drop in the (unit) value placed on the firms' business asset, the customer, with the result that share prices, the hourly wage, and employment drop in tandem. This paradox of reduced activity through announcement of future “stimulus” does not hinge on an upward jump of long interest rates. A future tax-rate cut lacking a “sunset” provision has the same negative effects.     

A corporate balance-sheet approach to currency crises

This paper presents a general equilibrium currency crisis model of the ‘third generation’, in which the possibility of currency crises is driven by the interplay between private firms’ credit-constraints and nominal price rigidities. Despite our emphasis on microfoundations, the model remains sufficiently simple that the policy analysis can be conducted graphically. The analysis hinges on four main features (i) ex post deviations from purchasing power parity; (ii) credit constraints a la Bernanke-Gertler; (iii) foreign currency borrowing by domestic firms; (iv) a competitive banking sector lending to firms and holding reserves and a monetary policy conducted either through open market operations or short-term lending facilities. We derive sufficient conditions for the existence of a sunspot equilibrium with currency crises. We show that an interest rate increase intended to support the currency in a crisis may not be effective, but that a relaxation of short-term lending facilities can make this policy effective by attenuating the rise in interest rates relevant to firms.     

Financial markets’ behavior around episodes of large changes in the fiscal stance

Using a panel of OECD countries from 1960 to 2002, this paper shows that interest rates, particularly those of long-term government bonds, decrease when countries’ fiscal position improves and increase around periods of budget deteriorations. Stock market prices surge around times of substantial fiscal tightening and plunge in periods of very loose fiscal policy. In addition, the paper shows that results depend on countries’ initial fiscal conditions and on the type of fiscal consolidations: Fiscal adjustments that occur in country-years with high levels of government deficit, that are implemented by cutting government spending, and that generate a permanent and substantial decrease in government debt are associated with larger reductions in interest rates and increases in stock market prices.     

Interest Rate Pass-Through: Empirical Results for the Euro Area

Abstract. This paper empirically examines the interest rate pass‐through at the euro area level. The focus is on the pass‐through of official interest rates, approximated by the overnight interest rate, to longer‐term market interest rates, which, in turn, are a proxy for the marginal costs for banks to attract deposits or grant loans, and therefore passed through to retail bank interest rates. Empirical results, on the basis of a (vector) error‐correction and vector autoregressive model, suggest that the pass‐through of official interest to market interest rates is complete for money market interest rates up to three months, but not for market interest rates with longer maturities. Furthermore, the immediate pass‐through of changes in market interest rates to bank deposit and lending rates is found to be at most 50%, whereas the final pass‐through is typically found to be close to 100%, in particular for lending rates. Empirical results for a sub‐sample starting in January 1999 show qualitatively similar findings and are supportive of a quicker interest rate pass‐through since the introduction of the euro. It is shown that the difference between the adjustment speed of bank deposit and lending rates (typically around one versus three months since the common monetary policy) can to a large extent significantly be explained by credit risk considerations.     

Over- and Underbidding in Central Bank Open Market Operations Conducted as Fixed Rate Tender

Abstract. Open market operations play a key role in allocating central bank funds to the banking system and thereby in steering short‐term interest rates in line with the stance of monetary policy. Many central banks apply so‐called ‘fixed rate tender’ auctions in their open market operations. This paper presents, on the basis of a survey of central bank experience, a model of bidding in such tenders. In their conduct of fixed rate tenders, many central banks faced specifically an ‘under‐’ and an ‘overbidding’ problem. These phenomena are revisited in the light of the proposed model, and the more general question of the optimal tender procedure and allotment policy of central banks is addressed.     

Financial market imperfections and monetary policy strategy

In a model with imperfect money, credit and reserve markets, we examine if an inflation-targeting central bank applying the funds rate operating procedure to indirectly control market interest rates also needs a monetary aggregate as policy instrument. We show that if private agents use information extracted from money and financial markets to form inflation expectations and if interest rate pass-through is incomplete, the central bank can use a narrow monetary aggregate and the discount interest rate as independent and complementary policy instruments to reinforce the credibility of its announcements and the role of inflation target as a nominal anchor for inflation expectations. This study shows how a monetary policy strategy combining inflation targeting and monetary targeting can be conceived to guarantee macroeconomic stability and the credibility of monetary policy. Friedman's k-percent money growth rule, which can generate dynamic instability, and two alternative stabilizing feedback monetary targeting rules are examined.     

An argument in favor of long terms for central bankers

Drawing on the canonical New Keynesian model, we assess the impact of central bankers’ term duration on governments’ appointment choices. We show that longer terms induce the government to appoint more conservative central bankers, which is socially desirable.     

Inflation dynamics and the cost channel of monetary transmission

Evidence from vector autoregressions indicates that the impact of interest rate shocks on macroeconomic aggregates can substantially be affected by the so-called cost channel of monetary transmission. In this paper, we apply a structural approach to examine the relevance of the cost channel for inflation dynamics in G7 countries. Since firms’ costs of working capital increase with interest rates, we augment a (hybrid) New Keynesian Phillips curve by including the short-run nominal interest rate. We find significant and varying direct interest rate effects for the majority of countries, including member countries of the EMU. Simulations further demonstrate that the estimated interest rate coefficients can substantially affect inflation responses to monetary policy shocks, and can even lead to inverse inflation responses, when the cost channel is - relative to the demand channel - sufficiently strong.     

Optimal versus realized policy rules in a regime-switching framework

In this paper we compare a deterministic model and a Markov switching model to analyze the behavior of the US economy and the Federal Reserve. We examine both optimal and empirical monetary policies for the US Federal Reserve between 1960 and 2008. We compare the optimal monetary policy to the actual interest rates and to the empirical reaction function. We also evaluate the sensitivity of the results to the preferences assigned to each objective. We find that there is no unique optimal solution that fits the Federal Reserve behavior over the entire period. The best fit to the actual interest rates is obtained by an optimal policy with preference switches following the rule: a high-volatility regime coincides with a priority on inflation alone while in a low-volatility regime there is equal policy priority on output stabilization and inflation.     

The optimal choice of central bank independence and conservatism under uncertainty

This paper examines the optimal monetary delegation arrangement of central bank independence and conservatism in the presence of uncertainty about the central bank’s output objective. We show that full independence is no longer optimal with uncertain central bank preferences, and that optimal delegation involves the choice of both independence and conservatism. Further, we find that the usual trade-off between independence and conservatism no longer necessarily holds. Consequently, high central bank independence may also require a high level of conservatism.     

Are monetary-policy reaction functions asymmetric?: The role of nonlinearity in the Phillips curve

This paper investigates the implications of a nonlinear Phillips curve for the derivation of optimal monetary policy rules. Combined with a quadratic loss function, the optimal policy is also nonlinear, with the policy-maker increasing interest rates by a larger amount when inflation or output are above target than the amount it will reduce them when they are below target. Specifically, the main prediction of our model is that such a source of nonlinearity leads to the inclusion of the interaction between expected inflation and the output gap in an otherwise linear Taylor rule. We find empirical support for this type of asymmetries in the interest rate-setting behaviour of four European central banks but none for the US Fed.     

Taylor rules in the open economy

Taylor rules, which link short-term interest rates to fluctuations in inflation and output, have been shown to be a good guide (both positively and normatively) to the conduct of monetary policy. As a result they have been used extensively to model policy in the context of both closed and open economy models. Their determinacy properties have also been analysed in the context of closed and, to a more limited degree, in small open economy models. In this paper, we extend the analysis of the determinacy properties of Taylor rules to the case of a benchmark two-country model. When the rules are specified in terms of output-price inflation we confirm and extend the conventional results from the closed economy literature—satisfying the Taylor principle is the key to ensuring determinacy, although the presence of backward-looking price-setting can affect the determinacy properties of the two-country model. However, the conventional results do not hold when we replace output-price inflation with consumer price inflation in the specification of the rule. In this case, Taylor rules which satisfy the Taylor principle will be indeterminate, unless there is an unusually large home bias in consumption. Similar indeterminacy problems arise when one country targets CPI inflation and the other output-price inflation. In this case we show that, even if determinacy is achieved, large spillovers may occur between countries.     

Dynamic inefficiency in an overlapping generations economy with production

Reichlin [Equilibrium cycles in an overlapping generations economy with production, J. Econ. Theory 40 (1986) 89-102] has shown in an OLG model with productive capital that whenever the steady state is locally indeterminate and undergoes a Hopf bifurcation, it is Pareto-optimal. While these results were established under the assumption of Leontief technology, the author has partially extended them to show that the Hopf bifurcation is robust with respect to the introduction of capital-labor substitution. In this note, we prove that the Pareto-optimality of the steady state does not extend to technologies with capital-labor substitution. When the steady state is a sink or undergoes a Hopf bifurcation, it is characterized by over-accumulation with respect to the Golden Rule—the interest rate is negative—hence not Pareto-optimal. Most importantly, it follows that stabilization policies targeting the steady state leave room for welfare losses associated with productive inefficiency, apart from the very special case of Leontief technology.     

Comparing China and India: A factor accumulation perspective

The remarkable economic transformations in China and India in recent decades have been accompanied by almost equally remarkable different development patterns. For example, the empirical data during 1985–2004 show that, compared with India, China’s economy has exhibited (i) considerably higher rates of physical capital formation; (ii) much higher ratios of measured physical to human capital; and (iii) a more physical-capital-friendly public policy. Motivated by these empirical observations, we study the accumulation of both physical and human capital in a one-sector growth model with a CES production function. After deriving some qualitative implications from the model, we estimate the key technological parameters of the normalized CES production function using the panel data at the provincial level for China and at the state level for India. Our estimation results suggest that our model implications match broadly with the above stylized development patterns regarding China and India.