International macroeconomic interdependence and imports of oil in a small open economy

To the extent that oil imports may be relevant to the international dimension of policy, we study the transmission of shocks to open economies dependent on oil within a NOEM framework through a DSGE model of a small open economy with flexible prices, staggered price setting and local currency pricing. For this purpose we introduce imports of oil as a new intermediate good needed to produce the final good and, apart from the usual exogenous shocks when a small open economy is being modeled, we consider an uncovered interest-rate parity shock, a technology shock and an oil price shock. A second-order accurate solution method is used to solve numerically a calibrated model for Portugal and Spain and the simulation results are compared with historical data, showing similar volatilities and expected dynamic responses to exogenous shocks. The model is computed with an optimized Taylor-style interest rate rule that includes real exchange targeting, thus arguing in favour of an international dimension of monetary policy.     

Exchange Rate Regimes and Welfare Losses from Foreign Crises: The Impact of the US Financial Crisis on Mexico

We modify the Gali and Monacelli small open economy dynamic stochastic general equilibrium (DSGE) model, calibrate to Mexican data and simulate the impact of the financial crisis on Mexico, under floating and counter factual fixed exchange rates. The floating exchange rate ameliorates welfare losses for Mexico. They are greater under fixed exchange rates because the return paths to equilibrium are more volatile (higher variance) and output, consumption and employment impulse response functions (IRFs) overshoot. Monetary policy, inflation targeting with floating exchange rates, clearly reduced the welfare costs vis‐à‐vis other counter factual policies including consumer price index‐based Taylor rule, domestic inflation Taylor rule and fixed exchange rates.     

Monetary Policy and Exchange Rate Volatility in a Small Open Economy

We lay out a small open economy version of the Calvo sticky price model, and show how the equilibrium dynamics can be reduced to a simple representation in domestic inflation and the output gap. We use the resulting framework to analyse the macroeconomic implications of three alternative rule-based policy regimes for the small open economy: domestic inflation and CPI-based Taylor rules, and an exchange rate peg. We show that a key difference among these regimes lies in the relative amount of exchange rate volatility that they entail. We also discuss a special case for which domestic inflation targeting constitutes the optimal policy, and where a simple second order approximation to the utility of the representative consumer can be derived and used to evaluate the welfare losses associated with the suboptimal rules.     

Foreign output shock in small open economies: A welfare evaluation of monetary policy regimes

We examine the impact of negative foreign output shocks, which entail negative demand side effects by lowering exports and positive supply side effects by lowering oil prices, on the welfare of non-oil producing, small open economies under five exchange rate and monetary policy regimes. We use a dynamic stochastic general equilibrium model with parameter values calibrated for Hong Kong, Israel, Singapore, South Korea and Taiwan. We find that welfare levels among the five policy regimes depend on the economy's share of oil imports in world oil consumption. Hong Kong, Singapore and Israel, which have smaller shares, maximize welfare under the Taylor rule, which targets both CPI inflation and real output. South Korea, with higher shares, and Taiwan, with more rigid prices, maximize welfare under real output targeting. CPI inflation targeting, nominal output growth targeting and fixed exchange rate regimes generate lower welfare. However, optimal monetary policy, which generates the highest welfare, gives greater weight on real output than CPI inflation.     

UNEMPLOYMENT PERSISTENCE AND THE SUSTAINABILITY OF EXCHANGE RATE PEGS

It is commonly thought that an open economy can accommodate output shocks through either exchange rate or real sector adjustments. We formalize this notion by incorporating unemployment persistence into a two‐sided escape clause model of currency crises. We show that unemployment persistence makes a currency peg more fragile and undermines the credibility of the monetary authority in a dynamic setting. The fragility is captured by a devaluation premium in expectations that increases the average inflation rate when the currency peg is more vulnerable to ‘busts’ than ‘booms’. This interaction between macroeconomic and microeconomic rigidities suggests that a policy reform can only be consistent if it renders either exchange rates or the economy more flexible.     

The relationship between exchange rates and interest rates in a small open emerging economy: The case of Romania

This paper revisits the relationship between interest rates and exchange rates in a small open emerging economy using wavelet-based methodologies. Based on data for Romania, our results confirm the theoretical predictions on the interest rate - exchange rate relationship during turmoil or policy changes. In the short term, the relationship is negative, confirming the sticky-price models, and over the long term, the relationship is positive, confirming the Purchasing Power Parity theory. At the beginning of the turmoil, the exchange rate movements generally take the lead over the interest rates for the first month, but the monetary authorities take the lead afterwards. Our results reveal that in a small open emerging economy with a direct inflation targeting monetary policy regime, the relationship between exchange rates and interest rate is fundamentally different from that in an advanced economy. Also, our results stress the necessity that the central bank must pay simultaneous attention to both variables in order to achieve their monetary policy targets.     

TAYLOR RULE REACTION COEFFICIENTS AND REAL EXCHANGE RATE PERSISTENCE

Recent literature has established a link between the persistence of real exchange rates and the degree of inertia in Taylor rule monetary policy reactions functions. This paper provides a different view on this link by investigating how the size of Taylor rule reaction coefficients impacts the adjustment dynamics of the real exchange rate. Within a stylized sticky‐price open‐economy macro model, it is demonstrated that a stronger interest rate reaction to inflation in the Taylor rule raises the convergence speed of the real exchange rate. Conversely, raising the coefficient on the output gap or attending to the exchange rate in an open‐economy version of the Taylor rule slows down real exchange rate adjustment. In all cases, more rapid convergence comes at the cost of stronger initial real exchange rate misalignments in the wake of monetary policy shocks.     

A Union-bashing Model of Inflation Targeting

This paper shows that in an open two‐sector economy, centralization of wage setting may be important in determining the employment (and welfare) effects of different monetary targets. By disciplining unions in the sectors open to international trade, exchange rate targeting yields higher employment than inflation targeting when wage‐setting is more centralized in the open sector than in the shielded sector. When wage‐setting centralization is higher in the shielded sector, we show that general price‐level inflation targeting, while better than exchange rate targeting, is inferior to an inflation target that focuses more heavily on shielded sector prices.     

Evaluating inflation targeting as a monetary policy objective for India

This study formulates a small open economy model for India with exchange rate as a prominent channel of monetary policy. The model is estimated using the Instrumental Variable-Generalized Methods of Moments (IV-GMM) estimator and evaluated through simulations. This study compares different cases of domestic and CPI inflation targeting, strict and flexible inflation targeting, and simple Taylor type rules. The analysis highlights the unsuitability of simple Taylor-type monetary rules in stabilizing the Indian economy and suggests that discretionary optimization works better in stabilizing this economy. There seems to be a trade-off between output gap stabilization and exchange rate stabilization in flexible domestic inflation targeting and CPI inflation targeting respectively. However, flexible domestic inflation targeting seems a better alternative from an overall macro stabilization perspective in India where financial markets are still not sufficiently integrated to ensure quick transmission of interest rate impulses and existence of rigidities in the economy.     

The Simple Post-Keynesian Monetary Policy Model: An Open Economy Approach

Monetary policy with an inflation targeting rule is analyzed through a simple small-scale Post-Keynesian model that incorporates open economy issues. In contrast with previous Post-Keynesian attempts, the model embodies policy authorities that are committed not only to hitting inflation and/or output targets, but also to the achievement of the external balance. To take account of the external balance objective, we model the real exchange rate as an endogenous and moving target, with the nominal exchange rate being the instrument of that target. The model shows that in response to an adverse external shock the central bank has to consider first the required real exchange rate adjustment that will preserve the external balance, and secondly the level at which the interest rate must be set in order to maintain inflation stabilization. Keeping inflation to target requires higher interest rates and strong reliance on the unemployment channel which, under certain circumstances, also has adverse side effects on income distribution. We show that to deal with an exogenous external shock a policy mix of real exchange rate targeting and income distribution targeting outperforms inflation targeting.     

Money Demand in an EU Accession Country: A VECM Study of Croatia

The paper estimates the money demand in Croatia using monthly data from 1994 to 2002. A failure of the Fisher equation is found, and adjustment to the standard money‐demand function is made to include the inflation rate as well as the nominal interest rate. In a two‐equation cointegrated system, a stable money demand shows rapid convergence back to equilibrium after shocks. This function performs better than an alternative using the exchange rate instead of the inflation rate as in the ‘pass‐through’ literature on exchange rates. The results provide a basis for inflation rate forecasting and suggest the ability to use inflation targeting goals in transition countries during the EU accession process. Finding a stable money demand also limits the scope for central bank ‘inflation bias’.     

Inflation volatility,economic growth and monetary policy in Bangladesh

This article provides an overview of the trends and movements of CPI-inflation in Bangladesh since the early 1950s and examines the key issues in rule-based monetary policy for price stability, implying low and stable inflation, in this country. Under a fixed exchange rate system, inflation in Bangladesh was moderately high and volatile during the 1950s and 1960s. Since the country’s independence from Pakistan in 1971, inflation in Bangladesh has remained moderately high on average and highly volatile and persistent under a fixed-pegged exchange rate system or under a managed floating system since 2003. Using data from the early 1970s or earlier depending on data availability, the article undertakes both Granger-causality and the structural vector autoregression (SVAR) analysis with two models. The first model is comprised of such variables as inflation, the real interest rate, the real exchange rate and output growth, and the second model is comprised of the volatilities of money growth, real output growth and inflation. Then, based on the empirical findings, the article concludes that a rule-based monetary policy, namely monetary targeting or inflation targeting, remains appropriate for Bangladesh provided that it adopts a more flexible, if not freely floating, exchange rate system. The article suggests that the use of monetary policy to achieve multiple objectives under a fixed-pegged exchange rate system creates a time-inconsistency problem, reduces monetary policy credibility and makes it (monetary policy) ineffective in lowering inflation and its volatility. Low credibility of monetary policy in particular raises inflation persistence. Within the present monetary-policy framework in Bangladesh, the article illustrates how the fixed-pegged exchange rate system has generated money growth volatility in the presence of large-scale inflows of overseas workers’ remittances and readymade garments export earnings. This does not seem to be a concern of the central bank of Bangladesh (Bangladesh Bank); rather, it (Bangladesh Bank) pursues monetary-base targeting to keep inflation low and stable after considering economic growth. The consequent diminishing credibility of monetary policy has kept inflation volatile and persistent, which has adversely affected economic growth.     

Foreign output shocks,monetary rules and macroeconomic volatilities in small open economies

The 2008 financial crisis is marked by the drop in output of major industrial countries which affected small open economies in various degrees. We examine the role of three different types of monetary policy rules in mitigating or exacerbating the effects of a negative foreign output shock on key macroeconomic variables of a small open economy by numerically solving a dynamic stochastic general equilibrium (DSGE) model. We find that compared to the Taylor rule, small open economies that follow either fixed exchange rate regime or strict inflation targeting tend to stabilize real exchange rate and inflation at the expense of substantial instability in the real economy.     

Does exchange rate variability matter for welfare? A quantitative investigation of stabilization policies

This paper studies what degree of exchange rate stabilization is optimal for several types of open economies. This is accomplished through a quantitative evaluation of optimal monetary policy rules in a two-country sticky-price model. First, a calibrated benchmark model with incomplete asset markets supports past conclusions from simpler models, emphasizing inflation stabilization rather than exchange rate stabilization. It also highlights that the utility gains from optimal stabilization policy are small. Second, while an economy extended to include consumer habits implies greater sensitivity by households to consumption variability, it has only minor effects on the benchmark conclusions and benefits. Finally, these conclusions are altered under an alternative environment where international asset markets exhibit asymmetry in the form of “original sin.” Such countries can benefit from policies that aggressively stabilize the exchange rate, with utility gains larger than the previous cases.     

The Bernanke and Blinder Model in an Open Economy: The Italian Case

Abstract. This paper analyzes the functioning of monetary policy transmission mechanisms in Italy from 1984 to 1998, highlighting the role performed by the credit system. We extend the Bernanke and Blinder model (1988) to the case of an open economy under a quasi‐fixed exchange rate regime, deriving analytically the conditions for the functioning of the three monetary policy channels generally identified in the literature (‘money’, ‘exchange rate’ and ‘credit’). These conditions explain the partial effectiveness of monetary policy in achieving price and income targets, while maintaining external equilibrium. By means of a structural VECM analysis, we evaluate the effectiveness of the transmission of monetary policy through the three channels.     

Does the exchange rate pass-through into prices change when inflation targeting is adopted? The Peruvian case study between 1994 and 2007

This paper analyzes whether the exchange rate pass-through into prices changed when the inflation targeting scheme was adopted in Peru. First, a simple dynamic stochastic general equilibrium model is simulated, which shows that adopting this scheme induces an increase in exchange rate volatility. Furthermore, applying the theory of the currency denomination of international trade, it is demonstrated that increased exchange rate volatility reduces the share of firms that set their prices in foreign currency. Given that the pass-though has a direct relationship with this share, it is shown that adopting inflation targeting generates a pass-through contraction. Second, we empirically test whether the Peruvian Central Bank’s decision to adopt inflation targeting in January 2002 actually had an effect on the pass-through estimating a time-varying vector autoregressive model which allows for an asymmetrical estimation of the pass-through. It provides parameters for both the pre and post inflation targeting regimes based on the assumption that the transition from one regime to the other is smooth. An analysis of the generalized impulse response functions reveals that the decision to adopt inflation targeting significantly decreased the exchange rate pass-throughs into import, producer, and consumer prices. The results are consistent with economic theory and are robust to the specification of parameters of the model.     

NOMINAL GDP TARGETING AND CENTRAL BANK CONSERVATIVENESS

In the literature on monetary economics, there is the ‘inflationary bias’ result which predicts that the rate of inflation will be biased towards a higher level under discretionary monetary policy than under a rule‐based policy regime. It is established that a credible nominal target can eliminate this ‘inflationary bias’. In this paper, we examine the case of nominal GDP targeting, which is a rule‐based monetary regime. Depending on the degree of conservativeness by the central bank, we show in a stylized model the choice of different combination of inflation and real GDP targets can still result in an ‘inflationary bias’, and there also exists the possibility of a ‘dis‐inflationary bias’.     

On discretion versus commitment and the role of the direct exchange rate channel in a forward-looking open economy model

Abstract

This paper compares optimal monetary policy under discretion and commitment in an economy where the direct exchange rate channel is operative. The stabilization bias under discretion is shown to be weaker in an open economy relative to a closed economy. In an open economy, a ‘less conservative central banker’, one that attaches a smaller weight to the variance of inflation in the loss function, can be appointed to replicate the behaviour of real output that eventuates under commitment. Evaluating the social loss function under discretion and commitment, we find that the existence of a direct exchange rate channel in the Phillips Curve mitigates the pronounced differences between the two strategies in case of high persistence in the stochastic shocks.     

Non‐linearities,Business Cycles and Exchange Rates

This paper conjoins the disparate empirical literatures on exchange rate models and monetary policy models, with special reference to the importance of output, inflation gaps and exchange rate targets. It focuses in on the dollar/euro exchange rate, and the differential results arising from using alternative measures of the output gap for the US and for the Euro area. A comparison of ‘in‐sample’ prediction against alternative models of exchange rates is also conducted. In addition to predictive power, I also assess the various models' plausibility as economic explanations for exchange rate movements, based on the conformity of coefficient estimates with priors. Taylor rule fundamentals appear to do as well, or better, than other models at the 1‐year horizon.     

A small-scale DSGE-VAR model for the Romanian economy

This paper describes the theoretical structure and the estimation results for a DSGE-VAR model for the Romanian economy, an inflation targeting country since 2005. Having as benchmark the New-Keynesian model of Rabanal and Rubio-Ramirez (2005), the main additional feature introduced refers to the extension to a small open economy setting in order to account for this specific aspect of the Romanian economy.Within the inflation targeting monetary policy regime, forecasts of central macro variables, inflation in particular, play an important part. Because inflation reacts to monetary measures with a considerable lag, the central bank's policy has to be forward-looking. Based on univariate measures of forecast performance, it is shown that the VAR with DSGE model prior produces forecasts that improve on those obtained using an unrestricted VAR model and the popular Minnesota prior in case of inflation, real exchange rate and nominal interest rate. Moreover, the DSGE-VAR model is informative about the structure of the economy and can help the “story-telling” in the central banks.