The BMW Model: A New Framework for Teaching Monetary Economics

Abstract: Although the IS/LM-AS/AD model is still the central tool of macroeconomic teaching in most macroeconomic textbooks, it has been criticized by several economists. Colander (1995) demonstrated that the framework is logically inconsistent, Romer (2000) showed that it is unable to deal with a monetary policy that uses the interest rate as its operating target, and Walsh criticized that it is not well suited for an analysis of inflation targeting. The authors present a framework that develops the Romer approach into a very simple but, at the same time, comprehensive macroeconomic model. In spite of its simplicity, it can carry the main insights of the New Keynesian macroeconomics to an intermediate level and deal with issues like inflation targeting, monetary policy rules, and central bank credibility.     

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.     

Firms’ money demand and monetary policy

Standard New Keynesian models for monetary policy analysis are ‘cashless’. When the nominal interest rate is the central bank's operating instrument, the LM equation is endogenous and, it is argued, can be ignored. The modern theoretical and quantitative debate on the importance of money for monetary policy conduct, however, overlooks firms’ money demand. Working in an otherwise canonical New Keynesian setup, we show that macroeconomic dynamics are critically affected by the firms’ money demand choice. Under the conventional Taylor‐rule framework, we prove that equilibrium determinacy may require either an active interest rate policy, overreacting to inflation, or a passive interest rate policy, underreacting to inflation, depending on the elasticity of production with respect to cash balances. We then develop a numerical analysis to evaluate our theoretical results. We find that macroeconomic stability is more likely to occur under an active, but not overly aggressive, monetary policy stance. We also examine the dynamic effects of forward‐looking feedback rules. We show that, in this policy regime, indeterminacy is likely to be induced by both active and passive rules, even for relatively low productivity effects of money.     

Does the Reserve Bank of Australia follow a forward-looking nonlinear monetary policy rule?

ABSTRACT

The conventional monetary policy rule describes a simple linear relationship between the domestic interest rate, inflation rate and output gap. An important extension to this rule is to incorporate the forward-looking behaviour of central banks, where it is assumed that they target an expected level of inflation instead of its current realised value. Using quarterly observations for the period 1993:1-2018:2, this paper investigates whether the conduct of monetary policy in Australia can be described by a forward-looking linear monetary policy rule, or by a nonlinear forward-looking monetary policy rule. In particular, the nonlinear forward-looking monetary policy rule is analysed in a regime-switching framework using a smooth logistic transition regression model. While the results show that the conventional forward-looking linear monetary policy rule describes the application of monetary policy in Australia reasonably well, the interest rate setting behaviour of the RBA is best described by a nonlinear forward-looking monetary policy rule.     

Labor contracts,informational discrepancies and the role of monetary policy

This paper examines output stabilization and inflationary consequences of short-run monetary policy. The macroeconomic framework incorporates informational discrepancies between the monetary authority and economic agents who form long-term labor contracts. Economic agents are assumed to form rational expectations of the rate of inflation. One result of the analysis is that optimal monetary policy rules for stabilizing fluctuations in output and inflation are independent of the structure of the wage contracts and the degree of informational discrepancy. A second proposition shows that the monetary authority can actually make use of specific knowledge concerning the contract structure to reduce fluctuations in the rate of change in output. In particular, the monetary authority can reduce fluctuations in output below those occurring in a frictionless system by increasing fluctuations in the rate of inflation.     

The unbearable tightness of being in a monetary union: Fiscal restrictions and regional stability

We study how constrained fiscal policy can affect macroeconomic stability and welfare in a two-region model of a monetary union with sticky prices and distortionary taxation. Both government spending and taxes can be used to stabilize regional variables; however, the best welfare outcome is obtained under some tax variability and constant regional inflations. We use a variety of rules to characterize constrained fiscal policy and find that strict fiscal rules coupled with a monetary policy that targets union-wide inflation result in regional inflation stability and the welfare costs of such rules are not as unbearable as one would expect. Fiscal authorities can enhance welfare by targeting the regional output gap, while targeting regional inflation is less successful since inflation stability is guaranteed by the central bank.     

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.     

Asymmetric monetary policy rules for the euro area and the US

We analyse the implications of asymmetric monetary policy rules by estimating Markov-switching DSGE models for the euro area (EA) and the US. The estimations show that until mid-2014 the ECB’s response to inflation was more forceful when inflation was above than below the central bank’s aim. Since then, the ECB’s policy can be characterised as symmetric, and we quantify the macroeconomic implications of this policy change. We uncover asymmetries also in the Fed’s policy, which has responded more strongly in times of crisis. We compute optimal simple rules for the EA and the US in an environment with the effective lower bound and a low neutral real rate, and find that it prescribes a stronger response to inflation and the output gap when inflation is below target compared to when it is above target. We document its stabilisation properties had this optimal rule been implemented over the last two decades.     

The exchange rate and optimal monetary policy rules in open and developing economies: Some simple analytics

Using a simple, tractable model, this paper revisits and expands upon issues relating to optimal monetary policy rules (MPRs) in open economies. The optimality of the rule is explored through various specifications of a central bank loss function as it is the loss function that offers insight into central bank preferences. Many of the issues on this topic have centred on the role of the exchange rate: Is it optimal for the policy instrument to react to the exchange rate? What is the role of the exchange rate in a domestic inflation targeting vs CPI inflation targeting? Does a fear of floating have any bearing on the way optimal MPRs are constructed? While this paper is not empirical, the analysis is relevant for central banks in open and developing economies that face a choice between allowing exchange rates to float (and adopting an inflation targeting regime) and engaging in some degree of exchange rate fixity.     

Trade-offs between macroeconomic and financial stability objectives

Ten years after the 2008-09 global financial crisis, most advanced economies have recovered and global economic growth has taken hold. However, partly due to accommodative financial conditions, financial risks are on the rise while inflation remains subdued. This revives the debate on the role of monetary policy in containing financial risks. This paper provides a framework to investigate trade-offs between macroeconomic and financial stability when the central bank has a financial stability objective. Relying on a New Keynesian model with an endogenous financial bubble, our simulations suggest that a central bank attempting to “lean against the wind” may face trade-offs between inflation/output stability and financial stability. We therefore argue that the interest rate should be used for achieving traditional macroeconomic goals, and a second, macroprudential instrument should complement the policy rate to tackle financial risk accumulation.     

Should a central bank react to food inflation? Evidence from an estimated model for Chile

We examine whether food price shocks are a major source of macroeconomic fluctuations. We estimate a small open economy DSGE model using an alternative Taylor rule applied to Chilean data. The empirical evidence suggests that food inflation played a non-trivial role in shaping Chile's de facto monetary policy actions. Consistent with its commitment to price stability, the central bank increases the policy rate in reaction to food inflation. Despite an immediate monetary policy reaction to a food price shock, the policy rate gradually tapers off. This is due to a second-round effect on non-food inflation propagated by the food price shock. A main finding is that monetary policy that targets headline inflation is welfare improving.     

Structural Changes and the Scope of Inflation Targeting in Korea *

A small, open macroeconomic model that accounts for new financial accelerator effects (the effects of fluctuations in asset prices on bank credit and economic activity) is developed to evaluate various policy rules for inflation targeting. Given the conditions of asset markets and the fragility of the financial sector, monetary policy responses can potentially amplify the financial accelerator effect. Simulations are used to compare various forms of inflation targeting using a model that emphasizes long-term inflation expectations, output changes, and the asset price channels. The simulations suggest that a successful outcome can be obtained by adhering to simple forward-looking rules, rather than backward-looking policy rules. Furthermore, inflation targeting can contribute to price as well as output stability by helping to keep the financial accelerator from being activated. Inflation targeting in emerging economies can provide an environment conducive to long-term capital market development. [E51,F3,F4]     

DEBT NONNEUTRALITY,POLICY INTERACTIONS,AND MACROECONOMIC STABILITY*

We study the consequences of nonneutrality of government debt for macroeconomic stabilization policy in a sticky‐price model. Ricardian equivalence fails because debt has a negative impact on its rate of return and on private savings, which is induced by assuming transaction services of bonds. Under aggressive monetary policy regimes, macroeconomic fluctuations tend to be stabilized if nominal budget deficits are low. A smooth debt path limits inflation expectations, such that inflation variances can be reduced. Under a balanced budget policy, the central bank's output gap–inflation volatility trade‐off is improved relative to an environment where debt is neutral.     

Inflation targeting in a learning economy: An ABM perspective

This paper investigates the performances of an inflation targeting regime in a learning economy framed as an Agent-Based Model (ABM). We keep our ABM as close as possible to the original New Keynesian (NK) model, but we model the individual behaviour of the agents under procedural rationality à la Simon. Accordingly, we assume that their behaviour is guided by simple rules of thumb – or heuristics – while a continuous learning process governs the evolution of those rules. Under these assumptions that also allow the emergence of agents heterogeneity, we analyze the dynamics of the economy without assuming rational expectations, and study the role that a central bank, implementing an inflation targeting regime via a monetary policy rule, can play in the orientation of these dynamics. Consequently, our main goal is to analyse the interplay between the learning mechanisms operating at the individual level and the features and performances of the inflation targeting regime. Our results point to the prime importance of the credibility of central bank's inflation target regarding macroeconomic stabilisation, as well as the beneficial role played by that target as an anchoring device for private inflation expectations. We also establish the potential welfare cost of imperfect public information and contribute to the current debate on optimal monetary policy rules under imperfect common knowledge and uncertainty.     

Teaching Inflation Targeting: An Analysis for Intermediate Macro

Over the last decade, many central banks have adopted policies known as inflation targeting. If intermediate-level macroeconomics students are to be prepared to think about current policy issues, it is important to provide them with an introduction to the macroeconomic implications of inflation targeting. Unfortunately, the standard aggregate demand-aggregate supply frameworks commonly used to teach intermediate macroeconomics are not well suited for this task because they are expressed in terms of output and the price level and because they fail to make explicit the policy objectives of the central bank. The author provides a simple graphical device involving the output gap and the inflation rate that overcomes these problems and that can be used to teach intermediate macroeconomics students about inflation targeting.     

A comparison of optimal policy rules prior to and during inflation targeting: empirical evidence from Bank of Canada

We examine policy rules that are consistent with inflation targeting (IT) framework in a small macroeconomic model of the Canadian economy. We set up an optimal linear regulator problem and derive policy rules to compare the dynamics of pre-IT and IT eras. We find that while the optimal monetary policy rule in the pre-IT period is best described with a loss function that attaches equal weight to price stability, financial stability and output stability; the IT era is dominated by the price stability objective followed by the financial stability and output stability, consecutively. Moreover, we do not find an explicit role for exchange rate stability in the objective function of the Bank of Canada for both monetary policy eras. We, then, compare the properties of the derived optimal rules with those of an ad hoc Taylor rule for the IT period. In response to inflationary shocks, Taylor rule brings down inflation rates more quickly compared to the derived policy rules, but at the cost of a higher sacrifice ratio and more volatile interest rates.     

Budgetary policies in a DSGE model with finite horizons

This paper presents a dynamic stochastic general equilibrium model with nominal rigidities, capital accumulation and finite horizons. Our New Keynesian framework exhibits intergenerational wealth effects and is intended to investigate the macroeconomic implications of fiscal policy, which is specified by either a debt-based tax rule or a balanced-budget rule allowing for temporary deficits. The model predicts that fiscal expansions generate a trade-off in output dynamics between short-term gains and medium-term losses. It is shown that the effects of fiscal shocks crucially depend upon the conduct of monetary policy. Simulation analysis suggests that balanced-budget requirements enhance the determinacy properties of feedback interest rate rules by guaranteeing inflation stabilization.     

ROBUST MONETARY POLICY UNDER UNCERTAINTY ABOUT CENTRAL BANK PREFERENCES

In this paper, we study the impact of central bank opacity on macroeconomic performances in a new Keynesian framework with model uncertainty using robust control techniques. We identify a new source of central bank opacity, which refers to the lack of information about the central bank's preference for robustness in the sense of Hansen and Sargent . We find closed‐form solutions for the robust control problem, analysing the impact of the lack of transparency about the central bank's preferences for robustness. We show that an increased transparency about the central bank's preference for robustness makes monetary policy respond less aggressively to cost‐push shocks, thus reducing the inflation and output gap variability. As a consequence, inflation and output gap are less volatile than under central bank opacity about its preference for robustness.     

Macroeconomic transitions and the transmission mechanism: Evidence from Turkey

This paper investigates changes to the macroeconomic transmission mechanism in Turkey following a major reform of monetary policy in the early 2000s. We use a Threshold VAR (TVAR) framework to test for and then estimate a model with endogenous transitions between regimes. We detect two regimes, with a clear transition between them in 2003–4. The pre-reform regime is characterized by high inflation, passive monetary policy and persistent responses to shocks. The post-reform regime is characterized by low inflation, active and credible monetary policy and markedly less persistent responses to shocks. Using a model that contains sufficient variables to capture diverse transmission mechanisms, working through the real exchange rate, domestic credit and monetary policy, we find evidence of sharp changes in transmission mechanisms. Post-reform, the response of Turkey to macroeconomic shocks has changed to be similar to those in other modern, market-orientated economies.     

Estimating a monetary policy reaction function for the dominican republic

Abstract

The paper specifies and estimates a hybrid McCallum–Taylor monetary policy reaction function for the Dominican Republic (DR). The estimated reactions suggest that the Central Bank of the DR has been biased towards targeting the exchange rate. These findings are in line with the evidence on the fear-of-floating characteristic of developing countries. An evaluation of the estimated rule's historical performance shows that monetary base growth below (above) that implied by the ‘average’ policy reaction is associated with better (worse) macroeconomic performance.