Productivity Trends in Europe: Implications for Real Exchange Rates, Real Interest Rates, and Inflation

The paper examines a long–run (neoclassical) framework in which differences in productivity growth across sectors and countries lead to inflation differentials. In a currency union, these inflation differentials imply cross–country differentials in real interest rates. The authors estimate the likely size of these differentials for European Union countries, discuss the potential costs of persistent inflation differentials, and comment on the conflicts they may cause within Economic and Monetary Union (EMU). The analytical framework is a variant of the Balassa–Samuelson "productivity hypotheisis," which relates sectoral productivity trends to trends in the relative price of home goods.     

Did the Unconventional Monetary Policy of the U.S. Hurt Emerging Markets?

Open Economies Review - Policymakers in emerging markets complained that the unconventional US monetary policy response to the Great Recession hurt their economies. US policymakers responded that...     

Addressing International Empirical Puzzles: the Liquidity of Bonds

Models that assume bonds denominated in different currencies are perfect substitutes can not explain certain empirical puzzles: the exchange rate volatility puzzle is that these models can not explain the observed volatility in real and nominal exchange rates; the Backus-Smith puzzle is that these models can not explain the observed low correlation between real exchange rates and the ratio of home to foreign consumption; the Backus-Kehoe-Kydland puzzle is that these models can not explain the observed low correlation between home and foreign consumption; and finally, the uncovered interest parity puzzle is that these models can not explain the observed deviations from that parity. These long standing puzzles make the models harder to defend. In this paper, we present a symmetric two country portfolio balance model in which home and foreign bonds are imperfect substitutes for money in each country’s transactions technology; this of course makes home and foreign bonds imperfect substitutes for each other. Our calibrated model is capable of addressing the Backus-Smith puzzle and the Backus-Kehoe-Kydland puzzle. It does not fully resolve the exchange rate volatility puzzle, but it makes some headway. And finally it generates deviations from uncovered interest parity, though by some estimates these deviations are not large enough to be consistent with the data.     

Labor contracts and monetary policy

Fischer and others have shown that the very existence of long-term contracts can imply a stabilization role for monetary policy in models that incorporate the natural rate hypothesis and rational expectation formation. The present paper examines some of the factors that determine the length of labor contracts and how they are affected by monetary policy. It is argued that a successful stabilization policy might be expected to increase the length of contracts. The net effect of the imposition of such a policy would therefore be to dampen the amplitude of business cycles, but to make them more inertia ridden.     

Monetary policy and the choice of a monetary instrument in a stochastic setting

Should the FED try to set some monetary aggregate, or should it try to create certain credit conditions by setting interest rates? This question has been examined extensively within models that are essentially non-stochastic or certainty equivalent; however, the question is not meaningful to the monetary authority unless one postulates a stochastic setting. This paper attempts to analyze the question within a stochastic setting. It illustrates the new dimensions added by incorporating risk adverse economic behavior, “rational” expectations, and randomized policy settings.     

Optimal Exchange Intervention in an Inflation Targeting Regime: Some Cautionary Tales

Devaluations and fiscal retrenchments coming from developed countries are buffeting less developed countries. Many emerging market countries have adopted inflation targeting as “best practice,” but now they are being advised to enhance their inflation targeting regimes with foreign exchange intervention. Here we use a DSGE model to tell some cautionary tales about this advice. A Taylor rule guides interest rate setting, while foreign exchange interventions are used as a second tool of monetary policy. These interventions are effective in our model since domestic and key currency bonds are imperfect substitutes. We derive optimal (Ramsey) intervention policies in response to foreign devaluations and fiscal retrenchments, and find that they are rather complex. So, we compare the optimal responses to policies that simply smooth real or nominal exchange rate movements. Our results suggest that discretion may be the better part of valor: pure inflation targeting may come closer to the optimal policy than exchange rate smoothing. A secondary result may also be of some interest: foreign exchange interventions have a stronger impact on inflation and output in an inflation targeting regime than do sterilized interventions; the Taylor rule augments the effects of a given intervention.     

New Keynesian Explanations of Cyclical Movements in Aggregate Inflation and Regional Inflation Differentials

What determines the cyclical behavior of aggregate inflation and regional inflation differentials? The answer has strong implications for monetary policy and in Europe for the Stability and Growth Pact. In the United States, inflation rates move pro-cyclically, and across the Euro Area, inflation differentials are positively correlated with growth differentials. This suggests that demand shocks are the primary determinants of the cyclical behavior of aggregate inflation and regional inflation differentials. In this paper, we discuss New Keynesian explanations of these correlations, and we argue that demand shocks are either missing or inadequately modeled in the in typical New Keynesian model.     

The Stability and Growth Pact: A Delicate Balance or an Albatross?

The EU's Stability and Growth Pact tries to strike a delicate balance: it imposes the constraints on national fiscal policy that were deemed necessary to protect the new European Central Bank from outside pressures; at the same time, it allows flexibility for a counter-cyclical policy. First, we review official institutions' studies of the flexibility embedded in the Pact and find a rather strong consensus: the Pact seems likely to constrain counter-cyclical fiscal efforts in the years ahead, or at least until EU governments bring their structural deficits into balance. Then, we review conventional academic arguments that suggest a new central bank might need to be protected from external pressures, and we ask if the constraints that were actually written into the Pact are likely to be helpful in this regard. We conclude that the Pact is closer to an albatross than a delicately balanced package of necessary fiscal constraints.     

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.