Monetary policy strategies in the New Normal: A model-based analysis for the euro area

A calibrated New Keynesian model of the euro area is used to evaluate the stabilization properties of alternative monetary policy strategies when the natural rate of interest is low (“new normal”) and the probability of reaching the effective lower bound (ELB) is non-negligible. Price level targeting is the most effective strategy in terms of stabilizing inflation and output and reducing the duration and frequency of ELB episodes. Temporary price level targeting is also effective in mitigating the ELB constraint, although its stabilization properties are inferior to those of price level targeting. Backward-looking average inflation targeting performs well and is preferable to inflation targeting. The effectiveness of these alternative strategies hinges upon the commitment of a central bank to keeping the policy rate “lower for longer” and is influenced by agents’ expectation formation mechanism.     

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.     

Exchange rates,central bank news and the zero lower bound*

The zero lower bound (ZLB) may restrict the responsiveness of exchange rates to news. A proxy for central bank communication is added as a determinant in a model of exchange rate movements. Two reserve currencies, the British pound and euro, and two currencies of small open economies, the Canadian dollar and Swedish krona, are examined. Reserve currencies are more vulnerable to the ZLB constraint, while the currencies of small open economies become more responsive to foreign central bank announcements. Certain unconventional monetary policy announcements were found to significantly impact exchange rates at the ZLB.     

Demographics and real interest rates: Inspecting the mechanism

The demographic transition can affect the equilibrium real interest rate through three channels. An increase in longevity—or expectations thereof—puts downward pressure on the real interest rate, as agents build up their savings in anticipation of a longer retirement period. A reduction in the population growth rate has two counteracting effects. On the one hand, capital per-worker rises, thus inducing lower real interest rates through a reduction in the marginal product of capital. On the other hand, the decline in population growth eventually leads to a higher dependency ratio (the fraction of retirees to workers). Because retirees save less than workers, this compositional effect lowers the aggregate savings rate and pushes real rates up. We calibrate a tractable life-cycle model to capture salient features of the demographic transition in developed economies, and find that its overall effect is a reduction of the equilibrium interest rate by at least one and a half percentage points between 1990 and 2014. Demographic trends have important implications for the conduct of monetary policy, especially in light of the zero lower bound on nominal interest rates. Other policies can offset the negative effects of the demographic transition on real rates with different degrees of success.     

The natural rate of interest and the output gap in the euro area: a joint estimation

The notion of a natural real rate of interest, due to Wicksell (Interest and prices. Macmillan, London Translation of 1898 edition, 1936), is widely used in current central bank research. The idea is that there exists a level at which the real interest rate would be compatible with output at its potential level and stationary inflation. Such a concept is of primary concern for monetary policy because it provides a benchmark for the monetary policy stance. This paper applies the method suggested by Laubach and Williams (Rev Econ Stat 85(4):1063–1070, 2003) to jointly estimate the natural real interest rate and the output gap in the euro area using data from 1960 onwards. Our results suggest that the natural real rate of interest has declined gradually over the past 40 years. They also indicate that monetary policy in the euro area was on average stimulative during the 1960s and the 1970s, while it contributed to dampen the output gap and inflation in the 1980s and 1990s. The views expressed in this paper are those of the authors and do not necessarily reflect the opinions of the institutions to which they are affiliated. We are grateful to Siem Jan Koopman for very helpful suggestions and comments. We also thank P. Cour-Thimann, V. Curdia, F. Drudi, S. McCaw, D. Rodriguez-Palenzuela, R. Pilegaard, H. Pill, L. Stracca, T. Laubach, J. C. Williams and the participants of an ECB workshop on natural interest rates.     

Amplification of shocks at the zero lower bound in a small open and large closed economy

This letter compares the consequences of hitting the zero lower bound in small open and large closed economies. I show that in a large economy shocks are modified by the zero lower bound on interest rate much more than in a small one – as a result, the large economy may suffer more.     

Some empirical tests on the integration of economic activity between the euro area and the accession countries

This note looks at the correlation of short‐term business cycles in the euro area and the EU accession countries. The issue is assessed with the help of vector autoregressive models. There are clear differences in the degree of correlation between accession countries. For Hungary and Slovenia, euro area shocks can explain a large share of variation in industrial production, while for some countries this influence is much smaller. For the latter countries, the results imply that joining the monetary union could entail reasonably large costs, unless their business cycles converge closer to the euro area cycle. Generally, for smaller countries the relative influence of the euro area business cycle is larger. Also, it is found that the most advanced accession countries are at least as integrated with the euro area business cycle as some small present member countries of the monetary union. JEL classification: E32, F15, F42.     

Interdependency and adjustments in the European Union

Since the euro was launched, divergences in European economies'evolutions have been more significant than generally expected. The article, based on a multinational macroeconomic model describing the interdependence between 14 European countries, examines the role played by relative‐price adjustment mechanisms and difficulties inherent in asymmetric evolutions.

The efficiency of relative‐price adjustment mechanisms seems limited and, even in the most flexible countries, the return to equilibrium is slow and still incomplete after 10 years. Differences in relative‐price adjustment mechanisms remain a source of asymmetries between member countries. Extra‐European exchanges have a stabilizing role which is uneven on account of trade openness and price elasticities. A decrease of the world demand and a depreciation of the euro, still have an important impact with significant disparities between countries.

Several lessons can be drawn in terms of economic policy. A more restrictive European fiscal policy proves more costly in the long run in Germany and the Netherlands on account of the weakness of price compensation effects. On the contrary, thanks to their greater flexibility, the United Kingdom and Sweden can offset an initial negative shock more rapidly. The wage dimension in the definition of a good European policy mix has also to be examined.     

Further evidence on the PPP analysis of the Australian dollar: Non-linearities, fractional integration and structural changes

The aim of this paper is to analyse the empirical fulfilment of the Purchasing Power Parity (PPP) theory for the Australian dollar. In order to do so we have applied recently developed unit root tests that account for asymmetric adjustment towards the equilibrium [Kapetanios, G., Shin, Y., Snell, A., 2003. “Testing for a unit root in the nonlinear STAR framework”, Journal of Econometrics, 112, 359–379] and fractional integration in the context of structural changes [Robinson, P.M., 1994. “Efficient tests of nonstationary hypotheses”, Journal of the American Statistical Association, 89, 1420–1437; Gil-Alana, L.A., 2008. “Fractional integration and structural breaks at unknown periods of time”, Journal of Time Series Analysis, 29, 163–185]. Although our results point to the rejection of the PPP hypothesis, we find that the degree of persistence of shocks to the Australian dollar decreases after the 1985 currency crisis.     

Domestic financial market frictions,unrestricted international capital flows,and crises in small open economies

Summary. We present an example of a small open economy where small increases in the world interest rate may induce a sharp decline in output and a precipitous depreciation of the exchange rate. Due to a costly state verification problem in domestic credit markets, combined with unrestricted international capital flows, our economy generates two long-run equilibria, one with low GDP and a relatively depreciated real exchange rate (RER), and one with high GDP and a relatively appreciated RER. The first is always a saddle, while the second may be a sink or a source, depending on the level of the world interest rate. A crisis is identified with the economy switching from an equilibrium path approaching the high-output steady state to the saddlepath approaching the low-output steady state. In Mexicos recent history, periods of growth associated with appreciation of the RER have alternated with periods of sharp contraction and depreciation of the RER. Our economy displays such behavior in response to changes in the world interest rate.Received: 9 April 2002, Revised: 20 March 2003JEL Classification Numbers: E5, F4.G. Antinolfi, E. Huybens: We thank Steve Fazzari, Tim Kehoe, Todd Keister, Manuel Santos, Karl Shell and especially Bruce Smith for very helpful discussions. Jaime Calleja Alderete, Eduardo Camero Godínez, and Juan Vargas Hernández provided excellent research assistance. All remaining errors are ours. Huybens was an assistant professor in the Centro de Investigación Económica, ITAM, at the time this article was written, and part of this work was completed while Antinolfi was a visiting scholar at the Federal Reserve Bank of St. Louis. The views expressed herein are those of the authors, and do not reflect those of the World Bank or the Federal Reserve Bank of St. Louis. Correspondence to: G. Antinolfi     

Choosing sides in the trilemma: international financial cycles and structural change in developing economies

ABSTRACT

This paper analyzes the impact of international financial cycles on structural change in developing economies. It is argued that the impact of these cycles depends on the specific combination of macroeconomic and industrial policies adopted by the developing economy. The cases of Brazil and Argentina are contrasted with those of Korea and China. In the Asian economies, macroeconomic policy has been a complementary tool along with industrial policy to foster the diversification of production and capabilities. Inversely, in the case of the Latin American countries, long periods of real exchange rate (RER) appreciation, combined with the weaknesses (or absence) of industrial policies, contributed to the loss of capabilities and lagging behind.     

PPP in the medium run: The case of Norway

Existing studies generally reject purchasing power parity (PPP) on data sets from countries that have been affected by large real shocks, including Norway. However, we offer strong evidence of PPP between Norway and its trading partners during the post-Bretton Woods period, in which the Norwegian economy has experienced numerous real shocks such as discoveries of large petroleum reserves and oil price shocks. In particular, the behavior of the Norwegian real and nominal exchange rates appears remarkably consistent with the PPP theory. Moreover, convergence towards PPP is relatively rapid; the half-life of a deviation from parity is just about 1.5 years. We show that such deviations are primarily eliminated by adjustments in the nominal exchange rate and we offer some explanations for the relatively rapid convergence towards PPP.     

Using pre-EMU money market rates to assess monetary policy in the euro area

This note addresses the problems arising when using national pre-EMU interest rate data in the estimation of monetary policy reaction functions for the euro area. We provide evidence that failing to adjust for interest rate risk premia leads to an overestimation of the response of monetary policy both to inflationary pressures and to the output gap. A method for adjusting pre-EMU interest rate data for risk premia is proposed.     

Monetary policy synchronization in the ASEAN-5 region: an exchange rate perspective

In light of the long-standing vision of economic and monetary integration in the ASEAN (Association of Southeast Asian Nations) region and the importance of coordinating monetary policies to achieve it, the objective of this article is to assess the monetary policy synchronization among the founding members of the ASEAN, that is, Indonesia, Malaysia, the Philippines, Singapore and Thailand. Due to the importance of exchange rate movements to monetary policies, we approach this issue from a currency exchange rate perspective. Specifically, multivariate trend–cycle decomposition is employed to investigate common trends and common cycles among the exchange rates of these countries during the period 1976–2012. Our analysis reveals that the real exchange rates of Malaysia, the Philippines, Singapore and Thailand share common cycles in the short term and have common trends in the long term, but the Indonesian currency does not share these relationships. Thus, our results augur well for the synchronization of monetary policies among Malaysia, the Philippines, Singapore and Thailand. In contrast, the relatively turbulent dynamics of the Indonesian rupiah evident in frequent bouts of stark depreciation separated by periods of steady depreciation over the past three decades raise questions regarding the readiness of Indonesia for participating in a monetary alliance with the ASEAN-4 nations.     

Securitization,collateral constraints and consumption risk sharing in the euro area

Scarcity of housing collateral is associated with lower credit volumes and hence decreases consumption risk sharing among seven euro area countries in the time period from 1987Q1 to 2007Q4. At the same time, securitization improves risk sharing but does not seem to outweigh the collateral scarcity effect.     

Money velocity and asset prices in the euro area

Monetary growth in the euro area has exceeded its target since several years. At the same time, the money demand function seems to be increasingly unstable if more recent data are used. If the link between money balances and the macroeconomy is fragile, the rationale of monetary aggregates in the ECB strategy has to be doubted. In fact, a rise in the income elasticity after 2001 can be observed, and may reflect the exclusion of real and financial wealth in conventional specifications of money demand. This presumption is explored by means of a cointegration analysis. To separate income from wealth effects, the specification in terms of money velocity is preferred. Evidence for the presence of wealth in the long run relationship is provided. In particular, both stock and house prices have exerted a negative impact on velocity after 2001 and lead to almost identical equilibrium errors. The extended error correction model is stable over the entire sample period and survive a battery of specification tests.

New technologies and productivity growth in the euro area

This paper provides an overview of the available evidence on the importance of information and communication technologies (ICT) for developments in average labour productivity (ALP) growth in the euro area. The contribution of ICT to ALP growth is found to have increased both in terms of production and investment over the 1990s (up to 2001). However, there is no evidence of significant positive spillover effects from the use of ICT on ALP growth. This implies that there is no reason to believe that potential output growth in the euro area has increased significantly in recent years on account of new technologies. Comparing developments in the euro area and the United States, it appears, however, that ICT capital cannot account for much of the difference in ALP developments over the 1990s. This suggests that cyclical developments and, in particular, the structure of the economy are more important for explaining the difference in performance.First version received: March 2002/Final version received: May 2003We thank Bart van Ark, Neale Kennedy, Gerard Korteweg, Ad van Riet, Marcel Timmer, two anonymous referees and participants at the 17th Congress of the European Economic Association, Venice August 2002 for their comments. All errors and omissions remain ours, of course. We thank Erikos Velissaratos for his help in acquiring data on investment in ICT and Colin Webb for providing us with the OECD STAN database. This paper represents the views of the authors and does not necessarily reflect the views of the European Central Bank, the European Commission or their staff.     

Currency internationalization and valuation effects: based on the threshold model

ABSTRACT

Based on the three functions of currency internationalization, including exchange medium, pricing currency and foreign reserve, this paper explores how the degree of currency internationalization affects the impact of the exchange rate and the asset price on valuation effects. Using samples of 161 countries or regions from 2001 to 2016 and the threshold regression method, we find that, firstly, there is a threshold effect of the exchange rate on valuation effects due to currency internationalization. The higher the comprehensive level of currency internationalization is, the greater the positive impact of the exchange rate on valuation effects will be. Secondly, the threshold effect of the asset price on valuation effects due to currency internationalization is not significant because of the high stickiness of asset price. Besides, compared with developed countries, currency internationalization is more important to increase valuation effects through exchange rate channel and asset price channel in developing countries or regions. Finally, there are some differences in the three types of currency internationalization functions. The promotion of exchange medium function will lead to a greater positive impact of the exchange rate on valuation effects, as well as pricing currency function. However, the foreign reserve function has no such effect.     

An evaluation of the equilibrium value of the euro,its predecessors and their constituent currencies based on economic fundamentals

This study presents constructed equilibrium exchange rates (EERs) of the euro and its predecessors the European Unit of Account and the European Currency Unit, as well as the euro’s member states using a relative version of purchasing power parity (PPP) equilibrium. The revealed patterns of over- and undervaluation demonstrate how well suited the northern member states, in contrast to the southern states, were for the monetary union. Moreover, a relative persistent overvaluation for Greece and Portugal suggests that their ambition to join the euro reduced their competitiveness. The constructed EERs of the euro suggest the European Commission was able to set the initial value of the euro with a high degree of accuracy. Furthermore, the EERs indicate a successive strengthening of the fundamental value of the euro versus the U.S. dollar from 1999 to 2015. The analysis shows a close correlation between the deviations from equilibrium and the events of Greece’s sovereign debt crisis. In addition, the presented graphs show strong support for the PPP hypothesis. The results are robust to different constructed EERs and offer a guide to international market participants interested in the general equilibrium path of the euro and its predecessors.     

Asymmetric behavior of inflation differentials in the euro area: Evidence from a threshold unit root test

This paper tests the existence of persistent inflation rate differentials in the euro area by employing linear as well nonlinear unit root tests. Besides linear unit root tests, a two-regime threshold unit root test examines the conjecture that inflation rate differentials follow a nonlinear two-regime process towards a threshold, switching from the persistent regime to the transitory one and vice versa. The results imply that threshold nonlinearity is confirmed in 10 out of the 16 cases. However, we have found unit root regime-switching behavior only in six out of the 16 cases under investigation. This finding implies that these inflation rate differentials were persistent when they were low (regime 1), but transitory when they were high (regime 2). This asymmetric behavior can possibly be explained by the different degree of pressure exercised on governments, which is accompanied with different inflation rate differentials. On the contrary, despite the evidence of nonlinearity, the majority of the inflation rate differentials are found to be monotonically persistent. Our results have strong implications for policy makers. In particular, the documented persistency in the inflation rate differentials might have long-run costs in terms of price and macroeconomic stability.