Optimal Monetary Policy with Vertical Production and Trade*

This paper explores the optimal monetary policy response to domestic and foreign technology shocks in an open economy with vertical structure of production and trade. We find that any stage‐specific productivity shock in one country may have a transborder spillover effect on the other country via the vertical trade. So when choosing optimal monetary rules, each monetary authority should respond to both home and foreign productivity shocks. Also, the flexible exchange rate cannot replicate the flexible price equilibrium, even under producer currency pricing, due to price stickiness in multiple stages. We also find that the existence of a transborder spillover effect depends on the currencies of price setting. Finally, vertical trade may affect the value of exchange rate flexibility under PCP and LCP setting.     

Sectoral labor adjustment and monetary policy in a small open economy

This paper studies the welfare implications of sectoral labor adjustment cost in a two-sector small open economy model with sticky prices. We find that, when the economy faces external shocks, if monetary policy can stabilize the real economy, then sectoral labor market adjustment cost will lead to welfare loss. However, if monetary policy such as fixed exchange rates cannot stabilize real variables, then some degree of labor market friction will improve welfare instead and the gain will be significant. As a result, the welfare gap between flexible exchange rates and fixed exchange rates decreases with sectoral labor market friction. This is because the friction can offset some of the nominal rigidity and become a substitute for monetary policy to stabilize the real economy.     

A theory of the non-neutrality of money with banking frictions and bank recapitalization

The unconventional monetary policy actions of the Federal Reserve during the recent Global Financial Crisis often involve implicit subsidies to banks. This paper offers a theory of the non-neutrality of money associated with capital injection into banks via nominal transfers, in an environment where banking frictions are present in the sense that there exists an agency problem between banks and their private-sector creditors. The analysis is conducted within a general equilibrium setting with two-sided financial contracting. We first show that even with perfect nominal flexibility, the recapitalization policy has real effects on the economy. We then introduce banking riskiness shocks and study optimal policy responses to such shocks.     

Optimal Monetary Policy

Optimal monetary policy maximizes the welfare of a representative agent, given frictions in the economic environment. Constructing a model with two sets of frictions—costly price adjustment by imperfectly competitive firms and costly exchange of wealth for goods—we find optimal monetary policy is governed by two familiar principles. First, the average level of the nominal interest rate should be sufficiently low, as suggested by Milton Friedman, that there should be deflation on average. Yet, the Keynesian frictions imply that the optimal nominal interest rate is positive. Second, as various shocks occur to the real and monetary sectors, the price level should be largely stabilized, as suggested by Irving Fisher, albeit around a deflationary trend path. Since expected inflation is roughly constant through time, the nominal interest rate must therefore vary with the Fisherian determinants of the real interest rate. Although the monetary authority has substantial leverage over real activity in our model economy, it chooses real allocations that closely resemble those which would occur if prices were flexible. In our benchmark model, there is some tendency for the monetary authority to smooth nominal and real interest rates.     

A modern reincarnation of Mundell-Fleming's trilemma

A modern incarnation of the trilemma is essential for understanding the evolving global financial architecture, and for coming up with ways to mitigate financial fragility. The scarcity of policy instruments relative to the policy goals implies complex country-specific tradeoffs between the policy goals. The financial crises of the 1990s induced Emerging markets to converge to trilemma's middle ground -- managed exchange-rate flexibility, controlled financial integration, and viable but limited monetary independence. Capital flight crises added financial stability to trilemma's policy goals. New policies were added to deal with financial fragility associated with financial integration, including precautionary management of international reserves by emerging markets, swap lines among OECD's central banks, and macroeconomic prudential regulations. These trade-offs are impacted by a country's balance sheet exposure to hard currencies, the exchange-rate regime, and the growing sensitivity to shocks emanating from the U.S. and the Eurozone in the aftermath of the Global Financial Crisis.     

Capital Inflows,Dutch Disease Effects,and Monetary Policy in a Small Open Economy

This paper studies the role of monetary policy in a small open economy that experiences Dutch disease effects as a result of capital inflows, and examines the issue of whether such a policy should seek to address these effects from a welfare perspective. I find that Dutch disease effects occur under a fixed nominal exchange rate regime. However, a monetary policy regime characterized by generalized Taylor interest rate rules featuring either the real exchange rate or the nominal exchange rate avert Dutch disease effects. Welfare results reveal that the optimal rule is a generalized Taylor rule consistent with nominal exchange rate flexibility.     

Openness and the case for flexible exchange rates

Models of stabilization in open economy traditionally emphasize the role of exchange rates as a substitute for nominal price flexibility in fostering relative price adjustment. This view has been recently criticized on the ground that, to the extent that prices are sticky in local currency, the exchange rate does not play the stabilizing role envisioned by the received wisdom. An important question is whether, for this very reason, stabilization policies should limit exchange rate movements, or even eliminate them altogether. In this paper, I re-assess this issue by extending the [Corsetti Giancarlo, and Paolo Pesenti. 2001. Welfare and Macroeconomic Interdependence. Quarterly Journal of Economics 116 (2), 421–446.] model to allow for home bias in consumption—so that I can exploit the advantages of closed-form solutions. While this extension leaves most properties of the model unaffected, home bias implies that the real exchange rate in an efficient equilibrium is not constant, but fluctuates with the terms of trade. The weight that monetary authorities optimally place on stabilizing domestic marginal costs is increasing in home bias: with asymmetric shocks, fixed exchange rates are incompatible with efficient monetary rules. Yet, the adverse welfare consequences of exchange rate movements constrain the optimal intensity of monetary responses to domestic shocks. Openness matters: in our specification each country produces an equal share of the world value added; the lower the import content of consumption, the higher the exchange rate volatility implied by optimal stabilization rules. In relatively closed economy, optimal monetary rules tend to converge, regardless of the nature of nominal rigidities in the exports market.     

Financial frictions and optimal stabilization policy in a monetary union

Financial frictions differ across countries and thus cause international differences in the transmission of shocks. This paper shows how the optimal mix of monetary and fiscal policy depends on these country-specific financial frictions. To this end, we build a two-country DSGE-model of a monetary union. Financial frictions are captured by the cost channel approach. We show that the traditional solution to the assignment problem – the common central bank stabilizes the inflation rate at the union level and the national fiscal authorities stabilize the national economies – does not hold in a world with financial frictions. The cost channel decreases the efficiency of monetary policy and increases the need for fiscal stabilization even at the union level. Moreover, the more heterogeneous the union, the more important is fiscal policy in stabilizing shocks. Finally, we evaluate the scenarios in terms of welfare of the representative household.     

Is East Asia an optimum currency area?

This paper assesses the empirical desirability of the East Asian economies to an alternative exchange rate arrangement (a monetary union) that can potentially enhance the exchange rate stability and credibility in the region. Specifically, the symmetry in macroeconomic disturbances of the East Asian economies is examined as satisfying one of the preconditions for forming an Optimum Currency Area (OCA). We extend the existing literature by improving the methodology of assessing the symmetry shocks in evaluating the suitability of a common currency area in the East Asian economies employing the Bayesian State-Space Based approach. We consider a model of an economy in which the output is influenced by global, regional and country-specific shocks. The importance of a common regional shock would provide a case for a regional common currency. This model allows us to examine regional and country-specific cycles simultaneously with the world business cycle. The importance of the shocks decomposition is that studying a subset of countries can lead one to believe that observed co-movement is particular to that subset of countries when it in fact is common to a much larger group of countries. In addition, the understanding of the sources of international economic fluctuations is important for making policy decisions. The falling share of country specific factor and the rising role of region factor indicate that East Asia has become increasingly favorable for a monetary union. However, the share of country-specific factor that is still significant implies that it could be costly to renounce individual currencies to advance into a monetary union in East Asia.     

Optimal fiscal and monetary policy with sticky wages and sticky prices

We determine the optimal degree of price inflation volatility when nominal wages are sticky and the government uses state-contingent inflation to finance government spending. We address this question in a well-understood Ramsey model of fiscal and monetary policy, in which the benevolent planner has access to labor income taxes, nominally risk-free debt, and money creation. Our main result is that sticky wages alone make price stability optimal in the face of shocks to the government budget, to a degree quantitatively similar as sticky prices alone. Key for our results is an equilibrium restriction between nominal price inflation and nominal wage inflation that holds trivially in a Ramsey model featuring only sticky prices. Our results thus show that when nominal wages are sticky, setting real wages as close as possible to their efficient path is a more important goal of optimal monetary policy than is financing innovations in the government budget via state-contingent inflation. A second important result is that the nominal interest rate can be used to indirectly tax the rents of monopolistic labor suppliers. Taken together, our results uncover features of Ramsey fiscal and monetary policy in the presence of a type of labor market imperfection that is widely-believed to be important.     

The optimal choice of monetary policy instruments in a small open economy

Abstract.  This paper studies how the nature of shocks affects the optimal choice of monetary policy instruments in a small open economy. Three classic rules, fixed exchange rates, monetary targeting, and inflation targeting are studied and ranked by comparing with the optimal monetary policy under commitment. We find that the ranking of the simple rules can be mapped to the terms-of-trade variability that the rule allows relative to what a particular shock optimally calls for. It turns out that inflation targeting dominates the other two rules under productivity or velocity shocks, whereas monetary targeting is the best performer under fiscal shocks.     

OPTIMUM CURRENCY AREAS AND EUROPEAN MONETARY UNIFICATION

This paper examines the European experience from optimum currency areas perspective with a focus on the correlation of underlying aggregate shocks within a structural vector autoregression (VAR) framework. Appropriately identifying supply shocks, real fiscal shocks, and nominal shocks, the paper investigates the correlations of shocks and tries to evaluate the likely adjustment and other problems that may take place with the introduction of a single currency in Europe. Using data for 20 European market economies, the paper compares original members of the European Community to new members and non-members. Shocks are mostly country-specific, particularly for newer members and non-members, suggesting the importance of alternative adjustment mechanisms other than national monetary policies after the introduction of a single currency.     

Sources of exchange rate fluctuations with Taylor rule fundamentals

This paper investigates the sources of exchange rate fluctuations when monetary policy follows a Taylor rule interest rate reaction function. We first present a simple dynamic exchange rate model with Taylor rule fundamentals which is triangular in the long-run impacts of shocks to the output market, the interest rate differential, and the Taylor rule. We then proceed to assess the relative importance of various shocks in exchange rate determination by estimating a structural VAR with long-run identification restrictions based on the triangular structure of the model. We find demand shocks to be less important than in earlier VAR studies, with both supply shocks and nominal shocks explaining a substantial part of real exchange rate fluctuations.     

Monetary policy and noise traders: A welfare analysis

This paper studies the choice of monetary policy regime in a small open economy with noise traders in forex markets. We focus on two simple rules: fixed exchange rates and inflation targeting. We contrast the above two rules against optimal policy with commitment under productivity shocks. In general, the presence of noise traders increases the desirability of a fixed exchange rate regime. We also evaluate the welfare impact of Tobin taxes in this milieu. These taxes help unambiguously in the absence of productivity shocks; their welfare impact under productivity shocks depends on the monetary regime in place and trade elasticity between domestic and foreign goods.     

Shadow short rate and monetary policy in the Euro area

Empirical modelling of the monetary policy effects using conventional linear econometric models is put to a great test when interest rates approach the zero-lower bound. A possible remedy recently proposed in the literature is to introduce a shadow short rate (SSR) obtained from the yield curve model as an alternative monetary policy measure. This paper examines the usefulness of shadow rates as a policy stance measure for the Euro area. Moreover, the SSR can be used to study the country-specific monetary policy stance. We incorporate the shadow short rate in a standard vector autoregressive analysis to study the effects of monetary policy shocks both at the level of the Euro area and for two periphery EA countries, Italy and Spain, that endured significant financial stress during the crisis. Our analysis shows that monetary policy shocks identified form the SSR produce similar macro responses as shocks identified from the standard policy rate. The Euro area shocks can directly translate to a corresponding change in the country-specific financing conditions in the periphery, whereas the reverse effect is limited. The historical decomposition of the stochastic component of the SSR series shows that the unconventional policy measures were effective in stabilising the sovereign crisis in 2011, however, their relatively limited quantity provided only a weak stimulus to the economy.     

The Economic Case for Monetary Union in the European Union

Differential requirements for seigniorage provide a weak case for retaining monetary independence. As regards adjustment to asymmetric shocks, nominal exchange rate flexibility is at best a limited blessing and at worst a limited curse. Absence of significant fiscal redistribution mechanisms among EU members is not an obstacle to monetary union. Neither is limited international labour mobility. Convergence of real economic performance is irrelevant for monetary union. A common currency is the logical implication of unrestricted capital mobility. The Maastricht criteria need not hinder monetary union provided the political will exists to adopt a flexible interpretation of the fiscal criteria.     

Persistence, The Transmission Mechanism And Robust Monetary Policy

In this paper we first explore the impact of nominal and real persistence on the transmission process of various shocks in an estimated DSGE model of the euro area. We then analyse its impact on optimal monetary policy and investigate the performance of various monetary policies when the policy maker is uncertain about the degree of nominal and real persistence.     

Optimal Currency Areas Scottish Economic Society/Royal Bank of Scotland Annual Lecture, 1999

Microeconomic efficiency and market transparency argue in favour of UK membership in EMU and for Scotland’s membership in the UK monetary union and also in EMU. UK seigniorage (government revenues from money issuance) would be boosted by EMU membership. Lender of last resort arrangements would not be substantially affected by UK membership in EMU. The UK is too small and too open to be an optimal currency area. The same point applies even more emphatically to Scotland. The ‘one‐size‐fits‐all’, ‘asymmetric shocks’ and ‘cyclical divergence’ objections to UK membership are based on the misapprehension that independent national monetary policy, and the associated nominal exchange rate flexibility, can be used effectively to offset or even neutralise asymmetric shocks. This ‘fine tuning delusion’ is compounded by a failure to understand that, under a high degree of international financial integration, market‐determined exchange rates are primarily a source of shocks and instability. Instead, opponents of UK membership in EMU view exchange rate flexibility as an effective buffer for adjusting to asymmetric shocks originating elsewhere. I know of no evidence that supports such an optimistic reading of what exchange rate flexibility can deliver under conditions of very high international financial capital mobility. The economic arguments for immediate UK membership in EMU, at an appropriate entry rate, are overwhelming. Monetary union raises important constitutional and political issues. It involves a further surrender of national sovereignty to a supranational institution, the ECB/ESCB. It is essential that this transfer of national sovereignty be perceived as legitimate by those affected by it. In addition, the citizens of the UK have become accustomed to a high standard of openness and accountability of their central bank since it gained operational independence in 1997. The ECB/ESCB must be held to the same high standard, and, while there are grounds for optimism, there still is some way to go there.     

How should emerging economies float their currencies?

Floating exchange rates seem to be gaining ground in Latin America, East Asia and the transition economies. The recent crises left many economies with no alternative but to float. Others have moved toward floating, searching for greater flexibility and insulation from external shocks. The question for most emerging market economies, then, is no longer to float or not to float, but how to float. Four issues arise in this regard. The first is how to float and have low inflation. The second is whether floating provides as much insulation as conventional theory predicts, especially in the presence of dollarized liabilities. Which leads to the third point: the relationship between the stability of the exchange rate and that of the financial system. The fourth is how to conduct monetary policy under a float, and the role of inflation targeting. We consider each of these points in turn, and conclude that a workable model of how to float seems to be emerging from the so‐far successful experience of countries like Chile and Brazil. It involves the adoption of an inflation target as the main anchor for monetary policy, coupled with a monetary policy reaction function that — aside from reacting to the output gap and other determinants of the inflation rate — reacts also partially to movements in the nominal exchange rate. JEL classification: F3, F4, E4, E5     

Capital Controls,Global Liquidity Traps,and the International Policy Trilemma*

The zero bound on interest rates introduces a new dimension to the trilemma in international policy. The openness of the international financial market might render monetary policy ineffective, even within a system of fully flexible exchange rates, because shocks that lead to a liquidity trap in one country are propagated through financial markets to other countries. However, the effectiveness of monetary policy can be restored by the imposition of capital controls. We derive the optimal response of monetary policy to a global liquidity trap in the presence of capital controls. We show that, even though capital controls might facilitate effective monetary policy, capital controls are not generally desirable in terms of welfare.