Dangers of commitment under rational expectations

Within a New Keynesian framework, interest rate rules that respond to public expectations lead to determinate and expectationally stable solutions for any level of commitment, as shown by Waters (Macroecon Dyn 13(4):421–449, 2009). That paper also demonstrates gains to commitment, under least square learning, though over-commitment can lead to some very poor outcomes for some parameter values. This paper shows an identical outcome under rational expectations. The optimal level of commitment is unchanged if there are observation errors in the policymaker’s knowledge of public expectations, which is not the case under learning. However, if there is sufficient policymaker uncertainty about the parameter values, partial commitment is best.     

Exchange rate target zone models: a Bayesian evaluation

This paper develops a Bayesian approach to estimating exchange rate target zone models and rational expectations models in general. It also introduces a simultaneous-equation target zone model that incorporates stochastic realignment risk. Using FF/DM and IL/DM exchange rate data, we find that the signing of the 1987 Basle–Nyborg Agreement reduces both the magnitude and the likelihood of a central parity realignment, while the lagged exchange rate deviation from its central parity increases them. Furthermore, the interest rate policies and the monetary conditions of the participating countries signal a forthcoming realignment. In general, we are unable to improve upon a simple random walk model in out-of-sample exchange rate prediction by introducing target zone models. Copyright © 1999 John Wiley & Sons, Ltd.     

The Theory of Exchange Rate Target Zones

The theory of exchange rate target zones focuses on the role of exchange rate expectations in determining exchange rate behaviour and interest rate differentials in currency bands. This paper analyses earlier models of the target zone research programme as well as more recent developments including endogenous realignment expectations, price rigidities and alternative monetary feedback rules by means of a unified approach. Target zones may be the cause of stabilizing or destabilizing exchange rate expectations, the determinants of which crucially depend on the within-band central bank policy as well as the credibility of the central banks' commitment to defend the target zone. The paper closes with a discussion of the relative merits of implementing a target zone and some suggestions for further research.     

The MTFS or the EMS: Which Way for Credible Monetary Policy?

Since the latter part of 1988, the primary policy objective has been to head off a rise to double digit inflation. To this end, interest rates have been raised from 7112 per cent to 14per cent, while the public sector is running a large fiscal surplus. Despite this apparently very tight policy stance, policy is deficient in a crucial respect: it lacks credibility. The all too public divisions within government have weakened the efficacy of monetary policy, especially in financial markets. The ongoing uncertainty over who is in charge of the conduct of policy - No. 10 or No. 11 - further undermines confidence. The most urgent priority must be to reassert clear priorities and guidelines. In this Viewpoint, we consider how best to restore the credibility of monetary policy. There are two main possibilities: first, to reassert the Medium Term Financial Strategy (MTFS) in an appropriate form; or to join the (Exchange Rate Mechanism of the) European Monetary System (EMS). We argue that it will be very hard to derive credibility benefits from a reassertion of the MTFS: because of the inflation record of the past decade and the twists and turns of past versions of the MTFS, a mere restatement will not resolve the uncertainties that result from known differences within the government. In particular, any restatement will rely on discretion and judgement in its implementation and this will weaken its beneficial effects on expectations. Instead we argue that entry into the EMS offers a tougher and more credible commitment for monetary policy. The Chancellor has been pushed to rule out UK entry until the second half of 1990 at the earliest, but the government should make a virtue of this by announcing a firm dale for entry next year. In the interim, it should encourage a debate about the appropriate rate for entry, a debate which will increasingly guide the foreign exchange market. The government should make it clear that in choosing this rate it will do so with the commitment to low inflation very much in mind, favouring a high exchange rate. Once in the EMS, the government should rule out the possibility of devaluing the pound in an EMS realignment. This provides a firm non- discretionary anchor for both monetary policy and inflation expectations. With this commitment, the principal gain from EMS entry will be establishing a regime of low inflation for the next decade: in this, choice of the exchange rate will be less crucial than the fact of entry.     

A quantitative analysis of optimal sustainable monetary policies

This study examines the quantitative properties of optimal sustainable monetary policies using a monetary model with a stabilization bias. As in Kurozumi (2008), the optimal sustainable policy is a strategy considered in the absence of commitment technologies; however it is implemented following an optimal quasi-sustainable policy derived by assuming that the commitment technologies are present. This study finds that solving for the policy function of the optimal quasi-sustainable policy yields a result basically identical to the Ramsey-optimal commitment policy under a set of parameters commonly used in the literature. The simulation shows two further results: policymakers have incentive to deviate from the Ramsey-optimal commitment policy when the lagged output gap is large and the optimal quasi-sustainable policy endogenously diminishes the steadfastness of policymakers׳ commitment.     

Can money matter for interest rate policy?

In this paper it is shown that money can matter for macroeconomic stability under interest rate policy when transactions frictions are non-negligible. We develop a sticky price model with a shopping time function, which induces the marginal utility of consumption to depend on the (predetermined) stock of money held at the beginning of the period. Equilibrium stability and uniqueness are then ensured by a passive interest rate policy, whereas activeness is associated with an explosive equilibrium. By reacting to changes in beginning-of-period real balances, the central bank can restore stability. Interest rates further depend on lagged real balances even if the central bank acts in an entirely forward-looking way, as under discretionary optimization. If the model is revised such that end-of-period money provides transaction services, money can in principle be neglected for a stabilizing interest rate policy. Discretionary monetary policy is, however, likely to be associated with equilibrium indeterminacy, which can be avoided if interest rates are set contingent on beginning-of-period real balances.     

Conflict of Interest in Policing and the Public Sector

Abstract

Conflicts of interest are a key factor in the contemporary decline of trust in government and public institutions, eroding public trust in government and democratic systems. Drawing on two unique empirical studies involving policing and the broader public sector, this paper explores the meaning and dimensions of conflict of interest by examining public complaints about conflict of interest and providing distinctive insights into the nature of conflict of interest as a problem for public sector ethics. The paper analyses and explores appropriate regulatory and management approaches for conflict of interest, focusing on three elements: (1) dealing with private interests that are identifiably problematic in the way they clash with the duties of public officials; (2) managing conflicts as they arise in the course of public sector work (manifested in preferential and adverse treatment, and other problematic areas); and (3) developing ethical and accountable organisational cultures. It is concluded that effective and meaningful public sector ethics in the pursuit of the public interest must be based on an ethos of social accountability and a commitment to prioritise the public interest in both fact and appearance.     

A New Keynesian model with staggered price and wage setting under learning

This paper provides a study of the implications for economic dynamics when the central bank sets its nominal interest rate target in response to variations in wage inflation. I provide results on the existence, uniqueness, and stability under learning of rational expectations equilibrium for alternative specifications of the manner in which monetary policy responds to economic shocks when nominal rigidities are present. Monopolistically competitive producers set prices via staggered price contracts, and households set nominal wages in the same fashion. In this setting, the conditions for determinacy and learnability of rational expectations equilibrium differ from a model where only prices are sticky. I find that when the central bank responds to wage and price inflation and to the output gap, a Taylor principle for wage and price inflation arises that is related to stability under learning dynamics. In other words, a moderate reaction of the interest rate to wage inflation helps to avoid instability under learning and indeterminacy.     

Impact of macroeconomic surprises on the Brazilian yield curve and expected inflation

This study investigates how unexpected announcements in Brazilian and U.S. macroeconomic indicators affect the term structure of nominal interest rates, as well as implicit inflation expectations and real interest rates. Using daily data from March 2005 to December 2012, we employ an extended Vector Error Correction Model to take into account nonstationarity and the long-term equilibrium among different maturities of those curves. We found empirical evidence that macroeconomic surprises, domestic (Brazilian) and external (U.S. American), which lead the market to believe that there might be a higher risk of inflation or an overheated economy, raise nominal interest rates, implicit expected inflation and real interest rates. Surprisingly, in relation to the efficient-market hypothesis, we found that some macroeconomic surprises have a lagged effect on the yield curves. We also tested the impact of the global financial crisis of 2007–09 and found that the crisis affected significantly the direction and magnitude of the responses to macroeconomic news.     

Triumphs and tragedies: expectations and commitments upon repatriation

Building on and extending the literature on organizational commitment, this study examines the relationship between repatriates' work and non-work-related expectations and their commitment to their parent companies and new local work units after completing international assignments. The results, based on a sample of 174 repatriates and 92 partners within five US multinationals, indicate that positive, linear relationships exist between certain work and non-work expectations and commitment to the parent company and local work unit, while significant, nonlinear relationships exist between other expectations and these commitments. These results have both theoretical and practical implications, which are discussed.     

Gains from interest-rate smoothing in a small open economy with zero-bound aversion

We extend the Monacelli [Monacelli, T. (2005). Monetary policy in a low pass-through environment. Journal of Money, Credit and Banking, 37(6), 1047–1066] model to allow for a central bank that penalizes nominal interest rate paths that are too close to the zero lower bound. We analytically derive the optimal interest-rate policy rule in each equilibrium under four policy regimes: (i) benchmark commitment to an ex-ante optimal monetary-policy plan; (ii) benchmark discretionary policy; (iii) optimal delegation to a discretionary policy maker with similar preferences to society; and (iv) optimal delegation to a discretionary policy maker with an additional taste for interest-rate smoothing. Under the commitment benchmark, the optimal interest-rate rule is proved to be intrinsically inertial, whereas this property is non-existent under discretionary policy. In the absence of commitment, there are gains to delegating policy to an interest-rate smoothing central banker. We show that while the endogenous law of one price gap in the model exacerbates the optimal policy trade-off that arises under discretionary policy, the latter feature of interest-rate smoothing acts to weaken it, by mimicking intrinsic inertia under the commitment policy.     

Optimal interest rate stabilization in a basic sticky-price model

This paper studies optimal monetary policy with the nominal interest rate as the single policy instrument. Firms set prices in a staggered way without indexation and real money balances contribute separately to households’ utility. The optimal deterministic steady state under commitment is the Friedman rule—even if the importance assigned to the utility of money is small relative to consumption and leisure. We approximate the model around the optimal steady state as the long-run policy target. Optimal monetary policy is characterized by stabilization of the nominal interest rate instead of inflation stabilization as the predominant principle.     

The expectations hypothesis and decoupling of short- and long-term US interest rates: A pairwise approach

The link between short-term policy rates and long-term rates elucidate the potential effectiveness of monetary policy. We examine the US term structure of interest rates using a pairwise econometric approach advocated by Pesaran (2007). Our empirical modelling strategy employs a probabilistic test statistic for the expectations hypothesis of the term structure based on the percentage of unit root rejections among all interest rate differentials. We find support for the expectations hypothesis and provide new insights into the nature of interest rate decoupling which are of value to policymakers. The maturity gap associated with interest rate pairs negatively impacts on the probability of stationarity, and also on the speed of adjustment towards long-run equilibrium. We further show that the speed of adjustment has become more sensitive to the maturity gap over time.     

What is the best way to impede a central bank?

Recent work has found several ways of restricting central bank behavior to achieve much of the gain of commitment over discretion. This paper compares three such impediments: A quadratic penalty on interest rate changes, a fixed penalty on any rate change, and forced infrequency of rate change. All three achieve significant improvement over discretion, and often come close to interest rate rule commitment. The fixed penalty is frequently the best performing restriction, although the quadratic penalty does best in certain alternative parameterizations. Combinations are found to provide no improvement over the individual impediments alone.     

Testing the restrictions implied by the rational expectations hypothesis

The nature and form of the restrictions implied by the rational expectations hypothesis are examined in a variety of models with expectations and the properties of appropriate test statistics are analyzed with Monte Carlo evidence. Specifically, we consider the implications of lagged variables, simultaneous equations, and future period expectations upon the number and functional form of the rational expectations restrictions. Two asymptotically equivalent test statistics — a likelihood ratio and a Wald test — are available for implementing a test of these restrictions. Monte Carlo evidence is offered to provide a comparison between the properties of the alternative test statistics in small samples.     

Gains from Wage Flexibility and the Zero Lower Bound*

We analyse the welfare impact of greater wage flexibility in the presence of an occasionally binding zero lower bound (ZLB) constraint on the nominal interest rate. We show that the ZLB constraint generally amplifies the adverse effects of greater wage flexibility on welfare when the central bank follows a conventional Taylor rule. When demand shocks are the driving force, the ZLB implies that an increase in wage flexibility reduces welfare even under the optimal monetary policy with commitment.     

Gains from Wage Flexibility and the Zero Lower Bound*

We analyse the welfare impact of greater wage flexibility in the presence of an occasionally binding zero lower bound (ZLB) constraint on the nominal interest rate. We show that the ZLB constraint generally amplifies the adverse effects of greater wage flexibility on welfare when the central bank follows a conventional Taylor rule. When demand shocks are the driving force, the ZLB implies that an increase in wage flexibility reduces welfare even under the optimal monetary policy with commitment.     

The Narrow Band Option for Mr. Lamont

The dilemma facing Mr. Lamont as he prepares his first Budget is the conflict between the need to keep interest rates high to maintain the commitment to sterling's ERM band and the wish to reduce interest rates to ease the severe recession in the domestic economy. In large part, this conflict is intrinsic to the government's aim to bring down UK inflation to German levels through membership of the ERM: the process of reducing inflation is always painful and costly in terms of lost output and higher unemployment. But the dilemma is made worse by the uncertainties over future policy direction, reflected in the differential between UK and German interest rates. German monetary policy is set to remain tight to hold in check the inflationary pressures that might otherwise arise from German unification. Against this background success in reducing UK interest rates will depend on the government's success in establishing the credibility of its anti-inflation policy and of its ERM commitment. An expansionary Budget aimed at easing the recession would undermine this credibility, and remove the scope for additional interest rate reductions. An abandonment of the ERM commitment would signal the accommodation of inflation, and condemn the UK to continuing high inflation and interest rates. We argue in this Viewpoint that the best course open to the Chancellor is to adopt a broadly neutral Budget stance, and to strengthen the ERM commitment by moving to a narrow band for sterling within the ERM. This should enable the Chancellor to reduce UK interest rates again at around the time of the Budget and lay the basis for further subsequent cuts.     

Impacts of Monetary, Fiscal and Exchange Rate Policies on Output in China: A Var Approach

Applying the VAR model and using the interest rate as a monetary policy variable, we find that in the long run, output in China responds negatively to a shock to the interest rate, the real exchange rate, government debt, or the inflation rate, and it reacts positively to a shock to government deficits or lagged own output. When real M2 is chosen as a monetary policy variable, long-term output in China responds positively to a shock to real M2 or lagged own output, and it reacts negatively to a shock to the real exchange rate, government debt, or government deficits. Its response to a shock to the inflation rate is negative when government debt is used and is positive when government deficits are considered. In the short run, fiscal policy is more important than monetary policy in three out of four cases. In the long run, monetary policy is more influential than fiscal policy in three out of four cases. Therefore, the government may consider conducting monetary and fiscal policies differently in the short run and long run. The government needs to be cautious in pursuing deficit spending as its long-term impacts depend on the monetary variable employed. The policy of maintaining a relatively stable exchange rate is appropriate as the depreciation of the Yuan may hurt the economy in the short run.JEL Classifications: E5, F4, H6     

Foreign Currency Translation Reporting and the Exchange-Rate Exposure Effect

This study further explores a structural break in the relation between stock returns of firms with foreign currency positions and lagged exchange rate changes (exchange rate exposure effect) documented in Bartov and Bodnar (1994). We examine whether changes in the financial accounting reporting of foreign currency positions from SFAS No. 52 might have improved investors' ability to characterize firms' economic exchange rate exposures, and thus the impact of exchange rate movements on firm value. Our findings indicate that only firms reporting using the dollar as the functional currency (i.e., those reporting as if they were still under SFAS No. 8) retain a significant relation between the lagged change in the dollar and firm value in the post-SFAS No. 52 period. For firms reporting using the foreign currency as the functional currency (i.e., those who switched to the new translation method) the significant lagged relation disappears. This is consistent with the use of a foreign currency as the functional currency under SFAS No. 52 facilitating valuation of U.S. firms with foreign operations.