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.     

Inflationary expectations and monetary policy: evidence from Bangladesh

This article first estimates inflationary expectations using a Blanchard–Quah VAR model by decomposing the nominal interest rate into expected inflation and the ex ante real interest rate. Then I utilize this expected inflation along with other macroeconomic variables as inputs to the monetary policy function in a recursive VAR model to identify exogenous policy shocks. To calculate inflationary expectations, I assume that ex ante real interest rate shocks do not have a long-run effect on the nominal interest rate. This article finds that the public expects lower inflation for the future during periods of high inflation. Estimated results from the recursive VAR suggest that a contractionary policy shock increases the real interest rate, appreciates domestic currency, and lowers inflationary expectations and industrial output. However, I find a lagged policy response from Bangladesh Bank to higher inflationary expectations.     

The Fisher effect,survey data and time-varying volatility

In this paper we study the Fisher hypothesis using Livingston survey data on inflation expectations. We propose a simple model for the ex-ante real interest rate where the standard deviation of survey forecasts is used to correct for heteroskedasticity. The findings of this paper contradict earlier studies. We find supportive evidence for the Fisher hypothesis that the nominal interest rate and expected inflation move one-for-one both in the short and the long run. Our results also suggest that the change of US monetary policy does not have significant effect on the dynamics of the ex-ante real interest rate such as previous work assumes.     

The role of uncertainty in the term structure of interest rates: A GARCH-ATSM approach

This article examines the roles of uncertainties regarding various macro-variables in determining risk premiums of bond yields. We develop a multivariate GARCH-VAR to quantify uncertainties regarding inflation, real activities and monetary policy as time-varying conditional variances. We jointly estimate the multivariate GARCH and no-arbitrage bond pricing equations using a maximum likelihood method. The results indicate that the inflation uncertainty is the largest contributor to the dynamics of long-term yields since the 1980s, while the monetary policy uncertainty also plays noticeable roles.     

Real wage rigidities and optimal monetary policy in a small open economy

The main objective of the study is to provide a theoretical analysis of optimal monetary policy in a small open economy where households set real wage in a staggered fashion. The introduction of real wage rigidities plays a important role to resolve main shortcomings of the standard new Keynesian small open economy model. The main findings regarding the issue of monetary policy design can be summarized as three fold. First, the optimal policy is to seek to minimize variance of domestic price inflation, real wage inflation, and the output gap if both domestic price and real wage are sticky. Second, controlling CPI inflation directly or indirectly induces relatively large volatility in output gap and other inflations. Therefore, both CPI inflation-based Taylor rule and nominal wage-inflation based Taylor rule are suboptimal. Last, a policy that responds to a real wage inflation is most desirable.     

Money, expectations, and interest rates

This paper employs a model of nominal interest rate determination in a framework of rational expectations of inflation. Hypotheses are developed with respect to relative impacts of predictable and unpredictable changes in money supply. These hypotheses are tested using quarterly Italian data from 1966–1975. The nominal monetary base is the measure of money employed and one private and two government bond rates measure nominal interest rates. The results are insensitive to variations in estimation procedure and specification of adjustment processes (and even predictive functions for the monetary base). The rational expectations formulation is well supported in every case.     

Real and nominal effects of monetary policy shocks

Abstract.  We employ the identification scheme of Kahn, Kandel and Sarig (2002) to analyse the impact of Canadian monetary policy on ex ante real interest rates and inflationary expectations. First, we decompose nominal interest rates into ex ante real rates and inflationary expectations using the methodology of Blanchard and Quah (1989) . Then we estimate a recursive VAR model with innovations in a monetary aggregate and the overnight target interest rate as alternative measures of monetary policy shocks. We find that a negative policy shock raises both nominal and ex ante real interest rates, lowers inflationary expectations and real industrial output, and appreciates the Canadian dollar.     

Money and Prices Under Uncertainty

We study whether monetary economies display nominal indeterminacy: equivalently, whether monetary policy determines the path of prices under uncertainty. In a simple, stochastic, cash-in-advance economy, we find that indeterminacy arises and is characterized by the initial price level and a probability measure associated with state-contingent nominal bonds: equivalently, monetary policy determines an average, but not the distribution of inflation across realizations of uncertainty. The result does not derive from the stability of the deterministic steady state and is not affected essentially by price stickiness. Nominal indeterminacy may affect real allocations in cases we identify. Our characterization applies to stochastic monetary models in general, and it permits a unified treatment of the determinants of paths of inflation.     

The evolution of the monetary policy regimes in the U.S.

The existing literature on U.S. monetary policy provides no sense of a consensus regarding the existence of a monetary policy regime. This article explores the evolution of U.S. monetary policy regimes via the development of a Markov-switching model predicated on narrative and statistical evidence of a monetary policy regime. We identified five regimes for the period spanning 1956:I?C2005:IV and they roughly corresponded to the Chairman term of the Federal Reserve, except for the Greenspan era. More importantly, we demonstrate that the conflicting results regarding the response to inflation for the pre-Volcker period in the existing literature is not attributable to the different data but due to different samples, and also provided an insight regarding the Great Inflation??namely, that the near non-response to inflation in the early 1960s appears to have constituted the initial seed of the Great Inflation. We also find via analysis of the Markov-switching model for the U.S. real interest rate, that the regime changes in the real interest rate follow the regime changes in monetary policy within 2?years and that the evolution of real interest rate regimes provides a good explanation for the conflicting results regarding the dynamics of real interest rate.     

A dynamic Nelson-Siegel yield curve model with Markov switching

This paper proposes a model to better capture persistent regime changes in the interest rates of the US term structure. While the previous literature on this matter proposes that regime changes in the term structure are due to persistent changes in the conditional mean and volatility of interest rates we find that changes in a single parameter that determines the factor loadings of the model better captures regime changes. We show that this model gives superior in-sample forecasting performance as compared to a baseline model and a volatility-switching model. In general, we find compelling evidence that the extracted factors from our term structure models are closely related with various economic variables. Furthermore, we investigate and find evidence that the effects of macroeconomic phenomena such as monetary policy, inflation expectations, and real economic activity differ according to the particular regime realized for the term structure. In particular, we identify the periods where monetary policy appears to have a greater effect on the yield curve, and the periods where inflation expectations seem to have a greater effect in yield determination. We also find convincing evidence of a relationship between the regimes estimated by the various switching models with economic activity and monetary policy.     

Robust central banking under wage bargaining: Is monetary policy transparency beneficial?

We study the role of transparency in an environment of robust monetary policy under wage bargaining. The standard view from the game-theoretical literature is that, with unionised labour markets, monetary policy transparency is unambiguously “bad” (it induces increases in wage and price inflation, unemployment and may lead to higher inflation uncertainty). The empirical literature is instead ambiguous about the macroeconomic effects of transparency. By recasting the earlier theory into a robust monetary policy environment, and focusing transparency on the uncertainty about the preference for price stability, we show that the macroeconomic effects of transparency are more favourable than normally found. The impact on nominal wages, inflation and real variables (real wages and unemployment) is not parameter-free but depends on the public's informedness about this coefficient. The impact on real variables is found to disappear in case unions do not internalise the effect of wage decisions on the economy (i.e. in the case of atomistic unions). Finally, we find that the effect of transparency on inflation uncertainty is more complex than in the standard approach. We show that transparency may have the beneficial effect of reducing inflation variability not only when monetary uncertainty is low (as previously reported), but also when monetary uncertainty exceeds an upper threshold.     

Supply side inflation persistence

We explore the role of the cost channel in accounting for inflation persistence in the New Keynesian model with Calvo pricing. Hump-shaped responses of inflation to monetary shocks are obtained under purely nominal rigidities.     

Uncertainty shocks,precautionary pricing,and optimal monetary policy

Existing studies show that, in standard New Keynesian models, uncertainty shocks manifest as cost-push shocks due to the precautionary pricing channel. We study optimal monetary policy in response to uncertainty shocks when the precautionary pricing channel is operative. We show that, in the absence of real imperfections, the optimal monetary policy fully stabilizes the output gap and inflation, implying no policy trade-offs. Our result suggests that precautionary pricing matters only insofar as expected inflation is volatile. Thus, a simple Taylor rule that places high weight on inflation leads to a stabilized output gap, thereby attaining the “divine coincidence”.     

NOMINAL GDP TARGETING AND CENTRAL BANK CONSERVATIVENESS

In the literature on monetary economics, there is the ‘inflationary bias’ result which predicts that the rate of inflation will be biased towards a higher level under discretionary monetary policy than under a rule‐based policy regime. It is established that a credible nominal target can eliminate this ‘inflationary bias’. In this paper, we examine the case of nominal GDP targeting, which is a rule‐based monetary regime. Depending on the degree of conservativeness by the central bank, we show in a stylized model the choice of different combination of inflation and real GDP targets can still result in an ‘inflationary bias’, and there also exists the possibility of a ‘dis‐inflationary bias’.     

Inflation Expectations and Monetary Policy Surprises*

We estimate monetary policy surprises for European consumers over time, based on monetary policy changes that were unanticipated according to consumers’ stated beliefs. We find that such monetary policy surprises have the opposite impact on inflation expectations from the impact found when assuming that consumers are well informed. Relaxing the latter assumption by focusing on consumers’ stated beliefs, unanticipated increases in the interest rate raise inflation expectations before the 2008 financial crisis. This is consistent with imperfect information theoretical settings where interest rate hikes are interpreted as positive news about the state of the economy by consumers who know that policymakers have relatively more information.     

Monetary Policy, Nominal Interest Rates, and Long–Horizon Inflation Uncertainty

Empirical evidence presented in this paper shows that the predictability of inflation at long horizons varies considerably across countries. Both simple theory and empirical evidence suggest that the crucial factor is the extent to which systematic monetary policy succeeds in preventing a unit root in inflation. The mechanism by which it does this appears however to be complicated by strong empirical evidence that nominal as well as real interest rates have real effects, which implies that monetary policy need not be so vigorous in reactions to inflation. This helps to explain why inflation rates in the US and (especially) Germany have been relatively predictable, despite monetary policy rules which appear to have been barely stabilising. The paper also presents tentative evidence that the power of nominal interest rate effects is inversely related to long–horizon inflation uncertainty, and hence ultimately uncertainty about monetary policy.     

Quantification and characteristics of household inflation expectations in Switzerland

Inflation expectations are a key variable in conducting monetary policy. However, these expectations are generally unobservable and only certain proxy variables exist, such as surveys on inflation expectations. This article offers guidance on the appropriate quantification of household inflation expectations in the Swiss Consumer Survey, where answers are qualitative in nature. We apply and evaluate different variants of the probability approach and the regression approach; we demonstrate that models that include answers on perceived inflation and allow for time-varying response thresholds yield the best results; and we show why the originally proposed approach of Fluri and Spörndli (1987) has resulted in heavily biased inflation expectations since the mid-1990s. Furthermore, we discuss some of the key features of Swiss household inflation expectations, i.e. the fact that there has been a shift in expectation formation since 2000 (expectations are better anchored and less adaptive, and there is lower disagreement of expectations). We suggest that this may be linked to the Swiss National Bank’s adjustment of its monetary policy framework around this time. In addition, we outline how expectation formation in Switzerland is in line with the sticky information model, where information disseminates slowly from professional forecasters to households.     

Inflation targeting and inflation expectations in Mexico

In this article we analyse inflation expectations in Mexico. After a review of the theoretical and empirical literature, we apply unit root, normality and cointegration tests to the data provided by Banco de México (Banxico) in the Survey on the Expectations of the Private Sector Economics Specialists. Our results reject the null hypothesis of normality for inflation expectations over the period 2004:01–2011:12. The exchange rate has become one of the most relevant variables in the transmission mechanism of monetary policy in a small open economy. In this regard, we show the existence of a long-run relationship between nominal exchange rate and interest rate where inflation expectations matter for long-term dynamics.     

The macroeconomic risks of undesirably low inflation

This paper investigates the macroeconomic risks associated with undesirably low inflation using a medium-sized New Keynesian model. We consider different causes of persistently low inflation, including a downward shift in long-run inflation expectations, a fall in nominal wage growth, and a favorable supply-side shock. We show that the macroeconomic effects of persistently low inflation depend crucially on its underlying cause, as well as on the extent to which monetary policy is constrained by the zero lower bound. Finally, we discuss policy options to mitigate these effects.     

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.