Conservative central banks: how conservative should a central bank be?

Using Rogoff's, 1985 model, we determine how inflation averse a central banker should be, given the level of volatility and projected output gap in the economy. We confirm a strong degree of conservatism, almost twice what society would have chosen. But, for a range of developing countries and the OECD, economies that systematically experience higher levels of output volatility would do best to hire a central banker who is more inflation averse than society, but less so than in stable developed economies. Thus, while a conservative central banker remains desirable, the trade‐off is with output volatility rather than with the output gap itself.     

Evidence on inflation–output trade-off in developing and industrial countries

This paper subjects Lucas's output–inflation trade-off study to further empirical investigation. The cross-country study divides the 111 countries covered into 90 developing countries and 21 advanced countries. Lucas's proposition is that volatility of aggregate demand growth should reduce the impact of aggregate demand growth on the cyclical output and the implication of this is that there is no output–inflation trade-off in line with the natural rate theory. We employ annual data over periods that fall between 1958 and 1985 in order to conduct the test. Our findings suggest that Lucas's proposition is valid for developed economies but not for developing economies.     

Imperfect credibility,sticky wages,and welfare

This paper studies optimal monetary policy under imperfect credibility in a New Keynesian model with staggered price and wage setting. In our imperfect credibility framework, the central bank commits to a policy plan but occasionally reneges on past promises with a given common knowledge probability. We find that the welfare gains from increasing credibility are approximately linear on the initial credibility level. We also find that the output-inflation stabilisation trade-off is nonmonotonic as higher credibility does not always reduce output volatility. The variance decomposition shows that wage markup shocks are the main driver of economic fluctuations and that these shocks are better contained, even in relative terms, when credibility is high. We then show that the degree of credibility impacts the effect of wage flexibility on welfare. When credibility is low, monetary policy is less potent and the economy can experience a feedback loop between wage volatility and price volatility. We show, though, that once wage markup shocks are taken into account, wage flexibility is usually welfare improving.     

A Note on Income Inequality and Macro-economic Volatility

Income inequality may influence macro-economic variables by affecting the money multiplier and the trade-off between inflation and output. In an AD-AS model with imperfect foresight income inequality intensifies the volatility of output and inflation rate by increasing the likelihood of oscillations as well as their magnitude. Volatility is, however, moderated when income inequality prolongs the business cycles.     

Foreign interest rate shocks and exchange rate regimes in East Asia

Using a theoretical dynamic stochastic general equilibrium model and an empirical panel vector autoregression, we assess the transmission of foreign real interest rate shocks on the volatility of various key macroeconomic variables in nine small open economies in East Asia taking into account the role of exchange rate regimes. Both the theoretical and empirical findings confirm the hypothesis that flexible exchange rate may work as a shock absorber when the economy is hit by foreign real interest rate shocks. The findings suggest a clear trade-off between the volatility of real exchange rate and real output to foreign interest rate shocks, both the US and G7 real interest rates, where the responses of real output are mitigated in countries that have more flexible exchange rate regime.     

Parameter uncertainty and inflation dynamics in a model with asymmetric central bank preferences

This paper builds on the Lucas' (1973) signal extraction model to study the time-varying effect of uncertainty in the output-inflation trade-off on inflation, using a monetary model with asymmetric central bank preferences whereby deviations of output (relative to target) from above are weighted differently from deviations from below. The model is investigated empirically using data from the South African Reserve Bank (SARB). We show that the implication of the uncertainty element is to cause the authority to change its indirect control, output by less (and hence change it direct control, interest rate by less) whenever inflation is below or above the target, in line with Brainard's attenuation principle. We also find that SARB's asymmetric output stabilization explains inflation movements significantly, and that the monetary authority seems to be more averse to business cycle recessions than expansions, hence more keen to avoid recessions than expansions. Overall, a more transparent and committed monetary policy practice that would reduce uncertainty over the output-inflation trade-off would be helpful for economic stability.     

Cyclical fiscal rules for oil-exporting countries

Budget-balance tax-gap rules are preferred to other fiscal policy rules to stabilize the macroeconomic volatility and welfare in oil-exporting countries. The output-inflation trade-off is of particular concern for oil exporters relative to non-oil commodity exporters due to the pass through of oil prices into headline inflation which warrants fiscal reaction to crude oil revenue. This result is robust to several instruments satisfying the rule but with reduced efficiency for those instruments that impact potential output such as government investment and capital taxes. These rules are desirable for fixed exchange rate regimes but are unable to achieve the same degree of stability as when coordinated with inflation-targeting monetary policy. Even under optimal inflation-targeting regimes, the adoption of budget-balance tax-gap rules can produce reductions in macroeconomic volatility and welfare gains.     

An evaluation of ECB policy in the Euro's big four

The Taylor curve can be viewed as an efficiency frontier displaying the trade-off between the volatility of output and volatility of inflation. We build on the existing literature in this area and view Taylor curves as a lens through which to gauge the deviations of actual ECB policy from the optimum. We employ data over the period 1999-2013 period to measure the orthogonal distance of the observed volatilities from the Taylor curve in Germany, France, Italy, Spain, and the Euro area using a recursive VARs. We find that the distance has substantially increased in all four countries suggesting that monetary policy has become less efficacious for Germany, France, Italy, and Spain since the financial crisis in 2007-2008. We also estimate counterfactual Taylor rules and find that a simple Taylor rule would have only substantially improved monetary policy efficacy in Germany.     

The role of the financial sector in economic development: the Malaysian case

In this paper, we empirically examine the finance-economic development relations for the case of Malaysia. Using a battery of time series econometric techniques, we document robust evidence suggesting favorable output effects of financial market development. Likewise, there are consistent results showing the adverse real effects of financial volatility. The results of the development of financial intermediaries, however, are fragile. Moreover, the development of the financial markets hinges crucially on macro-economic performance and financial stability of the country. However, the process of financial market development is likely to be accompanied by financial volatility, leaving Malaysia with the trade-off between financial development and financial volatility. Lastly, we obtain limited evidence indicating the complementarity between financial market and banking sector developments.

DOES THE CLARITY OF CENTRAL BANK COMMUNICATION AFFECT VOLATILITY IN FINANCIAL MARKETS? EVIDENCE FROM HUMPHREY‐HAWKINS TESTIMONIES

By applying readability statistics to the Humphrey‐Hawkins testimonies given by the Federal Reserve Chairman, it is tested whether the clarity of central bank communication affects volatility in financial markets. There are three results. First, when clarity matters, it has a diminishing effect on volatility. Second, clarity of communication matters mostly for volatility of medium‐term interest rates. Third, the effects of clarity vary over time. Clarity mattered especially, but not exclusively during Alan Greenspan's Chairmanship. Overall, the analysis illustrates the importance of transparent communication on monetary policy. (JEL E44, E52, E58)     

Government Policy in a Stochastic Growth Model with Elastic Labor Supply

Endogenous labor supply is introduced into a stochastic growth model. Money is superneutral, and the real part of the equilibrium can be characterized by two nonlinear trade-off loci between the time devoted to leisure and the mean growth rate that ensure the following: (i) equality among the risk-adjusted rates of return and (ii) equilibrium in the output market. The balanced growth equilibrium is characterized analytically and policy implications derived. Extensive numerical simulations are also conducted. These assess the effects of risk on growth and the impact of fiscal policy on both the mean growth rate and its volatility. Implications for optimal monetary policy are also addressed.     

Automatic stabilizers, fiscal rules and macroeconomic stability

This paper analyzes the effect of the fiscal structure upon the trade-off between inflation and output stabilization induced by technological shocks in a DGE model with nominal and real rigidities that also integrates a rich menu of fiscal variables as well as a target on the debt to output ratio. The channels through which fiscal policy affects macroeconomic stability include supply-side effects of distortionary taxes, the procyclical behavior of public spending induced by fiscal rules and the conventional effect of automatic stabilizers operating through disposable (permanent) income. The paper investigates these channels and concludes that, contrary to what has been found in RBC models, distortionary taxes tend to reduce output volatility relative to lump-sum taxes when significant rigidities are present. We also study the stabilization effect of alternative (distortionary) tax structures and find that these are only relevant if substantial rigidities are present.     

The optimal choice of central bank independence and conservatism under uncertainty

This paper examines the optimal monetary delegation arrangement of central bank independence and conservatism in the presence of uncertainty about the central bank’s output objective. We show that full independence is no longer optimal with uncertain central bank preferences, and that optimal delegation involves the choice of both independence and conservatism. Further, we find that the usual trade-off between independence and conservatism no longer necessarily holds. Consequently, high central bank independence may also require a high level of conservatism.     

What horizon for targeting inflation?

We investigate optimal horizons for targeting inflation in response to different shocks and their properties. Our analysis is based on a well specified macroeconometric model of Norway. We find that optimal horizons are highly shock-specific and do not increase with concern for output and/or interest rate fluctuations beyond some shock-specific levels. Optimal horizons increase with the degree of persistence in shocks while they are not affected by the size of a shock unless the central bank is averse to interest rate volatility. In the face of multiple shocks, however, sizes as well as signs of shocks become important for optimal horizons even when the central bank is not averse to interest rate volatility. This is because shocks of different signs and sizes may amplify or outweigh each others’ effects.     

Macroeconomic Volatility and the Current Account: Evidence from a Panel of OECD Countries

ABSTRACT

This paper investigates the relationship between macroeconomic volatility and the current account. Using quarterly data for a panel of OECD economies, time-varying relative volatility measures are constructed for GDP, net output, and government consumption. The empirical evidence suggests that current account balances are positively affected by all three volatility measures. Moreover, the current account balance is found to be related positively to output growth and negatively to the growth of government consumption. Evidence from saving and investment rates also suggests that the precautionary saving motive is part of (though perhaps not the entire) mechanism that relates output volatility and the current account. Broadly consistent with the predictions of the standard theoretical model, these estimates are sizable, statistically significant, and robust.     

Inflation targeting in emerging economies: Panel evidence

This paper shows there is no evidence that the inflation targeting regime (IT) improves economic performance as measured by the behavior of inflation and output growth in developing countries. The control of common time effects results in less negative and less significant IT impacts on inflation, inflation volatility and output growth volatility than previously found in the literature. Additionally, our analysis shows robust evidence of lower output growth during IT adoption. On balance, although lower long-run mean inflation signals that the central banks of emerging economies with inflation targeting are more inflation-averse, the costs of disinflation have not been lower than under other monetary regimes.     

CENTRAL BANK STRATEGIC FORECASTING

In most of the literature on transparency it has been standard to assume that central banks release truthful information when communicating with the public. However, the monetary policymaker may act strategically and misrepresent private information intending to reduce economic volatility by manipulating inflation expectations. We set up a simple model which includes misrepresentation as a possible action for the central bank and derive some testable implications. The empirical evidence from the analysis of inflation forecasts of six central banks (Brazil, Canada, England, Iceland, New Zealand, and Sweden) is consistent with the existence of strategic forecasting. (JEL E52, E58)     

The economics and politics of output volatility: evidence from Indian states

Employing data for 1981–2009, this paper examines the factors influencing the volatility of state output, using India as a case study. The analysis appears to suggest that high income states exhibit relatively higher output volatility. At the state-level, the proximate determinants of a decline in output volatility can be traced to financial deepening, government expenditures and institutional quality. Also, state-level political factors are also found to play an important role. In addition, at the macroeconomic level, monetary policy considerations are observed to be the most important factor impacting output volatility.     

THE SOURCES OF THE DECLINE IN U.S. OUTPUT VOLATILITY

In this paper, we investigate the sources of the decline in U.S. output volatility. We estimate structural vector autoregression models before and after the structural break date of the first quarter of 1984. We find that the magnitude of both supply and demand shocks in the pre-1984 period is greater than that in the post-1984 period. We also find that the relative importance of the demand shocks in the post-1984 has decreased drastically compared to the pre-1984 period. Further counterfactual analyses show that good luck, good policies, and better business practices might have played a role in reducing U.S. output volatility. ( JEL E30, E60, C32)     

FOREIGN EXCHANGE INTERVENTIONS UNDER INFLATION TARGETING: THE CZECH EXPERIENCE

This article discusses the role of foreign exchange interventions in the inflation-targeting regime, focusing on the Czech experience since 1998. We find some evidence that the interventions had a statistically significant, but short lived and economically not very important, impact on the koruna's exchange rate and its volatility. We also discuss consistency of the interventions with the inflation-targeting framework. All the Czech intervention episodes are judged to be consistent with the inflation targets and output developments, but for two episodes not fully consistent regarding the mix of monetary conditions. (JEL E42, E44, E52, E58, E65, F31 )