Re-exploring the nexus between monetary policy and banks' risk-taking

In this paper, we analyse the link between monetary policy and banks' risk-taking behaviour. Some theoretical and empirical studies show that monetary easing increases banks' appetite for risk related to asset valuation and the search for higher yield. However, the low interest rate environment that began in 2010 is casting doubt on these findings. Our study adds to analyses of the monetary risk-taking channel considering non-linearity, especially testing threshold effects in this channel. Using a dataset of US banks, we find that the impact of low interest rates on banks' risk behaviour depends on the previous monetary regime, that is on the deviation of monetary rates from the Taylor rule. We complement the literature on the Taylor rule and provide arguments that extend the use of the Taylor rule by Central Banks to financial stability purposes.     

Credit policies,macroeconomic stability and welfare: The case of China

Using a new Keynesian DSGE model with credit constraints, we study the impact on macroeconomic volatility of a macroprudential credit policy of the type implemented by the Central Bank of China. We find that the countercyclical credit policy plays a non-negligible role in stabilizing the real economy, and that this effect is distinctly more pronounced when credit conditions are looser. By means of a second-order approximation method, we show that the macroprudential credit policy can significantly boost welfare, benefiting the entrepreneurial sector more than the household sector. The results can yield insights for the institutional and policy setting of China and other emerging countries.     

Sustainability, flexibility, and inflation targeting

This paper examines sustainability of an inflation-targeting policy regime in terms of sustainable equilibrium using a canonical model in the recent literature. Overly flexible inflation targeting is not sustainable. Strict inflation targeting is sustainable only when shock persistence is high enough.     

Financial imbalances and gradualism

In the last years, in the major OECD economies, while inflation has become lower and more stable, episodes of financial instability and large cycles in asset prices have shown up with (often) non-negligible effects on economic activity. These facts should call for a larger concern with financial imbalances by the central bank. Adapting the model by Caplin and Leahy (1996)—where a central bank, which is uncertain about the state of the economy and its reaction to policy, seeks an optimal search strategy to influence private agents' responses—by substituting the central bank's price stability objective with a financial stability one, we find that the monetary authority should follow a less aggressive policy than the one suggested by the original model. However, initial conditions play a crucial role in determining the degree of gradualism by the policy maker with the policy becoming more and more aggressive as the initial interest rate shrinks.     

Inflation targeting regimes

This paper divides the monetary frameworks of countries that use an inflation target to define their monetary framework into three different regimes: (i) full-fledged inflation targeting, (ii) implicit price stability anchor, and (iii) inflation targeting lite. The regimes are differentiated by the clarity and credibility of the commitment to the inflation target. The revealed preference for different regimes is related empirically to cross-country structural differences in economic and financial development. Policy implications of moving from one regime to another are drawn, especially for emerging market countries aiming at full-fledged inflation targeting.     

Trend inflation and macroeconomic stability in a small open economy

This paper estimates a small open economy New Keynesian model for Australia with positive trend inflation while allowing for multiple equilibria. We first show the extent to which positive trend inflation can shrink the determinacy region. We then conduct a Bayesian estimation over two separate periods: from 1983Q1 to 1993Q1, covering the pre-inflation-targeting regime, and from 1993Q2 to 2018Q4, covering the inflation-targeting regime. We find that Australian monetary policy before the adoption of inflation-targeting permitted multiple equilibria and self-fulfilling inflation expectations to arise, resulting in exacerbated macroeconomic volatility. The implementation of inflation-targeting in Australia in the early 1990s successfully eradicated equilibrium multiplicity and sunspot shocks, and thereby drove the economy towards greater stability.     

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.     

Interest rate policy and interbank market breakdown

Using a DSGE-model with interbank market frictions, calibrated to match the frequency of financial crises, I investigate central banks' ability to prevent credit-related recessions by following an interest rate rule which accounts for financial conditions —an approach called ‘leaning against the wind’. The model's key feature is that boom-bust cycles emerge as a result of a savings glut and moral hazard in the banking sector. Although financial conditions predict crises, the policy maker cannot break the boom-bust cycle and reduce the crisis-frequency. When crises become more likely, low inflation forces the central bank to decrease the interest rate despite its intention to do otherwise. Responding to crisis-predictors eventually dilutes the primary objective of stabilizing inflation and leads to higher inflation volatility. The results suggest that central banks should refrain from leaning against the wind.     

Managing financial market expectations: The role of central bank transparency and central bank communication

In this paper, we study the influence of central bank transparency and informal central bank communication on the formation of money market expectations. The sample covers nine major central banks from January 1999 to July 2007. We find, first, that transparency reduces the bias in money market expectations and dampens their variation. Second, informal communications help manage financial market expectations by reducing the variation of expectations. Third, various subcategories of the Eijffinger and Geraats (2006) transparency index lead to a smaller bias in expectations (in particular, evaluation of policy outcome and explanation of interest rate decisions) and to a reduction in the variation of expectations (in particular, explicit prioritization of objectives and provision of information on unanticipated macroeconomic disturbances).     

Are Central Bank Preferences Asymmetric? A Comment

A recent paper by Ruge-Murcia (2004) on asymmetric central bank objectives provides a new perspective on the policy roots of inflation in developed economies. More precisely, the paper demonstrates that if the distribution of the supply shocks is normal, then the reduced-form solution for inflation implies a positive (or negative) relation between average inflation and the variance of shocks. We argue that the evidence offered in support of this hypothesis suffers from lack of identification because Phillips curve nonlinearity combined with quadratic central bank preferences yield the same reduced-form solution for inflation. If so, estimating reduced form for inflation will not be able to discriminate between these models. Yet they have quite different implications for policy. Other, structural, evidence is needed.     

Trade-offs between conservation and socio-economic objectives in managing a tropical marine ecosystem

Understanding the trade-off relationships between ecological, economic and social objectives is important in designing policies to manage or restore ecosystems. Using the northern South China Sea (NSCS) as a case study, we explore the trade-offs between conservation and socio-economic objectives in managing fisheries in tropical marine ecosystems. Using a numerical optimization routine and ecosystem modelling (Ecopath with Ecosim), the study shows that current management of the NSCS is sub-optimal both in terms of conservation and economic objectives. Therefore, improvement in both conservation status and economic benefits can be achieved by reducing fishing capacity. However, the implementation of conservation plans may be hindered by the reduced number of fisheries-related jobs and the lack of alternative livelihoods. Similar trade-offs are apparent in many tropical marine ecosystems. Thus, this paper supports claims from previous studies that solving the alternative livelihood problems appears to be a priority for improving management and conservation in these ecosystems. A buy-back scheme that is funded by fishers might be effective in reducing fishing capacity. However, public funds are required if management objectives focus strongly on conservation. This might be justified by the direct or indirect benefits to society that could be provided by well-conserved ecosystems. This study highlights the conflict between maximizing conservation and social objectives, although win-win solutions between conservation and economic objectives may be possible.     

A small estimated euro area model with rational expectations and nominal rigidities

We estimate a small model of the euro area to be used for evaluating alternative monetary policy strategies. Starting with the relationship between output and inflation we compare the fit of the nominal wage contracting model due to Taylor (J. Political Econom. 88 (1980) 1) and the relative real wage contracting model proposed by Buiter and Jewitt (The Manchester School 49 (1981) 211; reprinted in Buiter (Ed.), Macroeconomic Theory and Stabilization Policy, Manchester University Press, Manchester, 1989) and estimated with U.S. data by Fuhrer and Moore (Quart. J. Econom. 110 (1995) 127). While Fuhrer and Moore reject nominal contracts in favor of relative contracts, which induce more inflation persistence, we find that both specifications fit euro area data reasonably well. When considering France, Germany and Italy separately, however, we find that nominal contracts fit German data better, while the relative contracting model does well with respect to formerly high inflation countries such as France and Italy. We close the model by estimating an aggregate demand relationship and investigate the implications of nominal versus relative contracts for the inflation-output variability tradeoff when monetary policy follows Taylor's rule.     

Data uncertainty and the role of money as an information variable for monetary policy

In this study, we perform a quantitative assessment of the role of money as an indicator variable for monetary policy in the euro area. We document the magnitude of revisions to euro area-wide data on output, prices, and money, and find that monetary aggregates have a potentially significant role in providing information about current real output. We then proceed to analyze the information content of money in a forward-looking model in which monetary policy is optimally determined subject to incomplete information about the true state of the economy. We show that monetary aggregates may have substantial information content in an environment with high variability of output measurement errors, low variability of money demand shocks, and a strong contemporaneous linkage between money demand and real output. As a practical matter, however, we conclude that money has fairly limited information content as an indicator of contemporaneous aggregate demand in the euro area.     

Household debt,macroprudential rules,and monetary policy

Today's Canadian economy features a historic high of household debt and persistently low growth rate. The average debt-to-GDP ratio has reached the level experienced in the U.S. just prior to the recent financial crisis. In this paper, we ask whether monetary policy should lean against the household indebtedness or macroprudential policies are better suited for the task. To provide a quantitative answer, we develop a small open economy dynamic stochastic general equilibrium model featuring a micro-founded banking sector. We estimate the model using Canadian data and conduct policy experiments. Our findings favor macroprudential approach to reining in indebtedness: using monetary policy that reacts to household debt increases inflation volatility and lowers borrowers' welfare, while using macroprudential policies such as lowering the loan-to-value ratio limit increases borrowers' welfare.     

Monetary policy and systemic risk-taking in the euro area banking sector

Available empirical evidence on the significance of the (micro) risk-taking channel of monetary policy is not enough to indicate a threat to financial stability. Evidence of risk-taking with systemic risk implications is necessary. Statistical measures that capture systemic risk in all its forms within a structural factor-augmented vector autoregressive model suggest that conventional and unconventional monetary policies have resulted in systemic risk-taking in the euro area banking sector. Systemic risk has taken the form of an increase in the banking sector’s vulnerability via contagion and interconnectedness. Banks’ balance sheets, however, do not account for the full transmission from (micro) risk taking to systemic risk-taking. The main policy implication is that a persistently accommodative monetary policy may drive a monetary authority with a price stability mandate to consider a possible trade-off with financial stability. At a minimum, coordination between monetary and macro-prudential policies requires serious consideration.     

Price‐level versus inflation targeting with financial market imperfections

Abstract Price‐level targeting (PT) is compared with inflation targeting (IT) in a DSGE model augmented with imperfections in both debt and equity markets. The PT regime outperforms the IT regime, and the gain depends on the degree of financial market frictions. This is because inflation is better anchored under PT, owing to the expectation channel, and therefore the monetary authority has more leverage to deal with the financial market distortions. We also find that the gain is higher if the optimal rule reacts to asset prices instead of the output gap, and the rule requires a positive response to asset prices.     

Complementary credit networks and macroeconomic stability: Switzerland's Wirtschaftsring

The Swiss Wirtschaftsring (“Economic Circle”) credit network, founded in 1934, provides residual spending power that is highly counter-cyclical. Individuals are cash-short in a recession, and economize by greater use of WIR-credits. A money in the production function (MIPF) specification implies that transactions in WIR form a stabilizing balance that makes up for the lack of ordinary currency. Thus, unlike the ordinary money, WIR money is negatively correlated with GDP in the short run. This implication is confirmed by empirical estimates. Such credit networks play a stabilizing role that should be considered in monetary policy.     

On the welfare costs of misspecified monetary policy objectives

This paper quantifies the effects on welfare of misspecified monetary policy objectives in a stylized DSGE model. We show that using inappropriate objectives generates relatively large welfare costs. When expressed in terms of ‘consumption equivalent’ units, these costs correspond to permanent decreases in steady-state consumption of up to two percent. The latter are generated by both the inappropriate choice of weights and the omission of variables. In particular, it is costly to assume an interest-rate smoothing incentive for central bankers when it is not socially optimal to do so. Finally, a parameter uncertainty decomposition indicates that uncertainty about the properties of markup shocks gives rise to the largest welfare costs.     

The evolution of monetary policy effectiveness under macroeconomic instability

This paper studies the evolution of the monetary policy transmission mechanisms in the US following the Great Recession. The implementation of a modified Dynamic Factor Model enables the identification of two different structural scenarios based on the information contained in a large dataset of 110 variables. Impulse Response Functions to an increase of official interest rate for this large dataset are estimated for each structural context. Three techniques are combined to deal with the dimensionality problems which emerge from an estimation procedure of this magnitude: (i) factor decomposition, (ii) an identification strategy independent of the number of variables included in the dataset and (iii) a blockwise optimization algorithm for the correct selection of the Bayesian priors. Results show the presence of a structural break in 2008 and the higher responsiveness of the economy to monetary policy after that date.     

Monetary and fiscal coordination in preventing bank failures and financial contagion

This paper uses a theoretical model to analyze the optimal combination of monetary response (lowering of interest rates) and fiscal bailouts in preventing bank failures and financial contagion. I show that the optimal way of rescuing failing banks is to combine the two. This is because lower interest rates reduce the size of the bailout required to rescue failing banks as they reduce the cost for banks to raise and retain deposits. The main result of the paper is that banks are willing to monitor their investments more closely when they anticipate a monetary response in addition to bailouts in case of a banking crisis. Additionally, capital requirements such as the Basel Accords do not always incentivize banks to monitor their investments if there is a potential contagion from unhealthy to healthy banks.