Home bias,exchange rate disconnect,and optimal exchange rate policy

This paper examines how much the central bank should adjust the interest rate in response to real exchange rate fluctuations. The paper first demonstrates, in a two-country Dynamic Stochastic General Equilibrium (DSGE) model, that home bias in consumption is important to replicate the exchange rate volatility and exchange rate disconnect documented in the data. When home bias is high, the shock to Uncovered Interest rate Parity (UIP) can substantially drive up exchange rate volatility while leaving the volatility of real macroeconomic variables, such as GDP, almost untouched. The model predicts that the volatility of the real exchange rate relative to that of GDP increases with the extent of home bias. This relation is supported by the data. A second-order accurate solution method is employed to find the optimal operational monetary policy rule. Our model suggests that the monetary authority should not seek to vigorously stabilize exchange rate fluctuations. In particular, when the central bank does not take a strong stance against the inflation rate, exchange rate stabilization may induce substantial welfare loss. The model does not detect welfare gain from international monetary cooperation, which extends Obstfeld and Rogoff's [Obstfeld, M., Rogoff, K.,2002. Global implications of self-oriented national monetary rules, Quarterly Journal of Economics May, 503–535] findings to a DSGE model.     

Monetary Policy Estimation in Real Time: Forward‐Looking Taylor Rules without Forward‐Looking Data

I propose a methodology for estimating forward‐looking Taylor rules in real time when forward‐looking real‐time central bank data are unavailable. The methodology consists of choosing appropriate models to closely replicate U.S. Greenbook forecasts and then applying these models to Canada, Germany, and the U.K. The results show that German and U.S. Taylor rules are characterized by inflation coefficients increasing with the forecast horizon and a positive output gap response. The U.K. and Canada interest rate reaction functions achieve maximum inflation response at middle‐term horizons of about 1/2 years and the output gap coefficient is insignificant.     

Nowcasting: The real-time informational content of macroeconomic data

A formal method is developed for evaluating the marginal impact that intra-monthly data releases have on current-quarter forecasts (nowcasts) of real gross domestic product (GDP) growth. The method can track the real-time flow of the type of information monitored by central banks because it can handle large data sets with staggered data-release dates. Each time new data are released, the nowcasts are updated on the basis of progressively larger data sets that, reflecting the unsynchronized data-release dates, have a “jagged edge” across the most recent months.     

Rational expectations,changing monetary policy rules,and real exchange rate dynamics

This paper reexamines the explanatory power of Taylor rule fundamentals for real exchange rate determination. We assume the agents know the time-varying parameters in central bank policy rules. The empirical results suggest that a monetary policy rule with regime switching is better able to explain the real Deutschemark/dollar exchange rate from 1976 to 1998 compared with a fixed-regime monetary policy rule. The findings show the importance of accounting for the expectation formation effect in changing policy rules as emphasized by the Lucas critique. Ignoring these effects can undermine the value of the rational expectations models.     

Disagreement and Biases in Inflation Expectations

Disagreement in inflation expectations observed from survey data varies systematically over time in a way that reflects the level and variance of current inflation. This paper offers a simple explanation for these facts based on asymmetries in the forecasters' costs of over- and underpredicting inflation. Our model implies (i) biased forecasts, (ii) positive serial correlation in forecast errors, (iii) a cross-sectional dispersion that rises with the level and the variance of the inflation rate, and (iv) predictability of forecast errors at different horizons by means of the spread between the short- and long-term variance of inflation. We find empirically that these patterns are present in inflation forecasts from the Survey of Professional Forecasters. A constant bias component, not explained by asymmetric loss and rational expectations, is required to explain the shift in the sign of the bias observed for a substantial portion of forecasters around 1982.     

International dimensions of optimal monetary policy

This paper provides a baseline general equilibrium model of optimal monetary policy among interdependent economies with monopolistic firms and nominal rigidities. An inward-looking policy of domestic price stabilization is not optimal when firms’ markups are exposed to currency fluctuations. Such a policy raises exchange rate volatility, leading foreign exporters to charge higher prices vis-à-vis increased uncertainty in the export market. As higher import prices reduce the purchasing power of domestic consumers, optimal monetary rules trade off a larger domestic output gap against lower consumer prices. Optimal rules in a world Nash equilibrium lead to less exchange rate volatility relative to both inward-looking rules and discretionary policies, even when the latter do not suffer from any inflationary (or deflationary) bias. Gains from international monetary cooperation are related in a non-monotonic way to the degree of exchange rate pass-through.     

Habit formation and the persistence of monetary shocks

The dynamic effects and relative importance of monetary shocks in the US business cycle are studied using a sticky-price dynamic stochastic general equilibrium model with habit formation and capital adjustment costs. The model is estimated via maximum likelihood using data on output, real money balances, and the nominal interest rate. Econometric results indicate that the model has a strong internal propagation mechanism that can explain the persistent and hump-shaped response of US output and consumption to monetary shocks.     

Real exchange rate persistence and monetary policy rules

The objective of this paper is to analyze the effects of alternative monetary rules on real exchange rate persistence. Using a two-country stochastic dynamic general equilibrium with nominal price stickiness and local currency pricing, we will show how the persistence of purchasing power parity deviations can be related to a monetary theory of these deviations. When monetary policy lean against the wind, there is no relationship of proportionality between the time during which prices remain sticky and the persistence of the response of the real exchange rate: in this case high nominal price rigidity is not sufficient, per se, in generating any persistence following a monetary shock. Moreover, we emphasize the role of interest rates smoothing policies and relative price stickiness within countries in understanding the relationship between the real exchange rate and monetary shocks. With reasonable parameters values, a wide range of monetary policy rules can generate real exchange rate autocorrelations around the ones observed in the data.     

Reexamining the Profitability of Technical Analysis with Data Snooping Checks

In this article we reexamine the profitability of technicalanalysis using White’s reality check and Hansen’sSPA test that correct the data snooping bias. Compared to previousstudies, we study a more complete "universe" of trading techniques,including not only simple rules but also complex trading strategies,and we test the profitability of these rules and strategieswith four main indices. It is found that significantly profitablesimple rules and complex trading strategies do exist in thedata from relatively "young" markets (NASDAQ Composite and Russell2000) but not in the data from relatively "mature" markets [DowJones Industrial Average (DJIA) and S&P 500]. Moreover,after taking transaction costs into account, we find that thebest rules for NASDAQ Composite and Russell 2000 outperformthe buy-and-hold strategy in most in- and out-of-sample periods.It is also found that complex trading strategies are able toimprove on the profits of simple rules and may even generatesignificant profits from unprofitable simple rules.     

Identifying Noise Shocks: A VAR with Data Revisions

We propose a new Vector Autoregression (VAR) identification strategy to study the impact of noise, in the early releases of output growth figures, which exploits the informational advantage of the econometrician. Economic agents, uncertain about the underlying state of the economy, respond to noisy early data releases. Econometricians, with the benefit of hindsight, have access to data revisions as well, which we use to identify noise shocks. A surprising report of output growth produces qualitatively similar but quantitatively smaller effects than a demand shock. We also illustrate how a noise shock cannot be identified unless ex‐post information is used.     

Do Data Revisions Matter for DSGE Estimation?

This paper checks whether the coefficient estimates of a famous dynamic stochastic general equilibrium (DSGE) model are robust to macroeconomic data revisions. The effects of revisions are captured by rerunning the estimation on a real‐time data set compiled using the latest time series available each quarter from 1997 through 2015. Results show that estimates of the structural parameters are generally robust to changes in the data that have occurred over the past 20 years. By comparison, standard error estimates are more sensitive to revisions. The latter implies that judgments about the statistical significance of certain parameters depend on which data vintage is used for estimation.     

Can a real business cycle model without price and wage stickiness explain UK real exchange rate behaviour?

This paper establishes the ability of a Real Business Cycle model to account for UK real exchange rate behaviour. The model is tested by the method of indirect inference, bootstrapping the errors to generate 95% confidence limits for a time-series representation of the real exchange rate, as well as for various key data moments. The results suggest RBC models can explain real exchange rate movements.     

Monetary policy under model and data-parameter uncertainty

Empirical Taylor rules are much less aggressive than those derived from optimization-based models. This paper analyzes whether accounting for uncertainty across competing models and (or) real-time data considerations can explain this discrepancy. It considers a central bank that chooses a Taylor rule in a framework that allows for an aversion to the second-order risk associated with facing multiple models and measurement-error configurations. The paper finds that if the central bank cares strongly enough about stabilizing the output gap, this aversion leads to significant declines in the coefficients of the Taylor rule even if the central bank's loss function assigns little weight to reducing interest rate variability. Furthermore, a small degree of aversion can generate an optimal rule that matches the empirical Taylor rule.     

The Advantage of Flexible Targeting Rules

This paper investigates the consequences of debt stabilization for inflation targeting. If the fiscal authority holds constant the real value of debt at maturity under strict inflation targeting, the equilibrium dynamics are indeterminate for a wide range of parameters and steady‐state fiscal stances. “Flexible” targeting rules that include a concern for stabilization of the output gap can restore determinacy of the equilibrium. Flexible inflation targeting appears to be more robust than flexible debt targeting to alternative parameterizations. The fiscal authority can prevent indeterminacy under strict targeting rules by committing to hold constant debt net of interest rate spending.     

Monetary Policy Choices in Emerging Market Economies: The Case of High Productivity Growth

We develop a general equilibrium model of an emerging market economy where productivity growth differentials between tradable and non-tradable sectors result in an equilibrium appreciation of the real exchange rate—the so-called Balassa-Samuelson effect. The paper explores the dynamic properties of this economy and the welfare implications of alternative policy rules. We show that the real exchange rate appreciation limits the range of policy rules that, with a given probability, keep inflation and exchange rate within predetermined numerical targets. We also find that the B–S effect raises by an order of magnitude the welfare loss associated with policy rules that prescribe active exchange rate management.     

The Cost of Nominal Rigidity in NNS Models

We present a model with Calvo wage and price setting, capital formation, and estimated rules for government spending and monetary policy. Our model captures many aspects of U.S. data, including the volatility that has been observed in various efficiency gaps. We estimate the cost of nominal rigidity—welfare under flexible wages and prices minus welfare with nominal rigidities—to be as much as 3% of consumption each period. Since there are interest rate rules that virtually eliminate this cost, our model suggests that—contrary to Lucas's (2003) assertion—there is considerable room for improvement in demand management policy.     

Identifying the influences of nominal and real rigidities in aggregate price-setting behavior

We formulate a generalized price-setting framework that incorporates staggered contracts of multiple durations and that enables us to directly identify the influences of nominal vs. real rigidities. We estimate this framework using macroeconomic data for Germany (1975-1998) and for the U.S. (1983-2003). In each case, we find that the data are well-characterized by nominal contracts with an average duration of about two to three quarters. We also find that new contracts exhibit very low sensitivity to marginal cost, corresponding to a relatively high degree of real rigidity. Finally, our results indicate that backward-looking price-setting behavior (such as indexation to lagged inflation) is not needed in explaining the aggregate data, at least in an environment with a stable monetary policy regime and a transparent and credible inflation objective.     

Asset liquidity,business risk,and beta

Extant literature posits that because of leverage, equity beta estimates from a single factor capital asset pricing model based on an equity-only market index are biased. We show analytically that this leverage bias is intimately related to the firm's asset structure per se, the firm's asset liquidity (i.e., cash holdings) and business risk. This is mainly because riskless cash holdings and risky real assets jointly determine the relevant risk for asset pricing. We empirically confirm that asset liquidity and business risk can marginally explain the leverage bias in the cross-section of stocks returns.     

Inflation targeting: What inflation rate to target?

In an economy with nominal rigidities in both an intermediate good sector and a finished good sector, and thus with a natural distinction between CPI and PPI inflation rates, a benevolent central bank faces a tradeoff between stabilizing the two measures of inflation, a final output gap and, unique to our model, a real marginal cost gap in the intermediate sector, so that optimal monetary policy is second-best. We discuss how to implement the optimal policy with minimal information requirement and evaluate the robustness of these simple rules when the central bank may not know the exact sources of shocks or nominal rigidities. A main finding is that a simple hybrid rule under which the short-term interest rate responds to CPI inflation and PPI inflation results in a welfare level close to the optimum, whereas policy rules that ignore PPI inflation or PPI sector shocks can result in significant welfare losses.     

Self-enforcing employment contracts and business cycle fluctuations

This paper incorporates risk-sharing employment contracts into an economy in which matching frictions characterize the labour market and in which agents cannot commit. In equilibrium, the terms of ongoing contracts are affected by those being negotiated in the job market because contracts must be self-enforcing. In this context, risk-sharing implies that hours worked and wages are negatively related, while enforcement considerations imply the converse. Overall, the sign of this relationship is ambiguous. Therefore, the existence of such contracts may explain why movements in hours worked appear weakly related to those in real wages in U.S. aggregate data.