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.     

Nominal debt as a burden on monetary policy

We characterize the optimal sequential choice of monetary policy in economies with either nominal or indexed debt. In a model where nominal debt is the only source of time inconsistency, the Markov-perfect equilibrium policy implies the progressive depletion of the outstanding stock of debt, until the time inconsistency disappears. There is a resulting welfare loss if debt is nominal rather than indexed. We also analyze the case where monetary policy is time inconsistent even when debt is indexed. In this case, with nominal debt, the sequential optimal policy converges to a time-consistent steady state with positive—or negative—debt, depending on the value of the intertemporal elasticity of substitution. Welfare can be higher if debt is nominal rather than indexed and the level of debt is not too high.     

Size-corrected inference in fiscal policy reaction functions: a three country assessment

As a reflection of both strong persistence of debt-to-GDP ratios and correlation of respective innovations with governments’ primary surpluses, standard t-tests in policy reaction functions show actual significance levels that are up to five times larger than their nominal reference. Adopting size-controlled inference by means of Monte Carlo-based and asymptotic Bonferroni critical values, we diagnose fiscal policies in the US and the UK to be sustainable in samples covering more than 100 years. Conditioning on post-WWII subsamples and 5% nominal significance, conventional t-tests signal fiscal sustainability for these countries. In contrast, size-corrected inference hints at a lack of fiscal sustainability and, thus is recommended for the ‘real-time’ monitoring of public debt. The fiscal policy of Portugal is found to lack sustainability irrespective of the considered sample period.     

The Perils of Taylor Rules

Since John Taylor's (1993, Carnegie–Rochester Conf. Ser. Publ Policy39, 195–214), seminal paper, a large literature has argued that active interest rate feedback rules, that is, rules that respond to increases in inflation with a more than one-for-one increase in the nominal interest rate, are stabilizing. In this paper, we argue that once the zero bound on nominal interest rates is taken into account, active interest rate feedback rules can easily lead to unexpected consequences. Specifically, we show that even if the steady state at which monetary policy is active is locally the unique equilibrium, typically there exist an infinite number of equilibrium trajectories originating arbitrarily close to that steady state that converge to a liquidity trap, that is, a steady state in which the nominal interest rate is near zero and inflation is possibly negative. Journal of Economic Literature Classification Numbers: E52, E31, E63.     

Monetary policy and heterogeneous expectations

This paper studies the implications for monetary policy of heterogeneous expectations in a New Keynesian model. The assumption of rational expectations is replaced with parsimonious forecasting models where agents select between predictors that are underparameterized. In a Misspecification Equilibrium agents only select the best-performing statistical models. We demonstrate that, even when monetary policy rules satisfy the Taylor principle by adjusting nominal interest rates more than one for one with inflation, there may exist equilibria with Intrinsic Heterogeneity. Under certain conditions, there may exist multiple misspecification equilibria. We show that these findings have important implications for business cycle dynamics and for the design of monetary policy.     

Endogenous Money Supply and the Business Cycle

This paper documents changes in the cyclical behavior of nominal data series that appear after 1979:Q3 when the Federal Reserve implemented a policy to lower the inflation rate. Such changes were not apparent in real variables. A business cycle model with impulses to technology and a role for money is used to show how alternative money supply rules are expected to affect observed business cycle facts. In this model, changes in the money supply rules have almost no effect on the cyclical behavior of real variables, yet have a significant impact on the cyclical nature of nominal variables.Journal of Economic LiteratureClassification Numbers: E32, E42, E50.     

Optimal monetary–fiscal policy in the euro area liquidity crisis

We build an euro-area level DSGE model featuring a liquidity shock in the sovereign bonds market to simulate the strong contraction in economic activity observed during the 2008–2009 crisis. In the model, a sudden deterioration of the liquidity property of sovereign bonds is associated with deep recession and deflation. Against this background we characterize optimal monetary and fiscal policy with full commitment. We find that the optimal policy contains three features: (i) the policy rate is lowered until hitting the zero lower bound (ZLB) and then is kept at the ZLB for more periods; (ii) a prolonged central bank’s balance-sheet expansion aimed at restoring the liquidity deteriorated; (iii) a counter-cyclical fiscal stimulus which offsets, to a large extent, the fall in private spending caused by the liquidity shock. Policy regimes involving (i), but not (ii) and (iii), are quite weak in stabilizing output gap and inflation. Monetary policy regimes such as full inflation-targeting or nominal GDP targeting perform remarkably well insofar as they are complemented with an optimally-implemented counter-cyclical fiscal policy. Our results tend to favour the view that, in case of recession, an euro-wide coordinated fiscal policy should supplement the role of the ECB in achieving its primary objective.     

Is there a self-enforcing monetary constitution?

A self-enforcing monetary constitution has rules that agents acting within the system will uphold even in the presence of deviations from ideal knowledge and complete benevolence. It thus does not require external enforcement. What would such a constitution look like? I show that two regimes—a version of nominal gross domestic product targeting that relies on market implementation of monetary policy, and free banking—meet these requirements for self-enforcing monetary constitutions. The analysis draws insights from political economy, and from constitutional political economy in particular.     

The Optimal Inflation Tax

We determine the second best rule for the inflation tax in monetary general equilibrium models where money is dominated in rate of return. The results in the literature are ambiguous and inconsistent across different monetary environments. We derive and compare the optimal inflation tax solutions across the different environments and find that Friedman's policy recommendation of a zero nominal interest rate is the right one.Journal of Economic LiteratureClassification Numbers: E31, E41, E58, E62.     

Price Level Determinacy under a Pure Interest Rate Peg

In this article we reexamine a famous result by T. J. Sargent and N. Wallace (1975, Journal of Political Economy83, 241–254) according to which a “pure interest rate peg” leads to nominal price indeterminacy. We use P. Weil's (1991, International Economic Review32, 37–53) generalization of the Sidrauski–Brock model, where arrival of new “generations” of infinitely lived agents is allowed, and we obtain the following results: (i) Nominal indeterminacy holds in the traditional Sidrauski–Brock framework; (ii) This nominal indeterminacy disappears as soon as new generations arrive in time, via some rigorous version of Patinkin's “real balance effect”; (iii) A multiplicity of solutions may still remain, but full determinacy occurs in some cases, depending notably on fiscal policy or the distribution of endowments in time. Journal of Economic Literature Classification Numbers: E4, E5     

Transactions technology and the time consistency of optimal policy

In a perfect foresight, continuous time model of the macro economy. Turnovsky and Brock (1980) have demonstrated that the government's choice of an optimal policy will be time inconsistent only if it is bound by a k% rule regarding the growth of nominal monetary balances. This result is shown to be invalid when bonds bear a liquidity yield. Under such circumstances, it is shown that all optimal policies are time inconsistent. The conclusion is that the liquidity properties of the government's financing instruments play an important role in determining the consistency properties of its optimal policies.     

A survey of the literature on the optimal peg

It is widely agreed that floating is not an appropriate exchange rate policy for most developing countries, but in a world of generalized floating the question of exchange rate policy is not resolved by deciding to peg rather than to float: it is also necessary to decide to what to peg. This is the question of the ‘optimal peg’, on which a significant literature has emerged since 1976. The present paper provides a survey of that literature. Section 2 summarizes the principal papers. Section 3 compares the objectives and rules advocated by different authors. Section 4 evaluates the alternative approaches, arguing that in general the peg should be chosen to stabilize the nominal trade-weighted effective exchange rate. Section 5 considers whether this criterion points to the SDR as a satisfactory peg.     

Monetary Policy Rules and Business Cycles

Basic features of business cycle properties under both exogenous and endogenous monetary policy rules are examined in calibrated dynamic stochastic general equilibrium models with nominal rigidities (the nominal wage contract model, the monopolistic competition model with price adjustment costs and a combination of these models). The experiments show that the difference in business cycle features under exogenous and endogenous monetary policy rules is as large as the change generated by introducing nominal rigidities (and monetary disturbances). This result suggests that, for monetary business cycle research, developing a proper way to incorporate endogenous monetary policy rules may be as important as developing new transmission mechanisms of monetary policy disturbances.     

Capital Inflows,Dutch Disease Effects,and Monetary Policy in a Small Open Economy

This paper studies the role of monetary policy in a small open economy that experiences Dutch disease effects as a result of capital inflows, and examines the issue of whether such a policy should seek to address these effects from a welfare perspective. I find that Dutch disease effects occur under a fixed nominal exchange rate regime. However, a monetary policy regime characterized by generalized Taylor interest rate rules featuring either the real exchange rate or the nominal exchange rate avert Dutch disease effects. Welfare results reveal that the optimal rule is a generalized Taylor rule consistent with nominal exchange rate flexibility.     

On the welfare implications of nominal GDP targeting

This paper examines the welfare implications of a nominal GDP growth targeting rule, a nominal GDP level targeting rule, and inflation targeting regime in a New Keynesian model featuring positive trend inflation, two measures of welfare, and both high and low growth environments. The paper finds that (i) in general, nominal GDP growth targeting dominates other rules with changes in all dimensions; (ii) nominal GDP growth targeting framework is superior to the level targeting regime for most scenarios; (iii) inflation targeting is preferred to nominal GDP level targeting regime, but to minimize short-run fluctuations, the latter is advantageous; (iv) nominal GDP level targeting may be desirable only in a low growth environment with both low inflation indexation and consumption equivalence criteria. The simulation results provide solid evidence to policy makers on the desirability of nominal GDP growth targeting.     

Monetary policy in open economies

The recent literature on monetary policy in open economies has produced a strong presumption in favor of activistic policy and flexible exchange rates. We argue that this result may owe much to the combination of two commonly made assumptions: That nominal goods prices are rigid. And that the monetary authorities have a lot of information about the economy. When the source of nominal rigidity is found in wages and monetary policy is conducted according to less information demanding rules (such as a standard interest rate rule) policies that stabilize the money supply or the nominal exchange rate may perform better.     

Monetary Policy in the Open Economy Revisited: Price Setting and Exchange-Rate Flexibility

This paper develops a welfare-based model of monetary policy in an open economy. We examine the optimal monetary policy under commitment, focusing on the nature of price adjustment in determining policy. We investigate the implications of these policies for exchange-rate flexibility. The traditional approach maintains that exchange-rate flexibility is desirable in the presence of real country-specific shocks that require adjustment in relative prices. However, in the light of empirical evidence on nominal price response to exchange-rate changes—specifically, that there appears to be a large degree of local-currency pricing (LCP) in industrialized countries—the expenditure-switching role played by nominal exchange rates may be exaggerated in the traditional literature. In the presence of LCP, we find that the optimal monetary policy leads to a fixed exchange rate, even in the presence of country-specific shocks. This is true whether monetary policy is chosen cooperatively or non-cooperatively among countries.     

Economy as Instituted Process: Change,Transformation, and Progress

During the past two decades, chronic fiscal deficits have led to elevated and rising ratios of government debt to nominal GDP in Japan. Nevertheless, long-term Japanese government bonds' (JGBs) nominal yields initially declined, and have since stayed remarkably low and stable. This is contrary to the received wisdom which holds that higher government deficits and indebtedness will exert upward pressures on nominal yields. This paper examines the relationship between JGBs' nominal yields and short-term interest rates, as well as other factors, such as low inflation, persistent deflationary pressures, and tepid growth. We also argue that Japan has monetary sovereignty, which gives the Japanese government the ability to service its debt, and enables the Bank of Japan (BOJ) to keep JGBs' nominal yields low by ensuring that short-term interest rates are low, and by using various other tools of monetary policy. The argument that short-term interest rates and monetary policy are the primarily drivers of long-term interest rates follows John Maynard Keynes's (1930) insights.     

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.     

Disinflation costs in China and monetary policy regimes

This paper investigates the real effects of a disinflationary policy in China, in which we conduct a disinflation experiment in a medium-scale New Keynesian model. We highlight two key features of China's economy: the relevance of money to monetary policy rules and household inequality. For the former, we consider two monetary policy regimes: an expanded Taylor rule with money and a money supply rule. For the latter, we take into account a share of the population that is limited in its ability to participate in assets markets. Our analysis suggests that a disinflation policy is more costly when the central bank controls the money supply than the case in which the nominal interest rate is the policy instrument. Our results are driven by the different impacts of disinflation on nominal and real interest rates under the two regimes.