Riding the wave: Monetary responses to aid surges in low-income countries

We focus on the management of highly persistent shocks to aid flows in the presence of currency substitution by the domestic private sector. Such shocks have beneficent long-run effects, but when currency substitution is high they can produce dramatic macroeconomic management problems in the short run. What is the appropriate mix of money and exchange rate targeting in such cases, and the role of temporary sterilization? We analyze these and related issues in an intertemporal optimizing model that allows a portion of aid to be devoted to reducing the government's seigniorage requirement. Our results show that a managed float, with little or no sterilization of increases in the monetary base, supports the smooth absorption of the increased aid without incurring higher inflation, higher real interest rates or overshooting of the real exchange rate.     

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.     

Optimal choice of monetary policy instruments under velocity and fiscal shocks

This paper, in the spirit of Poole [Poole, William, 1970. The Optimal Choice of Monetary Policy Instruments in a Simple Macro Model. Quarterly Journal of Economics, 84, 192–216.], studies how differently monetary and fiscal shocks influence the appropriate choice of the monetary policy regime. Velocity shocks are introduced by embedding a stochastic cash-in-advance constraint within the New Keynesian framework. In addition to optimal policy under discretion, three classic rules, interest rate targeting, monetary targeting, and the Taylor rule are ranked under both fiscal and velocity shocks. The non-stationarity of prices under the Taylor rule makes it inferior to the other rules under which prices are stationary. Monetary targeting, by stabilizing aggregate demand under fiscal shocks, outperforms interest rate targeting, while the latter provides a better insulation against velocity shocks. Monetary targeting (under fiscal shocks) and interest rate targeting (under velocity shocks) even outperform the optimal policy under discretion for sufficiently high intertemporal elasticities of consumption substitution.     

Foreign Money Shocks and the Welfare Performance of Alternative Monetary Policy Regimes*

The welfare properties of monetary policy regimes for a country subject to foreign money shocks are examined in a two‐country sticky‐price model. Money targeting is found to be welfare superior to a fixed exchange rate when the expenditure switching effect of exchange rate changes is relatively weak, but a fixed rate is superior when the expenditure switching effect is strong. However, price targeting is superior to both these regimes for all values of the expenditure switching effect. A welfare‐maximising monetary rule yields lower output and exchange rate volatility than price targeting for a wide range of parameter values.     

Superneutrality, indeterminacy and endogenous growth

In this paper, we explore the possibility of having money as a source of indeterminacy in endogenous growth models. We adopt the simple Ak model of endogenous growth to be the main analytical vehicle whose balanced growth paths do not display local indeterminacy. Money is introduced via either a general cash-in-advance (CIA) constraint or a pecuniary transactions costs (PTC) technology. It is shown that local indeterminacy of the dynamics is due to the presence of an intertemporal substitution effect on capital accumulation that works against and dominates the conventional inflation effect of Tobin [1965, Money and economical growth. Econometrica 33(4), Part 2, 671]. If money is growth-rate superneutral, then the intertemporal substitution effect is absent so that local indeterminacy cannot occur. Finally, the strength of the intertemporal substitution effect depends positively on the intertemporal elasticity of substitution in consumption.     

Intertemporal substitution and the liquidity effect in a sticky price model

The liquidity effect, defined as a decrease in nominal interest rates in response to a monetary expansion, is a major stylized fact of the business cycle. This paper first confirms that, with separable preferences, a low degree of intertemporal substitution in consumption is a necessary condition for the existence of the liquidity effect. In contrast to this result, in a model with non-separable preferences and capital accumulation it takes an implausibly high elasticity of intertemporal substitution to produce a liquidity effect. The robustness of these results to alternative degrees of nominal rigidities, capital adjustment costs and stochastic monetary processes is also analysed. We conclude that price stickiness, by itself, does not guarantee the existence of a liquidity effect.     

Eurosystem monetary targeting: Lessons from U.S. data

Using a small empirical model of inflation, output, and money estimated on U.S. data, we compare the relative performance of monetary targeting and inflation targeting. The results show monetary targeting to be quite inefficient, yielding both higher inflation and output variability. This is true even with a nonstochastic money demand formulation. Our results are also robust to using a P∗ model of inflation. Therefore, in these popular frameworks, there is no support for the prominent role given to money growth in the Eurosystem's monetary policy strategy.     

Efficient propagation of shocks and the optimal return on money

We study optimal allocations in an environment in which money is essential due to lack of commitment and anonymity of individuals. Because the economy features aggregate preference shocks, we apply a notion of implementability that allows for allocations with non-trivial business-cycle dynamics for the propagation of shocks. We show that history dependence is predicted by the theory of second best and becomes necessary for optimality when the degree of patience is neither too low nor too high. Our analysis concludes with a discussion of whether there is a role for the propagation of shocks in alternative economic environments.     

MONEY,SOCIAL STATUS AND ENDOGENOUS GROWTH IN A GENERALIZED CASH‐IN‐ADVANCE MODEL

This paper analytically examines the equilibrium growth effect of money/inflation in a standard one‐sector AK model of endogenous growth with the most generalized cash‐in‐advance constraint and relative wealth‐induced preferences for social status. We show that on the economy's unique balanced growth equilibrium path, the sign of the correlation between money and output growth depends crucially on: (i) the intertemporal elasticity of substitution in consumption; and (ii) the liquidity‐constrained ratio of consumption to investment expenditure. Moreover, our model economy always exhibits a positive output–growth effect in response to changes of the strength for social status. We also undertake numerical experiments to assess the quantitative importance of our theoretical results under an empirically plausible set of parameters.     

Microeconomic uncertainty and macroeconomic indeterminacy

We propose a stylized intertemporal macroeconomic model wherein the combination of decentralized trading and microeconomic uncertainty (taking the form of privately observed and uninsured idiosyncratic shocks) creates an information problem between agents and generates indeterminacy of the macroeconomic equilibrium. For a given value of the economic fundamentals, the economy admits a continuum of equilibria that can be indexed by the sales expectations of firms at the time of investment. The Walrasian equilibrium is one of these possible equilibria but it is reached only if firms are optimistic enough. With a weaker degree of optimism, equilibrium output, employment and real wages will be lower than in the Walrasian equilibrium. Moreover, the range of possible equilibria will depend positively on the wage elasticity of the labour supply and on the magnitude of the information problem between buyers and sellers (in our case, the variance of the idiosyncratic shocks).Stochastic simulations performed on a calibrated version of the model show that pure demand expectation shocks may generate business cycle statistics that are not inconsistent with the observed ones.     

Monetary policy and consumers' demand

This paper puts to scrutiny the way monetary policy propagates its effects and the way it should be conducted, focusing on the behavior of consumers. Specifically, it considers a price elasticity of demand that increases with the level of consumption as is observed in the data. A realistic demand structure has remarkable implications for monetary policy. Three main results stand out. First, it can amplify the real effects of monetary and technology shocks. Second, it can weaken the ability of a simple Taylor rule to stabilize the economy. Third, it can attenuate the trade-off in the stabilization of output and inflation. These findings provide support to the notion of a dual mandate for the central bank. They are based on a novel mechanism of intertemporal substitution, whereby consumers have a weak incentive to smooth out the effects of income fluctuations. The mechanism lends itself to addressing questions of stabilization policy and business cycle analysis.     

Intertemporal production and intertemporal substitution in output supply and input demand

This article presents an intertemporal model of production with multiple inputs to investigate substitution opportunities facing firms over time. The firm’s intertemporal profit maximization problem is characterized with the familiar cost function, and various intertemporal substitution elasticities are delineated for output supply and input demand. The absence of intertemporal substitution in production can imply production smoothing, and allowance for intertemporal substitution in labour demand reinforces the prediction of the real business cycle model. For aggregate US manufacturing, we find substantial substitution in output supply and labour demand over time due to intertemporal changes in output price and wage rates.     

MONEY, CREDIT, AND BUSINESS CYCLE COMOVEMENT

Abstract.  We developed a two-sector general equilibrium model with money and credit to study cross-sector comovement over the business cycle. Through a working capital channel, both money and productivity shocks can generate procyclicality of sectoral activities and positive cross-sector correlations of output, employment and investment. In our model, firms in each sector borrow in the credit market to finance their purchase of labour inputs, part of which are used in the adjustment process of capital stock. The shocks affect sectoral employment and investment through their impacts on interest rates and external finance premia.     

THE DYNAMIC PROPERTIES OF ALTERNATIVE ASSUMPTIONS ON PRICE ADJUSTMENT IN NEW KEYNESIAN MODELS

This paper presents a classification of the different new Phillips curves existing in the literature as a set of choices based on three assumptions: the choice of the structure of price adjustments (Calvo or Taylor), the presence of backward indexation and the type of price contracts (fixed prices or predetermined prices). The paper suggests study of the dynamic properties of each specification, following different monetary shocks on the growth rate of the money stock. We develop the analytical form of the price dynamics, and we display graphics for the responses of prices, output and inflation. We show that the choice made for each of the three assumptions has a strong influence on the dynamic properties. Notably, the choice of the price structure, while often considered as unimportant, is indeed the most influential choice concerning the dynamic responses of output and inflation.     

The impact of Chinese monetary policy shocks on East and South‐East Asia1

We study the effects of Chinese monetary policy shocks on China's major trading partners in East and South‐East Asia by estimating structural vector autoregressive (SVAR) models for six economies in the region. We find that a monetary expansion in Mainland China leads to an increase in real GDP (temporary) and the price level (permanent) in a number of economies in our sample, most notably in Hong Kong and the Philippines. The impact could result from intertemporal substitution present in a general equilibrium framework, which allows for positive domestic impacts of foreign monetary expansions. Our results emphasize the growing importance of China for its neighbouring economies and the significance of Chinese shocks for the design of monetary policy in Asian economies.     

SOCIAL STATUS AND THE GROWTH EFFECT OF MONEY*

It has been shown that in a standard one‐sector AK model of endogenous growth with wealth induced preferences for social status, the economy's growth rates of real output and nominal money supply are positively related when the cash in advance constraint is applied solely to the household's consumption purchases. However, a positive output growth effect of money/inflation is not consistent with the existing empirical evidence. We show that when gross investment must be financed by real money balances as well, this result is overturned, i.e. higher inflation is detrimental to economic growth, because of a dominating portfolio substitution effect.     

Shocking the eurozone

In this paper, the monetary transmission mechanism within the European Monetary Union is investigated. The impulse response functions and forecast error variance decompositions of a structural vector error correction model (SVECM) are compared with those of a New Keynesian theoretical model. The identifying restrictions of the SVECM are directly derived from the theoretical model. Two permanent shocks are identified, one having only nominal, and one having only real effects. The three transitory shocks comprise a short-term interest-rate shock, an aggregate demand shock and a money demand shock. The main conclusions are that permanently reducing the inflation objective depresses output in the first year, but has no real effects in the long run. Regarding output variability, the results indicate that aggregate demand shocks are most important during the first year, after which aggregate supply shocks dominate.     

Fiat money and the value of binding portfolio constraints

We establish necessary and sufficient conditions for the individual optimality of a consumption-portfolio plan in an infinite horizon economy where agents are uniformly impatient and fiat money is the only asset available for intertemporal transfers of wealth. Next, we show that fiat money has a positive equilibrium price if and only if for some agent the zero short sale constraint is binding and has a positive shadow price (now or in the future). As there is always an agent that is long, it follows that marginal rates of intertemporal substitution never coincide across agents. That is, monetary equilibria are never full Pareto efficient. We also give a counter-example illustrating the occurrence of monetary bubbles under incomplete markets in the absence of uniform impatience.     

Nominal GDP targeting for developing countries

Interest in nominal GDP (NGDP) targeting has come in the context of large advanced economies. Developing countries are better suited for it, however, in light of big supply shocks and terms of trade shocks, such as monsoon rains and oil import price shocks in the case of India. Under annual inflation targeting (IT), the full impact of adverse supply shocks is felt as lost real GDP. NGDP targeting automatically accommodates such shocks, while retaining the advantage of anchoring expectations. We derive the condition under which NGDP targeting would dominate other regimes such as annual IT, to achieve objectives of output and price stability. We estimate key parameters for the case of India and conclude that the condition may indeed hold.