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.     

Incomplete interest rate pass-through under credit and labor market frictions

By introducing search and matching frictions in both the labor and the credit markets into a cash in advance New Keynesian DSGE model, we provide a novel explanation of the incomplete pass-through from policy rates to loan rates. We show that this phenomenon is ineradicable if banks possess some power in the bargaining over the loan rate of interest, if the cost of posting job vacancies is positive and if firms and banks sustain costs when searching for lines of credit and when posting credit vacancies, respectively. We also show that the presence of credit market frictions moderates the reactions of employment and wages to a monetary shock. Finally, we confirm the finding that pass-through incompleteness has limited short-term impacts on the transmission of monetary policy shocks to output and inflation.     

Capital market imperfections in a monetary growth model

Summary. We consider a monetary growth model essentially identical to that of Diamond (1965) and Tirole (1985), except that we explicitly model credit markets, a credit market friction, and an allocative function for financial intermediaries. These changes yield substantially different results than those obtained in more standard models. In particular, if any monetary steady state equilibria exist, there are generally two of them; one of these has a low capital stock and output level, and it is necessarily a saddle. The other steady state has a high capital stock and output level; either it is necessarily a sink, or its stability properties depend on the rate of money creation. It follows that monetary equilibria can be indeterminate, and nonconvergence phenomena can be observed. Increases in the rate of money creation reduce the capital stock in the high-capital-stock steady state. If the high-capital-stock steady state is not a sink for all rates of money growth, then increases in the rate of money growth can induce a Hopf bifurcation. Hence dynamical equilibria can display damped oscillation as a steady state equilibrium is approached, and limit cycles can be observed as well. In addition, in the latter case, high enough rates of inflation induce the kinds of “crises” noted by Bruno and Easterly (1995): when inflation is too high there are no equilibrium paths approaching the high-activity steady state. Received: November 18, 1995; revised version: March 26, 1996     

Financial market imperfections and monetary policy strategy

In a model with imperfect money, credit and reserve markets, we examine if an inflation-targeting central bank applying the funds rate operating procedure to indirectly control market interest rates also needs a monetary aggregate as policy instrument. We show that if private agents use information extracted from money and financial markets to form inflation expectations and if interest rate pass-through is incomplete, the central bank can use a narrow monetary aggregate and the discount interest rate as independent and complementary policy instruments to reinforce the credibility of its announcements and the role of inflation target as a nominal anchor for inflation expectations. This study shows how a monetary policy strategy combining inflation targeting and monetary targeting can be conceived to guarantee macroeconomic stability and the credibility of monetary policy. Friedman's k-percent money growth rule, which can generate dynamic instability, and two alternative stabilizing feedback monetary targeting rules are examined.     

Credit market imperfections, income distribution, and capital accumulation

Summary. This paper builds a model in which the distribution of income matters for capital formation, and uses it to analyze the effects of a simple policy intended to create a more equal distribution of income on the severity of certain credit market imperfections and, through this channel, capital accumulation. A neoclassical growth model is developed in which some capital investment must be externally financed, and external finance is subject to a standard costly state verification (CSV) problem. In particular, some fraction of the population is capitalists, who have access to risky but high return capital production technologies. Successful capitalists leave bequests to their offspring, thereby permitting them to internally finance some fraction of their own investment projects. However some external finance is also required. This is provided by workers who save out of labor income. As is well known, the greater the capability of capitalists to provide internal finance, the less severe is the CSV problem. Thus bequests mitigate credit market frictions and, in that sense, promote financial market efficiency and capital accumulation. However, they also perpetrate income inequality. The structure is used to show that a policy that taxes the bequests of capitalists, and transfers the proceeds to workers, necessarily reduces the steady state capital stock. Indeed, when this effect is sufficiently strong, these redistributive tax/transfer schemes can reduce the total (wage plus transfer) incomes of workers, as well as their welfare. Thus some simple policies intended to redistribute income can be highly counterproductive.Received: June 3, 1996; revised version: February 4, 1997This revised version was published online in February 2005 with corrections to the cover date.     

Unique monetary equilibria with interest rate rules: An extension

In a recent paper, Adão et al. (2011), using a cash-in-advance framework, derive an interest rate rule that results in a unique monetary equilibrium. The resulting interest rate rule is forward looking and the interest rate responds positively to forecasts of future real activity and to forecasts of the future price level. This paper extends their approach to a transactions cost environment. The resulting interest rate rule has the added feature that, in line with previous studies, the nominal interest rate responds positively to forecasts of future inflation.     

Arbitrage-free valuation of interest rate securities under forward curves with stochastic speed and acceleration

Arbitrage-free models for valuing interest rate securities posit that stochastic changes in spot or forward interest rates (forward rate “speed”) follow a diffusion process. This paper extends the Heath, Jarrow and Morton [Bond pricing and the term structure of interest rates: a new methodology for contingent claims valuations, Econometrica 60 (1992) 77-105], HJM framework by allowing diffusive shocks to both the “speed” and “acceleration” of forward rates. The arbitrage-free restriction on forward rates is identified and involves volatilities of the speed and acceleration dynamics and their correlation. Although the extended forward rates remain in the diffusive framework and evolve continuously, they may exhibit large changes over short intervals (as with jumps) due to stochastic acceleration. Comparisons of bond prices show that the proposed model generates more complex and intricate shapes for the restricted forward curve with the same number of stochastic factors and volatility.     

Equilibrium unemployment with outsourcing and wage solidarity under labour market imperfections

We evaluate the effects of outsourcing and wage solidarity on wage formation and equilibrium unemployment in a heterogeneous labour market, where wages are determined by a monopoly labour union. We find that outsourcing promotes the wage dispersion between the high- and low-skilled workers. When the labour union adopts a solidaristic wage policy, it will dampen this tendency. Further, higher outsourcing will increase equilibrium unemployment among the high-skilled workers, whereas it will reduce it among the low-skilled workers. Overall, outsourcing will reduce economy-wide equilibrium unemployment under the reasonable condition that the proportion of high-skilled workers is sufficiently low.     

An evaluation of private forecasts of interest rate targets in Brazil

This study shows that the private sector accurately predicts short-term interest rate targets set by the Brazilian monetary authorities. With increased transparency under inflation targeting, such evidence suggests that the public perceives the central bank as credible.     

Optimal interest rate rule in a DSGE model with housing market spillovers

This paper studies the optimal interest rate rule in a DSGE model with housing market spillovers (Iacoviello and Neri, 2010). We find that the optimal rule responds to house price inflation even when the stabilization of house price is not among the objectives of the policymaker, and that the strength of the response depends crucially on a few structural parameters.     

Trade credit, bank lending and monetary policy transmission

This paper investigates the role of trade credit in the transmission of monetary policy. Most models of the transmission mechanism allow firms to access only financial markets or bank lending according to some net worth criterion. In our model we consider external finance from trade credit as an additional source of funding for firms that cannot obtain credit from banks. We predict that when monetary policy tightens there will be a reduction in bank lending relative to trade credit. This is confirmed with an empirical investigation of 16,000 UK manufacturing firms.     

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.     

Dichotomy between macroprudential policy and monetary policy on credit and inflation

This paper compares macroprudential policy and monetary policy using a simple New Keynesian model with credit. Macroprudential policy is effective in stabilizing credit with limited impact on inflation. Monetary policy stabilizes inflation, but is ‘too blunt’ for credit stabilization.     

Housing and credit market shocks: Exploring the role of rule-based Basel III counter-cyclical capital requirements

This paper examines the extent to which the Basel III bank capital regulation attenuates fluctuations in housing and credit markets and fosters financial and macroeconomic stability. We use a positive housing demand shock to mimic a housing market boom and a negative financial shock for credit squeeze and economic meltdown. The results show that the rule-based Basel III counter-cyclical capital requirement effectively attenuates fluctuations in housing and credit markets and prevents bubbles. In the case of a negative financial shock, it significantly reduces the magnitude of economic meltdown. Our analysis of the transition from Basel II to Basel III suggests that it is the counter-cyclical capital buffer that effectively mitigates the pro-cyclicality of its predecessor, while the impact of the conservative buffer is marginal. In contrast to the credit-to-GDP ratio, the optimal policy analysis suggests that the regulatory authority should adjust the capital requirement to changes in credit and output when implementing the counter-cyclical buffer. Future research could extend the study by comparing the effectiveness of the rule-based Basel III with other macroprudential tools in achieving financial and macroeconomic stability.     

Effects of interest rate caps on credit access

Journal of Regulatory Economics - We study the liberalization of the microcredit usury rate in Colombia and its effects on loan expansion. In February 2007 the interest rate ceiling for microcredit...     

Estimating the interest rate semi-elasticity of the demand for money in low interest rate environments

We estimate the time profile of the interest rate semi-elasticity of the demand for money that is theoretically derived from a money-in-the-utility-function (MIUF) model. This semi-elasticity increases to infinity as interest rates fall to zero. Therefore, the use of this semi-elasticity has an advantage when examining the highly interest-elastic demand for money in low interest rate environments. Using Japanese and U.S. data, we find that the semi-elasticity increases exponentially in low interest rate environments. For example, the highest value of the semi-elasticity in Japan is observed in 2005, and is approximately 350 times larger than the value in 1990.     

Balanced-budget rules: Chaos and deterministic sunspots

Schmitt-Grohé and Uribe [11] illustrate that a balanced-budget rule can lead to aggregate instability. In particular, under such a rule it is possible for a steady state to be locally indeterminate, and therefore sunspot equilibria are possible. In this paper, I extend their analysis to investigate the possibility of chaotic equilibria under a balanced-budget rule. A global analysis reveals Euler equation branching which means that the dynamics going forward are generated by a differential inclusion of the form . Each branch alone will not imply interesting dynamics. However, by switching between the branches, I show that the existence of Euler equation branching in an arbitrarily small neighborhood of a steady state implies topological chaos in the sense of Devaney on a compact invariant set with non-empty interior (the chaos is “thick”). Moreover, the chaos is robust to small C¹ perturbations. This branching under a balanced-budget rule occurs independently of the local uniqueness of the equilibrium around the steady state(s).     

Distributional role of monetary policy under limited credit access

The paper explores the redistributive effects of a monetary policy shock in a limited participation framework with limited credit access. Expansionary monetary policy redistributes consumption from traders to non-traders. This redistribution is the largest when only financial market participants have a choice between multiple means of payments while non-participants do not. Welfare analysis reveals that the effectiveness of monetary policy on the economy is the greatest when all agents (financial market participants and nonparticipants) can choose from alternative means of payment in a financially segmented model. The model is calibrated to the US economy for quantitative analysis.     

Cross-country differences in monetary policy execution and money market rates’ volatility

Volatility patterns in overnight interest rates display differences across industrial countries that existing models—designed to replicate the features of individual countries’ markets—cannot account for. This paper presents an equilibrium model of the overnight interbank market that matches cross-country differences in patterns in interest volatility by incorporating differences in how central banks manage liquidity in response to shocks. Our model is consistent with central banks’ practice of rationing access to marginal facilities when the objective of stabilizing short-term interest rates conflicts with another high-frequency objective, such as an exchange rate target.     

The stabilization role of police spending in a neo-Keynesian economy with credit market imperfections

Motivated by a seemingly persistent “twin-high” phenomenon in Latin America, we present a novel theoretical framework that has linkages between three institutions (education, criminal justice, and credit) to study policy-pertinent research questions with regards to whether police spending has the potential to serve as an unconventional policy tool for macroeconomic management. Based on a stylized parameterization, we find formal and illegal human capital to share common cyclical properties, which can be "decoupled" under a rule-based regime to police spending. This nonetheless comes at a cost of a greater propagation of the credit friction-induced financial accelerator effect.