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.     

Inflation dynamics and the cost channel of monetary transmission

Evidence from vector autoregressions indicates that the impact of interest rate shocks on macroeconomic aggregates can substantially be affected by the so-called cost channel of monetary transmission. In this paper, we apply a structural approach to examine the relevance of the cost channel for inflation dynamics in G7 countries. Since firms’ costs of working capital increase with interest rates, we augment a (hybrid) New Keynesian Phillips curve by including the short-run nominal interest rate. We find significant and varying direct interest rate effects for the majority of countries, including member countries of the EMU. Simulations further demonstrate that the estimated interest rate coefficients can substantially affect inflation responses to monetary policy shocks, and can even lead to inverse inflation responses, when the cost channel is - relative to the demand channel - sufficiently strong.     

Banking crises in monetary economies

Abstract.  This paper analyzes the effect of inflation on banking crises in a model in which money and banks play essential roles. The model's equilibrium replicates some key features of actual banking crises, namely, the partial suspension of payments and the desire to hold cash even in the absence of pressing liquidity needs. When banks have access to a stable foreign currency, inflation has a threshold effect on banking crises: higher inflation reduces the likelihood of crises when inflation is below the threshold; the reverse happens when inflation exceeds the threshold. This result appears to be broadly consistent with available evidence.     

Viewpoint: A microfoundation of monetary economics

Abstract .  In this lecture, I explain what the microfoundations of money are about and why they are necessary for monetary economics. Then, I review recent developments of a particular microfoundation of money, commonly known as the search theory of money. Finally, I outline some unresolved issues.     

Bank loan portfolios and the Canadian monetary transmission mechanism

Abstract .  Following a monetary tightening, bank loans to consumers decrease. This is true for both mortgage and non-mortgage loans, and it is true for a tightening by the Bank of Canada that is, and is not, a response to a tightening by the Federal Reserve System. In contrast, business loans increase following a monetary tightening. The 'perverse' response of business loans cannot be explained by an increase in the demand for funds due to a reduction in real activity. These results are consistent with a change in bank portfolio behaviour in favour of business loans in response to a monetary tightening.     

Forward-looking monetary policy and anticipated shocks to inflation

This paper extends a standard New Keynesian model to describe the effects of anticipated shocks to inflation and forward-looking monetary policy. Using the data generated from this modified model suggests that overlooking these two factors in the standard Cholesky structural vector autoregressive identification scheme will generate a price puzzle. Furthermore, this paper demonstrates that failing to account for these two factors may result in significant estimates of two other explanations of the price puzzle—the cost channel of transmission of monetary policy and indeterminacy due to violation of the Taylor principle—even though neither features in the data generating process.     

Identifying monetary policy shocks with changes in open market operations

In this paper, we reexamine the effects of monetary policy shocks by exploiting the information contained in open market operations. A sticky price model is developed where money is the counterpart of securities deposited at the central bank. The model's solution reveals that a rise in central bank holdings of open market securities can be interpreted as a monetary expansion. Estimates of vector autoregressions for US data are further provided showing that reactions to an unanticipated rise in open market securities are consistent with common priors about a monetary expansion, i.e., a decline in the federal funds rate, a rise in output, and inertia in price responses. Compared to federal funds rate shocks, prices do not exhibit a puzzling behavior and a larger fraction of the GDP forecast error variance can be attributed to open market shocks. However, the explanatory power of the latter has decreased since federal funds rate targets have been announced.     

Optimal monetary policy: distribution efficiency versus production efficiency

This paper investigates the trade‐off between distribution effect and production effect of monetary policy when there exist unobservable idiosyncratic liquidity shocks. In the absence of risk‐sharing arrangements such as a credit market, monetary policy serves to provide ex post insurance to smooth consumption. Specifically, issuing interest‐bearing bonds restores credit transactions on money through bond‐money exchanges. Such a policy has a positive distribution effect, but the resulting inflation hampers production efficiency. It is demonstrated that the trade‐off between distribution efficiency gain and production efficiency loss would result in net welfare enhancement if consumers are relative‐risk‐averse enough.     

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.     

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.     

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.     

Distribution shocks in a Kaleckian model with hysteresis and monetary policy

This study presents a dynamic Kaleckian model with different demand and distribution regimes, a monetary policy rule and hysteresis in the natural output level. We analyse the local stability of the steady state and the transitional dynamics in different combinations of demand and distribution regimes. Our model indicates that the initial condition in an economy matters for the steady state selection from multiple ones. Using impulse response function analysis, we show that a temporary shock to the income distribution can cause permanent effects on the dynamics of endogenous variables. Moreover, the degree of hysteresis influences the magnitude of impact on output levels. Monetary policy cannot stabilise output levels in the face of temporary shocks. Finally, we find that in a wage-led demand regime, a rise in inequality of functional income may lead to secular stagnation.     

Bank behavior, incomplete interest rate pass-through, and the cost channel of monetary policy transmission

This paper employs a New Keynesian DSGE model to explore the role of banks within the cost channel of monetary policy transmission for shaping the interest rate pass-through from money market rates to loan rates. Banks extend loans to firms in an environment of monopolistic competition by setting their loan rates in a staggered way, which means that the adjustment of the aggregate loan rate to a monetary policy shock is sticky. We estimate the model for the euro area by adopting a minimum distance approach. Our findings exhibit that (i) financial costs are an important factor for price changes, (ii) frictions in the loan market have an effect on the propagation of monetary policy shocks as the pass-through from a change in money market rates to loan rates is incomplete, and (iii) the strength of the cost channel is mitigated as banks shelter firms from monetary policy shocks by smoothing loan rates.     

Optimal monetary policy with the cost channel and monopolistically-competitive banks

This paper studies the optimal nominal policy interest rate in a model with the cost channel and imperfect competition in the banking sector. Due to this market power, the interest rate on deposits is relatively low; in particular it is lower than the policy interest rate. This, in turn, leads to a suboptimal level of deposits and, as a result, to a low level of intermediation. Deviations from the Friedman Rule are optimal in this setup regardless of the assumption about price rigidity; since households can hold their assets in the form of cash or deposits, taxing money, which is an imperfect substitute for deposits, is optimal in order to increase the level of deposits and encourage intermediation. The main results of the paper are robust to the introduction of market power in the loan market as well as stickiness in both the deposit and the loan markets.     

External monetary shocks and monetary integration: Evidence from the Bulgarian currency board

Starting July the 1st 1997, Bulgaria adopted a Currency Board (CB) monetary system. This paper aims at investigating if the adoption of the CB monetary system, which involves the cost of losing monetary autonomy, has provided a relatively better (with respect to other CEEC) monetary integration of Bulgaria with the European Monetary Union (EMU). Since Bulgarian monetary variables are endogenous under a CB, we focus on the ECB and FED interest rates as the main sources on monetary volatility. First, we find that ECB shocks are more rapidly absorbed and have less significant impact of domestic variables, with respect to other external monetary shocks (FED rate changes). Second, the responses of Bulgarian variables following changes in the ECB interest rate present lower persistence and significance, with respect to what the previous literature emphasized for other CEEC with monetary autonomy. This latter result still holds when accounting for different sources of cross-country heterogeneity outlined in the literature, thus supporting that the adoption of the CB may have worked as a rather good device in terms of integration of Bulgaria into the EMU.     

Unions, monetary shocks and the labour market cycle

This paper provides a new growth model by considering strategic behaviour in the supply of labour. Workers form a labour union with the aim of manipulating wages for their own benefit. We analyse the implications on labour market dynamics at business cycle frequencies of getting away from the price-taking assumption. A calibrated monetary version of the union model does quite a reasonable job in replicating the dynamic features of labour market variables observed in post-war U.S. data.     

Distortionary fiscal policy and monetary policy goals

We reconsider the role of an inflation conservative central banker in a setting with distortionary taxation. To do so, we assume monetary and fiscal policy are decided by independent authorities that do not abide to past commitments. If the two authorities make policy decisions simultaneously, inflation conservatism causes fiscal overspending. But if fiscal policy is determined before monetary policy, inflation conservatism imposes fiscal discipline. These results clarify that in our setting the value of inflation conservatism depends crucially on the timing of policy decisions.     

Euler equations and monetary policy

Euler equations are the key link between monetary policy and the real economy in NK models. Under separable preferences, they fail to match interest rates. Non-separability between leisure and consumption significantly improves their fit and reliability for studying monetary policy.     

Changing transmission of monetary policy on disaggregate inflation in India

This paper investigates the time-varying effects of monetary policy on aggregate, sectoral, and disaggregate inflation in India from 1997 to 2017 using a large dataset of 439 variables. We find that the effectiveness of a contractionary monetary policy in controlling aggregate inflation has improved over time. This improvement in the policy's effectiveness can be attributed to better transmission through credit and asset price channels. In investigating disaggregate inflation, we find that a contractionary monetary policy is more effective in reducing inflation in the manufacturing sector than in the agricultural sector. Further, the sacrifice ratios in all manufacturing sectors have improved over time. However, the commodities prices of some sectors respond positively after a monetary contraction, which demonstrates the presence of a cost channel in the Indian economy. Our findings suggest that the monetary authority in India should have an interest rate rule that incorporates sectoral inflation and reacts to each with different intensity.     

Wage restraint and monetary union

Existing work on wage bargaining predicts more aggressive wage setting under monetary union. This is exemplified by Cukierman and Lippi (2001) who postulate that wages are set having area-wide prices in mind. The insight of aggressive wage behaviour has not been confirmed by the EMU experience, which has been characterised by wage moderation. The present paper investigates the possibility of wage restraint using a monetary union model which, realistically, assumes that trade unions set wages with national prices in mind. Drawing on plausible ranges for all parameter values (and macroeconomic shocks), our simulations show that a monetary union elicits real wages that are broadly comparable to those obtained under monetary autonomy. The confidence bounds around these results are rather wide, in particular including scenarios of wage restraint.