The open economy consequences of U.S. monetary policy

We consider the open economy consequences of U.S. monetary policy, extending the identification approach of Romer and Romer (2004) and adapting it for use with asset prices. Intended policy changes are orthogonalized against the economy’s expected future path, which captures any effects from open economy variables. Estimated from a set of bilateral VARs, the dynamic responses of the exchange rate, foreign interest rate, and foreign output are consistent with recent work that identifies U.S. policy via futures market changes and a priori impulse response bounds. We compare the two approaches, finding important commonalities. We also outline some advantages of our approach.     

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.     

The high-frequency response of exchange rates to monetary policy actions and statements

This paper investigates the impact of US monetary policy on the level and volatility of exchange rates using an event study with intraday data for five currencies (the US dollar exchange rate versus the euro, the Canadian dollar, the British pound, the Swiss franc, and the Japanese yen). I construct two indicators of news about monetary policy stemming separately from policy decisions and from balance of risk statements. Estimation results show that both policy decisions and communication have economically large and highly significant effects on the exchange rates, with the surprise component of statements accounting for most of the explainable variation in exchange rate returns in response to monetary policy. This paper also shows that exchange rates tend to absorb FOMC monetary surprises within 30-40 min from the announcement release.     

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.     

Behind the scenes of abandoning a fixed exchange rate regime

This paper explores the process of abandoning a fixed exchange rate regime during sudden stops in a small open economy. The Bank of Korea’s exchange rate policy reports during the East Asian crisis suggest that its fixed exchange rate regime was forced to collapse due to the depletion of usable foreign reserves, which resulted from the credit policy of the Korean central bank to support domestic banks in need of foreign currency liquidity. To capture the Korean crisis experience, I build a quantitative small open economy model in which, in response to the country risk premium shock, the foreign-currency credit policy of a central bank under fixed regime leads to the exhaustion of international reserves and consequent exchange rate regime shift. This model does well at replicating the observed contraction in Korean aggregate variables.     

Inventories and optimal monetary policy in a small open economy

We study how inventory investment affects the design of optimal monetary policy in a New Keynesian small open economy model. We find that under producer currency pricing, when the intratemporal elasticity of substitution is smaller than 1, optimal monetary policy in our model with inventories is similar to a standard model without inventories. However, when the intratemporal elasticity of substitution is larger than 1, inventory investment increases the importance of nominal exchange rate stabilization relative to a standard model without inventories. The importance of nominal exchange rate stabilization increases with the intratemporal elasticity of substitution.     

The impact of foreign stock markets on macroeconomic dynamics in open economies: A structural estimation

With the increased international financial integration in recent years, bilateral financial linkages between countries may have a growing influence on their real economies. This paper employs a structural two-country New Keynesian model, which incorporates a cross-border wealth channel, to estimate the effect that foreign stock market fluctuations may have on macroeconomic variables in open economy countries.The model is estimated using Bayesian methods on a sample of open economies that can potentially be affected by changes in a larger foreign stock market: Australia, Canada, New Zealand, Ireland, Austria, and the Netherlands. The estimation allows for deviations from rational expectations and for learning by economic agents.The empirical results indicate important cross-country wealth effects for Ireland and Austria, from fluctuations in the U.S. and U.K. and in the U.S. and German stock markets, respectively; the wealth effect is largest in Ireland. The data favor, instead, specifications with no significant wealth effect for the remaining countries. Foreign stock price fluctuations, however, still play a role by affecting domestic expectations about future output gaps in all countries in the sample.     

Designing targeting rules for international monetary policy cooperation

This study analyzes a two-country dynamic general equilibrium model with nominal rigidities, monopolistic competition and producer currency pricing. A quadratic approximation to the utility of the consumers is derived and assumed as the policy objective function of the policymakers.It is shown that only under special conditions there are no gains from cooperation and moreover that the paths of the exchange rate and prices in the constrained-efficient solution depend on the kind of disturbance that affects the economy. Despite this result, simple targeting rules that involve only targets for the growth of output and for both domestic GDP and CPI inflation rates can replicate the cooperative allocation.     

International welfare effects of monetary policy

In this paper, I examine the international welfare effects of monetary policy. I develop a New Keynesian two-country model, where central banks in both countries follow the Taylor rule. I show that a decrease in the domestic interest rate, under producer currency pricing, is a beggar-thyself policy that reduces domestic welfare and increases foreign welfare in the short term, regardless of whether the cross-country substitutability is high or low. In the medium term, it is a beggar-thy-neighbour (beggar-thyself) policy, if the Marshall-Lerner condition is satisfied (violated). Under local currency pricing, a decrease in the domestic interest rate is a beggar-thy-neighbour policy in the short term, but a beggar-thyself policy in the medium term. Both under producer and local currency pricing, a monetary expansion increases world welfare in the short term, but reduces it in the medium term.     

Flexible inflation targets,forex interventions and exchange rate volatility in emerging countries

Emerging economies with inflation targets (IT) face a dilemma between fulfilling the theoretical conditions of “strict IT”, which imply a fully flexible exchange rate, or applying a “flexible IT”, which entails a de facto managed-floating exchange rate with foreign exchange (forex) interventions to moderate exchange rate volatility. Using a panel data model for 37 countries we find that, although IT lead to higher exchange rate instability than alternative regimes, forex interventions in some IT countries have been more effective to lower volatility than in non-IT countries, which may justify the use of “flexible IT” by policymakers.     

Interest rate pass-through,monetary policy rules and macroeconomic stability

In this paper we analyze equilibrium determinacy in a sticky price model in which the pass-through from policy rates to retail interest rates is sluggish and potentially incomplete. In addition, we empirically characterize and compare the interest rate pass-through process in the euro area and the U.S. We find that if the pass-through is incomplete in the long run, the standard Taylor principle is insufficient to guarantee equilibrium determinacy. Our empirical analysis indicates that this result might be particularly relevant for bank-based financial systems as for instance that in the euro area.     

An investigation of the gains from commitment in monetary policy

We propose a simple framework for analyzing a continuum of monetary policy rules characterized by differing degrees of credibility, in which commitment and discretion become special cases of what we call quasi-commitment. The monetary policy authority is assumed to formulate optimal commitment plans, to be tempted to renege on them, and to succumb to this temptation with a constant exogenous probability known to the private sector. By interpreting this probability as a continuous measure of the (lack of) credibility of the monetary policy authority, we investigate the welfare effect of a marginal increase in credibility. Our main finding is that, in a simple model of the monetary transmission mechanism, most of the gains from commitment accrue at relatively low levels of credibility.     

Optimal sustainable monetary policy

In recent monetary policy literature, optimal commitment policy and its variant from a timeless perspective have been studied with emphasis on welfare gains from policy commitment. These policies, however, involve a time-consistency problem called a stabilization bias in forward-looking models. We analyze Chari and Kehoe's [1990. Sustainable plans. Journal of Political Economy 98, 783-802] sustainable equilibrium and examine optimal sustainable policy, i.e. a policymaker's strategy in the best sustainable equilibrium. This paper shows that such a policy becomes consistent with the optimal commitment policy in sufficiently later periods. It also shows that whether the optimal sustainable policy can attain the Ramsey equilibrium outcome depends on the magnitude of shocks hitting the model economy. Moreover, the paper finds a sustainable policy that attains higher social welfare than discretionary policy does.     

Discretionary monetary policy and inflation persistence

Rational expectations models of staggered price/wage contracts have failed to replicate the observed persistence in inflation and unemployment during disinflationary periods. The current literature on this persistency puzzle has focused on augmenting the nominal contract model with imperfect credibility and learning. In this paper, I re-examine the persistency puzzle by focusing on the discretionary nature of monetary policy. I show that when the central bank is allowed to re-optimize a quadratic loss function each period, imperfect credibility and learning, even in the absence of staggered contracts, can generate a significant amount of inflation persistence and employment losses during a disinflationary period.     

The impact of monetary policy on asset prices

Estimating the response of asset prices to changes in monetary policy is complicated by the endogeneity of policy decisions and the fact that both interest rates and asset prices react to numerous other variables. This paper develops a new estimator that is based on the heteroskedasticity that exists in high-frequency data. We show that the response of asset prices to changes in monetary policy can be identified based on the increase in the variance of policy shocks that occurs on days of FOMC meetings and of the Chairman's semi-annual monetary policy testimony to Congress. The identification approach employed requires a much weaker set of assumptions than needed under the “event-study” approach that is typically used in this context. The results indicate that an increase in short-term interest rates results in a decline in stock prices and in an upward shift in the yield curve that becomes smaller at longer maturities. The findings also suggest that the event-study estimates contain biases that make the estimated effects on stock prices appear too small and those on Treasury yields too large.     

Definition-consistent measurement of exchange market pressure

Currencies can be under severe pressure, but in a managed exchange rate regime that is not fully visible via the change in the exchange rate. The literature has proposed a way to measure such exchange market pressure (EMP) indirectly, by adding interest rate changes and forex interventions to the exchange rate change. We demonstrate that this measure is not consistent with the definition of EMP and develop a new measure that is consistent. This is first derived within the commonly used monetary exchange rate model. Then we generalize the analysis by avoiding the use of an exchange rate model. We find that the interest rate should not be taken in the first-difference form used so far, but rather in level form and relative to the interest rate chosen if the country had no exchange rate objective. Applications on the European Monetary System and East Asian crises confirm that this improvement is highly relevant in practice.     

A model in which monetary policy is about money

Optimal monetary policy is studied in a model with (i) heterogeneity in the degree to which different people are monitored (have publicly known histories); (ii) idiosyncratic shocks that give rise to heterogeneity in earning and spending realizations; and (iii) central-bank intervention in a “market” in claims or credit in which the participants are those who are heavily monitored. A special case of the model has everyone perfectly monitored. In that case, there is no role for money and no role for central-bank intervention. In the example displayed with imperfect monitoring, optimal intervention is not simple.     

Discretionary monetary policy and the zero lower bound on nominal interest rates

Ignoring the existence of the zero lower bound on nominal interest rates one considerably understates the value of monetary commitment in New Keynesian models. A stochastic forward-looking model with an occasionally binding lower bound, calibrated to the U.S. economy, suggests that low values for the natural rate of interest lead to sizeable output losses and deflation under discretionary monetary policy. The fall in output and deflation are much larger than in the case with policy commitment and do not show up at all if the model abstracts from the existence of the lower bound. The welfare losses of discretionary policy increase even further when inflation is partly determined by lagged inflation in the Phillips curve. These results emerge because private sector expectations and the discretionary policy response to these expectations reinforce each other and cause the lower bound to be reached much earlier than under commitment.     

Real exchange rate dynamics: The role of elastic labor supply

Empirical evidence suggests that the flexibility of labor supply is closely related to the dynamic adjustment of the real exchange rate. This paper investigates this relationship in a two-sector dependent economy model. While, the long-run equilibrium real exchange rate is independent of the elasticity of labor supply, our analysis confirms that the nature of the labor supply can be a crucially important determinant of its short-run dynamics. The extent to which this is so depends to some degree on the source of the underlying structural change that is driving the dynamics of the real exchange rate. Numerical simulations confirm that this mechanism may help explain the larger short-run volatility and more rapid convergence typically associated with developing countries having less flexible labor markets.     

Regime switching and monetary policy measurement

This paper applies regime-switching methods to the problem of measuring monetary policy. Policy preferences and structural factors are specified parametrically as independent Markov processes. Interaction between the structural and preference parameters in the policy rule serves to identify the two processes. The estimates uncover policy episodes that are initiated by switches to “dove regimes,” shown to Granger-cause both NBER recessions and the Romer dates. These episodes imply real effects of monetary policy that are smaller than those found in previous studies.