Signalling commitment with monetary and inflation targets

This article studies a two-period game between the public and a central bank about whose ability to commit to an announced target the public is uncertain. The central bank chooses between announcing a target for an intermediate variable (money growth) and its goal variable, inflation. Prior to setting its instrument, the central bank receives private, noisy information about the link between money growth and inflation. Monetary targeting facilitates communication of the central bank's type, in that the probability of separation is always higher than under inflation targeting. This advantage of monetary targets from a dependable central bank's perspective is outweighed for most parameter values by the advantage of inflation targeting in terms of inflation control. If the regime choice is treated as a strategic decision, over a large range of parameter values both central banks choose the regime that a dependable central bank would prefer.     

More effective than we thought: Central bank independence and inflation in developing countries

This study examines the effect of legal central bank independence on inflation in developing countries. In spite of the policy consensus suggesting that central bank independence is an effective tool to control inflation, the evidence is still limited, particularly for developing countries. Using a novel dataset, we analyze the effect of central bank independence on inflation for a sample of 118 developing countries between 1980 and 2013. We find that higher central bank independence is associated with lower inflation rates. This effect on inflation is stronger the more democratic a country is, but it is also present in non-democratic countries. Our results are robust to different specifications and methodologies. Furthermore, we find that all dimensions included in the measurement of central bank independence (objectives, personnel, policy, and financial independence) contribute to curb inflation. Our results shed light on which types of reforms may be more effective at fighting inflation in developing countries.     

Are Central Bank Preferences Asymmetric? A Comment

A recent paper by Ruge-Murcia (2004) on asymmetric central bank objectives provides a new perspective on the policy roots of inflation in developed economies. More precisely, the paper demonstrates that if the distribution of the supply shocks is normal, then the reduced-form solution for inflation implies a positive (or negative) relation between average inflation and the variance of shocks. We argue that the evidence offered in support of this hypothesis suffers from lack of identification because Phillips curve nonlinearity combined with quadratic central bank preferences yield the same reduced-form solution for inflation. If so, estimating reduced form for inflation will not be able to discriminate between these models. Yet they have quite different implications for policy. Other, structural, evidence is needed.     

Public debt indexation and denomination with an independent central bank

This paper examines the interaction between public debt management and the design of monetary institutions. The analysis shows that delegation of monetary policy to an independent central bank is more effective in containing inflationary expectations than the use of foreign currency or inflation-indexed debt. If delegation of monetary policy is viable, the optimal policy is to issue nominal debt. This increases the sensitivity of taxes and output to unexpected inflation, thus minimizing the inflation needed to offset supply shocks. Evidence on central bank independence, debt composition and output variability suggests that the normative argument has some positive content.     

Central bank forecasts and private expectations: An empirical assessment from three emerging economies

As part of their monetary policy strategy, many central banks are attempting to manage private sector expectations about key macroeconomic variables. In this article, we investigate whether forecasts provided by central banks in three inflation targeting emerging economies (Brazil, Mexico, and Poland) affect the expectations of private forecasters. In particular, we analyze whether the disagreement between the central bank and private sector forecasts applies to explain changes in private sector expectations regarding inflation and economic growth. The findings show that while central bank forecasts are higher than those made by private sector forecasters, the result is an update upwards of private forecasts and that this effect is stronger for GDP growth forecasts than for inflation forecasts.     

Political influence,central bank independence and inflation in Africa: A comparative analysis

This paper develops a new de facto measure of central bank independence (CBI) based on two recent measures of the turnover rates of central bank governors introduced by Vuletin and Zhu (2011), complemented with measures of alliance with the government in power, captured by prior executive appointment, tribe proximity, and political party affiliation. Using 1980–2009 data from 13 countries from the CFA zone (a currency union) and 18 non-CFA countries, the new index is used to 1) examine whether CBI can help achieve price stability in Africa and 2) show how CBI affects African countries that are part of a monetary union. We find that higher turnover rates lead to higher inflation. Our results are robust to the decomposition of the turnover rates into premature removals and ally replacements. Furthermore, we find that for CFA zone countries, central bank autonomy has no effect on inflation and instead inflation is driven by other variables such as the fixed exchange rate regime or commodity price shocks.     

Monetary Institutions,Monopolistic Competition,Unionized Labor Markets and Economic Performance*

Recent literature on the interactions between labor unions and monetary institutions features either a supply or a demand channel of monetary policy, but not both. This leads to two opposing views about the effects of central bank conservativeness. We evaluate the relative merits of those conflicting views by developing a unified framework. We find that: (i) the effect of conservativeness on employment depends on unions’ relative aversion to unemployment versus inflation, and (ii) for plausible values of this relative aversion (and more than one union), social welfare is maximized under a highly conservative central bank. We also evaluate the effects of centralization of wage bargaining and product market competition on unemployment and inflation.     

Announcements and credibility under inflation targeting

We inspect how inflation target announcements are instrumental in building central bank credibility and shaping inflation expectations. Investigating the role of announcements by using a time varying credibility measure, we find that both the accuracy and the frequency of inflation announcements have a positive impact on how much attention the public pays to target announcements.     

The Interaction between the Central Bank and a Single Monopoly Union Revisited: Does Greater Monetary Policy Uncertainty Reduce Nominal Wages?

Previous papers modelling the interaction between the central bank and a single monopoly union demonstrated that greater monetary policy uncertainty reduces the union's nominal wage. This paper shows that this result does not hold in general, since it depends on peculiar specifications of the union's objective function. In particular, I show that greater monetary policy uncertainty raises the nominal wage whenever union members tend to be more sensitive to the risk of getting low real wages than to the risk of remaining unemployed. This conclusion appears consistent with the evidence showing that greater monetary authority's transparency reduces average inflation .     

A classroom experiment in monetary policy

The authors propose a classroom experiment implementing a simple version of a New Keynesian model suitable for courses in intermediate macroeconomics and money and banking. Students play as either the central bank or members of the private sector. The central banker sets interest rates to meet twin objectives for inflation and the output gap or to meet only an inflation target. In both settings, private sector agents are concerned with correctly forecasting the inflation rate. The authors show that an experiment implementing this setup is feasible and yields results that enhance understanding of the New Keynesian model of monetary policy. They propose alternative versions where the central bank is replaced by a policy rule and provide suggestions for discussing the experimental results with students.     

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.     

INTERACTION BETWEEN MONETARY AND FISCAL AUTHORITIES UNDER INCOMPLETE INFORMATION

This paper analyzes the interaction between monetary and fiscal authorities under incomplete information. The inflation goal of the central bank is assumed to be unknown to the fiscal authority and the public. The central bank signals the goal by choosing the first‐period monetary policy before the fiscal authority joins the policy‐making game. If the central bank would like the fiscal authority and the public to believe that it is wet (dry), the central bank would distort the money supply upward (downward) in order to reveal its actual type.     

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.     

The Role of Central Bank Transparency for Guiding Private Sector Forecasts*

Central banks have become remarkably more transparent over the last few decades. In this paper, we study the effects of this evolution, focusing on whether enhanced central bank transparency lowers dispersion among professional forecasters of key economic variables. We use a large set of proxies for central‐bank transparency in 12 advanced economies. We find evidence for a sizeable effect (e.g., by announcing a quantified inflation objective, or by publishing inflation and output forecasts). However, there are decreasing marginal effects to increases in transparency, and the disagreement among the expectations of the general public is not affected. This suggests that there are possible limits to transparency.     

Trade-offs between macroeconomic and financial stability objectives

Ten years after the 2008-09 global financial crisis, most advanced economies have recovered and global economic growth has taken hold. However, partly due to accommodative financial conditions, financial risks are on the rise while inflation remains subdued. This revives the debate on the role of monetary policy in containing financial risks. This paper provides a framework to investigate trade-offs between macroeconomic and financial stability when the central bank has a financial stability objective. Relying on a New Keynesian model with an endogenous financial bubble, our simulations suggest that a central bank attempting to “lean against the wind” may face trade-offs between inflation/output stability and financial stability. We therefore argue that the interest rate should be used for achieving traditional macroeconomic goals, and a second, macroprudential instrument should complement the policy rate to tackle financial risk accumulation.     

Monetary Policy Delegation and Transparency of Policy Targets: A Positive Analysis

Abstract. We show that, in a two‐stage model of monetary policy with stochastic policy targets and asymmetric information, the transparency regime chosen by the central bank does never coincide with the regime preferred by society. Independent of society's endogenous choice of delegation, the central bank reveals its inflation target and conceals its output target. In contrast, society would prefer either transparency or opacity of both targets. As a conclusion, the choice of the transparency regime should be part of the optimal delegation solution.     

On the determinants of long-run inflation uncertainty: Evidence from a panel of 17 developed economies

Based on a cross section of 17 advanced economies and data for the period 1975 to 2015, we examine how the interaction between monetary policy and macroeconomic conditions affects inflation uncertainty in the long-term. We construct a proxy for the unobservable inflation uncertainty based on the slowly evolving long-term variance component of inflation from a Spline-GARCH model (Engle and Rangel, 2008). We show that long-run inflation uncertainty is high if an inflation-tolerant central bank governor is in power during a period of high inflation, if the policy rate is below the one that is prescribed by the Taylor rule and during times of heightened stock and exchange rate volatility.     

How strong is the case for a populist central banker? A note

Conventional wisdom holds that a conservative central banker reduces equilibrium inflation with no cost in terms of real activity. More recently, this proposition has been turned around in models with inflation averse wage setters who are Stackelberg leaders vis-à-vis the central bank: In this case a populist central banker with no interest in inflation was shown to lead to the first-best equilibrium. This note demonstrates that the Stackelberg assumption is crucial for this result and that the Nash solution of the same model does not generally support the case for a populist central banker.     

Financial imbalances and gradualism

In the last years, in the major OECD economies, while inflation has become lower and more stable, episodes of financial instability and large cycles in asset prices have shown up with (often) non-negligible effects on economic activity. These facts should call for a larger concern with financial imbalances by the central bank. Adapting the model by Caplin and Leahy (1996)—where a central bank, which is uncertain about the state of the economy and its reaction to policy, seeks an optimal search strategy to influence private agents' responses—by substituting the central bank's price stability objective with a financial stability one, we find that the monetary authority should follow a less aggressive policy than the one suggested by the original model. However, initial conditions play a crucial role in determining the degree of gradualism by the policy maker with the policy becoming more and more aggressive as the initial interest rate shrinks.     

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.