Optimal monetary policy with the cost channel

In the standard new Keynesian framework, an optimizing policy maker does not face a trade-off between stabilizing the inflation rate and stabilizing the gap between actual output and output under flexible prices. An ad hoc, exogenous cost-push shock is typically added to the inflation equation to generate a meaningful policy problem. In this paper, we show that a cost-push shock arises endogenously when a cost channel for monetary policy is introduced into the new Keynesian model. A cost channel is present when firms’ marginal cost depends directly on the nominal rate of interest. Besides providing empirical evidence for a cost channel, we explore its implications for optimal monetary policy. We show that its presence alters the optimal policy problem in important ways. For example, both the output gap and inflation are allowed to fluctuate in response to productivity and demand shocks under optimal monetary policy.     

Monetary policy transmission in vector autoregressions: A new approach using central bank communication

In this paper, we study the role played by central bank communication in monetary policy transmission. We employ the Swiss Economic Institute’s Monetary Policy Communicator to measure the future stance of the European Central Bank’s monetary policy. Our results indicate, first, that communication has an influence on inflation (expectations) similar to that of actual target rate changes. Communication also plays a noticeable role in the transmission of monetary policy to output. Consequently, future work on monetary policy transmission should incorporate both a short-term interest rate and a communication indicator. A second finding is that the monetary policy transmission mechanism changed during the financial crisis as the overall effect of monetary policy on (expected) inflation and output is weaker and of shorter duration during this period compared to the overall sample period.     

基于产出缺口的菲利普斯曲线对我国通胀预测的研究

基于菲利普斯曲线理论中产出缺口与通货膨胀率的关系,应用卡尔曼滤波方法估算我国的潜在产出与产出缺口,通过格兰杰因果关系验证产出缺口与通货膨胀的因果关系,并建立产出缺口的菲利普斯曲线模型进行通货膨胀预测。实证结果表明该模型能够较好地预测我国通货膨胀,从而能为制定相应的货币政策提供良好的参考。     

Can central banks’ monetary policy be described by a linear (augmented) Taylor rule or by a nonlinear rule?

The original Taylor rule establishes a simple linear relation between the interest rate, inflation and the output gap. An important extension to this rule is the assumption of a forward-looking behaviour of central banks. Now they are assumed to target expected inflation and output gap instead of current values of these variables. Using a forward-looking monetary policy reaction function, this paper analyses whether central banks’ monetary policy can indeed be described by a linear Taylor rule or, instead, by a nonlinear rule. It also analyses whether that rule can be augmented with a financial conditions index containing information from some asset prices and financial variables. The results indicate that the monetary behaviour of the European Central Bank and Bank of England is best described by a nonlinear rule, but the behaviour of the Federal Reserve of the United States can be well described by a linear Taylor rule. Our evidence also suggests that only the European Central Bank is reacting to financial conditions.     

The Central Banker as a Risk Manager: Estimating the Federal Reserve's Preferences under Greenspan

We derive a natural generalization of the Taylor rule that links changes in the interest rate to the balance of the risks implied by the dual objective of sustainable economic growth and price stability. This monetary policy rule reconciles economic models of expected utility maximization with the risk management approach to central banking. Within this framework, we formally test and reject the standard assumption of quadratic and symmetric preferences in inflation and output that underlies the derivation of the Taylor rule. Our results suggest that Fed policy decisions under Greenspan were better described in terms of the Fed weighing upside and downside risks to their objectives rather than simply responding to the conditional mean of inflation and of the output gap.     

Optimal monetary policy in a small open economy with staggered wage and price contracts

We study optimal monetary policy for a small open economy in a model where both domestic prices and wages are sticky due to staggered contracts. The simultaneous presence of the two forms of nominal rigidities introduces an additional trade-off between domestic inflation and the output gap. We derive a second-order approximation to the average welfare losses that can be expressed in terms of the unconditional variances of the output gap, domestic price inflation, and wage inflation. As a consequence, the optimal policy seeks to minimize a weighted average of these variances. We analyze welfare implications of several alternative simple policy rules, and find that domestic price inflation targeting generates relatively large welfare losses, whereas CPI inflation targeting performs nearly as well as the optimal rule.     

The role of liquidity constraints in the response of monetary policy to house prices

We analyse the optimal response of monetary policy to house prices in a New Keynesian framework. A positive wealth effect from housing is derived from liquidity constrained consumers. Housing equity withdrawal allows them to convert an increase in housing value into consumption and we show that monetary policy should react to house prices due to their effect on consumption by constrained agents. Moreover, we allow the share of liquidity constrained consumers to vary with house prices. Consequently, the optimal weights on expected inflation, the output gap and house prices in the optimal interest rate rule vary over time too.     

Inflation targeting: What inflation rate to target?

In an economy with nominal rigidities in both an intermediate good sector and a finished good sector, and thus with a natural distinction between CPI and PPI inflation rates, a benevolent central bank faces a tradeoff between stabilizing the two measures of inflation, a final output gap and, unique to our model, a real marginal cost gap in the intermediate sector, so that optimal monetary policy is second-best. We discuss how to implement the optimal policy with minimal information requirement and evaluate the robustness of these simple rules when the central bank may not know the exact sources of shocks or nominal rigidities. A main finding is that a simple hybrid rule under which the short-term interest rate responds to CPI inflation and PPI inflation results in a welfare level close to the optimum, whereas policy rules that ignore PPI inflation or PPI sector shocks can result in significant welfare losses.     

Real Activity, Inflation, Stock Returns, and Monetary Policy

We find that contractionary monetary policy shocks generate statistically significant movements in inflation and expected real stock returns, and that these movements go in opposite directions. Since positive shocks to output precipitate monetary tightening, we argue that the countercyclical monetary policy process is important in explaining the negative correlation between inflation and stock returns. Examining the 1979–1982 period, we find that monetary policy tightens significantly in response to positive shocks to inflation, and that the impact of monetary policy shocks on stock returns is negative and volatile. Therefore, we see evidence that an “anticipated policy” hypothesis is at work.     

Stock liquidity and the Taylor rule

This paper examines how stock market liquidity and commonality in liquidity are impacted by real-time output gap and inflation, as these macroeconomic variables have been shown to be the main drivers of monetary policy according to the Taylor rule. We show that an increase in the output gap and inflation lowers stock liquidity and increases commonality in liquidity, since it points to a contractionary monetary policy and is likely to lead to a decline in the liquidity providers' funding liquidity. This effect is larger for stocks with low market capitalization and low liquidity.     

高货币化、通货膨胀预期与通货膨胀

通货膨胀成为信用货币经济中循环往复的问题,货币是症结关键。通过建立包含货币缺口和收入差距的凯恩斯Phillips曲线理论模型,利用中国1979-2010年的数据实证得出:货币化通过两种途径作用于通货膨胀,一是通过扩大货币缺口、直接推动当期物价上升,二是高货币化导致了较高的通货膨胀预期,这种预期又推动了通货膨胀的自我实现。因此,在经济平稳发展情况下,货币化是一个金融发展程度指标,但在严重依赖货币扩张推动经济增长的情况下,货币化却可能是货币超发的指标,与通货膨胀存在着密切关系。     

Output Gap Estimation and Monetary Policy in China

Using the Bayesian multivariate Beveridge-Nelson decomposition method, this paper estimates China's output gap based on a multivariate dynamic model featuring distinct interactions among real output, inflation, money, and the exchange rate in China during the period 1980-2010. The authors compare the statistical nature and potential forecasting effects of the resulting multivariate gap measure on monetary policy with those of the output gap measures based on univariate models. The empirical results show that only the measure based on the multivariate system significantly predicts monetary policy, which indicates that the output gap estimated by the multivariate system contains more information than the traditional measures for macroeconomic policy adjustments do.     

A Historical Analysis of the Taylor Curve

Taylor (1979) shows that there is a permanent trade‐off between the volatilities of the output gap and inflation. Although a number of papers argue that the so‐called Taylor curve is a policy menu, we use it as an efficiency locus to gauge the appropriateness of monetary policy. We examine the efficiency of U.S. monetary policy from 1875 onward by measuring the orthogonal distance between the observed volatilities of the output gap and inflation from the Taylor curve. We also identify time periods in which the variability of the U.S. economy changed by observing shifts in this efficiency frontier.     

Risk management,nonlinearity and aggressiveness in monetary policy: The case of the US Fed

We contribute to the empirical literature on the risk-management approach to monetary policy by estimating regime switching models where the strength of the response of monetary policy to macroeconomic conditions depends on the level of risk associated with the inflation outlook and risk in financial markets. Using quarterly data for the Greenspan period we find that: (i) risk in the inflation outlook and in financial markets are a more powerful driver of monetary policy regime changes than variables typically suggested in the literature, such as the level of inflation and the output gap; (ii) estimation of regime switching models shows that the response of the US Fed to the inflation outlook is invariant across policy regimes; (iii) however, in periods of high economic risk monetary policy tends to respond more aggressively to the output gap and the degree of inertia tends to be lower than in normal circumstances; and (iv) the US Fed is estimated to have responded aggressively to the output gap in the late 1980s and beginning of the 1990s, and in the late 1990s and early 2000s. These results are consistent with Mishkin (2008)’s view that in periods of high economic risk monetary authorities should respond aggressively to changes in macroeconomic conditions while the degree of inertia should be lower than in normal circumstances.     

On the optimal monetary policy response to noisy indicators

We describe a behavior of a central bank when its measures of current inflation and output are subject to measurement errors, in a framework of optimizing models with nominal price stickiness. In our model, a central bank sets the interest rate equal to its current estimate of the so-called Wicksellian natural rate of interest. This is shown to imply that the interest rate responds to the central bank's estimates of both current inflation and output gap, as advocated by Taylor (1993). It is also shown that the noise contained in the indicators justifies a degree of policy cautiousness. A reduced-form representation of optimal policy should exhibit interest-rate smoothing, which is often found in the empirical literature on monetary policy reaction functions.     

Endogenous nominal rigidities and monetary policy

Recent empirical research finds that the degree of nominal rigidities varies over monetary policy regimes. This implies that monetary policy analysis with exogenously given nominal rigidities is subject to the Lucas critique. We allow firms to choose the probability of price adjustment in a Calvo-style sticky price model, and analyze how this probability changes according to an inflation coefficient of the Taylor rule. The model shows that a more aggressive monetary policy response to inflation makes firms less likely to reset prices and gives the resulting New Keynesian Phillips curve a flatter slope and a smaller disturbance, as observed during the Volcker-Greenspan era. Also, such a policy response can stabilize both inflation and the output gap by exploiting the feedback effects of this policy response on firms’ price-setting. These results offer theoretical support for the good policy hypothesis about the Great Moderation.     

Implications of habit formation for optimal monetary policy

We study the implications for optimal monetary policy of introducing habit formation in consumption into a general equilibrium model with sticky prices. Habit formation affects the model's endogenous dynamics through its effects on both aggregate demand and households’ supply of output. We show that the objective of monetary policy consistent with welfare maximization includes output stabilization, as well as inflation and output gap stabilization. We find that the variance of output increases under optimal policy, even though it acquires a higher implicit weight in the welfare function. We also find that a simple interest rate rule nearly achieves the welfare-optimal allocation, regardless of the degree of habit formation. In this rule, the optimal responses to inflation and the lagged interest rate are both declining in the size of the habit, although super-inertial policies remain optimal.     

The Great Inflation of the 1970s

The two leading explanations for the poor inflation performance during the 1970s are policy opportunism ( Barro and Gordon 1983 ) and "inadvertently" bad monetary policy ( Clarida, Gali, and Gertler 2000 , Orphanides 2003 ). The main models of the latter category are that of Orphanides (loose monetary policy was the outcome of mis-perceptions about potential output rather than of inflation tolerance) and of Clarida, Gali, and Gertler (weak policy reaction to expected inflation led to indeterminacies). We show that both of these models can account for high and persistent inflation and also have satisfactory overall performance if an exceptionally large decrease in productivity took place at that time.     

Notes on the Underground: Monetary Policy in Resource‐Rich Economies

The central bank of a commodity‐exporting small open economy faces the traditional trade‐off between domestic inflation and output gap. The commodity sector introduces a terms‐of‐trade inefficiency that gives rise to an endogenous cost‐push shock, changes the target level for output, reduces the slope of the Phillips curve, and increases the importance of stabilizing the output gap. Optimal monetary policy calls for a reduction of the interest rate following a drop in the oil price. In contrast, a central bank with a mandate to stabilize consumer price inflation raises interest rates to limit the inflationary impact of an exchange rate depreciation.