Unconditionally optimal monetary policy

We develop a simple and intuitive approach for analytically deriving unconditionally optimal (UO) policies, a topic of enduring interest in optimal monetary policy analysis. The approach can be employed in both general linear-quadratic problems and in the underlying non-linear environments. A detailed example is provided using a canonical New Keynesian framework.     

Simple versus optimal rules as guides to policy

This paper compares the performance of different policy rules. Our comparisons focus on simple feedback rules versus rules which are optimal, given knowledge of the correct economic structure and the appropriate loss function for the policymaker. First, we compare rule performance when the correct model is not known. Second, we compare rule performance with respect to the frequency-specific behavior for variables of interest. Taken as a whole, our results indicate how the case for a model-specific optimal rule can break down when one relaxes the assumption that the true model is known as well as the assumption that the appropriate loss function is known. Links are made to the literature on monetary policy.     

Optimal simple and implementable monetary and fiscal rules

Welfare-maximizing monetary- and fiscal-policy rules are studied in a model with sticky prices, money, and distortionary taxation. The Ramsey-optimal policy is used as a point of comparison. The main findings are: the size of the inflation coefficient in the interest-rate rule plays a minor role for welfare. It matters only insofar as it affects the determinacy of equilibrium. Optimal monetary policy features a muted response to output. Interest-rate rules that feature a positive response to output can lead to significant welfare losses. The welfare gains from interest-rate smoothing are negligible. Optimal fiscal policy is passive. The optimal monetary and fiscal rule combination attains virtually the same level of welfare as the Ramsey-optimal policy.     

International dimensions of optimal monetary policy

This paper provides a baseline general equilibrium model of optimal monetary policy among interdependent economies with monopolistic firms and nominal rigidities. An inward-looking policy of domestic price stabilization is not optimal when firms’ markups are exposed to currency fluctuations. Such a policy raises exchange rate volatility, leading foreign exporters to charge higher prices vis-à-vis increased uncertainty in the export market. As higher import prices reduce the purchasing power of domestic consumers, optimal monetary rules trade off a larger domestic output gap against lower consumer prices. Optimal rules in a world Nash equilibrium lead to less exchange rate volatility relative to both inward-looking rules and discretionary policies, even when the latter do not suffer from any inflationary (or deflationary) bias. Gains from international monetary cooperation are related in a non-monotonic way to the degree of exchange rate pass-through.     

Real-Time Model Uncertainty in the United States: The Fed, 1996–2003

We study 30 vintages of FRB/US, the principal macro-model used by the Federal Reserve Board staff for forecasting and policy analysis. We document the surprisingly large and consequential changes in model properties that occurred during the period from July 1996 to November 2003 and compute optimal Taylor-type rules for each vintage. Model uncertainty is shown to be a substantial problem; the efficacy of purportedly optimal policy rules should not be taken on faith. We also find that previous findings that simple rules are robust to model uncertainty may be an overly sanguine conclusion.     

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.     

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.     

Real exchange rate persistence and monetary policy rules

The objective of this paper is to analyze the effects of alternative monetary rules on real exchange rate persistence. Using a two-country stochastic dynamic general equilibrium with nominal price stickiness and local currency pricing, we will show how the persistence of purchasing power parity deviations can be related to a monetary theory of these deviations. When monetary policy lean against the wind, there is no relationship of proportionality between the time during which prices remain sticky and the persistence of the response of the real exchange rate: in this case high nominal price rigidity is not sufficient, per se, in generating any persistence following a monetary shock. Moreover, we emphasize the role of interest rates smoothing policies and relative price stickiness within countries in understanding the relationship between the real exchange rate and monetary shocks. With reasonable parameters values, a wide range of monetary policy rules can generate real exchange rate autocorrelations around the ones observed in the data.     

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.     

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.     

Excess liquidity,bank pricing rules,and monetary policy

This paper studies the implications of excess bank liquidity for the effectiveness of monetary policy in a simple model with credit market imperfections. The demand for excess reserves is determined by precautionary factors and the opportunity cost of holding cash. It is argued that excess liquidity may impart greater stickiness to the deposit rate in response to a monetary contraction and induce an easing of collateral requirements on borrowers – which in turn may translate into a lower risk premium and lower lending rates. As a result, asymmetric bank pricing behavior under excess liquidity may hamper the ability of a contractionary monetary policy to lower inflation.     

Estimation of a forward-looking monetary policy rule: A time-varying parameter model using ex post data

In this paper, we consider estimation of a time-varying parameter model for a forward-looking monetary policy rule, by employing ex post data. A Heckman-type (1976. The common structure of statistical models of truncation, sample selection, and limited dependent variables and a simple estimator for such models. Annals of Economic and Social Measurement 5, 475-492) two-step procedure is employed in order to deal with endogeneity in the regressors. This allows us to econometrically take into account changing degrees of uncertainty associated with the Fed's forecasts of future inflation and GDP gap when estimating the model. Even though such uncertainty does not enter the model directly, we achieve efficiency in estimation by employing the standardized prediction errors for inflation and GDP gap as bias correction terms in the second-step regression. We note that no other empirical literature on monetary policy deals with this important issue. Our empirical results also reveal new aspects not found in the literature previously. That is, the history of the Fed's conduct of monetary policy since the early 1970s can in general be divided into three subperiods: the 1970s, the 1980s, and the 1990s. The conventional division of the sample into pre-Volcker and Volcker-Greenspan periods could mislead the empirical assessment of monetary policy.     

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.     

Adaptive learning, forecast-based instrument rules and monetary policy

This paper argues that recently popular forecast-based instrument rules for monetary policy may fail to stabilize economic fluctuations. In a New Keynesian model of output gap and inflation determination in which private agents face multi-period decision problems, but have non-rational expectations and learn over time, if the monetary authority adopts a forecast-based instrument rule and responds to observed private forecasts then this class of policies frequently induce divergent learning dynamics. A central bank that correctly understands private behavior can mitigate such instability by responding to the determinants of private forecasts. This suggests gathering information on the determinants of expectations to be useful.     

The expectations theory works for monetary policy shocks

In practice, the expectations theory of the term structure is employed extensively in monetary policy analysis despite its empirical failure. This paper performs a conditional test of the theory that is directly relevant to monetary theory and policy. It finds that the theory holds quite well conditional on identified monetary policy shocks, but fails conditional on aggregate supply shocks that prompt an immediate jump in prices. It also finds that policy responses to movements in the term structure play an important role in uncovering evidence for the theory as predicted by McCallum [1994. Monetary policy and the term structure of interest rates. NBER Working Paper Series, no. 4938].     

Deconstructing credibility: The breaking of monetary policy rules in Brazil

Can political interference deconstruct credibility that was hardly-earned through successful stabilization policy? We analyze the recent switch in the conduct of monetary policy by the Central Bank of Brazil (BCB). Brazil is the largest Emerging Market Economy to formally target inflation, having adopted the Inflation Targeting (IT) regime in 1999. In the early years of IT, the BCB engaged in constructing credibility with price setting agents and succeeded to anchor inflation expectations to its target even under adverse conditions such as exchange rate crises. We argue that this effort to maintain IT rules-based policy ended in 2011, as a new country president and BCB board came to power. We then discuss the consequences of this credibility loss. Our main results can be summarized as follows: (i) we provide strong empirical evidence of the BCB’s shift toward looser, discretionary policy after 2011; (ii) preliminary evidence suggests that this shift has affected agents’ inflation expectations generating social and economic costs.     

Coordination between monetary policy and fiscal policy for an inflation targeting emerging market

Several studies including Blanchard (2004) and Favero and Giavazzi (2004) imply that in emerging market economies, a tight monetary policy within an inflation-targeting framework could actually increase the price level due to the lack of fiscal discipline and the associated high risk premium. We extend their arguments in two ways. First, we introduce a semi structural model with time-varying parameters, where the risk premium is ‘unobserved’ and it is derived within the system. Such an approach fits better with the volatile nature of emerging market economies by allowing us to track down the time-varying effects of macroeconomic dynamics on both the model-consistent risk premium and the other key variables. Second, we obtain impulse response functions and analyze the implications of a tight monetary policy on major macroeconomic variables. Taking the Turkish economy as our reference point, we find that the arguments of Blanchard (2004) and Favero and Giavazzi (2004) seem to be valid.     

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.     

Optimal monetary policy in a ‘sudden stop’

In the wake of the 1997-98 financial crises, interest rates in Asia were raised immediately, and then reduced sharply. We describe an environment in which this is the optimal monetary policy. The optimality of the immediate rise in the interest rate is an example of the theory of the second best: although high interest rates introduce an inefficiency wedge into the labor market, they are nevertheless welfare improving because they mitigate distortions due to binding collateral constraints. Over time, as the collateral constraint is less binding, the familiar Friedman forces dominate, and interest rates are optimally set as low as possible.     

Information variables for monetary policy in an estimated structural model of the euro area

A small scale new keynesian model for the euro area is estimated with maximum likelihood under the assumptions of imperfect information and discretionary monetary policy. The estimated parametrization of this widely used dynamic stochastic model unveils the monetary authorities’ objectives and the information content of two indicator variables: monetary aggregates and real unit labour costs. The results highlight a significant policy concern about interest-rate smoothing and inflation; almost no concern for output gap stabilization emerges. Regarding indicator variables, unit labour costs provide information on potential output that is helpful for stabilization policy; no useful information role emerges for monetary aggregates.