Modern monetary economists argue that institutional aspects such as central bank independence and central bank conservatism play an important role for the performance of an economy. In order to be able to compare the effects of different institutions it is necessary to measure both central bank independence and conservatism. In this paper we propose a new methodol- ogy of uncovering the degree of effectivemonetarypolicy conservatism from observed central bank behavior. Employing a variant of the Barro-Gordon- model we derive an optimal prime rate reaction function and show that more effectively conservative monetarypolicy tends to react less active to shocks to the real economy. In order to illustrate the proposed methodology we then estimate a common prime rate reaction function for a sample of 11 central banks in a panel setting and allow the reaction to real disturbances to differ between countries.
Economists, and mainly of the classical, school, argue that expectations of individuals and firms play an important role in transforming the effect of monetarypolicy actions to stability of macroeconomic variables, while this debate goes on, many hold the view that; the relative strength of the various channels of transforming monetarypolicy to productive economic activities is likely to vary from one country to another, depending on institutional arrangements and economic circumstances. It may also be the case that the time lags inherent in the various channels of transmission differ. Another area of debate in monetary theory policy where differences remain relatively wide is the question of the efficacy of monetarypolicy in nominal changes. Here, the difference in views ranges from that of the Keynesians who argue that monetarypolicy could influence real output , in both the short and long runs, to the neo-classical who argue that no such change in real output is possible even in the short run. The monetarist view is captured by an aggregate supply curve which is upward sloping to a point represented by full employment, which is the natural rate and vertical thereafter. This shape of the aggregated supply curve allows for inflation/output trade-off, `
Allowing recipient countries to save aid directly for later use is an alternative to be considered if greater coordination of donor countries turns out to be an unrealistic objective. Donors could set up coun- try-specifi c reserve funds in which aid is accumulated and then spent when aid fl ows or other resources dry up. The key challenge would, however, be the governance of such funds, which requires resolving the tension between predictable and timely assistance, on the one hand, and donors’ desire to subject the use of the Fund’s resources to conditionality, on the other. Indeed, for aid-receiving countries, international reserves are an appealing alternative, as they allow these countries to save resources and use them at their discretion. Nonetheless, given that sterilization policy may be costly, there is still scope for future work aimed at designing a governance structure of aid reserve funds that might become acceptable to both recipients and donors.
A decrease in the positive monetary interest rate impulse is caused in the sector a by a reduction in the price of interest-rate domestic inputs Z (Pz (r)) such as the capital input. In Figure 2, the result is an increase in sector demand until supply YSN derivative "of input. The Z feeds increase in the correlative level of macro, increasing the component of the aggregate demand sensitive the interest rate. The effect indirect monetarypolicy transiting the exchange rate will partially diminish this outcome. Indeed, the depreciation of the nominal exchange rate induced the reduction in interest rates increases the price of imported inputs PJe) and thereby reduces the optimal supply of sector n, this reduction in supply is for example by the displacement of the curve of 'offer YSN the net effect of these direct and indirect transmission channels of monetarypolicy on sector offers here depends on the relative size of these two effects.
policymakers cannot articulate and specify the various models that they wish to be robust against and therefore cannot assign probabilities to each of the models. This situation is known as Knightian uncertainty (Knight 1921). In such environments, the robust control approach comes into play. Robust control suggests that policymakers should formulate policy to guard against the worst form of model misspecification that is possible. Thus, rather than focusing on the “most likely” outcome or on the average outcome, robust control argues that policymakers should focus on and defends against the worst-case outcome.
On the basis of our empirical results, we conclude that output growth falls by about one-third of a per cent in the first and second years after a one percentage point rise in the short-term real interest rate and by about one-sixth of a per cent in the third year, implying that the majority of the effect on growth occurs more than a year after a change in interest rates. These relatively long lags, combined with the problems inherent in forecasting economic growth more than a year into the future, point to the difficulty of trying to use monetarypolicy to iron-out fluctuations in the business cycle.
We develop a macroeconomic model where money policy is modelled as an asset exchange, which is usually neglected in current macroeconomic theory. 2 Accounting for the fact that only few securities are eligible for central bank transactions in open market operations pro- vides a novel perspective on the relation between monetarypolicy, interest rates and real activity. The crucial property of the model is that monetarypolicy determines the liquidity of securities by declaring them as eligible or not. It is well-established from nance studies (e.g. Holmstrom and Tirole, 2001, Acharya and Pedersen, 2005) that dierences in market liquidity of assets can aect pricing kernels. We contribute to this research by deriving a liq- uidity premium on interest bearing assets that originates in monetarypolicy implementation. We show that changes in the policy rate are not one-for-one passed through to all short-term interest rates, without introducing arbitrage opportunities. As a consequence, the eects of monetarypolicy on private savings and real activity dier from what standard models predict, where the rate of intertemporal substitution (and thus expectations of growth in the marginal utility of consumption) solely depends on the real policy rate.
Figure 9 reports the impact of a 100 basis points increase in the nominal interest rate on euro area real GDP and inﬂation in the 11 models when interest rates in subsequent periods are set according to the GR rule. Thus, diﬀerences in the transmission of monetarypolicy to output and inﬂation are solely due to diﬀerences in the structural assumptions and parameter estimates of these models. All models have Keynesian features. Due to nominal rigidities the increase in the nominal interest rate raises real interest rates and lowers real output. Inﬂation typically reacts more slowly and declines in response to slowing output consistent with a Phillips curve. There are substantial diﬀerences in terms of magnitude and persistence of the eﬀect of such a monetarypolicy shock. They arise because of diﬀerent structural assumptions and diﬀerent data used in estimation. Some models use more data series than others and the sample periods vary.
This short paper argues that the view that monetarypolicy is ineffective during financial crises is not only wrong, but may promote policy inaction in the face of a severe contractionary shock. To the contrary, monetarypolicy is more potent during financial crises because aggressive monetarypolicy easing can make adverse feedback loops less likely. The fact that monetarypolicy is more potent than during normal times provides a rationale for a risk-management approach to counter the contractionary effects from financial crises, in which monetarypolicy is far less inertial than would otherwise be typical – not only by moving decisively through conventional or nonconventional means to reduce downside risks from the financial disruption, but also in being prepared to quickly take back some of that insurance in response to a recovery in financial markets or an upward shift in inflation risks.
Private agents form beliefs through a signal extraction problem, thus making the sig- naling e¤ect of policy actions dependent on the relative uncertainty over the two shocks. When uncertainty about demand is high relative to uncertainty about the policy target, interest rate surprises lead to larger belief revisions about demand and smaller revisions to beliefs about the output gap target. The recent crisis provides a good example of a time when uncertainty about economic strength was particularly high and indeed, the press has interpreted many recent policy actions as indicators of economic strength. Following the release of the December 2007 FOMC meeting minutes, a New York Times story entitled "Discussion of a Fed Cut Only Stirs Up Concerns About a Weak Economy"? stated that "while investors usually cheer an impending rate cut, the minutes only fueled anxiety that the economy would fall into a recession". Later on, after the February 2010 decision to raise the discount rate, the Financial Times released an article entitled "Fed Discount Rate Rise Sends Recovery Signal"?. Interestingly, this was despite the Federal Reserve’s press release
The analysis of a calibrated version of the model developed here suggests that labor market frictions are unlikely, either by themselves or through their interaction with sticky prices, to have large e¤ects on the equilibrium response to shocks, in an economy with nominal rigidities and a monetarypolicy described by a simple Taylor type rule. In that respect, perhaps the most important contribution of those frictions lies in their ability to reconcile the presence of wage rigidities with privately e¢ cient employment relations. The presence of those nominal wage rigidities has, on the other hand, impor- tant consequences for the economy ’s response to shocks as well as for the optimal design of monetarypolicy. Thus, in the model developed above, the optimal policy allows for signi…cant deviations from price stability, in order to facilitate the adjustment of real wages to real shocks. Furthermore, the outcome of that policy can be approximated by means of a simple interest rate rule that responds to both price in‡ation and the unemployment rate.
These surveys suggest that expected inflation, which stood at about 5 per cent in 1990, declined to around 2 per cent by 1999—i.e., to the midpoint of the infla- tion-control target range. Moreover, according to these surveys, for the entire period during which the Bank has had a target range for inflation, expected inflation rates remained within that range. On the other hand, the measure of expectations derived from the differ- ence between the yield on conventional bonds and that on bonds indexed to the consumer price index suggests a much slower gain in credibility for the cen- tral bank. According to this measure, expected infla- tion rates fluctuated around 4 per cent for the 1992–95 period and fell outside the target range in 1994, sug- gesting that the credibility of monetarypolicy was rather weak. However, using this yield gap as a meas- ure of inflation expectations is in itself problematic. 11 In addition, the size of public deficits during the first half of the past decade may well have created uncer- tainty about the longer-term outlook for monetarypolicy, and this would have been reflected in the yield spreads. 12 In any case, this measure of expectations finally began to decline and ended up close to the middle of the target range, where it has remained. In light of the inflation-expectations measures in Chart 1, it is reasonable to think that explicit inflation-control targets have enhanced the credibility of Canadian monetarypolicy.
The second paper I choose to review is titled “What Explains the Stock Market’s Reaction to Federal Reserve Policy?” by Ben Bernanke and Kenneth Kuttner. In this paper, the authors analyze the linkage between monetarypolicy and asset prices. They use the Fed funds futures as a proxy of monetarypolicy expectations. Using a stock market value-weighted index, the authors find that an unexpected 25 basis point rate cut would increase stock prices by 1 percent. This result is robust. Moreover, there is evidence of a larger stock market response to monetarypolicy changes that are more permanent. For example, a reversal in the direction of the Fed funds rate generates a larger stock market response. Lastly, they find that stock market prices respond as they do to monetarypolicy due to its effects on expected future excess returns or on expected future dividends. This result contradicts the notion that the reaction of stock market prices to monetarypolicy is not attributable to
interest rates was interpreted as evidence of a change in the response of policy to changes in inflation, then these interest rate expecta- tions could have declined because of the policy decisions at the short end of the term structure. Indeed, policy rules estimated during the 2003-2005 period show a large downward shift in the responsive- ness of the federal funds rate to inflation. The responsiveness appears to be at least as low as in the late 1960s and 1970s. As discussed in Smith and Taylor (2007), this could have led investors to believe that there was a longer run change in policy which would have reduced the response of long-term interest rates. A key lesson here is that large deviations from business-as-usual policy rules are difficult for market participants to deal with and can lead to surprising changes in other responses in the economy.
With regards to comparing the three di¤erent models listed above, they all do capture the same broad patterns of volatility for all variables. However, some interesting di¤erences do exist. This is most noticeable in Figure 1 where the heteroskedastic VAR yields a much smoother pattern of volatility for the in‡ation equation. There are also noticeable divergences between our model and that of Primiceri (2005), particularly in the crucial mid-1970s through early 1980s time period where most of the change in the parameters appears to happen. For the other two equations (see Figures 2 and 3), fewer di¤erences exist. Our mixture innovation model and the TVP-VAR with stochastic volatility are yielding quite similar patterns of volatility, but the heteroskedastic VAR diverges from this pattern a few times, particularly in the unemployment equation. However, with respect to the monetary shock (Figure 3), these three models are yielding very similar results.
We therefore advocate a ‘neutral’ policy stance in light of the short-run need for fiscal stimulus, with- out compromising the long-run need for consolida- tion. The balance between these two needs may be different from country to country. In some cases, the long-run consolidation should be given higher priority over short-run stabilisation. Yet, it is quite clear that stabilisation and consolidation require much more than looking at quantitative targets in terms of debt and deficits. They are likely to require reforms of tax codes and spending struc- ture, efficiency standards in the provision of public goods, and a rethinking of the scope and scale of government intervention. While reforms are hard to implement at times of slow economic growth, it is not obvious that their further delay will help in any way the countries that mostly need them – not surprisingly, the countries in which growth rates have been consistently the lowest during the past few years.
the Federal Reserve’s holdings of longer-term securities at sizable levels. The Committee has also continued to provide forward guidance bearing on the anticipated path of the federal funds rate. In particular, the FOMC has stressed that in deciding how long to maintain the current target range, it will consider a broad set of indicators to assess realized and expected progress toward its objectives. On the basis of its assessment, the Committee indicated in its two most recent postmeeting statements that it can be patient in beginning to normalize the stance of monetarypolicy. To further emphasize the data-dependent nature of its policy stance, the FOMC has stated that if incoming information indicates faster progress toward its policy objectives than the Committee currently expects, increases in the target range for the federal funds rate will likely occur sooner than the Committee anticipates. The FOMC has also indicated that in the case of slower-than-expected progress, increases in the target range will likely occur later than currently anticipated. Moreover, the Committee continues to expect that, even after employment and inflation are near mandate- consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.