This paper studies optimalinterest-rate policies when the central bank op- erates a channelsystem of interest-ratecontrol. We conduct our analysis in a dynamic general equilibrium model with infinitely-lived agents who are subject to idiosyncratic trading shocks which generate random liquidity needs. In re- sponse to these shocks agents either borrow against collateral or deposit money at the central bank at the specified rates. We show that it is optimal to have a strictly positive interest-rate corridor if the opportunity cost of holding col- lateral is strictly positive and that the optimal corridor is strictly decreasing in the collateral’s real return.
analyzing optimalmonetarypolicy. That is, it is taken for granted that the economic consequences of interest-rate rules do not hinge on the speci…c details of monetarypolicy implementation. However, our analysis reveals that a characterization of op- timal policy and its implementation cannot be separated. To see this, consider any interest-rate rule in a system with zero deposit rate as operated, for example, by the US Federal Reserve System. Such an interest-rate rule uniquely determines how “tight”or “loose”policy is. In contrast, the same rule or any other interest-rate rule has no meaning in a channelsystem, since it does not determine whether a policy is “tight” or “loose.” Consequently, in a channelsystemoptimalpolicy must not only state an interest-rate rule, but it must also state an interest-rate corridor rule. This is a new insight, which goes beyond what we already know from the large and growing body of literature on the optimal design of interest-rate rules.
We have analyzed the theoretical properties of a channelsystem of interestratecontrol in a dynamic general equilibrium model with infinitely-lived agents and a central bank. With this model we could match the stylized facts regarding the use of channel systems by central banks. First, all central banks set a strictly positive corridor. Second, central banks typically react to changing economic conditions by shifting the interest-rate corridor. Third, the money market rate tends to be in the middle or above the middle of the corridor. We have also shed light on the role of collateral and the link between the corridor and the conditions prevailing in the money market.
The second reason is related to the widespread belief that modeling the details of the framework used to implement a given interest-rate rule is unimportant when analyzing optimalmonetarypolicy. That is, it is taken for granted that the economic consequences of interest-rate rules do not hinge on the specific details of monetarypolicy implementation. However, our general equilibrium analysis reveals that a char- acterization of optimalpolicy and its implementation cannot be separated. To see this, consider any interest-rate rule in a system with zero deposit rate as operated, for example, by the US Federal Reserve System. Such an interest-rate rule uniquely de- termines how “tight” or “loose” the policy is. In contrast, the same rule or any other interest-rate rule has no meaning in a channelsystem since it does not determine whether a policy is “tight” or “loose.” Consequently, in a channelsystemoptimalpolicy must not only state an interest-rate rule but it must state an interest-rate corridor rule. This is a new insight, which goes beyond what we already know from the large and growing body of literature on the optimal design of interest-rate rules. The paper is structured as follows. Section 2 outlines the environment. The equilibrium without the money market and the optimalmonetarypolicy are derived in Section 3. The equilibrium with the money market is characterized in Section 4. Finally, in Section 5, we discuss the policy implications that arise from the model, and Section 6 concludes. All proofs and a description of the Euro money markets and the ECB’s operating procedures can be found in the Appendix.
This paper investigates the conduct of optimalmonetarypolicy in the presence of a cost channel of monetary transmission. The framework is a two-country New Keynesian model, where these countries constitute a currency union with a single central bank. The existence of a cost channel implies that a change in the interestrate now a¤ects both the demand- and the supply-side of the economies. There is now a meaningful trade-o¤ between stabilising union in‡a- tion and stabilising the union output gap. It is shown that the optimal response to aggregate, asymmetric and idiosyncratic shocks very much depends on the strength of the cost channel. The cost channel makes monetarypolicy less e¤ective in combatting in‡ation, but the optimal response to the decline in ef- fectiveness is a stronger use of the instrument. For a strong cost channel the interestrate turns into a supply-side instrument. In order to reduce in‡ation, a direct cut in marginal costs is more e¤ective than a decline in marginal costs via lower aggregate demand. An analogous result holds for an aggregate cost-push shock. For perfect asymmetric shocks we replicate the "do nothing"-result of Lane (2000). Despite the distribution of in‡ation, production and employment varies across countries with the relative strength of the cost channel, the mon- etary authority does not react to this kind of shocks. Finally, we derive the optimal response to idiosyncratic shocks. We show how the sign and size of the spillover e¤ects depend on the strength of the cost channel.
One possible explanation for the lead-lag pattern in Figure 1 is that both central banks change their interest rates according to movements in the business cycle and that the Euro area business cycle lags that of the U.S. (e.g. Begg et al., 2002). This eﬀect can be accounted for by estimating interestrate reaction functions for the central banks that include macroeconomic variables and control for the stage of the business cycle. Breuss (2002) and Ullrich (2005) estimate Taylor rules for the ECB augmented by the lagged Federal Funds Rate and show that the U.S. interestrate enters the Euro area mone- tary policy reaction function in a statistically signiﬁcant way. Belke and Cui (2010) augment their VECM by Euro area and U.S. inﬂation rates and output gaps. Their results still indicate a cointegrating relationship between the EONIA and the Federal Funds Rate. However, the U.S. interestrate is estimated to be weakly exogenous to the VECM indicating an asymmetry in the relationship between the ECB and the Fed by which only the ECB and not the Fed responds to deviations from the cointegrat- ing relation. Scotti (2006) analyses the interdependence of the timing of interest-rate changes by the ECB and the Fed and controls for the eﬀects of output and inﬂation
At the advent of global financial crisis conventional monetarypolicy has failed to regulate the money market and the consequence of which was seen in the global financial and capital market. This paper takes an attempt to give a brief outline of how Islamic monetarypolicy can be a sustainable alternative to the conventional. In order to understand Islamic monetarypolicy better we went back to early Islamic period and discussed how money was evolved and monetarypolicy was performed at that time. Reemergence of Islamic economic system in the latter half of the last century encouraged scholars in this field to have a fresh look at this issue. Comparative analysis shows that Islamic monetarypolicy can adopt many conventional instruments which are in line with the Shariah guidance such as: Legal Reserve Ratio, Credit Rationing, Selective credit control, Issue of directive, and Moral suasion etc. As interestrate, the key tool of conventional monetarypolicy regulation, is prohibited in Islamic economic system, the need for sustainable alternative is the order of the day. Unfortunately, Islamic banks and financial institutions set their benchmark based on London Interbank Offered Rate (LIBOR) which raises doubt and controversy of the uniqueness of Islamic finance. Literature shows that this a growing field of knowledge and many theoretical works have been conducted in this area but little empirical work, moreover, very few on alternative benchmark for Islamic economic system. By analyzing literature we propose in our study that GDP growth rate adjusted for inflation can be set as a benchmark for money market instrument and reference for financial and capital market as we argue GDP growth rates reflect real balanced growth potential of an economy as it is correlated with national income, savings, inflation, exchange rate and investment compare to real interestrate, which is fixed in the money market and does not take into account the real sector.
In this model we have interestrate smoothing when the agenda setter is either the first or the third member, and the reaction function is non-linear on the lagged interestrate and expected inflation. An important issue in this model is to determine if this non-linear policy rule can guarantee the existence of a rational expectations equilibrium. The following proposition shows that the determination properties of the rational expectations equilibrium are satisfied. Proposition 6 A sufficient condition for the determinacy of a rational expectations equilib- rium with the reaction functions described in propositions (5.4) and (5.5) is that φ 1 < 1+2 1+β λϕ . The proof is in the appendix D. The intuition behind this is that, as the response in the reaction function to expected inflation is bounded between the optimal response for members 1 and 3. And also, since each of those optimal responses satisfy the conditions for the existence of an equilibrium, this also guarantees the existence of the equilibrium in the context of voting on a MPC. From the political economy equilibrium it can be some sluggishness on the response of the interestrate, but this response always will be high enough in order to control inflation.
Currently there is a growing literature exploring the features of optimalmonetarypolicy in New Keynesian models under both commitment and discretion. Generally, the literature fo- cuses on solving for allocations. Recently, however, attention has been paid to analyzing more decentralized policies, and this paper is part of a growing investigation studying implementa- tion of planning problems. We believe that this is an important area of inquiry, because the institutions responsible for setting policies rarely have direct control over allocations. It is, therefore important to understand whether or not a planner’s allocations are obtainable with a given institutional structure.
However, as the recent experience of several Asian economies suggests, unless the central bank adopts a …xed exchange rate regime like China, it is not always possible to achieve a nominal depreciation. Orphanides and Wieland (2000) and Coenen and Wieland (2003), who also recommend that in the presence of the zero lower bound, the central bank should rely on the exchange-ratechannel, suggest that the central bank can create a depreciation via a portfolio-balance e¤ect. In particular, this can be done by expanding the monetary base on a large scale. This paper, on the other hand, argues that in order to create a depreciation successfully, the central bank also has to rely on the expectations channel. That is, the present paper implies that aggressive monetary-base expansion proposed by Orphanides and Wieland (2000) may be e¤ective, but only if the central bank can make a credible promise to keep injecting liquidity into the economy going forward even when the de‡ationary pressure begins to subside. According to the analysis in this paper, by expanding the monetary base, but on a discretionary basis, and thereby only relying on the portfolio- balance e¤ect, the central bank may not be able to generate a depreciation.
The exit out of ZLB varies from one economy to other depending on its characteris- tics. Di¤erent degrees of interestrate pass-through (or varying strength of cost channel) originating from di¤erent extent of credit market imperfection is possibly one such char- acteristic leading to disparate exit dates. In absence of cost channel, exit under discretion is exogenous and the exit under commitment is endogenous. Along with this, commit- ment outperforms discretion by promising future boom and in‡ation and by delaying exit. Introduction of cost channel makes exit date endogenous under both commitment and dis- cretion. This is due to the trade-o¤ between in‡ation and output gap induced by the cost channel. Exit date rises monotonically under discretion with magnitude of demand shock and degree of interestrate pass-through. Commitment still outperforms discretion with a promise of future boom and in‡ation and post exit expected boom and in‡ation. This gives an extra stimulus to the system under commitment. System compensates the stim- ulus by preponing its exit compared to discretion. On the other hand, though a T-only policy promises future boom and in‡ation, it does not promise post exit in‡ation. As a result, T-only policy needs to postpone its exit to gain stimulus and producing results closer to commitment.
22.214.171.124 The Nature, Roles of Money, and MonetaryPolicy in New Keynesian Economics Monetary theory in New Keynesian (NK) economics has many interesting aspects and it comes in various shapes of economic models that emphasise representative agents such as household, representative firm, government, and external sector. In order to gain understanding about the features of the NK monetary theory, we start by analysing the three log-linearized macroeconomics equations that form the bedrock of this new consensus. In appendix we gave a summary of the main elements that will help us understand the monetarypolicy and its transmission thereof in New Keynesian monetary theory. The step by step solutions of the basic New Keynesian model are given in main texts such as (Gali, 2008) and Woodford (Woodford, 2001). In these textbook authors solved the model in (A.28) and construct the three macroeconomics equations in a canonical form. A typical fully solved New Keynesian model contains an expectation- augmented New Philips Curve, a forward-looking dynamic DIS curve, and an interestrate equation describing the policy rule of the central bank (Arestis & Sawyer, 2006; David, 2008; Gali, 2008; Gottschalk, 2005). 31 These standard system of equations in the New Keynesian theory do not have any explicit reference to money (Fontana, 2006). That is there is no explicit role assigned to money as target in the model to control inflation. As a consequence, some economists characterize New Keynesian economics as an economic analysis without money. This is particular when the utility function used has real money balances separable from consumption. The appearance of money ends with identification of money demand equation in (A.33). However, this is not the cashless economy as implied in some cases; this is because money is endogenously determined by financial institution in response to the demand for credit. Money supply is lurking in the background, indicated by Mankiw & Taylor (2007) that money supply is adjusted to whatever level is necessary to ensure that equilibrium interestrate hits the target. This endogenous feature will be discussed in detail under the post Keynesian monetary theory in section 1.3 ahead.
Financial stability is an important element in the development of a country, and the global financial crisis has shown the key role of financial intermediation in the stability of an economy, and in policy making. (Reinhart & Rogoff, 2008) argued that the newly set up and unregulated or lightly regulated financial entities such as the Sub Prime Mortgage market in the United States before the wake of the 2008 global crises had increased vulnerability of the United States financial system and intermediation, which resulted into the crises. Using a UK Bank as an example, (Shin, 2009)argued that vulnerability in financial intermediation system stemming from institutional investor reliance on short term financing has resulted it being prone to negative external financial shocks. The Mortgage back securities debacle in The United States has resulted in the wake of de-leveraging of the UK and global credit markets, disturbed financial intermediation and resulted in the global financial crisis of 2008. (Claessens, Dell’Ariccia, Igan, & Laeven, 2010) argued that new more sophisticated financial intermediaries and instruments and household debts coupled with flaws with policy framework and weak supervision of the state of health of the intermediation system were at the heart of the global financial crises. In addition this paper argued that although monetarypolicy and micro-prudential policies are necessary but they are not sufficient in safeguarding the economy from shocks which may have detrimental effects to the economy. Furthermore (Blanchard, Dell’Ariccia, & Mauro, 2010) argued that financial intermediation regulation cannot be left outside the core macroeconomic policy framework because a stalled financial intermediary system have detrimental effects on the real economy as shown from the global financial crisis. (Adrian & Song Shin, 2010) argued that financial intermediaries is the engine of the financial cycle. The financial cycle in turn is at the heart of the risk taking channel of monetarypolicy transmission mechanism. And (Rey, 2016) argued that the global financial A
When setting the volatility surprise as the policy instrument, we are not intended to pre- sume that the Federal Reserve attempts to control or manipulate expected volatility of an interestrate. Instead, the Federal Reserve’s communication, such as communication styles, languages in the summary of economic projections and more, may contribute to the exoge- nous impact of monetarypolicy on financial markets. In the SVAR model, as unexpected by economic agents other than the Federal Reserve, the influences of communication in FOMC announcements constitute a portion of exogenous monetarypolicy shocks to the VAR sys- tem. These effects thus should be incorporated to identify the monetarypolicy shocks. The two monetarypolicy surprises demonstrate two distinctive and orthogonal dimensions of the impact of monetarypolicy announcements, such as the influence on short rates level versus the effects on long rate volatility. Another critical difference between the two monetary pol- icy surprises is the measuring objects. The policyrate surprise lasers the focus on changes in the policyrate, while the volatility surprise comprehensively evaluates monetarypolicy announcements in terms of the risk implication. In the model, we stimulate monetary pol- icy shocks with the policyrate surprise in the credit channel and the interestratechannel. Both channels are characterized by a Taylor rule type of monetarypolicy reaction function. On the contrary, the risk-taking channel accepts a broader definition of monetarypolicy. Therefore, the volatility surprise is ideal for initiating the monetarypolicy shocks in the risk-taking channel in order to investigate the risk-side monetarypolicy transmission.
It is in the wholesale money market that the central bank implements monetarypolicy by ensuring that banks are always indebted to the central bank (Moore and Smit, 1986:83). As already noted, legislation imposes certain required reserve ratios on banks to ensure the liquidity of the banking system, and the central bank acts to set the wholesale rate at which banks can borrow reserves to support any level of deficit incurred through their business of granting credit, thereby allowing banks to maintain legislated reserve requirements (Lavoie, 1992:178). Banks can obtain the needed funds from two primary sources; the interbank market or the central bank. The interbank market is a wholesale market in which banks can lend surplus funds to deficit banks at the interbank-overnight rate in order to meet their increased liabilities (retail loans) and is often cheaper than borrowing at the repurchase rate from the central bank (Lavoie, 1992:161). The implication of the above analysis is that the central bank will manipulate the repurchase rate in order to influence the borrowing behaviour of retail borrowers, and the money supply is endogenously determined by the demand for retail credit (this is left to the next section). As a result of liability management and the existence of overdraft facilities, banks have a limited ability to control their rate of loan expansion and thus view the volume of loans and deposits as non-discretionary variables (Moore, 1988:51).
While our model elucidates the impact of the lending channel and of bank capital requirements on output-inflation trade-oﬀs, there are several reasons for believing that this impact is likely to be rather smaller than reported in our simulations, at least within the normal range of macroeconomic fluctuations. First our results are predicated on a quantification of the cost channel that is towards the upper end of the range of estimates found in the literature. While there is no consensus on the magnitude of the cost channel it is quite possible that it is smaller than we have assumed and hence that our simulations overstate the impact of the bank lending channel on output inflation trade-oﬀs. Second there is no strong reason for believing that bank loan rates have such a relatively large imapact on marginal costs and relatively small impact on intertemporal tradeoﬀs, compared to market rates as we assume in our baseline B2. If the relative impact of bank loan rates and market rates on aggregate demand and on marginal costs are similar then the bank lending channel makes little diﬀerence to macroeconomic outcomes. Third, it maybe that our parameterisations exaggerate somewhat the degree of counter-cyclical fluctuations in bank capital ratios, especially in banking systems such as the US where banks conduct a relatively large amount of fixed interestrate lending. Introducing this relationship into our model, the rise of interest rates following a macroeconomic shock would reduce bank interest income and hence lead to less pronounced cyclical fluctuations in bank capital buﬀers than we report here.
loan growth in our data, which equals 1.8%: Hence, the estimated effect is large in spite of the natural noise in our income gap measure. Moreover, this estimate is robust to various checks that we perform. In particular, it is unchanged when we control for factors previously identified in the literature as determining the rate sensitivity of lending: leverage, bank size and asset liquidity. In the cross-section of banks, these effects are larger for smaller banks, consistent with the idea that smaller banks are more financially constrained. Similarly, the effect is more pronounced for banks that report no hedging on their balance sheet –we only have notional, not net, exposure. Overall, our results suggest that the income gap significantly affects the lending channel, and therefore establish the importance of this mode of transmission of monetarypolicy.
In 2008, when the Fed initiated LSAPs, many critiques of the policy cited irrelevance and neutrality propositions (e.g. Wallace, 1981). Integral to all of these results are assumptions re- garding: timing; household homogeneity; perfect asset substitutability; non-distortionary taxa- tion; and the link between government and central bank balance sheets. The logic behind these results is as follows. The purchase of long-term assets by the central bank can increase house- holds’ pre-tax state-contingent income. However, the purchase of the asset does not remove risk from the aggregate economy. LSAPs will reduce the returns earned by the central bank portfolio, necessitating an increase in lump-sum taxation by a non-distortionary government to balance the joint government and central bank budget constraint. The after-tax state-contingent in- come of homogeneous households will be unchanged, rendering LSAPs neutral for the economy. Within these models, LSAPs can only circumvent neutrality propositions through signalling; portfolio rebalancing is ineffective. In Eggertsson and Woodford (2003), only when LSAPs are perceived to engender a commitment to keep interest rates lower for longer can they stimulate the real economy. Bhattarai, Eggertsson, and Gafarov (2015) show that, following the purchase of longer-term assets and a shortening of the duration of privately held outstanding government debt, it is optimal for the central bank to keep short-term interest rates lower for longer to avoid capital losses on their balance sheet. Therefore, at the ELB, LSAPs can optimally stimulate the real economy by lowering the expected future path of real short-term interest rates. 2.2 Portfolio Rebalancing
A …nancial shock in general generates both aggregate and distributional ine¢ ciencies. An increase in the spread works as a negative aggregate demand shock, exerting a contractionary pressure on aggregate output and in‡ation –as discussed earlier and as can be seen from (16). Therefore, under optimalpolicy, the central bank decreases the policyrate to mitigate the adverse e¤ects on in‡ation and the output gap that the increase in interestrate spread would cause otherwise. Our numerical results indicates that optimalpolicy maintains in‡ation and output close to their respective target levels, which is not surprising given the large weight attached to in‡ation stabilization relative to the other policy objectives in (22). 44 In addition, the central bank’s lowering of the deposit rate optimally reduces the distributional ine¢ ciency caused by wealth redistribution – which is once again an illustration of the “leaning against the wind” policy discussed in Section 4.2.1. Since an increase in the spread redistributes wealth in favor of the saver country, relative consumption tends to increase. This in turn raises the marginal cost in the saver country relative to the borrower country through income e¤ects, which increases the relative price. By lowering the deposit rate, which also leads to in‡ation, the central bank can counter such ine¢ cient wealth redistribution, and thereby moderate ine¢ cient variations in relative consumption and prices. In contrast to the general case, variations in relative consumption and price are more pronounced under NoFF, as then the central bank does not (and cannot) control cross-country distributions, and thus focuses entirely on the two aggregate target variables.
iv. The above point raises an important issue about the central bank’s communication. In reality, the stance of the monetarypolicy, when sending to the public, is often summarized by only one indicator: the interbank rate. Indeed, this is a common and good practice as the interbank rate is a unique short-term target that the central bank controls completely. In normal times, it is a good predicator of inflation path. However, the current situation is very tricky. The interbank rate in most developed countries has been near zero for a long time and the inflation is persistently lower than its target. The growth rate of the money supply should be included as part of the central bank’s communication with the public.