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4451. Monetary Discretion, Pricing Complementarity and Dynamic Multiple Equilibria

Author:
Robert G. King and Alexander L. Wolman
Publication Date:
04-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
In a plain-vanilla New Keynesian model with two-period staggered price-setting, discretionary monetary policy leads to multiple equilibria. Complementarity between the pricing decisions of forward-looking firms underlies the multiplicity, which is intrinsically dynamic in nature. At each point in time, the discretionary monetary authority optimally accommodates the level of predetermined prices when setting the money supply because it is concerned solely about real activity. Hence, if other firms set a high price in the current period, an individual firm will optimally choose a high price because it knows that the monetary authority next period will accommodate with a high money supply. Under commitment, the mechanism generating complementarity is absent: the monetary authority commits not to respond to future predetermined prices. Multiple equilibria also arise in other similar contexts where (i) a policymaker cannot commit, and (ii) forward-looking agents determine a state variable to which future policy responds.
Topic:
Economics, Government, and International Trade and Finance

4452. The Optimal Degree of Discretion in Monetary Policy

Author:
Susan Athey, Andrew Atkeson, and Patrick J. Kehoe
Publication Date:
04-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
How much discretion should the monetary authority have in setting its policy? This question is analyzed in an economy with an agreed-upon social welfare function that depends on the randomly fluctuating state of the economy. The monetary authority has private information about that state. In the model, well-designed rules trade off society's desire to give the monetary authority discretion to react to its private information against society's need to guard against the time inconsistency problem arising from the temptation to stimulate the economy with unexpected inflation. Although this dynamic mechanism design problem seems complex, society can implement the optimal policy simply by legislating an inflation cap that specifies the highest allowable inflation rate. The more severe the time inconsistency problem, the more tightly the cap constrains policy and the smaller is the degree of discretion. As this problem becomes sufficiently severe, the optimal degree of discretion is none.
Topic:
Civil Society, Economics, Government, and International Trade and Finance
Political Geography:
Europe

4453. Equal Size, Equal Role? Interest Rate Interdependence Between the Euro Area and the United States

Author:
Michael Ehrmann and Marcel Fratzscher
Publication Date:
04-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
This paper investigates whether the degree and the nature of economic and monetary policy interdependence between the United States and the euro area have changed with the advent of EMU. Using real-time data, it addresses this issue from the perspective of financial markets by analysing the effects of monetary policy announcements and macroeconomic news on daily interest rates in the United States and the euro area. First, the paper finds that the interdependence of money markets has increased strongly around EMU. Although spillover effects from the United States to the euro area remain stronger than in the opposite direction, we present evidence that US markets have started reacting also to euro area developments since the onset of EMU. Second, beyond these general linkages, the paper finds that certain macroeconomic news about the US economy has a large and significant effect on euro area money markets, and that these effects have become stronger in recent years. Finally, we show that US macroeconomic news has become good leading indicators for economic developments in the euro area. This indicates that the higher money market interdependence between the United States and the euro area is at least partly explained by the increased real integration of the two economies in recent years.
Topic:
Economics, Government, and International Trade and Finance
Political Geography:
United States

4454. The Great Inflation of the 1970s

Author:
Fabrice Collard and Harris Dellas
Publication Date:
04-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
Was the high inflation of the 1970s mostly due to incomplete information about the structure of the economy (an unavoidable mistake as suggested by Orphanides, 2000)? Or, to weak reaction to expected inflation and/or excessive policy activism that led to indeterminacies (a policy mistake, a scenario suggested by Clarida, Gali and Gertler, 2000)? We study this question within the NNS model with policy commitment and imperfect information, requiring that the model have satisfactory overall empirical performance. We find that both explanations do a good job in accounting for the great inflation. Even with the commonly used specification of the interest policy rule, high and persistent inflation can occur following a significant productivity slowdown if policymakers significantly and persistently underestimate ”core” inflation.
Topic:
Economics, International Trade and Finance, and Political Economy
Political Geography:
United States

4455. Ramsey Monetary Policy and International Relative Prices

Author:
Ester Faia and Tommaso Monacelli
Publication Date:
04-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We analyze welfare maximizing monetary policy in a dynamic two-country model with price stickiness and imperfect competition. In this context, a typical terms of trade externality affects policy interaction between independent monetary authorities. Unlike the existing literature, we remain consistent to a public finance approach by an explicit consideration of all the distortions that are relevant to the Ramsey planner. This strategy entails two main advantages. First, it allows an accurate characterization of optimal policy in an economy that evolves around a steady-state which is not necessarily efficient. Second, it allows to describe a full range of alternative dynamic equilibria when price setters in both countries are completely forward looking and households' preferences are not restricted. In this context, we study optimal policy both in the long-run and along a dynamic path, and we compare optimal commitment policy under Nash competition and under cooperation. By deriving a second order accurate solution to the policy functions, we also characterize the welfare gains from international policy cooperation.
Topic:
International Relations, Economics, and International Trade and Finance
Political Geography:
United States

4456. Indeterminacy with Inflation-Forecast-Based Rules in a Two-Bloc Model

Author:
Nicoletta Batini, Paul Levine, and Joseph Pearlman
Publication Date:
04-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We examine the performance of forward-looking inflation-forecast-based rules in open economies. In a New Keynesian two-bloc model, a methodology first employed by Batini and Pearlman (2002) is used to obtain analytically the feedback parameters/horizon pairs associated with unique and stable equi-libria. Three key findings emerge: first, indeterminacy occurs for any value of the feedback parameter on inflation if the forecast horizon lies too far into the future. Second, the problem of indeterminacy is intrinsically more serious in the open economy. Third, the problem is compounded further in the open economy when central banks respond to expected consumer, rather than pro-ducer price inflation.
Topic:
International Relations, Economics, and International Trade and Finance
Political Geography:
United States

4457. Sand in the Wheels of the Labor Market: The Effect of Firing Costs on Employment

Author:
Andrea De Michelis
Publication Date:
04-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
This paper examines the effects of firing costs in a dynamic general equilibrium model where firms face stochastic demand. It derives analytically two simple closed-form equations, one for the supply of labor, the other for its demand. These equations determine the comparative static effects of changes in firing costs on the labor market. When negative shocks are more likely to occur than positive shocks, and when the frequency of these shocks is high, firing costs have a substantial negative impact on aggregate employment. In addition, product market integration, as it has occurred in the formation of the European Union, induces firms to be more wary of future possible downturns and therefore intensifies the negative consequences of firing costs.
Topic:
International Relations, Economics, and International Trade and Finance

4458. Price-level Determinacy, Lower Bounds on the Nominal Interest Rate, and Liquidity Traps

Author:
Dale W. Henderson and Ragna Alstadheim
Publication Date:
04-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We consider monetary-policy rules with inflation-rate targets and interest-rate or money-growth instruments using a flexible-price, perfect-foresight model. There is always a locally-unique target equilibrium. There may also be below-target equilibria (BTE) with inflation always below target and constant, asymptotically approaching or eventually reaching a below-target value, or oscillating. Liquidity traps are neither necessary nor sufficient for BTE which can arise if monetary policy keeps the interest rate above a lower bound. We construct monetary rules that preclude BTE when fiscal policy does not. Plausible fiscal policies preclude BTE for any monetary policy; those policies exclude surpluses and, possibly, balanced budgets.
Topic:
International Relations, Economics, and International Trade and Finance
Political Geography:
United States

4459. Foreign Participation in Local-Currency Bond Markets

Author:
Francis E. Warnock and John D. Burger
Publication Date:
02-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We analyze the development of, and foreign participation in, 49 local bond markets. Countries with stable inflation rates and strong creditor rights have more developed local bond markets and rely less on foreign-currency-denominated bonds. Less developed bond markets have returns characterized by high variance and negative skewness, factors eschewed by U.S. investors. Results based on a three-moment CAPM indicate, however, that it is diversifiable idiosyncratic risk that U.S. investors appear to shun. Taken as a whole our results hint at a virtuous cycle of bond market development: Creditor friendly policies and laws can spark local bond market development that enables the development of derivatives markets and, in turn, attracts foreign participation.
Topic:
Development, Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

4460. Is China "Exporting Deflation"?

Author:
Steven B. Kamin, Mario Marazzi, and John W. Schindler
Publication Date:
01-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
In the past few years, observers increasingly have pointed to China as a source of downward pressure on global prices. This paper evaluates the theoretical and empirical evidence bearing on the question of whether China's buoyant export growth has led to significant changes in the inflation performance of its trading partners. This evidence suggests that the impact of Chinese exports on global prices has been, while non-negligible, fairly modest. On a priori grounds, our theoretical analysis suggests that China's economy is still too small relative to the world economy to have much effect on global inflation: a back-of-the-envelope calculation puts that effect at about 1/3 percentage point in recent years. In terms of the empirical evidence, we identify a statistically significant effect of U.S. imports from China on U.S. import prices, but given the size of this effect and the relatively low share of imports in U.S. GDP, the ultimate impact on the U.S. consumer prices has likely been quite small. Moreover, imports from China had little apparent effect on U.S. producer prices. Finally, using a multi-country database of trade transactions, we estimate that since 1993, Chinese exports lowered annual import inflation in a large set of economies by 1/4 percentage point or less on average, similar to the prediction of our theoretical model.
Topic:
Economics and International Trade and Finance
Political Geography:
China and Asia