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201. Inflation Persistence and Optimal Monetary Policy in the Euro Area

Author:
Pierpaolo Benigno and J. David Lopez-Salido
Publication Date:
12-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
In this paper we first present supporting evidence of the existence of heterogeneity in inflation dynamics across euro area countries. Based on the estimation of New Phillips Curves for five major countries of the euro area, we find that there is significant inertial (backward looking) behavior in inflation in four of them, while inflation in Germany has a dominant forward looking component. In the second part of the paper we present an optimizing agent model for the euro area emphasizing the heterogeneity in inflation persistence across regions. Allowing for such a backward looking component will affect the evaluation of the degree of nominal rigidities relevant for the monetary policy design. We explore the welfare implications of this circumstance by comparing the adjustment of the economies and the area as a whole in response to terms-of-trade shocks under four monetary policy rules: fully optimal, optimal inflation targeting, HICP targeting and output gap stabilization.
Topic:
Development, Economics, and International Trade and Finance
Political Geography:
Europe

202. International Monetary Policy Coordination and Financial Market Integration

Author:
Alan Sutherland
Publication Date:
12-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
The welfare gains from international coordination of monetary policy are analysed in a two-country model with sticky prices. The gains from coordination are compared under two alternative structures for financial markets: financial autarky and risk sharing. The welfare gains from coordination are found to be largest when there is risk sharing and the elasticity of substitution between home and foreign goods is greater than unity. When there is no risk sharing the gains to coordination are almost zero. It is also shown that the welfare gain from risk sharing can be negative when monetary policy is uncoordinated.
Topic:
Economics, Human Welfare, and International Trade and Finance
Political Geography:
United States

203. Monetary Policy and the Financial Accelerator in a Monetary Union

Author:
Simon Gilchrist, Jean-Olivier Hairault, and Hubert Kempf
Publication Date:
12-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
In this paper, we consider the effect of a monetary union in a model with a significant role for financial market imperfections. We do so by introducing a financial accelerator into a stochastic general equilibrium macro model of a two country economy. We show that financial market imperfections introduce important cross-country transmission mechanisms to asymmetric shocks to supply and demand. Within this framework, we study the likely costs and benefits of monetary union. We also consider the effects of cross-country heterogeneity in financial markets. Both the presence of financial frictions and the use of a single currency have significant impacts on the international propagation of exogenous shocks. The introduction of asymmetries in the financial contract widens the difference in cyclical behavior of national economies in a monetary union, but financial integration compensates the loss of policy instruments.
Topic:
Development, Economics, and International Trade and Finance
Political Geography:
United States

204. The Road to Adopting the Euro: Monetary Policy and Exchange Rate Regimes in EU Candidate Countries

Author:
Fabio M. Natalucci and Federico Ravenna
Publication Date:
12-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
This paper examines the choice of exchange rate regime in EU candidate countries during the process of accession to the European Monetary Union (EMU). In the presence of real exchange rate appreciation due to the Balassa-Samuelson effect, candidate countries face a trade-off between trend appreciation of the nominal exchange rate and high inflation rates. In a general equilibrium model of an emerging market economy, we show that under a fixed or heavily managed exchange rate the Balassa-Samuelson effect might prevent compliance with the Maastricht inflation criterion, unless a contractionary policy is adopted. We then discuss how the real exchange rate appreciation shifts the output gap/inflation variance trade-off, increasing the cost of managing or fixing the exchange rate. As a consequence, the requirement of membership in the Exchange Rate Mechanism (ERM-II) and the Maastricht inflation criterion constrain the policy choice while providing no additional benefit to countries credibly committed to joining the Euro. Finally, we show that relaxing either the exchange rate requirement or the inflation criterion has sharply different business cycle implications for the accession countries.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
Europe

205. Productivity, Investment, and Current Accounts: Reassessing the Evidence

Author:
Jaime Marquez
Publication Date:
11-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
The most widely accepted explanation for the inverse association between private investments and current accounts [Glick and Rogoff, 1995] rests on data for manufactures through 1990. Is this consensus robust to revisions to the national accounts and the expansion of information technologies since 1990? To address this question I replicate their results and I find that post 1990 developments eliminate the support for such a conclusion. I also implement alternative formulations and find, again, a lack of empirical support for their findings. Thus I examine the role of measurement errors and focus on the treatment of the manufacturing sector as representative of the whole economy and the exclusion of the contribution of capital when measuring productivity. Correcting these two measurement errors restores to Glick and Rogoff's conclusion its original strength.
Topic:
Economics, International Trade and Finance, and Science and Technology
Political Geography:
United States

206. Key Judgments (from October 2002 NIE) - Iraq's Continuing Programs for Weapons of Mass Destruction

Publication Date:
10-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We judge that Iraq has continued its weapons of mass destruction (WMD) programs in defiance of UN resolutions and restrictions. Baghdad has chemical and biological weapons as well as missiles with ranges in excess of UN restrictions; if left unchecked, it probably will have a nuclear weapon during this decade. (See INR alternative view at the end of these Key Judgments.)
Topic:
International Relations, United Nations, and Weapons of Mass Destruction
Political Geography:
Iraq and Middle East

207. Monetary Union, Price Level Convergence, and Inflation: How Close is Europe to the United States?

Author:
John H. Rogers
Publication Date:
10-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
In light of 50 years of economic policies designed to integrate Europe -- culminating in the elimination of euro zone national currencies in early 2002 -- and a vast academic literature on international economic integration, it is of interest to assess how far European integration has come in practice. Using a unique data set, I document the pattern of price dispersion across European and U.S. cities from 1990 to 2001. I find a striking decline in dispersion for traded goods prices in Europe, most of which took place between 1991 and 1994. The level of traded goods price dispersion in the euro area is now quite close to that of the United States. A decline in dispersion of non-tradeables prices in Europe has also taken place, but to a smaller extent. For U.S. cities, there is no evidence of a decline in price dispersion, even for tradeables. I examine several possible explanations for the decline in European price dispersion, including harmonization of tax rates, convergence of incomes and labor costs, liberalization of trade and factor markets, and increased coherence of monetary policy. I also investigate how much of the variation in national inflation rates in Europe can be explained by price level convergence. Finally, after showing that prices in likely next-round entrants into the euro zone are well below prices in Western Europe, I discuss the potential inflationary consequences of accession into monetary union for Eastern Europe.
Topic:
Economics and International Trade and Finance
Political Geography:
United States and Europe

208. Identifying the Effects of Monetary Policy Shocks on Exchange Rates Using High Frequency Data

Author:
John H. Rogers, Jonathan H. Wright, Jon Faust, and Eric Swanson
Publication Date:
10-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
This paper proposes a new approach to identifying the effects of monetary policy shocks in an international vector autoregression. Using high-frequency data on the prices of Fed Funds futures contracts, we measure the impact of the surprise component of the FOMC-day Federal Reserve policy decision on financial variables, such as the exchange rate and the foreign interest rate. We show how this information can be used to achieve identification without having to make the usual strong assumption of a recursive ordering.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

209. Exchange Rate Regimes and Financial Dollarization: Does Flexibility Reduce Bank Currency Mismatches?

Author:
Carlos Ó. Arteta
Publication Date:
09-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
The dollarization of bank deposits and credit is widespread in developing countries, resulting in varying degrees of currency mismatches in domestic financial intermediation, which in turn might accentuate bank balance sheet fragility. It is widely argued that flexible exchange rate regimes encourage banks to match dollar-denominated liabilities with a corresponding amount of dollar-denominated assets, ameliorating currency mismatches. Does the behavior of dollar deposits and credit in financially dollarized economies support that presumption? A new database on deposit and credit dollarization in developing and transition countries is assembled and used to address this question. Empirical results suggest that, if anything, floating regimes seem to exacerbate, rather than ameliorate, currency mismatches in domestic financial intermediation, as those regimes seem to encourage deposit dollarization more strongly than they encourage matching via credit dollarization.
Topic:
International Relations, Economics, and International Trade and Finance
Political Geography:
United States

210. Are Depreciations as Contractionary as Devaluations? A Comparison of Selected Emerging and Industrial Economies

Author:
Steven B. Kamin, Shaghil Ahmed, Christopher J. Gust, and Jonathan Huntley
Publication Date:
09-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
According to conventional models, flexible exchange rates play an equilibrating role in open economies, depreciating in response to adverse shocks, boosting net exports, and stimulating aggregate demand. However, critics argue that, at least in developing countries, devaluations are more contractionary and more inflationary than conventional theories would predict. Yet, it is not clear whether devaluations per se have led to adverse outcomes, or rather the disruptive abandonments of pegged exchange-rate regimes associated with devaluations. To explore this hypothesis, we estimate VAR models to compare the responses to devaluation of developing economies and two types of industrial economies: those that have consistently floated, and those that have sustained fixed exchange-rate regimes as well. We find that both of these types of industrial economies exhibit conventional (i.e., expansionary) responses to devaluation shocks, compared with the contractionary responses exhibited by developing countries. This finding suggests that exchange rate movements may be more destabilizing in developing countries than in industrial countries, regardless of exchange rate regime.
Topic:
Economics, Emerging Markets, Industrial Policy, and International Trade and Finance