Introduction: Recent Developments in Monetary Macroeconomics

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In many countries, the monetary policy instrument sometimes remains unchanged for a long period and shows infrequent responses to exogenous shocks. The purpose of this paper is to provide a new explanation on why the central bank's policy instrument remains unchanged. In the analysis, we explore how uncertainty on the private agents' expectations affects robust optimal monetary policy. We apply the Choquet expected decision theory to a new Keynesian model. A main result is that the policymaker may frequently keep the interest rate unchanged even when exogenous shocks change output gaps and inflation rates. This happens because a change of the interest rate increases additional uncertainty for the policymaker. To the extent that the policymaker has uncertainty aversion, it can therefore be optimal for the policymaker to maintain an unchanged policy stance for some significant periods and to make discontinuous changes of the target rate. Our analysis departs from previous studies in that we determine an optimal monetary policy rule that allows time-variant feedback parameters in a Taylor rule. We show that if the policymaker has small uncertainty aversion, the calibrated optimal stop-go policy rule can predict actual target rates of FRB and ECB reasonably well.

Business Cycles and Monetary Policy Analysis in a Structural Sticky Price Model of the Lebanese Economy

This paper presents a framework for analyzing how bounded rationality affects monetary and fiscal policy. The model is a tractable and parsimonious enrichment of the widely-used New Keynesian model - with one main new parameter, which quantifies how poorly agents understand future policy and its impact. That myopia parameter, in turn, affects the power of monetary and fiscal policy in a microfounded general equilibrium. A number of consequences emerge. (i) Fiscal stimulus or helicopter drops of money are powerful and, indeed, pull the economy out of the zero lower bound. More generally, the model allows for the joint analysis of optimal monetary and fiscal policy. (ii) The Taylor principle is strongly modified: even with passive monetary policy, equilibrium is determinate, whereas the traditional rational model yields multiple equilibria, which reduce its predictive power, and generates indeterminate economies at the zero lower bound (ZLB). (iii) The ZLB is much less costly than in the traditional model. (iv) The model helps solve the forward guidance puzzle : the fact that in the rational model, shocks to very distant rates have a very powerful impact on today's consumption and inflation: because agents are partially myopic, this effect is muted. (v) Optimal policy changes qualitatively: the optimal commitment policy with rational agents demands nominal GDP targeting ; this is not the case with behavioral firms, as the benefits of commitment are less strong with myopic firms. (vi) The model is neo-Fisherian in the long run, but Keynesian in the short run: a permanent rise in the interest rate decreases inflation in the short run but increases it in the long run. The non-standard behavioral features of the model seem warranted by the extant empirical evidence.

Inflation Targeting and an Optimal Taylor Rule for an Open Economy: Evidence for Colombia 1990-2011

Optimal monetary policy in a small open economy with inflation and output persistence

This paper examines the impact of a permanent shock to the productivity growth rate in a New Keynesian model when the central bank does not immediately adjust its policy rule to that shock. Our results show that inflation and productivity growth are negatively correlated at business cycle frequencies when the central bank follows a Taylor-type policy rule that targets the output gap. We then demonstrate that inflation is more stable after a permanent productivity shock when monetary policy targets the output growth rate (not the output gap) or the price-level path (not the inflation rate). As for the welfare implications, both the output growth and price-level path rules generate much less volatility in output and inflation after a productivity shock than occurs with the Taylor rule.

This doctoral dissertation is composed of three articles focused on analyzing international spillovers of monetary policy. The first article investigates the spillover effects of monetary policy among OECD countries. First, it appears that, more recently, monetary policy decisions diverge from those indicated by the Taylor Rule. Thus, the article aims to verify if there is a spillover effect in the interest rate decisions of central banks. We apply the methodological framework of spatial econometrics to circumvent the endogeneity problem. Considering the SAR model and a W weight matrix that shows the trade relationship between countries, it is found that countries take into account the international interest rate, besides considering the differential between inflation and its target and the output gap. In the second article, based on classical DSGE models, we analyze the spillover effects of monetary policy by including the foreign interest rate in the domestic monetary agent\\'s decision process. The model shows that the relationship between domestic and foreign interest rates depends on the parameters used, particularly the intertemporal elasticity of consumption and the country\\'s degree of openness. Considering reasonable values for these parameters, we found a positive relationship between the foreign and domestic rates. Furthermore, in the model estimated for Brazil considering the Taylor Rule with Consumer Price Index (CPI), it was found that a negative shock in the US interest rate generates a drop in the Brazilian rate, stimulating activity and consumption. Therefore, domestic prices rise. However, the CPI declines with the appreciation of the exchange rate, leading to a slow return of the interest rate to the steady state. The third paper seeks to measure the welfare costs generated by the spillover effects of monetary policy. Starting from a non-linear model, we apply the methodology proposed by Schmitt-Grohe and Uribe (2004b) and found that regardless of the importance of the foreign interest rate in domestic decisions, the optimal monetary policy is consistent with an aggressive response of interest rates to inflation and a more mild reaction to the output gap. Comparing different rules, we found some evidence that the central bank incurs social welfare loss when considering the international interest rate. Finally, it is worth noting that the cost depends on the Taylor Rule\\'s coefficients and, to a greater extent, on the degree of openness of the economy.

Optimal Simple Monetary Policy Rules and Non-Atomistic Wage Setters in a New-Keynesian Framework

Taylor rule deviations and out-of-sample exchange rate predictability

The U.S. appears to have experienced a pronounced shift toward higher productivity over the last five years or so. We wish to understand the implications of such shifts for the structure of optimal monetary policy rules in simple dynamic economies. Accordingly, we begin with a standard in which a version of the Taylor rule constitutes the optimal monetary policy for a given inflation target and a given level of productivity. We augment this model with regime switching in productivity, and calculate the optimal monetary policy rule in the altered environment. We find that in the altered environment, a rule that incorporates leading indicators about regimes significantly outperforms the Taylor rule. We use this result to comment on the new economy events of the 1990s and the stagflation events of the 1970s from the perspective of our model.

Recent empirical research shows that a reasonable characterization of federal-funds-rate targeting behavior is that the change in the target rate depends on the maturity structure of interest rates and exhibits little dependence on lagged target rates. See, for example, Cochrane and Piazzesi (2002). The result echoes the policy rule used by (1994) to rationalize the empirical failure of the `expectations hypothesis' applied to the term- structure of interest rates. That is, rather than forward rates acting as unbiased predictors of future short rates, the historical evidence suggests that the correlation between forward rates and future short rates is surprisingly low. showed that a desire by the monetary authority to adjust short rates in response to exogenous shocks to the term premiums imbedded in long rates (i.e. yield-curve smoothing), along with a desire for smoothing interest rates across time, can generate term structures that account for the puzzling regression results of Fama and Bliss (1987). also clearly pointed out that this reduced-form approach to the policy rule, although naturally forward looking, needed to be studied further in the context of other response functions such as the now standard Taylor (1993) rule. We explore both the robustness of McCallum's result to endogenous models of the term premium and also its connections to the Taylor Rule. We model the term premium endogenously using two different models in the class of affine term structure models studied in Duffie and Kan (1996): a stochastic volatility model and a stochastic price-of- risk model. We then solve for equilibrium term structures in environments in which interest rate targeting follows a rule such as the one suggested by (i.e., the McCallum Rule). We demonstrate that McCallum's original result generalizes in a natural way to this broader class of models. To understand the connection to the Taylor Rule, we then consider two structural macroeconomic models which have reduced forms that correspond to the two affine models and provide a macroeconomic interpretation of abstract state variables (as in Ang and Piazzesi (2003)). Moreover, such structural models allow us to interpret the parameters of the term-structure model in terms of the parameters governing preferences, technologies, and policy rules. We show how a monetary policy rule will manifest itself in the equilibrium asset-pricing kernel and, hence, the equilibrium term structure. We then show how this policy can be implemented with an interest-rate targeting rule. This provides us with a set of restrictions under which the Taylor and Rules are equivalent in the sense if implementing the same monetary policy. We conclude with some numerical examples that explore the quantitative link between these two models of monetary policy.

This paper studies the welfare costs of price rigidities in a closed economy without labor mobility. First, in a one-sector model, I find a significant welfare cost of price rigidities under a standard Taylor rule, especially when labor is immobile. In the one-sector model, strict CPI inflation targeting is able to eliminate the welfare cost of price rigidities, with or without labor mobility. Then, I develop a vertically integrated two-sector model with nominal and real rigidities where there is a natural distinction between the rates of inflation in the final and intermediate goods sectors. In the two-sector model, the real rigidities are introduced by assuming that labor is immobile across sectors and firms. In the model, labor immobility plays an allocative role and causes large fluctuations in hours of work. This, in turn, magnifies the welfare costs of nominal rigidities. I find that the welfare costs range from 1.62 percent to 2.33 percent of consumption per period for different degree of price rigidities under an estimated Taylor rule over the Volcker and Greenspan years. Taking the household welfare under optimal (Ramsey) monetary policy as a benchmark, I show that an optimal modified Taylor rule with two measures of inflation is able to bring welfare closer to the benchmark value and reduces the welfare costs substantially, even if labor mobility is restricted.

We estimate Taylor (1993) rules and identify monetary policy shocks using no-arbitrage pricing techniques. Long-term interest rates are risk-adjusted expected values of future short rates and thus provide strong over-identifying restrictions about the policy rule used by the Federal Reserve. The no-arbitrage framework also accommodates backward-looking and forward-looking Taylor rules. We find that inflation and output gap account for over half of the variation of time-varying excess bond returns and most of the movements in the term spread. Taylor rules estimated with no-arbitrage restrictions differ from Taylor rules estimated by OLS, and the resulting monetary policy shocks are somewhat less volatile than their OLS counterparts.

This paper characterizes optimal monetary policy for a range of alternative economic models in terms of a flexible inflation targeting rule, with a target criterion that depends on the model specification. It shows which forecast horizons should matter, and which variables besides inflation should be taken into account, for each specification. The likely quantitative significance of the various factors considered in the general discussion is then assessed by estimating a small, structural model of the U.S. monetary transmission mechanism with explicit optimizing foundations. An optimal policy rule is computed for the estimated model, and shown to correspond to a multi-stage inflation-forecast targeting procedure. The degree to which actual U.S. policy over the past two decades has conformed to the optimal target criteria is then considered.