Monetary policy with sticky prices and segmented markets

We present a pricing kernel that summarizes well the main features of the dynamics of interest rates and risk in postwar U.S. data and use it to uncover how the pricing kernel has moved with the short rate in this data. Our findings imply that standard monetary models miss an essential link between the central bank instrument and the economic activity that monetary policy is intended to affect, and thus we call for a new approach to monetary policy analysis. We sketch a new approach using an economic model based on our pricing kernel. The model incorporates the key relationships between policy and risk movements in an unconventional way: the central bank's policy changes are viewed as primarily intended to compensate for exogenous business cycle fluctuations in risk that threaten to push inflation off target. This model, while an improvement on standard models, is considered just a starting point for their revision. It leads to critical questions that researchers need to answer as they continue to revise their approach to monetary policy analysis. Copyright © 2009 by the National Bureau of Economic Research.

Home production and sticky price models: Implications for monetary policy

Optimal Simple and Implementable Monetary and Fiscal Rules

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

Attenuating the Forward Guidance Puzzle: Implications for Optimal Monetary Policy

Attenuating the forward guidance puzzle: Implications for optimal monetary policy

In economic literature there are two different views on the effects of inflation expectations on interest rates, called liquidity effect and Fisher effect. According to the liquidity effect, an increase in inflationist expectations results as a decrease in both nominal and real interest rates. According to the Fisher effect, there is a one-to-one correspondence between a change in inflation expectations and nominal interest rate in the long-run which implies that monetary policy is irrelavant on the real interest rate. Therefore a test of the long run relationship between nominal interest rate and inflation rate is important on understanding the effects of the monetary policy on interest rates. In this study the presence of the Fisher effect is investigated for Turkey under the assumption of adaptive expectations.

From 1750 until 1950 inflationary expectations, and nominal and real interest rates, remained roughly constant, in the UK at least, while inflation was a function of occasional wars and the vagaries of harvest. After the 1950s there was a strong upwards trend in inflation, inflationary expectations and nominal interest rates (1950–1980), followed by an extraordinary downwards trend in inflation, inflationary expectations and both nominal and real interest rates (1980–2020). The earlier trend can be ascribed to a doomed, but well intentioned, attempt to keep unemployment below its rising Natural Rate, with the monetary regime allowing that to happen. The subsequent downwards trend is ascribed by Goodhart and Pradhan to underlying demography and globalisation factors. Given the expansionary intent of monetary policies, it is hard to claim that such disinflation was a monetary phenomenon. But in that case the forthcoming reversal of the previous demographic and globalisation trends should lead to a revival of inflation and nominal (but not necessarily real) interest rates. But this view is at odds with most current mainstream analysis, even of those who do focus on demography, who generally continue to foresee secular stagnation, ‘lower for longer’. Goodhart and Pradhan outline why they differ from the mainstream. Their view of the future is not encouraging, but it is coherent and plausible.

Comment

We construct a utility-based model of fluctuations with nominal rigidities and unemployment. We first show that under a standard utility specification, productivity shocks have no effect on unemployment in the constrained efficient allocation. That property is also shown to hold, despite labor market frictions, in the decentralized equilibrium under flexible prices and wages. Inefficient unemployment fluctuations arise when we introduce real-wage rigidities. As a result, in the presence of staggered price setting by firms, the central bank faces a trade-off between inflation and unemployment stabilization, which depends on labor market characteristics. We draw the implications for optimal monetary policy. (JEL E12, E24, E52)

This paper quantitatively evaluates the relative importance of the efficiency and stabilization effects of monetary policy. While maximum efficiency in the spirit of Friedman advocates long-run deflation so that the nominal interest rate is zero, business cycle consideration requires positive long-run inflation so that the nominal interest rate can be adjusted for stabilization without encountering the zero bound. In an estimated DSGE model for the US economy that can generate both effects, we find that the welfare-maximizing monetary policy rule is characterized with a steady-state inflation rate of 0.12% per annum, significantly above the rate required for maximal efficiency and significantly below what is believed to have been targeted by the Federal Reserve. It is also found that, if the monetary authority tries to minimize typical loss functions comprising volatilities of macro variables such as output and inflation, the resultant policy rules are flawed: they lead to too high long-run inflation and too much policy activism, compared to rules that maximize welfare.

The paper discusses some fundamental problems in monetary economics associated with the determination and role of the numeraire. The issues are introduced by formalising a proposal, attributed to Eisler, to remove the zero lower bound on nominal interest rates by unbundling the numeraire and medium of exchange/means of payment functions of money. The monetary authorities manage the exchange rate between the numeraire ('sterling') and the means of payment ('drachma'). The short nominal interest rate on sterling bonds can then be used to target stability for the sterling price level. The paper puts question marks behind two key bits of conventional wisdom in contemporary monetary economics. The first is the assumption that the monetary authorities define and determine the numeraire used in private transactions. The second is the proposition that price stability in terms of that numeraire is the appropriate objective of monetary policy. The paper also discusses the merits of the next step following the decoupling of the numeraire from the currency: doing away with currency altogether -the cashless economy. Because the unit of account plays such a central role in New-Keynesian models with nominal rigidities, monetary economics needs to devote more attention to numerairology -the study of the individual and collective choice processes that govern the adoption of a unit of account and its role in economic behaviour.

I examine the impact of alternative monetary policy rules on a rational asset price bubble, through the lens of an overlapping generations model with nominal rigidities. A systematic increase in interest rates in response to a growing bubble is shown to enhance the fluctuations in the latter, through its positive effect on bubble growth. The optimal monetary policy seeks to strike a balance between stabilization of the bubble and stabilization of aggregate demand. The paper's main findings call into question the theoretical foundations of the case for "leaning against the wind" monetary policies.

Imperfect Credit Markets: Implications for Monetary Policy

Implications of Habit Formation for Optimal Monetary Policy