Optimal Monetary Policy Under Financial Sector Risk

[ACCESS RESTRICTED TO THE UNIVERSITY OF MISSOURI AT REQUEST OF AUTHOR.] The 2007-2009 economic events have renewed interests in the relationship between the financial sector and the macroeconomy and suggested that shocks originated in the financial sector may be a potential source of business cycle fluctuations. In this regard, this dissertation focuses on quantifying and assessing the role of shocks originated from the financial sector in driving business cycle fluctuations and how monetary policy could possibly respond from a welfare prospective. The dissertation consists of three chapters. The first chapter attempts to model the relationship between the financial sector and the macroeconomy theoretically. Specifically, I build a dynamic stochastic general equilibrium (DSGE) model by incorporating a financial sector with frictions between investors and banks. The existence of such frictions affect the healthiness of the financial sector and increase its riskiness, whereas would not affect those of the non-financial sector by much. I regard this type of frictions as supply-side financial shocks that are originated in the financial sector. Under this framework, the external finance premium in the financial sector can be determined endogenously. To study how the financial shocks would affect the dynamics of the model, impulse responses are used to show that the inclusion of those financial shocks yield larger amplification effects. Thus the model is able to generate higher volatility in aggregate outcomes, especially in the financial sector. This provides theoretical grounds to study the role of supply-side financial shocks for the next two chapters. Chapter two seeks to quantify empirically the effects of the financial shocks on the macroeconomy in a structural vector autoregression (SVAR) model. Based on the model implications derived from Chapter one, two types of financial shocks can be discriminated|the demand-side financial shock that comes from the entrepreneurial sector and the supply-side financial shock that comes from the financial sector. The identification strategy is that these two types of shocks affect the standards deviation of the equity returns in financial and entrepreneurial sectors in opposite directions. The overall SVAR results show that the effects of financial shocks on the real economic activities are non-trivial, although not major. In particular, the supply-side financial shocks originating from the financial sector explain a non-negligible part of the variabilities for the key macro variables; whereas for the financial variables, they are the main drivers, especially during the 2007-2009 crisis period. Chapter three studies how monetary policy should respond to this type of supplyside financial shocks from a prospective of social welfare. In particular, I consider a Taylor-type monetary policy rule augmented with a financial variable|the external finance premium. By doing so, it allows the central bank to react to the changes in the riskiness of the financial sector, in addition to the conventional output and inflation targets. The welfare results show that it is optimal for the central bank to respond to the financial variable. In other words, when there are shocks originated in the financial sector, the riskiness of the financial sector increases, and so do the external financing costs and the external finance premium in the financial sector. The banks' balance sheet conditions worsen and the central bank should cut its policy rate. The welfare analysis also implies that the inflation stabilization is still the most important target of the central bank, which in line with the literature that emphasizes the importance of inflation targeting.

Risk sharing in an asymmetric environment

IntroductionRecent Developments in Monetary Macroeconomics David Altig The contents of this volume hardly require explanation beyond its title: "Recent Developments in Monetary Macroeconomics." Our intent for the conference was to collect a set of papers reflecting the cutting edge of applied monetary macroeconomics. As befitting such an ambitious-sounding goal, the contributions are wide ranging. For purposes of this brief introduction, however, we might organize the papers as answers to three questions. (1) What is the "optimal" Taylor rule? (2) Are "New Keynesian" or "New Neoclassical Synthesis" models the final word on the monetary transmission mechanism? (3) Is there a role for money in the conduct of monetary policy? What is the "Optimal" Taylor Rule The inclusion of the Taylor rule issue is almost a prerequisite for any collection of papers purporting to survey recent developments in monetary macroeconomics. In policy discussions, the Taylor rule is ubiquitous, and it is currently the choice among alternative specifications of central bank behavior. More precisely, perhaps, the general form of the Taylor rule is the choice, as it has come to represent the general class of equations that relate the federal funds rate to some measure of an output gap and inflation rate. There is substantially less unanimity about whether output gaps and inflation rates should be past, present, or (expected) future values, whether past values of the funds rate need to be included, and what are the appropriate magnitudes of the responses to each of these measures. Marc Giannoni and Michael Woodford offer the natural approach to addressing the dispute: find the representation that is optimal within the framework being employed for policy analysis. The model in question here is essentially a derivative of the "New Neoclassical Synthesis" class of models that are currently the workhorses of most monetary policy analyses among academic and central bank staffs alike. Their approach to discovering the optimal policy within this structure has the flavor of [End Page 1039] the "Ramsey problem" familiar from optimal tax policy, although with the strong requirement that the derived policy rule be "robustly optimal": it must support the optimal equilibrium no matter what the distribution of disturbances the model policymakers face. Giannoni and Woodford offer two essential lessons. First, whether optimal policy incorporates forecasts of future price-level growth or output gaps depend critically on the dynamics of the inflation rate. If the adjustment of the price-level to shocks is inertial, then optimal policy necessarily depends on forecasts of future inflation. Second, the response of the funds rate to its own past is inertial. In fact, it is super-inertial, meaning that (all else equal), the contemporaneous funds rate responds more than one-for-one with the lagged value of the funds rate (and lagged changes in the rate). The proposition that monetary authorities ought to aggressively respond to lagged values of the funds rate also arises in the papers by Jess Benhabib, Stephanie Schmitt-Grohé, and Martín Uribe, and George Evans and Seppo Honkapohja. In the latter case, the authors consolidate and expand on their well-known work on learning dynamics. A central contribution of the work presented in this article is the notion that convergence to a unique rational expectations equilibrium under learning, as well as the stability of that equilibrium, serves as basis for the choice (or rejection) of an optimal policy formulation. An apparent lesson from Evans and Honkapohja's analysis is that the learnability criterion prescribes a policy rule that differs in some important ways from the conventional wisdom coming from analyses that invoke the Taylor rule in a pure rational expectations environment. In particular, they conclude that the optimal policy rule in the environment they consider requires the monetary authority to respond directly to private-sector expectations. The environment they consider is essentially the same as in Giannoni and Woodford, with the exception of the central bank's assumed loss function: Giannoni and Woodford assume a preference for interest rate smoothing, Evans and Honkapohja do not. In his comments, John Duffy points out that the introduction of interest-smoothing motive yields an optimal policy rule under learning that is much closer to the conventional view. In particular, it does not require...

Monetary Policy and Debt Deflation: Some Computational Experiments

INTERRELATIONSHIP OF INFLATION, EXCHANGE RATE AND INTEREST RATES IN THE CONTEXT OF HUNGARY'S STRATEGIC POLICY

Woodford (2001) has presented evidence that the new-Keynesian Phillips curve fits the empirical behavior of inflation well when the labor income share is used as a driving variable, but fits poorly when deterministically detrended output is used. He concludes that the output gap--the deviation between actual and potential output--is better captured by the labor income share, in turn implying that central banks should raise interest rates in response to increases in the labor share. We show that the empirical evidence generally suggests that the labor share version of the new-Keynesian Phillips curve is a very poor model of price inflation. We conclude that there is little reason to view the labor income share as a good measure of the output gap, or as an appropriate variable for incorporation in a monetary policy rule.

Comment

Many empirical studies argue that the inertial behavior of policy rates in industrialized countries can be well explained by a linear partial adjustment version of the Taylor rule. However, the explanatory power of the lagged interest rate has been questioned from various points of view. This paper formally examines a situation in which a central bank has an aversion to frequent policy reversals. Imposing an irreversibility constraint on the control space makes the lagged interest rate a state variable. However, the policy function cannot then be expressed as a partial adjustment form, even if the original Taylor rule would be the correct policy function in the absence of the irreversibility constraint. The simulation results reveal that conventional regression tends to falsely support the functionally misspecified partial adjustment model. This implies that the significant role of the lagged interest may simply reflect the central banks’ aversion to policy reversal.

It is indisputable that the real sector of the economy requires investment, especially in the current technological age. Banks, on the other hand, possess significant financial resources, but due to insufficient, asymmetric information and the underdeveloped financial system, the interaction between the real and financial sectors is ineffective. The "late response" of the financial sector to changes in the real sector has become the cause of a chronic oversupply of financial services, resulting in a situation where the level of liquidity in banks is largely independent of economic cycles. The paper aims to identify the ways in which interest rate fluctuations impact the real and financial sectors of the RA economy and to evaluate this impact. The paper analyzes trends in the main indicators characterizing the real and financial sectors of RA, as well as the behavior of various types of interest rates according to the factors determining them. It comments on the macroeconomic developments in RA caused by interest rate fluctuations. With the help of econometric models, the study estimates the effect sizes between various links on the interest rate path. The study made it possible to highlight the problems with the transmission mechanisms of the monetary policy of RA and suggest possible solutions. As a result of the assessment, it was found that deposit and credit interest rates, interbank repo rates, and one-year government bond yield rates respond to changes in the refinancing rate of the Central Bank in different time lags.

L’objectif de cet article est d’étudier le comportement de la Banque centrale de Tunisie dans la conduite de sa politique monétaire. À cette fin, une règle de Taylor pour le taux d’intérêt est estimée en utilisant un modèle de régression à transition lisse sur la période 1990-2008. Les résultats suggèrent que la fonction de réaction est non-linéaire, convexe par rapport à l’inflation , concave par rapport à l’écart de production, et que l’aversion contre le risque d’inflation domine l’aversion contre le risque de récession. Ces résultats indiquent que les risques d’inflation et de récession qui guettent la conduite de la politique monétaire incitent la banque centrale à mettre en œuvre une approche de la politique en termes de gestion de risque quant à la manipulation de son taux directeur.

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.

Mr. Taylor and the Central Bank: Two Inference Exercises

Many observers argue that the world has changed after the latest financial crisis. If that is the case, monetary policy and the process informing it will have to be reconsidered and 'learned' anew by all stakeholders. Perhaps, a new Taylor rule will emerge. A 'Taylor rule' is predicated upon two successful inference exercises: one by the researcher who is interested in identifying the Central Bank's behavior and one by the Central Bank, which tries to infer how the economy works and interacts with its monetary policy interventions. Because of certain granularities imposed by institutional arrangements and the need for transparent communication in policy making, this paper proposes an analytical framework based on computability theory to model these inference exercises and to assess their general possibility of success. So, is it possible to infer/learn the central bank's policy rule? The answer is a qualified positive and depends on the 'complexity' of the economy and on the quality of information. As for policy implications, the results show that transparency and understandable 'reaction functions' will go a long way in fostering learnability.

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.

Research background: The previous studies on monetary policy transparency suggest that the dependence between the degree of transparency and monetary policy effectiveness exists. In this examination, we tackle this issue for the most recent sample with the application of novel transparency measure, which is de-signed to cover forward-looking policy approach.
 Purpose of the article: We aim at evaluating forward-looking transparency of the European central banks and juxtapose it with their effectiveness in achieving monetary policy goals: price stability and output stabilization. The sample covers the central banks of the following countries: Sweden, the UK, Czechia, Hungary, Poland, and Romania. We also search for the patters of similarity in our sample.
 Methods: We apply a novel, index-based transparency measure to assess central banks? transparency. We also estimate inflation gap and the output gap. The methods used are based on data and statistical analysis. The comparison of the behaviour of individual central banks is carried out for the variables measuring transparency and inflation and output gaps. The similarity of the performance of individual central banks is assessed with the use of measures of the distance between objects, including our own measure.
 Findings & Value added: Our results suggest the existence of different degrees of similarity in the sample, but some common tendencies can be found as well. For example, central banks with comparable transparency degree are found more similar. Novelty of the examination is related to our methodology: transparency and similarity measures applied and the most recent time span covered.