Showing papers on "Inflation published in 2002"

The Modern History of Exchange Rate Arrangements: A Reinterpretation

Abstract: We develop a novel system of re-classifying historical exchange rate regimes. One difference between our study and previous classification efforts is that we employ an extensive data base on market-determined parallel exchange rates. Our 'natural' classification algorithm leads to a stark reassessment of the post-war history of exchange rate arrangements. When the official categorization is a form of peg, roughly half the time our classification reveals the true underlying monetary regime to be something radically different, often a variant of a float. Conversely, when official classification is floating, our scheme routinely suggests that the reality was a form of de facto peg. Our new classification scheme points to a complete rethinking of economic performance under alternative exchange rate regimes. Indeed, the breakup of Bretton Woods had a far less dramatic impact on most exchange rate regimes than is popularly believed. Also, contrary to an influential empirical literature, our evidence suggests that exchange rate arraignments may be quite important for growth, trade and inflation. Our newly compiled monthly data set on market-determined exchange rates goes back to 1946 for 153 countries.

Asset prices, financial and monetary stability: exploring the nexus

Abstract: This paper argues that financial imbalances can build up in a low inflation environment and that in some circumstances it is appropriate for policy to respond to contain these imbalances. While identifying financial imbalances ex ante can be difficult, this paper presents empirical evidence that it is not impossible. In particular, sustained rapid credit growth combined with large increases in asset prices appears to increase the probability of an episode of financial instability. The paper also argues that while low and stable inflation promotes financial stability, it also increases the likelihood that excess demand pressures show up first in credit aggregates and asset prices, rather than in goods and services prices. Accordingly, in some situations, a monetary response to credit and asset markets may be appropriate to preserve both financial and monetary stability.

Asset prices, financial and monetary stability: exploring the nexus

Abstract: This paper argues that financial imbalances can build up in a low inflation environment and that in some circumstances it is appropriate for policy to respond to contain these imbalances. While identifying financial imbalances ex ante can be difficult, this paper presents empirical evidence that it is not impossible. In particular, sustained rapid credit growth combined with large increases in asset prices appears to increase the probability of an episode of financial instability. The paper also argues that while low and stable inflation promotes financial stability, it also increases the likelihood that excess demand pressures show up first in credit aggregates and asset prices, rather than in goods and services prices. Accordingly, in some situations, a monetary response to credit and asset markets may be appropriate to preserve both financial and monetary stability.

Some Evidence on the Importance of Sticky Prices

Abstract: We examine the frequency of price changes for 350 categories of goods and services covering about 70% of consumer spending, based on unpublished data from the BLS for 1995 to 1997. Compared with previous studies we find much more frequent price changes, with half of prices lasting less than 4.3 months. The frequency of price changes differs dramatically across categories. We exploit this variation to ask how inflation for 'flexible-price goods' (goods with frequent changes in individual prices) differs from inflation for 'sticky-price goods' (those displaying infrequent price changes). Compared to the predictions of popular sticky price models, actual inflation rates are far more volatile and transient, particularly for sticky-price goods. The data appendix for this paper can be found at http://www.nber.org/data-appendix/w9069/

Time Varying Structural Vector Autoregressions and Monetary Policy

Abstract: Monetary policy and the private sector behavior of the US economy are modeled as a time varying structural vector autoregression, where the sources of time variation are both the coefficients and the variance covariance matrix of the innovations. The paper develops a new, simple modeling strategy for the law of motion of the variance covariance matrix and proposes an efficient Markov chain Monte Carlo algorithm for the model likelihood/posterior numerical evaluation. The main empirical conclusions are: 1) both systematic and non-systematic monetary policy have changed during the last forty years. In particular, long run systematic responses of the interest rate to inflation and unemployment exhibit a trend toward a more aggressive behavior, despite remarkable oscillations; 2) this has had a negligible effect on the rest of the economy. The role played by exogenous non-policy shocks seems much more important than monetary policy in explaining the high inflation and unemployment episodes in recent US economic history.

Estimating the Effects of Fiscal Policy in OECD Countries

Abstract: This Paper studies the effects of fiscal policy on GDP, inflation and interest rates in five OECD countries, using a structural Vector Autoregression approach. Its main results can be summarized as follows: 1) The effects of fiscal policy on GDP tend to be small: government spending multipliers larger than 1 can be estimated only in the US in the pre-1980 period. 2) There is no evidence that tax cuts work faster or more effectively than spending increases. 3) The effects of government spending shocks and tax cuts on GDP and its components have become substantially weaker over time; in the post-1980 period these effects are mostly negative, particularly on private investment. 4) Only in the post-1980 period is there evidence of positive effects of government spending on long interest rates. In fact, when the real interest rate is held constant in the impulse responses, much of the decline in the response of GDP in the post-1980 period in the US and UK disappears. 5) Under plausible values of its price elasticity, government spending typically has small effects on inflation. 6) Both the decline in the variance of the fiscal shocks and the change in their transmission mechanism contribute to the decline in the variance of GDP after 1980.

A Simple Framework for International Monetary Policy Analysis

Abstract: We study the international monetary policy design problem within an optimizing two-country sticky price model, where each country faces a short run trade-off between output and inflation. The model is sufficiently tractable to solve analytically. We find that in the Nash equilibrium, the policy problem for each central bank is isomorphic to the one it would face if it were a closed economy. Gains from co-operation arise, however, that stem from the impact of foreign economic activity on the domestic marginal cost of production. While under Nash central banks need only adjust the interest rate in response to domestic inflation, under co-operation they should respond to foreign inflation as well. In either scenario, flexible exchange rates are desirable.

A Simple Framework for International Monetary Policy Analysis

Abstract: We study the international monetary policy design problem within an optimizing two-country sticky price model, where each country faces a short run tradeoff between output and inflation. The model is sufficiently tractable to solve analytically. We find that in the Nash equilibrium, the policy problem for each central bank is isomorphic to the one it would face if it were a closed economy. Gains from cooperation arise, however, that stem from the impact of foreign economic activity on the domestic marginal cost of production. While under Nash central banks need only adjust the interest rate in response to domestic inflation, under cooperation they should respond to foreign inflation as well. In either scenario, flexible exchange rates are desirable.

Monetary Policy and Exchange Rate Volatility in a Small Open Economy

Abstract: We lay out a small open economy version of the Calvo sticky price model, and show how the equilibrium dynamics can be reduced to simple representation in domestic inflation and the output gap. We use the resulting framework to analyze the macroeconomic implications of three alternative rule-based policy regimes for the small open economy: domestic inflation and CPI-based Taylor rules, and an exchange rate peg. We show that a key difference among these regimes lies in the relative amount of exchange rate volatility that they entail. We also discuss a special case for which domestic inflation targeting constitutes the optimal policy, and where a simple second order approximation to the utility of the representative consumer can be derived and used to evaluate the welfare losses associated with the suboptimal rules.

The Fed and Interest Rates - A High-Frequency Identification

Abstract: We measure monetary policy shocks as changes in the Fed funds target rate that surprise bond markets in daily data. These shock series avoid the omitted variable, time-varying parameter, and orthogonalization problem of monthly VARs, and do not impose the expectations hypothesis. We find surprisingly large and persistent responses of bond yields to these shocks. 10 year rates rise as much as 8/10 of a percent to a one percent target shock. The usual view that monetary policy only temporarily raises long term rates and influences inflation would lead one to predict a negative long rate response.

The NAIRU in Theory and Practice

Abstract: This paper discusses the NAIRU -- the non-accelerating inflation rate of unemployment. It first considers the role of the NAIRU concept in business cycle theory, arguing that this concept is implicit in any model in which monetary policy influences both inflation and unemployment. The exact value of the NAIRU is hard to measure, however, in part because it changes over time. The paper then discusses why the NAIRU changes and, in particular, why it fell in the United States during the 1990s. The most promising hypothesis is that the decline in the NAIRU is attributable to the acceleration in productivity growth.

Is Inflation Persistence Intrinsic in Industrial Economies

Abstract: Many empirical studies have indicated that inflation exhibits very high persistence throughout the post-war period in nearly every industrial economy. In this paper we challenge this conventional wisdom and instead argue that in many cases, high inflation persistence is an artifact of empirical techniques that fail to account for occasional shifts in the monetary policy regime. In particular, we estimate autoregressive models of inflation for twelve OECD countries over the period 1984-2004, and we then perform tests for the existence of a structural break at an unknown date. For eight of the twelve countries, we find strong evidence for a break in intercept in the late 1980s or early 1990s; furthermore, conditional on the break in intercept, each inflation measure generally exhibits much lower persistence. Evidently, high inflation persistence is not an inherent characteristic of industrial economies.

The Big Problem of Small Change

Abstract: The Big Problem of Small Change offers the first credible and analytically sound explanation of how a problem that dogged monetary authorities for hundreds of years was finally solved. Two leading economists, Thomas Sargent and Francois Velde, examine the evolution of Western European economies through the lens of one of the classic problems of monetary history--the recurring scarcity and depreciation of small change. Through penetrating and clearly worded analysis, they tell the story of how monetary technologies, doctrines, and practices evolved from 1300 to 1850; of how the "standard formula" was devised to address an age-old dilemma without causing inflation. One big problem had long plagued commodity money (that is, money literally worth its weight in gold): governments were hard-pressed to provide a steady supply of small change because of its high costs of production. The ensuing shortages hampered trade and, paradoxically, resulted in inflation and depreciation of small change. After centuries of technological progress that limited counterfeiting, in the nineteenth century governments replaced the small change in use until then with fiat money (money not literally equal to the value claimed for it)--ensuring a secure flow of small change. But this was not all. By solving this problem, suggest Sargent and Velde, modern European states laid the intellectual and practical basis for the diverse forms of money that make the world go round today. This keenly argued, richly imaginative, and attractively illustrated study presents a comprehensive history and theory of small change. The authors skillfully convey the intuition that underlies their rigorous analysis. All those intrigued by monetary history will recognize this book for the standard that it is.

Monetary-Policy Rules and the Great Inflation

Abstract: The nature of monetary policy during the 1970s is evaluated through the lens of a forward-looking Taylor rule based on perceptions regarding the outlook for inflation and unemployment at the time policy decisions were made. The evidence suggests that policy during the 1970s was essentially indistinguishable from a systematic, activist, forward-looking approach such as is often identified with good policy advice in theoretical and econometric policy evaluation research. This points to the unpleasant possibility that the policy errors of the 1970s occurred despite the use of a seemingly desirable policy approach. Though the resulting activist policies could have appeared highly promising, they proved, in retrospect, counterproductive.

Dynamic Inconsistencies: Counterfactual Implications of a Class of Rational-Expectations Models

Abstract: A number of recent papers have developed dynamic macroeconomic models that incorporate rational expectations and optimizing foundations. While the theoretical motivation behind these models is sound, the dynamic implications of many of the specifications that assume rational expectations and optimizing behavior can be seriously at odds with the data, for both inflation and real-side variables exhibit gradual and \"hump-shaped\" responses to real and monetary shocks. For models that are intended for monetary policy analysis, these dynamic shortcomings should be considered quite serious. When monetary policy has only short-run effects on real variables, the inability to approximately capture the short-run responses of inflation or real variables to policy shocks makes a model unsuitable for policy analysis. This paper identifies a simple feature common to many dynamic specifications for prices and real variables that causes the problem. The paper also discusses several potential solutions to the problem, including alterations to the expectations assumption, to the order of differencing implicit in the model, and to the underlying behavioral assumptions. (This abstract was borrowed from another version of this item.)

Openness, imperfect exchange rate pass-through and monetary policy. NBB Working Paper Nr. 19

Abstract: This paper analyses the implications of imperfect exchange rate passthrough for optimal monetary policy in a linearised open-economy dynamic general equilibrium model calibrated to euro area data. Imperfect exchange rate pass through is modelled by assuming sticky import price behaviour. The degree of domestic and import price stickiness is estimated by reproducing the empirical identified impulse response of a monetary policy and exchange rate shock conditional on the response of output, net trade and the exchange rate. It is shown that a central bank that wants to minimise the resource costs of staggered price setting will aim at minimising a weighted average of domestic and import price inflation.

The Role of Models and Probabilities in the Monetary Policy Process

Abstract: THis IS A PAPER ON THE way data relate to decisionmaking in central banks. One component of the paper is based on a series of interviews with staff members and a few policy committee members of four central banks: the Swedish Riksbank, the European Central Bank (ECB), the Bank of England, and the U.S. Federal Reserve. These interviews focused on the policy process and sought to determine how forecasts were made, how uncertainty was characterized and handled, and what role formal economic models played in the process at each central bank. In each of the four central banks, "subjective" forecasting, based on data analysis by sectoral "experts," plays an important role. At the Federal Reserve, a seventeen-year record of model-based forecasts can be compared with a longer record of subjective forecasts, and a second component of this paper is an analysis of these records. Two of the central banks--the Riksbank and the Bank of England-have explicit inflation-targeting policies that require them to set quantitative targets for inflation and to publish, several times a year, their forecasts of inflation. A third component of the paper discusses the effects of such a policy regime on the policy process and on the role of models within it. The large models in use in central banks today grew out of a first generation of large models that were thought to be founded on the statistical theory of simultaneous-equations models. Today's large models have completely lost their connection to this theory, or indeed to any other probability-based theory of inference. The models are now fit to data by ad hoc procedures that have no grounding in statistical theory. A fourth component of the paper discusses how inference using these models reached this state and why academic econometrics has had so little impact in correcting it. Despite their failure to provide better forecasts, their lack of a firm statistical foundation, and the weaknesses in their underlying economic theory, the large models play an important role in the policy process. A final component of the paper discusses what this role is and how the model's performance in it might be improved. The Policy Process At all four central banks the policy process runs in a regular cycle; that cycle is quarterly in frequency at all except the Federal Reserve, where it is keyed to the meetings of the Federal Open Market Committee (FOMC), which take place roughly every six weeks. Each central bank has a primary macroeconomic model but uses other models as well. The primary models are the ones used to construct projections of alternative scenarios, conditional on various assumptions about future disturbances or policies or on various assumptions about the current state of the economy. Where there is feedback between models and subjective forecasts, it is generally through the primary model. The primary models have some strong similarities. The ECB's model contains about fifteen behavioral equations, the Bank of England's twenty-one, the Riksbank's twenty-seven, and the Federal Reserve's about forty. (1) Each has at least some expectational components, with the Federal Reserve and Riksbank models the most complete in this respect. Those central banks whose models are less forward-looking describe them somewhat apologetically, suggesting that they are working on including more forward-looking behavior. The Riksbank and the Bank of England have publicly described "suites" of models of various types, including vector autoregressive (VAR) models, smaller macroeconomic models, and optimizing models. Some of these models produce regular forecasts that are seen by those involved in the policy process, but at both central banks none except the primary model has a regular, well-defined role. The other central banks also have secondary models with some informal impact on the policy process. …

The modern history of exchange rate arrangements: A reinterpretation

Abstract: We develop a novel system of re-classifying historical exchange rate regimes One difference between our study and previous classification efforts is that we employ an extensive data base on market-determined parallel exchange rates Our 'natural' classification algorithm leads to a stark reassessment of the post-war history of exchange rate arrangements When the official categorization is a form of peg, roughly half the time our classification reveals the true underlying monetary regime to be something radically different, often a variant of a float Conversely, when official classification is floating, our scheme routinely suggests that the reality was a form of de facto peg Our new classification scheme points to a complete rethinking of economic performance under alternative exchange rate regimes Indeed, the breakup of Bretton Woods had a far less dramatic impact on most exchange rate regimes than is popularly believed Also, contrary to an influential empirical literature, our evidence suggests that exchange rate arraignments may be quite important for growth, trade and inflation Our newly compiled monthly data set on market-determined exchange rates goes back to 1946 for 153 countries

Exchange Rate Pass-Through into Import Prices: A Macro or Micro Phenomenon?

Abstract: Exchange rate regime optimality, as well as monetary policy effectiveness, depends on the tightness of the link between exchange rate movements and import prices. Recent debates hinge on whether producer-currency-pricing (PCP) or local currency pricing (LCP) of imports is more prevalent, and on whether exchange rate passthrough rates are endogenous to a country’s macroeconomic conditions. We provide cross-country and time series evidence on both of these issues for the imports of twenty-five OECD countries. Across the OECD and especially within manufacturing industries, there is compelling evidence of partial pass-through in the short-run– rejecting both PCP and LCP. Over the long run, PCP is more prevalent for many types of imported goods. Higher inflation and exchange rate volatility are weakly associated with higher pass-through of exchange rates into import prices. However, for OECD countries, the most important determinants of changes in pass-through over time are microeconomic and relate to the industry composition of a country’s import bundle.

New Perspectives on Monetary Policy, Inflation, and the Business Cycle

Abstract: The present paper provides an overview of recent developments in the analysis of monetary policy in the presence of nominal rigidities. The paper emphasizes the existence of several dimensions in which the recent literature provides a new perspective on the linkages among monetary policy, insation, and the business cycle. It is argued that the adoption of an explicitly optimizing, general equilibrium framework has not been supersuous; on the contrary, it has yielded many insights which, by their nature, could hardly have been obtained with earlier non-optimizing models.

Price Index Convergence among United States Cities

Abstract: We study the dynamics of price indices for major U.S. cities using panel econometric methods and find that relative price levels among cities mean revert at an exceptionally slow rate. In a panel of 19 cities from 1918 to 1995, we estimate the half-life of convergence to be approximately nine years. The surprisingly slow rate of convergence can be explained by a combination of the presence of transportation costs, differential speeds of adjustment to small and large shocks, and the inclusion of nontraded goods prices in the overall price index. Do price indices in major U.S. cities share a common trend, and if so, how quickly do they revert to that trend following a local shock to the price index? To answer this question, we study the dynamics of consumer price indices for 19 major U.S. cities over the period from 1918 to 1995. The panel time-series methods we employ are now commonly used for studying real output growth rates and levels of real exchange rates across countries. We estimate that price index divergences across U.S. cities are temporary, but surprisingly persistent, with a half-life of nearly nine years. Our research has two primary motivations. First, we hope to gain a better understanding of the sources of persistence in the deviations from purchasing power parity (PPP) found in studies of national price indices and exchange-rate data. Second, and more importantly, we see the European Monetary Union as having many similarities to the United States, and believe that studying the behavior of prices across U.S. cities will help us in understanding the likely nature of inflation convergence in the Euro area. The European Central Bank’s stated inflation objective is a year-on-year change in the Harmonized Index of Consumer Prices (HICP) of not more than 2%. But how large might we expect regional deviations from this Euro-area-wide average to be, and how long are they likely to persist? The lack of data prevents us from answering this question directly using European prices under monetary union. Instead, we look to the United States, a mature common currency area of similar regional diversity, size, and industrial development,

Imperfect Knowledge, Inflation Expectations, and Monetary Policy

Abstract: This paper investigates the role that imperfect knowledge about the structure of the economy plays in the formation of expectations, macroeconomic dynamics, and the efficient formulation of monetary policy. Economic agents rely on an adaptive learning technology to form expectations and to update continuously their beliefs regarding the dynamic structure of the economy based on incoming data. The process of perpetual learning introduces an additional layer of dynamic interaction between monetary policy and economic outcomes. We find that policies that would be efficient under rational expectations can perform poorly when knowledge is imperfect. In particular, policies that fail to maintain tight control over inflation are prone to episodes in which the public's expectations of inflation become uncoupled from the policy objective and stagflation results, in a pattern similar to that experienced in the United States during the 1970s. Our results highlight the value of effective communication of a central bank's inflation objective and of continued vigilance against inflation in anchoring inflation expectations and fostering macroeconomic stability.

Openness, Imperfect Exchange Rate Pass-Through and Monetary Policy

Abstract: This paper analyses the implications of imperfect exchange rate pass-through for optimal monetary policy in a linearised open-economy dynamic general equilibrium model calibrated to euro area data Imperfect exchange rate pass through is modelled by assuming sticky import price behaviour The degree of domestic and import price stickiness is estimated by reproducing the empirical identified impulse response of a monetary policy and exchange rate shock conditional on the response of output, net trade and the exchange rate It is shown that a central bank that wants to minimise the resource costs of staggered price setting will aim at minimising a weighted average of domestic and import price inflation

Does model uncertainty justify caution? robust optimal monetary policy in a forward-looking model

Abstract: This paper proposes a general method based on a property of zero-sum two-player games to derive robust optimal monetary policy rules—the best rules among those that yield an acceptable performance in a specified range of models—when the true model is unknown and model uncertainty is viewed as uncertainty about parameters of the structural model. The method is applied to characterize robust optimal Taylor rules in a simple forward-looking macroeconomic model that can be derived from first principles. Although it is commonly believed that monetary policy should be less responsive when there is parameter uncertainty, we show that robust optimal Taylor rules prescribe in general a stronger response of the interest rate to fluctuations in inflation and the output gap than is the case in the absence of uncertainty. Thus model uncertainty does not necessarily justify a relatively small response of actual monetary policy.