Showing papers on "Inflation published in 2009"

Not All Oil Price Shocks Are Alike: Disentangling Demand and Supply Shocks in the Crude Oil Market

Abstract: Using a newly developed measure of global real economic activity, a structural decomposition of the real price of crude oil into three components is proposed: crude oil supply shocks; shocks to the global demand for all industrial commodities; and demand shocks that are specific to the crude oil market. The latter shock is designed to capture shifts in the price of oil driven by higher precautionary demand associated with concerns about future oil supply shortfalls. The paper estimates the dynamic effects of these shocks on the real price of oil. A historical decomposition sheds light on the causes of the major oil price shocks since 1975. The implications of higher oil prices for U.S. real GDP and CPI inflation are shown to depend on the cause of the oil price increase. Changes in the composition of shocks help explain why regressions of macroeconomic aggregates on oil prices tend to be unstable. Evidence that the recent increase in crude oil prices was driven primarily by global aggregate demand shocks helps explain why this oil price shock so far has failed to cause a major recession in the U.S.

Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework

Abstract: The article reviews the book "Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework," by Jordi Gali.

Optimal Sticky Prices under Rational Inattention

Abstract: This paper presents a model in which price setting firms decide what to pay attention to, subject to a constraint on information flow. When idiosyncratic conditions are more variable or more important than aggregate conditions, firms pay more attention to idiosyncratic conditions than to aggregate conditions. When we calibrate the model to match the large average absolute size of price changes observed in micro data, prices react fast and by large amounts to idiosyncratic shocks, but only slowly and by small amounts to nominal shocks. Nominal shocks have strong and persistent real effects. We use the model to investigate how the optimal allocation of attention and the dynamics of prices depend on the firms’ environment. JEL :E 3, E5, D8.

Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment

Abstract: THE CONVENTIONAL INSTRUMENT of monetary policy in most major industrial economies is the very short term nominal interest rate, such as the overnight federal funds rate in the case of the United States. The use of this instrument, however, implies a potential problem: Because currency (which pays a nominal interest rate of zero) can be used as a store of value, the short-term nominal interest rate cannot be pushed below zero. Should the nominal rate hit zero, the real short-term interest rate--at that point equal to the negative of prevailing inflation expectations--may be higher than the rate needed to ensure stable prices and the full utilization of resources. Indeed, an unstable dynamic may result if the excessively high real rate leads to downward pressure on costs and prices that, in turn, raises the real short-term interest rate, which depresses activity and prices further, and so on. Japan has suffered from the problems created by the zero lower bound (ZLB) on the nominal interest rate in recent years, and short-term rates in countries such as the United States and Switzerland have also come uncomfortably close to zero. As a consequence, the problems of conducting monetary policy when interest rates approach zero have elicited considerable attention from the economics profession. Some contributions have framed the problem in a formal general equilibrium setting; another strand of the literature identifies and discusses the policy options available to central banks when the zero bound is binding. (1) Although there have been quite a few theoretical analyses of alternative monetary policy strategies at the ZLB, systematic empirical evidence on the potential efficacy of alternative policies is scant. Knowing whether the proposed alternative strategies would work in practice is important to central bankers, not only because such knowledge would help guide policymaking in extremis, but also because the central bank's choice of its long-run inflation objective depends importantly on the perceived risks created by the ZLB. The greater the confidence of central bankers that tools exist to help the economy escape the ZLB, the less need there is to maintain an inflation "buffer," and hence the lower the inflation objective can be. (2) This paper uses the methods of modern empirical finance to assess the potential effectiveness of so-called nonstandard monetary policies at the zero bound. We are interested particularly in whether such policies would work in modern industrial economies (as opposed to, for example, the same economies during the Depression era), and so our focus is on the recent experience of the United States and Japan. The paper begins by noting that, although the recent improvement in the global economy and the receding of near-term deflation risks may have reduced the salience of the ZLB today, this constraint is likely to continue to trouble central bankers for the foreseeable future. Central banks in the industrial world have exhibited a strong commitment to keeping inflation low, but inflation can be difficult to predict. Although low inflation has many benefits, it also raises the risk that adverse shocks will drive interest rates to the ZLB. Whether hitting the ZLB presents a minor annoyance or a major risk for monetary policy depends on the effectiveness of the policy alternatives available when prices are declining. Following a recent paper by two of the present authors, (3) we group these policy alternatives into three classes: using communications policies to shape public expectations about the future course of interest rates; increasing the size of the central bank's balance sheet; and changing the composition of the central bank's balance sheet. We discuss how these policies might work, and we cite existing evidence on their utility from historical episodes and recent empirical research. The paper's main contribution is to provide new empirical evidence on the possible effectiveness of these alternative policies. …

Sticky Prices and Monetary Policy: Evidence from Disaggregated US Data

Abstract: This paper disentangles fluctuations in disaggregated prices due to macroeconomic and sectoral conditions using a factor-augmented vector autoregression estimated on a large data set. On the basis of this estimation, we establish eight facts: (1) Macroeconomic shocks explain only about 15% of sectoral inflation fluctuations; (2) The persistence of sectoral inflation is driven by macroeconomic factors; (3) While disaggregated prices respond quickly to sector-specific shocks, their responses to aggregate shocks are small on impact and larger thereafter; (4) Most prices respond with a significant delay to identified monetary policy shocks, and show little evidence of a "price puzzle," contrary to existing studies based on traditional VARs; (5) Categories in which consumer prices fall the most following a monetary policy shock tend to be those in which quantities consumed fall the least; (6) The observed dispersion in the reaction of producer prices is relatively well explained by the degree of market power; (7) Prices in sectors with volatile idiosyncratic shocks react rapidly to aggregate monetary policy shocks; (8) The sector-specific components of prices and quantities move in opposite directions

A Theory of Demand Shocks

Abstract: This paper presents a model of business cycles driven by shocks to consumer expectations regarding aggregate productivity. Agents are hit by heterogeneous productivity shocks, they observe their own productivity and a noisy public signal regarding aggregate productivity. The public signal gives rise to ''noise shocks, " which have the features of aggregate demand shocks: they increase output, employment, and inflation in the short run and have no effects in the long run. Numerical examples suggest that the model can generate sizable equilibrium (DSGE) models of the business cycle include a large number of shocks (to technol ogy, monetary policy, preferences, etc.), but typically do not include expectational shocks as independent drivers of short-run fluctuations.1 This paper explores the idea of expectation-driven cycles, looking at a model where technology determines equilibrium output in the long run and consumers receive noisy signals about technology in the short run. The presence of noisy signals produces expectational errors. This paper studies the role of these expectational errors in gener ating volatility at business cycle frequencies. The model is based on two ingredients. First, consumers take time to recognize permanent changes in aggregate fundamentals. Although they may have good information on the current state of the individual firm or sector where they operate, they have only limited information regarding the long-run determinants of aggregate activity. Second, consumers have access to public information that is relevant to estimate long-run productivity. This includes news about technological innovations, publicly released macroeconomic and sectoral statistics, financial market prices, and public statements by policy makers. However, these signals provide only a noisy forecast of the long-run effects of technological innovations. This opens the door to "noise shocks," which induce consumers to temporarily overestimate or underestimate the productive capacity of the economy.

Short Sellers and Financial Misconduct

Abstract: We examine whether short sellers detect firms that misrepresent their financial statements, and whether their trading conveys external costs or benefits to other investors. Abnormal short interest increases steadily in the 19 months before the misrepresentation is publicly revealed, particularly when the misconduct is severe. Short selling is associated with a faster time-to-discovery, and it dampens the share price inflation that occurs when firms misstate their earnings. These results indicate that short sellers anticipate the eventual discovery and severity of financial misconduct. They also convey external benefits, helping to uncover misconduct and keeping prices closer to fundamental values when firms provide incorrect financial information.

The Credit Crisis: Conjectures about Causes and Remedies

Abstract: What caused the financial crisis that is sweeping across the world? What keeps asset prices and lending depressed? What can be done to remedy matters? While it is too early to arrive at definite answers to these questions, it is certainly time to offer informed conjectures, and these are the focus of this paper.

Spatially and temporally varying adaptive covariance inflation for ensemble filters

Abstract: Ensemble filters are used in many data assimilation applications in geophysics. Basic implementations of ensemble filters are trivial but are susceptible to errors from many sources. Model error, sampling error and fundamental inconsistencies between the filter assumptions and reality combine to produce assimilations that are suboptimal or suffer from filter divergence. Several auxiliary algorithms have been developed to help filters tolerate these errors. For instance, covariance inflation combats the tendency of ensembles to have insufficient variance by increasing the variance during the assimilation. The amount of inflation is usually determined by trial and error. It is possible, however, to design Bayesian algorithms that determine the inflation adaptively. A spatially and temporally varying adaptive inflation algorithm is described. A normally distributed inflation random variable is associated with each element of the model state vector. Adaptive inflation is demonstrated in two low-order model experiments. In the first, the dominant error source is small ensemble sampling error. In the second, the model error is dominant. The adaptive inflation assimilations have better mean and variance estimates than other inflation methods.

Money, Bank Credit, and Economic Cycles

Abstract: Can the market fully manage the money and banking sector? Jesus Huerta de Soto, professor of economics at the Universidad Rey Juan Carlos, Madrid, has made history with this mammoth and exciting treatise that it has and can again, without inflation, without business cycles, and without the economic instability that has characterised the age of government control. Such a book as this comes along only once every several generations: a complete comprehensive treatise on economic theory. It is sweeping, revolutionary, and devastating -- not only the most extended elucidation of Austrian business cycle theory to ever appear in print but also a decisive vindication of the Misesian-Rothbardian perspective on money, banking, and the law. The author has said that this is the most significant work on money and banking to appear since 1912, when Mises's own book was published and changed the way all economists thought about the subject. Its five main contributions: A wholesale reconstruction of the legal framework for money and banking, from the ancient world to modern times; An application of law-and-economics logic to banking that links microeconomic analysis to macroeconomic phenomena; A comprehensive critique of fractional-reserve banking from the point of view of history, theory, and policy; An application of the Austrian critique of socialism to central banking; The most comprehensive look at banking enterprise from the point of view of market-based entrepreneurship. Those are the main points but, in fact, this only scratches the surface. Indeed, it would be difficult to overestimate the importance of this book. De Soto provides also a defence of the Austrian perspective on business cycles against every other theory, defends the 100% reserve perspective from the point of view of Roman and British law, takes on the most important objections to full reserve theory, and presents a full policy program for radical reform. It could take a decade for the full implications of this book to be absorbed but this much is clear: all serious students of these subject matters will have to master this treatise.

Trend Inflation, Taylor Principle and Indeterminacy

Abstract: Even low levels of trend inflation substantially affect the dynamics of a basic new Keynesian DSGE model when monetary policy is conducted by a contemporaneous Taylor rule. Positive trend inflation shrinks the determinacy region. Neither the Taylor principle, which requires the inflation coefficient to be greater than one, nor the generalized Taylor principle, which requires that in the long run the nominal interest rate should be raised by more than the increase in inflation, is a sufficient condition for local determinacy of equilibrium. This finding holds for different types of Taylor rules, inertial policy rules and price indexation schemes. Therefore, regardless of the theoretical set up, the monetary literature on Taylor rules cannot disregard average inflation in both theoretical and empirical analysis.

Predicting the bear stock market: Macroeconomic variables as leading indicators

Abstract: This paper investigates whether macroeconomic variables can predict recessions in the stock market, i.e., bear markets. Series such as interest rate spreads, inflation rates, money stocks, aggregate output, unemployment rates, federal funds rates, federal government debt, and nominal exchange rates are evaluated. After using parametric and nonparametric approaches to identify recession periods in the stock market, we consider both in-sample and out-of-sample tests of the variables’ predictive ability. Empirical evidence from monthly data on the Standard & Poor’s S&P 500 price index suggests that among the macroeconomic variables we have evaluated, yield curve spreads and inflation rates are the most useful predictors of recessions in the US stock market, according to both in-sample and out-of-sample forecasting performance. Moreover, comparing the bear market prediction to the stock return predictability has shown that it is easier to predict bear markets using macroeconomic variables.

Monetary Policy, Trend Inflation, and the Great Moderation: An Alternative Interpretation

Abstract: With positive trend inflation, the Taylor principle is not enough to guarantee a determinate equilibrium. We provide new theoretical results on restoring determinacy in New Keynesian models with positive trend inflation and combine these with new empirical findings on the Federal Reserve’s reaction function before and after the Volcker disinflation to find that 1) while the Fed likely satisfied the Taylor principle in the pre-Volcker era, the US economy was still subject to self-fulfilling fluctuations in the 1970s, 2) the US economy moved from indeterminacy to determinacy during the Volcker disinflation, and 3) the switch from indeterminacy to determinacy was due to the changes in the Fed’s response to macroeconomic variables and the decline in trend inflation during the Volcker disinflation.

Is Monetary Policy Effective During Financial Crises

Abstract: This short paper argues that the view that monetary policy is ineffective during financial crises is not only wrong, but may promote policy inaction in the face of a severe contractionary shock. To the contrary, monetary policy is more potent during financial crises because aggressive monetary policy easing can make adverse feedback loops less likely. The fact that monetary policy is more potent than during normal times provides a rationale for a risk-management approach to counter the contractionary effects from financial crises, in which monetary policy is far less inertial than would otherwise be typical -- not only by moving decisively through conventional or nonconventional means to reduce downside risks from the financial disruption, but also in being prepared to quickly take back some of that insurance in response to a recovery in financial markets or an upward shift in inflation risks.

Warm Inflation and its Microphysical Basis

Abstract: The microscopic quantum field theory origins of warm inflation dynamics are reviewed. The warm inflation scenario is first described along with its results, predictions and comparison with the standard cold inflation scenario. The basics of thermal field theory required in the study of warm inflation are discussed. Quantum field theory real time calculations at finite temperature are then presented and the derivation of dissipation and stochastic fluctuations are shown from a general perspective. Specific results are given of dissipation coefficients for a variety of quantum field theory interaction structures relevant to warm inflation, in a form that can be readily used by model builders. Different particle physics models realizing warm inflation are presented along with their observational predictions.

Time-Varying Risk, Interest Rates, and Exchange Rates in General Equilibrium

Abstract: Under mild assumptions, the data indicate that time-varying risk is the primary force driving nominal interest rate differentials on currency-denominated bonds. This finding is an immediate implication of the fact that exchange rates are roughly random walks. A general equilibrium monetary model with an endogenous source of risk variation–a variable degree of asset market segmentation– can produce key features of actual interest rates and exchange rates. In this model, the endogenous segmentation arises from a fixed cost for agents to exchange money for assets. As inflation varies, so does the benefit of asset market participation, and that changes the fraction of agents participating. These effects lead the risk premium to vary systematically with the level of inflation. This model produces variation in the risk premium even though the fundamental shocks have constant conditional variances.

Equilibrium Unemployment, Job Flows and Inflation Dynamics ∗

Abstract: This paper develops a general equilibrium model to explain a set of facts regarding job flows, unemployment and inflation dynamics. It integrates a theory of equilibrium unemployment into a monetary model with nominal price rigidities. The labor market displays matching frictions and endogenous job destruction. The model can explain the cyclical behavior of unemployment, job creation, job destruction and the joint fluctuations of the labor input along both the extensive and the intensive margin conditional on a shock to monetary policy. Allowing for variation of the labor input at the extensive margin leads to a significantly lower elasticity of marginal costs with respect to output. This helps to explain the sluggishness of inflation and the persistence of output after a monetary policy shock.

The Role of Labor Markets for Euro Area Monetary Policy

Abstract: In this paper, we explore the role of labor markets for monetary policy in the euro area in a New Keynesian model in which labor markets are characterized by search and matching frictions. We first investigate to which extent a more flexible labor market would alter the business cycle behaviour and the transmission of monetary policy. We find that while a lower degree of wage rigidity makes monetary policy more effective, i.e. a monetary policy shock transmits faster onto inflation, the importance of other labor market rigidities for the transmission of shocks is rather limited. Second, having estimated the model by Bayesian techniques we analyze to which extent labor market shocks, such as disturbances in the vacancy posting process, shocks to the separation rate and variations in bargaining power are important determinants of business cycle fluctuations. Our results point primarily towards disturbances in the bargaining process as a significant contributor to inflation and output fluctuations. In sum, the paper supports current central bank practice which appears to put considerable effort into monitoring euro area wage dynamics and which appears to treat some of the other labor market information as less important for monetary policy.

Oil and the Euro area economy

Abstract: We examine the macroeconomic effects of different types of oil shocks and the oil transmission mechanism in the Euro area. A comparison is made with the US and across individual member countries. First, we find that the underlying source of the oil price shift is crucial to determine the repercussions on the economy and the appropriate monetary policy reaction. Second, the transmission mechanism is considerably different compared to the US. In particular, inflationary effects in the US are mainly driven by a strong direct pass-through of rising energy prices and indirect effects of higher production costs. In contrast, Euro area inflation reacts sluggishly and is much more driven by second-round effects of increasing wages. The monetary policy reaction of the ECB to oil shocks is also strikingly different compared to the FED. The inflation objective, relative to the output stabilization objective, appears more important for Euro area monetary authorities than for the FED. Third, there are substantial asymmetries across member countries. These differences are due to different labour market dynamics which are further aggravated by a common monetary policy stance which does not fit all. — Gert Peersman and Ine Van Robays

The Transmission of International Shocks: A Factor‐Augmented VAR Approach

Abstract: The empirical literature on the transmission of international shocks is based on small scale VARs. In this paper, we use a large panel of data for 17 industrialized countries to investigate the international transmission mechanism, and revisit the anomalies that arise in the empirical literature. We propose a Factor Augmented VAR (FAVAR) that extends the model in Bernanke, Boivin and Eliasz (2003) to the open economy. The main results can be summarized as follows. First, the dynamic effects on the UK economy of an unanticipated fall of short-term interest rates in the rest of the world are: real house price inflation, investment, GDP and consumption growth peak after one year; wages peak after two years; CPI and GDP deflator inflation peak during the third year. Second, a positive international supply shock makes the distribution of the components of the UK consumption deflator negatively skewed. Third, in response to a domestic monetary shock, we find no evidence of the exchange rate and liquidity puzzles, and little evidence of the forward discount and price anomalies.

A Comparison of Forecast Performance Between Federal Reserve Staff Forecasts, Simple Reduced-Form Models, and a DSGE Model

Abstract: This paper considers the forecast performance of the Federal Reserve staff, five atheoretical reduced-form models, and an estimated dynamic stochastic general equilibrium (DSGE) model, focusing on the late 1990s through 2001. Our analysis finds that the DSGE model and atheoretical models forecast real GDP growth better than the Federal Reserve staff during this period by an economically significant margin; we find smaller differences across each method in the quality of inflation forecasts over this period. These results provide some support to the notion that richly specified DSGE models such the one used in this paper belong in the forecasting toolbox of a central bank. � Rochelle M. Edge (rochelle.m.edge@frb.gov), Michael T. Kiley (michael.t.kiley@frb.gov), and JeanPhilippe Laforte (jean-philippe.laforte@frb.gov) are affiliated with the Macroeconomic and Quantitative Studies Section at the Board of Governors of the Federal Reserve System. This paper represents ongoing work in the section on developing DGE models that can be useful for policy analysis; nevertheless, any views expressed in this paper remain solely those of the authors and do not necessarily reflect those of the Board of Governors of the Federal Reserve System or it staff. All errors are our own.

Long-Run Evidence on Money Growth and Inflation

Abstract: We investigate the correlation between inflation and the rates of growth of narrow and broad money in the United Kingdom since the 19th century. Empirical evidence points towards a remarkable stability across monetary regimes in the correlation for longer-run trends in the data, but some instability in the short to medium term. Additional evidence from the United States confirms the overall stability of the correlation for the longer-run trends.

Globalization, Macroeconomic Performance, and Monetary Policy

Abstract: The paper argues that many of the exaggerated claims that globalization has been an important factor in lowering inflation in recent years just do not hold up. Globalization does, however, have the potential to be stabilizing for individual economies and has been a key factor in promoting economic growth. The paper then examines four questions about the impact of globalization on the monetary transmission mechanism and arrives at the following answers: (i) Has globalization led to a decline in the sensitivity of inflation to domestic output gaps and thus to domestic monetary policy? No. (ii) Are foreign output gaps playing a more prominent role in the domestic inflation process, so that domestic monetary policy has more difficulty stabilizing inflation? No. (iii) Can domestic monetary policy still control domestic interest rates and so stabilize both inflation and output? Yes. (iv) Are there other ways, besides possible influences on inflation and interest rates, in which globalization may have affected the transmission mechanism of monetary policy? Yes.

External MPC Unit Discussion Paper No. 27 The global credit boom: challenges for macroeconomics and policy

Abstract: The recent financial crisis has put the spotlight on the rapid rise in credit which preceded it. In this paper, we provide an empirical and theoretical analysis of the credit boom and the macroeconomic context in which it developed. We find that the boom was unusually long and associated with neither particularly strong growth nor rising inflation in the economies in which it took place. We show that this type of credit and financial cycle is hard to reconcile with existing economic theory and argue that, while the ‘global savings glut’ may account for the cycle’s initial phase, other factors — such as the conduct of monetary policy and perceptions of declining macroeconomic risk — were more important from the mid-2000s onwards. We conclude by identifying some of the challenges now facing macroeconomics and policy.