Record ID

97     [ Page 30 of 34, No. 1 ]

Date

2010-11

Author

Charles Goodhart

Affiliation

London Shool of Economics

Title

The changing role of central banks

Summary /
Abstract

Although Central Banks have pursued the same objectives throughout their existence, primarily price and financial stability, the interpretation of their role in doing so has varied. We identify three stable epochs, when such interpretations had stabilised, i. e.,

1. The Victorian era, 1840s to 1914;
2. The decades of government control, 1930s to 1960s;
3. The triumph of the markets, 1980s to 2007.

Each epoch was followed by a confused inter-regnum, searching for a new consensual blueprint. The final such epoch concluded with a crisis, when it became apparent that macro-economic stability, the Great Moderation, plus (efficient) markets could not guarantee financial stability. So the search is now on for additional macro-prudential (counter-cyclical) instruments. The use of such instruments will need to be associated with controlled variations in systemic liquidity, and in the balance sheet of the Central Bank. Such control over its own balance sheet is the core, central function of any Central Bank, even more so than its role in setting short-term interest rates, which latter could be delegated. We end by surveying how relationships between Central Banks and governments may change over the next period.

Keywords

central banks, financial stability, financial regulation, bank taxes

URL

http://www.bis.org/publ/work326.pdf

Remarks

On 24–25 June 2010, the BIS held its Ninth Annual Conference, on “The future of central banking under post-crisis mandates” in Lucerne, Switzerland. The attached paper by Charles Goodhart is a provocative and controversial essay delivered and discussed in the first session chaired by BSP Governor Amando Tetangco, Jr. Among the paper's discussants, Stanley Fischer's comments are worth digesting.

Record ID

96     [ Page 30 of 34, No. 2 ]

Date

2010-12

Author

Gabriele Galati Richhild Moessner

Affiliation

De Nederlandsche Bank

Title

Macroprudential policy - a literature review

Summary /
Abstract

The recent financial crisis has highlighted the need to go beyond a purely micro approach to financial regulation and supervision. In recent months, the number of policy speeches, research papers and conferences that discuss a macro perspective on financial regulation has grown considerably. The policy debate is focusing in particular on macroprudential tools and their usage, their relationship with monetary policy, their implementation and their effectiveness. Macroprudential policy has recently also attracted considerable attention among researchers. This paper provides an overview of research on this topic. We also identify important future research questions that emerge from both the literature and the current policy debate.

Keywords

Macroprudential policy

URL

http://d.repec.org/n?u=RePEc:dnb:dnbwpp:267&r=mac

Record ID

95     [ Page 30 of 34, No. 3 ]

Date

2010-12

Author

Hiroyuki Taguchi Chizuru Kato

Affiliation

Ministry of Finance, Japan

Title

Assessing the Performance of Inflation Targeting in East Asian economies

Summary /
Abstract

This paper aims at assessing the performance of the inflation targeting framework from the quantitative perspective of the money and inflation relationship, focusing on the four East Asian economies, i.e. Korea, Indonesia, Thailand and the Philippines, who adopted the inflation targeting framework soon after the 1997-98 Asian currency crisis. Our estimation results told us that the inflation targeting framework in the sample economies, except for the Philippines, has functioned well as an anchor to curb inflation, in the sense that the framework speeds up price adjustment against money supply compared with their previous regime of pegged exchange rates. We interpret the speeding-up of price adjustment under inflation targeting framework in such a way that the framework may have been able to curb inflation through stabilizing inflationary expectations. We also found that the well-functioning inflation targeting framework was consistent with another estimation outcome: that of enhanced monetary autonomy under the post-crisis floating exchange rate regime.

Keywords

inflation targeting framework, East Asian emerging market economy, money-inflation relationship, co-integration test, error correction estimation

URL

http://d.repec.org/n?u=RePEc:eab:macroe:2421&r=mon

Remarks

Notice in their summary the authors' conclusion that the IT framework has functioned well as an anchor to curb inflation only in Korea, Indonesia, and Thailand, but not the Philippines. However, this conclusion is based on how well the quantity theory of money is upheld. But this is the major drawback of the authors' approach--the IT framework's success has nothing to do with the money demand-supply relationship, since inflation is affected by many variables, not just the money supply. In fact, among other reasons, IT was adopted precisely because of the instability of money demand and the breakdown of the link between money supply and inflation.

Record ID

94     [ Page 30 of 34, No. 4 ]

Date

2010-12

Author

Barajas, Adolfo ; Chami, Ralph ; Hakura, Dalia ; Montiel, Peter

Affiliation

International Monetary Fund and Williams College

Title

Workers' Remittances and the Equilibrium Real Exchange Rate: Theory and Evidence

Summary /
Abstract

This paper investigates the impact of workers' remittances on equilibrium real exchange rates (ERER) in recipient economies. Using a small open economy model, it shows that standard "Dutch Disease" results of appreciation are substantially weakened or even overturned depending on: degree of openness; factor mobility between domestic sectors; counter cyclicality of remittances; the share of consumption in tradables; and the sensitivity of a country's risk premium to remittance flows. Panel cointegration techniques on a large set of countries provide support for these analytical results, and show that ERER appreciation in response to sustained remittance flows tends to be quantitatively small.

Keywords

Worker’s remittances, equilibrium real exchange rate, low-income countries

URL

http://www.imf.org/external/pubs/ft/wp/2010/wp10287.pdf

Record ID

93     [ Page 30 of 34, No. 5 ]

Date

2010-12

Author

Ong, Li L. | Maino, Rodolfo | Duma, Nombulelo

Affiliation

Money and Capital Markets Department, International Monetary Fund

Title

Into the Great Unknown: Stress Testing with Weak Data

Summary /
Abstract

Stress testing has become the risk management tool du jour in the wake of the global financial crisis. In countries where the information reported by financial institutions is considered to be of sufficiently good quality, and supervisory and regulatory standards are high, stress tests can be of significant value. In contrast, the proliferation of stress testing in underdeveloped financial systems with weak oversight regimes is fraught with uncertainties, as it is unclear what the results actually represent and how they could be usefully applied. In this paper, problems associated with stress tests using weak data are examined. We offer a potentially more useful alternative, the "breaking point" method, which also requires close coordination with on-site supervision and complemented by other supervisory tools and qualitative information. Excel spreadsheet templates of the stress tests presented in this paper are provided.

Keywords

Ad hoc shock, breaking point, data quality, loan classification, provision, stress testing

URL

http://www.imf.org/external/pubs/ft/wp/2010/wp10282.pdf

Record ID

92     [ Page 30 of 34, No. 6 ]

Date

2010-09

Author

Andreas Steiner

Affiliation

Universitaet Osnabrueck

Title

Central Banks’ Dilemma: Reserve Accumulation, Inflation and Financial Instability

Summary /
Abstract

Central banks’ international reserves have increased significantly in the recent past. While this accumulation has been widely perceived as precautionary savings to prevent financial crises, rising reserves might also endanger monetary and financial stability. This paper sheds new light on the implications for financial stability and assesses the consequences for monetary policy on theoretical and empirical grounds. Our estimation results show that the accumulation of reserves raises the inflation rate, both on the global and the individual-country level.

Keywords

International Reserves, Inflation, Panel Data Analysis

URL

http://d.repec.org/n?u=RePEc:iee:wpaper:wp0084&r=mon

Record ID

91     [ Page 30 of 34, No. 7 ]

Date

2010-12

Author

Das, Udaibir S. ; Papaioannou, Michael G ; Pedras, Guilherme ; Ahmed, Faisal ; Surti, Jay

Affiliation

Money and Capital Markets Department, International Monetary Fund

Title

Managing Public Debt and Its Financial Stability Implications

Summary /
Abstract

This paper explores the relationship between the level and management of public debt and financial stability, and explains the channels through which the two are interlinked. It suggests that the broader implications of a debt management strategy and its implementation should be carefully analyzed by debt managers and policy makers in terms of their impact on the government’s balance sheet, macroeconomic developments, and the financial system.

Keywords

Public Debt Structure, Public Debt Management, Financial Stability

URL

http://www.imf.org/external/pubs/ft/wp/2010/wp10280.pdf

Remarks

This Working Paper was published as Chapter 15 of the book “Sovereign Debt and the Financial Crisis.” The World Bank is the source and copyright holder of this work. This Working Paper is based on an ongoing study by the authors of the recent global economic and financial crisis, cross-country experiences with debt management operations, and their implications for public sector balance sheets and financial stability.

Record ID

90     [ Page 30 of 34, No. 8 ]

Date

2010-10

Author

Gupta, Abhishek

Affiliation

Johns Hopkins University

Title

A Forecasting Metric for Evaluating DSGE Models for Policy Analysis

Summary /
Abstract

This paper evaluates the strengths and weaknesses of dynamic stochastic general equilibrium (DSGE) models from the standpoint of their usefulness in doing monetary policy analysis. The paper isolates features most relevant for monetary policymaking and uses the diagnostic tools of posterior predictive analysis to evaluate these features. The paper provides a diagnosis of the observed flaws in the model with regards to these features that helps in identifying the structural flaws in the model. The paper finds that model misspecification causes certain pairs of structural shocks in the model to be correlated in order to fit the observed data.

Keywords

Posterior predictive analysis; DSGE; Monetary Policy; Forecast Errors; Model Evaluation

URL

http://mpra.ub.uni-muenchen.de/26718/1/MPRA_paper_26718.pdf

Record ID

89     [ Page 30 of 34, No. 9 ]

Date

2010-11

Author

Céline Gauthier, Zhongfang He, Moez Souissi

Affiliation

Bank of Canada

Title

Understanding Systemic Risk: The Trade-Offs between Capital, Short-Term Funding and Liquid Asset Holdings

Summary /
Abstract

We offer a multi-period systemic risk assessment framework with which to assess recent liquidity and capital regulatory requirement proposals in a holistic way. Following Morris and Shin (2009), we introduce funding liquidity risk as an endogenous outcome of the interaction between market liquidity risk, solvency risk, and the funding structure of banks. To assess the overall impact of different mix of capital and liquidity, we simulate the framework under a severe but plausible macro scenario for different balance-sheet structures. Of particular interest, we find that (1) capital has a decreasing marginal effect on systemic risk, (2) increasing capital alone is much less effective in reducing liquidity risk than solvency risk, (3) high liquid asset holdings reduce the marginal effect of increasing short term liability on systemic risk, and (4) changing liquid asset holdings has little effect on systemic risk when short term liability is sufficiently low.

Keywords

Financial stability; Financial system regulation and policies

URL

http://d.repec.org/n?u=RePEc:bca:bocawp:10-29&r=ban

Remarks

This is a very informative, timely and useful paper by economists from the Financial Stability and Financial Markets Departments of the Bank of Canada.

Record ID

88     [ Page 30 of 34, No. 10 ]

Date

2010-11

Author

Strategy and Policy Review, and Money and Capital Markets Departments

Affiliation

International Monetary Fund

Title

Understanding Financial Interconnectedness

Summary /
Abstract

This paper seeks to advance our understanding of global financial interconnectedness by (i) mapping aspects of the architecture of global finance and (ii) investigating critical fault lines related to interconnectedness along which systemic risks were built up and shocks transmitted in the crisis. It thus takes initial steps toward operationalizing enhanced financial sector and macro-financial surveillance called for by the IMF’s Executive Board and by experts such as de Larosiere et al. (2009). Getting a better handle on interconnectedness would strengthen the Fund‘s ability, together with the Financial Stability Board, to track systemic risk concentrations. It would also inform spillover and vulnerability analyses, and sharpen bilateral and multilateral surveillance.

Keywords

International financial system | Economic integration | Financial sector | Banks | Nonbank financial sector | Globalization | Cross country analysis

URL

http://www.imf.org/external/np/pp/eng/2010/100410.pdf

Remarks

Useful for the ASEAN+3's AMRO.

Record ID

87     [ Page 30 of 34, No. 11 ]

Date

2010-11

Author

Ranciere, Romain ; Tornell, Aaron ; Vamvakidis, Athanasios

Affiliation

International Monetary Fund

Title

A New Index of Currency Mismatch and Systemic Risk

Summary /
Abstract

This paper constructs a new measure of currency mismatch in the banking sector that controls for bank lending to unhedged borrowers. This measure explicitly takes into account the indirect exchange rate risk that banks undertake when they lend to borrowers that will not be able to repay in the event of a sharp depreciation. Such systemic risk taking is not captured by indicators that are based only on banks' balance sheet data. The new measure is constructed for 10 emerging European economies and for a broader sample that includes 19 additional emerging economies, for the period 1998 - 2008. Comparisons with previous currency mismatch measures that do not adjust for unhedged foreign currency borrowing illustrate the advantages of the new approach. In particular, the new measure flagged the indirect currency mismatch vulnerabilities that were building up in a number of emerging economies before the recent global crisis. Measuring currency mismatch more accurately can help country authorities in their efforts to address vulnerabilities at the right time, avoiding hurting growth prospects.

Keywords

Currency mismatch; emerging economies; systemic risk; financial crises

URL

http://www.imf.org/external/pubs/ft/wp/2010/wp10263.pdf

Remarks

Written by RES and SPR economists of the IMF, this more meaningful new index of currency mismatch and systemic risk is constructed for the Philippines and other emerging economies of Asia and Europe. Highly useful in measuring the vulnerabilities of such economies. Their results suggest that the largest increases in vulnerabilities prior to the recent crisis were concentrated in six emerging European economies; were these measures available on a timely basis, they would have flagged vulnerabilities of these economies well before the crisis struck, and appropriate macro-prudential and other measures could have averted or minimize the crisis' impact on output and employment.

Record ID

86     [ Page 30 of 34, No. 12 ]

Date

2010-11

Author

John B. Taylor and Volker Wieland

Affiliation

Stanford University and Goethe University of Frankfurt

Title

Surprising comparative properties of monetary models: Results from a new model database

Summary /
Abstract

In this paper we investigate the comparative properties of empirically-estimated monetary models of the U.S. economy. We make use of a new database of models designed for such investigations. We focus on three representative models: the Christiano, Eichenbaum, Evans (2005) model, the Smets and Wouters (2007) model, and the Taylor (1993a) model. Although the three models differ in terms of structure, estimation method, sample period, and data vintage, we find surprisingly similar economic impacts of unanticipated changes in the federal funds rate. However, the optimal monetary policy rules are different in the different models. Simple model-specific policy rules that include the lagged interest rate, inflation and current and lagged output gaps are not robust. Some degree of robustness can be recovered by using rules without interest-rate smoothing or with GDP growth deviations from trend in place of the output gap. However, improvement vis-à-vis other models, comes at the cost of significant performance deterioration in the original model. Model averaging offers a much more effective strategy for improving the robustness of policy rules.

Keywords

monetary policy rules, New-Keynesian models, model uncertainty, robustness, monetary policy transmission.

URL

http://d.repec.org/n?u=RePEc:ecb:ecbwps:20101261&r=mon

Remarks

A must read for central bank monetary policy modelers. Authors check the robustness of popular monetary policy models, including DSGE models, and find that model-specific policy rules are not robust and that model averaging makes policy rules more robust. Therefore, they recommend that central bank modelers eschew reliance on a particular class of models, e.g. DSGE, and that they employ model averaging instead.

Record ID

85     [ Page 30 of 34, No. 13 ]

Date

2010-10

Author

Ali Dib

Affiliation

Bank of Canada

Title

Capital Requirement and Financial Frictions in Banking: Macroeconomic Implications

Summary /
Abstract

The author develops a dynamic stochastic general-equilibrium model with an active banking sector, a financial accelerator, and financial frictions in the interbank and bank capital markets. He investigates the importance of banking sector frictions on business cycle fluctuations and assesses the role of a regulatory capital requirement in propagating the effects of shocks in the real economy. Bank capital is introduced to satisfy the regulatory capital requirement, and serves as collateral for borrowing in the interbank market. Financial frictions are introduced by assuming asymmetric information between lenders and borrowers that creates moral hazard and adverse selection problems in the interbank and bank capital markets, respectively. Highly leveraged banks are vulnerable and therefore pay higher costs when raising funds. The author finds that financial frictions in the interbank and bank capital markets amplify and propagate the effects of shocks; however, the capital requirement attenuates the real impacts of aggregate shocks (including financial shocks), reduces macroeconomic volatilities, and stabilizes the economy.

Keywords

Economic models; Business fluctuations and cycles; Financial markets; Financial stability

Remarks

This DSGE model provides a theoretical explanation for the stringent capital requirements now being contemplated and discussed by central banks all over the world.

Record ID

84     [ Page 30 of 34, No. 14 ]

Date

2010-11

Author

Budina, Nina T ; Tuladhar, Anita

Affiliation

International Monetary Fund

Title

Post-Crisis Fiscal Policy Priorities for the ASEAN-5

Summary /
Abstract

Summary: This paper focuses on post-crisis fiscal priorities in the ASEAN-5 economies - Indonesia, Malaysia, Philippines, Singapore and Thailand. Sound economic fundamentals and timely and forceful policy responses to the crisis, including fiscal stimulus, contributed to rapid economic recovery in the ASEAN-5. As growth rebounds, these economies are beginning to identify, communicate and implement their strategies for unwinding the fiscal stimulus while addressing long-term growth challenges. In this context, the paper highlights the need for fiscal policies to address infrastructure gaps, stimulate private consumption and expand social safety nets. Creating fiscal space to address these challenges will require raising revenues and reorienting public spending rather than increasing borrowing. Supporting structural reforms, aiming to stimulate private infrastructure investment, could help address long-term growth challenges, while easing the burden on fiscal policy.

Keywords

Fiscal policy, fiscal reforms, revenue measures, government expenditures, infrastructure

URL

http://www.imf.org/external/pubs/cat/longres.cfm?sk=24343.0

Remarks

This is a nice template on how to draft a policy analysis paper, applying sound macroeconomic principles and yet very readable.

Record ID

83     [ Page 30 of 34, No. 15 ]

Date

2010-10

Author

Jaromír Baxa Roman Horváth Bořek Vašíček

Affiliation

Institute of Economic Studies, Faculty of Social Sciences, Charles University, Prague, Czech Republic Universitat Autonoma de Barcelona

Title

How Does Monetary Policy Change? Evidence on Inflation Targeting Countries

Summary /
Abstract

We examine the evolution of monetary policy rules in a group of inflation targeting countries (Australia, Canada, New Zealand, Sweden and the United Kingdom), applying a moment-based estimator in a time-varying parameter model with endogenous regressors. Using this novel flexible framework, our main findings are threefold. First, monetary policy rules change gradually, pointing to the importance of applying a time-varying estimation framework. Second, the interest rate smoothing parameter is much lower than typically reported by previous time-invariant estimates of policy rules. External factors matter for all countries, although the importance of the exchange rate diminishes after the adoption of inflation targeting. Third, the response of interest rates to inflation is particularly strong during periods when central bankers want to break a record of high inflation, such as in the UK or Australia at the beginning of the 1980s. Contrary to common wisdom, the response becomes less aggressive after the adoption of inflation targeting, suggesting a positive anchoring effect of this regime on inflation expectations. This result is supported by our finding that inflation persistence as well as the policy neutral rate typically decreased after the adoption of inflation targeting.

Keywords

Taylor rule, inflation targeting, monetary policy, time-varying parameter model, endogenous regressors

URL

http://d.repec.org/n?u=RePEc:fau:wpaper:wp2010_26&r=mon

Record ID

82     [ Page 30 of 34, No. 16 ]

Date

2010-09

Author

Martin Seneca

Affiliation

Central Bank of Iceland

Title

A DSGE model for Iceland

Summary /
Abstract

This paper presents a dynamic stochastic general equilibrium (DSGE) model for a small open economy fitted to Icelandic data. The model has been developed at the Central Bank of Iceland as a tool for policy analysis and forecasting purposes in support of inflation targeting. As the existing macroeconometric model at the Central Bank, the model is a dynamic quarterly model. But it differs by being fully founded on well-defined microeconomic decision problems of agents in the economy. This allows for a structural interpretation of shocks to the economy. The model features endogenous capital accumulation subject to investment adjustment costs, variable capacity utilisation, habit formation in consumption, monopolistic competition in goods and labour markets, as well as sticky prices and wages. The home economy engages freely in international trade, while international financial intermediation is subject to endogenous costs. Monetary policy is conducted by an inflation targeting central bank. The model is fitted to Icelandic data for the sample period 1991-2005 through a combination of calibration and formal Bayesian estimation. The paper presents the estimation results, and it discusses the model's properties. Finally, first applications are shown to illustrate the model's potential in guiding monetary policy.

Keywords

Central bank DSGE modeling, inflation targeting, monetary policy

URL

http://d.repec.org/n?u=RePEc:ice:wpaper:wp50&r=mon

Remarks

This paper should be useful to central bank monetary policy modeling using DSGE and IT frameworks, at least for comparative purposes. It is actually being used by the Central Bank of Iceland.

Record ID

81     [ Page 30 of 34, No. 17 ]

Date

2010-09

Author

Il Houng Lee and Woon Gyu Choi

Affiliation

International Monetary Fund

Title

Monetary Transmission of Global Imbalances in Asian Countries

Summary /
Abstract

The paper explores the linkages between the global and domestic monetary gaps, and estimates the effects of monetary gaps on output growth, inflation, and net saving rates using panel data for 20 Asian countries for 1980-2008. We find a significant pass-through of the global monetary gap to domestic monetary gaps, which in turn affect output growth and inflation, in individual emerging market and developing countries in Asia. Notably, we provide evidence that the global monetary condition is partly responsible for the current account surplus in Asia. We also draw implications for monetary policy coordination for global rebalancing.

Keywords

Asia , Balance of trade , Capital flows , Economic integration , Economic models , Export competitiveness , Globalization , Inflation , Monetary policy , Production growth , Reserves , Savings

URL

http://www.imf.org/external/pubs/ft/wp/2010/wp10214.pdf

Remarks

Il Houng Lee used to head Article IV IMF Consultation missions to the Philippines. He is now IMF Senior Resident Representative in China.

Record ID

80     [ Page 30 of 34, No. 18 ]

Date

2010-09

Author

Jordi Galí

Affiliation

Center for Economic Policy Research

Title

Are Central Banks' Projections Meaningful?

Summary /
Abstract

Central banks' projections--i.e. forecasts conditional on a given interest rate path-- are often criticized on the grounds that their underlying policy assumptions are inconsistent with the existence of a unique equilibrium in many forward-looking models. Here I describe three alternative approaches to constructing projections that are not subject to the above criticism, using two different versions of New Keynesian model as reference frameworks. Most importantly, I show how the three approaches generate different projections for inflation and output, even though they imply an identical path for the interest rate. The latter result calls into question the meaning and usefulness of such projections.

Keywords

conditinal forecats; constant interest rate projections; inflation targeting; interest rate path; interest rate rules; multiple equilibria

URL

http://d.repec.org/n?u=RePEc:cpr:ceprdp:8027&r=mon

Record ID

79     [ Page 30 of 34, No. 19 ]

Date

2009-03

Author

Vasco Cúrdia and Michael Woodford

Affiliation

Federal Reserve Bank of New York, Columbia University

Title

Credit frictions and optimal monetary policy

Summary /
Abstract

We extend the basic (representative-household) New Keynesian [NK] model of the monetary transmission mechanism to allow for a spread between the interest rate available to savers and borrowers, that can vary for either exogenous or endogenous reasons. We find that the mere existence of a positive average spread makes little quantitative difference for the predicted effects of particular policies. Variation in spreads over time is of greater significance, with consequences both for the equilibrium relation between the policy rate and aggregate expenditure and for the relation between real activity and inflation.
Nonetheless, we find that the target criterion - a linear relation that should be maintained between the inflation rate and changes in the output gap - that characterises optimal policy in the basic NK model continues to provide a good approximation to optimal policy, even in the presence of variations in credit spreads. We also consider a "spread-adjusted Taylor rule", in which the intercept of the Taylor rule is adjusted in proportion to changes in credit spreads. We show that while such an adjustment can improve upon an unadjusted Taylor rule, the optimal degree of adjustment is less than 100 percent; and even with the correct size of adjustment, such a rule of thumb remains inferior to the targeting rule.
This is part of a series of BIS Working Papers (273 to 278) collecting papers presented at the BIS's Seventh Annual Conference on "Whither monetary policy? Monetary policy challenges in the decade ahead" in Luzern, Switzerland, on 26-27 June 2008. The event brought together senior representatives of central banks and academic institutions to exchange views on this topic. BIS Paper 45 contains the opening address of William R White (BIS), the contributions of the policy panel on "Beyond price stability - the challenges ahead" and speeches by Edmund Phelps (Columbia University) and Martin Wolf (Financial Times). The participants in the policy panel discussion chaired by Malcolm D Knight (BIS) were Martin Feldstein (Harvard University), Stanley Fischer (Bank of Israel), Mark Carney (Bank of Canada) and Jean-Pierre Landau (Banque de France). This Working Paper includes comments by Olivier Blanchard and Charles Goodhart.

Keywords

Financial Frictions, Interest Rate Spreads

URL

http://www.bis.org/publ/work278.pdf

Record ID

78     [ Page 30 of 34, No. 20 ]

Date

2009-03

Author

Christopher A Sims

Affiliation

Princeton University, NBER

Title

Inflation expectations, uncertainty and monetary policy

Summary /
Abstract

Monetary economics as practiced by central bank modelers has made a great deal of progress in recent years. In a 2002 paper I interviewed research economists at four central banks and surveyed the models in use at those banks. I criticized the models for having lost all touch with statistical inference and with its connection to decision theory. I also criticized them for not following the rational expectations literature by jointly specifying and estimating the equations in their systems. And I pointed out that none of the models had a consistent treatment of asset markets. Since then many central banks, taking advantage of the new computational methods for Bayesian inference that economists are learning to use, have made substantial progress toward meeting the first two of these criticisms. They have still for the most part done little about the third. And academic economists are beginning to question some of the standard assumptions in the rational expectations framework that underlies these models.
Recent events in financial markets, and the difficulties that they raise for central banks, make it painfully clear that even the frontier Bayesian DSGE models like that in use at the Swedish Riksbank do not model asset markets in any depth. But the problem goes beyond that: these models, and most academic macro models as well, assume a standard rational expectations framework: there is only one probability measure in play, the "true" probability measure from which nature draws realizations. Agents in the model form expectations using this true distribution, conditioning on information sets that consist of all information in the model dated t and earlier. It is well documented that people do not actually behave this way, and in the literature on behavioral finance there is some suggestion that deviations from this standardized assumption of rational behavior given a common probability distribution may be important.
The recent events in financial markets - the dotcom boom, the US house price boom, perhaps the continuing commodity price boom - look to some observers like bubbles that must have fed off some sort of irrational behavior. Many observers think that monetary policy might have somehow fueled these bubble-like episodes in asset markets. These are important questions for monetary policy, and it is disturbing that the monetary policy models in use cannot even be used to pose these questions.
In this paper I focus on two particular, and related, deviations from the assumption that all agents have the same probability distribution and that they optimally process all information available up to some date t. I consider the implications of agents' being able to process information only at a limited rate, and the implications of agents' assuming differing probability distriubions.
This is part of a series of BIS Working Papers (273 to 278) collecting papers presented at the BIS's Seventh Annual Conference on "Whither monetary policy? Monetary policy challenges in the decade ahead" in Luzern, Switzerland, on 26-27 June 2008. The event brought together senior representatives of central banks and academic institutions to exchange views on this topic. BIS Paper 45 contains the opening address of William R White (BIS), the contributions of the policy panel on "Beyond price stability - the challenges ahead" and speeches by Edmund Phelps (Columbia University) and Martin Wolf (Financial Times). The participants in the policy panel discussion chaired by Malcolm D Knight (BIS) were Martin Feldstein (Harvard University), Stanley Fischer (Bank of Israel), Mark Carney (Bank of Canada) and Jean-Pierre Landau (Banque de France). This Working Paper includes comments by Athanasios Orphanides and Lars E O Svensson.

Keywords

Inflation Expectations, Expectations formation, Rational Inattention, Asset Prices, Monetary Policy

URL

http://www.bis.org/publ/work275.pdf