The form of bounded rationality characterizing the representative agent is key in the choice of the optimal monetary policy regime. While inflation targeting prevails for myopia that distorts agents' inflation expectations, price level targeting emerges as the optimal policy under myopia regarding the output gap, revenue, or interest rate. To the extent that bygones are not bygones under price level targeting, rational inflation expectations is a minimal condition for optimality in a behavioral world. Instrument rules implementation of this optimal policy is shown to be infeasible, questioning the ability of simple rules à la Taylor (1993) to assist the conduct of monetary policy. Bounded rationality is not necessarily associated with welfare losses.
This paper considers the problem of jointly decomposing a set of time series variables
into cyclical and trend components, subject to sets of stochastic linear restrictions
among these cyclical and trend components. We derive a closed form solution to an
ordinary problem featuring homogeneous penalty term difference orders and static
restrictions, as well as to a generalized problem featuring heterogeneous penalty term
difference orders and dynamic restrictions. We use our Generalized Multivariate Linear
Filter to jointly estimate potential output, the natural rate of unemployment and the
natural rate of interest, conditional on selected equilibrium conditions from a calibrated
New Keynesian model.
Zineddine Alla, Mr. Raphael A Espinoza, and Mr. Atish R. Ghosh
This paper analyzes the use of unconventional policy instruments in New Keynesian setups in which the ‘divine coincidence’ breaks down. The paper discusses the role of a second instrument and its coordination with conventional interest rate policy, and presents theoretical results on equilibrium determinacy, the inflation bias, the stabilization bias, and the optimal central banker’s preferences when both instruments are available. We show that the use of an unconventional instrument can help reduce the zone of equilibrium indeterminacy and the volatility of the economy. However, in some circumstances, committing not to use the second instrument may be welfare improving (a result akin to Rogoff (1985a) example of counterproductive coordination). We further show that the optimal central banker should be both aggressive against inflation, and interventionist in using the unconventional policy instrument. As long as price setting depends on expectations about the future, there are gains from establishing credibility by using any instrument that affects these expectations.
Ms. Bergljot B Barkbu, Pelin Berkmen, Pavel Lukyantsau, Mr. Sergejs Saksonovs, and Hanni Schoelermann
Investment across the euro area remains below its pre-crisis level. Its performance has been weaker than in most previous recessions and financial crises. This paper shows that a part of this weakness can be explained by output dynamics, particularly before the European sovereign debt crisis. The rest is explained by a high cost of capital, financial constraints, corporate leverage, and uncertainty. There is a considerable cross country heterogeneity in terms of both investment dymanics and its determinants. Based on the findings of this paper, investment is expected to pick up as the recovery strengthens and uncertainty declines, but persistent financial fragmentation and high corporate leverage in some countries will likely continue to weigh on investment.
We propose a method for solving and estimating linear rational expectations models that exhibit indeterminacy and we provide step-by-step guidelines for implementing this method in the Matlab-based packages Dynare and Gensys. Our method redefines a subset of expectational errors as new fundamentals. This redefinition allows us to treat indeterminate models as determinate and to apply standard solution algorithms. We provide a selection method, based on Bayesian model comparison, to decide which errors to pick as fundamental and we present simulation results to show how our procedure works in practice.
The simulated results of this paper show that New Keynesian DSGE models with capital accumulation can generate substantial persistencies in the dynamics of the main economic variables, due to the stock nature of capital. Empirical estimates on U.S. data from 1960:I to 2008:I show the response of monetary policy to inflation was almost twice lower than traditionally considered, as capital accumulation creates an additional channel of influence through real interest rates in the production sector. Versions of the model with indeterminacy empirically outperform determinate versions. This paper allows for the reconsideration of previous findings and has significant monetary policy implications.
Mr. Alin T Mirestean and Mr. Charalambos G Tsangarides
There has been a vast literature of cross-country studies of economic growth, but the mechanics of growth and development are still not fully understood. The lack of an explicit theory identifying growth determinants has recently prompted researchers to start investigating how robust the various possible empirical relations are by formally incorporating model uncertainty in the empirical growth analysis. This article surveys the latest research related to investigating growth empirics using robustness analysis.
Climate Change: Stimulating a Green Recovery” looks at the global problem of climate change. With the world apparently on an economic recovery path, policymakers are looking at ways to limit the impact of climate change through broad international action. One of the challenges is to balance actions to mitigate climate change with measures to stimulate growth and prosperity. This issue of F&D also examines a variety of issues raised by the crisis—including the future of macroeconomics, explored by William White, former chief economist at the Bank for International Settlements, and the longer-term impact of the crisis on the United States, the world’s largest economy. Our “People in Economics” profile spotlights Joseph Stiglitz, the Nobel Laureate who “can’t get any respect at home.” We also look at the need for rebalancing growth in Asia, which is leading the world out of recession, and we interview five influential Asians on the region’s fragile rebound. We turn our “Straight Talk” column over to Barbara Stocking of Oxfam, who makes a forceful case for stepping up help to the most vulnerable around the world. “Data Spotlight” looks at trends in inflation, which has fallen into negative territory in some countries during the crisis, and in “Point-Counterpoint,” two experts discuss the pros and cons of remittances—funds repatriated by migrant workers to family and friends back home. “Back to Basics” gives a primer on international trade.
We use a mean-adjusted Bayesian VAR model as an out-of-sample forecasting tool to test whether money growth Granger-causes inflation in the euro area. Based on data from 1970 to 2006 and forecasting horizons of up to 12 quarters, there is surprisingly strong evidence that including money improves forecasting accuracy. The results are very robust with regard to alternative treatments of priors and sample periods. That said, there is also reason not to overemphasize the role of money. The predictive power of money growth for inflation is substantially lower in more recent sample periods compared to the 1970s and 1980s. This cautions against using money-based inflation models anchored in very long samples for policy advice.
International Monetary Fund. External Relations Dept.
As in several other industrial countries, inflation in the United States has been low since the mid-1990s despite generally robust economic growth and—especially in recent years—substantial increases in the prices of oil and other primary commodities. A new IMF Working Paper investigates this apparent puzzle by decomposing changes in U.S. inflation into their structural (or long-run) and cyclical components and focusing on the roles that improved monetary policy credibility and globalization have played.