Bayoumi, Tamim, and Eswar Prasad, 1995, “Currency Unions, Economic Fluctuations and Adjustment: Some Empirical Evidence” CEPR Discussion Paper No. 1172.
Bayoumi, Tamim, and Barry Eichengreen, 1996, “Operationalizing the Theory of Optimum Currency Areas,” CEPR Discussion Paper No. 1484.
Blanchard, Olivier, and Danny Quah, 1989, “Dynamic Effects of Aggregate Demand and Supply Disturbances,” American Economic Review, Vol.79, pp. 655–673.
Clarida, Richard, Jordi Gali, and Mark Gertler, 1997, “Monetary Policy Rules in Practice: Some International Evidence,” NBER Working Paper No. 6254.
Clarida, Richard, Jordi Gali, and Mark Gertler, 1998, “Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory,” NBER Working Paper No. 6442.
Erceg, Christopher, Dale Henderson, and Andrew Levin, 1998, “Tradeoffs between Inflation and Output-Gap Variances in an Optimizing-Agent Model,” Board of Governors of the Federal Reserve System, International Finance Discussion Paper No. 627.
Frankel, Jeffrey, and Andrew Rose, 1994, “A Survey of Empirical Research on Nominal Exchange Rates,” NBER Working Paper No. 4865.
Frankel, Jeffrey, and Andrew Rose,, 1996, “The Endogeneity of the Optimum Currency Area Criteria,” CEPR Discussion Paper No. 1473.
Hansen, Niels Lynggard, 1997, “Monetary Condition Indices,” Danmarks Nationalbank Monetary Review, Vol. XXXVI, No. 1, pp. 31–43.
Kincaid, G. Russell, and others, 1997, Germany—Selected Issues, IMF Staff Country Report No. 1997/101 (Washington: International Monetary Fund).
Kongsted, Hans, and Merete Konnerup, 1998, “Structural VARs and Structural Changes—has “New Economics” Changed the way Economies Work?” Det 0konomiske Rad Working Paper No. 1998:2.
Meese, Richard, 1990, “Currency Fluctuations in the Post-Bretton Woods Era,” Journal of Economic Perspectives, No. 4, pp. 117–134.
Mundell, Robert, 1963, “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates,” Canadian Journal of Economics and Political Science, No. 29, pp. 475–485.
Ricketts, Nicholas, and David Rose, 1995, “Inflation, Learning and Monetary Policy regimes in the G-7 Economies,” Bank of Canada Working Paper No. 95-6.
Rose, Andrew, 1994, “Exchange Rate Volatility, Monetary Policy, and Capital Mobility: Empirical Evidence on the Holy Trinity,” NBER Working Paper No. 4630.
Rotemberg, Julio, and Michael Woodford, 1998a, “Interest-rate rules in an estimated sticky price model,” NBER Working Paper No. 6618.
Rotemberg, Julio, and Michael Woodford, 1998b, “An optimization-based econometric framework for the evaluation of monetary policy: Expanded version,” NBER Technical Working Paper No. 233.
Taylor, John, 1993, “Discretion Versus Policy Rules in Practice,” Carnegie-Rochester Conference Series on Public Policy, No. 39, pp. 195–214.
Taylor, John, 1998b, “The Robustness and Efficiency of Monetary Policy Rules as Guidelines for Interest Rate Setting by the European Central Bank,” Sveriger Riksbank Working Paper Series No. 58.
Prepared by Kornelia Krajnyak
For instance, participation in the EMU involves a transfer of monetary policy responsibilities from the national central bank to the ECB, which can be perceived as part of a wider process allocating various political prerogatives to supranational levels of government. Alesina and Wacziarg (1999) argue along these lines: “Firstly, European institutions have received policy attributions in practically every domain of public affairs—however limited these attributions may be… Secondly, the policies being transferred are in no way limited to those which seek to further the extent of economic integration within Europe. In fact, the list of policies with little or no economic content has grown steadily over time, and the extent of EU involvement in each of these policies has also deepened” page 26. Societies may dislike this process, which may have a substantial influence on the (essentially political) decision about entering the monetary union.
Capital controls were phased out in the early 1980s.
The cyclical sensitivity of the budget is one of the highest among the industrial countries. In addition, countercyclical discretionary policy action has often been undertaken. For example, the current recovery was “jump-started” by a modest fiscal stimulus in 1993, and the authorities have repeatedly tightened fiscal policy in 1998-99 to prevent overheating.
See for instance Taylor (1998b) or Ball (1998).
With (φ=l, inflation would be nonstationary, In this case, the economy described by equations (1)-(3) can stay non-explosive only if the monetary policy response to inflation is aggressive enough. In this case, if a structurally similar other country “borrowed” this monetary policy, and was hit by stochastic shocks not perfectly correlated with the disturbances of the anchor country, it would become explosive with probability one. In a richer model, where real interest rates are linked to the marginal product of capital and thus to capital accumulation and reallocation, this outcome could be avoided.
Assuming that the shocks are realized after the policymaker sets interest rates for period t, lagged output and lagged inflation are sufficient statistics for the state of the economy, and an appropriately parametrized lagged Taylor rule and non-lagged Taylor rule will be equally efficient in stabilizing the economy.
The real exchange rate is based on the GDP deflator.
Trend wage growth in the small country and trend inflation in the large country are assumed to be the same.
Denmark pegs its currency to the euro with a 2.25 percent band. For simplicity, nominal exchange rate movements within the band are abstracted away, and it is assumed that the “outsider” arrangement involves strictly fixing the exchange rate to the large country’s currency.
This parameter (the income elasticity of imports) is necessary only for auxiliary calculations and does not appear in the equations.
Kincaid and others (1997), Chapter I, “Labor Market Asymmetries and Macroeconomic Adjustment.”
The lagged inflation term in the ADAM wage adjustment equation corresponds to the average of inflation over the previous two years, which is conceptually equivalent to a one year lag.
In ADAM, a 1 percentage point increase in the actual unemployment rate is estimated to decrease wage growth by 0.8 percentage points, regardless of the structural unemployment rate. As all variables are assumed to be detrended in the model, this estimate cannot be directly used.
In general, the credibility of the peg would also depend on policy response to the real appreciation. Since monetary/exchange rate policy is the only instrument in the model, this consideration does not enter in the specification.
It is assumed that “credibility costs” are inherently asymmetric in the sense that while an appreciated real exchange rate leads to an increase in the risk premium, a depreciated real exchange rate does not trigger a matching decline. It should also be noted that the real exchange rate is supposed to be appreciated if its value falls below the threshold 0.83. The rationale for this is that in full deterministic equilibrium, the effect of a permanently higher real interest rate on output in the “outsider” country would be offset by a slightly depreciated real exchange rate. Correspondingly, the “outsider” country would run a small current account surplus. Thus, the choice of exchange rate regime is not neutral for the composition of aggregate demand in the model.
It is frequently assumed in the literature, cf. Taylor (1998b) or Ball (1998) that inflation (or supply) shocks are permanent, in line with Blanchard and Quah (1989). Other models, for example Erceg, Henderson and Levin (1998) or Christiano and Gust (1999), examine monetary rules under the assumption of less than fully persistent supply shocks. In addition, Ricketts and Rose (1995) find empirical evidence in the G-7 countries which indicates that inflation is mean-reverting in low inflation regimes. Here, it is assumed that all shocks, including supply shocks are temporary, which is consistent with the latter strand of theoretical models, and the evidence presented by Ricketts and Rose.
For example, the correlation coefficient is -0.44 for the 1980-1998 period.
See for instance Bayoumi and Eichengreen (1992) and (1996), Bayoumi and Prasad (1995) Fatas (1997), Kongsted and Konnerup (1998), OECD (1999). Although it could be argued that the correlation of shocks is bound to change after entry to the currency union, cf Frankel and Rose (1996), this possibility is not considered in the baseline.
An econometrician who, after observing the behavior of the two model economies, successfully recovers output shocks in the two countries, would however conclude that the shocks are positively correlated with a correlation coefficient slightly below 0.2. The reason is that the model separates the effect of the large country’s shock on the small country’s output from the “true” output shock in the small country by explicitly considering trade links, while the econometrician would not make this distinction.
Another crucial assumption is no difference in domestic and foreign trend inflation. This assumption is not relaxed. Although it would be formally possible, it would not fit the logic of the argument applied in building and calibrating the model in Section B.
In particular, the shock is assumed to be uniformly distributed over the [-0.5, 4.5] interval.