Robust Control and Persistence in the New Keynesian Economy

Since Keynes no economist would deny that expectations under uncer- tain conditions matter for the conduct of monetary policy, but still opin- ions about their formation are diverse. We build a hybrid New Keynesian Framework to analyze the influence of model uncertainty on optimal in- terest rates under di¤erent degrees of rational forward-looking behavior, using recently developed robust control techniques. Impulse response functions illustrate that uncertainty seems to be a rationale for more aggressive interest rate reactions, but also suggest that the degree of forward-looking behavior seems to be more important than an appro- priate fear about the misspecification of a given model. Furthermore, we argue that assuming to control inflation through expectations is a policy on the razor's edge, since robust expectations overestimate shock impacts. This questions the gains from commitment under uncertainty.Robust Control, Knightian Uncertainty, Monetary Policy, Forward-Looking Expectations, Model Uncertainty.

Monetary Policy Shocks in a Tri-Polar Model of Foreign Exchange

This paper investigates effects of third-currency monetary policy shocks on exchange rates. For this purpose we setup a structural VAR model containing the exchange rates of the three major currencies – the U.S. dollar, the euro and the Japanese yen – and short-term interest rates on the three currencies. In addition, we include the medium-term interest rates and price levels as control variables. Long-run restrictions in accord with tested hypotheses and the existing literature are used to identify the structural VAR. The impulse response analysis of the co- integrated VAR reveals that third-currency monetary policy shocks not only significantly impact on the considered exchange rates but their impacts are comparable to those of MP shocks associated with the quoted currencies in terms of their magnitude.Exchange Rates, Currency Substitution, Third-Currency Effects, SVAR

Were Fed’s active monetary policy actions necessary?

This work applies the two-stage Factor Augmented Vector Autoregression (FAVAR) developed by Bernanke, Boivin and Eliasz (2005) to investigate the appropriateness of frequent monetary policy actions that involve frequent adjustments of the policy interest rate in a prolonged manner. From time to time there are claims that the Federal Reverse Bank cut or raised the fed funds rate too frequently. This raises the concern that the Federal Reserve Bank mistakenly cut interest rate for too long and too frequently and then paused too short and raised rate again to “undo” the previous unnecessary interest rate cut or vice versa. To verify if such a claim is valid, we generate hypothetical scenarios assuming that the Federal Reserve Bank had shortened the time period of active monetary policies and lengthened the period of a pause. Then, we compare economic activities implied by impulse response functions from hypothetical scenarios with those generated from actual fed policies under the record of Alan Greenspan (1987-2006). We find that a less active monetary policy approach could control inflation with less negative impact on real economic activities, and major economic variables would be less volatile in a 48-month horizon. The investigation provides insights on the implementation of monetary policies not only for the U.S., but also for all central banks that control interest rates as their major monetary policy tool.Fed; monetary policy; Factor Model; Factor Augmented VAR; FAVAR

Brazilian Strategy for Managing the Risk of Foreign Exchange Rate Exposure During a Crisis

Even in a floating foreign exchange rate regime, monetary authorities sometimes intervene in the currency market due to liquidity demand and foreign exchange crises. Typically, central banks intervene using foreign currency trades and/or by changing domestic interest rates. We discuss this framework in the context of an optimal impulse stochastic control model. The control and performance equations include interventions with swap operations in the domestic market, since the Central Bank of Brazil also uses these operations. We evaluate risk management strategies for central bank interventions in case of crisis based on the model. We conclude that the Brazilian risk management strategy of increasing holdings of international reserves and decreasing short foreign exchange rate exposure in domestic public debt after 2004 gave the country more flexibility to manage foreign exchange rate risk in 2008 and to avoid higher interest rates to attract international capital as was necessary in previous crises.

Monetary Transmission Mechanism In An Open Economy Framework: The Case Of Turkey

Monetary transmission mechanism (MTM) is an illuminating policy tool in appreciating the monetary policy implementations by policy makers upon various nominal and real factors of interest in the eyes of economic agents. Especially in an open economy such as Turkish economy highly exposed to the effects of capital flows on domestic business cycles with a liberalised capital account, control over policy aggregates may be difficult since many other economic policy implementations would be of great consequence on some other policy targets on macroeconomic income generation process and in providing price stability and external balance. In this respect, in our paper we aim to estimate the MTM for the Turkish economy. Our ex-post estimates for the period 1992-2004 using contemporaneous vector autoregression models such as impulse response analysis indicate that weakly exogeneous capital inflows appreciate the real effective exchange rate, and in turn lower the real interest rates and domestic inflation while increasing both the real output growth and also the stock exchange index considering an asset-price channel for the latter and vice versa. We find some significant effects of the courses of capital flows and real effective exchange rate on monetary policy variable in the transmission mechanism, and such a case may impose an endogeneous characteristic on the policy variable given also that both domestic real interest structure is highly sensible to the monetary policy and that monetary policy is subject to the structural breaks in the sense of so-called Lucas’ critique of contemporaneous economics.Monetary Transmission Mechanism, Turkish Economy, Capital Flows, Real Exchange Rate, Real Interest Rate, Inflation, Income Growth, Stock Exchange, Price Puzzle

Common risk factors in the US and UK interest swap markets-evidence from a non-linear vector autoregression approach

This paper produces evidence in support of the existence of common risk factors in the US and UK interest rate swap markets. Using a multivariate smooth transition autoregression (STVAR) framework, we show that the dynamics of the US and UK swap spreads are best described by a regime-switching model. We identify the existence of two distinct regimes in US and UK swap spreads; one characterized by a "flat" term structure of US interest rates and the other characterized by an "upward" slopping US term structure. In addition, we show that there exist significant asymmetries on the impact of the common risk factors on the US and UK swap spreads. Shocks to UK oriented risk factors have a strong effect on the US swap markets during the "flat" slope regime but a very limited effect otherwise. On the other hand, US risk factors have a significant impact on the UK swap markets in both regimes. Despite their added flexibility, the STVAR models do not consistently produce superior forecasts compared to less sophisticated autoregressive (AR) and vector autoregressive (VAR) models

Frequency-Domain Analysis of Linear Time-Periodic Systems

In this paper, we study convergence of truncated representations of the frequency-response operator of a linear time-periodic system. The frequency-response operator is frequently called the harmonic transfer function. We introduce the concepts of input, output, and skew roll-off. These concepts are related to the decay rates of elements in the harmonic transfer function. A system with high input and output roll-off may be well approximated by a low-dimensional matrix function. A system with high skew roll-off may be represented by an operator with only few diagonals. Furthermore, the roll-off rates are shown to be determined by certain properties of Taylor and Fourier expansions of the periodic systems. Finally, we clarify the connections between the different methods for computing the harmonic transfer function that are suggested in the literature

Cross-country evidence on the relation between equity prices and the current account

This paper explores the relationship between equity prices and the current account for 17 industrialized countries in the period 1980-2007. Based on a panel vector autoregression, I compare the effects of equity price shocks to those originating from monetary policy and exchange rates. While monetary policy shocks have a limited impact, shocks to equity prices have sizeable effects. The results suggest that equity prices impact on the current account through their effects on real activity and exchange rates. Furthermore, shocks to exchange rates play a key role as well. Keywords: current account fluctuations, equity prices, panel vector autoregressio

The Effect of Fiscal Policy in Indonesia: Structural VAR Analysis

This paper is an attempt to investigate the effect of fiscal policy on output in Indonesia using Structural Vector Autoregression (SVAR) methodology for the period 1983:1 � 2010:1. We use contemporaneous restriction and follow Blanchard and Perotti (1999) technique to identify structural fiscal policy shocks in Indonesia. The estimation results show that the government spending shocks are found to have relatively small (though positive) but insignificant effect on output. Moreover, the spending composition matters as government investment gives better impact on output than government consumption. In this study, we investigate also the effect of fiscal policy on GDP component in term of private component and private investment. The results also show similar story with the aggregate level in which give positive sign but insignificant on both components. Overall, the findings indicate the less potent fiscal policy to stimulate output while putting upward pressure on nominal interest rate

Permanent and transitory policy shocks in an empirical macro model with asymmetric information

Despite a large literature documenting that the efficacy of monetary policy depends on how inflation expectations are anchored, many monetary policy models assume: (1) the inflation target of monetary policy is constant; and, (2) the inflation target is known by all economic agents. This paper proposes an empirical specification with two policy shocks: permanent changes to the inflation target and transitory perturbations of the short-term real rate. The public sector cannot correctly distinguish between these two shocks and, under incomplete learning, private perceptions of the inflation target will not equal the true target. The paper shows how imperfect policy credibility can affect economic responses to structural shocks, including transition to a new inflation target - a question that cannot be addressed by many commonly used empirical and theoretical models. In contrast to models where all monetary policy actions are transient, the proposed specification implies that sizable movements in historical bond yields and inflation are attributable to perceptions of permanent shocks in target inflation