A Segmented Markets Model of Inflation

Models of inflation usually have monetary policy impacting the economy through either an interest rate or a monetary/credit quantity channel but not through both. We argue that policy is transmitted via two distinct types of agents – those that are and that are not liquidity constrained. The implication is that both channels must be seen as complementary, joint indicators of inflation and must both be incorporated in models of inflation. We provide a formal representation of price level determination and behaviour in this segmented markets framework and evaluate it econometrically using US data. Length: 32 pages

Liquidity-Driven Risks to Large Valued Payments

During particularly stressed financial or macroeconomic circumstances, banks’ access to liquidity can become severely restricted. The recent financial crisis demonstrated this phenomenon all too plainly, when, in a climate of fear and uncertainty, both the interbank and international money markets ceased to function in a meaningful manner. Liquidity shortages can potentially create problems for a bank’s ability to meet its outward intraday payments obligations on the TARGET2 real-time gross settlement system. Such a situation not only has negative implications for the respective bank but could also produce contagion effects for the TARGET2 system as a whole. In order to provide increased clarity regarding liquidity driven risks to large value payment systems, the Central Bank of Ireland has developed a ‘liquidity buffer’ indicator for the domestic credit institutions. The initial focus of this project centred primarily upon the development of an ‘early warning’ system, capable of identifying TARGET2 liquidity issues as they occurred in real time. However, during the development of such a platform, the analysis has also presented a means from which it is possible to derive a proxy for the level of risk banks detect in their environment. The analysis undertaken reveals that the Reserve Requirement (RR) plays an important role in how banks formulate their liquidity management strategies throughout the maintenance period. In times of increased uncertainty banks appear willing to hold excess liquidity, at a greater expense, in order to be guaranteed access to liquidity towards the latter half of the maintenance period. In a similar fashion, during a period of stability or relative certainty, banks do not choose to maintain excess liquidity on the TARGET2 platform, implying a degree of increased confidence in accessing liquidity when they require it later in the maintenance period. In this sense we can, to some degree, infer the degree of risk a bank perceives to be present in its immediate environment, by examining the respective institutions’ liquidity management strategy over the maintenance period. In a broader fashion, the indicator also serves as a tool from which the Central Bank of Ireland can monitor banks’ liquidity position with increased precision.

The Real Interest Rate Spread as a Monetary Policy Indicator

This paper employs a consumption-based capital asset pricing model to derive the generalised Fisher equation, in order to estimate the natural rate of interest and corresponding real interest rate spread for the US. Analysis reveals not only is the estimated real interest rate spread a useful measure of the degree of looseness/tightness in the Federal Reserve’s monetary policy stance, but also the variable contributes substantially to an understanding of the evolution of US inflation over the period 1960-2005.

Central Bank Credibility and Income Velocity in a Monetary Union

The income velocity of circulation has been subject to a trend decline in all the member states of the European Monetary Union since its inception. In this paper, we propose an explanation for this in terms of a measure of the ECB’s inflation fighting credibility. This credibility gain variable, which is derived in this paper, is based on the ECB’s performance in maintaining price stability relative to the respective member states’ inflation experiences from the legacy monetaryinflation regimes of the past. Our empirical analysis reveals that this credibility gain variable has a highly significant and sizeable impact on income velocity in member states. On average across member states, a one per cent increase in credibility gain, according to our measure, leads to a decreace in income velocity of half a per cent. The model and results presented suggest that the ECB should, in formulating the second pillar of its monetary policy strategy, factor in its own price stability credibility. Our results also imply that, if inflation fighting credibility is lost temporarily, it is hugely important to re-establish it as soon as possible.

Money and uncertainty in democratised financial markets

Developments in broad money since the start of the new millennium cannot be explained by the traditional determinants of money demand, namely, income, prices and portfolio effects. Households’ direct and indirect participation in financial markets have led to the widespread democratisation of these markets in the US since the 1970’s. In the pre-democratised era, an increase in uncertainty would have resulted in a fall in the transactions demand for money due to pessimism regarding income and employment prospects. When markets become more democratised, the precautionary, or store-of-value function of money dominates the transactions demand in which case an increase in uncertainty results in a net increase in the demand for money. Our Kalman Filter estimates are consistent with this theory. The money-uncertainty coefficient has been subject to an increasing trend over the whole sample period shifting gradually from significantly negative values up to the mid-to-late-1990s before becoming significantly positive by the early years of the new millennium. There are important repercussions from these new behavioural patterns for both monetary and financial stability which are discussed in this paper.

Commodity prices, money and inflation

The influence of commodity prices on consumer prices is usually seen as originating in commodity markets. We argue, however, that long run and short run relationships should exist between commodity prices, consumer prices and money and that the influence of commodity prices on consumer prices occurs through a money-driven overshooting of commodity prices being corrected over time. Using a cointegrating VAR framework and US data, our empirical findings are supportive of these relationships, with both commodity and consumer prices proportional to the money supply in the long run, commodity prices initially overshooting their new equilibrium values in response to a money supply shock, and the deviation of commodity prices from their equilibrium values having explanatory power for subsequent consumer price inflation. JEL Classification: E310, E510, E520impulse response analysis, overshooting, VECM

A Monetary Perspective on the Relationship between Commodity and Consumer Prices

This article argues that long run monetary determination of both commodity and consumer prices may help explain US CPI and commodity price index data since the early 2000s.

Commodity Prices, Money and Inflation

The influence of commodity prices on consumer prices is usually seen as originating in commodity markets. We argue, however, that long run and short run relationships should exist between commodity prices, consumer prices and money and that the influence of commodity prices on consumer prices occurs through a money-driven overshooting of commodity prices being corrected over time. Using a cointegrating VAR framework and US data, our empirical findings are supportive of these relationships, with both commodity and consumer prices proportional to the money supply in the long run, commodity prices initially overshooting their new equilibrium values in response to a money supply shock, and the deviation of commodity prices from their equilibrium values having explanatory power for subsequent consumer price inflation.

Addressing Puzzles in Monetary Dynamics

This paper discusses some of the puzzles associated with monetary dynamics and proposes possible explanations, primarily the democratisation of financial markets and sounder money.