Central bank independence: the key to price stability?

Low inflation over long periods is the sign of an effective central bank. The authors suggest that a large fraction of the worldwide decline in inflation since the early 1980s results from an international movement toward more independent central banks.Banks and banking, Central ; Inflation (Finance)

Thinking about monetary policy without money: a review of three books: Inflation Targeting, Monetary Theory and Policy, and Interest and Prices

This paper reviews three recent books. Two books, one by Carl Walsh and one by Michael Woodford, focus on the development of monetary theory. In contrast, the third book is a collection of papers in an NBER volume on inflation targeting. This volume outlines some of the issues that arise when applying the tools described by Walsh and Woodford to the policy goal of targeting inflation rates. A central theme of all three works is the desirability of abstracting from money demand in the analysis of monetary policy. In our review we focus the bulk of our discussion on the absence of money in these models.Monetary policy ; Money

Oil prices, monetary policy, and the macroeconomy

Every U.S. recession since 1971 has been preceded by two things: an oil price shock and an increase in the federal funds rate. Bernanke, Gertler, and Watson (1997,2004) investigated how much oil price shocks have contributed to output growth by asking the following counterfactual question: Empirically how much would we expect oil price increases to have contributed to output growth if the Fed had kept the rate constant instead of letting it increase? They concluded that, at most, half of the observed output declines can be attributed to oil price increases. Most were actually caused by funds rate increases. A problem with their empirical analysis, however, is that it implicitly assumes that the Fed can continually “fool” the public. That is, the funds rate is led constant even though the public actually expects the Fed to follow its historical policy rule of raising the funds rate in conjunction with oil price increases. We show that if the new policy rule were anticipated oil price increases would have had a much larger impact on output than suggested by Bernanke, Gertler, and Watson’s analysis.Petroleum products - Prices ; Monetary policy

Investment and interest rate policy: a discrete time analysis

This paper analyzes the restrictions necessary to ensure that the interest rate policy rule used by the central bank does not introduce local real indeterminacy into the economy. It conducts the analysis in a Calvo-style sticky price model. A key innovation is to add investment spending to the analysis. In this environment, local real indeterminacy is much more likely. In particular, all forward-looking interest rate rules are subject to real indeterminacy.Interest rates ; Monetary policy ; Banks and banking, Central

Monetary policy and asset prices with imperfect credit markets

The Modigliani-Miller theorem is fundamental to the theory of corporate finance. One of the theorem's immediate implications is that there is no reason for the monetary authority to respond to asset prices. This article posits a world in which the Modigliani-Miller theorem does not hold. The authors assume that the amount of an entrepreneur's external financing is limited by the amount of collateral she holds. They examine the implications for the monetary authority in such an environment.Monetary policy

Co-movement in sticky price models with durable goods

In an interesting paper Barsky, House, and Kimball (2005) demonstrate that in a standard sticky price model a monetary contraction will lead to a decline in nondurable goods production but an increase in durable goods production, so that aggregate output is little changed. This lack of co-movement between nondurables and durables is wildly at odds with the data and occurs because, by assumption, durable goods prices are relatively more flexible than nondurable goods prices. We investigate possible solutions to this puzzle: nominal wage stickiness and credit constraints. We demonstrate that by adding adjustment costs as in Topel-Rosen, the sticky wage model solves the co-movement puzzle and delivers reasonable volatilities.Durable goods, Consumer

Optimal monetary policy in a small, open economy: a general-equilibrium analysis

This paper uses a model of a small, open economy to address two monetary policy issues: 1) What restrictions on the policy rule ensure that the central bank does not introduce real indeterminacy into the economy? and 2) What is the optimal long-run rate of inflation? The model's simplicity makes analyzing determinacy issues remarkably transparent. As for long-run inflation rates, a small, open economy takes the foreign nominal interest rate as a given. To the extent that this rate distorts domestic behavior, positive domestic nominal rates (in contrast to Friedman's celebrated optimum quantity of money) play a role.Monetary policy ; Inflation (Finance)

Expected inflation and TIPS

When inflation-indexed Treasury securities were first introduced, economists hoped that they could be used to measure expected inflation easily. The only difference between securities that were indexed to inflation and those that were not was thought to be the extra compensation regular securities had to pay for what the market thought inflation would be. By now it is pretty clear that inflation-indexed Treasuries differ from regular securities in other ways that show up in the yields. This Commentary suggests what these are and discusses a method of correcting for them.Government securities ; Inflation-indexed bonds

The benefits of interest rate targeting: a partial and a general equilibrium analysis

An argument that an interest rate peg is desirable because it mitigates the distortions that arise in a monetary economy, and that money growth should be procyclical in order to achieve the interest rate peg.Interest rates ; Monetary policy

Monetary policy and self-fulfilling expectations: the danger of forecasts

What rule should a central bank interested in inflation stability follow? Because monetary policy tends to work with lags, it is tempting to use inflation forecasts to generate policy advice. This article, however, suggests that the use of forecasts to drive policy is potentially destabilizing. The problem with forecast-based policy is that the economy becomes vulnerable to what economists term “sunspot” fluctuations. These welfare-reducing fluctuations can be avoided by using a policy that puts greater weight on past, realized inflation rates rather than forecasted, future rates.Monetary policy ; Inflation (Finance) ; Forecasting