The Greek financial crisis: growing imbalances and sovereign spreads

We discuss the origins of the Greek financial crisis as manifested in the growing fiscal and current-account deficits since euro-area entry in 2001. We then provide an investigation of spreads on Greek relative to German long-term government debt. Using monthly data over the period 2000 to 2010, we estimate a cointegrating relationship between spreads and their long-term fundamental determinants, and compare the spreads predicted by this estimated relationship with actual spreads. We find periods of both undershooting and overshooting of spreads compared to what is predicted by the economic fundamentals.Greek financial crisis; sovereign spreads

The New Keynesian Phillips Curve and Lagged Inflation: A Case of Spurious Correlation?

The New Keynesian Phillips Curve (NKPC) specifies a relationship between inflation and a forcing variable and the current period’s expectation of future inflation. Most empirical estimates of the NKPC, typically based on Generalized Method of Moments (GMM) estimation, have found a significant role for lagged inflation, producing a “hybrid” NKPC. Using U.S. quarterly data, this paper examines whether the role of lagged inflation in the NKPC might be due to the spurious outcome of specification biases. Like previous investigators, we employ GMM estimation and, like those investigators, we find a significant effect for lagged inflation. We also use time varying-coefficient (TVC) estimation, a procedure that allows us to directly confront specification biases and spurious relationships. Using three separate measures of expected inflation, we find strong support for the view that, under TVC estimation, the coefficient on expected inflation is near unity and that the role of lagged inflation in the NKPC is spurious.New Keynesian Phillips Curve; time-varying coefficients; spurious relationships

Estimation of Parameters in the Presence of Model misspecification and Measurement Error

Misspecifications of econometric models can lead to biased coefficients and error terms, which in turn can lead to incorrect inference and incorrect models. There are specific techniques such as instrumental variables which attempt to deal with some individual forms of model misspecification. However these can typically only address one problem at a time. This paper proposes a general method for estimating underlying parameters in the presence of a range of unknown model misspecifications. It is argued that this method can consistently estimate the direct effect of an independent variable on a dependent variable with all of its other determinants held constant even in the presence of a misspecified functional form, measurement error and omitted variables.Misspecified model; Correct interpretation of coefficients; Appropriate assumption; Time-varying coefficient model; Coefficient driver

A Portfolio Balance Approach to Euro-Area Money Demand in a Time-Varying Environment

As part of its monetary policy strategy, the European Central Bank has formulated a reference value for M3 growth. A pre-requisite for the use of a reference value for M3 growth is the existence of a stable demand function for that aggregate. However, a large empirical literature has emerged showing that, beginning in 2001, essentially all euro area M3 demand functions have exhibited instability. This paper argues that a proper understanding of the determination of money requires a portfolio analysis where the demand for broad money is seen as just one element in the wealth portfolio. Under this framework, wealth is the variable that constitutes the total budget constraint on the holdings of assets, including money, and changes in equity prices are a key transmission channel of monetary policy. Understanding money behaviour thus requires good data on euro area wealth which at present do not exist. Our basic premise is that there is a stable demand-for-money function but that the models that have been used until now to estimate euro area money-demand are not well-specified because they do not include a measure of wealth. Using two empirical methodologies - - a co-integrated vector equilibrium correction (VEC) approach and a time-varying coefficient (TVC) approach - - we find that a demand-for-money function that includes wealth is stable. The upshot of our findings is that M3 behaviour continues to provide useful information about medium-term developments on inflation.Money demand; VEC, time varying coefficient estimation; Euro area

Milton Friedman, the demand for money, and the ECB’s monetary policy strategy

The European Central Bank (ECB) assigns greater weight to the role of money in its monetary policy strategy than most, if not all, other major central banks. Nevertheless, reflecting the view that the demand for money became unstable in the early 2000s, some commentators have reported that the ECB has “downgraded” the role of money demand functions in its strategy. This paper explains the ECB’s monetary policy strategy and shows the considerable influence of Milton Friedman’s contributions on the formulation of that strategy. The paper also provides new evidence on the stability of euro area money demand. Following a conjecture made by Friedman (1956), the authors assign a role to uncertainty in the money demand function. They find that although uncertainty is nonstationary and subject to wide swings, it is nonetheless mean reverting and has substantial effects on the demand for money.https://research.stlouisfed.org/publications/reviewam2017Economic

Is the relationship between prices and exchange rates homogeneous?

Empirical tests of purchasing power parity (PPP) are implicitly based on the conditions of symmetry and proportionality of the price coefficients. We investigate a separate condition, which we term homogeneity. Specifically, while there may be factors that drive a wedge between prices and exchange rates, when these factors are held constant we would expect a change in exchange rates to be associated with a proportional, or homogeneous, change in prices. To test for the existence of homogeneity in prices, we conduct two experiments. First, we apply a time-varying-coefficient procedure to nine euro-area countries as well as the euro area as a whole during the (monthly) sample period, 1999:M1 to 2011:M3. Second we apply the same procedure to the same group of countries, plus Canada, Japan and Mexico, over the longer period, 1957:M4 to 2011:M3. We find that averages of the price coefficients, corrected for specification biases, are uniformly homogeneous in the long run, providing strong support for PPP

A suggestion for a dynamic multi factor model (DMFM)

We provide a new way of deriving a number of dynamic unobserved factors from a set of variables. We show how standard principal components may be expressed in state space form and estimated using the Kalman filter. To illustrate our procedure, we perform two exercises. First, we use it to estimate a measure of the current account imbalances among northern and southern euro area countries that developed during the period leading up to the outbreak of the euro area crisis, before looking at adjustment in the post-crisis period. Second, we show how these dynamic factors can improve forecasting of the euro exchange rate.https://www.cambridge.org/core/journals/macroeconomic-dynamicshj2023Economic

The effect of emergency liquidity assistance (ELA) on bank lending during the euro area crisis

We examine the impact of emergency liquidity assistance (ELA) on bank lending in eleven euro area countries during the financial crisis. With the intensification of the crisis, ELA took on a pivotal role in some countries. However, assessments of the quantitative impact of ELA in the literature are non-existent. We estimate a structural panel model for the determination of bank lending, which includes the amount of ELA received by each bank, allowing us to investigate the direct effect of ELA on lending. Our model corrects a mis-specification found in the prototype model used in the literature. We then undertake a VAR analysis, which allows us to address the effect of ELA on GDP. Finally, we examine spillover effects among banks, indicating that ELA generated positive spillovers to other banks.http://www.elsevier.com/locate/jimf2021-02-12hj2020Economic