Monetary policy and exchange rate interactions in a small open economy

This paper analyses the transmission mechanisms of monetary policy in a small open economy like Norway through structural VARs, paying particular attention to the interdependence between the monetary policy stance and exchange rate movements in the inflation-targeting period. Previous studies of the effects of monetary policy in open economies have typically found small or puzzling effects on the exchange rate; puzzles that may arise due to the recursive restrictions imposed on the contemporaneous interaction between monetary policy and the exchange rate. By instead imposing a long-run neutrality restriction on the real exchange rate, thereby allowing the interest rate and the exchange rate to react simultaneously to any news, the interdependence increases considerably. In particular, following a contractionary monetary policy shock, the real exchange rate appreciates immediately and thereafter depreciates back to baseline. Furthermore, output and consumer price inflation fall gradually as expected; thereby also ruling out any price puzzle that has commonly been found in the literature. Results are compared and found to be consistent with among other the findings from an “event study” that focuses on immediate responses in asset prices following a surprise monetary policy decision.VAR, monetary policy, open economy, identification, event study

Monetary policy and the illusionary exchange rate puzzle

Dornbusch’s exchange rate overshooting hypothesis is a central building block in international macroeconomics. Yet, empirical studies of monetary policy have typically found exchange rate effects that are inconsistent with overshooting. This puzzling result has developed into a “styled facts” to be reckoned with in policy modelling. However, many of these studies, in particular those using VARs, have disregarded the strong contemporaneous interaction between monetary policy and exchange rate movements by placing zero restriction on them. By instead imposing a long-run neutrality restriction on the real exchange, thereby allowing the interest rate and the exchange rate to react simultaneously to any news, I find that the puzzles disappear. In particular, a contractionary monetary policy shock has a strong effect on the exchange rate that appreciates on impact. The maximum effect occurs immediately, and the exchange rate thereafter gradually depreciates to baseline, consistent with the Dornbusch overshooting hypothesis and with few exceptions consistent with UIP.Dornbusch overshooting, VAR, monetary policy, exchange rate puzzle, identification

Forecasting inflation with an uncertain output gap

The output gap (measuring the deviation of output from its potential) is a crucial concept in the monetary policy framework, indicating demand pressure that generates inflation. The output gap is also an important variable in itself, as a measure of economic fluctuations. However, its definition and estimation raise a number of theoretical and empirical questions. This paper evaluates a series of univariate and multivariate methods for extracting the output gap, and compares their value added in predicting inflation. The multivariate measures of the output gap have by far the best predictive power. This is in particular interesting, as they use information from data that are not revised in real time. We therefore compare the predictive power of alternative indicators that are less revised in real time, such as the unemployment rate and other business cycle indicators. Some of the alternative indicators do as well, or better, than the multivariate output gaps in predicting inflation. As uncertainties are particularly pronounced at the end of the calculation periods, assessment of pressures in the economy based on the uncertain output gap could benefit from being supplemented with alternative indicators that are less revised in real time.Output gap, real time indicators, forecasting, Phillips curve

The ‘Dutch disease’ reexamined: Resource booms can benefit the wider economy

In the cases of Norway and Australia, there's evidence of productivity 'spillovers' between industries, write Hilde C. Bjørnland and Leif Anders Thorsru

Oil and macroeconomic (in)stability

We analyze the role of oil price volatility in reducing U.S. macroeconomic instability. Using a regime-switching structural model we revisit the timing of the Great Moderation and the sources of changes in the volatility of macroeconomic variables. We find that smaller or fewer oil price shocks did not play a major role in explaining the Great Moderation. Instead oil price shocks are recurrent sources of macroeconomic fluctuations. The most important factor reducing macroeconomic variability is a decline in the volatility of other structural shocks (demand and supply). A change to a more responsive monetary policy regime also played a role

A stable demand for money despite financial crisis: the case of Venezuela

The demand for broad money in Venezuela is investigated over a period of financial crisis and substantial exchange rate fluctuations. The analysis shows that there exist a long-run relationship between real money, real income, inflation, the exchange rate and an interest rate differential, that remains stable over major policy changes and large shocks. The long-run properties emphasize that both inflation and exchange rate depreciations have negative effects on real money demand, whereas a higher interest rate differential has positive effects. The long-run relationship is finally embedded in a dynamic equilibrium correction model with constant parameters. These results have implications for a policy-maker. In particular, they emphasize that with a high degree of currency substitution in Venezuela, monetary aggregates will be very sensitive to changes in the economic environment

A stable demand for money despite financial crisis: the case of Venezuela

Abstract: This paper investigates the demand for broad money in Venezuela, over a period of financial crisis and substantial exchange rate fluctuations. The analysis shows that there exist a long run relationship between real money, real income, inflation, the exchange rate and an interest rate differential, that remains stable over major policy changes and large shocks. The long run properties emphasize that both inflation and exchange rate depreciations have negative effects on real money demand, whereas a higher interest rate differential has positive effects. The long run relationship is finally embedded in a dynamic equilibrium correction model with constant parameters. These results have implications for a policymaker. In particular, they emphasise that with a high degree of currency substitution in Venezuela, monetary aggregates will be very sensitive to changes in the economic environment

Oil and macroeconomic (in)stability

We analyze the role of oil price volatility in reducing U.S. macroeconomic instability. Using a regime-switching structural model we revisit the timing of the Great Moderation and the sources of changes in the volatility of macroeconomic variables. We find that smaller or fewer oil price shocks did not play a major role in explaining the Great Moderation. Instead oil price shocks are recurrent sources of macroeconomic fluctuations. The most important factor reducing macroeconomic variability is a decline in the volatility of other structural shocks (demand and supply). A change to a more responsive monetary policy regime also played a role

Supply flexibility in the shale patch: Evidence from North Dakota

This paper provides new results to the literature, showing that output flexibility in oil production depends on the extraction technology. In particular, constructing a novel well-level monthly production dataset covering more than 16,000 crude oil wells in North Dakota, we find supply elasticity of shale wells to be positive and in the range of 0.3–0.9, depending on wells and firms characteristics. We find no such responses for conventional wells. We interpret the supply pattern of shale oil wells to be consistent with the Hotelling theory of optimal extraction. Reserves are an inventory, and the decision to produce is an intertemporal choice of when to draw down below-ground inventory.publishedVersio

The Price Responsiveness of Shale Producers: Evidence from Micro Data

We show that shale oil producers respond positively to favourable oil price signals, and that this response is mainly associated with the timing of production decisions through well completion and refracturing, consistent with the Hotelling theory of optimal extraction. This finding is established using a novel proprietary data set consisting of more than 200,000 shale wells across ten U.S. states spanning almost two decades. We document large heterogeneity in the estimated responses across the various shale wells, suggesting that aggregation bias is an important issue for this kind of analysis. Our empirical results call for new models that can account for a growing share of shale oil in the U.S., the inherent flexibility of shale extraction technology in production and the role of shale oil in transmitting oil price shocks to the global economy.publishedVersio