Business cycle forecasting and regime switching

This paper applies Hamilton's (1989) Markov-switching model of business cycle dynamics to real GDP in Iceland for the period of 1945 to 1998. The resulting model gives a reasonable description of the data generating process for real GDP and produces business cycles that correspond quite well to conventional wisdom concerning the Icelandic business cycle. Although the model cannot be distinguished from a simple, linear time series model, it offers some improvements in terms of mean absolute forecast errors and in forecasting business cycle turning points to the official forecasts made by the National Economic Institute.

The representative household's demand for money in a cointegrated VAR model

A representative household model with liquidity services directly in the utility function is used to derive a stable, data congruent error correction model of broad money demand in Iceland. This model gives a linear, long-run relation between real money balances, output and the opportunity cost of holding money that is used to over-identify the cointegrating space. The over-identifying restrictions suggest that the representative household is equally averse to variations in consumption and real money holdings. Finally, a forward-looking interpretation of the short-run dynamics, assuming quadratic adjustment costs, cannot be rejected by the data.

Inflation control around the world: Why are some contries more successful than others?

This paper focuses on two important questions concerning inflation performance in a country sample of forty-two of the most developed countries in the world. The firrst is why inflation tends to be more volatile in some countries than in others, in particular in very small, open economies and emerging market economies compared to the large and more developed ones. The empirical analysis suggests that the volatility of the risk premium in multilateral exchange rates, the degree of exchange rate pass-through to inflation, and monetary policy predictability play a key role in explaining the cross-country variation in inflation volatility. Other variables, related to economic development and size, international trade, output volatility, exposure to external shocks, and central bank independence are not found significant. The second question is what explains the general decline in inflation volatility over the sample period. Using a panel approach, the empirical analysis confirms that the adoption of inflation targeting has played a critical role in this improvement in addition to the three variables found important in the cross-country analysis. Inflation targeting therefore continues to play an important role in reducing inflation volatility even after adding the three controls to the panel analysis. The main conclusions are found to be robust to changes in the country sample and to different estimation methods.

How hard can it be? Inflation control around the world

During the last two decades, the level and variability of inflation has declined across the world. Some countries have, however, had more success in controlling inflation than others, and the fact is that these countries are usually the same countries that have been more successful over longer periods. The focus of this paper is to try to understand what factors explain this difference in inflation performance and, in particular, why inflation turns out to be more volatile in very small, open economies and in emerging and developing countries than in the large and more developed ones. Using a country sample of 42 of the most developed countries in the world spanning the period 1985-2005, the results suggest three main explanations: the volatility of currency risk premiums, the degree of exchange rate pass-through to inflation, and the size of monetary policy shocks. These three variables explain about three-quarters of the cross-country variation in inflation volatility. The results are found to be robust to changes in the country sample and to different estimation methods. In particular, they do not seem to arise because of reverse causality due to possible endogeneity of the explanatory variables.

Does inflation targeting lead to excessive exchange rate volatility?

This paper analysis whether the adoption of inflation targeting affects excessive exchange rate volatility, i.e. the share of exchange rate fluctuations not related to economic fundamentals. Using a signal-extraction approach to estimate this excessive volatility in multivariate exchange rates in a sample of forty-four countries, the empirical results show no systematic relationship between inflation targeting and excessive exchange rate volatility. Joint analysis of the effects of inflation targeting and EMU membership shows, however, that a membership in the monetary union significantly reduces this excessive volatility. Together, the results suggest that floating exchange rates not only serve as a shock absorber but are also an independent source of shocks, and that these excessive fluctuations in exchange rates can be reduced by joining a monetary union. At the same time the results suggest that adopting inflation targeting does not by itself contribute to excessive exchange rate volatility.

Out in the cold? Iceland’s trade performance outside the EU

Although entering a currency union involves both costs and benefits, an increasing body of research is finding that the benefits – in terms of international trade creation – are remarkably large. For example, Rose (2000) suggests that countries can up to triple their trade by joining a currency union. If true the impact on trade, income and welfare should Iceland join EMU could be enormous. However, by focussing simply on EMU rather than the broad range of currency unions studied by Rose, we find that the trade impact of EMU is smaller – but still statistically significant and economically important. Our findings suggest that the Iceland's trade with other EMU countries could increase by about 60% and that the trade-to-GDP ratio could rise by 12 percentage points should Iceland join the EU and EMU. This trade boost could consequently raise GDP per capita by roughly 4%. These effects would be even larger if the three current EMU outs (Denmark, Sweden and the UK) were also to enter EMU.

Wage Formation in a Cointegrated VAR Model: A Demand and Supply Approach.

Usually cointegrated VAR models of wage formation are analysed in a wage-price setup. However, theoretical wage bargaining models provide the background for a wage-employment setup. The two relations of interest are the labour demand equation from the profit maximizing firms and the (bargained) wage equation from maximizing the Nash product of the wage bargaining process. From the underlying economic model we derive explicit parameter restrictions which are analysed using a multivariate cointegration approach, using quarterly data from Denmark. These restrictions are not rejected and the theoretical model with maximizing agents can be said to give a good description of wage formation in Denmark.

Weathering the financial storm: The importance of fundamentals and flexibility

The recent global financial tsunami has had economic consequences that have not been witnessed since the Great Depression. But while some countries suffered a particularly large contraction in economic activity on top of a system-wide banking and currency collapse, others came off relatively lightly. In this paper, we attempt to explain this cross-country variation in post-crisis experience, using a wide variety of pre-crisis explanatory variables in a sample of 46 medium-to-high income countries. We find that domestic macroeconomic imbalances and vulnerabilities were crucial for determining the incidence and severity of the crisis. In particular, we find that the pre-crisis rate of inflation captures factors which are important in explaining the post-crisis experience. Our results also suggest an important role for financial factors. In particular, we find that large banking systems tended to be associated with a deeper and more protracted consumption contraction and a higher risk of a systemic banking or currency crisis. Our results suggest that greater exchange rate flexibility coincided with a smaller and shorter contraction, but at the same time increased the risk of a banking and currency crisis. Countries with exchange rate pegs outside EMU were hit particularly hard, while inflation targeting seemed to mitigate the crisis. Finally, we find some evidence suggesting a role for international real linkages and institutional factors. Our key results are robust to various alterations in the empirical setup and we are able to explain a significant share of the cross-country variation in the depth and duration of the crisis and provide quite sharp predictions of the incidence of banking and currency crises. This suggests that country-specific initial conditions played an important role in determining the economic impact of the crisis and, in particular, that countries with sound fundamentals and flexible economic frameworks were better able to weather the financial storm.

Optimal Exchange Rate Policy: The Case of Iceland

This paper analysis the appropriate exchange rate arrangement for Iceland, given its structural characteristics, on the one hand, and the need for a credible nominal anchor for monetary policy, on the other. It also discusses the current regime of a currency peg, its rationale, its success in terms of achieving its goals, and how the apparent conflict between the exchange rate arrangement suggested by the structural characteristics of the economy and the arrangement actually chosen, has been resolved. Finally, the paper provides an assessment of alternative future exchange rate regimes.

Exchange Rate Policy in Small Rich Economies

We look at the exchange rate policy choices and outcomes for small rich economies. Small rich economies face significant policy challenges due to proportionately greater economic volatility than larger economies. These economies usually choose some form of fixed exchange rate regime, particularly in the very small economies where the per capita cost of independent monetary policy is relatively high. When such countries do choose a free or managed floating regime, they appear to derive no benefit from those regimes; their exchange rate volatility seems to rise without any significant change in fundamental economic volatility. Thus, for these countries, floating exchange rates seem to create problems for policy makers without solving any.