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)

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

Inertial Taylor rules: the benefit of signaling future policy

This article traces the consequences of an energy shock on the economy under two different monetary policy rules: (i) a standard Taylor rule, where the Fed responds to inflation and the output gap, and (ii) a Taylor rule with inertia, where the Fed moves slowly to the rate predicted by the standard rule. The authors show that, with both sticky wages and sticky prices, the outcome of an inertial Taylor rule is superior to that of the standard rule, in the sense that inflation is lower and output is higher following an adverse energy shock. However, if prices alone are sticky, the results are less clear and the standard rule delivers substantially less inflation than the inertial rule in the short run.Taylor's rule

Imperfect capital markets and nominal wage rigidities

Should monetary policy respond to asset prices? This paper analyzes a general equilibrium model with imperfect capital markets and rigid nominal wages. Within the context of this model, there is a natural role for the benevolent central bank to dampen the real effects of asset price movements.Monetary policy ; Asset pricing

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)

Monetary policy rules and stability: inflation targeting versus price-level targeting

Monetary policy rules help central banks exercise the discipline necessary to achieve their long-term goals. The type of rule many banks are turning to these days is inflation targeting, which has several advantages. But because banks base their actions on forecasts of future inflation, following the rule can lead to inflation-rate instability in some cases. A price-level target offers the same benefits as an inflation target but, because actions are based on past inflation, it avoids this vulnerability.Monetary policy ; Inflation (Finance) ; Banks and banking, Central