Monetary misconceptions

The paper identifies a number of misconceptions about the monetary policy process and the monetary transmission mechanism in the UK. Among the misconceptions about the process are the alleged lack of regional and sectoral representativeness of the Monetary Policy Committee and the view that operational central bank independence means that monetary and fiscal policy are not properly coordinated. Among the transmission mechanism misconceptions, the "New Paradigm" figures prominently. Among the New Paradigm changes in the British economy that have been given prominence are the following: increasing openness; lower global inflation; lower profit margins, reflecting stronger competitive pressures; buoyant stock markets; a lower natural rate of unemployment; and a higher trend rate of growth of productivity. I argue that the New Paradigm has been over-hyped and misunderstood as regards its implications for monetary policy. Other misconceptions include the ''death of inflation'', the ''end of boom and bust'', a couple of Neanderthal Keynesian fallacies and the monetary fine tuning fallacy

It’s a long way to Copenhagen?. CEPS Policy Briefs No. 96, 1 March 2006

Turkey, which officially started negotiations for EU membership in October 2005, currently has a lower per capita income than that of any of the EU-25 countries – about at the level of Romania and Macedonia. With the right institutions and policies, Willem Buiter, Professor of European Political Economy at the European Institute of the London School of Economics and Political Science, argues that Turkey could become a true tiger economy. But with the institutions and policies of the second half of the 20th century, it could end up a mangy cat instead of a tiger. This policy brief is motivated by some rather optimistic official reports and especially by the World Bank’s recent Country Economic Memorandum for Turkey, Promoting Sustained Growth and Convergence with the European Union

Efficient "Myopic" Asset Pricing in General Equilibrium: A Potential Pitfall in Excess Volatility Tests

Excess volatility tests for financial market efficiency maintain the hypothesis of risk-neutrality. This permits the specification of the benchmark efficient market price as the present discounted value of expected future dividends. By departing from the risk-neutrality assumption in a stripped-down version of Lucas's general equilibrium asset pricing model, I show that asset prices determined in a competitive asset market and efficient by construction can nevertheless violate the variance bounds established under the assumption of risk neutrality. This can occur even without the problems of non-stationarity (including bubbles) and finite samples. Standard excess volatility tests are joint tests of market efficiency and risk neutrality. Failure of an asset price to pass the test may be due to the absence of risk neutrality rather than to market inefficiency.

Overcoming the zero bound on nominal interest rates with negative interest on currency : Gesell's solution.

An economy is in a liquidity trap when monetary policy cannot influence either real or nominal variables of interest. A necessary condition for this is that the short nominal interest rate is constrained by its lower bound, typically zero. The paper considers two small analytical models, one Old-Keynesian, the other New-Keynesian possessing equilibria where not only the short nominal interest rate, but nominal interest rates at all maturities can be stuck at their zero lower bound. When the authorities remove the zero nominal interest rate floor by adopting an augmented monetary rule that systematically keeps the nominal interest rate on base money (including currency) at or below the nominal interest rate on non-monetary instruments, the lower bound equilibria are eliminated, thus allowing an economic system to avoid the trap or to escape from it. This rule will involve paying negative interest on currency, that is, imposing a ‘carry tax’ on currency, an idea first promoted by Gesell. The administration costs associated with a currency carry tax must be set against the benefits of potentially lower shoe-leather costs and lower menu costs which are made possible by the its introduction. There are also output-gap avoidance benefits from eliminating the zero lower bound trap.

The elusive welfare economics of price stability as a monetary policy objective: why New Keynesian central bankers should validate core inflation

The paper studies the inflation rate associated with optimal monetary and fiscal policy in a number of standard dynamic stochastic general equilibrium models with nominal price rigidities. While the focus is on Calvo-style nominal price contracts with a range of indexation rules for constrained price setters, the conclusions have much wider validity: (1) Regardless of whether nominal price and/or wage rigidities are due to New-Keynesian, Old-Keynesian or sticky-information Phillips curves, optimal inflation policy requires the validation, that is, the full accommodation of core producer inflation by actual producer price inflation;(2) Optimal monetary policy implements Bailey-Friedman optimal quantity of money rule. No welfare-economics based argument for price stability as an objective (let alone the overriding objective) of monetary policy can be established for the class of DSGE models with nominal rigidities for which they have been proposed by Woodford and others. JEL Classification: E3, E4, E5, E6DSGE, inflation targeting, New Keynesian macroeconomics, Nominal price rigidities

Comment on T. J. Sargent and N. Wallace: "Some Unpleasant Monetarist Arithmetic"

Sargent and Wallace (S-W) show that, even when inflation is prima facie a strictly monetary phenomenon -- prices are flexible, markets clear and velocity is constant -- inflation is, in the long run, a fiscal phenomenon. This follows from the government budget constraint and the existence of an upper bound on the real per capita stock of interest bearing public debt held by the private sector. Together these ensure that in the long run the growth of the money stock is governed by the fiscal deficit, if we assign to the fiscal authorities the role of Stackelberg leaders and to the monetary authorities that of Stackelberg followers. The discussion of the formal S-W model focuses on the distinct roles of public spending and explicit taxes in their model and on the possibility that optimal policy involves public sector surpluses and a net credit position of the public sector vis-a-vis the private sector. It is also argued that the specification of the demand for and supply of - money is ad hoc, a weakness shared by most existing macro models.. Finally it is shown that if we adjust the published government deficit figures for the effect of inflation on the real value of the stock of nominal government debt (as should be done to obtain a deficit measure appropriate to the S-W model), the inflation-adjusted government deficit has been in balance or surplus in the U.K. in recent years. If the deficit is in addition adjusted for the cycle (as it should be to relate it to the full employment S-W model), the government has been a sizeable net lender. If we then also subtract net public sector capital formation from total public spending (assuming implicitly that the real rate of return on public sector investment equals the real rate of return on public sector debt), we get the inflation-corrected, cyclically adjusted government current account deficit. This is the deficit measure of the S-W model. This "deficit" has been a sizeable surplus in recent years and is likely to remain so in the future. The inflation tax implied by extrapolation of the past and present stance of fiscal policy is therefore a "deflation subsidy.'' The credibility of the Thatcher government's anti-inflationary policy should therefore, if the S-W framework is correct, not have been undermined by large inflation-corrected, cyclically adjusted current account surplus.

Death, Population Growth, Productivity Growth and Debt Neutrality

Debt neutrality is said to occur if, given a program for public spending on current goods and services over time, the real equilibrium of the economy (private consumption, investment, relative prices, etc.) is independent of the pattern of government borrowing and lump-sum taxation over time. The paper brings together work of Blanchard on individual uncertain lifetimes and debt neutrality and Weil on population growth and debt neutrality. It is shown that there will be debt neutrality if and only if the sum of the rate of growth of population and the individual probability of death equals zero. If this condition holds, non-zero rates of growth of labor productivity will not destroy debt neutrality.

Fiscal Prerequisites for a Viable Managed Exchange Rate Regime: A Non-technical Eclectic Introduction

The paper first reviews the budget identities of the fiscal and monetary authorities and the solvency constraint or present value budget-constraint of the consolidated public sector, for closed and open economies. It then discusses the new conventional wisdom concerning the fiscal roots of inflation and the budgetary prerequisites for generating and stopping hyperinflation. The popular rational expectations "Unpleasant Monetarist Arithmetic" model of Sargent and Wallace has ambiguous inflation implications from an increase in the fundamental deficit and is incapable of generating hyperinflation. The only runaway, explosive or unstable behavior it can exhibit is "hyperdeflation"! In the open economy, the need to maintain a managed exchange rate regime does not impose any constraint on the growth rate of domestic credit, arising through the government's need to remain solvent. Obstfeld's proposition to the contrary is due to the omission of government bonds and borrowing. There is not yet any "deep structural" theory justifying the (exogenous) lower bounds on the stock of foreign exchange reserves characteristic of the collapsing exchange rate literature. Absent such a theory of "international liquidity," one cannot model satisfactorily a foreign exchange crisis that is not at the same time a government solvency crisis. Given such a lower bound, the existence or absence of a pecuniary opportunity cost to holding reserves is shown to condition the fiscal and financial actions consistent with prolonged survival of the managed exchange rate regime.