Credit Market Distortions, Asset Prices and Monetary Policy

In this paper we develop a sticky price DSGE model to study the role of capital market imperfections for monetary policy implementation. Recent empirical and theoretical studies have stressed the effect of firms’ external finance on their pricing decisions. The so-called cost channel of the transmission mechanism has been explored within New Keynesian frameworks that pose particular emphasis on inflation dynamics. These models generally disregard the role of external …nance for the dynamics of asset prices. We ask whether monetary policy should respond to deviations of asset prices from their frictionless level and, more importantly, if the answer to this question changes when financial frictions are properly taken into account. We analyze these issues from the vantage of equilibrium determinacy and stability under adaptive learning. We show that usual conditions for equilibrium uniqueness and E-stability are significantly altered when the cost channel matters. Nevertheless, we find that responding to actual or expected asset price misalignments helps at restoring determinacy and stability under learning. These conclusions are further enforced in the presence of a high degree of pass-through from policy to bank lending rates

Inflation Expectations and Monetary Policy Design: Evidence from the Laboratory (Replaces CentER DP 2009-007)

Using laboratory experiments within a New Keynesian macro framework, we explore the formation of inflation expectations and its interaction with monetary policy design. The central question in this paper is how to design monetary policy in the environment characterized by heterogeneous expectations. Rules that use actual rather than forecasted inflation produce lower inflation variability and alleviate expectational cycles. Degree of responsiveness to deviations of inflation from its target in the Taylor rule produces nonlinear effects on inflation variability. We also provide considerable support for the existence of heterogeneity of inflation expectations and show that a significant proportion of subjects are rational in our experiment. However, most subjects rather than using a single model they tend to switch between alternative models.Laboratory Experiments;Inflation Expectations;New Keynesian Model;Monetary Policy Design

Credit Market Distortions, Asset Prices and Monetary Policy

Abstract: We study the conditions that ensure rational expectations equilibrium (REE) determinacy and expectational stability (E-stability) in a standard sticky-price model augmented with the cost channel. We allow for varying degrees of pass-through of the policy rate to bank-lending rates. Strong cost-side effects heavily constrain the policy rate response to inflation from above, so that inflation tar- geting policies may not be capable of ensuring REE uniqueness. In such cases, it is advisable to combine inflation responses with an appropriate reaction to the output gap and/or firm profitability. The negative reaction of real activity and asset prices to inflationary shocks adds a negative force to inflation responses that counteracts the borrowing cost effect and avoids expectations of higher inflation to become self-fulfilling.Monetary Policy;Cost Channel;Asset Prices;Determinacy;E-stability

Uncertainty and Disagreement in Forecasting Inflation: Evidence from the Laboratory (Replaced by CentER DP 2012-072)

We establish several stylized facts about the behavior of individual uncertainty and disagreement between individuals when forecasting inflation in the laboratory. Subjects correctly perceive the underlying inflation uncertainty in only 60% of cases, which can be interpreted as the overconfidence bias. Determinants of individual uncertainty, dis- agreement among forecasters and properties of aggregate distribution are analyzed. We find that the interquartile range of the aggregate distribution has the highest correlation with inflation variability; however the average confidence interval performs best in a forecasting exercise. Allowing subjects to insert asymmetric confidence intervals results in wider upper intervals than lower intervals on average, thus perceiving higher uncertainty with respect to inflation increases. In different treatments we study the influence of different monetary policy designs on the formation of confidence bounds. Inflation targeting produces lower uncertainty and higher accuracy of intervals than inflation forecast targeting.Laboratory Experiments;Confidence Bounds;New Keynesian Model;Inflation Expectations

Uncertainty and Disagreement in Forecasting Inflation:Evidence from the Laboratory (Replaced by CentER DP 2012-072)

We establish several stylized facts about the behavior of individual uncertainty and disagreement between individuals when forecasting inflation in the laboratory. Subjects correctly perceive the underlying inflation uncertainty in only 60% of cases, which can be interpreted as the overconfidence bias. Determinants of individual uncertainty, dis- agreement among forecasters and properties of aggregate distribution are analyzed. We find that the interquartile range of the aggregate distribution has the highest correlation with inflation variability; however the average confidence interval performs best in a forecasting exercise. Allowing subjects to insert asymmetric confidence intervals results in wider upper intervals than lower intervals on average, thus perceiving higher uncertainty with respect to inflation increases. In different treatments we study the influence of different monetary policy designs on the formation of confidence bounds. Inflation targeting produces lower uncertainty and higher accuracy of intervals than inflation forecast targeting.

Reference-dependent Preferences and the Transmission of Monetary Policy

This paper proposes a novel explanation of the vast empirical evidence showing that output and prices react asymmetrically to monetary policy innovations over contractions and expansions in the business cycle. We use VAR techniques to show that monetary policy exerts stronger e¤ects on the U.S. GDP during contractionary phases, as compared to expansionary ones. As to prices, their response is not statistically different across different cyclical stages. We show that these facts are consistent with a New Neoclassical Synthesis model based on the assumption that households' utility partly depends on deviations of their consumption from a reference level below which aversion to loss is displayed. In line with the theory developed by Kahneman and Tversky (1979), losses in consumption utility loom larger than gains. This implies state-dependent degrees of real rigidity and elasticity of intertemporal substitution in consumption that generate competing effects on the responses of output and inflation following a monetary innovation. The key predictions of the model are in line with the data. We then explore the state-dependent trade-off between inflation and output stabilization that naturally arises in this context. Greater elasticity of inflation to real activity during expansionary stages of the cycle promotes a stronger degree of policy activism in the response to the expected rate of inflation under discretion, compared to what is otherwise prescribed during contractions.Reference-dependent Preferences;Asymmetry;Monetary policy.

Inflation Expectations and Monetary Policy Design:Evidence from the Laboratory (Replaces CentER DP 2009-007)

Using laboratory experiments within a New Keynesian macro framework, we explore the formation of inflation expectations and its interaction with monetary policy design. The central question in this paper is how to design monetary policy in the environment characterized by heterogeneous expectations. Rules that use actual rather than forecasted inflation produce lower inflation variability and alleviate expectational cycles. Degree of responsiveness to deviations of inflation from its target in the Taylor rule produces nonlinear effects on inflation variability. We also provide considerable support for the existence of heterogeneity of inflation expectations and show that a significant proportion of subjects are rational in our experiment. However, most subjects rather than using a single model they tend to switch between alternative models.