Bruinshoofd, Allard

Candelon, Bertrand

English

Research Papers in Economics

Nonlinear monetary policy in Europe: fact or myth?
Allard Bruinshoofd
a, Bertrand Candelon
b,*
aDe Nederlandsche Bank-Research Department, P.O. Box 98, 1000 AB Amsterdam, The Netherlands
bMaastricht University-Department of Economics, P.O. Box 616, 6200 MD Maastricht, The Netherlands
Received 4 March 2004; accepted 25 August 2004
Available online 19 November 2004
Abstract
We hold the fort for linear specification of monetary policy and economic activity in Europe. Using data on the
last two and a half decades, we cannot reject the hypothesis that monetary policy is a linear process and we find
mixed results regarding economic activity.
D 2004 Elsevier B.V. All rights reserved.
Keywords: Time series model specification; Linearity tests; Nonlinear models
JEL classification: C51
1. Introduction
Nonlinear monetary policy is well documented in the theoretical literature. The phases of the business
cycle are argued to influence monetary policy in a different way. For instance Cukierman (1999)
assumes that policymakers fear failures that cause recession more than failures that cause expansion. In
such setting, monetary authorities may be tougher on inflation during economic upturns, whereas output
stabilization receives a relatively larger weight in downturns (see e.g., Dolado et al., 2000; Bec et al.,
2002, for empirical evidence). Economic theory also suggests that the impact of monetary policy on
economic activity may be nonlinear (cf. Ball and Mankiw, 1994), with asymmetric effects of monetary
expansion and contraction (see e.g., Cover, 1992; Karras, 1996; Sensier et al., 2002, for empirical
0165-1765/$ - see front matter D 2004 Elsevier B.V. All rights reserved.
doi:10.1016/j.econlet.2004.08.008
* Corresponding author. Tel.: +31 43 388 3442; fax: +31 43 388 4864.
E-mail address: b.candelon@algec.unimaas.nl (B. Candelon).
Economics Letters 86 (2005) 399–403
www.elsevier.com/locate/econbaseevidence) or asymmetric effects in booms and recessions (see e.g., Kakes, 1998; Peersman and Smets,
2001; Sensier et al., 2002, for empirical evidence).
Even if this idea is supported for the US, it is challenged for countries constituting the core of the
euro-area (of which we examine Germany, France, Italy, and the Netherlands).
Since the start of the Exchange Rate Mechanism (ERM) in 1979, European countries have
increasingly committed to independent monetary authorities with goals separated from political or
business cycle considerations. Within the current European Monetary Union (EMU), there is little room
for discretion in monetary policy and a priori little reason to expect nonlinear influence of economic
activity on monetary policy. Nevertheless, the commitment to reach EMU has not been the same for all
countries at all times during the process of European monetary integration. We therefore additionally
consider Denmark and the UK, who both abandoned the road towards EMU at some stage. Particularly
for the UK, the desire for discretion in monetary affairs contributed to their decision to distance from
further monetary integration. Thus, for these two non-euro economies, nonlinear effects of economic
activity on monetary policy decisions remain conceivable a priori.
This paper tests the relevance of nonlinear monetary policy in Europe. It relies on the Lagrange-
multiplier test of linearity proposed by Luukkonen et al. (1988), which tests smooth transition
nonlinearity against the linear benchmark. Section 2 presents the test while Section 3 discusses the
empirical application. Section 4 concludes.
2. Testing for smooth transition nonlinearity
Consider the logistic smooth transition autoregressive (LSTAR) model
yt ¼ xtV/ þ xtVh ðÞ G c;c;st ðÞ þ ut t ¼ 1; N T ðÞ ; ð1Þ
where yt alternately indicates monetary policy (term spread of interest rates or growth of real balances) or
economic activity (real output growth) and xt=(1, xk,t 1,..., xk,t 1 m)w i t hm lags of variable vector k
(containing real output growth, term spread of interest rates, and growth of real balances). The transition
function G (d ) is continuous, bounded between [0,1], follows G(c, c; st)=(1+exp( c(st c)))
 1 with cN0
and increases monotonically in the transition variable st (cf. Tera ¨svirta, 1998). ut is a white noise residual
with variance r
2, c indicates the speed of transition between 0 and 1, and c the switch-point between regimes.
This LSTAR model tends to a linear model for cY0 . The major challenge associated with a formal
linearity test is how to cope with the different numbers of nuisance parameters under the null of linearity
and the alternative of LSTAR nonlinearity. Luukkonen et al. (1988) tackle this issue by building an LM-
type statistic using the third-order Taylor approximation of the transition function G(c, c; st)u
d0+d1st+d2st
2+d3st
3+R(c,c;st)whereR isaremainderanddj,j=0,1,2,3areconstant.Substitutingbackinto
Eq. (1) gives
yt ¼ xtV/ þ xtst ðÞ Vb1 þ xts2
t
  
Vb2 þ xts3
t
  
Vb3 þ ut4 t ¼ 1; N ;T ðÞ ; ð2Þ
where ut*=ut+(xtVh)R(c, c; st). The LM test of linearity assesses H0; bj=0, j=1,2,3 against H1: at least
one bjp0. The statistic (n) associated with this test has the following form:
n ¼ r2 X T
t¼1
ˆ u utwt
 !
V ˆ M M 11   ˆ M M 10 ˆ M M  1
00 ˆ M M 01
    1 X T
t¼1
wtˆ u ut
 !
; ð3Þ
A. Bruinshoofd, B. Candelon / Economics Letters 86 (2005) 399–403 400where wt ¼ xtst;xts2
t ;xts3
t
  
V; ˆ M M 00 ¼
PT
t¼1 ˆ x xtxtV; ˆ M M 01 ¼
PT
t¼1 ˆ x xtwtV; ˆ M M 10 ¼
PT
t¼1 ˆ w wtxtV and ˆ M M 11 ¼ PT
t¼1 ˆ w wtwtV: Luukkonen et al. (1988) show that under the null nYv
2(3p) where p=k (m+1)+1
indicates the number of explanatory variables.
3. Test results for European countries
We use quarterly series on GDP, consumer prices (CPI), long- and short-term interest rates, and the
money supply (M3). German, French, Italian, Dutch and UK data is obtained from De Nederlandsche
Bank while Danish data is taken from Engsted and Nyholm (2000). We analyse the period 1979:1–
2002:1, which covers the entire process of monetary integration in Europe. We include the turbulent first
years of monetary integration to stack the deck against linear monetary policy.
For each country, LSTAR nonlinearity in economic activity (quarterly growth of GDP, denoted for
simplicity as DGDP) and monetary policy is assessed. We use the monetary policy reaction model
developed by McCallum (1994), which is based on the observation that central banks adjust short-term
rates in order to influence the term spread (the difference between long- and short -term interest rates,
denoted Spr). In addition, we capture the tightness or ease of monetary policy with the growth rate of
real balances (denoted DM/P).
1 Table 1 reports the test results. The optimal lag length in each individual
case is selected using the SBIC criterion, which is the most conservative model selection criterion and
therefore penalizes linear specifications.
In columns (1)–(3) LSTAR nonlinearity in economic activity is explored, using alternately lagged
DGDP, Spr and DM/P as the transition variable. The linearity test results show that there is little
evidence of nonlinear economic activity in the EMU countries when using lagged DGDP or Spr as the
transition variable. When lagged DM/P is used as the transition variable, nonlinear DGDP in the euro
area still remains limited to Germany. These findings agree with Kakes (1998), who concludes that there
are DGDP regimes in monetary policy effectiveness in Germany while Dutch monetary policy is
ineffective in both recessions and booms. Peersman and Smets (2001) share these findings, but also
report DGDP regimes for France and Italy. They do not, however, justify their nonlinear models with the
rejection of formal linearity tests. Regarding the non-euro economies, for the UK there is evidence of
distinct nonlinearities in economic activity (in line with Kakes, 1998; Sensier et al., 2002), while for
Denmark DGDP regimes associate only with lagged DM/P and economic activity. Knowledge of
economic activity regimes is useful for example for the purpose of improving recession probability
predictions (see e.g., Anderson and Vahid, 2001).
The relevance of monetary policy regimes driven by economic activity is explored in columns (4)
and (5). There, term spread and growth of real balances are modelled as LSTAR nonlinear processes
using lagged economic activity as the transition variable. The linearity test results are such that linear
monetary policy is accepted for all countries that we consider. For the EMU countries such finding
confirms our economic arguments: monetary policy on the way to EMU has been focused on business
cycle independence since its incipience. It also agrees with Dolado et al. (2000) who find no
asymmetric behaviour of German and French monetary policy with respect to business cycle
1 Cointegration relationships between level of output and real balances are rejected by the Johansen (1991) test. We thus consider in the
system the growth rate of output and real balances.
A. Bruinshoofd, B. Candelon / Economics Letters 86 (2005) 399–403 401considerations. Bec et al. (2002) reject linearity for Germany. For Denmark the linear monetary policy
result can also be explained as the Danes, although they rejected the single European currency, closely
follow ECB monetary policy. The UK, however, has ever been reluctant to commit to straitjacket its
monetary policy and is unattached to EMU monetary measures. Yet we find that UK monetary
authorities seem not to have exerted the discretion they have available as British monetary policy is
best characterized by a simple linear reaction function.
4. Conclusions
Formal tests fail to accept nonlinear monetary policy for the European economies that we analyze.
While for the euro economies this result relates to the very foundation of the European Monetary
Union—which considers price stability of paramount importance with disregard for the business cycle—
Table 1
Monetary policy and economic activity in Europe: linearity test results
Transition variable DGDP Spr DM/P
DGDP 1 Spr DM/P 1 DGDP 1 DGDP 1
Denmark
Lags 1 1 1 11
Linearity 0.05 0.38 0.01 0.59 0.47
France
Lags 1 1 1 1 5
Linearity 0.73 0.63 0.18 0.09 0.73
Germany
Lags 4 4 4 14
Linearity 0.42 0.95 0.00 0.94 0.19
Italy
Lags 1 1 1 1 4
Linearity 0.06 0.55 0.13 0.14 0.20
Netherlands
Lags 1 1 1 1 2
Linearity 0.10 0.37 0.07 0.68 0.18
United Kingdom
Lags 11 1 11
Linearity 0.00 0.01  0.01 0.23 0.11
Sample period is 1979:1–2002:1. Each model includes the indicated number of lags for DGDP , Spr and DM/P . The optimal
number of lags for the models presented has been selected using the SBIC information criterion, refer to the appendix for the
SBIC model selection results. The linearity test uses an F-approximation to n (Eq. (3)) with 3p and T-4p-1 degrees of freedom;
concomitant p-values are reported in the table. The Dutch models additionally include the German term spread. For Germany,
a dummy for reunification is used in the DGDP and DM/P models. Bold characters indicate the rejection of the null hypothesis
of linearity at the 5% significance level.
A. Bruinshoofd, B. Candelon / Economics Letters 86 (2005) 399–403 402our findings are similar regarding monetary policy in Denmark and the UK, both of which stopped their
pursuit of monetary integration short of monetary union.
For the EMU economies save Germany, similar conclusions follow for economic activity: linear
economic activity is accepted for France, Italy and the Netherlands. For Germany, Denmark and
distinctly for the UK, we do reject the null of linear economic activity. For these economies, business
cycle forecasts using nonlinear techniques should outperform forecasts using linear techniques.
The limited evidence of nonlinearity in European monetary policy and economic activity leads us to
emphasize once more that formal linearity testing should precede any nonlinear modelling.
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A. Bruinshoofd, B. Candelon / Economics Letters 86 (2005) 399–403 403

Are the effects of monetary policy asymmetric? Evidence from a sample of European countries.

Are the effects of monetary policy in the Euro area greater in recessions than in booms?

Asymmetric effects of positive and negative money-supply shocks.

Asymmetric interest rate effects for the UK real economy.

Asymmetric price adjustment and economic fluctuations.

Asymmetries in monetary policy reaction function: evidence for US, French and German central banks.

Asymmetries in monetary policy rules: evidence for four central banks.

Estimation and hypothesis testing of cointegration vectors in Gaussian vector autoregressive models.

Modeling economic relationships with smooth transition regressions. In: Ullah,

Monetary policy and the term structure of interest rates.

Monetary transmission and business cycle asymmetry.

Predicting the probability of a recession with nonlinear autoregressive leading-indicator models.

Regime shifts in the Danish term structure of interest rates.

Testing linearity against smooth transition autoregression.

The inflation bias result revisited. Tel-Aviv Foerder and Sackler Institute for Economic Research Working Paper 99/38,

Nonlinear monetary policy in Europe: fact or myth?.

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Nonlinear monetary policy in Europe: fact or myth?.

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