Monetary Policy Implementation at Different Stages of Market Development (IMFs Occasional Papers)


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Such a result could lead to a sharp real depreciation of the exchange rate. With the textile and spice industries reduced in size, exports could not respond to the depreciation, so imports would have to collapse to establish a current account equilibrium. Thus, it was possible that the FDI shock would mainly increase volatility, long before real structural change occurred.

Moreover, in the current environment it could lead to a massive rise in net foreign assets and a corresponding increase in money, unless sterilized. The authorities noted that the volatility of the exchange rate was more important than the level. In response, the CBM developed an exchange rate band intervention strategy to use intervention rules to reduce exchange rate volatility, and prepared a plan for a forward exchange rate market to allow traders to hedge. The authorities continued with their strategy of targeting broad money supply as the basis of monetary policy, but found that the IMF-proposed strategy of targeting a floor for CBM net foreign assets NFA and a ceiling for CBM net domestic assets NDA was more effective than straight reserve money programming.

Under this strategy, the floor on NFA was based on a balance of payments projection that aimed to stabilize the exchange rate. Overall growth in reserve money was targeted to control inflation. And NDA was the balance required to achieve the reserve money target, which depended on a combination of open market operations and the fiscal position. Under this approach, overshooting the NFA target and correspondingly the reserve money target was acceptable—as it largely reflected a strengthening of the exchange rate.

The NFA floor was also be subject to adjustors based on how close the actual amount of donor balance of payments support was to its programmed level. The CBM first faced the problem of lack of instruments for extensive sterilization. The sale of securities for monetary policy purposes would also compete with the sale of government securities for public finance, which threatened greater pressure on the interest rate. To this end, the government focused its treasury bill sales to the nonbank sector, while the CBM only conducted OMO in the banking sector.

The model hypothesized voluntary excess liquidity in the banking system in response to poor information and shallow financial markets. We found that this excess liquidity had little impact on the normal monetary transmission mechanisms. Similarly, the bank lending channel had a very weak impact on output and prices. Yet, monetary policy in Madagascar has tended to focus on management of excess liquidity and the bank lending channel.

We also tested the commonly held view in LICs that lending is not as interest rate sensitive as it is in advanced economies, owing to the so-called quality constraint of borrowers—i. However, we found the real interest rate channel was functional and important.

The impulse-response functions confirmed a significant impact of an interest rate shock on bank lending, the exchange rate, and the price level. The model found an initial depressing impact on output, as expected, but this reversed relatively quickly, for reasons associated with the unexpected long-run impact of the exchange rate discussed below. Notwithstanding the importance of the interest rate, the monetary authorities have only very indirect means of affecting interest rates—e.

They are lacking a repurchase rate on OMO instruments to directly influence the short-term interest rate. Fiscal policy shocks, as measured by changes in domestic debt, were shown to have the hypothesized impact on the real interest rate, bank lending and the price level. The importance of fiscal policy for monetary policy is simply not to be in conflict with it, i. According to the model, the exchange rate appears to be the most powerful transmission channel of monetary policy in Madagascar.

Evidence indicates that it feeds into the price level through purchasing power parity; it increases credit demand, owing to higher prices for imports; and it causes the real interest rate to rise as a policy response. However, we found that a depreciation shock to the exchange rate resulted in a decline in long-run decline in output, contrary to expectations. We explained this result by a likely failure of import and export price elasticities to meet the Marshall-Lerner conditions.

Thus the current account remains permanently weakened from a depreciation shock or permanently strengthened from an appreciation shock. This may be telling an important story for small open economies that have insensitive foreign trade prices. Notwithstanding the above conclusion, the exchange rate still plays an important distributional role, by influencing the balance between tradable and nontradable sectors of the economy—with a real appreciation stimulating the nontradables.

Executive Summary

A real appreciation of also favors the private sector in Madagascar, which has a net trade deficit, whereas a real depreciation favors the government, which receives a net surplus of donor aid. These results indicate that the operational strategy monetary authorities, to focus on management of bank liquidity and the bank lending channel, may be highly inefficient when the other channels of monetary transmission are doing most of the work.

Instead, more attention should be given to the management of interest rates and the interest rate transmission channel. This would be necessary to create a meaningful and effective policy interest rate, if the authorities wish to move toward inflation targeting in the future. Finally, the exchange rate appears to be the strongest transmission channel in the economy, but the Marshall-Lerner conditions may not be met.

At the same time, there remains a possible threat of Dutch Disease from the new mining investments relative to traditional exports. Looking to the future, the Malagasy authorities also need to think about a monetary policy that is consistent with its membership in SADC. February Al-Mashat, Rania and Billmeie, Andreas.

December Carlson, Beith. October August Enders, Walter. Ellyne, Mark. Hesse, Heiko. June Kubo, Akihiro. Macroeconomic impact of monetary policy shocks: Evidence from recent experience in Thailand, Journal of Asian Economics. Kuijs, Louis. Smal, M. September The basic series were generally expressed in log levels, and month annual differencing was sometimes done to create to create annual growth rates. Accumulated Impulse-Response Eviews calculates the accumulated response to the impulse variable for a one standard deviation innovation based on the Cholesky decomposition and with the variable ordering show in Table 3.

In Table A. Small figures less than 0. The table below shows the relative impact at period 30 at well as the average response. Variance Decomposition The Cholesky variance decomposition shows the share of the variation in the variable under consideration explained by each explanatory variable in the VAR. All of the column variables sum to percent each period row. Taking the average explained variance for all 30 periods allows us to rank the relative importance of each random variable over time relative to the variable being shocked. This difficulty created substantial problems in the spring of This has now been confirmed by clear evidence, and the magnitudes involved are significant.

There is precedent for throwing central bank articulated ranges for money growth overboard. The legal requirement to establish and to announce such ranges had expired, and owing to uncertainties about the behavior of the velocities of debt and money, these ranges for many years have not provided useful benchmarks for the conduct of monetary policy. Nevertheless, the FOMC believes that the behavior of money and credit will continue to have value for gauging economic and financial conditions, and this report discusses recent developments in money and credit in some detail.

Addressing uncertainties by bringing all possible information to bear — including that in broad monetary aggregates — is the obvious thing to do. Importantly, though, it leads to inflation-forecast targeting, and it would be helpful if the ESCB made it clear that this is what they are doing. The ECB: a view from across the ocean 3 15 Communication and transparency The next issue is communication and transparency. This is where the ESCB has, in my view, been at its worst. Let me give just one example from the spring of During March and April of that year there were numerous calls for policy easing.

Critics cited evidence of an impending slowdown in euro-area growth as the rationale for interest rate cuts. Initially, the ESCB responded that its objective was price stability, and inflation was in fact increasing. Its policy of maintaining relatively higher interest rates was consistent with this objective. The stated reason for this policy reversal was that euro-area M3 had been mismeasured see the previous quote.

When the correction was made, and inflation forecasts were adjusted, the proper policy was to ease. The ridicule was immediate and deafening. To understand, let us consider how an idealised central bank would communicate publicly. Blinder et al. I believe that on the first two of these, the ESCB has done well. It has been clear about what it is trying to do, and it has provided substantial insights into its data, models and forecasts.

It is the third point, transparency of the substance of policy deliberations that is the source of the problems. Here, the Governing Council speaks in many voices, and they are occasionally at odds. There are several possible solutions to this communication problem. This is probably politically impossible. But why not issue minutes of meetings when they still matter? Cecchetti 4 Performance Results are the real test of policy. Numerous people have examined the brief history of ECB policy in various ways.

A decade ago John Taylor suggested the history of the US Federal Funds Rate could be adequately explained by a simple rule in which the policy rate depended on a long-run equilibrium interest rate, the deviation of inflation from a target level and the output gap. I would ask whether it is possible to actually evaluate policy using such an exercise.

If the rule had been followed at the beginning of the period, then inflation and growth would have been different later. This is obvious, and what it means is that you cannot look at the actual policy relative to a Taylorstyle rule without embedding the rule in a fully articulated dynamic structural model of the euro area. Originally, Taylor viewed this as a way of summarising policy history, not as a prescription for future action.

In recent years, researchers and policymakers have taken this rule and examined its properties for policymaking. Such exercises must be done with great care, however. In particular, evaluation of the rule can only be done if it is embedded into a dynamic model of the economy as changes in the interest-rate instrument that deviate from historical experience will drive inflation and output away from their historical paths as well.

Rather than build such a model or borrow one I will simply look at the performance of the ESCB since its inception. Figures 1. Growth data begin in and inflation data in — this is what is available from Eurostat and the ECB. It is surely difficult to tell from these data what the consequence of recent policy will be, but we can nevertheless make a preliminary evaluation.

The results give the impression that policy has been more successful in fostering steady growth than in keeping inflation in check. It is harder to argue that it became too contractionary, as inflation has continued its rise. The ECB: a view from across the ocean 4. But this is not the end of the story. The future challenges of the ESCB are nearly as daunting as those that have passed. The biggest problem facing the ESCB is dealing with what is likely to be a constant conflict among national interests in policy setting.

Recent reports have suggested that the right policy for Germany is more stimulus, while France might be better off if policy were tighter. Cecchetti across the euro area will continue and create the need for a delicately balanced policy. During the early years of currency union and general economic harmonisation one can expect that there will be substantial relative price adjustments among the various regions of the euro area and that these will show up as measured differences in national inflation indices.

But in many cases these will be required real economic adjustments, not inflation differentials creating policy problems. In writing this chapter I have joined the nearly continuous stream of observers commenting on the performance of European Monetary Union. According to the story, Kissinger asked Chou if he believed that when all its consequences were taken into account the French Revolution benefited humanity. Blanchard, J. Giavazzi and H. Blinder, A. Cecchetti, Stephen G. Meyer, Laurence H. Unfortunately, I have not been able to find any reliable source for this exchange, which may well be apocryphal.

It is, however, a good story. Taylor, John B. Altig and B. Smith eds. Price indexes such the HICP for the euro area are constructed to measure the cost of living and are not necessarily the best target for monetary policy. Two contributions in this part of the book deal with the measure of an appropriate inflation target for the ECB.

I shall introduce the issue by first reviewing three years of ECB activity, as seen and judged by different groups of academic ECB watchers. The evidence shows that the uncertainty surrounding estimated econometric relationships is rather high, so high that it is very hard to extract from the data an assessment of the consistency between the deeds and the words of the European Central Bank. In fact, despite its apparently tight formulation, the mandate of the ECB, interpreted in the light of the uncertainty surrounding those relationships among the data relevant to the application of such a mandate, leaves plenty of room for flexibility.

In other words, the fact that inflation has been above its target for more than twenty-four months since January does not lead to the rejection of the null hypothesis that the ECB has not violated its mandate. Some watchers have proposed to deal with uncertainty by choosing inflation of less volatile indexes. Others have proposed to use uncertainty and target aggregates other than the HCPI, with weights chosen optimally for monetary policy purposes rather than for statistical purposes.

Given room for manoeuvre, it is important to establish a benchmark for the optimal price index for monetary policy and evaluate the difficulties in its empirical implementation. I would like to put the two other contributions of this section in this general framework. By definition, price stability means zero inflation. However, the Maastricht Treaty does not specify which price index is the relevant one for monetary policy.

The target is then specified very strictly and the strategy is very tightly defined. Figure 2. However, the data were also consistent with monetary targeting.

1 Introduction

Interestingly, the worst performing rule was one based on giving different weights to macroeconomic conditions in different countries. Neither the output gap nor money growth played any role in the preferred rule to explain ECB behaviour. Which measure of inflation should the ECB target? The watchers also re-emphasised the importance of uncertainty showing that the confidence intervals on simulated rates when the simulation is started at the beginning of have a lower limit at 2.

Again M3 played no role; in fact, the attack on the first pillar reached its strongest peak in this year. Overall, three years of monitoring the ECB based on estimated Taylor rules shows that the uncertainty surrounding estimated econometric relationships is rather high, so high that it is very hard to extract from the data an assessment of the consistency between the deeds and the words of the European Central Bank, or indeed of any central bank.

In fact, despite its apparently tight formulation, the mandate of the ECB, interpreted in light of the uncertainty surrounding the relevant relationships among the data relevant for the application of such a mandate, leaves plenty of room for flexibility. Interestingly, the information in the data is sufficiently powerful to reject the null that the ECB has been following a strict monetary targeting strategy. But, of course, the importance of the first pillar could be defended by stating that a reference value for money growth is not a target.

This evidence leads to a rather traditional communication problem. In fact, the literal interpretation by the public of the wording of the mandate might lead to an underestimation of uncertainty surrounding inflation. Core inflation is defined by the CEPS as the consumer price index excluding the most volatile components food and energy.

Note that the CEPS proposal deals with uncertainty about economic data in two ways: first, data are smoothed by changing the relevant definition of inflation; second, uncertainty is explicitly recognised by specifying limits around the target. Favero discussion of the problems likely to be encountered in its empirical implementation. Within such a framework different goods are naturally weighted by the share of each of them in the budget of the typical consumer.

Indeed the ECB has chosen to target the HICP but, as documented in the previous section, annual inflation has been above target for some considerable time. A possible interpretation of such evidence is that price indexes designed to measure the cost of living are not necessarily the best target for monetary policy. In fact, there are plenty of historical example of monetary regimes targeting inflation with non-standard price indexes: the price of gold is the implicit target in a gold standard, the price of foreign currency is the implicit target in a fixed exchange rate system.

I shall use a model recently proposed by Mankiw and Reis to frame the choice of the price index for monetary policy in the context of optimisation. Consider a central bank committed to inflation targeting in the sense that the institution must choose a price index and commit itself to keeping that index on target, before shocks are realised forecast inflation targeting.

The model includes many sectoral prices which differ according to a number of features1 : r Sectors differ in their budget share and thus in the weights attributed to their prices in standard cost of living index. The central bank is committed to target inflation, i. Without prejudice to the objective of price stability, the central bank supports the general economic policy in the community with a view to contributing to the achievement of the objectives of the community, including a high level of employment, substantial and noninflationary growth and a high degree of competitiveness and convergence of economic performance.

In other words, its goal is to minimise Var y. In general they show that a CPI target is suboptimal. In particular they show that: 26 C. The two authors also apply their model to annual data for the US economy from to They examine four sectoral prices: food, energy, other goods and services and the level of nominal wages. They obtain two main results: r The optimal price index gives most of its weight to the level of nominal wages. These results are interesting but they probably give insufficient weight to the risk of targeting an optimal price index.

Such risk crucially depends on the correct specification of the chosen model and on the uncertainty surrounding the relevant parameters in the definition of the optimal price index. The two authors do not run their exercise in real time, in fact they use data from the — period to estimate relevant parameters and then simulate the effect of choosing an optimal price index over the same period. This is not the situation with which central banks are usually confronted; rather, their decisions have to be taken in real time and only past data can be used to fit the parameters of interest.

In fact, the procedure implemented by Mankiw and Reis minimises the risk associated with structural change of the relevant parameters. These considerations are particularly relevant to the ECB when the usual risk associated with structural breaks is heightened by the fact that past data come from a different regime. In fact, optimal weights might depend on parameters which are poorly identified or time-varying, in which case the index changes over time.

Communicating to the public a modification in the price index due to a structural break in estimated parameters might prove a difficult task. However, it must be noted that in practice the Mankiw—Reis prescription for the optimal price index is very simple giving most of the weight to wages and if such a prescription is robust to some fluctuations in the key parameterisation of the model then the communication problem seems much less difficult to solve.

After all, Taylor rules can be interpreted as an approximation to the solution of the optimisation problem for the monetary policymaker. Such rules are widely used, but only a tiny subset of the users are concerned with the parameters describing the preferences of central banks as opposed to those describing the structure of the Which measure of inflation should the ECB target? Similarly, if the optimality of targeting wages is robust to variations in the parameters describing the structure of different sectors, a central bank could very well target wages rather than prices and communicate this modification effectively to the public, leaving the academics to debate the range of deep parameters in which targeting wages is optimal.

The empirical evidence on which their chapter is based suggests that European countries fall into two different groups in terms of their inflation dynamics. In Germany price-setters put more weight on their expectations about future economic conditions and revise their prices more frequently than price-setters do in other European countries.

As a consequence there is an important asymmetry in the monetary transmission mechanism in Europe. When such an asymmetry is introduced in an optimising framework to determine monetary policy a natural conclusion arises: monetary policy should seek to stabilise an inflation target that gives more weight to the inflation rates in regions with a higher degree of rigidity.

The intuition behind this result is rather simple: in a region with a high degree of flexibility a high inflation rate can be a symptom of efficient adjustment in prices in response to macroeconomic shocks, while in a region with a high degree of rigidity a high inflation rate might instead reflect an inefficient increase in prices. The existence of asymmetries in the mechanism of price-setting across Europe makes the optimal price index different from the HICP.

Identification of 2. This is not a trivial issue. Rudd and Whelan have shown that the hybrid model is the observational equivalent of the following 28 C. In practice, a high degree of estimated forward-looking behaviour might just be a reflection of mis-specification of a backward-looking model.

A second important issue for discussion is the possibility of non-linearity in the Phillips curve. In this case, linear specifications estimated for data coming from two different inflationary regimes will deliver different parameters. As it is well known that there is a difference in mean and standard deviation of pre-EMU inflation in Germany and in the rest of Europe, the issue of non-linearity seems to be worth some further investigation. Moreover, the existence of two different regimes in the pre-EMU data is totally irrelevant if EMU causes the convergence to the low-mean, low-variance regime for inflation in all member countries.

Their proposed measure of core inflation has the statistical interpretation of the long-run inflation forecast. Such a forecast is derived by specifying a VAR model for the six variables of interest, identifying the long-run cointegrating relationships among those variables, then identifying the two distinct sources of shocks having permanent effects on the system and hence two common trends. The identified long-run relations are a long-run money demand function, a term structure equation, a relation between the nominal long-term interest rate and inflation and capacity utilisation which, being stationary, is subject to a degenerate cointegrating relationship.

The two permanent shocks are identified as a real shock and a nominal shock. The nominal shock is differentiated from the real one by imposing the condition that it has no long-run effect on output. The specification is not derived by theory; however, the choice of variables and the identification strategy for the long-run relationships are designed to be consistent with a two-pillar strategy, attributing a special informative role to money growth.

Is that measure useful for monetary policy? The question is left unanswered. In principle such a question could be answered empirically by running a counterfactual based on a baseline scenario in which the monetary policymaker follows a rule designed to target HICP inflation and in the alternative scenario follows a rule designed to target core inflation.

Different effects on output and inflation could then be assessed. However, thinking of this counterfactual, a number of problems emerge. First, the specification of the rule. In fact, in the model proposed the interest rate rule is derived by inverting money demand and, as we have seen, there is evidence that such a rule does not fit the behaviour of the ECB from onwards. This again raises the question of whether we can use data from the period —99 unreservedly.

The problem becomes more serious here. Core inflation, as measured by Bagliano, Golinelli and Morana, has a trend. If the answer is yes and such conditions are imposed, then the volatility of core inflation becomes zero: 30 C. Favero the long-run forecast for inflation is just the target of a credible central bank. There is no need to use econometrics to measure it. Bagliano F. Golinelli and C. Begg D.

Canova, P. De Grauwe, A. Fatas and P. Benigno P. Dolado J. Dolores and F. Freixas, T. Persson and C. Gertler and J. Gros D. Davanne, M. Emerson, T. Mayer, G. Tabellini and N. Durrer, J. Jimeno, C. Monticelli and R. Mankiw N. In the month of September , the average inflation rate in the EMU area was 2. At the same time, the GDP of the area increased by 0. The Maastricht Treaty is not silent on this issue. The primary objective of the ECB is that of maintaining price stability.

Eventually, the monetary policymaker is permitted to stimulate the growth of the different regions, but only without jeopardising the goal of price stability. A more efficient allocation will raise the productive potential of the economy. Each country has a weight equal to the share of its consumption in total EMU consumption. Is the HICP targeting process a good conveyor of the information relevant to the final goal of price stability? The second finding is that the average duration of price contract, i.

In Germany, prices remain fixed on average for a period of five quarters, while in the other group they remain fixed for eight quarters. This result brings out an important asymmetry in the transmission mechanism of monetary policy in Europe, notwithstanding the difference in the economic sizes of the countries.

This asymmetry can be relevant in determining which target is a better indicator of efficiency in the allocation of resources. In this chapter we address this issue in a dynamic general equilibrium model of a currency area following Benigno , in which two regions are characterised by different price-setting mechanisms.

In one region sellers evidence forward-looking behaviour in setting prices while in the other past inflation plays a crucial role in understanding inflation persistence, through what we call the hybrid model. We then exploit the micro-foundations of our framework in order to provide a welfare criterion for the central bank in terms of consumer utility. The policymaker seeks to stabilise the output gap as well as a weighted average of inflation rates in the area.

Moreover, importance should be given to the deviation of the relative price between regions with respect to the natural level. Finally, given the role of past inflation in understanding inflation persistence in the area, monetary policymakers should also stabilise the change in inflation in the region characterised by the hybrid model.

Within this framework we will analyse both the dynamic adjustment of regional and area-wide driving macroeconomic variables to terms-of-trade shocks, as well as the welfare implications of alternative monetary policy rules. We focus on four alternative policy rules: i fully optimal policy, ii optimal inflation targeting policy, iii HICP targeting, and iv stabilisation of the area output gap. According to the criterion of efficiency followed by the ECB, we are able to show within our framework that, in principle, a quantitative target in terms of stabilisation of the HICP does not succeed in eliminating the distortions in the relative price mechanism.

We have proposed two policies that may perform better: the optimal inflation targeting policy the inflation rate in the region with the higher degree of rigidity should receive the greater weight , which generalises that outlined in Benigno , and the output-gap stabilisation policy. An evaluation of alternative targeting rules 33 The chapter is structured as follows: section 2 presents the model; section 3 shows the log-linear approximation to the structural equilibrium conditions; section 4 analyses the welfare criterion; and section 5 compares the optimal monetary policy under commitment with the HICP targeting and other targeting rules.

The analysis closely follows Benigno The simplest form of a currency area that is of interest for our analysis is a two-region area with a single central bank and two fiscal authorities. Each fiscal authority has sovereignty over only one region.


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The two regions are labelled H and F. The whole area is populated by a continuum of agents on the interval [0, 1]. The population on the segment [0, n belongs to region H, while the segment [n, 1] belongs to F. There is no possibility of migration across regions. A generic agent, which belongs to the area, is both producer and consumer: a producer of a single differentiated product and a consumer of all the goods produced in both regions. Each agent derives utility from consuming an index of consumption goods and from the liquidity services of holding money, and derives disutility from producing the differentiated product.

The whole area is subjected to three region-specific sources of fluctuations: demand, supply and liquidity-preference shocks. Households maximise the expected discounted value of the utility flow. Concerning the structure of financial markets, we assume that they are complete both within and across regions. Money is important because households derive utility from its liquidity services. If real money balances and consumption are separable in utility and prices are flexible, money is neutral.

In order to give a role to monetary policy, as it is common in the literature, we introduce both nominal rigidity and a market structure characterised by monopolistic competition. The latter assumption rationalises the existence of price stickiness, allowing producers not to violate any participation constraint. In this event the price is chosen to maximise the expected discounted profits if the decision on the price is maintained. The remaining sellers, when adjusting their prices, follow a rule-of-thumb in which prices are linked to the past-period inflation rate.

Similar definitions are given for PHi and PFi. Here we assume that there are no transaction costs in transporting goods across regions; furthermore, prices are set considering the whole area as a common market. Given these assumptions and given the structure of the preferences, it is also the case that purchasing power parity holds, i. We can then drop the index i from the consumption-based price indexes. Here we define the terms of trade T of region F as the ratio of the price of the bundle of goods produced in region F relative to the price of the bundle imported from region H.

Given a decision on C j , household j allocates optimally the expenditure on j j C H and C F by minimising the total expenditure PC j under the constraint given j j by 3. The latter is derived by combining an appropriate borrowing limit with the budget constraint of the households. With ht we denote the history of the states up to date t.

The exhaustion of the intertemporal resource constraint and the Euler equations if we assume an interior optimum describe the optimal allocation. To complete the demand side of the economy we compute aggregate demand in both regions by using the appropriate Dixit—Stiglitz aggregators related to 3. From 3.

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Firms and price setting Sellers are monopolists. Demand 3. On the other hand, sellers are small with respect to the overall market and they take as given the indexes P, PH , PF and C. Monopolistic competition does not imply price rigidity, but it creates the environment in which price rigidity can exist without violating any individual rationality participation constraint, assuming that the sequence of shocks is bounded. In region F, prices are subjected to changes at random intervals as in Calvo It is important to note that all sellers in the same region who can modify their price at a certain time will face the same discounted future demands and future marginal costs under the hypothesis that the new price is maintained.

Thus they will set the same price. In this section we present the log-linear approximation to the equilibrium conditions. Indeed, real marginal costs coincide with the real wages in units of the price index of the produced good. However, in an openeconomy framework, the real marginal costs are not proportional to the output gap, as a consequence of the interdependence induced by international relative prices. This result was first shown by Svensson The smaller and more open the country is, the more relative prices influence real marginal costs and thus inflation rates.

As the welfare criterion, we assume the discounted sum of the utility flows of the household belonging to the whole union.

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We have further disregarded the utility derived from real money balances, as is common in the literature. Monetary policymakers should also stabilise a weighted average of the squares of the producer inflation rates in each region. However, there is a trade-off between stabilising inflation in both regions and stabilising relative prices to their natural level, in fact as prices are stable within a region, the terms of trade cannot be moved to offset asymmetric shocks.

This trade-off is further amplified by the last term in the loss function. Given the importance of past inflation for understanding inflation persistence in the area, as in Amato and Laubach and Steinsson , we find that monetary policymakers should also stabilise the growth of inflation in the hybrid region H. This term follows from the presence in this region of backward-looking agents who behave according to the rule of thumb. In the case in which the fraction of backward-looking agents 6 Details are available in the appendix.

An evaluation of alternative targeting rules 43 becomes zero, the last term disappears and the welfare criterion collapses to the one in Benigno This study found evidence supporting the existence of two different zones inside the euro area. In one country Germany the forward-looking character of inflation could not be ignored. In another group of four countries France, Italy, Spain and the Netherlands , inflation dynamics were found to have both forward and backward-looking components.

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This empirical analysis suggests a possible partition of the countries analysed into two groups. The elasticity of the disutility of producing the differentiated goods is set equal to 0. Considering a reasonable value of the share of labour in total output to be 0. As results from the micro-foundation of the model, these terms-of-trade shocks originate from asymmetric supply shocks. Backus, Kehoe and Kydland ; Kehoe and Perri Nevertheless, these values are higher than the ones emerging from the microeconometric estimates of the labour-supply literature e. Killingsworth and Heckman, In particular, we focus on four alternative policy rules.

The first policy under consideration is the fully optimal policy. Formally, this implies that monetary policymakers are committed to maximising the welfare function 3. In particular under our calibration, it turns out that the optimal choice of p is 0. The third class is HICP targeting, which is similar to the previous class but, unlike the previous case, the parameter p is set equal to the size of the H country, say n. Finally, we further analyse a policy aimed at stabilising the output gap of the area, i. We summarise the comparisons in terms of the variability of the variables that are relevant for the computation of welfare, using the statistic v.

This operator, v. By using this operator, it is possible to analyse welfare, W, as a composite of the operator v. Thus, we are able to understand the contribution of the relative volatilities of inflation and output to welfare under alternative policy rules. In table 3. In particular, we provide a measure of the losses in terms of permanent percentage shift in steady-state consumption. Table 3. The optimal inflationtargeting policy performs considerably better than HICP-targeting but less than the optimal policy and output-gap stabilisation policy.

Indeed, the costs of the HICP targeting and the optimal inflation targeting policies are of the order of 0. The output stabilisation policy is quite close to the fully optimal one since many of the welfare gains in the fully optimal 9 Notice that the output-gap differential is proportional to the terms-of-trade gap, i. Notice also that in the fully optimal policy the output gap of the area is not fully stabilised but the relative output gaps or the terms of trade are much more stabilised than in the case of the output-gap stabilisation policy.

Inflationtargeting policies are far enough from the previous two policies, because they imply that the output gap of the area is far from stabilised. An interesting observation is that all the policies under consideration perform equally in terms of the variance of the terms-of-trade gap. Given the high degree of price rigidity, and the persistence of the relative price shock, the terms of trade can adjust only slowly. Hence, monetary policy cannot efficiently shift the unfavourable shocks in region H to region F.

In terms of the welfare function 3. However, for this calibrated example, the weights on the inflation rates are of an order of magnitude times larger than the weights on the output gap, thus they matter far more for the maximisation of welfare. Interestingly, in our case, the output-gap policy also does not destabilise the inflation rate.

This shock can be interpreted as a decrease in productivity in region H relative to region F. Efficiency would require that terms-of-trade changes offset completely terms-of-trade shocks, without any movements in domestic inflation rates and output gaps. However, in a currency area, such efficient equilibrium is not feasible.

Monetary Policy Implementation at Different Stages of Market Development (IMFs Occasional Papers) Monetary Policy Implementation at Different Stages of Market Development (IMFs Occasional Papers)
Monetary Policy Implementation at Different Stages of Market Development (IMFs Occasional Papers) Monetary Policy Implementation at Different Stages of Market Development (IMFs Occasional Papers)
Monetary Policy Implementation at Different Stages of Market Development (IMFs Occasional Papers) Monetary Policy Implementation at Different Stages of Market Development (IMFs Occasional Papers)
Monetary Policy Implementation at Different Stages of Market Development (IMFs Occasional Papers) Monetary Policy Implementation at Different Stages of Market Development (IMFs Occasional Papers)
Monetary Policy Implementation at Different Stages of Market Development (IMFs Occasional Papers) Monetary Policy Implementation at Different Stages of Market Development (IMFs Occasional Papers)
Monetary Policy Implementation at Different Stages of Market Development (IMFs Occasional Papers) Monetary Policy Implementation at Different Stages of Market Development (IMFs Occasional Papers)
Monetary Policy Implementation at Different Stages of Market Development (IMFs Occasional Papers) Monetary Policy Implementation at Different Stages of Market Development (IMFs Occasional Papers)

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