Dale W. Henderson

Optimal Monetary Policy with Staggered Wage and Price Contracts

We formulate an optimizing-agent model in which both labor and product markets exhibit monopolistic competition and staggered nominal contracts. The unconditional expectation of average household utility can be expressed in terms of the unconditional variances of the output gap, price inflation, and wage inflation. Monetary policy cannot replicate the Pareto-optimal equilibrium that would occur under completely flexible wages and prices; that is, the model exhibits a tradeoff between stabilizing the output gap, price inflation, and wage inflation. The Pareto optimum is attainable only if either wages or prices are completely flexible. For reasonable calibrations of the model, we characterize the optimal policy rule. Furthermore, strict price inflation targeting is clearly suboptimal, whereas rules that also respond to either the output gap or wage inflation are nearly optimal.

Market Anticipations of Government Policies and the Price of Gold

This paper is an analysis of the effects of anticipations of government sales policies on the real price of gold. Although the risk of a future government gold auction depresses the price, it also causes the price to rise in percentage terms faster than the real rate of interest and at an increasing rate. Even risk-neutral investors require this rate of return as inducement to hold gold in the face of the asymmetric risk of a price collapse. Announcements making a government auction more probable cause a sudden drop in the price. Government attempts to peg the price or to defend a price ceiling with sales from its stockpile must result eventually in a sudden attack by speculators.

Monetary Policy When the Nominal Short-Term Interest Rate is Zero

In an environment of low inflation, the Federal Reserve faces the possibility that it may not have provided enough monetary stimulus even though it had pushed the short-term nominal interest rate to its lower bound of zero. Assuming the nominal Treasury-bill rate had been lowered to zero, this paper considers whether further open market purchases of Treasury bills could spur aggregate demand through increases in the monetary base. Such action may be stimulative by increasing liquidity for financial intermediaries and households; by affecting expectations of the future paths of short-term interest rates, inflation, and asset prices; through distributional effects; or by stimulating bank lending through the credit channel. This paper also examines the alternative policy tools that are available to the Federal Reserve in theory, and notes the practical limitations imposed by the Federal Reserve Act. The tools the Federal Reserve has at its disposal include open market purchases of Treasury bonds and certain types of private-sector credit instruments; unsterilized and sterilized intervention in foreign exchange; lending through the discount window; and, in some circumstances, may include the use of options.

The Information Content of the Interest Rate and Optimal Monetary Policy

Optimal monetary policy rules are derived in a rational expectations cum contracting framework. Monetary policy is redundant if wage setters exploit the incomplete current information embodied in todays nominal interest rate. However, the monetary authorities can save wage setters the costs of “indexing†to the interest rate. A contemporaneous money supply feedback rule is as effective as wage indexation. A lagged rule, relevant under a regime of money supply targeting, is also as effective if investors use the interest rate. Both rules have the same implications for the real interest rate as Pooles combination policy. However, the two rules have strikingly different implications for the nominal interest rate.

Negative net foreign asset positions and stability in a world portfolio balance model

Abstract Negative net foreign asset positions have been associated with a troublesome stability problem in flexible exchange rate regimes. In this paper a symmetrically-specified, two-country, portfolio balance model is employed to provide some perspective on this problem. It is concluded that negative net foreign asset positions do not constitute an independent source of instability. Instability can arise only under nonrational expectations or because of destabilizing speculation.

Is Inflation Targeting Best-Practice Monetary Policy?

We describe the inflation targeting framework (ITF) and compare it against hypothetical best-practice based on optimization. The core requirements of the ITF are an explicit long-run inflation goal and a commitment to transparency in policymaking. Advocates and practitioners of the ITF have made many contributions to clear goal setting and communication by central banks. However, we contend that ITF communication policies both as advocated and practiced often have some elements that either obfuscate or, in some cases, explicitly contradict the dictates of optimization in a stabilization-policy paradigm. In this paradigm, the central bank has an objective function that places weight on both inflation and output-gap stabilization and faces a conventional (exploitable) Phillips-curve trade-off. We point out some problems that the ITF communication policy may generate in this setting. Our analysis leads us to make four suggestions for communication policy intended to help central banks avoid these problems.

Financial capital movements and central bank behavior in a two-country, short-run portfolio balance model

Abstract This paper analyzes financial capital movements in a two-country, short-run, portfolio balance model which includes two securities that are imperfect substitutes. Following a disturbance, equilibrium is, in general, reattained, but the effects on interest rates, money supplies, and international reserve holdings depend on the monetary and reserve asset management policies of the two central banks. Special attention is focused on the case in which one central bank holds its international reserves in the form of ‘key currency’ securities, thereby sterilizing for the ‘key currency’ country. There are several applications of the central result that, for any disturbance, the less changes in international reserves are allowed to affect money supplies, the larger the change in reserves required to reestablish equilibrium.

Chapter 15 The specification and influence of asset markets

Publisher Summary This chapter discusses portfolio balance models with postulated asset demands, asset demands broadly consistent with but not directly implied by microeconomic theory. The demand for the sum of assets denominated in each currency is homogeneous of degree one in nominal wealth, and the demand for money in each country depends on the return on the security denominated in that countrys currency but not on the return on securities denominated in other currencies. However, under these same assumptions the demand for money depends on real wealth. Because the conclusions of macroeconomic analysis often depend crucially on the form of asset demand functions, it is important to continue to explore the implications of the microeconomic theory and other microeconomic approaches. The chapter discusses that the consumer arrives at his or her asset demands by maximizing his or her utility given interest rates and the parameters of the distributions of prices and exchange rates. The distributions of prices and exchange rates are not invariant to changes in the distributions of policy variables and stochastic components of tastes and technology. It has been recognized that a very important item on the research agenda is imbedding consumers asset demands based on utility maximization in a general equilibrium model in which the distributions of prices and exchange rates are determined endogenously.

Price-Level Determinacy, Lower Bounds on the Nominal Interest Rate, and Liquidity Traps

We consider monetary-policy rules with inflation-rate targets and interest-rate or money-growth instruments using a flexible-price, perfect-foresight model. There is always a locally-unique target equilibrium. There may also be below-target equilibria (BTE) with inflation always below target and constant, asymptotically approaching or eventually reaching a below-target value, or oscillating. Liquidity traps are neither necessary nor sufficient for BTE which can arise if monetary policy keeps the interest rate above a lower bound. We construct monetary rules that preclude BTE when fiscal policy does not. Plausible fiscal policies preclude BTE for any monetary policy; those policies exclude surpluses and, possibly, balanced budgets.

Inflation targeting and nominal-income-growth targeting: When and why are they suboptimal?

Abstract We compare optimal and simple interest-rate rules. Our model features optimizing agents, monopolistic competition in both product and labor markets, and one-period nominal contracts (for wages alone or for both wages and prices) signed before shocks are known. Exact solutions ensure that we obtain correct welfare rankings. Optimal rules maximize the unconditional expected utility of the representative agent with commitment subject to the information set of the policymaker. Even with monopolistic distortions, the optimal full-information rule makes the economy mimic the hypothetical full-flexibility equilibrium. Strict versions of inflation targeting, nominal-income-growth targeting, and other such simple rules are suboptimal under both full and partial information but flexible versions are optimal under certain partial-information assumptions. Nominal-income-growth targeting dominates inflation targeting for plausible parameter values.