James Yetman

Predetermined Prices and the Persistent Effects of Money on Output

This note illustrates a model of predetermined pricing, where firms set a fixed schedule of nominal prices at the time of price readjustment, based on the work of Fischer (1977). This contrasts with the model of fixed pricing, the specification underlying most recent dynamic sticky-price models. It is well known that predetermined pricing cannot generate substantial persistence in the real effects of monetary shocks when prices are set via fixed duration contracts unless the contracts are of long duration. However, we show that with a probabilistic model of price adjustment, a predetermined pricing specification can produce almost as much persistence as the more conventional model of fixed prices, without the assumption of long average contract duration.

Capital Controls, Global Liquidity Traps, and the International Policy Trilemma*

The zero bound on interest rates introduces a new dimension to the trilemma in international policy. The openness of the international financial market might render monetary policy ineffective, even within a system of fully flexible exchange rates, because shocks that lead to a liquidity trap in one country are propagated through financial markets to other countries. However, the effectiveness of monetary policy can be restored by the imposition of capital controls. We derive the optimal response of monetary policy to a global liquidity trap in the presence of capital controls. We show that, even though capital controls might facilitate effective monetary policy, capital controls are not generally desirable in terms of welfare.

Asia's Decoupling: Fact, Fairytale or Forecast?

Standard measures of economic co-movement between Asia-Pacific economies and those elsewhere had been observed to follow a downward trend, leading some commentators to suggest that the region was decoupling. However, this process reversed in response to the 2008 international financial crisis, and co-movement increased to historically high levels for some economies. We examine co-movement patterns and show that these are very sensitive to changes in macroeconomic volatility over time. Controlling for this, however, co-movement is closely linked to underlying trade and financial integration. If international links continue to strengthen in future, co-movement will strengthen in tandem. Decoupling is more a fairytale than a fact or a forecast.

Currency Unions, Trade Flows, and Capital Flows

Trade within currency unions has been shown to be much larger than outside of currency unions, even after factoring in many relevant variables. The existing empirical evidence is based on reduced form models of trade, and therefore indicates that there exists a high correlation between currency union membership and trade, but does not indicate the causality, or the mechanism at work. This paper argues that the balance of evidence points to a large and statistically significant causal relationship from currency unions to trade, and then considers two possible mechanisms behind this: (1) being a member of a currency union reduces trade resistance; and (2) being a member of a currency union reduces investment resistance. Based on a small theoretical model that incorporates both of these, we argue that both mechanisms are important in explaining the economic impact of currency union membership.

Estimating Dynamic Euler Equations with Multivariate Professional Forecasts

Dynamic Euler equations restrict multivariate forecasts and so can be estimated and tested using the predictions of professional forecasters. We illustrate this novel, empirical method by studying the links between forecasts of U.S. nominal interest rates, inflation, and real consumption growth since 1981. Using forecast data for both returns and macroeconomic fundamentals exploits the complete panel of forecasts from the Survey of Professional Forecasters, which yields 3,400 observations, many more than the 117 quarterly time‐series observations. Harnessing the full panel enhances precision in testing asset‐pricing models and may avoid aggregation bias. We find clear evidence for the Fisher effect but mixed evidence of a relationship between expectations of real interest rates and real consumption growth.

The Evolution of Inflation Expectations in Canada and the US

We model inflation forecasts as monotonically diverging from an estimated long-run anchor point towards actual inflation as the forecast horizon shortens. Fitting the model with forecaster-level data for Canada and the US, we identify three key differences between the two countries. First, the average estimated anchor of US inflation forecasts has tended to decline gradually over time in rolling samples, from 3.4% for 1989-1998 to 2.2% for 2004-2013. By contrast, it has remained close to 2% since the mid-1990 for Canadian forecasts. Second, the variance of estimates of the long-run anchor is considerably lower for the panel of Canadian forecasters than US ones following Canadas adoption of inflation targets. And third, forecasters in Canada look much more alike than those in the US in terms of the weight that they place on the anchor. One explanation for these results is that an explicit inflation targeting regime (Canada) provides for less uncertainty about future monetary policy actions than a monetary policy regime where there was no explicit numerical inflation target (the US before 2012) to anchor expectations.

Currency Boards When Interest Rates are Zero

In a fixed exchange rate system, any expectation that the peg may be abandoned will normally be reflected in an interest rate differential between instruments denominated in domestic and anchor currencies: the possibility of a revaluation will drive domestic interest rates below those in the anchor currency, for example. However, when interest rates are close to the zero lower bound, there is limited scope for exchange rate expectations to be reflected in interest rate differentials. Here we introduce a new mechanism, based on the central bank balance sheet, which works to bring about equilibrium in currency markets even when interest rates are zero. An expectation of exchange rate appreciation will cause foreign exchange reserves to swell, increasing the cost to policy-makers of allowing an appreciation and, therefore, lowering the likelihood of the fixed exchange rate being abandoned. Under normal circumstances, this channel reinforces the equilibrating effect of interest rate differentials. When interest rates cannot adjust only this channel operates, implying that much larger changes in reserves are required to equilibrate currency markets. We develop a simple model to illustrate these arguments and find support for the predictions of the model using data for Hong Kong, the worlds largest economy with a currency board.

Hong Kong Consumer Prices are Flexible

It is generally believed that prices in Hong Kong are flexible. If this received wisdom is correct then the Currency Board system, which precludes a nominal exchange rate adjustment in response to macroeconomic shocks, may have little macroeconomic cost. However, this belief in price flexibility is based on very little empirical evidence. In this paper, we seek to rectify this in a study the behaviour of sub-indices of the Hong Kong Consumer Price Index. We compare estimated moments in the data against the predictions of models based on flexible prices, capacity constraints, rational inattention, and menu costs. We find evidence in favour of flexible prices.

The long-run output-inflation trade-off with menu costs

We examine the long-run output-inflation trade-off under the assumption that firms face menu costs and set prices in a state dependent fashion. We argue that these characteristics capture the idea that the long-run output-inflation trade-off is driven by (predictable) trend inflation, and the degree of price rigidity should be chosen optimally by firms in the long run, at least on average. We find that state dependent pricing implies a non-trivial departure from long-run monetary neutrality in terms of output, and a larger one in terms of utility. This is because trend inflation substantially influences average mark-ups and relative price distortions. We find that price stability is optimal.

Publishing Central Bank Forecasts

In this paper, a simple model of information asymmetry is used to study central bank forecast publication. Central banks are assumed to choose between not publishing a forecast, publishing a forecast that conditions on current policy, publishing an unconditional forecast, or publishing both. There is no incentive for the central bank to publish forecasts unless it faces conflicting output and inflation objectives, and also possesses an information advantage over agents. A conservative central bank that does not have a large information advantage over agents may prefer not to publish forecasts at all, while a central bank that enjoys a large information advantage will prefer to publish unconditional forecasts.