Lars E.O. Svensson

Open-Economy Inflation Targeting

The paper extends previous analysis of closed-economy inflation targeting to a small open economy with forward-looking aggregate supply and demand with some microfoundations, and with stylized realistic lags in the different transmission channels for monetary policy. The paper compares targeting of CPI and domestic inflation, strict and flexible inflation targeting, and inflation-targeting reaction functions and the Taylor rule. The optimal monetary policy response to several different shocks is examined. Flexible CPI-inflation targeting stands out as successful in limiting not only the variability of CPI inflation but also the variability of the output gap and the real exchange rate. Somewhat counter to conventional wisdom, negative productivity supply shocks and positive demand shocks have similar effects on inflation and the output gap, and induce similar monetary policy responses. The model gives limited support for a so-called monetary conditions index, MCI, of the monetary policy impact on aggregate demand, but the impact on inflation is too complex to be captured by any single index. The index differs from currently used indices in combing (1) a long rather than a short real interest rate with the real exchange rate and (2) expected future values rather than current values. Because of (2), the index is not directly observable and verifiable to external observers.

Why a Stubborn Conservative would Run a Deficit: Policy with Time-Inconsistent Preferences

A conservative government, in favor of a low level of public consumption, knows that it will be replaced by a government in favor of a larger level of public consumption. We show that the resulting level of public consumption is in between the levels the two governments would choose if each were in power both in the present and in the future. In particular, we show that if the conservative government is more stubborn (in a particular sense) than the succeeding government, the conservative government will borrow more than it would had it remained in power in the future.

Estimating and Interpreting Forward Interest Rates: Sweden 1992 - 1994

The use of forward interest rates as a monetary policy indicator is demonstrated, using Sweden 1992-1994 as an example. The forward rates are interpreted as indicating market expectations of the time- path of future interest rates, future inflation rates, and future currency depreciation rates. They separate market expectations for the short, medium and long term more easily than the standard yield curve. Forward rates are estimated with an extended and more flexible version of Nelson and Siegels functional form.(This abstract was borrowed from another version of this item.)

The Terms of Trade and the Current Account: The Harberger-Laursen-Metzler Effect

The paper examines the effect of terms-of-trade changes on a small countrys spending and current account, assuming optimizing behavior in an intertemporal framework with perfect international capital mobility. A temporary (future) terms-of-trade deterioration implies a deterioration (improvement) of the trade balance, whereas a permanent terms-of-trade deterioration has an ambiguous effect, depending on the rate of time preference. Nominal and real variables are considered via exact price indexes. Two periods and an infinite horizon are examined.

Transparency and Credibility: Monetary Policy with Unobservable Goals

We define and study transparency, credibility, and reputation in a model where the central banks characteristics are unobservable to the private sector and are inferred from the policy outcome. A low-credibility bank optimally conducts a more inflationary policy than a high-credibility bank, in the sense that it induces higher inflation, but a less expansionary policy in the sense that it induces lower inflation and employment than expected. Increased transparency makes the banks reputation and credibility more sensitive to its actions. This has a moderating influence on the banks policy. Full transparency of the central banks intentions is generally socially beneficial, but frequently not in the interest of the bank. Somewhat paradoxically, direct observability of idiosyncratic central bank goals removes the moderating incentive on the bank and leads to the worst equilibrium.

Money and Asset Prices in a Cash-in-Advance Economy

An asset-pricing model with money introduced via a cash-in-advance constraint is presented. The monetary velocity is variable; hence money demand does not obey the trivial quantity equation. The effects of disturbances in output and money growth on real balances, the price level, and interest rates are examined. Monetary policy has effects on real asset prices. The Fisher relation and the premium on nominal bonds are discussed. The precise role of the timing of information and transactions for properties of price levels and interest rates are clarified.

New Techniques to Extract Market Expectations from Financial Instruments

This paper is a selective survey of new or recent methods to extract information about market expectations from asset prices for monetary policy purposes. Traditionally, interest rates and forward exchange rates have been used to extract expected means of future interest rates, exchange rates and inflation. More recently, these methods have been refined to rely on implied forward interewst rates, so as to extract expected future time paths. Very recently, methods have been designed to extract not only the means but the whole (risk neutral) probability distribution from a set of option prices.

Price-Level Targeting versus Inflation Targeting: A Free Lunch?

Price level targeting (without base drift) and inflation targeting (with base drift) are compared with persistence in output (generated by sticky prices, for instance). Counter to conventional wisdom, price level targeting results in lower short-run inflation variability than inflation targeting (if output is at least moderately persistent). Price level targeting also eliminates any average inflation bias. Even if the preferences of society correspond to inflation targeting, it may nevertheless prefer to assign price level targeting to the central bank. Price level targeting thus appears to have more advantages than what is commonly acknowledged.

Social Value of Public Information: Morris and Shin (2002) is Actually Pro Transparency, Not Con

The main result of Morris and Shin (2002) (restated in papers by Amato, Morris, and Shin (2002) and Amato and Shin (2003) and commented upon by Economist (2004)) has been presented and interpreted as an anti-transparency result: more public information can be bad. However, some scrutiny of the result shows that it is actually pro transparency: except in very special circumstances, more public information is good. Furthermore, for a conservative benchmark of equal precision in public and private information, social welfare is higher than in a situation without public information.

Inflation Targeting: Should it Be Modeled as an Instrument Rule or a Targeting Rule?

The paper discusses how current inflation targeting should be modeled, and argues that it is better represented as a commitment to a targeting rule (a rule specifying operational objectives for monetary policy or a condition for the target variables), than as a commitment to a simple instrument rule (like a Taylor rule).