Maria Demertzis

Inflation Targets as Focal Points

In a world characterised by noisy information and conflicting signals, no Central Bank is always able to affect private sector expectations. Based on Morris and Shins model, monetary policy then becomes an information game, in which individuals form their expectations based on all the information that is available to them (public and private). However individual agents also know that ultimately inflation is affected by both the objectives of the Central Bank (and hence the policies it pursues) as well as the average expectation formed by the all agents. They thus need to evaluate both actions. Central to our argument is the way that individuals interpret these actions to form their expectations. We apply Bacharachs methodology to provide a framework for assessing everyones interpretations. Our contribution is to merge these two models to show that a monetary policy regime that has explicit quantitative objectives may provide individuals with better anchors for expectations to coordinate at. However, that is only true first, if no great shocks are anticipated to hit the economy and second, when all other public information is very unclear thus rendering the inflation target the only clear piece of information. We derive in detail the conditions under which this is true.

Is the European union a natural currency area, or is it held together by policy makers?

Is the European Union a Natural Currency Area, or Is It Held Together by Policymakers? — In 1999, EMU started with 11 members, but with considerable uncertainty about the depth of the convergence between them. The optimal currency area literature stresses the need for shocks which are symmetric and of similar size across countries. Our results show that symmetries in the core are only marginally stronger than those in the periphery; and that these symmetries have been increasingly maintained by policy interventions. Consequently, Europe may evolve into an optimal currency area; but the symmetries will be policy-induced rather than a market phenomenon. This suggests a fragility which could be reflected in the value of the new currency.ZusammenfassungIst die EuropÄische Union ein natürlicher WÄhrungsraum oder wird sie durch Politiker zusammengehalten? — Im Jahre {dy1999} startete die EWU mit 11 Mitgliedstaaten, aber mit erheblicher Unsicherheit hinsichtlich der Tiefe der Konvergenz zwischen ihnen. Die Literatur über den optimalen WÄhrungsraum betont die Notwendigkeit von Schocks, die symmetrisch und lÄnderweit von Ähnlicher StÄrke sind. Die Ergebnisse der Verfasser zeigen, da\ Symmetrien im Kernraum nur unwesentlich stÄrker sind als in der Peripherie und da\ diese Symmetrien zunehmend durch politische Eingriffe aufrechterhalten worden sind. Folglich könnte sich Europa zum optimalen WÄhrungsraum entwickeln, aber die Symmetrien werden eher politik-induziert als ein MarktphÄnomen sein. Das deutet auf eine SchwÄche hin, die sich im Wert der neuen WÄhrung wiederspiegeln könnte.

Monetary Policy and Excessive Bank Risk Taking

If monetary policy is to aim at financial stability, how would it change? To analyze this question, this paper develops a general-form model with endogenous bank risk profiles. Policy rates affect both bank incentives to search for yield and the cost of wholesale funding. Financial stability objectives are then shown to make a monetary authority more conservative and more aggressive. Conservative as it sets higher rates on average. And aggressive because, in reaction to negative shocks, cuts are deeper but shorter-lived than otherwise. Keeping cuts short is crucial as bank risk responds primarily to stable low rates. Within the short span, cuts then must be deep to achieve standard objectives.

'Leaning Against the Wind' and the Timing of Monetary Policy

If monetary policy is to aim also at financial stability, how would it change? To analyze this question, this paper develops a general-form framework. Financial stability objectives are shown to make monetary policy more aggressive: in reaction to negative shocks, cuts are deeper but shorter-lived than otherwise. By keeping cuts brief, monetary policy tightens as soon as bank risk appetite heats up. Within this shorter time span, cuts must then be deeper than otherwise to also achieve standard objectives. Finally, we analyze how robust this result is to the presence of a bank regulatory tool, and provide a parameterized example.

Can the ECB be Truly Independent? Should It Be?

Most of the literature on the independence of the Central Bank assumes only one policy instrument is available: monetary policy. If we introduce fiscal policy as well, when preferences may differ among policy-makers, the situation is radically different. In this case fiscal policy will substantially weaken the impact of the Central Banks actions, and may annihilate them altogether. The Stability Pact may then be a liability, instead of an asset, because it renders both policies impotent (even if credible). We examine whether there is any incentive to retain monetary policy independence; and whether accountability can and should be used to ensure fiscal and monetary policies support each other, rather than undermine each other.

Identifying Booms and Busts in House Prices under Heterogeneous Expectations

We introduce heterogeneous expectations in a standard housing market model linking housing rental levels to fundamental buying prices. Using quarterly data we estimate the model parameters for eight different countries, US, UK, NL, JP, CH, ES, SE and BE. We find that the data support heterogeneity in expectations, with temporary endogenous switching between fundamental mean-reverting and trend-following chartists beliefs based on their relative performance. For all countries we identify temporary house price bubbles, amplified by trend extrapolation, and crashes reinforced by fundamentalists. The qualitative predictions of such non-linear models are very different from standard linear benchmarks, with important policy implications. The fundamental price becomes unstable, e.g. when the interest rate is set too low or mortgage tax deductions too high, giving rise to multiple non-fundamental equilibria and/or global instability.

Complex Methods in Economics: An Example of Behavioral Heterogeneity in House Prices

We show how simple statistical techniques for capturing critical transitions used in natural sciences, fail to capture economic regime shifts. This implies that we need to use model-based approaches to identify critical transitions. We apply a heterogenous agents model in a standard housing market model to show that these family of models generate non-linear responses that can capture such transitions. We estimate this model for the United States and the Netherlands and find that first, the data does capture the heterogeneity in expectations and, second, that the qualitative predictions of such nonlinear models are very different to standard linear benchmarks. It would be important to identify which approach can serve best as an early warning indicator.

Aiming for the Bull's Eye: Inflation Targeting under Uncertainty

We study the implications of uncertainty for ination targeting. We apply Brainards static framework which imposes multiplicative uncertainty in the monetary transmission. Brainards main result is that in the presence of uncertainty, monetary authorities become naturally more cautious. But this also implies that monetary objectives are seldom achieved. We there- fore attempt next to ...nd a monetary rule that reaches the objectives set more often, improving therefore the welfare of the Central Bank. Such a rule is the result of a new algorithm that we put forward, in which the ination target is state contigent. The Central Bank sets (as an auxil- liary step) therefore, a variable ination target that depends optimally, on both the degree of uncertainty as well as on the shocks that occur each time. We show that such a rule helps the CB attain its objectives more often thereby reducing the losses incurred. Moreover, and as a corollary to such an approach, the rule derived is ex ante neutral to the degree of uncertainty.

A credibility proxy : tracking US monetary developments

The purpose of this paper is two-fold: first, we propose a method for checking empirically whether inflation expectations are anchored in the long run, and at what level. The extent of anchoring then serves as a proxy for the credibility of the monetary authority. Second, to assess how well this measure proxies credibility, we cross-check it against periods for which the level of credibility is known and generally agreed upon. To this end, we apply our measure to the US inflation history since 1963, which includes both the period of the Great Inflation, in which credibility was poor and deteriorating, as well as the period of the Great Moderation during which credibility in the monetary authority was gradually re-established. Finally we check what our measure of credibility tells us about the crisis period.

Will Macroprudential Policy Counteract Monetary Policy's Effects on Financial Stability?

HHow does monetary policy impact upon macroprudential regulation? This paper models monetary policy’s transmission to bank risk taking, and its interaction with a regulator’s optimization problem. The regulator uses its macroprudential tool, a leverage ratio, to maintain financial stability, while taking account of the impact on credit provision. A change in the monetary policy rate tilts the regulator’s entire trade-off. We show that the regulator allows interest rate changes to partly “pass through” to bank soundness by not neutralizing the risk-taking channel of monetary policy. Thus, monetary policy affects financial stability, even in the presence of macroprudential regulation