Riccardo Rovelli

Macroeconomic Stability and the Preferences of the Fed. A Formal Analysis, 1961-98

The rate of inflation in the U.S. has declined from an average of 4.5% in the period 1960-79 to an average of 3.6% in 1980-98. Between those two periods, the standard deviations of inflation and the output gap have also declined. These facts can be attributed to the interaction of three possible factors: a shift in central bank preferences, a reduction in the variability of aggregate supply shocks, and a more efficient conduct of monetary policy. In this paper we identify the relative roles of these factors. Our framework is based on the estimation of a small structural macro model for the U.S. economy jointly with the first order conditions, which solve the intertemporal optimization problem faced by the Fed. Overall, our results indicate that the policy preferences of the Fed, and in particular the (implicit) inflation target, have changed drastically with the advent of the Volcker-Greenspan era. In addition, we find that the variance of supply shocks has been lower and monetary policy has been conducted more efficiently during this period.

How much (a)symmetry in Europe? Evidence from industrial sectors

Abstract To what extent do European countries differ with respect to the sources of cyclical fluctuations of industrial output? We look at output data disaggregated by industry for 11 European countries, and on the basis of a cointegrated vector autoregression model we examine the correlation of output innovations at the industry and country levels. We also discuss to what extent output innovations can be considered ‘symmetric’ or ‘asymmetric’. Our results point to the fact that, on average, more variance of output innovations is explained at the country, rather than the industry level. We also find that the importance of asymmetric disturbances is quite varied among the 11 countries, and we identify a ‘core’ of countries with a higher degree of symmetry.

Monetary Policy Transmission, Interest Rate Rules and Inflation Targeting in Three Transition Countries

In 1991, the rate of inflation in the Czech Republic, Hungary and Poland was between 35% and 70%. At the end of 2001, it is below 8%. We setup a small structural macro model of these economies to explain the process of disinflation. Contrary to a widespread skepticism, which permeated a large part of previous research on these issues, we show that a simple open macroeconomic model, along the lines of Svensson (2000, Journal of International Economics), with forward-looking inflation and exchange rate expectations, can adequately characterize the relationship between the output gap, inflation, the real interest rate and the exchange rate during the course of transition. We use the estimated models to interpret the main features of monetary policy in each country and identify the channels of policy transmission. We characterize the policy rules and assess the relative importance of the interest rate channel (on aggregate demand) and the exchange rate channel (which affects both aggregate demand and supply) in determining the path of (dis)inflation. In the same context, we also tentatively analyze the consequences of attempting a faster path of disinflation. Finally, we evaluate the appropriateness of the inflation targeting framework which has been adopted recently in all three countries, and discuss to what extent it represents a discontinuity with the past.

Capital markets, financial intermediaries, and liquidity supply

Abstract We study a dynamic economy endowed with a sequence of overlapping generations of consumers and production processes, and where productive assets are illiquid and consumption preferences are subject to uninsurable demand for liquidity. We characterize the steady states that can be achieved with alternative financial systems. We show that infinitely lived financial intermediaries offering a liability with age-dependent restrictions may implement a social optimum with full insurance. If, instead, they offer anonymous, unrestricted contracts, then only second-best consumption allocations with partial insurance obtain. We also examine the consumption allocations available when agents can trade shares in competitive stock markets. While allowing for trade across generations may or may not improve upon generational autarky, we show that this competitive equilibrium is not a social optimum, and is dominated by a system of infinitely lived, unrestricted intermediaries.

Monetary and Fiscal Policy Coordination and Macroeconomic Stabilization. A Theoretical Analysis

We examine the relations between monetary and fiscal policies in the process of macroeconomic stabilization.Our model suggests that each policimaker prefers to be the second mover in a “Stakelberg” situation, i.e. where one policy makers precommits its policy choce. At the same time, both Stakelberg solutions are preferable, for each policumaker, to the Nash solution. We argue that there is a natural way to choose among two Stakelberg games. The solution implies that the government acts as a leader and sets fiscal policy according to the minimization of the Social Welfare Function (which fully internalizes also the objective of price stability). This optimal solution mirrors the existing institutional arrangements, where fiscal policy decisions ate typically taken before, and less frequently than monetary policy decisions. We interpret our results in relation to the debate on monetary-fiscal coordination in EMU and on the role of the Stability and Growth Pact. We argue that a coordination mechanism along the lines of the Broad Economic Policy is desirable.

Modeling and Identifying Central Banks' Preferences

We propose an approach to identify independently the parameters describing the structure of the economy from those describing central bank preferences. We first estimate a parsimonious structural model for US inflation, US output-gap and the world commodity price index. We then proceed to the identification of central bank preferences by estimating by GMM the Euler equations for the solution of the intertemporal optimization problem relevant to the central bank. The empirical analysis of the structural model shows that the persistency of real interest rates effects on aggregate demand is sufficient to generate an autoregressive structure in any interest rate rule. From estimation of the Euler equations, we infer that strict inflation targeting together with real interest rate smoothing delivers an optimal policy rule capable of replicating the observed path of real interest rates over the sample 1983:1 - 1998:3. Our empirical findings imply that the output gap enters into the optimal interest rate rule only as a leading indicator of future inflation, and we reject the hypothesis that output stabilization is an independent argument in the loss of function of the Fed.

Central banks and seigniorage: A study of three economies in transition

Abstract The paper examines the relations between central banks and other macro sectors in the Czech Republic, Hungary, Romania, with respect to the creation and distribution of seigniorage, taking Austria and Germany as a reference. In economies in transition, transfers of seigniorage from the central bank to the government and to the banking sector may appear as a natural way to soften the financial constraints of both sectors. We propose a simple framework for the analysis of central bank seigniorage, based on the opportunity cost approach, and measure both the amount and allocation of seigniorage for the five countries in 1993. We find central bank seigniorage to be approximately four times our benchmark value in Hungary, and thirty times in Romania (the latter due to the high level of the inflation tax). In Hungary and Romania most seigniorage is appropriated (as an interest rate subsidy) by the government; in Romania a large part also goes as a subsidy to the financial sector. In none of the five countries we find that central banks retain an excessive amount of seigniorage for reserve accumulation or for current expenditures. In the last part of the paper we discuss the implications of our findings on seigniorage for the evaluation of central bank independence vis-a-vis the government.

Independent or Coordinated? Monetary and Fiscal Policy in EMU

We examine, in a suitable theoretical framework, the relations between monetary and fiscal policies within the European Economic and Monetary Union (EMU). Our stylized setup of EMU includes the following political agents, each endowed with an objective function: (i) A central authority (EC), which aims at maximizing a Social Welfare criterion; (ii) National Fiscal Authorities (FA), which pursue domestic output stabilization, (iii) the European Central Bank (ECB) which has a mandate to stabilize inflation. In this context we ask the following questions: - How would the EC want to direct (or coordinate) the national FA? - Do the EC decisions make control of inflation (the ECB mandate) easier or more difficult? - Do national FA have an incentive to obey to or to deviate from the EC directives? In response to the last question, our main result is that national FA may have an incentive to deviate, even if we exclude time-inconsistent motives in their preference functions, or motives linked to a failure to internalize aggregate demand spillovers. In particular, even in the absence of asymmetric shocks and of aggregate demand spillovers, EC authorities and national governments may have conflicting incentives, depending upon the relative size of disturbances to aggregate demand and supply. When both aggregate demand and supply shocks are positive (resp. negative) and the latter are large enough in absolute terms, then national governments will pursue a more expansionary (resp. contractionary) fiscal policy than it would be desirable from the point of view of social welfare. Our results imply that, if the EC authorities are required to enforce a social welfare function defined over aggregate output and inflation, then it may be necessary to endow the EC with appropriate enforcement devices with respect to the fiscal policy stance of individual member countries. This points to the necessity of having institutions (such as the Stability and Growth Pact, SGP) which help to coordinate and discipline the fiscal stance of member countries. While we do not discuss the specific provisions of the SGP, our conclusions strongly support the idea that the setting of fiscal policies by member countries needs to be disciplined, and in some instances possibly over-ruled, by the EC authorities.

Painless Disinflation? Monetary Policy Rules in Hungary, 1991-99

We estimate a small structural model for inflation, the output gap, the domestic interest rate and the exchange rate for Hungary during the period of the transition (1991-1999). The transmission of monetary policy impulses to macro variables is characterized in a similar fashion to that of advanced open industrial countries. In particular, in the context of our rational expectations, forward-looking model, the interest rate channel on aggregate demand and the exchange-rate channel work together as parts of the same disinflation policy. We draw several conclusions on understanding and modeling the effects of monetary policy, and also on the desirable design of policy rules during the process of disinflation. Keywords: disinflation policy, interest rate rules, transition economies, small open-economy macro models, estimation and simulation of rational expectations models

Investor Risk Aversion and Financial Fragility in Emerging Economies

Bank intermediated short-term capital inflows play a crucial role in the financial structure of many emerging economies. Yet since these funds are subject to the risk of early withdrawal, an excessive reliance on this financing is often associated with a financial or currency crisis. We model a situation where withdrawals are motivated by a change in either the domestic or foreign fundamentals. We show that, for a given change in fundamentals, a sudden reversal in the capital flows, and hence a financial crisis, is more likely the more risk averse are the foreign investors. We also show that a policy to tax early withdrawals may discourage the inflows more likely to cause fundamental runs, as it prevents the relatively more risk averse investors from investing. However, the policy must be fine-tuned to avoid discouraging all capital inflows.