Links to Recent Research Papers

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Links to Recent Research Papers

MONETARY POLICY STRATEGY

„Banking and Interest Rates in Monetary Policy Analysis: A Quantitative Exploration“


by Marvin Goodfriend and Bennett McCallum (Carnegie Mellon)

In this paper, which is to appear in the Journal of Monetary Economics, the authors try to rectify a glaring omission in standard macro models: they do not have a banking sector and there is only one interest rate, making them woefully inadequate to analyse situations of financial distress. The authors introduce banks as producers of credit. The cost of production drives the interbank rate, which is the target rate of most central banks, below the interest rate that borrowers have to pay. Over the business cycle, or due to shocks, the demand for credit and the production cost of credit vary in ways, which standard models cannot grasp. One important channel is the value of collateral, which enters the model as a resource making credit production cheaper. The paper is an extension of Goodfriend’s earlier paper »  (here) in which he outlined the model. With this paper the two authors calibrate Goodfriend's model with US data to provide information on the quantitative importance of these issues. The result indicates that single-interest-rate-models can be very flawed guides to monetary policy. Of particular interest is a policy experiment in which the authors assume a one percent decline in collateral to capture the consequences of financial distress. In their model a need for a drastic decrease of the central banks target rate is needed to restore non-deflationary equilibrium. A further contribution of the model is to help explain the equity premium puzzle. Bonds yield a lot less than equity, because bonds provide better collateral services, which make them more attractive to hold. »  Working Paper, this version, November 2006

The Folly of the Fed or: Why is the Fed so Hardcore?


by, Willem Buiter (London School of Economics and ECB Shadow Council)

In his usual provocative manner, Willem Buiter critizises the focus of the Federal Reserve on core inflation as outdated and dangerous. He argues that demand from China and India is driving up prices of non-core goods and headline inflation, while at the same time depressing core inflation. He warns that the Fed is about to lose control over the inflation process. »  Maverecon, June 30, 2007

Money, Money, Money


The Bundesbank has answered to recent attacks on the ECB's monetary pillar, (»  like this latest one by Christian Noyer of the Banque de France ) with a series of working papers. In an unpublished background paper distributed to selected journalists participating in a background briefing the bank layed out the following conclusions of its research:
“1. Monetary indicators contain important information for future inflation and should therefore play a role in the monetary-policy decision-making process. The information content of single monetary indicators for inflation varies across time. (…) In communicating with the public, this calls for not stressing single monetary indicators too much. The general information content of monetary developments for future inflation can be represented by money-based inflation forecasts (…) presented using fan-charts (…) as average inflation rates over the forecast horizon.
2. There is a stable money demand relationship if the standard money demand specification is augmented by house price or housing wealth developments (while) the exact interrelationship between house price developments and HICP inflation remains an open issue (…)”
Interestingly, further down into the long background paper the Bundesbank economists admit that “it is now largely undisputed that recently standard money demand specifications fail econometric stability tests”. The official line of the Bundesbank is, that it is too early to tell.

One of the presented papers is:
Reconsidering the Role of Monetary Indicators for Euro Area Inflation from a Bayesian Perspective Using Group Inclusion Probabilities
by Michael Scharnagel and Christian Schumacher (Bundesbank)
The authors describe their methodology and results as follows: “ We apply a Bayesian Model Averaging (BMA) exercise that selects the relevant indicators endogenously according to their marginal contribution to forecast inflation. We estimate posterior probabilities of a particular variable being in the forecast model. A novel aspect of the paper is the introduction of group inclusion probabilities, which helps to address the empirical question whether the group of monetary variables is relevant for forecasting euro area inflation. Apart from a trend measure of M3, the individual inclusion probabilities of monetary indicators are rather low and not constant over time. On the other hand, empirical group inclusion probabilities are high for joint forecast models”
The last finding would seem to imply that integrating monetary and other indicators into a single forecasting model would be desirable. However, the Bundesbank economists claim in the unpublished background paper, that this conclusion cannot be drawn.
Unfortunately, the estimated coefficients of inflation on the monetary variables are not reported. It is not even reported, if the long-run predicted effect of higher monetary growth on inflation is positive or negative. One wonders, what it tells us, that ex-post always SOME monetary indicators would have been useful predictors of inflation, if there is no way ex ante of knowing which ones will be useful in real time.
»  Discussion Paper No 09/2007.

A second paper in this series :
Money and Housing – Evidence for the Euro Area and the US
by Claus Greiber and Ralph Setzer (Bundesbank)
might be part of the reason, why Bundesbank-president Axel Weber has recently been pushing for the inclusion of owner occupied housing costs into the consumer price index. The authors find that the money demand function is stable if housing variables are taken into account, but admit that the relationship of housing prices and consumer prices, the ultimate target of the ECB’s monetary policy is unclear. In the unpublished briefing paper (see above) Bundesbank economists argue that such a relationship would be established directly, if “property prices are (or should be) part of the consumer price index because they are components of the costs of living.”
»  Bundesbank Discussion Paper Nr 12, 2007.

After a long silence on money the Bank of Italy also published a working paper with relevance to the discussion:
The Sectoral Distribution of Money Supply in the Euro Area

by Giuseppe Ferrero, Andrea Nobili and Patrizia Passiglia (Bank of Italy)
The authors obtain the result that the inflation risks from the prolonged deviation of money growth from its reference value since 2001is lower “than generally considered”. They attribute a significant part of the excessive money growth to money demand by non-bank financial intermediaries, a larger role of investment funds and foreign demand for high denomination euro notes. They conclude with the sceptical remark that: “permanent changes in the fincancial system produced by the increasing role of non-bank financial intermediaries in the economy can (…) offset the leading indicator properties of excess liquidity measures for future inflation.” »  Discussion Paper No 627 - April 2007.

Is There a Structural Break in Equilibrium Velocity in the Euro Area?
by Christian Bordes (Sorbonne), Laurent Clerc (Banque de France) and Vêlayoudom Marimoutou (GREQAM; and CNRS)
This study, published on the website of the Banque de France, contains dynamite. Its first sentence questions the “reliability of M3 growth as a pillar of the ECB’s monetary policy strategy.” The working paper contains the results of the research that BdF-president Christian Noyer referred to in his November-presentation (see entry below). The authors conclude that the money overhang would disappear if the reference value for M3 was revised, to take into account a dramatic and persistent upward-shift in the rate of decline of M3 velocity. This would contradict the recent assertion of ECB-Chief Economist Juergen Stark that the reference value is still correctly fixed at 4.5 percent.
»  Notes d' Études et de Recherche, February 2007.

Does Money Matter? A European Perspective


by Christian Noyer (Banque de France and ECB Governing Council)
This interesting speech, held at the ECB Central Banking Conference on 9 November 2006 is not posted on the ECB website with the other papers and speeches. The link below goes to the BIS website. Noyer cites ongoing research by the Banque de France, which suggests a structural break in the income velocity of money. He mentions “chronic instability, if not unpredictability” of money demand in modern market economies. These are remarkable comments from a member of the ECB Governing Board The sensitivity of the issue for the monetary pillar of the ECB strategy is underlined by a quote from the ECB’s Monthly Bulletin (May 2001): “M3 has a stable relationship with the price level and displays good leading indicator properties for future inflation. These empirical properties are preconditions both for a meaningful monetary analysis and for money to be informative for monetary policy.” While Christian Noyer and Lucrezia Reichlin had no problem admitting that money demand functions had become unstable, it has proven very hard to get an official statement by the ECB on anything having to do with either the stability of money demand or on the reference value for M3 growth, which critically depends on stable money demand functions. The last time the ECB officially visited the issue, in October 2004, they concluded that instability could not be proven with sufficient certainty. A more recent official judgement could not be found. October 2004 was also the last time that the “reference value for M3 growth”, was mentioned in the ECB’s Monthly Bulletin, according to research done by Handelsblatt. On March 2, Handelsblatt quoted ECB Chief Economist Juergen Stark as saying: “Monetary developments in the past few years can’t be completely explained by the determinants of traditional money-demand functions”. Mr. Stark later denied the newspaper's interpretation that he admitted a problem for monetary analysis. He also insisted that the reference value for M3 growth was still in use and that the value of 4.5 percent was still appropriate.
»  Speech at the 4th ECB Central Banking Conference “The role of money: money and monetary policy in the twenty-first century”, Frankfurt am Main, 9 November 2006.
Monetary Policy and Potential Output Uncertainty: A Quantiative Assessment
by Simona Delle Chiaie (Tor Vergata, Rome)
The author makes the case for a strong focus of central banks on unit labour costs. She revisist Orphanides finding that central banks can make large and persistant mistakes in estimating potential output iin the face of cost push and productivity shocks. She estimates DSGE models in two scenarios: one in which unit labour costs are not observed or neglected, the other in which unit labor costs are used, The first class reproduces the Orphanides result. The introduction of unit labor costs, however, makes the forecast error in estimating the output gap very small. As an aside the author interprets these results to confirm objections against the common practice of using detrended GDP as a proxy for the output gap.
»  Working Paper, March 2007

The role of money: money and monetary policy in the twenty-first century
The ECB managed to bring together most of the leading academic experts in monetary policy to present papers on and discuss the role of money in monetary policy. Michael Woodford (Columbia) explained in his presentation why mainstream New Keynesian models do not have a role for money and why this does not make them incomplete or inconsistent. Discussant Harald Uhlig (Humboldt) agreed, as did prominent speakers from the audience. Woodford’s paper is a terrific, not too technical primer on the type of models that most central banks and monetary economists work with these days. The ECB’s Director General for Research, Lucrezia Reichlin , presented a paper co-authored with three ECB colleagues, in which she presents some hitherto unpublished information about the development of monetary analysis within the ECB. The paper also contains a comparison of the accuracy, bias and volatility of inflation forecasts derived from monetary and other indicators. As another first, the paper puts a number on the ECB’s definition of price stability of “under but close to two percent”. The number is 1.9 percent. Reichlin stressed that the ECB had found money demand not to be stable and had consequently downgraded the role of money demand functions in their analysis. ECB Vice-President Lucas Papademos indicated in his dinner-speech, that (at least some in) the ECB would like to integrate the two pillars of the ECB strategy. ECB Chief Economist Juergen Stark later denied in a interview that this was desirable
»  Conference: “The role of money: money and monetary policy in the twenty-first century”

Rethinking Inflation Targeting and Central Bank Independence
by Willem Buiter (London School of Economics)
In his usual eloquent and outspoken way, Willem Buiter gives a tour de force of the economic and political foundations of monetary economics. He claims that all the microeconomic foundations for price stability attempted to far are shaky. He is particularly vicious regarding the New Keynesian variants, comparing these to an attempt to re-establish that the earth is flat. In his view the only reason to pursue price stability is that it is the law. If it is the law, it has to be pursued with zeal. A central bank with a mandate to pursue price stability cannot trade it off against other targets, lest “flexible inflation targeting” becomes “soft inflation targeting”. The operational independence of most central banks is only justifiable for a narrow and clearly defined task, says Buiter. Therefore, central banks should not meddle in affairs beyond that. This includes not commenting on anything outside monetary policy, not to be involved in bank oversight and for the ECB, to divest itself of TARGET and not start any new clearing and settlement ventures.
»  Background paper for the Inaugural Lecture for the Chair of European Political Economy in the European Institute at the London School of Economics and Political Science, given on Thursday 26th October 2006
The Danger of Inflating Expectations of Macroeconomic Stability: heuristic switching in an overlapping generations monetary model
by Alex Brazier, Richard Harrison, Mervyn King and Tony Yates (Bank of England)
The governor of the Bank of England and his co-authors provide a theoretical argument in favour of (i) inflation targeting and (ii) managing inflation expectations, rather than pursuing the monetary policy that would be optimal for an economy with fully informed and completely rational inhabitants. The main ingredient is the assumption that people use rules of thumb to form their inflation expectations. Some use the inflation target of the central bank as their rule of thumb, others past inflation. The share of the population who use either of the two rules of thumb shifts over time, depending on how well they did in the past. The authors find that in this model inflation variability is reduced if monetary policy reacts to changes in inflation expectations.
»  Bank of England Working Paper No. 303, August 2006
Do monetary indicators (still) predict euro area inflation?
by Boris Hofmann (Bundesbank)
Hofmann finds that “M3, especially its trend or core growth rate, was on average a useful indicator for inflation at medium term horizons (up to 12 quarters), which is consistent with the role of the monetary analysis in the ECB’s monetary policy strategy as a tool for the assessment of the medium to long-term risks to price stability. But, a closer look at the forecasting performance reveals that, over the last three years, the forecasting performance of M3 has not been as good anymore as it used to be in the early years of EMU. The further analysis reveals, however, that it might be premature to neglect monetary indicators on these grounds.”
»  Bundesbank Working Paper, No. 18/2006
Inflation Targeting under Imperfect Knowledge
by Athanasios Orphanides (Federal Reserve Board) and John C. Williams (San Francisco Fed)
Orphanides and Williams show in an estimated model of the US-economy that the public’s imperfect knowledge of the macroeconomic landscape has profound implications for the optimal monetary policy. A policy that is optimal under perfect understanding can produce bad results under imperfect understanding. The upshot is that central banks should be transparent (i.e. set an explicit inflation target) and focus a lot on short term inflation behaviour and/or inflation expectations. They agree with Knut Wicksell that setting rates on the basis of an estimate of the natural rate is neither practical nor useful.
»  Federal Reserve Board Discussion Paper, April 2006
Interpreting Euro Area Inflation at High and Low Frequencies
by Katrin Assenmacher-Wesche (Swiss National Bank) and Stefan Gerlach (BIS)
The main finding is that variations in inflation are well explained by low-frequency movements of money and real income growth and high-frequency fluctuations of the output gap. Short frequency end and long frequency starts at about 5 1/2 years. »  BIS Working Papers No 195, February 2006)
Is Inflation Always and Everywhere a Monetary Phenomenon?
by Paul De Grauwe and Magdalena Polan (Leuven)
The answer is no. De Grauwe and Polan examine inflation and money growth in a sample of 160 countries over 30 years. They find a close relationship between money growth and inflation in high inflation countries (two digit inflation rates) but only a weak relationship in low and moderate inflation countries.
»  Scandinavian Journal of Economics, Vol. 207, 2005

PRACTICAL ISSUES OF MONETARY POLICY

An evaluation of Swedish monetary policy 1995-2005


by Francesco Giavazzi (Bocconi, Milan) and Frederic Mishkin (Columbia at the time, now Federal Reserve)
with Comment by Gouvernor Stefan Ingres
Annotations to follow soon.
A wide ranging evaluation wiith an overall very positive verdict. Highlights inlude point 2.5.3 in which Giavazzi and now-board-member of the Federal Reserve Mishkin critizise the lack of an explicit nominal anchor in the strategy of the Fed. The Riksbank has already announced that they will follow the advice of the authors to publishing own forecasts for the desired path of interest rates, although details are not clear yet (see entry under "Central Bank Communication"). Giavazzi and Mishkin suggest in their report to publish a fan chart without particular reference to the most likely path.
»  Report
»  Comment by Ingres
The Nat-EUR-al Rate of Interest
by Joachim Fels and Manoj Pradhan (Morgan Stanley)
Using the Wicksellian approach the authors estimate that the natural rate of interest for the euro area currently stands at around 1.3% real, or 3.5% nominal, one percentage point above the present level of the ECB refi rate.
»  Morgan Stanley Research Note, May 2006
A “neutral” ECB interest rate?
by Laurence Boone (Barclays Capital)
According to Boone's model, the “neutral” real rate would be around 2.25%, which means the neutral nominal rate would be around 3.75/4%, given an inflation objective of 1.5/1.75%.
»  Barclays Capital Research Note, May 2006

The Core of Inflation
by Giada Giani (Lehman Brothers)
This study finds that a measure of core inflation using Optimally Trimmed Mean (OTM) Granger-causes headline inflation in the Eurozone, a feature that is not shared by traditional measures of core inflation. Unlike traditional core, OTM is not biased. »  Research Note, March 2006
Diverse Patterns in Underlying and Headline Inflation
by ECB Staff
The ECB staff present the view of the European Central Bank in a debate on whether central banks should focus more on core inflation than on headline inflation. They present arguments against a greater focus on core rates. » ECB Monthly Bulletin, November 2005, p.36-43
The argument in favor of using core rates had been presented by former Fed-Vice-President Alan Blinder and his Princeton colleague Ricardo Reis, in their »  paper presented at the Jackson Hole Symposium in August 2005, page 42-45. They present econometric evidence (for the US) according to which core inflation is more useful than headline inflation in predicting price developments in the medium term.

CENTRAL BANK COMMUNICATION

Riksbank to introduce own path for the repo rate


by Irma Rosenberg
Not really an academic paper but very important as it indicates that the dominant academic view, that inflation targeting central banks should communicate a path for interest rates is finally spreading amoung central bankers themselves. The deputy gouvernor of the Sveriges Riksbank explains why the bank joins its cousins in New Zealand and Norway in publishing forecasts of its own future decisions. »  Speech, January 17, 2007
How Much Information Should Interest Rate-Setting Central Banks Reveal?
by Pierre Grosselin, Aileen Lotz and Charles Wyplosz (Graduate Institute of International Studies, Geneva
The authors extend the model of Morris and Shin (below) to the case where two instead of only one fundamental variable have to be forecast and the central bank is not offered the choice to reveal no information. Rather it is assumed that it does reveal some information by setting the interest rate. In contrast to Morris and Shin they find that in no circumstance is it optimal to restrict information to the minimum. »  DNB Working Paper (8/2006)
Does Central Bank Transparency Reduce Interest Rates?
by Petra Geraats (Univ. of Cambridge), Sylvester Eijffinger (Tilburg and Erasmus) and Carin van der Cruijsen (De Nederlandsche Bank) The researchers of the Dutch Central bank are scientifically active on both sides of the transparency debate. The authors of this study find that, controlling for macroeconomic conditions, increasing transparency often led to lower interest rates due to improved reputation while it only rarely had damaging effects. »  DNB Working Paper (8/2006)
The Costs of Increasing Transparency
by Maria Demertzis and Marco Hoeberichts, De Nederlandsche Bank, Two researchers of the Dutch Central Bank partly resurrect the claim by Morris and Shin (2002), that increased transparency of Central Banks can be harmful. The claim had been refuted by Woodford (2005) and Svensson (2005). » DNB Working Paper (12/2005) "Communication and Monetary Policy"
Morris and Shin argue that a central bank communicating beliefs openly can crowd out competing information in the market, because for market participant it sometimes matters more what the central bank beliefs than what they believe themselves. »  link to a later version of the paper that originally appeared in AER 
Social Value of Public Information: Morris and Shin (2002) is Actually Pro Transparency, Not Con.
by Lars Svensson. A critical review of Morris and Shin by one of the leading monetary economists next to Michael Woodford and Ben Bernanke, is to appear in »  American Economic Review 2006
Central Bank Communication and Policy Effektiveness
by Michael Woodford, Columbia University, As does Svensson, Woodford argues in favor of a high degree of transparency, including a Federal-Reserve-style conditional comittment to a certain interest rate path in the future. He dismisses the argument of Morris and Shin 2002in favor of limits to tranparency as relevant only under implausible conditions.»  Paper presented at the Jackson Hole Symposium in August 2005
Communication, Transparency, Accountability: Monetary Policy in the Twenty-First Century
by Otmar Issing. The outgoing Chief Economist of the ECB proposes a view more sceptical about transparency and sympathetic to Morris and Shin. »  Federal Reserve Bank of St. Louis Review, March/April 2005 

CURRENT ACCOUNT IMBALANCES

Global Imbalances and Low Interest Rates: An Equilibrium Model vs. a Disequilibrium Reality


by Jeffrey Frankel (Harvard)
Frenkel discusses eight non-mainstream arguments and papers, which argue that one need not worry (so much) about the US twin-deficits. Most of them are listed below. A special foucs is on Cabellero, Farhi and Gourinchas (2006). Her concludes that the mainstream view is correct and one should worry.
»  Working Paper RWP06-035, August 2006
The U.S. Current Account Deficit and the Expected Share of World Output
by Charles Engel (Wisconsin) and John H. Rogers (Federal Reserve Board)
The authors investigate the possibility that the large current account deficits of the U.S. are the outcome of optimizing behaviour, with a country's current account being determined by the expected discounted present value of its future share of world GDP relative to its current share of world GDP. The model suggests that even if future US GDP out-performance was somewhat smaller than over the past 20 years the current account deficit would be near optimal levels. If they use survey data on forecasted GDP growth in the G7, their model appears to explain the evolution of the U.S. current account remarkably well. They conclude that expectations of robust performance of the U.S. economy relative to the rest of the advanced countries are a contender for explaining the U.S. current account deficit.
»  Federal Reserve Board Discussion Paper, March 2006
Foreign Investment in the US (I): Disappearing in a black hole?
Foreign Investment in the US (II):Being taken to the cleaners?
by Daniel Gros (CEPS)
Daniel Gros joins Willem Buiter (below) in attacking the Hausaman(Sturzenegger assertion (below) that the US external disequilibrium is only due to bad accounting. In his two papers he argues that the external position of the US is even much worse than depicted by the official statistics because the returns of foreign direct investment in the US are under estimated by around 100 billion USD per annum and because the net external debtor position is worse than officially measured because the US authorities tend to loose track of foreign assets in the US. All in all, it seems likely to him that the net US indebtedness is at least 1 thousand billion higher than recorded in the official statistics.
»  CEPS Working Document April 2006
»  CEPS Working Document April 2006
A world out of balance? by Daniel Gros, Thomas Mayer and Angel Ubide
The ECB watching committee of the Centre of European Policy Studies examines scenarios, which could lead to an unwinding of global imbalances. They warn of serious risks to the world economy
»  Special Report of the CEPS Macroeconomic Policy Group, April 2006
Dark Matter or Cold Fusion?
by Willem Buiter, London School of Economics
This is a critique of the influential paper by Hausmann and Sturzenegger (below). Buiter recalculates and finds only a fraction of the "dark matter" of Hausmann and Sturzenegger.
»  Goldman Sachs Global Economics Paper No: 136, January 2006
»  Link to a written exchange of views between Willem Buiter and Ricardo Hausmann
Global Imbalances or Bad Accounting? The Missing Dark Matter in the Wealth of Nations
by Ricardo Hausmann and Federico Sturzenegger, Harvard
Authors blame the appearance of a US external imbalance to a gross mismeasurement of the evolution of the country’s net foreign assets. If US foreign direct investment, and trade in insurance and liquidity services was measured correctly, the current account imbalance would seize to exist. » Working Paper, January 2006
Could Capital Gains Smooth a Current Account Rebalancing?
by Michele Cavallo, Fereral Reserve Bank of San Francisco, and Cédric Tille, Federal Reserve Bank of New York
Authors use a novel modeling benchmark to examine the dynamics of a return of the US current account into balance. They ask what would need to happen for US external debt to remain constant. The outcome is a rather smooth rebalancing with a sizeable but fairly slow depreciation of the dollar. The depreciation produces large valuation gains for US external assets, allowing the current account deficits to be reduced over an extended period of time without an increase in foreign indebtness. » FRB of New York Staff Reports, no 237, Jan. 2006
An Equilibrium Model of Global Imbalances and Low Interest Rates
by Ricardo Caballero, MIT, Emmanuel Farhi, MIT and Pierre-Olivier Gourinchas, Berkley The authors present a model to explain the "conundrum" of stubbornly low bond yields, the rise of the US current account deficit and the rising share of US assets in the global portfolio in a unified framework. Potential growth differentials and heterogeneity in regions' capacity to gernerate financial assets from real investments are important inputs to the model. Unlike the conventional wisdom their analysis does not augur any catastrophic event resulting from the perceived "imbalances".»  MIT Working Paper, January 2006
The Global Saving Glut and the U.S. Current Account Deficit
by Ben Bernanke
The Fed Governor uses many of the arguments recently developed in the academic literature to make his case that the US current account deficit is the result of medium to long term global factors outside the US and that a disorderly adjustment is not likely. »  Speech at the Homer Jones Lecture, St. Louis, Missouri, April 14, 2005
Savings Gluts and Interest Rates: The Missing Link to Europe
Michael Dooley (Univ. of California and Deutsche Bank), David Folkerts-Landau and Peter Garber (Deutsche Bank)
The authors, who have popularized the so-called Bretton-Woods-II hypothesis conclude that a collapse of expected profits outside the US is a compelling explanation for the US current account deficit and depressed international interest rates. »  , NBER Working Paper No. 11520, August 2005
International Financial Adjustment
by Pierre-Olivier Gourinchas, Berkely, and Hélène Rey, Princeton
This study was among the first to put the spotlight on valuation gains for US foreign assets in case of dollar depreciation. This leads to a smoother adjustment of external imbalances. If finds that in the past these valuation gains accounted for a third of the adjustment of US current account imbalances. »  Working Paper, 2005
From World Banker to World Venture Capitalist: The US External Adjustment and the Exorbitant Privilege
by Pierre-Olivier Gourinchas (Berkely) and Helene Rey (Princeton) The authors find that due to its “exorbitant privilege” of issuing a world currency the US can afford much larger current account deficits than other nations. They dissect the privilege and find that the larger part of it results from the US receiving higher yields on foreign assets within each asset class. They also find an increasing composition effect, however: The US is moving increasingly into riskier assets. The authors conclude, that the dollar still faces a significant confidence risk. »  Working Paper, February 2005
Global Current Account Imbalances and Exchange Rate Adjustments
by Maurice Obstfeld (Berkley) and Kenneth Rogoff (Harvard)
The authors conclude that there is a high risk that the needed rebalancing of the US capital account will cause a severe dollar depreciation and further collateral damage to the rest of the world. The danger has increased considerably in recent years, they say, with the declining savings rate in the US a main culprit. »  Brookings Papers on Economic Activity, 1:2005

POLICY MIX

Public Debt and Long-Term Interest Rates

: The Case of Germany, Italy and the USA
by Paolo Paesani (University of Rome), Rolf Strauch and Manfred Kremer (ECB)
The authors study the influence of sustained debt accumulation on interest rates in the US, Germany and Italy from 1983 to 2003. They find that sustained debt accumulation leads to temporarily higher interest rates, while longer-term developments in interest rates are driven by output trends in the US and in Germany, and by (uncertainty about) inflation and the exchange rate in Italy.
»  ECB Working Paper No.656, July 2006

The ‘Sense and Nonsense of Maastricht’ revisited: What have we learnt about stabilization in EMU?
by Willem Buiter (London School of Economics)
Buiter revisits his paper “Excessive deficits: sense and nonsense in the Treaty of Maastricht”, co-authored with Giancarlo Corsetti and Nouriel Roubini and published 1993 in Economic Policy. He judges that the pact is dead and that it will not be missed. In his judgement, the pact addresses a problem, which is not really an EU concern, while ignoring the real problem of coordination of fiscal policies and of fiscal and monetary policy.
» Manuscript, July 2006
Is a Unified Macroeconomic Policy Necessarily Better for a Common Currency Area?
by Daniel Gros (CEPS) and Ansgar Belke (Hohenheim)
Not if fiscal policy is a source of shocks, say Gros and Belke. In this case national autonomy provides risk diversification.
»  Discussion Paper, 2005

ECB WATCHING

Shadowing the ECB


by Julia Giese and Peter Newland, Lehman Brothers
The authors, who work in the team of Shadow Council member John Llewellyn, perform a statistical analysis of the voting of the Shadow Council. They find differences between academics and financial sector economists and between Germans and non-Germans. They also find that changes in the balance of votes correlate closely with changes in market expectations regarding ECB rates. » Lehman Brothers, Global Economics, February 2006
Forecasting ECB Monetary Policy - Accuracy Is (Still) a Matter of Geography
by Helge Berger, Free University Berlin, Michael Ehrmann, ECB, and Marcel Fratzscher, ECB The authors find that banks with headquarters or subsidiaries in either Frankfurt or London do better at ECB forecasting than banks headquartered somewhere else. They attribute this to closeness to the ECB and the Bundesbank. They also find a relationship between national economic conditions and central banking histories with forecast accuracy. Authors do not seem to have checked for unobserved variable bias stemming from the plausible possiblilty that banks, which do not have a subsidiary in either Frankfurt or London might tend not to be the most sophisticated ones, attracting the best forecasters. »  ECB Working Paper, January 2006
Turning Point and Expectations
by Charles Wyplosz
Wyplosz shows that interest rate actions of the ECB are well explained by the development of inflation expectations, as exemplified by the forecasts of the ECB Shadow Council. »  Briefing Notes to the Committee for Economic and Monetary Affairs of the European Parliament, First Quarter 2006

ASSET PRICE INFLATION

Recent House Price Developments: The Role of Fundamentals


by Nathalie Girouard, Mike Kennedy, Paul van den Noord and Christophe André, OECD,
The authors conclude that only a relatively small number of countries has overvalued real estate markets. On one of the examined measures, the price-to-rent-ratio, they find overvaluation in the UK, Ireland, the Netherlands, Spain and Norway and a slight overvaluation in France and some others. In the US they find no overvaluation on the national level. Authors stress that the degree to which one assumes a continuation of the current low interest rate environment has strong implications for judging the appropriateness of real estate prices. » OECD Working Paper No 475, 2006
Why Central Banks Should Not Burst Bubbles
by Adam Posen, Institute of International Economics
Posen argues that asset bubbles are caused by factors which are only remotely related to monetary policy. Anything short of inducing a recession is unlikey to stem their rise. The cost benefit analysis does not justify such preemtive action, since in a modern economy with reasonable bank supervision the fallout from a bubble burting is limited. »  IIE Working Paper (01/2006)
How Should Monetary Policy Respond to Asset-Price-Bubbles?
by David Gruen, Michael Plumb and Andrew Stone, Reserve Bank of Australia
The authors argue that if a bubble can be diagnosed and a central bank wants to respond to it, this can require either tighter or looser monetary policy, depending on (uncertain) properties of the bubble. Tighter policy is advised, inter alia, if the bubble is unlikely to burst soon, is interest rate sensitive and can be expected to deflate gradually. In the opposite cases an adequate response would be to loosen monetary policy. »  International Journal of Central Banking, Dec 2005
A Housing Bubble in Euroland
by Thomas Mayer
Mayer presents arguments for the existence of a housing bubble.
»  Research Note, February 2006
Bubbles in Real Estate? A Longer-Term Comparative Analysis of House Prices in Europe and the US.
by Daniel Gros (CEPS)
After constructing an aggregate index of real house prices in the euro area from OECD data, Gros compares current prices in Europe and the US with their 30-year-averages and finds European prices just as "overvalued" as their US-counterparts. He also finds a rather stable pattern of price developments in Europe trailing the US by about two years.
»  Working Paper, First Draft, January 2006

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