EXCHANGE RATE REGIMES AND FISCAL DISCIPLINE: THE ROLE OF CAPITAL CONTROLS

How do exchange rate regimes influence fiscal discipline? This important question has typically been addressed exploiting the classic dichotomy of fixed versus flexible exchange rate regimes assuming perfect capital mobility. However, the role of capital controls cannot be neglected, particularly in developing countries. This paper analyzes the effects of capital controls on fiscal performance by focusing on dual exchange rate regimes. In a model in which the fiscal policy is endogenously determined by a nonbenevolent fiscal authority, dual regimes induce politicians to have higher fiscal deficits than under fixed and flexible regimes operating under perfect capital mobility. The model also shows this effect increases as fiscal authorities become more impatient. Dynamic panel regressions confirm that dual regimes lead to higher fiscal deficits than fixed and flexible regimes operating under unified rates. Using a dummy for pre‐electoral year as an indicator of fiscal authorities' shortsightedness, we also confirm that dual exchange rate has a more adverse effect on fiscal deficits as the authorities become more impatient. (JEL E50, E60, F31, F41)     

FINANCIAL FRICTIONS AND THE CHOICE OF EXCHANGE RATE REGIMES

This article provides a quantitative assessment of the role of financial frictions in the choice of exchange rate regimes. I use a two‐country model with sticky prices to compare different exchange rate arrangements. I simulate the model without and with borrowing constraints on investment, under monetary policy and technology shocks. I find that the stabilization properties of floating exchange rate regimes in face of foreign shocks are enhanced relative to fixed exchange rate in presence of credit frictions. In presence of symmetric and correlated shock, fixed exchange rates regimes can perform better than floating. This analysis can have important policy implications for accession countries joining the European Exchange Rate Mechanism II system and with high degrees of credit frictions. (JEL E3, E42, E44, E52, F41)     

FISCAL STABILIZATION WITH PARTIAL EXCHANGE RATE PASS‐THROUGH

This article examines the role of fiscal stabilization policy in a two‐country framework that allows for partial exchange rate pass‐through. Analytical solutions for optimal monetary and fiscal policy rules depend on the degree of pass‐through. Each country unilaterally uses its fiscal instrument to stabilize the costs facing exporters. The welfare effects differ strongly depending on the degree of pass‐through. For high levels, both countries are better off with the fiscal instrument and welfare is closer to the benchmark flex‐price level. For low levels, however, the unilateral equilibrium policy rules lead to high volatility in taxes, and fiscal policy ends up being destabilizing by transmitting exchange rate fluctuations. Because these results stem from strategic considerations by the two countries, the fiscal instrument is not used under policy coordination. In addition, imposing a monetary union increases welfare when pass‐through is low, including the case of local currency pricing. (JEL E52, E63, F41, F42)     

MONETARY POLICY AND ANTI‐CYCLICAL BANK CAPITAL REGULATION

The financial crisis of 2008–2009 revived attention given to booms and busts in bank credit, and their effects on real activity. This interest sparked two different strands of research in macro. The first one focuses on monetary policy in the context of financial frictions. The second studies capital regulation in banking. To the best of our knowledge, so far these two topics have mostly been studied in isolation from each other. Thus, we still lack an understanding of how monetary policy and bank capital regulation interact in the presence of financial fragility. This paper aims to contribute to furthering this understanding. Specifically, we ask how the monetary policy rule should look like in the presence of cyclical capital requirements. We extend the dynamic stochastic general equilibrium model with bank capital in Aliaga‐Díaz and Olivero by introducing price rigidities in the spirit of the New‐Keynesian literature. We find that: First, anti‐cyclical requirements have important stabilization properties relative to the case of constant requirements. This is true for all types of fluctuations that we study, which include those caused by productivity, preference, fiscal, monetary, and financial shocks. Second, output and consumption volatilities present in the no regulation economy can be recovered with anti‐cyclical requirements as long as the policy rate responds only slightly to credit spreads. Third, monetary policy rules that respond to credit conditions also perform better in terms of welfare. (JEL E32, E44)     

REAL EXCHANGE RATE,MONETARY POLICY,AND THE U.S. ECONOMY: EVIDENCE FROM A FAVAR MODEL

This paper examines the effects of exchange rate depreciation to the U.S. economy in a factor‐augmented vector autoregression model using monthly data of 148 variables for the post–Bretton Woods period of 1973–2017. Exchange rate shock is identified to reflect exogenous disturbances to the foreign exchange market, and movements in exchange rate that are not accounted for by changes in the U.S. monetary policy. We find that depreciation is expansionary and inflationary to the broad U.S. economy, the current account improves over time conforming to the J‐curve theory, and monetary policy is leaning against the wind. (JEL E3, E5, F31, F32, F41)     

ECONOMIES OF SCALE IN BANKING,INDETERMINACY, AND MONETARY POLICY

This paper investigates economies of scale (ES) in financial intermediation as a source of equilibrium indeterminacy. Financial intermediation is embedded into a standard flexible‐price monetary model, and provides deposits (inside money) that substitute with currency to purchase consumption. The results indicate that equilibrium indeterminacy does not depend on a large degree of ES in intermediation nor a large intermediation sector, but on monetary policy and the determination of nominal interest rates. Monetary policies not targeting nominal rates allow for indeterminacy to arise for any positive degree of ES, while policies targeting nominal rates eliminate indeterminacy for all degrees of ES. (JEL C62, E44, E52)     

OPTIMAL MONETARY POLICY AND IMPERFECT FINANCIAL MARKETS: A CASE FOR NEGATIVE NOMINAL INTEREST RATES?

This article studies optimal monetary policy in a model with credit frictions and money demand. We show that augmenting a standard New Keynesian model with money demand and financial frictions generates a mechanism that, in equilibrium, gives rise to optimal negative nominal interest rates. In addition, we find that the tighter credit markets are, the lower the optimal nominal policy interest rate and the more likely it is to be negative. Quantitatively, when credit constraints are binding, a standard calibration of the model generates an optimal nominal policy interest rate that is roughly ?4% annually. (JEL E31, E41, E43, E44, E52, E58)     

WHO IS AFRAID OF THE FRIEDMAN RULE?

We explore the connection between optimal monetary policy and heterogeneity among agents in a standard monetary economy with two types of agents where the stationary distribution of money holdings is nondegenerate. Sans type-specific fiscal policy, we show that the zero-nominal-interest rate policy (the Friedman rule) does not maximize type-specific welfare; it may not maximize aggregate ex ante social welfare either. Indeed, one or, more surprisingly, both types may benefit if the central bank deviates from the Friedman rule. ( JEL E31, E51, E58)     

LIMITED ASSET MARKET PARTICIPATION,STICKY WAGES,AND MONETARY POLICY

A small amount of nominal wage stickiness makes limited asset market participation (LAMP) irrelevant for the design of monetary policy. Recent research argues that LAMP could invert the slope of the IS curve in otherwise standard New Keynesian models. This, in turn, implies that optimal monetary policy rules should be passive. We show that the so‐called inverted aggregate demand logic (IADL) relies on nominal wage flexibility. Outside of extreme parameterizations, wage stickiness prevents the inversion of the slope of the IS curve. Hence, LAMP does not generally alter the trade‐offs faced by a welfare maximizing Central Bank, and for this reason it does not fundamentally affect the design of optimal simple rules and optimal monetary policy. (JEL E21, E52)     

UNION POWER,COLLECTIVE BARGAINING,AND OPTIMAL MONETARY POLICY

We study Ramsey policies and optimal monetary policy rules in a dynamic New Keynesian model with unionized labor markets. Collective wage bargaining and unions' monopoly power amplify inefficient employment fluctuations. The optimal monetary policy must trade off between stabilizing inflation and reducing inefficient unemployment fluctuations induced by unions' monopoly power. In this context the monetary authority uses inflation as a tax on union rents and as a mean for indirect redistribution. Results are robust to the introduction of imperfect insurance on income shocks. The optimal monetary policy rule targets unemployment alongside inflation. (JEL E0, E4, E5, E6)     

LEANING AGAINST WINDY BANK LENDING

Using an estimated dynamic stochastic general equilibrium model with banking, this paper first provides evidence that monetary policy reacted to bank loan growth in the United States during the Great Moderation. It then shows that the optimized simple interest‐rate rule features no response to the growth of bank credit. However, the welfare loss associated to the empirical responsiveness is small. The sources of business cycle fluctuations are crucial in determining whether a “leaning‐against‐the‐wind” policy is optimal or not. In fact, the predominant role of supply shocks in the model gives rise to a trade‐off between inflation and financial stabilization. (JEL E32, E44, E52)     

MONETARY POLICY AND ENDOWMENT RISK IN A LIMITED PARTICIPATION MODEL

A limited participation model is constructed to study the risk‐sharing role of monetary policy. A fraction of households exchange money for interest‐bearing government nominal bonds in the asset market and the government injects money through open market operations. In equilibrium, money is nonneutral and monetary policy redistributes consumption across households. Without idiosyncratic endowment risk, monetary policy becomes a perfect risk‐sharing tool, but with idiosyncratic endowment risk, it is not. The Friedman rule is not optimal in general. (JEL E4, E5)     

How To Prepare the EU Integration: Banking System, Monetary Policy, and Exchange Rate in Macedonia

The significant progress in the reform of the financial sector, including the amendments to the banking law and the reinforcement of the deposit insurance scheme, has been reflected in increased confidence in the Macedonia banking sector. Monetary policy and exchange rates represent a crucial aspect for the countries of Southeast Europe which would like to position themselves on the threshold of negotiations on their accession to the European Union. In the case of Macedonia, which has already formally applied for EU membership, a very cautious approach has to be taken in order to facilitate the stability of the economic system as a whole. Such a policy will make an important contribution to the stabilization of the whole West Balkan area and in particular to the quadrangle of Albania, Kosovo, Montenegro, and Serbia. The preparation of a favourable ground for EU membership negotiations leads first and foremost through a strict monetary and exchange rate policy, which the National Bank is pursuing firmly. Macedonia is now facing optimal conditions for creating the prerequisites for a faster negotiation with less rigorous internal repercussions of the pre-adhesion period. One should not forget the indirect impact of the shadow economy in the general context of efficiency of the instruments of economic and monetary policy. Finally, there is the question to be answered on the interrelation existing between transmission mechanisms linking productivity to the real exchange rate in Macedonia. At first glance, the stylized facts – low labor productivity growth and a trend of real depreciation – could even suggest that a Balassa–Samuelson effect is in play. But the depreciation of the real exchange rate could reflect mainly the behaviour of prices in the tradable sector and a prolonged transition associated with slow technological growth and the low quality of the country's tradable-goods basket.     

Exchange Rate Policy in Serbia

In August 2006, Serbia adopted an inflation targeting regime as its monetary regime. The initial period of implementation of this regime was characterized by an extremely high capital inflow and appreciation of the exchange rate of the dinar. Under such conditions, the selected monetary policy regime functioned well. However, at the end of 2008, when the global financial crisis caused the outflow of foreign capital, deterioration of foreign borrowing conditions and an increase in inflationary expectations, the dinar lost about 25 per cent of its value within a relatively short period, despite the interventions of the National Bank of Serbia in the foreign exchange market. Therefore, the authors of this paper raise a dilemma whether Serbia conducts an adequate policy of the exchange rate of the dinar. The authors point out that, at the moment, the policy of a free floating exchange rate is not adequate for Serbia. As an alternative, a two nominal-anchor regime—inflation and the exchange rate—is proposed.     

INTEREST RATE PROMINENCE IN CONSUMER DECISION‐MAKING

Variations in consumers' responsiveness to interest rates across households and over time have important implications for monetary transmission. Responses from the Michigan Survey of Consumers provide an indication of the degree to which interest rates are a prominent consideration in spending decisions, news recollection, and financial situations. Prominence is strongest in housing attitudes, increases with income, education, and homeownership, and declined in the Great Recession. Rate prominence is associated with stronger responsiveness of consumption attitudes to monetary policy. (JEL D84, D91, E21, E40, E50)     

NOMINAL WAGE CONTRACTS AND THE MONETARY TRANSMISSION MECHANISM

We introduce staggered and synchronized nominal wage contracts into a one‐sector monetary dynamic general equilibrium model to analyze the importance of the monetary transmission mechanism. We find a stronger monetary propagation mechanism under a synchronized setting as compared to a staggered setting. This causes the economy under staggering to be less volatile, better matching the data, as well as bringing about lower welfare costs (measured in terms of consumption). However, our results are mixed when it comses to evaluating the contemporaneous correlations and cross‐correlations. We conclude that overall staggered contracts do better in matching the U.S. economy. (JEL E32, E51, J41)     

THE EFFECTS OF ASSET PURCHASES AND NORMALIZATION OF U.S. MONETARY POLICY

This paper examines changes in the effects of unconventional monetary policies in the United States. To this end, we estimate a Markov-switching VAR model with absorbing regimes to capture possible structural changes. Our results detect regime changes around the beginning of 2011 and the middle of 2013. Before 2011, the U.S. large-scale asset purchases (LSAPs) had relatively large impacts on the real economy and prices, but after the middle of 2013, their effects were weaker and less-persistent. In addition, after the middle of 2013, which includes the monetary policy normalization period, the asset purchase (or balance sheet) shocks had slightly weaker effects than during the early stage of the LSAPs but stronger effects than during the late stage of the LSAPs, while interest rate shocks had insignificant effects on the real economy and prices. Finally, our results suggest that the positive responses of durables and capital goods expenditures to interest rate shocks weakened the negative impacts of interest rate hikes after the middle of 2013 including the period of monetary policy normalization. (JEL C32, E21, E52)     

LENDING RELATIONSHIPS AND MONETARY POLICY

Financial intermediation and bank spreads are the important elements in the analysis of business cycle transmission and monetary policy. We present a simple framework that introduces lending relationships, a relevant feature of financial intermediation that has been so far neglected in the monetary economics literature, into a dynamic stochastic general equilibrium model with staggered prices and cost channels. Our main findings are (a) banking spreads move countercyclically generating amplified output responses, (b) spread movements are important for monetary policymaking even when a standard Taylor Rule is employed, (c) modifying the policy rule to include a banking spread adjustment improves stabilization of shocks and increases welfare when compared to rules that only respond to output gap and inflation, and finally (d) the presence of strong lending relationships in the banking sector can lead to indeterminacy of equilibrium forcing the Central Bank to react to spread movements. (JEL E44, E52, G21)     

THE CREDIT‐CHANNEL TRANSMISSION MECHANISM AND THE NONLINEAR GROWTH AND WELFARE EFFECTS OF INFLATION AND TAXES

With the credit‐channel effect driven by the central bank's open market operations, this paper's model easily gives rise to the nonlinear inflation‐growth nexus, which is evidenced by a number of cross‐country empirical studies. The threshold level of the inflation rate is found to be lower when tax rates are higher. The presence of the credit‐channel effect also provides the rationale for setting positive (and smaller than 1) tax rates on consumption, labor income, and capital income. The optimal tax rates rise as the inflation target declines. Under a fiscal policy rule where labor and capital income taxes move proportionally to each other, the optimal capital income tax rate could be higher than the optimal labor income tax rate. Under a sufficiently large central bank balance sheet, the credit‐channel effect will be so weak that inflation and all kinds of taxes are growth and welfare repressing. This provides a rationale for central banks that have implemented quantitative easing policies to shrink their balance sheets. (JEL E58, E62, O42)     

THE OPTIMAL MONETARY RESPONSE TO TECHNOLOGY SHOCKS

This paper develops a model in which both technology and monetary shocks are important sources of variation in aggregate output and employment. The model rationalizes a policy under which money responds actively to technology shocks. The welfare cost of adopting the constant money growth rule advocated by Milton Friedman rather than the optimal activist policy is small, however. (JEL E52, E32)