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The Role of Policymakers in Open
Economies:
Stylized International Patterns
Jim Granato, Melody Lo, and M.C. Sunny Wong
The Goal of Our Research Project
• Provide monetary authorities with crosscountry evidence on the relation between the
conduct of open economy monetary policy
and business cycle outcomes.
• Methodology:
– Develop a formal theoretical framework and derive
a variety of empirical implications.
– Link the theory to the test in a direct way (We
follow the spirit of empirical implications of
theoretical models (EITM)).
– The significance of this linkage would help identify
stylized international patterns and is more
informative to policymakers than conventional
formal and empirical practice.
Background
•
This research project builds on Granato and Wong
(2006). In that book:
We derive a closed economy policy rule to
determine how an emphasis (and de-emphasis) on
inflation stabilization affects business cycle stability.
Findings:
•
•
–
–
According to our theoretical model, we find that when
policymakers place greater relative weight in stabilizing
inflation, this leads to the simultaneous reduction in both
inflation and output volatility -- Inflation-Output Costabilization (IOCS).
The theoretical result is supported by empirical tests of
inflation and business-cycle performance in the U.S. for the
period 1960 to 2000.
Background (cont.)
• Theory and Testable Implications
– Policymakers coordinate information using a policy rule
(Taylor Rule) to reduce inflation uncertainty.
– Aggressive inflation target (explicit or implicit) supplants
prior information used to forecast prices (inflation persists
less).
– Future plans are made with greater certainty and IOCS
achieved.
– Consequence: relation between IOCS and Aggressive
Policy.
– IOCS and “coordination” view of policy is a challenge to
existing orthodoxy (i.e., Time Consistency).
Estimated Taylor Policy Rule
it   t   y ( yt  y )   ( t   *)  rt
n
t
Aggressive
Aggressive .6
Non-Aggressive
.2
.0
The Inflation Target
Deviation Coefficient
.6
-.2
.4
-.4
.2
.0
-.2
-.4
-.6
1955
|
1970
1960
|
1975
1965
|
1980
1970
|
1985
1975
|
1990
1980
|
1995
1985
|
2000
The Output
Gap Coefficient
.4
2
Aggressive Non-Aggressive
IOCS
1
Aggressive
IOCS
0
-1
-2
-3
1960
1970
CPI Inflation Volatility
1980
1990
2000
Real GDP Growth Volatility
Figure 2.1. IOCS, 1960-2000 (5-year moving standard deviation).
1.0
5.0
Aggressive
Policy Rule
0.8
4.5
4.0
0.7
3.5
0.6
3.0
0.5
2.5
0.4
2.0
0.3
1.5
0.2
1960
|
19 70
1.0
1965
|
1975
1970
|
1980
I n fla t io n P e r s is t e n c e
1975
|
1985
1980
|
1990
1985
|
1995
1990
|
2000
I n fla t io n S t a n d a r d D e v ia t io n
Figure 7.7. Inflation Persistence and Volatility
Inflation St andard Deviation
Inflation Persistence
0.9
In This Research Project
•
We explore the necessary condition between inflation
stabilization policy and inflation performance --- in an
open economy model.
•
We follow Granato and Wong (2006), Granato, Lo
and Wong (2006 and Forthcoming) to study open
economy influence(s) on monetary policy regime
shifts.
•
In this particular paper/chapter we examine if open
economies are more likely to engage in inflation
stabilizing policy.
An Illustrative Study
What Explains Recent Changes in Monetary Policy Attitudes
Toward Inflation? Evidence from Developed Countries
• Focus:
– Did a universal monetary policy regime shift occur?
– What economic fundamentals drive such shifts?
• The literature:
– Since Alogoskoufis and Smith (AER, 1991), several studies have
stated that there are seemingly universal shifts in monetary policy
attitudes toward inflation due to the implementation of a floating
exchange rate regime.
– The major problem: difficulty in isolating the exchange rate shift
effect, if any, on monetary policy intentions.
– Burdekin and Siklos (JMCB, 1999) and Bleaney (IMF, 2001) both
show that inflation persistence has changed over time for ‘unknown’
reasons --- and that are unconnected to an exchange rate regime
shift.
Our Argument
• Economic Openness is a compelling candidate to account for
observed changes in the monetary policy responses to inflation
shocks.
• A line of literature starting with Romer (QJE, 1993) has used
economic openness to explain “cross-country” differences in
monetary policy implementation:
A negative economic openness-inflation relation
• This result, it is argued, derives from the fact that monetary
authorities in more open economies face greater costs for high
and variable inflation.
• We argue that, within a country, policymakers can also be
expected to react to inflationary pressures more strongly as its
economy grows more open.
Our Methodology


Our empirical results are based on both cross-country and individual-country
analyses on a group of 18 developed countries.
Our policy aggressiveness estimate:
h
 t  c  d t 1   e j  t  j  zt
j 1

The size of coefficient d indicates the average "die-out-rate“ of
the inflation shock (hereafter DOR).
Our economic openness estimate:
ptG     (et  pt* )   (mt  yt )
This estimate is based on both Purchasing Power Parity and Quantity Theory of
Money arguments.
 We examine:
DORi  f i  g i OPEN i  i
(Cross-country)
DORi ,t  hi ,t  ki ,t OPEN i ,t  i ,t
(Individual-country)
Empirical Results
• Table 1: Cross-country analysis:
– We use cutoff points of 1973 and 1990. The results show that it is
primarily after the 1990s when inflation shocks die out faster in more
economically open countries.
• Table 2: Individual-country analysis (pre-specified cutoff
points):
– About 61% of the sample countries seem to have shifted, around
1985-1990, in their monetary policy making.
– Policymakers in more recent years conduct monetary policy in
reaction to changes in the degree of economic openness.
• To validate this emerging shift, we also apply Bai and
Perron's (1998, 2003, henceforth BP) methodology.
The
BP method is designed to test and date multiple structural
breaks.
Empirical Results (cont.)
• Table 3:
– Panel A: Many countries did have a monetary regime shift in the
neighborhood of the 1985 to 1990s period.
– Panel B: 13 (out of 18) countries have their inflation shocks die out
faster in the latter regime shift period.
 Monetary regime shifts in recent years is more universal: policy
aggressiveness is increasing!
• Table 4:
– Panel A: The majority of countries did have their most recent break
dated in the neighborhood of 1985-1990.
– Panel B:
(1)14 out of 18 country's have their openness parameter from the
"last" regime period become significantly negative.
(2) In 12 out of 14 countries, this emerging negative DOR-openness
relation has no precedent (prior to the last regime period).
Conclusion
 Taking all evidence together, this study documents that
changes in the DOR in recent years is a stylized
international phenomena that has a coherent explanation.
 The recent universal decrease in the persistence of
inflation shocks is a reflection of monetary authorities in
many (developed) countries becoming more aggressive
(w.r.t. inflation shocks) due to changes in the degree of
openness within their economies.
 This universal change in monetary policymaking at the
individual country level is fundamental for the documented
cross-country pattern that more aggressive monetary
policies were adopted in more open economies (primarily)
in the 1990s.