Transcript Monetary Policy Rules in Practice: Some International Evidence

Monetary Policy Rules in Practice:
Some International Evidence
By Richard Clarida, Jordi Gali & Mark Gertler
Presented by Alyaa Ezzat
Sept. 1997
Overview
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This paper estimates the monetary policy reaction function
for two sets of countries: G3 & E3
Since 1979 each of G3 has followed an implicit form of
inflation targeting which achieved broad success of monetary
policy in those countries.
These central banks were forward looking responding to
anticipated inflation as opposed to lagged inflation.
For the E3, even prior to the “hard ERM” E3 central banks
were heavily influenced by German’s monetary policy
Using Bundesbank’s policy rule as a benchmark, the time of
EMS collapse, (i)’s were much higher than the domestic
macroeconomic conditions warranted.
Conclusion: some form of inflation targeting may be
superior to fixing exchange rates as means to gain nominal
anchor for monetary policy.
Two issues that motivate investigation
 First
1) After
nearly a decade of high inflation, a number of
important CB in 1979 wanted to reign inflation.
2) Inflation seemed a serious problem where major
economies of the world enjoy relative stable prices.
3) Monetary policy was viewed as out of control in
1970s
How policy was conducted in the post-79 era that had a
great influence over the global monetary policy &
policy management! That is why they wanted to
study G3
Two issues that motivate investigation
Second:
1) The collapse of the EMS in late 1992
2) Inability to major European CBs to sustain
the existing exchange rate system
Studying E3 to understand how constraints of
EMS influenced the policies of these
countries.
- They use the policy rule estimated for G3 as
guideline to evaluate future policy making
in Europe.
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Methodology
1) Estimating reaction function:
*Baseline specification has a central bank
adjust the nominal short term interest
rate in response to the gaps between
expected inflation & output with their
targets respectively. “not subject to any
external constraint”
A forward looking version of the simple backward looking
reaction function popularized by Taylor (1993)
Cont. Methodology
*Alternative baseline specification that
permits the CB respond to variables
other than the inflation & output as for
the case of the E3, these countries faced
an external constraints on monetary
policy. The alternative also permits a test
of Forward vs backward looking
specification of the reaction functions
Reaction function
It’s what the CB uses to respond to
shocks to the economy and steer it
toward an explicit or implicit inflation
target.
 Tasks of reaction function:
1) nominal anchor “inflation target” for the
medium run
2) Provide guidance to how the CB’s policy
instruments, i should be adjusted in
response to different shocks.
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Analysis
G3 :
1) baseline specification of the reaction
function worked well in characterizing
monetary policy post-79
 In response to the rise of expected
inflation relative to target, each central
bank raises the nominal rate sufficiently to
push real rate. r nominal = r real+ π
2) The estimated MR imply a clear focus on
controlling inflation.
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Background scenario
Policy reaction works as follows:
CB has a target for the nominal short term
interest rate based on the state of the economy
The target depends on both expected inflation
and output
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r Long run equilibrium real interest rate
r* short run nominal interest rate based on the economy
Ω information available to CB at the times it sets r
Background scenario
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When CB chooses target interest rate;
information about current output & price
level
rr* in the real interest rate
rr Long run equilibrium real interest rate
B is the CB preference
B could be > or < or = 1
Central Banks’ Preferences
CB is inflation averse B>1
Monetary Rule
Background scenario
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6 key variables in CB policy making
Forward looking
The alternative baseline: the alternative
variables are:
1) real exchange rates
2) foreign interest rates
3) the money supply with also the lagged
inflation
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