The Federal Reserve Bank of Kansas City's research staff produces a series of working papers. These technical papers cover a wide range of important topics.


Financial Crises, Unconventional Monetary Policy Exit Strategies, and Agents' Expectations

By Andrew T. Foerster (RWP 11-04 August 2011)
This paper considers a model with financial frictions and studies the role of expectations and unconventional monetary policy response to financial crises. During a financial crisis, the financial sector has reduced ability to provide credit to productive firms, and the central bank may help lessen the magnitude of the downturn by using unconventional monetary policy to inject liquidity into credit markets. The model allows parameters to change according to a Markov process, which gives agents in the economy expectation about the probability of the central bank intervening in response to a crises, as well as expectations about the central bank's exit strategy post-crises. Using this Markov regime switching specification, the paper addresses three issues. First, it considers the effects of different exit strategies, and shows that, after a crisis, if the central bank sells off its accumulated assets too quickly, the economy can experience a double-dip recession. Second, it analyzes the effects of expectations of intervention policy on pre-crises behavior. In particular, if the central bank increases the probability of intervening during crises, this increase leads to a loss of output in pre-crisis times. Finally, the paper considers the welfare implications of guaranteeing intervention during crises, and shows that providing a guarantee can raise or lower welfare depending upon the exit strategy used, and that committing before a crisis can be welfare decreasing but then welfare increasing once a crisis occurs.

Note on the Role of Natural Condition of Control in the Estimation of DSGE Models

By Martin Fukac and Vladimir Havlena (RWP 11-03 August 2011)
This paper is written by authors from technical and economic fields, motivated to find a common language and views on the problem of the optimal use of information in model estimation. The center of our interest is the natural condition of control -- a common assumption in the Bayesian estimation in technical sciences, which may be violated in economic applications. In estimating dynamic stochatic general equilibrium (DSGE) models, typically only a subset of endogenous variables are treated as measured even if additional data sets are available. The natural condition of control dictates the exploitation of all available information, which improves model adaptability and estimates efficiency. We illustrate our points on a basic RBC model.

How To Make Banks Reveal Their Information

By Michal Kowalik (RWP 11-02 March 2011)
The paper derives optimal capital requirements, when the bank’s quality is private information. The supervisor can inspect the bank and punish the undercapitalized one with recapitalization and downsizing. The cost of bank’s capital and its ability to sell its assets are crucial for the bank’s incentive to reveal its quality truthfully. The paper provides following policy implications. First, sensitivity of capital requirements to the bank’s quality should be low in good times and high in bad times. Second, a leverage ratio should be accompanied by a requirement that the bank selling its assets retains part of them. Third, using results from supervisory inspection on the secondary market for the bank’s assets increases the bank’s incentive to misreport its quality. Fourth, implementation of the sensitive capital requirements cannot rely solely on information revealed on the market for the bank’s assets.

Labor Market Search, the Taylor Principle, and Indeterminacy

By Takushi Kurozumi and Willem Van Zandweghe (RWP 11-01 October  2010)
In a sticky-price model with labor market search and matching frictions, forecast-based interest rate policy almost always induces indeterminacy when it is strictly inflation targeting and satisfies the Taylor principle. Indeterminacy is due to a vacancy channel of monetary policy that makes inflation expectations self-fulfilling. The effect of this channel strengthens as the sluggishness of the adjustment of employment relative to that of consumption increases. When this relative sluggishness is high, the Taylor principle fails to ensure determinacy, regardless of whether the policy is forecast-based or outcome-based, whether it is strictly or flexibly inflation targeting, or contains policy rate smoothing.