PDFGeneralizing the Taylor Principle
By Troy Davig and Eric M. Leeper
RWP 05-13, December 2005

Recurring change in a monetary policy function that maps endogenous variables into policy choices alters both the nature and the efficacy of the Taylor principle---the proposition that central banks can stabilize the macroeconomy by raising their interest rate instrument more than one-for-one in response to higher inflation. A monetary policy process is a set of policy rules and a probability distribution over the rules. We derive restrictions on that process that satisfy a long-run Taylor principle and deliver unique equilibria in two standard models. A process can satisfy the Taylor principle in the long run, but deviate from it in the short run. The paper examines three empirically plausible processes to show that predictions of conventional models are sensitive to even small deviations from the assumption of constant-parameter policy rules.

JEL Classification: E43, E52, E58
Keywords: Taylor rules, monetary policy, new Keynesian model, regime switching

PDFMonetary and Fiscal Policy Switching
By Troy Davig, Eric M. Leeper, and Hess Chung
RWP 05-12, December 2005

A growing body of evidence finds that policy reaction functions vary substantially over different periods in the United States. This paper explores how moving to an environment in which monetary and fiscal regimes evolve according to a Markov process can change the impacts of policy shocks. In one regime monetary policy follows the Taylor principle and taxes rise strongly with debt; in another regime the Taylor principle fails to hold and taxes are exogenous. An example shows that a unique bounded non-Ricardian equilibrium exists in this environment.

A computational model illustrates that because agents' decision rules embed the probability that policies will change in the future, monetary and tax shocks always produce wealth effects. When it is possible that fiscal policy will be unresponsive to debt at times, active monetary policy (like a Taylor rule) in one regime is not sufficient to insulate the economy against tax shocks in that regime and it can have the unintended consequence of amplifying and propagating the aggregate demand effects of tax shocks. The paper also considers the implications of policy switching for two empirical issues.

JEL Classification: E43, E52, E62, E63
Keywords: monetary policy, fiscal policy, policy interactions, regime switching

PDFConvenient Prices, Currency, and Nominal Rigidity: Theory with Evidence from Newspaper Prices
By Edward S. Knotek
RWP 05-11, December 2005

Newspapers, movie tickets, and concession stand items typically charge prices that facilitate rapid, simple transactions: their prices often coincide with available monetary units, require few pieces of money, or require little change. In this sense, these prices are more convenient than other proximate prices. I model a firm that explicitly incorporates convenience into its pricing decisions, where convenience is quantified by the number of currency units in a transaction. The model illustrates how alternating periods of price rigidity and flexibility can arise in such a setting, along with rapid switching between convenient prices. I compile time series data on newspaper cover prices and use simulations to show that convenience is an essential component of these prices. In the empirical data, firms set prices that were more convenient than adjacent prices 61% of the time. Standard menu costs cannot replicate this behavior. Because convenience appears to affect many of the consumer goods and services with the stickiest prices in the U.S. economy, studies focusing on very sticky prices must be cognizant of convenience’s role in effecting above-average price rigidity.

JEL Classification: E31, D40, C15, N81, N82
Keywords: convenient prices, relative inconvenience, price rigidity, menu costs, indirect inference, newspaper pricing history

PDFThe Impact of Wildlife Recreation on Farmland Values
By Jason Henderson and Sean Moore
RWP 05-10, December 2005

Wildlife recreation – hunting, fishing, and wildlife watching – appears to be an increasingly important past time for many Americans as people continue to increase their spending on wildlife recreation. Land lease and ownership expenditures by wildlife recreation participants are rising and appear to be capitalized into farmland values. This paper analyzes the impact of hunting lease rates on farmland values in Texas. The results indicate that counties with higher wildlife recreation income streams have higher land values.

JEL Classification: Q15
Keywords: farmland values, wildlife recreation

PDFA Park By Any Other Name: National Park Designation as a Natural Experiment in Signaling
By Stephan Weiler
RWP 05-09, December 2005

Back to Top Site designation by the National Park Service conveys a unique set of signals to information-constrained potential visitors. Changes in designation thus offer natural experiments to evaluate the signaling importance of names. This paper estimates the visitation effect of the conversion of National Monuments to National Parks through panel data analyses of the 8 designation changes that occurred between 1979 and 2000. These conversions have substantial and persistent effects on annual visitation, indicating that designation signals are indeed significant and credible. These signals appear to be particularly important to information-constrained visitors from a broad national audience compared to more proximate state and metro populations who have better information about nearby sites. Furthermore, increased annual visitor flows to newly designated parks do not appear to occur at the expense of visitation at alternative sites. Finally, visits to these parks appear to be quasi-inferior goods, as visitation is inversely related to various measures of national income.

JEL Classification: D83, Q26
Keywords: information, signaling, natural resources, recreation

PDFDiscretionary Monetary Policy and the Zero Lower Bound on Nominal Interest Rates
By Klaus Adam and Roberto M. Billi
RWP 05-08, November 2005

Ignoring the existence of the zero bound on nominal interest rates one considerably understates the value of monetary commitment in New Keynesian models. A stochastic forward-looking model with an occasionally binding lower bound, calibrated to the U.S. economy, suggests that low values for the natural rate of interest lead to sizeable output losses and deflation under discretionary monetary policy. The fall in output and deflation are much larger than in the case with policy commitment and do not show up at all if the model abstracts from the existence of the lower bound. The welfare losses of discretionary policy increase even further when inflation is partly determined by lagged inflation in the Phillips curve. These results emerge because private sector expectations and the discretionary policy response to these expectations reinforce each other and cause the lower bound to be reached much earlier than under commitment.

JEL Classification: E31, E52
Keywords: nonlinear optimal policy, occasionally binding constraint, sequential policy, Markov perfect equilibrium, liquidity trap

PDFOptimal Monetary Policy under Commitment with a Zero Bound on Nominal Interest Rates
By Klaus Adam and Roberto M. Billi
RWP 05-07, October 2005

We determine optimal monetary policy under commitment in a forward-looking New Keynesian model when nominal interest rates are bounded below by zero. The lower bound represents an occasionally binding constraint that causes the model and optimal policy to be nonlinear. A calibration to the U.S. economy suggests that policy should reduce nominal interest rates more aggressively than suggested by a model without lower bound. Rational agents anticipate the possibility of reaching the lower bound in the future and this amplifies the effects of adverse shocks well before the bound is reached. While the empirical magnitude of U.S. mark-up shocks seems too small to entail zero nominal interest rates, shocks affecting the natural real interest rate plausibly lead to a binding lower bound. Under optimal policy, however, this occurs quite infrequently and does not imply positive average inflation rates in equilibrium. Interestingly, the presence of binding real rate shocks alters the policy response to (non-binding) mark-up shocks.

JEL Classification: C63, E31, E52
Keywords: nonlinear optimal policy, zero interest rate bound, commitment, liquidity trap, New Keynesian

PDFTerm Structure Transmission of Monetary Policy (Why Bond Traders Are Paid More Than Central Bankers)
By Sharon Kozicki and P.A. Tinsley
RWP 05-06, December 2005

Back to Top The sensitivity of bond rates to macro variables appears to vary both over time and over forecast horizons. The latter may be due to differences in forward rate term premiums and in bond trader perceptions of anticipated policy responses at different forecast horizons. Determinacy of policy transmission through bond rates requires a lower bound on the average responsiveness of term premiums and anticipated policy responses to inflation.

JEL Classification: E3, E5, N1
Keywords: asymmetric information, no-arbitrage term structure, the Great Inflation, the Taylor Principle

PDFApproximately Normal Tests for Equal Predictive Accuracy in Nested Models
By Todd E. Clark and Kenneth D. West
RWP 05-05, November 2005

Forecast evaluation often compares a parsimonious null model to a larger model that nests the null model. Under the null that the parsimonious model generates the data, the larger model introduces noise into its forecasts by estimating parameters whose population values are zero. We observe that the mean squared prediction error (MSPE) from the parsimonious model is therefore expected to be smaller than that of the larger model. We describe how to adjust MSPEs to account for this noise. We propose applying standard methods (West (1996)) to test whether the adjusted mean squared error difference is zero. We refer to nonstandard limiting distributions derived in Clark and McCracken (2001, 2005a) to argue that use of standard normal critical values will yield actual sizes close to, but a little less than, nominal size. Simulation evidence supports our recommended procedure.

JEL Classification: C53, C52
Keywords: forecast evaluation, causality, nested models

PDFPerhaps the FOMC Did What It Said It Did: An Alternative Interpretation of the Great Inflation
By Sharon Kozicki and P.A. Tinsley
RWP 05-04, October 2005

Back to Top This paper uses real-time briefing forecasts prepared for the Federal Open Market Committee (FOMC) to provide estimates of historical changes in the design of US monetary policy an in the implied central bank target for inflation. Empirical results and FOMC transcripts support a neglected interpretation of policy during the Great inflation of the 1970’s.

JEL Classification: E3, E5, N1
Keywords: asymmetric information, the Great Inflation, time-varying policy responses

PDFMinding the Gap: Central Bank Estimates of the Unemployment Natural Rate
By Sharon Kozicki and P.A. Tinsley
RWP 05-03, October 2005

A time-varying parameter framework is suggested for use with real-time multiperiod forecast data to estimate implied forecast equations. The framework is applied to historical briefing forecasts prepared for the Federal Open Market Committee to estimate the U.S. central bank’s ex ante perceptions of the natural rate of unemployment. Relative to retrospective estimates, empirical results do not indicate severe underestimation of the natural rate of unemployment in the 1970s.

JEL Classification: E3, E5, N1
Keywords: FOMC Greenbook forecasts, the Great Inflation, time-varying natural rates

PDFDo We Really Know How Inflation Targeters Set Interest Rates?
By Marcela Meirelles Aurelio
RWP 05-02, July 2005

In inflation targeting (IT) regimes, the Monetary Authority announces an explicit objective, the target for inflation. However, other objectives that possibly conflict with the inflation goal are present, such as keeping output close to its potential level and the stability of financial markets. This multiplicity of objectives has spurred a debate on whether inflation targeting really provides a transparent framework for monetary policy. This question is addressed in this paper, focusing on the experience of six countries that adopted IT. The empirical investigation is based on a variety of data sets (including real time data and Central Bank's forecasts), as well as on alternative forward-looking reaction functions. The main finding is that, if transparency is interpreted as the short run predictability of policy actions, consistent with the announced inflation goal, then most of the IT regimes here examined are remarkably transparent. However, this is not necessarily true if a more broad interpretation of transparency is required. The data also reveals a certain degree of heterogeneity across countries and time, and therefore recommends caution with respect to general statements regarding the properties of IT regimes.

JEL Classification: E52, E61, F41, F42, F47
Keywords: monetary policy transparency, inflation targeting, forward-looking interest rate rules, forecasting

PDFThe Performance of Monetary and Fiscal Rules in an Open Economy with Imperfect Capital Mobility
By Marcela Meirelles Aurelio
RWP 05-01, January 2005

This paper studies monetary and fiscal policy rules, and investigates the characteristics of optimal policies. The central focus of the paper is on the comparison of two types of fiscal rules: a balanced budget and a target for the primary surplus. Balanced budget rules (or, more generally, numeric ceilings to the overall budget deficit) are criticized because they may dictate higher taxes in periods of weak economic activity. The primary surplus rule, in contrast, has a less pro-cyclical nature, given that it does not require higher fiscal austerity in periods when the cost of servicing public debt is higher. In a nutshell, it allows a higher degree of tax smoothing. It is not clear, however, if (inevitable) fiscal adjustments should be postponed. These issues are investigated in the context of a dynamic stochastic general equilibrium model that describes an open economy, with capital accumulation, and where nominal rigidities are present. The model shows that previous findings drawn from open economy models—in particular with respect to the characteristics of optimal monetary policy—do not hold once the implications of certain fiscal regimes are taken into account, and once different scenarios concerning the degree of capital mobility are considered. The model is calibrated and simulated for the case of Brazil, a country that since 1999 has targets for inflation and for the primary surplus. The main finding is that a fiscal regime characterized by a target for the primary surplus delivers superior economic performance, a property captured by the shape of the efficient policy frontier.

JEL Classification: E5, E6, F4, H3, H6
Keywords: fiscal and monetary policy rules, distortionary taxation, inflation target